Policy rate corridor

Also called: LAF corridor, Interest rate corridor · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Beyond NCERT

Meaning

The policy rate corridor (also called the LAF corridor or interest rate corridor) is the band within which overnight money-market rates move. Its ceiling is the MSF rate, its floor is the SDF rate, and the repo rate sits in the middle [1][2].

• Why it matters: the RBI announces only the repo rate. The corridor keeps the actual overnight rate, the WACR (Weighted Average Call Rate), inside a narrow band around the repo rate. Only then can a change in the repo rate pass through to loans and deposits [1].
• Formulas:
• Floor = SDF rate = repo − 25 bps [1]
• Ceiling = MSF rate = repo + 25 bps [1]
• Corridor width = MSF rate − SDF rate = 50 bps (100 bps = 1 percentage point)

Explanation

How the corridor works: the ceiling and the floor

The two edges are set by standing facilities. These are RBI windows that are always open, so a bank can use them on its own without waiting for an RBI auction.

• Ceiling = MSF (Marginal Standing Facility). The MSF is an overnight emergency borrowing window at a penal rate, meaning a rate set above the repo rate on purpose [1].
• A bank can always borrow from the RBI at the MSF rate.
• So no bank will pay more than the MSF rate to borrow from another bank.

• This means overnight market rates cannot rise above MSF.

• Floor = SDF (Standing Deposit Facility). The SDF is a collateral-free overnight window where banks park their extra cash with the RBI [2][1].

• A bank can always earn the SDF rate from the RBI.
• So no bank will lend to another bank for less than the SDF rate.

• This means overnight market rates cannot fall below SDF.

• Middle = repo rate. This is the policy rate, the interest rate at which the RBI lends to banks for a short time against government bonds. The RBI tries to keep the WACR close to it [1].

The three components (rates as of 5 December 2025)

Floor	Policy rate	Ceiling
SDF 5.00%	Repo 5.25%	MSF = Bank Rate 5.50%

• These rates were set in the 5 December 2025 policy, which kept a neutral stance [3].
• Width: 5.50 − 5.00 = 0.50 percentage point = 50 bps.
• Symmetric: 25 bps on each side of the repo rate [1].
• The Bank Rate is kept equal to the MSF rate. Both were 5.50% in December 2025 [3].

What moves the WACR within the corridor

The corridor sets the limits. Liquidity, meaning how much ready cash banks hold, decides where the WACR sits inside those limits.

• Liquidity surplus (banks have spare cash and few borrowers):
• call rates fall below the repo rate → the WACR is pulled toward the SDF floor

• the RBI runs a VRRR (Variable Rate Reverse Repo, an auction in which banks bid to park surplus funds) to absorb the extra cash → the WACR moves back up toward the repo rate [1]

• Liquidity deficit (banks are short of cash):

• banks borrow more → the WACR is pushed toward the MSF ceiling

• the RBI runs a VRR (Variable Rate Repo, an auction for RBI funds) to add cash → the WACR moves back down toward the repo rate

• Things that change liquidity without any RBI decision:

• Festivals and elections: people withdraw currency → liquidity falls.
• Tax dates: money moves into the government's account with the RBI → liquidity falls. When the government spends, liquidity rises.
• RBI selling dollars: banks pay rupees to the RBI → liquidity falls. When the RBI buys dollars, liquidity rises.

Worked example: is the WACR inside the corridor and near repo?

• WACR = Σ (rateᵢ × volumeᵢ) ÷ Σ volumeᵢ. It is the volume-weighted average rate in the one-day call money market, where banks lend to and borrow from each other.
• Deal A: ₹6,000 crore at 5.20%. Deal B: ₹4,000 crore at 5.35%.
• WACR = (6,000 × 5.20 + 4,000 × 5.35) ÷ 10,000 = (31,200 + 21,400) ÷ 10,000 = 5.26%.
• 5.26% lies between the SDF floor (5.00%) and the MSF ceiling (5.50%). It is very close to the repo rate (5.25%), so the corridor is working well.
• Cost of using the ceiling: a bank borrowing ₹2,000 crore under MSF at 5.50% for one night pays about 2,000 × 5.50% ÷ 365 ≈ ₹0.30 crore (about ₹30 lakh). Because of this penal cost, banks use MSF only when they really need to.

In India

• Who manages it: the Reserve Bank of India runs the corridor through its Liquidity Adjustment Facility (LAF). The LAF is its system of repo, reverse repo and standing facilities for managing day-to-day liquidity [1].

