Term Repos and the Development of the Money Market in India

After explaining how overnight Repos work in the last couple posts, in this post, I'm going to talk about RBI's move towards "Term" Repos in their endeavour to develop and deepen India's money market. 

Unlimited access to cheap funds from RBI till Mid-2013

Under the RBI’s Liquidity Adjustment Facility (LAF), banks had unlimited access to cheap funds through overnight repos till mid-2013. As a result, instead of raising short-term money through deposits, or borrowing in the inter-bank call market or through other money market instruments, banks would end up borrowing most of what they needed from the LAF overnight window at the fixed Repo rate set (7.25% currently) by the RBI. Why bother with anything else when you could get the cheapest funds here?

Why was this a problem?     

• Thwarted the development of money market yield curve: Being able to borrow an unlimited amount of overnight funds through the LAF window meant that banks could borrow overnight, and meet longer-term liquidity and funding needs by rolling over the repo collateral. In effect, they were borrowing longer-term funds at the overnight rate. This is a problem because when banks don’t need to borrow for longer terms (7 days, 14 days, 28 days and so on), they don’t learn how to price risk for such maturities which means they don’t understand how much interest to pay for such maturities. This thwarts the development of a money market yield curve (“Yield curve” is simply a graph where the yield of fixed-interest securities is plotted against their maturity) which is never a good thing. A deep, mature money market requires there to be an organized, developed and liquid market for instruments of various maturities where participants can confidently transact at rates/yields that move within a tight range.

• Banks using LAF to fund credit growth: Banks were using cheap overnight LAF funds for driving credit growth, rather than focusing on accelerating deposit growth in order to drive their credit portfolio. It was a no-brainer for them since the Repo rate was lower than the interest they’d have to pay to depositors. That said, this is unhealthy for the banking system on a fundamental level. The rates at which banks lend to customers should be determined by the rates they have to pay to depositors (along with other factors) for the same tenors. Having unlimited access to cheap funds can lead to excessive credit growth without the necessary due-diligence.

• No incentive for banks to manage liquidity needs better: Given that they could access whatever funds they needed through the LAF window, there was no real incentive for banks to better forecast and manage their short-term liquidity needs.

Starting July 2013, RBI began to restrict access to overnight funds; Introduced Term Repos in Oct 2013

·    July 15, 2013 - the RBI restricted overnight funds borrowed under the LAF to 1% of NDTL (Net demand and time liabilities) of the banking system (1% of NDTL was ~Rs 75,000 crores).

·     July 24, 2013 - the RBI cut overnight LAF borrowing limit again to 0.5% of NTDL (0.5% of NDTL was ~ Rs 38,000 crores).   

·    Oct 7, 2013 – the RBI introduced 7-day and 14-day “term” Repos, the borrowing limit under which was set at 0.25% of NDTL, to provided additional liquidity (in addition to overnight repo borrowing limit of 0.5% of NDTL). Variable rate auctions would be conducted for these term repos where banks would put in their bids expressing the term repo rate they were prepared to pay. The 14-day repo auction would be conducted every reporting Friday, while the 7-day repo auction would be conducted every non-reporting Friday.

·    Oct 29, 2013 - the RBI increased liquidity provided under term Repos to 0.5% of NTDL (~ Rs 40,000 crore) from 0.25% of NDTL.

·   Apr 1, 2014 – the RBI increased the liquidity provided under term repos from 0.5% of NDTL to 0.75% of NDTL (which was ~ Rs 60,000 crore). Liquidity provided under overnight repos was reduced from 0.5% of NDTL to 0.25% of NDTL (which was ~Rs 20,000 crore).  

What was the impact of these changes?

Lets recap - so, from July 2013 to April 2014, RBI had cut the unlimited overnight repo borrowing under the LAF window down to 0.25% of NDTL (i.e. from the Rs 100,000+ crore overnight borrowing in early 2013, the overnight borrowing limit was down to  ~Rs 20,000 crore in Apr 2014).  

