Business Standard<\/strong><\/a><\/p>\n\n\n\nThe Indian banking system is currently grappling with a paradox of abundant liquidity<\/strong> but a scarcity of “cheap money” for profitable lending, leading to a “money yo-yo” situation for bankers. This scenario is a direct consequence of the Reserve Bank of India’s (RBI) aggressive liquidity-infusion measures, including Open Market Operations (OMOs) and a recent Cash Reserve Ratio (CRR) cut, aimed at boosting credit growth in a slowing economy. However, despite these efforts to lower borrowing costs, the central bank faces the challenge of ensuring effective policy transmission<\/strong> and stimulating actual credit demand, while simultaneously guarding against potential asset bubbles and inflationary risks.<\/p>\n\n\n\nLiquidity Adjustment Facility (LAF):<\/u><\/strong><\/p>\n\n\n\nThe Liquidity Adjustment Facility (LAF)<\/strong> is the primary instrument of the Reserve Bank of India (RBI) to manage short-term liquidity<\/strong> in the banking system. It helps to keep overnight interest rates within a desired range, which is known as the LAF corridor<\/strong>.<\/p>\n\n\n\nHow it is used to maintain required liquidity:<\/strong> The LAF consists of daily auctions (or variable rate auctions) through which banks can borrow money from the RBI (repo) or deposit excess funds with the RBI (reverse repo\/SDF).<\/p>\n\n\n\n\n- When the system needs liquidity, the RBI injects money through repo operations<\/strong>.<\/li>\n\n\n\n
- When there is surplus liquidity, the RBI absorbs money through reverse repo operations or the Standing Deposit Facility (SDF)<\/strong>.<\/li>\n\n\n\n
- For managing short-term liquidity in the banking system, the RBI now uses the LAF.”<\/li>\n<\/ul>\n\n\n\n
Components of LAF:<\/strong> The LAF framework in India operates as a “corridor”. This corridor is defined by three key policy rates:<\/p>\n\n\n\n\n- Standing Deposit Facility (SDF) Rate:<\/strong>\n
\n- What:<\/strong> Introduced as the floor of the LAF corridor in 2022<\/strong>, replacing the fixed rate reverse repo (F-RRR). It is a facility through which banks can deposit surplus funds with the RBI without the need for collateral<\/strong> (unlike reverse repo).<\/li>\n\n\n\n
- Purpose:<\/strong> The RBI uses SDF to absorb excess liquidity from the banking system. Its rate effectively sets the lowest overnight interest rate banks can earn.<\/li>\n\n\n\n
- Current Rate:<\/strong> Currently, the SDF rate is 5.25 per cent<\/strong>.<\/li>\n<\/ul>\n<\/li>\n\n\n\n
- Repo Rate (Repurchase Option Rate):<\/strong>\n
\n- What:<\/strong> This is the rate at which commercial banks borrow money from the RBI by selling securities with an agreement to repurchase them<\/strong> at a pre-determined future date and price. It is the RBI’s main policy interest rate.<\/li>\n\n\n\n
- Purpose:<\/strong> The RBI uses the repo rate to inject liquidity into the system. It influences the cost of funds for banks and, consequently, their lending rates to customers.<\/li>\n\n\n\n
- Current Rate:<\/strong> The repo rate is 5.5 per cent<\/strong>. The RBI recently cut the repo rate for the third successive time, bringing it down from 6.5 per cent to 5.5 per cent in four months, including a 50-bps cut in June.<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n\n\n\n
\n- Marginal Standing Facility (MSF) Rate:<\/strong>\n
\n- What:<\/strong> This is a penalty rate at which banks can borrow funds from the RBI overnight<\/strong> when they face an acute shortage of liquidity. Banks can pledge government securities beyond the SLR limit to avail this facility.<\/li>\n\n\n\n
- Purpose:<\/strong> The MSF rate serves as the ceiling of the LAF corridor<\/strong>, setting the upper bound for overnight interest rates in the money market. It acts as a safety valve for banks.<\/li>\n\n\n\n
- Current Rate:<\/strong> Currently, the MSF rate is 5.75 per cent<\/strong>.<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n\n\n\n
