Question

Discuss the benefits and costs of using “repos” and “reverse repos” as part of managing the liquidity risk of a bank.

Answer 1

A repurchase agreement, also known as a repo is a form of short-term borrowing by commercial banks from the central bank by keeping securities as collateral mainly the government securities. The banks sell the underlying security to banks and buy them back shortly afterwards, usually the following day, at a slightly higher price.

Reverse repo rate is the rate at which the central bank borrows funds from the commercial banks in the country. In other words, it is the rate at which commercial banks park their excess money with the central bank usually for a short-term.

Benefits

1. Lender of last resort at times of liquidity crunch

The commercial banks can enter a repurchase agreement with the central bank of the country and can avail credit in case they face a liquidity crunch. So central bank becomes the lender of last resort where commercial banks can pledge their securities with the central bank at the condition of buying these securities at a later date.

2. Safe place to park excess funds

In case commercial bank have excess funds, they can park it with the central bank at the reverse repo rate and the central bank of a country is the safest medium of deposit.

Costs of using repo and reverse repo rates

1. Reverse repo rate is lower than repo rate

The rate at which banks could borrow or the repo rate is always greater than the rate at which banks can park their funds with central bank. So banks will always be at a disadvantage at this point of lending and borrowing.

2. Uncertainties of policies

The repo and the reverse repo rate are the outcomes of the monetray policies and are devised by the govt and the central bak of the country. so they keep changing as per the status of the economy. So the banks can not rely absolutely on these tools to manage their liquidity risk.