The Policy Rate Corridor: Repo, Reverse Repo, SDF and MSF

A policy rate corridor is a floor and a ceiling set around a policy rate so the market rate cannot escape either one. The floor is what a central bank pays a bank to leave money with it. The ceiling is what the same central bank charges a bank to borrow. Because both offers are open every day, no bank lends below the floor or borrows above the ceiling.

The corridor rests on one fact about a central bank that no ordinary lender shares: it can take in any amount of money at a price it names, and it can hand out any amount at a price it names, and it never runs out of the ability to do either. A policy rate on its own is only an announcement. A corridor is what turns that announcement into a price that actually holds in a market nobody is instructed to join. The operations that keep a system near the middle of the corridor, and the wider toolkit an authority carries, are covered separately. The two edges are where the corridor does its own work.

What is a policy rate corridor, and why does it hold without anyone being told to obey it?

The everyday version sits on a street that is already familiar. Suppose a purchase centre in a district will buy wheat from any farmer, in any quantity, on any working day, at a stated price. No farmer in that district sells to a passing trader for less. Not because selling for less is forbidden, and not because anybody is watching, but because a better offer is sitting there unused and everyone knows it. Now suppose a fair price shop in the same district will sell rice to any household, on any day, at another stated price. No household in that district pays a hawker more than that. Two standing offers, neither of them compulsory, and the whole street price is now penned between them.

A policy rate corridor is that street, with banks instead of households and one night instead of a season. Banks end each day uneven. One has taken in more than it has lent and is sitting on money it does not need until morning. Another is short and needs money before the day closes. The two banks deal with each other in the money marketThe place where very short borrowing and lending happens, often for a single night, between banks and other large institutions rather than with the public. How a bank funds itself there is a subject of its own., and the rate they settle on is the overnight rate. Left alone, that rate would be whatever the two of them agreed. The central bank does not leave it alone, and it does not do so by giving an instruction.

The central bank makes two offers instead. The first is a deposit offer: bring the central bank any amount of spare money tonight and it will pay a stated rate for it. The second is a lending offer: come to the central bank short tonight and it will lend a stated rate. The corridor works by being always available rather than by instruction. The corridor holds even though no bank has been told to obey anything. A bank with money can turn round and take the offer the central bank has already made, so it will not accept less from another bank. A bank that is short can turn round and take the lending offer instead, so it will not pay another bank more than the central bank already charges.

Two consequences follow and both are worth holding. The first is that the corridor is enforced entirely by the people it constrains: every bank polices it in its own interest, and no supervision is involved. The second is that the floor and the ceiling are not targets, they are refusal points. The central bank is not trying to make the overnight rate equal either edge. The central bank is making certain the rate cannot be found outside them, and then working, through its market operations, on where inside them the rate actually lands.

What are repo, reverse repo, the standing deposit facility and the marginal standing facility?

With the mechanism in place, the names can be attached to it. India runs four facilities that sit at the middle and the edges of its corridor, and each one is best understood by what it does rather than by its initials.

The repo facility is where the central bank lends to a bank against collateralSomething of value handed over for the duration of a loan, so the lender is not relying on the borrower alone. Banking as a subject in its own right covers which assets a bank may pledge and on what terms., usually government securitiesDebt issued by a government, in India by the central and state governments, widely held by banks and easy to value, which is why it is the usual thing pledged in short term lending. sold and bought back a short time later. The repo rate is the policy rate itself. It sits in the middle, and it is the number an authority moves when it wants everything else to move. The reverse repo facility is the mirror image: the central bank takes money in from a bank and hands over collateral for the night. The standing deposit facility takes money in as well, but it is unsecuredDone without anything pledged as security. Instead of an asset it can keep, the party handing over money relies on the standing of the other side., which is to say the central bank gives no collateral back, and that difference is the whole reason it exists as a separate thing: an authority that wants to absorb money without running down its own stock of securities needs a facility that does not consume any. The standing deposit facility sits at the floor. The marginal standing facility is the ceiling: a bank that finds itself short at the end of the day can borrow there at need.

