RBI, Monetary Policy and Banking Regulation: What Each Tool Does
The liquidity corridor: repo, reverse repo, SDF, MSF and bank rate
Banks end each day with either too much or too little cash. The RBI manages this through the Liquidity Adjustment Facility (LAF), a daily window where banks borrow from it or park money with it. The whole trick is to remember whose point of view each word takes: the names are all from the RBI's side.
| Instrument | What happens | Collateral | Effect on liquidity | Place in the corridor |
|---|---|---|---|---|
| Repo | RBI lends to banks and takes securities, to be repurchased | Government securities | Injects | Middle: the policy rate |
| Reverse repo | RBI borrows from banks and gives securities | Government securities, given by the RBI | Absorbs | Used at the RBI's discretion; no longer the floor |
| SDF (Standing Deposit Facility) | Banks park surplus funds with the RBI | None | Absorbs | Floor, below repo |
| MSF (Marginal Standing Facility) | Banks borrow overnight in an emergency, even by dipping into their SLR holdings | Government securities | Injects | Ceiling, above repo |
The SDF was introduced in April 2022 and made the floor of the corridor, because it lets the RBI absorb liquidity without handing out securities. The bank rate is the rate at which the RBI would lend to banks by rediscounting bills; it is aligned with the MSF rate and is also the reference rate for penalties on certain reserve shortfalls. Worked example (a hypothetical): suppose the policy repo rate is 6.50% and the RBI keeps the corridor 25 basis points either side (the width the RBI has used as of October 2026; the repo rate itself changes, so 6.50% is only an illustration). Then SDF = 6.50 - 0.25 = 6.25%; MSF = bank rate = 6.50 + 0.25 = 6.75%. The corridor is 50 basis points wide, and a bank with spare cash will never lend overnight below 6.25%.
(1) Reverse repo and SDF both absorb money, but only the SDF is collateral-free.
(2) MSF is dearer than the repo, so it is a penalty-style window for banks in difficulty; the cheaper way to borrow is the repo. Never call the repo rate the floor or the ceiling: it is the middle.
CRR, SLR and open market operations: what moves, and which way
The corridor handles daily liquidity. The next three tools change liquidity for longer. CRR (cash reserve ratio) is the share of a bank's net demand and time liabilities (NDTL), roughly its deposits, that it must keep as cash with the RBI; the RBI pays no interest on it. SLR (statutory liquidity ratio) is the share of NDTL that the bank keeps itself in cash, gold or approved securities such as government bonds, which do earn interest. Open market operations (OMOs) are the outright buying or selling of government securities by the RBI.
| Tool | If the RBI raises or sells | If the RBI cuts or buys | Stance |
|---|---|---|---|
| Repo rate | Loans dearer; credit and demand fall | Loans cheaper; credit and demand rise | Raise = tighten |
| CRR | Cash locked with the RBI; less to lend | Cash released; more to lend | Raise = tighten |
| SLR | More of the deposits tied in securities; less lendable | More lendable | Raise = tighten |
| OMO | Sale: banks pay rupees for securities, money is absorbed | Purchase: RBI pays rupees, money is injected | Sell = tighten; buy = ease |
Worked example (hypothetical figures). A banking system has NDTL of Rs 5,00,000 crore. If the RBI cuts the CRR from 4.5% to 4.0%, cash locked falls by 0.5% of NDTL: 0.5% x 5,00,000 = Rs 2,500 crore is released for lending. For one bank with NDTL of Rs 2,000 crore, CRR 4% and SLR 18%: it locks 4% = Rs 80 crore with the RBI and holds 18% = Rs 360 crore in securities, leaving at most 2,000 - 80 - 360 = Rs 1,560 crore to lend. The two ratios stack, because CRR cash is not counted towards SLR.
