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MrunalExplained:LiquidityAdjustmentfacility,LAF,MSF,BankRate

Mrunalhttp://mrunal.org

[Economy]LiquidityAdjustmentfacility(LAF),Marginal
Standingfacility(MSF),Repo,reverserepo,SLR,CRR,
NEFT,RTGS,NDTL:meaningexplained
PostedByOn16/03/2013@10:04pmInEconomy|321Comments

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Liquidity?
WhatisCashreserveratio(CRR)?
WHYCRR:Cashreserveratio?
WHYSLR:Statutoryliquidityratio?
BankRuns:SLR+CRR
WHYPrioritySectorlending?
WhatisNDTL?
Reversereporate?
Whatisreporate?
ReporatevsBankrate?
WhatisLAF?
WhatisRGTS?
WhatisMarginalStandingfacility(MSF)?
DifferencebetweenLAFandMSF
Foodforthought
Openmarketoperations?
MockQuestions

Liquidity?
Liquidityisarelativeterm.
Forassets:Rs.1croreworthgoldismoreliquidthanRs.1croreworth
farmhouse.Becauseyoucanquicklysellthegoldinafewdays,butfor
sellingfarmhouseyoullhavetodealwithsomanyprospective
customers,realestateagents,paperwork,stampdutyetc.,thiswould
takemorethan15days=notsoliquid.
Forbanking:ifyesterdaySBIhadRs.100togiveasloan
todaySBIhasRs.200togiveasloan,thenwesayliquidityhas
increased.(Andviceversa).
Inwinter,supplyofgreenvegetablesincreases(comparedtosummer)
sosellingpriceofgreenvegetablesdecreasesinwinter(comparedto
summer).
Similarlywhenliquidity(moneysupply)increases,thecostofborrowing
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(=interestrates)goesdown.
Veryhighliquiditycancreatedemandpullinflation=bad.formore,click
me

Verylessliquidity=costofborrowingisextremelyhighforbusinessman=
badbecausehecannoteasilystartorexpandhisbusiness=lesspeople
getemployment.
SooneofthejobofRBI=controlthisliquidityinbankingsystem.
RBImainlyusesfollowingtoolstocontrolthisliquidity/moneysupplyin
thebankingsystem.
1.
2.
3.
4.

CashreserveRatio(CRR)
StatutoryLiquidityRatio(SLR)
LiquidityAdjustmentFacilities(LAF)(Repoandreverserepo)
Openmarketoperations(OMO)

WhatisCashreserveratio(CRR)?
Forthesakeofsimplicity,letsassumethereareonlyfourpeoplein
India:1)commonmenand2)businessmen3)Commercialbanks(like
SBI)4)CentralBank(RBI.)
NowtheQuestion:Howdocommercialbanksmakemoney?
Commonmensavetheirmoneyinbank.Bankgivesthemsay7%
interestrateonsavings.
ThenBankgivesthatmoneyasloantobusinessmenandcharges12%
interestrate.So127=5%istheprofitofBank.Althoughthats
technicallyincorrect,becausewevenotcountedbanksinputcost=staff
salary,telephoneinternetelectricitybill,officerent,xeroxmachineetc.
Soactualprofitwillbelessthan5%.
Butanyways,firstletsconstructatechnicallyincorrectmodel.
1. SBIhasonlyonebranchinasmalltown.ItwasopenedonMonday.
2. Ontheverysameday,Total100commonmendeposited1lakheachin
theirsavingsaccountshere(=totaldepositis1crore)
3. andSBIofferedthem7%interestrateperyearontheirsavings

WHYCRR:Cashreserveratio?
OnTuesday,SBIBranchmanagergivesawayentire1croretoa
businessmanasloanfor12%interestratefor5years.
FromSBIspointofview,soundsverygoodright?127=5%profit!
ButwevenotconsideredthefactthatonWednesday,someofthose
commonmen(accountholders)willneedtotakeoutsomemoneyfrom
theirbankssavingsaccounttopayforgas,electricity,mobilebills,
collegefees,writingchequesanddemanddraftsetc.
ButSBIsofficedoesnthaveasinglepaisaleft!=problem,protest,
rioting,suicides.
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Socondition#1:Banksmustnotgiveawayallofthedepositmoneyto
businessmenforloans.Banksmustkeepsomemoneywithaside.
Okbutwholldecidehowmuchminimumcashshouldabankkeep
aside?Ans.RBIviaCRR.(Cashreserveratio).
ButbanksdonotlikehighCRR.WealreadysawthatintheCRR
controversyarticle:clickme

