Page 32 - Banking Finance July 2020

ARTICLE

part of its monetary policy measures sets the following rate penalty for premature closure in term deposits. Another
to control the liquidity in the economy. factor is the amount of fund available with banks. If banks
Y Repo: in repo or the repurchase agreement, Banks sells are unable to invest or lend to the tune of funds availability
fixed-income securities to RBI at one price and commits and have excess liquidity then also banks offer lesser rate
to repurchase the same assets from the central bank as the demand for money is less and they face difficulties to
at a different price at a future date. The rate at which pay higher rates on idle funds.
interest is paid on these securities is called Repo rate.
In a simplest way we can say that the rate of interest Now let us see how the lending rates are decided. The
at which the RBI lends short term money to banks is common equation for interest rate is
called repo rate.

Y Reverse Repo: In a reverse repo transaction the Interest Rate = Risk free rate + Other cost + Credit
(default)Risk Premium + Tenor Risk Premium +/-Strategic
opposite of above transaction takes place. So reverse
repo rate is the rate at which the RBI borrows money Premium/Discount
from commercial banks within the country.
Here risk free rate is decided depending upon the cost of
Y MSF-Marginal Standing facility: It is a special window
the funds and guidelines issued by central bank time to time.
for banks to borrow from RBI against approved
Then other costs like operational cost, capital charge etc.
government securities in an emergency situation like an are added to it to get the benchmark rate. Credit (default)
acute liquidity shortage. MSF rate is higher than repo
risk premium depends on the risk profile of the exposure
rate.
which is derived from past experience, market information
Y Bank Rate: This is the long term rate(repo rate is for etc. Tenor premium is also one kind of risk premium which
short term) at which central bank lends money to other arises out of the extra risks that banks have to bear due to
banks or financial institutions. longer expiry of the exposure as the external factors change
over a longer period of time and with that the repayment
Which rates ultimately offered to capacity of the borrower. Strategic premium or discount is
Consumers: decided depending upon the strategy adopted by higher
management. These all are added to the benchmark rate
Consumers are defined as the ultimate user who invest or
to get the card rate.
borrow the funds at grassroots levels i.e. business houses,
salaried individuals or pensioners. Banks accept deposits and
Over the years banks have used different rates as benchmark
pays interest and then lends that money and charge interest
rates such as Benchmark Prime Lending Rate (BPLR), Base
(price) on that. Other than that, banks also have to maintain Rate and Marginal Cost of Fund-Based Lending Rate (MCLR)
a certain level of capital for their lending portfolio. Let us
etc. At present banks are using a new benchmark rate called
first see how deposit rates are defined in banks.
External Benchmark Lending Rate (EBLR) for MSME and
Asset-Liability Committee (ALCO) in banks decides these
rates. Bank can raise funds by accepting deposits, borrowing
from market or borrowing from RBI as we have discussed
earlier in repo. Cost of raising fund is different from different
sources. So depending upon the rates of other sources bank
decides on rates to offer to its depositors. Another factor is
time i.e. the period for which the fund is available with banks.
If the fund is available for a longer period, banks tend to
offer a higher rate than those with shorter period as with a
fund available for longer period bank's treasury can take a
better investment decision and get a good return. That is
the reason why banks offer lower rates in savings bank
account than a term deposit account and also charge

32 | 2020 | JULY | BANKING FINANCE