Monetary Policy, Rep, SLR, CRR, Qualitative Tools

8/10/2019 Monetary Policy, Rep, SLR, CRR, Qualitative Tools

1/18

10/28/2014 Mrunal Explained: Monetary Pol icy, Rep, SLR, CRR, Qualitative Tools

http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr -revisi ted-before-upcomi 1/18

- Mrunal - http://mrunal.org -

[Banking] Monetary Policy: Quantitative & Qualitative Tools,applications & limitations MSF, LAF, Repo, OMO, CRR, SLR,Revisited before upcoming Urjit Article

Posted By On 30/01/2014 @ 7:13 pm In Economy | 177 Comments

1. Prologue2. What is monetary policy?3. Quantitative Tools

1. #1: Reserve Ratios (SLR and CRR)2. #2: Open Market Operation (OMO)3. #3: Policy Rate4. Bank Rate

1. Liquidity Adjustment facility (LAF)2. LAF Repo Rate3. Marginal Standing facility (MSF)4. Reverse repo Rate

5. Repo Rate in recent years:4. Monetary Policy: limitations5. Qualitative Tools

1. #1: Margin Requirements/ LTV2. #2: Consumer credit regulation3. #3: Selective credit control4. #4: Moral Suasion

6. Monetary policy tools: Quantiative vs Qualitative7. Appendix

1. #1: Why High SLR and High CRR are bad?2. #2: Narsimhan(I) Committee 19913. #3: Narsimhan (II) Committee 1998

8. Mock Questions

Prologue

Next article is about RBI appo inted Urjit Patel Committee on Monetary policyframework.But before dwelling into that, we must recap the basic concepts of what ismonetary policy: its tools and limitations. Otherwise Urjit wont make much sense.Hence in a way, this whole article is a prologue to next article.

Why RBI and Why Monetary policy?

Initially people used barter system for trading. But the barter system had many problems

(click me). Therefore, people switched to money system.

Financial intermediates= middlemen who help in the circular flow of moneybetween households and business firms.There are two types of financial intermediaries: banking institution and non-bankingfinancial institutions.RBI controls (all) banks and (some) non-banking financial institutions.RBIs main job is to control Money supply in this game, and thereby fight inflationand deflation.Inflation = price rise = bad for economy, you know that by common sense.

But Deflation= price decrease = we can buy things at a lower price. Isnt that good? Whyis deflation bad for economy?

Ans. Every business has fixed cost of production say minimum light bill, phone bill,office rent, staff salary etc. So, if prices keep falling and falling (say of Nano car),then car marker will suffer losses. He has no motivation to expand business. Hewants to cut down his production costs, by firing some of the employees= less new

jobs created= unemployment = social unrest.If prices of everything fall- then custom duty, VAT, excise duty, service tax- their
http://-/?-http://mrunal.org/2013/12/economy-barter-money-bitcoin-fungibility-double-coincidence-of-wants-division-of-labour-part-1.html#barter-limhttp://-/?-http://-/?-http://-/?-


2/18



collection will also decrease. Then government has less money to spend oneducation, healthcare, social sector, defense, law and order = poverty, disease ,crime.

by the way

TERM meaningDoes RBI wantit?

DEFLATION fall in the prices (and fall IN employment.) No.

DISINFLATION Fall in the prices but w ithout causing unemployment.yes (while

fighting inflation)

STAGFLATION

stagnation + inflation

prices and wages risebut people cant find jobs, companies cant findcustomers.

No

REFLATIONpolicy to stop the fall in price levels, but w ithout causingrise in the price levels (inflation).

yes

What is monetary policy?

Policy made by the central bank.To control money supply in the economy. (and thereby fight both inflation anddeflation).

RBI implements monetary policy using certain tools. Two types

quantitative tool qualitative tools

Lets start from here.

Quantitative Tools

#1: Reserve Ratios (SLR and CRR)SLR A Bank has to set aside this much money into gold or RBI approved securities. 23%

CRRA Bank has to set as ide this much as reserve. Bank cannot lend it to anyone.Bank earns no interest rate or profit on this.

4%

Reserve ratio: SLR, CRR

Suppose economy is showing inflationary trend. Prices of all goods and services areincreasing day by day.How can RBI stop it using Reserve ratio as a tool?In this case, RBI should RAISE the reserve ratios.

Observe:

Right now

People deposited total this much money in SBI (net demand & TIMEliabilities NDTL)

100 cr.

CRR (4%) [SBI has to keep this much cash aside for reserve] -4 cr

SLR (23%) [SBI has to invest this much money in RBI approvedsecurities]

-23 cr.

Money left with SBI100-4-23=73Cores.

Say RBI raises SRL to 40% and CRR to 15% then?

Originally 100 crSLR 40 -40

CRR 15 -15

Money left with SBI45 cr.

You can see, when Rajan has raised rese rve ratio, money with SBI is reduced (from 73


3/18



crores to just 45 crores.)

What will be its implication?

Imagine youre a money lender. Youve 100 crore rupees and you must make Rs.1crore profit in a year.Obviously, you should lend it @1% interest rate. (because 1% of 100 crore = 1crore.)But what if youve only 2 crore rupees, and you still want to make Rs.1 croer profitin a year?

