The Reserve Bank of India (RBI) and other central banks employ a range of monetary policy instruments to manage liquidity, control inflation, and promote economic growth. These instruments are broadly classified into direct and indirect tools.
Direct instruments immediately affect the reserves and liquidity of banks by adjusting the reserve requirements or through direct intervention in the securities market. For eg CRR, SLR
Indirect instruments influence market liquidity and interest rates more subtly, by changing the cost of borrowing or depositing funds. Eg. LAF including Repo, MSF, SDF, Bank Rate, OMOs.
In this guide we will explain these tools and their operations.
Repo Rate
Repo Rate is the interest rate at which the RBI lends short-term funds to commercial banks, using government-approved securities as collateral. In addition to providing loans, banks invest in various financial assets, such as government securities, which they can use as collateral in repo transactions to raise funds. The term “repo” stands for repurchase agreement, wherein banks agree to repurchase the securities at a future date. Repo transactions are part of the Liquidity Adjustment Facility (LAF), a crucial mechanism used by the RBI to manage short-term liquidity in the banking system.
◘ The standard tenor for repo transactions is typically overnight or 14 days.
◘ The 14-day term repo/reverse repo auctions, conducted at a variable rate, are aligned with the fortnightly CRR maintenance cycle and serve as the primary liquidity management tool for handling short-term liquidity requirements.
◘ Occasionally, longer tenors are employed during periods of liquidity stress. For instance, Variable Rate Repo (VRR) auctions are conducted on a need basis, where the rate is determined by market forces. These auctions can have longer tenors, like 28 days or 56 days.
◘ In special circumstances, such as the COVID-19 pandemic, the RBI can introduce longer term Targeted Long-Term Repo Operations (TLTRO), allowing banks to access liquidity for up to 3 years to support specific sectors of the economy.
This flexible approach to repo operations helps the RBI manage liquidity effectively, control inflation, and ensure financial stability.
Marginal Standing Facility (MSF)
The Marginal Standing Facility (MSF) is an emergency funding mechanism within the LAF that allows banks to borrow funds beyond the regular repo limit when faced with unexpected liquidity shortages. The MSF rate is set 25 basis points higher than the policy repo rate, making it a more expensive option for banks.
Unlike regular repo operations, where banks provide securities as collateral, the MSF allows banks to borrow by dipping into their Statutory Liquidity Ratio (SLR) holdings. However, banks can only use up to 2% of their Net Demand and Time Liabilities (NDTL) for MSF borrowings. This mechanism provides banks with an overnight liquidity solution and acts as a buffer resource during times of acute liquidity stress.
The MSF is typically accessed by banks as a last resort when they are unable to meet their liquidity needs through other channels, such as the repo window, and is designed to prevent systemic liquidity crises.
Bank Rate
Bank Rate is a long-term lending rate at which the RBI provides finance by buying or rediscounting bills of exchange or other commercial papers from banks. Unlike the repo rate, which is typically used for short-term borrowing, the bank rate is applied to longer-term loans. The Bank Rate also acts as a benchmark penal rate charged on banks for failing to meet their reserve requirements, such as the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
The Bank Rate is aligned with the Marginal Standing Facility (MSF) rate and changes automatically whenever the MSF rate or policy repo rate is adjusted. Because it impacts longer-term borrowing costs for banks, the bank rate also influences the interest rates commercial banks charge their customers, thereby affecting loans, credit availability, and the broader economy.
Standing Deposit Facility (SDF) Rate
The Standing Deposit Facility (SDF) is a tool introduced by the RBI in April 2022 to manage excess liquidity in the banking system. It’s a rate at which the Reserve Bank accepts uncollateralised deposits, on an overnight basis, from all LAF participants. The SDF rate is pegged at 25 basis points below the policy Repo rate. It replaced the fixed Reverse Repo rate as the floor of the LAF corridor (range within which policy rate vary – with MSF as the ceiling and SDF as the lower limit).
Primary role of the SDF is to absorb excess liquidity from the banking system, preventing surplus funds from causing inflationary pressures. It gives the RBI a non-collateralized tool to manage the surplus liquidity effectively.
Reverse Repo
A reverse repo transaction involves the RBI absorbing liquidity by selling government securities to banks with an agreement to repurchase them at a later date. This process helps the RBI manage short-term excess liquidity in the banking system. With the introduction of the Standing Deposit Facility (SDF) in April 2022, the use of fixed-rate reverse repo operations has become more discretionary and is used only when necessary.
In addition to fixed-rate operations, the RBI also uses the Variable Rate Reverse Repo (VRRR), where the interest rate is determined through an auction process. The VRRR is employed to absorb liquidity based on market-driven rates, providing flexibility in liquidity management during periods of surplus funds in the system.
