Liquidity is one of the crucial components of any banking system. To articulate its importance, it is safe to say that any bank’s growth, development, and survival depends on the liquid assets it holds. These assets are crucial to efficiently perform their daily obligations such as meeting depositors’ demands or withdrawals, settling wholesale commitments, and provision of funds when borrowers draw on committed credit facilities. If they fail to meet their commitments, banks stand the risk of being declared illiquid.
In India, banks are expected to keep sufficient funds with them to meet their short-term demand. If banks are unable to meet this demand, RBI steps in temporarily to avoid any kind of disruption in consumer needs.
During the pandemic, the Indian banking sector saw an excess supply of money on account of the cash pumped by RBI and a fall in credit requirements. Banks usually preferred to fund their short-term liabilities through money market instruments. Post-pandemic, the situation reversed and banks saw a potent boost in demand for credit. With RBI focusing on curbing the spiralling inflation and depreciating rupee, options for raising cheaper funds have dried up. Other than credit requirements, banks are also required to cushion their capital position so that they are prepared for any ‘worst case scenario’. This could happen if they experience sudden unexpected cash outflows by way of large deposit withdrawals, unanticipated market movements, or crystallisation of contingent commitments. The other cause may be some other event causing counter-parties to avoid trading with or lending to the bank.
Current Scenario
After 40 months, the liquidity in Indian banks has shifted from surplus mode to deficit mode. This happened largely on account of the GST and advance tax payments along with the foreign exchange outflows borne by the banks. The liquidity adjustment facility (LAF) that allows banks to borrow through repurchase agreements, reported that surplus liquidity reduced to ₹2.3 lakh crore during August – September 2022 in comparison to ₹3.8 lakh crore from June-July 2022.
This huge disbursement is largely due to the sale of Financial reserves by the RBI to cushion the fall of the Indian rupee. The government plans to maintain the balance of payment (BoP) gap by selling forex reserves will lead to further tightness of liquidity in the market.
Looking further, with the onset of the festive season, banks expect to witness an increased number of cash withdrawals and credit transactions. To prepare for such a situation, they are likely to take money from the central bank at the repo rate. Moreover, they also tend to invariably raise the deposit rates for the customers, which does benefit the depositors and also mobilizes more deposits. But the real challenge is the gap between deposit growth and loan interest rates, with both standing at a difference of good 600 basis points. With the growth rate for loan at 16.5% and deposit rate at 9.5%, the gap between the two is now at a 10-year high gap.
To control the current deficit situation and to soften call rate money, RBI made one of the biggest financial infusions of about ₹21,873 crores into the banking system. Following a review, RBI also facilitated a recourse to the marginal standing facility (MSF) by banks and liquidity injection through 14-day variable rate repo (VRR) auctions. This temporary moderation of surplus liquidity is seen in the context of the large potential liquidity in the system arising from the expected pick-up in government spending that usually happens in the festive season of the year.
Way forward
Currently, it is too soon to predict a correct path for the future as there is still no clear indication if the deficit situation will persist for a longer period. Necessary action by RBI is salient as:
•A tight liquidity condition could cause a rise in the yields on government bonds and securities, which would then lead to an increase in the interest rates for consumers
•The short-term rates would increase at a faster pace causing short-term lending to be more costly
•An increase in repo and bank rates would result in banks increasing their repo-linked lending rates and their funds-based lending rate, to which consumer loans are linked to
However, in a statement made by RBI on 30 September 2022, the repo rate has been increased by 50 basis points to 5.90 percent. This was done as a response to two issues: first, skyrocketing inflation, and second, the spillover risks from the aggressive monetary policy stance of major banks in the country. With the RBI actively draining liquidity in order to combat unbridled global inflation and credit growth at multi-year peaks, funding options for the Indian banks are looking dreary.
Looking at it with a temporary outlook, RBI plans to fine-tune its operations of various maturities for absorption as well as injection of liquidity from time to time. Some of the desired actions are to draw down the SLR and bank & repo rates, decrease the marginal standing rate and increase spending on government projects as and when required. All of these activities will increase the supply of money in the economy, ensuring that banks have enough liquid assets to meet their short-term obligations, especially in a high-demand festive season.
THE ECONOMICS CLUB IMI 