The Interbank Money Market in India: Evidence on Volatility, Efficacy of Regulatory Initiatives and Implications for

Interest Rate Targeting

Himanshu Joshi*
The working of the interbank money market (the call money market) and the conduct of monetary policy are inextricably linked in
economies that depend predominantly on indirect instruments of monetary policy. The stability of the call money rate, namely, the
rate at which short term funds are lent and borrowed is, therefore, of critical importance to central banks which view it as an
operational target to signal the stance of monetary policy. Experience shows that regulatory initiatives taken to improve the
efficiency of market functioning also help in fostering market stability. In the Indian case, for example, it may not be inappropriate
to postulate that permitting a wider section of market constituents to operate in the repos market (viz., outside the central bank)
since arch !""# led to a reduction in the volatility of the call money rate caused by improved matching of demand$supply
between deficit$surplus segments. %y the same token, therefore, there is a case for encouraging increased participation and,
more importantly, expanding the range of eligible collateral for market repos to enhance the efficacy of short term interest rate
targeting. The measures announced in the &nnual 'olicy statement for !""()"* and the suggestions made by the Technical
&dvisory +ommittee on oney arket to further expand the scope of activity in market repos are, therefore, highly significant in
the present context.
JEL Classification : E(!
Keywords : +all money market rate, ,i-uidity &d.ustment /acility (,&/), &utoregressive +onditional 0eteroscedasticity,
+onditional 1ariance.
Introduction
The overnight call money or the inter)bank money market rate is presumably the most closely watched variable in day)to)day
conduct of monetary operations and often serves as an operating target for policy purposes. The choice of operating tactics from
2 The views expressed in the paper are solely those of the author and must not be ascribed to the institution to which he belongs.
-uantity to rate based targeting, following the I3$, based analysis of 'oole (456"), has been largely accepted in favour of
interest rate targeting, because of the diminished link between monetary aggregates and economic ob.ectives of monetary policy
as a result of the fast pace of financial innovations. ost central banks, therefore, presently use indirect instruments in an attempt
to maintain the short term interest rate at a desirable level with the use of appropriate li-uidity management practices. The most
common of these instruments of li-uidity management is the central banks7 repo facility which enables modulation of the marginal
li-uidity on a day to day basis so as to ensure stable conditions in the money market and, particularly, to maintain the short term
money market rate as close as possible to the official$policy rate. +hanges in the short)term policy rate made by central banks
provide signals to markets, and various segments of the financial system, therefore, respond by ad.usting interest rates$returns
depending on their sensitivity and the efficacy of the transmission mechanism. Economic implications for investment and spending
decisions of producers and households follow as usual, thereby affecting the working of the real sector viz., changing aggregate
demand and supply, and eventually inflation and growth in the economy. It is, therefore, clear that the interest rate stance of a
central bank and its implications for economic activity and inflation play an important role in the conduct of monetary policy.
The ob.ective of the paper is, therefore, to assess the volatility pattern of the call money rate in India during the last three years
and to estimate its sensitivity vis--vis the 8eserve %ank of India7s li-uidity ad.ustment facility (,&/) auction decisions for the
purpose of eliciting underlying market characteristics. &ttempt is made to provide evidence, albeit indirectly, on how regulatory
changes related to other instruments in the money market may have affected the functioning of the interbank call money market.
/inally, some evidence is also offered on the link between money market volatility and interest sensitive financial markets,
particularly the government securities market.
The remainder of the paper is structured as follows. 3ection I provides an overview of li-uidity management in India while cross)
country experience is set out in 3ection II. 9ata used in the analysis are explained in 3ection III. ethodology used and the
empirical analysis are presented in 3ection I1 and concluding observations are given in 3ection 1.
Section I
Liquidity Management in India
The li-uidity management practice in India has undergone significant changes in the 455"s, from greater reliance on direct
instruments to almost full dependence on indirect instruments over these years. The transition to this framework has been enabled
because of far reaching changes in the framework of monetary policy enabled especially by the introduction of market based price
discovery mechanism and reduction in the financing of government deficits by the 8eserve %ank. &s a conse-uence, it was
possible to achieve a successful transition, since :une !""", to a full fledged li-uidity ad.ustment facility (,&/) permitting eligible
participants such as banks and primary dealers ('9s) to manage their day to day li-uidity needs through recourse to the facility.
