Introduction
Both the Bank Rate and the Repo Rate are monitored by the Reserve Bank of India (RBI). Both are rates of interest (ROI) on which the RBI offers commercial banks/financial institutions loans. The difference between the bank rate and the repo rate is marked by the terms and circumstances under which RBI loans the money. When banks provide collateral, the RBI loans money at a repo rate. It might be in the form of stocks, bonds, or agreements. For example, at the bank rate, there is no security. The merits of both instruments are determined by the objective for which RBI employs them.
Bank Rate vs. Repo Rate
Simply explained, the repo rate is the rate at which the RBI loans to commercial banks by purchasing securities, whereas the bank rate is the rate at which commercial banks may borrow money from the RBI without putting up any collateral.
Difference between Bank Rate and Repo Rate in Tabular Form
| Parameter | Bank Rate | Repo Rate |
| Charged for | Charged against the loans taken by commercial banks from the central bank | Involved with repurchasing securities sold to the central bank by commercial banks. |
| Collateral | No collateral is included | Securities, bonds, agreements, and collateral is included |
| Comparison | Higher than the repo rate | Lower than the repo rate |
| Financial needs | Helps with the long-term financial needs of the commercial bank. | Helps with the short term financial needs of the commercial bank |
| Tenure | Up to 28 days | Could be a 1-day tenure |
| Impact on interest rates | Has a direct impact on bank loan interest rates. | Does not have a direct impact on bank loan interest rates |
| Repurchasing | Repurchasing agreement is not allowed, money is directly lent at a fixed rate | Selling assets to the central bank under a repurchase arrangement |
What is the Bank Rate?
The country’s central bank often grants loans to other domestic banks. The interest rate at which the central bank offers these loans is known as the bank rate. These loans are usually short-term loans. It is also known as the discount rate, in America.
The bank rate is established by the Board of Governors of the Federal Reserve System of the United States.
Change in the bank rate affects significantly the economy. Hence, if FED wants to boost or ease up the economy, they increase or decrease the bank rate.
The Reserve Bank of India sets the bank rate, which is the standard rate at which it is willing to buy or re-discount bills of exchange or other commercial bills that are eligible for purchase under the RBI Act 1934. (sec. 49). According to the RBI's Monetary Policy, the current bank rate is 4.25 %.
Types of Bank Rates:
There are three types of bank rates-
- Primary credit
- Secondary credit
- Seasonal credit
1. Primary credit:
Primary credit is suitable for commercial banks with strong financial backup. There are no rules whatsoever for how the loan amount should be used by the bank.
Repayment methods and the amount needed is the only requirement to take a primary credit.
Since the financial background of these banks is well established, the interest rate is much lower as compared to secondary credit.
2. Secondary credit:
Secondary credit is suitable for those banks that do not have the perfect financial background. Banks that are not eligible for primary credit can opt for secondary credit.
Because of a lack of better financial background, interest rates are quite higher than primary credit. There are restrictions on how and where the loan amount should be used.
These loans are for a shorter period, generally overnight.
More documentation is needed to take this credit such as the purpose for the loan, as well as an assessment of the bank's financial situation, and so on.
3. Seasonal credit:
Seasonal credit is given to banks that have seasonal fluctuations in liquidity and reserves, as the name indicates. These banks must get a seasonal qualification from their respective Reserve Bank and be able to demonstrate that these fluctuations occur regularly. Seasonal rates are based on market rates, unlike main and secondary credit rates.
Decrease In the bank rate
The Federal Bank a.k.a. Fed is a bank of banks. It sets rules and regulations for banks. When it experiences a downfall in the economy, it decreases the discount rate.
- A lower bank rate makes borrowing money more affordable for commercial banks, resulting in more accessible credit and lending activity across the economy.
- Slow economy means a decrease in the country’s financial growth. If the money supply is increased, growth of the economy can be encouraged and this will in return solve the problem of slow economic movement.
- This usually motivates banks to cut their lending rates, resulting in more borrowing.
- Banks have more money accessible when reserve limits are likewise eased, allowing them to expand their lending activity.
- Toto makes money during periods when loan creation is limited, banks raise account fees, and market fee-based services.
Increase in the bank rate
- When the RBI raises the Bank Rate, the cost of borrowing for banks rises, reducing the amount of money available in the market.
- Interest rates will rise as the need for money or credit increases, while they will fall if the demand for credit decreases.
Overnight rates
Bank rates are most commonly confused with overnight rates. To solve this misconception let us see what overnight rates are and how they work.
The overnight market is the part of the money market where the shortest-term loans are traded. Banks and other financial organizations are the primary users of the overnight market. Lenders agree to lend money to borrowers exclusively "overnight," meaning the borrower must repay the money plus interest the next day at the beginning of the business.
Because the loan is granted for the shortest period, the rates for these loans are the lowest.
Since these loans are dependent upon the money market, these rates are influenced by the market conditions that day.
How are the bank rates calculated?
The bank rate is set by the Reserve Bank of India. The interest rate is set by a country's national financial authority, which is in charge of the economy's money supply as well as the banking industry. This is normally done every three months to keep inflation under control and regulate the country's currency rates.
When a bank rate changes, it sets off a cascade of events that affect every aspect of a country's economy. Interest rate swings, for example, cause price movements in the stock market. Customers are affected by changes in bank rates since it impacts the rates at which they can borrow money.
