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Banking in India - Part 4 (Monetary Policy)

Bankers Corner

Monetary policy

  • Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Act.
  • The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.
  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
  • Since 1952, Monetary Policy of the RBI emphasises on twin goals. These are:
    1. Economic growth
    2. Inflation Control

Instruments of Monetary Policy

  • There are several direct and indirect instruments that are used for implementing monetary policy.
    1. Repo Rate
    2. Reverse Repo Rate
    3. Open Market Operations (OMOs)
    4. Bank Rate
    5. Cash Reserve Ratio (CRR)
    6. Liquidity Adjustment Facility (LAF)
    7. Marginal Standing Facility (MSF)
    8. Statutory Liquidity Ratio (SLR)
    9. Market Stabilisation Scheme (MSS)

 

Liquidity Adjustment Facility (LAF)

  • 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 range of tenors. 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.

Marginal Standing Facility (MSF)

  • RBI has introduced a new mechanism-Marginal Standing Facility(MSF) under which banks are permitted to borrow short-term funds(overnight) upto 2 per cent of their respective net demand and time liabilities outstanding at the end of the second preceding fortnight. Banks can borrow for an overnight period from RBI through this emergency funding window under exceptional circumstances when all other avenues are exhausted. MSF allows banks to borrow money from the central bank at a higher rate when there is a significant liquidity crunch.
  • This new instrument has been introduced by RBI in its monetary policy, announced in May 2011. This instrument is likely to reduce the volatility in overnight rates and improved monetary transmission.
  • Banks can access MSF only when all other avenues (like repo and CBLO) are exhausted for overnight money. That is why it is meant to be exceptional.
  • The purpose of MSF is to provide an additional window to bridge gaps in overnight liquidity, always above the repo rate.
  • This provides a safety valve against unanticipated liquidity shocks to the banking system.

 

Market Stabilisation Scheme (MSS)

  • This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.

Corridor

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

Difference between MSF and Repo rate

  • Banks can borrow under the LAF-Repo rate, by pledging Govenrment securities, over and above the statutory liquidity requirement. Under the MSF, banks can borrow funds within the statutory liquidity ratio. They do not need to pledge government securities under MSF, while such a pledge is required when availing of the Repo rate. However, MSF can be used only when all other avenues are exhausted, at an extra cost of 3 per cent above Repo rate.

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