The evolution in li-uidity management practices over these years is a logical outcome of the economic reforms which led to the
phasing out most of the standing facilities and reduced the emphasis on direct monetary policy instruments. The ,&/ allows the
8eserve %ank to have a strong grip on system7s li-uidity, on a day to day basis, and conse-uently helps in achieving its goals of
policy more successfully than was the case hitherto. In the recent times, as li-uidity conditions have turned surplus because of
capital flows, reverse repo auctions have been operated to sterilise excess li-uidity to maintain stability in the money market rate
around a desired level. 8everse repo operations are conducted on a daily overnight basis and, also for relatively longer period to
enable absorption of excess li-uidity depending on evolving conditions. &lthough the presence of excess li-uidity naturally ordains
that bids are fully accepted to gain the comfort of maintaining the market rate around the official rate, the decision on the
acceptance of a given proportion of bids out of the total submitted is taken in keeping, inter alia, the daily
primary li-uidity flow pro.ections arising from various transactions of the 8eserve %ank with the rest of the economic system.
;hile a number of transactions capturing li-uidity flows are pre)known to the 8eserve %ank, -uite a few like ways and means
advances, changes in currency demand and cash balances of the government are not known a priori with certainty.
The inevitability of large open market operations under conditions of unabated capital flows is virtually preordained given the
sensitivity of the inter)bank market to sudden changes in li-uidity flows. 0owever, the declining stock of +entral <overnment
securities with the 8eserve %ank made it necessary to evolve alternative mechanisms to augment the inventory of repoable
securities to ensure stability of the money market. Towards this end, the 8eserve %ank in consultation with <overnment
introduced the arket 3tabilisation 3cheme (33) in !""= to absorb excessive$ enduring li-uidity in the system. >et given the
unrelenting surge in foreign exchange inflows, the task of maintaining stability in the money market continues to remain a difficult
task. In the current milieu, when the auction rate for ,&/ is generally kept fixed, the -uantity is automatically determined, as all
reverse repo bids are fully accepted. In this case, the market rate also -uickly stabili?es around the reverse repo rate as the
system7s surplus li-uidity is taken away at a given price. The comfort level achieved through daily li-uidity management based on
,&/ however is occasionally disturbed when sudden li-uidity shortages cause sharp fluctuations in the money market rate.
&lthough, such spikes have often been short lived given the timely li-uidity support offered by the 8eserve %ank, yet there is a
need to moderate these fluctuations in the larger interest of overall li-uidity management.
@n the other hand, for prudential reasons and as recommended by the Aarsimham +ommittee in 455B, the 8eserve %ank has
transited to a system of pure interbank call$notice money market. &ccordingly, the average lending by non banks in a reporting
fortnight, based on their average daily lending in call $notice market during !""")"4, was progressively reduced from B( percent
(ay !""4) to 6( percent (:une !""#) to *" percent (9ecember !""#) to =( percent (:une !""=)
to #" percent (:anuary "B, !""() to 4" percent (:une 44, !""() and completely phased out from the fortnight beginning &ugust "*,
!""(. Aon bank participants except '9s are also not permitted to borrow from the call$notice market. &s these limits on lending
have been imposed, the parallel development of the repos market outside of the 8%I managed by the +learing +orporation of
India ,imited (++I,) as a central counterparty has taken shape. Aon banks are expected to take recourse to the collateralised
repos outside the 8%I for purposes of borrowing and lending of funds.
