The banking system is going through a totally crazy time. People have deposited over Rs. 500,000 cr. in two weeks since demonetization was announced. Since there are withdrawal limits, they have not withdrawn quite as much (only Rs. 100,000 cr.). So, there’s some Rs. 400,000 cr. or more that has been deposited in bank accounts since November 10.
That money has to go somewhere. Right now, it’s going straight to the RBI. As “reverse repo”. Let’s explain this a little further now. What is Repo and Reverse Repo?
RBI: the Liquidity Source and Sink
Banks need cash all the time – sometimes to just meet their reserve requirements (4% of all deposits need to be stored with the RBI as CRR). At other times, when they loan money out, they will need cash until they get the money back as deposits. Usually they might borrow from other banks through the CALL and CBLO markets (mentioned below). But when every bank wants to borrow, they’ll just go to the RBI (the lender of last resort).
They tend to borrow this cash from the RBI at the “repo” rate. This is a transaction that involves a sale and “repurchase” of a security – typically a government bond.
Banks give the RBI a government bond, and RBI gives them money. Then RBI sells the government bond back to them the next day, at a price that reflects the interest rate that is being charged, called the repo rate. Effectively, the RBI buys the bond at the market rate, and sells the bond back at the purchase price plus the repo interest for one day. (Accrued interest is also adjusted accordingly)
A simplistic way to do this: If a bank wants to borrow Rs. 100 cr. from the RBI, it will give bonds worth Rs. 100 cr. to the RBI for, say, a repo rate of 7%. For one day, it will pay approximately Rs. 1.9 lakh (0.019 cr.) as interest at 7% a year. (7% / 375 x 100 cr.) So it buys backs the bonds at Rs. 100.019 cr. the next day.
This is like RBI lending money to banks at the repo rate using the government bond as collateral, but it’s structured as a purchase/sale transaction. (The bonds actually leave the bank’s books for that day, and come back the next day).
Reverse repo is the opposite. When banks park money with the RBI, the RBI gives them bonds. It pays them the “reverse repo” rate effectively, and the above math is how the sale and purchase transaction are structured.
The repo rate is higher than the reverse repo rate. These rates are decided by the RBI from time to time in the monetary policy.
Does Repo mean anything?
If banks can’t borrow from anywhere else, they can borrow from the RBI. So effectively the RBI’s repo rate will help determine the cost of funds for a bank, and in turn determine the bank’s lending interest rates.
Similarly, since banks can park cash to the RBI at the reverse repo rate, they will not lend for lower – so that forms the basis for rate transmission. The RBI sets the repo/reverse repo and banks add their spread and lend onward.
Does Repo and Reverse repo happen daily?
Banks get a repo “window” every day for such fixed rate repo – when they have to tell RBI they want money and offer the bonds. The interest rate is fixed. Banks will typically get what money they want, at the repo rate. This is usually for an overnight transaction, till the next working day. (Friday fixed repos and reverse repos are for three days, for example, but on other days of the week the term is one day)
However, banks can’t just keep giving government securities to the RBI – they have to maintain their Statutory Liquidity Ratio (about 20% of all deposits need to be with banks as SLR, invested in Government bonds).
Reverse repo too is a fixed rate thing, done in another window at the end of the day.
Currently, repo and reverse repo rates are 6.25% and 5.75% respectively, but that can change.
The Variable Rate and Time Auctions
Rajan introduced more things called the “variable rate repos“. Meaning, instead of borrowing at a fixed rate overnight, repo could be done over a longer period (say a week or so) so that banks don’t need to do the same amount every day. The calculations are similar, except the time period differs. The rate itself is variable – meaning, there is an auction for determining the interest rate payable.
Each bank “bids” for the repo rate they want to pay. They can’t pay less than the repo-rate, but they can choose to pay more. So a 7-day variable rate repo auction for 50,000 crores may see bids from 6.25% to 6.28% by different banks based on how desperate they are for the money. (You can’t bid below 6.25% but can do any number above)
This helps banks borrow money for longer periods to avoid uncertainty and to plan better.
Similarly, variable reverse repo auctions also happen. This is when banks need to park excess cash and need a place to do so. Again banks bid for the interest rate they want RBI to pay. This can’t be above the repo rate, of course, because if that was allowed, banks would borrow at repo and park it back in a reverse repo auction. So for repo at 6.25% your best variable reverse repo bid is 6.24%.
