The Evolution Of Interest Rate Benchmarks In India

Pre-Independence

Going in to the 20th century, the Indian money market comprised of organised and unorganised players. The organised market had the Imperial Bank of India (State Bank of India today), other commercial banks and exchange banks. Before RBI, the Imperial Bank served as a quasi-central bank providing liquidity to commercial banks at the bank rate with government securities as collateral. The unorganised sector comprised the indigenous bankers such as shroffs, moneylenders, etc. whose main source of liquidity was hundis.

With the coming of the RBI in 1935, the setting of the bank rate shifted to the central bank. RBI provided liquidity by discounting eligible bills and commercial papers at the bank rate. However, the money markets did not function properly due to lack of a real bills market which also hampered RBI’s monetary policy. RBI also tried to integrate the unorganised and organised money markets but to no avail.

Before Liberalisation

By the 1970s, the money markets remained confined to overnight call and short notice (up to 14 days), inter-bank deposits or loans, inter-bank repo market, and bills rediscounting. The call rates touched a high of 25-30 percent, pushing authorities to impose a ceiling of 15 percent on the rate.

In 1985, the Chakravarty Committee which recommended monetary targeting also iterated the need to develop money markets for proper transmission. In 1986, the working group chaired by N Vaghul asked to study money markets paved way for new instruments such as inter-bank participation certificates in 1988, certificates of deposit in 1989 and commercial paper in 1990. In 1988, RBI prohibited banks from entering into buyback from non-banking entities but allowed inter-bank activity. Call rates were freed in 1989.

Harshad Mehta Scam And Fallout

Investigations into the 1992 Harshad Mehta stock market scam revealed that irregularities under interbank buyback had played a key role. The RBI banned this inter-bank arrangement for dated securities except treasury-bills. Then Special Judge SN Variava's judgment on the scam deemed all such inter-bank dealings as illegal and void as per the Securities Contract Regulation Act of 1956.

Parallelly, the Nadkarni Committee report published in 1992 argued for increased transparency in these inter-bank markets. The 1991 reforms had also paved way for the reset button and a change in thinking. On reviewing the report, the RBI thought of introducing electronic trading and settlement systems. The government also made changes in the law and permitted banks and primary dealers to engage in buyback markets.

Shift To Repo And Reverse Repo

In December 1992, the Reserve Bank of India also started to conduct fixed rate repo transactions initially for 1/2/3 days and replaced later by a 14-day cycle. In those days repo transactions then stood for absorbing liquidity. The securities acceptable under repo were T-bills and select dated securities. The repo was discontinued in 1995 due to tight liquidity.

In 1994, RBI started the primary dealer system to develop the government bond market. To provide liquidity to the PDs, RBI started reverse repo facility as a liquidity infusion tool. The RBI also introduced the Subsidiary General Ledger to record G-sec transactions.

The year 1997 was significant in India’s monetary history, as the RBI and government signed an agreement to stop deficit financing. RBI expanded the scope of repos and reverse repos to all dated government securities and T-bills, and also allowed non-banks holding SGLs to engage in reverse repo transactions with banks and PDs.

Liquidity Adjustment Facility

In 1998, the second Narasimham Committee proposed starting a Liquidity Adjustment Facility. Under the LAF, the RBI should set the repo and reverse repo rates and “provide a reasonable corridor for market play”.

The RBI started an Interim LAF in its April 1999 policy. Under ILAF, the bank rate became the main rate and also the ceiling rate under which liquidity was injected and fixed rate repo became the floor in which liquidity was absorbed on a day-to-day basis. Then RBI Governor Bimal Jalan remarked in the April 1999 policy that “the ILAF would provide a mechanism by which liquidity would be injected at various interest rates, and absorbed when necessary at the fixed repo rate”.

In the May 2000, RBI announced changes in the repo rate for the first time, and announced the transition from ILAF to a full-fledged LAF in three stages.

Aligned To Global Norms

In December 2003, RBI’s internal working group noted that internationally 'Repo' was for infusion and 'Reverse Repo' for absorption. Thus, it would be prudent for RBI to adopt this internationally accepted definition of the 'Repo' and 'Reverse Repo' terms, a switch that was made in October 2004.

The Repo and Reverse Repo were defined in the RBI Act in 2006 to give them statutory status. With this, the 'rate corridor' changed as well. The new corridor was that between the repo and reverse repo rates.

In May 2004, the central bank said that the reverse repo rate would be linked to the repo. The RBI shifted between the two interest rates in phases to signal policy. As inflation increased in the 2006-2008 period, the main policy rate was repo as the idea was to make liquidity costlier. So, the RBI increased repo rate higher than the reverse repo rate, and the spread widened to 300 basis points. As the 2008 crisis hit the world economy, RBI shifted to lowering the reverse repo much more rapidly, to make liquidity cheaper. Once that phase was over and inflation began to rise again, RBI shifted to the repo rate once again, though this time the spread was kept narrower, at 100 basis points.

Marginal Standing Facility Introduced

In May-2011, RBI implemented the Mohanty Committee recommendation that repo should be the single policy rate “to unambiguously signal the stance of monetary policy to achieve macro-economic objectives of growth with price stability.” The committee prescribed reactivating the bank rate as a ceiling rate, 50 basis points above the repo rate, and for the reverse repo to remain remain 150 basis points below the repo rate.

The RBI did not implement these recommendations to the letter, but drew from it. Instead of reactivating the bank rate, it started a new rate called the Marginal Standing Facility. The reverse repo was kept 100 basis points below the repo rate, and the MSF 100 basis points above it.

How The Current Framework Came About

In 2014, the Urjit Patel Committee set up to review the Monetary Policy Framework suggested the following changes.

• A Monetary Policy Committee will vote on the Repo rate but the target should shift from a call rate to 14-day term repo rate.
• MSF should be seen as a strictly penal rate and should be rarely used.
• The reverse repo rate to be replaced by a Standing Deposit Facility which will not need collateral while absorbing liquidity as collateral, which was seen as a binding constraint during the 2005-08 period.

The Patel Committee also suggested the restarting of variable rate auctions as markets had become used to availing and absorbing liquidity at fixed rates.

Where We Are Now

Today, the repo rate can only be changed by the MPC. The reverse repo stopped being an independent rate since 2011 and changed automatically with changes in the repo rate. By making a standalone move to lower the reverse repo rate, the RBI is, in a way, restoring its independence. The Covid-19 crisis has made policymakers look for solutions that were well outside the box in the not-so-distant past.

Amol Agrawal is a faculty member at Ahmedabad University. He has a PhD in Indian Banking History and writes the Mostly Economics blog.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.