What is Liquidity?
- Liquidity is a relative term.
- For assets: Rs.1 crore worth gold is more liquid than Rs.1 crore worth farmhouse. Because you can quickly sell the gold in a few days, but for selling farmhouse you’ll have to deal with so many prospective customers, real-estate agents, paper work, stamp duty etc., this would take more than 15 days= not so liquid.
- For banking: if yesterday SBI had Rs.100 to give as loan
- today SBI has Rs.200 to give as loan, then we say liquidity has increased. (And vice versa).
- In winter, supply of green vegetables increases (compared to summer) so selling price of green vegetables decreases in winter (compared to summer).
- Similarly when liquidity (money supply) increases, the cost of borrowing (=interest rates) goes down.
- Very high liquidity can create demand pull inflation=bad.
- Very less liquidity=cost of borrowing is extremely high for businessman = bad because he cannot easily start or expand his business=less people get employment.
- So one of the job of RBI= control this “liquidity” in banking system.
- RBI mainly uses following tools to control this liquidity / money supply in the banking system.
- Cash reserve Ratio (CRR)
- Statutory Liquidity Ratio (SLR)
- Liquidity Adjustment Facilities (LAF) (Repo and reverse repo)
- Open market operations (OMO)
What is Cash reserve ratio (CRR)?
- For the sake of simplicity, let’s assume there are only four people in India: 1) common men and 2) businessmen 3) Commercial banks (like SBI) 4) Central Bank (RBI.)
- Now the Question: How do commercial banks make money?
- Common men save their money in bank. Bank gives them say 7% interest rate on savings.
- Then Bank gives that money as loan to businessmen and charges 12% interest rate. So 12-7=5% is the profit of Bank. Although that’s technically incorrect, because we’ve not counted bank’s input cost=staff salary, telephone-internet-electricity bill, office rent, xerox machine etc. So actual profit will be less than 5%.
- But anyways, first let’s construct a technically incorrect model.
- SBI has only one branch in a small town. It was opened on Monday.
- On the very same day, Total 100 common men deposited 1 lakh each in their savings accounts here (=total deposit is 1 crore)
- and SBI offered them 7% interest rate per year on their savings
WHY CRR: Cash reserve ratio?
- On Tuesday, SBI Branch manager gives away entire 1 crore to a businessman as loan for 12% interest rate for 5 years.
- From SBI’s point of view, sounds very good right? 12-7=5% profit!
- But we’ve not considered the fact that on Wednesday, some of those common men (account holders) will need to take out some money from their banks savings account- to pay for gas, electricity, mobile bills, college fees, writing cheques and demand drafts etc.
- But SBI’s office doesn’t have a single paisa left! = problem, protest, rioting, suicides.
- So condition #1: Banks must not give away all of the deposit money to businessmen for loans. Banks must keep some money with aside.
- Ok but who’ll decide how much minimum cash should a bank keep aside? Ans. RBI via CRR.(Cash reserve ratio).
- But banks donot like high CRR.
WHY SLR: Statutory liquidity ratio?
- Continuing the same example. SBI got 1 crore on Monday.
- But suppose, RBI gave him order, “you must keep Rs.10 lakhs aside. (CRR)”
- Thus, SBI is left with only 1 crore – 10 lakhs = 90 lakh rupees.
- So SBI manager decides to get maximum profit out of remaining money. Suppose ongoing rate for business loans is 12%.
- But there is one businessman Mr.Parajay.
- No bank is offering him loan, because his past track record is not good: his earlier business adventures were epic fail.
- This Mr.Parajay comes to SBI
| Mr.Parajay, the businessman | I desperately need loan for my business. but no other bank is giving me loan. Tell you what, give me all of those 90 lakh rupees as loans, I’m ready to pay 36% interest rate on it! And trust me, I’m going to make lot of money in my new business project. And I’m ready to mortgage all of my factories, cars, farmhouses. So if I can’t repay loan, you can auction them and recover your money. |
| SBI manager | Good! I’ll give you all of my 90 lakhs as loan! |
- After six months, Mr. Parajay’s new business project = also #EPICFAIL.
- He cannot pay back the EMIs.
- Although SBI can attach his assets and auction them to recover the money. But it’ll take lot of time.
- In the mean time, common-men also read this story in local newspapers and they panic that SBI will collapse and bank manager will shut down the office and run away.