Every one of the four names above is real, and the rate on each of them is set and published by the authority that runs it. The shape is what matters: one facility in the middle that defines the policy rate, one mirror of it, one floor that absorbs without collateral and one ceiling that lends at need.

What does the corridor look like when a bank actually refuses a price?

The Sankhya central bank has set its policy rate at 6.00 per cent. It will take money in overnight at 5.75 per cent from any bank that brings it, and it will lend overnight at 6.25 per cent to any bank that asks. The corridor is therefore fifty basis pointsOne hundredth of one per cent. Twenty five basis points is a quarter of a per cent, and fifty basis points is half of one. A quarter point sounds smaller than it is, so rate moves are talked about this way. wide, and it is symmetric, because the distance from 5.75 up to 6.00 is twenty five basis points and the distance from 6.00 up to 6.25 is the same twenty five.

The refusals are the whole mechanism made visible, so watch two banks say no. Bank one has Rs 500 crore it does not need tonight. A second bank offers to take it at 5.60 per cent. One night at 5.60 per cent on Rs 500 crore is worth Rs 7,67,123/-, and one night at the Sankhya floor of 5.75 per cent on the same money is worth Rs 7,87,671/-. The difference is Rs 20,548/-, sitting there for the taking, so the first bank refuses the 5.60 and places the money with the central bank instead.

Bank two is short Rs 500 crore tonight and is asked 6.40 per cent for it. One night at 6.40 per cent costs Rs 8,76,712/-, and one night at the Sankhya ceiling of 6.25 per cent costs Rs 8,56,164/-. Fifteen basis points on Rs 500 crore for one night is Rs 20,548/- whichever direction the bank is facing, so refusing saves exactly the same Rs 20,548/-. So the second bank refuses the 6.40 and borrows from the central bank instead. Two refusals like these are the corridor working, and they are the only enforcement there is.

Rs 500 crore is a round figure that keeps one night of interest easy to read. Interest is worked on a 365 day year and rounded to the nearest rupee.

Why is the width of the corridor itself a decision?

An authority that has decided on a policy rate has not finished. The authority still has to decide how far either side of that rate the market may wander, and the answer is not obviously as wide as possible or as narrow as possible. Take Sankhya again and imagine two versions of the same country. In the first the corridor is fifty basis points wide, floor 5.75 and ceiling 6.25. In the second it is twenty basis points wide, floor 5.90 and ceiling 6.10. Same policy rate, same banks, same money.

In the wide version the overnight rate has room to move, and so do the differences between individual banks. A bank that other banks are slightly warier of pays a little more than one they are comfortable with, and that difference can show itself inside the space available. Suppose three Sankhya banks pay 5.86, 6.02 and 6.18 per cent on the same night, thirty two basis points apart from top to bottom. Anybody watching the market can see which bank is paying up. In the narrow version there is simply nowhere for thirty two basis points of difference to sit. The same three banks now pay something closer to 5.96, 6.02 and 6.08, twelve basis points apart, and the ranking that was obvious before is nearly invisible.

Width trades control against information. An authority choosing a width has also chosen how much it is willing to see. Narrow gives tighter control of the rate, which matters when the whole point is that everything else in the economy should price off one number. Narrow also costs the authority the signal it would otherwise get from watching who pays more and by how much. Wide gives that signal back, at the cost of a rate that can sit meaningfully away from the middle for stretches at a time. Neither is the correct answer in the abstract, and an authority may change its mind about which it wants as conditions change.

What does it mean when the market rate sits at one edge?

