This is a thematic paper submitted to Tribhuwan University. This paper follows the right format for thematic paper righting. Special Thanks to Prof. Raj Kumar Bhattarai and Mr. Nischal Rishal for the guidence.

1. A THEMATIC PAPER
ON
INTEREST RATE CORRIDOR
SUBMITTED TO
Mr.NISCHAL RISAL, M. Phil
FACULTY OF FINANCE
NEPAL COMMERCE CAMPUS
SUBMITTED BY
NITESH KHATIWADA
MASTERS IN BUSINESS MANAGEMENT (FINANCE)
NEPAL COMMERCE CAMPUS
14 AUGUST, 2016

2. MEANING
Interest is simply defined as the feeling of wanting to know or learn about
something or someone. However, when it comes to finance, interest means money
paid regularly at aparticular rate for the use of money lent or for delaying the
repayment of debt. Interest is also the charge for the privilege of borrowing money
and return received from any financial investments. Interest is typically expressed
as annual percentage rate.
Rate is the amount of a charge or payment with reference to some basis of
calculation. It is a certain quantity or amount of one thing considered in relation to a
unit of another thing and used as a standard or measure. Often it is a rate of change. If
a unit or quantity in respect of which something is changing is not specified, usually
the rate is per unit of time. However, a rate of change can be specified per unit
of time, or per unit of length or mass or another quantity. The most common type of
rate is "per unit of time", such as speed, heart rate and flux. Ratios that have a non-
time denominator include exchange rates, literacy rates and electric field.
Interest rate is the amount of interest, expressed as percentage of principal, due
per period that lender charges to the borrower for the use of fund or the asset.Principal
can be in the form of proportion of the amount lent, deposited or borrowed. The total
interest on principal depends on the principal sum, value of asset, the interest rate, the
compounding frequency, and the length of time over which it is lent, deposited or
borrowed. The assets borrowed could include, cash, consumer goods, large assets,
such as a vehicle or building.
Interest rates are typically noted on an annual basis, known as the annual
percentage rate (APR). Interest is essentially a rental, or leasing charge to the
borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the

3. interest rate is sometimes known as the "lease rate". When the borrower is a low-
risk party, they will usually be charged a low interest rate; if the borrower is
considered high risk, the interest rate that they are charged will be higher.
Corridor is a passage connecting different parts of the building. It may also be
a passage in which several rooms or apartments open. The term is also used to define
a narrow tract of land forming a passageway, as one connecting two major cities or
one belonging to an inland country and affording an outlet to the sea.
Interest rate corridor (IRC) refers to the window between the repo rate and the
reverse repo rate wherein the two-week term deposit rate acts as a floor and the
standing liquidity facility as the ceiling and two-week repo rate moves in the middle
of the corridor. Hence, the two rates i.e. standing liquidity facility (SLF) and two-
week term deposit rate makes the two opposite ends of a corridor and two-week repo
rate moves along the corridor. Ideally, IRC is introduced to stabilize the interest rate.
It aims to prevent interest rates from suddenly hitting rock bottom or going through
the roof. This ultimately lift deposit rates and stabilizes lending rates.
ETYMOLOGICAL DIMENSION
Interest
The word interest is originated from the word “en” from Indo-European
language, which was later used as “in” derived from Proto-German era. Later, merger
of words led to creation of word “Intĕr” in Classic Latin – meaning“in between”. In
the same era, several suffix were added to the word such as sum, ess, or es which
meant “to be” and hence the word was pronounced as Intersŭm, (esse) in classic and
late Latin literally giving it the meaning “to be between”.
The word was used as Interesse in Medieval Latin to mean legal claim or
right; a concern; a benefit, advantage, a being concerned or affected. In 1251, the

4. French adopted the word as “Interest”. By 1740, French used the same word as
“Intérêt”. Both of the words were used to mean damage, losses or harm.
The word currently used in English Literature seem to be influenced from the
word “Interesse” that was derived from Anglo Nomard, meaning what one has legal
concern in, “Interest” derived from Old French, meaning damage, loss or harm and
“Interesse” from Medieval Latin meaning compensation for loss. Financial sense of
“money paid for the use of money lent” (1520s) was earlier distinguished from usury
(illegal under Church Law) by referring to “compensation due from a defaulting
debtor”.

5. *en – (Indo-European)
*in – (Proto-German)
Intĕr (Classis Latin) Sum, es, ess (Classis
Latin)
Intersŭm, esse
(Classis/Late Latin)
Interesse (Medieval
Latin)
Interesse (Anglo
Nomard)
Interest (Old/Middle
French, 1251)
Interesse / Intersse/
enteresse/ entresse
(Middle English, 14th
C.) (Medieval Latin)
Interest / Intrest/
entrest (Middle
English, ≈ 1450)
Intérêt (Modern
French, 1740)
Interest (Modern
English)
Etymology of Interest
Source: Dictionary of Canada

