Repo Market – A Tool to Manage Liquidity in Financial Institutions

Repo is used in India as an instrument for monetary policy by institutionalizing daily Liquidity Adjustment Facility (LAF) which allows banks and Primary Dealers to manage their liquidity needs. Liquidity stress in the market has an impact on the short term interest rate. Entities not having adequate securities balances borrow funds from inter-bank uncollateralized call market and the call rates are prone to liquidity shocks in the system. The spread between Call and Repo rates is likely to widen when there is liquidity stress in the market. The study tried to find the determinant of the spread. It found that LAF window activity as well as total money market activity has an impact on the spread. In order to understand if the spread behaves in a different manner when the system has excess liquidity vis-à-vis shortage of liquidity, a Regime Switching model using Goldfeld and Quandt’s D-method for switching regression was used. The tests found that the monetary policy is stable in both the regimes and the effectiveness of monetary policy in both the regimes are not statistically different.