Impact of Repo Rate on Bank Lending-2014


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Impact of Repo Rate on Bank Lending-2014

  1. 1. Impact of Repo Rate on Bank‘s lending 2013-14 2014 Sudheer Parashar 5/5/2014
  3. 3. Amity Business School Page 2 DECLARATION I, hereby, declare that this research report entitled ―Analysis of Impact of Repo Rate on Bank Lending‖ submitted in partial fulfillment for the award of Master of Business Administration in Amity University, Rajasthan is a record of independent work carried out by me under the guidance of Dr. NUPUR AGRAWAL (Faculty member), AMITY BUSINESS SCHOOL, AUR. I, also declare that this report is a result of my own effort and has not been submitted earlier for the award of any degree or diploma of AMITY UNIVERSITY and other Universities. Place: Jaipur Name: Sudheer Parashar Date: - MBA 4th Semester
  4. 4. Amity Business School Page 3 Abstract Changes in Repo rate affect the cost of borrowing of Banks, which shows that RBI plays a very important role in supply of money in the market. This paper examines the recently impact of raise the repo rate on banking lending from the period of September-till now, it also explain what is the scenario of lending behavior towards personal loan and corporate loan. I have done recent theoretical and empirical work that relates to the ―lending‖ channel of monetary policy transmission and Monetary Policy and Long-Term Real Rates, Investigate the efficiency level of repo rate among the all monetary tools. This study aims to find out at what level the impact repo rate on deposit and loan, what should be investment strategy of general public towards change in it. Inflation beyond the threshold level makes growth costly and calls for policy change. As a result of increasing rate for control inflation, the cost of borrowing has been higher.
  5. 5. Amity Business School Page 4 Table of Content 1 Introduction 1.1 Background of Study 7 1.2 Impact of Repo Rate 8-10 2 Lending View 2.1 Concept of Lending 12 2.2 Sources of Fund 12-14 2.3 Use of Fund 15-16 2.4 Lending Segment of Banks 19-23 2.5 Key Driver in Lending Rate 23-27 2.6 Indian Prime Lending Rate 28 3 Repo Policy 3.1 Monetary Policy 30 3.1.1 Monetary Instrument 32 3.2 Inflation vs. Interest rate 33 4 Literature Review 5 Research Methodology 5.1 Research Methodology 44 5.2 Problems of Study 44 5.3 Objective of Study 45 5.4 Importance of Study 45 5.5 Hypothesis of Study 45 5.6 Sample of Study 46 5.7 Sample 46 5.8 Size of Data 46 5.9 Limitation 47
  6. 6. Amity Business School Page 5 6 Analysis & Interpretation 47-52 7 Banking Sector 53-65 8 Conclusion 66-67 9 Reference 68-69
  7. 7. Amity Business School Page 6 1 Introduction
  8. 8. Amity Business School Page 7 Introduction 1.1 Background of Study The inflation is continuously increasing which are the bad for Indian economy. Goal of Indian government is growth that is likely to lose the quantum in Q3 of 2013-14, with industrial activity in contractionary mode, mainly on account of manufacturing. The current account deficit for 2013-14 i s now expected to be below 2.5 percent of GD P as compared with 4.8 per cent i n 2012-13. Reserves have been rebuilt since September, and are expected to increase. And oil companies are buying foreign exchange for paying to RBI. Retail inflation, as measured by the consumer price index, eased to a two-year low of 8.10% in February from 8.79% in January, having touched a high of 11.24% in November. Inflation based on the wholesale price index fell to a nine-month low of 4.68% in February on the back of a drop in food and fuel prices, having been at 5.05% in January. But data from Barclay‘s shows inflationary expectation is running at 12%, the highest in recent memory. The hailstorm is likely to result in an estimated crop failure of about Rs 12,000 crore (0.1% of the full year GDP) and this could reverse the recent downtrend in retail price inflation Monetary authorities may also wait for signals from the new government that will present a full budget once it takes office in May. How quickly rate cuts may begin will also depend a lot on how efficient the new government will be in managing its finances. Although the continued tapering of bond purchases by the Federal Reserve is having little impact on India, international factors such as Ukraine, or a shakeup in the US markets could adversely affect the outlook on rates.
  9. 9. Amity Business School Page 8 1.2 Impact of Repo Rate We all Indian read and watch in newspapers, magazine and TV about the Reserve Bank of India changing Repo Rate and other monetary instrument. Debt markets affected by the change in ”Repo Rate and Reverse Repo Rate”. Banks decide their lending rates on the basis of change in Repo Rate, Reverse Repo Rate and other monetary instrument. RBI hikes repo rate by 25 bps to 8% in January`2014 credit policy. This is the third time that Governor of RBI, Rajan has raised rates after taking over as governor in September 2013 last year an increase of 75 basis points from 7.25% to 8% in four months. The move is unlikely to have an impact on rates charged by banks In a surprise move, the Reserve Bank of India release its third quarter monetary policy increased the short term lending rate or repo rate to 8 per cent from the existing 7.75 per cent. This move see as a surprise to most financial experts as it was announced despite the lower inflation rates released in December. While RBI justified the revision saying it is an essential option to bring down retail inflation, in point view of business leaders, this move is disappointing. Let us take a look at how RBI‘s repo rate policy impacts loans, fixed deposits and other areas of life for the common man. Before getting into the reasons why the increase in repo rates may be bad news for the common man with increased loan EMIs, it is essential to understand what repo rates are and how they impact the banking system. In a layman‘s term, Repo rate is the rate at which the Reserve Bank of India lends money to commercial banks. The increase in repo rates for 7.75% to 8% would mean that the RBI would charge a higher rate of interest for all money given out to various commercial banks. The bank in turn would be forced to charge its customers a higher rate of interest when it comes to home and auto loans to offset the higher interest rate.
  10. 10. Amity Business School Page 9 1.2.3 Impact on Deposit and Lending Rates: Most financial experts are of the opinion that the immediate impact of the increase in repo rates may not necessarily get translated into higher deposit and lending rates offered by the banks. The banks already fighting a weak loan growth rate due to a sluggish real estate sector are unlikely to pass on the increased rates to the customers immediately. Depending on the liquidity condition of the banks, the changed interest and deposit rates may be passed on once banks analyze their cost of funds over the next few days. 1.2.3 Increase EMIs: Once the banks analyze their cost of funds and their overall liquidity condition, the higher interest rates would have to be passed on to the end user or the retail customer. This would effectively mean higher EMIIs on home loans, auto loans as well as personal loans. The home loan segment is likely to face the brunt of this increase in repo rate. Financial experts believe that since the car loan market is dominated by various schemes, financers are likely to absorb the rate hike by increasing discount offers. Majority of car loans are on fixed rate basis compared to home loans with majority offered on floating rate basis. Any rate impact due to the repo rate increase would not necessarily impact the auto loan market as much as it would impact the home loan segment. Real estate companies and developers already facing the brunt of sluggish sales are disappointed with this rate hike as it is likely to dampen interest in the real estate segment.
  11. 11. Amity Business School Page 10 1.2.3 Impact on Loans: The question as to whether banks would actually increase the lending rates amid the hike in the repo rates remains an open one. Once done with analyzing their costs of funds and bank liquidity conditions, the banks would have no option but to increase their interest rates For example, assuming the interest rate on a 20 year housing loan of Rs 75 Lakh is increased from 11 to 11.25 %, it will translate into an increase of approximately Rs 1279 per month in the EMI 1.2.4 Impact on Fixed Deposits: The short term impact of such a hike is does not augur well for investors parking their money in fixed deposits. Being an election year, the banks may reduce retail deposit rates only slightly for below one-year fixed deposits simply to keep their margins intact. The long term policy of the RBI is now aimed at fighting retail inflation. Once the inflation rates are substantially lowered, the prospect of investing in fixed deposit over the long term offers lucrative gains. The immediate impact on small fixed deposits may be a damper but banks are unlikely to lower interest rates across the board as of now giving relief to a vast section of fixed deposit account holders. The unexpected hike in the benchmark lending rate came despite lower inflation rates in December. India‘s wholesale inflation rate eased to a five-month low of 6.16% last month while retail inflation — a more realistic index as it captures shop-end prices — grew at a three-month low rate of 9.87% compared to 11.16% the previous month as fresh seasonal arrivals pushed down vegetable prices.
