Decoding the MPC Announcement

Mandar asks a question:

So after Today's credit policy by @RBI, read many people commenting that reverse repo is all but dead with SDF and MSF. Didn't really understand why RBI had to come up with SDF when reverse repo was already there? A blog post on this would be great @ashish2727 🙏

— Mandar thatte (@thatte) April 8, 2022

This can be a short story, and a long story. Let’s make it a long one!

---

Here’s the very last paragraph from the third chapter of the RBI’s Annual Report of the year 2015-16:

III.39 Going forward, the focus of the Reserve Bank’s monetary policy stance during 2015-16 will be on fostering a gradual and durable disinflationary process towards the target of below 6 per cent by January 2016 in order to achieve the centrally projected rate of 4 per cent by the end of 2017-18. At the same time, the efficacy of the monetary policy transmission mechanism needs to improve since the pass-through of recent cuts in policy rate to the bank lending rate has been partial, reflecting constraints in transmission under the existing base rate system. Identifying the impediments in pass-through and implementing an alternative method, such as marginal cost based credit pricing or identifying an appropriate benchmark for the bank lending rate will be a priority for the Reserve Bank. In this regard, it is imperative to develop market based benchmarks by developing the term segment of the money market. Thus, liquidity support may have to be progressively provided through regular auctions of longer term repos with reduced dependence on overnight fixed-rate liquidity support. While doing so, it will also be important to dampen deviations of WACR and other money market rates such as CBLO rates from the repo rate in a narrow range. The Reserve Bank will continue to explore and augment its instruments of liquidity management, including standing deposit facility for absorption of surplus liquidity, as recommended by the Expert Committee.

https://www.rbi.org.in/Scripts/AnnualReportPublications.aspx?Id=1149 (emphasis added)

(Students should also look up, by the way, what WACR and CBLO are). But back to our story: in 2016, the RBI was “continuing to explore and augment its instruments of liquidity management” – including a facility that we’ve all read a bit about this past week, the standing deposit facility.

First, what is liquidity management?

The “liquidity management” of a central bank is defined as the framework, set of instruments and
especially the rules the central bank follows in steering the amount of bank reserves in order to control
their price (i.e. short term interest rates) consistently with its ultimate goals (e.g. price stability).

https://www.ecb.europa.eu/events/pdf/conferences/1b.pdf

In English: the central bank would like to try and control short term interest rates in the economy, in order to keep prices as stable as possible. The framework that allows them to do so is referred to as liquidity management.

So how does liquidity management work in practice, whether in India or abroad? In most cases, via the “repo” rate and the “reverse repo” rate. The first of these is the rate at which banks can borrow from the central bank, and the second of these is the rate at which the central bank can borrow from the banks. Here’s a good, basic, explainer.

So ok, we have a framework, and we now know how it works. Then why, Mandar asks, do we now have the SDF?

Which, of course, begs the question: what is the SDF?

At the last meeting, banks were offered a facility to park surplus liquidity through an auctioning system, which was in addition to reverse repo facility. The idea is to suck the surplus liquidity out of the system through the variable reverse repo rate. Now, RBI has regularized the same under the SDF window, which offers 3.75% interest rate for funds parked without any collateral backing. The SDF window will help banks earn a minimum return when they have surplus funds. The SDF rate of 3.75% would be the floor policy rate.

https://www.livemint.com/economy/decoding-rbi-s-latest-monetary-policy-decisions-11649613385417.html

If banks in our country have excess funds (and right now, they most certainly do) what can the banks do with them? One option is to use the reverse repo mechanism and park these funds with the central bank. Or you could use the auctioning system, as the excerpt above explains. But now, in addition to both of these, you can also make use of the SDF.

The reverse repo in our country is right now at 3.35%, while the SDF will give you 3.75%. If you are a bank with excess funds, the RBI says you can give me these excess funds and I’ll pay you a) an interest rate of 3.35% if you use the reverse repo route OR b) I’ll pay you 3.75% if you use the SDF.

The naïve response to this is to go with option b). The not so naïve response is to ask “Wait, what’s the catch?”

Well, the catch is that reverse repo’s come with collateralization. When the central bank accepts excess funds from you, what it does in practice is it “sells” you securities, and “buys” them back at a slightly higher rate when it gives the funds back. “Buying them back” is a repurchase, and hence the terms repo (bank to central bank) and reverse repo (central bank to bank). When securities are involved, we say the deal is collateralized.

SDF? No collateralization.

Why? Well, there’s so much of excess liquidity floating about that the central bank was running out of securities to offer as collateral.

But ain’t this a rather risky thing, parking excess funds without collateralization? Well, this is the RBI we’re talking about. If you don’t trust the central bank, then what else is there boss? So no, we don’t need to worry about the lack of collateralization is the current stance, and all are ok with this.

---

So the effective rate is now 3.75, not 3.35?

Um no, it’s actually 4.00%. Remember those reverse repo auctions? Those have been averaging around 4%. So (and if you think this is confusing, join the club), if you’re a bank and have excess funds, the central bank now gives you three choices:

1. Good ol’ reverse repo, with collateralization, but 3.35%
2. SDF, 3.75%, but no collateralization
3. Reverse repo auctions, 4.00%, with the same collateralization as is applicable for the LAF. (This last point is on a “best as I can tell” basis. If anybody reading this knows better, please help me and the readers out!)

So, (phew!), in effect the floor is 3.75% 4.00%.

And that’s the answer to Mandar’s question: this is why the RBI has introduced an SDF when we already have the reverse repo rate.

---