The working of Repo rates
& what actually happens at the back-end..
Today, we’ll talk about what actually happens when banks borrow from RBI. This is probably the shortest article I’ve written, won’t take more than 3 minutes to read! 😁
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So recently, you must have read that RBI increased the Repo Rate by another 50 basis points. This was expected, and in fact, further rate hikes are anticipated as per economists.
Wait, first, what is Repo or Interest rate?
For folks who don’t know, Repo rate (or commonly known as Interest Rate) is the rate at which banks borrow money from RBI, and increasing this rate is a way to control inflation (I had written a post explaining how this is done, so if you want to know more, read it HERE in under 2 minutes. But do come back to this post haan, don’t miss it!).
But how does a bank borrow money from RBI? Is it a simple loan that is given to the bank by RBI, which the bank repays with interest?
Technically yes, but the way this is done is slightly complicated.
So Repo is short for Repurchase agreement. This means that when a bank needs money, it sells certain securities to RBI, and agrees to repurchase them at a later date, at a different price. So it’s not a straightforward lending and repayment transaction.
Now, first, what are these securities that the bank sells?
Well, there’s a list of eligible securities that the RBI has permitted, which includes corporate bonds, government securities, debentures etc (you can find the entire list here). Any of these securities (issued by the govt, a corporate or anyone else, but owned by the bank), can be sold to RBI and then repurchased.
Now, a lot of these securities will have an interest (technically known as coupon) that will be paid out to the holder of the security.
So when RBI buys these securities, RBI becomes the holder.
And this is where it gets interesting.
You see, RBI should get some interest from the bank because it is lending money. But since RBI is the holder of the security, it is anyway getting some money from the coupon (interest) which is paid out by the security issuer (govt, corporate etc). Remember that it is paid to the security holder, so RBI will get it, and not the bank.
So there’s a price adjustment which is done.
If the coupon offered by the security is equal to the Repo rate, that means that RBI is getting a coupon amount equal to the interest it wanted to charge the bank. So the price at which the bank will repurchase the securities will be the same as the selling price.
If the Repo rate is higher than the coupon rate, then although RBI gets some money via the coupon, a part of the interest that it wants to charge the bank will still need to be paid by the bank, so there will be a price adjustment, and the repurchase price that the bank will pay, will be higher than the selling price. This is where RBI purchased the securities for X, but is selling it for X+Y, earning Y in the process.
And conversely, if the Repo rate is lower than the coupon rate, the RBI has got more money via the coupon than what it wanted, so the bank will pay lesser money for repurchasing, than what RBI paid it, and repurchase price will therefore be lower.
And that’s how banks borrow money from RBI - via repurchase agreements, known as Repo transactions.
Well, today’s newsletter was short but is a very interesting concept, and I wanted you guys to know about it. Hope the explanation was easy to understand; as always, let me know via mail or by commenting if you liked it! 🙂
By the way, I’ve been thinking of writing other business articles too (non-finance). But I’d first want to know if you guys would be keen on reading those - they’d be about business models, innovations in startups and other interesting stuff, provided you guys want to read about them. Let me know your view HERE! 😁
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See you next week!