WHYSLR:Statutoryliquidityratio?
Continuingthesameexample.SBIgot1croreonMonday.
Butsuppose,RBIgavehimorder,youmustkeepRs.10lakhsaside.
(CRR)
Thus,SBIisleftwithonly1crore10lakhs=90lakhrupees.
SoSBImanagerdecidestogetmaximumprofitoutofremainingmoney.
Supposeongoingrateforbusinessloansis12%.
ButthereisonebusinessmanMr.Parajay.
Nobankisofferinghimloan,becausehispasttrackrecordisnotgood:
hisearlierbusinessadventureswereepicfail.
ThisMr.ParajaycomestoSBI
Idesperatelyneedloanformybusiness.butnootherbankis
givingmeloan.Tellyouwhat,givemeallofthose90lakh
Mr.Parajay, rupeesasloans,Imreadytopay36%interestrateonit!And
the
trustme,Imgoingtomakelotofmoneyinmynewbusiness
businessman project.AndImreadytomortgageallofmyfactories,cars,
farmhouses.SoifIcantrepayloan,youcanauctionthem
andrecoveryourmoney.
SBImanager Good!Illgiveyouallofmy90lakhsasloan!
Aftersixmonths,Mr.Parajaysnewbusinessproject=also#EPICFAIL.
HecannotpaybacktheEMIs.
AlthoughSBIcanattachhisassetsandauctionthemtorecoverthe
money.Butitlltakelotoftime.
Inthemeantime,commonmenalsoreadthisstoryinlocalnewspapers
andtheypanicthatSBIwillcollapseandbankmanagerwillshutdown
theofficeandrunaway.
Soallthecommonmenlineupinfrontofbankanddemandbacktheir
money.RecallthatSBIstillhas10lakhleftinCRR.Butpeoplewanttotal
1croreback!
Againmoneyofaccountholders(commonmen)isstuck=problem,
protest,rioting,suicides.
So,Condition#2:Bankmustnotgiveawayallitsloanstoriskyloan
takers.Banksmustinvestpartofitsmoneyinsafeandliquid
investment.Soduringemergency,bankcansellthoseliquid
investmentsandtakeoutthemoney.
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Forexample,Governmentsecurities,gold,corporatebondsofreputed
companieslikeInfosys,reliance,TCS.Thesearesafeinvestments.
Thesearealsoliquid,becauseyoucansellthemquicklywheneveryou
want.(recallthatSBIcouldalsoauctionMr.Parajaysproperties,butitll
takelotoftimeinpaperwork,legalissuesetc.)
Okso,bankshouldinvestpartofcommonmensmoneyinsafe
investmentslikeGovernmentsecurities,goldandcorporatebondsof
highlyreputedcompanies.
BUTwhowilldecidehowmuchmoneyshouldbeinvestedinthis
sector?Ans.RBIviaSLR(Statutoryliquidityratio).Inearlierarticle,
wevealreadyseenSLRindetail.clickme
LetsassumeRBIorderedSBItokeepRs.25lakhsunderSLR.
Thus,outoforiginalRs.1crorethatSBIhad,10lakhs(CRR)+25lakhs
(SLR)aregone.

BankRuns:SLR+CRR
SupposearivalbankofSBI,hiressomepeopletospreadrumors
againstSBI.
Therumorissomethinglikethis=SBIinvestedlotofmoneyin
sharemarketbutsharemarketiscrashedsonowSBIdoesnthaveany
moneyleft.Theyregoingtoshutdowntheofficeandrunaway.
^thisistotallyridiculousrumorbecauseaccordingtoRBIrules,banks
cannotinvestdepositorsmoneyinthesharemarketinthefirstplace!
Anyways,outofthe100SBIaccountholders(commonmen),30
commonmenbelieveinthisrumorandruntotheSBIoffice.
TheydemandSBItoreturntheirentiresavingsdeposit.Suchpanic
movementofbankcustomersisknownasbankrun.
Thankfully,SBIhastotal10lakh(CRR),sotheycandirectlygiveitback.
SBIalsohassetasideRs.25lakhsunder(SLR),soSBIcansellaway
thoseGovernmentsecurities,goldworth25lakhsandgivethatmoney
backtoaccountholders.
Thus,SLR+CRRprotectsabankagainstBankruns.
Howeverincaseofatotallyawesomebankrun,nothingcanprotecta
bank.(i.e.whenalloftheaccountholderssimultaneouslydemandallof
theirmoneyonthesameday!)anywaysbacktothetopic:

