The liquidity challenge and banks

As liquidity conditions change from being abundant to tight, banks are becoming more risk-averse, which has an effect on their business plans. Despite the economy's inherent resilience and policy interventions, downside risks to the economy are gradually becoming more severe due to the ongoing pace of global rate hikes, tight liquidity conditions, sticky inflation, currency risks, volatile investment flows, haunting geopolitical risks, falling trade volumes, fear of recession flagged by leading global think-tanks, slowing economies, and their interconnected risks.

The average amount of net durable liquidity added to the banking system on a monthly basis in April was 8.3 trillion, but it is now only 3 trillion. As of October 21, 2022, credit growth in banks was 17.9%, up from the 6.8% (year-over-year) reported during the previous year.

In contrast, there is a big gap in resources because deposit growth is still only 9.5%. An increase in loan demand is beneficial for the economy, but it also presents liquidity issues that, if not properly addressed in a timely manner, might potentially slow down growth.

Due to the fierce competition for deposits, term deposit rates are rising to about 7%–7.5%, showing some signals of positive real interest rates at a time when inflation has started to drop. The share of current account savings account (CASA) deposits is declining as a result of rising term deposit rates, which could raise deposit costs. After being deregulated, banks reduced the interest rates on savings accounts.

Because of the size of the CASA deposit base, even a slight decrease in the interest rate on savings bank deposits could boost profitability. When CASA was operating well, the policy to reduce its interest rate did work, but as liquidity restrictions become more severe, banks should think about hiking interest rates on savings, especially as term deposit rates are on the rise. If not, money from CASA would logically go to the term deposit market, increasing the cost of resources—a pattern that was already well established.

Financial position-

Call rates are rapidly surpassing the reverse repo rate of 5.65% in the financial markets. Banks are required to use certificate of deposits (CDs) with interest rates as high as 7.97% to mobilise deposits. The high short-term CD rates of 7.15 percent for even 92 days indicate a lack of capital.

As a result, there are currently 2.41 trillion more outstanding CDs than there were a year earlier, or 0.57 trillion. From 2.74 trillion as of March 25, 2022, to 5.49 trillion as of October 21, 2022, banks' total borrowing grew.

There isn't much liquidity left for banks to work within the current liquidity conditions when the credit deposit (CD) ratio of banks is at 75% given that SLR is at 18% and CRR is at 4.5%. This is unless deposit mobilization is vigorous.

Some banks that were relying on easy money and have CD ratios close to 100 may confront significant liquidity issues. They might be forced to fill liquidity gaps at higher market-driven interest rates, putting their profits at risk. If they want to raise money, they must be aggressive and offer greater interest rates on term deposits.

Risk management techniques-

Banks have started implementing stricter risk management measures to deal with liquidity risk as a result of the limited liquidity constraints. Although the RBI has guaranteed liquidity, it would be expensive given that the benchmark yield on 10-year Indian government bonds ended at 7.27 on November 16.

Banks should proactively modify their strategy for managing their liquidity and credit risk now that the RBI has made them more aware of the changing macroeconomic environment, including global spillovers. Even banks with plenty of money only lend to applicants with excellent credit ratings.

As a result, business owners that lack a solid credit rating may find it challenging to finance their investment plans. It is noteworthy that debtors' credit ratings do not develop quickly. They must be developed over time with deliberate credit restraint.