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CASE STUDY ON RBI

A Reserve Bank of India study group has recommended sticking to the current
liquidity mechanism that targets the overnight call money rate hugging the
policy rate, while suggesting longer term variable-rate repo or reverse repo as
an alternative to open market operations.

The group has suggested minimizing central bank’s role in daily liquidity
management while the new liquidity framework would incentivise banks to
trade among themselves rather than with the central bank to make monetary
transmission of policy rates more effective. It has also suggested standalone
primary dealers be allowed to participate directly in all overnight liquidity
management operations.

The framework is envisaged to avoid build-up of large surplus or deficit while

a slightly deficit position would be favoured, in sync with the decade-long
practice, which helps the policy rate to gravitate towards the call rate.

“It is important to ensure that liquidity operations should be consistent with

the policy rate set by the Monetary Policy Committee. Liquidity management
by the central bank should be aimed at achieving the first leg of transmission
of the monetary policy, which is to align the target rate with the policy rate,”
said the study group, which was mandated to review and simplify the current
liquidity management framework.

The call money rate – with Weighted Average Call Rate (WACR) as the measure
– will continue as the target rate of the liquidity management framework as it
reacts to both surplus and deficit liquidity conditions, though asymmetrically.

Empirical analysis suggests that a deficit in bank reserves of Rs 1 lakh crore

leads to a 11 basis points rise in WACR by 11 bps. While a structural surplus
liquidity of Rs 1 lakh crore leads to a reduction in WACR by 4 bps. One basis
point is one hundredth of a percentage point.

The group said that the daily primary liquidity management operation should
be ideally one single overnight variable rate operation while the liquidity
framework should entirely meet the liquidity needs of the system.

“Reserve Bank should stand ready to undertake intra-day fine-tuning

operations, if necessary; however, such operations should be the exception to
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address unforeseeable intra-day shocks rather than the rule. Minimising the
number of operations should be a goal of efficient liquidity management
operations,” the group said.

The group suggested longer-term variable rate repos, of more than 14 days
and up to one-year tenor to infuse liquidity as an alternative to OMO
purchases. Similarly, longer-term variable-rate reverse-repos could be used to
absorb excess liquidity. As these are possible substitutes for OMOs, these
instruments should be operated at market determined rates.

There is no proposal to change in the difference of 25 basis points between the

repo rate and the reverse-repo rate, as well as between the repo rate and the
Marginal Standing Facility (MSF) rate. The standing liquidity facilities – fixed
rate reverse repo and MSF – may continue as at present.

The group has suggested retaining the present minimum requirement of

maintaining 90% of the Cash Reserve Ratio (CRR) on a daily basis as it has
helped avoid bunching of reserve requirement of maintaining 90% of the Cash
Reserve Ratio (CRR) on a daily basis as it has helped avoid bunching of
reserve requirements of individual banks.

The RBI study group recommended sticking to the current liquidity

mechanism.

The RBI study group recommended sticking to the current liquidity

mechanism.