Tag Archives: Repo Rate

Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

It has happened as expected. RBI has announced a 25 basis point cut in the Repo and Reverse Repo rates. For the less exposed, this means that the Repo Rate has fallen from 7.75% to 7.5% while Reverse Repo Rate has fallen from 6.75% to 6.5%. What does this mean to different people? The segments we cover in this article are Banks, Industry, ordinary people and the broader economy.

Impact on Banks

To understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is important to understand the role they play in banking. Repo and Reverse Repo are basically instruments used by the RBI to influence the total monetary base of banks.

To get a grip on this, it is important to understand how banks work and what the term monetary base means. Banks engage in a practice called Fractional Reserve Banking (FRB). As explained in the linked article, under FRB, a bank lends many multiples of the actual cash in hand. This cash they have is what I mean by monetary base. Clearly, any addition to the monetary base adds to the bank’s ability to make loans by creating money from nothing (as explained in the linked article).

In India, banks’ monetary base takes 2 forms – CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). CRR is the amount of actual cash that banks need to hold with the RBI. SLR refers to the amount (by value) of approved securities (government bonds, gold and approved, privately issued financial instruments) that banks are mandated to hold. Currently, CRR is 4% and SLR is 23%. Together, they constitute the monetary base of the Indian banking system.

However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks. That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement, the Repo seller (the bank) sells an approved security to the RBI with the understanding that at a certain date in the future, the bank will buy the security back from the RBI. The bank gets cash and the RBI the security.

One would expect that this would not influence the monetary base because while the bank gets cash and adds to its CRR base, it loses possession of the security and falls behind on its SLR base and can therefore not lend more. The interesting part is that this problem in the way of expanding bank lending is eliminated by the way the Repo system works.

Very interestingly, during the term of the Repo, the bank is allowed to count the security thus sold to the RBI as part of its investments to fulfil the SLR requirement. So, the net effect of a Repo transaction is an addition to the bank’s cash reserves without falling behind on SLR requirements. With this, the bank can now engage in much more lending.

At the end of the term of a Repo, the bank buys the security back from the RBI at a price higher than the original sale price. The difference expressed as a percentage of the original sale price is the Repo Rate. Thus, Repo Rate is used to calculate the price at which the security is bought back by the bank. It is the equivalent of an interest paid by the bank to RBI.

It might seem that at the time the bank buys the security back, its cash reserve falls. However, the bank can then enter into a fresh Repo transaction and sell the security back to the RBI, bringing the cash reserve back to the higher level. In this manner, Repo becomes a means for the RBI to maintain a steady level of lending to banks.

But all this additional lending would mean more purchases of securities to meet SLR requirements. This would mean the need to deploy cash for the same. That cash would go outside the system of lending and reduce the system’s lending potential. This problem is solved by what is called the Reverse Repo.

In a Reverse Repo, the RBI sells an approved security to the bank with the understanding that it will buy it back at a future date at a higher price. The difference between the 2 prices expressed as a percentage of the original selling price (per annum) is called the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received by the bank for lending cash to the RBI.

The important point for us to note is that a bank may show securities bought from the RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a fresh Reverse Repo with the RBI.

Summarising the understanding

Bank XYZ hits its lending limit based on its CRR and SLR. It sees potential for more lending. It offers RBI a portion of the securities it holds as part of a Repo transaction and gets cash. It deploys 23% of this new cash to obtain securities under the Reverse Repo window from the RBI, thus keeping the cash within the system. The bank now gets to create new money amounting to 1/(CRR+SLR) times the money borrowed under the Repo window and lend it out at interest. The Repo window thus becomes a cheap source of borrowing for banks.

The impact of a cut in Repo and Reverse Repo Rates

A cut in Repo and Reverse Repo rates basically reduces the bank’s cost of borrowing from the RBI to add to its reserves. It enables banks to either increase the interest rate spread on loans made by the bank or offer borrowers lower rates of interest without eating into its own interest rate spread. Thus, a cut in Repo and Reverse Repo Rates increases the banking system’s potential by expanding more loans in a profitable manner.

Impact on Industry

With lower repo and reverse repo rates, industry gets to borrow more and even gets to pay lower interest rates on its borrowing. Therefore, those businesses that are in a position to secure additional lending from the banking system will benefit from lower repo and reverse repo rates.

Impact on ordinary people

The impact on ordinary people can be felt in 2 ways. In the nearer term, greater lending to businesses will lead to more business investment and employment opportunities. In the medium and longer term, however, the dominant factor influencing ordinary people will be the increased money supply (inflation), which will send prices of consumers’ goods soaring, resulting in future pressure to raise interest rates thus forcing the pricking of the inflationary bubble and the onset of the depression.

Impact on the broader economy

In the long-run, reducing Repo and Reverse Repo rates is harmful for the economy as it is just a means to lend reserves to banks, enabling them to engage in far bigger inflation to undertake much more credit expansion through FRB. While this lending will have some short-term positive effects, in the long-run, it creates and worsens the inflationary boom of the familiar boom-bust cycle. It also sets the conditions for the inevitable raising of interest rates thus pricking the inflationary bubble and triggering the depression.

Conclusion

Thus we see that the policy of reducing Repo and Reverse Repo rates is essentially bad for the economy in the long-run because it greatly aids the creation of the business cycle. It also hurts ordinary people by sending prices soaring. Industry and the banking system, however, benefit in the short run. This explains why a policy of lowering repo and reverse repo rates finds fairly broad-based support from the banking industry and general industry as well.

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.