Banking & Monetary Policy

Liquidity Management in India

Context: India’s current liquidity deficit is due to various domestic and global factors, affecting deposit growth, credit expansion, exchange rates, and central bank policies.

Relevance of the Topic: Prelims: Key terms related to Liquidity management by RBI.

Liquidity Management in India

Liquidity management is a key function of the Reserve Bank of India (RBI) that ensures effective monetary policy transmission and smooth financial system operations.
It involves the central bank's procedures to align short-term interest rates with the policy rate.
RBI's liquidity management framework involves three key aspects: operating framework, liquidity drivers, and liquidity control mechanisms.
Since 2011, the fixed overnight repo (repurchase) rate under the Liquidity Adjustment Facility (LAF) has been formally announced as the single monetary policy rate, with the Weighted Average Call Money Rate (WACR) as the operating target of monetary policy.

Importance of Liquidity Management

Supporting economic growth: By maintaining optimal liquidity, banks can continue lending to businesses and consumers, supporting economic activity and growth.
Facilitating monetary policy transmission: Effective liquidity management by the RBI helps in the smooth transmission of monetary policy.
Ensuring financial stability: It helps Indian banks and financial institutions maintain adequate cash reserves and liquid assets to meet short-term obligations and withstand economic shocks.
Meeting regulatory requirements: RBI has implemented stringent liquidity requirements such as the Liquidity Coverage Ratio (LCR) for banks. Liquidity management is essential for banks to comply with these regulatory norms.
Managing volatility: Sound liquidity management helps banks and the RBI handle sudden inflows or outflows of foreign capital.
Building investor and depositor confidence: Strong liquidity positions enhance the credibility of banks among investors and depositors, crucial for maintaining stability.
Managing currency fluctuations: Liquidity management helps banks handle exchange rate volatility, which is important given India's increasing global financial integration.

Key drivers of Liquidity in the Banking System

Government cash balances with RBI: The government's higher cash holdings at the RBI reduce system liquidity and lower balances increase it.
Changes in currency in circulation: An increase in currency in circulation reduces liquidity in the banking system, while a decrease increases liquidity.
RBI's forex operations: When the RBI buys foreign currency, it injects rupee liquidity into the system, and when it sells foreign currency, it absorbs rupee liquidity.
RBI's market operations: Through its liquidity tools such as Open Market Operations (OMOs), the RBI can inject liquidity by purchasing government securities or absorb liquidity by selling them.
Changes in CRR, SLR: An increase in Cash Reserve Ratio (CRR) or Statutory Liquidity Ratio (SLR) requirements reduces liquidity in the banking system, while a decrease increases liquidity.

Factors contributing to current Liquidity Deficit in India

Mismatch between deposits and credit growth:
- Faster credit expansion compared to deposit growth has created liquidity pressure in the banking system.
- Many investors shifted funds from bank deposits to capital markets, driven by high stock market returns and mutual fund attractiveness.
- Banks were unable to increase deposit interest rates significantly due to the high repo rate (6.5%), which affected their profit margins.
Impact of government spending:
- Government spending was lower than usual due to the election code of conduct, leading to high cash balances with the RBI instead of commercial banks.
- Payments made to the government reduced bank deposit growth, further tightening liquidity.
Impact of US economic policies: US government's policies (higher tariffs, tax cuts, and strict immigration rules) have strengthened the US dollar, leading to:
- Depreciation of the Indian rupee and other currencies.
- Increased volatility in Foreign Portfolio Investments (FPIs), as investors factored in currency risks.
- Stock market fluctuations due to adjustments for currency depreciation and inflation.
RBI's role in managing forex reserves:
- RBI’s forex reserves peaked at $705 billion (Sept 2024) but have now declined to $630–640 billion due to forex interventions.
- RBI’s sale of dollars to stabilize the rupee led to a further liquidity crunch, reducing the money supply in the banking system.

Liquidity Management by RBI

Changes in RBI's Liquidity framework:
- The 2020 liquidity framework focused on:
  - Variable Repo Rate (VRR) and Variable Reverse Repo Rate (VRRR) to manage liquidity.
  - Discontinuation of daily overnight repo operations.
- Due to the liquidity crunch, RBI resumed daily overnight repo operations to fine-tune liquidity.
- This was done, while ensuring that the weighted average call rate (WACR) remains stable at around 6.30% (above repo rate of 6.25%).
Anomalies in the banking system:
- RBI is simultaneously injecting liquidity (~₹2 lakh crore through VRR) while banks are parking surplus funds in the Standing Deposit Facility (SDF) at 6% interest.
- Banks prefer SDF deposits over lending in the unsecured call money market, even though the call rate is slightly higher (~6.30%).
- Borrowers are shifting to the tri-party repo market, where borrowing is cheaper against securities like Treasury Bills.

Impact of a volatile Rupee on liquidity

FPI withdrawals have increased rupee volatility, leading to stock market fluctuations.
The US dollar index movements significantly affect the rupee’s value, even when US policies do not directly target India.
RBI's intervention to stabilize the rupee (selling dollars) has further tightened domestic liquidity, requiring more central bank action.

Way Forward

Domestic policies:
- Banks need to offer higher deposit rates or introduce new savings schemes to boost deposits.
- RBI could diversify its liquidity management tools beyond repo operations.
- Maintaining forex stability is crucial to prevent excessive rupee depreciation.
Global context:
- India’s trade negotiations with the US (on hold until March 2025) will be crucial in determining future liquidity trends.
- The US-imposed tariff hike could trigger a trade war, affecting Indian exports and overall liquidity.
- Central banks worldwide, including the RBI, need to remain vigilant in FY26 as global trade dynamics evolve.

