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The Reserve Bank of India (RBI) recently released the recommendations of its Internal Working Group (IWG) constituted to review the Liquidity Management Framework (LMF), which has been operational since February 2020. The review seeks to enhance efficiency, transparency, and predictability in liquidity operations—crucial for ensuring smooth monetary policy transmission.

Liquidity Management Framework (LMF):

• Objective: To manage systemic liquidity and guide short-term interest rates in alignment with monetary policy objectives.
• Core Mechanism: Operates through the Liquidity Adjustment Facility (LAF)—using repo (liquidity injection) and reverse repo (liquidity absorption) operations.
• Corridor System: The policy repo rate sits at the middle of the interest rate corridor, while the Weighted Average Call Rate (WACR) serves as the operating target of monetary policy.
• Other Tools: Open Market Operations (OMO), Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) for durable liquidity; and Standing Deposit Facility (SDF) for absorbing surplus liquidity.

Key Recommendations of the IWG

1. WACR as Operating Target
   • Recommendation: Continue using overnight WACR as the operating target.
   • Rationale: WACR strongly correlates with collateralized overnight money market rates, making it reliable for transmitting policy signals across the system.
2. Discontinuation of 14-day VRR/VRRR as Main Operation
   • Recommendation: Replace 14-day Variable Rate Repo/Reverse Repo (VRR/VRRR) as the main liquidity management tool.
   • Alternative: Manage transient liquidity primarily through 7-day repo/reverse repo operations and other operations (overnight to 14-day tenor) at RBI’s discretion.
   • Rationale: 14-day auctions have witnessed lower participation, as banks prefer shorter-tenor instruments like SDF.
3. Advance Notice for Liquidity Operations
   • Recommendation: RBI should provide at least one-day advance notice for repo/reverse repo operations.
   • Exception: Same-day operations may be undertaken in response to evolving liquidity shocks.
   • Rationale: Predictability reduces market uncertainty and stabilizes money market rates.
4. Variable Rate Auction Mechanism
   • Recommendation: Continue using variable rate auctions for repo and reverse repo operations, including longer tenors.
   • Rationale: Enhances price discovery and aligns market rates with liquidity conditions.
5. Cash Reserve Ratio (CRR) Norms
   • Recommendation: Continue with the 90% daily minimum maintenance requirement of CRR.
   • Rationale: Ensures banks maintain sufficient reserves, preventing liquidity shortfalls.
6. Durable Liquidity Tools
   • Observation: Existing instruments under the LMF are sufficient to meet durable liquidity needs; no changes are required at this stage.

Key Terms:

• WACR (Weighted Average Call Rate): The average overnight interest rate at which banks borrow and lend funds, weighted by transaction volume; RBI’s operating target for monetary policy.
• Repo Rate: Rate at which RBI lends to banks against collateral to inject liquidity.
• Reverse Repo Rate: Rate at which RBI borrows from banks to absorb excess liquidity.
• VRR/VRRR: Auction-based repo/reverse repo operations, where rates are determined by market bids.
• SDF (Standing Deposit Facility): Tool for absorbing liquidity without collateral.
• CRR (Cash Reserve Ratio): Portion of deposits banks must maintain with RBI as liquid cash.

Significance of Recommendations

• For Monetary Policy: Reinforces the role of WACR in aligning short-term rates with policy stance.
• For Markets: Enhances predictability, reducing volatility in money markets.
• For Banks: Offers greater flexibility in managing short-term liquidity needs.
• For RBI: Provides operational flexibility to balance stability with market efficiency.