- So all the common men line up in front of bank and demand back their money. Recall that SBI still has 10 lakh left in CRR. But people want total 1 crore back!
- Again money of account holders (common men) is stuck =problem, protest, rioting, suicides.
- So, Condition #2: Bank must not give away all its loans to risky loan takers. Banks must invest part of its money in “safe and liquid” investment. So during emergency, bank can sell those “liquid” investments and take out the money.
- For example, Government securities, gold, corporate bonds of reputed companies like Infosys, reliance, TCS. These are “safe” investments.
- These are also “liquid”, because you can sell them quickly whenever you want. (recall that SBI could also auction Mr.Parajay’s properties, but it’ll take lot of time in paperwork, legal issues etc.)
- Ok so, bank should invest part of common-men’s money in “safe” investments like Government securities, gold and corporate bonds of highly reputed companies.
- BUT who will decide how much money should be invested in this sector?Ans. RBI via SLR (Statutory liquidity ratio).
- Let’s assume RBI ordered SBI to keep Rs.25 lakhs under SLR.
- Thus, out of original Rs.1 crore that SBI had, 10 lakhs (CRR) + 25 lakhs (SLR) are gone.
Bank Runs: SLR+CRR
- Suppose a rival bank of SBI, hires some people to spread rumors against SBI.
- The rumor is something like this= “SBI invested lot of money in sharemarket but sharemarket is crashed so now SBI doesn’t have any money left. They’re going to shut down the office and run away.”
- ^this is totally ridiculous rumor because according to RBI rules, banks cannot invest depositor’s money in the sharemarket in the first place!
- Anyways, out of the 100 SBI account holders (common men), 30 common men believe in this rumor and run to the SBI office.
- They demand SBI to return their entire savings deposit. Such panic movement of bank customers is known as “bank run”.
- Thankfully, SBI has total 10 lakh (CRR), so they can directly give it back. SBI also has set aside Rs.25 lakhs under (SLR), so SBI can sell away those Government securities, gold worth 25 lakhs and give that money back to account holders.
- Thus, SLR+CRR protects a bank against Bank runs.
- However in case of a “totally awesome” bankrun, nothing can protect a bank. (i.e. when all of the account holders simultaneously demand all of their money on the same day!) anyways back to the topic:
WHY Priority Sector lending?
So far, You know what is CRR and SLR.Now SBI manager start making calculation, how much money is left with him?
| Money received from common men | 1 crore=100 lakh |
| Money set aside in CRR | MINUS 10 lakh |
| Money invested in SLR | MINUS 25 lakh |
| Money left | 100-10-25=Rs.65 lakh. |
- Out of that 65 lakhs, let’s assume SBI manager has to keep aside 15 lakh for Administrative costs, salaries of employees, electricity bill, internet bill, Xerox machine etc. So he has only 50 lakh left for providing “loan” to needy people.
- Now loan-takers line up in front of SBI office
| 50 farmers | Give us loans of 1 lakhs each for buying seeds and fertilizers. However, given the vagaries of monsoon and low profit margin in agriculture, we cannot pay more than 5% interest rate. |
| 25 Small businessman | Give us loans of 2 lakhs each to setup small retail shops / car mechanic / hair saloon etc. We offer 11% interest rate. we cannot offer a penny more because our profit margin isnot good. |
| 2 Students | Sir please give us loan of Rs.25 lakhs each, for paying self-financed medical college. We can pay atmost 9% interest rate. |
| 1 Big businessman | Give me those 50 lakhs. In a few months, Diwali is coming and I want to setup a new firecracker factory. I offer you 15% interest rate. |
- if SBI is run from purely profit point of view, then farmers, small businessmen, students and weaker sections of the society will never get any loan.
- Because SBI manager would want to give loan to a person that offers him highest interest rate.
- Then who is going to protect those weak people? Who is going to help them get loans at reasonable rates? Ans. RBI.
- Suppose RBI tells the SBI manager, “40% of the money you lend, must go to priorities sectors viz. agriculture, small scale business, housing and education.” (=40% of 50 lakh=20lakh).
- ^This is the basic funda of priority sector lending. More details are given on page 15.12 of Ramesh Singh.
What is NDTL?
- So far, We know that Banks have to comply with the CRR, SLR and priority sector lending rules of RBI.
