What is Reverse Repo Rate?

5paisa Research Team Date: 25 Nov, 2022 03:53 PM IST

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Introduction

A bank pays you interest when you deposit money. In contrast, when you borrow money, the bank charges interest. But what is the bank's source of funding for the loan? A bank can either use deposits in its custody or borrow money from the RBI—the central bank of the country. 

Similarly, the RBI borrows money from commercial banks when it needs funds. In such situations, the RBI pays an interest rate, also known as the reverse repo rate. This article explains the reverse repo rate meaning in detail.

What is Reverse Repo Rate?

Reverse Repo Rates refer to the short-term borrowing rates at which banking institutions lend the Reserve Bank of India money. This provides liquidity to the central bank whenever it is needed. It benefits the banks by allowing them to earn interest on their central bank holdings.

The Monetary Policy Committee (MPC), headed by the RBI Governor, determines the Reverse Repo Rate. Committee members decide at their bi-monthly meetings. 

Reverse repo rates and money supply are indirectly correlated; if the reverse repo rate declines, the money supply will increase, and vice versa. Reverse repo rates are increased by the RBI during times of high inflation. This encourages banks to deposit more funds with the RBI so they can earn a higher return on their excess funds. With fewer funds available, banks can offer consumers fewer loans and borrowings.
 

How Does Repo Rate Work?

After discussing what is reverse repo rate, let’s get into the details of how repo rates work.

You pay interest on the principal amount when you borrow money from the bank. It is called the cost of credit. Similarly, banks are also required to pay interest to RBI when they borrow money from RBI during a cash crunch. In this case, the interest rate is called the repo rate.

It is technically referred to as a 'Repurchase Agreement' or a 'Repurchasing Option'. In exchange for overnight loans, banks submit eligible securities to the RBI, such as Treasury Bills. Also, a repurchase agreement will be in place at a predetermined price. Hence, the central bank gets the security and the bank gets the cash. 
 

What are the Components of a Repo Transaction?

Listed below are the parameters under which the RBI agrees to execute the bank transaction:

●    Preventing Economy “squeezes” – Central banks adjust their Repo rates based on inflation. Thus, it aims to limit inflation to keep the economy under control.
●    Hedging & Leveraging – The RBI aims to hedge and leverage by purchasing securities and bonds from the banks and providing the banks with cash in exchange for collateral.
●    Collaterals & Securities – The RBI accepts gold, bonds, and other securities as collateral.
●    Cash Reserve (or) Liquidity – Banking institutions borrow money from the RBI to maintain liquidity or cash reserves.
●    Short-Term Borrowing – Banks can borrow money for short periods from the Reserve Bank, the maximum being overnight post when they buy back securities deposited with the Central Bank.
 

Reverse Repo Rate and Money Flow

When reverse repo rates rise, commercial banks can move additional funds into the safe custody of the RBI, earning attractive interest rates in the process. Taking this step reduces the banks' liquidity.

Government securities are used as collateral by the RBI to accept excess money from banks. LAF (Liquidity Adjustment Facility) facilitates this process.
 

Impact of Reverse Repo Rate on the Economy

When the Reserve repo rate is higher, it impacts the economy. When such a situation arises, commercial banks prefer to deposit the money in the RBI rather than lend it to individuals. As such, they can earn a good rate of interest. As a result of all these events, the rupee's value will rise. 

Reverse repo rates are also used to control inflation, increasing them when inflation is on the rise and reducing them when inflation is on the fall.  

Home loans will be affected by changes in reverse repo rates since banks will be encouraged to invest their surplus funds rather than providing credit to individuals when the reverse repo rate increases. Hence, increasing reverse repo rates increase home loan costs, whereas decreasing them has the opposite effect
 

Difference between Reverse repo rate and Repo rate

Now that we’ve covered the reverse repo rate definition and impact, let’s see how it differs from repo rate:
 

Parameter

Reverse Repo Rate

Repo Rate

Meaning

Interest paid by the RBI to commercial banks for parking surplus funds.

Interest charged to commercial banks upon borrowing funds from the RBI in exchange for collateral, at a predetermined rate and duration.

Impact

When the reverse repo rate is high, the economy is less liquid and vice versa.

 

When the repo rates are high, it leads to a high cost of borrowing funds for banks. This makes loans expensive and vice versa.

Agreement

Charged on reverse repurchasing agreement.

Charged on repurchasing agreement.

Uses

To control the money supply, the RBI uses the reverse repo rate.

As a result of the Repo rate, the RBI can control inflation.

Conclusion

For their own needs, banks need an entity to cater to them, just as we need a bank for our financial needs. This entity in India is the Reserve Bank of India, which borrows and distributes funds and applies repo and reverse repo rates. 

There is one important point to keep in mind: the repo rate is always higher than the reverse repo rate. Moreover, the difference between the two rates is a reflection of the monetary income earned by the RBI.

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