The Interest Rate Corridor: How the RBI Steers Overnight Rates

When the Reserve Bank of India announces a change in the repo rate, how does that actually change interest rates in the economy? The answer involves the interest rate corridor.

The operating target

The RBI aims to keep the weighted average call rate, the rate at which banks lend to each other overnight, close to the repo rate. This overnight rate then influences other rates, such as deposit and loan rates.

The corridor

The RBI sets a corridor with a floor and a ceiling:

• Ceiling: the marginal standing facility (MSF). Banks can borrow overnight from the RBI at a rate above the repo rate, usually by 25 basis points, by pledging government securities. No bank should need to borrow from others at a higher rate.
• Floor: the standing deposit facility (SDF). Introduced in April 2022, it allows banks to park surplus funds with the RBI overnight at a rate below the repo rate, usually by 25 basis points, without the RBI giving collateral. No bank should lend to others at a lower rate.
• Middle: the repo rate, the policy rate set by the Monetary Policy Committee.

Liquidity management

The RBI also conducts variable rate repo and reverse repo auctions to add or absorb liquidity, keeping the call rate near the repo rate.

• When banks have surplus cash, the call rate falls toward the floor.
• When banks are short of cash, it rises toward the ceiling.

Why the SDF mattered

Before 2022, the floor was the reverse repo rate, which required the RBI to give government securities as collateral. The SDF, needing no collateral, gave the RBI a more flexible tool to absorb large surpluses.

Transmission

Changes in the repo rate pass through the corridor to overnight rates, then to treasury bills, bank deposit rates and loan rates, including EMIs linked to external benchmarks.