Monetary Policy

1.Repo Rate:

•  The Repo Rate is the interest rate at which the Reserve Bank of India (RBI) loans money to commercial banks.
• More specifically, it is the interest rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) to all LAF participants against the collateral of government and other approved securities.
• Repo stands for “Repurchase Agreement.” When banks borrow funds from the RBI at the repo rate, they pledge government securities to the RBI and receive cash in exchange, agreeing to repurchase those securities by returning the borrowed funds (often overnight).
• The Repo Rate is also referred to as the “Policy Rate.”

2.Reverse Repo Rate:

• The interest rate at which the Reserve Bank absorbs liquidity from banks against the collateral of eligible government securities under the LAF.
• Following the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time.
• Currently, banks are allowed to deposit any amount with the RBI at the reverse repo rate without restriction. However, if necessary, the RBI has the authority to impose a cap on these deposits.

3.Standing Deposit Facility (SDF) Rate: 

• The rate at which the Reserve Bank accepts uncollateralised deposits, on an overnight basis, from all LAF participants.
• The SDF is also a financial stability tool in addition to its role in liquidity management.
• The SDF rate is placed at 25 basis points below the policy repo rate.
• With introduction of SDF in April 2022, the SDF rate replaced the fixed reverse repo rate as the floor of the LAF corridor.
• The use of SDF is entirely at the discretion of banks and is available every day of the week, year-round, unlike repo and reverse repo operations, which are conducted at the RBI’s discretion.

4.Marginal Standing Facility

• This facility, introduced in 2011, allows scheduled commercial banks to borrow additional overnight funds from the Reserve Bank, beyond what they can access through the repo window.
• Under this arrangement, banks can dip into their Statutory Liquidity Ratio (SLR) holdings up to a specified limit (2%) and borrow at a penal rate of interest.
• This provides a safety valve against unanticipated liquidity shocks to the banking system.
• The MSF rate is placed at 25 basis points above the policy repo rate.

5.Bank Rate:

• The rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers.
• The Bank Rate acts as the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio). The Bank Rate is published under Section 49 of the RBI Act, 1934.
• This rate has been aligned with the MSF rate and, changes automatically as and when the MSF rate changes alongside policy repo rate changes.

6.Liquidity Adjustment Facility (LAF)

• A Liquidity Adjustment Facility (LAF) is a monetary policy tool used by the Reserve Bank of India (RBI) to inject or absorb liquidity in the banking system as needed.It consists of overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF and MSF.
• Origin:
  • LAF was introduced by the Reserve Bank of India (RBI) in 2000 following the recommendations of the Narasimham Committee on Banking Sector Reforms (1998).
• Repo (Repurchase Agreement):
  • Used when banks need liquidity for their daily operations.
  • Banks borrow funds from RBI by pledging government securities.
  • Repo Rate is the rate of interest at which the RBI provides funds.
• Reverse Repo:
  • Used when banks have excess funds.
  • Banks park surplus liquidity with RBI.
  • Reverse Repo Rate is the rate of interest at which the RBI borrows funds from the SCBs.
• Purpose
  • To help banks meet daily liquidity mismatches (shortages or excesses of funds).
  • To allow RBI to absorb surplus liquidity from the banking system.
• The Repo Reverse Repo transaction can only be done in securities as approved by RBI (Treasury Bills, Central/State Govt, securities).
• RBI uses Repo and Reverse repo as instruments for liquidity adjusment in the system.
• Repo rate is known as policy rate and is used’as signal to the financial system to adjust their lending and borrowing operations.
• The government securities that banks and primary dealers use under the LAF are the securities that they have purchased over and above what they are mandated to purchase under the statutory
  liquidity ratio (SLR) requirement.

7.LAF Corridor

•  The LAF corridor has the marginal standing facility (MSF) rate as its upper bound (ceiling) and the standing deposit facility (SDF) rate as the lower bound (floor), with the policy repo rate in the middle of the corridor.

8.Reserve Requirements (Fractional Reserve Banking):

• Cash Reserve Ratio (CRR): 
  • The average daily balance that a bank is required to maintain with the Reserve Bank as a per cent of its net demand and time liabilities (NDTL) as on the last Friday of the second preceding fortnight that the Reserve Bank may notify from time to time in the Official Gazette.
  • CRR is governed by Section 42 of the Reserve Bank of India Act, 1934.
  • Under the RBI Act, 1934 the Reserve Bank, having regard to the needs of securing the monetary stability in the country, prescribes the CRR for banks without any floor or ceiling rate.
  • CRR deposits earn no interest.
  • A higher CRR means banks have less money available to lend to borrowers in the economy. During periods of high inflation, CRR is typically increased to absorb excess liquidity. Conversely, in times of moderate inflation, a lower CRR is maintained to support credit growth.
• Statutory Liquidity Ratio (SLR):
  • The Statutory Liquidity Ratio (SLR) refers to the proportion of deposits that scheduled commercial banks must maintain with themselves daily in the form of safe and liquid assets such as government securities, gold, and cash, relative to their Net Demand and Time Liabilities (NDTL).
  • Excess CRR balance is also treated as liquid assets for the purpose of SLR.
  • SLR aims at ensuring that the need for government funds is partly but surely met by the banks.
  • Scheduled Commercial Banks are mandated to maintain SLR under the provisions of the Banking Regulation Act, 1949.
  • The maximum ceiling for SLR is fixed at 40%.

9.Open Market Operations (OMOs)

• These include outright purchase/sale of government securities by the Reserve Bank for injection/absorption of durable liquidity in the banking system.
• When inflation in the economy is high, the RBI reduces the money supply by selling government securities, thereby absorbing liquidity from the system.
• Conversely, if the RBI wants to increase the money supply, it purchases government securities from banks and financial institutions, providing them with funds in exchange. This infusion of money ultimately raises the overall liquidity in the economy.