Liquidity Management

Financial Markets Department

What is Liquidity?

Liquidity in common parlance is the ability to have funds to meet obligations on an ongoing basis. Liquidity is the heart of viability of any banking organization. For a commercial bank it means the ability to meet its deposit obligations on demand Under liquidity management a central bank maintains appropriate liquidity in the system by using its instruments to bring the quantum of liquidity to a level that is consistent with its ultimate goals.
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Why bother about Liquidity?

Importance of liquidity for the smooth functioning of the markets is validated by the fact that most episodes of financial market distress were characterized by sudden and drastic reduction in market liquidity, causing panics, runs, and disorderly adjustments in asset prices, a sharp increase in the costs of executing transactions and, in the most acute cases, a seizing up or freezing of markets.

Need For Liquidity Management

Banks often borrow short and lend long, this inherent maturity transformation that they perform exposes them to asset liability mismatches and potential liquidity stress. If the ALM principles are not actively followed then banks are likely to face liquidity concerns that may snowball into solvency issues. Banks are systemically important as they can create money, by "multiple expansion Central banks can by altering the quantum of requisite reserves alter the size of their balance sheets.

Episodes of Financial Distress

1.Liquidity Shortfall in Banks/ Financial Institutions

Panics

2.Disorderly Shortfalls in Asset Prices

LOLR

4.Seizing up or Freezing of Markets

3. Sharp Increase in Cost of Executing Transactions

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Liquidity and Central banks

In most developed countries liquidity management is undertaken to address the mismatch between demand and supply of liquidity. In emerging markets liquidity management alternates between absorption and injections as conditions evolve from surplus and shortage.
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Major Factors Influencing Liquidity

Statutory Reserve Requirements Pattern in SCB's balances with RBI

Frontloading in the beginning of the reporting fortnight Flexibility to draw down up to 70 % of the requisite level on any day within the reporting fortnight

Banking systems liquidity needs for discharge of payment obligations Pattern of Changes in Currency in Circulation

Festive season currency drain from the banking system

Major Factors Influencing Liquidity

Changes in Central Government Account Government borrowing Program (Centre +State)

Issuance/ reissuance Redemptions, coupon payments

Tax collections Patterns of the Government Spending Capital flows affect liquidity only if RBI intervenes RBI actions

OMOs/Specific measures to take care of these issues

Government Balances

Source: Chart IV.2 Macroeconomic and Monetary Developments , January 24,2011

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Rs. Crore

200000 150000 100000 50000 0 -50000 -100000 -150000 -200000

31-Dec-07
02-Mar-08 02-May-08

02-Jul-08 02-Sep-08 02-Nov-08 02-Jan-09

02-Mar-09 02-May-09

Liquidity and Government Balances

LAF MSS GOI Balance

02-Jul-09 02-Sep-09 02-Nov-09 02-Jan-10
02-Mar-10 02-May-10 02-Jul-10

02-Sep-10 02-Nov-10 02-Jan-11

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02-Mar-11

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Levers of Liquidity Management

Liquidity management entails assessing the liquidity needs of the banking system and injecting or absorbing the appropriate amount of liquidity through various instruments. The Reserve Bank of India actively manages banking system liquidity through appropriate and flexible use of direct and indirect instruments at its disposal. Liquidity management provides sufficient levers to the central bank to modulate liquidity and smooth out unevenness.
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Liquidity Adjustment Facility (LAF)

Introduced in present form since June 5, 2000 Objective is to manage short run frictional liquidity under varied financial market conditions Eligible securities-generally SLR eligible SecuritiesGoI dated securities, T-bills, SDLs Number of LAF in a day is one except when decided by the RBI depending on the prevailing liquidity conditions

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Operation Details of LAF

RBI modulates short-term liquidity by conducting repo auctions (for injection of liquidity) and reverse repo auctions (for absorption of liquidity) at a fixed repo/reverse repo rates on a daily basis (Monday to Friday, excepting holidays). All Scheduled Commercial Banks (excl. RRBs) and PDs are eligible to participate in the LAF auctions.

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Liquidity Management: India

LAF: task of day-to-day liquidity mismatches CRR is used for supplementing liquidity management with above two instruments OMO liquidity of a more durable nature can be injected or withdrawn from the system using open market sales and purchases of GSecurities. MSS for addressing semi-durable liquidity management especially in the context of lumpy capital flows
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Market Stabilisation Scheme: MSS

Introduced in April 2004 (MoU between GoI and RBI) MSS semi-durable liquidity management during surges in capital flows Addressing the large liquidity impact of RBIs Forex operation MSS Thresholds and Ceiling decided by GOI & RBI MSS proceeds sequestered into a separate cash account maintained with RBI Interest cost borne by GoI During Liquidity shortage, unwinding of MSS balance became a key channel for expanding liquidity

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Open Market Operations

The outright sale of GOI securities by the RBI (to absorb liquidity) and purchase (to inject liquidity) is essentially geared to manage liquidity of long-term/durable nature. These operations can also be conducted either through scheduled auctions or over NDS-OM.

