Wednesday, January 04, 2017

Banking Awareness 2017 - Important Tools & Rates of RBI - MCLR | Repo Rate | Monetary Policy

Hello and welcome to exampundit. So here are the Important tools and rates of RBI used in the economy and banking sector.

Repo Rate and Reverse Repo Rate

Repurchase Options or in short Repo, is a money market instrument, which enables collateralised short term borrowing and lending through sale/purchase operations in debt instruments. This is an instrument used by the Central Bank and banking institutions to manage their daily / short term liquidity.

Legally it is

"repo" means an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed;
"reverse repo" means an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent."

This is the general definition of Repo and Reverse Repo in India. The securities transacted here can be either government securities or corporate securities or any other securities which the Central bank permits for transaction. Non-sovereign securities are used in many global markets for repo operations. Unlike them, Indian repo market predominantly uses sovereign securities, though repo is allowed on corporate bonds and debentures.

The Repo transaction, as adopted in India, has two legs:- in the first leg seller sells securities and receives cash while the purchaser buys securities and parts with cash. In the second leg, securities are repurchased by the original holder. He pays to the counter party the amount originally received by him plus the return on the money for the number of days for which the money was used by him, which is mutually agreed. All these transactions are reported on the electronic platform called the Negotiated Dealing System (NDS).

Types of Repos based on Maturity

There are basically four types of repos based on its maturity period.
  1. Overnight refers to repos with a single-day maturity (eg. Additional repos conducted in the Indian market on the reporting Fridays (i.e., the Fridays on which banks have to report to RBI on the fortnightly position on CRR and SLR). Indian Repo market is predominantly an overnight repo market.
  1. Term Repos refers to repos that have a fixed maturity longer than one day. If the period is fixed and agreed in advance, it is a term repo, where either party may call for the repo to be terminated at any time, though it may require one or two days' notice.

Market Stabilization Scheme

Market Stabilization scheme (MSS) is a monetary policy intervention by the RBI to withdraw excess liquidity (or money supply) by selling government securities in the economy. The MSS was introduced in April 2004. Main thing about MSS is that it is used to withdraw excess liquidity or money from the system by selling government bonds.

When MSS is to be used?
MSS is used when there is high liquidity in the system.

What securities to be sold under MSS?

           The issued securities are government bonds and they are called as Market Stabilisation Bonds (MSBs). Thus, the bonds issued under MSS are called MSBs. These securities are owned by the government though they are issued by the RBI.

The securities or bonds/t-bills issued under MSS are purchased by financial institutions. They will get an interest for purchasing the securities. 

 Statutory Liquidity Ratio

The Statutory Liquidity Ratio (SLR) is a prudential measure under which (as per the Banking Regulations Act 1949) all Scheduled Commercial Banks in India must maintain an amount in one of the following forms as a percentage of their total Demand and Time Liabilities (DTL) / Net DTL (NDTL);
[i] Cash.
[ii] Gold; or
[iii] Investments in un-encumbered Instruments that include;
(a) Treasury-Bills of the Government of India.
(b) Dated securities including those issued by the Government of India from time to time under the market borrowings programme and the Market Stabilization Scheme (MSS).
(c) State Development Loans (SDLs) issued by State Governments under their market borrowings programme.
(d) Other instruments as notified by the RBI.

SLR rate = (liquid assets / (demand + time liabilities)) × 100%


  • to control the expansion of bank credit. By changing the level of SLR, the Reserve Bank of India can increase or decrease bank credit expansion.
  • to ensure the solvency of commercial banks.
  • to compel the commercial banks to invest in government securities like government bonds.

If any Indian bank fails to maintain the required level of Statutory Liquidity Ratio, then it becomes liable to pay penalty to Reserve Bank of India. The defaulter bank pays penal interest at the rate of 3% per annum above the Bank Rate, on the shortfall amount for that particular day. But, according to the Circular, released by the Department of Banking Operations and Development, Reserve Bank of India; if the defaulter bank continues to default on the next working day, then the rate of penal interest can be increased to 5% per annum above the Bank Rate. This restriction is imposed by RBI on banks to make funds available to customers on demand as soon as possible. Gold and government securities (or gilts) are included along with cash because they are highly liquid and safe assets.