- CRR, SLR is counted on amount of money a bank receives. But bank receives lot of money,
- from depositors,
- from loan takers who’re re-paying EMI,
- (fraudulent) hidden charges imposed on credit cards
- Commission charged on giving demand draft
- Commission charged on online money transfer
- Commission charged on foreign currency conversion etc.etc.etc.
- So how does bank exactly count CRR, SLR requirements? = Net Demand and Time Liabilities (NDTL)
| Main example (list not exhaustive) | |
| Time liabilities |
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| Demand liabilities |
|
- I’m not going into minute nitty-gritty involved in computing NDTL because that’s irrelevant from exam point of view. So long story cut short, CRR and SLR are calculated on this NDTL number with some caveats.
- And banks have to send reports to RBI on fortnight basis that “our NDTL is xyz and we are maintaining xyz SLR and CRR on it as per your direction.”
- Now here comes the problem: In our example, SBI followed SLR, CRR and 50 lakh rupees left for loaning.
- However in the given period, priority sector loan takers (farmers, students etc.) and regular loan taker (businessmen, car/bike loans)….all of them together take total loans worth only Rs.30 lakhs.
- so SBI is left with 50-30=surplus of 20 lakh rupees.
- These 20 lakhs are just gathering dust in the office. Nobody is coming to take new loans! What should SBI do? because SBI has to give 7% interest even on these 20 lakh rupees, so SBI cannot afford to let this money gather dust!
- Now comes the Liquidity adjustment facilities, Repo Rate and reverse repo rate.
- Let’s start with reverse repo rate.
Reverse repo rate?
- The book definition of Reverse repo rate = “it is interest rate paid by RBI to itsclients for short term loans.” Ok but who are the clients of RBI?
- Central Government
- State Government
- Banks (commercial, regional rural banks, cooperative banks)
- Non-banking financial institutions etc.etc.etc.
- anyways, Reverse repo rate in crude words= when SBI parks its surplus money in RBI for short term, SBI makes ^this much profit.
- But actually reverse repo rate works in a bit complicated manner= via selling and repurchase of Government securities.
- You’re aware of Government securities: when Government wants to borrow money from market, Government security / Government bond is issued.
- Basically it’s a piece of paper. It has agreement something like: “whoever gives me Rs.100 will get 8% interest rate for 10 years and then principle will be repaid”.
- For the purpose of understanding Reverse repo, let’s construct a simplified technically incorrect model:
- RBI has Government securities worth Rs.100 lakhs.
- SBI has surplus Rs.100 lakhs and nobody is taking them as loans. But SBI is sure more people will come to take loans before Diwali. So SBI just wants to park this surplus 100 lakhs somewhere for the short-term.
- SBI enters into Reverse Repo agreement with RBI.
- The agreement reads “I (SBI) will give buy Government securities worth Rs.100 lakhs from the RBI, and RBI promises to buy back those securities from me after 6 months @Rs.106 lakhs.
- Time: after 6 months,
- SBI’s investment: Rs.100 lakhs
- After 6 months, SBI gets: Rs.106 lakhs.
- So profit of SBI (or interest earned by SBI or interest paid by RBI)=(106-100)/100 = 6%. This is reverse repo rate.
Tied to repo rate
In 2011, under RBI made following rule:- reverse repo rate would not be announced separately but will be linked to repo rate.
- The reverse repo rate will be 100 basis points below repo rate.(=minus 1%)
What is repo rate?
Common sense says, it has to be reverse of “reverse repo rate” right? Yes that is right.Textbook definition says
- Repo rate is the rate RBI charges on its clients for short term loans.
- To put this crudely, when SBI wants to borrow money from RBI for short term, SBI will have to pay ^this much interest rate.
- (again) For the purpose of understanding repo rate, let’s construct a simplified technically incorrect model:
- RBI has cash of Rs.100 lakhs.
- SBI has Government securities worth Rs.100 lakhs.
- SBI enters into Repo agreement with RBI.
- The agreement reads “I (SBI) am selling my Government securities worth Rs.100 lakh to RBI and I (SBI) promise to buy back(repurchase) those securities from RBI after 6 months @Rs.107 lakhs.
- Time: after 6 months.
- RBI’s investment: Rs.100 lakhs
- After 6 months, RBI gets: Rs.107 lakhs from SBI.
