To be sure, the provision of liquidity alone by no means solve the problems of credit risk, credit losses and inadequate demand; but it can reduce the liquidity premiums, help restore investor confidence and promote stability.
Ben Bernanke
The global economic conditions have come under intense pressure with the recent hint of a global slowdown. To couple it, the novel COVID-19 rushed into the world to add a lock down situation across various major economies (while a bunch of population was busy thinking it was not as fatal as it sounded). The two factors put together, have posed some serious questions on what is the way forward.
Notice the quote I started with? Most economies and their leaders are trying their best to control the spread which needs to be supported by LIQUIDITY for the working population to keep things going while the eradication process of the virus continues. And I think RBI’s out of policy action yesterday has been right on target. The target being “enough liquidity”.
The Reserve Bank of India implemented an ‘Out of a policy action’ on 27th March 2020 to address the various concerns of the economy and the current conditions. Out of the policy action is a move from the central bank which is taken outside of the usual bi-monthly cycle. Such policy is generally amidst external factors and risks rising.
Why did RBI find it relevant to take action?
- The global pandemic of COVID-19 has forced India to go into a lock down till 14th April 2020 as a precautionary measure to avoid a community spread situation
- While a few industries continue to work from home, most of the sectors have shut their operations.
- While a few companies have been generous enough to pay the salaries, a few have chosen to pay their employees for their period.
- There might be a set of population which might face extreme cash crunch or liquidity concerns
- In order to keep the liquidity in the hands of the citizens, the RBI came with the policy actions in their power to couple what has already been done by the Govt. from the fiscal side.
Here are the key measures introduced by RBI:
- Reduction of CRR from 4% to 3% of the NDTL
- Reduction of the repo rate from 5.15% to 4.4% and the reverse repo from 4.9% to 4%. Repo rate was reduced by 75 bps and reverse repo by 90 bps. (Generally both the rates are reduced by the same bps but this time it has been non-uniform. Do you know why? I will explain at the end!)
- A moratorium of 3 months has been advised to the banks for the EMIs of the various loans that are outstanding.
- Incremental Capital Conversion buffer and Net Stable Funding Ratio was to be implemented by the banks (to comply with Basel III regulations) which could have mandated them to provision for additional capital against each outstanding credit. The implementation timeline was further deferred which provided banks breathing space to have liquidity.
Impact
To sum up, RBIs measures have come at a very crucial time and a big thumbs up to the way liquidity has been made available. It is now up to the banks to ensure that the 75 bps rate cut is passed on to the consumers to the highest extent possible to ensure that the businesses stay solvent and be in a position to resume from where they left when this is all over 🙂
Why the repo rate was cut 75bps but the reverse repo was cut by 90 bps?
Rates | Previous Rates | If Both were cut by 75 bps | Actual New Rates |
Repo | 5.15% | 4.40% | 4.40% |
Reverse Repo | 4.90% | 4.15% | 4% |
Do you see the additional 15 bps? That additional 15 bps could have made the banks keep more funds parked with RBI at a risk free rate. To ensure that banks continue to lend more and park less with RBI, the 15 bps incentive was removed. Remember, liquidity in the system is more important than the bank’s profitability at this point to fight the crisis!
Key Terminologies
- What is CRR? https://www.investopedia.com/terms/r/reserveratio.asp
- What are NDTLs? – https://www.investopedia.com/articles/investing/112714/regulations-govern-banking-india.asp
- Incremental Capital Conversion Buffer – https://www.investopedia.com/terms/c/capital-buffer.asp
- NFSR – https://www.investopedia.com/terms/c/capital-buffer.asp
Thank you. Diverse opinions are welcome! 🙂