Economic terms demystified

Have made an attempt to explain some common terms that we come across in newspapers like Repo , CRR, SLR in layman's language. Hope you'd find it useful. Your suggestions are always welcome.

1. What is a Repo?

Repo stands for repurchase agreement. It is an agreement between a borrower and a lender wherein the lender lends cash to the borrower which deposits a financial security as collateral. The borrower also promises to repurchase the security by paying a fixed price to the lender at a future date. So it boils down to a scenario where the borrower sells a security to the lender and repurchases it when the contract comes to an end.

Let's say bank A is in urgent need of funds for 7 days. So it approaches bank B (which is dealer in Repos). Bank B says I can lend you funds but with two conditions:
i. You need to keep the financial security as collateral
ii. You have to repurchase the security after 7 days at a fixed price

So this translates to an agreement where Bank B is the lender and Bank A is the borrower. Bank A borrows cash by selling the security to B and B in turn sells it back to A at a higher price.
Let's give some numbers to this transaction. Bank A needs INR 1000 for 7 days. So Bank B lends INR 1000 to A today with the promise that it'd sell the security back to A after 7 days at a price higher than 1000. So it is as simple as a transaction where somebody gives you a short term loan today and collects the principal and interest after 7 days from you.

The difference between the loan amount taken today and the repurchase price of the borrower after 7 days is the interest paid by the borrower to the lender.

For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for the party on the other end of the transaction, (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement.

2. What is a repo rate?

In Indian banking scenario, repo rate is the rate at which our banks borrow rupees from RBI. Try to draw a parallel with the repo agreement that we discussed above. Here the Commercial Banks (CBs) are in a repo agreement with RBI. Whenever commercial banks have any shortage of funds then they can borrow from RBI at the prevailing repo rate.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. What does this imply for people like you and me? When RBI decreases repo rate it becomes easier for CBs to borrow short term funds from RBI. In this way RBI injects liquidity into the system.

3. What is a reverse repo rate?

It is the rate at which banks park their short-term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI Just try to draw a parallel between the role of RBI here and the role of bank B in the 1st example.

4. What is CRR?

It stands for Cash Reserve Ratio.

The primary business model for commercial banks is that they accept deposits and disburse loans. Deposits are liabilities for banks since they owe principal and interest to the depositors. loans are assets for the bank since the borrowers owe money to the bank and hence banks see an income generating ability in loans. The difference between the deposit rate and the lending rate is their profit. Hence lending rate is always greater than the deposit rate. However since banks deal with money of others they can't function as per their whims and fancies. They need to be regulated. Here comes RBI into the picture.

Banks in India are required to hold a certain proportion of the deposits in the form of cash. However, actually Banks don’t hold these as cash with themselves, but deposit such cash with Reserve Bank of India (RBI) / currency chests, which is considered as equivalent to holding cash with themselves.. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. Thus, When a bank’s deposits increase by Rs100, and if the cash reserve ratio is 10%, the banks will have to hold additional Rs 10 with RBI and Bank will be able to use only Rs 90 for investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be able to use for lending and investment.

This power of RBI to reduce the amount that can be lent by increasing the CRR, makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system.

5. What is SLR?

It stands for Statutory Liquidity Ratio. This term is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and some other approved to liabilities (deposits) It regulates the credit growth in India.

6. What is Bank Rate ?

This is the rate at which central bank (RBI) lends money to other banks or financial institutions. If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can said that in case bank rate is hiked, in all likelihood banks will hike their own lending rates to ensure and they continue to make a profit

7. What is the difference between Bank rate and repo rate?

Bank rate indicates the long term outlook of RBI on interest rates while repo rate increase or decrease is used as a tool for short term liquidity injection into/out of the system.

8. What is Prime Lending Rate?

Interest rate charged by banks to their largest, most secure, and creditworthy customers on short-term loans. This rate is used as a guide for computing interest rates for other borrowers.

RBI changes prime lending rate system to base rate

Reason:In the existing system, banks are free to fix their PLRs. Most of the variable rate loans, like home loan and some of the term loans are pegged against PLR. This means, if the PLR is not changed, the loan rates remain the same. Banks have taken advantage of existing PLR system at the cost of their borrowers. When interest rates increase, banks hike their PLRs immediately, leading to rise in the home loan rates. But, when interest rates fall, they don't reduce PLRs. Because of this, the existing customers are not benefited by the lowering of the interest rates.
Moreover, there is no transparency in the way banks treated top corporate clients and common borrowers. Banks normally lend at much lower rates, as low as 5-6 per cent, to woo corporate borrowers while common borrowers pay a much higher rate.

What is new in base rate? :

Home loans and other variable loans will be pegged against a base rate. As the new base rate is fixed on the basis of cost of funds, any change in the interest rate will reflect in the base rate. And therefore, it will be automatically passed on to the existing customers also. Banks are unlikely to be given any exemption on short-term loans (allowing them to lend below the base rate to corporate clients) in the base rate model three categories of loans are exempt from from the base rate's ambit. they are -- staff loans, loans against fixed deposits and loans under the differential rate of interest scheme

When is it going to be effective from?

This was earlier slated to be effective from April 1st. But due to demand from banks to postpone, this has been postponed to July 1st.