Saturday, November 01, 2008

Interest rates and reserve requirements

I was asked the following question yesterday in the Indian Current Affairs shout-box.

"When Federal bank of USA reduces interest rates, what rate exactly is that with context to RBI's? Is it in relation to CRR?"

The simple answer to the question is NO. The complicated answer is:

US Fed announces two different rates: the discount rate and the federal funds rate. The discount rate is the interest rate charged by the US Fed on the loans it gives to commercial banks. The federal funds rate is the interest rate at which banks lend to each other overnight. The US Fed only prescribes a target federal funds rate.

In contrast, the RBI announces only the bank rate. This is the same as the US Fed discount rate. There is no equivalent for the federal funds rate from the RBI. Instead, it announces its repo and reverse repo rates. Market rates (i.e., lendings and borrowings among the market participants) are determined based on these repo and reverse repo rates. Repo rate is the rate the RBI charges for the money lent by it to the banks. Reverse repo rate is the rate which it gives to the banks for lodging money with it. Both these types of transactions are backed by securities. In a repo transaction what happens is the banks lodge securities with the RBI in return for money. So, in effect what a repo transaction (a repo for the banks) does is infuse liquidity in the market. A reverse repo (for the banks) drains liquidity from the market.

Comparing rates with CRR is not correct. CRR and SLR are reserve requirements. That is, banks are mandated by the RBI to hold certain amount of money in the form of cash or invest a certain amount in prescribed securities. The US Fed has similar reserve requirements for banks operating there.

The US Fed has a single reserve requirement. It is at present 10% of the deposit liabilities of the banks. I am sure all of you know that RBI mandates two different reserve requirements: the CRR and the SLR. The former is the amount of funds that the banks have to keep with the RBI. The latter is the amount of money that the banks to keep invested in RBI approved securities to meet their liquidity requirements. We have covered about them in detail in this Disover-It post. However a repeat would be in order here:

Statutory Liquidity Ratio -- SLR, is the percentage of net demand and time liabilities of a bank that has to be maintained by a bank with the RBI. This can be in the form of cash, gold or approved securities. This percentage currently is at 25%. The Banking Regulation Act, 1949 actually prescribes a floor and ceiling for this percentage. The floor is at 25% and the ceiling is at 40%. That is, the RBI can't impound more than 40% of the net demand and time liabilities of banks nor can it prescribe a percentage which is below 25% for this purpose. It has to operate within this band. But recently the BR Act, 1949 was amended doing away with the floor. This gives RBI flexibility to prescribe a percentage of SLR which is lower than 25%. On the SLR funds, the RBI has to pay interest to the banks. It is currently at 6.5%.

Contrast this with CRR -- Cash Reserve Ratio, wherein the Bank has to maintain a certain percentage of its net time and demand liabilities in the form of cash with the RBI. CRR at present is 6. On the CRR funds, RBI will not pay any interest to the banks.
You can take the ‘net demand and time liabilities’ broadly to mean the deposits of the bank. Why this term is used is that many a time there will be situations in which the deposits figure will not be reflecting the actual deposits. It is the ‘net’ figure that is to be taken and not the ‘gross’ figure. Demand liabilities are those that have to be paid by the bank on ‘demand.’ And ‘time liabilities’ are those that have a time within which the bank has to pay these liabilities. Time deposits like bank FDs (Fixed Deposits) come under this ‘time liabilities’ category.

Note: This is one important link that gives a good explanation of repo and reverse repo rates.


saraswati said...

Was wondering if the reverse repo and repo rates are correctly defined here or there was some `reversal'!

ramkyc said...

Agree with you Saraswati. Since corrected. The concepts can be quite confusing. What is repo for RBI is reverse repo for the banks and vice versa. Was thinking that repo rate announced by the RBI is for its repo transaction. But it turned out that it announces it for the banks' repo transactions. Not for its repo transactions.

ramkyc said...

One more important ET article about SLR and CRR. It is here.