The change in the repo rate and bank rate was announced by Reserve Bank of India (RBI) on 6 June 2018. This was announced as part of the second bi-monthly monetary policy statement for 2018-19. The bank rate has increased to 6.50% and the repo rate has also seen an increase, rising from 6% to 6.25%. The repo rate has seen an increase for the first time in more than four years. The last time the repo rate increased was in January 2014.
Repo Rate and Bank Rate
Repo Rate and Bank Rate are the two most popular rates calculated for borrowing and lending activities carried on by commercial and central banks. They are the lending rates, at which The Central Bank of India lends funds to commercial banks and other financial institutions in India. While both rates are short term tools used to control the cash flow in the market and is often mistaken to be one and the same, there are some noteworthy difference between the two. If you take a close look at the current Repo and Bank Rate, you’ll figure out that they both aren’t the same.
What is Repo Rate?
When we experience a financial shortfall, we approach the bank for loans. Likewise, when banks fall short of funds, they approach the central bank for financial assistance. Repo Rate is the rate at which the country’s central bank, which is RBI in India, lends money to commercial banks during a financial crisis. In other words, commercial banks borrow money from Reserve Bank of India by selling securities or bonds with an agreement to repurchase the securities on a certain date at a predetermined price. The rate of interest charged by the central bank on the cash borrowed by commercial banks is called the “Repo Rate”. For example: if the Repo Rate is 10% and the loan amount borrowed by a commercial bank from RBI is Rs.10,000, the interest paid to the RBI will be Rs.1,000.
On the contrary, when a commercial bank has excess funds, they can deposit the same in central bank and earn “Reverse Repo Rate” interest. For example: if the Repo Rate is 10% and the funds deposited by the commercial bank to the RBI account is Rs.10,000 then the interest paid to the commercial bank by RBI is Rs.1,000.
Repo Rate also decides the liquidity rate in the banking system. If RBI wants to increase the liquidity rate, it will reduce the Repo Rate and encourage the banks to sell their securities. However, if the central bank wants to control liquidity, it will increase the interest rate, discouraging banks to borrow easily. An increased Repo Rate means that the central bank will earn a higher interest rate from the commercial banks while an increased Reverse Repo Rate means that the commercial banks earn high interest from the central bank.
What is Bank Rate?
The rate of interest charged by the central bank on the loans they have extended to commercial banks and other financial institutions is called “Bank Rate”. In this case, there is no repurchasing agreement signed, no securities sold or collateral involved. Banks borrow funds from the central bank and lend the money to their customers at a higher interest rate, thus, making profits. Bank Rate is usually higher than Repo Rate as it is an important tool to control liquidity. Also known as “Discount Rate”, Bank Rate is often confused with Overnight Rate. While the bank rate refers to the interest rate charged by the central bank on loans granted to commercial banks, overnight rate is the interest charged when banks borrow funds among themselves. When Bank Rate is increased by RBI, the borrowing costs of the banks increase which, in return, reduce the supply of money in the market.
Additionally, when the unemployment rate within a country increases, the central bank decreases the bank rate so that individuals can get loan at a reduced rate. This will not only help maintain the currency supply within a country for economic growth, but will also help the banking sector to function smoothly. In such a scenario, the loan borrowers will not have to provide any collateral in order to avail a loan.
Key Differences between Repo Rate and Bank Rate
Though Repo Rate and Bank Rate has few similarities like both is fixed by the central bank and used to monitor and control the cash flow in the market, they have some prominent differences too. Take a look at the differences between Repo Rate and Bank Rate below.
- Bank Rate is charged against loans offered by central bank to commercial banks, whereas, Repo Rate is charged for repurchasing the securities sold by the commercial banks to the central bank.
- Repo Rate is always lower than the Bank Rate.
- Increase in Bank Rate directly affects the lending rates offered to the customer, restricting people to avail loans and damages the overall economic growth, whereas Increase in Repo Rate is usually handled by the banks and doesn’t affect customers directly.
- No collateral is involved while charging Bank Rate but securities, bonds, agreements and collateral is involved when Repo Rate is charged.
- Comparatively, Bank Rate caters to long term financial requirements of commercial banks whereas Repo Rate focuses on short term financial needs.
- Since it is an overnight loan, the loan tenure under the repo is 1 one day. On the other hand, the loan tenure under the Bank Rate is 28 days.
Though Bank Rate and Repo Rate have their differences, both are used by RBI to control liquidity and inflation in the market. In a nutshell, the central bank uses these two powerful tools to introduce and monitor the liquidity rate, inflation rate, and money supply in the market. Bank Rate is a latent weapon to control the interest rate which, in turn, controls liquidity. However, Repo Rate is the topmost policy rate imposed by the RBI that acts as an anchor for the interest rate.