The RBI has come up with yet another esoteric concept. Standing Deposit Facility, proposed by the RBI and under examination by the Centre, is viewed as a strong tool to suck out the surplus liquidity and alleviate the banking system’s problem of plenty.
This concept, first recommended by the Urjit Patel committee report in 2014.
What is it?
Standing deposit facility is a remunerated facility that will not require the provision of collateral for liquidity absorption. Stumped? Let’s simplify this by going to the basics. Banks, at different points in time, may be short of funds or flush with money.
When they need money for the short-term, they borrow from the bankers’ bank—RBI. Repo rate — that RBI sets at every monetary policy — is the rate at which banks borrow funds, for which they pledge government securities. What happens when banks have excess funds? They lend it to the RBI at the reverse repo rate that is lower than the repo rate. Here too, government securities act as collateral.
The demonetisation exercise has left banks flush with funds. The past two months, banks have been lending left, right and centre to the RBI under the reverse repo window. And with the RBI increasing the reverse repo rate by 25 basis points to 6 per cent in the April policy, banks now earn more on these funds.
In short, everyone is happy. So, why is the RBI toying with the idea of a new instrument to suck out liquidity? The worry is there may be only so much collateral to go around. Collateral may become a constraining factor if the central bank runs out of securities to absorb liquidity under the reverse repo window. Enter the Standing Deposit Facility. This will allow the RBI to absorb surplus funds from banks without collateral. Banks too continue to earn interest (though possibly lower than the existing reverse repo rate). In effect, it will empower the RBI to suck out as much liquidity as needed.
Why is it important?
But why does the RBI need an unbridled mechanism to manage liquidity? Liquidity plays a key role in transmission of policy rates. In a falling rate cycle, pass-through of rate cuts will happen quickly if there is sufficient liquidity, as banks will be able to lower deposit rates comfortably. The reverse holds true now. Excess liquidity has led to short-term market rates slipping below the RBI’s policy repo rate.
Now, that’s not nice from the point of view of the RBI; it would want to keep a tight leash on rates. The RBI would want its key policy rate, aka the repo rate, to be the operational rate.
Why should I care?
The RBI’s management of rates impacts the rates on your deposits and loans too. The immediate fallout of excess liquidity in the past few months has been the sharp cuts in bank deposit rates.
If the RBI curbs excess liquidity and halts the fall in short-term rates, then you, dear depositor, can breathe a sigh of relief. But for borrowers who have seen lending rates fall sharply the past year, the party may be over.
Difference between Standing Deposit Facility, Reverse Repo and MSF
Within the existing liquidity management framework, liquidity absorption through reverse repos, open market operations and the cash reserve ratio (CRR) are at the discretion of the Reserve Bank.
On the other hand, the use of standing facilities (MSF, SDF) would be at the discretion of banks. The difference between the Standing Deposit Facility and Reverse Repo is that there is no need for collateral under the SDF.