In this post, I’m going to take one of those sudden turns and talk about the current liquidity situation in the Indian banking system. The Monetary Policy Review by Governor Rajan on Feb 2nd (no change in repo rate, CRR or SLR) drew my attention back to liquidity concerns - something banks have been complaining about recently.
This post and the few I’ll do following this one, tie up nicely with the posts I did in Aug-Oct last year where I talked about Repos, Term Repos, FII inflows, CRR, NDTL etc. Click on the links to these posts below for a quick run-through if your nerd heart so desires. Else, charge straight ahead!
Liquidity Deficit is the shortage of liquidity (cash/liquid assets) that the banking system encounters in relation to meeting near-term liabilities and regulatory requirements (maintaining CRR, SLR etc.). We can estimate the size of this deficit by adding net LAF Repo volumes (add up both overnight Repo and Term Repo volumes and subtract overnight Reverse Repo and Term Reverse Repo volumes) to the volume of funds borrowed under the Marginal Standing Facility (MSF) and Standing Liquidity Facilities. Basically, what this formula gives us is the quantum of funds that banks and Primary Dealers borrow from the RBI to meet near-term liquidity needs.
We’ve talked about the LAF Repo and Reverse Repo in our previous posts. Liquidity Adjustment Facility (LAF) is a facility provided by the RBI that allows banks to adjust their day-to-day liquidity imbalances. It includes Repo and Reverse Repo operations. Repo is a repurchase agreement wherein banks borrow money from the RBI by selling government securities to the Central bank, with an agreement to repurchase them at a predetermined future date at a pre-agreed price. This repurchase price includes the interest payable to the RBI for agreeing to buy the securities, which is called the “Repo rate” (currently 6.75%). A Repo transaction therefore injects liquidity into the banking system.
A Reverse Repo transaction is when the RBI borrows money from banks by selling them securities and buying them back later. The difference between the sale and the repurchase price is the interest payable to the banks for buying the securities. It is called the “Reverse Repo rate” and is always 100bps lower than the Repo rate. The current Reverse Repo rate is............you got it..........5.75%, you mathematical savant you! A Reverse Repo transaction absorbs liquidity from the system.
The LAF Repo and Reverse Repo are the key
facilities used by banks and Primary Dealers (PDs) to manage short-term
liquidity imbalances. They usually comprise 95%+ of the net liquidity
adjustment availed of from the RBI. MSF and Standing liquidity facilities usually
form a tiny portion (<5%).
Under the Marginal Standing Facility (MSF), banks can borrow funds from the
RBI by offering approved government securities (g-secs) as collateral, at the
Repo rate (6.75% currently) + 100 bps =
7.75%. Banks can borrow upto 1% of the NDTL under the MSF. Collateral for MSF includes g-secs held within
the SLR limit as well as those in excess of the SLR. (Read my previous posts -
mentioned above - to understand what SLR and NDTL mean. The post titles are self-explanatory).
Why
do banks need the MSF when they have the LAF Repo you ask? To borrow under the LAF Repo, banks use
excess g-secs held by them over and above the SLR of 21.5%. However, in
emergency conditions, when inter-bank liquidity dries up and banks don’t hold
g-secs in excess of the SLR (and thus cant borrow using the Repo facility),
they borrow under the MSF pledging securities within the limits of the SLR. As
you can imagine, for a bank to borrow under the MSF is not great - it’s the last
resort.
Standing
Liquidity Facilities refer
to collateralised liquidity support provided to Primary Dealers (PDs) at the
Repo rate. PDs are market makers in g-secs. They underwrite and participate in
the auctions of g-secs and T-bills, and then re-sell them to market
participants. They help in developing/deepening the g-sec market.
Below is a chart depicting the daily net liquidity situation in the banking system. I’ve estimated Liquidity Surplus (+)/ Deficit (-) as = Reverse Repo volumes (both Overnight + Term Reverse Repos) for the day - Repo volumes (both Overnight + Term Repos) for the day - MSF availed that day - Standing Liquidity Facilities availed that day.
IMPORTANT NOTE: For calculating the daily Liquidity Surplus/ Deficit, I simply add up the Net LAF Reverse repo volumes (I subtract Repo volumes) for the day to the MSF and SLF volumes for the day. The problem with this method is that while I take into account term Repos and term Reverse Repos conducted on that day, I ignore the term Repos and term Reverse Repos outstanding from previous days that are still adding/ absorbing liquidity from the system. Hence, the daily liquidity surplus/ deficit that I calculate is not accurate - it is basically just the net absorption / injection of funds by the RBI on that day. To estimate the full amount of surplus or deficit, I'd have to include term repo/reverse repo volumes still outstanding from previous days. That said, despite the inaccuracy of my measure, it gives us a qualitative idea of the liquidity situation - whether its positive or negative, whether it’s improving or deteriorating etc etc.
Daily Net Liquidity Situation in the Indian Banking System (Rs Billion). Read the note above.
Source: RBI Weekly Statistical Supplements, Nerdverve estimates
The area above the horizontal axis corresponds to Liquidity Surpluses - this is when banks park their excess funds with the RBI. The area below the horizontal access corresponds to Liquidity Deficits - this is when the RBI injects funds into the market.
As you can see from the chart above, the day-to-day liquidity situation in the Indian banking system is quite volatile. However, more broadly (as evident from the chart below), on an average, the system experienced a liquidity deficit in the Jan-May period last year, followed by a surplus liquidity situation in Jun-Sep, followed again by a liquidity deficit in Oct-Dec. This deficit has spilt into 2016 as well.
Average Daily Net Liquidity by Month (Rs Billion). Read the note above.
What are the Factors that determine System Liquidity?
This is a complicated question as many factors combine to determine the net liquidity situation in the banking system. They are:
- Government spending
- RBI intervention in the forex market
- FII inflows/ outflows (this factor is highly correlated with RBI intervention in the forex market)
- Policy Rate/ Ratio moves (Changes in Repo rate, CRR, SLR etc.)
- Demand for credit
- A topical factor - higher Liquidity Coverage Ratio (Basel III)
I’m going to take up some of these factors in subsequent posts.
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