Central Banks Monetary Policy

and Its Relevance to Banks

Presentation By
G V SUBBA RAO
M.Com,CS,CMA,CA(Inter),CAIIB,DFS,DIB,DTIRM,LIE(IBBI)

Course: Bank Management

IIM, Ranchi
Term : 5 Session No: 1
 Monetary policy
• Monetary policy is the process by which a
central bank manages money supply in the
economy.
• The central bank is nowadays primarily an
agency for monetary policy
• Objectives:
• A single or dominant objective – price stability
 Objectives of Central Banks
• Inflation: A central bank pursues a low and
stable rate of inflation.
• Employment: It aims for a high, stable real
growth and high employment rate in the
economy.
• Stability in markets: It promotes a stable
financial market and financial institutions.
• Interest Rates
• Exchange Rates
 FUNCTIONS OF CENTRAL BANKS
1. Monetary stability functions
 Monetary policy
 Exchange rate policy
2. Financial stability & regulatory functions
 Prudential policy development
 Supervision/oversight
3. Policy operation functions
 FX intervention
 FX reserves
 Liquidity management
 Lender of last resort
FUNCTIONS OF CENTRAL BANKS

4. Financial infrastructure provision functions

 Currency provision
 Banking/account management services
 Payment system (inter-bank)
 Settlement system for central bank money
 Other settlement systems
 Registry provision
 FUNCTIONS OF CENTRAL BANKS

5. Other public good functions

Debt management
Asset management
Development functions
Research (other than for functions above)
Statistics
Consumer services
 Federal Reserve – United States of America

• Target of keeping inflation at 2%

• Three instruments of monetary policy
are:
• 1.Open Market Operations
• 2.The discount rate and
• 3.Reserve requirements
 Bank of England -UK
• Target of keeping inflation at 2%
• Two main monetary policy tools
• 1. Bank Rate
• 2. Asset Purchase or Quantitative Easing (QE)
 EUROPEAN CENTRAL BANK
• Legal framework for monetary policy instruments.
• 1. Open market operations
• 2. Standing facilities
a) Marginal lending facility
b) Deposit facility
• 3.Minimum Reserve Requirements
 PEOPLE’s BANK OF CHINA- PBOC

• INSTRUMENTS OF MONETARY POLICY OF PEOPLE’s

BANK OF CHINA- PBOC
• 1. Price-based indirect instruments
• A) PBC lending and deposit rates
• B) Discount and rediscount rate
• C) Reserve requirements Ratio (13%)
• D) Open Market Operations (OMOs)
• 2. Quantity-based direct instruments
• A) Window guidance (stick to official guidelines)
• B) Direct People’s Bank of China lending
• C) Capital controls
 RBI objective of the monetary policy

• As per the amendment in the RBI Act in

May 2016 according to which “the primary
objective of the monetary policy is to
maintain price stability while keeping in
mind the objective of growth”
 Monetary Policy of RBI
• OBJECTIVES OF MONETARY POLICY
• 1.Price Stability
• 2. Maximum feasible output
• 3.High Rate of growth
• 4.Fuller employment
• 5. Healthy balance in balance of payments (BOP)
• 6. Inflation target to be set by the Government of
India, in consultation with the Reserve Bank, once
in every five years: target for the period from
August 5, 2016 to March 31, 2021: 4% with
upper or lower tolerance level of 2%
 The Monetary Policy Framework
• RBI communicates its monetary policy
decisions in terms of changes in the ‘Policy
Repo Rate’ and ‘Stance’ based on an
assessment of the current and evolving
macroeconomic situation.
• The stance of the monetary policy is
communicated as : neutral,
accommodative or calibrated tightening
• Statement on Developmental and
Regulatory Policies
 Stance of Monetary Policy during current
financial year 2019-20
• 1) 4.4.19 - First Bi-monthly monetary policy
stance: neutral.
• Reduced the policy repo rate under the liquidity
adjustment facility (LAF) by 25 basis points to
6.00%
• 2) 6.6.19 - Second Bi-monthly monetary policy stance is :
from neutral to accommodative
• Reduced the policy repo rate under the liquidity
adjustment facility (LAF) by 25 basis points to 5.75%
• 3) 7.8.19 - Third Bi-monthly Monetary Policy stance :
decided to maintain the accommodative
• Reduced the policy repo rate under the liquidity
adjustment facility (LAF) by 35 basis points to 5.40%
 RESERVE BANK OF INDIA
• Monetary policy tools/Instruments that RBI uses:
• 1. Liquidity Adjustment Facility (LAF):
• A) REPO (Repurchase obligations) Rate
: 5.40%
• B) REVERSE REPO RATE: Repo minus
0.25%
• C) Marginal standing facility (MSF)
Rate : Repo + 0.25%
• Corridor: The MSF rate and reverse repo
rate determine the corridor
 RESERVE BANK OF INDIA
• Monetary policy tools / Instruments that RBI
uses
• 2.Term Repo
• 3. Open Market Operations
• 4. Cash Reserve Ratio (CRR): 4% of NDTL
• 5. Statutory Liquidity Ratio (SLR) : 18.75%
of NDTL
• 6. Bank Rate : 5.65%
• 7. Market Stabilization Scheme (MSS)
Liquidity Adjustment Facility (LAF) with RBI