The ++I, meanwhile also introduced an innovative money market product called the +ollateralised %orrowing and ,ending
@bligation (+%,@) in :anuary !""# which provided investors the benefit of guaranteed settlement and an exit option before
maturity. &s a result of the introduction of market repos and the +%,@ and phased removal of non bank participation in the call
money market, the trading volumes in these markets have increased substantially. %etween !""#)"= and !""=)"(, for example,
the +%,@ market grew by a phenomenal 44B" percent. The +%,@ segment can be further encouraged by making it more
attractive especially for urban cooperative banks to participate in the market by expanding the range of eligible repoable assets
by making assets such as state development loans more acceptable through consolidation. Technical initiatives such as enabling
repo transactions through secured and cost effective communications links could also be introduced to improve the reach
amongst a multiplicity of small participants, thereby integrating dispersed pools of idle li-uidity with the needs of solvent
borrowers. In the past, significant regulatory reliefs such as that in arch !""# were offered when constituent subsidiary general
ledger (+3<,) account holders were permitted to participate in the interbank repo market. ore measures in this direction
especially, permitting wider sections of the constituents of '9s to participate in the +%,@ segment would in all likelihood help in
further deepening of the money market. In regard to the range of eligible collateral assets, depending on the comfort level of the
central counterparty, there is a need also to permit interbank repos in '3C bonds and private and corporate debt securities for
market repos provided they are held in dematerialised form and transactions are done through recognised stock exchanges. This
position has been indicated by the 8eserve %ank earlier. The same could, hence, also be considered in the case of +%,@
market. The range of participants in the market has also been widened over time. In case of +%,@, for example, while banks,
'9s and cooperative banks who are members of the Aegotiated 9ealing 3ystem (A93) are permitted, non)A93 members like
corporates, co)operative banks, A%/+s, 'ension /unds and Trusts also became eligible as associate members of the ++I,7s
+%,@ segment to borrow and lend in the +%,@ market from :anuary !""=. ;ith the phasing out of the non)bank participation in
the interbank call money market, once a greater range of market participants, especially deficit$surplus segments, is encouraged
to participate together in a common but secured market for repos$+%,@ and a wider array of repoable collateral is available, the
efficiency of targeting of the inter)bank call money market would improve on account of better li-uidity smoothing across market
participants, especially during phases when li-uidity shocks result in overshooting of the short term interest rate.
International evidence also underlines the fact that contrary to unsecured markets (especially, call money market), a collateralised
repo market is able to achieve much better li-uidity smoothing across solvent market participants despite the difficulties in the
management of collateral risk (/reixas and 0olthausen, !""4). In actual practice, the growth in the global market for repos with a
widening pool of collateral has been driven by the improved confidence in the management$mitigation of risk and increased
outsourcing of collateral risk management to central counterparties.
Section II
Some International Liquidity Management ractices
9ifferent market based intervention techni-ues are employed by central banks to manage li-uidity on a day)to)day basis. +entral
banks have been increasingly favouring market operations, especially buying and selling securities than standing facilities in
conducting their monetary policies. ;hile different practices and operational frameworks exist, the ob.ective continues to be the
same, namely, fostering stability of short)term interest rates around the operating target announced by central banks. The review
of the li-uidity management practices presented here is based on several published sources or material otherwise available in the
public domain.
The European +entral %ank (E+%) intervenes in the money market through its most important policy instrument namely the ain
8efinancing @perations (8@) conducted through repos. The 8@s provide the bulk of li-uidity support and are implemented
through weekly tenders for a maturity period of two weeks. The remaining li-uidity needs are met by ,ong Term 8efinancing
@perations (,T8@) which are operated once a month and have a maturity of three months. 3ince :une !""", the 8@s are
conducted at variable rates. 0owever, the E+% announces a minimum bid rate at which no bids are acceptable. %ids at the
highest rate are accepted first and bids with successively lower rates are accepted in turn until the total li-uidity to be in.ected is
exhausted. The minimum bid rate indicates the stance of monetary policy. %esides the 8@ the E+% also offers a marginal
lending and standing deposit facility to counterparties. 3ince :une !""" the E+% has set its lending rate one percentage point
above and its deposit rate one percentage point below the minimum bid rate announced for its 8@. The deposit facility is
operated by the E+% in order to facilitate overnight deposits with the E+%. In principle, the deposit facility allows banks to reduce
reserves when they have surplus reserves. The lending and deposit facilities of the E+% are made available half an hour after the
closure of T&8<ET (!rans)European "utomated #eal)time $ross settlement Express !ransfer system) D a 8T<3 system used
for settlement of central bank operations, large)value euro interbank transfers as well as other euro payments providing real)time
processing and settlement in central bank money with immediate finality. The Eurosystem accepts a wide range of collateral
assets from non financial institutions for its refinacing operations. Eligible collateral includes, apart from marketable debt
instruments, non marketable debt instruments and even some e-uities. Ao difference is made between these assets in terms of
-uality as they fulfil minimum eligibility criteria specified by the Eurosystem. In retrospect, given this framework for li-uidity
management, it has been found that the overnight inter)bank rate E@AI& (Euro @vernight Index &verage) has generally remained
within the corridor defined by lending and deposit rates, usually within one)half of a percentage point of the minimum bid rate. &s a
result, the marginal standing facilities that define the corridor for policy rates have seldom been used by market participants in the
Eurosystem.