Liquidity provided under term repos was increased from 0.25% of NTDL in Oct 2013  (~Rs 20,000 crore) to 0.75% of NDTL (~Rs 60,000 crore) in Apr 2014.  

So, the total liquidity support available through overnight and term repos was 1% of NDTL (~Rs 80,000 crore).

What was the impact of these measures?

• Firstly, bank began to start borrowing from the RBI at higher “term” repo rates. Maybe 20-50 bps higher vs. the fixed overnight repo rate they were borrowing at earlier. 
• With overnight LAF repo borrowing cut drastically, banks had trouble managing liquidity. As a result, call rates became volatile and fluctuated for some time in a rather broad range of ~100 bps. 
• In the 14-day Term repo auctions, banks would borrow everything they could, because they weren’t really sure how much they would need. If they had extra funds, they’d then lend them in the call market. This however, also led to call rate volatility. Note: when banks borrow from the RBI at the “term” repo rate, and then lend these funds in the call market at the call rate (RBI wants this to be close to the overnight repo rate) or do a reverse repo with the RBI at the reverse repo rate (repo rate – 100bps), they tend to lose money! This is usually not the way to go, unless the market is experiencing volatility. 

Basically, banks had trouble managing their liquidity needs, which manifested as volatility in call market rates.

Starting Aug 2014, RBI started conducting more frequent Term Repo auctions for better liquidity management and stable Call rates

On Aug 22, 2014, The RBI announced that it would now conduct variable rate, 14-day repo auctions 4 times in the fortnightly reporting cycle (on Tuesdays and Fridays). The amount auctioned under each 14-day repo auction would be equal to ¼^th of 0.75% of NDTL.  So, while the amount of liquidity offered under term repos every fortnight remained the same (0.75% of NDTL), it was now split into 4 tranches. This increase in frequency was to allow banks to better manage their liquidity needs, so that call market rates remained to close the Repo rate (as the RBI desires).  In fact, the RBI governor has often said that he wants the overnight call rate to “hug” the repo rate.

Why does the RBI want the overnight Call rate to “hug” to the Repo rate?

The RBI should ideally be the lender of “last resort” to the banking system. Banks should raise money from deposits, money market instruments and borrow from each other (call money), before they turn to the RBI. The call money market is where banks lend/borrow from each other overnight (no collateral security required).

However, in India, the RBI has been (and still is to large extent) the lender to whom banks tend to go first, because they offer Short term funds to banks at the cheapest rate. The RBI wants the call money market (overnight) rate to “hug” the repo rate, so that banks borrow more from each other in the call market rather than depending on the RBI for most of their needs. If the call rate remains stable and close to the Repo rate, the call market will automatically develop and deepen. If there is constant volatility in call rates, this will be hard to achieve.

How is the liquidity situation now?

The banking system has been flush with liquidity over the last 3 months due to higher government spending, lower credit growth and  increased dollar buying by the RBI. As a result, the RBI has been trying to mop up the excess liquidity in order to keep the call rate and other market rates in check and curb inflationary pressures.

It has been conducting overnight reverse repo and term reverse repo auctions (5-14 days) where banks place funds with the RBI and earn interest at the reverse repo rate (reverse repo rate = repo rate – 100bps; currently = 6.25%) and term reverse repo rate (decided at variable term repo auctions) respectively. The RBI has also conducted Open Market Operations (OMOs) where it sells government bonds to banks, thereby sucking in some liquidity.

If the RBI didn’t actively manage excess liquidity in this way, call rate would have fallen sharply and inflationary pressures would intensify. 

Are banks better at managing liquidity post these moves by the RBI?

While banks still have a long way to go as far as forecasting short-term liquidity needs and optimal liquidity management is concerned, these moves by the RBI are forcing them to move in the right direction.  The deepening and maturing of the money market in India and the development of a robust money market yield curve will take time. That said, the RBI is on the right track.