WHYPrioritySectorlending?
Sofar,YouknowwhatisCRRandSLR.
NowSBImanagerstartmakingcalculation,howmuchmoneyisleftwithhim?
Moneyreceivedfromcommonmen 1crore=100lakh
MoneysetasideinCRR
MINUS10lakh
MoneyinvestedinSLR
MINUS25lakh
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Moneyleft

1001025=Rs.65lakh.

Outofthat65lakhs,letsassumeSBImanagerhastokeepaside15
lakhforAdministrativecosts,salariesofemployees,electricitybill,
internetbill,Xeroxmachineetc.Sohehasonly50lakhleftforproviding
loantoneedypeople.
NowloantakerslineupinfrontofSBIoffice
Giveusloansof1lakhseachforbuyingseedsandfertilizers.
However,giventhevagariesofmonsoonandlowprofit
50farmers
margininagriculture,wecannotpaymorethan5%interest
rate.
Giveusloansof2lakhseachtosetupsmallretailshops/car
25Small
mechanic/hairsaloonetc.Weoffer11%interestrate.we
businessman cannotofferapennymorebecauseourprofitmarginisnot
good.
SirpleasegiveusloanofRs.25lakhseach,forpayingself
2Students
financedmedicalcollege.Wecanpayatmost9%interest
rate.
Givemethose50lakhs.Inafewmonths,Diwaliiscoming
1Big
andIwanttosetupanewfirecrackerfactory.Iofferyou15%
businessman
interestrate.
ifSBIisrunfrompurelyprofitpointofview,thenfarmers,small
businessmen,studentsandweakersectionsofthesocietywillneverget
anyloan.
BecauseSBImanagerwouldwanttogiveloantoapersonthatoffers
himhighestinterestrate.
Thenwhoisgoingtoprotectthoseweakpeople?Whoisgoingtohelp
themgetloansatreasonablerates?Ans.RBI.
SupposeRBItellstheSBImanager,40%ofthemoneyyoulend,must
gotoprioritiessectorsviz.agriculture,smallscalebusiness,housingand
education.(=40%of50lakh=20lakh).
^Thisisthebasicfundaofprioritysectorlending.Moredetailsaregiven
onpage15.12ofRameshSingh.

WhatisNDTL?
Sofar,WeknowthatBankshavetocomplywiththeCRR,SLRand
prioritysectorlendingrulesofRBI.
CRR,SLRiscountedonamountofmoneyabankreceives.Butbank
receiveslotofmoney,
1. fromdepositors,
2. fromloantakerswhorerepayingEMI,
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3.
4.
5.
6.

(fraudulent)hiddenchargesimposedoncreditcards
Commissionchargedongivingdemanddraft
Commissionchargedononlinemoneytransfer
Commissionchargedonforeigncurrencyconversionetc.etc.etc.
SohowdoesbankexactlycountCRR,SLRrequirements?=Net
DemandandTimeLiabilities(NDTL)

Mainexample(listnotexhaustive)

Time
liabilities

Demand
liabilities

1.
2.
3.
4.

MoneydepositedinFixeddeposits(FD)
Cashcertificates
golddeposits.
Staffsecuritydeposit.E.g.insomebankswhenyoujoinas
Probationaryofficer,youvetosignbondworthRS.12lakh
rupees.

1.
2.
3.
4.

