Liquidity Adjustment Facility
Repo and reverse repo rates are a part of RBI’s “Liquidity Adjustment Facility (LAF)”.
Repo Rate and Its Types
Repo rate refers to the interest rate at which the RBI provides liquidity to banks against the collateral of government securities.
Increase in repo rate → borrowing from RBI expensive → banks will borrow less from RBI → less credit will be provided by banks to households →money supply will decrease.
Decrease in Repo Rate→ Borrowing from RBI is cheaper→ Banks will borrow more→ More credit is available→ Money supply will increase
Depending upon the maturity period of the loans, there are different types of Repos in India. These are:
Overnight Repo Auctions: The banks can borrow money for one day from RBI at interest rate equal to repo rate by pledging the government security that the banks have over and above the SLR (Statutory Liquidity Ratio) requirement. If the banks do not possess government securities beyond the SLR requirement, it cannot borrow money under the LAF window.
Variable Repo Auctions: Banks can borrow money at variable repo rates decided through auctions. This instrument can be overnight or for a term. If variable rate repo auction is undertaken for one day, it is called overnight repo auction.
If it is undertaken for a term, it is called term repo.
Term Repos: There are different types of term repos depending upon the maturity period. Some of the term repos include 7-day, 14-day, 21 day, 28-day, 56-day.
Interest rate on the Term repos is determined through auction and hence is usually higher than the Repo rate.
Targeted Long Term Repo Operations (TLTROs)
New policy tool used by the RBI to inject more liquidity into the Economy. Like the term repos, but with a longer maturity period of 1 year and 3 years.
Total Funds to be injected: Up to Rs 1 Lakh crores.
Interest Rate: Repo Rate.
Why is it called On-Tap? This facility can be availed by any bank as and when the need for liquidity arises.
Conditions: Liquidity availed by banks must be deployed in corporate bonds, commercial papers, and non-convertible debentures issued by entities in specific sectors. Liquidity availed can also be used to extend bank loans to these sectors.
Method of Operations: Carried out through e-Kuber. e-Kuber is the Core Banking Solution of the RBI which enables each bank to connect their single current account across the country.
Rationale:
- Reduce rate of Interest on the long-term loans.
- The reduction in the long-term rate of interest would force the banks to reduce the rate of interest on short term loans. (The rate of interest on long term loans is usually higher than that on short term loans)
- Incentivize the Banks to reduce their overall lending rates and improve the monetary policy transmission.
Reverse Repo Rate
Reverse repo rate is the rate at which the RBI borrows money from commercial banks against collateral of eligible government securities.
An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.
A decrease in reverse repo rate means that commercial banks will get less incentive to park their funds with RBI and thus more money is available in the market increasing the money supply.
Standing Deposit Facility (SDF)
RBI has decided to introduce the Standing Deposit Facility (SDF).
SDF works like Reverse Repo. However, SDF is different from Reverse Repo in the following ways:
- Under the SDF route, the RBI would not be required to provide G-Secs as collateral to the Banks. Hence, it would enable RBI to absorb huge amount of liquidity from the economy without G-Secs acting as collateral.
- The SDF would be lower than Reverse Repo.
- Reverse Repo exercise is carried out at the discretion of the RBI depending upon market conditions. However, the SDF would enable the Banks to keep their surplus funds with the RBI at their own discretion.
- The SDF would be available for parking funds with the RBI on an overnight basis. But the duration of Reverse Repo could be longer.
- During times such as recent Demonetization, the RBI may not have adequate G-Secs to absorb huge amounts of liquidity from the economy. Hence, to handle such situations, the Urjit Patel Committee had recommended the introduction of a new tool known as "Standing Deposit Facility".
Note: The Finance Act (2018) has amended the RBI Act, 1934 to enable the RBI to use the new tool of SDF. Subsequently, the liquidity management framework adopted by the RBI in Feb 2020 has decided to use SDF in India.
Changes in the Monetary policy corridor
The RBI has also decided to replace Fixed Rate Reverse Repo in the monetary policy corridor with the Standing Deposit Facility.
| Earlier Monetary Policy CorridorRepo placed in middle; MSF at 25 basis points higher and Reverse Repo at 65 basis points lower than Repo (Asymmetric Corridor) | Modified Monetary Policy CorridorRepo placed in middle; MSF at 25 basis points higher and SDF at 25 basis points lower than Repo (Symmetric Corridor) | ||
| MSF | 4.25% | MSF | 6.75% |
| Repo | 4% | Repo | 6.50% |
| Reverse Repo | 3.35% | SDF | 6.25% |
Marginal Standing Facility
Liquidity management window under which banks can borrow additional overnight liquidity over and above LAF window.
Under Repo, banks can borrow overnight liquidity only by pledging securities over and above the securities held under SLR requirement.
Under MSF, banks can pledge securities held for SLR purposes. However, the rate of interest is higher than the repo rate. (Penal rate)
Earlier, the Banks can borrow only up to 2% of their deposits. But the limit was enhanced to 3% in March 2020. This enhanced borrowing limit was applicable until 31st Dec 2021.
Bank Rate
Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as “the standard rate at which the Reserve Bank is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under the Act.
On introduction of LAF, discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued. As a result, the Bank Rate became dormant as an instrument of monetary management. It is now aligned to MSF rate and used for calculating penalty on default in the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).
Cash Reserve Ratio (CRR)
CRR refers to the percentage of total deposits of a bank to be kept with RBI in the form of cash.
