Overview

Monetary and Credit Indicators

Repo rate

Reverse Repo rate

Base rate

CRR

SLR

Marginal Standing Facility Rate

Capital to Adequacy Ratio

MCLR

Exchange Rate

NEER, REER

Overvalued and Undervalued currency

Forex reserves

Non-Performing Assets

Capital to risk-weighted assets ratio CR AR

Standing Deposit facility (SDF)

Absorption of surplus liquidity from the system but without the need for providing collateral in exchange

SDF is a mechanism to drain surplus cash at a rate lower than the repo rate without the need for any collateral for central banker.
Implementation of SDF requires an amendment to the RBI Act
With the effect of demonetisation, Banks are flushed with surplus cash and are lending to RBI under reverse repo. The biggest limitation with reverse repo is the RBI should have enough securities as collaterals to borrow the surplus cash of Banks
Hence, RBI considering a new instrument, SDF that allows to borrow surplus of cash without need of collaterals. The advantage for banks is they earn the interest rate though less than the reverse repo rate
The long run advantage is that dependency on govt securities will be reduced to make market stabilization
SDF used to inject /suck liquidity without collateral.

As a temporary measure, Incremental CRR and MSS used to overcome

Capital Adequacy Ratio CAR

Also known as Capital to Risk Weighted Assets Ratio CRAR

Definition

To maintain certain amount of free capital to their assets as a cushion against probable losses in investments and loans
The Capital Adequacy Ratio is the percentage of total capital to the total risk-weighted assets

Each type of asset carries a risk factor with it and the percentage of risk depends on the type of asset

Banks has to maintain the such amount of free capital as the percentage of Capital Adequacy Ratio of total capital
For example, CAR worked out to be 9%. If the banks total capital is 100 crore, and its risk weighted assets are 20 crores, it ha s to keep 1.8 crore as free capital under CAR norms
CAR is a globally agreed standard accorded by BASEL agreements (Bank for International Settlements)
High CAR means rate of return to bank equity holders is less

Why

To protect depositors and promote the stability and efficiency of financial sector globally
The main cause is the subprime crisis in US in 2007-08 where the subprime borrowers unable to repay the housing loan debts
To lessen the chance of banks turning insolvent

How much

PSBs require 1.8 Lakh crore capital to comply to Basel III norms.
Of which, GOI promised 70K crore under mission Indradhanush scheme and rest has to be raised from Capital markets

Capital Conservation Buffer

Some capital set aside as buffer out of profits made during good times
During period of stress, this buffer will be used

Basel Agreements, norms, provisions

BASEL - city in Switzerland

Basel Accord /CAR

Basel accords are set of agreements set by BASEL Committee on Bank Supervision BCBS to recommend the banking regulations w.r.t capital risk, market risk, operational risk
CAR norms were agreed at Bank of International Settlements , BASEL
Till now Three Basel agreements and all are voluntary

Basel I	Basel II	Basel III
1998	2004	2011
CAR(minimum capital requirements)	Minimum capital, supervisory review, market discipline	Enhanced minimum capital, risk management, transparency
5 risk categories(0,20,40,60,100)	Tier 1 and Tier 2 Capital	Tier 1, 2, 3 Capital
To have risk weight of 8% or less	CAR 9% Tier1 - 6%	CAR 10.5% by 2019 Includes minimum 6% of Tier 1 capital, 2% of Tier 2 capital, rest 2.5% of Capital conservation buffer
	Macro prudential regulation	Macro prudential stability

Classification of Capital of banks - Tier1,2,3

Tier 1

Such capital that Bank can absorb losses without being required to cease trading
Most reliable form of capital
It includes liquid cash, primary stockholders equity(Total assets - Total liability), disclosed reserves

Tier 2

Such capital that Bank can absorb losses in case of winding up events and so provides a lesser degree of protection to depositors
Second most reliable form of capital
It includes after-tax surplus of retained earnings, revaluation reserves of fixed assets, long-term holding of equity securities, general loan-loss reserves, hybrid capital instruments, subordinated debt, undisclosed reserves

