Liquidity Crisis in Indian Banking System?

The Marginal Standing Facility

Deepak Shenoy

 

In an attempt to unravel what’s happening with liquidity in India, let me explain a new concept called the Marginal Standing Facility (MSF).

 

When you deposit money in a bank, it has to keep 6% of that money as a reserve called Cash Reserve Ratio (CRR) against withdrawals by depositors as a whole. It also has to put 24% in Government of India bonds as a “Statutory Liquidity Ratio” (SLR) requirement. The rest it can lend out.
Usually banks buy excess SLR-able bonds, maybe upto 28% of deposits. The excess they can use to generate quick liquidity if they so desire.

To meet liquidity requirements, banks get to borrow from the RBI, with auctions conducted everyday for overnight (or over weekend) borrowing. This is called “repo” – or “repurchase” operations, where banks borrow overnight from the RBI and place, as collateral, the excess SLR securities. This happens currently at 8.5% per annum, but repo rates change.
Now the operation is conducted as a sell-repurchase operation – so the RBI actually buys the security from the bank, but the bank is forced to buy it back at a higher rate (the rate differential is at the 8.5% annualized rate for the period borrowed).

What happens if banks don’t have any excess SLR bonds, but are desperate for some cash? This has happened in the early part of 2011, when the RBi started to conduct TWO repo auctions per day instead of one, and relaxed SLR requirements. (They are called LAF auctions, or “Liquidity Adjustment Facility”. Don’t ask.)

To avoid this – since the SLR is in a way a sacrosanct figure – the RBI introduced the Marginal Standing Facility or the MSF. I call this “despo” borrowing, since it’s done just like Repo except:
a) it comes at 9.5%, not 8.5% (a full percentage point higher than repo).
b) banks must place GOI bonds as collateral. But if they do that, since it’s a sell-and-repurchase operation, the bank will not own the GOI bond after the auction (it’s sold to the RBI). Which means it will violate SLR requirements of 24% of deposits. But if used for the MSF, the RBI allows the bank a relaxation of SLR limits. This relaxation is only upto 1% of the deposit base of the bank; above that is still subject to RBI penalties.

Now banks don’t pay 9.5% unless they are in a liquidity crisis, have maxed out repo and can’t access the call money markets. Then, the MSF borrowing is used, but is a sign of stress: that’s why it is “despo” borrowing. RBI reveals MSF figures every day in a press release marked “Money Market operations).

The RBI is the lender of last resort – that MSF is being used indicates that banks really need money, and they can’t get it from depositors (perhaps depositors are withdrawing money in large numbers – like for advance tax payments) Banks can’t generally go to people they have lent money and say give me back the loan earlier than its term, so they use the RBI facility like repo, and failing that, the MSF, to tide over any intermittent demands for money.