Higher bulk deposit reliance signals structural liquidity risks: RBI dy Guv

Outstanding Certificate of Deposit issuances highest since 2012

Reserve Bank of India (RBI) Deputy Governor M Rajeshwar Rao has cautioned that a higher reliance on wholesale funds to meet loan demand is an indicator of potential structural liquidity issues.

 

Speaking at the Mint Annual BFSI Summit & Awards on January 17, 2024, Rao highlighted that banks dependent on wholesale funding face heightened rollover risks and outflows during economic stress. Effective liability management, he said, is essential to mitigate these risks.

 

“Recently, banks have increased their reliance on short-term funding through Certificates of Deposit (CDs). The average CD outstanding has reached levels last seen in 2012. However, higher reliance on short-term liabilities can have significant repercussions if market conditions deteriorate,” Rao said in his speech, later published on the RBI website.

 

He emphasised that increased dependence on short-term funding could impact net interest margins (NIM) and profitability, particularly during adverse market conditions.

 

Deposit growth trailing credit growth

Rao expressed regulatory concerns over some banks’ deposit growth failing to keep pace with their loan growth, which increases their dependency on wholesale funding for credit disbursement. “Such imbalances signal potential structural liquidity vulnerabilities,” he said.

 

Short-term liquidity tools like the Liquidity Coverage Ratio (LCR) offer nuanced insights but require a holistic assessment of banks’ asset-liability management (ALM) profiles due to the complex relationship between these indicators.

 

Banks leveraging advanced technology and digital platforms for customer acquisition have a competitive edge in sourcing retail and corporate deposits. In contrast, differentiated banks tend to rely more on interbank deposits and wholesale funding, Rao added.

 

NBFCs’ market-driven liabilities 

Rao highlighted that non-banking financial companies (NBFCs) rely primarily on borrowing as they lack access to public deposits. Borrowings through debentures and bank loans dominate their funding structure, making their liabilities more sensitive to interest rate changes than those of banks.

 

To counter the increased risk weight on NBFC exposures to banks, the sector has raised funds through commercial papers (CPs) and non-convertible debentures (NCDs), which grew 26.2 per cent and 16.2 per cent, respectively, in FY24.

 

However, Rao warned NBFCs about additional currency risks when accessing international markets, which could lead to funding cost volatility and liquidity pressures due to exchange rate fluctuations. “NBFCs should integrate forex hedging into their ALM frameworks and monitor currency exposure to mitigate such risks,” he advised.

 

Stress testing and contingency planning

Rao urged banks and NBFCs to strengthen their deposit stability and customer behaviour modelling to better predict withdrawal patterns, prepayments, and interest rate sensitivities. He also recommended developing sophisticated stress-testing methodologies to evaluate resilience to extreme scenarios, including shocks across the interconnected financial network.

 

Regulated entities (REs) must establish formal contingency funding plans (CFPs) aligned with their complexity, risk profile, and role in the financial system. “CFPs should clearly outline available contingency funds, funding sources, and the amounts that can be derived from these sources,” he said.

 

Central bank as a last resort 

Rao cautioned against over-reliance on the central bank’s lender of last resort (LOLR) function, stressing that it should not be treated as a routine contingency funding mechanism. He noted that the RBI retains discretion over whether to extend emergency liquidity assistance, often accompanied by supervisory interventions and conditions.

 

“The LOLR function is a safety net for the entire financial system through judicious use of public funds and should not create moral hazards for individual institutions,” Rao concluded.

 

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