What are OMOs and how RBI rate decisions reach your loan EMI

What OMOs are and why the RBI uses them

The repo window lets individual banks borrow from the RBI against government securities when they are short of cash. But the repo window addresses individual bank shortfalls; it does not directly control the total level of rupee liquidity in the banking system as a whole. That is what open market operations do. When the RBI wants to inject liquidity into the system, it buys government securities from banks and primary dealers in the secondary market, paying rupees for those bonds. The banking system collectively receives those rupees and the RBI holds the bonds. When it wants to drain liquidity, it sells bonds and withdraws rupees.

OMOs are the RBI's primary tool for managing durable, system-level liquidity, as distinct from the short-term, window-based lending of the repo. A large government borrowing programme, for example, drains rupees from the banking system as banks buy those bonds. The RBI may conduct purchase OMOs to offset that drain and prevent the overnight rate from spiking above the repo corridor. OMOs are also used to manage the yield curve: large, announced purchases of longer-dated securities can suppress long bond yields, a form of yield-curve management that has parallels with quantitative easing elsewhere.

The transmission chain from policy rate to your EMI

A repo rate cut by the MPC does not immediately appear in your bank's loan rate. The transmission goes through multiple steps, each with its own lag. First, the repo rate cut lowers the cost at which banks can borrow from the RBI, making funds cheaper at the margin. Second, this tends to pull down the overnight money market rate (the call money rate and the overnight index swap), which are the rates at which banks lend surplus cash to each other. Third, this lower short-term rate feeds into the cost of funds for banks, especially those that rely on short-term borrowing.

For retail borrowers, the final link is the external benchmark-linked lending rate (EBLR). Since October 2019, RBI has required banks to link floating-rate retail and MSME loans to an external benchmark, usually the RBI repo rate or the Treasury bill rate, rather than an internal benchmark the bank itself controlled. Under EBLR, when the repo rate changes, the bank's benchmark rate must be reset at least every three months. So the transmission from a repo rate cut to your EMI now takes one reset cycle at most, much faster than under the older marginal cost of funds-based lending rate (MCLR) system.

Why transmission is sometimes incomplete

Even with EBLR, full transmission is not guaranteed. Banks pass on rate cuts only when they are fully priced into their cost of funds and the competitive environment does not allow them to defend wider margins. Deposit rates adjust slowly: a bank that cut its lending rate quickly but cannot simultaneously cut deposit rates immediately sees its margin compress, which creates a drag on earnings. Banks sometimes lag on cutting deposit rates or use the period between policy rate changes to partially rebuild margins.

The OMO link matters here too. If the RBI cuts the repo rate but banking system liquidity is tight because of heavy government borrowing or external capital outflows, the practical cost of funds for banks stays elevated above the policy rate. In that case OMO purchases, which inject liquidity and push short-term rates closer to the repo floor, are as important as the rate cut itself for ensuring the transmission actually reaches the borrower. This is why watching both the policy rate and the liquidity stance, expressed through OMO operations and the RBI's forward guidance, gives a fuller picture of monetary conditions than the repo rate number alone.

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