RBI as Money Controller
RBI regulates banks through Statutory Liquidity Ratio(SLR) and Cash Reserve Ratio(CRR). Let us understand these two terms but before that you should know:
LIQUIDITY:
Liquidity in case of 'assets' is its ability to be sold quickly. For instance if you have Rs 10 lac gold and equivalent amount of property, 10 lac gold is more "liquid" because you can quickly sell the gold in few days but for selling property you have to go through many procedures(paperwork and all). This would take more than 20 days. Hence not so liquid.
Liquidity in terms of 'banking' is when bank has more money to give as loan than yesterday. For instance yesterday bank has Rs 10 lac to give as loan but today a customer deposits Rs 10 lac in the bank. Now bank has 10+10= Rs 20 lac to give as a loan. This we can say, liquidity has increased.
NET DEMAND AND TIME LIABILITIES(NDTL):
Bank receives money from depositors, loan takers(through EMIs), online transfer, demand drafts etc. This total money with the bank at a certain point of time is called NDTL.
SLR and CRR are counted on NDTL.
CASH RESERVE RATIO(CRR):
"CRR is a certain percentage of the total bank deposits that has to be kept in the current account with RBI which means banks do not have access to that much amount for any economic activity or commercial activity."
Lets understand CRR in a more lucid way:
Suppose a new bank is opened in your area. Some people, say 10, deposit their cash in the bank worth of Rs 1 crore. Now bank has to make profit, but how? Bank promises the depositors(in this case 10) to give 10% interest on savings.(otherwise why would anyone deposit their money in the bank?). Then bank gives that money as loan to businessman and charges 15% interest rate. So, profit= 15-10= 5%.
But if bank branch manager gives away whole money(in this case Rs 1 crore) to the businessman, it will not left with any amount. In case some of those depositors need money from their banks savings account to pay for electricity, bills etc. they will not get anything as bank branch manager has given all the money to businessman.
To save this situation, BANK MUST NOT GIVE AWAY ALL OF THE MONEY to businessman for loans. Banks must keep some money aside. Thus RBI formulated CRR.
CRR at present - 4%(as in December 2014)
STATUTORY LIQUIDITY RATIO(SLR):
"SLR, statutory liquidity ratio is the amount of money that is invested in certain specified securities predominantly central government and state government securities."
Lets understand by continuing the same example:
Bank had Rs 1 crore. But RBI ordered to set Rs 5 lac as CRR. Now bank left with Rs 95 lac.
Suppose one businessman whose track record is not so good and no bank is offering him loan came to this bank. He asked for loans and ready to pay 36% interest rate. Bank give Rs 95 lac at 36% to the businessman. But after some time, businessman was not able to pay back the EMIs as his business collapsed. Then bank will find itself in trouble again.(Though bank can mortgage businessman's assets to recover money but that will take time). When this news reach the depositors, they will panic and demand their money. Here SLR will help.
BANK MUST NOT GIVE AWAY ALL ITS LOANS TO RISKY LOAN TAKERS. BANKS MUST INVEST PART OF ITS MONEY IN SAFE AND LIQUID INVESTMENT. So when bank requires money, it can sell those liquid investments and take money. (Safe investments are government securities, gold, corporate bonds of reputed companies).
SLR at present - 22%(as in December 2014)
REVERSE REPO RATE:
Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest.
To understand reverse repo rate lets take a hypothetical situation:
Suppose RBI has government securities worth Rs 100 lac. And XYZ bank has surplus Rs 100 lac and nobody is taking them as loans. This is bank's idle cash. Bank will try to extract benefit from this idle cash. Bank will park its money with RBI for short term. Hence XYZ bank enters into Reverse Repo agreement with RBI. Agreement reads, "I (XYZ bank) will buy government securities worth Rs 100 lac from RBI, and RBI promises to buy back those securities from me after 6 months at Rs 106 lac".
For Banks, it is a tool to extract profit from its idle cash.
For RBI, it is a tool which can be used to drain excess money out of the banking system.
REPO RATE:
The rate at which the RBI lends money to commercial banks is called repo rate. Whenever banks have any shortage of funds they can borrow from the RBI.
