Reduction In Repo Rate and associated economic terms

Date: January 17, 2015

Repo rate;reverse repo rate; Marginal standing facility;Liquidity adjustment ratio; CRR

RBI cuts repo rate by 25 basis points

 

The Reserve Bank of India (RBI) has decided to cut the benchmark interest rate by 0.25 per cent to 7.75 per cent under the liquidity adjustment facility (LAF), to boost growth and softening inflation. The RBI has kept  the cash reserve ratio (CRR), the portion of deposits unchanged at 4.0 per cent. Following reduction in the repo rate, the reverse repo rate has been adjusted to 6.75 per cent and the marginal standing facility (MSF) rate and Bank Rate to 8.75 per cent.

Important Economic Terms

Marginal Standing Facility-

 Marginal Standing Facility (MSF) is a new scheme announced by the Reserve Bank of India (RBI) in its Monetary Policy (2011-12) and refers to the penal rate at which banks can borrow money from the central bank over and above what is available to them.

MSF, being a penal rate, is always fixed above the repo rate. The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility by pledging through government securities, which has lower rate of interest in comparison with the MSF. The MSF would be a penal rate for banks and the banks can borrow funds by pledging government securities within the limits of the statutory liquidity ratio. The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.

Liquidity adjustment facility (LAF)-

Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity.LAF consists of repo and reverse repo operations. Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the system. Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system. The collateral used for repo and reverse repo operations comprise of Government of India securities. Oil bonds have been also suggested to be included as collateral for Liquidity adjustment facility.

Cash reserve Ratio (CRR)

Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system. 

Repo Rate

Repo Rate is the rate at which the RBI lends money to commercial banks. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. The repo rate in India is similar to the discount rate in the US.

Reverse Repo rate

Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.