What is the Repo Rate and Why Does Everyone Care So Much About It?

What is a Repo? A ‘repo’ is nothing but a ‘repurchase agreement’. Even normal individuals can enter in a repo agreement. I give you a signed piece of paper in exchange for Rs. 10k. The paper states that “I will repurchase the signed piece of paper from you at a given date in the future for Rs. 11k.” The Rs. 1k or 10% is the ‘Repo Rate’. In the case of repo agreements between a central bank and commercial banks, the piece of paper is called the ‘Repo Rate Agreement’.

Why does the central bank do this? Because a central bank needs to control the ‘cash in the system’, so to say. That’s in their job description. In order to do that, they usually put up a handful of rules, the primary being the reserve requirements for banks and the ‘repo’ rates.

banks-cut-base-rate-as-rbi-lowers-repo-rate-by-25-bps-financial-chronicle-03-june-2015

What are the reserve requirements? In India, the RBI has told the banks that they need to have a CRR (Cash Reserve Ratio) of 4% and a SLR (Statutory Liquidity Ratio) of 21%. This simply means that for every Rs. 100 that a bank has in its hands, it needs to give for safe-keeping Rs. 4 in hot cash and Rs. 21 as mostly investment in government bonds to the RBI. This Rs. 25 acts as a guarantee of sorts in case the bank collapses.

Where does Repo figure in this? Let’s suppose that a bank has only received Rs. 100 worth of deposits. The bank gives the RBI Rs. 25 by way of maintaining the CRR and SLR. Slowly, the bank lends out the remaining Rs. 75 to its customers. Now, the banks figures out that there is still some demand for loans. It’s out of money though. So the bank tells the RBI “Hey, lend me Rs. 50. I’ll give you back Rs. 12.5 by way of CRR and SLR. Let me utilize the remaining Rs. 37.50 for my business.” Remember, the RBI prints money. The RBI can never run out of money to lend, unlike the banks. The RBI replies “Fine, take this Rs. 50. But for your SLR requirements, you will have to purchase government bonds from me. So, at a given date in the future, you will repurchase your agreement from me at Rs. 50 plus 6.50% interest per annum and I will repurchase my government bonds from you at 6.00% per annum.” The first part of the agreement, where the bank repurchases its agreement from the RBI is called the Repo Agreement. The second part of the agreement, where the RBI repurchases its government bonds from the bank is called the Reverse Repo Agreement. You might have noticed that the Reverse Repo Rate is always lesser than the Repo Rate. That’s one of the perks of being the controller of the banking system of the country.

The central bank and the commercial banks engage in these repo transactions (Called ‘Repo Rate Auctions’) very often. The repo is basically how money flows from the central bank to the banks and into the system.

Why does the Repo Rate matter so much? So, we’ve seen how a repo works, both generally and in the banking system. But why does the 6.50% matter so much? Every two months, the RBI does a policy review. The most important part of it is the modification of ‘key rates’ (Repo, CRR, SLR, MSF), if any.

Indian banks are currently ‘borrowing’ from the RBI at 6.50%. Imagine that the RBI announces a 50 Basis Points ‘rate cut’. The 6.50% drops to 6.00%. The banks can now borrow more and pay lesser interest to the RBI. Higher cash in the hands of the bank will mean higher lending from the banks to the public. Higher cash in the hands of the public means more spending on goods and services. More spending and demand leads to inflation – or rise in prices of goods and services. The public starts suffering from inflation.

The RBI now intervenes and increases the Repo Rate, to say 7.25%. Now, the banks can borrow only lesser and pay a higher interest rate on it as well. You can probably fill in the gaps of what will happen next based on what we saw above. This gradually leads to a recession. The RBI again intervenes and ‘cuts’ the rate, again. It’s a vicious cycle and a cycle which needs to be monitored closely. Ineffective monetary policy will lead to depression, hyper-inflation and all sorts of economic anomalies. Although the Repo Rate is not the only weapon at the disposal of a central bank, it’s the quickest and deadliest.

Alice Rivlin, the former Vice-Chair of the U.S. Federal Reserve puts it in a nutshell: “The job of the Central Bank is to worry.

P. S. Incidentally, ‘Bps’ or ‘Basis Points’ refers to decimal places. 10 Basis Points is equal to 0.10%, 25 Basis Points is equal to 0.25% and so on.