Now you must lend it @50% interest rate. (because 50% of 2 cores = 1 crore.)Observe that as money decreased (from 100 to 2), loan interest rate increased(from 1% to 50%).

Same happens when SBI is left with less money (after RBI increases reserve ratio).

Lets prepare a flow chart.

Situation: Economy has inflationary trend. Prices of goods and services increasing everyday.

Solution: RBI raised reserve ratio (CRR, SLR)

Result:SBI is left with less money to lend.

Consequences:

1. SBI raises its loan interest rate2. Businessmen borrow less money from SBI3. Businessmen donot start new business. Donot expand existing business4. Result=Less jobs. Even existing employees discharged. If anyone remains in the

job, he doesnt get pay raise. He starts cutting down unnecessary expenditure (e.g.buying two newspapers, getting his shirts ironed, drinking tea @4PM in office andso on. Thus even paper-wall, dhobi, chai-walla- everyones income reduced.)

5. Result= Less income (Because of above reasons)6. Result= Less demand of goods and services (because less income).7. Ultimately shopkeeper will bring down the prices to attract people into buying more

things.

Thus inflation is reduced.

You may doubt- what about supply side bottlenecks, what about cost push and demandpull inflation : Im not going into a ll that details at the moment, else this article will becomelonger than five kilometers.

Lets just prepare a summary table:

Policy dear money cheap money

Tool To fight inflation To fight deflation

Reserve Ratio (CRR, SLR)Increase them. Decrease them.

Moving to the next (Quantitative) tool. Under monetary policy

#2: Open Market Operation (OMO)

Open Market Operation= when RBI starts buying/selling government securities tocontrol money supply.Government securities= piece of paper. It says something like this give me Rs.100,Ill give you 8% interest rate for next ten years and after that Ill repay the principleof Rs.100. This is how government borrows from others.Situation: Economy has inflationary trend. Prices of goods and services increasingevery day.Solution: RBI starts selling government securities in open market.Result: SBI buys them and thus SBIs lending money is reduced. Wait. How?

Imagine Rajan is selling sabzi (vegetables). If SBIs chairman Arundhati Madam goes tobuy vegetables. Obviously madams money will decrease when she buys vegetables.

Then same as usual:

1. SBI left with less money to lend.


4/18



2. SBI raises its loan interest rate (to keep profit margin same)3. Businessmen borrow less money from SBI.4. Businessmen donot start new business. Donot expand existing business5. Less jobs6. Less income7. Less demand8. Ultimately shopkeeper will bring down the prices to attract people into buying more

things.


During deflation, RBI will do the reverse. (i.e. RBI buys Sabzi from SBI). How will it stopdeflation? Think in your head.

Lets update our table



Reserve Ratio (CRR, SLR) Increase them. Decrease them.

Open Market Operation (OMO)RBI sell securities RBI buy securities

Mock Question

In 2013, UPSC walla asked a very chillar question from this topic.

In context of Indian Economy, Open Market Operation refers to

a. Borrowing by scheduled banks from RBIb. Lending by commercial banks to industries and tradec. Purchase and sale of government securities by the RBId. None of Above

Whenever you face a GS/GK type MCQ, Youve three choices

Skip If you dont know the answer, Just leave it instead of risking negative mark.

Attempt Correct answer is Opt C.

Mark nReview.

It means youve unsure of the answer. 50:50. So you mark the question number(say 45), at the back of your question paper. At the end of exam, if youre leftwith 10-15 free minutes. You look at the question again, and try to solve it.

So, should you put above question in mark n review?

No.Because its a definition based question. If you dont know the de finition of OMOyou might tick a wrong answer and fail. Most of the s incere players fail in prelimsbecause of this reason. They push their luck in negative marking to overcome an

imaginary cutoff and thus dig up their own grave. (especially during last 10-15minutes of the exam.)Moral of the story: never put fact/definition type MCQs in Mark-n-Review.

Lets solve a bit more complicated MCQ from 2012s CSAT paper.

Q.Which of the following measures would result in an increase in the money supply ineconomy?

1. Purchase of government securities from public by central bank2. Deposit of currency in commercial banks by the public3. Borrowing by government from the central bank.4. Sale of government securities to the public by central bank.

Answer choice

a. Only 1

b. 2 and 4c. 1 and 3d. 2, 3 and 4

Whenever you face such multiple statement type MCQs, always use elimination method.First find a statement that is definitely right or definitely wrong and eliminate choicesaccordingly.


5/18



Focus on first statement Purchase of government securities from public by centralbank: will it increase money supply in the system?Imagine Rajan puts an ad in newspaper: bring your Sabzi (vegetables), Ill buy it.Junta gives him their own veggies, Rajan gives them money. (a classic buy and sell).Ultimate result: money supply increased in the system- because junta got themoney. Meaning #1 definitely correct.If you think it on technical terms. Central bank purchases governmentsecurities=OMO (Open market operation), where money shifts hands from RBI topeople.Hence money supply increased. (In rea lity, money doesnt go to aam admi directly,

but those bankers and non-banking institutions who participate in OMO). Anyways,#1 is right, Eliminate choices that do not have #1

a. Only 1b. 2 and 4c. 1 and 3d. 2, 3 and 4

Now the final answer depends on whether statement #3 is right or wrong?

