Liquidity Management by RBI - A Primer

Introduction

Liquidity management is a key function of the Reserve Bank of India (RBI) that ensures effective monetary policy transmission and smooth financial system operations. It involves the central bank's procedures to align short-term interest rates with the policy rate. The RBI's liquidity management framework involves three key aspects: the operating framework, liquidity drivers, and liquidity control mechanisms.

The RBI’s liquidity management framework has evolved through progressive refinements since 1999 in response to changing domestic and global conditions. Since 2011, the fixed overnight repo (repurchase) rate under the Liquidity Adjustment Facility (LAF) has been formally announced as the single monetary policy rate, with the Weighted Average Call Money Rate (WACR) as the operating target of monetary policy. The effectiveness of liquidity management operations depends on being predictive in assessing liquidity and market conditions and deploying instruments productively, singly and/or in combinations. The liquidity management framework was modified in April 2016, assuring both durable and frictional liquidity, while aiming to progressively lower the average ex-ante liquidity deficit in the system to a position closer to neutrality.

Importance of Liquidity Management

Efficient liquidity management is critical to monetary policy operations. Even though liquidity management has short-term effects in financial markets, its implications are enduring in terms of its impact on consumption, investment and capital formation in the economy. 

• Supporting economic growth: By maintaining optimal liquidity, banks can continue lending to businesses and consumers, supporting economic activity and growth in India.
• Facilitating monetary policy transmission: Effective liquidity management by the RBI helps in the smooth transmission of monetary policy to the broader economy.
• Ensuring financial stability: Effective liquidity management helps Indian banks and financial institutions maintain adequate cash reserves and liquid assets to meet short-term obligations and withstand economic shocks. 
• Meeting regulatory requirements: The RBI has implemented stringent liquidity requirements such as the Liquidity Coverage Ratio (LCR) for banks. Proper liquidity management is essential for banks to comply with these regulatory norms.
• Managing volatility: Sound liquidity management helps banks and the RBI handle sudden inflows or outflows of foreign capital. 
• Mitigating systemic risk: Robust liquidity management practices reduce the risk of contagion, as the liquidity shortages at major banks can quickly spread through the financial system.
• Building investor and depositor confidence: Strong liquidity positions enhance the credibility of banks among investors and depositors, crucial for maintaining stability.
• Managing currency fluctuations: Liquidity management helps banks handle exchange rate volatility, which is important given India's increasing global financial integration.

Key Drivers of Liquidity in the Banking System

• Government cash balances with RBI: The government's higher cash holdings at the RBI reduce system liquidity and lower balances increase it.
• Changes in currency in circulation: An increase in currency in circulation reduces liquidity in the banking system, while a decrease increases liquidity.
• RBI's forex operations: When the RBI buys foreign currency, it injects rupee liquidity into the system, and when it sells foreign currency, it absorbs rupee liquidity.
• RBI's market operations: Through its liquidity tools such as Open Market Operations (OMOs), the RBI can inject liquidity by purchasing government securities or absorb liquidity by selling them.
• Changes in CRR, SLR: An increase in Cash Reserve Ratio (CRR) or Statutory Liquidity Ratio (SLR) requirements reduces liquidity in the banking system, while a decrease increases liquidity.

Key Factors Affecting Surplus Liquidity

• Credit and Deposit Mismatch: When there is an increase in bank deposits compared to the demand for credit, it creates a liquidity surplus in banks.
• Government Spending: Higher government spending at the end of the month (salaries, pensions) can contribute to surplus liquidity.
• Redemption of government bonds: When government bonds mature and are redeemed, it adds to the surplus liquidity in the banking system.
• Withdrawal of high denomination currency notes: Deposit of withdrawn currency notes contributes to increased surplus liquidity.
• RBI intervention in forex markets: The RBI buying dollars to weaken the rupee can increase rupee liquidity.

Key Factors Leading to Liquidity Tightness

• High demand for bank credit: If credit growth surpasses deposit growth, it can cause fund constraints and liquidity tightness.
• Advance tax payments by corporates: Quarterly advance tax outflows can aggravate liquidity tightness.
• RBI intervention in forex markets: The RBI selling dollars to defend the rupee can reduce rupee liquidity.

