What it means
Banks need a steady supply of cash to settle payments and meet reserve requirements. Some days they have too little and other days too much, so the central bank offers a standing way to borrow or deposit at known rates.
This keeps short-term interest rates stable and prevents sudden shortages. The facility has two sides.
Under repo, a bank sells government securities to the central bank and agrees to buy them back the next day or a few days later at a slightly higher price, which is effectively a collateralised loan at the repo rate. Under reverse repo, the central bank sells securities to banks and takes in their surplus cash, paying the reverse repo rate.
The rates act as signals and as a corridor. The repo rate is usually the policy rate that the central bank changes to tighten or loosen monetary policy, while the reverse repo rate sits below it.
Because banks will not lend to each other at rates much above the repo rate or below the reverse repo rate, the corridor keeps the overnight money market in line. The Reserve Bank of India introduced the facility in 2000, and it has since been adjusted several times as new tools such as a standing deposit facility have been added.
Other central banks run similar operations under different names, such as standing lending facilities and deposit facilities. Anyone comparing countries should check how each central bank defines its tools before comparing the rates.
For companies, the effect is indirect but real. The rates set through this facility shape the cost of short-term bank borrowing, the returns on money market funds and the pricing of loans linked to benchmark rates, so changes in them flow through to budgets and borrowing decisions.
In practice
Real-world examples.
Example
A commercial bank faces a large outflow on tax payment day and finds itself short of cash. It borrows overnight from the central bank under repo and repays the next morning, avoiding a spike in market rates. The bank's treasury desk records the borrowing as a routine liquidity operation, not a sign of trouble.
Example
After a period of heavy deposits, another bank holds more cash than it can lend. It places the surplus with the central bank under reverse repo and earns the reverse repo rate until it finds better uses. The central bank gains from this because it removes excess cash that might otherwise push short-term rates down.
Example
A corporate treasurer notices that the central bank has raised its repo rate. She expects floating-rate loans to cost more within weeks and updates her interest cost forecast. She also asks her bank whether any of the company's facilities are linked directly to the repo rate.
Formula
Calculation
Interest on a repo borrowing = amount borrowed x repo rate x days / 365.
Suppose a bank borrows $73,000,000 overnight at a repo rate of 6.00%, an illustrative rate. Interest = 73,000,000 x 0.06 x 1 / 365 = 4,380,000 / 365 = $12,000. The bank repays 73,000,000 + 12,000 = $73,012,000 the next day, and gets its securities back.Case study
Seen in the real world.
Marlborough National Bank is an illustrative, fictional lender in a country whose central bank runs a liquidity adjustment facility. During a busy quarter-end, the bank's cash fell short of its needs after a large corporate withdrawal.
Instead of paying a high rate in the overnight market, the bank used repo to borrow $73,000,000 against government bonds at the central bank's repo rate. It repaid the next day and paid the interest on the loan, which was far less than the market was charging that afternoon.
In this illustrative case, the bank's treasurer later reviewed the incident and increased the stock of government securities it kept available as collateral. She also set a limit on how often it would rely on the facility, since constant use might suggest weaker liquidity management. The board approved both changes and asked for a quarterly report on usage.
Watch out
Common mistakes.
- Confusing repo with reverse repo, when one means banks borrow from the central bank and the other means the central bank absorbs surplus cash from banks.
- Thinking the facility is only for emergencies, when it is a routine tool used daily for fine-tuning liquidity and often involves large sums.
- Ignoring collateral, since banks must hold enough eligible securities before they can borrow.
Questions
People also ask.
Who uses the facility?
Commercial banks and certain other financial institutions that are eligible to deal with the central bank.
How does it affect ordinary businesses?
It sets the floor and ceiling for short-term rates, which feed into lending rates, deposit rates and the cost of short-term finance, so a change in the policy rate can alter loan repayments within weeks.
Is it the same everywhere?
No, the details differ by country, and many central banks use standing facilities and open market operations with different names.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related