Standing Deposit Facility

The Standing Deposit Facility (SDF) is a monetary tool introduced by the Reserve Bank of India (RBI) to manage liquidity in the banking system. Launched on April 8, 2022, it replaced the reverse repo as the floor for the Liquidity Adjustment Facility (LAF) corridor. The SDF allows banks to deposit excess funds with the RBI without requiring government securities in return. This feature makes it a collateral-free arrangement, which is particularly useful during periods of high liquidity surplus.

Background of the SDF

• Before the introduction of the SDF, the reverse repo was the primary method for absorbing excess liquidity.
• The reverse repo required the RBI to provide government securities to banks in exchange for their deposits.
• This became cumbersome during periods of liquidity surplus, such as during demonetisation.
• The SDF was designed to simplify this process by eliminating the need for collateral, allowing banks to park their excess funds efficiently.

Functionality of the SDF

• The SDF operates as a facility where banks can deposit surplus funds and earn interest.
• This mechanism is crucial during times when banks have excess liquidity but are hesitant to lend in the uncollateralised call money market.
• The SDF ensures that banks can still earn returns on their deposits while the RBI manages overall liquidity in the economy.

Current Concerns Regarding the SDF

• Bbanks are increasingly choosing to park their funds in the SDF.
• This trend is notable despite liquidity deficit in the banking system.
• The overnight call money rate has been consistently higher than the RBI’s repo rate by 5 to 10 basis points.
• This indicates a reluctance among banks to engage actively in lending, which could hinder liquidity flow in the market.

Implications for the Call Money Market

The current situation poses challenges for the call money market. If banks continue to prefer the SDF, it can lead to a lack of activity in the call money market. This inactivity can prevent the market from functioning efficiently, as the weighted average call money rate may not reflect the true demand and supply dynamics. The RBI has nudged banks to participate more actively in the call money market to enhance its vibrancy and depth.

Future Outlook

The RBI’s focus will likely remain on encouraging banks to lend in the call money market. A more active participation by banks could lead to a decrease in the overnight interbank lending rates. This would help to normalise liquidity conditions and ensure that the banking system operates smoothly.

Questions for UPSC:

1. Critically analyse the impact of the Standing Deposit Facility on India’s monetary policy framework.
2. What are the key differences between the Standing Deposit Facility and the reverse repo rate? Provide suitable examples.
3. Estimate the potential consequences of banks’ reluctance to lend in the uncollateralised call money market.
4. Point out the significance of the call money market in the overall banking system of India.

Answer Hints:

1. Critically analyse the impact of the Standing Deposit Facility on India’s monetary policy framework.

1. SDF simplifies liquidity management by allowing banks to deposit excess funds without collateral.
2. It replaced the reverse repo, providing a more efficient tool for liquidity absorption.
3. The SDF impacts interest rates by influencing banks’ lending behavior and liquidity flow.
4. Concerns arise as banks prefer SDF over lending, potentially tightening liquidity in the market.
5. Encouraging active participation in the call money market is essential for effective monetary policy.

2. What are the key differences between the Standing Deposit Facility and the reverse repo rate? Provide suitable examples.

1. SDF allows banks to park funds without receiving government securities, while reverse repo requires collateral.
2. Reverse repo was cumbersome during high liquidity periods; SDF provides a streamlined alternative.
3. SDF was introduced in 2022, whereas reverse repo has been a traditional tool for longer.
4. Example – During demonetisation, reverse repo’s reliance on government securities became impractical.
5. SDF offers a collateral-free option, making it more attractive for banks with excess funds.

3. Estimate the potential consequences of banks’ reluctance to lend in the uncollateralised call money market.

1. Increased reliance on SDF can lead to higher overnight call money rates, affecting liquidity.
2. Reduced lending activity may hinder economic growth by limiting credit availability.
3. Market inefficiencies may arise, preventing accurate signals from the weighted average call money rate.
4. Long-term reluctance could destabilize the call money market, impacting monetary policy effectiveness.
5. Encouraging banks to lend is crucial to restoring balance in the banking system and liquidity flow.

4. Point out the significance of the call money market in the overall banking system of India.

1. The call money market facilitates short-term borrowing and lending among banks, ensuring liquidity management.
2. It serves as a barometer for short-term interest rates, influencing broader monetary policy decisions.
3. Active participation in this market helps maintain stability and efficiency in the banking system.
4. It plays important role in transmitting monetary policy signals to the economy.
5. A vibrant call money market enhances financial intermediation, supporting overall economic growth.