Tuesday, September 27, 2011

bps : It is an acronym for basis point and is used to indicate changes in rate of interest and other financial instruments. 1 basis point is equal to 0.01%. So when we say that repo rate has been increased by 25 bps, it means that the rate has been increased by 0.25%.

Repo Rate and Bank Rate

People often get confused between these two terms. Though they appear similar there is a basic difference between them.

Repo rate or repurchase rate is the rate at which banks borrow money from the central bank (read RBI for India) for short period by selling their securities (financial assets) to the central bank with an agreement to repurchase it at a future date at predetermined price. It is similar to borrowing money from a money-lender by selling him something, and later buying it back at a pre-fixed price.

Bank rate is the rate at which banks borrow money from the central bank without any sale of securities. It is generally for a longer period of time. This is similar to borrowing money from someone and paying interest on that amount.

Both these rates are determined by the central bank of the country (RBI in Indian Banking Context) based on the demand and supply of money in the economy.

Repo rate is basically the rate charged on this thing called a repo or “repurchase agreement”. Essentially, a repurchase agreement is an agreement between one party and another in which the former sells a security (like a bond) to the latter with a promise to buy it back after a particular period.

When we take a loan from any bank, we pay Interest for that. In the same way, Banks also take short-term loans from Central Federal Bank (RBI in Indian Context) & RBI charges the Interest at the rate, which is well-known as Repo Rate.

For instance, a bank may enter into a repo with RBI, selling a security to RBI and then telling RBI, that I will buy this security back from you after 3-months.

RBI tells the bank…OK I will pay Rs. 100 for this security now but when you buy it back from me, please pay me Rs. 103. The extra Rs. 3 that RBI charges constitutes the repo rate (translates into 12% pa for this example).

Hence, repos are a form of “collaterlised or secured borrowings” in which the borrower must place a collateral with the lender (in this case RBI). If the borrower does not manage to buy back the security, the lender can redeem its collateral value. Generally, repos are used for managing domestic liquidity in the economy.

Thus, the repo rate, often referred to as the short-term lending rate, is the interest charged by the central bank on borrowings by commercial banks. A hike in the rates makes cost of borrowing costlier for the commercial banks.

Reverse Repo Rate:

“Reverse Repo” rate is just what the name suggests. It’s the reverse of the repo.

A reverse repurchase agreement or a ‘reverse repo’ is something like a switch between the buyer and the seller in a repurchase agreement. More specifically it’s a switch in the perspective.

For example in the case of reverse repo, the RBI would be the one,who will be selling the security to the commercial bank and telling it….if you give me Rs. 100 for 3 months today, I’ll pay you Rs. 3 as interest on it after 3 months and you give me back this security.

So it is actually a ‘repo’ from RBI’s perspective but a ‘reverse’ repo from the commercial bank’s perspective.

I hope you got the difference. The interest rate that RBI promises the commercial bank for placing its money with RBI is the reverse repo rate.

The following table summarizes the terminology:

Repo Reverse repo
Participant Borrower Lender
Seller Buyer
Cash receiver Cash provider

Near leg Sells securities Buys securities
Far leg Buys securities Sells securities

Impact of these on Us:

When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate:)

Thus, a hike in these rates makes cost of borrowing costlier for the commercial banks.

An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI.

A hike in this rate makes it more lucrative for banks to park funds with the RBI(which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk).

Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while Repo rate signifies the rate at which liquidity is injected.

The Central bank uses these rates to control inflation.

Banks earn profit by borrowing at a lower rate of interest from the central bank, and lending the same amount at a higher rate to the customers.

If the repo rate or the bank rate is increased, bank has to pay more interest to the central bank. So in order to make profit, banks in turn increase their interest rate at which they take deposit from the customer and lend money to the customer. So the demand for loan decreases, and people start putting more and more money in bank accounts to earn higher rate of interest. This helps in controlling inflation.

An increase in Reverse repo rate causes the banks to transfer more funds to the central bank, because banks earn attractive interest rates and also their money is in safe hands. This results in the money being drawn out of the banking system, thus banks are left with lesser funds.

Thus, by lowering repo rate, central bank injects liquidity in the banking system and by increasing reverse repo rate it absorbs liquidity from the banking system.

Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks.

Increase in CRR rate means that banks will have less power to give loans (see our example above), which again controls the amount of money floating in the market; thereby controlling inflation. It also makes banks safer to keep money because banks will have a higher liquidity to meet the demand of customers. As we learnt from the recession, giving loans expose banks to great risks. So if banks have lesser funds to give as loan, they become relatively safer.


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