Other than public deposit, there are two major sources of liquidity for banking system: RBI’s liquidity adjustment facility and interbank money market.RBI provides liquidity to the banks at an interest rate called repo rate under liquidity adjustment facility. Under this facility it also absorbs excess liquidity from the banking system at an interest rate called reverse- repo rate. Banks park their excess liquidity with RBI and earn interest income @ reverse-repo rate.Moreover banks also exchange liquidity among themselves in interbank money market. In this market, banks with surplus liquidity lend to banks with liquidity deficit. The interest rate at which these lending and borrowing takes place is called call money rate. Unlike repo & reverse-repo rate which are given (decided by RBI), call money rate is determined by the demand and supply forces in the interbank call money market.
RBI strategically open and close the reverse-repo and repo window to absorb and inject liquidity in the system. Consequently, the availability of liquidity among the banks is the major determinant of call money rate in the interbank call money market.
The banks holding excess liquidity do not find reverse-repo rate to be profitable (to park money with RBI) hence they lend out it in interbank market to other banks (with liquidity deficit). On the other hand, banks with liquidity deficit do not find knocking repo window to be a prudential approach because they find borrowing at repo rate to be costlier than prevailing interbank call money rate.
The reading of the index below 100 implies acute liquidity stress in the banking system. And reading above 100 implies comfortable liquidity condition. Most of the time during 2018 the index remained below medium term average (48 months average).
It seems that RBI prefers to keep the liquidity condition slightly tight for their ease of liquidity management process.
RBI strategically open and close the reverse-repo and repo window to absorb and inject liquidity in the system. Consequently, the availability of liquidity among the banks is the major determinant of call money rate in the interbank call money market.
A drop in call money rate below reverse repo rate indicates considerably excess liquidity in the banking system. This happened during the demonetisation days when public deposited their money in hand with banks to get new currency note. Those were extra ordinary days and do not occur under regular banking practices.
Most of the time we see call money rate remain above the reverse-repo rate but below repo rate. Hence, the repo rate and call money rate differential can give meaningful indication about the liquidity condition of the banking system.
Most of the time we see call money rate remain above the reverse-repo rate but below repo rate. Hence, the repo rate and call money rate differential can give meaningful indication about the liquidity condition of the banking system.
Normal liquidity condition
Higher the differential better is the liquidity condition. Because it implies banks are sharing their liquidity among themselves in a reasonable manner in the interbank call money market.The banks holding excess liquidity do not find reverse-repo rate to be profitable (to park money with RBI) hence they lend out it in interbank market to other banks (with liquidity deficit). On the other hand, banks with liquidity deficit do not find knocking repo window to be a prudential approach because they find borrowing at repo rate to be costlier than prevailing interbank call money rate.
Tight liquidity condition
On the other hand, narrower the differential tighter is the liquidity condition. Under this condition, call money rate moves closer to repo rate. There are only few banks with excess liquidity hence they hold more power to jack up the call money rate. But if call money rate moves closer to repo rate (or go beyond repo rate) then the banks facing deficit liquidity prefer to knock repo window. The demand and supply forces in the call money market will collide and compete and eventually normalize call money rate.
Thus monitoring the repo rate – call money rate differential provide useful information about the liquidity condition of the banking system.
The Liquidity Index
Thus monitoring the repo rate – call money rate differential provide useful information about the liquidity condition of the banking system.
The Liquidity Index
The reading of the index below 100 implies acute liquidity stress in the banking system. And reading above 100 implies comfortable liquidity condition. Most of the time during 2018 the index remained below medium term average (48 months average).
It seems that RBI prefers to keep the liquidity condition slightly tight for their ease of liquidity management process.
Nevertheless the magnitude of the Liquidity Index gives an indicative understanding of status of liquidity condition in the banking system.
Assessment of current liquidity condition
The liquidity condition in the banking system was slightly tight since early 2018 (see the graph of Liquidity Index given above).
Moreover towards October 2018, the situation aggravated triggered by IL&FS related shocks. Secondly, the liquidity condition was further worsening by unsterilized forex market intervention by RBI to protect Rupee from fast depreciation. Under this, RBI sold US$ in the forex market against buying Rupee from the system. But somehow the Rupee was not adequately supplied back into the banking system.
However, as per latest reading of the Liquidity Index it seems the liquidity condition is normalizing. RBI is infusing liquidity into the system in tranche rather than all in one go because it is difficult to correctly estimate adequate level of liquidity required in the system under such extra ordination condition. For the first time in last 7 month the Liquidity Index improved to touch the medium term average (24 months average)
