We hear about banks and banking in our daily life. Banking is an interesting business. But how many of us really understand what bank does OR how it earns money. Here is a ready reckoner for you.

Well, if you are thinking that banks takes the money that we deposit with them and lends them for a higher rate in the form of loans, you are right. That is how banks earn money primarily but that’s not all. There are rules and regulations set by RBI, on how much of money that commercial banks can use and what it should be used for. To understand banking, we first need to understand these basic terminologies. i,e CRR, SLR, Repo Rate and Reverse Repo Rate. The financial wizards are known to give big jargons for simple concepts, so don’t be intimidated.

CRR – The Cash Reserves Ratio

Let’s assume, you deposited Rs.100 in a bank. It has been made mandatory by the Reserve Bank of India (RBI) that Rs.4 of every 100 rs must be deposited back into RBI current account. This money earns no interest. This is the money that bank has keep in cash. It’s that simple.

SLR – The Statutory Liquidity Ratio

RBI has also made it mandatory that banks will have to lend money to Govt Of India (GOI) by buying central & state govt securities (BONDs). Of course, the banks will earn some interest on these lending. This is called Statutory Liquidity Ratio. The current SLR rates is 21.5%, i,e Rs.21.5 will need to be used by the banks to buy central/state backed securities.

SLR is an important ratio in banking as these govt backed securities are considered to be highly liquid in nature. That means, you can sell your bonds to get back your money in case of money crunch in the banks. This rate basically governs the solvency of a bank.
So now the bank has Rs. 74.5 (100 – 4 – 21.5) that it can spend at its own will. Most often the banks use this money to loan it at an interest rate to fund its operational expenses.

Repo Rate – Repurchase Agreement Rate

Retail investor (us) deposits (74.5 of 100), more often isn’t enough for the banks to build their loan book. When the “King of good times”, Mr.Mallya visits your bank and asks for 1900 Crores of loan money, you aren’t going to tell him “Sorry buddy, we don’t got it”. So, the banks have been given the privilege of borrowing the money from the RBI. But the money isn’t free of cost. Banks will have to pay the RBI a defined rate of interest and that is called the Repo Rate.

The current Repo Rate set by RBI is 7.75% which is revised (if required) by RBI once every quarter.

Increase in repo rate increases the borrowing cost for Banks. Banks would be very happy to borrow money from someone who is willing to give them at a lower rate of interest. And that is retail investors like us who park our money in Fixed Deposits. The rate of fixed deposits will always be less than the repo rate. If repo rate increases to 8.5% from 7.75% tomorrow, banks will have no problem raising FD rates from 7 to 7.5%. However, that depends on bank’s need for money. If bank can’t grow its loan book, it may simply not borrow from us by giving lesser FD rates.

Inflation: While we are on the topic of repo rates, this is one of the parameters that RBI uses to control inflation. Do note that, Inflation is driven by many factors, so it does not mean that increasing the repo rate will bring down inflation. However, increasing the repo rate will certainly reduce the lending power of the banks and increases loan interest rates. As the rates increase, the demand reduces which in turn may reduce the inflation.

Reverse Repo Rates

As you can imagine, it is exactly opposite to the repo rate. It is the rate of interest paid by RBI to the banks for depositing their surplus money into RBI treasury. This rate is typically 1% less than the repo rate, i,e it is currently 6.75%.

There are times when banks have surplus money and just do not know what to do with it. Until they find the credit worthy borrower, the have the privilege to park the money in RBI where RBI will pay them an interest. That rate is called the reverse repo rate.

Logically, banks are not going to invest their money into anything that gives them less than reverse repo rate.

I came across a picture that best explains the repo rate and reserves repo rate concepts. 🙂