Key Terms

Call money rate: rate at which short term funds are borrowed and lent in the money market.
- The duration of the call money loan is 1 day.
- Banks resort to these types of loans to fill the asset liability mismatch, comply with the statutory CRR and SLR requirements and to meet the sudden demand of funds.
- RBI, banks, primary dealers, etc. are the participants of the call money market.
- Demand and supply of liquidity affect the call money rate.
- Tight liquidity conditions lead to a rise in call money rate and vice versa.
Weighted Average Call Rate (WACR): WACR represents the unsecured segment of the overnight money market and is best reflective of systemic liquidity mismatches at the margin.
- It is explicitly chosen as the operating target of monetary policy in India.
- The operating procedure of monetary policy is guided by the objective of aligning the operating target of monetary policy – the WACR (weighted average call rate) – to the repo rate through active liquidity management, consistent with the stance of monetary policy.
- Once the policy repo rate is announced, liquidity operations are conducted to keep the WACR closely aligned to the repo rate.

RBI to conduct $10 Billion USD-INR Swap Auction

Context: The Reserve Bank of India (RBI) has announced a $10 billion USD-INR Buy/Sell swap auction with a tenure of three years, scheduled for February 28, 2025. This move is aimed to inject liquidity into the banking system and stabilise Indian currency.

Relevance of the Topic: Prelims: Forex Buy/Sell Swap, AD Category-1 Banks; Measures used by RBI to inject liquidity.

About Forex Swap Auction

Forex Swap Auction is a financial instrument used by the Reserve Bank of India (RBI) to manage liquidity in the financial system.
In the Buy/Sell swap mechanism, RBI buys U.S. Dollars from banks in exchange for Rupees (first leg) and agrees to sell them back at a pre-determined future date along with a premium (reverse leg).

Criteria	Forex Buy/Sell Swap	Forex Sell/Buy Swap
What does the RBI do?	RBI buys dollars with an agreement to sell the dollars at a future date and at a fixed exchange rate.	RBI sells dollars with an agreement to buy back the same amount of dollars at a future date and at a fixed exchange rate.
When is it adopted?	Surplus of dollars → Rupee Appreciation pressureHence, RBI buys dollars and injects Rupee to control Rupee Appreciation.	Shortage of dollars → Rupee DepreciationHence, RBI sells dollars and sucks out Rupee to control Rupee Depreciation.
What does it lead to?	Potential Rupee Devaluation: Decrease in value of Rupee due to RBI’s Intervention	Rupee Revaluation: Increase in value of Rupee due to RBI’s Intervention
Impact on Rupee Liquidity	Increases Rupee Liquidity	Decreases
Impact on Rate of Interest on Loans	Increase in Rupee Liquidity → Decrease in Rate of Interest on Loans	Decrease in Rupee Liquidity → Increase in Rate of Interest on Loans
Impact on Forex Reserves	RBI Purchases dollars → Increase in Forex Reserves (temporarily)	RBI sells dollars → Decline in Forex Reserves (temporarily)

Significance of Swap Auctions

Liquidity management: Helps inject or absorb Rupee liquidity in the banking system.
Exchange rate stability: Reduces volatility in the USD/INR exchange rate by providing liquidity buffers.
Foreign exchange reserves management: Enhances the efficient utilization of forex reserves.
Inflation & Interest rate control: Manages liquidity, indirectly influencing inflation and interest rates.

RBI’s proposal for USD-INR Buy/Sell Swap Auction

Details of the auction:
- Swap amount: $10 billion
- Tenure: 3 years
Key features:
- Participants must place their bids in terms of the premium they are willing to pay to RBI for the tenure of the swap. Expressed in paisa terms up to two decimal places.
- The auction would be a multiple-price based auction, i.e., successful bids will get accepted at their respective quoted premium.
Authorised Dealers (ADs): Category-1 banks will be the eligible entities to participate in the auction.
Under the swap auction, minimum bid size would be USD 10 million and in multiples of USD 1 million thereafter. The eligible participants are allowed to submit multiple bids.
RBI reserves the right to:
- Decide on the quantum of US Dollar amount to be accepted in the swap auction.
- Accept offers for less than the aggregate notified US Dollar amount.
- Accept marginally higher than the notified US Dollar amount due to rounding-off effects.
- Accept or reject any or all the offers either wholly or partially without assigning any reason.

Authorised Dealers (ADs) – Category-1 Banks

RBI gives an AD Category-1 Bank permission to deal in foreign exchange transactions.
- AD stands for Authorised Dealer.
- Category-1 is the highest authorised dealer category in India's foreign exchange transactions.
These banks are allowed to carry out a wide range of activities related to foreign exchange, including:
- Buying and selling foreign currency
- Outward remittance of funds abroad
- Issuance of letters of credit and bank guarantees.
They act as intermediaries between the buyers and sellers of foreign currencies and help to provide liquidity in the foreign exchange market.

Recent Liquidity Issues in the Indian Banking System:

The Indian banking system encountered its worst liquidity crunch in more than a decade in January 2025. The liquidity deficit peaked at Rs 3.15 lakh crore on January 23, its lowest level in nearly 15 years.
The deficit led to increased dependence by banks on market borrowing, thereby keeping interbank call money rates (rate at which banks lend to each other) consistently above the policy repo rate of 6.50%.
The RBI has been selling dollars to stabilise the rupee, thereby sucking out an equivalent amount in rupee from the system. RBI’s outstanding net forward sales of the dollar surged to $67.93 billion as of December 31, 2024, as the central bank intensified its efforts to stabilize the rupee.

RBI’s measures to ensure liquidity

The RBI had infused over Rs 3.6 lakh crore of durable liquidity into the banking system in Jan-Feb 2025 through:
- Debt purchases
- Forex swaps (exchanging foreign currency with banks)
- Longer-duration repos.
Other measures included:
- Several variable rate repo (VRR) auctions
- $5 billion dollar-rupee swap
- Rs 60,000 crore Open market operations (OMO) purchase auctions of government securities.

Centre might raise the Deposit Insurance Limit

Context: The government is considering increasing the insurance cover limit on bank deposits from the current Rs. 5 lakh per depositor.

Relevance of the Topic: Prelims: Deposit Insurance, DICGC

What is Deposit Insurance?

Deposit insurance is a financial safety net that protects depositors from bank failures by guaranteeing a certain amount of their money.
In India, deposit insurance is managed by the Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly owned subsidiary of the Reserve Bank of India (RBI). This system helps maintain trust in the banking sector, prevent bank runs, and promote financial stability.

What is Credit Guarantee?

