India’s banking system is suddenly flush with cash. Surplus liquidity crossed Rs.11 trillion in the first week of September, a record high, according to Bloomberg data. It stood at Rs.10.5 trillion on 9 September 2026. For the average investor, banking liquidity may sound like a technical term meant for economists and the Reserve Bank of India (RBI). But it directly affects something far more familiar: the cost and availability of money.
The sharp rise in liquidity raises important questions. Where has all this money come from? And what does such a large surplus mean for borrowers, depositors, investors and the economy?
What is liquidity?
In simple terms, liquidity is the amount of money available in the financial system for lending and other transactions. For banks, it broadly means the funds they have available after meeting their reserve requirements with the RBI. When banks lack enough money to meet day-to-day needs, they need to borrow. This is a liquidity deficit. When they have more money than they need, it is a liquidity surplus. Banks can either lend this surplus in the money market or park it with the RBI.
Why the liquidity surge?
One reason for the recent surge has been the RBI’s special dollar-rupee swap facility linked to FCNR (B) or Foreign Currency Non-Resident (Bank) deposits and other overseas borrowings. FCNR(B) deposits are fixed deposits held by non-resident Indians in foreign currencies such as the US dollar. Since the deposits remain in foreign currency, depositors are protected from the risk of a fall in the rupee.
The scheme was introduced to stabilise the rupee amid pressure from foreign investor outflows and high crude oil prices. By the time the facility closed on 31 August 2026, banks had mobilised $127.2 billion through FCNR(B) deposits.
The RBI’s swap window made these deposits attractive. Banks could bring in dollars through FCNR(B) deposits and swap them with the RBI for rupees, which they could then use for lending and investment. To be sure, it’s the rupees banks lend, not the dollars. When a bank sells the dollars it has collected from an NRI depositor to the RBI, it gets paid back in rupees, and that money goes into loans and investments.
The NRI depositors need not worry about this. Their deposit remains in dollars throughout, and they get dollars back, with interest, when it matures. That’s because the swap works both ways: the bank has already agreed to buy back the same dollars from the RBI at maturity, by returning the rupees (plus a small premium). So when these deposits start maturing over the next three to five years, the swaps will unwind, and much of today’s liquidity surge will drain back out just as it came in.
To boost India’s depleting forex reserves, driven by high oil prices earlier this year amid the West Asia crisis (remember, India imports nearly 85% of its oil requirements), the RBI wanted to draw in more dollars. So it took on the foreign exchange risk that banks would otherwise have had to hedge, reducing their funding costs. It is to be noted that the banks are protected against exchange rate risk on the principal of FCNR (B) deposits. Banks remain responsible for managing the foreign exchange exposure associated with interest payments.
The large conversion of dollars into rupees therefore injected a substantial amount of money into the banking system.
Is high liquidity good or bad?
High liquidity is neither inherently good nor bad. What matters is whether the amount of money available aligns with the economy’s needs. The strong response to FCNR(B) deposits is encouraging because it reflects confidence among overseas investors. But if the inflows leave banks with more cash than they can productively deploy, the surplus can create problems. A recent Morgan Stanley report expects excess liquidity to persist through March 2027 despite seasonal drains like tax outflows and government spending, keeping short-term rates under downward pressure.
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Prolonged low short-term rates could weaken RBI’s monetary policy transmission. To understand why, it is important to see how the RBI manages liquidity.
From deficit to record surplus
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LAF: RBI’s short-term liquidity management system
Banks can borrow or lend money either among themselves or with the RBI. When banks lend to or borrow from one another in the overnight market, the interest rate applicable is the Weighted Average Call Rate (WACR). When they transact with the RBI, the rates are determined under the Liquidity Adjustment Facility (LAF).
At the heart of the LAF is the repo rate, the RBI’s main policy rate. It is the rate at which banks borrow from the RBI against eligible government securities. When the RBI raises the repo rate, borrowing becomes more expensive, which can reduce loan demand and help control inflation. When it cuts the rate, borrowing becomes cheaper, supporting spending and investment.
But repo isn’t an always-open counter. The RBI decides in advance how much it wants to lend on a given day and offers this through a repo auction, usually held once daily at a fixed time. A bank needing funds outside that window, or once the day’s repo allotment is exhausted, cannot rely on repo. Nor does repo work the other way around; it gives banks no place to park surplus cash.
The LAF creates a corridor around the repo rate. The Standing Deposit Facility (SDF) forms the lower end (25 basis points lower than the repo rate), while the Marginal Standing Facility (MSF) forms the upper end (25 basis points higher than the repo rate). With the current repo rate at 5.25%, the SDF rate is 5%, and the MSF rate is 5.5%.
The idea is straightforward. The SDF is essentially the RBI’s deposit counter for banks. When banks have excess cash, they can park it with the RBI through the SDF and earn 5%. This gives them little reason to lend to another bank at a significantly lower rate.
