Straight from the Specialists
How the RBI’s recent measures affect you
Banking is the backbone for growth in large economies such as India. Banks provide short-term finance to trade, industry and agriculture while also ensuring excess money is channelized into productive assets via deposits and financial intermediation.
Banks have to work under the stipulated policies of the central bank with respect to deposit mobilisation and lending for which they need to maintain minimum cash balances and government securities.
Banks may either run a surplus (deposits higher than lending) or a deficit (lending higher than deposits). Cash-rich banks lend to cash-deficient banks for a limited period through overnight call money, commercial deposits, etc. The central bank also offers liquidity through:
- Liquidity Adjustment Facility (LAF) at the repo rate (currently 7.25 percent) up to a limit for up to seven days against excess Statutory Liquidity Ratio (SLR) as collateral.
- Marginal Standing Facility (MSF) overnight at a higher rate without an upper limit and without SLR collateral, normally used by banks for last resort borrowing.
In a bid to bring down speculation in the currency market and stabilize the rupee, the Reserve Bank of India (RBI) came out with a set of policy measures including raising its MSF rate by 200 bps to 10.25 percent. This so-called temporary measure was a subtle but unequivocal signal to the markets that near-term money market rates are going to rise. It could have also used open market operations more effectively by putting more government securities on sale. The other option for the RBI to remove excess liquidity would have been to raise the repo rate or raise the CRR, which would have been a retrograde step in managing growth-inflation dynamics. The central bank can still do so at its monetary policy review on July 30.
The reaction to the RBI’s recent measures was immediate in the banking and capital markets. The yields of short-term money market instruments such as certificate of deposit, commercial paper and treasury bills shot up in excess of 50 to 100 bps.
The yield of government securities also went up over time. One casualty was the income and liquid fund categories of mutual funds whose net asset value (NAV) gave negative returns overnight. This was because they had to mark to market all traded instruments as per SEBI valuation norms and were not permitted to amortise over the remaining period. There were heavy redemptions (most of it would have been from banks) and the RBI opened up a special window for mutual funds to borrow at a repo rate of 10.25 percent for a couple of days.
One can but suspect a couple of banks would have redeemed from liquid funds and would have bought directly into other money market instruments which eventually didn’t pay off because the NAVs of MFs jumped back in successive days. Banking stocks fell on fear of profitability sustenance. The currency market for which these steps were initiated saw only limited success in holding up the rupee.
Banks derive revenues from three streams – treasury, credit and fee-based activities. The impact of the RBI measures will be more on the first two. They would take a hit on treasury books due to rise in yields. It would put a temporary pause on cheap availability of funds.
The arbitrage opportunity to utilize LAF funds at cheaper rates to invest into higher- yielding financial products like MFs and bonds stands reduced. These could affect the profitability and return on total assets. On the credit front, the banks may channelize their excess SLR into lending. It is also possible some banks may eventually raise short-term deposit rates to get bulk deposits. Credit costs may go up.
In an environment where overall credit growth is suspect and with non-availability of cheaper sources of funds, the net interest margin may get squeezed. Inflation, currently on a declining trend, may once again be in focus. All this could cast its shadow on overall GDP growth. It will be interesting to hear what the RBI has to say in its policy review.