What is Repo Rate and Reverse Repo Rate?

8 Jan 2021  Read 356 Views

Are you a banking enthusiast? Do you aspire to build your career in the banking industry? Well, there are many who wish to do the same, but there are only a few who succeed in achieving these goals. A proper dedication, passion, and most importantly, knowledge and understanding of the banking world will certainly help you in becoming a successful banker. 

In-depth knowledge of several concepts and terminologies is required to make you a prudent banker. Well, among those several concepts, there is one called, repo rates. 

So, let’s understand what repo rates and learn what they signify.

What is the Repo Rate?

The rate at which commercial banks borrow money by selling their securities to the central bank of the country, i.e., the Reserve Bank of India (RBI) to maintain liquidity, in case of shortage of funds or due to some statutory measures is known as the repo rate. It is among the main instruments of RBI that are used to tackle the problem of inflation.

Working of Repo Rate

When you borrow money from a bank, the transaction levies interest on the principal amount. This is known as the cost of credit. Similarly, banks borrow money from RBI during a cash crunch on which they are compelled to pay interest to the central bank. This interest rate is known as the repo rate.

Technically, repo means ‘Repurchasing Option’ or ‘Repurchase Agreement’. It is an agreement in which banks deliver capable securities such as Treasury Bills to the RBI while availing the overnight loans. An agreement to repurchase them at a predetermined price would also be there in place. Therefore, in this case, the bank gets the cash, whereas the central bank gets the security.

How repo rates affect the economy

Repo rate is considered to be an influential arm of the Indian monetary policy, which can govern the country’s money supply, inflation levels, and liquidity. Also, the levels of repo have a direct effect on the cost of borrowing for the banks. Higher the repo rates, higher will be the cost of borrowing for banks and vice-versa. In situations like the following, the RBI implements the repo rate to regulate the money supply in the economy:

a. Rise in the inflation

At the time of high levels of inflation, RBI makes strong attempts to decrease the flow of the money in the economy. One way by which it could be done is by increasing the repo rate. This makes the borrowing a costly affair for businesses and industries, which in turn slows the investment and money supply in the market. This negatively influences the growth of the economy, which further helps in controlling and monitoring the inflation.

b. Increasing Liquidity in Market

While on the other hand, when the RBI requires to pump funds into the system, it lowers the repo rate. Therefore, businesses and industries feel it cheaper to borrow money for different investment purposes. The overall supply of money in the economy is also increased by this. This eventually boosts the growth rate of the economy. 

                            

What is reverse repo rate?

A mechanism to absorb the liquidity in the market, thus restricting the borrowing power of investors is known as the reverse repo rate. 

The situation of Reverse Repo Rate is when the RBI borrows money from banks whenever there is excess or extra liquidity in the market. The banks take advantage of this by receiving interest for their holdings with the central bank.

At the time of high levels of inflation in the economy, the RBI increases this reverse repo rate. It motivates the banks to park more funds with the RBI to receive higher returns on to the excess funds. Thus, banks are left with lesser funds to give more loans and borrowings to customers.

What is the current repo rate and its impact?

The Reserve Bank of India keeps on changing the repo rate and reverse repo rate according to the changing macroeconomic factors of the Indian economy. Whenever RBI amends the rates, it affects all sectors of the economy; albeit in different ways. 

Some segments gain as a result of the rate hike while on the other hand, others may suffer losses as well. RBI has recently cut down the repo rate by 25 basis points to 5.15% from 5.75%. In the same line, the reverse repo rate was also reduced by the RBI to 4.9% from 5.5%.

Changes in the repo rates can directly impact big-ticket loans such as home loans. The reduction in repo rates is aimed at bringing in growth and enhancing economic development in the country. Consumers will borrow more from banks, thus stabilizing as well as controlling the inflation.

A decrease in the repo rate can lead to the banks bringing down their lending rate. This can prove to be useful for retail loan borrowers. However, to knock down the loan EMIs, the lender has to reduce its base lending rate. As per the guidelines of RBI, banks/financial institutions are compelled to transfer the advantage of interest rate cuts to their customers as soon as possible.

Difference between Repo and Reverse Repo Rate

Basis

Repo Rate

Reverse Repo Rate

Lender and Borrower

Borrower – Commercial Banks, Lender – RBI

Borrower – RBI, Lender – Commercial Banks

Rate of Interest

Higher than reverse repo rate

Lower than repo rate

Borrower’s Objective

To manage short term deficiency of funds

To reduce overall supply of money in the economy

Mechanism of Operation

Commercial banks get funds from RBI using government bonds as collateral.

Commercial banks deposit their excess funds with RBI and receive interest from the deposit.

Interest Charge Applicable to

Repurchase Agreement

Reverse Repurchase Agreement

Impact of Higher Rate

Cost of funds increases for commercial banks hence loans become more expensive.

Money supply in the economy decreases as commercial banks park more surplus funds with RBI.

Impact of Lower Rate

Cost of funds is lower for commercial banks leading to reduced interest rates on loans.

Money supply in the economy increases as banks lend more and reduce their deposits with RBI.

                                  

Conclusion

Repo rates are just the rate at which commercial banks borrow money by selling their securities to the Reserve Bank of India (RBI) to maintain liquidity. On the other hand, reverse repo rates are a mechanism to absorb the liquidity in the market. 

So as said above, one could climb the ladders of success in the field of banking if there is proper information of such terminologies, which are used on a daily basis in the economic world.

About the Author: Aditi Sagar | 34 Post(s)

Aditi is born and brought up in New Delhi. Right now she is in the 2nd year of her college. She is pursuing graduation from Deen Dayal Upadhaya College, Delhi University with Bachelor's In Management Studies degree. 

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