The recent times are visualizing quite some turmoil in the interest rate scenario of the country. Rising interest rates in both fixed deposit and advance domain, evanishment of teaser loan schemes from the home loan segment are the ones that have caught almost every eye. The major reason behind all such acts has been policy rate tightening measures adopted by banking and monetary regulator, Reserve Bank of India to curb the demonic inflation figures.

RBI controls the flow of liquidity in the system through both direct as well as indirect measures. RBI has raised policy rates six times so far in this fiscal to control the towering inflation figures and bring a check in the flow of liquidity. The repo rate has seen an increase by 125 basis points so far in this fiscal while cash reserve ratio (CRR) has been raised by 100 basis points so far.

Relationship between policy rates and bank interest rates

Policy rates like CRR, SLR, repo and reverse repo rate are instruments used by RBI to indirectly control the flow of liquidity in the system. Repo rate is the rate at which banks borrow funds from RBI while CRR is the portion of total deposits of the bank which has to be kept with RBI.
Inflation and liquidity can be said to be directly related to each other. Excess liquidity in the system leads to rising inflation rates.

In order to reduce the flow of liquidity, the central bank raises policy rates. With increase in repo rate banks come under pressure to pay more interest to RBI for their borrowings while with rise in CRR, they have to set aside larger chunk of deposits as reserve with the apex bank. In both cases, funds available with banks decrease.

In order to attract more funds, banks increase deposit rates so that depositors put more money with them. At the same time, since banks now have lesser funds left with them and are also paying higher interest to RBI (increased repo rate) they increase lending rates. Rising lending rates in a way discourage credit and gradually excess liquidity is sucked out from the system.