Always a bit of an enigma because of its chequered existence, the bank rate was originally defined in section 49 of the RBI Act, 1934, as `the standard rate at which the RBI is prepared to buy or re-discount bills of exchange or other commercial papers eligible for purchase under this Act.' However, because of the stymied development of the bill market, the bank rate metamorphosed instead into a reference rate for ways and means advances to state governments and other RBI advances. That it was not a signal at all then, and infact a rather dormant reference rate at that, was obvious from the fact that during the period from 1975 to 1996, the bank rate was changed only thrice, even in the teeth of numerous economic vicissitudes.

It was only during the past few years when reserve requirements started losing their primal importance as active monetary policy instruments and interest rates got increasingly de-regulated that the need for both a signal and a reference rate arose, and the bank rate -- ready at hand then and under-utilised -- was given its present status.

But, after the initial euphoria about having a signal rate at last wore off, the bank rate has continued to baffle large cross sections of financial sector participants even after it acquired its twin but inter-linked roles in the October 1997 credit policy: one, as a signal for the movement of interest rates for all tenures, and two, as a reference for some interest rates on RBI advances -- typically short-term -- such as the export credit re-finance, generalre-finance and special liquidity support facilities (the last two have since been scrapped), and more recently,the collateralised lending facility (in the recent credit policy) etc.

And, the dichotomy has left financial sector players questioning whether its role as a general interest rate signal can be effective, given its role as a short-term reference rate (this shows the rates at which the RBI is willing to lend, but only for a particular period). The rationale underlying these doubts is that its role as a short-term RBI reference rate means that a change in the bank rate could transmit the central bank's signals only with regard to short-term rates, and therefore, it could not impact interest rates across the board.

Past experience, however, does suggest something different. Based on that, it could, for one, be pointed out here that changes in the bank rate have moved interest rates across the board earlier -- as happened after the recent budget -- and therefore it's too simplistic to read too muchmeaning into the fact that since all these rates directly linked to it are short-term rates, it can only function as a short term signal. But one has to remember that the post-budget phenomenon was accompanied by a concomitant cut not just in the CRR but the repo rate, too. Many banks and financial institutions do point out that unless it is positioned more specifically the signal would increasingly require the help of other indicators such as a CRR cut (even if the liquidity situation did not merit it) to send across its messages. Which would denote that the bank rate was acquiring a blunted edge, more so as the deference towards a central bank signal wore off.

And that brings us to the other contention. It could also be argued here that adjusting a signal rate such as this may not make much sense unless it was accompanied by other indicators anyway, such as a CRR cut or hike, and therefore, the nature of the other indicators themselves would indicate whether a particular bank rate signal was for shortterm or all tenures.

But can we rule out the possibility of the bank rate's efficacy as a standalone signal being put to the test at some point of time (given the peculiar Indian scenario where lower credit offtake is today not the result of tight money conditions, and therefore,liquidity infusion may not always be the right remedy)? It does seem possible to visualise a scenario where the central bank may want to give a signal for the lowering of interest rates through the bank rate without creating unnecessary liquidity.

The bank rate is today at eight per cent. Given its identity, where should it logically be? Look at the nature of some interest rates on advances linked to it. The export credit re-finance facility, for example, is often regarded as an alternative to call (by convention, not by official mandate). When call is low, drawals under this head are also low, and vice versa, making it equivalent to an overnight rate, or, at best, 14 day rates. In this sense, whenever the bank rate is changed,it affects ultra short-term rates.

Again, the recently-introduced bank rate-linked collateralised lending facility which comes in two blocks of 14 days each (with a cooling period) is equivalent to around 30-day money. So, with large sections of bank rate-linked interest rates more or less within the overnight to 30-day range, the bank rate should logically be a short-term signal if it is to be clear enough. Even if one were to go by international convention, the bank rate, at best, pertains to 90-day money. In fact, that it should be a short- term signal gains even greater credence from a different angle when one sees that the world over it's short-term rates that are impacted by monetary policy, and for which it gives signals.

So,where could the bank rate be pegged? With the point to point one year inflation rate averaging at at four per cent currently, the one year rate could be around seven per cent to give a real return of at least three per cent. To arrive at an annual rate of seven per cent (on amonthly compounded basis), the one-month rate works out to around 6.5 per cent, which is the level at which the bank rate could be logically pegged.

It is true that even if the bank rate is not positioned as a broad spectrum signal, its lowering could have a salutary ripple effect under certain market conditions. If interest rates were to be aligned in perfect markets and under favourable economic conditions, the 364-day T-bill rate would also come down from 10 per cent to seven per cent, while, with the yield curve typically flattening out after three years, 10-year government paper could be at 10 per cent instead of around 12.25 per cent now. Without affecting M3, or inflation, interest rates can be brought down by synchronising the bank rate in its twin roles.

The other option would be to let the repo rate take over totally as a short-term rate signal -- in which case the bank rate could be de-linked from the short-term RBI interest rates linked to it to avoid transmitting confusing signals. Even ifthis act of divestiture leaves it without an identity, it may yet be a better situation than leaving it with a confused identity.