Moneydepositedinsavingsaccount
Moneydepositedincurrentaccount
Demanddrafts
unclaimeddeposits

ImnotgoingintominutenittygrittyinvolvedincomputingNDTL
becausethatsirrelevantfromexampointofview.Solongstorycut
short,CRRandSLRarecalculatedonthisNDTLnumberwithsome
caveats.
AndbankshavetosendreportstoRBIonfortnightbasisthatourNDTL
isxyzandwearemaintainingxyzSLRandCRRonitasperyour
direction.
Nowherecomestheproblem:Inourexample,SBIfollowedSLR,CRR
and50lakhrupeesleftforloaning.
Howeverinthegivenperiod,prioritysectorloantakers(farmers,
studentsetc.)andregularloantaker(businessmen,car/bikeloans).all
ofthemtogethertaketotalloansworthonlyRs.30lakhs.
soSBIisleftwith5030=surplusof20lakhrupees.
These20lakhsarejustgatheringdustintheoffice.Nobodyiscomingto
takenewloans!WhatshouldSBIdo?becauseSBIhastogive7%
interestevenonthese20lakhrupees,soSBIcannotaffordtoletthis
moneygatherdust!
NowcomestheLiquidityadjustmentfacilities,RepoRateandreverse
reporate.
Letsstartwithreversereporate.
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Reversereporate?
ThebookdefinitionofReversereporate=itisinterestratepaidbyRBI
toitsclientsforshorttermloans.OkbutwhoaretheclientsofRBI?
1.
2.
3.
4.

CentralGovernment
StateGovernment
Banks(commercial,regionalruralbanks,cooperativebanks)
Nonbankingfinancialinstitutionsetc.etc.etc.
anyways,Reversereporateincrudewords=whenSBIparksitssurplus
moneyinRBIforshortterm,SBImakes^thismuchprofit.
Butactuallyreversereporateworksinabitcomplicatedmanner=via
sellingandrepurchaseofGovernmentsecurities.
YoureawareofGovernmentsecurities:whenGovernmentwantsto
borrowmoneyfrommarket,Governmentsecurity/Governmentbondis
issued.
Basicallyitsapieceofpaper.Ithasagreementsomethinglike:whoever
givesmeRs.100willget8%interestratefor10yearsandthenprinciple
willberepaid.
ForthepurposeofunderstandingReverserepo,letsconstructa
simplifiedtechnicallyincorrectmodel:

1. RBIhasGovernmentsecuritiesworthRs.100lakhs.
2. SBIhassurplusRs.100lakhsandnobodyistakingthemasloans.But
SBIissuremorepeoplewillcometotakeloansbeforeDiwali.SoSBI
justwantstoparkthissurplus100lakhssomewherefortheshortterm.
3. SBIentersintoReverseRepoagreementwithRBI.
4. TheagreementreadsI(SBI)willgivebuyGovernmentsecuritiesworth
Rs.100lakhsfromtheRBI,andRBIpromisestobuybackthose
securitiesfrommeafter6months@Rs.106lakhs.
Readitcarefully:
Time:after6months,
SBIsinvestment:Rs.100lakhs
After6months,SBIgets:Rs.106lakhs.
SoprofitofSBI(orinterestearnedbySBIorinterestpaidbyRBI)=(106
100)/100=6%.Thisisreversereporate.

Tiedtoreporate
In2011,underRBImadefollowingrule:
1. reversereporatewouldnotbeannouncedseparatelybutwillbelinked
toreporate.
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2. Thereversereporatewillbe100basispointsbelowreporate.(=minus
1%)
SoifRBIdeclaresReporate=8%thenreversereporateisautomatically8
1=7%.Butnowcomesthequestion:

Whatisreporate?
Commonsensesays,ithastobereverseofreversereporateright?Yes
thatisright.
Textbookdefinitionsays
ReporateistherateRBIchargesonitsclientsforshorttermloans.
Toputthiscrudely,whenSBIwantstoborrowmoneyfromRBIforshort
term,SBIwillhavetopay^thismuchinterestrate.
(again)Forthepurposeofunderstandingreporate,letsconstructa
simplifiedtechnicallyincorrectmodel:
1.
2.
3.
4.

RBIhascashofRs.100lakhs.
SBIhasGovernmentsecuritiesworthRs.100lakhs.
SBIentersintoRepoagreementwithRBI.
TheagreementreadsI(SBI)amsellingmyGovernmentsecurities
worthRs.100lakhtoRBIandI(SBI)promisetobuyback(repurchase)
thosesecuritiesfromRBIafter6months@Rs.107lakhs.

Readitcarefully:
1.
2.
3.
4.

Time:after6months.
RBIsinvestment:Rs.100lakhs
After6months,RBIgets:Rs.107lakhsfromSBI.
SoprofitofRBI(orinterestearnedbyRBIorinterestpaidbySBI)=(107
100)/100=7%.ThisisReporate.