RBI's Liquidity Management Methods

Banks try to borrow their shortfall of reserves from the interbank market. If reserve requirements such as CRR and SLR cannot be met in the inter-bank market, then banks borrow funds from the RBI under LAF. If banks are net borrowers under LAF, the system liquidity can be said to be in deficit. Conversely, if banks deposit more than the reserve requirement, then they become a net lender to RBI, and the system liquidity can be said to be in surplus.

The RBI uses various tools to manage liquidity in the banking system, which is in line with its monetary policy stance. The RBI's main challenge is to ensure that changes in its policy instruments quickly and effectively influence its target interest rates. To achieve this, the RBI typically adjusts its liquidity operations in the following ways:

• Injecting funds into the system when needed, especially during periods of liquidity shortage. 
• Timing government borrowing strategically to smooth out cash flows and prevent sudden liquidity crunches.
• Encouraging banks to rely more on borrowing from each other (the inter-bank market) rather than depending heavily on the RBI for their daily liquidity needs.

Liquidity Adjustment Facility (LAF) Window of RBI

As part of the financial sector reforms launched in mid-1991, India began to move away from direct instruments of monetary control to indirect ones. To facilitate such a transition, considering country-specific features of the Indian financial system, India developed LAF in phases based on repo / reverse repo operations by the central bank.

In 1998, the Committee on Banking Sector Reforms (Narasimham Committee II) recommended the introduction of LAF under which the RBI would conduct auctions periodically, if not daily. Since October 29, 2004, RBI has adopted the international usage of ‘repo’ and ‘reverse repo’ terms under LAF operations. Accordingly, absorption of liquidity by the RBI in the LAF window is termed as ‘reverse repo’ and injection of liquidity as ‘repo’. LAF allows the RBI to manage market liquidity on a daily basis while helping the short-term money market interest rates to move within a corridor thereby imparting stability and facilitating the emergence of a short-term rupee yield curve.

Policy Corridor

With the introduction of the LAF, steering overnight money market rates emerged as the key challenge in daily liquidity management operations. Thus, the central bank follows a “corridor” liquidity management system, with a ceiling and a floor rate with the repo rate as the ceiling for the corridor, and the reverse repo rate as the floor of the corridor. 

While, the RBI has the flexibility to change the corridor, as warranted by the monetary conditions. In 2011, it introduced a new Marginal Standing Facility (MSF) and the width of the corridor was fixed at 200 basis points. RBI kept the reverse repo rate 100 basis points below the repo rate and the MSF rate 100 basis points above the repo rate. In April 2016, the policy rate corridor was narrowed from +/-100 bps to +/- 50 bps to ensure finer alignment of the WACR with the repo rate. 

In April 2022, the RBI introduced one more tool, the Standing Deposit Facility (SDF) as the floor of the LAF corridor and restored the policy corridor to 50 basis points. The difference between the MSF rate as the ceiling and the SDF as the floor is referred to as the policy corridor of LAF, and the policy repo rate at the centre of the corridor. The ideal situation is one where call rates move within this corridor which the central bank ensures through its LAF. 

Key Instruments Under LAF

Fixed Rate Repo

The repo or repurchase rate is a key tool of RBI’s monetary policy to manage liquidity in the banking system and influences the interest rates in the economy. The repo rate is the fixed interest rate at which the RBI lends money to commercial banks by purchasing government securities from them as collateral, with an agreement to repurchase at a fixed rate on a future date. 

The repo rate was introduced in India in 1998 as part of the LAF framework implemented by the RBI. Since the adoption of ‘repo’ for injection of liquidity in 2004, the repo rate has fluctuated significantly, reaching as high as 9% in 2008 and as low as 4% in 2020. It stands at 6.50% as of July 2024.

Repo rate signals the RBI's monetary policy stance which influences the borrowing and lending rates, liquidity,  inflation and economic growth.

