Indian banking is facing a peculiar challenge of liquidity imbalances. There are banks (large private sector banks, mainly) that are willing and able to lend and there are others (government owned) that are either unable to due to regulatory restrictions or are unwilling by choice to lend. As a result, we see incrementally credit deposit ratios of the lending banks exceeding 1 and those of the credit-shy banks below 0.5. What this means is that some banks are lending more money than they are raising through deposits, while others are not lending, and instead buying government securities.

This is not just a temporal issue but a structural one. It arises from the fact that market shares of banks on the credit side are far more fungible than those on the deposit side. Government-owned banks are losing their share of the loans business much more rapidly than the deposits. This is exacerbated by regulatory restrictions that have been imposed on several banks under the so-called preventive corrective action (PCA) rules. If the current situation continues, there may come a point where some banks are willing to lend but cannot due to lack of liquidity or excessive cost of liquidity, and some other banks have liquidity that they do not or cannot use for lending. For the banking system and the economy, this is a worrisome prospect.

How do we solve this? The simplest and obvious solution is to get the banks that are currently not lending, but have liquidity, to start lending again. But this has several challenges—shortage of capital, regulatory constraints, lack of confidence, and so on. These challenges are unlikely to be addressed soon. We then have to look at other means to address the liquidity imbalances.

The solution would entail moving money from liquidity-surplus banks (mainly deposit-gathering state-owned banks that have stopped or drastically reduced lending) to liquidity-deficit banks (mainly private banks that can lend). Currently, resources can move between banks through several mechanisms. At the shortest maturity, there is the interbank call money market where banks can lend to each other for up to 14 days. There are other mechanisms such as the inter-bank participatory certificates (IBPCs) and securitization that results in one bank essentially funding the loan books of another. But both IBPCs and securitization are narrow instruments that are used sparingly under specific circumstances. Hence, they are not helpful in resolving the structural imbalances in liquidity.

What we need is a set-up where liquidity-surplus banks will be able to lend to liquidity-deficit banks for terms of two to three years or more; much longer term than the 14-day lending in the interbank call money market. This is what I call the interbank term money market. Developing such a market will help structurally address the liquidity imbalances.

Currently, regulation restricts all interbank lending to three times the net owned funds (book capital) of banks. This is a fairly generous limit. However, we still do not see banks term lending to each other. The main impediment is the reserve requirements. If a bank lends to another for a period longer than a reporting fortnight (14 days), then this loan becomes a part of net demand and time liabilities (NDTL) for the borrowing banks on which it will have to maintain reserves—statutory liquidity ratio (SLR) and cash reserve ratio (CRR). These reserves dramatically increase the cost of such loans for the borrowing bank. Consequently, almost all interbank lending is restricted to a maturity of up to 14 days. The reserves are a major impediment to the development of an interbank term money market.

Hence, the solution is to remove this impediment. We need the interbank lending to be exempt from NDTL for the borrowing bank. Note that the lending bank has already provided reserves on this money when it took deposits. What we are avoiding is double incidence of reserves. This exemption can be extended up to the overall limit on interbank lending (three times net owned funds) that operates today.

In this set-up, the liquidity-surplus banks will have a choice of deploying their surplus liquidity into holding of government securities as they do today or lend it for a longer term to other banks. Every bank will make this choice based on its own circumstances and preference. As this lending is for a longer term, it will remove the liquidity imbalances in a structural sense.

A collateral benefit of such an interbank term money market will be a much more robust and well-behaved yield curve. In the last few months, the yield curve has gone haywire, making liabilities management very hard for companies, especially non-banking financial companies. A well-developed interbank term money market could smoothen liquidity imbalances, not just across entities, but also across maturities, and result in a more stable and well-behaved yield curve.

Sustained recovery in the Indian economy depends crucially on the banking system getting back to lending. Currently, almost half of the lending capacity of Indian banking is closed as many banks are unable or unwilling to lend. Liquidity imbalances, if not addressed soon, could add to capacity shortage. Developing an interbank term money market is a critically important step in this direction.

Harsh Vardhan is an executive-in-residence at the Centre for Financial Services of the SP Jain Institute of Management Research.

The author is thankful to M.B. Mahesh of Kotak Securities and Prof. Ananth Narayan for useful discussions.

Comments are welcome at theirview@livemint.com.

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