Inflation targeting and how a rate decision reaches your loan
India follows flexible inflation targeting. The Central Government, in consultation with the RBI, notifies the target; the RBI works to meet it. For the five years from 1 April 2026 to 31 March 2031 the target is 4% CPI inflation with a tolerance band of 2% to 6% (notified in March 2026, per the Department of Economic Affairs). The index is the Consumer Price Index (CPI), not the wholesale price index.
- Who decides the repo rate: the six-member Monetary Policy Committee (MPC): the Governor as chair, the Deputy Governor in charge of monetary policy, one RBI officer nominated by the Central Board, and three external members appointed by the Central Government. Decisions are by majority, and the Governor has a casting vote in a tie.
- How often: at least four meetings a year (in practice six, roughly every two months). The minutes are published on the fourteenth day after each meeting.
- What counts as failure: average inflation above the upper or below the lower tolerance level for three consecutive quarters. The RBI must then report to the Government why it failed and what it will do.
The transmission chain. Suppose inflation is running above the band. The MPC raises the repo rate; banks' funding costs rise; lending rates rise (loans linked to an external benchmark such as the repo rate reset quickly, which is why a floating-rate borrower sees the EMI change within a few months); credit and spending slow; demand falls short of supply; and price pressure eases. If instead growth is weak and inflation is low, the MPC cuts the rate and the chain runs the other way. Example: on a floating-rate loan, a hike of 0.25 percentage points raises the annual rate on a Rs 40,00,000 balance by 0.25% x 40,00,000 = Rs 10,000 a year in interest, other things equal.
Banking structure: the categories
Indian banks sit in two broad groups, and the exam asks which group a type belongs to and what it may not do. Scheduled banks are those included in the Second Schedule of the RBI Act, 1934; they can borrow from the RBI and must meet its conditions. Being scheduled is a different test from being commercial or cooperative: both kinds can be scheduled.
| Category | Group | Defining feature |
|---|---|---|
| Public sector and private sector banks | Commercial | Full-service banking; the difference is ownership (Government majority versus private) |
| Foreign banks | Commercial | Incorporated abroad, operating in India through branches or subsidiaries |
| Small finance banks | Commercial (differentiated) | Full banking with a focus on unserved and underserved segments: small farmers, micro enterprises, low-income households; a higher priority-sector target than other commercial banks |
| Payments banks | Commercial (differentiated) | Accept only savings and current deposits (with a cap per customer); cannot lend; no credit cards |
| Regional rural banks | Commercial | Rural credit, owned jointly by the Centre, the State and a sponsor bank (see the previous chapter) |
| Urban cooperative banks, state and district central cooperative banks | Cooperative | Owned by members; dual control: the RBI regulates the banking side, the Registrar of Cooperative Societies the management side |
Priority sector lending
Left to itself, a bank lends where returns look safest. Priority sector lending (PSL) is the RBI's rule that a set share of a bank's credit must go to sectors that are socially important but harder to finance. The RBI Directions group them into eight categories: agriculture; micro, small and medium enterprises; export credit; education; housing; social infrastructure; renewable energy; and others.
| Target, as a share of ANBC or CEOBSE (whichever is higher) | Domestic commercial banks |
|---|---|
| Total priority sector | 40% |
| Agriculture (within the total) | 18% |
| Small and marginal farmers (within agriculture) | 10% |
| Micro enterprises (within the total) | 7.5% |
| Weaker sections (within the total) | 12% |
ANBC is Adjusted Net Bank Credit, the bank's credit base, and CEOBSE is the credit equivalent of off-balance-sheet exposures. Worked example: a domestic commercial bank with an ANBC of Rs 20,000 crore must lend at least 40% = Rs 8,000 crore to priority sectors, of which 18% = Rs 3,600 crore to agriculture and 12% = Rs 2,400 crore to weaker sections. The sub-targets are inside the total, not added to it. Regional rural banks and small finance banks face a higher total than commercial banks; urban cooperative banks have their own target.
