Repo Rate vs Reverse Repo Rate

Repo rate vs Reverse Repo Rate

Repo Rate and Reverse Repo Rate are two very important terms in an Indian economy. Both play a very significant role in controlling inflation and stabilizing liquidity. Repo and Reverse Repo rates ensure that there is no surplus or dearth of money flow in the market. It is RBI that controls and fixes these rates according to the Monetary Policy of the country. So, here’s an attempt to distinctly explain both the terms and a comparison between both the rates to our readers. The article also aims at highlighting the impact of an increase or decrease in these rates. Repo Rate vs Reverse Repo Rate patently shows the key differences and the similarities between them.

What are Repo Rate and Reverse Repo Rate?

The term ‘REPO’ is an abbreviation for ‘Repurchasing Option’. In simple terms, the Central Bank lends loans to commercial banks and financial institutions at Repo Rate. As the term Reverse Repo Rate indicates, it is vice-versa of Repo Rate. When the Central Bank borrows money from commercial banks, it pays the interest at Reverse Repo Rate. A detailed understanding of Repo Rate and Reverse Repo Rate is as follows:

Repo Rate

When commercial banks have insufficient funds, they approach the apex bank in the country. It is the Reserve Bank of India that serves the purpose in our country. So the banks borrow loans from RBI against some securities. They pledge government securities, treasury bills, bonds, etc. Banks also offer to repurchase these securities once they pay the principal loan amount and the added interests. The interest is calculated at Repo Rate. It is called Repurchasing Option Rate for the reason that banks offer to buy them back. The agreement between the banks and RBI lays down the terms and conditions. One of the many T&Cs is to repurchase the securities on a given date and price. Hence, it is also termed a Repurchasing Agreement.

Banks can take a loan without pledging securities as collateral at the Bank Rate. The difference between Bank Rate and Repo Rate exists mainly on the grounds of collateral provision.

Reverse Repo Rate

The term ‘Reverse Repo Rate’ is suggestive enough that it is the reverse of Repo Rate. Therefore, the lending and borrowing conditions are contrary to that Repo Rate. Here, the Central Bank borrows money from commercial banks and pays interests. RBI pledges securities for the short term to banks to voluntarily park their excess money. In other words, RBI pays incentives to the banks to have deposits with it. This rate of interest applies to Repurchase Agreement where RBI rebuys the securities. The securities are Central & State Govt. securities, FI bonds, Corporate and PSU Bonds, etc.

Differences Between Repo Rate and Reverse Repo Rate

The key differences between Repo Rate and Reverse Repo Rate are based on the lender’s and borrower’s perspectives. It also differs on the impact the change in rates creates. They are:

  • Repo Rate and Reverse Repo Rate are contradictory. Banks borrow money from RBI at Repo Rate, and on the other hand, they lend money to RBI at Reverse Repo Rate
  • RBI uses Repo Rate as a mechanism to control inflation and Reverse Repo Rate to manage money flow
  • Repo Rate injects liquidity in the market whereas Reverse Repo Rate absorbs liquidity from the market
  • Usually, Reverse Repo Rate is lower than Repo Rate
Table of Comparision
ParametersRepo RateReverse Repo Rate
Lender & BorrowerRBI lends, commercial banks borrowBanks lend, RBI borrows
Operation MechanismBanks pledge securities to take loans from RBI and buy them backRBI pledges securities to banks to take loans or have their deposits with them
Rate of InterestHigher than Reverse Repo RateComparatively lower than Repo Rate
ROI ApplicableOn the Repurchase Agreement where banks repay the loan to RBI with interest as per Repo Rate to buy back the securitiesOn the Reverse Repurchase Agreement where banks withdraw back their money from RBI after the latter interest as per Reverse Repo Rate to buy back the securities
Purpose/ObjectiveControls inflation and deficiency of moneyControls overabundance of funds and cash flow
Impact of Increase in RateDiscourages banks to borrow. When the rate of loans rise for banks, bank loans for customers also get expensiveMoney supply in the market falls short as banks deposit their money in RBI to draw more interest
Impact of Decrease in RateIt supports lending to banks. As the cost of funds decreases, banks lend to customers at lower loan ratesThere is a superfluity of funds as banks reduce deposits with RBI and lend more in the market
Repo Rate Vs Reverse Repo Rate

Similarities

The policy rates may differ over who is the lender and the borrower between banks and RBI. However, they have the same governing body and similar objectives. The similarities between the two are:

  • Monetary Policy Committee (MPC) headed by RBI Governor decides both Repo Rate and Reverse Repo Rate
  • Both are a component of the Liquidity Adjustment Facility (LAF) which is a monetary policy that allows banks to borrow via repurchase agreements
  • Both are RBI tools to check the bank credit floating in the market. When there is a rate change, the volume of market money rises or declines.The concentration or dilution of the funds affects investments as well as their diversity in the financial markets
  • Both Repo Rate and Reverse Repo Rate aim at price stability which improves the efficiency of the financial system. This ensures economic development in the country
  • Both are short-term mechanisms of RBI to control liquidity and inflation.The tenure for both is 7 days or 14 days, since the money has to be paid back after the term ends

Wrapping it up:

Now that you know what Repo Rate and Reverse Repo Rate are, you understand the importance of both in an economy. In a nutshell, RBI imposes Repo Rate and Reverse Repo Rate to keep the economy going stably. It wants enough but not excessive liquidity that is the flow of money in the market. Likewise, rates are increased and decreased either to ensure cash flow during deficiency or absorb some during oversupply. Both are fixed cut-off rates to lend overnight funds for a short-term period to manage credit availability. Both work in opposite directions but are a part of the Monetary & Credit Policy of RBI.

FAQs
What happens if banks fail to repay the loan from RBI?
RBI has the authority to sell off the pledged securities by banks for loans at Repo Rate if they default and fail to repay on time.
Why is the Reverse Repo Rate lower than Repo Rate?
Reverse Repo Rate is lower than Repo Rate because:
  • RBI will not offer higher interest on deposits than loans
  • RBI earns more through lending than borrowing. It is the spread between deposits and loans through which RBI earns
  • RBI wants to discourage banks to deposit money with it instead of lending to customers and businesses
What is the link between home loans and Repo Rate as well as Reverse Repo Rate?
The link between home loans and Repo Rate as well as Reverse Repo Rate is:
  • When Repo Rates are high, banks increase their base rate of lending to compensate for the higher interests they pay to RBI. This may also lead to an increase in home loan rates
  • When Reverse Repo Rates are high, it also may increment the rate of home loans. It is profitable and safer for banks to grant loans against government-backed securities to RBI than home loans to individuals
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