Between the two edges, where the rate actually lands is a question about how much money is in the system relative to how much of it needs a home. When there is more money than there are places to put it, the banks with spare cash are competing to place it and the rate drifts down. When money is scarce, the banks that are short are competing to get it and the rate drifts up. An authority steers that balance with its open market operationsPurchases and sales of securities by a central bank in the market, used to put money into the system or take it out. Running those operations from day to day is a subject of its own., which is how a rate is nudged around inside a corridor rather than forced there.

Push it far enough and the rate reaches an edge and stops. On the invented Sankhya corridor, adding Rs 40,000 crore takes the overnight rate all the way down to the floor at 5.75 per cent. Add another Rs 16,000 crore on top of that and the rate does not move at all. Every bank holding the extra money already has somewhere to put it at 5.75, and none of them will accept less. Nothing stopped the rate. The floor is still open, and a standing offer that is still open is a price that cannot be beaten downward. The mirror holds at the top: drain enough and the rate climbs to the ceiling and stays, because the lending offer is still open and nobody pays more than an offer they can already take.

The position of the market rate inside its corridor moves every day, so it is a reading in its own right and often a fresher one than any statement. Near the floor means money is abundant. Near the ceiling means it is tight. Sitting in the middle means the balance is roughly where the authority wanted it. The position says nothing at all about what the authority has decided, and mistaking one for the other is the common failure.

Why does a rate spoil while the facility it belongs to does not?

Four real facilities have now been met by name, and not one real number. Which parts of this subject keep and which parts spoil is worth working out on its own account, because the answer applies to far more than a corridor.

Consider what would happen if the rate on each of the four were printed above. A standing deposit facility absorbs money without collateral by construction, and a ceiling facility lends at need by construction, so the words describing what each facility does would still be correct years from now. An authority may move the numbers within months, and from that day the numbers are wrong. A reader arriving after that point would find an account that is right about the mechanism and wrong about the figures, and would have no way of telling which half to trust. A rate printed in a teaching account is wrong within months while the mechanism it sits beside stays true, and mixing the two together damages the half that would have survived.

There is a second reason and it is about where responsibility sits. The rate on each of these facilities is decided by the Reserve Bank of India, and in the case of the middle of the corridor by its Monetary Policy CommitteeThe committee inside the Reserve Bank of India that decides the policy rate, publishing its decision and the votes behind it. Reading one of those statements is covered separately., and published by that authority as a maintained record. A teaching account that copies the number takes on a maintenance duty it cannot discharge and quietly competes with the issuer for the reader's attention. Naming the facility, saying exactly what it does and pointing at the issuer costs the reader one click and gains a number that is right. Hence the split: the mechanism in one place, the figures at the issuer, and a clear line between the two.

What does a treasury desk actually read off the corridor before it does anything else?

Everything above is mechanism. Here is what somebody does with it before nine in the morning. A treasury deskThe part of a bank or large company responsible for its cash: making sure there is enough on hand each day, placing what is spare and borrowing what is short. at a bank has one immediate question every working day. What does money cost today? Not what was announced at the last meeting, and not what anybody expects next quarter, but what a night of borrowing will actually cost between now and tomorrow morning.

The answer is not the policy rate. The answer is where the overnight rate is sitting inside the corridor this morning. If it has been near the floor for a fortnight, cash is cheap and abundant, and the desk knows two things at once: its own spare money will earn very little tonight, and if it needs to borrow, it will get a good price. If the rate has climbed toward the ceiling, the desk is looking at a system where money is being competed for, and it will think harder about leaving itself short in the afternoon. The position is today and the announcement was last month, so the desk reads the position rather than the announcement.

The same reading is useful well beyond a bank. A system stuck at the floor for months is one in which banks are struggling to lend as fast as money is arriving, and that shows up later in what they earn, so an analyst covering lenders watches the position. Somebody following a company that borrows short term reads it because the cost of that borrowing tracks the overnight rate far more closely than it tracks anything announced. Nobody in any of these seats is being told what to do about it. Each of them is reading a price, and the corridor sets the range that price can possibly be in.