Bad loans: the recovery toolkit by name and purpose
Asset classification (SMA stages and the 90-day NPA test) is in the first Banking Awareness chapter. This section is about what lenders do once a loan has gone bad. Learn each tool as a name plus one purpose.
| Tool | Purpose | Where it runs |
|---|---|---|
| SARFAESI Act, 2002 | Lender enforces its security (takes possession and sells) after a notice, without going to court | Out of court; challenge goes to the Debts Recovery Tribunal |
| Debts Recovery Tribunals (DRT) | Fast adjudication of recovery claims by banks and financial institutions | Recovery of Debts and Bankruptcy Act, 1993 |
| Lok Adalat | Settlement by compromise, usually for smaller dues | Legal Services Authorities Act, 1987 |
| Insolvency and Bankruptcy Code, 2016 | Time-bound resolution or liquidation of a defaulting company, led by its creditors | National Company Law Tribunal (NCLT) |
| Asset reconstruction company (ARC) | Buys a bank's NPAs so the bank can clean its books; the ARC then recovers | Registered with and regulated by the RBI under SARFAESI |
The National Asset Reconstruction Company Limited (NARCL), popularly called the bad bank, was set up in 2021 to take over large stressed loans from banks, paying partly in cash and partly in security receipts backed by a Government guarantee. It is an ARC, not a bank, and it takes no deposits.
AML, Basel and the customer safety net: the regulatory vocabulary
KYC and customer due diligence are covered in the first chapter. Here is what they feed into. The Prevention of Money-Laundering Act, 2002 (PMLA) makes banks reporting entities: they must verify customers, keep records and report certain transactions to the Financial Intelligence Unit-India (FIU-IND), set up in November 2004 under the Department of Revenue. It collects suspicious transaction reports (STRs) and cash transaction reports (CTRs). A bank that suspects layering of funds files an STR and must not tip off the customer.
Basel is the international rulebook. The three pillars are minimum capital (Pillar 1), supervisory review (Pillar 2) and market discipline through disclosure (Pillar 3). After the 2008 crisis, Basel III added a leverage ratio (Tier 1 capital divided by total exposure, without risk weights) and two liquidity ratios. The Liquidity Coverage Ratio (LCR) = high-quality liquid assets / net cash outflows over the next 30 days; the Net Stable Funding Ratio (NSFR) compares stable funding with the stable funding needed over one year. The Basel standard sets each at a minimum of 100%. Example: HQLA of Rs 120 crore against net 30-day outflows of Rs 100 crore gives LCR = 120%.
For the customer, two safety nets. Deposit insurance by the DICGC protects depositors if a bank fails, up to a limit per depositor per bank; the limit is perishable and is quoted with its date in the first chapter. The RBI Ombudsman is the free complaint route when a bank's own redress has failed. Both are RBI-linked protections, not government guarantees of the bank's profits.
Key takeaways
- Banking Awareness questions on the RBI split into monetary policy (rates, reserves, OMOs) and regulation (capital, KYC, priority sector). Keep the columns apart.
- The corridor runs SDF < repo < MSF = bank rate. Repo injects money, reverse repo and SDF absorb it, and only the SDF is collateral-free.
- Raising the repo rate, CRR or SLR, or selling securities in OMO tightens liquidity; cutting or buying eases it. CRR cash sits with the RBI and earns nothing; SLR is held by the bank.
- The Government notifies the inflation target (4% with a 2% to 6% band for April 2026 to March 2031); the six-member MPC sets only the repo rate. Failure means three consecutive quarters outside the band.
- Payments banks cannot lend; small finance banks serve the underserved with a higher priority-sector target; PACS are not banks under the Banking Regulation Act; cooperative banks have dual control.
- Priority sector sub-targets nest inside the 40% total (as of October 2026, per RBI). Recovery: SARFAESI enforces security out of court, DRT and NCLT are forums, an ARC buys NPAs, FIU-IND receives STRs, and LCR is a 30-day liquidity test.
