Answers to 5 questions about the Repo and Reverse Repo Rate

by Manshu on January 30, 2013

in Economy

The RBI released its Quarterly Review of Monetary Policy today, and brought down the Repo and Reverse Repo rate to 7.75% and 6.75% respectively effective immediately.

Monetary policy is what’s used by the central bank to influence the supply of money and rate of interest in the economy. RBI announces its monetary policy every quarter, and this quarter it has decided to bring down these two interest rates by 0.25%. If you are not familiar with what Repo and Reverse Repo is then Shiv did an excellent job of defining these and other important terms before the last announcement. (Read: A look at some key terms used in RBI announcements)

Mr. Ramamurthy posed some great questions about this in the Suggest a Topic section, and I thought I will do a quick post trying to answer these questions, but if you wanted to read about today’s policy announcement then Business Standard does a great job of summarizing them.

First, his comment:

Ramamurthy January 29, 2013 at 10:45 pm [edit]

The lending rate at which RBI lends to other Banks is now 7.75%.I have few questions here.
1. How does RBI ensure that the money lent will be repaid by the Banks?
2. Is there a limit up to which Banks can borrow money from RBI?
3. Is it only the last resort or can Banks borrow money as a matter of routine even when there is no genuine need?
4. Can the money borrowed be used by Banks for purposes other than lending to their customers?
5. Can the Banks borrow and use the money for say investment purposes?

Ramamurthy

Let’s look at these questions one by one.

How does RBI ensure that the money lent will be repaid by the banks?

Repos are collateralized agreements which means that the banks borrowing from RBI need to come up with a collateral if they want the money, and this collateral is Government of India securities in the Indian context. So, that’s a pretty good collateral in case the banks default which must be a really rare event and I certainly don’t know of an occasion where an Indian bank defaulted on their Repo agreement with RBI.

Is there a limit up to which Banks can borrow money from RBI?

Since you need collateral in order to get into these agreements, and this collateral is only GOI securities, it stands to reason that a bank can’t borrow more than the collateral it has.

Is it only the last resort or can banks borrow money as a matter of routine even when there is no genuine need?

Repo and Reverse Repo auctions are very common events which occur daily and they are conducted by the Liquidity Adjustment Facility (LAF) of RBI. These are routine auctions that helps bank manage their day to day liquidity through these instruments. To that extent, I’d say that banks borrow money using Repos as a matter of routine but there is a genuine need for this routine.

Can the money borrowed be used by banks for purposes other than lending to their customers?

At some level, all money borrowed by banks is for lending to customers, but in the case of Repos and Reverse Repos, their main objective is to manage the bank’s day to day liquidity as they are mainly instruments of overnight borrowing and lending.

Can the banks borrow and use the money for say investment purposes? 

Repos and Reverse Repos are loans of a very short term maturity and as such their primary purpose is a bank’s liquidity management and banks aren’t looking to invest this money by buying shares or bonds of Kingfisher Airlines for instance.

One other thought

The RBI sets the Repo Rate and then the Reverse Repo rate is always one percent lower than that. There are daily auctions under LAF (Liquidity Adjustment Facility) and RBI has a daily press release about the results of the auction. You can take a look at these at the RBI website to see how much was borrowed or lent, and usually the amount of borrowing far exceeds the amount of lending.

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{ 4 comments… read them below or add one }

Hari January 30, 2013 at 5:21 pm

Thanks Manshu, very informative

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Manshu January 31, 2013 at 6:53 am

Thanks Hari!

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Mohit Golchha January 30, 2013 at 10:57 pm

thanks manshu..very nice article..came to know lot about RBI..btw,I have some qns..
what is “bank liquidity” and what is maturity..??

Reply

Manshu January 31, 2013 at 6:53 am

Bank liquidity simply refers to the bank cash balances every day in this context, they are mandated by law to keep certain minimums. And maturity is when the debt has to be repaid, so for example, a 10 year loan has a 10 year maturity.

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