• Signalling Monetary Policy Stance: An increase in the repo rate indicates a tightening of monetary policy to curb inflation, while a decrease signals an expansionary policy to boost growth.
• Influencing Lending and Borrowing Rates: Changes in the repo rate directly impact the lending and deposit rates offered by commercial banks. This, in turn, affects the cost of borrowing for individuals and businesses, influencing their spending and investment decisions. For example, when the RBI raises the repo rate, it becomes more expensive for banks to borrow money from the RBI. For example, if the repo rate is increased from 4% to 5%, a bank that borrows ₹1,000 crore from the RBI will have to pay an additional ₹ 10 crore in interest (1% of ₹1,000 crore). 
• Managing Liquidity: RBI provides short-term funds to banks at the prevailing repo rate, when they are facing a liquidity crunch. This helps maintain stability in the financial system and ensures adequate credit is available for economic activities. 

When the RBI increases the repo rate, it becomes expensive for banks to borrow, leading to higher interest rates for borrowers, thus curbing demand and inflation. Lowering the repo rate has the opposite effect, stimulating economic growth. For example, when RBI lowers the repo rate, banks pass on the decreased borrowing costs to their customers, leading to reduced interest rates for home and personal loans. Lower interest rates encourage borrowing and spending by consumers and businesses, increasing the money supply in the economy and thus stimulating economic activity. 

Fixed Rate Reverse Repo

The reverse repo rate is the interest rate at which the banks park their excess money with the RBI, typically overnight, earning interest on their surplus liquidity. It is always lower than the repo rate and as of July 2024, the reverse repo rate stands at 3.35%. By adjusting this rate, the RBI can influence overall interest rates in the economy, through incentivising or disincentivising banks to park their excess funds with the central bank. The fixed reverse repo rate was replaced by the SDF as the LAF corridor's floor from April 2022.

When the reverse repo rate is increased:

• Banks are more likely to deposit excess funds with the RBI, reducing the money supply in the market.
• This can lead to higher interest rates on loans and deposits offered by banks.
• It may help control inflation but could potentially slow down economic growth.

When the reverse repo rate is decreased:

• Banks are encouraged to lend more to businesses and consumers rather than parking funds with the RBI.
• This increases liquidity in the market and can stimulate economic activity.
• It may lead to lower interest rates on loans, potentially boosting consumer spending and investments.

Variable Rate Repo (VRR)

VRR is a liquidity injection tool of the RBI, where the RBI lends money to commercial banks at a variable interest rate. VRR auctions help the RBI inject liquidity into the banking system, as and when the need arises, ensuring that banks have sufficient funds to meet their short-term obligations and support lending activities. 

When the weighted average call money rate trends above the repo rate in the interbank money market, it gives a signal to the RBI of a system liquidity deficit. RBI conducts VRR auctions, usually tenor varying from overnight to 13 days, for injection of short-term liquidity against collaterals. At the VRR auction, the cut-off rate of interest generally remains at one basis point above the prevalent policy repo rate. For injection of durable liquidity, the RBI conducts VRR auctions for a tenor beyond 14 days, but very rarely.

Variable Rate Reverse Repo (VRRR)

The RBI employs VRRR auctions to absorb surplus liquidity from the banking system through longer-term borrowing from commercial banks. The primary objective of VRRR auctions is to manage liquidity by offering banks a variable interest rate for their surplus funds, thereby influencing credit availability in the economy.

Mechanism of VRR and VRRR Auctions

Announcement and Bidding: The RBI announces the amount it intends to borrow through VRRR auctions or lend through VRR auctions. Participating banks submit bids specifying the interest rates they are willing to accept for parking funds or pay for borrowing from RBI.

Rate Determination: Bids are sorted in descending order of interest rates. The cut-off rate is determined based on these bids.

Allocation: The RBI accepts bids at or above the cut-off rate and allocates funds (VRRR) or accepts funds (VRR) accordingly. Bids below the cut-off rate get rejected.

Tenor: Typically, VRR and VRRR auctions have a tenor of 7 to 14 days.

