Monetary Transmission

Monetary transmission is the process by which changes in the central bank's monetary policy (particularly interest rate changes) are transmitted through the financial system to influence real economic variables like output, employment, and prices. For JAIIB candidates, understanding the various lending rate regimes and how RBI's policy signals reach borrowers through banks is critical for both the exam and daily banking operations.

• Defined under Section 49 of the RBI Act, 1934: "The Bank shall make public the standard rate at which it is prepared to buy or re-discount bills of exchange or other commercial papers eligible for purchase under this Act"
• It is the rate of interest paid by banks to RBI on their long-term borrowings
• Also referred to as the Discount Rate

Limitations as a monetary policy tool in India:

• The structure of interest rates is not automatically linked to the bank rate
• Commercial banks enjoy specific refinance facilities, not necessarily rediscounting at bank rate
• The bill market is under-developed and different sub-markets are not influenced by the bank rate

• Facility under which scheduled commercial banks can borrow additional overnight money from RBI
• Banks can dip into their SLR portfolio up to a limit (currently 2% of their NDTL outstanding at the end of the second preceding fortnight)
• Rate: 25 basis points above the repo rate (penal rate)
• Provides a safety valve against unanticipated liquidity shocks
• MSF rate and SDF rate determine the corridor for daily movement in short-term money market interest rates

• Allows banks to deposit money with RBI on an overnight basis
• RBI can absorb liquidity for longer tenors if needed
• Open to all LAF participants
• Introduced under amended Section 17 of the RBI Act (2018)
• Deposits under SDF are NOT eligible for CRR maintenance (Section 42, RBI Act)
• ARE eligible for SLR maintenance (Section 24, Banking Regulation Act, 1949)
• SDF is the lower band of the LAF corridor (replacing fixed-rate reverse repo)

• Replaced the Benchmark Prime Lending Rate (BPLR) system
• Defined as the minimum interest rate set by RBI below which banks cannot lend
• Unless there is a government mandate, no bank may offer loans below the base rate

• Minimum lending rate below which a bank is not permitted to lend
• Replaced the base rate system for determining lending rates
• Implemented to improve monetary policy transmission

Based on recommendations of the Internal Study Group headed by Dr. Janak Raj:

• Problem identified: Internal benchmarks (Base Rate/MCLR) had not delivered effective transmission of monetary policy
• Solution: Time-bound transition to an external benchmark

All new floating rate personal/retail loans (housing, vehicle, etc.) and loans to Micro and Small Enterprises must be benchmarked to one of:

• Rate at which RBI lends short-term money to banks
• Bank lending rates are determined by the movement of repo rate
• Primary instrument for monetary policy transmission

• Rate at which banks park short-term excess liquidity with RBI
• Used when RBI feels there is too much money in the banking system
• An increase means RBI borrows from banks at higher rates, incentivising banks to keep money with RBI

• Used to reduce money flow by absorbing existing cash from the system
• RBI has been rebalancing surplus liquidity by shifting from fixed-rate overnight reverse repo to VRRR auctions of longer maturity

• RBI buys or sells government bonds in the secondary market
• Buying bonds: drives up bond yields and injects money into the market
• Selling bonds: absorbs money from the system

• Introduced since October 2013 — repos of different tenors (7/14/28 days)
• Aim: Help develop the interbank money market and set market-based benchmarks for pricing loans and deposits
• Improves transmission of monetary policy

• 1-year and 3-year tenors to facilitate monetary transmission and support credit offtake

• Provide liquidity to specific sectors and entities experiencing liquidity stress
• An unconventional tool used alongside LTROs

• Specifically for Small Finance Banks (SFBs)
• Total: Rs. 10,000 crore at repo rate
• For fresh lending of up to Rs. 10 lakh per borrower
• Valid for 3 years; deployed for small business units, micro industries, and unorganised sector entities
• Conducted on CBS (E-KUBER) platform at fixed rate

• Introduced for mopping up liquidity of a more enduring nature
• Government issues T-Bills/dated securities by way of auctions under MSS
• In addition to normal borrowing requirements

• RBI provides sector-specific refinance at a cost linked to the policy repo rate

• A repo contract with a third entity (tri-party agent) acting as intermediary
• Agent handles: collateral selection, payment and settlement, custody and management
• Introduced on November 5, 2018
• CBLO was discontinued from November 2018 (replaced by TREPS)

Key reforms to improve monetary policy transmission include:

• Removal of administered interest rates
• Reduction of CRR and SLR from previously higher levels
• Discontinuation of ad hoc treasury bills
• Market-determined pricing for government securities
• Establishment of a pure inter-bank call money market
• Auction-based repos-reverse repos for short-term liquidity management
• Improved payments and settlement mechanisms

• Credit Information Bureau — for information exchange on defaulters and borrowers
• Clearing Corporation of India Limited (CCIL) — central counter party in payments and settlement for fixed income securities and money market instruments
• Implementation of SARFAESI Act to safeguard creditors' rights

1. Bank Rate (Section 49, RBI Act) = rate for rediscounting; limited as monetary tool due to underdeveloped bill market
2. MSF = 25 bps above repo rate; banks can dip into SLR up to 2% of NDTL
3. SDF (2018) = lower band of LAF corridor; NOT eligible for CRR but eligible for SLR
4. Base Rate replaced BPLR from July 1, 2010
5. MCLR replaced Base Rate from April 1, 2016
6. EBLR mandatory from October 1, 2019 (Dr. Janak Raj ISG recommendation)
7. Internal benchmarks (Base Rate/MCLR) failed to deliver effective transmission
8. EBLR benchmarks: Repo rate, 3-month T-Bill, 6-month T-Bill, or other FBIL rates
9. TREPS replaced CBLO from November 2018
10. SLTRO for SFBs: Rs. 10,000 crore at repo rate; lending up to Rs. 10 lakh per borrower
11. VRRR used to rebalance surplus liquidity from fixed-rate reverse repo
12. Term repos (since October 2013) aim to develop interbank money market and improve transmission