Difference Between Repo Rate Vs Reverse Repo Rate
The bank will charge interest when you borrow from them. Consequently, if you deposit money, the bank pays interest on the deposits. But have you ever wondered, how banks fund themselves? The answer is simple. Banks either utilise deposits or borrow from the central bank – the Reserve Bank of India (RBI).
For these transactions, the RBI puts into effect a tool called the Liquidity Adjustment Facility (LAF). Under this arrangement, banks can borrow from or lend money to the RBI through agreements called the repo and reverse repo.
The interest rate levied on these transactions is called Repo Rate and Reverse Repo Rate. This article explains the main differences between these two terms.
What is Repo Rate?
The Reserve Bank of India (RBI) charges interest on loans borrowed by commercial banks. This rate is called the repurchase agreement rate or Repo rate.
Typically, commercial banks secure loans from the RBI by pledging various government securities as collateral. These include treasury bills, bonds etc. The repo rate is nothing but the lending rate charged by the RBI.
The repo or repurchase agreement allows the RBI and commercial banks to repurchase securities at a pre-determined rate.
These agreements are set in motion when banks must maintain liquidity in the face of uncertain market situations.
The RBI uses the repo rate to control inflation. So, let us now understand how the repo rate works.
How does Repo Rate Work?
The RBI uses repo rates to regulate money moving through the market. It increases the rate when inflation strikes. Banks borrowing money from the RBI during inflation pay a high interest due to a raised repo rate. This severely affects the bank’s capacity to borrow from the RBI. The end customer feels the impact of a repo rate increase in two ways:
To increase the cash at their disposal, banks increase the rate of interest on a deposit account. Thus, investors can enjoy higher interest on fixed-income instruments.
To combat the repo rate hike, banks further increase the interest rate on loans, making them costlier and thus less sought after. With fewer loans to disburse, banks manage to retain greater liquidity.
The decrease in liquidity lowers demand in the economy, reducing inflation levels.
The RBI has stated that the repo period can be ‘overnight, open or flexible.’ Overnight repo does not extend beyond a night.
However, the situation gets complicated if the term is predetermined and agreed upon in advance. This type of repo is known as the term repo. In this case, either side may request to stop the repo at any moment with one or two days’ notice.
Term repo typically lasts for one week. However, there is no maximum limit on repo tenure.
Current Repo Rate
The current repo rate is 5.90%. The RBI increased the repo by 50 basis points in September 2022.
What is Reverse Repo Rate?
When commercial banks have surplus funds, they deposit money with the RBI and earn interest. This interest paid by the RBI is called the reverse repo rate. In other words, the reverse repo rate is the rate at which the central bank borrows from commercial banks.
How does Reverse Repo Rate Function?
RBI puts the reverse repo rate into effect often during inflation. It increases the rate, prompting banks to park more money with the RBI and earn higher returns. As a result, the banks have a lesser sum to extend in the form of loans. Thus, the liquidity in the economy decreases.
Current Reverse Repo Rate
As of November 2022, the reverse repo rate is unchanged at 3.35%.
Repo Rate Vs Reverse Repo Rate
|Parameters||Repo Rate||Reverse Repo Rate|
|Definition||The rate at which commercial banks borrow from the RBI.||The rate at which the RBI borrows from commercial banks.|
|Liquidity||A hike in the repo rate drains excess liquidity from the economy.||When the reverse repo rate goes up, the liquidity in the market increases.|
|Objective||Repo rate helps control inflation.||A reverse repo rate helps manage the money supply.|
|Interest Rate||The repo rate tends to be higher than the reverse repo rate.||The interest rate is lower than the repo rate.|
|Mechanism of Operation||The RBI lends funds to commercial banks against securities pledged as collateral.||Commercial banks deposit surplus funds with the RBI and earn interest on their deposits.|
|Current Rate||The current repo rate is 5.90%.,||The current reverse repo rate is 3.35%.|
The repo and reverse repo rates are vital tools to manage the economy. However, we must remember that the repo rate will always be higher than the reverse repo rate. Further, the RBI’s financial income is determined by the difference between these two rates.
Want to know more or explore loans before inflation strikes? Visit Piramal Finance.
Also Read: How to Plan a Trip to Tomorrowland with a Personal Loan?
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