Liquidity Adjustment Facility (LAF)
We have referred to LAF so many times, lets now understand what it is. Liquidity Adjustment Facility (LAF) is a key mechanism referring to various tools used by the RBI to manage short-term liquidity in the financial system. Most of the instruments discussed earlier—such as the Repo Rate, Reverse Repo Rate, Standing Deposit Facility (SDF), and Marginal Standing Facility (MSF)—fall under the LAF framework. In summary, LAF consists of:
◘ Overnight Repo and Reverse Repo operations, which provide immediate liquidity management.
◘ Term Repos/Reverse Repos that have tenors of longer durations (e.g., 14-day, 28-day), and may be conducted at fixed or variable rates.
◘ The SDF and MSF, which represent the lower and upper bounds of the interest rate corridor, respectively.
Together, these instruments ensure that the RBI can inject or absorb liquidity from the system as needed, while controlling short-term interest rates and maintaining financial stability.
Beyond LAF
Apart from the instruments within the LAF, the RBI employs additional tools for managing liquidity in the financial system, including:
Open Market Operations (OMOs)
OMOs are outright purchases or sales of government securities by the RBI on need basis. These operations help regulate the supply of liquidity in the market:
◘ Purchasing securities injects liquidity into the banking system.
◘ Selling securities absorbs excess liquidity. OMOs are used to manage short-term liquidity and maintain market stability, often in response to prevailing market conditions.
Market Stabilisation Scheme (MSS)
The Market Stabilisation Scheme (MSS) is a special tool used exclusively to absorb surplus liquidity. Under MSS, the RBI issues government securities that are specifically designated for this purpose. These are specific securities solely meant for liquidity management. The proceeds from MSS operations are kept in a separate account and are not used for funding government operations.
Forex Swaps
Forex swaps involve the RBI buying or selling foreign currency to manage liquidity in the domestic market. By entering into a foreign exchange transaction (e.g., purchasing dollars and selling rupees), the RBI can impact the rupee’s liquidity and stabilize the exchange rate as well as money market liquidity.
Together with the LAF, these instruments provide the RBI with a comprehensive framework for regulating liquidity, ensuring monetary stability, and maintaining control over inflationary pressures.
One key difference between all the various measures is some are standard and regular instruments while others are used on need basis, giving RBI a complete tool kit with variety to handle different liquidity targets and situations.
Direct Instruments
Cash Reserve Ratio (CRR)
The Cash Reserve Ratio (CRR) is a crucial monetary policy tool that requires banks to maintain a certain percentage of their Net Demand and Time Liabilities (NDTL) as reserves with the Reserve Bank of India (RBI). This percentage is determined by the RBI and must be held in the form of cash reserves. Banks do not earn any interest on the funds held as CRR, making it a direct control over bank liquidity.
CRR Maintenance: It is calculated based on a bank’s deposits and liabilities as of the last Friday of the second preceding fortnight, and the balance is maintained on an average daily basis.
By adjusting the CRR, the RBI controls the amount of money banks can lend, thereby influencing liquidity and inflation in the economy.
Statutory Liquidity Ratio (SLR)
The Statutory Liquidity Ratio (SLR) is a direct instrument of monetary policy that requires banks to maintain a percentage of their Net Demand and Time Liabilities (NDTL) in the form of liquid assets. These liquid assets typically include:
◘ Unencumbered government securities such as Treasury bills, bonds, and dated securities.
◘ Cash reserves that can be easily accessed.
◘ Gold, either physical or held in approved financial instruments.
Like CRR, the SLR is also maintained daily and calculated as of the last Friday of the second preceding fortnight. SLR ensures that banks have enough liquid assets to meet their obligations and while maintaining liquidity at desired levels.
Both CRR and SLR are essential tools for controlling liquidity in the banking system and ensuring financial stability. By adjusting these ratios, the RBI influences the availability of funds for lending and the overall economic environment.
Current Policy Rates
End Note
In summary, the RBI’s monetary policy instruments, including indirect tools like LAF (Repo, Reverse Repo, MSF, SDF), and OMOs, along with direct measures such as CRR and SLR, work together to manage liquidity, control inflation, and ensure financial stability. Globally, similar frameworks exist, such as the Federal Reserve’s Repo operations and Basel III’s Liquidity Coverage Ratio (LCR), all aimed at promoting economic resilience and financial security in volatile conditions.
Further Reading:
To enhance your understanding further do check out some key RBI circulars:
RBI Notifies Changes in Market Hours, April 2020
Repurchase Transactions (Repo) (Reserve Bank) Directions, 2018 – Amendment, Nov 2019
Maintenance of Statutory Liquidity Ratio (SLR), Oct 2016
Bucketing of excess SLR and MSF securities in Structural Liquidity Statement, July 2015
Master Circular – Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), July 2014
Disclaimer: The content is only for informational purposes only and not a professional advise. Refer RBI website for more info.