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Wednesday, October 3, 2012

What are Policy Rates?

Repo Rate and Reverse Repo Rate are key policy rates.

Repo Rate: Repo Rate is the annualized interest rate at which central bank lends to other commercial banks.
Reserve Bank of India (RBI) is the central bank of India. This should not be confused with the CBI (Central Bank of India) - which is just a commercial bank and not a central bank. Central bank acts as banker’s bank.
When commercial banks need funds they have an option to borrow from the central bank at the Repo Rate.
One thing to note is -this lending is done against collaterals. This means commercial banks have to deposit government dated securities, corporate bonds, money market securities, treasury bills or equity (shares) as collateral (as security).

In the USA, commercial banks borrow from the Federal Reserve (The name of USA’s central bank) at Federal Discount Rate (similar to repo rate of India).

Central banks use repo rate to control the supply of money in the system. Repo rate influences overall interest rates in a country and the consequent inflation.
To lower the supply of money in the financial system, Central banks hike the repo rate as it makes borrowing expensive  for commercial banks and as a result banks keep their lending rates high that discourages businesses and individuals to borrow and thus money supply in the system is constrained.
To curb rising inflation central banks often raise the Repo Rate. Higher Repo rate results in higher short term lending rates while lower Repo Rate translates into lower short term lending rates.

Reverse Repo Rate: Banks park excess money with the central bank and  central bank pays interest on it. This annualized rate of interest is called Reverse Repo Rate.
In Indian context, Reverse Repo Rate is the rate at which RBI borrows money from commercial banks of India.Reverse Repo Rate is also termed as a mirror image of the Repo Rate.

One basis point is .01 %. This means 100 basis point is 1 %.
Central banks use Reverse Repo Rate to absorb the liquidity from the financial system.
When banks park money with the RBI, they get collaterals (government dated securities, money market securities, treasury bills etc) in return.
Earlier RBI would  Reverse Repo Rate to suck the excess liquidity from the system (and the vice versa.) but now Reverse Repo Rate should be necessarily 100 basis points lower than the Repo Rate.
This means Reverse Repo Rate now moves in tandem with the Repo Rate.

Present rates as on 3/10/2012
Repo Rate
Reverse Repo Rate


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