Repo rate, reverse repo rate, bank rate- do they sound alien to you? You might have heard or read about these terms in news especially when there is a discussion of finances involved. Well if you don’t know the meaning of these terms, you are not alone. Through this post we would like to explain what exactly Repo Rate means and how it affects the common man. Apart from this we will also explain what Reverse Repo Rate means. You will also get to know what is bank rate and the difference between Repo rate vs Bank Rate.
Repo Rate Meaning & Definition
Repo rate is the term used for the rate at which the central bank of any country (The Reserve Bank of India, for India) lends money to commercial banks whenever there is a shortfall of funds. Monetary authorities use repo rate to control inflation. Whenever there is inflation, the central bank increases the repo rate. What it does is, it acts like a disincentive for the banks to borrow money from the central bank. This leads to reduction in the money supply in the economy of that country and hence helps in arresting inflation.
The central bank, like RBI in India has to take a contrary position in case of a fall in inflationary pressures. Repo and reverse repo rates facilitates the liquidity adjustment in the economy.
Reverse Repo Rate
Reverse repo rate is the inverse or Repo Rate. It is the term used for the rate at which the central bank of a country (Reserve Bank of India, for India) takes or borrows money from commercial banks within the country. The Central bank usually borrows money from commercial banks to control the money supply in the country. If the reverse repo rate increases, it will decrease the money supply. While a decrease in reverse repo rate would lead to increase in money supply. Other things would remain constant. Also, on increase of reverse repo rate, the commercial banks get more incentives to park their funds with the central bank (RBI). This leads to decrease in money supply in the market.
Recommended Read :
Bank Rate vs Repo Rate
Bank rate is often called as discount rate by financial institutions. The bank rate is used by commercial banks while borrowing money from the central bank. Commercial banks secure a loan when they anticipate shortage of funds in their own bank.
The Bank Rates have a direct impact on the money the commercial banks lend to their clients. The lending rate charged by the central bank is passed on by the commercial banks to the customers who take a loan from these banks. If the central bank charges a high rate from the commercial banks, the commercial banks will charge high interest rates to its customers who take a loan from the bank. Similarly, if the central bank charges low rate from the commercial banks, the commercial banks will charge low interest rate from the customers who take a loan from the bank.
One can say that repo rate and bank rate are quite similar. Repo rate is also known as repurchasing rate. Repo rate is used like a repurchase agreement in a banking transaction. Now, one would like to know what a repurchase agreement is. When a central bank like RBI sells securities to commercial banks and plans & agrees to repurchase those securities after a stipulated period of time at a pre-defined price, it is called repurchase agreement. Hence, the interest rate used for repurchase of these securities is known as a repo or repurchase rate.
Difference between Bank Rate and Repo Rate
Let’s take a look at some of the differences between bank rate and a repo rate.
- Usage of Collateral – In a bank rate no collateral is involved. But in a repurchase agreement securities are used as collateral, which are ultimately repurchased at a later date.
- Difference in rate – If you notice the general trend in the market, you will find that bank rate is comparatively higher than a repo rate.
- Effect on Lending Rate and Term Period – Repo rate is usually used to fulfill the short term fund requirements of businesses. Central banks try to reduce liquidity in the economy by increasing the repo rate. That said, it has no affect on the market rate of interest, as commercial banks take the additional burden for securing their customer base. However, when the bank rate increases, it affects the lending rate offered to customers directly. This discourages them from taking loans which lead to a damage of the overall economic growth. Repo rate may have an impact on the investment amount. But the impact is not as drastic and direct as a bank rate.
- Loan vs. Securities –Bank rate usually has to do with loans, while repurchase or repo rate deals with the securities. The bank rate is charged by the central bank upon lending loan to commercial banks. On the other hand, the repo rate is charged for repurchasing of securities.