MITS

Business School
FE
 Repo and Reverse Repo
• Reserve Bank of India formulates and administers monetary policies
• specifically for the purpose of controlling the supply of money in the
economy to stimulate various aspects of economic growth. 
• The primary objective of such monetary policies are promoting
economic development through price stability, regulation of the
volume of bank credits, improving efficiency of the financial system,
promoting investments and increasing diversification in financial
markets.
• In this context, repo rate and reverse repo rate are instruments of
RBI’s monetary policy that can help control the money supply in the
economy.
 What are Repo Rate and Reverse Repo Rate?

• Repo Rate: The term ‘Repo’ stands for ‘Repurchase agreement’. Repo is a form of
short-term, collateral-backed borrowing instrument and the interest rate charged
for such borrowings is termed as repo rate.

• In India, repo rate is the rate at which Reserve Bank of India lends money to
commercial banks in India if they face a scarcity of funds.

• Commercial banks sell government securities and bonds to Reserve Bank of India
with an agreement to repurchase the securities and bonds from Reserve Bank of
India on a future date at a pre-determined price including interest charges.

• Current Repo Rate as of February 2020 is 5.15%.

 Reverse Repo Rate: 

• Reverse repo as the name suggests is an opposite

contract to the Repo Rate.
• Reverse Repo rate is the rate at which the Reserve Bank
of India borrows funds from the commercial banks in the
country.
• In other words, it is the rate at which commercial banks
in India park their excess money with Reserve Bank of
India usually for a short-term.
• Current Reverse Repo Rate as of February 2020 is 4.90%.
 Importance of Repo Rate and Reverse Repo Rate

• Repo and reverse repo are the monetary measures used by the
Reserve Bank of India to deal with the deficiency of funds and liquidity
in the market.
• It is a vital money flow control mechanisms used by the central bank.
• Bank lending rates are impacted by repo rate and reverse repo rate. 
• Repo and reverse repo are the most effective and efficient tools used
by the Reserve Bank of India to achieve price stability and to boost
economic development.
• Repo and reverse repo agreements help banks manage their liquidity
requirements easily and with a high degree of safety.
 Significance of Repo Rate and Reverse Repo Rate 

• Liquidity Regulation: Under the liquidity framework designed by RBI, many

facilities are offered to commercial banks to meet their requirement of
immediate liquidity or deficiency of funds.
• The main motive of the liquidity framework is to avoid any liquidity crisis in
the Indian banking system through implementation of repo agreements.
• In the similar way, RBI has a framework for managing surplus funds/cash in
the banking system which ensures there is no excess liquidity in the
system.
• And this framework is referred to as reverse repo. Basically, repo
transactions inject liquidity into the Indian banking system.
• On the other hand, reverse repo absorbs liquidity from the Indian banking
system.
 Inflation Control: 
• Inflation Control: Reserve Bank of India holds a key
responsibility with respect to striking a balance between
inflation and economic growth by managing the repo rate
and/or reverse repo rate periodically.
• By changing the repo/reverse repo rate, the RBI can control
money flow i.e. liquidity in the economy – too much liquidity
usually leads to inflation which can adversely affect the
economy, while too little liquidity can lead to an economic
slowdown.
 Impact of Repo Rate and Reverse Repo Rate Increase by RBI

• Increase in Repo Rate: Increase in repo rate makes borrowing from the RBI more expensive for
commercial banks and this can lead to increase in rates applicable to loans.

• As the interest rates on various loans increases, fewer loans are applied for disbursed, which
restricts the money supply in the economy and may adversely affect the country’s economic
growth.

• Increase in Reverse Repo Rate: If there is excessive liquidity in the banking system, RBI may
decide to increase the reverse repo rate.

• When there is a hike in reverse repo rate, banks can earn higher interest on their excess funds
deposited with the Reserve Bank of India.