• The LAF began in June 2000, following the Narasimham Committee II.

• Who sets the repo rate: the Monetary Policy Committee (MPC). The SDF and MSF rates move with it, because they are fixed at 25 bps below and above the repo rate [1].

• Building blocks and their dates:
• MSF, introduced May 2011: overnight borrowing at a penal rate. Banks may use government securities held for their SLR (Statutory Liquidity Ratio, the minimum share of deposits a bank must keep in safe assets such as government bonds), even going below the requirement, up to 2% of NDTL. NDTL (net demand and time liabilities) is roughly a bank's deposits [1].

• SDF, introduced April 2022: the legal basis is Section 17(2A) of the RBI Act, 1934, which was inserted by the Finance Act 2018.

  • The SDF replaced the fixed-rate reverse repo (then 3.35%) as the floor. The fixed-rate reverse repo is now used only at the RBI's discretion [1].

• Main operation inside the corridor:

• Now (after the 2025 review): the 7-day VRR/VRRR auction [1].

• Feb 2020 framework: the 14-day VRR/VRRR, timed to match the fortnightly CRR (cash reserve ratio) maintenance cycle [2][4].

• Latest figures (5 December 2025): SDF 5.00%, repo 5.25%, MSF and Bank Rate 5.50%. Width is 50 bps and the stance is neutral [3]. Check the current rates before the exam, because later MPC meetings may have changed them.

Don't confuse with

• Repo rate vs WACR: the repo rate is the policy rate, the one the RBI announces. The WACR is the operating target, the market rate the RBI tries to keep near the repo rate [1].
• SDF vs reverse repo: both absorb banks' surplus cash. The SDF needs no collateral. In a reverse repo, the RBI must give banks government bonds, so large surpluses can leave it short of bonds. The SDF, not the fixed-rate reverse repo, is now the floor [1].
• MSF vs repo: the repo is the RBI's normal lending at the policy rate. The MSF is an overnight emergency window at repo + 25 bps, and it allows banks to dip into their SLR holdings [1].
• Standing facilities vs VRR/VRRR: the SDF and MSF are always open and are used at the bank's own choice. They form the edges of the corridor. VRR/VRRR are auctions the RBI decides to hold, and they keep the WACR near the middle.

Prelims Hooks

• Corridor: floor = SDF (repo − 25 bps), ceiling = MSF (repo + 25 bps), width = 50 bps, symmetric around the repo rate [1].
• MSF rate = Bank Rate. Both were 5.50% on 5 December 2025, with repo at 5.25% and SDF at 5.00% [3].
• The operating target is the WACR, not the repo rate. This is a common trap [1].
• The SDF (April 2022) is collateral-free. Its legal basis is s.17(2A) of the RBI Act, 1934, inserted by the Finance Act 2018. It replaced the fixed-rate reverse repo (3.35%) as the floor.
• Liquidity surplus → WACR moves toward the SDF. Liquidity deficit → WACR moves toward the MSF.
• LAF began in June 2000 (Narasimham Committee II). The current main operation is the 7-day VRR/VRRR, which replaced the 14-day one used under the Feb 2020 framework [1][2][4].

Mains Points

• A rate cut works only if liquidity follows:
• If the system has a liquidity deficit, the WACR stays near the MSF ceiling even after a repo cut.
• Then market rates do not fall, and borrowers do not get cheaper loans.

• So liquidity management (VRR/VRRR, OMOs, CRR) matters as much as the rate decision itself [1].

• The SDF as a structural reform:

• A floor that needs no collateral lets the RBI absorb large surpluses without running out of government bonds. Such surpluses can come from heavy dollar buying or large government spending.

• This makes the corridor more reliable. It is also a good example of a legal change (Finance Act 2018) creating a new monetary-policy tool.

• Defending the rupee vs keeping money easy (GS-III):

• When the RBI sells dollars to support the rupee, it drains rupee liquidity and pushes the WACR toward the MSF ceiling.
• This tightens credit, possibly at a time when the RBI wants easier money. The RBI must then add cash back through VRR or OMO purchases.
• A narrow, symmetric 50 bps corridor with one clear target (WACR) makes the RBI's signals easier for markets to read. The cost is that the RBI has to act in the market more often.

Related concepts

• Liquidity Adjustment Facility
• Variable Rate Repo
• Variable Rate Reverse Repo
• Marginal Standing Facility
• Standing Deposit Facility
• Weighted Average Call Rate
• Banking system liquidity

Read more

• The operating framework: LAF, the corridor and WACR