Example: During the COVID-19 pandemic, the RBI reinstated 14-day VRRR auctions on January 15, 2021, initially absorbing ₹2 lakh crore. These auctions were subsequently rolled over in fortnightly instalments. Despite concerns over potential liquidity tightening, enhanced participation and favourable bid-cover ratios in auctions demonstrated market acceptance. Notably, the RBI announced expanded fortnightly VRRR auctions totalling ₹2.5 lakh crore on August 13, 2021; ₹3.0 lakh crore on August 27, 2021; ₹3.5 lakh crore on September 9, 2021; and ₹4.0 lakh crore on September 24, 2021. It's crucial to emphasise that these expansions did not indicate a shift from the accommodative policy stance, with expected absorption through fixed-rate reverse repo operations surpassing ₹4.0 lakh crore by September 2021. The liquidity infused via VRRR auctions has significantly bolstered overall system liquidity. 

In June 2024, the RBI conducted a VRR auction for ₹1 lakh crore with a 7-day tenor to inject liquidity into the banking system to address a liquidity deficit estimated at around ₹1.56 lakh crore.

Marginal Standing Facility (MSF) Rate

The Marginal Standing Facility (MSF) rate is the upper limit at which banks can borrow additional funds from the RBI against their excess SLR securities and also by dipping into their SLR portfolio up to a specified limit at a penal rate of interest. This facility was introduced in May 2011, to manage liquidity and control overnight interest rate fluctuations. The MSF allows banks to borrow up to 1% of their Net Demand and Time Liabilities (NDTL) from the RBI. When introduced, the rate of interest on the amount accessed from this facility was kept at 100 basis points above the repo rate, which was gradually narrowed down by 50 basis points and 25 basis points. The MSF rate stands at 6.75% as of July 2024, and the repo rate is at 6.5%.

The RBI introduced the MSF to provide a last-resort borrowing option for banks facing unexpected liquidity shortages.

• Emergency Funding: It provides emergency liquidity to banks facing sudden liquidity shortages during times of financial stress or unexpected liquidity crunches. Banks can quickly access funds through the MSF, ensuring the smooth functioning of the banking system.
• Controlling Overnight Interest Rates: The MSF rate acts as a tool to control overnight interest rates in the financial markets. By setting the MSF rate higher than the repo rate, the RBI discourages banks from relying excessively on the MSF for their funding needs. This provides a safety valve against unanticipated liquidity shocks to the banking system, helps stabilise short-term interest rates and maintains monetary policy effectiveness.
• Monetary Policy Transmission: By influencing short-term interest rates, the MSF rate complements the repo rate in transmitting the RBI's monetary policy decisions to the broader financial system. Changes in the MSF rate signal the RBI's stance on liquidity conditions and its efforts to achieve monetary policy objectives such as controlling inflation or promoting economic growth.

Example: During the Covid-19 crisis, the RBI extended the MSF facility on March 27, 2020 and allowed banks to increase their borrowing capacity by leveraging their Statutory Liquidity Ratio (SLR) by an additional 1% of their NDTL. Initially intended until March 31, 2021, this measure was later extended for an additional six months until September 30, 2021. These measures were aimed at enhancing banks' liquidity during the crisis, providing access to funds totalling ₹1.53 lakh crore. 

Standing Deposit Facility (SDF)

SDF is an additional liquidity tool introduced by RBI under LAF, on April 8, 2022, to absorb excess liquidity from the banking system. The motive behind introducing the SDF is to assist in smooth liquidity management in the economy, especially in the wake of the COVID-19 pandemic, which resulted in a huge influx of funds into the banking system. SDF helps the RBI to manage the total amount of money circulating in the economy and, thus, helps to control inflation. By offering an overnight deposit facility, the RBI can absorb surplus funds from banks, thereby helping to maintain liquidity and stabilise short-term interest rates.

This tool allows eligible LAF participants to temporarily deposit their surplus funds with the RBI and earn an interest rate on it, while the RBI does not need to give securities to banks for these deposits. In simple terms, SDF is like a secured deposit facility for banks to keep their extra money, and the SDF rate is the interest they earn for doing so. Under SDF, the banks can place overnight deposits with the RBI. The RBI also has the flexibility to absorb liquidity for longer periods, as needed, with appropriate pricing. The interest rate on deposits under the SDF is determined by the RBI and is set at 25 basis points below the policy repo rate. As of July 2024, the SDF rate stands at 6.25%.

