As bond yields soften, banks see arbitrage opportunity

Banks using their excess SLR holding to borrow under LAF at the rate of 7.50%

Banks are taking an arbitrage advantage by borrowing from the Reserve Bank of India’s (RBI) daily Liquidity Adjustment Facility (LAF) and using the money to buy government securities, as yields on the latter have softened in the hope of a steep rate cut by the central bank during the annual monetary policy review on May 3.

Today, banks borrowed Rs 1.1 lakh crore from the LAF window. The treasury officials of some commercial banks said this was because they were using the excess Statutory Liquidity Ratio (SLR) holding to borrow under the LAF at the rate of 7.5 per cent and buy government bonds, as yields are expected to fall further next week.

The Street had already factored in a 25 basis points (bps) cut by the RBI in the repo rate (at which it lends to banks). The expectation is now building for a 50 bps repo rate cut. The expectation had built up with easing inflation and hopes of a narrowed current account deficit on the country’s external payments. Some also feel that even if RBI does not cut the repo rate by 50 bps, a 25 bps cut with a guidance for further cuts is in store. Today, Raghuram Rajan, the government’s chief economic advisor, said there was a case for a rate cut as core inflation had fallen and there was a need to push growth.

“There is an interest income advantage, as well as scope for capital gains in doing so,” said a government bond dealer with a private banks. According to the dealer, if RBI cuts the repo rate by 50 bps, then the yield on the 10-year benchmark government bond 8.15 per cent 2022, which closed at 7.74 per cent today, could drop to 7.60 per cent.

Another government bond dealer with a public sector bank said the system liquidity deficit was artificially high and a major part of it was being used for an arbitrage opportunity, as the average SLR holding of the banking system was currently above 30 per cent.

SLR is the portion of minimum investments in G-Secs and other approved securities by banks. It was cut by one per cent to 23 per cent in July and implemented in August.

In the mid-quarter review of RBI’s monetary policy on March 19, the Street expected a repo rate cut by 25 bps and a guidance for more reductions. Instead, RBI said “the headroom for further monetary easing remains quite limited” and this had dampened sentiment.