Liquidity in system

Liquidity in system

Subject: Economy

Context:

The Reserve Bank of India (RBI) injected Rs 72,860.7 crore of liquidity into the banking system on October 21 — the highest since April 2019

Details:

Liquidity infusion done after on the backdrop of liquidity tightening:

• Higher demand for credit during the festival season
  • Rise in demand for credit during festivals leads to higher growth in credit than in deposits automatically leading to the liquidity issue
• The central bank’s intervention in the foreign exchange market to curb volatility in the rupee.
  • Through intervention, the RBI sells dollars and sucks out rupee liquidity from the system

Concept:

• Liquidity in the banking system refers to readily available cash that banks need to meet short-term business and financial needs.
• When  the banking system is a net borrower from the RBI under Liquidity Adjustment Facility (LAF), the system liquidity is in deficit. 
• When  the banking system is a net lender to the RBI, the liquidity is in surplus. 

Liquidity Adjustment Facility (LAF)

• The LAF refers to the RBI’s operations through which it injects or absorbs liquidity into or from the banking system.
• The funds from the Facility are expected to be used by the banks for their day-to-day mismatches in liquidity.
• It was introduced in 2000 following the recommendation of Narasimham Committee Report on Banking Reforms. 
• Under the scheme, RBI conducts auctions to absorb (through reverse repo auctions) and inject (through repo auctions) liquidity into the financial system.
  • It allows banks to borrow money from the RBI in exchange of G-securities through repurchase agreements (repos) or for banks to make loans to the RBI through reverse repo agreements.
• Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Here, the central bank purchases the security.
• Reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country.

Policy rates under the LAF corridor to manage its monetary policy operations:

• Repo rate– at which it lends money to banks by taking g -sec from banks as collaterals.
• Reverse repo rate– at which it drains excess liquidity from banks i.e borrows money from commercial banks by giving g-sec as collaterals.
• Marginal standing facility-rate at which RBI supplies liquidity on overnight basis (above the repo rate). It acted as the ceiling rate under the LAF corridor.
• Standing Deposit Facility (SDF) –acts as the floor rate under the LAF corridor as being above the fixed reverse repo rate. Here RBI borrows from banks to absorb surplus liquidity from the banking system at a higher interest rate without parting Gsec as the collateral to the lenders.

When there is liquidity shortage in the system, RBI injects liquidity by buying back government securities (g-sec) through open market operations (OMO).

• It is not a formalised kind of G-SAP (G-sec acquisition programme) where securities are bought through open market operations.
• Open market operations (OMO) means buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system.
• Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite