CRR
CRR or the Cash Reserve Ratio is the proportion of Bank’s reserves that they have to hold with the RBI. It is mandatory under law for the banks to hold such reserves with the central bank and the RBI is under law, empowered to stipulate this ratio. This amount of reserves that are held with the RBI is known as Required Reserves. It is a percentage of total demand and time liabilities of banks (demand – short term reserves, time – long term reserves).
IMPACT OF CHANGE IN CRR
To understand this, we have to understand the concept of Ordinary Money and High Powered Money.
Ordinary Money (M) is defined as the sum of Currency and Demand Deposits in banks held by public
So, M = C + DD
High Powered Money (H) is money produced by RBI and Government (coins), held by public and banks. It is also called Reserve Money. It is the sum of (i) Currency held by public and (ii) Cash Reserves of Banks.
So, H = C + R
So comparing the two equations, the difference is DD and R, currency being the common factor. This difference arises from the presence of banks as producers of demand deposits, to produce which they have to maintain R, which is a part of H, produced by only RBI and not banks.
So R is the total reserves with the banks. These are further divided into (i) Required Reserves and (ii) Excess Reserves. Required Reserves is explained above. All reserves in excess of Required Reserves are Excess Reserves, which banks are free to hold as “cash in hand”, which banks use to meet their currency drains (net withdrawal of currency by their depositors) and their clearing drains (net loss of cash due to cross-clearing of cheques between banks).
Now the control measure of CRR attempts to affect the stock of money via the impounding (restricting) or release of bank reserves. When the average CRR is revised upwards, banks are required to hold larger reserves or balances with the RBI than before for the same amount of total reserves. Since reserves are a part of H, this amounts to a virtual withdrawal of a part of H from the public equal to the amount of additional reserves impounded.
In the opposite scenario, when the CRR is lowered, this amounts to releasing the reserves so a virtual increase in H.
SLR
The chief role of SLR is to govern the allocation of total bank credit between the government and the commercial sector,. There are two ways in which it plays this role:
- By affecting the borrowings of the government from the RBI
- By affecting the freedom of the banks to sell government securities or borrow against them from the RBI
In both ways the creation of H is affected and thereby variations in the money supply
Under this statutory liquidity requirement, each bank is required statutorily to maintain a prescribed minimum proportion of its daily total demand and time liabilities in the form of designated liquid assets.
The liquid assets consist of
- Excess reserves
- Unencumbered government and other approved securities
- Current account balances with other banks
This SLR is defined as:
SLR = (ER + I + CB)/L
ER = Excess Reserves
I = Investment in unencumbered government and ‘other approved’ securities
CB = Current account balances with other banks
L = Total demand and time liabilities
- Excess reserves are defined as total reserves (Cash on hand plus balances with the RBI) minus statutory or required reserves with the RBI.
- Securities are unencumbered if loans have not been taken against them from the RBI
- Other approved securities are those that enjoy government’s guarantee in respect of payment of interest and principal. E.g. – bonds of IDBI, NABARD, development banks, co-operative debentures, debentures of state electricity boards, state road corporations, port trusts etc.
Bank Rate:
Bank rate is the rate of interest which RBI charges on the loans and advances that it extends to commercial banks and other financial intermediaries.
Repo Rate
Repo or Repurchase rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they are facing for money (loans) and how much they have on hand to lend.
Both bank rate and repo rate are interest rates at which commercial banks borrow from the RBI. The essential difference is that bank rate is what is used for what is called “clean borrowing” and this is generally for a bit longer-term. For instance, a commercial bank may simply borrow from RBI promising to pay 6% pa on the loan from RBI. This is akin to the normal personal loan that we get from banks except in this case the central bank is the lender.
Repo rate is basically the rate charged on this thing called a repo or “repurchase agreement”. Essentially, a repurchase agreement is an agreement between one party and another in which the former sells a security (like a bond) to the latter with a promise to buy it back after a particular period. For instance, a bank may enter into a repo with RBI, selling a security to RBI and then tell RBI that I will buy this security back from you after 3-months. RBI tells the bank…OK I will pay Rs. 100 for this security now but when you buy it back from me, please pay me Rs. 103. The extra Rs. 3 that RBI charges constitutes the repo rate (translates into 12% pa for this example) Hence, repos are a form of “collateralized or secured borrowings” in which the borrower must place collateral with the lender (in this case RBI). If the borrower does not manage to buy back the security, the lender can redeem its collateral value. Generally, repos are used for managing domestic liquidity in the economy. While a bank rate has a direct impact on borrowing costs for banks, repo rates have a more of a fine-tuning impact. Furthermore, repos are short-term agreements and are entered into by banks to meet short-term shortfalls in their liquidity positions. By raising the repo rate, RBI signals to the commercial banks that …. Hey look, I will still be willing to enter into repurchase agreements with you all but you better pay a higher interest to me. The banks understand this extra cost and cut back on lending to hold more cash or other liquid assets just in case they have liquidity issues as now it’s more expensive to get funding from RBI. Hence, repo rate has an impact on total Money supply and hence inflation.
Essentially, both rates are instruments of monetary policy. The idea is the same for both. They are merely different in how quickly they impact money supply or growth.
“Reverse Repo” rate is just what the name suggests. It’s the reverse of the repo. A reverse repurchase agreement or a ‘reverse repo’ is something like a switch between the buyer and the seller in a repurchase agreement. More specifically it’s a switch in the perspective.
For example in the case of reverse repo, the RBI would be the one selling the security to the commercial bank and telling it….if you give me Rs. 100 for 3 months today, I’ll pay you Rs. 3 as interest on it after 3 months and you give me back this security. So it is actually a ‘repo’ from RBI’s perspective but a ‘reverse’ repo from the commercial bank’s perspective. I hope you see the difference. The interest rate that RBI promises the commercial bank for placing its money with RBI is the reverse repo rate. By hiking the reverse repo rate, RBI can make it attractive for commercial banks to actually enter into reverse repo agreements with RBI thus reducing money supply.
By slashing it, it makes it less attractive for the commercial bank to enter into reverse repo agreement with it. It’s akin to our personal deposits in banks. If deposit rate is high, we’re more likely to keep it with the bank. A closer look-alike of reverse repo in our day to day lives would be a fixed deposit or Certificate of Deposit.
Call money rate is simply another name for ‘inter-bank borrowing’ rate. We need to realize that banks don’t just lend to corporate and individuals like us. They lend to one another. Call money rate generally refers to overnight borrowing and lending among banks. Not all banks are flush with cash all the time. So they have to ask one another for very short-term funding needs like for one a night or a few days. So they will get these funds by borrowing from one another. The lending bank will charge the borrowing bank an interest rate for even a single night (true businessmen, aren’t they?). Call rates are generally the average of all the rates that banks have charged each other overnight. Recently call rates had shot up and banks were charging one another rates as high as 22-24% pa just to lend for one day.
Prime Lending Rate: is a rate fixed by a particular bank which acts as a benchmark for various rates it will charge its customer’s on various loans.
Now a bank borrows funds from various sources and this borrowing has a cost. Now for example the average of this cost works out to be 6%. Now it gives funds to borrowers through many forms: personal loan, car loan, home loan, business loan, term loan etc. every kind of loan has its own risks and returns, some higher and some lower. The bank decides interest rate it will charge on these loans depending upon the risk involved in that particular type of loan. A home loan will be of lower risk so interest rate will be lower than say a personal loan which is riskier because the former is securitized by the purchased home but the latter gives no security to the bank. So these different interest rates will be benchmarked to the PLR, which acts as a guideline. So term loan will be say PLR + 3% and so on.
