Review of RBI Internal Working Group on Liquidity Management

RBI has been on fire of late releasing one report after the other. I reviewed following reports: agriculture credithousing securitization, secondary market for corporate loans and of course the Jalan Committee.

On 26 Sep 2019, RBI released another report of an Internal Working Group (IWG) to Review the Liquidity Management Framework. This post reviews the committee report.

The central banks conduct their monetary policy via this liquidity management framework which shows its importance. The central banks change policy interest rates under this framework which then transmits to the entire economy, a mechanism called as monetary transmission. Before we discuss the IWG report, we need to understand some basics.

The central banks have over the years transitioned from discounting bills to engaging in repo securities currently. Repo is nothing but a jargon for repurchase, Repo securities mean those securities (mainly government bonds and bills) which can be bought and sold by the central bank and banks with little default risk.

The RBI moved to the Repo framework, also called as Liquidity Adjustment Facility or LAF in April-1999. Under LAF, there were two policy interest rates: repo and reverse repo (RR). Under Repo, RBI infuses overnight liquidity by buying securities from designated banks and other financial institutions. Under RR, RBI absorbs liquidity by selling securities. With the corridor in place, the idea is that money market rates such as call rate remain in the corridor. This was because if call rate became higher than Repo, one could always get liquidity at the lower Repo rate. Similarly call rates could not fall below reverse repo as one could always lend at a higher reverse repo rate.

The RBI changed the repo or reverse repo rate which in turn changed the overall interest rates and impacted economic activity.  If inflation increased, RBI increased repo rate to indicate tighter liquidity conditions as seen during 2005-08. We see how Repo rate rose by 300 bps from 6% in 2005 to 9% in 2008. The Reverse Repo rate increased by 150 bps from 4.5% to 6%. However post- 2008, RBI lowered policy rates and provided liquidity to mitigate the crisis. This led to attention shifting to reverse repo with it being lowered by 275 bps to 3.25% and Repo rate by 425 bps to 4.75%. The difference between repo and reverse repo in first period increased to 300 bps indicating tight liquidity conditions whereas it decreased to 150 bps in the second period indicating easier liquidity conditions.

In 2011, RBI formed a committee to review the LAF system which modified the corridor. It was decided that repo would be the main policy rate and RBI would manage liquidity in a way that Call money rate is kept as close as possible to Repo rate. In order to smoothen the volatility, RBI introduced another rate named Marginal Standing Facility (MSF) which was higher than Repo rate. MSF was the lender of last resort rate where banks could get liquidity but at a penal rate. These three rates became the new corridor, where MSF was the ceiling, Repo in the middle and Reverse Repo the floor. The MSF and RR would change automatically with change in Repo rate. The gaps of MSF & RR with Repo was 100 bps earlier (barring the jump in MSF during 2013 crisis) and has gradually come down to 25 bps as of today.

In 2014, the Urjit Patel Committee introduced term repos to the framework which reduced reliance on overnight liquidity. In 2018, Standing Deposit Facility (SDF) was introduced to accept money as deposits but it has not been operationalised. In 2019, RBI added forex swaps to its tool kit of liquidity operations which has been quite successful.

Given this background, we now review the proposals in the new committee report. The first task for the committee was to define liquidity as there was confusion over its meaning! The report defined three types of liquidity. The first is funding liquidity, which is needed by banks to manage their liabilities. Second is market liquidity which means the quickness with which financial assets can be sold in the markets. The third is central bank liquidity refers to injection and absorption of liquidity and this is the concern of our article and the report.

The committee noted that the liquidity management framework should continue to be based on the 3-tier corridor system, as it provides flexibility to deal with both surplus and deficit situations. It also recommended that the call money rate should continue as the target rate of the liquidity management framework. The RBI should stand ready to undertake intra-day fine-tuning operations in case of unforeseeable intra-day shocks but they should be minimum and not become the rule. An efficient liquidity management system implies minimising the number of operations.

For durable liquidity, the RBI currently relies on OMO purchases (or sales). The problem with OMOs is that securities once purchased remain on RBI balance sheet which could be questioned for financing the government deficit. IWG recommends introduction of longer-term variable rate repos (and reverse repos) for a period of 14 days to 1-year as a replacement for OMOs. It also asked to operationalize the SDF early to absorb liquidity.

The group noted that there is a need for better and more frequent dissemination of information about liquidity operations. RBI issues a daily press release on the Money Market Operations (MMO) which should be modified to show both the daily flow and stock impact of the Reserve Bank’s liquidity operations. Likewise, RBI should release a fortnightly assessment with a fortnightly lag of durable liquidity conditions in the banking system.

Let me conclude. It is interesting to note how the reforms in money markets began even earlier than 1991 reforms. In 1987, the RBI constituted a Committee (Chair: N Vaghul) and its main suggestion was to stop administering call market rates and allow markets to determine the levels! We have come a long way since then beginning with adoption of LAF system in 1999 followed by modifications in 2011 and 2014. Indian money markets faced multiple crises in the years 2008, 2013 and 2018 which tested the system but it broadly remained resilient. The current IWG review joins this ongoing journey of reforming money markets and suggests a few more additions to make the system more robust.

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