The %ank of England (%oE) introduced fundamental changes in the operating procedures following the grant of operational
independence in 4556 and the separation of 9ebt anagement @ffice (9@) in !""". &ccordingly, the %oE presently sets its own
official rate of interest so as to meet the target rate of inflation set by the government. The daily operations of the %oE include an
initial forecast of the li-uidity need which is amended throughout the day. arket interventions are made at two regular times
during the morning and noon. &dditional facilities are offered late in the day above the official repo rate, which sets the ceiling for
the overnight interest rate. %esides, the %oE also offers a standing deposit facility remunerated at rate lower than the official repo
rate by one percentage point which, in effect, sets a floor to the overnight interest rate. In an assessment of the open market
operations of the %oE, especially, in regard to the introduction of the special deposit facility, &llen (!""!) suggests that its
introduction since :une !6, !""4 somewhat narrowed down the range of fluctuation of short rates around the official repo rate. The
deposit facility, in fact, introduced as a EmoppingF facility for surplus li-uidity successfully limited the extent to which short dated
rates could fall below the official rate, resulting in a proper control over the volatility of short rates.
The C3 /ederal 8eserve (C3/8) intervenes through outright and temporary operations. @utright operations are conducted to
offset long term imbalances in li-uidity mismatches and conducted by way of treasury bill and coupons. Temporary operations are
conducted through repos in treasury securities and are used to offset daily imbalances. The li-uidity operations of the C3/8 are
supported by discount window borrowings which serve as a marginal lending facility. The /ederal 8eserve 3ystem accepts a wide
range of collateral such as mortgage based securities issued by federal agencies and government sponsored enterprises, apart
from securities that are direct obligation of the C3 treasury or other securities that are fully guaranteed as to principal and interest
by government agencies or government sponsored enterprises (Edwards, 4556).
%esides the central banks7 own initiatives aimed at li-uidity management, the repurchase transactions among domestic
counterparties have increased phenomenally. The collateral acceptable for these transactions in the C3 includes, apart from
treasuries, securities issued by &gencies (/annie ae, <innie ae, etc.) and mortgage based securities guaranteed by &gencies.
The /ederal 8eserve %anks also provide daylight overdraft facilities at a charge of #* basis points to allow dealers to finance
positions. @bviously, this is done to ensure that all genuine li-uidity needs of the wider market are met and the settlement is
completed without any problems. &s at end 9ecember !""= the outstanding volume of domestic market repos in the C3 was G (
trillion. In the case of Eurosystem also the growth in repo market has been encouraging although this segment is less integrated
than the swap and unsecured segments, due to existing differences in practices, laws, regulations and fragmentation of market
infrastructure. The E+% has been keenly interested in the activity in the repo market segment and has supported the integration of
the euro market for short term securities. &s at end 9ecember !""=, the Euromarket had about EC8@ ( trillion outstanding as
market repos. The enormous growth in the repos transactions has resulted from the perceived benefits of such transactions.
8epo markets compete with banking system by providing a method of granting and receiving loans and generally tend to reduce
interest rates for borrowers while increasing it for depositors. In addition, the market for repos based on bonds helps in improving
the efficiency and li-uidity of bond markets and minimise the probability of undue price fluctuations.