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

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The Economics of a Religious Ritual

India is a very religious country. As such, there are numerous religious rituals involved. Once such religious ritual is throwing coins into ponds located within a temple. In the non-religious parlance, this can be related to throwing coins into fountains and wells for luck. How do the wasted coins affect the economy? Does the economy become poorer for all the lost wealth? Well, not quite.

scientific-reasons-behind-hindu-customs-throwing-coins-in-river-1
(Source: www.democraticpaper.com)

Imagine that there is a lunatic out on the loose whose sole purpose in life is to steal money from people – and burn it. Now he has successfully burnt down all but Rs. 100 worth of money in the hands of every single person in the country. Imagine now what would be the likely effect on the economy. There will be deflation, heck, depression.

People will not spend at all. They will guard their Rs. 100 with their life. They will spend it sparingly, only for food and other necessities. The prices of all other goods and services will crash. Businesses will shut down. If at all some business remains operational, their good or service will be sold at a very marginal rate. Dresses will sell for Rs. 10 or so, cars will sell for Rs. 1000 and so on (Okay, not really, but at least in theory).

Putting aside the destruction and despair, think for a moment what happened to the value of money. Before the lunatic, you could get a Lay’s chips for Rs. 10, but after the fiasco, you are able to get a dress for the same amount. The value of money increased multi-fold.

This is the economic impact of what we call ‘money burning’ in Economics. When you burn money/throw it away, you make everyone else using the same currency richer by a very, very, very tiny part. In the long term you also become richer, but of course you become immediately poorer if you burn your money/throw your money away.

For those of us economically inclined, the Quantity Theory of Money establishes exactly this. Although there are some strong critics of the theory, it holds true. Otherwise, Central Banks across the world would not have ‘controlling money supply’ as one of their major motives.

Before you try this experiment for yourself, note that destroying money is a punishable offense is most countries. This is due to the fact that money is not something you own. Money is simply an instrument created by the government to represent what you own aka your wealth. But at least, the next time you throw away a few coins into a pond, pause for a second and realize how you’ve made your country richer by a teeny-tiny part.

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

Should the RBI be Independent?

The debate arises because of the new Monetary Policy Committee. It points us towards two important aspects of any central bank – Independence and accountability. So how do we resolve all these two objectives and make sure that the Central Bank is capable of tackling the issues that it faces meeting the objectives that it is supposed to meet while at the same time remaining accountable to the people.

 

urijit-patel

 

What are the major functions of RBI?

 

  • Regulating the economy or regulating other players in the economic system.
  • RBI acts as a monetary authority in India.

 

This in turn means that RBI is a complete authority as far as Monetary Policy is concerned. It not only makes the rules, not only implements them but also monitors them. Whereas if we think in terms of the political structure of India ,formulation is done by legislature, implementation is done by the executive and monitoring is done by the judiciary, whereas here RBI is doing all three functions.

 

What is the objective of Monetary Policy itself?

 

  • Maintaining price stability
  • Ensuring adequate flow of money
  • Credit to required areas.
  • It acts as a regulator and supervisor of financial system

 

This is what RBI tries to achieve through its Monetary Policy. Maintaining the overall stable level primarily through controlling the interest rates and all this is done so as to maintain public confidence in the system. So, RBI puts some rules to the banks to follow so that banks maintain the trust of the public. It manages the FEMA, Foreign Exchange Management Act, so as to facilitate foreign trade to develop Indian trade as well as to maintain rupee stability in the foreign exchange market as well. RBI is also the issuer of currency because it is controlling the money supply in the country, so it issues currency and also destroys currency. Specific to a developing country RBI also has a development role in which it tries to promote what the Government is trying to do with the development agenda. It also has some major banking functions such as being a banker to the Government, being a banker to other banks and even being a lender of last resort in the economy.

 

What are the goals of the RBI?

 

RBI governor also consults with important bodies like FICCI CRISIL etc. so as to get a good understanding of the sentiments in the business sector of the country. In addition to all this RBI also publishes the annual report on the official website for public discussion and for transparency. So a good amount of transparency is being maintained in the current system itself. Now this structure of the RBI makes it one of the most independent agencies of the Government. It is comparable to Supreme Court in terms of independence that it commands. However RBI governor is appointed by the Government of India so that is one notch below in terms of independence. It is also one of the most independent Central banks in the entire world.

Now there are two different viewpoints about the RBI. One is that RBI has too much power and should be controlled more by democratically elected Government. So one viewpoint is we have to control RBI’s power so that democratically elected Government has power over RBI, or power over the Monetary Policy making. Another viewpoint is RBI should remain independence or else politicians including the Parliament and the Prime Minister’s office could order the RBI to boost money supply, increase credit etc. just before an election.  Government could misuse Monetary Policy for its own purposes because of that RBI has to remain as a separate institution. That is another viewpoint.