Practice questions (18)
Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.
Under the RBI's liquidity corridor, through which facility can a bank park its surplus overnight funds with the RBI without giving or receiving any collateral?
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Answer: A — Standing Deposit Facility (SDF)
The SDF lets banks deposit surplus funds with the RBI and take no securities in return, which is why it can serve as the floor of the corridor. The tempting repo is the opposite flow: the RBI lends and the bank hands over securities as collateral.Suppose, for this question only, that the policy repo rate is 6.50%. The RBI keeps the SDF 25 basis points below it and the MSF 25 basis points above it, and the bank rate equals the MSF rate. What are the SDF rate, MSF rate and bank rate?
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Answer: B — SDF 6.25%, MSF 6.75%, bank rate 6.75%
SDF = 6.50 - 0.25 = 6.25%; MSF = 6.50 + 0.25 = 6.75%; the bank rate is aligned with the MSF, so it is also 6.75%. The distractor that puts the SDF above the repo reverses the ladder: the SDF is the floor and the MSF the ceiling.A banking system has net demand and time liabilities of Rs 5,00,000 crore. The RBI cuts the CRR from 4.5% to 4.0%. How much cash is released for lending, other things unchanged?
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Answer: D — Rs 2,500 crore
The change is 0.5 percentage points of NDTL: 0.5% x 5,00,000 = Rs 2,500 crore. Rs 20,000 crore would be the whole 4% reserve, not the 0.5% reduction, and Rs 22,500 crore is the old 4.5% reserve.Consider these statements about RBI tools. P: In a reverse repo the RBI borrows from banks. Q: The SDF requires banks to receive government securities as collateral. R: The MSF rate is above the policy repo rate. S: The bank rate is aligned with the MSF rate. Which are correct?
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Answer: C — P, R and S only
P, R and S are correct. Q is false because the SDF is collateral-free: banks park money and receive no securities. The tempting set with P, Q and R wrongly accepts Q and drops S.When the RBI sells government securities to banks in an open market operation, what happens to liquidity in the banking system?
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Answer: B — It is absorbed, because banks pay rupees to the RBI for the securities
In a sale the banks pay rupees and receive securities, so rupees leave the banking system: liquidity is absorbed, a tightening step. A purchase by the RBI does the reverse. Bonds and cash are not interchangeable for the bank's day-to-day settlement.Which of the following is NOT a step that tightens liquidity?
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Answer: D — An outright purchase of government securities by the RBI
A purchase pays rupees to the sellers and so injects money: it eases liquidity. The other steps lock more cash, remove cash through sales or make borrowing dearer, and all tighten. Students often confuse purchase with sale because both involve securities.A bank has net demand and time liabilities of Rs 2,000 crore. Treat the CRR (4%) and the SLR (18%) as applied to this NDTL, with CRR cash not counted towards SLR, and ignore every other requirement. What is the most it can lend?
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Answer: A — Rs 1,560 crore
CRR = 4% of 2,000 = 80; SLR = 18% of 2,000 = 360; lendable = 2,000 - 80 - 360 = Rs 1,560 crore. Rs 1,640 crore subtracts only the SLR, forgetting that CRR cash also leaves the lendable pool.Who notifies the inflation target that the RBI must work towards?
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Answer: C — The Central Government, in consultation with the RBI
The target is notified by the Central Government in consultation with the RBI, for a period of five years. The tempting answer, the MPC, is wrong: the MPC works to meet the target and sets only the policy repo rate.For the inflation target of 4% with a tolerance band of 2% to 6%, which sequence of three consecutive quarterly average CPI inflation readings counts as a failure under the framework?
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Answer: B — 6.1%, 6.3%, 6.6%
Failure needs average inflation outside the band for three consecutive quarters. Only 6.1, 6.3 and 6.6 are all above 6%. In each other sequence a reading inside the band (5.9, 4.0 or 3.0) breaks the run, so there is no failure even though some quarters were outside.Which decision is taken by the Monetary Policy Committee?