  12. 12. Amity Business School Page 11 2 Lending View
  13. 13. Amity Business School Page 12 2.1 Concept of Lending in India Banks make generally commercial loans designed to meet the specific needs of a borrower. They also make standardized loans as in the case of mortgage and credit card loans which can be packaged into securitized loans and sold in pools in the secondary markets. Banks which are uniquely qualified to make, monitor and collect commercial loans as well as standardized loans however face competition from insurance companies, Unit Trust and non-bank finance companies. Borrower‘s especially large corporates also have choice to raise funds directly in the primary market by issue of shares and debentures and public fixed deposits and in the money market through issue of commercial paper. The competition from other types of lenders and direct financing by prospective borrowers has reduced the profitability of banks. To offset lower profits banks abroad have shifted some of their loans to higher yielding and higher risk real estate loans and loans to emerging countries. The crash in real estate values and large scale defaults on LDCs debts in 1980s and 1990s has highlighted the tradeoff between risk and return. 2.2 Source of Banking Fund The money that a bank raises to lend is often called the capital. So, how does banks raise capital is something that has to be understood in this background. Banks have to raise money from sources in order to have it with them to be lent to customers, from whom they charge a rate of interest that is higher than that at which they borrow. This accounts for their profit. Since capital is one of the critical components of a banking business, it is important to understand where all and how to banks raise capital. As mentioned before, banks basically make money by lending money at rates higher than the cost of the money they lend. More specifically, banks collect interest on loans and interest payments from the debt securities they own, and pay interest on deposits, CDs, and short-term borrowings. The difference is known as the "spread," or the net interest income, and when that net interest income is divided by the bank's earning assets; it is known as the net interest margin.
  14. 14. Amity Business School Page 13 2.2.1 Deposits The largest source by far of funds for banks is deposits; money that accounts holders entrusts to the bank for safekeeping and use in future transactions, as well as modest amounts of interest. Generally referred to as "core deposits," these are typically the checking and savings accounts that so many people currently have. In most cases, these deposits have very short terms. While people will typically maintain accounts for years at a time with a particular bank, the customer reserves the right to withdraw the full amount at any time. Customers have the option to withdraw money upon demand and the balances are fully insured, up to $250,000, therefore, banks do not have to pay much for this money. Many banks pay no interest at all on checking account balances, or at least pay very little, and pay interest rates for savings accounts that are well below U.S. Treasury bond rates. 2.2.2 WholesaleDeposits If a bank cannot attract a sufficient level of core deposits, that bank can turn to wholesale sources of funds. In many respects these wholesale funds are much like interbank CDs. There is nothing necessarily wrong with wholesale funds, but investors should consider what it says about a bank when it relies on this funding source. While some banks de-emphasize the branch-based deposit-gathering model, in favor of wholesale funding, heavy reliance on this source of capital can be a warning that a bank is not as competitive as its peers. Investors should also note that the higher cost of wholesale funding means that a bank either has to settle for a narrower interest spread, and lower profits, or pursue higher yields from its lending and investing, which usually means taking on greater risk.
  15. 15. Amity Business School Page 14 2.2.3 Share Equity While deposits are the primary source of loanable funds for almost every bank, shareholder equity is an important part of a bank's capital. Several important regulatory ratios are based upon the amount of shareholder capital a bank has and shareholder capital is, in many cases, the only capital that a bank knows will not disappear. Common equity is straight forward. This is capital that the bank has raised by selling shares to outside investors. While banks, especially larger banks, do often pay dividends on their common shares, there is no requirement for them to do so. Banks often issue preferred shares to raise capital. As this capital is expensive, and generally issued only in times of trouble, or to facilitate an acquisition, banks will often make these shares callable. This gives the bank the right to buy back the shares at a time when the capital position is stronger, and the bank no longer needs. Equity capital is expensive, therefore, banks generally only issue shares when they need to raise funds for an acquisition, or when they need to repair their capital position, typically after a period of elevated bad loans. Apart from the initial capital raised to fund a new bank, banks do not typically issue equity in order to fund loans. 2.2.4 Debt Banks will also raise capital through debt issuance. Banks most often use debt to smooth out the ups and downs in their funding needs, and will call upon sources like repurchase agreements or Repo market, to access debt funding on a short term basis. There is frankly nothing particularly unusual about bank-issued debt, and like regular corporations, bank bonds may be callable and/or convertible. Although debt is relatively common on bank balance sheets, it is not a critical source of
  16. 16. Amity Business School Page 15 capital for most banks. Although debt/equity ratios are typically over 100% in the banking sector, this is largely a function of the relatively low level of equity at most banks. Seen differently, debt is usually a much smaller percentage of total deposits or loans at most banks and is, accordingly, not a vital source of loanable funds. 2.3 Use of Fund 2.3.1 Loans For most banks, loans are the primary use of their funds and the principal way in which they earn income. Loans are typically made for fixed terms, at fixed rates and are typically secured with real property; often the property that the loan is going to be used to purchase. While banks will make loans with variable or adjustable interest rates and borrowers can often repay loans early, with little or no penalty, banks generally shy away from these kinds of loans, as it can be difficult Part and parcel of a bank's lending practices is its evaluation of the credit worthiness of a potential borrower and the ability to charge different rates of interest, based upon that evaluation. When considering a loan, banks will often evaluate the income, assets and debt of the prospective borrower, as well as the credit history of the borrower. The purpose of the loan is also a factor in the loan underwriting decision; loans taken out to purchase real property, such as homes, cars, inventory, etc., are generally considered less risky, as there is an underlying asset of some value that the bank can reclaim in the event of nonpayment. As such, banks play an under-appreciated role in the economy. To some extent, bank loan officers decide which projects, and/or businesses, are worth pursuing and are deserving of capital.
  17. 17. Amity Business School Page 16 2.3.2 Consumer Lending Consumer lending grew at a higher rate in 2013 than in 2012 and in 2011. This was despite negative economic sentiment in terms of low growth, high inflation and high interest rates. The high growth was partly due to smart positioning of products by banks, such as pushing credit cards, housing loans and auto loans to self- employed individuals and partly it was because the impact of recession was less on individuals compared to the corporate segment. Not only growth was higher in 2013, but bad assets were also on the lower side than in previous years. Sentiment remained negative in Indian economy in 2013 The overall sentiment remained negative in the Indian economy through 2013. The growth in gross domestic product was a fraction of its peak level in 2007. Inflation continued to remain high in certain pockets, as the price of vegetables soared. The Indian rupee depreciated significantly throughout the year. Reserve Bank of India – the apex body – did not find conditions conducive to cutting key rates. In the absence of rate cuts, banks were not in a position to cut lending rates, which was considered important to boost credit growth. The only silver lining was that the retail side of lending performed better than the corporate side, giving breathing space to all financial institutions Scheduled commercial banks continue to lead consumer lending in 2013 Banks such as State Bank of India, Punjab National Bank, ICICI Bank Ltd, HDFC Bank Ltd, Bank of India, Bank of Baroda and Axis Bank Ltd continued to dominate consumer lending in 2013. These entities fall under scheduled commercial banks (SCBs). The reason that these entities dominated was their decades-long experience in the Indian market, huge capital bases and wide branch networks. Apart from banks, several non-banking financial companies (NBFCs) were also a part of consumer lending. Such entities were smaller in scale than banks because they could not raise money through savings and current deposits. NBFCs had to raise money from money markets and, therefore, they operate on a much smaller scale than banks. Apart from NBFCs, several microfinance institutions (MFIs) also operated in this business. SCBs, NBFCs and MFIs continued to attempt to reduce the share of informal money lenders in 2013. Card lending witnesses fastest growth in 2013 Credit card outstanding balance witnessed the fastest growth in 2013. This was because retail banking consumers continued to report significant growth in disposable incomes. Based on this, banks felt assured of their creditworthiness and
  18. 18. Amity Business School Page 17 focused more on credit cards in 2012 and 2013. Banks realised that the slowdown affected the corporate segment more than retail consumers. This was because a very small fraction of Indians worked in the corporate sector. A large part of the population continued to be self-employed in small businesses. Such consumers continued to post growth in their income and bankers realised their continued creditworthiness. Therefore banks targeted such individuals to grow their credit card portfolios. Consumer lending expected to post strong growth over the forecast period Consumer lending is expected to see continued strong growth in outstanding balance in constant value terms over the forecast period. This will be due to rising disposable incomes, the growth of banks and other financial institutions and increasing financial inclusion. More consumers will come under the ambit of organised means of financing, rather than informal money lenders, who generally charge exorbitant rates of interest.
