Context: Reserve Bank on Friday took steps towards normalisation of liquidity management to pre-pandemic levels, with the introduction of the standing deposit facility (SDF) as the basic tool to absorb excess liquidity, and narrowing the liquidity adjustment facility (LAF) to 0.50% from the 0.90%.

• Further, to enable banks to better manage their investment portfolio in FY23, it had now been decided to enhance the limit for inclusion of SLR (statutory liquidity ratio) eligible securities in the held-to-maturity category to 23%, compared with 22% earlier.

Historical Background

• This concept, first recommended by the Urjit Patel committee report in 2014, may soon become part of the central bank’s toolkit to manage liquidity.
• Standing deposit facility is a remunerated facility that will not require the provision of collateral for liquidity absorption.
• Banks, at different points in time, may be short of funds or flush with money.
• When they need money for the short-term, they borrow from the RBI (Repo Rate) for which they pledge government securities.
• When banks have excess funds they lend it to the RBI at the reverse repo rate that is lower than the repo rate. Here too, government securities act as collateral.
• In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the SDF – an additional tool for absorbing liquidity without any collateral. 

Role of SDF

• The main purpose of SDF is to reduce the excess liquidity of Rs 8.5 lakh crore in the system, and control inflation.
• The SDF has its origins in a 2018 amendment to the RBI Act and is an additional tool for absorbing liquidity without any collateral.
• The SDF is also a financial stability tool in addition to its role in liquidity management.
• By removing the binding collateral constraint on the RBI, the SDF strengthens the operating framework of monetary policy. 
• The SDF is also a financial stability tool in addition to its role in liquidity management.

How it will operate

• SDF would be at 3.75%, ie, 0.25% below the repo rate and 0.5% lower than the marginal standing facility (MSF) which helps the banks with funds when required.
• The SDF rate will be 25 bps below the policy rate (Repo rate), and it will be applicable to overnight deposits at this stage. 
• It would, however, retain the flexibility to absorb liquidity of longer tenors as and when the need arises, with appropriate pricing. 
• The RBI’s plan is to restore the size of the liquidity surplus in the system to a level consistent with the prevailing stance of monetary policy.

Key Objective

• The objective is to restore the size of the liquidity surplus in the system to a level consistent with the prevailing stance of monetary policy, 

Reverse repo rate

• The fixed rate reverse repo (FRRR) rate which is retained at 3.35 per cent will remain part of the RBI’s toolkit, and its operation will be at the discretion of the RBI for purposes specified from time to time. 
• The FRRR along with the SDF will impart flexibility to the RBI’s liquidity management framework.