The methodology can be classified into two categories:
Quantitative Credit Control Methods:
These are the instruments of monetary policy that affect over all supply of money/credit in the economy. Some are as follows:
Statutory Liquidity Ratio:
The Statutory Liquidity Ratio refers to that proportion of total deposits which the commercial banks are required to keep with themselves in a liquid form. The commercial banks generally make use of this money to purchase the government securities.
Thus, the Statutory Liquidity Ratio, on the one hand, is used to siphon off the excess liquidity of the
banking system, and on the other, it is used to mobilize revenue for the government.
The Reserve Bank of India is empowered to raise this ratio up to 40 per cent of aggregate deposits of commercial banks. At present it is 18.5 per cent. It used to be as high as 38.5 percent at one point of time.
Cash Reserve Ratio:
The Cash Reserve Ratio (CRR) is the ratio fixed by the RBI of the total deposits of a bank in India, which is kept with the RBI in cash form.
CRR deposits do not earn any interest for banks.
Initially, limits of 4% (lower) and 20% (upper) were set for CRR, but respective amendments removed the limits, therefore providing RBI with much needed operational flexibility. The more the CRR the less the money available for lending by the banks to players in the economy. RBI increases CRR to tighten many supple and lowers CRR to expand credit in the economy.
CRR as a tool of monetary policy is used when there is a relatively serious need to manage credit and inflation.
Otherwise, RBI relies on signaling its intent through the policy rates of repo and reverse repo. At present it is 4 percent.
In basic terms, bank rate is the interest rate at which RBI provides long term credit facility to commercial banks. A change in bank rate affects the other market rates of interest. An increase in bank rate leads to an increase in other rates of interest, and conversely, a decrease in bank rate results in a fall in other rates of interest. Bank rate is also referred to as the discount rate. A deliberate manipulation of the bank rate by the Reserve Bank to influence the flow of credit created by the commercial banks is known as bank rate policy.
An increase in bank rate results in an increase in the cost of credit or cost of borrowing. This in turn leads to a contraction in demand for credit. A contraction in demand for credit restricts the total availability of money in the economy, and hence results as an anti-inflationary measure of control.
Likewise, a fall in the bank rate causes other rates of interest to come down. The cost of credit falls,
i.e., borrowing becomes cheaper. Cheap credit may induce a higher demand both for investment and consumption purposes. More money through increased flow of credit comes into circulation. A fall in bank rate may, thus, prove an anti-deflationary instrument of control. Penal rates are linked with Bank Rates. For instance if a bank does not maintain the required levels of CRR and SLR, then RBI can impose penalty on such banks. Currently Bank Rate is 7%.
Nowadays, bank rate is not used as a tool to control money supply, rather Liquidity Adjustment Facility (LAF) (Repo Rate) is used to control the money supply in economy.
If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate.
Similarly, if RBI wants to make it cheaper for banks to borrow money, it reduces the repo rate. Repo
rate stood at 5.75%.
Reverse Repo Rate:
Reverse Repo is the rate at which the Central Bank (RBI) borrows from the market. This is called as reverse repo as it the reverse of repo operation. Reverse repo rate at present is 50 basis points (or 0.5%) lower than the Repo Rate. Repo and Reverse
Repo Rates are also referred to as the Policy rates and are often used by the Central Bank (RBI) to send single to the financial system to adjust their lending and borrowing operations.
Repo rates and reverse repo rates form a part of the liquid adjustment facility.
Open Market Operations (OMOs):
It refers to buying and selling of government securities in open market in order to expand or contract the amount of money in the banking system. This technique is superior to bank rate policy.
Purchases inject money into the banking system while sale of securities do the opposite.
It is a common misconception that OMOs change the total stock of government securities, but in reality they only change the proportion of Government Securities held by the RBI, commercial and co-operative banks.
The Reserve Bank of India has frequently resorted to the sale of government securities to which the commercial banks have been generously contributing. Thus, open market operations in India have served, on the one hand as an instrument to make available more budgetary resources and on the other as an instrument to siphon off the excess liquidity in the system.
Marginal Standing Facility:
Marginal Standing Facility is a liquidity support arrangement provided by RBI to commercial banks if the latter doesn’t have the required eligible securities above the SLR limit.
It is a window for banks to borrow from the Reserve Bank of India in an emergency situation when
inter-bank liquidity dries up completely.
The MSF was introduced by the RBI in its monetary policy for 2011-12.
Under MSF, a bank can borrow one-day loans from the RBI, even if it doesn’t have any eligible securities excess of its SLR requirement (maintains only the SLR). This means that the bank can’t borrow under the repo facility.
In the case of MSF, the bank can borrow up to 1% (can be changed by the RBI) below the SLR (means
1% of Net Demand and Time Liabilities or liabilities simply).
The working of MSF is thus related with SLR. For example, imagine that a bank has securities holding
of just 19.5 % (of NDTL). This is equal to its mandatory SLR holding. The bank can’t borrow using the
repo facility. But as per the MSF, the bank can borrow 1 % of its liabilities from the RBI. Sometimes the RBI increases the limit of borrowings to 2% of NDTL. As in the case of repo, the bank has to mortgage the securities with the RBI.
MSF rate and the Repo rate: The bank has to give higher interest rate to the RBI. The interest rate for
MSF borrowing was originally set at one percent higher than the repo rate. As on November 2017,
the RBI has lowered the difference between repo rate and MSF to 0.25%. The MSF rate and Bank
rate are equal.