It is the guarantee that often provides for a specific remedy to the creditor if his debtor does not return his debt.

Deposit Insurance and Credit Guarantee Corporation (DICGC)

All deposits and interest income are insured by Deposit Insurance and Credit Guarantee Corporation (DICGC). It is the second oldest insurer in the world.
It is a statutory body created by the Deposit Insurance and Credit Guarantee Corporation Act, 1961.
It is a wholly owned subsidiary of RBI.
Insured banks by DICGC:
- All Scheduled Commercial Banks
- Foreign Banks
- Small Finance Banks
- Payment Banks
- Regional Rural Banks
- Local Area Banks
- State Co-operative Banks
- District Central Co-operative Banks
- Urban Co-operative Banks.
Note: Primary Cooperative Societies are not covered by DICGC.

Deposit Insurance in India:

Evolution:
- 1993: The deposit insurance limit was fixed at ₹1 lakh.
- 2020: The government raised it to ₹5 lakh, following the Punjab and Maharashtra Cooperative Bank (PMC Bank) crisis.
- 2024: RBI’s Deputy Governor proposed a periodic increase in deposit insurance based on factors such as inflation, deposit growth, and rising income levels.
- 2025: Finance Ministry is actively considering increasing the deposit insurance limit further, following the New India Cooperative Bank crisis.

Insurance Cover amount:
- Currently, the DICGC has set the insurance cover limit to 5 lakhs. This covers all the money (Principal + Interest) with the bank e.g., savings, term deposit, recurring deposits etc.
- Deposits kept in different branches of a bank are aggregated for the purpose of insurance cover and maximum amount of up to rupees 5 lakhs is paid.
- If funds are in different types of ownership or are deposited into separate banks they would then be separately insured.
Insurance Premium is provided by banks. This amount stands at Rs 12 paisa per Rs 100.
When is DICGC liable to pay: If a bank goes into liquidation, DICGC is liable to pay to the liquidator the claim amount of each depositor up to Rs. 5 lakhs within two months from the date of receipt of the claim list from the liquidator.

Importance of Deposit Insurance:

Ensures Financial Stability:
- Prevents bank runs (mass withdrawal of deposits during financial crises).
- Strengthens confidence in the banking system, especially for small depositors.
Protects Small Depositors:
- A large percentage of depositors (97.8%) are fully covered, ensuring their money remains safe.
Encourages Savings and Banking Growth:
- With insured deposits, people are more likely to trust banks and deposit their money, promoting financial inclusion.

Challenges in Deposit Insurance

Inadequate Coverage Limit: The current ₹5 lakh insurance cap may not be sufficient in the face of rising inflation and increasing deposits.
Delays in Payouts: When a bank collapses, depositors often face delays in receiving insured amounts.
Moral hazard: Since deposits are insured, banks might take excessive risks, knowing that the government will protect depositors.
Limited coverage of high-value deposits: While 97.8% of accounts are insured, only 43.1% of total deposit value is covered, leaving large depositors exposed.

Way Forward

Increase the Deposit Insurance limit periodically: The insurance cap should be linked to inflation and economic growth, ensuring depositors receive adequate protection.
Strengthen regulation of Cooperative banks: RBI must closely monitor urban cooperative banks and take pre-emptive action to prevent failures.
Faster claim settlement mechanism: DICGC must speed up payout processing to ensure depositors do not suffer delays.
Enhance public awareness: Many depositors are unaware of deposit insurance coverage, necessitating awareness campaigns.

RBI could cut Repo rate for the first time in 5 years

Context: RBI’s Monetary Policy Committee (MPC) is expected to cut the repo rate by 25 basis points (bps) in its upcoming meeting (February 2025), from 6.5 per cent to 6.25 per cent.

If implemented, this would be the first rate cut in nearly five years. This decision is influenced by easing inflation, government stimulus measures, and the need to boost economic growth.

Relevance of the Topic:Prelims: Repo Rate, External benchmark lending rate, Marginal cost of fund-based lending rate; RBI’s Inflation targeting framework

Repo Rate:

Repo rate is the interest rate at which the commercial banks borrow money from the Reserve Bank of India (RBI) during a short-term liquidity crunch.
Repo stands for ‘Repurchasing Option’ or ‘Repurchase Agreement’.
- In the agreement, banks provide eligible securities such as Treasury Bills to the RBI, while availing overnight loans. They agree to repurchase securities at a predetermined price later from RBI.
- Thus, the bank gets the cash and the central bank the security.

How does Repo Rate affect the Economy?

Rise in inflation:
- During high levels of inflation, RBI increases the repo rate to bring down the flow of money in the economy.
- This curbs excessive spending, makes borrowing costly for businesses and industries, slows down investment and money supply in the market, and eases inflation.

Increasing Liquidity in the Market:
- When the RBI needs to pump funds into the economy, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes.
- It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.

Related Monetary Policy Tools:

1. Reverse Repo Rate:

Reverse Repo Rate is when the RBI borrows money from banks when there is excess liquidity in the market.
- The banks benefit out of it by receiving interest for their holdings with the central bank.
Reverse Repo Rate is a mechanism to absorb the liquidity in the market, thus restricting the borrowing power of investors.
During high levels of inflation in the economy, the RBI increases the reverse repo.
- It encourages the banks to park more funds with RBI to earn higher returns on excess funds.
- Banks are left with lesser funds to extend loans and borrowings to consumers.

2. Marginal Cost of Lending Rate (MCLR):

MCLR is the minimum interest rate at which commercial banks can lend.
This rate is based on four components:
- Marginal cost of funds
- Negative carry on account of cash reserve ratio
- Operating costs
- Tenor premium
MCLR is linked to the actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up.

3. External Benchmarks Lending Rate:

To ensure complete transparency and standardisation, RBI mandated the banks to adopt a uniform external benchmark within a loan category, effective from 1st October, 2019.
Unlike MCLR which was internal system for each bank, RBI has offered banks the options to choose from 4 external benchmarking mechanisms:
- RBI repo rate
- 91-day T-bill yield
- 182-day T-bill yield
- Any other benchmark developed by Financial Benchmarks India Pvt. Ltd.