6. Rate
The word “rate” finds its origin from Medieval Latin word “rata” which
meant fixed or settled which was derived from Latin word “reri” meaning to reckon
or think. Old French use the word “rate” to mean price or value. By combining these
words, English literature started using the word “rate” to mean estimated value or
worth since 15th
century. In 1650s, rate was used to mean degree of speed or to
identify the ratio between distance and time.
Words such as first rate, second rate etc. were used by British Navy Division
in 1640s to class ship into six classes based on size and strength. Phrase at any rate
used in 1610 meant at any cost. Its weak form meaning “at least” was derived in
1760. Currency exchange sense was first recorded in 1727. Intransitive sense of
having a certain value, rank, or standing is from 1809 and specifically as have high
value is from 1928.
Corridor
The word finds its origin in 1590s from French word corridor. In Italian
language, corridore was used to mean a gallery and in Latin, currere was used to
mean to run. The word was used to give its first modern meaning was recorded in
1814. Then it was widely used to mean “long hallway in fortifications”.
Interest Rate Corridor
The idea of a symmetric corridor set by standing facilities around the target
overnight rate is relativelynew, namely 10 to 15 years old. Still, a much earlier debate
of relevance for the issue is the one ofmakingbank rate effective in 19th century
central banking (Bindseil 2004). 19th century monetary policyimplementation was
based largely on a systematic recourse to one liquidity providing facility, namely a
discount facility in which first quality trade bills could be submitted. Already in the

7. 19th century, theoptimal spread between the market and the central bank facility rate
was a topic of lengthy discussions. They can be regarded as closely linked to the topic
of the optimal spreadin a symmetric corridor approach.
The Bank of Canada was the first central bank to introduce a corridor system
in 1994,with a width of 50 basis points, and called the “operating band”. Even though
the framework did not evolveinto a fully-fledged symmetric corridor approach until
2001, it has nonetheless from the very beginning beendirected at containing the rates
at which money market participants borrow and lend overnight funds withinnarrow
bounds.
The term as it is understood today was introduced by Central Bank of
Republic of Turkey (CBRT), where central bank let go of money market instrument to
control liquidity. Rather, interest rates are effectively used to control the fluctuations
of interest rates and liquidity in the market. The IRC was introduced by CBRT in
2010 and, due to its effectiveness and capacity to manage liquidity, is rapidly adopted
by many banking institutions around the world. IRC has been especially useful to
manage the value of deposits, predict the future lending rates and manage inflation
rates.
ONTOLOGICAL DIMENSION
Interest rate corridor, or IRC, is a mechanism that guides short-term market
rates and helps keep all interest rates within certain band, reducing interest rate
volatility. Interest Rate Corridor refers to the distance between the overnight
borrowing and lending rates of the central bank. IRC follows macro prudential
measures in order to address the financial stability challenges posed by volatile capital
flows.IRC provides clear signals to bankers, policymakers, borrowers and depositors

8. on how short-term interest rates will move in the market, enabling them to make
decisions accordingly.
Interest Rate Corridor (IRC) is composed of three different dimensions. Two
of them making the opposite ends of the corridor and one moving along the corridor.
The Standing Liquidity Facility (SLF), makes the upper bound or the ceiling rate of
IRC. Two-week term deposit rate works as the lower bound or the floor rate and two-
week repo rate moves along the corridor, between the ceiling and floor rate.
SLF rate is the rate at which central bank provides loan to banking and
financial institutions for maximum of five days in case there is severe shortage of
cash.Two-week term deposit rate is the rate at which central bank borrows money
from banking and financial institution for two weeks in case of excess liquidity in the
banking system.Two-week repo rate is the rate at which the central bank providesloan
to banking and financial institutions for two weeks in case of liquidity crunch
inbanking and financial system. Though these are the basic component of IRC, the
duration which is considered while calculating the different rates are fixed by the
central bank of respective country.

9. EPISTEMOLOGICAL DIMENSION
The relationship between the various dimensions IRC can be explained with
the help of following figure.
The vertical axis in the figure shows the interest rates, while the horizontal
axis depicts the quantity of liquidity. The supply and demand curves represent the
short term net liquidity supply and demand. Although the liquidity is heterogeneously
distributed across banks, the net position of the system is in deficit. The liquidity
supply is provided by central bank via two-week repo operations and standing
liquidity facility. Since these two liquidity facilities have different interest rates and
the quantity of the two-week repo provision is directly set by the central bank, the
supply curve takes a stepwise form. In this setup the central bank decides on both the
interest rate (price) and the quantity of the two-week repo.
Market
rate
Quantity of
Liquidity
SLF
Rate
Two-week
deposit
Rate
Two-
week
Repo
Rate
Liquidity Demand Curve
Liquidity Supply Curve
RepoFun
ding
Margin
Funding
Interest
Rate
Corridor
Total
Funding
Figure 1.1: Determination of short term interest rate.
Source: Central Bank of Republic of Turkey

