The two Liquidity Adjustment Facility with the Central Bank are the Repo Rate and Reverse Repo Rate. Repo Rate is the rate at which interest is charged by the central bank, i.e. Reserve Bank for granting loans to a commercial bank. As against, the Reverse Repo Rate is the rate at which interest is given to the banks which park their excess money with the Reserve Bank of India.
What is a Repurchase Option Agreement?
Repo is an abbreviation for the Repurchase Option Agreement. It is a contract between the buyer and seller of the debt instrument, promising that the seller will repurchase the instrument after the specified period of time. It requires the seller to repurchase securities at a higher price than the price at which it was actually sold.
So, the difference in the amounts paid by the buyer of securities (at the time of buying) and the seller of securities (at the time of repurchasing) is termed the repo rate. It helps the seller of securities to raise short-term funds.
To influence short-term interest levels, generally, RBI conducts Repo transactions. The tool is used to manage excess liquidity in the monetary system.
Further, Repo/Reverse Repo transaction takes place between parties approved by the RBI and that too in the securities approved by RBI, such as Government of India and State Government Securities, Treasury Bills, FI Bonds, Corporate Bonds, PSU Bonds, etc.
These two rates are mainly used to maintain the supply of money in the economy, i.e. to increase or decrease liquidity.
What is a Liquidity Adjustment Facility?
Liquidity Adjustment Facility or LAF implies a monetary policy that facilitates banks to borrow money by way of Repurchase agreements.
In this piece of writing, you will find the differences between repo rate and reverse repo rate.
Content: Repo Rate vs. Reverse Repo Rate
- Comparison Chart
- Key Differences
- How these rates help in controlling Inflation?
|Basis for Comparison
|Reverse Repo Rate
|Repo Rate is a benchmark interest rate, at which money is lent to commercial bank by the Central bank, for short period, against collateral.
|Reverse repo rate is the interest rate offered by the RBI, to the commercial banks on the deposits, who park their surplus funds with RBI.
|What is it?
|It is the rate at which liquidity is absorbed in the economy.
|It is the rate at which liquidity is injected into the economy.
|To fulfill the deficiency of funds.
|To manage liquidity in the economy.
|Money supply in the economy.
|Reverse Repurchase Agreement
|Impact of the increase in the rate
|It will make commercial bank borrow less from the Central bank, due to high-interest rate.
|It encourages commercial banks to transfer more money to the central bank and earn interest.
|Impact of decrease in the rate
|Taking loans from RBI will become cheaper for the banks.
|Banks will invest their money in better avenues than depositing their money with RBI.
Definition of Repo Rate
A repurchase Option or a Repo rate is the rate at which the Reserve Bank of India (RBI) grants loans to commercial banks against government securities with an agreement to repurchase the securities at a future date and predetermined price.
In finer terms, the repo rate is:
- The rate of interest at which banks raise money from a central bank when there is any deficiency of funds.
- Banks also borrow money in the case of an emergency or to comply with CRR or SLR requirements.
- It is a tool to control inflation and liquidity and regulate the money supply in the economy.
- RBI makes increases or decreases the Repo Rate considering the macroeconomic factors.
A fall in the repo rate facilitates commercial banks to avail funds at a cheaper rate, whereas a hike in the repo rate discourages commercial banks from raising funds from RBI, as with the increase in rate, loans get expensive.
Repurchase Option Agreement
The Repurchase Option Agreement is a forward agreement between the commercial bank and the central bank, in which the commercial bank commits to repurchase government securities after the Repo period at a predetermined rate.
It is usually overnight. However, term repo has been introduced by the Reserve Bank of India, wherein the term is for 7 days or 14 days, which means that the interest on the amount borrowed from the central bank is to be paid for seven days at the specified rate.
What if the bank defaults on the repayment?
In case the commercial bank defaults in repayment of the amount, the Reserve Bank of India, has the authority to sell the collateral, i.e. government securities in the open market, to recover the amount.
Current Repo Rate
As of Feb 2021, the Policy Repo Rate in India is 4%. The cut in the rates will make loans cheaper for the banks, which in turn reduces the loan lending rates.
Definition of Reverse Repo Rate
When banks have excess money, they deposit their surplus cash with the Reserve Bank of India for a short term, at a specified interest rate, or the rate at which RBI borrows money through commercial banks by providing government securities is called as Reverse Repo Rate.
Simply put, in reverse repo rate:
- Banks deposit their surplus money with the central bank and earn interest for it.
- Considering the macroeconomic forces, RBI increases or decreases the interest rate.
An increase in the rate acts as an incentive to the banks to deposit their excess funds with RBI, for a short term, against collateral and get interest at lucrative rates on an overnight basis. In this way, the liquidity in the economy will be absorbed.
