LAF Repo Rate: The Single Policy Rate-VRK100-23Jul2013

  

Rama Krishna Vadlamudi, HYDERABAD      23 July 2013
www.ramakrishnavadlamudi.blogspot.com

As shown in the above graph, Repo Rate under RBI’s Liquidity Adjustment Facility (LAF) has been declining indicating the gradual easing of monetary policy stance by RBI following the moderation of inflationary pressures.

Before the introduction of revised operating monetary policy in May 2011, Reserve Bank of India (RBI) had been using various monetary instruments to signal the monetary policy stance. Since May 2011, RBI has been using Repo Rate as the single policy rate and all the other policy rates are linked to the Repo Rate. Rates that are linked directly to Repo Rate are: Reverse Repo Rate and Marginal Standing Facility (MSF) Rate. Bank Rate is indirectly linked to Repo Rate. Reverse Repo rate is kept at 100 basis points (or one percentage point) below Repo Rate.

Short-term interest rates represented by call money rates and CBLO rates are supposed to move in a range between the Repo Rate and the Reverse Repo Rate. LAF Corridor is the excess of LAF-Repo Rate over the LAF-Reverse Repo Rate. The objective of RBI is to keep the short term interest rates in the banking system within this LAF corridor.

Timeline for LAF Repo Rate:

The following is a timeline of Liquidity Adjustment Facility (LAF) and Repo Rate:

April 1998	The Narasimham Committee II on Banking Sector Reforms recommended introduction of LAF
5 June 2000	RBI introduced a full-fledged LAF
16 Aug. 2004	One-day fixed rate reverse repo was re-introduced while continuing with the 7-day and 14-day reverse repos and overnight fixed rate repos
29 Oct. 2004	The nomenclature of repo and reverse repo were interchanged as per international usage
1 Nov. 2004	The 7-day fixed rate and 14-day variable reverse repos were phased out and the LAF was operated through overnight fixed rate repo & reverse repo

Salient Features of RBI’s LAF:

Ø  Liquidity Adjustment Facility (LAF) is a facility by which the RBI adjusts the daily liquidity in the domestic markets (India) either by injecting funds or by withdrawing them out

Ø  The LAF enables the RBI to smoothen short-term liquidity under varied financial market conditions, ensuring stable conditions in the overnight (call) money market

Ø Repo denotes injection of liquidity by RBI against collateral of eligible instruments. Repo rate is the rate at which RBI lends overnight funds to banks.

Ø Reverse Repo denotes absorption of liquidity by RBI against collateral of eligible instruments. Under Reverse repo, banks park their surplus overnight funds with the RBI and the RBI pays interest to banks at the Reverse repo rate.

Ø Both the Repo and Reverse Repo operations are conducted at a fixed rate

Ø The Repo rate is fixed by RBI from time to time. At present, Repo rate is 7.25 percent. Reverse Repo rate is pegged at 100 basis points below the Repo rate and as such the current Reverse Repo rate is 6.25 percent.

Ø  All Scheduled Commercial Banks (excluding Regional Rural Banks) and Primary Dealers are permitted to participate in Repo and Reverse Repo auctions

Ø   The minimum bid size will be Rs 5 crore and in multiples of Rs 5 crore thereafter

Ø  The LAF avoids targeting a particular level of overnight money market rate due to external factors impacting short-term liquidity, such as volatile government cash balances and unpredictable foreign exchange flows

Ø Repos and Reverse Repos are undertaken in all SLR-eligible transferable Government of India Dated Securities/Treasury Bills

Ø A margin of five percent is required for the above eligible securities. The amount of securities offered or tendered on acceptance of a bid for Rs.100 will be Rs.105 in terms of face value.

Ø In this direction, the LAF introduced in June 2000 has now emerged as the principal operating instrument of monetary policy

RBI’s Measures to Curb Exchange Rate Volatility:

The measures concerning LAF taken by RBI on 15Jul2013 to rein in rupee volatility are:

ü   The MSF rate has been readjusted to 300 basis points (from the earlier 100 basis points) above the policy Repo rate under the Liquidity Adjustment Facility (LAF). As such, the MSF rate is raised to 10.25 per cent from 8.25 percent with effect from 16Jul2013.

ü   With effect from 17Jul2013, the total amount under RBI’s LAF is restricted to one percent of the net demand and time liabilities (NDTL) of the banking system, reckoned as Rs 75,000 crore (Earlier, there was no such quantitative restriction)

Additional measures concerning LAF taken by RBI on 23Jul2013 to curb rupee volatility are:

ü The overall limit for access to LAF by each individual bank is set at 0.5 per cent of its own NDTL. This measure will come into effect immediately, i.e., from 24 July 2013 and will remain in force until further notice.

