India’s central bank currently operates a liquidity adjustment facility (LAF). Under it, the overnight repo rate is the one at which banks borrow from the central bank for one day, while the overnight reverse repo rate is the rate at which banks lend to the central bank for one day. This system is, in some ways, well suited for managing daily mismatches between a bank’s cash inflows and cash outflows: It can help banks tide over daily liquidity deficit or surplus situations. But that’s not how the financial system works in developed countries.

Major central banks such as the European Central Bank, the US Federal Reserve, the Bank of Japan and even most members of the South East Asian Central Banks are similar in their attempt to achieve a structural liquidity deficit at most times—unlike in India, where banks actually hold surplus cash often. As a result, the banking system in the euro zone or the US is generally required to borrow from the central bank. As the central bank becomes the monopolist supplier of liquidity, this state of structural liquidity deficit ensures that the policy interest rate becomes the marginal cost of funds.

RBI needs its policy rate to matter for banks’ funding. If India is to make its policy transmission as effective as, say, the euro zone’s, it may follow a six-point approach:

Like so many topics, my thinking on this is evolving. I look forward to reader comments.