THE UNPRECEDENTED BANKING SCENARIO – THE PROBLEM OF THE PLENTY
Till recently the banks were facing a liquidity crunch whereby they were unable to meet the demands of the market by way of cash flow and the credit growth was affected greatly. The banking system was in deficit of about Rs. 2 trillion at the end of 2024. Since then, there has been substantial growth of cash flow into the banking system rising up to Rs. 4 trillion on some days. Globally Central Banks like RBI in India sometimes keep the system in deficit or surplus to attain monetary policy objectives as per the dictates of the market, but an excess on either side could lead to inadvertent consequences. Not so long ago, RBI was accused of liquidity deficit which partly resulted from intervention in currency market to support the rupee, pushing up market interest rates. However, the trend has changed as the pressure on rupee declined and the Indian inflation rate is stabilised favourably.
While announcing monetary policy for the year 2025-2026 on June 6 RBI Governor Sanjay Malhotra stated that RBI brought in durable liquidity worth Rs. 9.5 trillion since January and decided to reduce cash reserve ratio (CRR) by 100 basis points, to be introduced in four tranches, which will add another durable liquidity to the extent of Rs. 2.5 trillion in to the system because of which some economists predict that the excess liquidity in the system would increase to Rs. 5 trillion by the end of this year. Whereas the liquidity deficit raises the money market rates and lending rates in general, surplus liquidity can lead to the reverse effect and may also lead to an upsurge in inflationary risk. Even though as per Consumer Price Index, inflation in India is under control for the predictable future, excess liquidity can trigger asset-price inflation which lead to banks cutting savings deposit rates, among other rates, which may in turn induce depositors to shift their funds to high-yielding assets.
Yet another impact of having excess liquidity is that the banks may resort to lend at lower rates which may even be almost at par with the cost of funds. Further, the banks may tend to lend to even for non-deserving cases. Considering the prevailing volatile market situation and geo-political uncertainties which affect the investment decisions in the private sector, the fact that many of the corporations are raising more funds from the capital market, the probability of lower policy rate or excess liquidity may not by themselves push bank credit for a variety of reasons such as financial policy reasons, geo political situations, market conditions etc which are exemplified as per the latest Financial Stability Report that resource mobilisation through capital markets increased 32.9 per cent in 2024-25 , and as over 60% was in debt segment as seen from the debt market operations that the year saw that the highest quantum wise increase was through bond issuance of about Rs.10 trillion. Since the debt market becomes vibrant, the corporations and the corporate sector will likely to find it more attractive to raise funds through debt market than from banks and financial institutions which is likely to affect the net interest margins in the financial sector.
RBI has taken certain steps to arrest the adverse impact of excess liquidity problem by resorting to variable rate reverse repo auctions. But the operational part of the monetary policy of the weighted average 1.5 call rate is trading well below the policy rate. The RBI may keep up the present policy as such for some time as a strategy to study the impact of the policy. But RBI will have to charter out new ways and means to contain the influx of excess liquidity and its adverse impact in the wake of the envisaged release of the next tranches of Cash Reserve Ratio (CRR) reduction. But how to discover a new strategy?
RBI is reviewing its liquidity management frame work (LMF). RBI Governor Sanjay Malhotra had said during the post policy press briefing in the month of April 2025, “Currently regarding the liquidity frame work, we are primarily focussed on the overnight rate in the money market. We are evaluating whether it should remain the same for policy transmission purposes, or if we should target something else.” But “something else” is not elaborated. I am remined of two important quotes as given here below.
“The only way to discover the limits of the possible is to go beyond them into the impossible”. (Arthur Clark) and
“We cannot solve our problems with the same thinking we used when we created them”. (Albert Einstein)
I hope that RBI will find a solution to the problem of plenty by going beyond the possible limits to the impossible and creating a new out of box thinking of possibility.
Author Bio
