Basics of Key Policy Rates

Reserve Bank of India, RBI, has released the Mid-Quarter Review of Monetary Policy 2012-13 whereby, it reduced the Cash Reserve Ratio, CRR, of scheduled banks by 25 basis points from 4.75 per cent to 4.50 per cent. All the other key policy rates have been kept unchanged. Here are some of the basic questions and their answers:

What are Key Policy Rates?

The following rates are considered to be Key Policy Rates or signally rates

  1. Bank Rate
  2. Repo Rate
  3. Reverse Repo Rate
  4. Marginal Standing Facility
  5. Cash Reserve Ratio
  6. Statutory liquidity ratio (SLR).

Please note that all the above rates are decided by RBI. The following rates are fixed by banks themselves and are not considered to be key policy rates

  1. Base Rate
  2. Interest Rates on Saving Accounts
  3. Interest Rates on Current Accounts

What is Bank Rate?

RBI lends to the commercial banks through its discount window to help other banks meet depositors’ demands and reserve requirements. The interest rate that the RBI charges the banks for this is called bank rate. If the RBI wants to increase liquidity and money supply in the market, it will decrease the bank rate, and vice versa.

What is Repo Rate and how it is different from Bank Rate?

Bank Rate and Repo Rate are two rates on which RBI lends to other Banks. However, the key difference is that Repo Rate is the rate at which RBI lends to banks for short periods. In Repo Rate, there is no direct lending but the lending is done by RBI buying government bonds from banks with an agreement to sell them back at a fixed rate. If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate

What is reverse repo rate?

Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. Opposite to Repo, Reverse Repo is done by RBI selling government bonds to banks with the commitment to buy them back at a future date. The banks use the reverse repo facility to deposit their short-term excess funds with the RBI and earn interest on it. RBI can reduce liquidity in the banking system by increasing the rate at which it borrows from banks. Hiking the repo and reverse repo rate ends up reducing the liquidity and pushes up interest rates.

What is Cash Reserve Ratio?

Cash reserve Ratio (CRR) is the Cash that banks have to park with Reserve Bank. The objective of CRR is that it ensures that a portion of bank deposits are always available to meet withdrawal demand, and secondly, it enables that RBI control liquidity in the system. If RBI decides to increase the cash reserve ratio, the available amount with banks would reduce. The bank increases CRR to impound surplus liquidity.

What is SLR? (Statutory Liquidity Ratio)

While in CRR, the Banks have to park Cash with RBI, in SLR, they have to maintain a minimum percentage of deposits with themselves at the end of every business day, in the form of gold, cash, government bonds or other approved securities. This minimum percentage is called Statutory Liquidity Ratio.

Marginal Standing Facility

MSF was launched by Reserve Bank of India (RBI) from May 2011. It is another lending facility to the commercial banks whereby they can borrow up to 1 per cent of their net demand and time liabilities for a very short term such as overnight lending. Since this is a window to get quick funds from RBI, it is costlier than REpo Rate. The rate of interest for the amount accessed through this facility is fixed at 100 basis points (i.e. 1 per cent) above the repo rate for all scheduled commercial banks. Please note that MSF is the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility by pledging through government securities, which has lower rate of interest in comparison with the MSF.

  • How they work?
  1. RBI wants to control inflation

RBI alters any or all of the above rates on the basis of several factors at play complicate decision-making, especially in trying to balance the twin objectives of keeping inflation anchored and boosting economic growth. The fundamental concept is that to control the inflation which is a situation of too much money chasing too few goods, RBI would do something which control that too much part of the money available in economic system. To control that too much available money it is necessary that either the money is imbibed from the markets or interest rates are increased so that money becomes costlier. Thus, RBI would take any or all of the following steps:

  • It may increase Key Policy Rates. This means that bank can now borrow on higher interest rates. Increased interest rates make the money costlier, which in turn impact negatively on inflation.
  • It may increase Reverse Repo rate. An increase in the reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool that can be used by the RBI to drain excess money out of the system.
  • It may hike the CRR and SLR: Both of these tools can be used to imbibe the money from the system.
  1. RBI wants to allow growth

Any of the steps taken to control inflation has its own side effects. Here we need to know that the inflation-versus-growth trade-off in monetary policy management, in the Indian context, has critical political overtones. Corporate India is directly and immediately hurt by the high interest rates. It therefore becomes natural for them to lobby aggressively to lower interest rates. They argue that the downside risks to economic growth associated with higher rates are much higher than corresponding inflation risks. However, monetary loosening, especially when inflationary forces are still at play and when the economy is close to breaching its potential output limit, poses significant inflation risks.

To allow growth, the system would need more money than is available. When there is a liquidity crunch or recession, RBI would lower its key policy rates to inject more money into the economic system.

  1. Open Market Operations

OMO is a two sided sword. It’s an instrument of credit control through which the RBI purchases and sells securities. When inflation is up, the RBI sells securities to mop up the excess money in the market. When it has to increase money supply, the RBI buys securities.

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