Structure of Interest Rates in India

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INTEREST RATES IN INDIA

BANK RATE

Bank Rate is the rate at which central bank of the country (in India it is RBI) allows finance to

commercial banks. It is a tool, which central bank uses for short-term purposes.

Any upward revision in Bank Rate by central bank is an indication that banks should also

increase deposit rates as well as Prime Lending Rate.

In 1962 there was Chinese aggression that required more money to be diverted in warhence there was rise in inflation that lead to increase in Bank rate.

CRR (CASH RESERVE RATIO)

Banks are required to maintain a percentage of their deposits as cash, and can use only the

remaining amount for lending/investment. This minimum percentage which is determined by the

central bank is known as Cash Reserve Ratio.

E.g.So if CRR is 6% then it means for every Rs. 100/- deposited in bank, it has to maintain a

minimum of Rs. 6/- as cash. However banks do not keep this cash with them, but are required to

deposit it with the central bank, so that it can help them with cash at the time of need.

SLR (STATUTORY LIQUID RATIO)

Apart from keeping a portion of deposits with the RBI as cash, banks are also required to

maintain a minimum percentage of deposits with them at the end of every business day, in the

form of gold, cash, government bonds or other approved securities. This minimum percentage iscalled Statutory Liquidity Ratio.

E.g.If you deposit Rs. 100/- in bank, CRR being 6% and SLR being 8%, then bank can use 100-

6-8= Rs. 84/- for giving loan or for investment purpose.

The SLR was stable till 1963.In 1964 India had IMF debt that led to inflation hence the steep. It

Kept on increasing due to Bangladesh War 1971, 72-74 the price situation worsened.

CALL MONEY RATE

It is the money used to finance short term needs and lend short term surpluses, ranging fromovernight to maximum tenor of 14 days.

Overnight usually means 12:00 p.m. one day to 12:00 p.m. the next day.

If the lending period is more than 24 hours then it is called as notice money.


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Usually brokers and dealers borrow money from call money market to cover their customers

margin accounts or finance their own inventory of securities. Banks act as both lenders and

borrowers of this market.

REPO RATE

Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the

rate at which our banks borrow rupees from RBI.

A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate

increases borrowing from RBI becomes more expensive. (Repo Rate signifies the rate at which

liquidity is injected in the banking system by RBI)

To control the inflation government has to control the repo rate and reverse repo rate and

generally both are controlled together.

2003 the repo rate and reverse repo rate is very low due to control the inflation which was 8.3 soto absorb the liquidity form the economy.

REVERSE REPO RATE

Reverse repo rate is the rate of interest at which the central bank borrows funds from other banks

for a short duration. The banks deposit their short term excess funds with the central bank and

earn interest on it.

Reverse Repo Rate is used by the central bank to absorb liquidity from the economy. When it

feels that there is too much money floating in the market, it increases the reverse repo rate,

meaning that the central bank will pay a higher rate of interest to the banks for depositing moneywith it. (Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the

banks)

PLR

The prime lending rate is what banks charge their best customers. It is based on the RBI rate

It is important because it affects liquidity in the financial markets. A low rate increases liquidity

by making loans less expensive, therefore easier to get. When prime lending rates are low,

businesses expand and so does the economy.

Similarly, when the prime lending rate is high, then liquidity dries up, and the economy will start

to slow. For this reason, banks will usually only raise the prime lending rate when the RBI rate is

increased. This is true even though banks would technically make more on an individual loan

when rates are higher. However, since this would decrease the number of loans applied for, this

would slow the loan business overall.


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For example, a Blue Chip company may borrow at a prime rate of 5%, but a less-well-established small

business may borrow from the same bank at prime plus 2, or 7%.

What Does London Interbank Offered Rate (LIBOR) Mean?

LIBOR is the interest rate that the most credit-worthy banks around the world charge each otherfor loans ranging from twenty-four hours to five years. This global inter-bank market provides a

means for financial institutions with excess capital to earn higher rates of return by its loaningliquid assets to those in need of the funds. It is fixed on a daily basis by the British Bankers'

Association.

Base Rate

The Base Rate is the minimum interest rate of a Bank below which it cannot lend, except for DRI

advances, loans to bank's own employees and loan to banks' depositors against their own deposits. (i.e.

cases allowed by RBI)

RBI had made it mandatory for all banks to introduce Base Rate wef 1st July, 2010.
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Structure of Interest Rates in India