We all read in newspapers about the Reserve Bank of India changing Repo Rate and Reverse Repo Rate. Stock markets keenly see the change in “Repo Rate and Reverse Repo Rate”. Banks decide their lending rates on the basis of change in Repo Rate and Reverse Repo Rate. What is repo rate and reverse repo rate in 2014.
Why repo rate and reverse repo rate are so important?
What is the purpose of changing repo rate and reverse repo rate?
Do repo rate and reverse repo rate affect us?
What is current repo rate and reverse repo rate?
Before attempting to answer the above questions, let us see what these Rates are
Repo Rate is the interest rate at which the Reserve Bank of India lends money to the banks to meet their short-term needs. Banks have to provide security for such loans. Banks borrow funds from RBI to bridge the gap between loans demand and money supply.
Example:Suppose ABF Bank has a loan demand of Rs. 100, while the bank has only Rs. 80 in its system. In this scenario, ABF will borrow Rs. 20 from RBI at current Repo Rate and will bridge the gap.
Reverse Repo Rate?
Reverse Repo Rate is the rate at which the banks park their surplus money with RBI.
Example:Suppose ABF Bank has a loan demand of Rs. 80, while the bank has Rs. 100 in its system. In this scenario, ABF will park Rs. 20 in RBI at current Reverse Repo Rate.
Purpose of Repo Rate and Reverse Repo Rate
Repo Rate is an important tool used by the RBI to control the supply of money in the banking system. If the rate is increased, the banks will find it difficult to borrow from RBI and the cost of fund will increase. This will result in an increase in interest rate in the system. By reducing the Repo Rate RBI can reduce the cost of borrowing and thereby the interest rate in the system.
RBI uses Reverse Repo Rate to control liquidity in the system. If RBI increases the Reverse Repo Rate, it indicates its readiness to accept money at a higher rate. Cash rich banks will use this facility to park their surplus money with RBI.
In what way is the common man affected by these rates?
The banks will decide the interest rates based on their cost of funds. Repo Rate will affect the rate of interest charged by banks on various loans like Home Loan, Personal Loan, Car Loan etc. As customers of various loans, all of us will be affected by these rates indirectly.
In what way is Repo Rate and Reverse Repo Rate connected?
As per the current practice, the Reverse Repo Rate is maintained at 100 basis points lower than the Repo Rate. It simply means, if any bank wants to borrow from RBI, it will pay 100 basis point more than what it will get, while parking their money with RBI.
Why Repo Rate is always higher than Reverse Repo Rate?
Repo Rate is always higher than Reverse Repo Rate, otherwise it will give an opportunity for arbitrage.
Example: Here, we are assuming that Reverse Repo Rate(8%) is higher than Repo Rate(7%).Suppose, ABF Bank has Rs. 100 in the system, it will park all the money with RBI and will borrow the same amount from RBI at a lower interest rate. So the bank will earn an extra 1% of interest without any risk, which we call it as arbitrage.
Who decides the Repo Rate and Reverse Repo Rate?
The Reserve Bank of India (RBI) will be declaring the above rates, after studying the needs of the market and the future trends. These rates are the most important tools in the hands of RBI to control liquidity of money in the system.
Current Repo Rate and Reverse Repo Rate
The current Repo Rate is 7.75% and Reverse Repo Rate is 7%. RBI cuts repo rate to 25BPS on 15 January,2015. Inflation may be less than 6% by January, 2016, said RBI Governor, Raghuram Rajan.