What is SDF, the RBI’s new tool to absorb excess liquidity to control inflation?

While retaining the reverse repo rate at 3.35%, the Reserve Bank of India (RBI) introduced the Standing Deposit Facility (SDF), an additional tool for absorbing liquidity, at an interest rate of 3.75%.

Recent MPC Highlights

What is SDF?

• This concept, first recommended by the Urjit Patel committee report in 2014
• Standing deposit facility is a remunerated facility that will not require the provision of collateral for liquidity absorption.
• Banks, at different points in time, may be short of funds or flush with money.
• When they need money for the short-term, they borrow from the RBI (Repo Rate) for which they pledge government securities.
• When banks have excess funds they lend it to the RBI at the reverse repo rate that is lower than the repo rate. Here too, government securities act as collateral.

Role of SDF

• The main purpose of SDF is to reduce the excess liquidity of Rs 8.5 lakh crore in the system, and control inflation.
• In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the SDF – an additional tool for absorbing liquidity without any collateral.
• By removing the binding collateral constraint on the RBI, the SDF strengthens the operating framework of monetary policy.
• The SDF is also a financial stability tool in addition to its role in liquidity management.
• The SDF will replace the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor.
• Both the standing facilities — the MSF (marginal standing facility) and the SDF will be available on all days of the week, throughout the year.

How it will operate

• The SDF rate will be 25 bps below the policy rate (Repo rate).
• Applicaility : Overnight deposits at this stage.
• The RBI’s plan is to restore the size of the liquidity surplus in the system to a level consistent with the prevailing stance of monetary policy.

Why is it important?

• Liquidity plays a key role in transmission of policy rates.
• In a falling rate cycle, pass-through of rate cuts will happen quickly if there is sufficient liquidity, as banks will be able to lower deposit rates comfortably.
• The reverse holds true now. Excess liquidity has led to short-term market rates slipping below the RBI’s policy repo rate.
• Now, RBI would want to keep a tight leash on rates. The RBI would want its key policy rate i.e., the repo rate, to be the operational rate.
• The RBI’s management of rates impacts the rates on your deposits and loans.
• The immediate fallout of excess liquidity in the past few months has been the sharp cuts in bank deposit rates.
• If the RBI curbs excess liquidity and halts the fall in short-term rates, then the depositors can breathe a sigh of relief.

Reverse repo rate

• The fixed rate reverse repo (FRRR) rate which is retained at 3.35 per cent will remain part of the RBI’s toolkit, and its operation will be at the discretion of the RBI for purposes specified from time to time.
• The FRRR along with the SDF will impart flexibility to the RBI’s liquidity management framework.

Question of liquidity

• The “extraordinary” liquidity measures undertaken in the wake of the pandemic, combined with the liquidity injected through various other operations of the RBI, have left a liquidity overhang of the order of Rs 8.5 lakh crore in the system.
• This has pushed up the retail inflation level in the system.

Exam Track

Prelims Take Away

• MPC
• Qulaitative and Quantitative Tools of Monetary policy