  19. 19. Amity Business School Page 18 2.4 Impact of Repo on lending segment Date Repo Rate Borrowings from RBI Balances with Reserve Bank Investments in Government and other approved securities Bank credit Food credit Non- food credit 1/10/2014 8% 414.28 3205.14 22255.25 57718.72 1137.08 56581.64 1/24/2014 8% 298.04 3233.33 22107.91 57757.35 1117.74 56639.61 2/7/2014 8% 406.39 3151.89 22308.84 58355.48 1107.09 57248.39 2/21/2014 8% 405.04 3120.05 22369.84 58458.33 1065.67 57392.66 3/7/2014 8% 311.04 3216.77 22374.97 59372.49 1000.30 58372.19 3/21/2014 8% 416.13 3163.44 22216.53 60130.85 984.77 59146.08 4/4/2014 8% 371.88 3265.98 22715.64 60868.81 896.13 59972.68 4/18/2014 8% 318.69 3266.24 22726.38 60360.83 926.90 59433.93 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 0 10000 20000 30000 40000 50000 60000 70000 1 2 3 4 5 6 7 8 Impact on Lending Segment Borrowings from RBI Balances with Reserve Bank Investments in Government and other approved securities Bank credit Food credit Non-food credit Repo Rate
  20. 20. Amity Business School Page 19 2.4.1 Types of Loans Auto Loan Most of the banks provide car loans. Car loan also termed as Auto Loan. One can get car loan up to 85% of ex-showroom price of the car with some amount of processing fee. Education Loan Education Loan is also termed as Student Loan. Educational loan is offered to the students, who are having brilliant academic records, studying at recognized colleges/universities in India or abroad. Educational loan is generally offered to meet the expenses on tuition fees, books and other educational related cost. Home Loan Hiking the key policy rate today will hit property sales, particularly in the residential segment , real estate developers. Raised the key policy rat e by 0. 25 per cent to 8 percent in a bid to curb inflation, a move that may translate into higher EMI s and push up the cost of borrowing f or the corporate, There is already a slowdown in the property market and the overall economy. So, there would not be much adverse impact on sales, make corporate and retail loan more expensive. It may increase EMI burden on common man Personal Loan Credit costs are lower in segments such as home loans, which are secured loans, it may be possible to lower the rates in that segment Re- pricing in loan rates might be seen i n segment s such as personal loans, which were riskier than home loans
  21. 21. Amity Business School Page 20 The fact that most banks were consciously going slow on credit growth, owing asset quality concerns, was another reason why arise in lending rates was unlikely at this point Impact of Repo on Bank’s Loan Segment Date Repo Rate Personal Loans Housing Loan Vehicle Loans Education Loans 2/21/2014 8 10,159.34 2,984.51 1,285.26 571.30 1/24/2014 8 10,091.32 2,974.58 1,274.37 570.48 12/27/2013 7.75 9,989.87 2,952.49 1,261.46 567.90 11/29/2013 7.75 9,843.87 2,945.91 1,240.36 564.74 10/18/2013 7.5 9,702.01 2,922.66 1,202.32 564.25 9/20/2013 7.5 9,652.79 2,909.59 1,185.79 558.04 8/23/2013 7.5 9,564.45 2,888.38 1,174.09 550.73 7/26/2013 7.25 9,423.13 2,873.54 1,167.62 544.76 6/28/2013 7.25 9,347.73 2,865.71 1,167.05 534.11 5/31/2013 7.25 9,272.94 2,833.56 1,167.02 530.97 4/19/2013 7.5 9,124.53 2,791.81 1,141.62 546.31 3/22/2013 7.5 8,975.84 2,672.03 1,110.89 526.12 2/22/2013 7.75 8,719.95 2,633.97 1,082.42 525.86 1/25/2013 7.75 8,658.81 2,623.32 1,063.21 523.46 6.8 7 7.2 7.4 7.6 7.8 8 8.2 0.00 2,000.00 4,000.00 6,000.00 8,000.00 10,000.00 12,000.00 1/1/2013 2/1/2013 3/1/2013 4/1/2013 5/1/2013 6/1/2013 7/1/2013 8/1/2013 9/1/2013 10/1/2013 11/1/2013 12/1/2013 1/1/2014 2/1/2014 AxisTitle Impact on Repo Rate Personal Loans Housing Loan Vehicle Loans Education Loans Repo Rate
  22. 22. Amity Business School Page 21 2.4.2 Deposit Rates In 2013-14 for many quarters, deposit rates have not changed. The reason is deposit rates are linked to the rate of inflation. You should give positive returns to your depositors. You should watch the trends in inflation and deposits, which impact the cost of funds and lending rates. While there is a need to retain deposit rates at these levels due to the high inflation, banks also need to see if the increase can be passed on to borrowers. But credit demand has not started picking up. So, if banks raise deposit rates, the cost will have to be absorbed. Each bank‘s asset liability management committee will meet and take a decision on whether to raise rates or not. Though returns to depositors were negative because of the high inflation, banks were unlikely to raise deposit rates, as that would impact their margins. Reasons:  banks are comfortable on the liquidity front most have already made provisions to address asset quality issues  There is no immediate requirement for funds it is unlikely they will raise deposit rates immediately Types of Deposit 1. Demand Deposits  Savings account deposits  Current account deposits 2. Term Deposits 3. Hybrid Deposits / Flexi Deposits 4. Non-Resident Accounts  Foreign Currency Non-Resident Account (FCNR)  Non-Resident External Rupee Account (NRE)  Non-Resident Ordinary Account (NRO)
  23. 23. Amity Business School Page 22 Impact of Repo rate on Demand deposit and Time deposit Date Repo Rate Demand deposits Time deposits 4/18/2014 8% 7265.94 71433.72 4/4/2014 8% 7677.41 71633.63 3/21/2014 8% 7208 70185.85 3/7/2014 8% 7031.62 69891.5 2/21/2014 8% 6878.38 68887.71 2/7/2014 8% 6792.05 68921.38 1/24/2014 8% 6892.04 68353.06 1/10/2014 8% 6662.5 68565.79 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 0 10000 20000 30000 40000 50000 60000 70000 80000 1 2 3 4 5 6 7 8 AxisTitle Demand and Time Deposits Demand deposits Time deposits Repo Rate
  24. 24. Amity Business School Page 23 2.4.3 Loan Rate and Deposit Rate The repo rate cut is unlikely to have any impact on the lending and deposit rates immediately, say bankers as well as analysts. Says Clyton Fernandes, analyst, Anand Rathi Financial Services Ltd, ―Banks are not expected to pass on the repo rate cut benefit immediately as liquidity is still tight. RBI will have to first improve liquidity in the markets and only then will the benefits be passed to the consumers. Banks were earlier borrowing Rs.1 trillion, now it has come down to Rs.85, 000 crore. Borrowing is expected to turn positive in the open market. If this happens, banks will lower the lending rate. However, this will take at least six months.‖ Agrees Abhishek Kothari, research analyst, Violet Arch Securities Pvt. Ltd, ―There are two reasons for no immediate impact: tight liquidity and higher cost of funding for banks. Only when cost of funding comes down banks will be able to reduce rates.‖ Inflation has a major impact on deposit rates. With inflation at high levels, the real rate of return will be close to negative. Hence, deposit rates will be subdued. Says Fernandes, ―We expect inflation to be at 5% by March 2015. As long as inflation is high, deposit rates will remain where they are. In case of a rate cut, first lending rates will fall and then deposit rates will come down.‖
  25. 25. Amity Business School Page 24 So what about loan customers? Says Surya Bhatia, managing partner, Asset Managers, ―Lending and deposit rates will not come down immediately. But whenever it happens there will not be a big drop in deposit rates. In case of fall in lending rates, floating rate consumers will benefit while those on fixed rate will miss out.‖ Planners also advise caution. Says Suresh Sadagopan, ―Lock-in your fixed deposits at current level even though rate will not come down immediately. Overall we know that rates are falling and hence, after a period of time deposit rates may fall.‖ Overall, the credit policy was largely a non-event. While markets would once again look out for government action and global cues, if you were looking for lowering your loan instalments, you would be disappointed as there is no change expected in loan or deposit rates
  26. 26. Amity Business School Page 25 2.5 Key Driver of Fluctuation in Lending Rates The rate of interest in general is the price we pay for borrowing money. It is the price that the lender charges for taking the risk and investing in the money market. If you borrow/ take a loan from the bank for personal requirements like buying a house or car or starting a business, you will have to pay interest to the bank on your loan. If you deposit money in a bank in the form savings or fixed or recurring deposits, the bank pays you interest for the use of your money. Banks use a formula to calculate the interest amount you will have to pay . The standard formula for computing simple interest is - Principal x Rate of interest x Time. If you borrow Rs. 10000 at an annual interest rate of 6% for a period of 1 year, the interest amount you pay will be Rs. 600. 10000 (Principal balance) x 0.005 (Monthly interest rate) x 12 (no. of months) The monthly interest rate is calculated as follows the decimal equivalent of 6% is 0.06 0.06 is divided by 12 equal s which is 0.005. So the total amount you pay back to the bank at the end of the y ear would be Rs. 10600 (principal + interest). This is simple interest when the principal is paid all together at the end of the loan period. The interest rate and the amount of total interest paid are usually higher when the loan is paid in installments, in the form of EMI. Amortization The gradual reduction of the loan balance through regular interest and principal payments is Called ‗amortization‘. The bank uses an amortization calculator to determine the amount of monthly payment, so that each payment is the same amount.
