Mumbai: Tucked away in Page 8 of the Reserve Bank of India’s (RBI’s) 11-page latest monetary policy is a proposal that could shake up short-term fund-raising by banks and liquid mutual funds.

The first monetary policy of 2015-16, announced by RBI governor Raghuram Rajan on Tuesday, proposes to throw open the government bond market to retail investors. The move, aimed at deepening the bond market dominated by banks and financial institutions, could choke off some short-term deposits of banks.

How would it work? As of now, retail investors are allowed to buy government bonds, but only through banks and mutual funds. Once the proposal takes effect, they can freely and directly buy and sell over RBI’s bond trading platform, without involving any intermediary.

Generally, retail investors who need funds at short notice, or high networth individuals, park their surplus money in short-term bank fixed deposits (FDs). However, government bonds of similar tenure offer much higher interest rates, an irresistible attraction for retail investors. This means banks that typically raise cheap, short-term funds through short-duration FDs must raise those rates to keep the short-term depositors interested.

“It may have a huge impact for intermediaries like banks and liquid mutual funds. The bank rates offered for short-term deposits are often less than the reverse repo rate, while the treasury bills have yields matching repo rate," said Soumyajit Niyogi, an analyst at SBI DFHI Ltd, a primary dealer that deals with government bond auctions.

Treasury bills are short-term government bonds maturing in less than a year.

For example, interest rates for 7-45 day deposits at State Bank of India, ICICI Bank Ltd and HDFC Bank Ltd range between 3.5% and 5%, but a one-month treasury bill gives an interest rate of 7.8% while the three-month one gives 7.85%.

The reason why retail investors are not much interested in the bond market could be the complicated entry barriers and lack of small lots to trade. The market, dominated by institutional investors, trades in a minimum lot size of 5 lakh and a retail investor may not even get sellers offering small numbers of securities.

However, once RBI finalizes the rules, any investor with a linked demat account can probably trade even in a single bond, which could buoy several illiquid bonds neglected by institutions, bond traders said.

That’s not all.

Retail investors will also get to participate in a so-called non-competitive bidding to invest in treasury bills.

In non-competitive bidding, a person can bid for dated government securities without quoting the yield or price. The bidder will be allotted securities fully or partially, even if the bid doesn’t match others. This option, currently open only in dated government securities (with tenure more than a year), will be extended to short-term treasury bills as well, making it easier for potential bond buyers.

Top ratings of government bonds will be an additional attraction, said Niyogi, adding “banks may have to really slog it hard to get short-term resources once retail investors get direct access to treasury bills".

Bank depositors have other reasons to look at the bond market as well.

A bank deposit cannot be liquidated at a short notice without some form of penalty, but selling securities in the market costs nothing. Also, income from FDs attracts a 30% tax, while that from treasury bills will attract only a short-term capital gains tax of 20%.

However, not all are convinced that banks will find it difficult to raise short-term funds.

“The rates on offer by banks is low now because of comfortable liquidity. Once banks face a liquidity crunch, the interest rates will go up," said N.S. Venkatesh, head of treasury at IDBI Bank Ltd and chairman of Fixed Income Money Market and Derivatives Association of India. “It is indeed a fact that some high networth individuals may try this, but in the long run, the arbitrage opportunity will shrink and government bonds will offer far less in yields than what it is now," he said.

“But of course, if more investors come in the segment, there will be more stability in the market and the market will not have a unidirectional movement," added Venkatesh.

Broadbasing the bond market participants was mooted in the Financial Sector Legislative Reforms Commission Report of 2008, which was headed by current RBI governor Rajan.

However, the Jehangir Aziz committee report on public debt management had proposed that the government’s liquidity should be sourced through money market instruments, in line with international best practice.

But Niyogi of SBI DFHI is convinced that the treasury bills will still have an edge. “Imagine a situation like in July 2013 when 91-days treasury bill jumped to 11%. No financial intermediary will be able to offer that much of risk-free return to its customers," he said.

In such a case, banks will have to hike their short-term deposit rates. And if the banks are pushed to calculate their lending rates based on incremental cost of deposit, rather than the average cost, as proposed in the monetary policy, then the lending rates will harden as well.

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