For years now, different financial market participants and regulators have all talked past each other on the subject of “rupee liquidity”. Rupee liquidity is a lubricant for the economy that also impacts foreign exchange markets, monetary policy transmission, and lending incentives of financial institutions.
Given the critical role it plays in financial stability, we need a comprehensive rupee liquidity framework that ties in with monetary, currency and macroprudential policies.
To help build such a framework, in this piece, we examine what “rupee liquidity” means to different stakeholders.
In the sequel to this piece, we will draw an inventory of tools available to manage rupee liquidity and suggest a framework to determine which tool to use under what circumstance.
The Blind Men And The Liquidity Elephant
Different stakeholders such as the
Reserve Bank of India (RBI), banks, good borrowers and stressed borrowers often mean different things when they speak of “rupee liquidity”. The RBI viewpoint
The RBI has so far evaluated rupee liquidity by focusing on the Weighted Average Call Rate (WACR) at which banks borrow and lend overnight funds amongst themselves. Since WACR has largely been well-behaved and close to the RBI policy rate for a while now, the central bank has often struggled to appreciate why markets constantly complain about rupee liquidity.
Before we come to the banker’s perspective of liquidity, let’s understand what it means to say that the banking system is “short of liquidity”, say by Rs 1 trillion.
As on date, the banking system holds deposits of about Rs 125 trillion. Banks need to keep 4 percent of this, or about Rs 5 trillion, with the RBI under statutory Cash Reserve Ratio (CRR). They also need to hold government bonds of around Rs 31 trillion for Statutory Liquidity Ratio (SLR) and Basel Liquidity Coverage Ratio (LCR).
If the banking system is “short of liquidity” by Rs 1 trillion today, that implies that before taking corrective action, the banking system expects to end with only Rs 4 trillion as CRR with RBI, instead of the statutory Rs 5 trillion.
This isn’t a problem, because banks today also hold Rs 34 trillion of government bonds, Rs 3 trillion more than the statutory Rs 31 trillion required. They can meet the CRR shortfall by effectively borrowing Rs 1 trillion from the RBI against Rs 1 trillion of excess bonds, through short-term “repo” transactions.
This isn’t “lazy banking” where banks are borrowing from RBI rather than raising customer deposits – systemic banking liquidity status is largely determined by the central bank using the many tools at its disposal. As a corollary, RBI would simply not allow a situation where the banking system is simultaneously short of CRR and has inadequate surplus bonds to fill the CRR shortfall.
Banks can raise funds via RBI repos at or close to the policy repo rate. As a result, WACR is also usually close to the repo rate, irrespective of the size of banking liquidity shortfall.
When bankers fret about liquidity, therefore, WACR is not really their concern, nor is the fear that statutory CRR might not be met.
Banker’s Perspective On Liquidity
The liquidity concern for banks is usually around asset-liability mismatches.
Running a “negative asset-liability gap”, or using short-term deposits to fund long-term loans, involves the liquidity risk that funds may not be available to the bank when its deposits mature. There are strict regulatory limits on the liquidity gaps that banks can run.
Market rates such as WACR or bond yields are irrelevant to such liquidity risks.
Lending banks are constantly looking for durable deposits so that they can lend to their clients without breaching liquidity limits.
Over the past few years, banks have struggled to raise adequate durable deposits.
For one, clients can obtain better tax-adjusted returns from mutual funds and small saving schemes, than from bank term deposits. While funds placed with any financial institution eventually flow into the banking system, these are not as durable for individual banks as regular bank deposits.
In addition, regulatory liquidity risk limits such as Basel LCR have been tightened over the years. This has left the banking system requiring more durable deposits than ever before.
In this context, having a persistent banking liquidity shortage transmits higher interest rates.
Consider a large private sector bank that currently offers 7.40 percent for durable 1-year fixed deposits and holds surplus 1-year government T-bills yielding 6.40 percent. If it is also constantly short of CRR, it would much rather sell the T-bill and effectively release 1-year money at 6.40 percent, rather than continuously raise overnight money at the repo rate.
In summary, under consistent banking liquidity shortfall, individual banks would focus on raising deposits and selling bonds, rather than borrowing short-term repo funds or giving out term loans. This would keep term yields high across bonds, deposits and loans.
The Good borrower’s Perspective – Where’s My Rate Cut?
When good quality borrowers moan about liquidity, they usually refer to high borrowing costs.
Transmission of lower rates can be helped by surplus systemic banking liquidity.
In today’s context, if the banking system ended with a CRR balance of Rs 6 trillion against the statutory requirement of Rs 5 trillion, banks would have to dump the excess Rs 1 trillion with the RBI at a very low reverse repo rate of 6 percent.
Individual banks would then rather buy 3-month government T-bills at 6.3 percent, or give loans to clients at higher yields than lend overnight money to the RBI at the 6.0 percent reverse repo.
In summary, keeping the banking system in constant liquidity surplus, even by a small amount, is a powerful carrot to incentivise individual banks to buy bonds, give loans, and ensure transmission of lower rates, consistent with an accommodative monetary stance.
Conversely, as described earlier, keeping the banking system liquidity consistently short is a good stick to force banks to raise lending rates, consistent with a tight monetary stance.
In essence, the banking liquidity status is a powerful transmission adjunct to the monetary policy committee's (MPC) stance.
The Stressed Borrower’s Perspective – Water, Water Everywhere
Finally, when stressed borrowers refer to liquidity problems, their real issue revolves around their credit worthiness.
In fact, trying to address funding for stressed sectors by infusing surplus banking liquidity can be downright dangerous.
As discussed, a consistent banking liquidity surplus is a powerful carrot for banks to give out customer loans. If this collective chase for assets and yields leads to systemwide compromises on credit and risk standards, we could severely risk financial stability.
In the short run, banking liquidity can be an expedient palliative for credit stresses. But such palliatives at best help kick the can down the road. Unless accompanied by tougher, deeper correctives such as asset restructuring, policy reform and asset recapitalisation, surplus liquidity alone can eventually lead to even more severe financial instability.
The RBI has multiple tools to manage overall banking liquidity. In part II of this piece, we will catalog the various tools, the duration of their impact, and their inevitable side-effects. We will then suggest a framework to help determine the liquidity objectives of the system and choose the right mix of tools to achieve these, with acceptable side-effects.
Read the second part here. Ananth Narayan is Associate Professor-Finance at SPJIMR.