Statement #3 says Borrowing by government from the central bank. (So, will itincrease money supply?)How does Government borrow from Central bank? Does Mohan just callup Rajanand demand 1 lakh crores? No. Mohan will have to give Rajan that much

government securities (vegetables) and Rajan w ill give him cash.Is money supply increased? Yes Mohan sold veggies to Rajan and got Money.Whenever Rajan buys veggies and pays the money supply is increased. (this issimilar to Open Market operation)Besides, Mohan can then use money to pay salaries of government staff, pay forrail-road-bridges and other infrastructure projects, pay for MNREGA and so on.Therefore Answer C: 1 and 3 correct.

Counter- argument?

What if Rajan subsequently sells those (Mohans) securities to bankers. Thenbankers money reduced. Hence #3 is wrong. Therefore final answer A only 1.

So, whats the final answer: is it A or is it C?

Ultimate judge= UPSCs official answer key uploaded on the ir site.

In 2012s Question paper Test series A, this is Q77: and its official answer is C.Therefore, both 1 and 3 are correct.

Anyways, what to do in the exam?

Skip If you dont know the concept better skip.

Attempt This question is attemptable if you dont drag the logic too much in statement #3.

Mark nReview.

Yes, it can be put under mark and review because this is not an absolute fact/absolute de finition type MCQ. If you apply some concepts, you can e liminatewrong choices. But still if doubt persists in the mind (e.g whether Statement 3 is

right or not) then its always safe to skip and avoid negative marking.

By the way, What about Statement #2: Deposit of currency in commercial banks by thepublic. (Will it increase money supply or not?)

Viewpoint 1: yes. Because bank can used it to expand loanable credit. (asexplained in Money creation topic in Class 12 NCERT Macroeconomics page 39onwards).Viewpoint 2: no. (Because Bank will have to put some money as ide as CRR- so thatmuch money is less in the system.)

Either way it doesnt change the answer. Because We know that statement 1 is definitelycorrect. And there is no option where (1,2) are given simultaneously.

Anyways, Moving onSo far, RBI has two tools under monetary policy:

1. reserve ratios (SLR, CRR)2. Open market operation.

Third and the most important quantitative tool is


6/18



#3: Policy Rate

Policy rate= in case of India its Repo rate . Before moving further, lets refresh ourconcepts of Bank rate, LAF, MSF, Repo and Reverse repo.

Bank Rate

When banks borrow long term funds from RBI. Theyve to pay this much interest

rate to RBI. [Note: different books give different explanation of Bank Rate. I've usedNDTV's definition]At present, Bank rate= 9%Collateral: nothing. (Bank can borrow money without pledging governmentsecurities to RBI)Bank rate is not the main tool to control money supply these days.Nowadays, RBI uses LAF Repo rate as the main tool, to control money supply.

Ok then Whats the use of Bank rate?

Penal rates are linked with Bank rate. For example, If a bank doesnt maintain CRR,SLR as per the prescribed limit.Then RBI can impose penalty interest on such notorious bank.At present, Penalty rate = Bank rate + 3% (or 5% in some cases)

Meaning if Bank rate = 9% then penalty rate=9+3=12%

Anyways, what if RBI wants to fight inflation using bank rate as a tool?

Obviously they should increase bank rate. That way it becomes harder (more expensive)for banks to borrow from RBI.=> SBI increases its loan rates (to keep the profit marginsame). Result?

Less people get home loan, bike loan, business loans.Less business expansionLess jobsLess incomesLess demand

Ultimately shopkeeper w ill bring down the prices to attract people into buying morethings.


Lets update our (stupid) table




Open Market Operation (OMO)RBI sell securities RBI buy securities

Bank rate Increase decrease

Liquidity Adjustment facility (LAF)

Liquidity Adjustment facilityRBI started this in 2000. You can imagine it as a Adda/gambling den/gang-hideoutwhere RBIs clients gather, consumer desi liquor, play cards, watch item songs andborrow money from RBI (or lend Money to RBI).By the way, who are the clients of RBI?= Central and state governments, Banksand non-banking financial institutions (NBFI). NBFI further includes:

AIFI (all India finance institutions) NABARD, SIDBI, EXIM Bank and Nationa lHousing Bank.Primary dealers (Morgan Stanley , Goldman Sachs, JP Morgan Chase,Standard Chartered Bank, HSBC etc.)Non-Banking financial companies.

Anyways, Under this LAF adda, RBI has two tools:

RepoIf client borrows money from RBI (for short term) then client has to pay this muchinterest rate to RBI. At present Repo is 8%. (article written on 29th Jan 2014)

ReverseRepo

If client lends money to RBI (for short term) then RBI has to pay this muchinterest rate to client. RBI doesnt like headache. So they made a s imple formula:
http://profit.ndtv.com/news/corporates/article-repo-rate-and-other-terms-explained-302105


7/18



Reverse repo rate= Repo MINUS 1%=8-1=7%.

