Opening the knots in Bank Rate

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In the second article of getting to know the banking sector, we would cover how change in the Bank rates in the recent times is affecting the general public.

The changes in the bank rates, not only changes the cost of borrowing for the general public but also effects the prices at which good are available in the market (a.k.a-Inflation) in the short term.

To get started on this ‘knowledge journey’ read the first article by clicking on the below link: https://www.fromthegenesis.com/know-banking-sector/

Now, let’s first understand the relationship between Bank interest rates and Inflation.

Bank Rate is the rate which the central bank (RBI in India) charges (cost of borrowing) for the loans given to commercial banks.

  • Therefore, if the bank rate increases, the cost of borrowing becomes expensive, people borrow less, public has less money at their disposal, so the demand for goods decreases and supply remaining same in the short turn, prices (inflation) comes down.
  • Similarly, if the bank rate decreases, the cost of borrowing becomes cheaper, people borrow more, public has more money to spend, demand for goods increases and with the increase in demand and supply remaining same in the short run the prices increases.

What is happening in India?

As per the Flexible Inflation Targeting Framework (FITF) that was introduced in India post the amendment of the Reserve Bank of India (RBI) Act, 1934 in 2016. The Government of India sets the inflation target every 5 years after consultation with the RBI. While the inflation target for the period between 5 August 2016 and 31 March 2021 has been determined to be 4% of the Consumer Price Index (CPI), the Central Government has announced that the upper tolerance limit for the same will be 6% and the lower tolerance limit can be 2% for the same.

RBI has been following a neutral policy for some time now. This means that with inflation being at an all-time low of 4.0%, and the growth projections of the Indian economy being at a constant 7.30%, the RBI will try not to destabilize the delicate balance, by either infusing or removing too much funds from the markets.

To this end, the Central Bank has increased the repo rate and reverse repo rate on 1 August 2018 by 25 basis points taking them to 6.50% and 6.25%, respectively. It has also increased the Bank Rate and MSF Rate to 6.75% each. This ensures that the government’s requirement for more liquidity for industry growth is fulfilled, without the risk of increase in inflation being too high.

So what does it mean for you as an investor in the banking Sector?

So when the RBI increases the Bank rate, people borrow less because of the increased cost of borrowing, which weakens the asset section of the bank (read the first article) making financials weak.

In fact, when the RBI announced increase in the bank rate by 25 basis points to 6.25% in its 2nd bimonthly policy- major bank stock such as- ICICI Bank (down 0.58 per cent), Axis Bank (down 0.43 per cent), HDFC Bank (down 0.38 per cent), YES Bank (down 0.31 per cent) and IndusInd Bank (down 0.27 per cent).

Moving forward with the next articles, we would cover the fundamentals of the bank based on financial ratios, which would help us in understanding this sector better.

Stay tuned for the next update on the banking sector.

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