  27. 27. Amity Business School Page 26 Interest on saving account and other deposits in bank Compound interest is paid on our deposits with the bank. Interest on such deposits is calculated using the same formula (as of simple interest), but it is done according to a ―compounding‖ schedule, which can be daily , monthly , quarterly or annual l y . Compounding refers to the frequency with which the bank calculates the interest on the deposits. The interest is then added to the balance. A simple example- if you deposit Rs. 1000 with the bank at 10 % interest rate maturing after 3 y ears , after one year i t becomes Rs . 1100. Another Rs. 100 As interest will be added in the second year, and yet another in the third year. So the amount you will receive on maturity will be a bigger amount- Rs. 1300. 2.5.1 Factors affecting Interest rate Interest rate depends on the activities and fluctuations in the money market. It depends on the demand and supply of money in the economy at a given time. The three main economic factors that affect interest rates. Policies of the Central bank- The apex bank or the central bank of the country (RBI in India) is responsible for monetary stability in the country . To achieve this objective an important function of the Central bank is credit control. The apex bank controls the money supply in the economy through measures like changing the Cash Reserve Ratio and the Repo Rate and Reverse repo Rate. The repo rate in common terms , is the interest rate at which the commercial banks borrow from the RBI . When there is inflation and the central bank wants to curb money supply and credit creation in the economy to check inflation, it will raise the interest rate and CRR, thus making borrowing costly . The commercial banks in turn pass on this increased rate to it ‘ s customers . The reverse happens during recess i on. To boost the economy, interest rate is lowered by the Central bank, thus making credit cheaper for investment.
  28. 28. Amity Business School Page 27 Recession- During recession economic activities slow down. Expectation of fall in profit margins discourages investment, reducing the demand for credit. This results in fall in interest rate. Inflation- Inflationary pressures tend to raise the market interest rates. This is because, when prices are expected to rise considerably , the lender will be reluctant to lend during that period, fearing a loss of purchasing power of the loaned amount , on maturity . To compensate this loss, a higher interest rate is charged. State of the economy- When the economy is growing, the demand is also growing with increased expectation of profit in the future. Hence there is more deem and for credit for investment purpose, which raises the interest rate. The opposite happens during recession.
  29. 29. Amity Business School Page 28 2.6 INDIA PRIME LENDING RATE Bank Lending Rate in India remained unchanged at 10.25 percent in April of 2014 from 10.25 percent in March of 2014. Bank Lending Rate in India is reported by the Reserve Bank of India. Bank Lending Rate in India averaged 14.08 Percent from 1978 until 2014, reaching an all-time high of 20 Percent in October of 1991 and a record low of 8 Percent in July of 2010. In India, the prime lending rate is the average rate of interest charged on loans by commercial banks to private individuals and companies. This page provides - India Prime Lending Rate - actual values, historical data, forecast, chart, statistics, economic calendar and news. 2014-04-26 ACTUAL PREVIOUS HIGHEST LOWEST FORECAST DATES UNIT FREQUENCY 10.25 10.25 20.00 8.00 10.15 | 2014/05 1978 - 2014 PERCENT MONTHLY
  30. 30. Amity Business School Page 29 3 Repo Policy
  31. 31. Amity Business School Page 30 3.1 What is monetary policy? The instruments of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector. Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money. The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public. Open Market Operations: The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money. Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base. Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most favorable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP). Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee
  32. 32. Amity Business School Page 31 to preferred loans. In this way the available savings is allocated and investment directed in particular directions. Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment. Prudential Guidelines: The Central Bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized. Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making. Exchange Rate: The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real 3exchange rate. The real exchange rate when misaligned affects the current account balance because of its impact on external competitiveness. Moral suasion and prudential guidelines are direct supervision or qualitative instruments. The others are quantitative instruments because they have numerical benchmarks
  33. 33. Amity Business School Page 32 3.1.1Instruments of monetary policy The RBI has numerous instruments of monetary policy at its disposal in order to regulate the availability, cost and use of money and credit. Using these monetary policy instruments, the RBI must walk a tightrope between trying to stimulate growth while keeping inflation under control Direct regulation: Cash Reserve Ratio (CRR): Commercial Banks are required to hold a certain proportion of their deposits in the form of cash with RBI. CRR is the minimum amount of cash that commercial banks have to keep with the RBI at any given point in time. RBI uses CRR either to drain excess liquidity from the economy or to release additional funds needed for the growth of the economy. For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks will now have to keep a lesser proportion of their total deposits with the RBI making more money available for business. Similarly, if RBI decides to increase the CRR, the amount available with the banks goes down. Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the form of gold or government approved securities before providing credit to the customers. SLR is stated in terms of a percentage of total deposits available with a commercial bank and is determined and maintained by the RBI in order to control the expansion of bank credit. For example, currently, commercial banks have to keep gold or government approved securities of a value equal to 23% of their total deposits. Indirect regulation: Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate. Whenever commercial banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI increases the Repo Rate, it makes borrowing expensive for commercial banks and vice versa. As a tool to control inflation, RBI increases the Repo Rate, making it more expensive for the banks to borrow from the RBI with a view to restrict the availability of money. The
  34. 34. Amity Business School Page 33 RBI will do the exact opposite in a deflationary environment when it wants to encourage growth. Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest rate to commercial banks to park their money with the RBI. This results in a reduction in the amount of money available for the bank‘s customers as banks prefer to park their money with the RBI as it involves higher safety. This naturally leads to a higher rate of interest which the banks will demand from their customers for lending money to them. The RBI issues annual and quarterly policy review statements to control the availability and the supply of money in the economy. The Repo Rate has traditionally been the key instrument of monetary policy used by the RBI to fight inflation and to stimulate growth. Date Bank Rate Repo Reverse Cash Reserve Ratio Marginal Standing Facility Statutory Liquidity Ratio April,2014 9.00 8 7 4 9 23 March,2014 9.00 8 7 4 9 23 Feburary,2014 9.00 8 7 4 9 23 January,2014 9.00 8 7 4 9 23 December,2013 8.75 7.75 6.75 4 8.75 23 November,2013 8.75 7.75 6.75 4 8.75 23 Octomber,2013 8.75 7.75 6.75 4 8.75 23 Octomber,2013 9.00 7.5 6.5 4 9 23 September,2013 9.5 7.5 6.5 4 9.5 23 September,2013 10.25 7.25 6.25 4 10.25 23 Augest,2013 8.25 7.25 6.25 4 8.25 23 July,2013 8.25 7.25 6.25 4 8.25 23 June,2013 8.25 7.25 6.25 4 8.25 23 May,2013 8.5 7.5 6.5 4 8.5 23 April,2013 8.5 7.5 6.5 4 8.5 23 March,2013 8.75 7.75 6.75 4 8.75 23 Feburary,2013 8.75 7.75 6.75 4 8.75 23 January,2013 8.75 7.75 6.75 4.25 8.75 23
  35. 35. Amity Business School Page 34 Repo Rate vs. Reserve repo Rate Repo or repurchase option is a means of short-term borrowing, wherein banks sell approved government securities to RBI and get funds in exchange. In other words, in a repo transaction, RBI repurchases government securities from banks, depending on the level of money supply it decides to maintain in the country's monetary system. Repo rate is the discount rate at which banks borrow from RBI. Reduction in repo rate will help banks to get money at a cheaper rate, while increase in repo rate will make bank borrowings from RBI more expensive. If RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Reverse repo is the exact opposite of repo. In a reverse repo transaction, banks purchase government securities form RBI and lend money to the banking regulator, thus earning interest. Reverse repo rate is the rate at which RBI borrows money from banks. Banks are always happy to lend money to RBI since their money is in safe hands with a good interest. Thus, repo rate is always higher than the reverse repo rate. 0.00 5.00 10.00 15.00 20.00 25.00 March,2014 Feburary,2014 January,2014 December,2013 November,2013 Octomber,2013 Octomber,2013 September,2013 September,2013 Augest,2013 July,2013 June,2013 May,2013 April,2013 March,2013 Feburary,2013 January,2013 Rate Monetary Policy Rate Bank Rate Repo Reverse Cash Reserve Ratio Marginal Standing Facility Statutory Liquidity Ratio
