RBI cuts rates, home & car loans to be cheaper (RBI Credit Policy)

By ACA Sanjeev Jain

Latest amendment by RBI

RBI cuts rates, home & car loans to be cheaper are expected to become cheaper with the Reserve Bank of India cutting interest rates on Tuesday for the first time in three years by a more-than-expected half a percentage point aimed at boosting the sagging economy.

RBI in its annual policy reduced by 50 bps its repo rate - the rate at which it lends overnight funds to banks and also announced a slew of consumer-friendly measures such as zero balance savings account for all and abolition of pre-payment charges for home loans. The availability of cheaper funds is expected to spur individuals to spend more and business to increase investment and expectedly was cheered by bankers and industrialists across the board. Giving the policy a thumbs up the BSE Sensex closed 206 points higher at 17357 points, buoyed largely by the magnitude of the cuts since it was only expecting a 25 bps reduction. Bond's also rallied with yield on 10-year benchmark bond falling to 8.34% down from 8.44% on Monday. In the forex market the rupee rallied against the dollar to 51.49 up from Monday's close of 51.68.

Though banks are unequivocal about lending rates falling but all of them may not bring rates down immediately. "With the reduction in interest rates, of course EMIs (equated monthly instalments) will fall that is the good news. But how fast the transmission takes place we will have to watch depending on our cost of funds. But clearly the trend is downward" said Chanda Kochhar, MD & CEO, ICICI Bank, the country's largest private bank. The country's largest bank SBI is meanwhile looking at a `comprehensive' reduction in lending rates. "On car loans and all other loans wherever the spreads over the base rate (benchmark rate for loans) is high we will look at bringing down rates. I am not sure about base rate but it is our Asset liability committee that will take a call" said Pratip Chaudhuri, chairman, SBI.

How many of you read the latest news of yesterday “ where RBI decreased  rate by 50 bps”? 

For most of us these words do not make sense, and we move on to next news item. Little do we realize that we are affected by these rates and a basic knowledge about it is a must. So let’s first understand what these banking terms means, and then we’ll see how these rates affect a layman.

BPS

It is an acronym for basis point and is used to indicate changes in rate of interest and other financial instruments. 1 basis point is equal to 0.01%. So when we say that repo rate has been increased by 25 bps, it means that the rate has been increased by 0.25%.

Repo Rate and Bank Rate

People often get confused between these two terms. Though they appear similar there is a basic difference between them.

Repo rate or repurchase rate is the rate at which banks borrow money from the central bank (read RBI for India) for short period by selling their securities (financial assets) to the central bank with an agreement to repurchase it at a future date at predetermined price. It is similar to borrowing money from a money-lender by selling him something, and later buying it back at a pre-fixed price.

Bank rate is the rate at which banks borrow money from the central bank without any sale of securities. It is generally for a longer period of time. This is similar to borrowing money from someone and paying interest on that amount.

Both these rates are determined by the central bank of the country based on the demand and supply of money in the economy.

Reverse Repo Rate

Reverse repo rate is the rate of interest at which the central bank borrows funds from other banks for a short duration. The banks deposit their short term excess funds with the central bank and earn interest on it.

Reverse Repo Rate is used by the central bank to absorb liquidity from the economy. When it feels that there is too much money floating in the market, it increases the reverse repo rate, meaning that the central bank will pay a higher rate of interest to the banks for depositing money with it.

CRR (Cash Reserve Ratio)

Banks are required to maintain a percentage of their deposits as cash, meaning that if you deposit Rs. 100/- in your bank, then bank can’t use the entire Rs. 100/- for lending or investment purpose. They have to maintain a portion of the deposit as cash and can use only the remaining amount for lending/investment. This minimum percentage which is determined by the central bank is known as Cash Reserve Ratio.

So if CRR is 6% then it means for every Rs. 100/- deposited in bank, it has to maintain a minimum of Rs. 6/- as cash. However banks do not keep this cash with them, but are required to deposit it with the central bank, so that it can help them with cash at the time of need.

SLR (Statutory Liquidity Ratio)

Apart from keeping a portion of deposits with the RBI as cash, banks are also required to maintain a minimum percentage of deposits with them at the end of every business day, in the form of gold, cash, government bonds or other approved securities. This minimum percentage is called Statutory Liquidity Ratio.

Example

If you deposit Rs. 100/- in bank, CRR being 6% and SLR being 8%, then bank can use 100-6-8= Rs.84/- 86/- for giving loan or for investment purpose.

How it effects us

Having understood the meaning of these banking terms, let us now see how we are affected by increase/decrease of these rates.

The central bank uses these rates to control inflation.

All About Inflation:
Inflation and Types of Inflation

Banks earn profit by borrowing at a lower rate of interest from the central bank, and lending the same amount at a higher rate to the customers. If the repo rate or the bank rate is increased, bank has to pay more interest to the central bank. So in order to make profit, banks in turn increase their interest rate at which they take deposit from the customer and lend money to the customer. So the demand for loan decreases, and people start putting more and more money in bank accounts to earn higher rate of interest. This helps in controlling inflation.

An increase in Reverse repo rate causes the banks to transfer more funds to the central bank, because banks earn attractive interest rates and also their money is in safe hands. This results in the money being drawn out of the banking system, thus banks are left with lesser funds.

Thus, by lowering repo rate, central bank injects liquidity in the banking system and by increasing reverse repo rate it absorbs liquidity from the banking system.

Increase in SLR and CRR rate means that banks will have less power to give loans (see our example above), which again controls amount of money floating in the market; thereby controlling inflation. It also makes banks safer to keep money because banks will have a higher liquidity to meet the demand of customers. As we learnt from the recession, giving loans expose banks to great risks. So if banks have lesser funds to give as loan, they become relatively safer.

Conclusion

Thus we conclude that the central bank of a country uses these rates to fight inflation and to keep a check on economy.

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