Repo rate and Reverse repo rate - A conversation between dad and son

Son: I have heard today in news that RBI Governor has reduced Repo Rate by 40 basis points, and I am so confused. What does that mean? I want to understand this. Does this mean my schools will not open for another month? Please tell me....

Dad: (With a gentle smile and a hug), To understand this you first need to know, what is Bank and How does a bank function?

Son: I know, I have a piggy bank, I save my daily pocket money there.

Dad: No Son, it is not entirely like your piggy bank but somewhat like that only. The only difference is after you deposit money in your piggy bank, your piggy bank does not give that money to someone else. But, in the real world, A bank accepts your money as deposits and lends it to someone else who needs it. In the middle of it, Banks earn interest income.

Son: Bank takes money from us and gives loans to earn interest. Wow!

Dad: Correct, but there is more to it. Let me explain this. A bank needs money. Bank can get money from you and me and from RBI.

Son: RBI?

Dad: RBI - Reserve Bank of India, just like The Rock in WWE, RBI is at the top of all banks. But the bank also needs to pay certain interest to us and to RBI.

Son: Ok.

Dad: Let us try to understand first – what happens when we deposit, say, Rs. 500 with a bank.

Son: I know that. Bank gives that Rs. 500 to someone who needs it. You just told me!

Dad: Yes, but remember, though the bank can earn interest by giving it to others, it is also very risky. There are many cases of loan defaults which means many people who take loans may not be able to pay on time. This way banks takes some risk also which must be protected.

Son: How?

Dad: Ok, RBI has made it mandatory that upon receiving, say, Rs. 500, banks first must deposit Rs. 100 with RBI. RBI keeps this Rs. 100 in its current a/c and do not give any interest on this money. This is known as Cash Reserve Ratio or CRR.

Son: Hmmm, then?

Dad: RBI has also made it mandatory that upon receiving, say, Rs. 500, banks need to compulsorily buy central and state govt securities of some amount. Banks earn some interest income here. This is known as Statutory Liquidity Ratio (SLR).

Son: Ok, so you mean to say that upon receiving Rs. 500, banks can spend only what is left after CRR and SLR at its own will.

Dad: Correct, my child. You got it.

Son: But you were saying that banks can also borrow from RBI. What interest banks pay to RBI?

Dad: Good Question! Today, 22nd May 2020 banks were already paying some interest to RBI when it borrowed money from RBI. Now this rate has been reduced by 40 basis points to 4%. So, banks now need to pay interest to RBI, if it borrows from RBI, at the rate of 4%. This is known as Repo Rate.

Son: Can fixed deposit rate be affected by a reduction of Repo Rate?

Dad: Of course. If banks get money from RBI @4%, why will banks pay higher interest to you and me? Interest rates on FD will go down.

Son: But as now banks are getting money at a cheaper rate, then they should reduce the loan interest rate as well which it will give it to other.

Dad: Correct. They should. If companies whether small or large/ individuals get a loan at a cheaper rate, they will likely expand their businesses. That will create more jobs, more income and boost the economy.

Son: How is inflation linked to this?

Dad: Another good question! Obviously when interest on a loan becomes less, people will borrow more. That means people will have more money to spend. This will increase the demand for goods, and if the supply does not increase to match this demand, then prices will increase.

Son: So, there is a chance, that inflation may rise also?

Dad: Well, there is. Yes, my child! But inflation depends on many other factors as well. So, inflation may increase or may not.

Son: One last question. Like we deposit our money with banks, can banks also deposit their money with someone?

Dad: They cannot deposit their money with someone except the one and only RBI and earn interest too. Today, 22nd May 2020, RBI has reduced reverse repo rate to 3.35%. This interest rate is known as the Reverse Repo Rate.

Son: Great! Thank you, dad. My schools will open soon :)

(End of conversation)

Thank you for reading.

Yeeshu Sehgal

Chartered Accountant

[email protected]