In this article, we shall discuss various instruments/measures Reserve Bank of India  uses to ensure liquidity, money supply in the market, control  inflation and solvency of the banks.  

The credit operations in the banking system, relating to various aspects are guided by the directives issued by RBI from time to time. Traditionally, RBI translates its views on economy into affirmative actions through changes in the monetary policy four times a year. (The MPC, Monetary Policy Committee is required to meet at least four times a year). RBI announces the credit policy twice a year – Generally in April and in October.  While in April it announces new policy initiatives, the October pronouncement is a review of the April Policy. The policy normally aims at fine tuning the availability and cost of funds to productive sectors and to ensure non-inflationary growth. RBI attempts to lower the cost of funds using different tools to spur growth so that cheap and abundant money may persuade industry to set up new capacities or produce to the maximum extent available. On the other hand, if the money growth is too fast with supply falling to keep pace with demand, prices of goods and commodities tend to rise, leading to inflation. In such a situation, RBI tightens the money supply through various tools to control inflation.

The credit policy has monetary and credit objectives. The monetary objective is basically to achieve price stability by controlling the supply of money. The credit objective is to ensure adequate supply of credit to realise targeted growth. With the onset of liberalisation process, the name of monetary policy has been changed and it is now known as Monetary and Credit Policy to signify the importance of credit to the economic activity.

The Instruments used by RBI to implement Monetary and Credit Policy are as below:-

CASH RESERVE RATIO (CRR):

It is the ratio of cash mandated by RBI to be maintained by commercial banks against its total deposits. CRR refers to the ratio of bank’s balance with RBI to the bank’s net demand and time liabilities ( NDTL) which consists of aggregate deposits, inter- bank deposits and borrowings, market borrowings and other liabilities of bank minus inter-bank assets (balances with other banks, money at call and short notice and due from other banks). The objective of maintaining a minimum balance with RBI was basically to ensure the liquidity and solvency of the scheduled commercial banks and restrict the banks from extending credit beyond a point. Current CRR to be maintained- 3%

STATUTORY LIQUIDITY RATIO ( SLR):

SLR is the reserves required to be maintained by commercial banks in the form of liquid cash, gold reserves and RBI approved securities (un-encumbered approved securities) or in the form of net balances in current accounts maintained in India by banks with nationalised banks which shall not at the close of the business in any day be less than 18% (currently) of the total of its NDTL (to be computed in line with CRR as stated above) in India. RBI control the SLR stipulations from time to time and force the banks to keep a large portion of funds mobilised by them in liquid assets, particularly govt and other approved securities and resultantly control the lending funds.

REPURCHASE AGREEMENT /OPTIONS ( REPO):

A repurchase agreement is a form of short term borrowing for dealers (Commercial banks, Financial Institutions, Brokers, hedge funds etc) in government securities. In case of a repo, a dealer sells govt securities (say treasury Bills/fixed income securities) to investors, usually on an overnight basis and buys them back the following day at a slightly higher price. Repo transactions are structured to suit the requirement of both the borrower and the lender (who is having spare cash say money market mutual funds).  The borrower has advantage of raising funds against its securities without altering its asset mix while lender finds a safe avenue earning attractive return (without much risk). Moreover the Fund management of both borrower and lender improves as the date of reversal of transaction is known in advance. Repo rate is the most important policy interest rate in India.

REVERSE REPO RATE:

It is the rate at which the Central bank of a country (RBI in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country. An increase in the reverse repo rate will decrease the money supply and vice versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the money supply in the market. A reverse repo rate is, however, lower than a repo rate and is often used to control cash flow. When RBI reduces reverse repo rate, banks tend to invest their money in other sources like lending loans rather than keeping the same in RBI and by this way liquidity in the market increases.

BANK RATE :

Bank rate is the rate at which RBI offers loans and advances to domestic banks, whereas, the reverse repo rate is the rate at which RBI borrows money from commercial banks.

LIQUIDITY ADJUSTMENT FACILITY (LAF):

LAF is a tool used in monetary policy, primarily by the RBI that allows banks to borrow money through repurchase agreement (repos) or for banks to make loans to the RBI through reverse repo agreement. Repo or repurchase option is a collaterised lending i.e; banks borrow money from RBI to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The minimum bidding amount is Rs 5 crore, all clients of RBI are eligible to bid. Bank cannot sell Govt securities to RBI that is bank’s SLR quota. Bank can borrow any amount of money as long as it has the securities to sell.

MARGINAL STANDING FACILITY (MSF):

Marginal Standing Facility, under which banks could borrow funds for overnight at repo rate against pledging government securities. MSF is 1% above the Liquidity Adjustment Facility. This scheme has been introduced to reduce volatility in the overnight rates and improve monetary transmissions. The minimum bid amount is Rs. 1 cr and only scheduled commercial banks can bid. Bank can sell the Govt securities from SLR quota to RBI. Bank can maximum borrow up to 2% of its NDTL( Net Demand and time liabilities).

WAYS AND MEANS ADVANCES (WMA ) :

The Ways and means Advances is a mechanism used by RBI to provide the state governments to help them tide over temporary mismatches in the cash flow of their receipts and payments. The WMA limit are decided by the Governments and RBI mutually and revised periodically. Beyond the WMA limit, Govts can draw through an overdraft facility but that will carry higher interest. Nowadays, no overdraft facility will be permitted for more than 10 consecutive working days. WMA are temporary advances extended to the govt. to bridge the interval between expenditure and receipts. Unlike adhocs, they are not sources of finance but are meant to provide support, for purely temporary difficulties that may arise on account of shortfall in revenue or other receipts for meeting the govt. liabilities. Consequently, they have to periodically vacate to enable use of such finances for future mis-matches. Presently WMAs are allowed to state govt. repayable in not more than 3 months, rate of interest being on a graduated scale based on the duration of the loan. RBI has the powers to suspend payments to the state govts, whose account runs into overdraft for more than 7 days. These are subject to limits which are time to time revised considering the rise in aggregate receipts and expenditure on both revenue and capital account of States, the arrangement of release of State’s share of central taxes, the quantum of grants and central assistance for plans, among other things.