Liquidity framework can be fine-tuned

MONEY MATTERS. The RBI working

group on liquidity management could

consider slight changes in CRR

compliance and VRRR norms

he money market is quite

fascinating. There is the

inter-bank call market

where the interest rate is

determined by demand and

supply forces. Intuitively, the rates

decrease when there is surplus in the

system, and increase in times of deficit.

During the 1990s the call rate would

at times soar to over 50 per cent on a

reporting fortnight as banks hurried to

adhere to the CRR requirements. The

myriad changes brought in the market

since has ensured that such volatility

does not exist. Therefore, there is a

corridor of 50 bps with the SDF ensuring

that rates do not go below 5.25 per cent

and the MSF capping rates at 5.75 per

cent. These two windows do not involve

any pledging of securities.

It is against this background that the

liquidity framework adopted by the RBI,

reviewed recently and put out for

discussion, can be examined. Today,

with daily surplus liquidity of around

*3-4 lakh crore, call rates hover in the

lower part of the window.

Yet the volumes that are traded are

quite low by market standards at around

20,000-30,000 crore.

This can be contrasted with the

triparty repo market, where the trades

are secured against government paper

which trades 15-20 times the volumes

and has rates which are lower than the

call rate.

This means that banks which have

excess SLR can borrow in this market at

lower rates. Others will have to go the

call market and borrow at a higher rate.

The repo and MSF rates act as ceilings

here depending on the RBI's policy. This

can be contrasted with the time when

there were daily fixed rate repo auctions

where the repo rate became the effective

rate with the call rate hovering in the

range of repo and MSF rates.

The liquidity framework targets the

weighted average call rate (WACR). The

question raised was whether this was

appropriate or not. If greater volumes

are witnessed in the triparty repo

market, then the weighted average

triparty repo rate (WATRR) should be

targeted by the RBI. While this is a

compelling argument, the review found

that as there was strong correlation

between the two, the WACR was still

appropriate.

In fact, this is tautologically true

because the WATRR would always adjust

to the WACR; and as a central bank

targeting the latter would also control

the former.

And more importantly, as pointed out

by the Working Group, the call market

involves players who are fully regulated

by the RBI unlike the other segments

which have mutual funds, insurance and

pension companies among others who

are not under the ambit. Therefore, the

WACR will continue to be the targeted

rate.

The second part of the mandate

There have been

times when the system

is in deficit at the

aggregate level, but some

banks have been putting in

surpluses in the Standing

Deposit Facility

involved the liquidity framework toolkit

of using different maturities of VRR and

VRRR. Here there can be some

discussion. The Working Group has

chosen to move over from using 14 days

VRRR to seven days VRRR on grounds of

interest in a longer duration not being

there from the point of view of banks.

Banks would not like to park

surpluses of large magnitude for longer

periods as they could end up in deficits

during the interim period. However, on

the repo side, i.e. VRR auctions, all

tenors tended to be oversubscribed.

Hence, the preference has been given by subsequently put large sums in the SDF.

the Group to the seven days tenor for

VRRR.

While this argument is pertinent, an

alternative can also be considered. This

would be to announce different

maturities of VRRR on the same day.

Hence there can be auctions for one,

seven and 14 days for ₹50,000 crore each

under the VRRR. This will actually

provide options to banks to park their

funds according to their positions. This

will also help to develop the yield curve

at the shorter end. Today there is a

convergence of the cut-off yields to 1 bps

lower than the repo rate. By having these

options, there will be a difference across

the spectrum.

FOREX SWAPS

As part of liquidity management, forex

swaps have been a part of the tool kit.

This is to remain after this review.

The issue with forex swaps is that

there can be bunching of reversal of

transactions in a buy-sell swap, where

dollars were purchased in return for

liquidity.

The problem really surfaces in future

when the transaction is reversed and

would mean reverse flow of liquidity. As

these are normally for a period of six

months to over three years, one cannot

gauge the liquidity position of banks at a

later date.

This conundrum can be addressed by

capping the quantum of swaps in

monetary terms.

The review also discusses the issue of

CRR. The rule today is that while banks

have to maintain CRR on the reporting

fortnight, 90 per cent has to also be

adhered to on a daily basis.

This high level creates uncertainty for

banks which wait till the end of the day

to ensure that there is no breach and

That's why SDF balances tend to be very

high during the surplus phases even

after the VRRR auctions are conducted.

The point put forward is that since

banks maintain above 95 per cent on all

days there is no need to go lower.

Here a counter argument can be

made. Let us assume that hypothetically

a lower level of 75-80 per cent has to be

maintained. Banks would then have

more space to plan their funds and

would hence prefer to use the VRRR

funds to deploy their surpluses and not

put in large amounts in the SDF.

In fact, there have been times when

the system is in deficit at the aggregate

level, but some banks have been putting

in surpluses in the SDF.

If there were no concerns over CRR,

then these surpluses could have gone to

the call market or triparty repo market

making those rates more vibrant.

Having gone through the finer aspects

of the functioning of the market, the

Working Group has concluded that the

existing framework has worked very well

and would be retained. However, the

suggestions made could be considered.

The writer is Chief Economist, Bank of Baroda. Views

expressed are personal