Collateral:

Problem with running a adda/gambling-den = sometimes client drinks too muchdes i liquor and passes out on floor. Sometimes he even dies because of hooch.Sometimes po lice raids the den, and clients run away with cash and register.If such things happen, Rajan will be a t loss. So, he demands governmentsecurities as collataral. So even if client doesnt repay money on time, Rajan cansell those securities (in open market operations) and recover money.

LAF Repo Rate

Lets get a bit technically correct now. Observe following image

Scenario

SBI chairman Arundhati mam wants to borrow Rs.100 crore (for short term).She gives her stash of government securities to Rajan.Rajan gives her Rs.100 crore.Madam Also signs an agreement

I, Arundhati Bhattacharya, agree to buy same securities from Rajan, at 108 croresafter 14 days.Notice that she has agreed to re-purchase same securities from Rajan. Thereforeits called Repo.And how much interest rate did she pay on this loan? [108-100]/100=8%. Thatsour repo rate.Important:

Recall that SBI also has to keep part of her money in RBI approved securities (underSLR).So Madam cannot USE those government securities to borrow under Repo Ratefrom Rajan.

That leads to a new topic
http://www.flickr.com/photos/97816112@N02/12220419083/


8/18



Marginal Standing facility (MSF)

MSF mechanism is same as repo. But some differences

LAF (Repo) MSF

Rajan says dont come hereunless you want to borrowminimum Rs.5 crores.

Minimum Rs. 1 crore.

All clients are welcome i.e.

Central and stategovernmentsBanks be it commercialbank or RRB orcooperative bankNon-banking financialinstitutions.

Sorry. Not all clients welcome here.Only scheduled commercial banks can borrow underthis window. SBI, PNB, BoB, ICICI etc.This MSF facility is specially created to help themsolve short-term cash mis-match.

You (bankers) cannot pledgesecurities from SLR quota toborrow from this window.

Can use securities from SLR quota.

No limit. You may borrow asmuch as you want. (as long asyou have governmentsecurities to pledge to me.)

Maximum 2% of NTDL. To put this in crude words, if SBIreceived 100 crores from aam-admi under savingsaccount, current account, fixed deposit etc. then SBI canborrow only upto Rs.2 crores from RBI.

Rajan decides Repo rate (8%right now)

MSF = Repo Rate +1% = 8+1=9%. (earlier this margin of1% used to be higher. But nowadays just 1%!)

for those who still have doubt about Repo vs MSF:for repo borrowing, bank will need to pledge securities to Rajan. But bank cannot useSLR-reserved securities for this.so, imagine if a bank is in dire need of cash, but doesnt have spare governmentsecurities- then they can borrow using MSF by pledging those SLR securities. (and underMSF window , Rajan will demand 1% higher than Repo as one type of punishment forpledging SLR securities.)

Reverse repo Rate

Although self-explanatory. But lets checkRepo = clients borrow from Rajan and pay this much interest rate. (short term loan)Reverse repo= when Rajan himself borrows from clients, then he has to pay thismuch interest rate to clients.Collateral = yes. What if police raids this gambling-den, and Rajan runs away toNepal? Clients can se ll Rajans Government securities and recover their money.Reverse repo = Repo MINUS 1% = 8-1% =7%.Note: in official parlance, they call percentages in basis points so 1%=100 basispoints. So in that official language, Reverse repo = Repo MINUS 100 bas is points.

Enough cheap jokes. What have we learned so far?

That Rajan controls money supply using monetary policy.Under Monetary policy, Rajan has various weapons (or tools)

1. Reserve ratios (SLR, CRR)2. OMO: Open market operation3. Rates: Bank rate , LAF (Repo, Reverse repo), MSF.

We already know how to apply SLR, CRR and OMO to fight inflation (and deflation.) let mepaste the table aga in.



Reserve Ratio(CRR, SLR) Increase them. Decrease them.

Open MarketOperation(OMO)

RBI sell securities RBI buy securities

Bank Rate increase it decrease it


9/18



Repo rate increase it decrease it

Reverse Repoits value is linked with Repo, hence cannot be increased/decreasedindependently.

MarginalStandingFacility

its value is linked with Repo, hence cannot be increased/decreasedindependently. Besides MSF= temporary firefighting, cashmismanagement.

We learned that Rajan doesnt use Bank rate much, to control money supply.We learned that Rajan doesnt decide Reverse repo and MSF. (theyre automatically-1% and +1% of Repo rate).

Thus the only thing Rajan has to decide under monetary policy= Repo rate.Therefore, Repo rate is called the policy rate

Lets revisit out flow chart:

Situation: Economy has inflationary trend. Prices of goods and services increasingevery day.Solution: Rajan increases Repo rate. (say from 7.75% to 8%).Result: it becomes expensive for SBI to borrow from Rajan. Theyll increase theirown rates as well.Wait. How?

Just like how things roll in Onion biz.

If prices of Onion rise in Maharashtras wholesa le yard (in Lasangaon), then immediately,retail veggie @Ahmedabad will also raise their onion prices to keep the profit marginsame.

Whatll be the consequences (if repo rate is hiked / increased)?