However, RBI reduces the reverse repo rate; the banks will earn less interest on their money deposited with RBI. So, they will invest their money in those investment avenues in which the rate of interest is comparatively higher, such as the money market. Thus increasing the overall liquidity in the economy as more money is infused into the system.
Reverse Repurchase Option Agreement
It is a buying and selling agreement between the Bank and RBI, in which the bank promises to resell government securities to RBI once the Reverse Repo period is over, at a predetermined rate of interest.
Reverse Repo Period
Just like the repo period, the reverse repo period is commonly overnight. Also, the term reverse repo is for 7 days or 14 days, which means that the interest on the amount borrowed by the central bank is to be paid for 7 days or 14 days, at the specified rate.
Current Reverse Repo Rate
As of Feb 2021, Reverse Repo Rate is at 3.35% in India. The cut in the rate will encourage the bank to lend more to the general public, instead of depositing their excess money with the Reserve Bank.
Also Read: Difference Between Repo Rate and MSF Rate
Key Differences Between Repo Rate and Reverse Repo Rate
In the points given below, you will find the difference between repo rate and reverse repo rate in detail:
- Repo Rate is the interest rate at which RBI lends money to commercial banks against collateral, i.e. government bonds, for a short term. On the contrary, the Reverse Repo Rate refers to the interest rate that the RBI pays to the commercial banks when they park their surplus money with the RBI.
- Basically, the Repo Rate is a rate at which liquidity is absorbed in the economy by offering lucrative interest rates to the bank if they park their surplus money with RBI. Conversely, Reverse Repo Rate is the rate at which liquidity is injected into the economy, by granting loans to the banks.
- In the case of the Repo rate, there are two main reasons why banks borrow money from RBI – shortfall or emergency of funds and to fulfil CRR/SLR requirements. On the contrary, in the case of the Reverse Repo Rate, the purpose is to drain excess liquidity from the economy by increasing or decreasing the rate.
- In general, the repo rate is higher in comparison to the reverse repo rate.
- The Repo Rate is a monetary tool used by the central bank for controlling Inflation, whereas a central bank uses a Reverse Repo Rate to control the supply of money in the economy.
- Repo Rate is charged on the Repurchase Option Agreement, whereas the Reverse Repo Rate is charged on the Reverse Repurchase Option Agreement.
- When there is an increase in the Repo Rate, the commercial bank borrows less from the Central bank due to the high interest rate. As against, if there is an increase in the reverse repo rate, it encourages the commercial bank to transfer more money to the central bank and earn interest on that amount.
- It is quite obvious that if there is a decrease in the repo rate, the banks will be able to avail of a loan at cheaper rates, as a result of which loans will be available to the general public at economical rates. On the other hand, if there is an increase in the reverse repo rate, the banks will invest their funds in the money market in better investment avenues than depositing their money with RBI.
- Both are quantitative methods of credit control
- These are bank policy rates, which are prescribed by the Reserve bank of India.
- Both influence the liquidity and money supply in the economy.
So, on the first day, Reserve Bank grants a loan to ABC bank worth ₹ 1 crore, against collateral (government securities). And on the second day, the bank repays the amount along with the interest @ of 4% per annum, i.e. ₹ 1,096. And RBI transfers government securities to the bank.
Reverse Repo Rate
So, on the first-day bank transfer ₹ 1 crore to RBI, against government securities as collateral. And next day, RBI repays the amount along with interest @ 3.35% per annum which is ₹ 918. And the bank transfers government securities to RBI.
How these rates help in controlling Inflation?
When RBI wants to control inflation, it increases the repo rate and reverse repo rate, due to which raising loans become dearer, which decreases the money supply in the economy, and it reduces the spending power of the consumers, i.e. the demand will fall, and the impact will be displayed in the prices of the goods and services, which will be fallen due to less demand.
Now you must be thinking, how the loans will become dearer, As RBI charges a high-interest rate for providing loans, the bank will also charge a high rate of interest to extend loans to the general public. Similarly, a high-interest rate will be paid by the RBI on depositing money with RBI, so the banks will be encouraged to park their money with RBI, rather than extending loans to the general public, which will drain out excess liquidity from the economy.
Further, to accelerate growth RBI decreases interest rates, due to which availing loans become cheaper for the customers and this infuses money into the economy. As a result the overall demand increases and thus the prices of goods and services also rise. RBI attempts to stabilize the price of the commodities, to maintain a balance in the economy. And to do so, it uses Repo Rate and Reverse Repo Rate as a tool to maintain that balance.
An increase in the repo rate and reverse repo rate is an indicator of the tightening of monetary policy.
Also Read: Difference Between Bank Rate and MSF Rate
The significant difference between the Repo Rate and Reverse Repo Rate is that in the case of a repo transaction, the Central Bank infuses liquidity into the economy, by providing loans at cheaper rates to a commercial bank But in the case of reverse repo transaction, banks absorb liquidity from the economy by increasing the rate.