To understand repo rate lets take another hypothetical situation:
Suppose RBI has cash worth of Rs 100 lac. XYZ bank has government securities worth Rs 100 lac. But bank needs cash to lend it to the businessman immediately. In this situation bank enters into repo rate agreement with RBI. Agreement reads,"I(XYZ bank) am selling my government securities worth Rs 100 lac to RBI and I promise to buy back(repurchase) those securities from RBI after 6 months at Rs 107 lac".
Note:
1. Government securities act as 'collateral'(collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan). So that if any one of the party doesn't honor the repurchase agreement, other party can sell away the government security to third party and recover money.
2. Reverse repo rate is linked with repo rate. Reverse repo rate will be 100 basis points below repo rate(i.e. minus 1%).
3. Repo rate and reverse repo rate are short term loans.
As in December 2014,
Repo rate- 8%
Reverse repo rate- 7%
LIQUIDITY ADJUSTMENT FACILITY(LAF):
LAF is a tool used by RBI to control short term money supply. RBI introduced it in 2000 on the recommendation of Narsimha committee(1998).
LAF helps banks to quickly borrow money in case of any emergency or for adjusting in their CRR/SLR requirements.
Under LAF, RBI auctions government securities starting at the repo and reverse repo rate and minimum bidding amount is Rs 5 crore.
MARGINAL STANDING FACILITY(MSF):
RBI started MSF in 2011. Under MSF, scheduled commercial banks can borrow money from RBI at 1% higher rate than ongoing repo rate under LAF.
Repo rate = Reverse repo + 1%
MSF rate = Repo rate + 1%
OPEN MARKET OPERATIONS(OMO):
When RBI buys/sells securities in open markets, it is called OMO.
In LAF/MSF, one party buys government security from second party. But second party has agreed to buy back(repurchase) the same security from first party after some time. So, government security is not permanently sold, it is only used as "collateral".
But in case of OMO, first party permanently sells the government security to second party. Second party is free to do whatever it wants to do with that security.
When RBI purchases government securities liquidity is increased as RBI is paying that party some money to buy that money thus RBI pouring money into the system.
When RBI sells government securities liquidity is decreased as other party is giving cash to RBI to buy securities thus RBI is draining out the money from system.
LIQUIDITY:
Liquidity in case of 'assets' is its ability to be sold quickly. For instance if you have Rs 10 lac gold and equivalent amount of property, 10 lac gold is more "liquid" because you can quickly sell the gold in few days but for selling property you have to go through many procedures(paperwork and all). This would take more than 20 days. Hence not so liquid.
Liquidity in terms of 'banking' is when bank has more money to give as loan than yesterday. For instance yesterday bank has Rs 10 lac to give as loan but today a customer deposits Rs 10 lac in the bank. Now bank has 10+10= Rs 20 lac to give as a loan. This we can say, liquidity has increased.
NET DEMAND AND TIME LIABILITIES(NDTL):
Bank receives money from depositors, loan takers(through EMIs), online transfer, demand drafts etc. This total money with the bank at a certain point of time is called NDTL.
SLR and CRR are counted on NDTL.
CASH RESERVE RATIO(CRR):
"CRR is a certain percentage of the total bank deposits that has to be kept in the current account with RBI which means banks do not have access to that much amount for any economic activity or commercial activity."
Lets understand CRR in a more lucid way:
Suppose a new bank is opened in your area. Some people, say 10, deposit their cash in the bank worth of Rs 1 crore. Now bank has to make profit, but how? Bank promises the depositors(in this case 10) to give 10% interest on savings.(otherwise why would anyone deposit their money in the bank?). Then bank gives that money as loan to businessman and charges 15% interest rate. So, profit= 15-10= 5%.
But if bank branch manager gives away whole money(in this case Rs 1 crore) to the businessman, it will not left with any amount. In case some of those depositors need money from their banks savings account to pay for electricity, bills etc. they will not get anything as bank branch manager has given all the money to businessman.
To save this situation, BANK MUST NOT GIVE AWAY ALL OF THE MONEY to businessman for loans. Banks must keep some money aside. Thus RBI formulated CRR.
