November 29, 2012

MA0036 [Financial Systems and Commercial Banking] Set1 Q3

Q3. Discuss the quantitative tools of Monetary policy by the Reserve Bank of India to reduce money supply in the economy. 

Ans:

Quantitative Measures aim to control the quantity of money supply directly such as Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open Market Operations (OMO).

Cash Reserve Ratio: It is a quantitative tool of monetary and credit policy to regulate the money supply in the economy. Cash reserve ratio (CRR) is that slice of a bank's deposits, which the bank has to compulsorily deposit with RBI. A CRR of six per cent means that out of every Rs 100, bank has to deposit Rs. 6 with RBI. Interestingly, RBI does not pay any interest on this money to banks. When RBI wants to reduce liquidity from the system, like in times of high inflation, it increases the CRR. RBI by varying the CRR regulates the lend able funds of commercial banks.

An increase in CRR would also mean that money is being sucked out of the system. This would mean that funds are hard to come by and hence banks will have to pay more to depositors in order to induce them to keep their funds with banks. This will push up cost of funds for banks. The banks therefore will also have to raise lending rates in order to meet the increased cost while maintaining their margins. For example RBI has increased the CRR of scheduled banks by 6% of their Net Demand and Time Liabilities (NDTL). As a result of this increase in the CRR, about 12,500 crore of excess liquidity will be absorbed from the system.

Statutory Liquidity Ratio: It is a quantitative tool of monetary and credit policy to regulate the money supply in the economy. Under the provision of Banking Regulation Act governing the banking operations, banks are required to hold liquid assets such as government securities, or other unencumbered approved securities, cash or gold, against their demand and time liabilities as on the last Friday of second preceding fortnight in India. This is known as supplementary reserve requirement or secondary reserve requirement. The main objective of this monetary policy instrument is to ensure solvency of commercial banks by compelling them to hold low risk assets up to a stipulated extent. It also helps to regulate the pace of credit expansion to commercial sector. SLR refers to the ratio of holdings of the prescribed liquid assets to total time and demand liabilities. At present, SLR is 25%, means 25 out of 100 are invested in prescribed liquid assets.

The objectives of SLR are:
1. To restrict the expansion of bank credit.
2. To augment the investment of the banks in Government securities.
3. To ensure solvency of banks. A reduction of SLR rates looks eminent to support the credit growth in India.

Open Market Operations: A monetary policy instrument which is used by the Reserve Bank mainly with a view to affect the reserve bases of the banks and thereby the extent of monetary expansion. It also, in the process, helps to create and maintain a desired pattern of yield on government securities (G-Sec) and to assist the government in raising resources from the capital market. Under the RBI Act, the RBI is authorized to purchase and sell the securities of the Union Government and State Governments of any maturity and the security specified by the Central Government on the recommendation of Bank's Central Board. Presently the RBI deals only in the securities issued by the Union Government. Open market operations are by way outright sale and purchase of securities through the Securities Department and repo and reverse repo transactions. When RBI buys the securities in the open market, It increases the liquidity and reserves of commercial banks, making it possible for banks to expand their loans and investments. If RBI sells the securities, the effects are reversed.

QUALITATIVE MEASURES: They aim to control the quantity of money supply indirectly through cost of credit. These measures are Bank Rate, Repo & Reverse Repo Rates, and Interest Rates etc.

Bank Rate: An instrument of general credit control and represents the standard rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the provisions of the Act. In short, Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate. Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect the lending rates through altering the cost of credit. At present Bank rate is 6%.

Repo Rate: Repo and Reverse Repo Rates are Liquidity adjustment Facility (LAF) tools used by RBI. Repo is an instrument meant for injecting the funds required and Reverse Repo for absorbing the excess liquidity out of system. In bond markets, interest rates are the most important factor, and the RBI controls interest rates. RBI uses various rates like repo, reverse repo and CRR to give direction to interest rates in the country. Take an example Repo refers to 'repurchase obligation'. In case of tight liquidity conditions (as you saw in 2008), when banks need funding for the short term, they approach the RBI and ask for a temporary loan. RBI gives them a loan only after taking some collateral.

This collateral is Government Securities (G-Secs). So banks give G-Secs to RBI and take money to meet their temporary requirements. The interest rate which RBI charges to banks for such short-term loan is known as the repo rate. After the short-term period is over, banks have the obligation to repay the money back to RBI, along with the interest and '' its G-Secs, hence the word repurchase obligation. In short, Banks borrow from RBI or RBI lends to banks at this rate.

It must be understood that when RBI does not want more money to go into the economy, it will raise this rate. When repo rate increases, the cost of money for banks also increases. Banks in turn increase the interest rates for their borrowers. This prevents borrowers from taking loans from banks and thus RBI's objective of controlling money supply is achieved.

Reverse Repo Rate: Reverse repo is that rate which RBI pays to banks. When banks have surplus liquidity and there are not enough borrowings from banks by consumers (as is the condition now), banks park their surplus money with RBI and earn some minimum interest. The rate at which RBI pays interest is known as reverse repo rate. When RBI wants the economy to grow, it will reduce reverse repo rate. By this By doing so, it will give a signal to banks thatinstead of deploying surplus money with RBI for a low return they should deploy the same in projects in the economy, whichwill help to kick-start the economy. In times of ample liquidity, repo rate is practically redundant. Hence you will observe RBI focusing more on cutting reverse repo rates in times of slowdown, as was seen in the recent past.

Liquidity Adjustment Facility (LAF): LAF is a monetary policy instrument introduced in 2000 to modulate liquidity in the system in the short term and to send interest rate signals to the market. LAF operates through repo and reverse repo transactions. RBI conducts repo to inject liquidity into the system through purchase of government securities with an agreement to sell them at a predetermined date and repo rate. In the reverse repo transaction RBI sells securities with a view to absorb excess liquidity with a commitment to repurchase them at a predetermined date and reverse repo rate.

Other instruments of liquidity management are Open Market Operations (OMO) in the form of outright purchase/sale of securities and Market Stabilization Scheme (MSS). Under the OMO, the RBI buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system.

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