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Currently, the government parks all its excess cash with the RBI.
Delays and cuts in government expenditure early this year as the government sought to rein in its fiscal deficit had forced banks to borrow about Rs 1 trillion daily from the central bank for much of 2013.
The cash balances will be placed with banks against government bonds as security, an arrangement similar to the RBI's repo auction window, where banks borrow at the repo rate of 7.25% against gilts, the officials said, declining to be identified as they are not authorised to speak with media.
While the RBI has been trying to convince the government to auction its cash balances for the last two years, New Delhi agreed to it only in April after banks complained about their constraints over easing lending rates due to tight cash despite the RBI's policy rate cuts.
"The overnight auctions will help banks manage flows better, and it will smoothen out the volatility," one of the officials said.
The measure would also take pressure off the RBI to buy bonds through open market operations, which are inflationary.
It is yet to be decided whether the government will want to sell all of its balances, or whether it will be a fixed rate or a variable rate auction.
"It can be either multiple rates, where a large part of the balances go to the best rate, followed by the next best rate, and so on," the official said.
The proposal is awaiting final government approval, the sources said.
Now, up to Rs 50,000 crore of government cash surplus is invested in government bonds and any amount above that stays with RBI without earning any interest.
Reuters reported in April that India was considering cash balance auctions to make monetary policy more effective and encourage banks to cut lending rates.
The government does not disclose its cash balance, which creates market uncertainty over cash conditions. The RBI has often expressed worry over managing fluctuating market liquidity caused by lumpy cash balances.
