For stock markets, lower pressure of CRR & SLR rates on Banks means they have higher liquidity and can thus earn more depending upon the operational efficiency of their business model. Markets always gives thumbs up to rate cuts! As this drives profitability of the rate sensitive listed companies such as banks, real estate and automobile sector.
- If market perceives that current rate of interest is at appropriate level then it expects 'no change in RBI monitory policy'.
- If it is perceived that current market scenario has high inflation pressure then RBI increases rates to suck liquidity from market viz less money to buy means value of money is high and inflation goes down slowly.
- Alternately, if market participants perceive that inflation has gone down and stabilizing then it expects RBI to cut rates which leads to rally in stock markets. Its an euphoric situation!
Brief description of RBI's interest rates:
The Reserve Bank of India (RBI) is India's central banking institution, which controls the monetary policy of the Indian rupee.
The RBI plays an important part in the development strategy of the Government of India. It is a member bank of the Asian Clearing Union. The general superintendence and direction of the RBI is entrusted with the 21-member- Central Board of Directors—the Governor (currently Raghuram Rajan), four Deputy Governors, two Finance Ministry representative, ten government-nominated directors to represent important elements from India's economy, and four directors to represent local boards headquartered at Mumbai, Kolkata, Chennai and New Delhi.
Each of these local boards consists of five members who represent regional interests, as well as the interests of co-operative and indigenous banks.
Banker of Banks
RBI also works as a central bank where commercial banks are account holders and can deposit money.RBI maintains banking accounts of all scheduled banks. Commercial banks create credit. It is the duty of the RBI to control the credit through the CRR, bank rate and open market operations. As banker's bank, the RBI facilitates the clearing of cheques between the commercial banks and helps inter-bank transfer of funds.
Reserve requirement cash reserve ratio (CRR)
Every commercial bank has to keep certain minimum cash reserves with RBI. RBI can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate.
An increase in Cash Reserve Ratio (CRR) will make it mandatory on the part of the banks to hold a large proportion of their deposits in the form of deposits with the RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the money supply.
Less money in market means higher demand for money means inflation is lower viz you can buy more product/service for same amount of money as demand of money is higher!
Thus to control inflation RBI increase CRR rate. It is one of the measures. Other popular measure is SLR viz. Statutory Liquidity ratio
Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans and advances to investment in government and approved securities.
What are Repo rate and Reverse Repo rate?
Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate
Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI.
Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks
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