Factors influencing Repo Rate Cut Decision:

Easing Inflation:
- Retail inflation fell to 5.22% in December 2024, the lowest in four months. Lower inflation allows for monetary easing without major inflationary risks.
Union Budget 2025-26 stimulus:
- Tax cuts and revised TDS limits aim to boost disposable income and consumption.
- Increased consumer demand may require monetary support for sustained economic growth.
Liquidity Measures by RBI: Recent liquidity enhancement steps of RBI ensure banking system liquidity before a rate cut. RBI announced liquidity enhancement measures such as:
- $5 billion forex swap.
- ₹60,000 crore open market operations.
- ₹50,000 crore variable repo rate operations.
Global Economic Uncertainty:
- Trade tensions: US imposing tariffs on China, Canada, and Mexico, is creating instability in global trade.
- Impact on currency markets, with rupee hitting an all-time low of ₹87.29 per USD.
- The RBI must balance rupee stability and domestic liquidity management.

Impact of Repo Rate Cut on Economy

Reduce Borrowing costs:
- Repo-linked lending rates (EBLR): A cut in repo rate will reduce borrowing costs, making home, vehicle, and business loans cheaper.
- MCLR-linked loans: Banks may also reduce rates for loans linked to the marginal cost of funds-based lending rate (MCLR). This will lead to lower lending rates for borrowers.
- The expected 25 bps rate cut will lower EMIs for borrowers.
Boost Economic Growth: A rate cut could stimulate investment and consumption, boosting GDP.

The anticipated repo rate cut signals a pro-growth strategy while ensuring inflation remains in check.

Balancing Monetary and Fiscal Policy

Context: The Union Budget 2025-26 has set the fiscal deficit target for 2025-26 at 4.4%. This will enable the Reserve Bank of India (RBI) to consider reducing interest rates to stimulate economic growth.

Relevance of the Topic:Prelims: Monetary Policy Committee, Inflation targeting

Monetary Policy Committee (MPC)

The Monetary Policy Committee is a statutory body established under Reserve Bank of India Act, 1934 (as amended by the Finance Act, 2016).
MPC is responsible for setting benchmark policy rate (repo rate) required to contain inflation, within the specified target level.
Composition: The Central government is empowered to constitute a six-member MPC.
- RBI Governor (ex officio chairperson)
- Deputy Governor in charge of monetary policy
- An RBI officer nominated by the Central Board
- Three members to be appointed by the central government.
Decision-Making:
- Quorum: At least four Members (at least one of whom shall be RBI Governor and, in his absence the Deputy Governor).
- Decisions are based on a majority vote.
- In case of a tie, the RBI governor has the casting vote.
- MPC decisions are binding on the Bank.

What is Inflation Targeting?

It is a monetary policy framework where the Central Bank aims to maintain the rate of Inflation within a targeted (pre-defined) range.
India has adopted inflation targeting through the Monetary Policy Framework Agreement (MPFA) signed between the Government of India and the Reserve Bank of India in 2015.
India’s Inflation Targeting Framework:
- India adopted Flexible Inflation Targeting (FIT) in 2016, with an inflation target of 4% (with a deviation of +/- 2%).
- The Consumer Price Index (CPI) serves as the key indicator.
- The inflation target is set by the government in consultation with RBI every five years, under the amended RBI Act, 1934.

Current Inflation Trends:

Retail inflation declined to 4.5%-4.7% in January 2025 (down from 5.2% in December 2024).
Essential commodities prices fell by 2.4% in January, indicating a cooling trend.

Fiscal Policy: Maintaining fiscal discipline & controlling inflation

The Budget 2025 has maintained a fiscal deficit target at 4.4% of GDP to avoid excessive borrowing. Non-inflationary budget to ensure long-term economic stability.
Rationale:
- Excessive spending can lead to high inflation and economic instability.
- Fiscal prudence supports monetary policy efforts, ensuring economic predictability.

Coordination between Fiscal and Monetary Policy

Fiscal policy (government spending & taxation) and Monetary policy (RBI’s control over interest rates and money supply) need to work together to maintain economic stability.
The government’s disciplined spending approach allows the RBI to lower interest rates, when inflation is under control. Lower interest rates can boost borrowing, investment, and economic growth.
Government’s subtle Message to the RBI:
- The government is signaling RBI that since inflation is under control, it may be a good time to start cutting interest rates.
- RBI’s Monetary Policy Committee (MPC) will decide whether to cut repo rates in its upcoming meeting.
- Lower interest rates make loans cheaper, helping businesses and individuals invest more.

A well coordinated approach between Fiscal and Monetary Policy is crucial for achieving economic growth and long-term economic stability.

RBI announces Liquidity Injection Measures

Context: The Reserve Bank of India (RBI) doubled down on its liquidity injection measures for the banking system by announcing measures such as a $5 billion USD/INR buy/Sell swap auction of six months tenor and open market operation (OMO) purchase auctions of G-Secs aggregating ₹60,000 crore.

Relevance of the Topic:Prelims: Important terms related to Banking System

RBI’s Liquidity Injection Measures

Rationale: Banking system in India is facing a high liquidity deficit, prompting RBI to undertake actions to inject liquidity into the system.
- Liquidity deficit has arisen due to tax outflows and limited government spending.
- The liquidity deficit is estimated at about ₹3 lakh crore.
Measures announced: VRR Auction, USD/INR Buy/Sell Swap, OMO Purchase of G-Secs.
VRR Auction: A 56-day variable rate repo (VRR) auction for a notified amount of ₹50,000 crore.
- This will probably be the first time that a VRR auction for such a long tenor will be conducted.
- Possible Impacts:
  - Liquidity infusion of about ₹1.50 lakh crore for the banking system in a phased manner
  - Softening effect on the yields of Government securities (G-Secs).
USD/INR Buy/Sell Swap auction of $5 billion for a tenor of six months to be held on January 31, 2025.
OMO purchase auctions of G-Secs for an aggregate amount of ₹60,000 crore in three tranches of ₹20,000 crore each.

What is Liquidity in the Banking System?

