Difference Between Repo Rate Vs Reverse Repo Rate

The bank will charge interest when you borrow from them. Consequently, if you deposit money, the bank pays interest. But have you ever wondered how banks fund themselves? The answer is simple. Banks either utilise deposits or borrow from the central bank – the Reserve Bank of India (RBI).

For these transactions, the RBI implements a tool called the Liquidity Adjustment Facility (LAF). Under this arrangement, banks can borrow from or lend money to the RBI through the repo and reverse repo agreements.

The interest rate levied on these transactions is the Repo Rate and Reverse Repo Rate. This article explains the main differences between these two terms.

What is the Repo Rate?

The Reserve Bank of India (RBI) charges interest on loans borrowed by commercial banks. This rate is called the repurchase agreement rate or Repo rate.

Typically, commercial banks secure loans from the RBI by pledging various government securities as collateral, such as treasury bills and bonds. The repo rate is nothing but the lending rate charged by the RBI.

The repo or repurchase agreement allows the RBI and commercial banks to repurchase securities at a pre-determined rate.

These agreements are set in motion when banks must maintain liquidity in uncertain market situations.

The RBI uses the repo rate to control inflation. So, let us now understand how the repo rate works.

How Does Repo Rate Work?

The RBI uses repo rates to regulate money moving through the market. It increases the rate when inflation strikes. Banks borrowing money from the RBI during inflation pay a high interest due to a raised repo rate. This severely affects the bank’s capacity to borrow from the RBI. The end customer feels the impact of a repo rate increase in two ways:

Banks increase the rate of interest on deposit accounts to increase the cash at their disposal. Thus, investors can enjoy higher interest on fixed-income instruments.

To combat the repo rate hike, banks further increase the interest rate on loans, making them costlier and thus less sought after. With fewer loans to disburse, banks manage to retain greater liquidity.

The decrease in liquidity lowers demand in the economy, reducing inflation levels.

Repo Period

The RBI has stated that the repo period can be ‘overnight, open, or flexible.’ Overnight repo does not extend beyond a night.

However, the situation gets complicated if the term is predetermined and agreed upon in advance. This type of repo is known as the term repo. In this case, either side may request to stop the repo at any moment with one or two days’ notice.

Term repo typically lasts for one week. However, there is no maximum limit on repo tenure.

Current Repo Rate

The current repo rate is 5.90%. The RBI increased the repo by 50 basis points in September 2022.

What is the Reverse Repo Rate?

Commercial banks deposit money with the RBI and earn interest when they have surplus funds. This interest paid by the RBI is called the reverse repo rate. In other words, the reverse repo rate is the rate at which the central bank borrows from commercial banks.

How does the Reverse Repo Rate Function?

RBI often applies the reverse repo rate during inflation. This increases the rate, prompting banks to park more money with the RBI and earn higher returns. As a result, the banks have less money to extend in the form of loans. Thus, the liquidity in the economy decreases.

Current Reverse Repo Rate

As of November 2022, the reverse repo rate is unchanged at 3.35%.

Repo Rate Vs Reverse Repo Rate

Conclusion

The repo and reverse repo rates are vital tools for managing the economy. However, we must remember that the repo rate will always be higher than the reverse repo rate. Further, the difference between these two rates determines the RBI's financial income.