Reserve Bank of India – Structure, Functions and Monetary Policy

---

Repo Rate

The Repo Rate is the interest rate at which the Reserve Bank of India lends money to commercial banks for a short term, against the collateral of government securities. It’s the most powerful tool in the RBI’s monetary policy toolkit.

Simple Analogy: Think of the Repo Rate as the interest rate that your main bank (the RBI) charges you (a commercial bank like BoB or HDFC) for an overnight loan.

How Repo Rate Works

When commercial banks face a shortage of funds, they can borrow money from the RBI. In return, they pledge government securities (like bonds) as collateral. The rate at which the RBI lends this money is the Repo Rate. The name “Repo” comes from Repurchase Option, as it involves an agreement by the commercial bank to repurchase the securities at a predetermined future date and price.

Role of the Repo Rate in the Economy

The Repo Rate is the primary instrument the RBI uses to control inflation and manage economic growth. By changing this single rate, the RBI can influence the entire financial system.

To Control High Inflation (Hawkish Stance)

• Action: The RBI increases the Repo Rate 🔼.
• Impact Chain:
  1. Borrowing from the RBI becomes more expensive for commercial banks.
  2. Commercial banks, in turn, increase their own lending rates for the public (e.g., home loan, car loan, and personal loan interest rates go up).
  3. This discourages people and businesses from taking new loans.
  4. Spending in the economy reduces, which helps to bring down the demand for goods and services.
  5. This reduction in demand helps to control inflation.

To Stimulate Economic Growth (Dovish Stance)

• Action: The RBI decreases the Repo Rate 🔽.
• Impact Chain:
  1. Borrowing from the RBI becomes cheaper for commercial banks.
  2. Commercial banks pass on this benefit by lowering their lending rates for the public.
  3. Cheaper loans encourage people to borrow more for things like homes and cars, and for businesses to invest in new projects.
  4. Spending and investment in the economy increase.
  5. This boost in demand and investment helps to stimulate economic growth.

Summary of Impact

RBI Action	Impact on Banks	Impact on Public	Economic Outcome
Increase Repo Rate	Cost of borrowing from RBI rises.	Loans (home, car) become expensive.	Reduces money supply, Controls Inflation.
Decrease Repo Rate	Cost of borrowing from RBI falls.	Loans (home, car) become cheaper.	Increases money supply, Boosts Growth.

---

Reverse Repo Rate

The Reverse Repo Rate is the interest rate at which the Reserve Bank of India (RBI) borrows money from commercial banks for a short term.

It’s the exact opposite of the Repo Rate.

Simple Analogy: Think of the Reverse Repo Rate as the interest rate you (a commercial bank) earn for parking your excess funds with your main bank (the RBI).

---

How Reverse Repo Rate Works

When commercial banks have surplus funds they don’t need for their lending or operational activities, they can deposit this money with the RBI. The RBI pays them interest on these deposits, and that interest rate is the Reverse Repo Rate. This process helps the RBI to absorb excess money from the financial system.

---

Role of the Reverse Repo Rate in the Economy

The Reverse Repo Rate is a key tool used by the RBI to manage liquidity (the amount of money) in the banking system. It works as a floor for the interest rate corridor.

To Absorb Excess Liquidity (Fight Inflation)

• Action: The RBI increases the Reverse Repo Rate 🔼.
• Impact Chain:
  1. Parking funds with the RBI becomes more attractive for commercial banks, as they can earn a higher, risk-free interest.
  2. Banks are encouraged to deposit their surplus money with the RBI instead of lending it out to the public or businesses.
  3. This sucks out excess money from the banking system.
  4. With less money available to lend, the overall money supply in the economy tightens, which helps in controlling inflation.

To Inject Liquidity (Boost Growth)

• Action: The RBI decreases the Reverse Repo Rate 🔽.
• Impact Chain:
  1. Parking funds with the RBI becomes less attractive for commercial banks due to lower returns.
  2. Banks are encouraged to lend out their surplus funds to the public and businesses rather than depositing them with the RBI.
  3. This increases the money available for lending in the banking system.
  4. An increased money supply can lead to lower lending rates, which helps to stimulate economic growth.

Summary of Impact

RBI Action	Impact on Banks	Economic Outcome
Increase Reverse Repo Rate	More attractive to park funds with RBI.	Reduces liquidity/money supply, Helps control inflation.
Decrease Reverse Repo Rate	Less attractive to park funds with RBI.	Increases liquidity/money supply, Helps boost growth.

---

Cash Reserve Ratio

The Cash Reserve Ratio (CRR) is the percentage of a commercial bank’s total deposits that it is mandatory for them to keep with the Reserve Bank of India (RBI) in the form of cash.

Simple Analogy: Think of the CRR as the portion of your pocket money that your parents require you to keep in a safe box at home, which you cannot spend.

How CRR Works and Its Purpose

Every bank has to maintain a certain minimum amount of cash reserves with the central bank. This amount is calculated as a percentage of its Net Demand and Time Liabilities (NDTL), which is essentially the sum of all its demand deposits (like current and savings accounts) and time deposits (like fixed deposits).

A crucial point to remember is that banks earn no interest on the money they park with the RBI as CRR.

The CRR serves two main purposes:

1. Safety & Liquidity: It ensures that a portion of a bank’s deposits is always safe with the RBI, providing a cushion to meet sudden, large-scale withdrawal demands from customers.
2. Monetary Policy Tool: It is a powerful instrument for the RBI to control the money supply in the economy.