Liquidity in the banking system refers to readily available cash that banks need to meet short-term business and financial needs.
Liquidity Deficit: On a given day, if the banking system is a net borrower from the RBI under Liquidity Adjustment Facility (LAF), the system liquidity can be said to be in deficit.
- LAF refers to the RBI’s operations through which it injects or absorbs liquidity into or from the banking system.
Liquidity Surplus: If the banking system is a net lender to the RBI on a given day, the system liquidity can be said to be in surplus.

What are Open Market Operations?

Open Market Operations (OMOs) are market operations conducted by RBI by way of sale/purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market.
If there is excess liquidity, RBI resorts to sale of securities and sucks out the rupee liquidity.
Similarly, when the liquidity conditions are tight, RBI buys securities from the market, thereby releasing liquidity into the market.

What is Forex Swap?

Criteria	Forex Sell/Buy Swap	Forex Buy/Sell Swap
What does the RBI do?	RBI Sells dollars with an agreement to buy back same amount of dollars at future date and at fixed exchange rate	RBI Buys dollars with an agreement to sell amount of dollars at future date and at fixed exchange rate
When is it adopted?	Shortage of dollars -> Rupee Depreciation.Hence, RBI sells dollars and sucks out Rupee to control Rupee Depreciation	Surplus of dollars -> Rupee Appreciation.Hence, RBI buys dollars and injects Rupee to control Rupee Appreciation.
What does it lead to?	Rupee Revaluation: Increase in value of Rupee due to RBI’s Intervention	Rupee Devaluation: Decrease in value of Rupee due to RBI’s Intervention
Impact on Rupee Liquidity	Decreases	Increases
Impact on Forex Reserves	RBI sells dollars -> Decline in Forex Reserves	RBI Purchases dollars -> Increase in Forex Reserves

What is Variable Rate Repo (VRR)?

VRR is a mechanism where the RBI permits banks to borrow funds at rates determined by the market.
- This differs from the fixed Repo Rate at which banks borrow directly from the RBI.
VRR typically lasts up to 14 days.
It serves as a means to inject short-term liquidity into the banking system.

What is Variable Rate Reverse Repo (VRRR)?

VRRR is used to absorb surplus liquidity from the system.
It is used by the RBI to effectively manage liquidity and influence short-term interest rates in the Indian banking system.
VRRR represents the interest rate at which the RBI borrows funds from commercial banks for varying durations, typically in the slots of 7, 14 and 28 days.

RBI Guidelines on Settlement of Dues by ARCs

Context: The Reserve Bank of India (RBI) has modified its guidelines on the settlement of dues of borrowers by asset reconstruction companies (ARCs). RBI says that ARCs should use the settlement option only after examining all possible ways to recover the dues.

Relevance of the Topic: Prelims: Key facts about the Asset Reconstruction Companies.

What are Asset Reconstruction Companies?

Rationale: While banks can take legal action against defaulting borrowers, such actions are often economically unfeasible. To minimise losses and to clear their balance sheets, banks can sell their bad debts to Asset Reconstruction Company (ARC).
ARC is a special type of financial institution that buys debts of the bank at a mutually agreed value and attempts to recover the debts or associated securities independently.
- ARCs take over the debts of the bank that are Non-Performing Assets.
- ARCs are engaged in asset reconstruction, securitisation, or both.
- All the rights that were held by the lender (bank) in respect of the debt are transferred to ARC.
- Funds required to purchase such debts can be raised from Qualified Buyers.
Registration & Regulation:
- ARCs are registered under the Reserve Bank of India.
- They are regulated under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act, 2002).

TERMS	MEANING
Asset Reconstruction	- Acquisition of any right or interest of any bank or financial institution in loans, advances granted, debentures, bonds, guarantees or any other credit facility extended by banks for the purpose of its realisation.
Securitisation	- Acquisition of financial assets either by way of issuing security receipts to Qualified Buyers.
Qualified Buyers	- Include Financial Institutions, Insurance companies, Banks, State Financial Corporations, State Industrial Development Corporations, trustee or ARCs registered under SARFAESI. - Also include Asset Management Companies (AMCs) registered under SEBI that invest on behalf of mutual funds, pension funds, FIIs, etc. - Qualified Buyers (QBs) are the only persons from whom ARC can raise funds.

Working Mechanism of ARC

RBI’s New Guidelines on Settlement of Dues of borrowers by ARCs

Board-approved policy for dues settlement:
- Every ARC shall frame a Board-approved policy for settlement of dues payable by the borrowers.
- This policy shall cover aspects such as:
  - cut-off date for one-time settlement eligibility.
  - permissible sacrifice for various categories of exposures while arriving at the settlement amount.
  - methodology for arriving at the realisable value of the security.
Settlement as last resort:
- Settlement with the borrower shall be done only after all possible ways to recover the dues have been examined and settlement is considered as the best option available.
Minimum Net Present Value (NPV):
- NPV of the settlement amount should generally be not less than the realisable value of securities.
Lump Sum payment:
- The settlement amount should preferably be paid in lump sum.
- Where the settlement does not envisage payment of the entire amount agreed upon in one instalment, the proposals should be in line with and supported by an acceptable business plan, projected earnings and cash flows of the borrower.
Procedure to be followed when borrower have aggregate value of more than ₹1 crore of outstanding principal:
- Settlement of dues with the borrower shall be done only after the proposal is examined by an Independent Advisory Committee (IAC).
- Board of Directors including at least two independent directors or a Committee of the Board shall deliberate on IAC’s recommendations.
Procedure to be followed when borrower have aggregate value of ₹1 crore or below of outstanding principal:
- Any official who was part of the acquisition of the concerned financial asset shall not be part of approving the proposal for settlement of the same financial asset.
- A quarterly report on the resolution of these accounts shall be placed before the Board/ Committee of the Board.
Borrowers classified as frauds or wilful defaulters:
- For settlement of dues payable by the borrowers classified as frauds or wilful defaulters, guidelines are same as that applicable to borrowers of aggregate value of more than ₹1 crore of outstanding principal, irrespective of the amount involved.

