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Banking Awareness Notes: Policy Rates & Lending Rates

Reserve Bank of India (RBI), the central bank, one of its primary functions is to control the supply as well as the cost of credit. Which means how much money is available for the industry or the economy and what is the price that the economy has to pay to borrow that money which is nothing but liquidity and interest rates.

So, RBI has a role to play to control these two things because eventually these two have an impact on the inflation and growth in the economy. For this, RBI has got some tools available in their hands and these tools are maintaining certain basic ratios or maintaining certain rates.

What is repo rate and reverse repo rate?

Repo or repurchase alternative is a methods for here and now getting, wherein banks offer endorsed government securities to RBI and get finances in return. As such, in a repo exchange, RBI repurchases government securities from banks, contingent upon the level of cash supply it chooses to keep up in the nation’s financial framework.

Repo rate is the markdown rate at which banks obtain from RBI. Decrease in repo rate will help banks to get cash at a less expensive rate, while increment in repo rate will make bank borrowings from RBI more costly. In the event that RBI needs to make it more costly for the banks to get cash, it expands the repo rate. Additionally, in the event that it needs to make it less expensive for banks to get cash, it decreases the repo rate.

Reverse repo is the correct inverse of repo. In a reverse repo transactions, banks buy government securities frame RBI and loan cash to the saving money controller, along these lines procuring premium. Reverse repo rate is the rate at which RBI obtains cash from banks. Banks are constantly cheerful to loan cash to RBI since their cash is in safe hands with a decent premium.

In this manner, repo rate is constantly higher than the reverse repo rate.

What is CRR & SLR?

CRR and SLR are the two ratios. CRR is a cash reserve ratio and SLR is statutory liquidity ratio. Under CRR a certain percentage of the total bank deposits has to be kept in the current account with RBI which means banks do not have access to that much amount for any economic activity or commercial activity. Banks can’t lend the money to corporates or individual borrowers, banks can’t use that money for investment purposes. So, that CRR remains in current account and banks don’t earn anything on that.

SLR, statutory liquidity ratio is the amount of money that is invested in certain specified securities predominantly central government and state government securities. Once again this percentage is of the percentage of the total bank deposits available as far as the particular bank is concerned. The SLR, the money goes into investment predominantly in the central government securities as I mentioned earlier which means the banks earn some amount of interest on that investment as against CRR where it earns zero.

Let us look at this combination of CRR and SLR. That is the amount of money which remains blocked for statutory reasons and is not available for investment in various other high earning avenues like loans are securities markets or other bonds. That means it puts a certain amount of pressure on the banks balance sheets. However, at the same time that money remains safe and with that mechanism RBI also offers safety to the depositors who have invested money in the banks.

What is MCLR?

The marginal cost of funds based lending rate (MCLR) alludes to the base financing cost of a bank underneath which it can’t loan, aside from sometimes permitted by the RBI. It is an inward benchmark or reference rate for the bank. MCLR really portrays the technique by which the base financing cost for credits is controlled by a bank – based on peripheral cost or the extra or incremental cost of organizing one more rupee to the planned borrower.

The MCLR approach for fixing interest rates for advances was presented by the Reserve Bank of India with impact from April 1, 2016. This new approach replaces the base rate framework presented in July 2010. As it were, all rupee advances endorsed and credit limits reestablished w.e.f. April 1, 2016 would be valued with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which will be the interior benchmark (implies a reference rate decided inside by the bank) for such purposes.

Reasons for introducing MCLR:

  • To improve the transmission of policy rates into the lending rates of banks.
  • To bring transparency in the methodology followed by banks for determining interest rates on advances.
  • To ensure availability of bank credit at interest rates which are fair to borrowers as well as banks.
  • To enable banks to become more competitive and enhance their long run value and contribution to economic growth.

Banks may publish every month the internal benchmark/ MCLR for the following maturities:

  • Overnight MCLR,
  • One-month MCLR,
  • Three-month MCLR,
  • Six month MCLR,
  • One year MCLR.

MCLR for any other maturity which the bank considers fit.

