Corrected: Finance ministry calls banks to discuss new facility to drain cash

(Corrects to clarify "Finance ministry" instead of "Finance minister" in the headline)

By Suvashree Choudhury and Devidutta Tripathy

MUMBAI (Reuters) - The finance ministry has called bankers into a meeting on Friday to discuss setting up a new facility to absorb surplus cash in the banking system, according to a letter sent to heads of lenders seen by Reuters on Thursday.

The finance ministry wants to discuss implementing a new framework called a "standing deposit facility", the letter said, that would drain surplus cash at a rate lower than the repo rate without the need for any collateral.

The cash would be deposited with the Reserve Bank of India, and revives a proposal issued by the central bank in 2014 as another way to drain funds.

If implemented, the plan would resolve a major headache facing Indian regulators: how to reduce a surge in cash deposits since Prime Minister Narendra Modi banned higher-value notes in November.

Those cash deposits have resulted in liquidity rising to around 4 trillion rupees ($61.13 billion) in March from 2 trillion in January.

That amount of cash had raised concerns about inflation at a time when the RBI is seeking to prevent rising prices by changing its policy stance to "neutral" from "accommodative."

Bonds fell sharply after Reuters reported the plan, with the benchmark 10-year government bond yield up five basis points at 6.83 percent, as it could tighten cash conditions in markets.

The Finance Ministry said it was calling the meeting with bankers to address "the absorption of surplus liquidity from the system, but without the need for providing collateral in exchange," according to the letter.

A Finance Ministry spokesman declined to comment.

By offering a rate below the repo rate, the regulator could also be looking to encourage banks to lower their lending rates, which in India track short-term money market rates.

In a potential boost to an economy struggling to revive private investments, banks have cut their lending rates by around 80 basis points since Modi's shock move resulted in the surge in deposits,

Banks would need to incorporate the rate offered by the RBI into calculating its lending rate under India's complex rules, though lenders typically have leeway in how they arrive at a final borrowing cost.

At the moment, the RBI removes funds through various facilities, including mandating banks to park excess certain types of cash and deposits with the central bank as well as through repos and reverse repos based on market rates.

But using a "standing deposit facility" would differ by not requiring collateral and by determing a set rate.

"If the RBI drains cash at a lower rate than the repo rate then effectively all (short-term market) rates will converge to that rate, and therefore, help banks to lower their lending rates as well," said a senior bank treasury official.

($1 = 65.4375 Indian rupees)

(Editing by Rafael Nam and Kim Coghill)