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Repo Rate – How it Works?

Last Update Date : April 30, 2019
Estimated Read Time: 5 min

Repo Rate is a rate by which central bank of the country (for e.g. India it is Reserve Bank of India) which lends the money to a commercial bank in the event of any shortfall off funds. It also comes under monetary policy authority which helps in inflation.

Introduction of Repo Rates by RBI and Its Roles

Repo rate is one of the key components of the LAF (Liquidity Adjustment Facility). LAF in India is one of the major steps in the banking sector reforms which was introduced based on the recommendations of the Narasimhan Committee. Basically, the repo rate was introduced by the Reserve Bank of India to control the amount of liquidity in the economic system. When a commercial bank has a shortage of funds, they can borrow funds by providing securities to RBI. If there is an increase in the Repo Rate, the lending of money becomes expensive by RBI and vice versa. As a monetary tool to control inflation, there is an increase in repo rate by RBI, for making it more expensive to the commercial bank to forbid the availability of money, on the contrary RBI will do the reverse in a deflated market.

Current Repo Rate and Its Impact

Macroeconomic factor changes lead to the change in repo rate and reverse repo rate by RBI. Whenever RBI changes these rates, it affects almost all the sector of the economy, differently. Some sectors may lead by profits while others may face losses. Focusing on the inflationary forces, RBI recently increased by 25 points to 6.50% and the Reverse Repo Rate to 6.25%.

In some circumstances, big loans like mortgage loans might be impacted due to a change in reverse repo rates. If the RBI decreases the repo rate, it doesn’t mean mortgage loan EMIs would get lesser, or the interest rate would also decrease as well. EMIs rates are not affected by the change of RBI monetary Rates. The rate of interest is fixed with respect to fixed loans.

Advantages of Repo Rate

  1. Helps the central bank to control ‘cash in the system’.
  2. As RBI prints money. the RBI can never run out of money to lend, unlike the bank.
  3. The central bank and commercial bank engage in repo rate auction.
  4. More the cash in the hand of the bank, the higher will be the lending from the bank to the public that result top more consumption of goods and services, which leads to inflation.
  5. Increases the turnover of money in the market.

Difference Between Repo Rate and Reverse Repo Rate

FactorsRepo RateReverse Repo Rate
DefinitionRepo rate is the rate at which the Central bank of India grants a loan to the commercial banks for a short period against government securities. Repo rate is charged by RBI when commercial banks sell their securities.Reverse repo rate is the rate at which the commercial banks grant a loan to the Central Bank of India.

Reverse repo rate is the rate at which RBI borrows money from banks within the country.

Rate RatioThe repo rate is always higher than the reverse repo rate.The reverse repo rate is always lower than the repo rate.
ControlsInflationMoney Flow in Economy
ObjectiveRepo rate is to deal with deficiency of fundsReverse repo rate deals with liquidity in the economy
Charged onRepurchase AgreementReverse Repurchase Agreement

Table Difference of Monetary Policy

 

FULLFORM

CRR

(CASH RESERVE RATIO)

SLR

(STATUTORY LIQUIDITY RATIO)

MSF

(MARGINAL STANDING FACILITY)

RRR

(REVERSE REPO RATE

BANK RATES
 

 

TABLE DIFFERENCE OF MONETARY POLICY

1. CRR is the percentage of money, which a bank has to keep with RBI in the form of cash.1.SLR is the proportion of liquid assets to time and demand liabilities.1. Marginal Standing Facility (MSF) rate refers to the rate at which the scheduled banks can borrow funds overnight from RBI against government securities.1.Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in the case of India) borrows money from commercial banks within the country.1.Bank rate also referred to as discount rate in American English, is the rate of interest which a central bank charges on its loans and advances to a commercial bank.

 

2. CRR regulates the flow of money in the economy.

 

2. SLR ensures the solvency of the bank.

 

2.MSF is a very short-term borrowing scheme for scheduled commercial banks.

 

2.It is a monetary policy instrument which can be used to control the money supply in the country.

People Also Ask

Q. Why the Percentage of Repo Rate is more than Reverse Repo Rate?

A. Repo Rate is always more than the Repo Rate because RBI cannot give more interest on security deposits and charge lesser interest on loans.
Since RBI is a very secured institution, so the commercial banks also prefer depositing their money in RBI else giving loans to individuals and businesses, RRR (Reverse Repo Rate) is not kept high for the above scenario. This is just to ensure that commercial bank will have sufficient funds to invest rather or use liquidity thereby increasing the buying capacity of a consumer by buying goods and services.

Q. What are the reserve requirements?

A. In India, the RBI has told the banks that they need to have a CRR (Cash Reserve Ratio) or 4% and a SLR (Statutory Liquidity Ratio) of 21%. This simply means that for every Rs. 100 that a bank has in its hands, it needs to give for safe-keeping Rs. 4 in hot cash and Rs. 21 as either cash and/or investment government bonds to the RBI. This Rs. 25 acts as a guarantee of sorts in case the bank collapses

Q. How does the CRR affect the economy and inflation?

A. Lower CRR means the bank can give more money as loan = lower interest rates = cheap loan = more people take loans to start a business; translating to more entrepreneurship; building houses or buying cars leading to a boost in the economy. However, this can also lead to inflation, if people have more cash in their hands than the items available for purchase in the market.

Higher CRR equates to the fact that banks can give less money as loan = Higher interest rate = then it becomes expensive to start a new factory, buy a new house/car/bike. This can curb inflation but may also lead to a slowdown in the economy, because people wait for the interest rates to go down, before taking loans.
With every cut in 25 basis points in CRR; theoretically supposed to infuse more liquidity in the system. Everything is dynamic and volatile in the world of economics.

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Niteesh Singh
Niteesh is a Tax Researcher and Content Lead at H&R Block (India). He holds an MBA with a specialisation in BFSI domain. In his career spanning over six years, he has helped thousands of people understand taxes in a simple and effective manner. Outside work, Niteesh is an astronomy geek who is also involved in wildlife conservation activities.

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