Reserve Bank of India ( RBI ) is the controller of the credit system in the economy created by commercial banks. It controls the credit on the basis of two methods and these methods are also known as credit controllers. The methods are as follows :
- Quantitative method
- Qualitative method
| Quantitative Method | Qualitative Method |
| Repo rate | Rationing of credit |
| Reverse Repo rate | Regulating loans for consumption purposes |
| Bank rate | Variation in margin requirements |
| CRR-Cash Reserve Ratio | Moral suasion |
| SLR-Statutory Liquidity Ratio | Direct action |
| SDF-Standing Deposit Facility | |
| MSF-Marginal Standing Facility |
Refinancing and Rediscount
Refinancing occurs in India when government securities are further utilized by commercial banks to get a loan from RBI.
A rediscount is a process of discounting for a second time. ( Discounting : When the lender cancels the paper (security) when the borrower gives the lenders money back)
Quantitative methods followed by RBI
Cash Reserve Ratio (CRR)
- It is the minimum percentage of a bank’s Total Demand and Time Liabilities (DTL) (adjusted for certain exemptions) that Schedule commercial banks (SCB) is obliged to deposit with the Central Bank (RBI) in the form of cash.
- RBI does not pay any interest on CRR balances maintained by SCBs with RBI. The provisions of the RBI Act do not prescribe any range (ceiling rate or floor rate) for fixing CRR.
- The current CRR is 4.5%.
- CRR is maintained on an average basis during the fortnight. All SCBS are required to daily maintain a minimum CRR balance of 95 per cent of the average requirement. If the SCB fails to maintain CRR as fixed by RBI, then it is liable to pay penal interest at 3 percent per annum above the bank rate, on the shortfall amount. If the shortfall continues for the next succeeding day, penal interest is to be paid at Bank Rate + 5 per cent.
- CRR is defined under section 42 of the RBI Act 1934 and currently there is no upper and lower limit of CRR.
- When the RBI increases CRR, it is known as a tight monetary policy.
- When the RBI decreases CRR, it is known as a liberal monetary policy.
- In order to decrease the money supply, the RBI increases CRR, and vice versa and thus controls inflation.
Statutory Liquidity Ratio (SLR)
- It is the percentage of Net Demand and Time Liabilities (NDTL) of SCBs that are to be kept with them only, in the form of combination of the below three :
- Cash, or
- Gold, valued at a price not exceeding the current market price or
- Other instruments of SLR Securities:
- Certain dated securities or GoI Bonds,
- Treasury bills of Government of India,
- State Development Loans of the State Governments issued under their Market Borrowing Programme and
- Any other instrument notified by RBI.
- Every bank shall maintain such a percentage of the total of its demand and time liabilities.
- In India as on the last Friday of the second preceding fortnight as Reserve Banks specify from time to time and such assets shall be maintained as may be specified (Cash, gold, government securities).
- The current SLR is 18%.
- SLR is defined under section 24 of the Banking regulation act, 1949 and currently there is an upper limit of SLR as 40% and there is no lower limit to it.
The purpose of maintaining this ratio is that on one hand, it enables the Government to borrow from the banking system and on the other hand to have enough cash so as to run the bank. In the time of inflation, RBI increases SLR and in the time of deflation, RBI decreases SLR.
Repo Rate
- It is the interest rate at which the central bank of a country lends money to commercial banks. The central bank in India i.e. the Reserve Bank of India (RBI) uses the Repo rate to regulate liquidity in the economy. In banking, repo rate is related to the ‘repurchase option’ or ‘repurchase agreement’. When there is a shortage of funds, commercial banks borrow money from the central bank which is repaid according to the repo rate applicable.
- The central bank provides these short-term loans against securities such as treasury bills or government bonds.
- This monetary policy is used by the central bank to control inflation or increase the liquidity of banks. The government increases the repo rate when they need to control prices and restrict borrowing.
- On the other hand, the repo rate is decreased when there is a need to infuse more money into the market and support economic growth.