So what is the case for Central Bank independence? The first is that RBI avoids inflationary spending by the government. The government might spend more to meet its own political agenda, such as, spending more before an election so that people have a perception that the country is improving etc. So government can sell this by forcing the banks to buy bonds so that the government can spend more. This is banned because this can lead to inflation very fast. So one reason an independent organization is good is that this kind of problems can be avoided. And we can avoid the use of Monetary Policy for political goals.

So we cannot lower interest rates before an election so as to win an election. We can only lower the interest rates when we feel that the inflation is low enough to allow that. Otherwise, the election will in turn cause inflation. The election cycle used to be matching with the inflation cycle but independent RBI can control this kind of mismatches. If the government is given power over Monetary Policy, governments have a tendency, automatic tendency to misuse that power.

 

What is the case against central bank independence? 

 

The biggest reason is that central bank is not directly accountable to the voters. What the voters want and what the bank does might be slightly at odds. So RBI might sometimes be implementing monetary policy against the wishes of the electorate. For example, there could be a stack inflation situation in which economy is not growing. At the same time unemployment is high as well and RBI cannot reduce interest rates. Instead it has to hike interest rate because inflation is high. Now the electorate might not appreciate that. People might start feeling why should the RBI have this power, why can’t we decide, why can’t our government decide? So those kind of questions can come. Also government might sometime blame RBI for not allowing India to develop etc. So in these situations this accountability issue becomes a problem.

 

This article was written by Paulami Paul (PGDM, Batch 22, XIME-B)

From the Vault: Looking to Invest? Game for P2P?

cash
(Source: MasterCard)

 

Imagine that you are sitting on a cash pile, with no idea on where to invest it. Well, you have a range of options. You can

1.Open an FD Account with a bank.
2.Invest in securities
3.Invest in Real Estate
4.Invest in gold

These are the traditional avenues to which you can shift your money. Logically, going by the diversification rule, your portfolio will consist of a mix of these. Why? Every option has a level of risk and return attached to it. So, a mix of these options will ensure that the risk is rewarding.

Let’s draw a risk-returns matrix and see where each option sits

pic

So, now where would you place your pile? On one option or many?

To most of the readers, this is elementary knowledge. You guys are probably wondering, “This is Financial Management 101! Where is she going with this?”

I agree with you guys. However, I am about to present to you a fifth option. And that is Peer-to-Peer lending. Yes, I am talking about “shadow banking”.

According to Wikipedia, “Peer-to-peer lending, commonly abbreviated as P2PL is the practice of lending money to unrelated individuals, or “peers”, without going through a traditional financial intermediary such as a bank or other traditional financial institution.”

I learnt of the existence of P2P when I received a spam mail from one of the P2P marketplace site, called Faircent.com. I decided to explore more and uncover this investment trend. Apart from Faircent, we have i-lend. There are other P2Ps in the market, but they focus on lending to companies and not retail investors/borrowers.

So, how does this model work and why will anybody choose P2P?

P2P portals help lenders meet borrowers. Lenders can choose from a list of verified borrowers on the website. They are also advised to spread their investment among borrowers to lessen the risk of default. The investment begins from INR 5k upwards and for this risk, the lenders get a return of 15%-24% on i-lend and upto 25% on Faircent. The borrowers can borrow from INR 25k to 100k at 12% upwards. The portals charge an upfront fee from both lenders and borrowers and get the borrower’s documents and employment details verified by a third party. A contract with terms and conditions is signed within a week, with a recovery process in place for those who default on payments.

What is the advantage of P2P?

Bank customers can sometimes struggle to secure bank loans because of employer credentials, salary requirements or credit history. Around INR 3.8 trillion ($61 billion) in personal loans, excluding home loans, were outstanding in March 2012, a Reserve Bank of India report shows. This includes education loans and credit card dues. Thus with bad loans mounting, banks in India have become wary of lending in certain sectors in the past few years.

Informal lending is common in India, with businessmen and family members often lending money in times of need. P2P is a progression of that, with the money flowing not from family/friends but from other like-minded people. According to a research article by Mr Ankit Shah, a Senior Associate Consultant for Finacle (Infosys), the advantage of P2P lending is the likelihood for the borrower to secure the loan at a lower rate of interest as compared to a bank loan and the likelihood for the lender to receive a better interest rate as compared to a bank deposit. P2P lending asset class is different from the traditional savings account or stock market linked investments. The only risks involved here are the counterparty risk and the concentration risk. Concentration risk can be greatly mitigated by spreading the loan amount across a large number of borrowers. As for the Credit risk, lenders can decide to lend only to borrowers having a specific credit profile, which is listed on the sites.

What is RBI’s take on P2P?

