Misuse of RBI lending window

The Liquidity Adjustment Facility (LAF) is now the principal operating instrument of monetary policy by the Reserve Bank of India (RBI). In the current phase of tightening policy stance, which began around January 2010, some profound changes have taken place in the way the LAF operates. Considering the net LAF position, the system by and large has shifted from a surplus to deficit mode since May 2010.

The average daily net absorption through LAF gradually moved down from around Rs 90,000 crore for the fortnight ending February 12, 2010 to Rs 35,000 crore by May 21, 2010. Since then, the system is by and large in deficit mode, but practically because of passive liquidity injection, the RBI lending remained far in excess of what a normal frictional liquidity adjustment would warrant.

EXCESSIVE RBI LENDING

The net daily average liquidity released by RBI exceeded Rs.1 lakh crore for three out of four fortnights between mid-December 2010 and end-January 2011. On other periods as well, excepting a brief spell of three fortnights during April-May, for most fortnights, the daily average liquidity injection mostly ranged between Rs 60,000 and Rs 90,000 crore.

The Reserve Bank's policy during this period was aimed at managing liquidity to ensure that it remained broadly in balance, with excess liquidity not diluting the effectiveness of policy rate actions. RBI stated that while frictional liquidity shortage was expected to ease as government balances adjusted to the expenditure schedule, it cautioned the banks that they needed to focus on the underlying structural cause of liquidity tightness arising out of the gap between the credit and deposit growth rates. The recent Financial Stability Report (FSR) also cautioned against banks expanding their credit portfolios out of borrowed funds.

In this context, the recommendations of the Deepak Mohanty Working Group released in March 2011, were an important landmark. On that basis, RBI inter alia decided to manage liquidity to ensure that it remained broadly in balance, with neither a large surplus diluting monetary transmission nor a large deficit choking off fund flows. RBI also instituted a new Marginal Standing Facility (MSF) enabling commercial banks to borrow overnight up to 1 per cent of their respective NDTL at an interest rate of 100 basis points above the repo rate. Despite these measures, liquidity management remains very passive, making the RBI as lender of the first and not the last resort, and the banking system evidently exploited this opportunity to fill structural gap between growth in credit plus investments and deposit growth during the entire period since January 2010. This calls for further fine-tuning of the operations of the LAF.

THE EVIDENCE

Let us consider injection of liquidity above 1 per cent of net demand and time liabilities of the banking system as excessive. An estimate made on this basis shows that the liquidity injection by RBI was excessive, except for three fortnights during the period since December 17, 2010, to July 1, 2011 (see Table).

A graphical illustration and the results of an empirical exercise show that the net LAF during the period was influenced by two factors, viz., the deposit growth and the credit plus investment (both SLR and non-SLR) growth. The graph shows the close alignment of fortnightly movement between the net LAF position and the ratio of credit plus investments to deposits. It is significant to note that the credit plus investment to deposit ratio remained in the range of 104- 109 per cent and this stretch of credit plus investments has been enabled at least partly by the LAF window.

An empirical exercise relating the daily average net LAF position to growth in volume of deposits and credit plus investments for the past about 40 fortnights showed that as high as about 80 per cent of variation in net LAF was quantitatively explained by the movements in deposit growth and growth in credit plus investments.

TIGHTEN THE SCREWS

This may apparently look like an obvious relationship. But while the LAF operation in a deficit mode no doubt helps in effective interest rate policy transmission, consistently excessive liquidity injection by RBI is also evidently fraught with the problem of moral hazard and perhaps even adverse selection, as the FSR has brought out recently.

One may be tempted to take a drastic step of fixing strict bank-wise limits for borrowing through LAF window and beyond that limit, to automatically activate the operation of the marginal standing facility at a higher interest rate. But, this will be a retrograde step and jeopardise the market-based nature of LAF operations and smoothening of liquidity. This could impact smooth adjustment of liquidity between surplus and deficit units on a day-to-day basis.

What the RBI should do is closely monitor the chronic borrowers through LAF window and caution such banks to improve their asset-liability management within a time frame. Failing that, RBI should fix limits for such banks to borrow from LAF window and automatically activate the marginal standing facility for such banks.

RBI should not hesitate to publicly disclose the information on bank-wise borrowing and lending through LAF window. The earlier the RBI moves, the better it is for systemic stability.

(The author is Director, EPW Research Foundation. The views are personal. >blfeedback@thehindu.co.in )

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