During this time of pandemic COVID-19, we have seen multiple times that Our Hon’ble Finance Minister Mrs. Nirmala Sitharaman and RBI Governor Mr. Shaktikant Das has come up with lots of economic measures to prevent the economy from going into a deep depression which most of the other developed countries have yet failed to do so including USA, UK, Russia, Brazil, Italy, and the list continues.
There are so many doubts among the general public about the terminologies being used by RBI Governor in their Monetary Policy.
So, lets deep dive into what this monetary policy is all about, and let’s decode the varied terminologies being used in it.
Monetary Policy:
- The term monetary means basically money. So, in a general sense, it means policy measures related to money.
- Monetary policy means the steps and actions taken by RBI to control the money flow in the economy so as to achieve the macroeconomic and microeconomic goals with Sustainable development of the economy.
- The objective is to monitor and control inflation, consumption, growth, liquidity, etc.
Let’s understand the same with the help of an example the need for monetary policy and how it works.
Example:
Suppose there is only one bank in the country and there are only 10 customers of the bank. Now let’s assume that all the customers have deposited Rs. 100 each in the bank in their respective accounts.
So, the total deposit with bank is now Rs.100 x 10 = Rs. 1,000.
Now the banks have to pay interest on such deposited funds. The basic source of income for the banks is from lending money to the borrowers and charging interest thereon.
Now, one day an industrialist came to the bank for credit requirements to fund its industrial expansion. The total credit requirement of the industrialist is Rs. 800. Bank manager thinking that they have got good customers and after accessing the complete credibility and background check of the customer they sanctioned and disbursed the same to the industrialist’s account.
Afterward, 3 out of 10 customers come to the bank for the withdrawal of their money for some emergency purpose. But as the bank has funded Rs. 800 out of total deposits of Rs.1,000, they are left with only Rs. 200 surplus now.
And if they will give away that also to the account holders, what answer they will give to the rest of the customers if they also come afterward. Or there are possibilities that if the project of industrialist fails due to certain non-controllable factors then that entire amount will be a loss to the bank.
The entire banking system will lapse and the faith of customers on banks will doldrum.
For keeping the banking operations going smoothly and the faith of customers remains intact in banks, there is one central body that governs the entire banking system named Reserve Bank of India (RBI).
RBI from time to time come up with monetary policies to govern the economic situation in the market so the panic doesn’t create.
Basic Terminologies:
1. Liquidity Adjustment Facility (LAF):
- It is a monetary policy tool used by RBI to manage liquidity and provide economic stability.
- Both Repo & Reverse Repo Operations are covered under LAF.
- It was introduced by RBI as a result of the Narasimham Committee on Banking Sector Reforms (1998).
- It helps manage inflation in the economy.
2. Repo Rate:
- Repo Rate is the rate at which commercial banks borrow money from Reserve Bank of India (RBI), typically against Government Securities.
- So, keeping it simple, if RBI wants to increase the flow of money in the economy, it reduces the Repo Rate and vice-versa. So, when banks get funds at a lower interest rate, they also lend at a reduced rate, and the reverse is the case if RBI increases the Repo Rate.
- For Example, if RBI reduces Repo Rate by 25 bps i.e. 25 basis points that means RBI has reduced rate by 0.25%. So, 1 bps = 0.01%.
- Generally, under Repo operations, banks borrow money on an overnight basis from RBI.
- One myth among most of the readers is that banks have not reduced the rate of interest by the same rate which RBI has done for the banks. So, the answer is, it’s not compulsory for the banks to reduce by the same bps. Even its upon the discretion of the banks whether to reduce the same or not and if yes, then by how much bps.
- The reason for the same is that the banks consider different factors for the same like their interest rate on other sources of funding, their NPAs (Non-Performing Assets) for the same period, their operational cost, their cost of customer acquisition, the target segment to whom they are lending, etc.
3. Reverse Repo Rate:
- Reverse Repo Rate is the rate at which RBI borrows money from the banks for a short period of time and RBI pays interest to banks for the same.
- Sometimes when banks have an excess cash reserve, they park the same with RBI with an opportunity of earning interest on idle money.
