Third Quarter Review of Monetary Policy

My friends have asked me too many questions on "Satyam" (How can the accounts be fudged) and also on the recent Monetary policy review. I prefer to answer the Monetary policy, which is of interest in the current slowdown!

I reproduce below the portion of the speech relating to Monetary measures and then explain what is Repo rate, reverse repo, bank rate etc.
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Third Quarter Review of Monetary Policy - Press statement by Dr.Subbarao, Governor - RBI

Following are the summary of the Monetary Measures

Bank Rate
The Bank Rate has been kept unchanged at 6.0 per cent.

Repo Rate/Reverse Repo Rate

• The repo rate under the LAF has been kept unchanged at 5.5 per cent.
• The reverse repo rate under the LAF has been kept unchanged at 4.0 per cent.
• The Reserve Bank has the flexibility to conduct repo/reverse repo auctions at a fixed rate or at variable rates as circumstances warrant.
• The Reserve Bank retains the option to conduct overnight or longer term repo/reverse repo under the LAF depending on market conditions and other relevant factors.
• The Reserve Bank will continue to use this flexibly including the right to accept or reject tender(s) under the LAF, wholly or partially, if deemed fit, so as to make efficient use of the LAF in daily liquidity management.

Cash Reserve Ratio
The cash reserve ratio (CRR) of scheduled banks has been kept unchanged at 5.0 per cent of NDTL.

Liquidity Facilities

The Reserve Bank has allowed banks to avail liquidity support under the LAF for the purpose of meeting the funding requirements of mutual funds (MFs), non-banking financial companies (NBFCs) and housing finance companies (HFCs) through relaxation in the maintenance of SLR up to 1.5 per cent of their NDTL. Second, a special refinance facility for scheduled commercial banks (excluding RRBs) was provided by the Reserve Bank on November 1, 2008 under Section 17 (3B) of the RBI Act, 1934 up to 1.0 per cent of each bank’s NDTL as on October 24, 2008. Both these facilities are currently available up to June 30, 2009. In order to ensure that banks continue to have flexibility in their liquidity management operations in the current market conditions, it has been decided:

• To extend both the refinance facilities up to September 30, 2009.
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Okay. For those who are not familiar with the terminologies, let me try to explain in a simple way.

1. What is BANK RATE?

Bank Rate is the rate at which the Reserve Bank of India lends to the other Banks / Financial Institutions. The bank borrows money and then lend it. The difference between the rate at which it lends and borrow is called the SPREAD. Any movement in the bank rate will have am impact on the interest rate of the bank. This is more of an long term nature. When RBI increases the Bank Rate, the Banks will also increase their lending rates to maintain their spread. When RBI reduces the Bank rate, the banks will aslo reduce their lending rates.

Now you may understand why the Housing Loan market looks at the Bank rate!

2. What is REPO RATE?

Repo (means Repurchase Agreement) Rate is the rate at which the banks borrow funds from the Reserve Bank of India to fund their shortfall (the money they require to do business vis-a-vis the money they have with them to lend). Repo rates plays a critical role in the liquidity position. If RBI wants more liquidity in the market, it will reduce the repo rate so that the borrowing cost becomes cheap for the banks. So they will borrow more and lend more. If the RBI wants to cut the liquidity position, it will increase the repo rate, so that the borrowings will be more expensive for the banks and result in reduced borrowings by the bank. This borrowings are of short-term in nature and often for overnight borrowing. It will help the RBI to push money into the banking system for more float.

3. What is a Reverse Repo Rate (RRR)?

As you would have guessed, it is the opposite of repo rate. It is the rate at which the RBI borrows or Banks placing their monies with RBI. This is a very handy tool for the RBI to control the availability of money in the banking system.

If the RRR is increased, the banks would prefer to place their funds with RBI, as it is the safest one. By this, the money circulation is curtailed. When RBI feels that there should be more money in the system, it would reduce the rate, so that the banks would lend to outsiders for a better interest rate. The RRR helps the RBI to absorb the liquidity from the banks.

4. What is LAF?

LAF stands for Liquity Adjustment Facility. It was introduced in Jun 2000 by RBI. The main objective is that the funds under LAF are used by the banks for their day-to-day mismatches in liquidity.

To know more on LAF, click here.

5. What is CRR?

CRR stands for Cash Reserve Ratio. It is the portion of the deposits (in cash) that a bank has to maintain with the RBI. This is done to make sure that a part of the bank deposits are risk-free and liquid. Whenever the RBI increases the CRR, the banks are forced to keep more money with the RBI resulting in controlling the liquidity. The CRR is computed as a percentage of the Net Demand & Time Liabilities (NDTL). Oh! What is this NDTL?

Demand Liabilites are those which are payable on demand and include Savings bank, current deposits, balance in overdue Fixed Deposits etc.,

Time Liabilities are those which are payable otherwise on demand and include Fixed Deposit, Cumulative Deposit, Recurring Deposit

6. What is SLR?

SLR stands for Statutory Liquidity Ratio. The banks are required to keep a portion of their deposits in Government securities for liquidity purposes. SLR also acts in playing around the bank's lending pattern. More the SLR, lesser the lending and vice-versa.

Cheers,
Gopal