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Monday, November 17, 2008

Liquidity crisis - failure of banking system!

It was a supreme irony to hear the head of one of the country's leading private sector bank, call on the government and the RBI to ease the liquidity crunch. The irony arose from the fact that the liquidity crunch facing the Indian financial markets, despite the unprecedented monetary easing by the RBI over the past few weeks, is due to the ostrich like reluctance of bankers to open their lending taps. The RBI can only facilitate the proverbial "bank" horse to lower rates, it is for the banks to in turn respond! The liquidity crunch is therefore more a psychological than a monetary phenomenon, atleast for now. And it is a testament to the inadequate maturity of the Indian banking and financial sector.

The banking sector has responded to the dramatic monetary easing, which released atleast Rs 2.8 lakh crore into the system, by parking them in the safety of Government securities, as evidenced by the sharp increase in G-sec holdings and downward pressures on the yields. The lending taps remained dry and the lending rates did not budge.

Standard economic theories tell us that monetary policy signals from the Central Banks gets automatically transmitted across the entire financial system resulting in either increase or decrease in the lending and deposit rates. The RBI has, through its dramatic monetary policy actions over the past few weeks, sent out clear enough signals that inflation concerns are secondary and it is committed to monetary easing. The only reason that could have justified the reluctance to lower rates was if, like in the US, there were uncertainty on counter party risks arising from a solvency crisis. However, the same bankers have been on all television channels claiming that they have no exposure to the toxic sub-prime mortgage like assets.

It was therefore natural to expect the banks to respond by lowering their commercial and retail lending and deposit (which was slashed immediately!) rates. If the banks did not do so and had to be arm-twisted by the Finance Ministry (and not the RBI) to fall in line, then it only indicates that the banks are not playing by the rules of the game. Further, by giving the Finance Ministry the chance to twist their arms, the banks may have to share the blame for setting unhealthy trends.

The RBI was right in tightening the monetary policy in the first half of the year in response to galloping inflation. The higher rates had the expected effect of raising the cost of capital for the corporate India and slowing down economic growth. The small and medium enterprises in India have long been excessively dependent on bank loans. The consumer durables and real estate sector too have become sensitive to interest rates, more so in recent years.

The larger corporates had been hurt more by the restrictions imposed on External Commercial Borrowings (ECBs) and the falling stock markets. Equity markets and external credit markets provided over 40% of the funds for Indian industry in 2007-08. The declining profits too added to the tight liquidity situation. All these developments have made the industry more reliant on bank credit. On the other hand, government borrowings, direct (loan waivers for farmers) and indirect (through borrowings by the oil companies against the oil bonds issued to cover the subsidies), have exerted substantial "crowding out" effect on private sector borrowing.

The reluctance of banks to lend is not completely psychological, and has partly to do with the strains faced by their balance sheets. The banks responded to the RBI's monetary tightening by outbidding each other in raising their rates to attract deposits. The rate increase reactions were excessive, and the result is that many banks are left holding high cost short and medium term liabilities without the means to finance them. The reluctance of the banks to lend may be partially explained as an effort to make up for some of their previous profligacy with deposit rates.

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