Balance between Liquidity and efficiency management in Financial Intermediation

There is serious concern on leverage of financial intermediaries which RBI sees as systemic risk. The system at this stage is well-balanced at the shorter end (up to 30 days) of ALM profile; most PSU banks being the source (lenders in call money market, maintaining positive gap in 1-28 days time buckets), and Private/Foreign banks as the users of funds through short term liability products of Call/CBLO/CDs and sale of assets with or without pass-through of credit risk through judicious management of negative gap in 1-28 days time buckets. The going is good on the system as whole with Banks holding around 28-30% of NDTL as against mandatory 22% SLR. This stance is reflected in higher efficiency ratios of Private/Foreign banks versus Public sector banks measured against Return on Assets (and Equity), hence higher multiplier on Price to Book and P/E multiple for private banks. If SLR/CRR holding is reckoned for LCR, there is no major risk in play, and RBI allowing dip in to SLR of upto 5% of NDTL is step in the right direction to balance efficiency with prudent liquidity management.

Banks do encounter serious constraints in managing ALM gaps and to insulate margin risk from interest rate sensitive gaps from mismatch in fixed/floating assets/liabilities. The demand for fixed rate long term funds is much higher to availability of fixed rate long term liabilities; so, Banks are forced to fund long term assets through short term liabilities, not by design. There is no efficient IRS markets for Banks to close interest rate sensitive gaps. All taken, RBI should ensure to provide suitable environment for Banks to manage LCR without impact on efficiency margins by removing restrictions on accessing long term liability products and market platforms for efficient management of related market risk.

Most banks do understand the benefits of cutting the leverage, and manage judiciously through higher capital adequacy ratio and take on asset products which consume lower risk-weight. Banks have now learned the art of managing LCR through behaviour modelling; higher percentage of CASA outflows pulled-out and higher share of working capital repayments pulled-in, along with excess SLR and capital funds. The pressure on LCR is from build-up long term assets through long term loans to  infrastructure, funding leverage of capital expenditure and Home loans. RBI does discourage Banks from these asset classes in the absence of back-to-back liability profile, but given the pressure on top-line growth, Banks find it tough to manage combine impact of growth, LCR and risk-adjusted returns.

There is lot to do by the regulators before Banks are mandated to maintain near-zero gap in the shorter end of ALM profile. It is good to be efficient but there should be ways and means to stay efficient on liquidity with minimal damage on efficiency, which generates money to the exchequer and investors!

Moses Harding