In a bid to simplify the liquidity management framework, the RBI on Thursday announced the setting up of an Internal Working Group to come up with suggestions.

This move has been received with great optimism by bankers, and not without reason.

With liquidity hampering transmission of policy rate actions, ironing out complexities in the existing framework is imperative.

Earlier structure

Here are some of the changes that have been effected in the liquidity management framework in the past few years, which may be reviewed by the group. Prior to 2013, banks were allowed to borrow any amount under the LAF (liquidity adjustment facility) at the fixed repo rate.

But in October 2013, the RBI decided to move to ‘term repo’. The ‘term repo’ window allows the RBI to supply funds from time to time, with banks bidding for the rates at which they will borrow this money.

The idea was to develop a yield curve across various maturities which could act as a benchmark for various money market instruments. But the term repo failed to serve this purpose and, instead, the multiple term repos have led to complexities.

Additionally, in its April policy in 2016, the RBI made substantial changes in the liquidity management — moving from deficit to neutral liquidity. The RBI lowered the rate corridor between the repo, reverse repo and marginal standing facility (MSF) rate to 50 basis points from 100 basis points earlier.

The repo rate is the rate at which banks borrow short-term funds from the RBI, and reverse repo is the rate at which banks lend surplus money to the RBI. If banks exhaust their limits under the repo window, they can borrow under the MSF at higher rate.

The underlying purpose of narrowing the rate differential between the three was to ensure quicker transmission of policy rates to borrowers.

But post demonetisation, when banks were flush with funds, excess liquidity led to a sharp fall in deposit rates. Hence, the RBI reviewed its measures in April 2017 and narrowed the rate corridor between repo, reverse repo and MSF from 50 basis points to 25 basis points.

Course correction

All these measures were to ensure that the operational rate (weighted average call rate, WACR) is aligned well with the policy repo rate.

Industry players and bankers are of the view that there is a re-think needed on the objective of keeping WACR aligned to the repo rate. The system should be able to move between surplus and deficit, which will ensure that the repo rate becomes the operational rate when the system is in deficit, while the reverse repo becomes the operational rate in times of surplus.

This could iron out complexities in the framework and help in smoother transmission.

Related Topics
comment COMMENT NOW