  36. 36. Amity Business School Page 35 Relationship between Repo Rate and Reverse Repo rate Date Repo Rate Reverse 1/25/2013 7.75 6.75 2/22/2013 7.75 6.75 3/22/2013 7.5 6.5 4/19/2013 7.5 6.5 5/31/2013 7.25 6.25 6/28/2013 7.25 6.25 7/26/2013 7.25 6.25 8/23/2013 7.5 6.25 9/20/2013 7.5 6.5 10/18/2013 7.5 6.5 11/29/2013 7.75 6.5 12/27/2013 7.75 6.5 1/12/2014 8 6.75 2/28/2014 8 7 2/23/2014 8 7 0 1 2 3 4 5 6 7 8 9 Percentage Repo vs. Reverse Repo Repo Rate Reverse
  37. 37. Amity Business School Page 36 Repo rate vs. inflation Inflation occurs due to excess of money in the market. So RBI uses repo rates and reverse repo rates to control money in the market. The rate at which RBI lends money to commercial banks is called Repo-rate. When repo rates are increased, commercial banks have to return more money to RBI thus banks lend less money from RBI as a result of which the money available with banks is less to lend out in the market. Consequently, banks increase their loan interest rate as they have less money to hand out in the market which decreases amount of money in the market. Now, when people have less money with them they spend less which decreases demand of products and as a result prices go down. However, when money in the market decreases, money available with industries diminishes and as a result production decreases. The reduction in production leads to soaring of prices of products which are in demand which can lead to further inflation. Therefore, high repo rates and low repo rates both are dangerous and RBI carefully monitors and governs the repo rate to control the market. Raghuram Rajan, the governor of RBI increased the interest rate of banks shortly after he said that bank could loan 100% of their TIER-1 strength. Policy repo rates for banks act as an instrument for controlling the short term liquidity. Repo rates are defined as "The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI." Raghuram Rajan would have commented that bank could loan 100% of their TIER-1 strength is a long term measure. Banks‘ lending 100% of the TIER-1 strength would be them being able to earn higher return and increase their Net Interest Margins, Return on Equity and Return on Capital Employed. So the comment and the policy change are inherently different because one is a short-term measure and the other a long term. Now by changing the repo rates and
  38. 38. Amity Business School Page 37 the reverse repo rates, RBI indirectly affects the CALL MONEY Market rates, these are market driven interbank short duration rates and mostly are in between the Repo rate and the reverse repo rate. No When RBI increases the Repo Rates and hence leading to an increase in the call money market rates. The cost of short term funds for the banks increase and hence in order to stay profitable they would be do the short term lending to the corporate and individuals at a higher rate than before. This makes the corporates and individuals to restrain excess spending and hence a decrease in the demand. This cumulative decrease in demand leads to change in the prices of goods as now supply is at the same level but the demand has decrease in the short term. Hence a real decrease in prices leads to a reduction in inflation Relationship between Inflation and Repo Rate Period Inflation Repo Rate May 2013 10.680 7.25 June 2013 11.058 7.25 July 2013 10.849 7.25 August 2013 10.748 7.25 September 2013 10.698 7.50 October 2013 11.060 7.50 November 2013 11.468 7.50 December 2013 9.132 7.50 January 2014 7.240 8.00 February 2014 6.726 8.00
  39. 39. Amity Business School Page 38 3.2 Relation between Inflation and Bank interest Rate Now days, you might have heard lot of these terms and usage on inflation and the bank interest rates. We are trying to make it simple for you to understand the relation between inflation and bank interest rates in India. Bank interest rate depends on many other factors, out of that the major one is inflation. Whenever you see an increase on inflation, there will be an increase of interest rate also What is Inflation? Inflation is defined as an increase in the price of bunch of Goods and services that projects the Indian economy. An increase in inflation figures occurs when there is an increase in the average level of prices in Goods and services. Inflation happens when there are fewer Goods and more buyers; this will result in increase in the price of Goods, since there is more demand and less supply of the goods 0.000 2.000 4.000 6.000 8.000 10.000 12.000 14.000 Ratio Relationship between Inflation and Repo Rate Inflation Repo Rate
  40. 40. Amity Business School Page 39 Inflation causes increase of Interest Inflation can be recognized as a combination of 4 factors:  The Supply of money goes up  The Supply of Goods goes down  Demand for money goes down  Demand for goods goes up Our Indian government gets involved in it to control the inflation by adjusting the level of money in our economic system. The most noticeable way to increase the money flow in the system is to print more currency, and then the rupees will become more relative to goods Inflation and Global Liquidity Factors like rates of import and export, the production cost of farms, value of dollar, and price of oil (crude oil), market movements of other overseas markets cause global liquidity. In India, we can also feel the effects of global liquidity. We are not isolated from all these issues now. Due to the remarkable economic growth of India over the recent years, increase in foreign currency inflow caused the demand in multiples for many Merchandise and services in India. RBI (Reserve Bank of India) needs to control this excess liquidity in our economic system. For this, RBI increases the ―Repo rates‖ which makes ―Costly Credits‖ and thus increases the CRR rate (Cash Reserve Ratio). This kind of measures by RBI can only control the inflation to a certain extent only
  41. 41. Amity Business School Page 40 4 Review Of Literature
  42. 42. Amity Business School Page 41 Literature Review In the development and developing countries, many studies have been conducted to test the impact banking lending with respect to monetary policy announcements. In India, only very few studies has been conducted. Some of the select studies relevant to the present study are reviewed. The study ―The Effect of Monetary Policy on Bank Lending and Aggregate Output (2005)‖ explains Asymmetries from Nonlinearities in the Lending Channel is also reflects asymmetric effects of monetary policy on output and the role of bank- lending behavior. This investigate whether contractionary and expansionary policies have asymmetric impacts on bank loans, and whether there are further differences in the response of small banks and big banks to policy actions. We also investigate the link between changes in bank lending and aggregate economic activity. Our goal is to simultaneously capture the existence of the lending view of the monetary transmission mechanism, the strong relationship between loan growth and output growth, and the asymmetric effect of monetary policy on output. This study uses a nonlinear vector autoregressive approach to carry out our analysis. Results show that asymmetry in the response of bank lending to monetary policy is not a substantially contributing factor in explaining the different responses of output to contractionary and expansionary policy. ―Monetary Policy and Long-Term Real Rates (July, 2012)‖ it document that changes in the stance of monetary policy have surprisingly strong effects on very distant forward real interest rates. Concretely, we show that a 100 basis-point (bop) increase in the 2-year nominal yield on a Federal Open Markets Committee (FOMC) announcement day—which we use as a proxy for changes in expectations regarding the path of the federal funds rate over the following several quarters—is associated with a 42 bps increase in the 10-year forward overnight real rate, extracted from the yield curve for Treasury Inflation Protected Securities (TIPS). ―The Bank Lending Channel of Monetary Policy and Its Effect on Mortgage Lending (May, 2010)‖ explains the bank lending channel suggests that banks play a special role in the transmission of monetary policy. In this theory, monetary policy has an effect on banks‘ cost of funds in addition to the change in the risk-
  43. 43. Amity Business School Page 42 free rate, leading to an additional response in bank lending. The supply of intermediated credit therefore has a unique response to monetary policy. To analyze the bank lending channel, the study the response of banks to monetary policy in the context of mortgage funds and mortgage lending. We focus on lending in subprime communities, because it is a form of information-intensive lending which affects banks‘ choices in funding sources and their response to changes in funding costs. Our paper helps explain how mortgage loan supply responds to monetary policy by addressing the role of banks in the transmission of monetary policy.
