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The economic survey speaks of a revised liquidity management framework, which has helped reduce volatility in the overnight inter-bank segment. What is it?
The economic survey speaks of a revised liquidity management framework, which has helped reduce volatility in the overnight inter-bank segment. What is it?
The revised liquidity framework was put in place by the RBI in Sept last year to reduce volatility in the overnight call money markets. Overnight call money market is the place where banks borrow from and lend to each other to manage their deficit / surplus scenario. Typically the rate of transaction in this market, the overnight call money rate is supposed to trail the repo / reverse repo rate which in turn are dictated by the RBI. Whenever the call money rate begin to diverge from the repo / reverse repo rate by an excess if 1% ('wild swings') - termed as 'volatility' - RBI steps up its liquidity operations.
Until the revised framework was put in place in Sept. RBI was conducting overnight repo auctions daily, 7/14 day term repo auctions on an ad hoc basis to smoothen this volatility. But when call rates began to swing in excess of 1% of the repo / reverse repo rates - RBI put in place the revised framework - conducting 7/14 day term repo auctions on fixed days or according to a schedule. It also put in place special variable-rate ST repo/reverse repo auctions at short notice to reduce this 'volatility'
As you might have already guessed, RBI stepping in to do repo / reverse repo increases / reduces the total liquidity in the market. Same happens when RBI does a term repo / reverse repo auction. This management of liquidity reduces the volatility i.e. overnight call money market becomes less prone to 'wild swings'.
The RBI has begun conducting repo and reverse repo term auctions to establish a corridor around the repo rate within which the overnight call money market rate can vary. This will have the net effect of reducing volatility in the overnight call money market. Unlike the developed markets, India is yet to have a standard term repo market - a place where most borrowing / loaning between banks happens.
FIs typically indulge in term repo auctions to raise ST capital, park excess capital with RBI and manage their daily liquidity better. It is like a standard repo operation but for a duration longer than a day.
I know this could have gotten a bit slippery. Happy to help with any followups!
@sss_2503, @ClarKent : thanks for the explanations and weblinks. It solved my doubts about the 'revised liquidity mgmt framework'. However, i don't understand why RBI would need a new repo auction window, when it were already conducting on an ad-hoc basis 7/14 day term repo auctions. And how short a notice are we talking of in the case of variable rate repo or reverse repo auctions?
@sss_2503, @ClarKent : thanks for the explanations and weblinks. It solved my doubts about the 'revised liquidity mgmt framework'. However, i don't understand why RBI would need a new repo auction window, when it were already conducting on an ad-hoc basis 7/14 day term repo auctions. And how short a notice are we talking of in the case of variable rate repo or reverse repo auctions?
An ad hoc term repo auction comes with an uncertainty over 'when' and 'if' the repo facility will be available from the RBI for the banks. So RBI decided to make the auction 'scheduled' - meaning fixing time/date (Tuesday/Friday mornings). This helps reduce anxiety about liquidity situation. ST notice for variable rate repo or reverse repo could be 60 minutes before a daily decided time slot i.e. 3:00 pm Mon-Fri
The spread between clean Call rate and Market Repo Rate gives the perceived credit risk in the system. At the time of stress, the spread widens and at the time ample liquidity, the spread shrinks.
Keeping this in mind as he mentioned earlier if the spread widens by more than 1% it's a sign of worry. RBI was unable to manage this with the fixed ad hoc term repo, so, it also introduced overnight variable rate repo (with a greenshoe clause) Greenshoe: it means giving more than the notified amount
So if RBI feels that it wants to infuse money in market it could change the variable rate (based on bid of investors) + give out more money than notified (greenshoe clause) and solve the credit crunch situation even on a daily basis, getting more control of market
Keeping this in mind as he mentioned earlier if the spread widens by more than 1% it's a sign of worry.
Why is this spread of >1% a sign of volatility? Why does it happen and what impact does it have on the FIs? Could you please elaborate on these?
I am a novice at this but will try to answer your query:
The diff between repo and reverse repo is 1%. Now call rate trail repo but if it falls by more than 1%, banks would be more eager to lend the money to RBI than to FIs. If this happens there would be credit crunch in the market leading to slower growth (and what not). Even if RBI doesnt borrow, the mere speculation of something like this could happen upsets the equity market or in short creates money imbalance. Hence to maintain short-term credit flow in the market, RBI came with this revised scheme so that it can infuse more money in the market and sustain growth in short-term (giving govt breathing space)
If I get some more insight into this I will certainly tell you..
Keeping this in mind as he mentioned earlier if the spread widens by more than 1% it's a sign of worry.
Why is this spread of >1% a sign of volatility? Why does it happen and what impact does it have on the FIs? Could you please elaborate on these?
Adding to what has already been said: Call money market rates are typically required to be in the range of +/- 15-20 bps of repo / reverse-repo for a smooth functioning of the inter-bank or call money market. A higher than amount causes banks difficulty in making lending / borrowing operations.
