Liquidity of the Banking system is one of the most discussed issues by bankers, investors, media and others across the world. In Nepal too, it has been a topic of discussion from time to time. In this blog, I attempt to explain the concept of liquidity and how it should be understood and also lightly touch upon the implications of shortage and excess of liquidity.
Let me start with the term liquidity which means the quality of being converted into cash with ease. However, in the economy, liquidity does not refer to such a general meaning. It neither refers to the amount of liquid assets with the market participants not the amount of liquid assets with the banks. The amount of liquid assets with the banks is reflected in liquidity ratio rather than the term liquidity. In banking system, liquidity has a specific meaning. It is simply the amount of idle cash at the hands of bank and financial institutions that is either kept at their own vault or at their accounts maintained at the central bank.
Let us clarify this with an example. Suppose that the bank 'ABC' has total deposits of Rs. 4000 billion and cash reserve ratio set by the central bank is 5 percent. In such a case the 'ABC' bank should keep Rs. 200 billion at its account opened at the central bank. And suppose that at some particular day, the bank can not lend the 95 percent of its deposits. The total investment of the bank is say Rs. 3500 billion only. Now the bank has Rs. 500 billion cash out of that Rs. 200 billion should be compulsorily deposited at the central bank. The bank keeps 50 billion at its vault for cheque and other payment purposes and deposits the extra 250 billion at its account maintained at the central bank. The ABC bank does not keep all the extra amount at its vault because of the security issues and because it has to bear insurance costs for keeping such large amount at vault.
Okay, now the bank has kept an excess of Rs. 250 billion at the central bank that does not earn anything. That is why this excess amount is called excess liquidity. The 50 billion kept at vault of the bank is not counted as excess liquidity as it is kept for transaction purpose and therefore not idle.
If we add such liquidity positions of all banks, we get the status of banking system liquidity. A real life example can be given from the Nepali banking industry. As of September 15, 2021, total deposits of the banks was Rs. 4545 billion and the amount to be maintained in CRR accounts is Rs. 136 billion (around 3 percent). The banks kept Rs. 156 billion on their CRR accounts maintained at the NRB. As such the amount of excess liquidity in the banking system on that day stood around Rs. 20 billion.
Chart below shows the movement of excess liquidity in Nepali banking industry during the last five years. The chart shows that from the last of 2017 to mid 2018, the banking industry suffered from low liquidity and high interbank rates. The second major stress appeared in the first half of 2019 when liquidity fell as low as Rs. 13 billion and interbank rate rose to as high as 8 percent. As expected, liquidity during the peak of the COVID crisis remained quite high and interbank rate staggered around zero. And from the second quarter of 2021, liquidity in the system has been under pressure and reflected in the interbank rate.
How do the banks manage liquidity?
There are a few ways at the hands of banks to manage the liquidity stress. The easiest way for the banks is to borrow from the interbank market. Secondly, the central banks might have overnight repo facilities that the banks can use. Thirdly, the banks can make use of the repo facilities provided by the central bank. Such repos can be from 7 days to few months. Fourthly, the banks can resort to the lender of the last resort facility provided by the central bank. However, interest rate on such facility is generally higher compared to interbank rate and repo rate. In Nepal such facility is provided at 5 percent currently. Fifthly, the banks can focus on deposit mobilization in the medium term.
Why liquidity position is important for the general public?
The general public now a days is quite conscious about the movements in banking liquidity. The primary reason for this concern arises from the fact that liquidity position determines the interbank rate (also called short term interest rate). In a developed financial market, the movements in the short term market can guide the long term interest rate well and with short lag. In a less developed market of Nepal, though, there does not seems to be one to one correspondence between the short term and long term interest rate, it broadly provides a guideline to build expectations about the long term interest rate. Thus, investors may worry for an increase in lending rate in the times of liquidity stress and may postpone short term investment decisions.
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The blogger can be reached at siddhabhatta@gmail.com . Comments and queries are always welcome.
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