A Seshan

Putting liquidity in its place

A. Seshan | Updated on April 04, 2011

BL24SESHAN.1

BL24SESHAN1.1

The RBI Working Group that reviewed the Liquidity Adjustment Facility could have made it clear that the objectives of the LAF was to solve problems of temporary mismatches in financial flows and not for meeting the requirements of the regular business of banks.

The Working Group on Operating Procedure of Monetary Policy should be congratulated for bringing out a well-articulated report reviewing the Liquidity Adjustment Facility (LAF). While I agree broadly with the findings and recommendations of the Group, I have a few comments to make.In the first place, as a formal document, the report could have recapitulated the objectives of the LAF to make it clear that it is intended to solve problems of temporary mismatches in the financial flows of the system and not for meeting the requirements of the regular business of banks. It would have helped the reader, had there been a discussion on the measurement of ‘liquidity' reported to be done in the RBI.

Discussing LAF without this definition is like holding a baraat without the bridegroom! Even if the RBI is not willing to share the liquidity forecasts, there should not be any difficulty in revealing the methodology for a wider debate in the banking community. The RBI reviews of the monetary policy in the recent past carried estimates of the ‘overhang of liquidity', as reflected in the LAF, the Market Stabilisation Scheme (MSS) and the Central government's cash balances with the Reserve Bank. This estimation of the overhang (or, for that matter, deficit) of liquidity is conspicuous by its absence in the more recent reviews of the RBI.

Estimation of overhang

I think it is a useful measurement for analysis which the researcher can, of course, derive, even without the RBI indicating it. In my opinion, excess/shortfall in liquidity should be defined and measured by the amount available to the banking system in relation to what it needs to carry on its normal banking operations to meet the legitimate needs of the economy. Excess liquidity should include not only what the RBI has reckoned with but also surplus investments in the securities coming under the Statutory Liquidity Ratio.

Banks do this partly due to lack of lending opportunities or simply because it is more remunerative and risk-free compared with lending and provides an arbitrage opportunity in accessing the repo window of the RBI. The Report says that recent experience suggests that the response to the RBI OMO purchase was less- than-expected even under high liquidity shortage conditions. In fact, market participants preferred to access the RBI's LAF window rather than meet their liquidity needs through the OMO.

Relieving shortage

The proposal to introduce the auctioning of government deposits with the RBI to relieve liquidity shortage is a belated acceptance of an analyst's recommendation made long ago. The build-up of Government balances could be seasonal or ad hoc. The former refers to the advance payment of income-tax every quarter; the other arises due to such events as the auctioning of 3G telecom licences last year.

In the case of the known seasonal build-up, one way of relieving fund stringency is to allow the money as a float for a short period at a rate of interest that could be related appropriately to the Treasury Bill rate. Now banks are required to remit the tax payments to the RBI without delay. The proposal will avoid time and effort involved in auctioning. The auction procedure could be attempted whenever there is a sudden accumulation of funds like in the 3G telecom case. In both cases, the underlying amounts should be surplus to the government's requirements.

There is a recommendation to the effect that the weighted average overnight call money rate should be the operating target of the RBI. The operating objective should be to contain this rate around the repo rate within the corridor. How exactly this is to be achieved with the existing arrangements is not clear. It sounds similar to what the US Fed does in relation to the targeted Federal Funds Rate through market intervention.

The Report recommends that persistent liquidity in excess of plus or minus one per cent of the Net Demand and Time Liabilities (NDTL) should be managed through other instruments. The one-percentage surplus or deficit seems to be arbitrary. It may get frozen at that level as has happened in the case of the desirable money supply being 5 per cent more than what is warranted by money demand to accommodate inflation. With the base rising dramatically over the years, the absolute increase has become massive year after year.

Repo window

I have contended all along that there has been no shortage of liquidity in the banking system.(“Some truths about liquidity crisis”, Business Line, December 11, 2010). The excess investments in SLR and the tepid response to the buy-back of securities testify to this. A few banks have built up substantial surplus volumes of securities, which they utilise to get funds from the RBI for relending in the money market.

Data show that the number of banks resorting to the repo window remains more or less the same day after day giving rise to the suspicion that they may be the same institutions that take advantage of the facility to convert overnight repos into short-term accommodation at a rate much lower than the one prevailing in the market. The Working Group could have undertaken the exercise of an audit for a few weeks on the repo operations of the persistent borrowers to look at their sources and uses of funds, and asked questions through the RBI on the need for borrowing.

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Published on March 24, 2011
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