  44. 44. Amity Business School Page 43 5 Research Methodology
  45. 45. Amity Business School Page 44 1.1 Research Methodology 1.2 Statement of the problem Repo rate and other monetary ratio are important measures which control the liquidity in the market. Changes in repo rate have direct impact on bank‘s cost of borrowing. Aam Aadmi are interested to know the interest rate of loan and deposit in banking sector during the change in reverse repo rate and other monetary rate announcement period. In the recent years small and medium scale investors in property market may not aware about loan rate movements in banking sector after the announcement of repo rate this change at what level affect their EMI. Hence, the present study is an attempt to test the impact of rising repo rate on bank‘s lending. 1.3 1.4Objectives of the study The following are the objectives of the study. 1. To analyze the impact of repo rate on bank‘s interest rate after announcement period. 2. To test the relationship between repo rate and Inflation 3. Analysis the relationship between Interest rate and Inflation 1.4 Need of the study The study aims to help investors and general person to making investment by providing adequate information about impact of change in repo rate which help to take making strategy for their EMI and Investment portfolio.
  46. 46. Amity Business School Page 45 1.5 Hypothesis of the study The following hypotheses are tested in this study. 1. H0: There is significant impact of Repo Rate on Banking Interest Rate 2. H1: There is no significant impact of Repo Rate on banking Interest rate 1.6 Sample Selection The sample selection for this study included Repo rate and reserve repo rate and inflation and base rate data available on RBI website for the period 2013 to 2014. 1.7 Size of Data The study shows the impact of rising repo rate on bank‘s lending from 2013 to 2014. 1.8 Source and collection of the data The study used mainly contains secondary data. Information relating to inflation and base rate data. The announcements of reverse repo rate and cash reserve ratio change were collected from website The other related sources were obtained from Books, Journals and websites 1.9 Period of the study The present study is an attempt to test the impact of repo rate on the interest rate of Indian Bank during the period from May 2013 to March 2014. 1.10 Tools To test the impact of repo rate on interest rate of Indian Banks, the following tools were used for study  Correlation  Regression Analysis
  47. 47. Amity Business School Page 46 1.11 Limitations 1. The report consider only Secondary data 2. This considers only the effect of repo rate on banking lending but does not consider effect of CRR, SLR and Market operation. 3. Time period is short
  48. 48. Amity Business School Page 47 5 Analysis & Interpretation
  49. 49. Amity Business School Page 48 Impact of Repo Rate on Inflation Period Inflation Repo Rate May, 2013 10.680 7.25 June, 2013 11.058 7.25 July 2013 10.849 7.25 August 2013 10.748 7.25 September 2013 10.698 7.50 October 2013 11.060 7.50 November 2013 11.468 7.50 December 2013 9.132 7.50 January 2014 7.240 8.00 February 2014 6.726 8.00 10987654321 12 11 10 9 8 7 Index Data Inflation Repo Rate Variable Time Series Plot of Inflation, Repo Rate
  50. 50. Amity Business School Page 49 Data analysis Correlation between Repo Rate and Inflation Correlations: Inflation, Repo Rate Pearson correlation of Inflation and Repo Rate = -0.877 P-Value = 0.001 Fairly High degree of Correlation negative relationship R (Pearson Correlation) = -0.877 indicates  There is negative correlation i.e. as the amount Repo increases the inflation decreases.  There is meaningful correlation between Repo and inflation Regression S = 0.861346 -Sq = 76.9% R R-Sq(adj) = 74.0% Repo Rate -5.1343 0.9946 -5.16 0.001 S = 0.861346 R-Sq = 76.9% R-Sq(adj) = 74.0% Analysis of Variance Source DF SS MS F P Regression 1 19.771 19.771 26.65 0.001 Residual Error 8 5.935 0.742 Total 9 25.706
  51. 51. Amity Business School Page 50 Correlation between Repo Rate and Banks Loan Segment Date Repo Rate Personal Loans Housing Loan Vehicle Loans Education Loans 2/21/2014 8 10,159.34 2,984.51 1,285.26 571.30 1/24/2014 8 10,091.32 2,974.58 1,274.37 570.48 12/27/2013 7.75 9,989.87 2,952.49 1,261.46 567.90 11/29/2013 7.75 9,843.87 2,945.91 1,240.36 564.74 10/18/2013 7.5 9,702.01 2,922.66 1,202.32 564.25 9/20/2013 7.5 9,652.79 2,909.59 1,185.79 558.04 8/23/2013 7.5 9,564.45 2,888.38 1,174.09 550.73 7/26/2013 7.25 9,423.13 2,873.54 1,167.62 544.76 6/28/2013 7.25 9,347.73 2,865.71 1,167.05 534.11 5/31/2013 7.25 9,272.94 2,833.56 1,167.02 530.97 4/19/2013 7.5 9,124.53 2,791.81 1,141.62 546.31 3/22/2013 7.5 8,975.84 2,672.03 1,110.89 526.12 2/22/2013 7.75 8,719.95 2,633.97 1,082.42 525.86 1/25/2013 7.75 8,658.81 2,623.32 1,063.21 523.46 Correlations: Repo Rate, Personal Loa, Housing Loan, Vehicle Loan, Education Lo Repo Rate Personal Loans Housing Loan Personal Loans 0.371 0.192 Housing Loan 0.161 0.966 0.581 0.000 Vehicle Loans 0.406 0.987 0.945 0.150 0.000 0.000 Education Loans 0.483 0.944 0.899 0.080 0.000 0.000 Vehicle Loans Education Loans 0.922 0.000 Cell Contents: Pearson correlation P-Value
  52. 52. Amity Business School Page 51 Covariances: Repo Rate, Personal Loa, Housing Loan, Vehicle Loan, Education Lo Repo Rate Personal Loans Housing Loan Repo Rate 0.06 Personal Loans 44.98 231335.14 Housing Loan 5.02 57285.62 15211.32 Vehicle Loans 7.00 32450.92 7969.66 Education Loans 2.18 8125.99 1984.69 Vehicle Loans Education Loans Vehicle Loans 4671.59 Education Loans 1127.15 320.05 Relationship among the monetary Instrument Date Bank Rate Repo Reverse Cash Reserve Ratio Marginal Standing Facility Statutory Liquidity Ratio April,2014 9.00 8 7 4 9 23 March,2014 9.00 8 7 4 9 23 Feburary,2014 9.00 8 7 4 9 23 January,2014 9.00 8 7 4 9 23 December,2013 8.75 7.75 6.75 4 8.75 23 November,2013 8.75 7.75 6.75 4 8.75 23 Octomber,2013 8.75 7.75 6.75 4 8.75 23 Octomber,2013 9.00 7.5 6.5 4 9 23 September,2013 9.5 7.5 6.5 4 9.5 23 September,2013 10.25 7.25 6.25 4 10.25 23 Augest,2013 8.25 7.25 6.25 4 8.25 23 July,2013 8.25 7.25 6.25 4 8.25 23 June,2013 8.25 7.25 6.25 4 8.25 23 May,2013 8.5 7.5 6.5 4 8.5 23 April,2013 8.5 7.5 6.5 4 8.5 23 March,2013 8.75 7.75 6.75 4 8.75 23 Feburary,2013 8.75 7.75 6.75 4 8.75 23 January,2013 8.75 7.75 6.75 4.25 8.75 23
  53. 53. Amity Business School Page 52 Correlations: Bank Rate, Repo, Reverse, Cash Reserve, Marginal Sta, ... Bank Rate Repo Reverse Repo 0.131 0.604 Reverse 0.131 1.000 0.604 * Cash Reserve Rat -0.044 0.101 0.101 0.864 0.690 0.690 Marginal Standin 1.000 0.131 0.131 * 0.604 0.604 Statutory Liquid * * * * * * Cash Reserve Rat Marginal Standin Marginal Standin -0.044 0.864 Statutory Liquid * * * * Cell Contents: Pearson correlation P-Value * NOTE * All values in column are identical. Covariances: Bank Rate, Repo, Reverse, Cash Reserve, Marginal Sta, Statutory Li Bank Rate Repo Reverse Bank Rate 0.22794118 Repo 0.01715686 0.07516340 Reverse 0.01715686 0.07516340 0.07516340 Cash Reserve Rat -0.00122549 0.00163399 0.00163399 Marginal Standin 0.22794118 0.01715686 0.01715686 Statutory Liquid 0.00000000 0.00000000 0.00000000 Cash Reserve Rat Marginal Standin Statutory Liquid Cash Reserve Rat 0.00347222 Marginal Standin -0.00122549 0.22794118 Statutory Liquid 0.00000000 0.00000000 0.00000000
  54. 54. Amity Business School Page 53 6 Indian Banking Sector
  55. 55. Amity Business School Page 54 Management of Capital Bank Capital Banks hold capital to provide protection against unexpected losses. Traditionally capital of a bank constitutes a very small fraction of its total assets. The leverage ratio of banks is very small when compared to similar ratios of non-financial institutions. Even the 8% ratio of capital to risk weighted assets does not aim at protecting banks against losses. Provisions and reserves should take care of them. Long-term Debt Debentures and subordinated debt are sources of external funds. Debt is ―subordinated‖ because debt is second in priority to depositor claims in the event of liquidation. Bank debt by and large is in the form of short and intermediate term deposit and non-deposit funds derived from money market Loss Reserve There are two reserves that banks set aside. Loan loss reserve is set up to meet anticipated loan losses. Earnings are set aside towards the provision for loan loss (PLL). Tax burden is reduced when expensing PLL. When a loan defaults the loss is deducted from the reserve account Correction of Capital Deficiency Capital requirements are used by regulators to control risk taking by bank. A bank with abnormal risk level has to have capital in excess of minimum requirements. Banks judged to be capital deficient need to take corrective action by  Change in the assets to capital ratio.  Change in the dividend payout ratio.  Change in profitability.  Employee stock ownership.  Raising funds from capital market.  Recapitalisation.  Mergers.