Interlinkages:<\/strong> These three rates define the LAF corridor: SDF Rate < Repo Rate < MSF Rate<\/strong>. The objective of LAF is to keep the overnight call money rate within this range. The corridor was as high as 300 basis points (bps) in 2010<\/strong>, gradually narrowing to 50 bps in 2017<\/strong>, where it now stands.<\/p>\n\n\n\nF-RRR vs. V-RRR:<\/strong><\/p>\n\n\n\n\n- Fixed Rate Reverse Repo (F-RRR):<\/strong> A tool where the RBI used to absorb liquidity from banks at a fixed interest rate. It was replaced by the SDF.<\/li>\n\n\n\n
- Variable Rate Reverse Repo (V-RRR) Auctions:<\/strong> These are auctions conducted by the RBI to drain excess liquidity from the system at variable (market-determined) rates. The RBI conducts V-RRR auctions to “drain excess liquidity from the system and bring the overnight rate within the LAF corridor”.<\/li>\n\n\n\n
- Difference:<\/strong> F-RRR offered a fixed return, whereas V-RRR allows the market to determine the rate, making it more responsive to liquidity conditions.<\/li>\n<\/ul>\n\n\n\n
SDF vs. F-RRR:<\/strong><\/p>\n\n\n\n\n- The SDF replaced the F-RRR as the floor of the LAF corridor in 2022<\/strong>.<\/li>\n\n\n\n
- Key Advantage of SDF:<\/strong> Unlike F-RRR, SDF does not require the RBI to provide collateral (government securities)<\/strong> to absorb liquidity. This gives the RBI greater flexibility to absorb any amount of surplus liquidity, particularly large, persistent surpluses, without being constrained by the availability of government securities in its balance sheet. This is crucial for managing “too much money in the system”.<\/li>\n<\/ul>\n\n\n\n
Analysis of the Article: Decoding the “Money Yo-Yo” and Credit Growth Puzzle<\/u><\/strong><\/p>\n\n\n\nThe article highlights the state of liquidity in the Indian banking system, where despite abundant money and low policy rates, bankers are struggling with profitability and subdued credit growth.<\/p>\n\n\n\n
1. The Paradox of Liquidity and Cost of Funds:<\/strong><\/p>\n\n\n\n\n- “Water, water, everywhere, nor any drop to drink”:<\/strong> The banks are “slush with money” (surplus liquidity), but the “pile of low-cost savings and current accounts is depleting every quarter”.<\/li>\n\n\n\n
- “Money, money, everywhere, but the cost is high”:<\/strong> There is “no cheap money to lend at a decent margin”. Bankers are perplexed by this “money yo-yo”.<\/li>\n\n\n\n
- Low Lending Rates:<\/strong> Some large public sector banks disbursed one-year loans at 5.75%-5.97%<\/strong> towards the end of June, making it difficult to “make money if they give loans at such low rates”.<\/li>\n<\/ul>\n\n\n\n
2. Shift from Liquidity Deficit to Surplus:<\/strong><\/p>\n\n\n\n\n- Rapid Shift:<\/strong> Liquidity in the system shifted from a deficit of \u20b92.4 trillion<\/strong> at the end of March 2025 to a surplus of around \u20b93 trillion<\/strong>. On July 4, the surplus even crossed \u20b94 trillion<\/strong>.<\/li>\n\n\n\n
- RBI’s Aggressive OMOs:<\/strong> This shift is due to “aggressive open market operations, or OMOs, by the Reserve Bank of India (RBI)”. The RBI bought \u20b94.95 trillion worth of bonds through OMOs<\/strong>, releasing money into the system.<\/li>\n\n\n\n
- Government Buyback:<\/strong> Additionally, there was a buyback of \u20b91.5 trillion worth of government bonds<\/strong>, further adding to core liquidity.<\/li>\n\n\n\n
- CRR Cut:<\/strong> The RBI’s June policy also pared the Cash Reserve Ratio (CRR) by 100 bps to 3%<\/strong>. This cut will release \u20b92.5 trillion into the system<\/strong> in four installments between Sept 6 and Nov 26.<\/li>\n\n\n\n
- Liquidity Management “Yo-Yo”:<\/strong> The RBI infused \u20b99.5 trillion in liquidity between January and early June<\/strong>, and is “now sucking out money from the system”. This suggests a dynamic but somewhat erratic liquidity management.<\/li>\n<\/ul>\n\n\n\n