Insolvency & Bankruptcy Code: Mechanism and Challenges

Context: Certain issues have cropped up in the Insolvency and Bankruptcy Code, 2016 (IBC). The recent Supreme Court judgment in Jet Airways case highlighted the structural infirmities in India’s insolvency regime.

Relevance of the topic:

Prelims: Key facts about Insolvency and Bankruptcy Code.

Mains: Insolvency & Bankruptcy Code- Issues & Way Forward.

Insolvency and Bankruptcy Code 2016 (IBC)

Rationale: IBC Code was introduced to-
- Consolidate all the existing laws related to Insolvency and Bankruptcy in India.
- Simplify the process of insolvency resolution.
Deals with: All aspects of insolvency and bankruptcy of all kinds of companies, LLPs, Partnerships and Individuals. However, it does not deal with insolvency of banks.

Institutional Mechanism

Insolvency Professionals:
- to administer the resolution process
- manage the assets of the debtor
- provide information for creditors to assist them in decision making.
Insolvency Professional Agencies to conduct examinations to certify the insolvency professionals.
Information Utilities to report financial information of the debt owed to them by the debtor.
Adjudicating authorities:
- National Companies Law Tribunal (NCLT) for companies
- Debt Recovery Tribunal (DRT) for individuals.
Committee of Creditors (CoC):
- Either decide to restructure the debtor’s debt by preparing a resolution plan or liquidate the debtor’s assets.
- However, such a decision has to be approved by at least 66% of the votes. (Earlier threshold: 75%).
Insolvency and Bankruptcy Board:
- to regulate insolvency professionals, insolvency professional agencies and information utilities set up under the Code.

Procedure- Insolvency Resolution Process (IRP)

Liquidation (Sale of Assets)

It takes place if the Committee of Creditors (CoC) fails to come up with a resolution plan within the time limit of 330 days.

Issues in Insolvency Resolution in India

Double burden for Tribunals:
- National Company Law Tribunal (NCLT) and National Company Law Appellate Tribunal (NCLAT) face the dual burden of handling corporate insolvencies under IBC and cases under Companies Act.
Not aligning with contemporary demands:
- NCLT was conceived in 1999 based on Eradi Committee’s recommendations. However, it was operationalised in 2016.
- NCLT’s structure reflects the economic realities of a bygone era. This leaves it ill-equipped to meet contemporary demands.
Inadequatestrength:
- The sanctioned strength of 63 members divide their time across multiple benches.
- Thus, NCLT has become a bottleneck for insolvency resolutions and corporate transactions such as mergers and amalgamations.
Delay in functioning:
- Several NCLT benches do not operate for the full working day, even when not tasked with handling cases from other benches. As a result, delays have worsened.
- According to the Insolvency and Bankruptcy Board of India (IBBI), average time for insolvency resolutions increased to 716 days in FY2023-24, up from 654 days in FY2022-23.
Lack of domain experience:
- The current method of appointment ignores the need for domain experience. Members often lack the domain knowledge required to understand the nuanced complexities involved in high-stakes insolvency matters.
- This creates a paradox where an institution tasked with resolving complex cases is hindered by a lack of specialized knowledge. (Supreme Court in the Jet Airways case).
Institutional inefficiency:
- There is no effective system in place before the NCLTs for urgent listings. The Supreme Court has highlighted a growing tendency among NCLT & NCLAT members to ignore or defy its orders.
  - This threatens the very foundation of India’s judicial hierarchy.
- This impacts both institutional efficiency as well as institutional integrity.
Sparse use of alternatives:
- The limited use of alternative dispute settlement methods adds to the problems of an already overworked system.

Way Forward: Reform proposals

Mandatory mediation: The initiative for mandatory mediation prior to the submission of insolvency applications.
Hybrid model:There is the need for a hybrid model that values judicial experience and domain expertise.
Specialised benches:
- Creation of specialised benches for different categories of cases could enhance both efficiency and expertise. This also ensures that mergers and amalgamations are cleared in time.
Proper Infrastructure:
- Adequate courtrooms and a qualified, permanent support staff are critical to sustaining these institutions within the broader economic framework.

India’s insolvency regime must evolve beyond mere debt resolution to serve as a proactive driver of economic rejuvenation, especially as the country aims to attract greater foreign investment. The time for a bold reimagining is now.

RBI to conduct daily VRR auctions to infuse liquidity

Context: To ease liquidity tightness in the banking system, the Reserve Bank of India (RBI) has decided to conduct daily variable rate repo (VRR) auctions until further notice. The first such auction will be conducted on January 16 for ₹50,000 crore.

Relevance of the Topic:Prelims: Key facts about Variable Repo Rate (VRR).

Why is there a liquidity deficit?

RBI’s intervention in the forex market aimed at ensuring gradual depreciation of the rupee against the dollar have caused the current liquidity deficit in the economy.
As of January 2025, the RBI’s intervention in the forex market is estimated at about ₹2 lakh crore.

What is Variable Repo Rate?

Also called Term Repo Rates, VRR is a liquidity injection tool used by the RBI for managing short-term liquidity in the economy.
VRR Auctions: They are conducted by the RBI, when the weighted average call money rate trends above the repo rate in the interbank money market, serving as a signal to the RBI of System Liquidity Deficit.
Tenure: It is a short-term liquidity injection against collaterals, with a tenor of overnight to 13 days.
- For injection of durable liquidity, the RBI conducts VRR auctions for a tenor beyond 14 days (but very rarely).
Rate of Interest: Borrowing through VRR is at a rate decided by market, generally lower than the Repo Rate (though not less than Reverse Repo Rate).
Who can participate in VRR: Standalone primary dealers along with all other eligible participants are allowed to participate in these auctions.
What VRR will do?
- The daily liquidity support via VRR auction could neutralise the (rupee) liquidity-draining effect of RBI’s forex market intervention.
- Improved liquidity conditions could lead to softening of government securities (G-Sec) yields.

