To enable better transmission of its monetary policy, the Reserve Bank of India (RBI) has recently introduced Long Term Repo Operation (LTRO). Under LTRO, RBI will conduct term repos of one-year and three-year tenors of appropriate sizes for up to a total amount of Rs 1 lakh crore at the policy repo rate.
LTRO- Long Term Repo Operation
LTRO is a tool that lets banks borrow one to three-year funds from the central bank at the repo rate, by providing government securities with similar or higher tenure as collateral.
- LTRO was first introduced by the European Central Bank during its sovereign debt crisis that began in 2008. LTRO was an acronym coined by the ECB that stood for “long-term refinancing operations”.
- LTRO operations are intended to prevent short-term interest rates in the market from drifting a long way away from the policy rate, which is the repo rate.
- It is a measure that market participants expect will bring down short-term rates and also boost investment in corporate bonds.
- These new measures are an attempt by the central bank to manage bond yields and push transmission of earlier rate cuts.
- RBI conducted its first LTRO on February 15, at the policy rate.
Reason to introduce LTRO
- Ever since the economic slowdown hit India and the IL&FS fiasco triggered a spike in borrowing costs, the RBI has been trying to stimulate the economy through easy-money policies.
- Since January 2019, the repo rate (the rate at which banks borrows quick money from RBI) has been cut by 139 basis points.
- But only a part of these rate cuts have as yet been passed on to borrowers by banks and other lenders.
- When charged with this slow transmission of rate cuts, bankers complained that repo loans constituted only a miniscule portion of their overall funds, making it difficult for them to cut lending rates.
- Further COVID-19 ignited large sell-offs in the domestic equity, bond and forex markets leading to an increase in redemption pressures.
- This led to a surge in liquidity premium on instruments such as corporate bonds, commercial paper and debentures and it became difficult for these instruments to access working capital through bank credit.
- To counter the economic impact and subsequent pressure on cash flows, the central bank decided to conduct auctions of targeted term repos of up to three years tenor of appropriate sizes for a total amount of up to Rs 100,000 crore at a floating rate linked to the policy repo rate.
- RBI introduced LTRO with a view to
- Assuring banks about the availability of durable liquidity at reasonable cost relative to prevailing market conditions,
- Further encourage banks to undertake maturity transformation smoothly and seamlessly so as to augment credit flows to productive sectors.
- Ensure transmission of rates
LTRO operations are conducted via a fairly standard auction mechanism.
Impacts of LTRO on Indian Banks and Economy
Under LTRO, RBI provides longer term (one- to three-year) loans to banks at the prevailing repo rate.
- LTROs provide banks with access to cheaper capital from the RBI.As banks get long-term funds at lower rates, their cost of funds falls. In turn, they reduce interest rates for borrowers.
- This may also mean lower deposit rates for savers.
- This helps banks get funds for a longer duration as compared to the short-term (up to 28 days) liquidity provided by the RBI through other tools such as liquidity adjustment facility (LAF) and marginal standing facility (MSF)
- The RBI believes that offering banks durable longer-term liquidity at the repo rate (5.15 per cent), can help them lower the rates they charge on retail and industrial loans, while maintaining their margins. This, in turn, encourages them to lend more and spur economic activity.
- They can also invest these long-term funds in assets that yield better returns to improve profitability.
- Also, as banks provide government securities as collateral, the demand for such government bonds increases and helps in lowering yield.
- The LTRO will also help bring down the yields for shorter-term securities (in the 1-3-year tenor) in the bond market.
- LTRO helps RBI ensure that banks reduce their marginal cost of funds-based lending rate, without reducing policy rates.
- LTRO also showed the market that RBI will not only rely on revising repo rates and conducting open market operations for its monetary policy, but also use new tools to achieve its intended objectives.
- RBI intends to conduct these LTROs to improve transmission of earlier rate cuts within the economy.