Bank Rate Dynamics

Bank Rate Dynamics

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The bank rate is often referred to as a penal rate. This characterization arises from its function as the rate at which the central bank lends funds to commercial banks for a more extended period, often ranging from a few days to several months. When commercial banks find themselves in need of short-term liquidity and approach the central bank for funds, they typically utilize the repo rate for these short-term borrowings. However, in cases where banks breach regulatory or liquidity norms, the central bank may resort to the bank rate as a penal rate.

There is a profound effect of bank rates on the money supply within an economy. When the bank rate is increased by the Reserve Bank of India (RBI) then commercial banks have to face expensive borrowing. This, in turn, prompts them to reduce their borrowing activities, which subsequently leads to a decrease in the money supply. Less borrowing leads to a contraction in the overall money supply. Conversely, when the central bank lowers the bank rate, it aims to stimulate economic activity. Lower borrowing costs encourage commercial banks to take out loans, thereby increasing lending and investment activities.

The Marginal Standing Facility (MSF) is closely linked to the bank rate. The MSF allows commercial banks to borrow funds from the central bank in emergencies or for liquidity management at a rate higher than the bank rate. This premium rate above the bank rate serves as a disincentive for banks to frequently use the MSF. The relationship between the bank rate and the MSF is notable. Typically, the MSF rate is set as a fixed percentage above the bank rate. A higher bank rate results in a proportionally higher MSF rate, making it costlier for banks to access emergency funds.

The repo rate, often confused with the bank rate, is another crucial policy rate set by the central bank. It determines the rate at which commercial banks can borrow short-term funds from the central bank against collateral. While the repo rate and the bank rate serve distinct purposes, they are closely related. The key difference lies in their tenor. The bank rate is used for more extended lending periods and acts as a penal rate in certain situations. In contrast, the repo rate is used for short-term borrowings, typically ranging from overnight to a few days.