ü The earlier instructions issued by RBI on 15Jul2013 regarding cap on overall allocation of funds at Rs 75,000 crore under LAF stand withdrawn

LAF Repo Rate: The Single Policy Rate:

As part of the Deepak Mohanty Committee Report (March 2011) on the operating procedure of the monetary policy, the RBI in its Annual Policy statement 2011-12 made the following important changes with effect from 03 May 2011*:

1  The weighted average overnight call money rate will be the operating target of monetary policy of the RBI

2 There will henceforth be only one independently varying policy rate and that will be the repo rate. The transition to a single independently varying policy rate is expected to more accurately signal the monetary policy stance.

All central banks have a single policy rate for liquidity and monetary management. Now, RBI too is following the international norm of a single policy rate. All the refinance facilities (e.g., export refinance and general refinance) provided by RBI are at the Repo Rate. At present, Repo Rate has emerged as the single policy rate to unambiguously signal the stance of monetary policy to achieve macroeconomic objective of growth with price stability.

(* Before 03May2011, RBI was using both LAF Repo rate and LAF Reverse Repo rate as policy rates to signal monetary policy actions).

To Sum Up:

The RBI has over the years has used a variety of direct and indirect instruments to signal monetary policy actions. Prior to late 1990s, monetary policy was conducted with the help of direct instruments, such as, SLR, CRR, and selective credit control.

In an effort to move away from direct instruments of monetary control to indirect instruments in a market-based economy, a fundamental change in the conduct of monetary policy in India was effected through the introduction of LAF in June 2000. Since then, the LAF scheme has evolved in a series of steps taken by RBI to move towards monetary management based on short-term market interest rates.

With the adoption of Deepak Mohanty Committee recommendations, LAF Repo rate has become the single policy rate and overnight call monetary rate has become the operating target for conducting monetary policy in India. 

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Annexure 1:

Direct instruments of monetary control used by RBI in the past were:

§       Prescribing deposit and lending rates of commercial banks

§       Selective credit control over sensitive commodities

§       Sector-specific standing facilities

§       Statutory liquidity ratio (SLR) & Cash reserve ratio (CRR); and

§       Bank Rate

Indirect monetary policy instruments  are:

§       Open market operations (OMO)

§       Purchase and repurchase of government securities

§       LAF Repo rate and Reverse Repo rate

§       Marginal Standing Facility Rate (MSF)

§       Market Stabilization Scheme or MSS (used for sterilization of large capital flows)

Notes: CBLO-Collateralized Borrowing and Lending Obligation of the Clearing Corporation of India Limited. It is a money market instrument through which CCIL imparts liquidity to market participants.

Reference: Report of the Deepak Mohanty committee, other RBI reports and Paper by Rakesh Mohan on Monetary Policy Transmission,

Disclaimer: The author is an investment analyst and freelance writer. His articles on financial markets and Indian economy can be reached at:

http://ramakrishnavadlamudi.blogspot.in/ and www.scribd.com/vrk100

Bank Rate: Is It Relevant Now?-VRK100-23Jul2013

Rama Krishna Vadlamudi, HYDERABAD      23 July 2013
www.ramakrishnavadlamudi.blogspot.com

As the above graph illustrates, Bank Rate had been kept in comatose for almost a decade between 2003 and 2012. Suddenly, one fine morning in 2012 RBI rediscovered the Bank Rate and raised it by 350 basis points (or 3.5 percentage points) to 9.50 percent. Since then, it has been revised on five other occasions as shown in the above graph.  

The reactivation of Bank Rate since 2012 is broadly on the lines of the report (March 2011) of the Deepak Mohanty Committee on the operating procedure of the monetary policy. This article explores the relevance of Bank Rate in the context of monetary policy. 

What is Bank Rate?:

Informally, Bank Rate is the rate of interest charged by a central bank on the funds lent to banks. However, under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as “the standard rate at which the RBI is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under this Act.” Bank Rate is essentially a discount rate.

Since its introduction in 1935, the Bank Rate was revised by RBI on 35 occasions till now. At present, the Bank Rate is 10.25 percent. (Bank Rate was 3.5 percent when it was first introduced in 1935). Bank Rate has been made equal to Marginal Standing Facility (MSF) rate since 13 February 2012 and so whenever the MSF rate is revised, the Bank Rate also gets revised.