Features 

• The fixed reverse repo rate was replaced by the SDF as the LAF corridor's floor.
• The RBI decides the interest rate periodically, and currently, the SDF rate shall be 25 basis points less than the policy repo rate.
• The SDF is a liquidity absorption facility, and the RBI might be able to increase its duration at any time.
• The SDF facility can be used by any entity that is eligible for the LAF.

The SDF enables the management of surplus liquidity to be flexible as it abolishes the rule that the RBI must display government securities on its balance sheet. There will be two entries for each SDF on the balance sheet: one under assets, net claims on banks, and the other under liabilities, currency in circulation. With this reduction in the impact on the central bank's balance sheet, there is a greater possibility for the RBI to carry over surplus liquidity.

Challenges

• SDF can affect the demand for government securities in the market, as the banks may prefer to deposit their funds with the RBI rather than buying government bonds. This may increase the borrowing cost for the government and affect its fiscal position.
• SDF discourages banks from lending to the private sector, as they find it more convenient and profitable to deposit their funds with the RBI rather than taking credit risks.

Market Stabilisation Scheme (MSS)

The Market Stabilisation Scheme (MSS) is a monetary policy tool used by the RBI to manage excess liquidity in the economy and is typically used as a short-term measure to address temporary surges in liquidity.

Key Components

• Issuance: MSS involves the RBI issuing Market Stabilisation Bonds (MSBs) to absorb excess liquidity created primarily from foreign exchange market interventions. RBI issues MSBs to financial institutions on behalf of the government, without impacting the government's fiscal position.
• Interest Payments: Financial institutions purchase MSBs and earn interest. The government funds these interest payments, known as the carrying cost of MSBs, from its budget.
• Separate Cash Account: Proceeds from the sale of MSBs are held in a dedicated cash account with the RBI and are not available for government spending. This account is used exclusively for the redemption or buyback of MSBs.
• Managing Liquidity: MSS is deployed to absorb excess liquidity in the banking system during significant capital inflows or other liquidity surges. This prevents excessive money supply growth that could lead to inflationary pressures.
• Impact on Interest Rates: MSS operations influence interest rates by adjusting the money supply. The issuance of MSBs absorbs liquidity, potentially raising interest rates. Conversely, the buyback of MSBs injects liquidity, which can lower interest rates.

Example

During the 2016 demonetisation period, when there was a surge in bank deposits, the RBI utilised MSS to address the excess liquidity in the banking system, which averaged ₹4.2 trillion in April and ₹3.5 trillion in May. 

• Treasury Bills (TBs) worth ₹1 trillion are issued under MSS with tenors ranging from 312 to 329 days.
• Auctioning Cash Management Bills (CMBs) worth ₹0.7 trillion due to lower government cash balances.

Cash Management Bills: CMBs are one of the short-term instruments, typically with maturities of less than 91 days used under the MSS along with TBs and dated securities. CMBs issued under MSS help in transferring liquidity from the banking sector to the government in a manageable form. For instance, in 2016, the RBI conducted an auction of 35-day Government of India CMBs under the MSS.

The issuance of CMBs under the MSS is a strategic tool employed by the RBI to manage the liquidity surplus in the banking system. It ensures financial stability, helps maintain appropriate money market rates and supports the broader economic objectives without impacting government expenditure.

Targeted Long-Term Repo Operations (TLTRO)

Targeted Long-Term Repo Operations (TLTRO) is a monetary policy tool introduced by the RBI to provide long-term funding to banks aimed at specific sectors of the economy. The RBI provides funds to banks and financial institutions at the prevailing policy repo rate for tenors of up to three years. Banks pledge government securities as collateral with the RBI to obtain these funds. This allows banks to access cheaper funds than they would in the open market, encouraging them to lend to specific sectors.

TLTRO aims to address liquidity constraints faced by certain sectors, such as small and mid-sized corporates, Non-Banking Financial Companies (NBFCs), and Microfinance Institutions (MFIs), which are crucial for economic recovery.

Deployment Requirements and Timeframe: Funds availed under TLTRO must be invested in specific investment-grade securities to ensure that the liquidity injected reaches the intended sectors. Banks have a specified timeframe to deploy the funds, typically around 30 to 45 working days, depending on the TLTRO variant. If funds remain un-deployed beyond this period, banks are penalised with an interest rate higher than the repo rate to discourage liquidity hoarding.

