As a lender or borrower
the regulatory rates and controls that set a direction to the liquidity and
financial markets are important, and I thought to share a note on the same.
Hope this is useful as a refreshing tool of those definitions:
Suppose a bank has USD
100 million of equity. Now what is the limit upto which this bank is allowed to
raise funds from public in the form of deposits, and what is the limit (of its
own equity and deposits raised from public) upto which it is allowed to lend to
borrowers?
There is a concept
of capital adequacy which controls the lending by banks. The concept
explains that the more own capital the bank has the more it can lend. The
concept prescribes the minimum capital as a percentage of total credit given by
the bank, which is required to be maintained by the bank at all time. So say
minimum capital prescribed is 10% of total credit issued, and total credit
issued is USD 1000 million, then the minimum capital required to be maintained
is USD 100 million. The 10% limit translates that bank is allowed to lend 10
times (i.e. 100/10=10 times) of the capital it maintains. Now suppose that this
minimum capital required ratio is reduced to 9% then? This reduction translates
into 11.11 times (i.e. 100/9=11.11) of the capital bank can lend. So in our
example, the capital of the bank is USD 100 million and reduction in capital
adequacy ratio increases its capacity of lending to USD 1111.11 million (USD
100 million X 11.11=USD 1111.11 million) which means the bank can further lend
USD 111.11 million (USD 1000 million – USD 1111.11 million=USD 111.11 million).
This results in release of funds in the market by bank, thereby improving the
liquidity in market. The concept of minimum capital adequacy acts a lever to
control lending by banks. Hope sounds simple.
For controlling the
deposit raising by banks from public, there is a concept of cash and other form
of securities to be kept aside by banks as percentage of total
deposits/liabilities mobilized by them. These funds cannot be used by banks for
lending. These controls are in the form of Cash Reserve Ratios (CRR) and
Statutory Liquidity Ratio (SLR). Under Cash Reserve Ratio a bank has to
keep certain percentage of deposits/liabilities raised from public/banking
system with RBI in the form of cash. Therefore, the entire funds raised by bank
from public are not entirely available to it for lending.
Similarly, under
Statutory Liquidity Ratio, a bank is required to keep certain percentage of
deposits/net demand & time liabilities raised from public, in the form of
approved liquid securities (Cash, Dated Securities, Gold, Treasury Bills etc).
Therefore, the bank is not allowed to lend entire funds (equity and deposits
from public/liabilites) available with it.
RBI has levers in the
form of interest rates at which banks can lend to or borrow huge lot of money
and these bulk borrowing or lending rates set the direction of interest rates
as well as liquidity in the market. So the high rates, less is liquidity, and
low rates more liquidity. These interest rates levers of RBI are Repo Rate,
Reverse Repo Rate, Bank Rate, Marginal Standing Facility Rate. Push & pull
of these levers sets the tone of interest rates and liquidity on your corporate
loans and home loans! Gotcha.
Cash Reserve Ratio
(CRR): It is the amount of funds that the banks have to
keep with the RBI. For example, when a bank’s deposits increase by Rs.100, and
if the cash reserve ratio is 4 per cent, the banks will have to hold additional
Rs. 4 with RBI and bank will be able to use only Rs. 96 for investments and
lending / credit purpose. Therefore, higher the CRR, the lower is the amount
that banks will be able to use for lending and investment.
RBI uses the CRR to
drain out excessive cash from the system.
CRR is calculated as a percentage of the total of the Net Demand and
Time Liabilities (NDTL), on a fortnightly basis. RBI can prescribe CRR for
scheduled banks between 3 per cent and 20 per cent.
NDTL:
is sum of demand and time liabilities (deposits) of banks with public and other
banks wherein assets with other banks is subtracted to get net liabilities of
the other banks.
Repo Rate: The rate at which the RBI lends money (short
term overnight lending) to commercial banks is called Repo Rate. Whenever banks
have any shortage of funds they can borrow from the RBI by selling the approved
securities. A reduction in the repo rate helps banks get money at a cheaper
rate and vice versa. Repo rate is used by RBI to control inflation. In the
event of inflation, RBI increases Repo Rate as this acts as a disincentive for
banks to borrow. This ultimately reduces the money supply in the economy and
thus helps in arresting inflation.
RBI takes the contrary
position in the event of a fall in inflationary pressures. Repo and Reverse
Repo rates form a part of the Liquidity Adjustment Facility(LAF). Repo Rate
mainly targets for short term effect to control the liquidity in the market and
inflation. Banks can borrow in the RBI Repo auction upto to 0.5 per cent of
their NDTL.