As per a Jun 2014 RBI report, “India’s ‘shadow banking’ sector essentially refers to the large number of ‘unregulated’ entities of varying sizes and activity profiles, raises concern partly because of the public perception that they are regulated. Technology-aided innovations in financial disintermediation such as peer-to-peer lending warrant a regulatory preparedness.” “While in certain regulatory jurisdictions this space is being looked at as more favorable, some other regulators have raised concerns mainly relating to distress for lenders in the event of a sudden closure of such platforms. While these platforms are still new to India and the scale of transactions is insignificant, this is a gap which requires regulatory attention. This is all the more important since in developed markets, mainstream financial market participants and products are making an entry into this space amidst concerns over regulatory arbitrage.”

What’s on the cards?

Mr Shah continues to say that, P2P lending is still in its nascent stage. With evolving models, better regulatory mechanisms and improved credit rating facility, we may see more and more lenders and borrowers participating in this new way of lending. In the coming years, it can have the depth to support a larger participation. Also, with internet users spending more time on social networks, it is likely to generate higher interest in people in the time to come.

So, if you are sitting on a cash pile, where would you place your bet? The traditional avenues or P2P?

This article was written by Vinita Jagannathan (PGDM, Batch 19, XIME-B)

Islamic Banking: The Implications of an Interest-less Banking System

Quite a few heads were turned when the Reserve Bank of India (RBI) recently set up a three-member panel to review the feasibility of the Islamic Banking System in India, including Rajesh Verma, a deputy general manager, department of banking operations, Archana Mangalagiri, general manager, non-banking supervision and Bindu Vasu, joint legal adviser. This move was a surprise, considering how an earlier committee appointed in 2007 rejected the idea of implementing such a system in India.

 

dubai-islamic-bank-3_tcm87-21629
(Source: ILMABAD)

 

What is Islamic Banking?

 

Islamic Banking is a Banking System being followed in several parts of the world, mostly in Islamic nations like the Middle East. It follows the Islamic rulings or Shari’ah. Among other things, Islamic Banking prohibits ‘Riba’, roughly translated to ‘Money earned by money’, or in the modern parlance, Interest. The justification given is that money is not seen as an asset in Shari’ah, rather only a medium of exchange. This also means that there is no ‘creditor’ or ‘debtor’ in the system.

 

How do Islamic Banks function?

 

First and foremost, since Interest payments are prohibited, Islamic Banks do not accept deposits. They only ‘lend’ money. In return, instead of interest, the banks take a share of equity in the company. Whatever profit the company makes will then directly translates into better share value for the bank. Of course, if the company does not do well, the bank loses out as well. It is a kind of ‘brotherhood’ under which Islamic Banking operates. In addition to the prohibition of interest, Islamic Banking also prohibits all activities deemed evil by Shari’ah, such as investing in businesses that are related to pork, involving in activities that are highly risky and gambling. The functioning of an Islamic Banking system can be explained somewhat through the below diagram:

 

islamic-banking-cycle

 

Why Islamic Banking in India?

 

The reasoning behind considering the implementation of Islamic Banking in India is that a lot of Muslims in the country shy away from conventional Banking because Shari’ah prohibits it as ‘haram’. The Reserve Bank of India in tandem with the Modi government wants to explore this reform solely for the purpose of furthering financial inclusion, an agenda that is dear to both the central bank and the central government.

 

What are the implications of Islamic Banking?

 

Islamic Banking is very similar to traditional banking, except that traditional banking exchanges its funds for a liability (Debt), whereas Islamic Banking exchanges its funds for equity. In both the cases, the banks earn a ‘fee’ for parting with their funds, over several periods. In case of a default, the traditional bank loses out on interest payment and potentially the principal amount. In Islamic Banking, when the businesses in the bank’s portfolio do badly, the equity value held by the Islamic Bank will erode and the bank will eventually run out of liquidity. But at least, in traditional banking, there is a scope for recovery via Strategic Debt Restructuring and the central bank can control the supply of money via interest rates. In these frontiers, the Islamic Banking system offers little to no solution. There is also a major concern that Islamic Banking is convenient for illegal funds to flow through easily.

But Islamic Banking has become an inevitable part of modern banking and will also be implemented in India. It is only a question of whether or not the entire traditional banking system in India should be overthrown and replaced by Islamic Banking or should both the systems co-exist, that needs answering the most (Islamic Banking system is already allowed in very few banks across India). Hopefully, the latest committee set up by the Reserve Bank of India will find an answer. If not for anything else, there is a good chance that Islamic Banking will be introduced as an add-on service to traditional banking in order to encourage the marginalized sections of the Muslim population to take part in Banking activities.

 

This article was written by Dinesh Sairam (PGDM, XIME-B, Batch 21)