- So, whenever RBI feels to reduce the flow of money in the system, it increases the Reverse Repo Rate thus making it more profitable for the banks to invest in Government-backed securities instead of lending money to market borrowers that too at risk.
- Basically, the equation runs in a format that if Reverse Repo Rate is increased then the interest rate on all the loans increases, and if Reverse Repo Rate is reduced then generally the interest rate on loans reduces.
4. Cash Reserve Ratio (CRR):
- Bank has to deposit a certain percentage of their Net Demand and Time Liabilities (NDTL) with RBI in the form of cash which is known as Cash Reserve Ratio.
NDTL = Demand and time liabilities with public and other banks – Deposits with other banks
- This CRR is to be maintained on a daily basis with RBI, failing which penalty and interest are to be borne by the banks applicable at that time.
- RBI makes it compulsory for the banks to maintain this ratio so as to govern the credit flow in the market.
- By reducing the CRR, RBI infuses the flow of money in the economy and reduces the same if it wants to pull the money back.
- The interest rate on loans given by banks is not directly linked with the increase or decrease in CRR rate. But if CRR increases then the flow of money in the market decreases and if the demand for credit does not fall proportionately then the interest rates are bound to increase.
5. Statutory Liquidity Ratio (SLR):
- The statutory liquidity ratio is the percentage of funds banks need to maintain in the form of liquid assets at any point in time.
- But banks need to maintain these funds in the form of government securities, bonds or precious metals, and not in the form of cash.
- Both the CRR and the SLR influence the extent to which commercial banks can lend out money to potential borrowers. If the RBI keeps both these rates too high for too long, banks would become cautious and lend less. Potential borrowers seeking loans would find this to be a difficult situation to be in.
6. Base Rate:
- Base Rate is the lowest interest rate bank charges form the customer when it lends money to them.
- It is decided by the bank’s management without any interference by RBI.
- However, it is not that interest rate at which the banks generally lend to the potential customers. Generally, banks charge a margin upon such base rate at the time of lending money.
7. Long Term Repo Operations (LTRO):
- RBI in February came with a revolutionary step of introducing the LTRO tool to govern the repo operations in the market.
- In LTRO, RBI lends the money to banks for the fixed period of 1 to 3 years tenure at the prevailing Repo Rate and in turn, banks offer Government Securities with the same or higher maturity tenure.
- In the year 2019, RBI in its 6 monetary policies has reduced the rates cumulatively by almost 135 bps but banks have not even passed on half of the benefit to the customers.
- In the LTRO system, RBI believes that offering banks durable longer-term liquidity at the repo rate can help them lower the rates they charge on retail and industrial loans while maintaining their margins.
- Use of LTRO: LTRO is used to inject liquidity into the market and ensure the flow of credit to the economy.
- Minimum Bid = Rupees one crore and multiples thereof
- Maximum Bid = Notified amount of that auction
- Interest Rate of this LTRO = Fixed rate of Policy Repo Rate
- Tenor = 1 to 3 years
8. Targeted Long-Term Repo Operations (TLTRO):
- It is the same as that of LTRO but the main difference between LTRO and TLTRO is that the money borrowed from RBI under TLTRO operation is to be deployed in investment-grade corporate bonds, commercial paper, and non-convertible debentures.
- This means the purpose of this tool is targeted towards specific requirements as is the name.
9. Marginal Standing Facility (MSF):
- Marginal Standing Facility is a new Liquidity Adjustment Facility (LAF) window created by RBI in May 2011. It is the rate at which the banks are able to borrow overnight funds from RBI against approved government securities.
- The question is – Banks are already able to borrow from RBI via Repo Rate, then why MSF is needed? This window was created for commercial banks to borrow from RBI in certain emergency conditions when inter-bank liquidity dries up completely and there is volatility in the overnight interest rates.
- Thus, the overall idea behind the MSF is to contain volatility in the overnight inter-bank rates.
10. Primary Market:
- Whenever corporates raise fresh funds from the public either by way of IPO’s, in the form of Debt or in any other form then the place from where such funds are raised is known as Primary Market.
- In Primary Market securities are created for the first time.
11. Secondary Market:
- The place where the securities created in Primary Market are traded is known as Secondary Market.
- Normally these securities are traded on Exchanges.
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