Banking Liquidity | Credit | Money Supply

Understanding banking liquidity

There’s plenty talks about banking liquidity and credit crunch – headlining on a regular basis. What does the financial jargon mean and can result into? Prabodh Sharma, a banker, explains:

- By Prabodh Sharma |

Photo by Jason Dent on Unsplash
Photo by Jason Dent on Unsplash

We often hear news that the economy or the banking industry is facing liquidity crisis. Sometimes, they say it’s just credit crunch silly – a shortage of loanable funds and not exactly liquidity crisis but what’s the actual difference. Other times, the market is swamped with funds but the banks sit idle atop those reserves due to lack of credit demand. 

What do these banking terminologies/phrases mean and what are some of their implications? A simple explanation:

Background

Banks’ ultimate business is to collect deposits from individuals/institutions (shown in the liabilities side of their balance sheets) and lend to needy borrowers (assets side) – again to individuals/institutions – who use the credit in fulfilling their financial requirements.

While doing so, banks require adequate liquidity to perform daily operations including abiding regulatory provisions. Deposits placed by individuals/institutions are short-term and volatile in nature, while the lending made by the banks is long-term – so liquidity stress is always a chance. This requires banks to maintain adequate liquid assets to meet short term financial obligations like withdrawal demands.

Photo by Johny vino on Unsplash

In general, liquidity refers to cash or any other cash equivalent assets which are used to meet short term financial obligations. A fraction of banks’ deposits is mandatorily parked at the central bank as liquidity. This practice is called fractional-reserve banking – a common form of banking worldwide.

Banks also maintain a fraction of their deposits as vault cash and buy government issued bills and bonds which are other best examples of liquid assets.

If the banks are short on funds to repay back their depositors, they also borrow money from interbank market - manage adequate funds by trading of currencies between banks and/or the central bank. The availability of sufficient liquidity displays their financial vigor and is one of the key elements to their growth.

Not having sufficient liquidity or sometimes even loss of market confidence can cause panic and bank run, leading to collapse in no time. This can also set in motion systemic disintegration of the banking system – as the industry players are highly intertwined.

One way to explain how global financial crisis 2007/08 got off the ground was banks refused to lend to each other because each began suspecting the others’ financial health after realising the extent of sub-prime lending in the banking industry.

Bank Liquidity 

Let me explain in a more elaborate fashion with respect to Nepal. 

Banks and financial institutions (BFIs) in Nepal are currently allowed to lend up to 85% of the sum of their core capital and total deposits (CCD). This is called CCD ratio, a prudential lending limit, set with a view to utilise the rest of the funds in covering any liquidity requirements out of contingencies. It was earlier set at 80% and relaxed lately through monetary policy 2020/21. 

Out of the remaining funds, BFIs have to first manage Cash Reserve Ratio (CRR) – park cash reserves at the Nepal Rastra Bank - currently set as three percent (earlier four percent) of their total deposits by the NRB. 

Second, banks have to maintain certain liquid assets in the form of cash (vault) and money market investments like government securities (treasury bills, bonds etc) including CRR of deposits. This is called Statutory Liquidity Ratio (SLR) – which is fixed at 10%, 8% and 7% for A, B & C classes of BFIs respectively.

Table 1: Regulatory provisions for liquidity level
CCD ratio was raised to 85 percent from 80 percent in the monetary policy 2020/21. That leaves liquidity level to 15 percent. However, we assume NLA here at 20 percent because the monetary policy 2020/21 is silent about it.

Third, banks have to maintain Net Liquid Assets (NLA) of 20% of deposits. NLA is the sum of placement up to 90 days and investment in government securities, vault cash and CRR. This means NLA comprises of BFIs’ deposit/placement (local and foreign currencies placed with other banks maturing in 90 days) and SLR.

NLA can also be met by additional investment in government securities or by holding higher level of CRR but meets the regulatory prescribed ratio without the need for the placements.

Moreover, BFIs are permitted to invest up to 30% of their core capital in the secondary market (barring stocks of other BFIs), and mutual funds but they don’t count as liquidity.

These regulatory liquidity requirements are adjusted by the central bank (increased/reduced) depending on the market dynamics for funds. If the CCD is increased and CRR and SLR are reduced, it frees up some funds for BFIs to lend, while a tight ratio means banks are expected to stay more liquid while money supply is restrained. The manoeuvring of liquidity ratios is mainly exercised when banks face shortage of loanable funds helping them to cope up with credit crunch (discussed below). The monetary policy 2020/21 had eased the CCD ratio to 85 percent and reduced CRR by one percentage point for the same purpose. 

On day to day basis, liquidity management plays out in a different fashion. BFIs have to deal with large number of daily transactions, so their respective liquidity requirements change accordingly. They may require funds from different sources, NRB or interbank, to  meet their needs – satisfy the regulatory reserve requirements as well as prepare for payment need arising from withdrawal claims and making loans to individual/institutions.

Supply and demand for the NRB fund also determines the liquidity of the banking system. NRB has implemented Interest Rate Corridor (IRC) to keep interest rates at desired level and for that it exercises interest rate ceiling and floor and stabilise liquidity.

IRC comprise three liquidity instruments – Standard Liquidity Facility (SLF) Overnight Repo and Term-Deposit (weekly deposit collection). SLF is exercised by BFIs when they cannot manage daily liquidity from interbank market. Here, NRB acts as ‘lender of last resort’ for BFIs to manage daily liquidity requirements. 