%esides the rapid growth of domestic repos markets, the international financial system has experienced increasing global
integration and depth of the money markets in the recent years, helping to cover short term li-uidity mismatches experienced by
large banks$other financial institutions by means of repurchase transactions facilitated by the International 3ecurities arket
&ssociation (I3&). &t present repurchase transactions are easily carried out across national borders besides those among
domestic counterparties. &ccording to the survey carried out by the I3& in 9ecember !""#,
the total si?e of repo outstanding was estimated at EC8 #.66 billion. 3urvey results also suggested that whereas #5.# per cent of
reported outstanding repo contracts were with domestic counterparties, (!.4 per cent were cross)border including both euro and
non)euro ?one counterparties. The share of electronic trading of these transactions was also on the rise. The collateral analysis
suggested that while fixed income securities issued by the sovereign governments in the EC were predominantly used as
collaterals in repo transactions, the pool of collateral was widening with the increasing acceptance of non)government bonds
('fandbrief and mortgage backed securities) and e-uity. It is widely believed that the growth of the collateralised repo market has
served an important role, viz., enhancing the overall stability of the financial system by removing counterparty risks by means of
funded credit protection against risky transactions in unsecured wholesale financial markets.
&n empirical analysis of the behaviour of volatility of short term money market rate conducted by Thompson (!""#) for ma.or
developed countries shows that while volatilities have generally been reduced over time in the recent years, higher volatilities in
countries such as the CH are ascribable to low reserve re-uirements. &ccording to Thomson (also Hasman, 455!) low reserve
re-uirements have tended to impede the flexibility of banks in managing their reserve positions leading to higher fluctuations in the
overnight rate. 0owever, most central banks in the developed world have taken initiatives to expand the scope of the market by
enhancing the range of collateral acceptable for monetary operations and in some cases improving the participation rate itself.
Section III
%ata : Sam&le and %efinitions
&s mentioned before, the empirical exercise is devoted to eliciting the volatility of the call money rate in the recent past including
possible relationship with certain important regulatory initiatives taken by the 8eserve %ank. The analysis is also devoted to
assessing the sensitivity of interest rate targeting especially in relation to the ,&/ auction decisions of the 8eserve %ank on a day
to day basis. 9aily data on reverse repo auctions (submitted and accepted), weighted call money rate and the official repo rate are
taken for the period from &pril !""! to arch !""( which, by and large, has been a period characterised by surplus li-uidity
except for some sporadic periods of li-uidity stress. The data employed is available in the public domain and is regularly
disseminated through the official website of the 8eserve %ank (www.rbi.org.in). ;herever re-uired, data have been appropriately
transformed for testing the hypothesis put forward in the paper.
Section I'
Methodology and Em&irical E(idence
The econometric methods used in estimation are the Aelson %everidge (A%) time series decomposition and an &8+0)I4,4J
(&utoregressive +onditional 0eteroscedasticity in ean) model estimation which is widely used for modelling volatility in financial
markets. ;hile the A% decomposition serves to differentiate between permanent and cyclical components in a time series, the
&8+0 model introduced by Engle (45B!) imposes a systematic structure to the variance process making it amenable to
interpretation and use in forecasting. These methods are briefly explained below in an understandable language, without using
mathematical notations. 8eferences pertaining to the statistical methods are given at the end.
)i* +elson ,e(eridge %ecom&osition
This decomposition method was proposed by %everidge and Aelson (45B4).The A% method is based on the presumption that
stationary short term fluctuations tend to shift the long run path or the trend of the series in -uestion. In the A% method, the
contemporaneous innovation to the trend is perfectly negatively correlated with itself. /or example, a positive shock to the call
money rate because of consistent tightening of li-uidity will be contemporaneously negatively correlated with the trend until
shocks force the trend to ad.ust upwards over time. The A% method was applied to the weighted call money rate with
&8I&(4,",4) structure to obtain estimates of the cyclical (or temporary) component which are plotted in +hart 4 below.
+hart 4 clearly reveals a substantial containment of market volatility beginning arch !""# (observation number *"" onwards on
the K)axis when the transient component looks considerably subdued) coinciding with the 8eserve %ank7s decision to permit
+3<, account holders to participate in the market for interbank repos.
