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Repo Rate vs Bank Rate

IndianMoney.com Research Team | Posted On Tuesday, October 09,2018, 04:32 PM

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Repo Rate vs Bank Rate

 

 

Repo Rate and Bank Rate are two of the tools used by the Central Bank (Reserve Bank of India) to control money supply, interest rates, inflation and so on. They are short term measures used to control liquidity and many people are under the impression that they are both the same and can be used interchangeably. However, there are some prominent differences that set the two apart. In this article, we will try to understand what a Repo Rate and Bank Rate is, what the difference between the two is, and how they are used by RBI.

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Repo Rate vs Bank Rate

What is Repo Rate?

Repo Rate is the rate at which RBI lends money to commercial banks. At times when there is a shortage of available funds, banks sell short term securities or bonds to the RBI with an agreement to repurchase them at a later date at a predetermined price. RBI charges interest on the amount, and this interest rate is called Repo Rate, also called Repurchase rate. A repurchase agreement involves a contract between a security holder and purchaser. It allows the holder to sell and repurchase the security in order to raise money. The security is used as collateral and the repo rate serves as a profit to the purchaser. The features of a repo transaction between a commercial bank and RBI are:

  • Bank provides eligible securities which are recognized by RBI.
  • RBI gives a loan to the bank
  • RBI charges interest called Repo Rate from the bank
  • Banks repurchase the security after a fixed time by repaying the loan.

If the bank borrows Rs 10 Lakhs from RBI, under the current Repo rate of 6.5%, the interest payable is Rs 65,000. A higher repo rate reduces the borrowing incentive of banks and results in lesser money supply in the market and vice versa. RBI controls the liquidity in the banking system by using the Repo rate. If it wants to increase the liquidity, it will decrease the repo rate and encourage banks to sell securities. In case liquidity needs to be reduced, it will raise the repo rate and banks will reduce their borrowing. The cost of credit for banks will increase with rising repo rates.

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What is Bank Rate?

The rate of interest charged by the RBI on the money borrowed by commercial banks and other Financial Institutions is called Bank Rate or Discount Rate. There is no security or collateral and no repurchasing agreement in this type of borrowing. Bank Rate must not be confused with Overnight Rate, which is the rate at which banks borrow among themselves.

When banks face a shortage of funds or anticipate a shortage in the near future, they borrow from the Central Bank and use these funds to give out loans to individuals and organizations at a higher rate. The Bank Rate has a direct impact on the interest rates that banks charge from individuals and organizations on loans taken by them.

A rise in the bank rate means higher borrowing charges to the banks, which leads to an increase in the lending rates charged to the banks’ customers. When the supply of money is low in the economy, RBI reduces the bank rate. Individuals and organizations can now avail loans for various purposes, at cheaper rates of interest, which increases the funds available to the public.

Key Differences between Repo Rate and Bank Rate

Basis of Difference

Repo Rate

Bank Rate

Loan

Securities are sold by the commercial banks to the Central Bank, which are to be repurchased at a later date.

Banks borrow money from the RBI, and there is no repurchase agreement.

Collateral

The securities are used as collateral for the amount borrowed.

There is no collateral for the borrowed amount.

Rate

Repo Rates are comparatively lower than Bank Rates

Bank Rates are always higher than Repo Rates

Purpose of Loan

Caters to the short term financial needs of the bank.

Long term financial requirements are satisfied.

Effect on Lending Rates

Banks usually bear the burden of an increase in Repo Rate, so the customers aren’t affected to a large extent.

Bank rates have a direct impact on the lending rates. Higher bank rates increase lending rates and vice versa.

How can RBI control Inflation?

The main way RBI controls inflation is by controlling the supply of money in the economy. It does this by controlling the liquidity rates which are applicable to banks. Some of these rates include Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Bank Rate, Repo Rate and Reverse Repo Rate. Such methods are called Quantitative Methods.

  1. Cash Reserve Ratio (CRR) is the percentage of money that the bank must maintain with the Central Bank. If the CRR is 4%, then for every Rs 1,000 deposited with the bank, it can retain Rs 960 and deposit Rs 40 with RBI.
  2. Statutory Liquidity Ratio (SLR), is the percentage of available funds that banks have to invest in specified government securities.
  3. Bank Rate is the interest charged by RBI for the money borrowed by commercial banks.
  4. Repo Rate or Repurchase Rate is the interest rate on money lent to commercial banks by RBI.
  5. Reverse Repo Rate is the opposite of Repo Rate, where the banks charge interest to RBI on money borrowed.

All these rates, with the exception of reverse repo rate, have a direct relationship with lending rates charged by banks to clients. This means that when these rates increase, the cost of borrowing will rise for the clients as well. Reverse Repo Rate is inversely related to lending rates, because when the reverse repo rate increases, banks have more funds available and a fall in reverse repo rate decreases the available funds to banks.

Whenever the economy is slowing down or the unemployment rate is on the rise, RBI cuts down the rates to allow greater lending capacity to the banks. Lower borrowing cost encourages people to take loans and use them for various purposes, thus mobilizing funds where they are needed. The reverse is also true for when inflation is on the rise, RBI raises the rates and the supply of money decreases in the economy. 

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