Thursday, October 4, 2012

Liquidity Adjustment Framework of RBI

For effective implementation of monetary policy(which is a long term plan), it needs support of a robust operating framework (day to day management).
An operating framework is defined as day-to-day management of monetary conditions consistent with the overall stance of monetary policy. It involves
(i) defining an operational target interest rate
(ii) setting a policy rate which could influence the operational target
(iii) setting the width of corridor for short-term market interest rates
(iv) conducting liquidity operations to keep the operational target interest rate stable within the corridor
(v) signalling of policy intentions.

This operating framework is also called Liquidity Adjustment Framework = LAF !!

In the annual monetary policy 2011-12, RBI had made changes in the operating framework of monetary policy. Earlier it was both reverse repo rate and repo rate which changed (along with CRR, SLR depending on the situation). But RBI then decided to adopt a new one rate framework with a corridor like seen in other central banks(US/UK/European to be precise).
New operating framework is:
(i) There will be only one variable rate, which is the repo rate, which will be defined by RBI. This will be the policy rate. All other rates will be calculated based on this rate.
(ii) Reverse repo rate will be 100 bps (or 1%) below repo rate. Thus this will be the floor of the corridor(we mentioned above).
(iii) A new rate called – Marginal Standing Facility (MSF) was introduced, which is 100 bps above Repo rate.

So the new operating framework is as follows:

Now, these operating framework helps banks in day to day management of liquidity conditions. RBI has “range of instruments” to address liquidity deficit concerns as shown in picture below:
Note: SCBs = Scheduled Commercial Banks
So the liquidity management approaches (shown above) have involved making a distinction between the monetary stance and the liquidity stance of RBI. So if you see CRR and SLR are monetary policy measures to control liquidity conditions of banks and others are "liquidity control measures".

1.  Resorting to MSF frequently by any bank will raise alarm bells with RBI. First of all MSF rates are highest (See LAF corridor above) and it is supposed to meet overnight liquidity needs. This would signal RBI that there is something fishy with the banks "book" !!
2. Lowering SLR by RBI, will lower the demand for government securities which in turn might lead to some fiscal discipline on part of Govt.
3. RBI may not resort to excessive OMOs (though its their most preferred method), because OMOs (i.e. bonds) give lower yields.
4. CRR lowering is the ultimate resort when nothing else works.

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