Tier 3

Such capital that Banks used to meet/support market risk, commodities risk, foreign currency risk
Tertiary capital
Includes varieties of debts other than that of Tier 1,2, other undisclosed reserves, other loan loss reserves, other subordinated issues
To qualify as Tier3 capital

Asset must be limited to 250% of Tier1 capital
Unsecured
Subordinated debts
Minimum maturity of 2 years

RBI Governor stated that India should follow BASEL-III norms for the banking sector because of India's Govt commitment in G20

Disclosed and Undisclosed reserves

Disclosed reserves

Total liquid cash and SLR assets of banks
Can be used at any time

Undisclosed reserves

Unpublished or hidden reserves that may not appear on publicly available documents
Common in most banking institutions
Cannot be used at will by the bank

Indian Scenario

RBI introduced CRAR system in India in 1992 in accordance with BIS standards

Basel I

Norm was to be achieved by Mar 1997 by Indian banks

Initially 8 % later 9% from 2000

Basel II

From 31 Mar 2008- Indian banks with foreign presence and foreign banks

Not later than 31 Mar 2009 - SCB

CAR 12% (9 +3)

Basel III

By March 2019. Postponed to 2023 due to COVID-19 pandemic

(Deadline for implementation of las tranche of an additional 0.625% for Capital Conservation Buffer is extended by a year upto March 2020 by RBI)

Tier 1 + Tier 2 = 2 9 ?

Tier 3 not decided/not required now

To make PSBs and RRBs complaint with Basel III norms by 2019, GoI started to infuse capital in phased manner under Indradhanush scheme with an outlay of 70K crores and the remaining required 1.8L crores has to be raised by banks in capital markets

RBI can make rules for CRAR and CCCB Counter Cyclical Capital Buffer norms under BASEL III

CCCB implies that setting some capital free at the time of boom which will be helpful in case of recession

Other instruments

Differential Rate of Interest DRI

Obligatory on Public Sector Banks to lend 1% of total lending of the preceding year to the poorest among the poor at an interest rate of 4 percent per annum
Started in 1972

Repo rate - Rate of Re Purchase

It is called repurchase rate because the banks re purchases their securities at a discounted rate called Repo rate

When banks borrow their money from RBI, it deposits Govt securities as collateral and when they pay the money back, banks take back/ re purchases their collaterals

Policy Corridor

Difference of window of rates b/w different tools/instruments of RBI
Ex: Diff b/w repo and reverse repo rate
Can be wider or narrower
In India, now as on Sept 2020, it is 25 basis points

Incremental CRR

It is a temporary tool used post demonetisation
In a normal CRR, banks used to deposit Cash with RBI at CRR ratio of NDTL
In Incremental CRR, banks asked to deposit cash with RBI at 100% CRR of NDTL that are deposited in banks b/w September 16 and November 11.
How

Normally banks park 4% (Sept 2020- 3%) of NDTL with RBI as part of CRR compliance
But due to demonetisation, excess liquidity is with banks
Hence whatever the deposits made b/w that period, they had to park all the excess liquidity (100%) with RBI as part of Incremental CRR
This is temporary measure to suck the excess liquidity till the time market stabilization scheme is in place
MSS Cash Management Bill used to suck excess liquidity after Incremental CRR

Standing Deposit Facility is not used as it require collateral to be substituted with the surplus deposited cash.

