RBI’s Monetary Tools

The Monetary Policy is designed by the Central bank to strategies the key factors in the economy to help control inflation and manage liquidity in the system. It helps lay down a structure for the banking system in the country. It aims to keep inflation and currency fluctuations in check, while keeping an objective of growth.

Reserve Bank of India (RBI) is the regulator and supervisor of India’s financial ecosystem. RBI formulates, implements and manages the Monetary Policy. The Monetary Policy Committee (MPC) led by the Governor of RBI, usually meets every 2 months. The MPC uses a few monetary tools to formulate the current monetary policy. Understanding these tools in detail, will give an insight on the operations of the RBI and how the monetary policy impacts the money supply in the system.

1. LAF – Liquidity Adjustment Facility

As the name suggests this tool is used to inject or absorb liquidity from the banking system. In 1998, Narasimham Committee on banking, recommended LAF. In April 1999, an interim LAF was introduced keeping ceiling and floor money market rates. Eventually in June 2000,LAF was introduced full-fledged.

LAF has 2 components- Repo Rate and Reverse Repo Rate

•  Repo Rate: Repo Rate is rate at which Banks lend money from the RBI, in exchange of government securities. The word Repo stands for Repurchase Agreement. The banks sell the government securities to the RBI and repurchases it back at a predetermined rate and tenure. This lending helps to meet the shortage of funds at the bank’s end and helps in injecting liquidity in banking system. This temporary collateral lending is used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Repo rate is also colloquially called the policy rate. These rates have an impact on the inflation; hence one will always see a rise in repo rates during the rising inflation times. A rate cut is expected, when inflation is in control.
•  Reverse Repo Rate: It is the mirror image of a repo rate. Here, RBI sells government securities to banks, to be bought back for a predetermined rate and date. In other words, the banks lend money to the RBI. It is a way to absorb excessive liquidity in the system. Also, it encourages banks to park their temporary surplus with the RBI in exchange for an interest incentive.

RBI undertakes auctions for repo rate agreements or reverse repo rate agreements. They are usually in multiples of Rs. 5 crores. The auctions generally happen on the CBS(e-Kuber) platform. Banks place their bids and a cut off rate is later determined by the RBI. All scheduled commercial banks having current accounts and SGL accounts with RBI are eligible for availing of the Liquidity Adjustment Facility. However, Regional Rural Banks are not allowed to avail of LAF.

Repo rates have been 4% in the last 3 years until May 2022, when RBI started hiking the rates. They were last hiked in Jan 2023 to 6.5%. In Feb, April, June, Aug, Oct and Dec 2023, PMC has declared no change in the policy rate, neither hike nor rate cut.

Repo Rate and Inflation:

An increase in Repo rates can also increase the cost of borrowing for businesses and individuals, which can reduce demand for goods and services. If demand decreases, producers may reduce prices to attract buyers, which can help control inflation. Also banking rates on deposits improve, encouraging more investments in the economy, leading to more liquidity, lesser spendings, leading to decrease in demand, eventually bringing prices down and helping control inflation.

Time Lag Effect: Like RBI has been continuously increasing their policy rates since May 2022. We see a few weeks’ time lag till the inflation rates start showing an inverse traction. Even when RBI took a pause on rate hike in April 2023, we saw a fall in inflation rates on account of effect of previous rate hikes.

In the past one year we have seen several Variable reverse repo rate (VRRR) auctions by the RBI. Especially June-23 followed by Jan-23.

A reverse repo rate helps banks park their excessive funds temporarily with the RBI, it helps absorb surplus liquidity. In VRRR auctions, RBI states details in a press release informing banks a date and time for the auction, along with the notified amount. Usually, 30 minutes are given for banks to place bids and then a cut off rate is decided. Rate at or above repo rate are considered void.

Variable Reverse Repo Rate Auctions from Oct 2023 till date

2. Marginal Standing Facility (MSF) and Standing Deposit Facility (SDF)

• Marginal Standing Facility (MSF): was started in 2011. It gave scheduled commercial banks a provision to borrow from the RBI in an emergency situation when inter-bank liquidity was compromised. The process is similar to LAF, where the RBI will purchase G-Securities to sell it back at a fixed date and rate. The MSF lending rate is 100bps more than the repo rate under LAF. Banks are allowed to borrow funds upto 1% of their NDTL (net demand and time liabilities)

* From December 2020, RBI has extended the scope of LAP and MSF to include Rural Regional Banks. This to help boost efficient liquidity management at pan India level.

• Standing Deposit Facility (SDF): is an option given by RBI to banks to park excess funds without a collateral. It is like reverse repo rate but without any collaterals. RBI announced SDF in April 2022, as an additional facility to help absorb surplus liquidity. Both MSF and SDF will be available, throughout the year, all days of the week.

*LAF corridor is known as the difference between the repo rate(cap) and reverse repo rate(floor). When SDF was introduced, it replaced FRRR (fixed reversible repo rate) as the floor for LAF corridor.

3. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

• Cash Reserve Ratio (CRR): It is a monetary policy tool used by central banks to regulate the amount of funds that commercial banks must maintain as reserves with the central bank. The reserve requirement is usually expressed as a percentage of a bank's total deposits or liabilities. CRR helps in controlling lendings made by banks. When the central bank increases the CRR, banks are required to hold a higher proportion of their deposits as reserves, reducing the amount of money available for lending. On the other hand, when the central bank decreases the CRR, banks have more funds to lend, which can stimulate economic growth

*Since Feb 2023, banks were urging RBI to allow amounts parked in dormant accounts to be used at as CRRs. Almost Rs. 50,000 crores are locked up in the same. There has been no update from the RBI on this front yet.

• Statutory Liquidity Ratio (SLR): It is a regulatory requirement set by RBI that mandates commercial banks to maintain a certain percentage of their net demand and time liabilities (NDTL) in the form of specified liquid assets, such as government securities, cash, or gold. The purpose of SLR is to ensure the liquidity and solvency of banks and to control the expansion of credit in the economy.

4. Open Market Operations (OMO)

Open Market Operations are the buying and selling of government securities (such as Treasury bills and bonds) by the central bank in the open market. The objective is to regulate the money supply in the economy and manage liquidity in the banking system. When the central bank wants to increase the money supply, it purchases government securities from banks and other financial institutions. This injects money into the system, providing liquidity to banks and encouraging lending and economic activity. Conversely, when the central bank wants to reduce the money supply, it sells government securities, thereby absorbing excess funds from the system and reducing liquidity.

Rates as per the latest Monetary Policy Meeting (Dec 2023)