3. RBI’s Efforts to Align Overnight Rates:<\/strong><\/p>\n\n\n\n\n- Overnight Rates Below SDF:<\/strong> With too much money, “overnight rates started dipping below the standing deposit facility, or SDF, the floor of the RBI\u2019s liquidity adjustment facility (LAF) framework”. The weighted average overnight call rate is “hovering around 5.25 per cent, the floor of the LAF corridor” and “at times, it falls below that”.<\/li>\n\n\n\n
- V-RRR Auctions:<\/strong> This prompted the RBI to conduct Variable Rate Reverse Repo (V-RRR) auctions<\/strong> to “drain excess liquidity from the system and bring the overnight rate within the LAF corridor”. A \u20b92.5 trillion V-RRR auction (highest ever)<\/strong> was announced in the second week of July.<\/li>\n\n\n\n
- RBI’s Goal:<\/strong> The RBI “doesn\u2019t want the overnight rate to go below the SDF rate”.<\/li>\n<\/ul>\n\n\n\n
4. The Puzzle of Credit Growth and Demand:<\/strong><\/p>\n\n\n\n\n- Low Rates, Slow Credit:<\/strong> The RBI has cut the repo rate (from 6.5% to 5.5% in four months) and CRR to “encourage banks to lend as well as pare the cost of funds for the borrowers”.<\/li>\n\n\n\n
- Credit Growth Lags:<\/strong> Despite this, “year-on-year bank credit, until the last week of June, continues to be in single digits \u2014 9.5 per cent<\/strong>, sharply down from 19 per cent in the year-ago period”. Deposit growth “continues to outpace credit growth”.<\/li>\n\n\n\n
- Demand is Key:<\/strong> The article argues that “there is no direct correlation between low interest rates and growth in credit. Demand is the key”<\/strong>. This is evidenced by the FY06-FY08 period<\/strong>, when credit growth was very strong (average 27%) even as the repo rate rose from 6.75% to 9%.<\/li>\n\n\n\n
- Recent Credit Surge:<\/strong> Credit growth in FY23 was 15%<\/strong> (highest since FY12). The fortnight ending June 27 saw the “highest credit growth in the current financial year”.<\/li>\n<\/ul>\n\n\n\n
5. Risks of Excessive Liquidity and Future Outlook:<\/strong><\/p>\n\n\n\n\n- Potential for Cracks:<\/strong> If credit demand does not pick up but banks “start pushing for credit growth aggressively, throwing caution to the wind,” it could lead to “cracks in their balance sheets”.<\/li>\n\n\n\n
- Asset Bubbles and Inflation:<\/strong> “Too much money can also create asset bubbles and impact inflation”. Retail inflation hit a six-year low of 2.1% in June<\/strong> (Q1 FY26 average 2.69%, below RBI estimate of 2.9%), but this could reverse.<\/li>\n\n\n\n
- Liquidity Impact on Markets\/Inflation:<\/strong> Empirical research shows that “liquidity has a positive impact on asset markets, with higher liquidity pushing equity prices higher, and corporate bond spreads over government bonds lower.” It also “results in higher consumption and retail inflation with a lag of three quarters”.<\/li>\n\n\n\n
- RBI’s Dilemma:<\/strong> The key question for the RBI is “how much liquidity does it want in the system? Appropriate, adequate, or abundant?”. The choice will determine whether it leads to “asset bubbles and inflation shooting up \u2014 or the smooth, hiccup-free return of the growth impulse “.<\/li>\n<\/ul>\n\n\n\n
In conclusion, the RBI’s aggressive liquidity injection policies have transformed the system from deficit to surplus, but have created a challenge in ensuring effective policy transmission and stimulating genuine credit demand. While the central bank is actively managing this liquidity through tools like V-RRR auctions to keep overnight rates aligned, the article highlights that credit growth is primarily driven by demand, not just cheap money. The RBI faces a delicate balancing act to foster growth without inadvertently fueling asset bubbles or reigniting inflation, emphasizing the need for an “appropriate” level of liquidity.<\/p>\n\n\n\n
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