Home >Market >Mark-to-market >RBI is a seat belt for liquidity, not the driver

The liquidity deficit of the banking system has widened in the last two months and is now estimated to be over 1 trillion. This has triggered demands that the Reserve Bank of India (RBI) should fix the current liquidity crisis. The argument is that the central bank is the lender of the last resort and, therefore, should leave no stone unturned in making money available in times of deficit.

Some of the demands were that RBI should provide funds to NBFCs through a dedicated window, buy more government bonds from the market to infuse money and even cut the cash reserve ratio.

But before we examine the solutions, here is a look at the problem first.

The leakage through cash, or in other words currency with the public, has grown 23% from a year ago. Another drain on the banking system’s liquidity is of credit growth far outstripping deposit growth. As of 9 November, credit had grown 14.9% from a year ago, while banks were able to mop up just 9.1% more deposits than they did a year ago. RBI’s own forex intervention has sucked out close to $18.7 billion (roughly 1.3 trillion) from the banking system between April and September.

Clearly, the stock of liquidity has ebbed and it is not at the neutral level envisaged by RBI. To that effect, the central bank needs to infuse funds into the banking system, which it has. RBI has infused 1.29 trillion into banks so far in the current fiscal year by buying government bonds from them. It has reiterated it would buy more, if needed.

By giving the option to borrow from its various repo tenders, RBI provides the necessary seat belt for banks for their daily manoeuvres on liquidity. It even gives long-tenure money through term repos. For durable liquidity, it takes sovereign bonds off the books of banks and gives them cash.

The current liquidity crisis is not just of stock, but also of flow. The blow to the sterling image of non-banking financial companies (NBFCs) has made them unworthy of credit in the eyes of banks. Capital markets are willing to lend, but the price of trust is steep here.

Thus, the flow of money from one agent to another has been blocked. At such times, the central bank can only prod the agents through incentives to restart the flow. It has done this by allowing banks to give partial credit enhancements to bond issuances of finance companies.

While demands for doing more are not unusual, asking RBI to take on the credit risk of non-banks, by giving them a direct line to funds, would be akin to taking on the driver’s seat. Guaranteed money tends to manifest into slack risk assessments and it could be dangerous in this case. RBI is justified in allowing NBFCs to find their own feet in this liquidity crisis through discipline and consolidation.

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