Layman’s view of Credit Policy - Part 2

This is continuation of the two part series on the recent credit policy Layman’s view of Credit Policy - Part 1

LAF cap removed
The RBI has also allowed banks to keep more funds with it under the daily liquidity adjustment facility by removing the Rs 3,000-crore cap imposed in March this year.

What is LAF ?
Prior to this policy, there was a cap on the amount of cash that a bank can hold with the RBI after taking care of the basic reserves that it has to maintain with the RBI. This was called the Liquidity Adjustment Facility (LAF) where excess money can be given to the RBI.

However, the interest paid by the RBI on such short-term funds can henceforth be either at fixed rate or at variable rates. In other words, the RBI will undertake short-term lending and borrowing through repo and reverse repo at a rate of interest which its thinks appropriate.

The removal of the Rs 3,000-crore LAF limit is expected to push up overnight call rates which have been ruling at below 1 per cent.

All other rates have been retained have been retained at the previous rates.

What is Repo rate and Reverse repo rate ?
Repo rate is the rate that RBI charges the banks when they borrow from it. Repo operations increase liquidity in the system. Reverse repo rate is the rate that RBI offers the banks for parking their funds with it. Reverse repo operations suck out liquidity from the system.

What is Call Rate ?
Call rate is the rate that one bank has to pay another bank for borrowing funds between themselves. These rates are typically charged for deposits that are borrowed overnight (typically to meet RBI commitments etc)

How does Repo rate relate to the call rate?
Repo rate typically acts as a floor rate (bare minimum rate) for the call rate. If not, banks would make arbitrage profits. How? Suppose call rate is lower than repo rate, banks will borrow on call (if there are lenders) at a lower rate, and lend on repos to the RBI at a higher rate. As the Repo acts as a floor rate, the call rates will tend towards the Repo rate.

Thus in the recent past because of the high liquidity in the system, the overnight call rates became very low and also the LAF ensures that the banks could not park more than what was allowed with the reserve bank of India. Now this ceiling has been removed.

Layman’s view of Credit Policy - Part 1

This is part 1 of the series where I will try and explain the key terms and the changes that have been made by the Reserve Bank of India (RBI) in the policy announced on July 31.

What is CRR?
Yesterday the RBI increased the CRR from 6.5% to 7%. What does CRR mean and how does it impact you ?. Read on. Indian banks are required to hold a certain percentage of their deposits as cash. This means if you deposit Rs 100 in a bank, they will have to maintain Rs 7 as cash and can only use Rs 93 for their business purpose as against Rs. 93.5 that was available to business earlier(There is something called SLR also, which we will see later on). However, in reality the banks don’t hold these as cash with themselves, but with Reserve Bank of India (RBI), which is as good as holding cash. Thus the RBI uses the CRR an instrument in the hands of a central bank through which it can control the amount by which banks can lend or do business.

The RBI kept unchanged its key rates such as the reverse repo at 6 per cent, the repo rate at 7.75 per cent, and the bank rate at 6 per cent. We will look at these terms at a later point of time.

What does a hike in this rate mean ?
The hike in CRR from 6.5 to 7 per cent will increase the amount that banks have to hold with RBI. It will therefore reduce the amount that they can lend out. The move is expected to shift Rs 16,000 crore of resources that could have otherwise been lent for business to the RBI. In the past few months the money that banks had for giving credit (read as loan to others) was much higher than the amount they have been actually lending out. The objective of the CRR hike is to mop up some of the excess liquidity in the system.

Will this mean a rise in interest rates on my deposits and home loans too? By when and by how much?
The hike in CRR is not likely to lead to an immediate increase in interest rates. There is excess liquidity in the system even after a higher amount is deposited with RBI as reserves. In fact banks have started reducing the deposit rates for 1 year deposits which has reduced from on an aveerage 9.5% to 9% p.a. At the same time, while lending rates may not come down immediately, most bankers feel that the interest rates have peaked out atleast for some time to come.