Thu, 13 Oct 2011
Is there a two tier inter bank market in India?
Update October 13, 2011:
After I posted this yesterday, the RBI published the results of the Reverse Repo auction yesterday showing that there was no money parked with the RBI yesterday. Possibly, the top tier banks are also now cash deficit in the aggregate, and they do not have any surplus to deposit with RBI. Or perhaps, the two tier market is de-tiering. I do not know.
Original post (October 12, 2011):
In a well functioning inter bank market, cash surplus banks lend to cash deficit banks and only the aggregate cash surplus or deficit of the banking system is absorbed by the central bank’s liquidity operations (repo or reverse repo). In a two tier market, there is a top tier of healthy banks that lend to and borrow from each other, but this tier refuses to lend to the second tier of banks whose financial health is suspect. In such a market, if the top tier banks in the aggregate have a cash surplus, they would not lend it to the second tier banks, and would instead park the surplus with the central bank. If the second tier banks have a cash deficit, they would be borrowing from the central bank because they are unable to borrow from anybody else. The central bank would thus be partially supplanting the inter bank market. A two tier market is of course better than a complete seizure of the inter bank market where there is no inter bank market at all and all cash surpluses are parked with the central bank which on-lends it to the deficit banks. After 2008, this progression from a normal inter bank market to a non existent one is well known and understood.
What I am worried about is whether there is a two tier inter bank market in India today. Since the end of last month, we have been seeing the odd situation of some banks parking cash with the RBI at 7.25% while other banks are borrowing from the RBI at 8.25%. If there is no tiering of the banking system, this does not make sense. The surplus bank could lend to the deficit bank at 7.75% and both banks would be better off. The surplus bank would earn ½% more than what the RBI pays, while the deficit bank would reduce its borrowing cost by ½%. That this is not happening suggests that the surplus bank does not have confidence in the solvency of the deficit banks and prefers a safe deposit with RBI. Put differently, there are some banks who are able to borrow only from the central bank as other banks are unwilling to lend to them.
When I started observing this phenomenon at the end of September, my first reaction was that it was due to the distortions caused by the half yearly closing on September 30. When it lasted beyond that, I thought that this was just the effect of the holiday season (Durga Puja and Dussehra). But all that is now over and still the phenomenon persists. Are some bankers worried about the solvency of their fellow bankers?
Posted at 10:41 on Thu, 13 Oct 2011 11 comments permanent link
Comments...
R Sivakumar wrote on Thu, 13 Oct 2011 19:17
Re: Is there a two tier inter bank market in India?
Prof,
You were right the first time around. It was a temporary mis-match around the quarter end and the following weekend (again a short week). Banks tend to over-cover their cash reserve requirements at the quarter end, and the first week of the new quarter tends to see release of this. This is just missed opportunities. The surplus banks would simply have bid in the reverse repo without exploring the inter-bank repo market.
V Raghunathan wrote on Fri, 14 Oct 2011 16:50
Re: Is there a two tier inter bank market in India?
You have said that the fact that the arbitrage between 7.25% and 8.25% does not happens suggests “that the surplus bank does not have confidence in the solvency of the deficit banks and prefers a safe deposit with RBI.”
Well, as I see it, it may well be that some banks think the risk premium implied in the spread between 7.25% and 8.25% above is not good enough for them to assume the risk. Why, even I prefer SBI’s 7% FD rate to some banks’ 8%, though I may find them acceptable risk at 9%... Put simply, confidence in deficit bank is not a zero-one matter…May be the spreads are not right…may be the deficit banks need to get more realistic…
Raghu
Prof. Jayanth R. Varma wrote on Fri, 14 Oct 2011 16:55
Re: Re: Is there a two tier inter bank market in India?
Sure, confidence is not a zero-one matter. But these are overnight deposits. For a smart person to believe that there is a non trivial risk that a particular bank might not be solvent tomorrow, the bank must be in pretty bad shape.
V.Raghunathan wrote on Fri, 14 Oct 2011 17:10
Re: Re: Re: Is there a two tier inter bank market in India?
But Jayant, any one deposit may be overnight; but if banks have to do this day in and day out, surely they cannot overlook the risk? It is like saying, I don't need to use my seat belt for the next one minute because the risk is negligible, and then again for the next one minute because the risk is negligible and so on, till you face that crash without the seat belt!!
