The World of Regulatory Rates

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