Indian banks’ liquidity crunch is partly RBI’s own doing

For now, it is a relief that RBI has acted to ease the crunch. (Mint)
For now, it is a relief that RBI has acted to ease the crunch. (Mint)

Summary

  • The central bank is trying to address a market problem in which it played a significant role. The lesson is that prudential norms for banks—like their liquidity coverage ratio—should be calibrated to suit our own specific conditions.

The chickens are coming home to roost. That might seem an inappropriate statement to make in the context of a central bank. But it may uncannily be true of the Reserve Bank of India (RBI) today. Why? Because the liquidity tightness of the past few weeks that it is currently trying to address is partly, though not entirely, the consequence of its own proposed new rules on the liquidity coverage ratio (LCR) of banks. 

In July 2024, RBI had suggested that banks assign an additional 5% ‘run-off factor’—broadly, the portion of deposits kept handy to cover a surge in withdrawals—for retail deposits that can be accessed via internet and mobile banking. This category is further split into ‘stable’ and ‘unstable’ deposits, with the former’s run-off factor raised to 10% from 5% and the latter’s to 15% from 10%. 

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The rules, which are still in draft form, are set to take effect on 1 April. They will require lenders to set aside more money in high quality liquid assets (HQLAs), which serve as a buffer to meet unexpected demands for liquidity in case of disruptions.

No doubt, the intent behind the new draft norms is worthy. For two reasons. One, in accordance with the Basel III framework of the Basel Committee on Banking Supervision, banks are required to maintain sufficient HQLAs to meet 30 days’ net outgo of funds in stressed conditions. And two, because the greater use of digital banking platforms, be it an internet website or a mobile app, has exposed non-fixed deposits to quick and frequent retail withdrawals. 

Consider the snappy use of handsets to scan QR codes for UPI payments. Potentially, easy online transfers can de-stabilize banks. That’s on paper. However, it is important to adapt the Basel norms to India’s own situation. In a scenario where our banks maintain both a cash reserve ratio of 4% and a statutory liquidity ratio of 18%, the case for an overly strict LCR is weak. Especially since banks in India depend on retail rather than wholesale deposits, which means that the kind of collapse witnessed in the case of US-based Silicon Valley Bank in 2023 is highly unlikely, if not impossible.

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Inevitably, with banks moving to fall in line with tighter LCR guidelines, liquidity has been drying up within the country’s banking system. This forced RBI to announce a host of measures this week to inject liquidity. 

Collectively, these measures—bond purchases, longer-term variable rate repo auctions and dollar/rupee swaps—are expected to infuse about 1.5 trillion and ease the liquidity crunch in banking that had pushed up overnight and short-term lending rates. A variable rate repo auction is slated for 7 February 2025, soon after the budget and coinciding with Sanjay Malhotra’s first Monetary Policy Committee meeting as RBI governor. By then, what the government’s borrowing programme implies will be clear. 

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For now, it is a relief that RBI has acted to ease the crunch. After all, the system’s liquidity deficit had reportedly widened to a one-year peak in the previous fortnight. This was not a surprise. 

It is estimated that banks may need to buy a sizeable chunk of additional government securities to meet RBI’s new LCR norms. They have already expressed their apprehension to both the central bank and finance ministry that the revised rules would constrain their ability to lend; they have also sought a deferral of their implementation. Their plea deserves a hearing.

 

 

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