An increase in CRR→ higher proportion of deposits to be kept with RBI by banks→ less funds are available to be provided as credit to the economy→ money supply will decrease.
Statutory Liquidity Ratio (SLR)
SLR refers to the percentage of total deposits of a bank to be kept with itself in the form of liquid assets such as cash, gold, government securities such as T-Bills, Dated Securities, State Development loans (SDLs).
An increase in SLR→ higher proportion of funds to be kept aside by banks in liquid form→ less funds available to be provided as credit to the economy→ money supply will decrease.
Foreign Exchange Sell/Buy Swap
Swap is in the nature of a simple sell/buy foreign exchange swap from RBI side. Under the swap, RBI sells dollars to banks and simultaneously agrees to buy the same amount of US dollars at the end of the swap period. This mechanism shall involve mainly 2 steps:
- In the first leg of transaction, bank buys US Dollars from the Reserve Bank at prevailing exchange rate.
- In the second leg of transaction, the Bank would be required to sell the same amount of dollars to get back the Rupee.
Hence, this mechanism essentially works as a swap mechanism wherein the dollars with the RBI would be swapped with Indian rupees with the Banks for a specified duration.
WHEN IS IT CARRIED OUT? To Check Rupee Depreciation and to Inject Dollars.
What would be the likely impact?
- Increase in the dollar supply and consequently increase in value of Rupee (Rupee Appreciation)
- Check Exchange rate volatility
- Decrease in the forex reserves of RBI.
Open Market Operations (OMO)
OMO refers to sale and purchase of government securities by RBI in the open market with the aim of influencing liquidity in the economy in the medium term.
Open market purchase by RBI→RBI will release liquidity in the economy→ money supply will increase.
Recent Developments: RBI has decided to carry out OMOs in the State Development Loans (SDLs) as well.
Operation Twist
Operation Twist is the special Open Market Operations (OMOs) carried out by the RBI. Typically, the RBI carries out OMO sales to suck out excess liquidity and OMO purchases to inject liquidity.
However, under Operation Twist, the RBI carries out simultaneous sale and purchase of G-Secs to influence the yield rates on the G-Secs.
The RBI sells short-term G-Secs to the Banks and financial institutions and collect money. The same money would then be used by the RBI to buy long term G-Secs.
Impact of Operation Twist
- RBI purchases long-term G-Secs--> Decrease in supply of long-term G-Secs--> Higher Demand--> Increase in Bond Prices--> Decrease in Yields on Long-term G-Secs.
- RBI sells short-term G-Secs--> Increase in supply of Short-term G-Secs--> Lower Demand--> Decrease in Bond Prices--> Increase in Yields on Short-term G-Secs
Why is it important to lower the yields on G-Secs?
- To lower the borrowing cost of the Government
As the supply of G-Secs in the market increase--> Lower Demand for G-Secs--> Lower Bond Prices--> Higher Yields on G-Secs--> RBI has to offer higher yields to investors on issuance of new G-Secs--> Higher Borrowing cost for the Government.
- As Yields on G-Secs increase--> Investors would demand higher yields on Corporate Bonds--> Increased Borrowing cost for Corporate Bonds--> Adverse impact on Private sector Investment
- As yields on G-Secs increase--> Higher returns for Investors in Bonds in comparison to Equities--> Sale of Shares and reinvest money in the Bonds--> Adverse impact on the Equity Market--> Fall in SENSEX and NIFTY.
- Banks use yields on long term G-Secs as a reference for fixing interest rates on long term loans such as home loans, vehicle loans etc. As Yields on long-term G-Secs increase--> Increase in the rates of Interest on long term loans--> Decrease in Credit creation--> Hamper Economic growth and development.
G-SAP Program
G-SAP is a special Open Market Operations (OMOs) wherein the RBI purchases G-Secs from the Banks. It is different from OMOs in three ways:
Firstly, under the OMOs, the RBI may either purchase or sell G-Secs depending upon the market conditions. But, under the G-SAP, the RBI would only be purchasing G-Secs. The RBI would not be selling the G-Secs.
Secondly, the RBI uses OMOs either to inject or suck out excess liquidity depending upon the liquidity conditions. But the G-SAP is used for controlling the yield rates on the long-term G-Secs.
Thirdly, the OMOs are carried out as per the discretion of the RBI. Hence, the Banks are not aware as to how much G-Secs the RBI would purchase and when would it purchase. Hence, under OMOs, the market is quite clueless with respect to what action RBI would take. But, under the G-SAP, the RBI comes out with a clear-cut commitment to purchase G-Secs within a definite time.
Qualitative Tools
Margin requirements: Margin refers to the difference between the Loan and Collateral value. The RBI may lay down different margin requirements for different categories of loans (Vehicle, Home, Business etc) to control credit to different sectors.
Consumer Credit Regulation: RBI can issue rules to set the minimum/maximum level of down-payments and periods of payments for purchase of certain goods.
Rationing of credit: Rationing of credit is a method by which the RBI seeks to limit the maximum amount of loans and advances and, also in certain cases, fix ceiling for specific categories of loans and advances.
Moral Suasion: Is a milder form of credit control in which the RBI can persuade the commercial banks to co-operate with the general monetary policy. Since it involves no administrative compulsion or threats of punitive action it is a psychological and informal means of selective credit control.
Direct Action: This step is taken by the RBI against banks that don’t fulfil conditions and requirements.