)ii* !he "#CH-M Model
The standard &8+0 effect in data implies Lvolatility clusters7 which can be captured to place appropriate structures to the volatility
of the series, which may be otherwise highly unpredictable and difficult to interpret. The coefficients derived from estimated &8+0
models are more efficient than those obtained from simple @,3 method and offer a special ground for inference making. +hart !
provides evidence on &8+0 effects in call money rate suggesting episodic volatility including clusters of low amplitude variations
followed by lower values and vice versa. It is, therefore, reasonable to specify the model for call money rate in terms of the mean
and conditional variance e-uations in &8+0 models.
&s a variant to the general &8+0 model described above, we employ here the &8+0) model introduced by Engel et.al (45B6)
wherein each time the mean of the process is determined by additional information contained in standard deviation seen at the
same time. The &8+0) modelling is of special interest in studying financial time series as the conditional variance plays an
important role in determining an explicit trade)off between expected returns and the variance or the covariance among returns. In
the traditional capital asset pricing model (+&'), for example, the expected excess return on the market portfolio is linear in its
conditional variance, suggesting the usefulness of &8+0) type models.
The algebraic structure of the &8+0) model is presented below.
!he Mean Equation
DIFRATE =the difference between weighted call one! rate and the reverse repo rate "#$.
T%TA&&' =total ao(nt of reverse repo bids accepted dail! "Rs crore$ h = odel based conditional variance ERR%R = error
ter
The mean e-uation explains the variations in the gap between call money rate and the policy rate (viz., repo rate) by decision
taken by the 8eserve %ank in respect of the daily amounts of bids accepted from counterparties in reverse repo auctions and the
recursive conditional variance itself. The model posited above does not use any lag(s) of the dependent variable in the e-uation.
Taking lags of the dependent variable in the e-uation is often sub.ect to criticism from practitioners, especially, the rationale of
taking past information on the dependent variable into account. +ritics often also -uestion the validity of such empirical models
arguing that since much of the explanation in the estimated e-uation is attributed to lagged dependent variables, they do not have
much practical use. %y dropping lagged endogenous variables therefore, we avoid this criticism, and the only term that is left
unexplained is the error term, which may arise from factors such as less accurate pro.ections of cash flows in the banking system
arising from exogenous factors such as changing demand for currency by the public, government cash flows and flows on account
of external capital$private remittances and even news and expectations etc. These mismatches in supply and demand of funds
can be addressed by expanding the scope of the repo market especially when regulatory concerns re-uire that the participation in
the interbank call market should be limited to banks only. The error term is expected to be highly variable but can be suitably
modelled by imposing systematic structure as proposed in the econometric literature so as to be useful in decision)making.
Conditional 'ariance
&s the system is highly volatile and shows volatility clusters, the conditional variance of the process can be systematically
captured using the s-uare of previous error terms obtained from the mean e-uation. The estimation of conditional variance based
on &8+0 models has been customarily found -uite successful in modelling financial markets with high fre-uency market
operations and
volatility. They have also been used to forecast volatilities to address the needs of trading desks to help in evolving operating
strategies.
&s is evident from the recursive nature of the estimation, coefficients of the &8+0) models are obtained from non linear
numerical optimisation techni-ues applied to the .oint estimation of the mean and variance e-uations. In this paper we employ the
%erndt, 0all, 0all and 0ausman (%000) procedure for maximising the log)likelihood function.
The estimated model specifies the daily difference between the weighted call rate and the official reverse repo rate as a function
of the amount of the reverse repo bids accepted by the 8eserve %ank daily and the conditional variance ) assuming that
conditional volatility itself plays an important role in explaining the gap between the two rates.
