Liquidity risk arises when a bank is not able to meet payment obligations primarily from its depositors and give, simultaneously, enough loans to its existing or potential borrowers.
Thus, liquidity risk can impair a bank’s intermediation function on daily basis. Liquidity risk became materially visible during the 2007-09 Global Financial Crisis.
Post-crisis, the Basel Committee on Banking Supervision introduced two measures to mitigate the liquidity risk: (a) Liquidity Coverage Ratio (LCR) to measure and limit a bank’s liquidity risk over 30 calendar days and (b) Net Stable Funding Ratio (NSFR) as a longer-term liquidity metric to measure and limit banks’ structural asset and liability mismatches. Both LCR and NSFR, albeit separate, complement each other to maintain a safe and sound banking system.
LCR = [Total Stock of High-Quality Liquid Assets (HQLAs)*100]/(Total Net Cash Outflows over the next 30 calendar days)
LCR seeks to ensure that a bank has adequate stock of unencumbered HQLAs that can be converted into cash easily and quickly to meet its liquidity needs under a 30-day liquidity stress scenario.
LCR helps improve the banking sector’s ability to absorb the financial or economic shocks and reduce the ‘contagion risk’, within and outside.
Indian LCR Framework
RBI issued the Indian framework for LCR requirements on June 9, 2014 for all scheduled commercial banks [excluding Regional Rural Banks (RRBs)].
Introduced in five phases starting January 1, 2015, the minimum LCR requirement stipulated by RBI is 100 per cent since January 1, 2019.
With their establishment, Small Finance Banks (SFBs) came under the framework. Currently, the LCR framework excludes RRBs, Payments Banks and Local Area Banks.
Draft LCR Guidelines
On July 25, 2024, RBI brought out Draft Guidelines (DGs) containing “Review of Haircuts on High Quality Liquid Assets (HQLAs) and Run-off Rates on Certain Categories of Deposits.” DGs, which aim at further enhancing the liquidity resilience of banks, will be operational from April 1, 2025.
Two salient proposals in DGs are: (a) Banks to assign an additional 5 per cent run-off factor for retail deposits which are enabled with Internet and Mobile Banking (IMB) facilities, i.e., stable retail deposits enabled with IMB to have 10 per cent run-off factor and less stable deposits enabled with IMB to have 15 per cent run-off factor and (b) Unsecured wholesale funding provided by non-financial small business customers to be treated in accordance with the treatment of retail deposits as at (a).
With this, LCR perhaps covers nearly all bank accounts now.
Comments
Deposits are the key driver of LCR. We feel that the two proactive proposals are far-sighted against the backdrop of proliferating popularity of IMB, even for smaller transactions.
Banks can easily accommodate the additional run-off factors proposed, as most banks have their LCR much above the minimum requirement (Table 1). Nevertheless, banks have to accelerate their efforts to mobilise stable or non-callable deposits.
Unlike the 1980s and 1990s, banks now purely depend on walk-in deposits and canvassing via electronic means. Banks have to revive their special deposit mobilisation campaigns for stable deposits for longer maturity periods. Currently deposits growth is lagging credit growth which makes our proposal apt.
Today, banks are financially in a good position to offer higher interest rates on deposits to calm financial disintermediation. First, banks are enjoying good NIM (Table 1) which, in our view, can accommodate ‘up to 100 bps’ increase in deposit rates without increasing lending rates.
Second, according to RBI, during May 2022 to March 2024 (Tightening Cycle), Repo Rate went up by 250 bps and Weighted Average Domestic Term Deposit Rate (WADTDR) (Fresh Deposits) by 259 bps, but WADTDR (Outstanding Deposits) by 185 bps.
Further, as an empirical study by the Federal Deposit Insurance Corporation demonstrated, even while a bank approached failure and tried to mobilise deposits at higher rates, there was significant run-in of deposits along with deposit run-off.
However, if regulators overestimate outflows in LCR, banks could be forced to hold too much liquidity, introducing inefficiencies into the financial system by way of reduced credit availability.
In fact, this will be a double whammy for banks — slower deposit growth and higher liquidity which may impact their future profitability.
Missing Explanations
However, what isn’t clear in the draft guidelines is that how much deposits accrue through IMB, and of these, how much is stable and how much less stable. It is presumed that RBI must have collected these data, and transparency requires their disclosure in the Final Guidelines.
Another question is whether IMB deposits are observed to be more volatile than the “bulk” deposits which are characteristically observed to be less stable. Bulk depositors select their banks by analysing banks’ financials rigorously, and they regularly monitor their banks’ activities.
Therefore, they can detect the likelihood of a bank’s fragility prior to retail depositors, and move their deposits to safer banks. And, to add fuel to the fire, they flaunt it in the social media which influences retail depositors to follow suit.
LCR tests a bank’s readiness to meet outflows for 30 days. However, even after LCR was operationalised, liquidity imbroglio led to the crises in Silicon Valley Bank (US) and Credit Suisse, where withdrawals took no time. In India, the regulator is well prepared to deal with any serious drag on liquidity.
The document titled “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools (January 2013)” supports that deposit insurance bolsters funding stability.
In this context, the Indian deposit insurance system needs to be overhauled in order to make it more conducive to well-run banks and quicker resolution of troubled banks.
In sum, the draft guidelines constitute a small sacrifice that banks should make today for a large gain, i.e., financial stability, in future. Nevertheless, a basic question remains: even if maintaining the stipulated LCR logs Indian banking to the international benchmarks, in reality, are banks not considered as ‘too-big-to fail’ in the country?
Das is a former senior economist, SBI; and Rath a former central banker. Views expressed are personal