Tag Archives: Interest Rate cut

Why the SBI Chairman is calling for rate cuts

I just chanced upon this article and thought it would be helpful to explain why representatives of the banking industry frequently make such demands. This is meant as a primer for those with little introduction to banking and finance.

Here’s how the banking system works. It is called a system of Fractional Reserve Banking. Unlike ordinary people, banks can lend many times the amount of money that they actually have on hand. If you have Rs. 1000 on hand, the maximum amount you can lend to someone is Rs. 1000. A bank, however, gets to lend many multiples of Rs.1000 depending on the regulatory regime, i.e., the reserve requirements imposed by the central bank (the RBI in India).

This is made possible by a simple accounting trick. Imagine a bank with the following balance sheet

Table 1 - Balance Sheet of a Hypothetical Bank upon launch

One would expect that the bank will be able to lend a maximum of 1,000,000 and end up with a balance sheet that looks like this.

Table 2 - Expected Balance Sheet of a fully loaned up bank

We think that the bank has 1,000,000 in cash to pay all deposit holders if need be. However, under fractional reserve banking, a bank needs to keep only a fraction of the total deposits as cash in reserve. This fraction is called the reserve ratio. These days, it is usually set by the central bank of each country though prior to central banking, banks used to set their own reserve ratios.

A bank with a 10% reserve ratio needs to keep only 100,000 as reserve against deposits of 1,000,000. Conversely, a cash base of 1,000,000 can support a deposit base of 10,000,000. This means that the bank’s balance sheet can look like this.

Table 3 - Balance Sheet of a fully loaned up Fractional Reserve Bank with a 10% Reserve Ratio

Thus, we see that fractional reserve banking enables banks to lend far in excess of their actual cash holdings. They do this by adding units of money to the total money supply by adding it into new or existing deposit accounts. This is reflected in the jump in deposits held in bank from 1,000,000 to 10,000,000.

Basic arithmetic tells us that if a bank gets to borrow 1,000,000 at 8% and lend 10,000,000 at 12%, it must be enormously profitable. So, there is phenomenal incentive for banks to borrow to add to their cash base and grow by increasing the total amount they have loaned out. In order to do this, banks need a source of near unlimited lending. That source is the central bank (the RBI in India).

The Repo window of the RBI is basically a means for banks to augment their cash reserves through sale of bonds to the RBI (repo) or borrowing reserves from the RBI (reverse repo). Interest rates (Update: Please note that interest rate here stands for repo/reverse repo rates) determine how much a bank can add to its cash base through this window. Higher interest (Update: repo/reverse) rates mean lower addition to the cash base while lower interest (Update: repo/reverse repo) rates mean higher addition to the cash base. Therefore, it must be obvious that banks would prefer lower interest (Update: repo/reverse repo) rates all the time.

Lowering the reserve ratio has a dramatic effect on how much the banking system can lend out on the same cash base. A drop in the reserve ratio from 10% to 9% will leave our hypothetical bank’s balance sheet looking like this.

Table 4 - Balance Sheet of fully loaned up Fractional Reserve Bank after cut in Reserve ratio to 9%

The banking system thus gets to lend out an additional amount greater than its actual cash base. While the actual additional amount of lending possible depends on the original reserve ratio and the extent of the cut, the simple arithmetical point is that it a cut in the reserve ratio necessarily means additional lending possibilities for banks. Combined with a cut in repo and reverse repo rates, it can indeed add significantly to the banking system’s ability to create new loans.

Thus, it becomes clear why the banking industry is perpetually calling for lower interest rates and lower reserve ratios. The economic consequences of these are, of course, an entirely different matter and I shall tackle them some other time.