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How new LAF will help RBI

How new LAF will help RBI
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First Published: Mon, Mar 28 2011. 01 17 AM IST
Updated: Mon, Mar 28 2011. 01 17 AM IST
The Indian central bank has put on its website a report of an internal group on operating procedures of monetary policy and invited comments from the public. The group, headed by Deepak Mohanty, one of its executive directors, was set up in October to take a close look at the liquidity corridor run by the Reserve Bank of India (RBI) and the role of the bank rate, among other things.
The bank rate was introduced in 1935 as a signal rate but lost its relevance in the later half of the century. Former RBI governor C. Rangarajan reactivated it in April 1997. Last changed in 2003, it has remained at 6% and became defunct while the repurchase, or repo, rate and the reverse repo rate have continuously been changed in sync with the stance of the monetary policy. The repo rate is the rate at which banks raise money from RBI, and they lend money to the central bank at the reverse repo rate.
The repo rate is now 6.75% and the reverse repo 5.75%. The difference between the two rates is the liquidity corridor, technically known as liquidity adjustment facility (LAF). The rates of the overnight call money market—where banks lend to each other to help tide over their temporary asset-liability mismatches—are expected to rule between the two rates. But there have been occasions when the overnight rates cross the upper end of the corridor.
Banks are required to offer government bonds as collateral to borrow from RBI. They can do so if they have bonds in excess of the regulatory requirement, known as SLR (statutory liquidity ratio). Banks need to invest at least 24% of their deposits in government bonds.
If they have excess investments in government bonds over and above 24%, they can offer them as collateral to raise money from RBI’s repo window. Those that do not have excess investment need to borrow from the overnight market; and if demand for money is far higher than supply, the rate rises.
While keeping the bank rate unchanged for years, RBI has been using the repo and reverse repo rates as policy rates. In a tight liquidity situation—which has been the case for past one-and-a-half years—the repo rate is the policy rate. But when there is excess liquidity in the system and banks are parking money with RBI, the reverse repo rate becomes the policy rate. In 2009, in the aftermath of the collapse of US investment bank Lehman Brothers Holdings Inc., RBI flooded the market with money and brought down its reverse repo rate, then policy rate, to 3.25%.
Since then, the policy rate has been raised by 3.5 percentage points to 6.75% now (as the repo is the policy rate in a liquidity-starved system). Over the past two years, RBI has also shrunk the liquidity corridor, or the difference between its repo and reverse repo rates, by half a percentage point to 1%.
The RBI committee has recommended that the bank rate should be repositioned as a discount rate through which the central bank can inject liquidity in the system in exceptional circumstances against collateral of bonds. There is, however, a limit to what extent banks can borrow money from RBI through this window—1% of their deposit base. In such times, banks’ SLR requirement will be pared by one percentage point.
Banks will have to pay half a percentage point higher than the repo rate to access this facility, the ceiling of the new liquidity corridor. The floor will continue to remain the reverse repo rate, which will always be one percentage point lower than the repo rate. So, in the new scheme of things, the repo rate will remain in between two rates—half a percentage point lower than the bank rate and one percentage point higher than the reverse repo rate.
Theoretically, if the repo rate is 6.75% (which it is now), the bank rate should be 7.25% and reverse repo 5.75%. Currently, the repo rate is 6.75%, bank rate 6%, and reverse repo rate 5.75%.
The committee wants the repo rate to be the key policy rate and a two-tier liquidity corridor, one between reverse repo and repo and another between repo and the bank rate. In order to make the repo rate the key policy rate, the system should always run in a cash-deficit mode as has been the case with most developed markets. This will give RBI better grip of the monetary policy and transmission will be quicker. The European Central Bank, too, has a three-rate architecture—an intervention rate, a marginal deposit facility and a penal lending rate.
A critical suggestion of the panel is auctioning of the government’s surplus cash kept with RBI (this column on 13 December suggested this). The government keeps its money with the central bank, and if it is allowed to auction the money for the short term to the best bidders, the money will come back to the system and ease pressure on liquidity.
The Chinese central bank periodically does so as part of the finance ministry’s cash management programme. Agence France Trèsor, the debt management agency of Banque de France, too, invests surplus cash in the inter-bank market in the form of unsecured loans.
If the system is always kept in the deficit mode, banks will focus more on deposit mobilization and pay the savers a little bit extra—something RBI governor D. Subbarao has been repeatedly emphasizing on. Indeed, banks have raised their deposit rates, but with inflation still ruling above 8%, even one-year deposits of most banks are offering negative or no returns to savers.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to bankerstrust@livemint.com
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First Published: Mon, Mar 28 2011. 01 17 AM IST