Instruments of Monetary Policy

Quantitative / General Credit Control by the RBI

Quantitative credit controls are used to control the volume of credit and indirectly to control the inflation and deflation caused by expansion and contraction of credit.

The quantitative measures of credit control are :

There are several direct and indirect instruments that are used for implementing monetary policy:

Liquidity Adjustment Facility (LAF)- It is a monetary policy tool which allows banks borrow money through repurchase agreements. It consists of repo and reverse repo operations.

Repurchase- one who sells the agreement buys it again.

• Liquidity- A measure of the extent to which a person or organization has cash to meet immediate and short-term obligations, or assets that can be quickly converted to do this.

The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of tenors ranging between overnight and 56 days. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.

• Repo rate- Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).

It is the rate at which banks borrow money from the RBI to meet short term needs by selling securities to the RBI with an agreement to purchase those securities again at the pre decided rate and date.

• Due to it, liquidity is injected into the market. It is an instrument ofmonetary policy. Whenever banks have any shortage of funds they can borrow from the RBI.
• A reduction in the repo rate helps banks get money at a cheaper rate and vice versa

 

• Reverse Repo rateis the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest.An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.

It is the (fixed) interest rate – currently 50 bps below the repo rate – at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.

• Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit [currently two per cent of their net demand and time liabilities deposits (NDTL)] at a penal rate of interest, currently 50 basis points above the repo rate. This provides a safety valve against unanticipated liquidity shocks to the banking system.

The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

Marginal Standing Facility (MSF): It refers to the rate at which the scheduled banks can borrow funds overnight from RBI against government securities.

Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short. Marginal Standing Facility (MSF) rate refers to the rate at which the scheduled banks can borrow funds overnight from RBI against government securities.

MSF is a very short term borrowing scheme for scheduled commercial banks. Banks may borrow funds through MSF during severe cash shortage or acute shortage of liquidity.

Banks often face liquidity shortfalls due to mismatch in their deposit and loan portfolios. These are usually very short term and banks can borrow from RBI for one day period by offering dated government securities.

MSF had been introduced by RBI to reduce volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.

Under MSF, banks can borrow funds overnight up to 1% (100 basis points) of their net demand and time liabilities (NDTL) i.e. 1% of the aggregate deposits and other liabilities of the banks. NDTL liabilities represent a bank’s deposits and borrowings from others.

In a move to stem the continuing fall of rupee, the RBI raised the MSF rate to 300 basis points (i.e. 3%) above the repo rate in July 2013. Thus, both rate of borrowing and percent of borrowing allowed under MSF can be varied by RBI.

Introduction of MSF

• The RBI had introduced the marginal standing facility (MSF) in its Monetary Policy (2011-12).
• MSF came into effect on from May 9, 2011.
• Banks used the facility for the first time in June 2011 and borrowed Rs.1 billion via the MSF.

Does a hike in MSF rate affect us?

• Hiking MSF rate makes borrowing expensive for a bank which means loans become expensive for individual and corporate borrowers and this in turn translates to lesser availability of the rupee. RBI uses MSF and other measures to control money supply in the financial system.
• MSF rate hike is being done to control excess availability of the rupee and to control its depreciation with respect to the dollar.

Borrowing under MSF

• Banks can borrow through MSF on all working days except Saturdays, between 3:30pm and 4:30pm in Mumbai where RBI has its headquarters.
• The minimum amount which can be accessed through MSF is Rs. 1 crore and in multiples of Rs. 1 crore.
• The application for the facility can be submitted electronically also by the eligible scheduled commercial banks.

• Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
• Cash Reserve Ratio (CRR): The average daily balance that a bank shall maintain with the Reserve Bank as a share of such per cent of its NDTL that the Reserve Bank may notify from time to time in the Gazette of India.

Cash Reserve Ratio(CRR) : Cash reserve Ratio is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system.

Scheduled banks are required to maintain with the RBI an average cash balance, the amount of which shall not be less than 4% of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis.Statutory Liquidity Ratio: It refers to that portion of deposits with the banks which it has to keep with itself as liquid assets (Gold, approved govt. securities etc.) . If RBI wishes to control credit and discourage credit it would increase CRR & SLR.

Statutory Liquidity Ratio (SLR): The share of NDTL that banks shall maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
It is the part of total deposits and time deposits that the banks are required to maintain in the form of specified Liquid assets, like government bonds and securities.

 

• Open Market Operations (OMOs): These include both outright purchase and sale of government securities for injection and absorption of durable liquidity, respectively.
  The Open market Operations refer to direct sales and purchase of securities and bills in the open market by Reserve bank of India. The aim is to control volume of credit.
• Market Stabilisation Scheme (MSS)- This instrument for monetary policy was introduced in 2004.

Under this scheme, RBI, on behalf of government, raises money from the market by providing government securities, like Treasury Bills, Dated Securities, etc.

But the difference is – the raised money doesn’t go to the government account (as in normal cases). Instead, the money is stored in separate Market Stabilization Scheme Account (MSSA). The sole purpose of this scheme is to suck out the over-liquidity from the market (as in the above situation), not for government expenditure.