Table of Contents
Cash Reserve Ratio (CRR-4.5%)
The Cash Reserve Ratio (CRR) is currently set at 4.5% by the Reserve Bank of India (RBI). It represents the portion of a bank’s total deposits mandated by the RBI to be held as reserves in the form of liquid cash. In simple terms, it is the minimum lending rate below which a bank is not permitted to lend funds. The CRR rate is calculated as a percentage of each bank’s net demand and time liabilities & Banks don’t earn returns on money parked as CRR.
A higher CRR means that banks have less money available to lend out or invest, leading to lower liquidity in the financial system, and vice versa. The primary objective of CRR is to ensure that banks maintain sufficient cash reserves to meet their depositors’ payment demands, thereby safeguarding financial stability.
To adjust the level of liquidity in the economy, the RBI sets the CRR rate in response to changes in monetary supply. When there is an excess of funds, the RBI may increase the CRR rate to drain liquidity from the market.
CRR offers several advantages. It helps commercial banks to maintain their solvency position by ensuring they have adequate reserves to cover potential liabilities. Additionally, a reduction in the CRR rate by the RBI allows banks to extend more loans to borrowers, thereby increasing the flow of cash to the public.
Comparatively, the implementation of CRR is considered more effective than other monetary instruments such as Market Stabilization Scheme bonds. However, a higher CRR rate reduces banks’ lending capacity, while a lower rate enables banks to invest more in other ventures, consequently reducing interest rates on loans.
Statutory Liquidity Ratio (SLR-18%)
SLR, currently set at 18% in India, is a mandatory requirement for all banks, including scheduled commercial banks, state cooperative banks, cooperative central banks, and primary cooperative banks. As per RBI guidelines, banks compute and maintain SLR by reporting their latest net demand and time liabilities to the RBI fortnightly, on Fridays.
SLR, often referred to as the minimum percentage of deposits that banks must maintain in the form of gold, cash, and approved securities, is crucial for financial stability. It’s worth noting that these deposits are held by the banks themselves and not by the RBI.
Every bank is required to allocate a specific portion of their Net Demand and Time Liabilities (NDTL) in the form of cash, gold, or other liquid assets daily. This ratio of liquid assets to demand and time liabilities constitutes the SLR. The RBI has the authority to adjust this ratio, with the power to increase it by up to 40%.
The RBI typically raises SLR during inflationary periods to control bank credit and lowers it during recessions to stimulate bank credit.
Advantages of SLR include banks earning returns on the funds parked as SLR, and the fact that the securities required for SLR are held by the banks themselves, ensuring sufficient liquidity.
The primary objective behind SLR is to prevent commercial banks from over-liquidating, thereby promoting stability in the financial system.
Marginal Cost of Funds based Lending Rate (MCLR)
Banks are typically restricted from lending money below a reference rate known as the MCLR. Under the MCLR framework, banks are mandated to adjust their interest rates promptly whenever there are changes in the repo rate.
Calculation of MCLR
MCLR is determined based on the loan tenor, representing the duration within which a borrower is expected to repay the loan. This tenor-linked benchmark is internally established by the bank. The actual lending rates are then set by adding a spread to this benchmark.
The marginal cost, inclusive of various interest rates incurred in mobilizing funds, is a critical component of MCLR calculation. Unlike the base rate system, MCLR incorporates the repo rate. Additionally, banks are required to include a tenor premium in MCLR, enabling them to levy higher interest rates on loans with longer repayment horizons.
Banks retain the flexibility to offer loans under either fixed or floating interest rates. Furthermore, they are obligated to adhere to specific deadlines for disclosing the MCLR or the internal benchmark, which can vary from one month to any other maturity period as determined by the bank.
MCLR is the minimum interest rate below which financial institutions cannot lend, serving as a benchmark for floating-rate loans.
The calculation of MCLR incorporates several key aspects:
- Marginal cost of funds
- Operating costs
- Cost of Carry in the Cash Reserve Ratio (CRR)
- Tenor premium
Unlike the base rate, which is determined by the average cost of funds, MCLR is based on the current cost of funds. This system enhances transparency in banks’ procedures for setting interest rates on loans.
MCLR offers several advantages over the base rate system. Rates determined through MCLR are more responsive to changes in the policy rate, such as the Repo Rate. This ensures effective implementation of the country’s monetary policy across all sectors.
For individuals seeking floating-rate loans, such as a home loan, the interest rate will be linked to MCLR. Moreover, borrowers have the option to convert their loans from the base rate system to MCLR.
Repo Rate (RR-6.5%)
The repo rate, set by the central bank (Reserve Bank of India in India), determines the interest rate at which commercial banks can borrow funds from the central bank when facing a shortfall. This mechanism is crucial for managing inflationary pressures in the economy.
In times of inflation, the central bank raises the repo rate to discourage banks from borrowing, thereby reducing the money supply and curbing inflation. Conversely, during periods of low inflation, the central bank lowers the repo rate to encourage borrowing, stimulating economic activity and increasing liquidity.
Repo, short for ‘Repurchase Agreement’, involves banks selling securities to the central bank and agreeing to repurchase them at a predetermined price. This transaction provides banks with immediate cash while the central bank obtains securities.
The repo rate directly influences borrowing costs for banks; higher repo rates increase borrowing costs, while lower rates reduce them. When inflation is high, raising the repo rate restrains borrowing, slowing economic growth. Conversely, lowering the repo rate stimulates borrowing, boosting economic activity.
The repo rate serves as a pivotal tool in monetary policy, allowing the central bank to regulate inflation, liquidity, and overall economic growth. Adjustments to the repo rate influence borrowing costs for banks, thereby affecting investment, money supply, and economic activity.
Reverse Repo Rate (RRR-3.35%)
The reverse repo rate serves as a mechanism for the central bank (RBI) to absorb excess liquidity in the market, thereby curbing the borrowing capacity of investors.
When there is surplus liquidity in the market, the RBI borrows money from banks through the reverse repo rate. Banks benefit by earning interest on their excess funds held with the central bank. Increasing the reverse repo rate during periods of high inflation incentivizes banks to park more funds with the RBI, reducing the availability of funds for lending to consumers.
The reverse repo rate manages cash flow by transferring money between accounts, aiming to absorb excess liquidity in the market and limit investors’ borrowing power. This rate adjustment influences the money supply; an increase in the reverse repo rate decreases money supply, as banks prefer to park funds with the RBI to earn higher returns.
The reverse repo rate functions as the inverse of the repo rate, representing the rate at which the RBI borrows funds from commercial banks. It is employed to reduce the overall money supply in the economy, with higher rates prompting banks to park excess funds with the RBI, thus decreasing liquidity. Conversely, lower reverse repo rates encourage increased lending by banks, leading to higher liquidity levels in the economy.
Benchmark Prime Lending Rate (BPLR)
The Benchmark Prime Lending Rate (BPLR) is the rate at which commercial banks charge their most creditworthy customers for loans.
Introduced by the Reserve Bank of India in 2003, the BPLR was designed for banks to apply to their top-tier clients. However, one significant issue with the BPLR system was its lack of transparency, as banks could offer loans below the BPLR to select customers.
In response to this transparency concern, the Reserve Bank of India introduced the Base Rate system in 2010, replacing the BPLR. The Base Rate served as the benchmark rate for lending until June 2010. Presently, housing finance companies often utilize the Retail Prime Lending Rate, which resembles the BPLR.
According to RBI guidelines, banks have the authority to determine the BPLR with approval from their Boards. The base rate is typically influenced by factors such as the cost of raising funds, unallocated resource costs, and return on net worth.
