Banking — UPSC Mains Model Answer

The LAF operates through a corridor defined by a ceiling and a floor rate, with the policy repo rate as the anchor. Banks borrow from or lend to the RBI within this corridor, enabling the central bank to manage systemic liquidity without direct credit controls. The corridor approach gives markets a predictable band for overnight rates.

Under the repo window, banks pledge eligible government securities as collateral to borrow overnight funds from the RBI at the repo rate, with an agreement to repurchase them the next day. This collateralised structure limits counterparty risk and ensures that liquidity injection is temporary and self-reversing.

Introduced in April 2022, the Standing Deposit Facility allows the RBI to absorb surplus liquidity from banks without providing government securities as collateral in return. Priced below the repo rate, the SDF rate forms the effective floor of the LAF corridor, replacing the fixed-rate reverse repo as the operative floor.

The Marginal Standing Facility permits banks to borrow overnight funds from the RBI at a rate above the repo rate, forming the corridor's ceiling. Crucially, banks can borrow under MSF by dipping into their Statutory Liquidity Ratio holdings up to a prescribed limit, providing an emergency liquidity backstop.

The LAF corridor anchors market overnight rates, influencing lending and deposit rates across the economy. A narrow, credible corridor reduces rate volatility, strengthens monetary policy transmission, and signals the RBI's liquidity stance — whether accommodative, neutral, or restrictive.