Banks (while performing ST lending) require ST capital to maintain capital adequacy ratio. This is often obtained from the inter-bank market. If rates are higher, this can lead to a cost on the banks operating margin. Also, higher spread between repo and call money market rate gives opportunity for arbitrageurs to step in and further drive up rates. This could cause call rates to go as high as 14-17% in extreme cases. Such high lending rate can affect lending / financing decision of banks, mutual funds, insurance companies which often borrow from banks. To avoid all this hassle, 'volatility', 'wild swing' in call money market, RBI makes timely interventions.
@sss_2503 Thanks man. One more doubt: What would be the impact of further narrowing this 1% corridor? Theoretically, it should keep volatility under better control.
Keeping this in mind as he mentioned earlier if the spread widens by more than 1% it's a sign of worry.
Why is this spread of >1% a sign of volatility? Why does it happen and what impact does it have on the FIs? Could you please elaborate on these?
Adding to what has already been said: Call money market rates are typically required to be in the range of +/- 15-20 bps of repo / reverse-repo for a smooth functioning of the inter-bank or call money market. A higher than amount causes banks difficulty in making lending / borrowing operations.
Banks (while performing ST lending) require ST capital to maintain capital adequacy ratio. This is often obtained from the inter-bank market. If rates are higher, this can lead to a cost on the banks operating margin. Also, higher spread between repo and call money market rate gives opportunity for arbitrageurs to step in and further drive up rates. This could cause call rates to go as high as 14-17% in extreme cases. Such high lending rate can affect lending / financing decision of banks, mutual funds, insurance companies which often borrow from banks. To avoid all this hassle, 'volatility', 'wild swing' in call money market, RBI makes timely interventions.
Thanks for the detailed reply. It cleared the air. Could you please elaborate on this.
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Comments
http://articles.economictimes.indiatimes.com/2014-08-23/news/53139513_1_evolving-liquidity-conditions-repo-notified-amount
http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=31904
Until the revised framework was put in place in Sept. RBI was conducting overnight repo auctions daily, 7/14 day term repo auctions on an ad hoc basis to smoothen this volatility. But when call rates began to swing in excess of 1% of the repo / reverse repo rates - RBI put in place the revised framework - conducting 7/14 day term repo auctions on fixed days or according to a schedule. It also put in place special variable-rate ST repo/reverse repo auctions at short notice to reduce this 'volatility'
As you might have already guessed, RBI stepping in to do repo / reverse repo increases / reduces the total liquidity in the market. Same happens when RBI does a term repo / reverse repo auction. This management of liquidity reduces the volatility i.e. overnight call money market becomes less prone to 'wild swings'.
The RBI has begun conducting repo and reverse repo term auctions to establish a corridor around the repo rate within which the overnight call money market rate can vary. This will have the net effect of reducing volatility in the overnight call money market. Unlike the developed markets, India is yet to have a standard term repo market - a place where most borrowing / loaning between banks happens.
FIs typically indulge in term repo auctions to raise ST capital, park excess capital with RBI and manage their daily liquidity better. It is like a standard repo operation but for a duration longer than a day.
I know this could have gotten a bit slippery. Happy to help with any followups!
@ClarKent has explained the part regarding the perception of liquidity excellently
The spread between clean Call rate and Market Repo Rate gives the perceived credit risk in the system. At the time of stress, the spread widens and at the time ample liquidity, the spread shrinks.
Keeping this in mind as he mentioned earlier if the spread widens by more than 1% it's a sign of worry. RBI was unable to manage this with the fixed ad hoc term repo, so, it also introduced overnight variable rate repo (with a greenshoe clause)
Greenshoe: it means giving more than the notified amount
So if RBI feels that it wants to infuse money in market it could change the variable rate (based on bid of investors) + give out more money than notified (greenshoe clause) and solve the credit crunch situation even on a daily basis, getting more control of market
Hope this helps
The diff between repo and reverse repo is 1%.
Now call rate trail repo but if it falls by more than 1%, banks would be more eager to lend the money to RBI than to FIs. If this happens there would be credit crunch in the market leading to slower growth (and what not). Even if RBI doesnt borrow, the mere speculation of something like this could happen upsets the equity market or in short creates money imbalance.
Hence to maintain short-term credit flow in the market, RBI came with this revised scheme so that it can infuse more money in the market and sustain growth in short-term (giving govt breathing space)
If I get some more insight into this I will certainly tell you..
Banks (while performing ST lending) require ST capital to maintain capital adequacy ratio. This is often obtained from the inter-bank market. If rates are higher, this can lead to a cost on the banks operating margin. Also, higher spread between repo and call money market rate gives opportunity for arbitrageurs to step in and further drive up rates. This could cause call rates to go as high as 14-17% in extreme cases. Such high lending rate can affect lending / financing decision of banks, mutual funds, insurance companies which often borrow from banks. To avoid all this hassle, 'volatility', 'wild swing' in call money market, RBI makes timely interventions.
Thanks man.
One more doubt: What would be the impact of further narrowing this 1% corridor? Theoretically, it should keep volatility under better control.
Could you please elaborate on this.