Consequences:

1. SBI raises its loan interest rate (to keep profit margin same)2. Businessmen borrow less money from SBI.3. Businessmen donot start new bus iness. Donot expand existing business.4. Less jobs5. Less income

6. Less demand7. Ultimately shopkeeper will bring down the prices to attract people into buying morethings.





Open Market Operation (OMO) RBI sell securities RBI buy securities

Policy Rate (Repo Rate) Increase it Decrease it

Repo Rate in recent years:

Lets observe with a graph: how RBI fought inflation/deflation in recent times using Reporate as the main-weapon of monetary policy.


10/18


http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr -revisi ted-before-upcom 10/18

From above above graph, you can see RBI has frequently changed its repo rate to combatboth inflationary and deflationary trend. But Youd agree that inflation has not been

contained. No matter what number juggling or statistical interpretations are given- thehardship of common man has not stopped- be it milk, petrol, onion, LPG anything.

Agreed that prices of onion, sugar, pulses and food are subject to vagaries ofmonsoon and black marketeering. Rajan cannot do anything about it.Agreed that crude oil prices are subject to rupee-Dollar exchange rate, externalfactors and governments de-regulation of their prices. Rajan doesnt have muchcontrol over this.

But still even in the non-food, non-fuel type commodities- RBIs monetary policies havefailed to curb inflation. WHY? Observe the following image.


11/18



Suppose Vijay Mallay got 100 crore loan from State Bank of India. If you trace the sourceof that money, itll turnout 60-70 crores came from banks savings account, fixed depositetc. Rajan lends money in repo rate yes, but that doesnt mean banks depend only onRajan to arrange the cash for its clients.

Suppose Rajan reduces repo rate from 8% to 5%. Banks are not lega lly required toreduce their loan interest rates.

The current system is following:Banks are free to decide their base rate. E.g. SBIs base rate is 10%.It means SBI wont loan money to anyone at an interest rate lower than 10%(except those farmers under Interest subvention scheme.)SBI will link all of its loan products with Base rate. For example

SBI Base rate =10% Calculation Result

Car loan 0.75% above Base rate 10.75%

Two wheeler loan 8.25% above base rate 18.25%

Education loan (upto 4 lakh) 3.5% above base rate 13.5%

Home loan for women (upto 75 lakh)0.10% above base rate 10.10%

Meaning if SBI changes her Base rate then all of above loan interest rates w ill changeautomatically.

If Rajan changes his repo rate, will SBI change her base rate?

Not always.

Because those common men are the main suppliers of money to SBI.RBI is not the main supplier of money to SBI.


12/18



SBI will only change its base rate, when she feels necessary for its own profit / losscompared to its competitors.

Does it mean Repo rate system is bogus and ineffective?

Not always.

In developing countries like India, most people park their money in only four things:savings account, fixed deposit (FD), provident fund and LIC. Weve mutual funds,weve NPS, weve ULIPs, weve Rajiv Gandhi equity savings scheme but most people (particularly the older generation) feels insecure in into such newthings. Therefore lot of money flows into Savings accounts and fixed deposits=SBIs main source of money.But, In advanced economies, like USA, people dont invest large portion their incomein savings account or FD. Theyve variety of investment options. So, for thoseAmerican banks, their own Central bank (US Feds) is a significant money supplier.Hence US Feds monetary policy shows faster impact on their American Banks, THANRajans monetary policy on Des i banks.

Monetary Policy: limitations

In developing countries, Monetary fails to bring quick results because

1. People dont have many investment alternatives. Commercial banks have largedeposits. Rajan is not the main or even prominent money supplier for these banks.Whatever Rajan does, its effect will be felt only after 6-8 months but by that time,new factors would cause another rise in inflation and Rajan will have to start fromscratch again.

2. Non-Monetized economy: in rural areas, many transactions are still of barter nature.(E.g. kiranawa lla cum middleman supplies seeds, pesticides, fertilizers- in exchangeof share in farmers produce.)

3. Lack of financial inclusion. Since most people are not in the banking net. They relyon Shroffs and moneylenders. Many of them circulate the black money of cops andpoliticians, and charge 36% interest rate on loans . Rajan has no control over them.

4. Monsoon uncertainty, cyclone, flood, draughts and their effect on food production.Food inflation =>newspaper walla, washerman, barber, car mechanic everyone w ill

raise their service fees to accommodate their raised cost of living. Rajan has nocontrol over them.

5. Crude oil and gold import + negative effect when rupee weakens. Rajan can try tobring 1$=Rs.65 to $1=63 Rs. But he has not enough forex reserves to bring$1=Rs.50.

6. Fiscal deficit, illogical schemes. e.g MNREGA worker digs a temporary road. Afterfirst rain, t he road is w iped out= physical infrastructure added to economy no.Wages raised..yes. = this mismatch leads to more inflation.

7. Subsidy leakage, Black money, underground economy.8. And most importantly, because Rajan uses Multi-indicator approach, he focuses on

WPI (minus food and fuel). Thats why Urjit Patel recommends him to target CPI.More on that in next article.