Interestingly, the MSF Rate itself is linked to LAF-Repo rate, with a positive spread of 300 basis points (or 3 percentage points) over the Repo rate. So practically, Bank Rate changes whenever the Repo rate is revised by RBI or the spread between the Repo Rate and the MSF Rate is changed. Now, Repo Rate is the single policy rate used by RBI for setting interest rates (monetary management) in the economy. The current rates of RBI’s policy rates and reserve ratios are given below:

RBI’s Policy Rates				RBI’s Reserve Ratios
Rate	%	Effective		Ratio	%	Effective
		Date				Date
LAF-Repo	7.25	3-May-2013		CRR	4.00	9-Feb-2013
LAF-Reverse Repo	6.25	3-May-2013		SLR	23.00	11-Aug-2012
MSF	10.25	16-Jul-2013
Bank Rate	10.25	15-Jul-2013

To know more about MSF and LAF-Repo, just click:

1. Update on Marginal Standing Facility-20Jul2013

2. LAF Repo Rate: Single Policy Rate-23Jul2013

How was Bank Rate used by RBI in the past?

Bank Rate was used by RBI as a general instrument of monetary policy in the past though RBI had used various other instruments also—such as, statutory liquidity ratio (SLR), cash reserve ratio (CRR), selective credit control, open market operations (OMO), and prescribing interest rates on deposits and advances. RBI used to provide short-term funds to commercial banks at Bank Rate against the collateral of eligible instruments.

Bank Rate was also used as a reference rate for various standing facilities, such as general refinance and export refinance, provided by RBI to banks. Bank Rate acted as refinance rate at which liquidity was to be injected to banks and primary dealers (PDs). On a few occasions, it was used for exchange rate management. It was also used for charging penalties on banks for not meeting reserve requirements (CRR and SLR).

The Relevance of Bank Rate Now:

The importance of Bank Rate as an important instrument of monetary control has declined after the introduction of Liquidity Adjustment Facility (LAF) in June 2000 and RBI’s standing facilities to banks/PDs were completely delinked from the Bank Rate. Now, all the refinance facilities are provided at the LAF-Repo Rate, which has emerged as the single signaling rate for monetary policy.

RBI is required to buy or re-discount bills of exchange or other commercial paper at the Bank Rate as per RBI Act, 1934. Since discounting/rediscounting by the RBI has remained in disuse, the Bank Rate had become inactive for several years. Under the revised operating procedure of the monetary policy (since May 2011), the MSF rate has in many ways serves the purposes of Bank Rate as a discount rate.

On 13Feb2012, the Bank Rate was raised by 350 basis points and since then it has been made equal to the MSF Rate. This increase was a one-time technical adjustment by RBI to align the Bank Rate with the MSF Rate and was not to be viewed as a change in the monetary policy stance.

    

The role of Bank Rate is now limited to:

1. It is now used for calculating penalty on default in CRR and SLR requirements as required by Section 42(3) of the RBI Act, 1934 and Section 24 of the Banking Regulation Act, 1949, respectively

  2. The penal interest on shortfalls in CRR and SLR (depending on the duration of the shortfalls) are Bank Rate plus 3.0 percentage points or Bank Rate plus 5.0 percentage points

  3. It is also used by several organizations as a reference point for indexation purposes. For example, under Section 372A of the Companies Act, 1956, inter-corporate loans shall not be made at a rate of interest lower than the prevailing Bank Rate.

For all practical purposes, the Bank Rate has become irrelevant as an instrument of liquidity and monetary management.

Summary:

Over the years, the Bank Rate has had its years of glory and gross negligence. RBI had used it for a variety of purposes—in the process confusing the markets and other stakeholders about the relevance of Bank Rate in liquidity and monetary management. With RBI’s flip-flop on Bank Rate, vague signals were sent to the market. One hopes that in future RBI will follow a consistent policy on Bank Rate. 

Today, the Bank Rate largely plays a technical-but-limited role only. Its role is confined to penalties charged by RBI on banks for not maintaining SLR and CRR requirements. The importance of Bank Rate as a monetary policy instrument has waned after the introduction of LAF-Repo rate in June 2000.

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Notes: LAF-Repo Rate under RBI’s Liquidity Adjustment Facility (LAF) is the rate at which RBI lends overnight funds to banks; CRR – Cash Reserve Ratio; and SLR – Statutory Liquidity Ratio.

Reference: RBI Act, Deepak Mohanty Committee report, other RBI reports and www.mca.org.in.

Disclaimer: The author is an investment analyst and freelance writer. His articles on financial markets and Indian economy can be reached at:

http://ramakrishnavadlamudi.blogspot.in/ and www.scribd.com/vrk100