Before we delve into the details, first, let’s understand what a bank is? A bank is a financial institution where a person can deposit or borrow money. Then the institution invests that money to build up its capital and pay interest to the person who invests his money with it.
What is a Bank Rate?
Having understood what a bank is, let us try to figure out what the meaning of Bank Rate is? In general, the rate at which a central bank lends money to other commercial banks, whether private or government, without any security or collateral in return of money lent is known as bank rate. In India, the banks are run by the nodal or central bank as instituted by the government like the Reserve bank of India (RBI). The function of the central bank or the Reserve Bank of India is to lend money to these commercial banks, whether government or private. These domestic banks pay interest to the Reserve bank of India in lieu of the money received from the Reserve bank. In simple language, the rate of interest at which the RBI offers loan or money advance to the other commercial banks or financial institutions, or we can say this interest paid by the commercial banks to the central bank or the RBI is what is known as bank rate in India and is also called as the discount rate. The increase or decrease in bank rate directly impacts the borrower who takes money on loan from the bank. If the central bank increases the interest on which it lends to the commercial banks, these commercial banks, to break even and make a profit, would charge their customers a higher bank rate. The loans inevitably would become costlier, and if you go for a loan from the bank, you will get a loan at a higher rate of interest. It discourages people from availing loans from the bank for making purchases and restricting their growth, thereby slowing down the economy of the country. On the contrary, if the bank rate reduces, you will get a loan at a lower rate of interest. It is, therefore, generally advised to go for a floating rate of interest rather than a fixed bank rate when taking a bank loan. Now, it is important to understand what is repo rate before we start comparing the bank rate and repo rate. Also Read: What Are The Different Types Of Banking Transactions?
What is a Repo Rate?
When an individual needs money, he/she approaches a bank or a financial institution similarly, when any domestic, commercial bank falls short of funds, it approaches the central bank to maintain its liquidity. It borrows money for a limited short time period from the central bank, against a security deposit, which it can repurchase at a mutually agreed date in the future at the predetermined price. The rate of interest which this central bank charges in lieu of the money lent to these domestic banks, when they come to repay the borrowed money and get back their security deposit, is known as repo rate. Repo rate is also known as the Repurchase rate. Technically speaking, repo stands for ‘Repurchasing Option’ or a ‘Repurchase Agreement‘ and is an agreement in which banks provide eligible securities to the RBI while availing overnight loans and enter an agreement to repurchase them at a predetermined price. The securities could be in the form of gold, bank bonds, etc. Thus, the bank gets the cash, and the central bank the security. The more the repo rate, the loans become costlier for customers. An increased repo rate would imply discouraging other commercial banks from borrowing money. It helps the central bank to maintain its funds and thereby control its liquidity. In mathematical terms, let us try to understand repo rate this way that if the Repo rate is 5% then on a loan amount of Rs.10,000 borrowed by a commercial bank from a centralized bank like RBI, the rate of interest paid by this commercial bank to the RBI would be Rs. 500. So, the bank rate can be defined as the rate of interest charged for loans which are made by a central bank to a commercial bank whereas the repo rate can be defined as the rate of interest charged for repurchasing the securities which are given by the commercial banks to the central bank. The basic function, however, of both the rates is to control liquidity and inflation and money supply in the market. In a bank rate, no collateral is required, whereas, in repo rate securities, bonds, agreements, or collateral is required in lieu of the money lent by the central bank to any commercial bank. Any increase in the bank rate will directly impact the customers where-in the bank charges a higher rate of interest on the money lent by it to its customer (it increases the lending rate). This, in a way, discourages people from taking loans and holds them back till such time this rate of interest charged or the so-called lending rate is reduced. This directly affects the money flow in the market. This restriction in money flow, in turn, damages or slows down the overall growth of the economy. In contrast, the repo rate has no direct impact on the customer as it is a transaction between bank to bank, i.e., the central bank, which in India is the Reserve Bank of India. Also Read: Top 10 Non-Banking Financial Companies (NBFCs) in India
How Does Repo Rate Affect the Economy?
Repo rate is a powerful tool of the Indian Monetary Policy with which the country’s money supply, inflation levels, and liquidity can be regulated.
1. Rise in inflation
At the time of high levels of inflation, the central bank (RBI) tries to bring down the flow of money in the economy. One way, it can be done is by increasing the repo rate. This makes it more costly for the companies to borrow, which, on the other hand, slows down investment and money supply in the market. As a consequence, it negatively impacts the growth of the economy, which helps in controlling inflation.
2. Increasing Liquidity
RBI lowers the repo rate when it needs to pump funds into the system. As a result, businesses and industries get loans at a lower rate for different investment purposes. It ultimately increases the overall supply of money in the economy, boosting the growth rate of the economy.
The difference between bank rate and repo rate:
The difference between the bank rate and the repo rate is that bank rate caters to long term monetary requirements of the commercial banks and is applicable to long term funding over a longer period of time whereas the repo rate is used for short term money requirement of the commercial banks and is therefore applicable to short term funding over a short time period which could be as short as one day or overnight funding to a limited number of weeks. Reduction in repo rates or bank rates could imply a reduction in the equated monthly installments or EMI’s of the borrowers if these cuts in rates are passed on by the bank to their customers. This decision to reduce the lending rate depends a lot on the health of the banking system, which can only be deduced after a thorough evaluation of the operating costs, cost of the deposit, etc. of the commercial banks. Unfortunately, when there is an increase in the interest rates, the banks increase the tenure to keep the EMI constant. It is always better for a borrower to opt for higher EMI if there is no monetary or cash flow problem. It is any day a better option in terms of interest costs over the period of the loan. A borrower can also opt for transfer of balance to a better home loan rate after comparing the rates offered by other banks or financial institutions. The central bank or the RBI increases or decreases the repo rates depending on the inflation, thereby keeping a check on the economy, which in turn keeps a check on inflation. The increase in repo rates gives rise to inflation. It implies that taking a loan for start-up or growing industry or business by an industrialist or a businessman becomes costlier, thereby slowing down investment and reducing the flow of money supply in the market, impacting the market growth. On the contrary, when RBI brings down the repo rate, it reduces the lending rates, giving a resultant push to the ease in borrowing money for business purposes, and more money comes into the market resulting in a boost in the economy which in turn boosts growth and helps stabilize inflation. When there is excess money or liquidity in the market, the central bank, i.e., the RBI borrows money from the commercial banks. These commercial banks receive interest on the amount borrowed by the RBI or central bank and as such get benefitted from the central bank. It is known as Reverse repo rate. Reserve bank of India keeps on changing the repo rate depending on the changing market economics. This change tends to impact almost every segment of the market and all sectors of the economy. As a result of this change in the repo rates, the market experiences a mixed response where some market segments gain while some others suffer losses.
What is recent in Repo Rate and Bank Rate?
On 4 October 2019, The Reserve Bank of India slashed the repo rate by 25 Basis Points(bps), after which the repo rate stands at 5.15%, and the bank rates have also been slashed to 5.40%. Earlier, the central bank had reduced the repo rate in the monetary policy review that took place in August 2019, by 35 bps.
