The treasury head of a large public sector bank told me last week that the liquidity crunch is no threat to a bank’s business of giving loans or investing in government and private bonds and making money. Theoretically, a smart banker can earn a cool risk-free return of 1% to 3% even in these days when the system is running a deficit of at least 1 trillion daily.

This is possible by arbitraging between the Reserve Bank of India’s (RBI) repo window through which the Indian central bank gives money to cash-strapped banks and investing the money in the government’s short-term treasury bills or debt instruments such as three-month commercial papers of corporations. One can raise money at 6.25% from RBI and invest in a three-month treasury bill at 7.20% or a commercial paper of similar maturity at around 9.5%.

Of course, the money that banks raise from RBI is ultra-short, overnight money but banks can rollover the fund continuously to support a three-month asset, particularly when they are certain that the liquidity crunch is here to stay and RBI will not close its repo window anytime soon.

Also Read Tamal Bandyopadhyay’s earlier columns

Since June, banks have been borrowing from RBI and they will continue to do so till the end of the current fiscal ending March 2011 as there is no sign of the system being flush with liquidity. Theoretically, it is possible to earn a virtually risk-free return even when banks do not have enough cash in their kitty, the treasury head argued.

No prudent banker should use one-day money to create a three-month asset, but anyone may get tempted to do this, particularly when one is assured that the one-day money will not dry up and the window will remain open for months. Banks need to offer government bonds as collateral to get money from RBI and they have these bonds in plenty. They are required to invest 24% of their deposits in government bonds, known as statutory liquidity ratio (SLR), and excess SLR holdings can be used to borrow from the regulator.

Currently, the banking system has at least 28% of deposits invested in government bonds. Since RBI has allowed banks to keep their SLR holdings as low as 23% for the time being, they can use 5% SLR holdings as collateral to borrow money. This roughly translates into 2.5 trillion.

The Indian financial system is going through a peculiar phase with liquidity scarcity driving banks’ loan rates and not the policy rates. In the past few weeks, most banks have raised their prime lending rate, or the rate at which they are expected to lend to their best borrowers, to 13.25-13.5%, something that was last seen in July-August 2008, ahead of the collapse of US investment bank Lehman Brothers Holdings Inc. that led to an unprecedented global credit crisis.

At that time, RBI’s policy rate was 9% and the inflation rate was in double digits. Now, the policy rate is 6.25% and the inflation rate moderated to an 11-month low of 7.48% in November.

The gap between RBI’s policy rate and banks’ loan rate is wide and can get wider if the pressure on liquidity doesn’t ease. One can say that RBI doesn’t need to raise its policy rates any further; as long as there is a liquidity crunch, there is no need to raise the rates as scarcity of money will continue to drive up the effective cost of cash for consumers. The cost of a one-year certificate of deposit that paid 6% in April, 8% in September and is now 9.6%.

But this cannot continue for long and RBI knows this pretty well. Which is why its December review of monetary policy has focused on easing the pressure on liquidity.

A 1 percentage point cut in SLR will not make any material difference as banks have already been allowed to keep a lower SLR holding, but its plan to buy back bonds worth 12,000 crore every week for four weeks will infuse 48,000 crore and bring down the cash deficit in the system to some extent. (There is a catch though. Since bond prices are going up and yields down, banks may not like to sell bonds to RBI booking losses.) Once a semblance of normalcy returns to the system, RBI is likely to raise rates again as it continues to be bullish on economic growth and hawkish on inflation. This can happen as early as January. If the liquidity situation doesn’t improve by then, RBI may wait for its next review as it’s fairly certain that inflation will continue to remain high and above its comfort level and there is nothing in the horizon that suggests the growth story is under strain.

RBI has very few choices. The threat of inflation is real and it cannot afford to let the scarcity of liquidity dictate the rate trajectory for long as that will create chaos in the market. At the same time, it cannot take any permanent measure to ease the pressure on liquidity. A cut in banks’ cash reserve ratio, or the portion of deposits that banks need to keep with RBI, would have released money into the system but it will eventually stoke inflation. A cut in SLR doesn’t infuse cash; it merely helps banks redistribute their assets as, instead of buying bonds, they can use the money to give loans.

The policy rate cannot continue to remain below the inflation level for long and the gap between the policy rate and banks’ loan rate cannot widen much.

One could expect RBI to raise its policy rate in phases to at least to 7% next year. Since January it has raised its repo rate by 1.5 percentage points to 6% and reverse repo, or the rate at which it sucks out liquidity from the system, by 2 percentage points to 5.25%.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to

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