The coefficient estimates of the model suggest that variations in amounts accepted in reverse repo auctions have a statistically
significant, though small, impact on the gap between the weighted call money rate and the reverse repo rate (aggregate
coefficient estimate is invariant if even the first lag of the accepted amount is included in the estimation). /or example, for the time
sample under consideration, accepting additional 8s 4",""" crore on a current day would have reduced the said gap between the
call money rate and the reverse repo rate, on an average, by barely two basis points. The
Em&irical Estimate of the daily "#CH-M model ."&ril/ 0110 to mid +o(em2er/ 01134
implication of this finding is that even as the entire bid amount at reverse repo auction is accepted, and if the amounts accepted
were to actually signify the total excess li-uidity in the system, the model should be in a position to explain the gap almost fully.
0owever, since the model, on an average, explains only != percent of the actual average gap of !( basis points over the sample
period, the usual law of e-uilibrium wherein if a rate is fixed, the amount is automatically determined and vice versa appears to be
perceptibly violated. &s it will be shown later, the average margin of error between the estimated gap and the actual gap reported
above is attributable mainly to the phases when the money market suddenly became tight and the 8eserve %ank had to offer
accommodation through its repo window. @n the other hand, the actual gap between the call rate and reverse repo rate during
times of surplus li-uidity especially, when the reverse repo window was open, is fairly well explained by the model with a minimal
margin of error. It therefore, follows that any unexplained gap between the two rates could be ascribed to market segmentation
(especially, the inability of the cash surplus and deficit segments to meet fully to clear the market) instead of auction decisions
alone. It appears that the impedance in reaching an overall market wide e-uilibrium is because of frictions in the functioning of the
money market which may need to be resolved to allow the market operate near its potential strength. This conclusion is
corroborated by the fact that the coefficient of the &8+0) effect in the mean e-uation is significantly much higher at ".=# and
hence, explains a large proportion of the average gap between the call and the reverse repo rate as compared to the reverse
repo accepted variable. It is obvious that reduction of the gaps between the market rate and the policy rate could be achieved
satisfactorily by containing the volatility of the money market, especially that occurring during instances of sudden li-uidity stress,
by widening the participation rate of economy wide deficit (demand)$surplus (supply) segments and expanding the range of
repoable collateral in the repos market. It is noteworthy that recognising this aspect, the 8eserve %ank in arch !""# permitted
+onstituent 3ubsidiary <eneral ,edger (+<3,) account holders to participate in the repo market, thereby increasing the
participation rate of constituents and substantially reducing the volatility in the market ) a fact substantiated by empirical A%
decomposition. <iven the integral link between the money and government securities market, increasing the range of repoable
securities may also help in insulating the government securities market from exposures to market risks caused by random
li-uidity shocks.
+hart # compares the actual call money rate with the estimated rate derived from the mean e-uation of the &8+0) model
estimated above. It is observed that though the estimated tra.ectory tracks the actual path of call money rate closely throughout
the sample period, there are certain occasions when large spikes are observed which are not explained fully by the empirical
model. These spikes caused by sudden mismatches in li-uidity of the otherwise stable e-uilibrium re-uire appropriate balancing
through timely li-uidity in.ection measures.
The daily e)-ante (out of sample) forecasts of call money rate for the period from mid Aovember !""= up to end arch !""( are
plotted against the actual out turns in +hart =.
odel estimates suggest that while the out of sample forecasts closely track the policy rate following the law of e-uilibrium mostly
during periods of surplus li-uidity with an average error of .ust three basis points, the call money rate shows the tendency to
overshoot (average e)-ante tracking error of 46 basis points) during times of li-uidity shortages which are seen as large spikes in
the +hart =, necessitating 8%I to open its repo window. &s depicted in +hart ( the forecast performance is not significantly
improved
even if the model is augmented with the information on repo interventions (viz., repo amounts accommodated by 8%I during
periods of li-uidity shortages). Therefore, since the accommodation provided during shortages does not explain the variation in
gaps substantially, it appears that much more explanation should be owed by other factors, namely the operational aspects in the
market itself.
The inter)bank money market volatility may be transmitted to other financial markets causing financial entities to bear the costs of
portfolio ad.ustments. @ne of these financial markets is the
government securities market which has a significant bearing on the balance sheets of banks and other financial institutions
(especially, insurance companies and pension funds) given the large holdings of such securities in their portfolios. In order to test
the impact of money market volatility on the volatility in the yields of government securities, a simple &84 regression for the full
sample is performed to compute the volatility in the yield of government securities (based on secondary market yield of the
representative central government security with 4")year residual maturity). & regression is then performed with volatility of
government securities as independent variable and the conditional volatility derived from the &8+0) model as explanatory
variable.