10. Given these parameters,the financial institutions resort to SLF facility should
there beany additional liquidity need.The demand curve shows the relationship
between the short term liquidity demand and themarket interest rate. An increase in
market rates, ceteris paribus, would lead to a fall in thedemand for liquid funds.
Hence the demand curve is downward sloped. Since the marketinterest rates would
never fall below the central bank borrowing rate, the demand curvebecomes flat after
reaching this level. In other words, the discontinuity of the negative slopereflects the
fact that all the funds will be lent to the central bank if the market interest rate islower
or equal to the central bank borrowing rate.
In Nepal, Nepal Rastra Bank (NRB), the central monetary authority of Nepal,
introduceIRCon August 10 for the first time in Nepal. It had announced the
introduction of IRC in the monetary policy of 2073/74, to formally deal with the
problem of frequent fluctuations in interest rates by keeping interest rates within a
band.IRC is basically introduced to ensure that excess liquidity in the banking system
does not exceed around Rs. 20 billion. In case of shortage of cash, interventions can
be made to inject liquidity.
There are three dimensions to IRC i.e. SLF, repo rate and term deposit rate.
Simply put, SLF rate will form the upper bound, or ceiling, of the corridor. Two-week
repo rate will move in the middle of the corridor. And two-week term deposit rate will
form the lower bound, or floor, of the corridor.
In an ideal condition, the difference between the ceiling and floor rates do not
exceed one per cent. This means: if SLF rate is, say, six per cent, then two-week term
deposit rate should hover around five per cent, while two-week repo rate stands at 5.5
per cent.

11. However, due to excess liquidity in Nepal, weighted average interbank rate of
commercial banks has remained suppressed for a long time. Hence, repo rate is fixed
by adding 200 basis points, or two percentage points, to weighted average interbank
rate of two working days ago, while term deposit rate is fixed by deducting 10 basis
points, or 0.10 percentage point, from weighted average interbank rate of two working
days ago. The SLF rate is fixed by NRB on its own.
According to Executive Director at NRB Public Debt Management
Department Mr. Min Bahadur Shrestha,once IRC is introduced, NRB will focus on
reducing wedge. For this, NRB will float two-week term deposit instruments every
week to mop up excess liquidity. It will be continued until the gap between the ceiling
and floor are around four percent.NRB will then increase the frequency of issuance of
these instruments to twice a week. And ultimately float these instruments every day.
Once enough liquidity is absorbed from the market, interbank rates will start going
up, putting an upward pressure in two-week term deposit and repo rates. This will
ultimately reduce the wedge between different rates in the corridor.
THEMATIC REMARKS
Interest Rate Corridor, formed by the combination of simple terms from
psychology and physics undergoes a transition across time and space to mean a very
effective liquidity management term, which is used by central bank and bankers
around the world in daily basis. The sole purpose being limiting the fluctuations of the
interest rates within the corridor formed by combination of fund borrowing rate and
fund supply rate of central bank.
In this context, IRC was introduced to the world by Bank of Canada in 1994,
to decrease wedge between the rate of market and banks.Through continuing changes

12. and transformation, the corridor system as it is known today differ in form and
characteristics as it was first introduced by Bank of Canada.
The ratio of use of IRC has increased exponentially since 2010.The main
purpose of shifting form the monetary instruments system to micro prudential system
was to reduce the impact of the excess liquidity flow in the developing countries
followed by the expansionary monetary policy assimilated by the developed world to
cope up with the problem of recession.
The system has been successful in CBRT. Through use of IRC, CBRT has
been able to control interest rate volatility, predict short term interest rates and
manage long term inflation rate.
In addition to corridor system, Bank of Canada had stopped using the treasury
instruments by 2004. This phenomenon is just being witnessed in Nepal.
Though IRC has become a buzz word in Nepalese banking industry, Banking
and financial institutions are reluctant to subscribe the instrument. Hence, the
instruments that NRB had floated for the first time, on 10th
August, 2016, was under-
subscribed. Banking and financial institutions were hesitant to take part in the process,
while funds sits idle in their coffers. The major reason being larger wedge and low
two-week deposit rate. At the first issue of the instruments under IRC, the wedge
between the floor rate and the ceiling rate was 6.6955 per cent. The higher wedge
means the interest rate can fluctuate around 7 per cent which will not be able to
prevent the deposit rates from suddenly hitting the rock bottom and lending rate going
through the roof. Hence, though IRC has been introduced, it seems it will take some
time to feel the full impact of the system to stabilize the interest rates and to predict
the interest rates on lending and deposits.

13. Bibliography
Bindseil, U., & Jabłecki, J. (2011). The Optimal Width of the Central Bank Standing
Facilities Corridor and Banks' Day-to-Day Liquidity Management. Frankfurt
am Main, Germany: European Central Bank.
Binici, M., Erol, H., Kara, H., Özlü, P., & Ünalmış, D. (2013). Interest Rate Corridor:
A New Macroprudential Tool? . Turkey: Central Bank of Republic of Turkey.
Harper, D. (2016, July 28). Online Etimology Dictionary. Retrieved from
http://www.etymonline.com/
Küçük, H., Özlü, P., Talaslı, A., Ünalmış, D., & Yüksel, C. (2014). Interest Rate
Corridor, Liquidity Management and the Overnight Spread. Turkey: Central
Bank of the Republic of Turkey.
Maehle, N. (2014). Monetary Policy Implementation: Operational Issues for
Countries with Evolving Monetary Policy Regimes. International Monetary
Fund.