This is a type of collateral lending by RBI. Here, banks sells securities (gov. securities) to RBI with a repurchase agreement (meaning banks will buy back those securities at future date with extra interest). The rate charged by RBI is known as Repo rate.
It comes under Liquidity Adjustment Facility (LAF) of RBI monetary policy (i.e., a way to adjust market liquidity, along with reverse repo).
Banks borrow money by repo to meet their daily mismatches. Repo auctions are conducted by RBI on a daily basis, except Saturdays. Here, minimum bid size is of Rs. 5 crore and multiple. All commercial banks (except RRBs) can borrow through repo facility. Repo borrowings have a tenure of 1 day to 90 days.
How does Repo Rate work?
When you borrow money from the bank, they charge an interest on the principal. Basically, it is cost of credit. Similarly, banks too can borrow money from RBI during cash crunch on which they must pay pay interest to the Central Bank. This interest rate is repo rate.
Technically, Repo stands for ‘Repurchasing Option’. It is a contract in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans. An agreement to buy them back at a predetermined price will also be in place. So, this interest rate is levied on these kinds of repo transactions as well.
What are the components of a Repo transaction?
The components of a repo transaction between the RBI and the bank are as follows:
a. Banks provide eligible securities (RBI-recognized securities that are above the Statutory Liquidity Ratio limit).
b. RBI gives 1 day or overnight loan to the bank.
c. RBI charges an interest (repo rate) from the bank.
d. Banks repay the loan after one day and repurchase the security they gave as collateral.
How does Repo Rate affect the economy?
Repo rate is a powerful arm of the Indian monetary policy that can regulate country’s money supply, inflation levels and liquidity. Additionally, the levels of repo have a direct relationship with the cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks and vice-versa.
a. When inflation rises
During high levels of inflation, RBI makes strong attempts to reduce the money supply in the economy. One way to do this is to increase the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the economy. As a result, it negatively impacts the growth of the economy. This also helps bring down inflation.
b. When RBI wants to flow cash into the system
On the other hand, when the RBI needs to pump funds into the system, it lowers repo rate. Consequentially, businesses and industries find it cheaper to borrow money for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
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