Classification of Investments: Investments made under TLTRO are classified as Held To Maturity (HTM), which means securities acquired by banks to hold them up to maturity will be classified under the HTM category. Despite exceeding the usual 25% limit for HTM securities under regulatory norms, these investments are exempt from the Large Exposure Framework (LEF), which allows banks to manage their exposure more flexibly during economic stress.

Example: During the COVID-19 pandemic, the RBI implemented TLTRO to mitigate market disruptions and liquidity challenges exacerbated by the crisis. The first TLTRO auction commenced on March 27, 2020, with subsequent auctions contingent on reviewing the outcomes and liquidity conditions. The RBI conducted multiple TLTRO auctions totalling up to ₹1,00,000 crore. 

The RBI separately issued detailed operational guidelines for TLTRO to ensure effective implementation and monitoring. Under TLTRO, banks were incentivised to invest in investment-grade corporate bonds, commercial paper, and non-convertible debentures issued by sectors severely affected by the pandemic. These sectors included hospitality, retail, and small-scale industries. The scheme aimed to supplement existing holdings as of March 27, 2020, with a substantial portion sourced from primary market issuances and the remainder from secondary markets, including mutual funds and NBFCs.

Open Market Operations (OMOs)

OMOs refer to the buying and selling of government securities by the RBI to inject or absorb liquidity in the banking system. They are a part of the monetary policy and hence considered different from the government borrowings which fall under the purview of fiscal policy. Also under OMO, there is no participation of the public, as the securities are purchased by the commercial banks and financial institutions, unlike the case for government borrowing which is made for the primary purpose of welfare and development actions.

Liquidity Management: When the RBI perceives excess liquidity in the banking system it conducts OMO sales, where it sells government securities to the market. This action withdraws money from circulation, thereby reducing the money supply and tightening liquidity. Conversely, when liquidity is tight, the RBI conducts OMO purchases by buying government securities from the market, thus injecting money into the system and increasing liquidity.

Influencing Interest Rates: The RBI utilises OMOs as one of the primary monetary policy tools to manage liquidity. By adjusting the money supply through OMOs, the RBI can influence short-term interest rates in the economy. Selling government securities (contractionary OMOs) reduces available funds for lending, in turn raising interest rates. Conversely, buying government securities (expansionary OMOs) lowers interest rates by increasing available funds.

Signalling Monetary Policy: The RBI's OMO decisions signal its stance on monetary policy. Selling government securities indicates a tightening policy to curb inflation while buying government securities signals an expansionary policy to stimulate economic growth. Suppose the RBI observes excess liquidity in the banking system, potentially leading to inflationary pressures. The RBI conducts an OMO sale of government securities. The sale reduces the amount of money in circulation, thereby increasing short-term interest rates. Higher interest rates make borrowing more expensive for consumers and businesses, reducing their spending and investment. This helps control inflation by dampening overall economic demand.

Cash Reserve Ratio (CRR)

CRR is a mandatory reserve that banks must maintain with the RBI. It is calculated as a percentage of a bank's NDTL and serves as a liquidity buffer without earning any interest. The CRR requirement ensures that banks hold a specified portion of their deposits as reserves with the RBI to maintain financial stability. CRR stands at 4.50% as of July 2024.

Financial System Stability & Consumer Protection: CRR safeguards depositors' funds and plays a crucial role in protecting the banking sector against liquidity risks, reducing the likelihood of bank failures and contributing to overall financial stability. 

Liquidity Management: CRR helps regulate liquidity within the banking system, ensuring stability by controlling the amount of funds available for lending.

Inflation Control: By curbing excessive credit creation, CRR helps control inflationary pressures, thereby stabilising the economy.

Example: Following the "taper tantrum" in May 2013, global and domestic financial markets faced volatility. In response, the RBI implemented stricter daily average CRR maintenance requirements, reaching up to 99%, and restricted access to RBI liquidity. These measures significantly tightened the Weighted Average Call Rate (WACR). 