Reverse Repo Rate: Reverse Repo rate is the rate at which the
RBI borrows money from commercial banks. Banks are always happy to lend their
idle cash (which they are not able to deploy) to the RBI since their money is
in safe hands with a good interest.
An increase in 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 which is used by the RBI to drain
excess money out of the banking system. In May 2011, RBI decided that Reverse
Repo Rate will not be announced separately, but will be linked to Repo rate and
it will always be 100 bps (i.e. 1 per cent) below the Repo rate.
Bank Rate:
This is the rate at which RBI lends money (long term) to banks or financial
institutions. If the bank rate goes up, long-term interest rates also tend to
move up, and vice-versa. Thus, it can be said that in case bank rate is hiked,
in all likelihood banks will hikes their own lending rates to ensure that they
continue to make profit. Bank Rate mainly targets for long term effect to
control the liquidity in the market and inflation. Bank Rate is also known as
Discount Rate. In contrast, Repo Rate is also called Repurchase Rate.
The Bank Rate involves
loans while the Repo Rate involves securities. Bank Rate doesn’t involve
collateral of any kind while the Repo Rate (especially the repurchase
agreement) requires the securities as the collateral in the agreement.
The Bank Rate is
usually higher compared to the Repo Rate. A high Bank Rate will reflect in the
high lending rate of the commercial bank to its clients. On the other hand, the
Repo Rate may not be not passed to the clients of the commercial banks.
The bank rate also has
importance since this impacts inter-corporate loans & investments. As per
Sub Section (3) of Sec 372A “No loan to any Body Corporate shall be made at a
rate of interest lower than the prevailing bank rate, being the standard rate
made public under section 49 of the RBI Act, 1934 (2 of 1934)”. In case of
banks failing in maintaining their required CRR and SLR ratio penal interest is
charged by RBI which is linked to Bank Rate.
Liquidity Adjustment Facility
(LAF): RBI’s liquidity adjustment facility helps banks to
adjust their daily liquidity mismatches. LAF has two components: Repo
(Repurchase Agreement) and Reverse Repo. When banks need liquidity to meet its
daily requirement, they borrow from RBI through Repo. The rate at which they
borrow fund is called the Repo Rate. When banks are flush with fund, they park
with RBI through the Reverse Repo mechanism at Reverse Repo Rate.
Statutory Liquidity
Ratio (SLR): Every bank is required to maintain at
the close of business every day on fortnightly basis, a minimum proportion of their
NDTL as liquid assets in the form of cash, gold and un-encumbered approved
securities. The ratio of liquid assets to demand and time liabilities is known
as SLR. Present SLR is 23%. RBI is empowered to increase this ratio up to 40%.
An increase in SLR restrict the bank’s leverage position to pump more money
into the economy.
Marginal Standing
Facility (MSF):
Earlier there was no limit on borrowing under Repo by banks. A bank only
had to maintain the SLR Ratio and any government securities it owned above that
limit could be used for Repo borrowing. Later on cap of 0.50 percent of NDTL
for maximum borrowing under Repo was introduced. Now, when a bank is in need to
borrow more than what it can under Repo after exhausting its excess SLR
securities, it can borrow under MSF by offering its SLR securities (i.e.
securities already used for maintaining its SLR Ratio). Under MSF banks can
borrow upto 2 percent of their respective NDTL outstanding at the end of the
second preceding fortnight. Banks borrow funds through MSF during acute
shortage of liquidity. MSF Rate is kept
higher than the Repo rate to make it as penal rate.
For availing MSF, the
securities which can be offered to RBI include all SLR-eligible transferable
Government of India (GoI) dated Securities/Treasury Bills and State Development
Loans (SDL).
MSF rate increase is
done by RBI to control excess availability of the rupee and to control its
depreciation with respect to the dollar. MSF represents the upper band of the
interest corridor and Reverse Repo as the lower band and the Repo Rate in the
middle.
Capital to Risk
Weighted Assets Ratio (CRAR): Capital Adequacy Ratio (CAR) is also known as
CRAR. It is the measure of a bank's capital and is expressed as a percentage of
a bank's risk weighted credit exposures.
CAR = Total Capital /
Total Risk Weighted Assets
Total capital comprises
of the bank's Tier I and Tier II capital. Total risk weighted assets takes into
account credit risk, market risk and operational risk. This ratio is maintained
to ensure that banks have enough capital to sustain operating losses while
still honoring withdrawals.
Current Rates
(as on December 23, 2013):
Bank Rate : 8.75 per
cent
Repo Rate : 7.75 per
cent
Reverse Repo Rate :
6.75 per cent
MSF Rate : 8.75 per
cent
CRR : 4 per cent
SLR : 23 per cent
CRAR: 9 per cent
