Banking terms explained

Friends, in many of the posts on this website, our analysts have used terms like repo rate, reverse repo rate and host of other ratios which might not be easily comprehensible to many of us. I have been receiving some queries regarding them as well. So here goes my small bit on few of these important ratios. I have also tried to explain in brief how these ratios are used by regulators to control inflation-

Repo transaction

The term Repo has been derived from the word repurchase which literally means selling today and buying back at a later date. To be specific, in money market terms, it means a repo trader sells securities, gets funds for a certain specified time, and after this time period, purchases back the securities by paying the previously taken (read borrowed) funds along with some interest for the said period. The securities in question basically act as an insurance against borrower’s default. A forex money market also repo works on similar terms.

Repo rate

In the above transaction, if the lender of the funds is RBI, it I termed as a repo transaction with RBI. Following may be noted-

  • Whenever the banks have any shortage of funds they can borrow it from RBI.
  • Repo rate is the rate at which banks borrow rupees from Reserve Bank of India (RBI).
  • A reduction in the Repo rate will help banks to get money at a cheaper rate.
  • When the Repo rate increases borrowing from RBI becomes more expensive.
  • The rate charged by RBI for its Repo operations is 5.25%.
  • When RBI lends money to bankers against approved securities for meeting their day to day requirements or to fill short term gap, it takes approved securities as security and lends money. These types of operations are generally for overnight operations.
  • Repo rate is the medium through which RBI infuses funds in the system. Recently, in view of the decreased (read tightening) liquidity conditions, RBI has allowed a second Repo facility which means that RBI is giving banks to borrow money from RBI and thus RBI is looking to infuse more money into the system
  • A bank’s money market trader typically can use RBI’s LAF and money market for arbitrage opportunities sometimes

Reverse repo rate

If the borrower of the funds is RBI, it is termed as reverse repo transaction.

  • Reverse Repo rate is the rate at which RBI absorbs money from the system.
  • Banks are always happy to lend money to RBI since their money is in safe hands with a good interest.
  • An increase in Reverse Repo rate can cause the banks to transfer more funds to RBI due to attractive interest rates.
  • It can cause the money to be drawn out of the banking system.
  • The rate charged by RBI for its Reverse Repo operations is 3.25%.

Cash Reserve Ratio (CRR)

CRR is the amount of funds that the banks have to keep with RBI. It is calculated on the total deposits that the bank has as on the date. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks. In order to understand this, consider following example-

  • Suppose RBI says the CRR as 5%. Now if a bank A receives Rs.100 as deposit then it can lend Rs.95 as loan and will have to keep Rs.5 as balance in Deposit account.
  • Now the Borrower who has received Rs.95 as loan will deposit the same in his bank, borrower’s bank will now lend him Rs.90.25 and keep Rs.4.75 in deposit account.
  • This process continues in the banking system resulting to expand its initial deposit of Rs.100 to maximum of Rs.2000.
  • Similarly if suppose RBI says the CRR as 10%. Now if a bank A receives Rs.100 as deposit then it can lend Rs.90 as loan and will have to keep Rs.10 as balance in Deposit account.
  • Now the Borrower who has received Rs.90 as loan will deposit the same in his bank, borrower’s bank will now lend him Rs.81 and keep Rs.9 in deposit account.
  • This process continues in the banking system resulting to expand its initial deposit of Rs.100 to maximum of Rs.1000.
  • Higher the CRR, the lower the money available for lending, resulting into reduction in credit expansion by controlling the money that goes out of loans.
  • Thus RBI increases the requirement of CRR whenever they feel the need to control money supply.

Central bank of any country uses a combination of these 3 rates to influence the lending rate in the economy and thus contain inflation and stimulate growth. This adjustment of the 3 rates (commonly known as policy rates) is known as monetary policy.

Relation between Inflation and Bank interest Rates: How does inflation affect rates?

Inflation, in simple terms is a sustained increase in general price level. In other words, it can also be described as a situation in which excess money chases fewer goods, causing increase in demand of goods and thus leading to an increase in price. Thus if this demand created by excess money can be curtailed, inflation would be contained. This is the genesis behind controlling inflation through monetary policy.

If inflation is high, interest rates are increased. If repo, ie rates at which banks borrow from RBI, is increased, such borrowing will become costly and banks would thus either borrow less or pass on this increased cost to their borrowers. Again if reverse repo is increased, banks would divert more funds towards RBI and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy. In either of the cases, actual lending will be less and demand for goods and services will be less

In the case of CRR, if the rate is increased, it affects in two ways. First, immediate liquidity in the system is absorbed to the extent CRR is increased as more money needs to be placed with the regulator. Second, in the incremental lending, potential capacity of banks to lend is curtailed. This again leads to less lending by banks.

Another ratio which does not directly affect inflation but is important for banking is statutory liquidity ratio.

Statutory Liquidity Ratio (SLR)

SLR is the amount a commercial bank needs to maintain in the form of cash or gold or approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI in order to control the expansion of bank credit. SLR is determined as the percentage of total demand and percentage of time liabilities. Time Liabilities are the liabilities a commercial bank liable to pay to the customers on their anytime demand. RBI ensures the solvency of a commercial bank from SLR. It is helpful to control the expansion of Bank Credits. By changing the SLR rates, RBI can increase or decrease bank credit expansion. Also through SLR, RBI compels the commercial banks to invest in government securities like government bonds.

Currently, in India, banks have to maintain a SLR of 25% which means that 25% of the value of demand and time liabilities has to be invested in approved securities. SLR of banking system in India has a SLR of about 27% ie above the statutory SLR because due to the economic crisis, banks were conservative in lending and invested in sae heaven Government securities.

Hope this article would be useful and help you in understanding the economic scenario better.

Author: CA Shalini Tibe

Related posts:

  1. Policy meet: RBI could cut repo rate on May 3
  2. RBI Raises Repo, Reverse Repo Rates
  3. Annual Monetary policy 2010 – Highlights
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One Response to “Banking terms explained”

  1. My cousin recommended this blog and she was totally right keep up the fantastic work!

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