What is Repo and Reverse Repo Rate? – A Brief Guide to How The Money Flows in An Economy

The Repo Rate refers to an interest rate at which commercial banks borrow funds by selling securities to the RBI. Banks do this either to maintain liquidity or due to statutory measures that have been enacted. It is one of the primary tools that the RBI uses to combat the problem of inflation. 

The Repo Rate is such an important factor that will affect the interest rate of your loan. It would be beneficial for you to know “What is Repo and Reverse Repo” before applying for a loan from a financial institution. The Repo Rate is the primary tool that monetary authorities utilize to control inflation, the availability of credit, and overall economic expansion.

How exactly does the Repo Rate work?

When customers borrow money from the bank, the financial institution will charge interest on the total amount of the loan. The phrase “cost of credit” refers to this concept. Therefore, if financial institutions have an emergency need for cash and borrow money from the RBI, they must make interest payments to the RBI on the whole amount they have borrowed. It is referred to as the Repo Rate, and it refers to the interest rate at which they borrow money from the RBI.

How is Repo Rate decided?

When it comes time to decide the current Repo Rate, the Monetary Policy Committee gets together for a meeting presided over by the Governor of the RBI.

What is Reverse Repo Rate?

The RBI will borrow money from commercial banks when an excess of liquid assets is available on the market. The reverse repo rate represents the rate at which the RBI borrows money from commercial banks. In return for their holdings, the banks receive interest from the RBI.

What Is the Current Repo Rate?

As a result of the harm that COVID-19 did to the Indian economy, the RBI decided to maintain the Repo Rate at its previous level of 4% in its first bi-monthly monetary policy for the year 2021. This choice was made to limit the extent of the damage. The Repo Rate is one of the primary channels the RBI infuses cash into the banking system.

What Role Do the Repo Rate and the Reverse Repo Rate Play in Keeping Inflation and Cash Flow Under Control?

Reverse Repo Rate and High Repo Rate

A high Repo Rate leads to banks borrowing less money from the RBI due to the higher costs associated with doing so. The reason for this is that the Repo Rate determines the costs of borrowing money. Taking advantage of the fact that the banks can make higher returns by holding more of their money with the RBI when the Reverse Repo Rate is high, banks tend to behave.

Reverse Repo Rate and Low Repo Rate 

Since borrowing money is reduced when the Repo Rate is kept low, financial institutions are encouraged to borrow more cash from the RBI. When the Reverse Repo Rate is also low, banks park less money into the RBI due to the low profits generated by doing so.

  • Parameters of a Repo Transaction

Based on the following considerations, the RBI has reached an agreement with the banks to proceed with the repo transaction:

  • Hedging & Leveraging

The RBI will acquire bonds and securities from the banks, and in exchange, it will provide the banks’ cash in exchange for the collateral that was deposited.

  • Having Complete Control of the Economy

By adjusting the Repo Rate up or down as necessary, the RBI works to maintain economic stability and limit inflation within acceptable ranges.

  • Borrowing for a Short Term

The RBI makes short-term funds loans to the nation’s banking institutions. After some time has passed, the banks will eventually purchase back their deposited securities at a price that has already been determined.

  • Reserves of Cash or Liquidity

When it comes to maintaining their liquidity or cash reserves, banks often take out loans from the RBI.

  • Collaterals and other forms of security

The RBI will take collateral in bonds, gold, and other commodities.

It will be necessary for the lender to lower the base lending rate to reduce the loan EMIs. In the guidelines released by the RBI, banks and financial institutions are expected to pass the benefit of interest rate cuts on to their clients as soon as possible. Repo Rate is very different from Reverse Repo Rate, which is a very significant difference.