Reverse Repo Rate

Key Takeaways

  1. Reverse repo rate is the rate of interest that commercial banks earn for parking their surplus fund with the central bank (RBI in India’s case)
  2. A reverse repo is always lower than the repo rate
  3. Currently, the reverse repo rate stands at 3.35 percent

Reverse repo rate meaning

What is the reverse repo rate India?

Reverse Repo rate is the rate of interest the central bank (i.e. Reserve Bank of India) pays commercial banks for parking their money with them. The repo rate is always higher than its reverse counterpart. 

They are instruments used by the central banks to regulate short-term liquidity in the system.

Repo rate is the rate that commercial banks pay for borrowing money from the central bank (i.e. Reserve Bank of India).

Under this arrangement, financial securities are sold to commercial banks by the central bank with a promise to repurchase them back at a specified price and a specified future date. The duration of the contract varies but generally ranges from 1 to 30 days.

What is current repo rate and reverse repo rate?

Repo Rate 2020

The current repo rate stands at 4 percent. The RBI in its latest monetary policy review on the 4th December 2020 left the rates unchanged, due to an elevated inflation rate above the 2-6 percent band.

Reverse Repo Rate 2020

The reverse repo rate current 2020 stands at 3.35 percent. This again was left unchanged in the latest monetary policy review.

Difference between Repo Rate and Reverse Repo Rate

Both these rates are instruments used by the central banks and other banking institutions to govern their daily short-term liquidity.

While repo rate is the rate of interest at which commercial banks borrow money from the central bank (RBI), reverse repo rates, on the other hand, is the rate of interest at which commercial banks park their surplus money with the central bank. In other words, the reverse repo rate is the interest earned on the surplus funds deposited with commercial banks.

The primary difference between the two rates is that under repo rate interest is earned by the central bank by lending to commercial banks and the opposite is true under reverse repo rate.

More importantly, the reverse repo rate is used to control the liquidity in the system and repo rates are used to control the inflation

Reverse repo rate during inflation

Banks with surplus funds would want to either lend that surplus out or park it with the central bank. The decision depends on the return that the bank would earn on the two alternatives.

Lending that surplus would stimulate demand causing further inflation. The central bank in this case could increase the reverse repo rate enticing the commercial bank to deposit the surplus with them and hence pulling the inflation causing surplus liquidity out of the system.

Why RBI increase reverse repo rate?

When RBI increases the reverse repo rate, it leads to a reduction in the liquidity in the system. The reduced liquidity decreases the funds that the banks would have otherwise lent, leading to a slowdown in credit growth and therefore the inflation.

A reduction in the reverse repo rate has the opposite effect to an increase in those rates, as mentioned above.

Who decides the reverse repo rates in India?

The Monetary Policy Committee, a committee headed by the governor of the Reserve Bank, sets the reverse repo rates in India.

What is CRR and SLR?

Cash reserve ratio or CRR is the minimum percentage of commercial banks’ deposits that those banks have to hold in the form of cash. They deposit the cash with the central bank’s currency chest, instead of keeping it with themselves.

This deposit of funds with the central bank is considered equivalent to holding the cash with themselves. At present, the CRR is 3 percent.

On the other hand, SLR stands for statutory liquidity ratio. It is the minimum proportion of the deposits that those banking institutions have to keep in the form of cash, gold, and other approved securities.

SLR is currently at 18.5 percent.

Why is repo rate higher than reverse repo?

This is because the repo rate is the rate at which the commercial banks borrow from the central banks and the reverse repo is the rate at which commercial banks lend to central banks.

Now, the rate at which the central bank lends (repo rate) cannot be lower than the rate at which it borrows (reverse repo). If that happens, commercial banks will borrow money from the central bank and lend it back to the central bank, in the process pocketing the difference.

So it only makes sense for the repo rates to be higher than reverse repo.

Effect of reverse repo rate on home loan

When the central bank increases the reverse repo rate, banks may respond by increasing the home lending rates because lending out money becomes less profitable compared to parking it with the central bank.

Also, given the higher risk involved with lending it only makes sense to increase the home loan rates. The home loan rate may come down when the reverse repo rates decrease.