CRR at present - 4%(as in December 2014)
STATUTORY LIQUIDITY RATIO(SLR):
"SLR, statutory liquidity ratio is the amount of money that is invested in certain specified securities predominantly central government and state government securities."
Lets understand by continuing the same example:
Bank had Rs 1 crore. But RBI ordered to set Rs 5 lac as CRR. Now bank left with Rs 95 lac.
Suppose one businessman whose track record is not so good and no bank is offering him loan came to this bank. He asked for loans and ready to pay 36% interest rate. Bank give Rs 95 lac at 36% to the businessman. But after some time, businessman was not able to pay back the EMIs as his business collapsed. Then bank will find itself in trouble again.(Though bank can mortgage businessman's assets to recover money but that will take time). When this news reach the depositors, they will panic and demand their money. Here SLR will help.
BANK MUST NOT GIVE AWAY ALL ITS LOANS TO RISKY LOAN TAKERS. BANKS MUST INVEST PART OF ITS MONEY IN SAFE AND LIQUID INVESTMENT. So when bank requires money, it can sell those liquid investments and take money. (Safe investments are government securities, gold, corporate bonds of reputed companies).
SLR at present - 22%(as in December 2014)
REVERSE REPO RATE:
Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest.
To understand reverse repo rate lets take a hypothetical situation:
Suppose RBI has government securities worth Rs 100 lac. And XYZ bank has surplus Rs 100 lac and nobody is taking them as loans. This is bank's idle cash. Bank will try to extract benefit from this idle cash. Bank will park its money with RBI for short term. Hence XYZ bank enters into Reverse Repo agreement with RBI. Agreement reads, "I (XYZ bank) will buy government securities worth Rs 100 lac from RBI, and RBI promises to buy back those securities from me after 6 months at Rs 106 lac".
For Banks, it is a tool to extract profit from its idle cash.
For RBI, it is a tool which can be used to drain excess money out of the banking system.
REPO RATE:
The rate at which the RBI lends money to commercial banks is called repo rate. Whenever banks have any shortage of funds they can borrow from the RBI.
To understand repo rate lets take another hypothetical situation:
Suppose RBI has cash worth of Rs 100 lac. XYZ bank has government securities worth Rs 100 lac. But bank needs cash to lend it to the businessman immediately. In this situation bank enters into repo rate agreement with RBI. Agreement reads,"I(XYZ bank) am selling my government securities worth Rs 100 lac to RBI and I promise to buy back(repurchase) those securities from RBI after 6 months at Rs 107 lac".
Note:
1. Government securities act as 'collateral'(collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan). So that if any one of the party doesn't honor the repurchase agreement, other party can sell away the government security to third party and recover money.
2. Reverse repo rate is linked with repo rate. Reverse repo rate will be 100 basis points below repo rate(i.e. minus 1%).
3. Repo rate and reverse repo rate are short term loans.
As in December 2014,
Repo rate- 8%
Reverse repo rate- 7%
LIQUIDITY ADJUSTMENT FACILITY(LAF):
LAF is a tool used by RBI to control short term money supply. RBI introduced it in 2000 on the recommendation of Narsimha committee(1998).
LAF helps banks to quickly borrow money in case of any emergency or for adjusting in their CRR/SLR requirements.
Under LAF, RBI auctions government securities starting at the repo and reverse repo rate and minimum bidding amount is Rs 5 crore.
MARGINAL STANDING FACILITY(MSF):
RBI started MSF in 2011. Under MSF, scheduled commercial banks can borrow money from RBI at 1% higher rate than ongoing repo rate under LAF.
Repo rate = Reverse repo + 1%
MSF rate = Repo rate + 1%
OPEN MARKET OPERATIONS(OMO):
When RBI buys/sells securities in open markets, it is called OMO.
In LAF/MSF, one party buys government security from second party. But second party has agreed to buy back(repurchase) the same security from first party after some time. So, government security is not permanently sold, it is only used as "collateral".
But in case of OMO, first party permanently sells the government security to second party. Second party is free to do whatever it wants to do with that security.
When RBI purchases government securities liquidity is increased as RBI is paying that party some money to buy that money thus RBI pouring money into the system.
When RBI sells government securities liquidity is decreased as other party is giving cash to RBI to buy securities thus RBI is draining out the money from system.
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