Reserve Bank of India plays an important role in controlling the interest rates in the banking system, by adjusting the liquidity in the system.
How RBI control the interest rates in India? If you want to understand the above, we should understand certain commonly used terms by RBI.
These are CRR, SLR, Repo Rate and Reverse Repo Rate.
What is Cash Reserve Ratio (CRR)
Each bank has to keep a certain percentage of its total deposits with RBI as cash reserves. It is called Cash Reserve Ratio (CRR). On 30th October.2012, RBI reduced the CRR by 25 basis points to 4.25%. If the bank is having a deposit of 100/-, it has to keep Rs.4.25 as cash reserve with RBI and it can use only the balance 95.75 for lending or investments.
What is the role of CRR in the banking system
RBI uses CRR as a means to control the money supply in the system. When the money supply is on the higher side, RBI will increase the CRR to reduce the supply and vice versa.
What is Statutory Liquidity Ratio (SLR)
Every bank has to maintain at the close of every day a certain percentage of its total liabilities (Deposits) in cash, gold or government approved securities. This is called SLR. At present, the SLR is 23%.
What is the role of SLR in the banking system
Its role is more or less similar to CRR and controls the money circulation the banking system. If RBI wants to suck, excess liquidity from the system, it will increase the SLR. Banks will be forced to keep the higher percentage as liquid assets and its power to lend will come down.
What is Repo Rate
When banks require short term money, RBI will lend member banks against securities held by them. RBI will charge interest on these loans and this rate of interest is called Repo Rate. At present, Repo Rate is 8%.
What is the importance of Repo Rate in the economy
When RBI wants to decrease the lending activities in the country, it will increase the Repo Rate. Once the Repo Rate is increased, the cost of funds to banks from RBI will increase and it will in turn increase the lending rates to customers. This will reduce the lending transactions. But if the RBI feels the need of more lending activities, it will decrease the Repo Rate and reduce the cost of funding. This will translate into lower rates on loans and lending will pick up.
What is Reverse Repo Rate
If banks have excess amount with them, they can park the surplus money with RBI and earn interest on this. The interest on such amount is called Reverse Repo Rate. At present the Reverse Repo Rate is 7%.
RBI will increase the reverse Repo rate, if it wants to reduce liquidity in the system. Banks will be tempted to park money with RBI rather than lending, if this rate is high. At present Reverse Repo Rate is kept 100 basis points below Repo Rate.
By adjusting CRR, SLR, Repo Rate and Reverse Repo Rate, RBI will ensure that the banking system is working fine. It will adjust these factors to promote an orderly growth of the economy by controlling interest rates and liquidity in the system.