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Banking system liquidity

  • Published
    26th Sep, 2022
Context

For the first time since May 2019, the banking system liquidity situation turned into a deficit mode of Rs 21,873.4 crore in September 2022.

About

Banking system liquidity:

  • Liquidity in the banking system refers to readily available cash that banks need to meet short-term business and financial needs.
  • On a given day, if the banking system is a net borrower from the RBI under Liquidity Adjustment Facility (LAF), the system liquidity can be said to be in deficit and if the banking system is a net lender to the RBI, the system liquidity can be said to be in surplus.
    • The LAF refers to the RBI’s operations through which it injects or absorbs liquidity into or from the banking system.

What has Triggered this Deficit?

  • The change in the liquidity situation has come due to advance tax outflows. This also increases the call money rate temporarily above the repo rate.
    • Call money rate is the rate at which short term funds are borrowed and lent in the money market.
    • Banks resort to these types of loans to fill the asset liability mismatch, comply with the statutory CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio)requirements and to meet the sudden demand of funds. RBI, banks, primary dealers etc. are the participants of the call money market.
  • Besides, there is the continuous intervention of the RBI to stem the fall in the rupee against the US dollar.
  • The deficit in the liquidity situation has been caused by an uptick in bank credit, intervention of the RBI into the forex market, and also incremental deposit growth not keeping pace with credit demand.

How Can a Bank Achieve Liquidity?

  • Large banking groups engage themselves in substantial capital markets businesses and they have considerable added complexity in their liquidity requirements. This is done to support repo businesses, derivatives transactions, prime brokerage, and other activities.
  • Banks can achieve liquidity in multiple ways. Each of these methods ordinarily has a cost, comprising of −
    • Shorten asset maturities
    • Improve the average liquidity of assets
    • Lengthen
    • Liability maturities
    • Issue more equity
    • Reduce contingent commitments
    • Obtain liquidity protection

Impact of Tight Liquidity Condition on Consumers:

  • A tight liquidity condition could lead to a rise in the government securities yields and subsequently lead to a rise in interest rates for consumers too.
  • RBI may increase Repo Rate, which can lead to a higher cost of funds.
  • Banks will increase their repo-linked lending rates and the marginal cost of funds-based lending rate (MCLR), to which all loans are linked to. This rise will result in higher interest rates for consumers.
  • The MCLR is the minimum interest rate that a bank can lend at.

Steps that needs to be taken:

  • RBI’s actions will depend upon the nature of the liquidity situation. If the current liquidity deficit situation is temporary and is largely on account of advance tax flow, the RBI may not have to act, as the funds should eventually come back into the system.
  • However, if it is long-term in nature then the RBI may have to take measures to improve the liquidity situation in the system.
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