- An increase in repo rate means commercial banks have to pay more interest for the money lent to them and therefore, a change in repo rate eventually affects public borrowings such as home loans, EMIs, etc. From interest charged by commercial banks on loans to the returns from deposits, various financial and investment instruments are indirectly dependent on the repo rate.
Reverse Repo Rate
- This is the rate the central bank of a country pays its commercial banks to park their excess funds in the central bank.
- The Reverse repo rate is also a monetary policy used by the central bank (which is RBI in India) to regulate the flow of money in the market.
- When in need, the central bank of a country borrows money from commercial banks and pays them interest as per the reverse repo rate applicable.
- At a given point in time, the reverse repo rate provided by RBI is generally lower than the repo rate. While the Repo rate is used to regulate liquidity in the economy, the Reverse Repo rate is used to control cash flow in the market.
- When there is inflation in the economy, RBI increases the reverse repo rate to encourage commercial banks to make deposits in the central bank and earn returns. This in turn absorbs excessive funds from the market and reduces the money available for the public to borrow.
Fixed Reverse Repo Rate
- The interest rate at which the RBI accepts deposits from the bank against the collaterals of government securities.
- Currently, this rate is fixed at 3.35%.
Standing Deposit Facility (SDF)
- It is the rate at which the RBI accepts uncollateralized deposits from the banks.
- SDF is implemented by RBI from April 2022 onwards and the current interest rate of SDF is Repo Rate minus 0.25%.
- With the introduction of SDF in April 2022, The SDF rate replaced the fixed reverse repo rate as the floor of the liquidity facility adjustment corridor.
- In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the SDF, an additional tool for absorbing liquidity without any collateral.
- SDF is a monetary tool that allows banks to park their access liquidity with RBI without any collateral.
- RBI has introduced this tool to absorb excess liquidity in the market as it plays an important role in determining the policy rates
- By removing the binding collateral constraint on the RBI, the SDF strengthens the operating framework of monetary policy.
- The SDF is also a financial stability tool in addition to its role in liquidity management.
- The SDF will replace the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor. Both the standing facilities: The MSF (marginal standing facility) and the SDF will be available on all days of the week, throughout the year.
Liquidity Adjustment Facility (LAF)
- A Liquidity Adjustment Facility (LAF) is a tool used in monetary policy, mainly by the Reserve Bank of India (RBI), which enables banks to borrow money through repurchase agreements or banks to lend to the RBI using reverse repo contracts.
- It contains the Repo rate and Reverse Repo rate.
- The RBI may use the facility for adjusting liquidity to manage high levels of inflation. It does this by raising the repo rate, which increases the cost of debt servicing. This, in turn, reduces the supply of investment and money within the economy of India.
- Alternatively, if the RBI tries to boost the economy after a period of slow economic growth, the repo rate can be lowered to encourage businesses to borrow, thus increasing the supply of money
Open Market Operation (OMO)
- Open market operation is an operation which is conducted by RBI in India from time to time to absorb or inject liquidity into the system.
- Under OMO RBI sales and purchases of government securities and treasury bills.
- The objective of OMO is to regulate the money supply in the economy.
- RBI carries out the OMO through commercial banks and does not directly deal with the public.
- When the RBI wants to increase the money supply in the economy, it purchases government securities from the market and it sells government securities to suck out liquidity from the system.
Marginal Standing Facility (MSF)
- A Marginal Standing Facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency situation when interbank liquidity dries up completely (borrowing for 24 hours only).
- Bank has to return it overnight (i.e. in 24 hours)
- MSF is the penalty rate of interest at which banks can borrow on an overnight basis, from RBI by dipping into their SLR portfolio up to a predefined limit (2%). This provides a safety valve against unanticipated liquidity shocks to the banking system.
- Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under a liquidity adjustment facility or LAF. The MSF rate is pegged 0.25 per cent above the repo rate. Under MSF, banks can borrow funds up to two percent of their net demand and time liabilities (NDTL) currently.
