Basics of Banking, Rate cuts, CRR, SLR and their impact on Stocks!

A valued reader has asked this question:

Question: Can you please cover basics of Credit policy, Inflation, GDP and their effect on market in your future posts. Now-a-days Repo rate, CRR, Inflation all are in news but since I am not from a finance background it is difficult for me to understand the effects of cuts and why market goes up or down because of it?

Which stocks to invest and which stocks to not when all these changes take place? I think there would be many investors like me who find difficult in relate all these with investment and market trends.

Answer:

The basic concept of the banking system is very simple and at its core, a bank simply accepts deposits from their customers and uses these deposits to provide loans to other customers. The profitability of bank simply depends on the Net Interest Margin, popularly called NIM, i.e. the difference between interest it charges to borrowers and interest it offers to a depositor. A depositor might be receiving 6% per annum on its savings account and bank will use this money to lend to a Home Loan customer at 9.5%. This margin of 3.5% is what is known as Net Interest Margin or NIM for the bank.

Now, Banking being such a lucrative business, everyone would want to open a Bank. So RBI regulates the licenses and does not allow unregulated mushrooming of banks which might fleece customers and run away with their savings.

Another risk is that banks might take your deposits and lend it all to companies like Kingfisher Airlines which will not be able to refund the loans. So to regulate the banking sector, RBI comes up with a set of ratios like SLR and CRR.

SLR stands for Statutory Liquidity Ratio. This term indicates the minimum percentage of deposits that the bank has to maintain in form of liquid and safe components such as gold, cash and other approved securities. This ensures that Bank remains liquid and does not fails when there are large withdrawals and does not runs out of cash. The SLR ratio currently is at 23% now, which is a decent high number.

CRR is Cash Reserve Ratio and Banks in India are required to park a portion of their deposits with RBI in form of cash. This is to ensure that Banks do not go overboard and lend with high leverage with no safety net behind them. The CRR ratio is also a tool in RBI’s hand to control the liquidity in overall Indian economy. Current CRR ratio is at 4% and was reduced by 0.25% recently. A cut of 0.25% would increase the liquidity by 18,000 crores in the Indian Banking system.

Repo rate is the rate at which RBI lends money to Banks and Reverse Repo is the rate at which banks park their money with RBI. This is currently at 7.75% and 6.75% respectively.

The economic outlook for next one year is that rate cut cycle has begun and RBI would continue slow cut in rates throughout the year. What it means for the overall economy is that, Industries and Sectors that have borrowed from Banks would have to pay less interest rate going forward and they would be profitable. Non-performing Assets (NPA) of Banks would reduce as well. Common man would also benefit as his Home loan and Car loan rates would come down and he would be motivated to use his additional savings in making other purchases, thus helping economic growth in general.

So sectors like Real Estate, Infrastructure, Retail, and Debt laden sectors like Textiles, Sugar, Manufacturing Industries would benefit from this rate cut cycle. Overall, this is a positive development for Indian Equity and Bond markets.