Liquidity surplus in the banking system must be managed deftly

M Suresh Babu | Updated on January 19, 2021

Merely pushing loans to already indebted firms without overall demand creation in the economy would be counterproductive to the banking system in the long run. The problem gets accentuated when there is a lack of quality borrowers

India’s banking system has been witnessing liquidity surplus since May 2019, touching ₹6.23 lakh crore on December 3, 2020, its highest level since then. The outstanding liquidity as on December 4 stood at ₹5.52 lakh crore, which is ₹45,806 crore higher than that of November 27.

This sustained liquidity surplus in the banking system can be attributed to two factors. First, the deposit growth has been persistently more than the bank credit growth. Second, the RBI’s liquidity infusion measures via open market operation (OMO) purchases have supported liquidity in the banking system. This flush of funds in the banking system is to be treated with caution as it is amidst an economy tottered by a slump in demand which has perverse effects on most of the sectors.

The question that comes up in this scenario is whether the current policy stance has used up too much of its arsenal to load banks with liquidity when the options for deploying in productive assets are few. The non-food bank credit growth in the past few months provide some pointers here. Non-food credit growth decelerated to 5.6 per cent in October 2020 compared to a growth of 8.3 per cent in October 2019.

Even though growth in loans to agriculture accelerated, credit to industry contracted by 1.7 per cent in October 2020 compared to the same month of the previous year. Credit to large industries have been hit more severely than those for medium industries, which registered a robust growth. While credit growth to the service sector grew mainly on account of loans to professional services, computer software and trade, growth in personal loans decelerated and vehicle loans continue to perform well.

The tepid demand for credit underscores the fact that ensuring liquidity by itself does not stimulate demand for more credit. There is an asymmetry in the way monetary policy functions. Similar to the case of tackling inflation, where monetary policy is able to handle better rise in inflation than deflation, the role of monetary policy in managing excess demand for credit is more effective than in situations of sluggish demand.

There is the famous observation that the central banking system is equipped with ‘efficient brakes but the accelerator is uncertain’. The effects of monetary policy as brakes on the economy is more pronounced as it can prevent the economy from going too fast (high inflation or a bubble) by increasing interest rates.

However, the accelerating role by cutting interest rates or letting go of the existing applied pressure on the brakes is dependent on demand for borrowed funds and banks’ willingness to supply the funds. It is basically a case of the old saying “you can take the horse to the pond but cannot compel it to drink”. The central bank can continue to provide liquidity and lower interest rates, however, if the demand for credit is low, then obviously it is like a car sitting idle on the driveway.

Pressure on banks

Despite accommodative regulatory and supervisory actions, banks might remain hesitant to maintain higher credit provision in times of uncertainty as they face difficulty in judging the demand for credit. The government has taken steps by guaranteeing emergency loans and easing capital constraints that would otherwise keep banks from lending, but much depends on the actions of banks.

However, in stressed markets, it is hard to determine ex ante the marked-based threshold of an adequate credit deployment limit, so banks may rationally decide not to play it close. Further, providing credit at the time of crisis may simply be deemed too risky for the banks, particularly when the central bank is paying interest on the risk-free reserves held with them. So even when the government issues partial or full guarantees for certain Covid-related loans, banks may hesitate to lend due to operational and reputations risks when more businesses are likely to fail than in normal circumstances.

Thus there emerges a scenario in which banks are nudged by both the RBI and the government. Banks have been pushed to lower lending rates and improve monetary transmission through various means. This pressure on banks runs the risk of triggering instability in the banking system. Merely pushing loans to already indebted firms without overall demand creation in the economy would be counterproductive to the banking system in the long run. The problem gets accentuated when there is a lack of quality borrowers.

Under such conditions banks end up with large credit exposure to substandard borrowers and there exists the risk of genuine business decisions going wrong in a downturn as well. Even with the assurance of a government guarantee the system’s exposure to risk persists as the possibility of loans going bad and the government delaying compensating the banks cannot be ruled out, as enforcing government guarantee is a lengthy process.

Loans sanctioned under the Emergency Credit Line Guarantee Scheme (ECLGS) have to be viewed from this perspective. The total sanctioned amount has crossed the ₹2-lakh crore mark as on December 4, and as much as ₹1,58,626 crore has been disbursed. While loans have been sanctioned for 80,93,491 accounts, disbursal have been made for 40,49,489 accounts.

Nearly 45 lakh MSMEs are supposed to have benefited from this scheme. However, the 20 per cent rule would mean that MSMEs might actually end up getting only a small additional amount which may not be enough for business revival. Further, given the uncertain demand situation, MSMEs may not want fresh loans as they are unsure about business revival and might be averse to having higher interest burden in the coming months.

Transmission mechanism

The prevalence of surplus liquidity also has the potential to disrupt the transmission mechanism of monetary policy, especially in affecting the demand side to reach the targeted inflation. In addition, surplus liquidity in the banking system will push the central bank to absorb it through monetary operations to eliminate its pressure on financial market and when the surplus liquidity is very large and persistent, it puts pressure on the sustainability of central bank’s balance.

On the other hand, from the banks’ perspective, they prefer holding surplus liquidity than giving loan or buying government obligation, especially in the long run. The reason for this is liquidity trap, a condition where return from banking credit is too small to cover intermediation cost and banks get higher yield in reserves than giving loans.

The persistent liquidity surplus has to be managed deftly. On one hand there is the option of making ‘banking boring’, as noted by Paul Krugman in the wake of the financial crisis in 2009, which tightens the credit flows and might not find favour from the optimists of faster economic revival. On the other hand, the choice is to maintain surplus levels and keep nudging the banks to ease the choked credit lines.

As former RBI Governor C Rangarjan notes, “bankers should also be cautious. They should not be too timid to lend, but not adventurous as well”. Any approach in the current environment needs to weigh in a long-term perspective on the stability of the banking sector.

The writer is Professor of economics at IIT Madras. The views expressed are personal

Published on January 19, 2021

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