  56. 56. Amity Business School Page 55 Capital Issues Banks may raise capital by issuing new securities, either equity or debentures. Prior to July 1998, banks in private sector had to obtain prior approval of the Reserve Bank for issue of all types of shares, public, preferential, rights/special allotment to employees and bonus shares. After July 1998, private sector banks whose shares are already listed can make further issues. The issue of bonus shares requires prior approval Refund of capital The reduction in capital results in an improvement in earnings per share and helps the concerned banks in better pricing of their share at the time of public issue. Between 1995-96 and 2003-04, public sector banks have returned to Government of India, paid-up capital aggregating Rs.1,303 crores. Write off Write off of accumulated losses against paid-up capital would enable public sector banks to have Earning Per Share (EPS) at a higher level for public issues. Public sector banks have been provided to write off losses of Rs.8,680 crores. Recapitalization Recapitalization involves a fundamental change in the ownership position of shareholders. Through a large stock offering, or merger into another bank or withdrawal of shares to reduce shareholders‘ equity, a bank in difficulties is recapitalized
  57. 57. Amity Business School Page 56 Criteria for Evaluation: According to the Working Group the criteria for evaluation of a bank are,  Capital adequacy ratio.  Coverage ratio.  Return on assets (ROA).  Net interest margin.  Ratio of operating profit to average working funds  Ratio of cost to income.  Ratio of staff cost to the net interest income plus all other income. Rollover Loans and Flexi rates To avoid interest rate risk in variability of future funding costs and loans at fixed rate, the syndicated international loans were made at variable rates of interest linked invariably to LIBOR and adoption of rollover loans. Rollover lending involved the adjustment of assets in accordance with potential liabilities. Rollover lending however, resulted in a shifting of risk to bank borrower who faced additional uncertainty in managing cash flow and impairing his ability to service the debt. While avoiding interest rate risk credit risk is created Overall Risk of Banks A bank‘s overall risk can be defined as the probability of failure to achieve an expected value and can be measured by the standard deviation of the value. Banks that manage their risks have a competitive advantage. They take risks consciously, anticipate adverse changes and protect themselves from such changes. The chart of check list for risk management compiled by Bank of Japan and quoted by RBI in the Report on Trend and Progress of Banking in India, 1996-97 which is quite comprehensive.
  58. 58. Amity Business School Page 57
  59. 59. Amity Business School Page 58 Interest Rate Risk Net Interest Risk Net interest income which is the difference between interest income and interest expense is the principal determinant of the profitability of banks. Net interest income is determined by interest rates on assets and paid for funds, volume of funds and mix of funds (portfolio composition). Changes in interest rate affect the net interest income. Whenever rate of interest conditions attaching to assets and liabilities diverge, then changes in market interest rates will affect bank earning. If a bank attempts to structure its assets and liabilities to eliminate interest rate risk, the profitability of the bank would be impaired. Mismatch of Assets and Liabilities A bank may borrow short and lend long. The mismatch of assets and liabilities gives rise to interest rate risk. In such a case a rise in interest rates can result in losses for the bank. Variable Interest Rate Each bank through its choice from different types of assets and liabilities can alter the structure of its balance sheet in order to increase or decrease interest rate exposure Yield Curve Yield curve plays an important role in interest rate risk management. Banks accept interest rate risk and maintain a slight liability sensitive position (rate sensitive assets less than rate sensitive liabilities) Maturity or Funding Gap The interest sensitivity position of a bank is usually measured by its gap, which is defined as the difference between the volume of interest sensitive assets and liabilities. Interest sensitive
  60. 60. Amity Business School Page 59 Duration Duration measures the interest rate risk of a financial instrument. It shows the relationship between the change in value of a financial instrument and change in the general level of interest rates Modified Duration Modified duration provides a standard measure of price sensitivity to calculate the duration of the portfolio as the weighted average of the duration of its individual components. Future, option and Swap These derivative instruments allow a bank to alter interest rate exposure and each has advantages and disadvantages compared with the other. When taken together they give a bank enormous flexibility in managing interest rate risk Futures A futures contract is a standardized agreement to buy or sell an asset on a specified date in future for a specified price. The buyer agrees to take delivery at a future date at today‘s determined price; and the seller agrees to make delivery at a future date at today‘s established price. Options on Futures Contracts Interest rate risk may also be hedged through options on futures contracts. An option provides the buyer with the right, but not the obligation, to buy or sell an agreed amount of an underlying instrument (such as a T-bill futures contract) at an agreed price. A call option gives the buyer the right but not the obligation to buy an underlying instrument at a specified price, called exercise or strike price. A put option gives the buyer the right (and not the obligation) to sell a specified underlying security at the agreed price Swaps Swaps came into vogue in 1981. They are used widely by banks. At the end of 2004 outstanding (OTC) amount of interest rate swaps was $147 trillion. Swaps are private arrangements to exchange cash flow in future according to a prearranged formula.
  61. 61. Amity Business School Page 60 Interest Rate Swaps: In an interest swap two parties, called counter parties, agree to exchange periodic interest payments. The amount of interest payments exchanged is based on some predetermined principal which is called the notional principal amount. Types of Interest Rate Swaps  Fixed-for-Floating  Base Swaps (Floating-to-Floating Swaps  Zero Coupon for Floating Swap  Forward Swaps (or Delayed Rate Setting Swaps)  Rate Capped Swaps Separation of Interest Rate Risk and Credit Risk Banks do not want to make long-term loans at fixed rates of interest because of the interest rate risk. Banks prefer the floating rate loan. With a swap, the borrower can transform the floating rate loan to fixed rate and thus avoid the interest rate risk. The swap allows the separation of interest rate risk from credit risk. The bond market carries the former and the bank carries the later. In pure interest rate swaps there is no exchange of notional or actual principal. If the times of reciprocal interest payments coincide only the net difference is paid. Pricing Interest Rate Swaps Pricing covers relevant interest rates and interest payment schedules and fees for swap dealer‘s services. The interest rates are set to provide a spread which runs from 5 to 10 basis points. Interest rate swaps are standardized and do not generate fee income. Spreads on interest rate swaps are quite narrow reflecting low risks and the huge and liquid financial markets. Narrow spreads provide an incentive to use interest rate swaps
  62. 62. Amity Business School Page 61 REPOS REPO and reverse REPO operated by RBI in dated government securities and Treasury bills (except 14 days) help banks to manage their liquidity as well as undertake switch to maximize their return. REPOs are also used to signal changes in interest rates. REPOs bridge securities and banking business. A REPO is the purchase of one loan against the sale of another. They involve the sale of securities against cash with a future buy back agreement. They are well established in USA and spread to Euro market in the second half of 1980s to meet the trading demand from dealers and smaller commercial banks with limited access to international interbank funding. REPOs are a substitute for traditional interbank credit. REPOs are part of open market operations. With a view to maintain an orderly pattern of yields and to cater to the varying requirements of investors with respect to maturity distribution policy or to enable them to improve the yields on their investment in securities, RBI engages extensively in switch operations. In a triangular switch, one institution‘s sale/purchase of security is matched against the purchase/sale transaction of another institution by the approved brokers. In a
  63. 63. Amity Business School Page 62 triangular switch operation, the selling bank‘s quota (fixed on the basis of time and demand deposit liabilities) is debited (the Reserve Bank being the purchaser). The objective behind fixing a quota for switch deals is to prevent the excessive unloading of low-yielding securities on to the Reserve Bank. The Bank maintains separate lists for purchase and sale transactions with reference to its stock of securities and the dates of maturity of the different loans. REPO auction was allowed since 1992-93. Particulars of transactions in government securities including treasury bills put through SGL accounts were released to press since September 1, 1994. REPO facility with the RBI in government dated securities was extended to STCI and DFHI to provide liquidity support to their operations. A system of delivery versus payment (DVP) in government securities was introduced in July 1995 to synchronize the transfer of securities with the cash payment thereby reducing the settlement risk in securities transaction and also preventing diversion of funds in the case of transactions through SGL Repos and Reserve Repo The RBI (Amendment) Act, 2006 enables RBI to undertake REPO and reverse REPO operations as also lending and borrowing of securities including foreign securities. In order to activate the REPOs market so that it serves as an equilibrating force between the money market and the securities market, REPO and reverse REPO transactions among select institutions have been allowed since April 1997 in respect of all dated Central Government securities besides Treasury Bills of all maturities. A system of announcing a calendar of REPO auctions to enable better treasury management by participants was introduced on January 1997. Reverse REPO transactions can be entered into by non-bank entities who are holders of SGL accounts with the Reserve Bank (from April 1997) with banks, primary dealers in Treasury Bills of all maturities and all dated central government securities. The first step of the transaction by non-bank entities should be by way of purchase of securities eligible for REPOs from banks/ primary dealers and the second step will be by way of selling back securities to banks/primary dealers.
