Nuances of management of liquidity in banks

Dr. Kembai Srinivasa Rao, Former Director, NIBSCOM

It is evident that the onset of the pandemic crisis led to RBI pumping ample liquidity using conventional and non-conventional tools and reducing policy rates to a new low. Loans were made cheaper and government guaranteed loans too were made sufficiently available. Opening new accommodative windows – permitting restructuring of loans, granting moratorium on loan repayments for 6 months, putting Kamath committee to work for restructuring bigger corporate sector loans and many more measures were meant to maintain financial stability during unprecedented pandemic times.

These timely measures nursed the economy even during most critical phase of the crisis and suffering of entrepreneurs was reduced. Subsequently, the pandemic led dislocations, supply chain blockades exacerbated by the geopolitical risks – Russia – Ukraine war, sanctions and its consequences, climate risks heightened inflation headwinds and truncated growth and added woes of unemployment in a big way breaking historic records in major economies. The interconnectedness led to fall in international trade due to sanction led restrictions and embargos.

1. Impact of easy money policy:

The two years of easy money regime raised inflation in many economies as supplies depleted in different geographies, price of inputs increased due to lockdowns and supply side interruptions. It led to many central banks taking proactive measures by different countries in different ways to tackle internal woes.

As a result of domino impact of such adverse external sector and internal domestic headwinds, the CPI inflation in India too touched a new high of 7.79 percent in April 2022 against the upper target of 6 percent and WPI reached a scary level of 15.08 percent in April prompting the central banks to intensify its fight against inflation. RBI therefore went for an off-cycle policy intervention on May 4, raising repo rate by 40 basis points marking the beginning of fight against the fiery inflation.

In response to these adversities, the liberal monetary and fiscal policies followed in the last two years began to get realigned to fight inflation and restore balanced growth. Raising interest rates, going beyond stopping infusion of fresh funds through nonconventional liquidity windows, RBI had to start absorbing liquidity as part of normalisation. Moderating supply side windows and opening liquidity absorbing windows have been on aggressive mode to unwind liquidity. In the same league, RBI raised cash reserve ratio (CRR) by 50 basis points and it earlier introduced standing deposit facility (SDF) for non-collateralised absorption of liquidity.

2. State of liquidity:

In nutshell, RBI pumped liquidity through various policy interventions of the order of Rs. 17.2 lakh crore of which Rs.11.9 lakh crore was utilised. Till April, Rs. 5.0 lakh crore has been returned to RBI or withdrawn on the lapse of various facilities on their due dates. The extraordinary liquidity measures undertaken in the wake of the pandemic, combined with the liquidity injected through various other operations of the RBI have left a liquidity overhang of the order of Rs. 8.5 lakh crore in the system. The RBI began to engage in a gradual and calibrated withdrawal of this liquidity over a multi-year time frame in a non-disruptive manner beginning the current year. The objective of RBI has been to restore the size of the liquidity surplus to a level consistent with the prevailing stance of monetary policy, so that it does not push inflation up. At the same time, RBI had been mindful to ensure availability of adequate liquidity to the financial entities to meet the productive requirements of the economy. As banker to the government, RBI is also to remain focused on completion of the borrowing programme of the Government to monetise the deficit and for the purpose monitor yields on government bonds. RBI therefore had to balance liquidity, interest rates and yield on government securities.

Amid the new dear money policy, liquidity management is characterised by two-way operations of the central bank, (i) through variable rate reverse repo (VRRR) auctions of varying maturities to absorb liquidity and (ii) variable rate repo (VRR) auctions to meet transient liquidity shortages and offset mismatches.

Average surplus liquidity in the banking system – reflected in total absorption through SDF and VRRR auctions – amounted to Rs 7.5 lakh crore during April 8-29, 2022. The large liquidity overhang in the form of daily surplus funds parked under the SDF (average of Rs.2.0 lakh crore during April 8-29, 2022) has resulted in the weighted average call money rate (WACR) – the operating target of monetary policy – dipping below the SDF rate. When RBI has moved from providing liquidity to absorbing liquidity, it will impact the treasury operations of banks.

3. Impact of liquidity absorption:

With the shift of liquidity management strategies of RBI to fight inflation, banks will have to gear up to alter their internal asset liability management (ALM) approach. It is also clear that interest rates in India will further rise during FY23. It can be recalled that RBI began to reduce repo rates even before the pandemic to boost the economic growth. Repo rate was cut by 250 basis points from February 2019 to May 2020 and the hiking policy rates began only on May 4, 2022. In response, banks began to raise their term deposit rates and marginal cost of funds-based lending rates (MCLR) on loans to reprice their assets and liabilities. There is an uptick in uncollateralized money market rates too influencing the costing of banks.

There has been a spurt in call, notice and term money market rates after RBI triggered the rate hike and pressure of liquidity reversal was felt. The collateralized segment too witnessed changes in the pattern. So much so that the response to the 14-day VRRR (collateralised) auctions was far less than the SDF though banks had an arbitrage advantage. The cut off of VRRR was 4.39 percent and SDF (Non-collateralised) is at 4.15 percent. But banks opted to place surplus funds under SDF and not in VRRR with the apprehensions that there could be demand for liquidity and it is desirable to hold funds under overnight options under SDF instead of blocking funds for longer duration. At the same time, due to renewed demand for bank credit, banks had to augment resources to increase lending capacity particularly when deposit growth is falling and borrowings costs are rising. Banks are increasingly exposed to asset liability management (ALM) risks. Banks have to shift their focus on deposit mobilisation by further raising term deposit rates and shore up their capital base to be in better readiness to cope with the new dear money regime.