Do you Know what the situation would be if banks run out of money? We know that is a very difficult situation for any organization like bank and so difficult for the Bank job aspirants to answer. So, let we ask you have you ever been told that a Bank has no funds with it to pay money to it’s clients? We are 100% sure you have never come across such a situation.
But it is noteworthy that banking is basically a business – a business
where:-
i. banks take money from people; and
ii. then give it to people as loan who seek it.
So we want to analyse what do a Bank do when shortage of money is felt in the banks?
The answer is simple & quite straightforward – Banks take help from it’s central bank like Indian banks take help from Reserve Bank of India (RBI).
Repo Rate
The Central Bank of any country uses the mechanism of “Repo rate” to revive the banks from the situation of financial deficit or bankruptcy. Repo rate is defined as the rate of interest at which the central bank of a country lends money to the banks (of commercial nature) for short term purposes in case of shortage of funds. It is significant to understand that Repo rate defines the rate of interest for one day maturity period which is famously termed as the key short term lending rate.
The Central Bank is a supreme financial institution in a country that is solely responsible for money supply in an economy and thus responsible for regulating interest rates. Central Bank as a governing body for all commercial banks in country, is meant for supervising the commercial banks’ functioning.
The commercial banks are the banks that deal with the money of the general public. They accept deposits from the general public and extend loans. They provide various banking services such as fixed deposits, cheques etc to businesses, institutions and some individuals. They are accountable to the central banks for their functioning.
Let us consider a bank named XYZ of our country where you supposedly have kept Rs. 1 Crore. Now you urgently require money. Suppose the bank has given a large number of loans as a result of which the Bank doesn?t have enough funds to pay you at present. In such a scenario, the XYZ which is a commercial bank will ask Reserve Bank of Bank (the Central Bank of India) so that it can fulfill our request.
Definition : The Central bank (say RBI in our case) will provide financial aid to the commercial bank (say XYZ in our case) fixed at certain rate of interest which is termed as ?Repo Rate?.
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Reverse Repo Rate
Now the question is What happens if the commercial banks (say XYZ in our case) deposit/keep their money with the central bank?
Obviously, the banks will receive/get interest on the money which they have kept with the central bank.
Definition : The interest rate received by commercial banks for the amount of money thay have kept with the central bank is termed as the reverse Repo Rate.
Note :Reverse Repo Rate is always lower than the Repo Rate.
Mechanism for controlling inflation through Repo rate?
Inflation is a situation when there is a sudden rise in prices of commodities in a country. As a result, the RBI has to increase the repo rate so as to reduce the money supply in the commodity.
“The banks has to induce in not to borrow money from the RBI in case of increased repo rate and due to which the supply of money in the economy will definitely reduce. And it is certain that as a result of reduced money supply, people will spend less money due to which there will be decrease in the demand of commodity. The prices of the commodities will definitely fall due to decreased demand for commodities, which at last will control inflation.”
Conclusion : By lowering repo rate and increasing the reverse repo rate, inflation can easily be controlled. Furthermore, they also controls the interest rate of commercial banks in loans, mortgages, savings and so on.
Current Rate of Interests |
|
|
Repo Rate |
7.25% |
| Reverse Repo Rate |
6.25% |
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