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Banking System Liquidity

Banking System Liquidity

  • Banking System Liquidity is defined as readily available cash that banks require to meet short-term business and financial needs.
  • If the banking system is a net borrower from the RBI under Liquidity Adjustment Facility (LAF), then the system liquidity is said to be in deficit.
  • If the banking system is a net lender to the RBI, the system liquidity is said to be in surplus.
  • During Deficit situation, banks seek funds from Reserve Bank of India to serve the credit demands from the businesses and individuals.
  • Indication: The liquidity deficit indicates that business sentiments and activities are on the rise and they require funds from the financial institutions to further expand their activities.
  • LAF: It is an action by the RBI through which it injects or absorbs liquidity into or from the banking system.
    • This system offers banks the opportunity to borrow money through repurchase agreements or repos or to make loans to the RBI via reverse repo agreements.
    • This arrangement is effective in managing liquidity pressures and assuring basic stability in the financial markets.
    • The RBI introduced the LAF because of the Narasimham Committee on Banking Sector Reforms (1998).


Possible Reasons for current Banking System Liquidity deficit

  • Increase in the bank credit
  • Advance corporate tax payments
  • Intervention of the RBI into the forex market to stem the fall in the rupee against the US dollar
  • Incremental deposit growth is unable to keep pace with credit demand
  • Capital spending of the government


Impact of Banking System Liquidity Deficit on Consumers

  • Rise in deposit rates: The condition would increase the yields of government securities and depositors may expect increase in interest rates on their fixed deposits and others.
  • Rise in loan rates: Banks will increase their repo-linked lending rates (as they have to borrow more from RBI) and the marginal cost of funds-based lending rate (MCLR), to which all loans are linked to.
  • A rise in the repo rate will increase cost of funds.


Way forward

  • Temporary situation: If RBI feels that current liquidity deficit situation is temporary and is mainly due to advance tax flow, it may not have to act, as the funds would eventually come back into the system.
  • Long term situation: However, if RBI believes that the liquidity deficit is long-term in nature then the RBI will have to take measures to improve the liquidity situation in the system.


Important Terms

  • Call money:  Call money rate is defined as the rate at which short term funds are borrowed and lent in the money market. The duration of call money is 1 day.
  • T-bills: Treasury Bills are money market instruments issued by the central bank (on behalf of the government) to raise money for a short duration (less than 1 year).
  • Repo rate: It is the rate at which the central bank of a country lends money to commercial banks. It is an important monetary policy tool.
  • Marginal Cost of funds-based Lending Rate (MCLR): MCLR (Marginal Cost of Funds Based Landing Rate) is the minimum interest rate below which financial institutions cannot lend money, except for certain cases.


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