The empirical evidence suggests that the volatility in the government securities market is significantly influenced by the volatility
(or li-uidity shocks) in the money market, explaining about !! per cent of the fluctuation in yield. It is therefore necessary that the
volatility in the money market caused by li-uidity shocks is moderated to the maximum extent possible so that securities yields are
determined on the basis of fundamental economic factors such as inflationary expectations rather than day to day li-uidity
conditions.
Section '
Concluding 52ser(ations
The deviations of the call money rate from the policy rate particularly aggravated during periods of li-uidity stress, notwithstanding
complete accommodation offered to eligible counterparties by the 8%I suggests that encouraging greater participation and
permitting a wider range of collateral in the repos market would help in improving the efficiency of interest rate targeting. The task
of doing so though is admittedly difficult under the present circumstances given the perceived difficulties in collateral management
such as pricing and risk mitigation for classes of collaterals other than sovereign securities.
It may, however, be mentioned that the willingness of central banks particularly those in developed economies to accept a wider
array of commercial collaterals even for direct monetary operations is predicated upon the need to uphold the integrity of the
policy rate and to minimise the cost of volatility in interest sensitive financial markets. It is in this context that the present structure
of the money market needs to be viewed, given the implications for related financial markets. The evidence provided by the
empirical model brings out that while the call money rate is tracked reasonably accurately during surplus li-uidity conditions, the
predictive power suffers a loss when li-uidity shortages suddenly emerge. The fluctuations in the call money rate during these
periods of shortage are observed to continue for a couple of days notwithstanding the fact that most often full accommodation is
provided by the 8eserve %ank. The average daily in)sample bias of !( basis points in forecast seen during the sample period is
attributable mainly to random li-uidity shocks experienced by the market. This bias could be expected to increase whenever the
market begins to return to the deficit mode. It, therefore, stands to reason that further integration of the money market by
expanding participation in market repos and, perhaps more importantly, finding ways to introduce other classes of eligible
collateral could help in the timely matching of the needs of the surplus and deficit sectors. eanwhile, the feasibility of increasing
the number of ,&/ operations alongside options to separate the timing of repo and reverse repo operations for market
stabilisation could also be considered.
<iven the increasing market orientation of the financial system and the significant interest sensitivity in the recent years, ensuring
long term consistency between the policy rate and the targeted rate would serve to limit the volatility in different segments of
interest sensitive financial activities.
The experience regarding the improvement in the stability of the money market rate since the expansion, in arch !""#, of inter)
bank repos market due to the participation of +3<, account holders, lends support to the idea that enhanced participation rate in
the repos market would promote stability. The &nnual 'olicy 3tatement of the 8eserve %ank for the year !""()"* has taken
important initiatives to increase participation by permitting non)scheduled urban co)operative banks and listed companies having
gilt accounts with scheduled commercial banks sub.ect to eligibility criteria. The development of the market repos would also be
benefited by the draft guidelines in respect of securitisation of standard assets leading to orderly growth of the market for asset
backed papers, which may then have the likelihood of being accepted as eligible repoable collateral. The proposal for an
electronic trading platform for market repos would also improve the price discovery process.
The introduction of other eligible collateral for repos$+%,@ would reduce risk of unsecured lending in the call money market,
and in others such as in the inter)corporate deposit market and hence serve to foster greater stability of the financial system. It is
notable that the report of the Technical &dvisory +ommittee on money market has also favoured the introduction of asset backed
commercial papers. &n expected externality from the expansion of eligible securities for market repos is the stimulus that would
be imparted to the hitherto dormant markets for these financial products.
/inally, as a technical point of interest, since systematic or conditional element in volatility is a dominating feature of the market
process, it is desirable that conditional volatility is estimated on an ongoing basis for forecasting the volatility of inter)bank money
market rate for policy support.
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