Role of CRR in the Economy

By changing the CRR, the RBI can directly influence the amount of money that banks have available to lend.

To Control High Inflation (Tighten Money Supply)

• Action: The RBI increases the CRR 🔼.
• Impact Chain:
  1. Banks are required to park a larger percentage of their deposits with the RBI.
  2. This reduces the amount of lendable funds available with the commercial banks.
  3. With less money to lend, banks may increase their lending rates.
  4. This reduces credit and money supply in the economy, helping to curb inflation.

To Stimulate Economic Growth (Increase Money Supply)

• Action: The RBI decreases the CRR 🔽.
• Impact Chain:
  1. Banks need to keep a smaller percentage of their deposits with the RBI.
  2. This frees up more funds for the commercial banks.
  3. With more money available to lend, banks may lower their lending rates.
  4. This increases credit and money supply in the economy, encouraging investment and boosting growth.

Summary of Impact

RBI Action	Impact on Banks’ Lendable Funds	Impact on Money Supply	Economic Outcome
Increase CRR	Decreases 🔽	Decreases 🔽	Helps control inflation
Decrease CRR	Increases 🔼	Increases 🔼	Helps boost growth

---

Statutory Liquidity Ratio

The Statutory Liquidity Ratio (SLR) is the percentage of a commercial bank’s total deposits that it is mandatory for them to maintain in the form of liquid assets.

Simple Analogy: While CRR is like cash you must keep in a safe box, SLR is like a mandatory investment you must make in safe, easily sellable assets (like gold or government bonds) before you can use the rest of your money.

How SLR Works and Its Purpose

Every bank must maintain a certain percentage of its Net Demand and Time Liabilities (NDTL) as liquid assets. Unlike CRR, which must be kept with the RBI, banks keep their SLR assets with themselves.

The SLR serves two primary purposes:

1. Ensuring Solvency: It ensures that a bank always has a minimum cushion of liquid assets to meet unexpected, large-scale withdrawals from depositors. This protects the bank from failure.
2. Financing the Government: By requiring banks to invest in government securities, SLR creates a captive and stable market for government bonds, helping the government to finance its fiscal deficit.

What are Liquid Assets?

For the purpose of SLR, liquid assets include:

• Cash (held by the bank itself).
• Gold.
• Government Securities (G-Secs): These are bonds issued by the central and state governments.

Role of SLR in the Economy

Like CRR, the SLR is a monetary policy tool used by the RBI to control the expansion of bank credit.

To Control High Inflation (Tighten Money Supply)

• Action: The RBI increases the SLR 🔼.
• Impact Chain:
  1. Banks are required to hold a larger portion of their funds in the form of liquid assets.
  2. This reduces the amount of money available with the banks to lend to businesses and the public.
  3. A reduction in available credit helps to tighten the money supply in the economy, which in turn helps to control inflation.

To Stimulate Economic Growth (Increase Money Supply)

• Action: The RBI decreases the SLR 🔽.
• Impact Chain:
  1. Banks need to hold a smaller portion of their funds as liquid assets.
  2. This frees up more funds for the banks to lend out.
  3. An increase in the availability of credit can lead to lower interest rates, encouraging borrowing and investment, thereby boosting economic growth.

Summary of Impact

RBI Action	Impact on Banks’ Lendable Funds	Impact on Money Supply	Economic Outcome
Increase SLR	Decreases 🔽	Decreases 🔽	Helps control inflation
Decrease SLR	Increases 🔼	Increases 🔼	Helps boost growth

---

Open Market Operations

Open Market Operations (OMOs) are a monetary policy tool used by the Reserve Bank of India (RBI) to manage the money supply in the economy by buying or selling government securities (G-Secs) in the open market.

It’s one of the most effective and flexible tools the RBI has for managing day-to-day liquidity in the banking system.

How OMOs Work

The process is quite straightforward:

• The Buyer/Seller: The RBI.
• The Goods: Government Securities (G-Secs), which are like IOU slips from the government.
• The Market: The open market, where the RBI trades with commercial banks, financial institutions, and the public.

By conducting these transactions, the RBI can directly increase or decrease the amount of money in the banking system.

The Role of OMOs in the Economy

OMOs are used to fine-tune the money supply to meet the objectives of monetary policy, which are typically to control inflation or stimulate growth.

To Inject Liquidity (Increase Money Supply)

This is done to stimulate the economy, especially during a slowdown.

• Action: The RBI buys government securities from the market (from commercial banks).
• Impact Chain:
  1. The RBI pays the banks for these securities.
  2. This payment injects money directly into the banking system.
  3. Commercial banks now have more funds available to lend to the public and businesses.
  4. This increase in the money supply can lead to lower interest rates, which encourages borrowing and spending, thereby boosting economic growth.

To Absorb Liquidity (Decrease Money Supply)

This is done to fight inflation by tightening the money supply.

• Action: The RBI sells government securities in the market.
• Impact Chain:
  1. Commercial banks and other entities buy these securities from the RBI.
  2. They pay the RBI for these securities, which effectively transfers money from the banking system to the RBI.
  3. This sucks out excess money from the system.
  4. With less money available to lend, the growth of credit slows down.
  5. This reduction in money supply helps to control inflation.

Summary of Impact

RBI Action	Purpose	Impact on Banks’ Funds	Impact on Money Supply	Economic Outcome
Buys G-Secs	Inject Liquidity	Increases 🔼	Increases 🔼	Helps boost growth
Sells G-Secs	Absorb Liquidity	Decreases 🔽	Decreases 🔽	Helps control inflation