Layman’s view of Credit Policy - Part 2

This is continuation of the two part series on the recent credit policy Layman’s view of Credit Policy - Part 1

LAF cap removed
The RBI has also allowed banks to keep more funds with it under the daily liquidity adjustment facility by removing the Rs 3,000-crore cap imposed in March this year.

What is LAF ?
Prior to this policy, there was a cap on the amount of cash that a bank can hold with the RBI after taking care of the basic reserves that it has to maintain with the RBI. This was called the Liquidity Adjustment Facility (LAF) where excess money can be given to the RBI.

However, the interest paid by the RBI on such short-term funds can henceforth be either at fixed rate or at variable rates. In other words, the RBI will undertake short-term lending and borrowing through repo and reverse repo at a rate of interest which its thinks appropriate.

The removal of the Rs 3,000-crore LAF limit is expected to push up overnight call rates which have been ruling at below 1 per cent.

All other rates have been retained have been retained at the previous rates.

What is Repo rate and Reverse repo rate ?
Repo rate is the rate that RBI charges the banks when they borrow from it. Repo operations increase liquidity in the system. Reverse repo rate is the rate that RBI offers the banks for parking their funds with it. Reverse repo operations suck out liquidity from the system.

What is Call Rate ?
Call rate is the rate that one bank has to pay another bank for borrowing funds between themselves. These rates are typically charged for deposits that are borrowed overnight (typically to meet RBI commitments etc)

How does Repo rate relate to the call rate?
Repo rate typically acts as a floor rate (bare minimum rate) for the call rate. If not, banks would make arbitrage profits. How? Suppose call rate is lower than repo rate, banks will borrow on call (if there are lenders) at a lower rate, and lend on repos to the RBI at a higher rate. As the Repo acts as a floor rate, the call rates will tend towards the Repo rate.

Thus in the recent past because of the high liquidity in the system, the overnight call rates became very low and also the LAF ensures that the banks could not park more than what was allowed with the reserve bank of India. Now this ceiling has been removed.