Sterilization

Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply.
Sterilization most frequently involves the purchase or sale of financial assets by a central bank,
It is used to neutralise the effects of excess inflow of foreign investments in an economy

Dollar-Rupee Swap

New Liquidity management tool by RBI in Mar 2019
Generally, To infuse liquidity into economy, RBI traditionally uses the option of open market purchase of bonds

However, RBI decided to use new tool Dollar-Rupee swap to infuse liquidity this time

Under this, RBI purchases dollars for exchange in rupees in a three year currency swap scheme
Advantages

Injects liquidity into the economy
For banks, they earn some interest out of the forex reserves lying idle in their kitty
Bond yields rise

Traditional open market operations distort the bond market

Single tool to directly influence both the value of the rupee and the amount of liquidity in the economy at the same time
RBI forex reserves will be increased
It may lower private borrowing costs

Negatives

New forex swap scheme will introduce new distortions in the currency market.
Rupee depreciates generally in this swap scheme unless no other externalities

Special Liquidity Facility for Mutual Funds (SLF-MF)

It is a special on-tap, open-ended liquidity adjustment facility for all LAF eligible banks and must be used for meeting requirements of mutual funds

On-tap - whenever needed (opposite to happening during a particular period)
Open-ended -No limits on the borrowing limit
Liquidity adjustment facility to banks - RBI conduct repo operations of 90 days tenor at the fixed repo rate
Funds must be used for meeting requirements of mutual funds

Banks extend loans to Mutual Funds
Collateral: collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.

Benefits provided by RBI under this scheme

These funds are classified as Held to Maturity HTM in Banks and not as Available for Sale and Held for Trading.

Investment portfolio of banks may be categorised into 3 types

Held to Maturity - Funds/Securities that are purchased to be owned until maturity. Hence the market dynamics will not be reflected/accounted for in this type of securities as they are bought to be owned until maturity. These are not marked to market
Available for Sale - Funds/securities that are available for sale and they are accounted as mark to market as their value depends on the markets of that day
Held for Trading - Funds/securities that are eld for trading and they are accounted as mark to market as their value depends on the markets of that day

Exposures under this facility will not be reckoned under the Large Exposure Framework (LEF)
Funds extended to MFs are exempted from banks’ cap al market exposure limits

Why

To ease liquidity crisis of MFs in the wake of crisis of Franklin Templeton Mutual Fund
This will help MFs to service its bonds rather than selling its assets at discounted value to meet the short term requirements

Fully Accessible Route FAR

RBI introduced FAR to enable non-residents to invest in specified Government of India dated securities without any ceiling limits
Domestic investors can also invest in these

Liquidity trap

The liquidity trap is the situation in which prevailing interest rates are low and monetary policy is ineffective.
Central bankers decreases the interest rate to stimulate investments but people believe that in future, the interests rates will rise and similarly the savings rate and hence they don’t show interest in investments instead they still m intain in liquid form hoping of rise in interest rate. This makes the policy ineffective since it was introduced to stimulate investments but end up in liquidity trap

Quantitative Easing

Central bankers buys bonds of Financial Institutions and pumps money to market which reduces interest rates and thereby stimulating growth which is called Quantitative Easing

Operation Twist

It is an unconventional step taken by RBI on 23 Dec 2020
Aim

to make the long-term borrowing cheaper
rate transmission in the corporate bond market

Inspired from US fed reserve in 2011-12
It is simultaneously buying and selling of Govt securities

RBI will purchase the long term maturities of worth 10k crore and sell short term maturities of same worth

Intermediate Treasury Bills (ITB)

14-day ITBs are non-marketable instruments issued by Central Govt to State Govt to enable State Govts to deploy their short term surplus cash at fixed interest rate.
It is obsolete now

Quantitative Easing

It is an unconventional monetary policy where Central bank flood Financial institutions with excess liquidity to revive economic activity
US used it to get out of the Global Financial Crisis 2007-08

LIBOR

London Inter-Bank Offer Rate
It is global reference rate for unsecured short term borrowing in the interbank market
It is a benchmark for short term interest rates
It is used for pricing of interest rate swaps, currency rate swaps as well as mortgages
The Indian equivalent is known as The Mumbai Inter-Bank Offer Rate (MIBOR)

SOFR

Secured Overnight Financing Rate
It is a benchmark interest rate for dollar-denominated derivatives and loans
It replaces LIBOR
India in transition to SOFR is a replacement for USD LIBOR that may be phased out end 2021

NOTE:

Mumbai Inter-Bank Offer Rate (MIBOR) and Mumbai Inter-Bank Bid Rate (MIBID) are the benchmark rates at which Indian banks lend and borrow money to each other respectively.