What is the Repo Rate?
Repo, RP, or sale and repurchase agreement are all different ways to define a repurchase agreement. It is a type of short-term loan in government securities. to understand this in simple words, the dealer sells his underlying securities to the investor and purchases them back the following day as per the agreement between the two. The dealer buys the agreement at a bit higher rates.
The repo rate is the rate at which commercial banks borrow money by selling their assets to our country's central bank, the Reserve Bank of India (RBI), to sustain liquidity pursuant to mandatory measures or in the case of a cash shortfall. It is one of the RBI's primary strategies for managing inflation.
The current repo rate is 4% in 2021, while the current reverse repo rate is 3.35 percent in India.
Reverse repo rate
The reverse repo rate is the rate at which a country's central bank that is the Reserve Bank of India, in India borrows money from domestic commercial banks. It is a financial instrument that may be used to regulate a country's money supply.
Difference between repo rate and reverse repo rate
These rates are set by RBI and they both influence the money supply in the market. The following are the main distinctions between the two:
- At repo rate RBI lends money to other commercial banks and at reverse repo rate, as the name suggests RBI borrows the money from other banks.
- Repo rate is always higher than the reverse repo rate.
- Repo rate comprises the selling of securities to repurchase them in the future, while reverse repo rate includes money being transferred from one account to the other.
- Reverse repo rate is used to manipulate cash flow, on the other hand, the repo rate is used to control fund deficiency.
Increase and decrease in the repo rate and its impact on the economy
Increase in the repo rate-
During periods of high inflation, the RBI takes concerted efforts to reduce the flow of money in the economy. Increasing the repo rate is one approach to do this. Borrowing becomes prohibitively expensive for businesses and industries, slowing investment and money supply in the market. As a result, it has a negative impact on economic growth, which helps to keep inflation under control.
Decrease in the repo rate-
When the RBI has to introduce funds into the system, the repo rate is lowered. As a result, borrowing money for various investment goals is less expensive for enterprises and industries. It also enhances the economy's total money supply. This, in turn, enhances the economy's growth rate.
The subprime mortgage crisis in the USA.
The subprime mortgage crisis in the United States was a worldwide financial crisis that occurred between 2007 and 2010 and contributed to the global financial crisis of 2007–2008. Banking institutions, governments, credit bureaus, subsidized housing policies, and consumers, among others, were all blamed at varying levels for the crisis, according to analysts.
A run on the repo market in 2007–2008, when liquidity for investment banks was either unavailable or at extremely high-interest rates, was a significant aspect of the subprime mortgage crisis that contributed to the Economic Downturn.
Types of repo
- Due bill/hold in-custody repo / bilateral repo
- Tri-party repo
- Whole loan repo
- Equity repo
- Sell/buybacks and buy/sell backs
- Reverse repo
Due to bill/hold in-custody repo / bilateral repo
Investors and security providers trade money and assets directly without the need for a settling bank in the bilateral repo market.
Tri-party repo
A Tri-Party Repo is a form of repo contract in which a third party, called a Tri-Party Agent, works as an intermediary between the borrower and lender to provide services such as collateral selection, and payment and settlement, custody and administration throughout the life of the transaction.
Whole loan repo
A whole loan repo is a type of repo in which the transaction is secured by a credit or other type of liability (such as mortgage receivables) rather than a security.
Equity repo
Repos on equity instruments such as common (or ordinary) shares are known as equity repos. Because the tax laws for dividends are more complicated than those for coupons, certain difficulties may occur.
Sell/buybacks and buy/sell backs
The first is the purchase of a bond or other asset, followed by the selling of the same item from the same seller at a future date for settlement. From the perspective of the counterparty, a sell/buy-back is the same transaction.
Main Differences between Bank Rate and Repo Rate in Points
- The Bank Rate is used for central bank loans to commercial banks, whereas the Repo Rate is applied to the central bank's repurchase of securities sold by commercial banks.
- Both are interest rates at which the RBI lends money. The interest on loans and the principal amount for loans are paid at the bank rate. Banks pay the Reserve Bank of India to purchase back securities in exchange for loans at the repo rate.
- The repo rate requires collateral in the form of government assets or bond papers, whereas bank rate loans are unsecured. One of the most significant and fundamental differences between the two is this.
- Credits at the repo rate have a one-day term, but loans at the bank rate can last up to 28 days.
- Increases in Bank rates have a direct impact on the lending rates given to customers, limiting people's ability to get loans and harming general economic growth, but increases in Repo rates are normally handled by banks and have no direct impact on customers.
- In bank rates, repurchasing of the agreement is not possible and a direct loan is granted to the bank. On the other hand, selling assets to the central bank under a repurchase arrangement at a repo rate is possible.
Conclusion
If contrasted to the Bank Rate, the Repo Rate is the better option. Bank Rate is thought to be a more abstract idea. Repo rate loans, on the other hand, are desirable since they are short-term and secured. When the RBI lowers either the bank rate or the repo rate, the economy accelerates. When the RBI raises its rates, both the bank rate and the repo rate harm cash flow. They do, however, halt inflation while it is on the rise. As a result, the RBI uses both of these methods to ensure that economic activity remains balanced. As a result, it keeps growing prices and people's falling purchasing power under control.
