Bank Rate: Is It Relevant Now?-VRK100-23Jul2013

Rama Krishna Vadlamudi, HYDERABAD      23 July 2013
www.ramakrishnavadlamudi.blogspot.com

As the above graph illustrates, Bank Rate had been kept in comatose for almost a decade between 2003 and 2012. Suddenly, one fine morning in 2012 RBI rediscovered the Bank Rate and raised it by 350 basis points (or 3.5 percentage points) to 9.50 percent. Since then, it has been revised on five other occasions as shown in the above graph.  

The reactivation of Bank Rate since 2012 is broadly on the lines of the report (March 2011) of the Deepak Mohanty Committee on the operating procedure of the monetary policy. This article explores the relevance of Bank Rate in the context of monetary policy. 

What is Bank Rate?:

Informally, Bank Rate is the rate of interest charged by a central bank on the funds lent to banks. However, under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as “the standard rate at which the RBI is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under this Act.” Bank Rate is essentially a discount rate.

Since its introduction in 1935, the Bank Rate was revised by RBI on 35 occasions till now. At present, the Bank Rate is 10.25 percent. (Bank Rate was 3.5 percent when it was first introduced in 1935). Bank Rate has been made equal to Marginal Standing Facility (MSF) rate since 13 February 2012 and so whenever the MSF rate is revised, the Bank Rate also gets revised.

Interestingly, the MSF Rate itself is linked to LAF-Repo rate, with a positive spread of 300 basis points (or 3 percentage points) over the Repo rate. So practically, Bank Rate changes whenever the Repo rate is revised by RBI or the spread between the Repo Rate and the MSF Rate is changed. Now, Repo Rate is the single policy rate used by RBI for setting interest rates (monetary management) in the economy. The current rates of RBI’s policy rates and reserve ratios are given below:

RBI’s Policy Rates				RBI’s Reserve Ratios
Rate	%	Effective		Ratio	%	Effective
		Date				Date
LAF-Repo	7.25	3-May-2013		CRR	4.00	9-Feb-2013
LAF-Reverse Repo	6.25	3-May-2013		SLR	23.00	11-Aug-2012
MSF	10.25	16-Jul-2013
Bank Rate	10.25	15-Jul-2013

To know more about MSF and LAF-Repo, just click:

1. Update on Marginal Standing Facility-20Jul2013

2. LAF Repo Rate: Single Policy Rate-23Jul2013

How was Bank Rate used by RBI in the past?

Bank Rate was used by RBI as a general instrument of monetary policy in the past though RBI had used various other instruments also—such as, statutory liquidity ratio (SLR), cash reserve ratio (CRR), selective credit control, open market operations (OMO), and prescribing interest rates on deposits and advances. RBI used to provide short-term funds to commercial banks at Bank Rate against the collateral of eligible instruments.

Bank Rate was also used as a reference rate for various standing facilities, such as general refinance and export refinance, provided by RBI to banks. Bank Rate acted as refinance rate at which liquidity was to be injected to banks and primary dealers (PDs). On a few occasions, it was used for exchange rate management. It was also used for charging penalties on banks for not meeting reserve requirements (CRR and SLR).

The Relevance of Bank Rate Now:

The importance of Bank Rate as an important instrument of monetary control has declined after the introduction of Liquidity Adjustment Facility (LAF) in June 2000 and RBI’s standing facilities to banks/PDs were completely delinked from the Bank Rate. Now, all the refinance facilities are provided at the LAF-Repo Rate, which has emerged as the single signaling rate for monetary policy.

RBI is required to buy or re-discount bills of exchange or other commercial paper at the Bank Rate as per RBI Act, 1934. Since discounting/rediscounting by the RBI has remained in disuse, the Bank Rate had become inactive for several years. Under the revised operating procedure of the monetary policy (since May 2011), the MSF rate has in many ways serves the purposes of Bank Rate as a discount rate.

On 13Feb2012, the Bank Rate was raised by 350 basis points and since then it has been made equal to the MSF Rate. This increase was a one-time technical adjustment by RBI to align the Bank Rate with the MSF Rate and was not to be viewed as a change in the monetary policy stance.

    

The role of Bank Rate is now limited to:

1. It is now used for calculating penalty on default in CRR and SLR requirements as required by Section 42(3) of the RBI Act, 1934 and Section 24 of the Banking Regulation Act, 1949, respectively

  2. The penal interest on shortfalls in CRR and SLR (depending on the duration of the shortfalls) are Bank Rate plus 3.0 percentage points or Bank Rate plus 5.0 percentage points

  3. It is also used by several organizations as a reference point for indexation purposes. For example, under Section 372A of the Companies Act, 1956, inter-corporate loans shall not be made at a rate of interest lower than the prevailing Bank Rate.

For all practical purposes, the Bank Rate has become irrelevant as an instrument of liquidity and monetary management.

Summary:

Over the years, the Bank Rate has had its years of glory and gross negligence. RBI had used it for a variety of purposes—in the process confusing the markets and other stakeholders about the relevance of Bank Rate in liquidity and monetary management. With RBI’s flip-flop on Bank Rate, vague signals were sent to the market. One hopes that in future RBI will follow a consistent policy on Bank Rate. 

Today, the Bank Rate largely plays a technical-but-limited role only. Its role is confined to penalties charged by RBI on banks for not maintaining SLR and CRR requirements. The importance of Bank Rate as a monetary policy instrument has waned after the introduction of LAF-Repo rate in June 2000.

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Notes: LAF-Repo Rate under RBI’s Liquidity Adjustment Facility (LAF) is the rate at which RBI lends overnight funds to banks; CRR – Cash Reserve Ratio; and SLR – Statutory Liquidity Ratio.

Reference: RBI Act, Deepak Mohanty Committee report, other RBI reports and www.mca.org.in.

Disclaimer: The author is an investment analyst and freelance writer. His articles on financial markets and Indian economy can be reached at:

http://ramakrishnavadlamudi.blogspot.in/ and www.scribd.com/vrk100