Bank Rate/Repo Rate/ Bank Rate Vs Repo Rate / Reverse Repo Rate / Cash Reserve Requirement

Bank Rate:

Bank rate is the rate at which the central bank provides money to the other financial institutions or banks. Bank rate enables the financial institutions (or banks) to borrow money from the central bank to fund any money need. Increase in bank rate leads to higher prime lending rate, the rate at which financial institutions lends money to other entities. So by increasing bank rate, the central bank can increase the interest rate in the market and reduce the demand. At the same time, as the lending becomes dearer, it reduces the lending by the financial institutions. Because of these two reasons bank rate hike is used to tame inflation.

Repo Rate:

Repo rate (also known as Repurchase Rate) is the rate at which the Central Bank lends money to the banks on short term basis. Increase in Repo rate leads to higher short term borrowing rate for the banks which again leads to higher prime lending rate, the rate at which banks lends money to other customers or corporates. Increase in Repo rate mainly leads to higher interest rate on home loan, car loans, and corporate borrowings.

The main effect is reduced demand of home, cars by the normal citizen and corporate loans by the Companies used for business expansion. It impacts the revenue and profit margin of the auto sector and housing sector companies aversely and makes the business and industrial expansion more expensive, thus reduce the industrial activity. That’s why increase in repo rate is very effective to control inflation. But at the same time, it hurts the economic and industrial growth severely. Central Bank’s job is to maintain the repo rate properly so that it won’t affect the economic growth activity.

Bank Rate Vs Repo Rate:

The Repo rate and Bank rate are almost similar except the difference that Repo rate is applicable to short-term lending specially for overnight lending to banks by the central bank and governed by the short term interest rate and inflation target but Bank rate is applicable to long term lending by the central bank and governed by the long term interest rate and inflation target.

Both are used in the same manner to control the liquidity in the market and control inflation. But Bank rate mainly aims for long term effect and Repo rate mainly aims for short term effect.

Like China’s Central Bank uses its one year deposit and lending rate to control liquidity and inflation. This is same as Bank rate. While India uses the overnight lending and deposit rate to control liquidity and inflation. This is same as repo rate (for lending) and reverse repo rate (for deposit).

Reverse Repo Rate:

Reverse Repo rate is the rate at which banks deposit their excess money with the central bank for short term only. Central bank uses this tool to reduce liquidity in the market when there is high liquidity in the banking system. If the reverse repo rate is high then the banks will prefer to deposit the excess money with the central bank, thus reduce the liquidity in the system.

The money deposited with the central bank is risk free, that’s why for high reverse repo rate banks always prefer to deposit the excess money with the central bank rather than lending it to the customers which involves significant risks. High reverse repo rate helps to reduce the lending by the banks and reduces the loan supply in the market. Lower loan supply decreases the lending for auto, home etc. which helps to tame inflation.

Cash Reserve Requirement (CRR):

Cash Reserve Requirement or Cash Reserve Ration (CRR) mandates the banks to hold a certain percentage of the deposit in the form of cash or cash equivalents. Banks can lend the rest of the money to the lenders after maintaining the reserve ratio or requirement. Banks do not normally keep the reserved cash with them; instead they deposit it with the RBI or invest in Government bonds or treasury bills which are considered to be cash equivalents. Cash Reserve Requirement is a very strong monetary tool with some important benefits. They are:

• It helps to reduce the liquidity in the financial system. It is a very strong monetary policy tool to check the liquidity in the financial system.
• It encourages the banks to invest in the government bonds and treasury bills, which the government sells to borrow money from the market.
• It also reduces the risk of banking operation by restricting the lending percentage. Reserved money also helps the banks to cater any sudden liquidity crisis.

Statutory Liquidity Ratio (SLR):

Statutory Liquidity Ratio indicates the minimum percentage of total demand and liabilities the banks has to maintain as liquid assets at the close of every business day to support any sudden increase in withdrawal and cash demand. The liquid assets can be in the form of cash, gold and government approved securities. It is an efficient monetary policy tool and the benefits it provides are

• It helps to reduce the liquidity in the financial system by restricting banks to hold some liquidity with them.
• It encourages the banks to invest in the government bonds and treasury bills, which the government sells to borrow money from the market.
• It also reduces the risk of bank being default on sudden increase in demand and liabilities.
• CRR uses total deposit as the reference while SLR uses the total demand or liabilities as the reference while calculating the money to be held. This is the main difference between SLR and CRR.