• This is a safer investment option for banks so overall flow of money into the markets will be
decreased as more of the bank’s surplus funds are deposited with RBI instead of being lent out.
 Impact of Repo Rate and Reverse Repo Rate cuts by RBI

• Repo Rate Cut Impact: Banking is the first sector to get affected by any change in monetary policies.
• A cut in repo rate can allow banks to borrow from the Reserve Bank of India at a cheaper rate and infuse
higher liquidity in the banking system.
• This can lead banks to reduce their lending rates for customer leading to cheaper loans in the long term.
• As bank loans get cheaper, consumers can borrow and spend more which boosts consumption and can
eventually lead to economic growth.
• However, this is depends on the decision by the bank whether to pass on the RBI repo rate cut benefits
to their customers through cheaper loan offers.
• Reverse Repo Rate Cut Impact: Whenever RBI decides to reduce the reverse repo rate, banks earn less
on their excess money deposited with the Reserve Bank of India.
• This leads the banks to invest more money in more lucrative avenues such as money markets which
increases the overall liquidity available in the economy.
• While this can also lead to lower interest rate on loans for the bank’s customers, the decision will
depend on multiple factors including the bank’s internal liquidity situation and the availability of other
potentially less risky and equally lucrative investment opportunities.
 Current Repo Rate and its Impact

• RBI keeps changing the repo rate and the reverse repo rate according to changing
macroeconomic factors.
• Whenever RBI modifies the rates, it impacts all sectors of the economy; albeit in different ways.
• Some segments gain as a result of the rate hike while others may suffer losses. RBI recently cut
down the repo rate by 25 basis points to 5.15% from 5.75%.
• In the same line, the reverse repo rate was also reduced to 4.9% from 5.5%.
• Changes in the repo rates can directly impact big-ticket loans such as home loans.
• The decrease in repo rates is to aim at bringing in growth and improving economic development
in the country.
• Consumers will borrow more from banks thus stabilizing the inflation.
• A decline in the repo rate can lead to the banks bringing down their lending rate.
• This can prove to be beneficial for retail loan borrowers.
• However, to bring down the loan EMIs, the lender has to reduce its base lending rate.
• As per the RBI guidelines, banks/financial institutions are required to transfer the benefit of
interest rate cuts to consumers as soon as possible.
• ELIGIBLE INSTRUMENTS

• Different instruments can be considered as collateral security for undertaking the ready forward deals and they include Government
dated securities, Treasury Bills, corporate bonds, money market securities and equity.

• TYPES OF REPOS
• 2.12. Broadly, there are four types of repos available in the international market when classified with regard to maturity of underlying
securities, pricing, term of repo etc. They comprise buy-sell back repo, classic repo bond borrowing and lending and tripartite repos.

• 2.13.Under a buy-sell repo transaction the lender actually takes possession of the collateral . Here a security is sold outright and
bought back simultaneously for settlement on a later date. In a buy-sell repo the ownership is passed on to the buyer and hence he
retains any coupon interest due on the bonds. The forward price of the bond is set in advance at a level which is different from the
spot clean price by actually adjusting the difference between repo interest and coupon earned on the security. The spot
buyer/borrower of securities in effect earns the yield on the underlying security plus or minus the difference between this and the
repo interest rate.

