Bank Rate

Bank rate is an important concept in economics that affects the interest rates, money supply, inflation, and growth in a country.

What is bank rate?

Bank rate is the interest rate at which the central bank of a country lends money to commercial banks. For example, in India, the central bank is the Reserve Bank of India (RBI), and the current bank rate is 6.75%. This means that if a commercial bank wants to borrow money from the RBI, it has to pay 6.75% interest per year on the borrowed amount.

Why do commercial banks borrow money from the central bank?

Commercial banks borrow money from the central bank for various reasons, such as:

• To meet their reserve requirements: Commercial banks are required to keep a certain percentage of their deposits as cash reserves with the central bank. This is called the cash reserve ratio (CRR). For example, if the CRR is 4%, then for every 100 rupees deposited in a bank, the bank has to keep 4 rupees with the RBI and can use the remaining 96 rupees for lending or investment purposes. Sometimes, due to high demand for credit or unexpected withdrawals by customers, banks may face a shortage of cash reserves and may need to borrow money from the RBI to meet their CRR obligations.
• To manage their liquidity: Commercial banks also need to maintain a certain level of liquidity, which means they have enough cash or liquid assets to meet their short-term obligations and customer demands. Liquidity is essential for banks to operate smoothly and efficiently. Sometimes, due to seasonal fluctuations or market conditions, banks may face a liquidity crunch and may need to borrow money from the RBI to improve their liquidity position.
• To take advantage of arbitrage opportunities: Commercial banks also borrow money from the central bank to take advantage of arbitrage opportunities, which means they can earn a profit by borrowing at a lower rate and lending at a higher rate. For example, if the bank rate is 4.25% and the market lending rate is 6%, then a bank can borrow money from the RBI at 4.25% and lend it to its customers at 6%, earning a profit of 1.75%.

How does the central bank control the bank rate?

The central bank controls the bank rate as one of its tools of monetary policy, which means it uses the bank rate to influence the money supply, inflation, and economic growth in the country. By changing the bank rate, the central bank can affect the cost and availability of credit in the economy.

For example, if the central bank wants to stimulate economic activity and growth, it can lower the bank rate. This will make borrowing cheaper for commercial banks, who will then pass on the benefit to their customers by lowering their lending rates and increasing their credit supply. This will encourage more borrowing and spending by households and businesses, which will boost aggregate demand and output in the economy.

On the other hand, if the central bank wants to reduce inflation and excessive demand, it can raise the bank rate. This will make borrowing more expensive for commercial banks, who will then pass on the burden to their customers by raising their lending rates and reducing their credit supply. This will discourage more borrowing and spending by households and businesses, which will reduce aggregate demand and output in the economy.

The bank rates vary across countries depending on their economic conditions and monetary policy objectives. Some countries, such as Japan, have negative bank rates, which means they charge commercial banks for keeping their excess reserves with them. This is done to encourage banks to lend more money to the economy and stimulate growth.

Difference between Bank Rate and Repo Rate

Bank rate is the interest rate that the central bank of a country charges to the commercial banks when they borrow money from it without any collateral. For example, in India, the central bank is the Reserve Bank of India (RBI), and the current bank rate is 6.75%. This means that if a commercial bank wants to borrow money from the RBI without providing any security, it has to pay 6.75% interest per year on the borrowed amount.

Repo rate is the interest rate that the central bank of a country charges to the commercial banks when they borrow money from it by selling some of their government securities as collateral. Repo rate is short for repurchase rate, which means that the commercial banks have to repurchase or buy back the securities that they sell to the central bank as collateral for the loan. For example, in India, the current repo rate is 6.50%. This means that if a commercial bank wants to borrow money from the RBI by selling some of its government securities, it has to pay 6.50% interest per year on the borrowed amount and also agree to buy back those securities from the RBI at a later date.

The main difference between bank rate and repo rate is that bank rate is charged on loans without any collateral, while repo rate is charged on loans with collateral. Bank rate is usually higher than repo rate because it involves more risk for the central bank. Repo rate is usually lower than bank rate because it involves less risk for the central bank.

Both bank rate and repo rate are tools of monetary policy that the central bank uses to control the money supply, inflation, and economic growth in the country. By increasing or decreasing these rates, the central bank can affect the borrowing and lending activities of commercial banks and their customers, which in turn affect the aggregate demand and output in the economy.