Note :
1. SDF is 0.25% less than the Repo rate.
2. MSF is 0.25% above the Repo rate.
3. The Repo Rate is called the Policy Interest Rate ( The most important rate in the country right now ) .
Bank Rate
- It is the rate at which the RBI is ready to buy or rediscount bills of exchange or other commercial papers.
- The bank rate acts as the penal rate charged on banks for shortfall, in meeting their reserve requirements (CRR and SLR).
- The bank rate is published under section 49 of the RBI Act 1934. This rate has been aligned to the MSF rate and therefore changes automatically as and when the MSF rate changes alongside policy rate changes.
- The current Bank Rate is the Repo rate plus 0.25% is equal to 6.75%.
Long-Term Repo Operation (LTRO)
Under LTRO, RBI provides longer-term loans (1 to 3 years) to banks at the prevailing repo rate. As banks get long-term funds at lower rates, they reduce interest rates for borrowers and to help the economy grow.
Interest Rate Corridor
The interest rate corridor refers to the window between the highest rate of interest (Now, MSF) and the lowest rate of interest (Now, SDF) wherein the SDF acts as a floor and the MSF as the ceiling.
Qualitative Tools followed by RBI
Rationing of Credit
It refers to the credit ceilings (that can be granted by SCBs) being controlled by the RBI.
Under this measure, RBI rations credit is to be given by the banks in accordance with the priorities of the economy and as per the importance of various sectors of the economy. In India priority sectors include
- Agriculture
- Micro, Small, and Medium enterprises
- Export credit
- Education
- Renewable energy
- Backward section of the society
- Housing
- Social infrastructure (Schools, health care facilities, drinking water facilities, sanitation facilities)
- Others.
Division of Priority Sector Lending
Indian Banks need to lend 40 per cent to the priority sector every year (public sector as well as private sector banks) of their total lending.
Out of the 40% priority sector lending
- 18% is reserved for the agriculture sector (In 2022-23, 9.5% for small and marginal farmers, and in 2023-24, it will be 10% for marginal farmers)
- In 2022-23 11.5% reserve for the weaker sections and in 2023-24 it will be 12% for weaker sections (SC, ST, Disabled people, self-help groups, farmers under debt)
- 7.5% for micro-enterprises.
Like Indian banks, foreign banks that have more than 20 branches in India, follow the same rule with respect to priority sector lending.
In the case of foreign Banks, having less than 20 branches can lend up to 32% in the form of lending to Exports and the remaining 8% can be lent to any other priority sector.
Priority Sector Lending Certificate (PSL Certificate)
- PSL certificates are a mechanism to enable banks to achieve the priority sector lending target and sub-targets by the purchase of these instruments in the event of a shortfall.
- This also incentivizes the surplus banks as it allows them to sell their excess achievement over target thereby enhancing lending to the categories under the priority sector.
- Under the PSL certificate mechanism, the seller fulfils the priority sector obligation and the buyer buys the obligations with no transfer of risk on loan assets.
Variation in Margin Requirements
It means that RBI may instruct banks from time to time to raise margins on loans for essential commodities so as to prevent hoarding, speculation, and black marketing.
Regulating Loans for Consumption Purposes
Under this measure, RBI regulates and limits loans given by banks for consumption purposes and would like to direct more credits for productive purposes as it may be a possibility that too much consumption may fuel inflation.
Moral Suasion
- It is a combination of persuasion and pressure, under which a central bank is always in a position to use it on banks in general and particularly on those banks that do not follow the directions of RBI. This is exercised through discussions, letters, speeches, hints, emails, messages, meetings, etc.
- Moral suasion is a request by the RBI to commercial banks to take specific measures as per the economy’s trends. For instance, RBI may direct banks not to give out certain loans.
- It includes psychological means and informal means of selective credit control.
Direct Action
- Under direct action, RBI may take punitive actions against those banks that do not follow the moral advice of the RBI and function against the RBI and depositors’ interests.
- It may be in the terms of penalty, dropping the refinancing facilities or temporary suspension of bank working.
- Such measures may be in the form of charging a penalty rate of interest, refusal to refinance, and even extreme steps of placing a moratorium on the banks and ultimately cancelling bank licenses to operate.
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