Variable rate and time auctions are held ad-hoc by the RBI. They decide when they want to have one and sometimes have multiple auctions in the same day.
The CALL and CBLO markets
Cash borrowing should not need the RBI. A bank that wants cash should be borrowing from a bank that has too much cash, or from a mutual fund or such. This is how the business works normally- and the CALL and CBLO markets are such. Call money is simply money-on-call, when you give money to a bank and demand it back the next day.
There’s also the Collateralised Lending and Borrowing Obligation (CBLO) market. This is a sort of exchange for banks to deposit securities and borrow cash, or deposit cash and borrow securities. Effectively you lend one or the other (securities or cash), and the bank that gets cash will pay an interest rate. CBLO can be overnight, or for a few days.
You can see all of this in action at http://ccilindia.com.
What’s Happening Now?
After demonetization, banks have been getting massive amounts of deposits. They now have no way to lend the money out right now. So they park it with the RBI. (This is oversimplified – in reality, lent money comes back to banks as deposits, since you lend by crediting a bank account. So this money is really excess in some way, but we’ll leave that discussion for later)
There is so much money now that RBI has conducted gazillion variable rate reverse repo auctions because banks can’t put the money anywhere else. And you can see this in their daily money market update:
This is enormous. Banks have parked money with the RBI for 91 days! And because banks are a cartel, they get 6.24% or so for parking their money.
And all of this money is in savings accounts paying out just 4% in interest. So the banks earn a decent 2% spread or so. For SBI, which has about Rs. 100,000 cr. extra right now, it will earn about 1,600 cr. per quarter as income (at 6.2% a year) which is a small fraction of the Rs. 42,000 cr. it makes otherwise per quarter. And then it has to pay an interest of 4% or Rs. 1,000 per quarter, and there are other costs, so the profit isn’t substantial.
Ooh, Check Out The Chart: 5 lakh crores parked with the RBI
Just November in Reverse repo – mostly variable rate – shows you that the banks have, collectively, parked nearly 5 lakh crore rupees with the RBI!
Consequences of High Liquidity
Now, a rate cut only hurts banks. They don’t need to borrow, and they are parking excess money with the RBI. So effectively if RBI cuts rates, they need to cut savings bank account interest rates too.
Banks will sharply cut deposit rates. This may be temporary but banks do not need more money now. SBI has already cut bulk deposit rates. All other banks may do so too.
Banks may HAVE to cut lending rates. The MCLR is a function of their cost of funds. That has substantially fallen now. So come December, they will have to cut all their lending rates appropriately, and perhaps the base rate as well. Banks don’t like to do this, but because of new rules they may have to.
Reverse repo auctions will continue until people that have deposited, start to withdraw the money out. At such a point, banks may restore their deposit rates to higher levels as well.
There’s a weird situation now, which has no impact on the market. RBI may run out of bonds! RBI has only about 750,000 cr. of bonds on its balance sheet. For Reverse Repo, they have to give banks bonds and take their money. Right now, banks have parked nearly 500,000 cr. with the RBI. If this goes on quickly, we will see that nearly all of RBI’s bonds will have to be sold and repurchased – and they might fall short. There will be innovative solutions, undoubtedly, and this has no impact on anything at all, just a fun statistic.
The money multiplier will fall. For every Rs. 1 in currency printed, there was Rs. 10 in bank deposits (savings + term etc). Because if you deposit Rs. 1 in a bank, the bank lends it out to X, and then X deposits that Rs. 1 in the bank, which is further lent out etc. The multiplier is simply the number of times this can happen. (Speaking simplistically). Effectively now, until such time as lending picks up, the money multiplier falls.
This is not a great period for banks, no matter what you say. Banks don’t lend because they have money. They lend because they have opportunities to lend, and are constrained only by capital (as you can see, banks are the ones that create new money). The new money that comes in is debt, not capital. Until such time as they can earn greater profits, the extra money gets them very little. And they will report a much lower ROA (return on assets) because of the lower multiplier.
Lastly, to find out where the situation is stabilizing, look at RBI press releases. The daily money market release tells you how much is being dumped into reverse repo. This figure is likely to keep increasing till December 30. It is when this figure rapidly changes downwards is that people are looking to withdraw money out (if the withdrawal limits are removed).
We hope this has helped you understand the repo and reverse repo framework of the RBI.