Both Cash Reserve Ratio (CRR) and SLR are instruments in the hands of RBI to regulate money supply in the hands of banks that they can pump into the economy.

Traditionally the amount to be held thus was stipulated to be no lower than 25 percent and not exceeding 40 percent of the bank’s total DTL. However, effective from January, 2007 the floor of 25 percent on the SLR was removed following an amendment of the Banking Regulation Act, 1949.

Liquidity Adjustment Facility (LAF)

LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of Government securities including State Government securities. Basically LAF enables liquidity management on a day to day basis.

Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos.

Marginal Cost of Funds Based Lending Rate

The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI.

It is an internal benchmark or reference rate for the bank. MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank - on the basis of marginal cost or the additional or incremental cost of arranging one more rupee to the prospective borrower.

Reasons for introducing MCLR

RBI decided to shift from base rate to MCLR because the rates based on marginal cost of funds are more sensitive to changes in the policy rates. 

This is very essential for the effective implementation of monetary policy. Prior to MCLR system, different banks were following different methodology for calculation of base rate /minimum rate – that is either on the basis of average cost of funds or marginal cost of funds or blended cost of funds.

Calculation of MCLR

The MCLR is a tenor linked internal benchmark (tenor means the amount of time left for the repayment of a loan). The actual lending rates are determined by adding the components of spread to the MCLR. Banks will review and publish their MCLR of different maturities, every month, on a pre-announced date.

Banks may publish every month the internal benchmark/ MCLR for the following maturities:
  1. Overnight MCLR,
  2. One-month MCLR,
  3. Three-month MCLR,
  4. Six month MCLR,
  5. One year MCLR.

Base Rate

The Base Rate is the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI. It is the minimum interest rate of a bank below which it is not viable to lend. The base rate, introduced with effect from 1st July 2011 by the Reserve Bank of India, is the new benchmark rate for lending operations of banks.

Base Rate vs MCLR

Base rate calculation is based on cost of funds, minimum rate of return, i.e margin or profit, operating expenses and cost of maintaining cash reserve ratio while the MCLR is based on marginal cost of funds, tenor premium, operating expenses and cost of maintaining cash reserve ratio. The main factor of difference is the calculation of marginal cost under MCLR. Marginal cost is charged on the basis of following factors- interest rate for various types of deposits, borrowings and return on net worth. Therefore MCLR is largely determined by marginal cost of funds and especially by deposit rates and repo rates.

Cash Reserve Ratio (CRR)

Cash Reserve Ratio refers to the fraction of the total Net Demand and Time Liabilities (NDTL) of a Scheduled Commercial Bank held in India, that it has to maintain as cash deposit with the Reserve Bank of India (RBI). The requirement applies uniformly to all banks in the country irrespective of an individual bank’s financial situation or size. In contrast, certain countries e.g. China stipulates separate reserve requirements for ‘large’ and ‘small’ banks.

Policy Rate

The policy rate is the key lending rate of the central bank in a country. It is a monetary policy instrument under the control of the Central Bank -Reserve Bank of India (RBI) - to regulate the availability, cost and use of money and credit.

A change in the policy rate alters all other short term interest rates in the economy, thereby influencing the level of economic growth and inflation. (A low interest rate regime is considered conducive to growth while it generally fuels inflation)

Interest Rate Corridor

An interest rate corridor or a policy corridor refers to the range within which the operating target of the monetary policy - a short term interest rate, say the weighted average call money market rate - moves around the policy rate announced by the central bank. 

Monetary Policy Framework Agreement

Monetary Policy Framework Agreement is an agreement reached between Government and the central bank in India – The Reserve Bank of India (RBI) - on the maximum tolerable inflation rate that RBI should target to achieve price stability.

Monetary Policy Committee (MPC)

The Monetary Policy Committee (MPC) is a committee of the Central Bank in India (Reserve Bank of India), headed by its Governor, which is entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level.

Bank Rate

Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as "the standard rate at which the Reserve Bank is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under the Act."

Bank rate is the rate at which central bank lends money to the commercial banks by buying their eligible rated securities - bills of exchange or commercial paper.



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