Prof. Jayanth R. Varma wrote on Fri, 14 Oct 2011 17:38
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The difference is that a car crash happens all of a sudden while a bank failure typically happens in slow motion. Whether it is Bear Stearns or Lehman or any other failing bank, the time lag between the first rumours of distress to actual failure is usually several months giving more than enough time for the overnight lender to exit.
V.Raghunathan wrote on Fri, 14 Oct 2011 17:52
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I recall a few years ago ICICI Bank having a run on it virutally overnight (until RBI stepped in, of course!) I would think all business is about expectation of risk adjusted returns...It is not about having or not having confidence...
R Sivakumar wrote on Mon, 17 Oct 2011 14:42
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Both of you have made interesting points, but one important facet of the original issue is to be borne in mind. The repo and reverse repo (and the CBLO market) overnight deposits are fully collateralised. It may be argued that the collateral may not be exactly marked to market (but from my own personal experience, it usually is). Thus expectation of counterparty bank failure cannot be the cause for this disconnect. I re-submit that this happens because of timing asymmetry (e.g. surplus bank placed a reverse repo bid with RBI before realizing there is a willing borrower in the market).
Aseem Gupta wrote on Wed, 19 Oct 2011 17:50
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Sir,
I'm an alumni who's trading in overnight money markets for a foreign bank. I'll try to shed some light on the Sep-end phenomenon below.
The anomaly of large lendings to RBI in the LAF window in beginning-Oct does not reflect the fundamental deficit in the system and is not an indicator to credit squeeze in the markets. This happened due to purely technical reasons.
At quarter end nationalized and private banks tend to clean up their balance sheets for the reports to be sent to RBI and shareholders. * From the overnight lender's perspective Call money market leads to higher capital utilization (as it is unsecured). And between showing cash on the B/s vs lending in the collateralized markets, the first choice is a winner. * From the borrower's perspective it is better to show that you are converting your excess SLR into cash by borrowing from RBI in the LAF window OR from the cash-rich mutual funds. However mutual funds face large redemptions at quarter ends (Banks & corporates withdrawing to show cash on their B/s) and lend much lower amounts through the CBLO/Repo route.
Therefore overnight money markets tend to have lower volumes and most of the system deficit is funded through the LAF window.
For satisfying their CRR requirements, banks need to keep an average of 6% of their liabilities in cash over 14 days (the reporting fortnight). The sep-end reporting fortnight started from 24Sep11 to 07oct11. The banking system had an average shortfall of 50,000k for this fortnight however they had overcovered their positons in the first 9 days - LAF borrowing of 60k-78k the first 5 days and 95k for the next 4 days due to 29 Sep being the month-end. Even so, banks had a small borrowing position. However between 3rd and 4th Oct the govt. spent around 30k cr causing a flood of liquidity into the system. Since RBI does not give any return on the excess cash kept with it, it made sense for banks to just lend it back to RBI for the next few days @ 7.25%.
So if the banking system had not overcovered their deficit positions and the govt. had not spent that much cash in the new quarter, we would have seen the normal scenario of banks borrowing from RBI instead of vice versa.
Hope this has thrown some light on the Sep-end anomaly.
Overnight money markets in India are one the most liquid in EM with average daily volumes of 55k cr in CBLO, 15k cr in Call and 15k cr in CROMS/Market repo. During the Lehman period, RBI was very proactive to avert any freezing up of these markets. They had introduced a number of measures to ensure INR liquidity lines don't dry up although some stress was caused by USD availability. Indian banks are decently ring-fenced from the outside and since sovereign-backed nationalized banks form a majority of the banking system overnight markets are unlikely to dry up for them, although negative news would cause longer tenor credit to go up. The recent Europe crisis did not have much impact on the overnight money markets, though some impact was seen on foreign banks (however they form a small part of the banking system).
Currently the banking system liquidity is in deficit of approx. 50,000cr and is expected to grow further (since RBI has announced a larger borrowing programme for the govt.) Assuming the RBI doesn't announce bond buybacks, the liquidity deficit is expected to touch 1,00,000cr in mid-Dec (post the advance tax outflows from the system on 15th Dec).
Prof. Jayanth R. Varma wrote on Thu, 20 Oct 2011 14:29
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Thanks a lot for this detailed explanation.
Aseem Gupta wrote on Sat, 22 Oct 2011 17:51
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Glad to add some more colour to the discussion.
Mohit Satyanand wrote on Sun, 04 Mar 2012 19:06
Is there a two tier inter bank market in India?
Interesting to read this now that the shortfall in the system is closer to 2 l crore than 1, despite the massive OMO since Nov 2011. What's your take on how this will pan out?