Difference Between Repo Rate and Reverse Repo Rate
The repo rate is the interest rate at which the central bank lends money to commercial banks, while the reverse repo rate is the rate at which commercial banks can park their surplus funds with the central bank, creating a borrowing and lending relationship between them. The article discusses repo rates and reverse repo rates, how they work, their impact on financial markets, and the difference between repo rate and reverse repo rate.
The repo rate is the rate at which the central bank lends money to commercial banks in exchange for securities, while the reverse repo rate is the rate at which the central bank borrows money from commercial banks by selling securities. Let us understand the difference between repo rate and reverse repo rate in detail in this blog.
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| Repo Rate | Reverse Repo Rate | |
|---|---|---|
| Meaning | The rate at which the RBI or a central bank lends money to commercial banks. | The rate at which money commercial banks lend money to the RBI or a central bank. |
| How to define it? | Lender – RBI Borrower – Commercial Banks |
Lender – Commercial Banks Borrower – RBI |
| Objective | To manage short-term shortage of funds. | To reduce liquidity in the economy. |
| Rate of interest | Higher | Lower |
| Charged on | Repurchase agreement. | Reverse repurchase agreement. |
| Impact on economy | The higher the repo rate, the cost of the funds increases for commercial banks; hence, the loans become more expensive. | When the rate is high, the money supply in the economy gets lower as commercial banks park more excess funds with the RBI. |
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What is Repo Rate?
The Repo Rate full form or the term ‘REPO’ stands for ‘Repurchasing Option’ Rate. The repo rate is the interest rate at which the central bank or RBI gives loans to other commercial banks. Banks can secure loans from the RBI by selling qualifying securities.
How Does Repo Rate Work?
RBI uses the repo rate as a monetary tool to regulate the liquidity of money in the economy. Banks that need funds to meet their daily operations and financial obligations or maintain their reserve requirements can borrow from the RBI at the pre-defined repo rate. By adjusting the repo rate, the RBI can influence banks’ borrowing costs, affecting the interest rates that banks charge their customers.
Current Repo Rate in India
On February 8, 2023, the Monetary Policy Committee (MPC) stated that the repo rate was up by 25 basis points. As of March 31, 2024, the current repo rate is 6.50%. The bank and the marginal standing facility rates have been changed to 5.15% and 6.75%, respectively.
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How does an increase in repo rate affect banks and loans?
If the RBI increases the repo rate, the interest rates of loans will also increase, given that borrowing funds from the RBI will be more expensive for commercial banks. High interest rates lead to a decrease in loans and trigger an increase in consumer savings, causing a slowdown in economic growth. An increase in the repo rate typically leads to more capital flowing into the central bank. However, if rising rates are not accompanied by rapid economic growth, it can lead to economic stagnation.
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What is the Reverse Repo Rate?
Reverse Repo Rate is the exact opposite of the Repo Rate. In this case, central banks borrow money from commercial banks for a short term.
Central banks use this monetary policy as a tool to maintain liquidity in the market and keep inflation in check. The Reverse Repo Rate allows the RBI to get money from the banks when needed and offers attractive interest rates.
Commercial banks voluntarily park their excess funds with the central banks to earn higher interest on surplus capital. In India, the Monetary Policy Committee (MPC), headed by the RBI Governor, decides both interest rates in a bi-monthly committee meeting.
Reduced repo rates encourage banks to sell securities to the government as cash compensation. This increases the money supply available to the economy as a whole. By increasing the rates, central banks can reduce the money supply by discouraging banks from reselling these securities.
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Impact of Repo Rate and Reverse Repo Rate Cuts by RBI on Financial Markets
The following is the impact of repo and reverse repo rate cuts by RBI:
- Repo Rate Cut Impact: The change in banking policies affects the banking sector. If the RBI cuts the repo rate, banks can borrow the loan from the RBI at a lower rate and allow higher liquidity into the banking system. Furthermore, banks can reduce their lending rates, and consumers can get loans at lower interest rates for the long term. With a lower interest rate on bank loans, consumers can borrow more and spend more, boosting consumption and eventually leading to economic growth. However, it is totally up to the bank if it is willing to trickle down the benefits of the lower repo rates to its customers via cheaper loan offers.
- Reverse Repo Rate Cut Impact: If the reverse repo rate is cut, banks earn less on their excess amount lent or deposited with the RBI whenever they decide to reduce the reverse repo rate. The banks can invest in more lucrative options, such as money markets, which increases the overall liquidity of the economy.
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FAQs
How does the repo rate affect fixed deposits (FDs)?
The repo rate set by the central bank has a direct impact on fixed deposits (FDs). When the repo rate increases, banks often raise their lending and deposit rates, including the interest rates offered on FDs. This means that FD investors can potentially benefit from higher returns on their deposits. An increased repo rate makes FDs more attractive to individuals seeking safe and low-risk investment options, encouraging them to allocate more funds to FDs for better yields. However, it's important to note that while rising FD interest rates can benefit investors, they should also consider the potential impact on their overall investment portfolio and liquidity needs.
What is the effect of an increase in repo rate in the case of banks and loans?
If the repo rate is increased, interest rates of loans will also increase because borrowing funds from the RBI will be more expensive for commercial banks.
Who uses repo agreements?
Dealers who buy repo agreements are the ones who generally raise cash for short-term purposes. Hedge funds, insurance companies, and money market mutual funds may use repo agreements to receive a short-term cash infusion. Central banks also use repos to temporarily increase the supply of reserve balances in the banking system.
What happens if the reverse repo rate increases?
If the RBI increases the reverse repo rate, banks can earn higher interest rates on the funds they have invested with the central bank. However, if banks choose to invest more with the RBI than lend their money into the market, the economy will have less liquidity.
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