Why Is RBI Providing Banks With Taxpayer Funds?

In the realm of policymaking, there is a growing trend among state institutions in India to draw inspiration from ancient Indian philosophies. The Defence Minister recently unveiled Project Udbhav for the Indian Army, emphasising the utilisation of ancient treatises like the Arthashastra, Nitisara and Thirukkural to derive strategic insights. The National Council of Educational Research and Training (NCERT) has advocated teaching the Ramayana and Mahabharata as historical lessons in schools. 

The Reserve Bank of India (RBI) Governor frequently references Arjuna to convey the central bank's commitment to managing inflation while considering various factors influencing the achievement of the 4 per cent inflation target. Over the past year, the Reserve Bank of India (RBI) has incrementally raised the policy rate by 250 basis points from April 2022 to February 2023 to curb inflation, maintaining a steady rate thereafter.

During the pandemic, the RBI implemented extraordinary liquidity measures, resulting in a substantial liquidity surplus of around Rs 8,500 billion in the banking system by April 2022. The challenge faced by the RBI was how to withdraw this liquidity gradually over several years without causing disruption. The Standing Deposit Facility (SDF) was introduced at the onset of the rate hike cycle to reduce the liquidity surplus to a level consistent with the RBI's monetary policy stance.

The SDF's objective was to enhance the operating framework of monetary policy by providing an additional tool for absorbing liquidity without requiring collateral. It replaced the reverse repo rate as the floor of the Liquidity Adjustment Facility corridor, positioned 25 basis points below the policy rate and symmetric to the upper end of the Marginal Standing Facility corridor, which was 25 basis points above the policy rate. 

In 2020, during the pandemic, the Liquidity Adjustment Facility corridor width had been expanded to 90 basis points through asymmetric adjustments in the reverse repo rate relative to the policy rate. The RBI argued that, with the return of financial markets to normalcy in April 2022, restoring the corridor's width to its pre-pandemic level was optimal. However, the RBI has been criticised for not clarifying how it labels this as a symmetric corridor when the roof, used for injecting liquidity, requires collateral from banks, while the floor absorbs liquidity without collateral.

The SDF operates by channeling money to banks that opt not to lend and instead deposit it in this RBI-provided facility. The daily absorption under the SDF averaged Rs 1,500 billion during 2022-23, with the RBI paying out Rs 74,447 million in interest over the year. The average interest rate paid by the RBI on SDF absorption is 4.9 per cent, constituting 8.5 per cent of the surplus transferred by the RBI to the government in the year and 24.5 per cent of the surplus transferred the previous year—a substantial loss of revenue for the government.

Additionally, there is a observed weakening of the transmission channel of monetary policy. The RBI's transfers to banks during liquidity absorption elevate their equity value, reducing the cost of funding for bank loans and incentivising banks to lend. Simultaneously, the RBI's efforts to combat inflation involve raising interest rates, impacting asset prices and lowering the collateral value of loans, thereby making loans more expensive. This dual effect diminishes the effectiveness of the monetary policy transmission channel.