The humble repo turns 25

RBI accepted the suggestions and announced in its October 1998 policy that it would implement LAF gradually. (Pixabay)

By Amol Agrawal

In April 2024, the Repo rate will turn 25 years old. It is a testament to the long-term commitment of reforming India’s financial markets, a process that started in 1991. The first Narasimham committee of 1991 laid the foundation for reforming financial markets. In 1998, a second Narasimham committee was constituted to review the outcomes of the first report and suggest next set of reforms. The second committee suggested that RBI should adjust liquidity “through a Liquidity Adjustment Facility (LAF)”. The LAF would work as a corridor with repo and reverse repo rates to be adjusted by the RBI periodically.

RBI accepted the suggestions and announced in its October 1998 policy that it would implement LAF gradually. The LAF required upgradation in technology and legal/procedural changes to facilitate electronic transfer and settlement.

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In the April 1999 monetary policy, the RBI first instituted interim LAF (ILAF). Under the ILAF, the central bank infused liquidity via multiple facilities and export credit finance. The two major facilities infusing liquidity were Collateralised Lending Facility (CLF) and Additional Collateralised Lending Facility (ACLF), which provided liquidity over a fortnight. The liquidity was absorbed via the fixed repo rate. Repo is a short for repurchase, where the transactions are reversed after the end of the period.

A year later, the RBI replaced the ILAF with a full LAF. The central bank introduced daily variable repo auctions and reverse repo rate auctions. Repo was used for absorbing liquidity and reverse repo for infusing liquidity.  The purpose behind daily auctions was to meet primarily the day-to-day liquidity mismatches in the system and not the normal financing requirements of eligible institutions.

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Before constitution of LAF rates, bank rate was the major policy rate. Post-LAF repo, RBI said that the both bank rate and repo rate were perceived as signals for movements in money market interest rates.  While the bank rate reflected changes in the medium-term stance of policy, LAF rates facilitated short-term liquidity management in the financial markets on a day-to-day basis.

In November 2003, the RBI constituted a committee to review the functioning of the LAF market. The committee argued that the multiplicity of rates did not help in proper signaling of stance of policy rates. As the LAF system had become more popular, the interest rate corridor should comprise LAF rates. Moreover, repo rates had become more important as call rates changed based on repo rate, even as bank rate remained unchanged.

The Committee noted that globally, repo rates infuse liquidity and are at the centre of the corridor. Accordingly, the RBI should switch the role of the two rates with repo rate becoming the infusing liquidity facility and reverse repo rate becoming the absorbing liquidity facility. The Committee recommended the central bank conduct daily seven-day fixed rate repo auctions and daily overnight fixed rate reverse repo on weekdays.

The central bank accepted the recommendations and implemented the changes in end of March 2004, ahead of the April 2004 monetary policy. In November 2004, the central bank phased out the seven-day fixed rate and 14-day variable rate reverse repos and the LAF, operated only through overnight fixed rate repo and reverse repo. Repo transactions meant banks gave securities and the central bank gave them liquidity. Reverse repo transactions meant the banks parked their surplus funds and central bank gave them securities.

In 2011, the central bank formed another committee to review the LAF corridor system. The Committee suggested to revive the bank rate as a new rate above the repo rate. Instead, the central bank introduced Marginal Standing Facility (MSF) as the upper band of the corridor. The corridor now had three policy rates: repo rate in the middle, MSF above the repo rate and reverse repo rate lower than the repo rate. The other two rates change automatically in response to changes in repo rate.

In 2022, the central bank replaced collateralised reverse repo rate with uncollateralised Standing Deposit Facility (SDF). The SDF gives RBI more powers to absorb liquidity as it does not have to park the securities with the banks.

The sweeping history of repo shows how it takes so many steps and sequences to reform and develop financial markets. The overnight repo rates linked nearly perfectly to the call market rates and the money market rates remained within the corridor for most trading days. In 2003, a new money market instrument based on repo, Collateralised Borrowing and Lending Obligation (CBLO), was introduced. It played an instrumental role in the development of money markets. The repo rate also played an influential role in monetary transmission, where the change in policy rates transmit to bond yields and lending and deposit rates. The monetary transmission was inefficient, leading the central bank to nudge banks to price their loans and deposit interest rates based on the repo rate.

While recommending the repo rate, the second Narasimham committee added “that such a rate cannot be anointed but has to earn its place in the market”. Twenty-five years later, one can say that the humble repo has not just earned its place but also transformed India’s money markets, banking system, and monetary policy.

The author teaches at Ahmedabad University

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