Understanding Policy Rates and Credit Controls in India’s Banking System: A Comprehensive Guide for Banking Students
Hello, banking students! Welcome back to the Pareeksha, where we make learning about India’s banking system easy and fun. In this article, we’ll explore how policy rates and credit controls work in the banking system. The Reserve Bank of India (RBI) plays a vital role in maintaining monetary stability and economic growth in the country. We’ll take a closer look at various policy rates, reserve ratios, open market operations, and qualitative credit controls to understand how the RBI regulates the flow of money in the economy. So, let’s get started!
Money flows through various transactions in the economy, and most of it goes in and out of commercial banks. Banks pay interest to depositors and earn income by lending money to those who need it for various purposes. The RBI acts as a banker to the banks and provides them with money in case of a bank failure. To maintain monetary stability, the RBI uses various policy rates and credit controls. Let’s explore them in detail.
1. Money Flows in the Banking System
The Reserve Bank of India (RBI) Act, 1934, was amended in 2016 to establish a Monetary Policy Committee that aims to maintain price stability and promote economic growth.
When the RBI releases money into the economy, it circulates through various transactions, such as government payments, subsidies, and purchasing goods and services. A part of this money is kept by recipients, and the rest goes back into bank accounts.
Most of the money in the economy moves in and out of commercial banks, where businesses and households maintain their accounts. Banks pay interest to depositors and earn income by lending money to those who need it for various purposes.
If all depositors were to withdraw their money at once, a bank would not be able to pay them, leading to a bank failure. That’s where the RBI comes in, acting as a banker to the banks and providing them with money.
2. Types of Reserve Ratios
i) Cash Reserve Ratio (CRR): All banks must maintain a minimum CRR of their Net Demand and Time Liabilities (total deposits) with the RBI as cash. There is no ceiling limit, and the CRR helps secure monetary stability in the country.
For example, if a bank receives Rs100 in deposits and the CRR is 10%, it has to deposit Rs10 with the RBI. It can now lend Rs90, which will eventually reach another bank that has to deposit Rs9 with the RBI.
ii) Statutory Liquidity Ratio (SLR): Banks must maintain a portion of their total deposits with the RBI as cash, gold, or approved securities. There is no floor rate, but the ceiling is 40%. The SLR helps banks hold a certain percentage of their Net Demand and Time Liabilities in the prescribed forms.
That’s a brief overview of how money flows in India’s banking system. Good luck with your studies, and stay tuned to the Pareeksha Blog for more educational content!
3. Policy Rates
i) Repo Rate: This is the rate at which banks sell securities to the RBI, with a promise to buy them back at a predetermined date and interest rate. When the RBI reduces the Repo Rate, banks can borrow more at a lower cost. Repo rate loans are short-term, ranging from 1 to 90 days.
ii) Reverse Repo Rate: This is the rate at which the RBI borrows money from banks. An increase in this rate can make banks transfer more funds to the RBI due to attractive interest rates, allowing the RBI to withdraw excess money from the banks.
iii) Marginal Standing Facility (MSF): MSF is an overnight borrowing facility from the RBI, with a minimum amount of Rs. 1 crore. Only scheduled commercial banks are eligible, and no additional security is required.
iv) Bank Rate: This is the interest rate at which the RBI lends money to domestic banks, either through direct lending or by rediscounting bills. Bank rate is also known as the discount rate and is used for long-term lending (up to 365 days).
4. Open Market Operations (OMO):
OMO involves the RBI purchasing government securities to infuse liquidity, or selling government securities to remove liquidity from the system.
5. Quantitative Credit Controls:
- Policy Rates:
- Bank Rate
- Repo & Reverse Repo Rates
- Reserve Ratios:
- Cash Reserve Ratio (CRR)
- Statutory Liquidity Ratio (SLR)
- Open Market Operations
6. Qualitative Credit Controls:
- Margin Requirements
- Rationing of Credit
- Regulation of Consumer Credit
- Moral Suasion
- Direct Action
- RBI Guidelines
That’s it, folks! Now you have a clearer understanding of policy rates and credit controls in the Indian banking system. Good luck with your studies, and stay tuned to the Pareeksha Blog for more educational content!