The Reserve Bank of India (RBI), has on 1 August 2018, revised its repo rate to 6.50%. There has been an increase in the repo rate by 25 basis points over the previous repo rate of 6.25%. This is the second rate hike by the RBI after the last rate hike in the previous policy review. There has been a gap of almost 4 and a ½ years in the revision of repo rates. The reverse repo rate was also hiked by 25 basis points and at the moment, stands at 6.25%.
Difference between Repo Rate and Reverse Repo Rate
The terms “Repo Rate” and “Reverse Repo Rate” are often used in the banking sector. Repo rate is the interest charged by the RBI while repurchasing securities sold by commercial banks while reverse repo rate is the interest rate offered by the RBI to commercial banks depositing their excess funds in the central bank.
When a commercial bank goes through financial crisis, they approach RBI. The interest at which banks borrow funds from RBI by selling their securities and bonds is called “Repo Rate”. In other words, it is simply the rate at which the central bank of India lends funds to commercial banks when they are facing a financial crunch and are unable to take care of their expenses. In this case, a repurchasing agreement is signed by both the parties stating that the securities will be repurchased on a given date at a predetermined price. For example: If the repo rate fixed by the RBI is 10% p.a and the amount borrowed by a bank from RBI is Rs 10,000, the interest rate to be paid by the bank to RBI is Rs 1,000. Repo rate in India is fixed and monitored by India’s central banking institution, the Reserve Bank of India. It proves beneficial for short-term financial crisis. It is one of the powerful tools used by the central bank to control liquidity, money supply and inflation level in the country. If the economy needs less money supply, RBI increases the repo rate, making it difficult for banks to borrow funds. Likewise, to pump funds into the system, the central bank may reduce the repo rate, encouraging banks to borrow funds.
Reverse Repo Rate
Once you have understood the meaning of repo rate, reverse repo rate is self-explanatory. It is the interest rate offered by RBI to banks who deposit into its treasury. Simply put, when banks generate excess funds, they choose to deposit it with RBI which is safer than lending it to their account holders or other companies. The rate of interest earned by the depositing bank is called reverse repo rate. For example: If the reverse repo rate fixed by RBI is 5% p.a and the amount deposited by commercial banks into RBI’s account is Rs. 10,000, the interest rate by the depositing bank is Rs 500 p.a.
Reverse repo rate is a monetary policy instrument used by the RBI to control the supply of money in the nation. Also, there are chances when RBI falls short of money and asks the commercial banks to pitch in and offer them excellent reverse repo rates. It creates an opportunity for commercial banks and other leading financial institutions to make profits within a short period of time.
5 Major differences between Repo Rate and Reverse Repo Rate
- Repo rate is charged by RBI when commercial banks sell their securities. Whereas, reverse repo rate is the rate at which RBI borrows money from banks within the country.
- While high repo rate drains excess liquidity from the market as the banks have to pay high interest to obtain loan from RBI, high reverse repo rate injects liquidity into the economic system by offering high profits to banks.
- The repo rate is always higher than the reverse repo rate.
- While repo rate is used to control inflation, reverse repo rate is used to control money supply in the market.
- The main objective of repo rate is to deal with deficiency of funds. Whereas, reverse repo rate deals with liquidity in the economy.
- Repo Rate involves selling securities to RBI with a motive to repurchase it in the future at a fixed rate of interest but reverse repo rate is mere transferring of funds from one bank account to RBI account.
To conclude, repo rate and reverse repo rate are two opposite terms used in the banking sector. The major difference between these two are that increase in repo rate will make commercial banks borrow less and therefore pumps less money into the system, while increase in reverse repo rate will allow commercial banks to transfer more funds to RBI which will eventually contribute to the supply of money in the country.