So far, we learned that RBI has two se ts of tools/instruments under monetary policy:

Quantitative tool Qualitative tools

1. Reserve ratios2. OMO3. Policy rate (Repo

Rate)

We ll see them in a moment

Qualitative Tools

#1: Margin Requirements/ LTV

Mallya wants to borrow from SBI. He pledges his companys shares worth Rs.100crores as collateral.For such loans, Rajan can prescribe margin, say 65%.In that case even if Mallya pledges 100 crores worth shares, SBI can give him 100-


13/18



65=only 35 Crore rupees as loan.Using this tool, Rajan can control money supply. e.g. during inflation, he shouldincrease margin requirement, so Mallya can borrow less=> less job=>lessincome=>less demand=>prices reduced.If Rajan changes repo rate, it is not compulsory for SBI to change her loan interes trates. (we saw how Alok Nath keeps giving money to SBI, so they are not entirelydependent on Rajan.)But if Rajan changes margin requirements, then SBI and all other banks must obeyit. In other words, this tool has direct impact on money supply.

#2: Consumer credit regulation

Suppose Nano car sells @1 lakh and Rajan has made rule that downpaymentcannot be less than 30%.It means customer must bring Rs.30,000 from his pocket and bank can only give himmaximum 70000 as loan.

How can Rajan fight inflation w ith this tool?

Increase downpayment from 30%=>50% (meaning bank can give less loan.Customer himself has to arrange lot of money from his own pocket)Rajan can make rule banks cannot accept EMI less than 5000 on car loan.Observe:

Case #1: 100 EMIs worth 1000 each = 1,00,000. (ignore interest rates)

Case #2: 20 EMIs worth 5000 each=1,00,000. (ignore interest rates)

In case #2: some of the lower-middleclass families may postpone their decision topurchase nano car (Because they cant afford higher EMIs.)

Result= less demand=>prices reduced. (indirectly- because car mechanics get lesswork, number-plate painters get less orders etc. so they reduce fees to attract newclients and retain existing clients.)Thus, Rajan can control money supply by changing downpayment and installment(EMI) rules.

#3: Selective credit control

Under this, Rajan can specifically instruct bankers not to give loans to traders o fcertain commodities e.g. sugar, gur, edible oil etc.even if the said trader is ready to mortgage hisshares/bonds/factory/machine/vehicle anything.this prevents speculations/ hoarding of commodities using money borrowed frombanks.

#4: Moral Suasion

Here Rajan tries to persuade the bankers to do xyz thing. Example

1. Please reduce giving automobile loans- instead park your money in governmentsecurities. (above the SLR requirements.)

2. Ive reduced my repo rate, now you also reduce your base rate.

Rajan will try to influence those bankers via- direct meetings, conference, giving mediastatements, giving speeches @public seminars, university convocations etc. (even wherebankers are not present.) Hell do so, to build a public opinion, media opinion andinfluence those bankers by making them feel guilty.

Rationing

of credit

Found in Planned economies/communist nations.Here central bank w ill decide upper limit to loans in each sector (heavy

industries, service, agriculture, small-scale etc.)So once that quota is over. Additional loans cannot be given to thatborrowers from that sector. This also controls money supply.

Directaction

Means RBI gives punishment to erring banks. Punishment can involve: pena linterest, refuses to lend them money from LAF etc. and in worst case evencancels their banking license.


14/18



Lets recap

Monetary policy tools: Quantiative vsQualitative

Quantitative Qualitative

1. Reserve ratios (SLR, CRR)2. Open Market Operation3. Policy rate (Repo Rate)

1. Margin requirements / LTV2. Consumer credit regulation3. Selective credit control4. Moral Suasion5. Rationing of Credit6. Direct Action

Indirect in nature. (Even if Rajan changes repo rate, itsnot necessary SBI will immediately change its baserate / loan interest rates.)

Direct in nature. (e.g. thosemargin requirements)

General- they affect money supply in entire economy-be it housing, automobile, manufacturing- everything.

Selective- can affect moneysupply in a specific sector ofeconomy e.g. automobile.

Lets solve an Official MCQ from UPSC 2012 Question paper

Q. RBI Acts as bankers bank. This would imply which of the following?

1. Other banks retain their deposits with RBI2. RBI lends funds to commercial banks in the times of need.3. RBI advises commercial banks on monetary matters.

Correct Statement

1. Only 2 and 32. Only 1 and 23. Only 1 and 34. 1, 2 and 3

Approach:

Whenever you face such 3 statement MCQ or 4 statement MCQ, Always use eliminationmethod. First you find out a statement that is definitely right or definitely wrong. In abovecase, we can see #2 is definitely right. RBI lends funds to banks in the times of need(Repo, MSF)

So lets eliminate choices that dont involve statement #2

1. Only 2 and 32. Only 1 and 23. Only 1 and 3

4. 1, 2 and 3

This did not help much. We still have three choices left. Observe s tatement #1:Other banks retain their deposits with RBI. That is correct with respect to cashreserve ratio. CRR is one type of deposit that banks make to RBI. (RBI doesnt payinterest on it- thats a different story).Meaning #1 is also correct eliminate choices that donot have #1

1. Only 2 and 32. Only 1 and 23. Only 1 and 34. 1, 2 and 3

Only two choices left and the ultimate solution = is statement #3 is correct or not?