Difference between Repo and Variable Repo

S.No.	Aspect	Repo Rate	Variable Repo Rate
1.	Definition	Fixed rate at which RBI lends money to commercial banks	Market-determined rate in auctions conducted by RBI
2.	Usage	Used in regular monetary policy operations to control liquidity	Used in fine-tuning short-term liquidity
3.	Determination	Set directly by the RBI	Determined through market bidding in RBI auctions
4.	Purpose	To influence borrowing costs for banks and control inflation or liquidity	Manage short-term liquidity needs
5.	Impact on banks	Provides liquidity to banks at a predictable cost.	Provides liquidity at market-driven rates.

Urban Cooperative Banks need Prompt Action

Context: Urban Cooperative Banks (UCBs) in India face various operational challenges like frequent license revocations and other regulatory actions. To address this, the Reserve Bank of India is set to replace the Supervisory Action Framework with the Prompt Corrective Action (PCA) Framework in 2025.

Relevance of the topic:

Prelims: Urban Cooperative Banks- Prelims-related facts

Mains: Challenges associated with UCBs, Way Forward

What are Cooperative Banks?

Cooperative Banks refer to financial institutions under the Banking System in India that operate on the principles of cooperation and mutual benefit for their members.
Their members are both the owners and customers of the bank.
They operate on the principle of “one person, one vote” in decision making and are managed on the basis of cooperation, self-help, and no profit no loss.
Along with lending, these banks also accept deposits.
They are incorporated and registered under the States’ Cooperative Societies Act passed by the concerned state.

What are Urban Cooperative Banks?

Urban Cooperative Banks (UCBs) are financial institutions that operate in urban and semi-urban areas in India.
They primarily serve the banking needs of small businesses, individuals, and communities in urban areas.
UCBs were brought under the purview of the Banking Regulation Act, 1949 through an amendment in 1966.
Until 1996, these banks were allowed to lend money only for non-agricultural purposes. This distinction does not hold today.

Regulation of Urban Cooperative Banks:

UCBs are registered as societies under the Co-operative Societies Acts of the respective State Governments.
UCBs that have a multi-State presence are registered under the Multi State Co-operative Societies Act administered by the Government of India.
Previously, the UCBs were under dual regulation by the state registrar of societies and the RBI.
- Registration, administration, amalgamation and liquidation of UCBs were governed by the provisions of the State Co-operative Societies Acts.
- Banking related functions were governed by the provisions of Banking Regulation Act, 1949 (AACS).
This dual regulation resulted in ambiguity and a lack of clarity, creating additional impediments to effective governance of UCBs.
In 2020, all UCBs and multi-state cooperatives were brought under the supervision of RBI for banking-related functions through the Banking Regulation (Amendment) Act, 2020.

Banking Regulation Amendment Act, 2020:

Applicability	- Applicable to Scheduled Cooperative banks which include Urban Cooperative Banks, District Cooperative Banks and State Cooperative Banks. - Not applicable to Non-Scheduled Cooperative Banks.
Enhanced Regulatory Powers of the RBI	- Empowers RBI to remove the chairperson of the Cooperative Banks. - Extends RBI’s power to supersede the Board of Directors of all the Scheduled Cooperative Banks. (Earlier, RBI was only empowered to supersede the Board of Directors of the Multi-State Cooperative Banks) - RBI can order a special audit of Cooperative Banks.
Issue of Shares	- Cooperative Banks are allowed to issue shares to members or persons residing within Banks’ area of operation.

Challenges Associated with Urban Cooperative Banks:

Board members as borrowers:
- Cooperative bank board members can borrow from the banks, unlike the commercial bank board members.
- The board members in several cases have misused their borrowing powers to siphon off large sums of money, resulting in major cooperative bank failures. E.g., PMC Bank Failure due to misuse of power by board.
Financial Challenges: Such as low capitalisation, high levels of Non Performing Assets (NPA), inadequate Capital Adequacy Ratio (CAR).
Technological Limitations: Many UCBs lag in adopting technologies like Core Banking Solutions (CBS).
Decline in number of UCBs: Due to various reasons like unsafe operations to the interests of depositors and the general public, insufficient capital, low earnings, etc.

RBI’s Prompt Corrective Action:

To strengthen UCBs in India, RBI will implement the Prompt Corrective Action (PCA) Framework for UCBs starting April 1, 2025. This will replace the current Supervisory Action Framework (SAF).
The PCA framework will be applied based on different tiers of UCBs.
- Tier 1 UCBs: deposits up to ₹100 crore
- Tier 2 UCBs: deposits b/w ₹100 crore - ₹1,000 crore
- Tier 3 UCBs: deposits b/w ₹1000 crore - ₹10,000 crore
- Tier 4 UCBs: deposits above ₹10,000 crore
Tier 1 UCBs are excluded from PCA Framework for now.
PCA framework applies to UCBs in Tier 2, Tier 3 and Tier 4.
- The framework establishes risk thresholds for capital adequacy, asset quality, and profitability.
- For capital adequacy, breaches are categorised based on the extent to which the levels fall below the regulatory minimum — by up to 250 basis points, 250-400 basis points, or exceeding 400 basis points.
- In terms of asset quality, thresholds are determined by the level of net non-performing assets (NNPAs), with categories set at 6-9 per cent, 9-12 per cent, and 12 per cent or higher.
A UCB may exit the PCA framework if it reports no breaches in risk parameters for four consecutive quarters.

Way Forward

Strict diligence practices through credit assessments, proper documentation, and compliance with legal and regulatory standards.
Regular compliance checks: A well-designed compliance programme with a dedicated Chief Compliance Officer (CCO) can help UCBs to adhere to regulatory complexities and maintain operational stability.
Enhance risk management through risk management committees to oversee activities related to credit and operational risks.
Upskilling staff: Regular staff training on compliance and risk management is essential for effective functioning of UCBs.
Strengthening Audit mechanisms to help meet regulatory standards and restore depositor confidence.

The PCA framework emphasises the need for UCBs to manage credit and concentration risks effectively. This involves diversifying loan portfolios, reducing exposure to risky sectors, and maintaining healthy asset quality.

India’s Financial System showing Stability & Resilience: RBI

Context: The RBI’s Financial Stability Report released in December 2024, highlights significant improvements in the asset quality of Scheduled Commercial Banks (SCB), with Gross NPA ratios at a 12-year low.

