Question

Identify and briefly explain any three factor which influence interest rates set by commercial banks

Answer 1

The interest rate is the rate at which a person borrows money from a lender. The amount that is borrowed is called the ‘principle’. The cost you pay for borrowing it is called the ‘interest’. In modern times, the interest charged depends not only on the types of loans, but also on various economic factors. The rate of interest is directly influenced by Bank rate and indirectly affected by Repo rate. Repo rate, in turn, is influenced by and influences various socio-economic conditions.

Let us look at those factors which affect the rate of interest:

1. Bank Rate: A bank rate is the rate at which the RBI (Reserve Bank of India) lends money to commercial banks. This lending is for a longer duration, ranging from 90 days to one year, and involves no collateral. Banks profit by charging customers higher interest than the RBI. Thus, when the RBI lends at a higher interest, the interest rates rise.
2. Repo Rate: Also known as the repurchase rate, it is the rate at which commercial banks borrow money from the RBI to close the gap between the demand for finances (loans) from customers and how much they have left to lend (supply). It is a short term loan (two days to three months) provided to the banks against securities (usually bonds), with a promise from the banks to repurchase the securities within a short span of time. Repo rate helps the RBI in maintaining the liquidity in the market. When the RBI wants to make it more expensive for banks to borrow funds, it increases the repo rate, thus, increasing the cost of borrowing (interest) for the common man.
3. Demand and supply: An increase in the demand for loans and credit will increase the rate of interest, while a higher supply of credit will cause a fall in the rate of interest. There is a rise in the supply of credit when people open bank accounts, making money available to lend. However, when people defer payments towards their loan, it decreases the amount of credit available, thus, increasing the rate of interest.

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