MIBOR is fixed for overnight to 3 month long funds and these rates are published every day at a designated time.
Of the above tenors, the overnight MIBOR is the one most widely used
MIBOR for banks' lending to each other
MIBID for banks borrow from other banks

Monetary policy committee MPC

Statutory body [RBI Act 1934 amended by Finance Act 2016]

6 member committee of monetary policy against 5 members suggested by Urjit patel
Governor, one Deputy Governor(in charge of Monetary policy), one RBI Executive Director, Three external members nominated by Govt [Urjit suggested two external members]
In case of tie, Governor has a casting vote
Decision of MPC is binding on RBI
The Cash Reserve Ratio CRR is not in the ambit of MPC
Mandate:

for maintaining price stability, while keeping in mind the objective of growth.
fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.

RBI accommodative policy vs neutral policy

Hawkish policy - tight policy- fighting inflation

Dovish policy - easy money policy -fighting deflation

There are three monetary policy stances – 1) Accommodative/Easy: It means that inflation is easing and there are prospects of rate cuts in the near term. Chances for repo rates coming down

2) Neutral: Inflation is under control but there is a need to be cautious since macroeconomic conditions show that inflation may rise. Don't expect rate cuts in the near term. Rates can go in either direction - increase/decrease - gives sufficient flexibility to move in either direction

3) Tight: Inflation is rising and needs to be contained. Thus there is a need to raise the interest rates in the near term.

Things usually considered while framing/reviewing a credit policy

US Fed reserve policy - if US Fed raises intertest rates, it will take away investments from India. If Indian interest rates are too low, it will further be a reason to outflow the investments from India.
Inflation control. Should be 2-6
Exchange rate volatility
Crude oil prices

Growth

Timing of rate cut is also important to optimize its impact

Impossible Trinity / Trilemma

Confronted with this Trilemma policy makers have to choose a combination of any two objectives because all three goals can be mutually inconsistent.
Free capital flows, fixed exchange rate, and independent monetary policy.
The trilemma propped up in the context of the Mundell-Fleming Model developed in the 1960s which analysed the effectiveness of monetary policy in an open economy (free capital movement) under different exchange rate regimes.

Interest and Exchange Rate preferences for various sectors

Group	Preference	Rea sons
Manufacturers, services exporters, and farmers Low interest rates,	Weak currency	Profits increase, even if some inputs are imported, since market share grows. This applies both to exporters (clothing) and firms producing for domestic market but competing with imports (steel, aluminium). Software exporters with high domestic value added will favor weak rupee.
Exception: Import-intensive manufacturers	No strong preference	Weaker rupee increases export revenues but increases import costs
Domestically oriented firms	Low interest rates Profits increase	debt burden declines
Infrastructure companies (especially power and renewables)	Strong currency, low interest rates	Strong currency reduces costs without affecting revenues, which are earned in rupees. Costs fall because firms typically import capital equipment, financed with dollar loans. Low interest rates reduce debt service burden on domestic loans.
Households	High interest rates	Returns on savings increase. Household saving far outweighs household borrowing.
Equity investors -- Domestic	Low interest rates	Corporate profits increase, so returns rise.
Equity investors -- Foreign	Low interest rates, Strong currency	Combination boosts dollar returns. Tension: low rates typically lead to weaker currency.
Bond investors -- Domestic	Falling interest rates	Generates capital gains. Banks prefer low rates; other investors (such as LIC) prefer high rates.
Bond investors -- Foreign	High but falling interest rates, strong currency	Combination maximizes dollar returns. Tension: falling rates weaken currency.
Government	Low interest rates	Low rates reduce debt service. Extra growth or inflation increases revenues.
Non-economic actors	Strong currency	Strong currency equated with national economic strength

Monetary and Credit policy