Question:
Whyallthisgadhaamajoori(donkeylabour),involvingGovernment
security?WhycantRBIandSBIgivemoneytoeachotherwithout
involvingGovernmentsecuritiesjustlikethenormalpeopleborrowand
lendtoeachother?
Answer=BecauseGovernmentsecurityactsascollateral.Soiffirst
partydoesnthonortheagreement(ofrepurchase),thensecondparty
cansellawaytheGovernmentsecuritytoathirdpartyandrecoverits
money.
JustlikepawningyourjewelryinMuthootfinanceorMannapuramgold
loans.

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Repo
rate

ReporatevsBankrate?
RBIlendsmoneytobanksforshorttermloans@this
interestrate.

Bank
rate

RBIlendsmoneytoitsclientsforlongtermloans@this
interestrate.

WhatisLAF?
liquidityadjustmentfacilities(LAF).
RecallthatoneofthemaintaskofRBIistocontrolmoneysupplyinthe
economy.
RBIcontrolsmoneysupplyviamonetarypolicy.ForthisRBIuses
varioustoolse.g.SLRandCRR.
Liquidityadjustmentfacilities(LAF)isalsoatoolusedbyRBItocontrol
shorttermmoneysupply.
LAFtimeline
1998 NarsminamCommitteeonbankingrectorreforms,recommendsLAF
1999 RBIintroducesinterimLAF
2000 RBIintroducesfullfledgedLAF.
IntheoldBollywoodmovies,internationalsmugglersoftencometomain
villainshideoutwithsuitcasesloadedwithcash.Thenmainvillainwill
auctionsomeancientIndianstatuestothem.Somethingsimilarhappens
underLAF.
LAFhelpsbankstoquicklyborrowmoneyincaseofanyemergencyor
foradjustingintheirSLR/CRRrequirements.
UnderLAF,RBIauctionsGovernmentsecurities,startingattherepoand
reversereporate.MinimumbiddingamountisRs.5crore.
SoLAFisatoolusedbyRBItocontrolshorttermliquidity/money
supplyinthemarket.
InLAF,moneytransactionisdoneviaRTGS.(RTGSisanonlinemoney
transfermethod).Sointhisauction,playersdontneedtobringsuitcases
loadedwithcash.

WhatisRGTS?
RTGS,NEFT=Theseareonlinefacilitiesfortransferringmoneywithin
thecountry.
RealTimeGrossSettlement(RTGS)
Fast(immediatemoneytransfer)
Canbeusedonlyifmoneytransfer

NationalElectronicFundTransfer
(NEFT)
Slow(doneonhourlybasis)
Canbeusedforanyamount.

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amountisminimum2lakhrupeesor
more.

Thereisnominimumormaximum
limit.

WhatisMarginalStandingfacility(MSF)?
RBIstartedthisthingin2011.
UnderMSF,ScheduledCommercialBankscanborrowmoneyfromRBI
@1%higherthantheongoingReporateunderliquidityadjustment
facility(LAF.)
Although,thesystemoflendingremainssamejustlikeunderrepo.=SBI
sellsGovernmentsecuritytoRBI,andpromisestobuyitbackafter
sometime,atahigherrate.Differenceinsellingandpurchase=interest
rateearnedbyRBI.
wecanmemorizeitlike
1. Reporate=reverserepo+1%
2. MSFrate=reporate+1%
DifferencebetweenLAFandMSF

LAF
Liquidityadjustmentfacility
Minimumbiddingamountis5cr.
AllclientsofRBIareeligibletobid.
BankcannotsellGovernmentsecurity
toRBIthatispartofbanksSLRquota.
Bankcanborrowanyamountofmoney
aslongasithasthesecuritiestosell.
Supposereporateisr%

MSF
Marginalstandingfacility
1cr.
Onlyscheduledcommercial
bankscanbid.
bankcanselltheGovernment
securityfromitsSLRquotato
RBI.
Bankcanmaximumborrowupto
2%ofitsNDTL.
MSFlendingrateisalways
(r+1)%

Foodforthought
Letstakesomeapprox.numbersbasedonpastfewmonths.
Reporatehasbeenaround8%.Thatmeansreverserepoisaround7%
andMSFis9%.
SBIoffers0%interestoncurrentaccount,4%onsavignsaccount,
around7%interestrateontermdeposits.
SBIchargesaround10%onhomeloans,12%oncarloansand18%on
bikeloans.
NowconsiderwhatIfSBIparksitsmoneyinRBI(viareversereporate).
WellRBIsreverserepoisalsoaround7%!maybeafew0.250.75%
higherthanSBIstermdepositinterestrate.Pointbeing,SBIisbetteroff
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findingmoreloantakersthanparkingmoneyinReversereporate
becauseitcanearnmoreprofitthatway.

