The specific interest rate that determines bank lending rates and the cost of credit for borrowers is known as Key Rate or Repo Rate. The two key interest rates in India are the Repo rate and Bank Rate. These are rates that are set, either directly or indirectly, by the Reserve of Bank of India (RBI), these influence lending and the supply of money and credit in the economy.
Understanding Key Rates
A bank or other institution uses the key rate to determine the interest rate on debt. In India, there are two key rates: Repo rate and Bank Rate. How Does a Key Rate Work? To understand key rates, it is important to understand that banks derive income from making loans. When lending generates profit for banks, they are motivated to lend as much of their deposits as possible. This is a problem when a large number of depositors suddenly want to withdraw their money. To prevent the panic that would naturally occur in this situation, RBI has made provisions for legal reserve requirements which requires banks to keep a certain percentage of their deposits in cash and deposit minimum percentage of banks money with the central bank
Uses Of Key Rates
Monetary Policy
Another important aspect of the key rate is that it serves as the primary tool used by the central bank to carry out monetary policy. The key rate directly influences other interest rates used by consumers, such as credit card rates, personal loans, mortgage loans, and more. Interest rates influence the economy through incentives for borrowing and saving. If interest rates are high, people have an incentive to save money. Conversely, if interest rates are low, people have an incentive to borrow and spend money. Because of this relationship, interest rates are used in monetary policy to shape the macro economy.
Reserve Requirements
Because the key rate is the target rate of borrowing between financial institutions, it is also a significant component used in meeting the reserve requirement. The reserve requirement is a specified percentage of cash that financial institutions must keep on deck to meet liquidity needs, such as customer requests to withdraw funds. The reserve requirement is in place to mitigate insolvency. The key rate is used by financial institutions to borrow cash if they dip below the reserve requirement.
Special Considerations
Open Market Operations
One of the chief tools used by the Government to implement monetary policy is Key rates. When the RBI wants to expand the money supply in the economy, it will typically buy bonds on the open market with newly created money using the funds to increase the money supply in the economy. When the Central Bank is in a contractionary phase, it will sell the government bonds in the open market to decrease the money supply which does helps in controlling inflation. Sale of securities by central bank reduces the reserves of commercial banks it adversely affects the bank’s ability to create credit therefore decrease the money supply in the economy. Whereas, purchase of securities by central bank increases the reserves and raises the bank’s ability to give credit.
Why Does A Key Rate Matter?
An increase in the Repo rate or Bank rate discourages banks from borrowing to meet reserve requirements, causing them to build up reserves (and thus lend out less money). A reduction in the Repo rate or Bank rate has the opposite effect: it encourages banks to borrow to meet reserve requirements, which makes more money available for lending.
Accordingly, the Central Bank can trigger a change in the Repo rate to control credit in the economy, That is also a major function central bank to control Money Supply and Credit.
The Repurchase Rate
When a bank is unable to meet the reserve requirement, it can borrow those funds from another bank or directly from the RBI. The rate at which this short term unsecured loan is available is known as Repo rate.
The Reverse repo Rate
The interest rate banks charge each other on loans used to meet reserve requirements the reverse repo Rate. It is often confused with the Repo Rate. When a bank is unable to meet the reserve requirement, it can get a reverse repo loan. These loans are usually made through brokers who specialize in such transactions, or they are made directly between the banks themselves.
What Is Key Rate Duration?
Key rate duration is the change in maturity value of a debt security in respect to the 1% or 100 bps change in its yield.