Repo (Fixed Rate)

Repo (Variable rate)
Reverse Repo (Fixed rate)
Reverse Repo (Variable rate)
Marginal Standing Facility (MSF)
 Liquidity Adjustment Facility (LAF)
 LAF is a facility extended by the Reserve Bank of India to SCBs
(excluding RRBs) and PDs to avail of liquidity in case of requirement or
park excess funds with the RBI in case of excess liquidity on an
overnight basis against the collateral of SLR securities.
 Basically LAF enables liquidity management on a day to day basis.
 The operations of LAF are conducted by way of repurchase agreements
(repos and reverse repos) with RBI being the counter-party to all the
transactions.
 The interest rate in LAF is fixed by the RBI from time to time.
 Currently the rate of interest on repo under LAF (borrowing by the
participants) is 5.4 % and that of reverse repo (placing funds with RBI) is
5.15 %.
 LAF is an important tool of monetary policy and enables RBI to transmit
interest rate signals to the market
 LAF (Liquidity Adjustment Facility):
 Cap for Repo borrowings :Up to 0.25% of bank wise
NDTL and
 Cap for Term Repo borrowings: 7-day and 14-day term
repos of up to 0.75% of NDTL of the banking system.
 Operating since year : 2000
 Minimum credit limit: Rs. 5 crore and in multiples of Rs 5
crore
 Users: Banks, PDs
 Rate of Interest: Repo rate.
 Collateral used: All the government securities
 Term Repo under Liquidity Adjustment
Facility ( RBI 8.10.2013)
 TERM REPO- 7 DAYS, 14 DAYS and 28 DAYS .
 Term repos of up to 0.75% of NDTL of the banking system
through auctions
 Term repo auctions would be conducted on Fridays between
1.30 pm to 2.00 pm
 RBI notifies the amount, timing , tenor in advance
 Banks would be required to place their bids with the term repo
rate that they are willing to pay to RBI
 Minimum bid amount for the auction would be Rupees one
crore and multiples thereof.
 All bids lower than the cut-off rate would be rejected
 The eligible collateral for term repo and the applicable haircuts
will remain the same as daily LAF repo and MSF.
 Substitution of Collateral under the LAF Term Repos will be
available from April 17, 2017.
 REPO -Advantages
 Facilitates investment of surplus SLR investments
 Borrowers can raise funds at better rates.
 Collateralized
 Convenient for adjusting SLR / CRR positions
simultaneously
 It helps investor achieve money market returns with
sovereign risk.
 An SLR surplus and CRR deficit bank can use the
Repo deals as a convenient way of adjusting
SLR/CRR positions simultaneously.