SLF and Repo pump liquidity in the system (NRB lend out to BFIs) while Reverse Repo and deposit collection by NRB (BFIs place deposits at NRB) mops it out. 

SLF forms the ceiling rate (at five percent) of the corridor while the term-deposit (Deposit Collection) forms the floor rate (at one percent). Overnight repo costs three percent.

Market Liquidity

The above explanations are mainly about the inner workings of banking sector’s regular liquidity management. 

Banks also require a sound cycle of liquidity flow to provide credit, without which they can’t grow, neither the economy. Credit creation is its major function. For that, it needs funds to flow through its system. 

If individuals/institutions/governments withdraw funds from banks or market and freeze the funds inside their vaults or employ them in the informal economy, the money is not going back to the banking system obstructing banks to create further credit. We then face the problem of credit crunch.

Photo by The New York Public Library on Unsplash

It however doesn’t mean that banks aren’t liquid anymore to meet its daily financial obligations – it’s just that the banks don’t have sufficient money to lend leaving credit demand go unmet. But the starvation can be economically disastrous if it spirals out of control for long because when you can’t lend, it impedes deposit creation too. 

Time and often, BFIs in Nepal face this unique shortage - credit crunch - for several economic reasons – which can be understood by examining different economic indicators. 

Table 2: Some useful economic indicators

Source: Nepal Rastra Bank Data; *Seven months’ data

Among many other contributions to the national economy like strengthening of foreign exchange reserves, strengthening of current account and poverty alleviation, remittance also contributes to the growth in deposits at BFIs – strengthening the fund position of the banks and enabling them to increase their credit disbursals. There’s a catch though.

Table 3: Some useful economic indicators

Source: Nepal Rastra Bank Data; *Seven months’ data

In Nepal’s context, remittance income effect on liquidity flow into banking system is negated by the country’s rising import bill. Nepal is one of the largest recipients of remittances but in essence those incomes don’t stay in the domestic banking system – they exit the economy covering the country’s much larger import bills.

On the other hand, Nepal’s export volume, as we all know, is too miniscule to make a difference.

Table 4: Some useful economic indicators

Source: Nepal Rastra Bank Data; *Seven months’ data

Government spending strengthens fund positions of BFIs but……

Another crucial reason behind credit crunch is governments’ failure in spending. 

While the federal government’s budgetary plan can help stabilize the market liquidity at desired level, it can only happen if all levels of the government can really spend. 

First, the governments can run deficit spending (not a necessary condition). Deficit spending, it is argued, stimulates economy through monetary expansion.

Table 5: Budget Plan 2020/21 (In NRs billion)

How the government runs deficit - manage its shortfall - is by external and internal borrowing in the form of foreign grants and debt and public debt respectively. Economists use many phrases for this deficit situation - deficit spending, and budget, fiscal or government deficit.  

Second, it has to spend what it has collected and parked in its treasury (a necessary condition). The problem begins when governments (federal and local) fail to spend these revenues (mainly composed of taxes) and borrowings (public and foreign) earmarked for development/capital expenditures. 

While the governments have no problems with meeting recurring expenditures like paying government salaries, successive governments have failed utterly in realising their capital expenditure plans (for instance, delays in small, medium or large development projects like the one we experienced over the decades with Melamchi Drinking Water Project). 

Those funds, in real, stay in the coffer when unspent – held at the government treasury. This means they don’t stream into the market and then to the banking system which is equivalent to absorbing the money out from the market. When you take in the money but don’t put it back into the system by spending it, there will be problems.

In the seven months of the current fiscal year, the government has been able to spend only around 33% of its capital budget, and although it may spike later during the end of fiscal year, such erratic flow doesn’t make up a sound payment cycle.

So, despite flooded with idle deposits earlier due to the pandemic, the banking system is now worried about the looming credit crunch while economic activities start picking up. 

When the system is too liquid!

The pandemic harshly slowed down the economic activities also slowing down the credit demand. As a result, banking system was left with deposits nowhere to lend. During August 2020, market liquidity in commercial banks was recorded at excess of NRs 175 Billion. 

In such cases, the central bank can stabilize the liquidity by performing money market operations i.e. issuing reverse repos, or deposit collection to mop up excess liquidity from the market. 

The growth has rather pushed down the interest rates – an obvious occurrence after declining economy and growth of deposits outpacing credit. Decrease in interest rates and effortless access to credit (because many credit avenues have squeezed at the moment) may be good news for some borrowers, but it could lead to unintended consequences if the real economy isn’t doing well, lending priorities are misplaced and there is large idle fund in the system. 

It is likely that funds will flow into unproductive (trading) or unorganised sectors (real estate) or concentrate investments into few sectors resulting in bubble or inflated asset prices (financial assets as stock prices or real estate prices). 

To put it in perspective, check out the rise in margin lending, NEPSE and market capitalization over the period of pandemic. 

Margin lending has reached Rs 77.35 billion this year – an increment by 70.6 percent when compared on the y-o-y basis and by 53.5 percent in seven months of the fiscal year, says the NRB’s seven month macroeconomic data. 

NEPSE and market cap has also registered a considerable rise (see chart below):

Graph 1: NEPSE index and Market Capitalisation

The growth was also aided by NRB’s relaxation steps in the latest monetary policy. Margin lending limit was increased by five percentage point to 70 percent of the share value while the valuation consideration was reduced to the average share price of 120 days from 180 days.

Prabodh Sharma is a banker. He has extensive experience working as treasurer at different banks. Currently, he is into digital banking.

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