Incremental CRR

Incremental CRR is an additional cash reserve requirement imposed on banks over and above the regular CRR. This tool is used by the RBI to manage liquidity in the banking system, particularly during periods of excess liquidity caused by extraordinary events. This measure aims to maintain financial stability by preventing an oversupply of liquidity, which could lead to inflationary pressures and disrupt the balance in the money market. Additionally, it ensures that banks have sufficient liquidity to meet the credit needs of productive sectors of the economy. This move temporarily reduces the available funds by banks for lending or investment and helps to absorb the surplus liquidity from the banking system, preventing potential inflationary pressures and ensuring stability in the money market.

Example: The RBI observed a significant surge in bank deposits in response to the withdrawal of ₹500 and ₹1,000 denomination bank notes (Specified Bank Notes - SBNs) beginning November 9, 2016. The RBI implemented an incremental CRR (maintain a 100% incremental CRR over the 4% CRR) to manage this excess liquidity as a temporary measure. Similarly, on August 10, 2023, to absorb surplus liquidity in the banking system which was generated by the return of ₹2000 notes, the RBI mandated banks to maintain an I-CRR of 10% on the increase in their NDTL between May 19, 2023 and July 28, 2023. 

For instance, suppose a bank's NDTL increased by ₹10,000 crore between September 16, 2016, and November 11, 2016, under the incremental CRR requirement, the bank would need to hold an additional ₹10,000 crore reserves with the RBI, in addition to the base CRR requirement.

Statutory Liquidity Ratio (SLR)

SLR  is a regulatory mandate that requires commercial banks to maintain a minimum percentage of deposits in the form of liquid assets, such as gold, cash, and approved securities to ensure stability in the banking system. The SLR plays a critical role in safeguarding depositors' funds and maintaining the overall stability of the financial system. SLR is used to manage bank credit and ensure the solvency of commercial banks. SLR stands at 18.0% as of July 2024.

The SLR serves several key purposes:

• Prevent Over-Liquidation: By mandating banks to hold a portion of their deposits in liquid assets, the SLR prevents banks from over-liquidating their assets to meet other reserve requirements like the CRR.
• Regulate Credit Flow: The SLR allows the RBI to control the flow of credit in the economy. Increasing the SLR restricts credit flow, helping to control inflation, while decreasing it boosts credit flow, aiding in economic growth during recessions.
• Ensure Solvency: By requiring banks to maintain liquid assets, the SLR ensures that banks remain solvent and can meet their financial obligations. 
• Consumer Protection: By ensuring that banks hold a portion of their deposits in liquid assets, the SLR reduces the risk of bank failures and enhances the resilience of the banking sector against liquidity crises. 
• Liquidity Management: The SLR is a vital tool for managing liquidity within the banking system. By adjusting the SLR, the RBI can influence the amount of funds available for lending and investment. A higher SLR restricts liquidity, while a lower SLR increases it, thereby helping to maintain financial stability. 
• Inflation management: The SLR helps control inflation by regulating the amount of credit that banks can extend. By increasing the SLR, the RBI can reduce the money supply in the economy, thereby curbing inflationary pressures. Conversely, decreasing the SLR can increase the money supply, promoting economic growth.

Example

During periods of economic instability, such as the global financial crisis of 2008, the RBI adjusted the SLR to manage liquidity and credit flow. By increasing the SLR, the RBI was able to restrict excessive credit creation and stabilise the financial system. Conversely, during economic downturns, the RBI has reduced the SLR to encourage lending and stimulate economic activity.

Conclusion

Liquidity management is an important function of the RBI that ensures the smooth functioning of the financial system and the effective transmission of monetary policy. The RBI's liquidity management framework has evolved to address changing economic conditions and challenges and the RBI employs various direct tools such as CRR, SLR, or indirect tools through LAF to regulate the money supply and manage the Indian economy as and when required. 

As the Indian economy continues to grow and integrate with global markets, effective liquidity management will remain crucial for maintaining financial stability and supporting economic growth. The RBI's ability to adapt its liquidity management tools and strategies to address emerging challenges, such as shifts in customer preferences and technological disruptions, will be key to ensuring the continued effectiveness of its monetary policy implementation.