Openmarketoperations?
Openmarketoperation=whenRBIbuys/sellssecuritiesinopenmarket.
HowisitdifferentfromLAForMSF?
WellinLAForMSF,onepartybuysGovernmentsecurityfromsecond
party.Butsecondpartyhasagreedtobuyback(repurchase)thesame
securityfromfirstpartyaftersometime.SoGovernmentsecurityisnot
permanentlysold,itisonlyusedasacollateral=thatslikepawning
yourjewelryinMuthootfinancecompany.
ButincaseofOMO,firstpartypermanentlysellstheGovernment
securitytosecondparty.Secondpartyisfreetodowhateveritwants
withthatsecurity.
WhenRBIpurchasesGovernmentsecurities=liquidityincreased
(becauseRBIispayingthatpartysomemoneytobuythatsecurity,
right?soRBIispouringadditionalmoneyintothesystem.)
Onreverse,whenRBIsellsGovernmentsecurities=liquidityis
decreased.(becausethoseplayersaregivingtheircashtoRBIto
purchasethesecurities=moneyissuckedoutofthesystembyRBI).

Summary
FromSBImanagerspointofview
Imustkeepthismuchmoneyaside.Icannotgiveitasloanto
CRR
anyone.Iwillnotearnanyinterestrateonit.
Ivetoinvestthismuchmoneyingold,Governmentsecurities
SLR
(Gsec)andRBIapprovedcorporatebonds.
IfIborrowmoneyfromRBIforshortterm,Illhavetopaythem
Reporate
thismuchinterestrate.
Reverse
IfIparkmymoneyinRBI,theyllpaymethismuchinterestrate.
reporate
IfIborrowmoneyfromRBIforlongterm,Illhavetopaythis
Bankrate
muchinterestrate.

MockQuestions
Q1.IfRBIpurchasesGovernmentsecuritiesviaopenmarketoperations,then
liquidity_______.
a.
b.
c.
d.

increases
decreases
Staysthesame.
Noneofabove.

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Q2.Correctstatement?
a.
b.
c.
d.

Reporateisalways100basispointshigherthanMSFlendingrate.
Reversereporateisalways100lowerthanMSFlendingrate.
Reporateisalways100basispointhigherthanreversereporate.
Noneofabove.

Q3.Incorrectstatement?
1. RTGSandNEFTaretwoonlinemoneytransfermethodswithinIndia.
2. NEFTisfasterthanRTGS.
3. NEFTcanbeusedonlyfortransectionsaboveRs.2lakh.
Choice
a.
b.
c.
d.

Only1
Only1and2
Only2and3
Allofthem

Q4.Inwhichofthefollowing,Bankwillnotbemakinganymoney?
1. MeetingCRRrequirement.
2. MeetingSLRrequirement.
3. ParkingmoneyinRBIunderReverserepo.
Choice
a.
b.
c.
d.

Only1and3
Only2and3
Only1
Allofthem

Q5.IfRBIwantstoinjectmoreliquidityinthesystem,itshould
a.
b.
c.
d.

IncreasetheCRRrate
IncreasetheSLRrate
DecreasetheReversereporate.
Decreasethereporate.

Q6.IfRBIwantstoreduceliquidityfromthesystem,itshould
a.
b.
c.
d.

decreasethereversereporate
decreasethereporate
increasetheCRRrate
decreasetheSLRrate

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Q7.Timeliabilitiesofabankincludes
a.
b.
c.
d.

demanddrafts
cheques
fixeddeposits
creditcards

Q8.Demandliabilitiesofabankincludes
a.
b.
c.
d.

fixeddeposits
cashcertificates
currentaccount
Staffsecuritydeposits.

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