  64. 64. Amity Business School Page 63 Non-bank entities are however not allowed to enter into REPO transactions with banks/primary dealers. The transactions have to be effected at Mumbai. It may be noted that according to the international accounting practices, the funds advanced by the purchaser of a security under a firm repurchase agreement are generally treated as collateralised loan and the underlying security is maintained on the balance sheet of the seller. Types of Government Securities: Treasury bills 14 days Auction Treasury Bills Introduced on June 6, 1997. Auctions were discontinued with effect from May 14, 2001. 91 day Treasury Bills Open market operations are conducted by RBI in these bills. These bills are self- financing in character. The notified amount is varied between Rs.500 to Rs.1500 crores depending on liquidity conditions. The implicit yield at cutoff price 4.3672%. 182 day Treasury Bills The 182 day bills were discontinued effective from May 14, 2001. Total issues were Rs.600 crores. They have been reintroduced from April 6, 2005. 364 day Treasury Bills The notified amount is Rs.1000 crores. The implicit yield at cutoff price was 4.44% on March 31, 2004. Liquidity Adjustment Facility (LAF) Liquidity Adjustment Facility (LAF) is operated by RBI through REPOs and reverse REPOs in order to set a corridor for money market interest rates. This is pursuant to the recommendations of the Committee on Banking Sector Reforms. LAF is introduced in stages. In the first stage with effect from June 5,2000, RBI introduced variable REPO auctions with same day settlement. The amount of REPO and reverse REPO are changed on a daily basis to manage liquidity. The auctions are held in Government dated securities and treasury bills of all maturities except 14 days treasury bills for parties holding SGL account and current account with RBI in Mumbai. While liquidity is absorbed by RBI to minimize volatility in
  65. 65. Amity Business School Page 64 the money market, LAF can also augment liquidity through export credit refinance and liquidity support to primary dealers. The fortnightly average utilisation including export credit refinance has ranged between Rs. 4,119 crores and Rs.7,697 crores during April - October 1999. Reserved Liquidity Adjustment Facility (March 29, 2004) LAF is operated with overnight fixed rate repo and reverse repo. Auctions of 7 day and 14 day repo (reverse repo in international parlance) were discontinued from November 1, 2004. Absorption of liquidity by RBI in the LAF window is termed reverse repo and injection of liquidity repo. LAF has emerged as the tool for both liquidity management and signaling device for the interest rates in the overnight market. Yield to Maturity of Central Government Dated Securities Of the outstanding central and state government securities of Rs.8,07,292.6 crores in 2003 SCBs owned 58.56%; and their ownership of Central government securities was 38.47% (of total Rs.3,74,203 crores) and state governments securities was 58.99% (of total Rs.1,33,089.6 crores). The distribution of their investment in government securities of Rs.5,51,230 crores between centre and states was 85.8% and 14.2% in 2003. The one year yield rate was 5.66% in March 2005; in the medium term segment, the 5 year yield rate was 6.36% and at the longer end, the 10 year yield rate was 6.65%. The trends in the-yield movement in the government securities market during 2004-05 showed that, while the short-term rates responded quickly to changes in monetary policy, long-term rates exhibited sticky behaviour reflecting the ripple impact of policy changes. The average yield spread between 1 and 10 year maturity for central government dated securities was 114 basis points in 2003-04; and the average spread between 1 and 20 year maturity was 148 basis points. The components of spread are term risk premia and inflation expectation. The stickiness of long term rates may be reflecting rigid long-term inflation expectations, relatively higher risk premia arising from uncertainties surrounding the fiscal policy and the government borrowing programme in future and information bottlenecks.
  66. 66. Amity Business School Page 65 Timely and adequate information plays a critical role in drawing long-term contracts, reducing rate volatility, basing investment decision on rational criteria and reacting to market developments in a quick and efficient way. For infrastructure sector, India needs long-term debt market Bad debt held by Indian banks is growing, as the economy slows down and infrastructure projects stall. From Rs 1.3 lakh crore at the end of March 2012, these have jumped to Rs2.4 lakh crore at the end of December 2013. India's infrastructure companies grew at a rapid pace through most of the 2000s, embarking on spectacular projects fuelled by debt. As they have slowed down, critics say that they should not have taken on as much debt as they did. This criticism is largely unfair. For companies to emerge from being relatively puny contracting entities to publicly-listed infrastructure developers, funding was necessary and loans the only viable option. Equity alone could not keep up with the rate at which projects were growing. The biggest flaw in India's infrastructure funding model is that it was largely financed by banks, which hold mostly short-term cash, but lend for longer- term projects like building highways and power plants. Today, this has resulted in a large and growing asset-liability mismatch for the banks. They, in turn, are forcing borrowers to liquidate assets, often at throwaway prices. If this continues, no businessman will have any appetite to embark on infrastructure projects. How can we get out of this hole? India needs to develop a market for long-term debt, ring-fenced according to maturity. In other words, funds raised for 20 years, say, should fund projects for 20 years. The world over, the longest-term investors are insurers and pension funds. In India, insurers find it difficult to invest in long-term project debt. Rules must change and special vehicles meant to develop infrastructure, such as IDFCBSE - 2.23 % and IIFCL, must develop the expertise to vet projects and guarantee their debt services.
  67. 67. Amity Business School Page 66 Conclusion The decision to raise or reduce rates depends on the demand and supply conditions, not a mere rise or fall in repo rates Lending rates weren‘t directly linked to repo rates, but were dependent on banks ‗cost of funds But banks could raise lending rates in some segments, depending on the credit rating of the client and the relative cost to the bank The RBI changes the repo rate etc., to control the money supply of the country. This study is an effort to understand whether reverse repo rate announcements hold any informational content for the Debt market that may lead to changes in the interest rate and to test the impact of reverse repo rate on interest rate of Indian banking. The results of the study showed that the amount of loan varies to the announcements of reverse repo but its impact not immediately on banking loan That is becoming clearer in the current scenario. Lending rates are dependent on the cost of funds. For many quarters, deposit rates have not changed even when the repo rate went down or up. Deposit rates in a way are linked to inflation There is enough liquidity in the system, so there will be no immediate increase in deposit and lending rates. Banks have seen huge inflows in the form of FCNR deposits and they are looking at avenues at (for) deploying those funds, The gravest risk to the value of the rupee is from CPI (consumer price index) inflation which remains elevated at close to double digits, despite the anticipated disinflation in vegetable and fruit prices.
  68. 68. Amity Business School Page 67 Suggestion of Study  This study suggests that any announcement of repo rate is not impact banks rate immediately.  Investor should be focus on all instruments like SLR, CRR, Reserve Repo and Market operation.  Also consider the other environmental factors which affect the repo rate decision.  Find out the reason behind the repo rate announcement.
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