• 2.14. Classic repo is an initial sale of securities with a simultaneous agreement to repurchase them at a later date. In the case of this
type of repo the start and end prices of the securities are the same and a separate payment of "interest" is made. Classic repo makes it
explicit that the securities are only collateral for the loan of the cash . Here the coupon income will be accrued to the seller of the
security.
• 2.15. Under a hold in custody repo the counterparties enter into an agreement whereby the
securities sold are held in custody by the seller for the buyer until maturity of the repo thus
eliminating the settlement requirements.
• 2.16. In a bond lending/borrowing transaction, the customer lends bonds for an open ended
or fixed period in return for a fee. The fee charged would depend on the type of underlying
instrument, size and term of the loan and the credit rating of the counterparty. The
transaction would be taken care of by an agreement on securities lending and cash or other
securities of equal value could be provided as collateral in the transaction.
• 2.17 Under a Tripartite repo a common custodian /clearing agency arranges for custody,
clearing and settlement of repos transactions. They operate under a standard global master
purchase agreement and provides for DVP system, substitution of securities, automatic
marking to market, reporting and daily administration by single agency which takes care of
the risk on itself and automatic roll overs while does not insist on disclosing the identities by
counterparties.The system starts with signing of agreements by all parties and the
agreements include Global Master Repurchase and Tripartitle Repo Service Agreements. This
type of arrangement minimises credit risk and can be utilised when dealing with clients with
low credit rating.
• REPO PERIOD
• 2.18. Repo period could be overnight term, open or flexible. Overnight repos lasts only one day. If the period
is fixed and agreed in advance, it is a term repo where either party may call for the repo to be terminated at
any time although requiring one or two days' notice. Though there is no restriction on the maximum period
for which repos can be undertaken generally term repos are for an average period of one week. In an open
repo there is no such fixed maturity period and the interest rate would change from day to day depending on
the money market conditions. In such cases the lender agrees to provide money for an indefinite period and
the agreement can be terminated on any day. Under flexible repos the lender places funds, but they are
withdrawn by the borrower as per his requirements over an agreed period.
• RISKS
• 2.19. As far as risks are concerned although repos are collateralised transactions they are still exposed to
counterparty risk and the issuer risk associated with the collateral. As far as the counterparty risk is
concerned, the investor should be able to liquidate the securities received as collateral, thus largely offsetting
any loss. Against this the seller /lender of bonds will hold cash or other securities as protection against
nonreturn of the lent securities. In both the cases it is to be ensured that the realisable value equals or
exceeds the exposure. There is also the concentration risk resulting from illiquid issues which are used as
collateral in the transaction.
• 2.20. Again, even where global agreements are signed full transfer of ownership as per contractual
protections could be enforced only where a clean legal opinion is available in respect of jurisdiction
concerned. In otherwords, repos are also prone to legal risks if care is not taken.
 Components of a Repo transaction

• The components of a repo transaction between the RBI

and the bank are as follows:
• Banks provide eligible securities (RBI-recognized
securities that are above the Statutory Liquidity Ratio
 limit).
• RBI gives 1 day or overnight loan to the bank.
• RBI charges interest from the bank.
• Banks repay the loan after one day and repurchase the
security they gave as collateral.
 How does Repo Rate affect the economy?

• 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 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.
 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 the 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.

 Impact of Repo Rate

• Impact on the Banking System

• Increase in Repo Rate: Lending rates and deposits offered by banks are impacted by a rise or
fall of repo rate. 

• Banks may analyze their liquidity position and cost of funds before increasing the deposit rates
and lending rates.

• After analyzing the cost of funds and liquidity position, banks may begin to pass on their
interest rate burden to its end customer in the form of elevated lending rates.

• Home loans, business loans, and other loans get majorly affected due to rate change.

• Higher lending rates may lead to a slowdown of the lending business for the banking sector,
which will have an impact on their profitability.
 Reduction in Repo Rate: 

• Reduction in Repo Rate: 

• Banking is the first sector to get affected by any change in monetary policies.

• It’s a big relief to the bank when the RBI decides to reduce the repo rate.

• With the dip in repo rate, banks can borrow from RBI at a cheaper rate.

• With the accessibility of low-cost credit, banks may even reduce the lending rates
to their customers after analyzing the liquidity condition and the deposit inflows.

• Banks may offer credit to its end customer at a reduced rate. As bank loans get
cheaper, consumers can spend and borrow more while spending a lot less on
borrowing.
 Impact on the Common Man
• Increase in Repo rate: When RBI decides to hike the repo rate; it becomes costlier for
commercial banks to borrow short term funds from RBI.

• Increased repo rate discourages the bank from availing short-term loans and advances from
RBI.

• That means loan becomes costlier for a common man.

• This may automatically reduce consumer purchasing power.

• On the other hand, banks may begin to offer fixed deposits at an increased rate to attract more
inflow of funds.