When liquidity is tight, banks can normally borrow through the repo facility. But if they face an urgent shortage of funds, they can turn to the MSF at 5.5%. Unlike repo, the MSF isn’t rationed or limited to a fixed auction window; any bank can tap it at any time, for however much it needs. It costs more because it’s meant to be the last resort, not the everyday route. Since banks have this option, they are unlikely to pay substantially more than that to borrow overnight from another bank.
Thus, the SDF and MSF act as the lower and upper boundaries of the short-term interest rate (or LAF) corridor, while the repo rate sits in the middle. The RBI uses this framework to keep the WACR aligned with its policy rate.
How excess liquidity weakens monetary policy transmission
The RBI influences the economy largely by influencing the cost of money. The repo rate is its main tool. Normally, a change in the repo rate is gradually reflected in other interest rates—such as deposit rates, lending rates and bond yields. These changes then influence borrowing, spending and investment decisions. In effect, the repo rate is the RBI signalling what it wants the cost of money to be, and this “transmission” is that signal actually showing up in real-world rates.
But this process can become less effective when banks are sitting on large amounts of surplus cash. If banks have more money than they need, they compete to lend the excess in the overnight market. With almost every bank trying to lend and few needing to borrow, this competition pushes rates down rather than up. This can push the WACR lower towards the SDF rate.
That creates a problem for the RBI. It may be signalling a higher cost of money through the repo rate, while the market is effectively pricing money much more cheaply. In other words, the RBI’s intended rate and the rate banks are actually dealing at start to drift apart.
Sneha Pandey, Fund Manager, Equity, Quantum AMC, says prolonged excess liquidity can weaken RBI’s policy transmission by pushing money-market rates lower and distorting the pricing of instruments such as certificates of deposit and Treasury bills.
This matters even more when inflation is above the RBI’s target. In such a situation, the central bank wants its inflation-fighting stance to be reflected across the financial system. If market rates remain unusually low because of excess liquidity, that signal becomes less effective. The RBI may want borrowing to feel expensive everywhere to cool inflation, but if market rates are quietly drifting lower because of the cash surplus, the message will not go through as intended.
“With consumer inflation already above the RBI’s 4% target and the central bank itself projecting inflation to peak at around 5.9% in the third quarter of FY27, allowing call money rates to drift towards the SDF rate would send a signal that is inconsistent with the Monetary Policy Committee’s inflation-control objective,” Pandey says. The WACR stood at 5.04% on 9 September 2026, which is very close to the SDF rate, according to data compiled from Bloomberg.
RBI’s LAF corridor
Excess liquidity & investments
Equity: Excess liquidity generally supports stocks, although share prices are driven by many other factors, including earnings, economic growth, and investor sentiment. When banks and financial institutions have surplus cash, some of it can flow into financial assets through channels such as loans against shares, margin funding extended by brokers, and lending to Non-Banking Finance Firms (NBFC) that in turn finance investors. Lower borrowing costs can also reduce financing expenses for companies, providing another support to equities.
Debt: The impact can be more direct in the debt market. When more money is looking for investment opportunities, demand for bonds and other fixed-income securities can rise. Higher demand for bonds pushes their prices up and yields down.
Short-term debt funds: Liquid and ultra short-duration funds invest in instruments such as Treasury bills, commercial paper and certificates of deposit. Their returns are closely linked to short-term money- market rates. When liquidity is abundant and these rates fall, the yields available on new investments also decline. Over time, this can reduce returns for these funds.
Duration funds: Longer-duration debt funds are influenced more by interest-rate expectations and the RBI’s policy outlook than by short-term liquidity alone. However, sustained surplus liquidity can support bond prices. Here’s why: when the system is flush with cash, more money chases the same pool of bonds, and higher demand pushes bond prices up. As bond prices rise, the effective return, or yield, they offer actually falls. This is a well-known inverse relationship between bond prices and yields: when one rises, the other typically falls. Since these funds mainly hold bonds, and their NAVs rise when their bond holdings appreciate, a fall in yields translates into a rise in NAVs for duration-oriented debt funds.
Fixed deposits: Excess liquidity can hurt depositors as cash-rich banks have less incentive to offer high rates on new deposits.
Loans: For borrowers, surplus liquidity can mean cheaper loans.
RBI’s other tools to absorb liquidity
The RBI has several other tools to drain surplus money from the banking system.
Variable Rate Reverse Repo: Under VRRR auctions, banks can park surplus funds with the RBI for a specified period. The interest rate is determined through an auction. This allows the RBI to absorb liquidity for different periods—from overnight to several weeks—without making a permanent change to the banking system.
Open Market Operations: The RBI can sell government securities to banks and other financial institutions. When these institutions buy such securities, they pay the RBI, effectively taking money out of the banking system. This reduces the amount of surplus cash available for lending and investment.
Cash Reserve Ratio: The CRR is the portion of deposits banks must keep with the RBI. If the RBI raises the CRR, banks have less money available for lending and investment, making it an effective way to drain liquidity.
