Coronanomy — 02

Enhancing Liquidity

“Root of the problem is to make Indian banks take risk and lend.” — Subhash Chandra Garg, former finance secretary, Government Of India

All Financial Institutions are bracing for a new wave of defaults especially from small businessmen and individuals whose wages have eroded. Thus, banks are wary of any further lending to MSMEs and small retailers. With no revenue source, they are in desperate need of funding to cover their fixed costs. The Indian economy will be severely impacted which we talked about in the previous blog

Thus, In view of heightened volatility, and unprecedented uncertainty, RBI unleashed an array of instruments from its arsenal to rekindle growth and preserve financial stability.

To fully understand the steps taken by RBI, first, we need to understand a few tools that RBI has on its table.

RBI Tools

• Repo rate: Repo rate is the interest rate at which the central bank of a country lends money to commercial banks in case of shortfall of funds.
• Reverse repo rate: Reverse repo rate, as the name suggests is exactly opposite of the repo rate, that is, the interest rate at which commercial banks keep their reserve money with the central bank.
• Cash Reserve Ratio: Cash Reserve Ratio is a specified minimum fraction of the depositors money that banks have to keep as reserves with the central bank.
• LTRO (Long term repo operations): LTRO is a tool that allows commercial banks to obtain funds from RBI at repo rate for longer durations such as 1–3 years. Targeted LTRO (in this case) implies that the RBI wants the banks to invest funds specifically in corporate debt, i.e. the target is to invest funds by lending to the corporates.

A Quick word on NBFCs and MFIs

NBFCs (Non-Banking Financial Companies) and MFIs (Microfinance Institutions) are financial institutions that borrow money from big banks and provide credit to customers which are largely ignored by mainstream banking institutions. They are usually low-income customers from remote areas. Some of the notable NBFCs are Muthoot Finance Ltd, Bajaj Finance Ltd, etc.

Now, these institutions face a different dilemma during the lockdown. Most of the EMI payments are fulfilled on a cash basis at physical checkpoints which have been halted substantially but on the other hand, they have millions in repayment obligations. So there is a visible cash flow disruption in their activities which has brought small and mid-size NBFCs and MFIs on to their knees.

RBI Announcements

Collapse in consumer demand, stalled industrial production, towering unemployment rate, and increase in poverty (a large number the population not being able to afford two times meal due to job losses) have led RBI to take some tough steps whose main aim is:

1. To enhance liquidity in the system to ensure the normal functioning of financial markets and institutions
2. To ease financial stress by relaxing repayment pressures

Announcements to Boost Liquidity

1. Reduction in policy rate

• Announcement
  On 27 March, RBI announced a reduction in policy repo rate by 75 basis points from 5.15% to 4.40% while the reverse repo rate was reduced by 90 basis points from 4.90% to 4% and from 4% to 3.75% on April 17.

• Now, banks can borrow at a lower interest rate, and banks usually pass this benefit to their customers offering loans at a lower rate. Also, the reverse repo rate cut makes it less attractive for banks to park their money with RBI and gives them an incentive to take risks and issue more loans.
• Impact
  Due to the uncertain financial markets, all the banks have been pulling out their money from various investments which have become riskier leading to mass sell-offs of various types of securities and an evident drop in the stock market. After decreasing the repo rate and the reverse repo rate, banks still have been parking close to Rs. 7 lakh crores on a daily basis with RBI at reverse repo rate showing their reluctant lending nature at the time. Banks are in risk-off mode and their current priority is to preserve capital and reduce chances of current exposure becoming default in future. So, there is less appetite for fresh exposures and rather than extending loans, banks have resorted to parking surplus liquidity back with RBI at a very low reverse repo rate of 3.75%.
  “Even if they would be earning less at reverse repo, they have little option” — said Soumyajeet Niyogi, associate director at India Ratings.

2. Reduction in CRR

• Announcement
  RBI decided to reduce CRR of all banks from 4% to 3% of net demand and time liabilities (NDTL). This reduction of CRR would now restrict banks to keep a lower fraction of money with RBI as a reserve and unlocking Rs 1.37 lakh crores liquidity into the banking system.
• Impact
  Money unlocked for the banks due to a reduction in CRR have mostly found its way back to RBI under reverse repo rate proving reduction in CRR more or less fruitless.

3. TLTRO (Targeted Long term repo-operations)

• TLTRO 1.0 Announcement
  On 27 March, RBI announced a TLTRO of Rs 1 lakh crores in 4 auctions of Rs 25000 crores each. RBI stated that liquidity obtained under this scheme has to be deployed in investment-grade corporate debt. That is, banks were to deploy these funds to the companies which have very little risk of default. It was also stated that funds acquired under this operation were to be deployed in 30 working days. Later, the duration was increased to 45 days.
• Impact of TLTRO 1.0
  However, it was found out that banks used the first lot of TLTRO money worth Rs 1 lakh crores in AAA-rated companies. Top-rated companies usually don’t need emergency liquidity support so the whole purpose of helping those who are in dire need of funds was defeated.
• TLTRO 2.0 announcement
  Soon, RBI realized that mid and small size NBFCs and MFIs who usually lend to the people who are most vulnerable are still facing a massive liquidity crunch and in a bid to help these institutions, On 17 April, RBI announced TLTRO 2.0 of Rs. 50000 crores in 2 auctions of Rs 25000 crores each. Under this TLTRO 2.0 scheme, banks have to invest 50% of the funds in mid and small size NBFCs and MFIs.
• Impact of TLTRO 2.0
  On April 23, the first auction under TLTRO 2.0 was conducted but the RBI only received bids for half of the money that is, only for about Rs. 12500 crores out of Rs. 25000 crores it decided to offer indicating the reluctance of banks to lend to more risky NBFCs and MFIs. Such cold shoulders by all the banks is indicative of a credit freeze that is hard to overcome.
  Sanjiv Bajaj, MD, Bajaj Finserv tweeted that “RBI must give a direct line (direct loans) to NBFCs and MFIs and the Finance Ministry must offer to bear loss for some time. Let’s get our smaller but important lenders ready for the start of economy”

4. Special Credit facility for NABARD, SIDBI, and NHB

• On 17 April, RBI announced a special credit facility of Rs 25000 crores to NABARD (National Bank for Rural And Agricultural Development), Rs. 15000 crores to SIDBI (Small Industries Development Bank of India) and Rs. 10000 crores to NHB (National Housing Bank) to help NBFCs and MFIs on a local level.

Result

RBI took some tough but necessary measures and was doing most of the heavy lifting before the recent Rs 20 lakh crore fiscal stimulus package from the Government Of India. There is panic and fear among all financial institutions as they expect a large number of defaults especially from small businessmen and individuals. Although loan growth rate restored back to pre-COVID levels (thanks to RBI) which was already very low, still, much of the lending has been done to big top-rated institutions rather than the ones who are desperate for money.

All these measures were estimated to infuse a liquidity of about Rs. 4.74 lakh crores into the system and while RBI was successful in doing that, there is hesitation among banks to lend and a lack of interest among borrowers to borrow especially cottage, small and medium businesses.

In the next blog, we will talk about the measures taken by RBI to relax repayment pressures for the borrowers.