• It helps the consumer to save more with the increased rate on bank deposits.
 Reduction in rate: 

• Reduction in rate: When RBI decides to reduce the repo rate, loans and
advances become cheaper for the commercial banks as they can avail
short-term credit from RBI at the reduced rate.

• General consumers have more investment options.

• The rate cut may push banks to reduce their home and personal loan
 rates.

• Reduction in prime lending rate encourages more borrowers by making

credit accessible at lower rates to the common man.
 Impact on the Economy
• Increase in Rate: When RBI hikes repo rates, it becomes costlier for banks to borrow.
• In other words, banks will have to pay more interest on their short-term borrowings from the RBI.

• Costlier credit option for banks prompts them to hike the lending rate which they offer to their
end customers.

• Expensive bank loans discourage the borrower from availing credit. This reduces the money
supply in the market and thereby stabilizes the liquidity in the system.

• Consumption, Expansion, and production also take a downfall with the lesser money supply.

• Hence, the RBI revises the repo rate regularly to keep the inflation rate under control and also to
strike a balance between both economic growth and rising inflation.

• Here are some of the vital impacts of the increase in repo rate on the economy.
 Reduction in Rate: 
• Reduction in Rate: When RBI decides to cut the repo rate, the short-term loans for
commercial banks become cheaper.
• This prompts them to offer consumer loans at a relatively cheaper rate.
• Many times, the base lending rate gets reduced with the reduction in the repo rate.
• The base lending rate is the rate below which banks cannot lend to their
customers.
• Reduced base rate increases the consumption as people will have more money at
their disposal.
• Increased consumption positively impacts the country’s Gross Domestic Product
(GDP) growth.
• Cheaper availability of credit encourages businesses to grow and expand. Prices of
products get lower with the availability of low-cost capital.
• ACCOUNTING
• 2.21. Generally, norms are laid down for accounting of repos and valuation of
collateral are concerned. While there are standard accounting norms, generally the
securities used as collateral in repo transactions are valued at current market price
plus accrued interest (on coupon bearing securities ) calculated to the maturity date of
the agreement less "margin" or "haircut". The hair cut is to take care of market risk
and it protects either the borrower or lender depending upon how the transaction is
priced. The size of the haircut will depend on the repo period, riskiness of the
securities involved and the coupon rate of the underlying securities.
• 2.22. Since fluctuations in market prices of securities would be a concern for both the
lender as well as the borrower it is a common practice to reflect the changes in market
price by resorting to marking to market. Thus, if the market value of the repo
securities decline beyond a point the borrower may be asked to provide additional
collateral to cover the loan. On the other hand, if the market value of collateral rises
substantially, the lender may be required to return the excess collateral to the
borrower.
• There are a variety of advantages repos can provide to the financial market in general, and debt market, in particular as under:
• An active repo market would lead to an increase in turnover in the money market, thereby improving liquidity and depth of the
market;
• Repos would increase the volumes in the debt market as it is a tool for funding transactions. It enables dealers to deal in higher
volumes. Thus, repos provide an inexpensive and most efficient way of improving liquidity in the secondary markets for
underlying instruments. Debt market also gets a boost as repos help traders to take a position and go short or long on security.
For instance, in a bullish scenario one can acquire securities and in a bearish environment dispose them of thus managing cash
flows taking advantage of flexibility of repos.
• For institutions and corporate entities repose provide a source of inexpensive finance and offers investment opportunities of
borrowed money at market rates thus earning a good spread;
• Tripartite repos will offer opportunities for suitable financial institutions to intermediate between the lender and the borrower.
• A large number of repo transactions for varying tenors will effectively result in a term interest rate structure, especially in the
interbank market. It is well known that absence of term money market is one of the major hindrances to the growth of debt
markets and the development of hedging instruments.
• Central banks can use repo as an integral part of their open market operations with the objective of injecting/withdrawing
liquidity into and from the market and also to reduce volatility in short term in particular in call money rates. Bank reserves and
call rates are used in such instances as the operating instruments with a view to ultimately easing /tightening the monetary
conditions.
THANK YOU