Explained: What is SDF, and how can it improve the banking system?

The SDF will help the central bank in absorbing liquidity (deposits) from commercial banks without giving government securities in return to the banks.

The Reserve Bank of India (RBI) on April 8 announced the introduction of the standing deposit facility (SDF) as the basic tool to absorb excess liquidity under the new monetary policy. The SDF will help the central bank in absorbing liquidity (deposits) from commercial banks without giving government securities in return to the banks.

Governor Shaktikanta Das said that the SDF will be at 3.75 percent, 0.25 percentage points below the repo rate, and 0.50 percentage points lower than the marginal standing facility (MSF) which helps banks with funds when required.

When the central bank has to absorb a tremendous amount of money from the banking system through the reverse repo window, it becomes difficult for it to provide the required volume of government securities in return. This happened during the time of demonetisation.

In this sense, the SDF is a collateral-free arrangement meaning that RBI need not give collateral for liquidity absorption.

SDF was proposed previously too

The idea of an SDF was first mooted in the Urjit Patel Monetary Policy Committee report in 2014, which later received the government’s nod following an amendment to the RBI Act in 2018, vide the Finance Bill. Since then, the central bank has proposed introducing the SDF for liquidity management so that banks can park as much money with it as they want without getting collateral, and at a lower rate than the reverse repo rate. The RBI again dusted off the idea of introducing the SDF when the pandemic hit in 2020 too but no decision was taken.

At the time, the State Bank of India (SBI) also supported the idea of an SDF. “Absorption of additional surplus liquidity at a lower rate through SDF will pull down the entire interest rate structure. In particular, lower operative overnight rate, short-term rate and lower supply and generation of additional demand will bring down the yield of long-dated government bonds also, thereby pulling down the sovereign yield curve. This will also reduce the interest cost of RBI,” stated Ecowrap, SBI’s research report, dated May 8, 2020.

Why has it been introduced now?

Economists say it is difficult to state the exact reason behind introducing the SDF now, but some of the contributing factors may include bank mergers and encouraging the borrowing programme.

The reverse repo rate was a collateralised facility and SDF is a non-collateralised facility.

“The moment it becomes non-collateralised, the rate on the SDF will be lower than the reverse repo rate. But it would have affected the monetary policy previously because the corridor was the reverse repo rate and the upper level was the MSF,” said Indranil Pan, chief economist, Yes Bank.

According to economists, the reverse repo rate was very much operational previously, but with the SDF now it has been buried as an instrument as this move will remove the biggest constraints between the liquidity absorption facility being collateralised versus non-collateralised.

“Anyways, in terms of operations, the RBI has been driving the market away from the reverse repo,” added Pan.

According to the circular issued on Friday by the RBI, amounts deposited will also count towards the statutory liquidity ratio (SLR). “The SLR holdings will effectively come down, so banks that are merging due to the SLR requirement will probably need to buy fresh SLR to keep up to the statutory level,” said Saugata Bhattacharya, chief economist, Axis Bank.