Banks have the freedom to offer all categories of advances on fixed or floating interest rates. Banks have to determine their actual lending rates on floating rate advances in all cases by adding the components of spread to the MCLR. Accordingly, there cannot be lending below the MCLR of a particular maturity, for all loans linked to that benchmark. Fixed rate loans upto three years are also priced with reference to MCLR.

However, certain loans like Fixed rate loans of tenor above three years, special loan schemes formulated by Government of India, Advances to banks’ depositors against their own deposits, Advances to banks’ own employees etc. are not linked to MCLR.

What is Base Rate?

The Base Rate is the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI. It is the minimum interest rate of a bank below which it is not viable to lend. The base rate, introduced with effect from 1st July 2011 by the Reserve Bank of India, is the new benchmark rate for lending operations of banks.

The reason for introducing Base Rate was to bring out the transparency in bank lending rates as well as to improve monetary policy transmission.Since the Base Rate will be the minimum rate for all loans, banks are not permitted to resort to any lending below the Base Rate.

Base Rate vs MCLR

Base rate calculation is based on cost of funds, minimum rate of return, i.e margin or profit, operating expenses and cost of maintaining cash reserve ratio while the MCLR is based on marginal cost of funds, tenor premium, operating expenses and cost of maintaining cash reserve ratio. The main factor of difference is the calculation of marginal cost under MCLR. Marginal cost is charged on the basis of following factors- interest rate for various types of deposits, borrowings and return on net worth. Therefore MCLR is largely determined by marginal cost of funds and especially by deposit rates and repo rates.

Liquidity Adjustment Facility (LAF)

A liquidity adjustment facility (LAF) is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets.

LAF includes both repos and reverse repo agreements.

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks will use eligible securities as collateral through a repo agreement and will use the funds to alleviate their short-term requirements, thus remaining stable.

The facilities are implemented on a day-to-day basis as banks and other financial institutions ensure they have enough capital in the overnight market. The transacting of liquidity adjustment facilities are conducted via auction at a set time of the day. An entity wishing to raise capital to fulfill a shortfall will engage in repo agreements and one with excess capital will do the opposite; a reverse repo.

The spread between repos and reverse repos has been as high as 300 basis points during the financial crisis. However, in the years following the crisis the spread has been set at 50 basis points to alleviate any excess volatility in short-term interest rates. A with most financial instruments, the wider the spread the higher the potential volatility.

What is marginal standing facility?

Marginal Standing Facility (MSF) is a new scheme announced by the Reserve Bank of India (RBI) in its Monetary Policy (2011-12) and refers to the penal rate at which banks can borrow money from the central bank over and above what is available to them through the LAF window.

MSF, being a penal rate, is always fixed above the repo rate. The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility by pledging government securities, where the rates are lower in comparison with the MSF. The MSF would be a penal rate for banks and the banks can borrow funds by pledging government securities within the limits of the statutory liquidity ratio. The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.

MSF represents the upper band of the interest corridor with repo rate at the middle and reverse repo as the lower band.

To balance the liquidity, RBI uses the sole independent “policy rate” which is the repo rate (in the LAF window) and the MSF rate automatically gets adjusted to a fixed per cent above the repo rate (MSF was originally intended to be 1% above the repo rate). MSF is at present aligned with the Bank rate. Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as “the standard rate at which the Reserve Bank is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under the Act. On introduction of Liquidity Adjustment Facility (LAF), discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued. As a result, the Bank Rate became dormant as an instrument of monetary management. It is now aligned to MSF rate and is used only for calculating penalty on default in the maintenance of cash reserve ratio(CRR) and the statutory liquidity ratio (SLR).

MSF came into effect from 9th May 2011.

The rate of interest on MSF is above 100 bps above the Repo Rate.  The banks can borrow up to 1 percent of their net demand and time liabilities (NDTL) from this facility. This means that Difference between Repo Rate and MSF is 200 Basis Points.  So, Repo rate will be in the middle, the Reverse Repo Rate will be 100 basis points below it, and the MSF rate 100 bps above it. Thus, if Repo Rate is X%, reverse repo rate is X-1% and MSF is X+1%.


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