A REPO is the purchase of one loan against the sale of another. They involve the sale of securities against cash with a future buy back agreement. REPO and reverse REPO are operated by RBI in dated government securities and Treasury bills. These help banks to manage their liquidity as well as undertake switch to maximize their return. REPOs are a substitute for traditional interbank credit.
Repo (Repurchase) Rate
Repo rate is the rate at which banks borrow funds from the RBI. If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
Reverse Repo Rate
The reverse Repo rate is the rate at which RBI borrows money from the banks. The RBI uses this tool when it feels there is too much money floating in the banking system. If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI risk free instead of lending it out. Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.
In view of the limited role of the interest rate policy in India and the weak linkages as between the various segments in the market, it has become necessary for the RBI to resort to direct controls on banks’ lending and borrowing rates. Minimum lending rates of scheduled commercial banks were first fixed in 1960 and the maximum lending rates in 1964. Similarly, interest rates on deposits have been fixed by the Reserve Bank of India since September 1969. The control encompasses almost all categories of borrowers and different maturities of deposits.
The rationale of direct controls on interest rates may be briefly set out here.
- In view of the weak linkages between the Bank rate and/or refinance rate of the RBI with other money market rates, the effectiveness of monetary and credit policy can only be ensured by the direct fixation of various categories of interest rates.
- The banking structure of India is such that there is uneven competition amongst the banks, namely, as between the weaker and smaller banks and dominant bigger banks. It is, therefore, necessary that competition in matters of interest rates has to be regulated by the Reserve Bank.
- With the acceptance of social obligations by the Banking system following the nationalisation of banks in 1969, the multiplicity of lending rates has become necessary to encourage lending to priority sectors, neglected segments of the economy and backward classes of people. The geographical and sectorial credit gaps have to be filled in through price and non-price incentives.
- The developmental needs of the country have to be met at the lowest possible costs by the banking system through bank credit to government borrowings through bonds, treasury bills, etc. This has also necessitated the differential interest rate system in India.