- So profit of RBI (or interest earned by RBI or interest paid by SBI)=(107-100)/100 = 7%. This is Repo rate.
Repo rate vs Bank rate?
Repo rate | RBI lends money to banks for short term loans @this interest rate. |
Bank rate | RBI lends money to its clients for long term loans @this interest rate. |
What is LAF?
- liquidity adjustment facilities (LAF).
- Recall that one of the main task of RBI is to control money supply in the economy.
- RBI controls money supply via monetary policy. For this RBI uses various “tools” e.g. SLR and CRR.
- Liquidity adjustment facilities (LAF) is also a tool used by RBI to control short-term money supply.
LAF timeline
| 1998 | Narsminam Committee on banking rector reforms, recommends LAF |
| 1999 | RBI introduces interim LAF |
| 2000 | RBI introduces full-fledged LAF. |
- In the old Bollywood movies, international smugglers often come to main villain’s hideout with suitcases loaded with cash. Then main villain will auction some ancient Indian statues to them. Something similar happens under LAF.
- LAF helps banks to quickly borrow money incase of any emergency or for adjusting in their SLR/CRR requirements.
- Under LAF, RBI auctions Government securities, starting at the repo and reverse repo rate. Minimum bidding amount is Rs.5 crore.
- So LAF is a tool used by RBI to control short-term liquidity / money supply in the market.
- In LAF, money transaction is done via RTGS. (RTGS is an online money transfer method). So in this auction, players don’t need to bring suitcases loaded with cash.
What is RGTS?
- RTGS, NEFT=These are online facilities for transferring money within the country.
| Real Time Gross Settlement (RTGS) | National Electronic Fund Transfer (NEFT) |
| Fast (immediate money transfer) | Slow (done on hourly basis) |
| Can be used only if money transfer amount is minimum 2 lakh rupees or more. | Can be used for any amount. There is no minimum or maximum limit. |
What is Marginal Standing facility (MSF)?
- RBI started this thing in 2011.
- Under MSF, Scheduled Commercial Banks can borrow money from RBI @1% higher than the ongoing Repo rate under liquidity adjustment facility (LAF.)
- Although, the system of lending remains same just like under repo. = SBI sells Government security to RBI, and promises to buy it back after sometime, at a higher rate. Difference in selling and purchase = interest rate earned by RBI.
- we can memorize it like
- Repo rate = reverse repo + 1%
- MSF rate= repo rate + 1%
Difference between LAF and MSF
LAF | MSF |
| Liquidity adjustment facility | Marginal standing facility |
| Minimum bidding amount is 5 cr. | 1 cr. |
| All clients of RBI are eligible to bid. | Only scheduled commercial banks can bid. |
| Bank cannot sell Government security to RBI that is part of bank’s SLR quota. | bank can sell the Government security from its SLR quota to RBI. |
| Bank can borrow any amount of money as long as it has the securities to sell. | Bank can maximum borrow upto 2% of its NDTL. |
| Suppose repo rate is “r%” | MSF lending rate is always (r+1)% |
Open market operations?
- Open market operation= when RBI buys/sells securities in open market.
- How is it different from LAF or MSF?
- Well in LAF or MSF, one party buys Government security from second party. But second party has agreed to buy back (repurchase) the same security from first party after some time. So Government security is not “permanently” sold, it is only used as a collateral= that’s like pawning your jewelry in Muthoot finance company.
- But in case of OMO, first party permanently sells the Government security to second party. Second party is free to do whatever it wants with that security.
- When RBI purchases Government securities =liquidity increased (because RBI is paying that party some money to buy that security, right? so RBI is pouring additional money into the system.)
- On reverse, when RBI sells Government securities= liquidity is decreased. (because those players are giving their cash to RBI to purchase the securities= money is sucked out of the system by RBI).
Also you can take a look at Very important basics of WPI, CPI, Inflation
Summary
From SBI manager’s point of view| CRR | I must keep this much money aside. I cannot give it as loan to anyone. I will not earn any interest rate on it. |
| SLR | I’ve to invest this much money in gold, Government securities (G-sec) and RBI approved corporate bonds. |
| Repo rate | If I borrow money from RBI for short term, I’ll have to pay them this much interest rate. |
| Reverse repo rate | If I park my money in RBI, they’ll pay me this much interest rate. |
| Bank rate | If I borrow money from RBI for long term, I’ll have to pay this much interest rate. |
