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Bank rate is the rate charged by the central bank for lending funds to commercial banks.
Bank rates influence lending rates of commercial banks. Higher bank rate will translate to higher lending rates by the banks. In order to curb liquidity, the central bank can resort to raising the bank rate and vice versa.
The Bank Rate also called as a Discount Rate is the rate at which the commercial bank rediscounts their bills of exchange from the central bank.
As per the RBI Act, 1935 the bank rate is the standard rate at which the bank buy or rediscounts the bills of exchange and other commercial papers that can be purchased under this act. Only the approved bills and first-class bills of exchange can be produced for rediscounting. Why the commercial banks get their bills of exchange rediscounted? Whenever the commercial banks are faced with the shortage of cash reserves, they approach the central bank to borrow money by discounting their bills of exchange.
The central bank rediscounts the commercial papers or bills of exchange because it is the function of the central bank- it is the lender of the last resort. The central bank charges a rate for rediscounting the bills of exchange; this rate is traditionally called as a Bank Rate and more appropriate name used today is Discount Rate.
The central bank can raise or reduce the bank rate at its discretion, based on whether the commercial bank’s flow of credit is to be increased or decreased. Such as, if the central bank wants to increase the credit creation capacity of the banks, will reduce the bank rate and vice-versa. This action of the central bank is termed as bank rate policy or discount rate policy.
The working of the bank rate policy is quite simple. When the central bank changes the discount rate, the commercial banks also change their discount rates. Such as, if the central bank increases the discount rate the commercial bank also increases the discount rate and vice-versa. Often, the central bank rate is one percentage point higher than the commercial bank discount rate.
Let us see how the change in the bank rate affects the availability of credit. Suppose the central bank seeks to control the flow of credit and to achieve this objective it raises the discount rate. The flow of credit will be reduced in three ways:
1) The net worth of the government securities reduces with an increase in the discount rate against which the commercial banks borrow money from the central bank. This reduces the bank’s capacity to borrow funds and as a result, the commercial banks find it difficult to maintain a high cash reserve. Ultimately, the credit creation capacity of the commercial banks is reduced and as a consequence, the flow of credit to the market is also reduced.
2) As the central bank raises the discount rate, the commercial banks also increase the discount rate due to which the business sectors get discouraged to get their bills of exchange discounted. Besides, a rise in the bank rate leads to an upward shift in the interest structure. This rise in the interest rate discourages the borrowings or the demand for funds reduces. Such policy is therefore called as “dear money policy”.
3)The lending rate is quickly adjusted to deposit rates and hence a rise in the bank rate causes an increase in the deposit rate. As a result, the borrowers become depositors and the savings flow into the banks in the form of deposits. This is known as a “deposit mobilization effect”.
Thus, the bank rate is the rate that the central bank charges against the lending to the commercial banks.