Correlation between Repo Rate and Base Rate

by

Pannvalan
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Whenever RBI reduces its Repo Rate, there is a widespread demand for reduction of Base
Rate by banks in India. The media also gives greater publicity to changes particularly
reductions - in Repo Rate. There is a tremendous pressure from Ministry of Finance and
RBI too on the banks to reduce their Base Rate, as when a reduction effected in Repo Rate
by RBI.
Lets see how far the RBIs Repo Rate impacts the interest rates of scheduled commercial
banks be it in private sector or public sector.
Statutory Reserve Requirements
1. As per Sec. 42(1) of RBI Act, 1934, all scheduled commercial banks in India are
required to keep a portion of their Demand and Term Deposits with RBI. This
mandatory deposit with RBI will act as emergency cash reserve, so as to ensure
short term liquidity of the banks.
2. RBI has powers to stipulate any CRR without any floor or ceiling rate.
3. At present, the CRR stands at 4% (in June 2015) (For latest Policy Rates CLICK
HERE) and banks do not earn any interest on deposits parked with RBI for CRR
purpose.
4. To the extent of CRR, banks loanable funds are brought down. In other words, out of
every deposit of Rs.100, banks have to earmark Rs.4 towards CRR and this will be
an idle reserve generating zero income.
5. In addition to CRR, all banks in India have to invest a portion of their demand and
term deposits in gold, cash and other approved securities. Percentage of this
additional reserve is known as Statutory Liquidity Ratio (SLR) and it is imposed on
banks in accordance with Sec.24 of Banking Regulation Act, 1949.
6. While RBI has powers to fix SLR at the maximum level of 40%, the present SLR (in
June 2015) is at 21.50%. (For latest Policy Rates CLICK HERE) Here, only cash
balances over and above the mandatory CRR will be reckoned for SLR purpose.
7. While cash and gold do not generate any income, investments made in approved
securities fetch returns, but they are usually less than the returns on the credit /

loans
8. Thus, to the extent of CRR and SLR, banks loanable funds are brought down. In
other words, out of every deposit of Rs.100, banks have to earmark Rs.25.50
towards CRR and SLR and only the balance of Rs.74.50 can be given as loans and
advances.
Rate of Interest contracted for Term Deposits is fixed and cannot be altered
1. As we all know, deposits constitute a major source of funds for the banks.
2. Rate of Interest offered on bank deposits are fixed and cannot be changed until the
maturity of such deposits. Thus, cost of funds for a scheduled bank does not change
much in the short term.
3. Whenever the interest rates are falling, it will result in reduction in cost of deposits for
the banks. But, since more than 60% of the banks term deposits fall in the time
bucket of 1 to 3 years, banks do not gain anything in the short term, even in the
falling interest rate regime.
4. When average cost of deposits goes up, banks will be constrained to increase their
Base Rate too (Base Rate is the minimum lending rate).

Size of funds mobilised through Repo route is very small

1. Banks can borrow funds from RBI through Repo window only up to the ceiling of 2% of their
net demand and time liabilities.
2. Funds mobilised through Repo are meant only to bridge the gap in short term liquidity
requirements of banks.
3. Average borrowings made by banks under Repo range only from 0.5% to 1% of their total
deposits, at a given point of time.
4. Thus, size of funds mobilised through repo route, in relation to bank deposits is very small
and funds borrowed by banks through Marginal Standing Facility (Repo) create little impact
on the average cost of funds of commercial banks.
Play of Market Forces
1. Since RBI has freed the interest rates, except on DRI advances, each bank enjoys autonomy
in fixing their own Base Rate, but it shall be non-discriminatory in nature.
2. Thus, the business strategies and operational efficiency of each bank will decide its Base
Rate. Base Rate undergoes changes many times in a year.
3. Market forces also greatly influence the interest rates. So, a banks average cost of funds

alone cannot determine its Base Rate.