Viewpoint #1 Viewpoint #2The statement says RBI advises commercial banks onmonetary matters.The word advises makes thisstatement incorrect. Because RBI doesnt Advice they justorder the banks- be it SLR, CRR, PSL. RBI doesnt advice, RBIgives orders and direction. Therefore statement #3 is

RBI does advice thosebanks. We saw it under

Moral Suasion. Therefore,Statement #3 is right.


15/18



wrong.

Even if we accept that RBI advices, still the questions askswhat is implied by RBI as Bankers bank. So, RBI advices

moral suasion that is a monetary policy tool. RBIs notdoing it as a Banker to those banks. Therefore, Statement#3 is definitely wrong.

Money Banking and finance,E Narayan Nadar (PHIpublication). He hasspecifically listed this

Advice function underBankers bank topic.

Answer (B) Answer (D)

So, is it B or is it D? Final judge is UPSC.

They had uploaded CSAt-2012 official answer key on their site.This question is Test Series A, Question #75 and its official answer is D = meaningall three statements a re correct.

If you face such MCQ in exam, what should be your approach?

Skip

Upto you. But if you start skipping all such question (OMO, Money supply,Bankers bank), because youre completely unaware of those topics=that is notpardonable.it shows youre underprepared for this exam. You should eitherchange your study method or change the game- try for someeasierexam.

AttemptThis question is attemptable, if you dont nitpick over the word advises in thirdstatement.

Mark nReview

If youve thoroughly prepared the RBIs monetary tools (both qualitative and

quantitative), you can solve it by applying concepts/principles- particularly themoral suasion thing. But if youre still doubtful over whether #3 is right or wrong,then better skip. If you skip because youre doubtful = that is pardonable. But ifyou skip because youre completely unaware of this topic= non-bailable offense.

Appendix

These are the topics I wanted to discuss in the article, but they would break the flow ofother topics. Hence writing them @bottom:

#1: Why High SLR and High CRR are bad?

From the discussion so far, you might think why Rajan only focuses on Repo rate tocontrol money supply. Why not simply raise SLR and CRR requirements.

Lets check the de-merits of high SLR and CRR:

Prior to LPG reforms in 90s, RBI used to keep SLR and CRR very high. Lets take anexample

A Bank can two types of deposits

Deposit type examples

Time Deposit Fixed deposit (FD) recurring deposit.

Demand DepositSavings account, current account

Using this money, bank has to count its Net Demand and Time liabilities (NDTL),every fortnight. Suppose its 100 crores.Both CRR and SLR are counted on this figure. In the old times, these reserve ratiosused to be as high as 15% and 40% respectively. Observe the effect:

Net Demand and Time Liabilities (NDTL)+100 cr.

Reserve ratios

CRR (15%) (-) 15 [no profit]

SLR (40%) (-) 40 [some profit]

Money left with bank =45 cr.

From 100 crores, barely 45 crores left with the bank. But adding insult to the injury- evenhere RBI mandates Priority sector lending (PSL). Meaning, at least 40% of the loans hasto be given to farmers, small businessmen, students etc. groups.

Lets update the table:


16/18



Net Demand and Time Liabilities (NDTL) +100 cr.

Reserve ratios

CRR (15%) (-) 15 [no profit]

SLR (40%) (-) 40 [some profit]

Money left with bank =45

PSL (40%)=45 x 0.4 =18crore.

Money left for big borrowers (i.e. big businessmen, uppermiddleclass)

=45-18=27 crores.

By the way, PSL is counted on annual basis while SLR, CRR counted on fortnightbas is so above table is technically incorrect but Ive plugged in those numbers onlyfor the sake of explanation.before the 90s- Government would even interfere and order public sector banks togive PSL-loans @cheap interest rates. The local politicians would coerce the branchmanager to give PSL-loans to ineligible people. They default on loans, Branchmanager cannot recover money (because defaulter will goto civil court then taarikhpe taarikh.) So, bank would have to forget about most of those 18 crores given inPSL loans.Anyways you can see people deposited 100 crores in the bank yet bank is left withbarely 27 crores (over which, bank has Freedom to decide whom they should givethe loan.)

What are the consequences for businessmen?

1. High cost of credit (because bank will try to make maximum profit from those 27crores- so bank will charge very high interest rate on the bus iness loans- to pay offfor the staff salaries, branch office rents and everything.)

2. Businessman cannot expand his business.3. Less exports.4. Less tax income for the government.

So in a way- that was also one of the factors leading to Balance of Payment crisis (andsubsequently LPG reforms.) You can read more about that in NCERT Class 11- chapter 2and 3.

#2: Narsimhan (I) Committee 1991

Plagued by problems and losses in nationalized banks, Government of India formed thisCommittee. Recommendations were:

1. Deregulate interest rates. Let the banks decide their loan interest rates. Accepted.Gradually, we moved to the Base Rate system.

2. PSL loans should be given at normal interest rates. Accepted (but with exception=>interest subvention- that we saw under Nachiket articles.)

