Banking Jargons

When thought to gwt the difference between repo, reverse repo, CRR, SLR etc.  nth time, i got some good pieces. Why nth time, because i really dont know why it always slips from my mind and whenever i am supposed to explain all these jargons. I start feeling like dumb. im thankful to RAMKYC who is one of the people whom i respect and admire a lot. WIll sure try to emulate him very soon. The way he works hard and that too regularly is sure an inspiration. I would be taking some notes from him and would also post some excerpts from ET. So further delay here we go...

What is Repo rate?

PUT simply, the repo rate is simply the annualised interest rate at which banks borrow money from the Reserve Bank of India (RBI) over a short term. This is generally seen as a way of tiding over a short-term liquidity crunch that is experienced by banks. However, to understand how this works, we need to understand the word repo. Repo technically stands for the word repurchase agreement. Most banks generally have a certain amount of government bonds or securities in their possession. When banks are in need for money they borrow money from the RBI using these government bonds or securities as a collateral. There is however the assurance that the bank will recover these later when the borrowed money is returned. The cost of the transaction takes the form of the repo rate. The repo rate is dependent on factors such as the credit worthiness of the borrower, how liquid the collateral is and the rates of other money market instruments. 
What is reverse repo? 
The word reverse repo generally accompanies most definitions of repo and is generally considered to be the opposite process. A reverse repo is when the RBI borrows money from the bank. The interest rate at which the bank borrows the money becomes the reverse repo rate. While the repo is generally used to infuse liquidity into the system, the reverse repo is used to reduce the supply of money in the market. 
What’s the impact of a repo rate reduction? 
While the RBI last initially slashed the repo rate by 100 basis points and brought it down to 8% on October 20, if further reduced it by 50 basis points and brought it down to 7.5%. This reduction, now makes it easier for banks to borrow money from the RBI at lower rates of interest. This is expected to increase the supply of money in the system. It is expected that with banks being able to arrange their own funds more easily, they will also extend this privilege to their customers and allow them to borrow at lower rates of interest. 
    The RBI had taken a similar decision to cut repo rates in August 2003. However, in the last few years, the rate has repeatedly been increased in order to tackle inflationary pressures.

"When Federal bank of USA reduces interest rates, what rate exactly is that with context to RBI's? Is it in relation to CRR?" The simple answer to the question is NO. The complicated answer is:

US Fed announces two different rates: the discount rate and the federal funds rate. The discount rate is the interestrate charged by the US Fed on the loans it gives to commercial banks. The federal funds rate is the interest rate at which banks lend to each other overnight. The US Fed only prescribes a target federal funds rate.

In contrast, the RBI announces only the bank rate. This is the same as the US Fed discount rate. There is no equivalent for the federal funds rate from the RBI. Instead, it announces its repo and reverse repo rates. Market rates (i.e., lendings and borrowings among the market participants) are determined based on these repo and reverse repo rates. Repo rate is the rate the RBI charges for the money lent by it to the banks. Reverse repo rate is the rate which it gives to the banks for lodging money with it. Both these types of transactions are backed by securities. In a repo transaction what happens is the banks lodge securities with the RBI in return for money. So, in effect what a repo transaction (a repo for the banks) does is infuse liquidity in the market. A reverse repo (for the banks) drains liquidity from the market. Comparing rates with CRR is not correct. CRR and SLR are reserve requirements. That is, banks are mandated by the RBI to hold certain amount of money in the form of cash or invest a certain amount in prescribed securities. The US Fed has similar reserve requirements for banks operating there. The US Fed has a single reserve requirement. It is at present 10% of the deposit liabilities of the banks. I am sure all of you know that RBI mandates two different reserve requirements: the CRR and the SLR. The former is the amount of funds that the banks have to keep with the RBI. The latter is the amount of money that the banks to keep invested in RBI approved securities to meet their liquidity requirements. We have covered about them in detail in this Disover-It post. However a repeat would be in order here: Statutory Liquidity Ratio -- SLR, is the percentage of net demand and time liabilities of a bank that has to be maintained by a bank with the RBI. This can be in the form of cash, gold or approved securities. This percentage currently is at 25%. The Banking Regulation Act, 1949 actually prescribes a floor and ceiling for this percentage. The floor is at 25% and the ceiling is at 40%. That is, the RBI can't impound more than 40% of the net demand and time liabilities of banks nor can it prescribe a percentage which is below 25% for this purpose. It has to operate within this band. But recently the BR Act, 1949 was amended doing away with the floor. This gives RBI flexibility to prescribe a percentage of SLR which is lower than 25%. On the SLR funds, the RBI has to pay interest to the banks. It is currently at 6.5%. Contrast this with CRR -- Cash Reserve Ratio, wherein the Bank has to maintain a certain percentage of its net time and demand liabilities in the form of cash with the RBI. CRR at present is 6. On the CRR funds, RBI will not pay any interest to the banks. You can take the ‘net demand and time liabilities’ broadly to mean the deposits of the bank. Why this term is used is that many a time there will be situations in which the deposits figure will not be reflecting the actual deposits. It is the ‘net’ figure that is to be taken and not the ‘gross’ figure. Demand liabilities are those that have to be paid by the bank on ‘demand.’ And ‘time liabilities’ are those that have a time within which the bank has to pay these liabilities. Time deposits like bank FDs (Fixed Deposits) come under this ‘time liabilities’ category.