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Answer: D — The policy repo rate
The MPC sets the policy repo rate and nothing else. The target is notified by the Government; CRR, SLR and OMOs stay with the RBI. The inflation target is the most tempting distractor because the MPC is tied to it.Which description fits a payments bank?
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Answer: A — It takes savings and current deposits but cannot lend
A payments bank accepts only savings and current deposits, within a per-customer cap, and may not lend. Lending to small farmers describes a small finance bank, joint ownership describes a regional rural bank, and dual control describes cooperative banks.In the RBI's grouping, which of the following is NOT a category of scheduled commercial bank?
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Answer: B — Urban cooperative bank
Urban cooperative banks belong to the cooperative group, under dual control. Foreign banks, regional rural banks and small finance banks are all grouped with the scheduled commercial banks. The regional rural bank is the tempting one because of its rural, cooperative-like image.P: Primary agricultural credit societies are regulated by the RBI as banks under the Banking Regulation Act. Q: Urban cooperative banks are under the dual control of the RBI and the Registrar of Cooperative Societies. R: Small finance banks are payments banks that may not lend. S: Being scheduled means being included in the Second Schedule of the RBI Act, 1934. Which statements are correct?
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Answer: C — Q and S only
Q and S are correct. P is false because PACS are not banks under the Banking Regulation Act and the RBI does not regulate them. R is false because small finance banks lend; only payments banks cannot.As per RBI's Priority Sector Lending Directions, 2025 (in force from 1 April 2025, as amended), a domestic commercial bank has an ANBC of Rs 20,000 crore. What are the minimum total priority sector lending and the minimum agriculture lending, in that order?
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Answer: D — Rs 8,000 crore and Rs 3,600 crore
Total = 40% of 20,000 = Rs 8,000 crore; agriculture = 18% of 20,000 = Rs 3,600 crore. Rs 2,400 crore is the weaker-sections figure (12%), and Rs 11,600 crore wrongly adds agriculture to the total, though sub-targets sit inside it.Under which law can a bank take possession of a defaulting borrower's secured asset and sell it after a notice, without approaching a court?
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Answer: B — The SARFAESI Act, 2002
SARFAESI gives secured lenders the right to enforce security out of court. The IBC is a creditor-led resolution process before the NCLT, and the Legal Services Authorities Act is the source of Lok Adalat compromises.P: Debts Recovery Tribunals decide recovery claims of banks under the Recovery of Debts and Bankruptcy Act, 1993. Q: The Insolvency and Bankruptcy Code, 2016 is administered through the National Company Law Tribunal. R: An asset reconstruction company buys NPAs from banks. S: An asset reconstruction company accepts deposits from the public and lends them. Which statement is NOT correct?
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Answer: D — S
S is wrong: an ARC buys stressed assets and recovers on them; it does not take public deposits and does not lend. P, Q and R each match the law and forum named. R is the tempting one for students who think buying loans means lending.A bank officer notices a customer splitting cash deposits into many small amounts just below the reporting level, apparently to avoid scrutiny. What does the PMLA framework require the bank to do?
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Answer: A — File a suspicious transaction report with FIU-IND and not tip off the customer
Structured deposits are a classic red flag, and a bank must file an STR with FIU-IND without alerting the customer. Doing nothing is wrong because suspicion, not the amount alone, triggers an STR, and telling the customer breaches the no-tipping-off rule.A bank holds high-quality liquid assets of Rs 120 crore, and its expected net cash outflows over the next 30 days are Rs 100 crore. What is its liquidity coverage ratio, and does it meet the Basel minimum of 100%?
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Answer: C — 120%, yes
LCR = HQLA / net 30-day outflows = 120 / 100 = 120%, which is above 100%. The inverted ratio 100/120 = 83% is the trap, and it would wrongly give a failure.