It is not surprising that many of those involved in finance cannot distinguish between the Repo Rate and Bank Rate. These are the two most essential rates calculated for borrowing and lending activities carried on by commercial and central banks. While both of these rates are applied to manage inflation and maintain market liquidity, they can be confusing. However, several significant differences can allow us to differentiate these two rates, as we will demonstrate in this blog.
Repo Rate & Bank Rate: Definitions and Differences:
What is a Repo Rate?
The Repo rate is the rate at which the Central Bank lends money to commercial banks for meeting short-term fund requirements in order to control inflation. Thus, central banks grant loans to banks and the latter provides some securities. These securities are sold by banks with an agreement to repurchase them, and are bought back when the banks pay the interest at the rate of ‘REPO’. So, REPO refers to ‘Repurchase Option’.
The repo rate is increased when policymakers need to control prices and restrict borrowings. On the contrary, the repo rate is decreased when there is a need to infuse more money into the market and support economic growth. However, the increase in repo rate means commercial banks have to pay more interest for the money lent to them and therefore, a change in repo rate eventually affects public borrowings such as home loan, EMIs, etc.
What is the Reverse Repo Rate?
The Reverse Repo Rate is the rate that the central bank of a country pays to commercial banks to park their excess funds in the central bank. In other words, it is the money borrowed by the central bank from commercial banks and pays them interest as per the reverse repo rate applied.
This rate is also a monetary policy used by the central bank to regulate the flow of money in the market. But, the reverse repo rate is totally different from the repo rate. First, it is lower than the repo rate. Besides, the repo rate is used to regulate liquidity in the economy, whereas the reverse repo rate is used to control cash flow in the market.
In case of inflation, the reverse repo rate is increased to encourage commercial banks to make deposits in the central bank and earn returns. On the other hand, this allows the absorption of excessive funds from the market and the reduction of the money available for the public to borrow.
What is a bank rate?
The Bank rate is the interest rate charged to commercial banks and other financial institutions for short-term loans they take from the Federal Reserve Bank. Hence, it is also called Discount Rate.
For bank rates, there is no repurchasing agreement signed, no securities sold or collateral involved. Aiming for profits, banks borrow funds from the central bank and lend the money to their customers at a higher interest rate. Thus, the bank rate is an important tool to control liquidity.
Bank Rate vs. Overnight Rate
It is common for investors to be confused between Bank Rate and Overnight Rate. The bank rate refers to the interest rate charged by the central bank on loans granted to commercial banks, while the overnight rate is the interest charged on funds borrowed among commercial banks themselves. When Bank Rate is increased by RBI, bank’s borrowing costs increase which in return, reduces the supply of money in the market.
What is the difference between the Repo Rate and the Bank Rate?
Although Repo Rate and Bank Rate have many features in common; ie both are fixed by the central bank RBI and used to monitor and control the cash flow in the market, they have some prominent differences as well. First thing to consider is that the Bank Rate is usually higher than Repo Rate.
The main key differences between the two rates are listed as follows:
|Repo Rate||Bank Rate|
|charged for repurchasing the securities sold by the commercial banks to the central bank||charged against loans offered by the central bank to commercial banks|
|securities, bonds, agreements and collateral is involved when Repo Rate is charged||No collateral is involved while charging Bank Rate|
|Increase in Repo Rate is usually handled by the banks and doesn’t affect customers directly.||Increase in Bank Rate directly affects the lending rates offered to the customer, restricting people to avail loans and damages the overall economic growth|
|Focuses on short term financial needs||Caters to long term financial requirements of commercial banks|
|Overnight funds with 1-day tenure||Tenure can be up to 28 days|
After the demonstration about the meaning and features of the Repo Rate and the Bank Rate, we can now easily distinguish between the two rates. What should be clear is that both are used by RBI. In a nutshell, the central banks use these two rates to introduce and monitor the liquidity rate, inflation rate and money supply in the market.
Eventually, what can be understood is that banks resort to borrowing only when there is an imminent shortage of funds. Based on the comparison above, we can notice that both the bank rate and repo rate negatively impact the cash flow when RBI increases their rates.
However, both rates contribute to controlling inflation when it is rising. Therefore, the RBI applies both these rates to keep the economic activities going in a balanced way, thus, keeping the rising prices and declining purchasing power of the people within limits.