Temporary liquidity squeeze

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The Reserve Bank of India continued its monetary tightening policy by increasing both the repo and reverse repo rates by 25bps in its second quarter review.

Liquidity concerns

Despite tight liquidity scenario, the regulator has left the cash reserve ratio (CRR) at 6 per cent, indicating that it would rely more on other measures to pump in liquidity into the system rather than a decrease in CRR.

Moreover, the current liquidity squeeze is temporary on account of the huge subscription of the Coal India IPO and will ease as and when the funds are released.

Large foreign inflows in recent months also substantiate the fact that the liquidity squeeze is temporary.

However, these inflows might strengthen the rupee, which might prompt the RBI to sterilise dollars and, in turn, cause further demand-led inflationary pressure. Going forward, inflation might ease by the end of the financial year as policy rates are transmitted to the economy. The policy review was also characterised by announcement of significant development and regulatory areas.

By December 2010, the regulator plans to place a discussion paper on the deregulation of the savings bank deposits interest rate, besides issuing final guidelines on compensation practices by private and foreign banks. It also plans to issue the draft guidelines for additional bank licences to private sector players by January 2011.

Segregation of risks

Besides these, the regulator is also likely to release a discussion paper on the form of presence of foreign banks in India in the near future followed by draft guidelines on holding company structure for financial conglomerates in India. A significant announcement has been on the Prudential Norms on Financial Conglomerates (FCs) for which the detailed guidelines will be issued later.

However, the regulator has touched upon two aspects, namely capital adequacy for FCs where capital above 20 per cent invested in subsidiaries will be deducted at 50 per cent from Tier-I and 50 per cent from Tier-II. This will be applicable at the individual bank and FC levels.

The major impact of this will be segregation of the risks arising from different businesses.

Also, the capital requirements of the banks and FCs with substantial stakes in subsidiaries might increase. All in all, we expect a number of measures by the RBI on monetary and development fronts which will shape the growth of the banking sector in India.

(The author is National Leader,Global Financial Services, Ernst & Young.)

(This article was published in the Business Line print edition dated November 3, 2010)
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