The Plumbing in the Monetary Policy Architecture

What happens after the Monetary Policy Committee deliberates, votes and adopts the policy decision, my students asked? How is that decision reflected in financial markets, in transactions by banks and financial institutions, and in spending/saving choices of common people? 

It is the responsibility of the RBI to implement the MPC’s decision. 

For this purpose, it has assiduously built an institutional framework and systematic hierarchy of stepping stones that connect its overarching goals like price stability to operational tools such as interest rates and open market operations. The MPC’s policy rate decision becomes the benchmark. Thereafter, through a web of interlocking balance sheets, the cost of borrowing or lending in various segments of the financial markets gets influenced by the RBI, determining loan and deposit rates, business and consumer credit availability, asset prices and expectations.

The Hydraulics: Liquidity Management
The immediate task for the RBI is to ensure that the policy rate decided by the MPC is reflected at the shortest end of the market continuum as soon as possible. This is done through the management of stocks and flows of liquidity or cash. Hence, liquidity management is often referred to formally as the operating procedure of monetary policy. It implements monetary policy. Hence, it is interesting to explore the intricacies of liquidity management.

Liquidity Management by Banks
A good point to begin is by comparing and contrasting liquidity management by a bank as a representative market participant and by the RBI.

Every bank must manage its cash flows in such a manner that it always has some funds to meet demands from the public within the day or within 24 hours. This is the first consideration. The second consideration is that, for this purpose, it must gather liquid assets that can be converted swiftly into cash in the most cost-effective way that is feasible.

Why do Banks Need Liquidity
The demand for liquid funds may arise from various sources such as the withdrawal of a deposit either because it is maturing or it is being prematurely taken out. Funds may also be needed immediately if a cash credit account is being drawn down.

The cash credit is a short-term, secured revolving credit facility provided by banks to businesses for managing working capital, allowing them to withdraw funds up to a pre-approved limit. It acts like an overdraft, where interest is charged only on the amount utilised, not on the total limit. Funds are also needed to settle payment and settlement needs such as National Electronic Funds Transfer (NEFT)/Real Time Gross Settlement (RTGS)/Immediate Payment Service (IMPS)/cheque clearing, and the like.

If the bank has participated in a government securities auction or in a variable rate repo (VRR) auction under the RBI’s Liquidity Adjustment Facility (LAF), it has to pay up the first thing in the morning on the next day. Banks also have to ensure that the CRR, which is a fixed proportion of their net demand and time liabilities, is maintained fully on a daily average basis.

The Supply of Liquidity  
Where do the liquid funds come from to meet this demand? The first charge may be on the cash in hand or vault cash that all banks keep. This is usually very little as every bank tries to maximise the deployment of funds rather than keep anything idle. Sometimes banks may keep CRR balances a little more than what is stipulated, and this can be freely drawn down. The most important source of funds, and perhaps the most cost-effective, is what is called wholesale funding. This is borrowed from the market for a period of a few minutes to less than 24 hours.

India’s Money Markets
Overnight money markets in India take the form of the call money market, the Collateralised Borrowing and Lending Obligation (CBLO) or tri-party repo (TREPS) market, and the repo market. The call money market is a highly liquid segment of the money market for extremely short-term, unsecured, inter-bank lending. It handles overnight transactions (“call money”) or up to 14 days (“notice money”), allowing banks to manage temporary liquidity shortages. The repo market is a high-volume segment of the money market, with daily transactions exceeding ₹2 trillion. It acts as a collateralised funding mechanism for banks, primary dealers, and financial institutions to manage short-term liquidity. 

The CBLO/TREPS market in India enables secure, short-term borrowing and lending against government securities. Primarily designed to provide liquidity to non-bank entities restricted from the call money market, it operates with maturities from 1 day to 1 year, with the Clearing Corporation of India Limited (CCIL) acting as the central counterparty. The CCIL performs the role of an intermediary that provides institutional clearing, settlement, and risk management services for India's financial markets. By doing so, it mitigates counterparty risk. Currently, the CCIL clears and settles transactions across several core segments of the Indian financial ecosystem such as transactions in government securities, money market instruments and foreign exchange. It is an important facilitator of liquidity management by banks through the settlement of repos, reverse repos, call money, and tri-party repos (TREPS). It also acts as a trade repository and central clearing framework for Over-The-Counter (OTC) interest rate derivatives such as interest rate swaps.

Liquidity Management by the RBI
If all these options are exhausted, the bank has to approach the RBI for liquidity. Often the RBI is the first port of call, because the liquidity it provides is assured, cheap even relative to wholesale funding and stable. For the purpose of liquidity management, it is useful to distinguish between types of liquidity. That distinction will determine what instruments are to be used for liquidity management.

Frictional Liquidity
Frictional or transient liquidity is associated with short-term, reversible fluctuations in bank reserves. The sources of demand for frictional liquidity are government tax collections/spending, seasonal and festival-related currency demand, temporary mismatches in bank flows, and the like.

