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Banking System liquidity & its ‘deficit mode’

  • Category
    Economy
  • Published
    29th Sep, 2022

Liquidity Adjustment Facility (LAF):

  • The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998).
  • LAF is a tool used in monetary policy, primarily by the Reserve Bank of India (RBI) that allows banks to borrow money through repurchase agreements (repos) or to make loans to the RBI through reverse repo agreements.

Context

The Surplus liquidity in the banking system has been decreasing sharply for the past couple of months due to numerous reasons.

About

Details:

  • Since, May 2019, the “banking system liquidity” situation turned into a deficit mode of Rs.21, 873.4 crore on September 20, 2022.

Banking System Liquidity:

  • Liquidity is a measure of the cash and other assets banks have available to quickly pay bills and meet short-term business and financial obligations. It is different from the capital, which is the measure of the resourcebanks have to absorb losses.
    • 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
    • If the banking system is a net lender to the RBI, the system liquidity can be said to be in

Possible Factors that triggered this Deficit:

  • Upward Trend in demand for Credit: The credit growth of commercial banks is at a near nine-year high of 5 per cent year-on-year for the week ended August 26.
  • Incremental deposit growth against high credit demand:Deposit growth lags far behind at 9.5 per cent.
  • Advance tax payments by corporates: Advance tax outflows have been responsible for the latest round of liquidity tightness.

Advance tax is paid as and when the money is earned in four instalments, rather than at the end of the fiscal year.

  • The intervention of the RBI to manage the fall of the rupee:When the RBI sells dollars in the currency market in order to prevent excessive volatility in the exchange rate, the central bank sucks out the rupee liquidity.
  • Other contributing factors are increased GST outflows and Festive season cash withdrawals.

Impact of tight liquidity conditions on customers:

  • Banking system liquidity being in deficit means, banks don’t have sufficient funds for the credit demands coming in from the customers.
  • A tight liquidity condition could cause a rise in the yields on government securities, which would then lead to an increase in interest rates for consumers.
  • Because the RBI is expected to raise interest rates by another 50 basis points (bps) this cycle, a rise in the repo rate will result in a higher cost of funds.
  • Banks will raise their repo-linked lending rates as well as the marginal cost of funds-based lending rate (MCLR), which is linked to all loans.
  • Consumers will face higher interest rates as a result of this increase.

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