Repo Rate

Introduction

The central banks of all countries form monetary policies to control the availability of liquidity in the markets according to the economic situation of the nation. The repo rate is probably the best of these policies that control the money supply to the secondary banks in an economy. The repo rate is the most influential tool in the hand of the authorized banks to maintain the day-to-day liquidity in an economy.

It must be noted that commercial banks in which consumers deposit their money are secondary banks that run for profit. These banks borrow money from the central bank, which is the Reserve Bank of India in the case of India, to run their business. Major part of such loans are again distributed as smaller loans to consumers, such as home loans, car loans, personal loans, travel loans, etc.

Commercial banks do not bear the heightened or lowered cost of their lending. Instead, they pass it to the consumers. That is when the repo rate is increased, commercial banks increase their lending rates to customers. So, credit becomes costlier and this offsets the demand for money in the economy. The reverse happens when the repo rate is slashed. As the cost of loans to commercial banks drops, the commercial banks reduce the interest on the loans. This raises the demand in the monetary market.

There are two key policy rates and two types of reserve ratios that need to be understood to properly understand the concept of the repo rate.

These are −

• Repo Rate or Repositioning Rate

• Reverse Repo Rate

• Cash Reserve Ratio (CRR)

• Statutory Lending Ratio (SLR).

What is Repo Rate?

The repo rate is the rate of interest in lending that is charged by the central bank when the bank offers funding to commercial banks. That is, the commercial banks have to pay the interest to the central bank (RBI) at the rate known as the repo rate. The central bank's role in devising the repo rate is not to earn profit. Instead, the central banks tend to control the liquidity in the market by using the repo rate.

• When the repo rate is increased the burden of interest on the secondary or general banks increases automatically because they need to pay more interest to the central bank for the money they lend from the central bank. Commercial banks, thereby, increase their rates of interest on the loans they offer to consumers. When this happens, credit becomes costlier. The increased rate of interest offsets the consumers from opting for a loan. Therefore, the money supply in the economy reduces automatically.

• The reverse happens when the repo rate is reduced by the central bank. When the demand for goods in the economy goes down due to a recession or a bad phase of the economy, the central banks reduce the repo rate. As the burden of loans decreases, commercial banks reduce the rates of general loans. This increases the money supply in the market and the demand for goods therefore rises automatically.

• Banks were mandated to link the lending rates to external benchmarks in 2019 by the Indian government and a majority of banks opted for repo rates as their external benchmark. It, therefore, became obvious that all loans such as car loans, personal loans, housing loans, and working capital, among others, would get affected by the repo rate.

Apart from these, fixed deposits and savings accounts also get hit by the repo rate.

The RBI has continually reduced the repo rate until it hit the mark of 4% in May 2020 during the phase of the Coronavirus pandemic. This repo rate remained unaltered and helped the economy to get a boost. However, the extent of increased demand is still not quite clear. The repo rate has now been restored to pre-COVID levels, and the central bank is tightening its grip to control inflation in the markets.

Example of Repo

Reverse Repo rate

It is not always the case that general banks take loans from the central bank or the Reserve Bank of India. Sometimes, they deposit their extra earnings in RBI. For this, the RBI pays interest to the banks. This interest is known as the Reverse Repo rate. Moreover, all banks need to maintain statutory reserves with the RBI as per the stipulated cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) on which they get interest as per the Reverse Repo rate.

Cash Reserve Ratio

All banks are mandated to share a part of funds to be maintained with the RBI (interest- free) as a reserve in the form of liquid cash. This is done to encourage making banking operations prudent and conservative. It also controls the liquidity in the system as a whole. CRR can also be used to increase demand or control inflation, and the current CRR rate that banks need to maintain is 4.5%.

Statutory Liquidity Ratio (SLR)

Banks need to follow Net Demand and Time Liabilities (NDTL) at all times during their operation. Net demand liability refers to the funds that need to be immediately repaid to savings and current accounts by the banks on demand. The time liability is attached to fixed deposits which banks must meet at the time of the FD’s maturity.

NDTL is usually kept as a reserve in the form of cash, gold, or other liquid assets. It is mandated that such reserves are maintained in the form of liquid assets, government bonds, and RBI-approved securities so that there is no shortage of funds when the bank needs to meet its liabilities when customers demand their money deposited in various forms in commercial banks.

The cash reserve that commercial banks need to maintain for NDTL is known as Statutory Liquidity Ratio (SLR). The current SLR is 18% but the RBI has the authority to stretch SLR up to 40% of the total cash at commercial banks’ possession.

SLR is also helpful in maintaining prudence and conservatism and they act together to maintain the required reserves as needed from time to time. It can be easily seen that after maintaining the CRR and SLR, a commercial bank can use only 77.5% of its net reserves for commercial purposes.

Conclusion

It is important for banks and general consumers to know the repo rate and how it functions to be able to understand the financial market as a whole. By learning how lending rates go up or down, one can use this for their own favor. That is why knowing how the repo rate works is essential for everyone.

FAQs

Qns 1. What is the repo rate?

Ans. The repo rate is the rate of interest in lending that is charged by the central bank when the bank offers funding to commercial banks. That is, the commercial banks have to pay the interest to the central bank (RBI) at the rate known as the repo rate

Qns 2. Does the central bank apply the repo rate for profit?

Ans. The central bank's role in devising the repo rate is not to earn profit. Instead, the central banks tend to control the liquidity in the market by using the repo rate

Qns 3. What are the CRR and SLR rates currently?

Ans. The CRR and SLR are currently 4% and 18.5%, respectively