Repo Rate Vs. Reverse Repo Rate

The Reserve Bank of India (RBI) revised its repo rate to 6.50% an increase of 25 basis points on 1st August 2018. This is the second repo-rate hike by the RBI in the financial year after the last repo-rate hike in the previous monetary policy review. There has been a hiatus of almost 4.5 years in the improvement of the repo rates. The reverse repo rate was also increased by 25 basis points, and it is fixed at 6.25% now.

Distinction between Repo Rate and Reverse Repo Rate

The terms "Repo Rate" and "Reverse Repo Rate" are very commonly used in the banking sector. Repo-rate is the interest rate imposed by the RBI while repurchasing securities sold by the commercial banks while reverse repo-rate is the interest rate offered by the RBI to commercial banks that deposit their excess reserves with the central bank.

Repo Rate

When a commercial bank goes through a fiscal crisis, they approach the RBI, so that the RBI lends them money and gets them out of the fix. The interest rate at which these commercial banks borrow funds from the RBI by selling securities and bonds that they own and it is termed as "Repo Rate." In simple words, its the rate at which the Reserve Bank lends money to commercial banks when they are experiencing a financial emergency and are incapable of financing their debts. In that case, the RBI lends money to the banks by buying securities and bonds from the banks and signing the repurchasing agreement which states that the central bank will be repurchasing the securities with a given rate of interest. For example: If the repo-rate fixed by the RBI is 10% p.a, and the amount of money borrowed by ICICI Bank from RBI is Rs 10,000, then the interest rate to be paid by the bank to RBI is Rs 1,000, so the repurchase agreement formulated by the Reserve Bank would state that the amount payable during repurchase would be 11,000. Reserve Bank of India controls the repo rate in the economy. It proves propitious for any short-term financial crisis faced by commercial and scheduled banks. Repo-rate is one of the powerful fiscal tools used by the central bank to control inflation, liquidity and money supply in the country. If the economy needs a limited money supply, RBI raises the repo rate, making it tough for banks to borrow funds. Likewise, to pump money into the system, the central bank might decrease the repo rate, prompting the banks to borrow funds.

Reverse Repo Rate

Once you have grasped the meaning of repo rate, reverse repo-rate is obvious. It is the rate of interest offered by RBI to scheduled banks who deposit into its treasury. Simply put, when banks have excess funds, they prefer to deposit it with the Reserve Bank that is more reliable than lending it to their account holders or any other companies. The rate of interest which is earned by the depositing bank is called reverse repo-rate. For instance, If the reverse repo-rate determined by the RBI is 5% per annum and the total amount deposited by the commercial banks in RBI's account is Rs. 10,000, then the aggregate interest charged by the depositing bank on RBI is Rs 500 per annum.

Reverse repo rate is a policy instrument which is used by RBI to constrain the supply of money in the nation. There are occasions when the central bank is low on funding and asks the commercial and scheduled banks to lend it money; it offers the banks with attractive interest rates so that they agree to park their money in the central bank. It creates an opportunity for commercial banks and other financial institutions to make profits in the short-term.

5 Significant differences between Repo Rate and Reverse Repo Rate

• Repo rate is imposed by the RBI when the commercial banks sell their securities. Whereas, the reverse repo rate is the rate at which the RBI borrows money from banks within the country.
• High repo rate drains excess liquidity from the financial market as the banks are required to pay high interest to secure a loan from RBI, high reverse repo rate infuses liquidity into the financial system by providing increased profits to the banks.
• Repo rate is always greater than the reverse repo rate.
• While the repo rate is used to check inflation, reverse repo-rate is used to regulate the money supply in the market.
• The primary objective of repo rate is to deal with funds deficiency. But the reverse repo-rate deals with the liquidity of the market.
• Repo-Rate involves selling of the securities to RBI with a ground to repurchase it in the future with a fixed interest rate but reverse repo-rate is a minor transfer of funds from bank's account to RBI's account.
• Concluding, we can say that the repo rate and reverse repo rate are contrary to the terms used in the financial sector. The primary distinction between these two terms is that the increase in repo-rate can make the commercial banks to borrow less, and hence it decreases the money supply in the economy while an increase in reverse repo rate will allow commercial banks to transfer more funds to RBI which will ultimately boost the money supply in the country.