3. NPA/Loan default matter should be handled by separate body and not civil courts.Result: Debt recovery tribunal created in 1993. Ultimate ly SARFAESI Act in 2002.

4. Reduce CRR, SLR. Accepted. Today we ve them @4% and 23% respectively.5. Allow Private banks and foreign banks. RBI invited applications in 1993. ICICI, Axis,

HDFC and many others got license.6. Liberate Branch expansion policy. Done (Except that 25% rural branching mandate

we saw under Nachiket articles).7. Prepare NBFC regulatory framework. Accepted.8. Government should reduce shareholding (and thereby its official influence) in the

public sector banks. Government agreed. Today governments shareholding in SBI=~60%.

#3: Narsimhan (II) Committee 1998

Suggested more reforms.

1. allow VRS in the banks so they can get rid of excessive staff.2. Suggested additional Legal reforms for loan recovery. =>SARFAESI 2002.3. Computerization, electronic fund transfer, legal framework => Payment and

Settlement Act=>Retail (ECS, NEFT, credit Card) + Wholesa le (RTGS)4. Permit new private /foreign banks. RBI invited license in 2001= Yes Bank and Kotak

Mahindra got licenses. 2013: RBI again invited applications for bank licenses.
http://mrunal.org/2012/12/economy-sarfaesi-asset-reconstruction-company-arc-security-receipt-sr-qib-drt.html


17/18



[Note: list of recommendations not exhaustive, Ive only highlighted important topics thatshow evolution of banking sector in recent times.]

Mock Questions

1. With open market operations, RBI cana. increase liquidity in the economy, but cannot decrease itb. decrease liquidity in the economy, but cannot increase itc. Can increase or decrease liquidity in the economy to control money supply.

d. None of above.2. By which of the following methods, government can reduce money supply in the

economy?a. taxationb. sale of securities to publicc. both A and Bd. neither A nor B

3. During the period of deflationa. RBI should use dear money policy to combat itb. Government should reduce its tax rates.c. both A and Bd. Neither A nor B.

4. IF prices are lowered without causing unemployment, we call it:

a. stagflationb. reflationc. disflactiond. Disinflation.

5. Which of the following contains correct set of quantitative instruments o f monetarypolicy?

a. reserve ratio, bank rate, margin requirementsb. open market operations, margin requirements, regulation of consumer creditc. cash reserve ratio, bank rate, open market operationd. None of above

6. Which of the following contains correct set of qualitative instruments of monetarypolicy?

a. reserve ratio, bank rate, margin requirements

b. credit rationing, margin requirements, regulation of consumer creditc. cash reserve ratio, bank rate, open market operationd. None of above

Q7. To counter the effect of deflation, which of the following steps should RBI initiate?

1. decrease reserve ratios2. buy government securities through open market operation3. increase policy rate

Answer choices

a. only 1 and 2b. only 2 and 3

c. only 1 and 3d. 1, 2 and 3

Q8. To counter inflation, which of the following steps should RBI initiate?

1. Increase reserve ratios2. sell government securities through open market operation3. Increase policy rate

Answer choices

a. only 1 and 2b. only 2 and 3c. only 1 and 3

d. 1, 2 and 3

Q9. Which of the following may cause deflation in the economy?

1. RBI raises policy rate2. RBI raises cash reserve ratio3. RBI sells securities


18/18


Choices:

a. only 1 and 2b. only 2 and 3c. only 1 and 3d. all 1,2 and 3

Q10. Money supply in the economy, is affected by

1. Cheap money policy and dear money policy.2. Open market operation and Moral Suasion.3. Consumer credit regulation and loan to value ratio.

Choices:

a. only 1 and 2b. only 2 and 3c. only 1 and 3d. all 1, 2 and 3

Q11. An increase in SLR

1. will restrict the expansion of banks credit2. will increase banks investment in safe securities

3. will ensure solvency of the banks

choices:

a. only 1 and 2b. only 2 and 3c. only 1 and 3d. all 1,2 and 3

Mains/interview type questions- after we check Urjit Patels recommendations onstrengthening monetary policy.

Hints

1. can increase by buying, can decrease by selling2. both [or only B, depending on how UPSC examiner interprets the effect of taxationon money supply. In one of the reputed book on Banking and finance, authorNarayan Nadar claimed taxation can a ffect money supply.]

3. dear money policy during deflation =adds insult to the injury of businessman. Ifgovernment reduces tax- then its revenue collection will drastically reduce. So bothincorrect. [OR debatable- depending on how UPSC examiner interprets the effect oftaxation during deflation.]

4. directly given in the article.5. see the last table in the article6. see the last table in the article7. observe the table before the topic repo rate in recent years8. same as above9. same as above

10. All correct. (Unless you nitpick and drag the logic too much.)11. same as above.

Visit Mrunal.org/EconomyFor more on Money, Banking, Finance, Taxation and Economy.

Article printed from Mrunal: http://mrunal.org

URL to a rticle: http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcoming-urjit-article.html

Copyright 2014 Mrunal. All rights reserved.
http://mrunal.org/Economy

Documents

Monetary Policy, Rep, SLR, CRR, Qualitative Tools