 RBI uses Repo and Reverse repo as instruments

for liquidity adjustment in the system
 Re-repo in Government Securities
Market( RBI circular 5.2.15)
 RBI permitted re-repo in government securities, including state development
loans and Treasury Bills, acquired under reverse repo, subject to following
conditions:
 SCBs and PDs maintaining subsidiary general ledger (SGL) account with the RBI
will be permitted to re-repo the securities acquired under reverse repo;
 MFs and Insurance Companies maintaining SGL account with the Reserve Bank
of India will also be permitted to re-repo
 Re-repo of securities can be undertaken only after receipt of
confirmation/matching of first leg of repo transaction
 Re-repo period should not exceed the residual period of the initial repo;
 Eligible entities undertaking re-repo transactions should ‘flag’ the transactions
as a re-repo on the authorized reporting platform
 Default in payment of cash or delivery of security shall be viewed seriously and
subject to penal measures
.
 MSF - Marginal Standing Facility
 Marginal Standing Facility (MSF) Scheme introduced by
Reserve Bank with effect from May 09, 2011.
 Under this facility, the eligible entities may borrow up to 2%
of their respective NDTL.
 Additionally, the eligible entities may also continue to
access overnight funds under this facility against their
excess SLR holdings
 In the event, the banks’ SLR holding falls below the
statutory requirement up to two per cent of their NDTL,
banks will not have the obligation to seek a specific waiver
for default
 MSF - Marginal Standing Facility
Minimum credit limit: Rs.1 crore
Users: Only Scheduled Commercial
banks.
Rate of Interest: Repo rate + 0.25%
 Collateral used: all the government
securities including SLR.
Maximum credit limit: 2% of NDTL.
 Open Market Operations
OMO or Open Market Operations is a market
regulating mechanism
Under OMO Operations RBI as a market
regulator keeps buying or/and selling securities
through it's open market window. It's decision
to sell or/and buy securities is influenced by
factors such as overall liquidity in the system,
 Cash reserve ratio(CRR)
under Section 42 (2) of the Reserve Bank of India
(RBI) Act, 1934
CRR for Schedule commercial banks without any
floor or ceiling rate
CRR @4% of net demand and time liabilities(NDTL).
No interest on CRR balances
Maintenance of CRR on Daily Basis -maintain
minimum CRR balances up to 90% of the average
daily required reserves for a reporting fortnight
Return form A-within 20 days from expiry of the
relevant fortnight.
Penalty for default : 3% above the bank rate , if
default continues 5% above the bank rate )
 Statutory Liquidity Ratio (SLR)
 SLR held on alternate Fridays during immediate preceding month
 SLR:18.75% of NDTL
 Schedule commercial banks actual SLR investments holding as on
31.3.2019 : 26.87% of NDTL
 Maximum not exceeding 40% of NDTL
 SLR assets in the form of cash ( cash with RBI in excess of CRR, cash
balance with other banks) , gold and SLR securities ,T Bills, cash
management bills, dated GOI securities ,state development loans.
 Encumbered SLR securities shall not be included
 Penalty (3% above the bank rate , IF DEFAULT CONTINUES 5% ABOVE
THE BANK RATE.)
 Procedure for Computation of SLR –similar way of CRR
 Return in Form VIII (SLR)- before 20th day of every month,( SLR held on
alternate Fridays during immediate preceding month )
 Bank Rate
• Bank rate is the rate charged by the central
bank for lending funds to commercial
banks.
• Present bank rate is: 5.40%
 Market stabilization scheme-MSS
• Object is: to withdraw excess liquidity by selling
government securities in the market alongside tools
like the Liquidity Adjustment Facility (LAF) and Open
Market Operations (OMO).
• The amount raised under the MSS does not get
credited to the Government Account but is
maintained in a separate cash account with the RBI
and are used only for the purpose of redemption/buy
back of Treasury-Bills/Dated Securities issued under
the scheme and the total outstanding under MSS
would not exceed Rs. 60,000 crore
 External Benchmark Based Lending
• It has been decided to link all new floating rate personal or retail
loans (housing, auto, etc.) ,Micro and Small Enterprises extended
by banks with effect from October 01, 2019 to external
benchmarks. (RBI Notification DT 4.9.19)
• External benchmarks are:
 Reserve Bank of India policy repo rate
 Government of India 3-Months Treasury Bill yield published by the
Financial Benchmarks India Private Ltd (FBIL)
 Government of India 6-Months Treasury Bill yield published by the
FBIL
 Any other benchmark market interest rate published by the FBIL.
 The Monetary Policy Process
• The Central Government in September 2016 constituted the 6
member MPC- as under:
1) Governor of the Reserve Bank of India – Chairperson, ex
officio;
2) Shri Bibhu Prasad Kanungo, Deputy Governor of the Reserve
Bank of India, in charge of Monetary Policy – Member, ex
officio;
3) Dr. Michael Debabrata Patra, Executive Director of the Reserve
Bank of India to be nominated by the Central Board – Member,
ex officio;
4) Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) –
Member;
5) Professor Pami Dua, Director, Delhi School of Economics –
Member; and
6) Dr. Ravindra H. Dholakia, Professor, IIM, Ahmedabad –
Member.
 Open and Transparent Monetary Policy Making

• 1.The MPC is required to meet at least four

times in a year.
• 2. The quorum for the meeting of the MPC is
four members.
• 3. Each member of the MPC has one vote,
and in the event of an equality of votes, the
Governor has a second or casting vote
• 4. The resolution adopted by the MPC is
published after conclusion of every meeting
of the MPC
Open and Transparent Monetary Policy Making

• 5. On the 14th day, the minutes of the

proceedings of the MPC are published
which include:
a. The resolution adopted by the MPC
b. The vote of each member on the
resolution, ascribed to such member; and
c. The statement of each member on the
resolution adopted.
 MONETARY POLICY TO CONTROL RECESSION PROBLEM:

RECESSION MEASURES
1.Central Banks buy securities through OMO.
2. Lowers Bank Rate
3. Reduces CRR
RESULT
i) Money Supply Increases
ii) Interest Rate Falls
iii) Investment Increases
iv) Aggregate Demand Increases
v) Aggregate Output increases
 MONETARY POLICY TO CONTROL INFLATION PROBLEM

1. Central Banks sells securities through OMO

2. Increases Bank Rate.
3. Raises CRR
RESULT
i) Money Supply Decreases
ii) Interest Rate Rises
iii) Investment Declines
iv) Aggregate Demand Declines
v) Price Level Falls
 Monetary Policy and Bank Profitability

• Impact on net interest income

• Return on assets