It shows the resilience of India’s financial system, supported by strong capital buffers, improved provisioning and healthy domestic financial fundamentals amidst global uncertainties.

Relevance of the Topic: Prelims: Important Banking-related terms.

RBI’s Financial Stability Report

Published bi-annually by the Reserve Bank of India.
It reflects the collective assessment of the Sub-Committee of Financial Stability and Development Council (FSDC), which is headed by the RBI Governor.
The report evaluates the resilience of the Indian financial system and identifies risks to financial stability.

Important Banking-related Terms

1. Asset Quality Ratio:

Asset quality ratio (AQR) is a key indicator that measures the proportion of non-performing assets (NPAs) to total assets in a bank.
A high AQR indicates that a bank has a large amount of bad assets that are dragging down its performance and posing a risk to its solvency.
A low AQR indicates that a bank has a healthy portfolio of assets that are generating income and interest for the bank, enhancing its profitability and stability.

2. Provisioning Coverage Ratio (PCR):

PCR provides insights into the adequacy of provisions made by banks to cover potential losses on their loan portfolios.
It is calculated by dividing the total provisions held by a bank by its total non-performing loans (NPLs).
It represents the percentage of NPLs that are covered by provisions.
A higher ratio indicates a stronger ability to absorb potential losses.

3. Capital Adequacy Ratio (CAR):

CAR is the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities. This is a measure of a bank’s ability to meet its obligations.
A high CAR means the bank can absorb losses without diluting capital.

4. CASA Ratio (Current Account Savings Account ratio):

CASA is the proportion of current account and savings account deposits in the total deposits of the bank.
A low CASA ratio means the bank relies heavily on costlier wholesale funding, which can hurt its margins.

5. Net Interest Margin (NIM):

This is the difference between interest earned by a bank on loans and the interest it pays on deposits.
NIM will be high for banks with higher low-cost deposits or high lending rates.
Low NIM and high NPA is a bad combination.

6. Return on Assets (RoA):

It shows how profitable a bank’s assets are in generating revenue.
A lower RoA means that the bank is not able to utilise assets efficiently.
Negative RoA implies the bank’s assets are yielding negative returns.

7. Capital Conservation Buffer (CCB):

CCB is a concept introduced under the international Basel III norms.
According to Basel III norms, during good times, banks must build up a capital buffer that can be drawn from, when there is stress.
In India, to adhere to Basel norms, RBI wants all the commercial banks to achieve a minimum total capital of 9 per cent and a capital conservation buffer of 2.5 per cent, with the minimum total capital and CCB adding up to 11.5 per cent.

Major Highlights of RBI’s Financial Stability Report

Gross NPA ratio has declined to a 12-year low of 2.6% in September 2024.
Scheduled Commercial Bank’s Net NPA ratio stayed at 0.6%.
Provisioning Coverage Ratio improved to 77% in September, mainly due to proactive provisioning by Public Sector Banks.
Improvement in Return on Assets and earnings before provisions and taxes.
Sequential decline in the net interest margin abetted by shift of deposits to higher interest rate buckets.
Decline in share of low-cost Current Account Savings Account (CASA) deposits.
Increase in share of term deposits, especially for higher interest-rate buckets.

CII suggests changes in Priority sector lending norms

Context: The Confederation of Indian Industry (CII) has proposed reforms in the Priority-sector lending (PSL) framework suggesting inclusion of emerging sectors and high-impact sectors like digital infrastructure, green initiatives, healthcare and innovative manufacturing into the PSL framework.

Relevance of the topic:

Prelims: Questions based on Priority sector lending.

Mains: Analytical question on needs to expand PSL criteria.

What is Priority sector lending?

Priority sector lending is a practice of lending a certain portion of a bank’s funds to specific sectors of the economy identified as priority sectors by regulatory authorities.
The policy tool is aimed at ensuring that key sectors crucial to the nation’s development receive adequate financial support or credit.
These sectors include- Agriculture and allied sectors, MSME, Export credit, Education, Housing, Social Infrastructure, Renewable Energy etc.

Also Read: Priority Sector Lending

Needs to reform PSL framework:

Change in sectoral dynamics: The sector dynamics like contribution in GDP has changed with time. For instance, Traditional sectors like agriculture have seen a reduction in their GDP contribution to 14% now, while PSL allocations to the sector remain at 18 percent. So, a recalibration in the PSL framework is needed to reflect current economic reality.
Requirements of sunrise sectors: Sectors like green energy, and digital infrastructure lack funding opportunities, therefore they require inclusion in the PSL for credit flow.
Learnings from globe: Nations like Brazil and Indonesia provide cheap and priority loans to emerging sectors like green initiatives.
Fostering promising growth: Providing PSL to sectors like digital infrastructure can ensure sustainable returns to the banks due to their profitable nature.

Issues in PSL reforms:

Vulnerable sectors: Various sectors like agriculture and small industries sectors are already less attractive for banks. Changes in the PSL norms will negatively impact funding in these sectors.
Exploring alternatives: Sectors like digital infrastructure are attractive for private investors and venture capitalists due to their scope and productivity. So, alternate funding mechanisms can be explored for them, without tapping into PSL.
Possible public resistance: The change in norms may be perceived as an anti-welfarist approach leading to opposition and backlash.
Uncertain potential: Emerging sectors like green initiatives lack proper research and their economic potential might be overestimated. This may lead to the issues in recovery of loans.

Way Forward

Reducing stagnant sector share: Stagnant and reducing sectors like agriculture need to be rationalised, while alternate mechanisms like private financing can be explored for these sectors.
Phased implementation: PSL norms need to be transformed in a phased manner by analysing the long-term and short-term impacts on the various stakeholders.
Pushing for holistic reforms: A holistic approach needs to be devised to enhance funding in emerging sectors. Liberalising the bond market and promoting private financing can be explored in this regard.

Way Forward: Priority sector norms are crucial to give a boost to the unserved and underserved sectors of the economy. But, reforms in PSL are crucial to keep the pace with economic dynamics, emerging opportunities and transforming social setup. Though these reforms need to be in a phased manner and should be extensively consulted with stakeholders.