The Reserve Bank of India is trying to prevent a liquidity crisis at banks by relaxing an important risk requirement

• On 27 September, India’s central bank eased a liquidity coverage requirement imposed on banks and said it would provide all necessary funding support to the banking sector.
  
• The RBI has raised the facility to avail funds for liquidity coverage ratio (LCR), which measures the amount of liquid assets held by banks against short-term debt, from 11% to 13%.
  
• This will allow banks to increase the weightage given to government securities when calculating their statutory liquidity ratio and free up deposits for their short-term funding needs.
  

Following a promise to investors that it would step in to prevent a liquidity crisis amongst Indian lenders as well as a subsequent push from India’s finance ministry, the Reserve Bank of India (RBI) looks like its making good on its word, albeit at the cost of its mandate to manage risk.

On 27 September, India’s central bank eased a requirement imposed on banks related to liquidity coverage and said it would provide all necessary funding support to the banking sector. The RBI raised the facility to avail funds for liquidity coverage ratio (LCR), which measures the amount of liquid assets held by banks against short-term debt, from 11% to 13%.

This will allow banks to increase the weightage given to government securities, which is a liquid asset, when calculating their statutory liquidity ratio, which measures the amount of deposits invested in liquid assets. Hence, this will free up banks’ deposits so they can meet their funding needs in the short-term.

And their funding needs are dire. Earlier this week, the liquidity deficit was estimated to be ₹1.4 trillion.

However, In doing so, the RBI is effectively trading short-term benefits for longer-term pain. The current liquidity crisis stems from the aversion of institutional investors to buy the debt instruments of non-banking financial companies like IL&FS, which is on the brink of default.

By relaxing liquidity coverage requirements for banks, the RBI is allowing banks greater freedom in how they use their deposits and also letting them take on riskier short-term debt so a lot more money will enter the system, which will have an inflationary effect.

In essence, domestic lenders are being allowed to use a greater percentage of their deposit-holders’ money to pay down their short-term debt obligations and extend credit to borrowers. In the event of a market downturn or a loss of faith in these banks, they could face a run on their deposits, which will be fatal given their lower risk buffer.

The finance ministry has insisted that the RBI also relax reserve requirements for banks, under which banks set aside a certain portion of funds with the central bank. Earlier this week, the RBI took a page out of the European Central Bank’s playbook on “quantitative easing” and said it would buy around ₹100 billion worth of government bonds from the open market to inject funds into the economy.