The instruments of the RBI for managing frictional liquidity changes are the LAF under which banks and primary dealers (PDs) avail of liquidity from the RBI or park excess funds with it. The floor of the LAF is the Standing Deposit Facility (SDF) through which banks can park funds overnight with the RBI, earning a rate of interest that is generally 25 basis points below the policy repo rate. It is an uncollateralised standing facility to which access is at the discretion of market participants.

Analogously, the Marginal Standing Facility (MSF) provides the ceiling of the LAF. Through it, banks can borrow funds from the RBI, generally 25 basis points above the policy repo rate, up to a specified percentage of the statutory liquidity ratio (SLR), which is the proportion of net demand and time liabilities that every bank has to maintain as eligible securities on a daily basis during a fortnight. Like the SDF, the MSF is an overnight standing facility.

The Variable Rate Repo (VRR) is an instrument under the LAF through which the RBI provides liquidity, but at its discretion, to eligible counterparties against the collateral of government and other approved securities. The cut off rate is decided by auction, with the proviso that the rates bid by banks must be above the policy repo rate. The Variable Rate Reverse Repo (VRRR) enables the RBI, at its discretion, to absorb liquidity from eligible counterparties, with the RBI providing the collateral of government and other approved securities. Here too, the cut off rate is decided by auction with the rates offered by banks having to be below the policy repo rate. There is also the Fixed Rate Reverse Repo/Repo (FRR/R) in which the cut-off rate is pre-set at which the quantity of liquidity is auctioned.

Durable Liquidity
Durable liquidity is associated with structural, permanent shifts in the banking system, the sources of demand being sustained growth in currency in circulation and bank credit, persistent capital inflows/outflows warranting foreign exchange operations by the RBI, and the like.

The RBI modulates durable liquidity through open market operations (OMOs) that involve the outright buying and selling of government securities, unlike repos/reverse repos which are reversible, foreign exchange swaps involving purchase and sale of foreign exchange by the RBI and reversed after a specified period (buy/sell swap injects liquidity while sell/buy swap absorbs liquidity), and changes in the CRR and SLR.

So, liquidity management by the RBI is quite unique and distinct from that conducted by banks. The RBI creates the demand for reserves through the application of the CRR, which is subject to daily maintenance or else banks will attract a penalty, typically calculated as 3% per annum above the RBI’s Bank Rate on the shortfall for the first day, increasing to 5% per annum above the bank rate if the default continues.

The SLR also creates demand for reserves at one stage removed because some part of the funds raised by banks that form their net demand and time liabilities has to be invested in government securities rather than other forms of deployment such as bank loans. Excess SLR is also eligible to be used as collateral for LAF borrowings. The RBI also provides the supply of reserves, as explained. Thus, by impacting both demand and supply of reserves, the RBI can influence money markets so fundamentally that interest rates in these segments evolve in close alignment with the repo rate decided by the MPC.

Operating Target of Liquidity Management
How does the public assess whether or not the monetary policy decision has been implemented? For this purpose, liquidity management requires a target that has to be achieved for conveying the decision of the MPC to market participants. It is called the operating target. It is typically the overnight money market rates or short-term liquidity levels. The operating target reflects the efficacy of liquidity management by the RBI.

This can be gauged from how quickly and completely it reflects the policy rate decided by the MPC. The RBI chooses the call money rate as the operating target. This is sometimes puzzling because entities would generally prefer the collateralised markets for their secureness. It is only when they lack collateral and cash that they would go to the call money market, which operates purely on trust. Hence it has the lowest volume in the money market. But it reflects the infra-marginal demand for funds. It is also the most volatile where borrowers are likely to be charged higher rates relative to other market segments. By influencing this rate, the RBI can influence all other money market rates in a stable and lasting manner.

The reflection of the policy repo rate in the call money rate is the first leg of monetary policy transmission.   Ends

This is Part 9 of the Masterclass with Michael Patra.

Masterclass with Michael Patra: Previous Sessions

Part 1
Origins, Ideas and Institutions
Michael Patra begins the masterclass by tracing how central banks evolved from fragile monetary experiments into institutions entrusted with preserving trust, stability and confidence.

Part 2
RBI and the Safeguarding of Confidence
The series then turns to the RBI’s evolution, its expanding institutional role, and the balance between autonomy, growth and price stability.

Part 3
The Rise and Fall of Monetary Policy Regimes
From Bretton Woods to monetary targeting, the masterclass examines how central banks repeatedly reinvented monetary policy frameworks when old anchors collapsed.

Part 4
When Monetary Anchors Collapse
As monetary targeting broke down globally, central banks were pushed again into uncertainty, instability and regime change.

Part 5
Central Banking and Monetary Policy Regimes: The Indian Experience
How India’s trysts with crises, policy responses and changing gears in the development strategy imposed monetary policy regime shifts upon the RBI.

Part 6
Inflation Targeting and the Contract of Trust
From time inconsistency to flexible mandates, Michael Patra explains how inflation targeting became the world’s most durable monetary policy regime.

Part 7
India: Survival of the FITtest
From the Urjit Patel committee to the first MPC, Michael Patra traces how India designed, legislated and launched flexible inflation targeting.

Part 8
Lessons From India’s Inflation Targeting Decade
After a decade tested by a pandemic and war, Michael Patra distils four lessons from India’s flexible inflation-targeting framework.