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Asset Liability Mismatch

1. As already mentioned, while most of the banks term deposits fall in the 1 to 3 years time
bucket, the average tenor of bank advances is from 3 to 5 years (for infrastructure loans it
extends even upto 10 years or so). Thus, there is a general mismatch in the assets and
liabilities of banks.
2. This is another reason for the banks vying with each other to vigorously go for higher
proportion of CASA in their Deposit Mix on an on-going basis (while the primary reason is to
bring down the average cost of deposits).
Others
1. Now, coming to the point, as and when RBI reduces its repo rate, banks cannot
immediately pass on the benefits to the borrowers.
2. No doubt, Repo funds inject further liquidity into the system, but it cannot be said that
the economy is willing and capable of increasing their credit off-take.
3. Credit expansion takes place over a period of time and it cannot happen quickly.
4. Composition of advances is also a key determinant in credit expansion. Demand for
additional credit will vary with different geographical regions and the activities/sectors
which are ready to borrow more also vary from one region to another.
5. To make credit cheaper, banks cannot unilaterally reduce the interest rates on their
deposits, as crores of people still depend on interest income for their sustenance.
6. It will be difficult for the banks to satisfy the aspirations of depositors and borrowers
at a time.
7. Each bank has its own business strategies and priorities. Financial health of each
bank also varies from each another. Such being the case, we cannot expect all
banks to react in the same way to changes in RBIs Repo Rate.
Date: 15-06-2015

Comments by Rajesh Goyal

I have no hesitation to say that Mr Pannvalan has wonderfully explained

the relationship between Repo Rate and Base Rate. Having worked in
Treasury Division and Risk Management Division of large PS bank for long time, I know
only few people know this concept in depth. To understand such intricacies may be
difficult for common banker (as they never got a chance to work in such departments).
With my experience of discussing these with top management people, I can confirm that
these are not even understood by many GMs, EDs and CMDs, and these are harder to
be learnt by officials in Finance Ministry. Let me sum up the truth of pulls and pushes of
present day situation in Indian banking industry / economy :(a) On number of occasions CMDs of PS Banks (without understanding the concept and
its implications) strongly advocate reduction in Repo Rates and blame the high credit
costs to higher Repo rate. Such statements give a wrong impression to the public
and specially media and corporates, that reduction in Repo Rates will result in
corresponding reduction in Base Rate immediately. This is a fallacy as explained
above in the article. There is a need to dispel this wrong notion. Reduction in Repo
Rate will certainly impact Base Rate but only marginally and that too with a time lag.
(b) The real reduction in Base Rate can be brought only by sizeable reduction in term
deposits rates. (CASA is relevant for a particular bank not for the industry as a
whole). The inflation in India in recent years has been very high and thus any large
reduction in deposit rates would have resulted in negative net returns which
seriously affects the senior citizens and savings. Thus, the real culprit is inflation for
high Repo Rates;
(c) Corporates unnecessarily create a hype of high rate of interests so as to extract as
much concession as possible from banks. In the total cost of a product the interest
on loans is only a small fraction and thus reduction of even 1% to 2% will never
reduce the cost to the extent that it will increase the demand in the corresponding
rate.
(d) RBI Governor is constantly kept under pressure by FM and corporates for reduction
of Repo Rate which is hyped by media with drumming that this is the only panacea
for reduction in prices of goods.
(e) There is a need to reduce other wasteful expenditure by the corporate and reduce
corruption so that the cost of the products can be reduced.
(f) We should not compare our high lending rates with almost near to 3%-4% lending
rates prevailing in countries like USA and Japan. In these countries the term
deposit rates also very low as inflation is almost zero percent. In India where we do
not have social security, the deposit rates have to be such that these gives senior
citizens enough income on their savings so that they can survive. In recent times,
we have seen that IBA and UFBU have even reduced the pension of future retirees.
In such situations, it will never be possible to reduce the deposit rates to say 2% or
3%.
India is passing through a tough phase on account of wrong policies of past
governments and RBI has to walk on a tight rope and needs to be tough who

wants the policies rates to be manipulated for their self interests.