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 borrowers 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 banks money market trader typically can use RBIs 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%.

RBI Raises Repo, Reverse Repo Rates

What is Repo Rate?
Definition of Repo Rate: Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which commercial banks borrow rupees from 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.

What is Reverse Repo Rate?

Definition of Reverse Repo Rate: It is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are 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 this attractive interest rates. It can cause the money to be drawn out of the banking system. In order to tame inflation, anchoring inflationary expectations and considering the signs of strong economic revival RBI on March 19 , 2010 announced Monetary Policy Measures with immediate effects:

to raise the repo rate under the liquidity adjustment facility (LAF) by 25 basis points from
4.75 % to 5 %

to raise the reverse repo rate under the LAF by 25 basis points from 3.25% to 3.5%
This is the second action since January when RBI announced a 75-basis point rise in the cash reserve ratio (CRR) to 5.75 per cent. But, unlike CRR, which is used to manage liquidity in the system, an increase in the repo and reserve repo rates is aimed at signaling an increase in interest rates.

The action by RBI is the first increase in policy rates since July 2008 when the repo rate was increased 50 basis points. The reverse repo was last raised in July 2006, when RBI raised the rate 25 basis points. Since October, 2008, RBI started the process to reduce interest rates and lowered the CRR to inject liquidity in the system to spur economic activity in the wake of the global downturn. These steps of RBI comes against the backdrop of rising inflation which touched 9.89 per cent in

February YoY basis which has exceeded the base line projection of 8.5% for end march 2010 set out in the third quarter review and RBI for the first time said that wholesale price index-based inflation may cross double digits in March 2010. As per RBI as liquidity in the banking system will remain adequate, credit expansion for sustaining the recovery will not be affected and the RBI will continue to monitor macroeconomic conditions, particularly the price situation, and take further action as warranted. Impact: The overall interest rate of banks on advances (like housing loans, consumer loans, auto loans etc) will go up. It is not expected to have a major impact on corporate borrowings in the immediate future. Yield on government securities, which eased to 7.82 per cent, from a 17-month high of 8.02 per cent last week, could harden in the days ahead. _ Author: Abhijeet Ahir, Economic Analyst, MBA Finance (SIIB)

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, borrowers 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, borrowers 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. Author: CA Shalini Tibe

Base rate Vs BPLR

What is BPLR?
BPLR is the reference rate for banks for pricing their loan products. It is calculated taking into account the cost of funds, operational expenses, and the minimum margin to cover regulatory requirements of provisioning and capital and profit margin. Banks are supposed to lend to their prime customers at BPLR and increase the rate with risk premium in case of sub-prime customers and tenor premium wherever applicable.

Problems with BPLR

1. Main problem with BPLR is that banks have resorted to sub-BPLR lending. On an average, 67% of the total loans and Advances of banks was sub-BPLR. For Private banks, the figure was even higher at 83%. Housing, agriculture, and corporate segments were the major beneficiaries of sub-BPLR lending. Nearly 31% of the housing loans in FY08 were disbursed at an interest rate of less than 10%, while 49% of the housing loans were disbursed at 10-12%. In the case of loans to the industry, around 32% were disbursed at an interest rate of 10-12%.

A study of BPLR and actual lending rates of the banks show that as on Sep2009, against a BPLR in the range of 11-13.5% for public sector banks, actual lending rates where in the range of 4.2-18%. For private banks, actual lending rates were 3-29.5% against BPLR of 12.5-16.7%. 2. Secondly, BPLR failed to respond to the changes in the monetary policy. Changes in monetary policy rates by RBI were not truly reflected in the BPLR. This was true during both the tightening phase as well as easing phase. This defeated the purpose of changes in these rates to some extent. Table below illustrates the point where changes in policy rates have not resulted in a

proportionate change in the BPLR of the banks.

What is base rate?

Base rate would be the new benchmark of pricing of loan products by the banks. It is proposed to be calculated by including the cost of deposits, cost of maintaining the statutory liquidity ratio and cash reserve ratio, cost of running the bank, and profit margin. This will be the minimum lending rate for banks. Hence, the actual rate will depend upon the base rate plus borrower specific charges, which will include product specific operating costs, credit-risk premium, and tenure premium. As per the calculation of RBI, using the date of financial year 2008-09, the base rate for Indian banks works out to be about 8.55%. Banks would not be allowed to lend below the base rate except for Loans against fixed deposits, loans given by a bank to its own employees, as well as restructured loans, where borrowers get more time and pay lower rates to avert defaults.

Expected impact of Base rate

It is expected that base rate system will increase transparency in credit pricing and address the shortcomings of the BPLR system. Benchmark rate of most of the banks will decline to single digit. Again with the base rate, including negative carry on Cash Reserve Ratio (CRR) and Statutory Liquidity ratio (SLR) it is anticipated that base rate will be directly impacted by the monetary measures initiated by the RBI. Taking the calculation of RBI, Ceteris paribus, with an increase of 75 bps in the CRR, the base rate increases by 8 bps to 8.63% and an increase of 100 bps in the SLR from 24% to 25% could push up the minimum lending rate by 12 bps to 8.67%. Small borrowers such as farmers who are close to BPLR rates would get credit at reasonable rates after the introduction of base rate. At the same time, large corporations that earlier utilised their negotiating power and bargained with banks in order to obtain loans at sub-BPLR rates, could find it difficult due to the minimum rate fixed by banks.

What this means for banks?

Large banks that have higher percentage of low cost deposits and better operating efficiency will have a lower base rate and thus they will be able to price their loan products competitively. Small banks on the other hand will face problems in extending credit to large corporate. This would render a number of banks uncompetitive and enable big banks to increase their business. Author: Praveen Bajaj, B.Com(H), MBA (SCMHRD)