Liquidity woes prompt RBI to hold largest VRR auction in a year
Context:
The Reserve Bank of India (RBI) recently conducted its largest variable rate repo (VRR) auction in nearly a year, aimed at addressing the mounting liquidity deficit in the banking system. The auction, with a notified amount of ₹2.25 lakh crore, saw bids totaling ₹2.77 lakh crore, leading to a second VRR auction worth ₹50,000 crore, which also received a robust response.
About the Current State of the Liquidity Crisis:
- Rising Liquidity Shortfall
- The liquidity shortfall in the banking system intensified significantly in January 2025, with the deficit crossing the ₹2 lakh crore mark on January 10. The tightening of liquidity is attributed to several factors:
- RBI’s Forex Interventions: Measures to stabilize the currency have absorbed liquidity from the market.
- Currency in Circulation (CIC) Outflows: Increased demand for cash has further strained the system.
- Future Bleak: Key Indicators
- End of Large Bond Redemptions: With major bond redemptions behind, liquidity inflows from this source have ceased.
- Persistent CIC Outflows: Currency outflows are expected to continue in the first quarter of 2025.
- Interbank Money Rate Surge: The interbank call money rate has jumped by 55 basis points above the RBI’s repo rate of 6.50%.
RBI VRR to Solve the Crisis:
The Variable Rate Repo (VRR)) is a Reserve Bank of India (RBI) liquidity management tool under the Liquidity Adjustment Facility (LAF) to address short-term liquidity mismatches. Banks borrow funds by pledging eligible securities like government bonds as collateral.
Key Features of VRR:
- Auction-Based System: Banks bid the amount and rate they are willing to borrow; RBI allocates funds based on bids.
- Market-Determined Rates: Operates at rates reflecting current liquidity conditions and demand.
- Short-Term Liquidity: Provides funds for tenors ranging from overnight to a few weeks.
- Collateralized Lending: Banks pledge securities to access funds, ensuring secured borrowing.
Benefits:
- Immediate Liquidity Relief: Bridges temporary liquidity gaps.
- Stabilizes Markets: Prevents volatility in interbank lending rates.
- Efficient Allocation: Competitive bidding ensures liquidity reaches needy banks.
- Supports Financial Stability: Mitigates disruptions in banking operations.
Limitations:
- Temporary Solution: Addresses short-term issues, not structural deficits.
- Collateral Constraints: Participation limited by availability of eligible securities.
- Rate Volatility: High demand can increase borrowing costs.
Need for This Step by RBI:
The VRR auctions were necessitated by:
- Soaring Borrowing Costs: The liquidity deficit has pushed borrowing costs higher, affecting overall financing conditions.
- Deterrent to Banking Operations: High costs discourage banks from maintaining healthy loan-to-deposit ratios and pricing their assets efficiently.
- Market Stability: Addressing liquidity ensures smoother financial operations and reduces volatility.
Negative Impacts of High Volatility and Liquidity Crisis:
The liquidity crisis has adverse effects on commercial banks:
- Increased Borrowing Costs: Higher interbank rates squeeze margins.
- Loan Pricing Challenges: Difficulty in maintaining competitive loan rates.
- Asset-Liability Mismatches: Strain on balancing short-term liabilities and long-term assets.
- Weakened Credit Growth: Reduced ability to extend credit hampers economic growth.
Steps Already Taken by RBI:
The RBI has undertaken several measures to address the liquidity crisis:
- Variable Rate Repos (VRRs): Conducted to inject short-term liquidity into the banking system.
- Forex Swaps: Implemented to stabilize currency movements and manage liquidity.
- Monitoring CIC Outflows: Regular interventions to assess and manage cash demand in the economy.
Additionally, the RBI has advised banks to:
- Optimize asset-liability management.
- Ensure prudent loan-to-deposit ratios.
Steps Banks Have Advised RBI to Take Further:
To further ease the liquidity crunch, banks have proposed:
- Cash Reserve Ratio (CRR) Cut: Reducing the CRR to free up more funds for lending.
- Open Market Bond Purchases: Conducting outright purchases of government securities to inject durable liquidity.
- Longer-Term Repurchase Operations: Extending the duration of repo operations to provide sustained liquidity support.
Why Liquidity Measures Are Proving Inadequate:
The current measures are falling short due to:
- Structural Deficits: The underlying liquidity shortfall exceeds the temporary relief provided by VRRs.
- CIC Outflows: Persistent cash demand keeps draining liquidity.
- Limited Bond Redemptions: With fewer redemptions, banks are not receiving enough liquidity injections from maturing bonds.