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Liquidity Management by CRR

A direct instrument of monetary policy that was earlier used for liquidity management Works through the credit multiplier affecting the capacity of the banks to create secondary deposits Impounds liquidity from the banking system CRR is changed depending on prevailing liquidity situations, stance of monetary policy and inflation expectations
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Pockets of Illiquidity

If available liquidity is unevenly distributed wherein those who need funds may not have excess SLR securities to borrow from LAF and those having excess securities may not need to borrow except to take advantage of arbitrage Such arbitrage may actually help in circulating the available liquidity The extent to which banks can take advantage of this arbitrage is limited by prudential and other limits on borrowing/lending.
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Prudential Limits

SCBs can borrow from the call market up to a maximum of 125% of capital funds on any day during the fortnight, their borrowing outstanding should not exceed 100% of capital funds (Tier I+II) of latest audited balance sheet. Primary Dealers are permitted to borrow on an average in a reporting fortnight up to 225 % of their net owned funds as at end-March of the previous financial year.

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RBIs Policy Stance on Liquidity Management

Liquidity management will continue to receive priority in the hierarchy of policy objectives over the period Autonomous Factors like volatility in capital and cash balances of the Government will continue to necessitate active liquidity management with a combination of instruments as warranted. Active management of liquidity through appropriate use of LAF,CRR OMO as the situation warrants.

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Defining Liquidity Comfort zone

The RBI's policy statement on November 2, 2010, had tried to explain a comfortable liquidity band, which is plus or minus one per cent of the net demand and time liabilities (NDTL) or around Rs 50,000 crore, over a period of time, on a persistent basis. Sometimes the liquidity stress situation may coincide with an antiinflationary stance.
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Frictional and Structural Liquidity Deficits

Frictional Liquidity Deficit occurs due to transient factors quarterly tax payments or lumpy GOI receipts, such as, 3G /BWA auction receipts Structural Liquidity Deficit is caused by the widening difference between credit pick-up and deposit growth coupled with high currency growth

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Balancing Monetary Policy & Liquidity Management

While the monetary policy objective of not letting excess liquidity spilling over into inflation cannot be compromised, liquidity management may require infusion of liquidity so as to ensure that temporary liquidity shortfalls do not culminate in hampering the productive potential of the economy. Liquidity management helps to balance objective of growth with price stability.

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Assessing the Systemic Liquidity Needs

The liquidity assessment exercise involves continuous estimation of liquidity on the basis of information contained in rates and volumes in money market as also forecasted changes currency in circulation and of GOI balances. The above exercise helps the Bank to undertake appropriate measures to equilibrate the demand and supply of systemic liquidity so as to ensure orderliness in the money market.

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Liquidity Forecasts
An Inter-Departmental Group comprising MPD, IDMD and FMD makes a liquidity assessment every week for the following four weeks. Liquidity projections are made weekwise, up to four weeks ahead and as required by the top management.

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Managing Liquidity Stress

Additional Measures Operation of a second LAF (SLAF) Waiver of penal interest on shortfall in maintenance of SLR upto some specified %, for making available securities to banks for additional liquidity support under the LAF Term Repo facility Special Refinance

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Cost of Liquidity Management

Cost of liquidity management and/or sterilization operations are shared by all stakeholders:

Government in case of MSS Reserve Bank in case of LAF reverse repo Banking system in case of CRR

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Mitigating Deficit Liquidity in 2011

RBI instituted a number of measures: (i) reduction in the SLR of SCBs by one per cent (ii)conducting open market operation (OMO) purchase of government securities of the order of over Rs 67,000 crore; (iii) additional liquidity support to SCBs under LAF; (iv) introduction of a second LAF window on a daily basis.

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Second LAF (SLAF)

First introduced on Nov 28, 2005 A second window to fine-tune the management of liquidity.
From 28 November 2005 1 Aug 2008 17 September 2008 8 May 2009 28 May 2010 31 July 2010 29 October 2010 9 November 2010 To Aug 5, 2007
5 May 2009 30 July 2010 28 October 2010 4 November 2010 8 April 2011

Status of SLAF Daily Only on Reporting Friday Daily Only on Reporting Friday Daily Only on Reporting Friday Daily Daily

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