RBI Reviews Liquidity Framework to Strengthen Rate Control

The Reserve Bank of India (RBI), in its 2025 review of the Liquidity Management Framework, released key recommendations through its Internal Working Group (IWG). The review aims to refine operational tools for managing liquidity more efficiently, strengthening RBI’s control over short-term interest rates, and ensuring better market stability and monetary transmission.

Discontinuation of 14-Day Variable Rate Repo

Shift in Liquidity Management Operations

The IWG proposes discontinuing the 14-day variable rate repo/reverse repo as the main liquidity operation, citing,

• Banks’ reluctance to lock surplus funds for two weeks
• Forecasting challenges due to erratic government cash flows and currency movements
• Instead, the RBI may rely on weekly operations supported by fine-tuning instruments to smooth short-term liquidity fluctuations.

WACR Retained as Operating Target

Call Rate vs Market Activity

• The RBI will continue to use the Weighted Average Call Rate (WACR) as the operational target for monetary policy, though activity in the overnight call money market has declined.
• Narrow interest rate corridor has discouraged inter-bank trading
• Banks now prefer RBI liquidity windows over market-based transactions
• The report recommends balancing the corridor width to ensure both rate stability and market vibrancy.

Reserve Requirements and Averaging Mechanism

Stabilising Inter-Bank Rates

The IWG highlights the importance of,

• Minimum reserve requirements
• Averaging over the maintenance period

These tools help absorb shocks from currency and government cash fluctuations. However, banks often over-maintain reserves daily, reducing the intended benefit. A lower daily reserve floor could promote arbitrage and reduce call rate volatility.

Addressing Standalone Primary Dealers’ Role

Market Volatility and Participation

Standalone Primary Dealers (SPDs) contribute to call money rate volatility due to,

• Heavy borrowing without access to Marginal Standing Facility (MSF)
• Rates occasionally breaching corridor limits during tight liquidity

While the IWG opposes MSF access for SPDs, it suggests gradually phasing out their participation in the call market and providing alternative liquidity avenues for their role in G-sec markets.

Structural Liquidity Surplus: A Key Challenge

Operating Target vs Policy Rate

• India’s persistent surplus liquidity has caused deviation of WACR from the policy repo rate, even breaching corridor limits. This impairs policy rate transmission.
• Maintaining WACR close to the policy rate is essential
• Better liquidity forecasting and tool flexibility are necessary
• The RBI must ensure that its operating target stays aligned with its monetary stance.

Corridor Width: Time for Re-evaluation

Comparative Analysis with Emerging Economies

India’s 50 basis points corridor is narrower than those of other emerging market peers. Though it limits volatility, it also,

• Suppresses inter-bank market activity
• Reduces market-based liquidity transmission

The IWG calls for an empirical study to evaluate trade-offs and potentially adjust the corridor width for optimal monetary operations.