Banks Facing Liquidity Challenges – What Does This Mean and How is the RBI Responding?

Mumbai, February 7, 2025 – Recent reports have highlighted that Indian banks are grappling with liquidity challenges, a situation that has raised concerns in financial circles. But what exactly does liquidity mean for banks, and why is it such a crucial issue for the economy and markets?

What is Banking Liquidity?

Liquidity in banking refers to the availability of cash and assets that can quickly be converted to cash to meet the daily operational needs of banks and the broader economy. The two key measures used to assess banking system liquidity are:

1. M0 (Reserve Money) – This is the most liquid form of money and includes currency in circulation, bank reserves with the Reserve Bank of India (RBI), and other reserve funds. The RBI primarily controls M0 through operations like repo and reverse repo rate adjustments, cash reserve ratio (CRR) changes, and open market operations (OMOs).
2. M3 (Broad Money) – A broader measure, M3 includes M1 (cash + demand deposits) plus time deposits with banks. A liquidity crunch in the banking system often refers to a shortage in M3 growth, typically caused by tight monetary policy or a high demand for credit.

While M0 helps measure short-term liquidity, M3 gives a broader view of money supply and credit availability in the economy.

Reasons Behind the Tight Banking Liquidity

In recent months, several factors have led to a liquidity shortfall in India’s banking system:

1. RBI’s Forex Interventions – The RBI’s foreign exchange interventions to stabilize the Indian rupee have absorbed liquidity. Each time the RBI sells dollars, it removes rupees from the domestic banking system, further tightening the availability of rupee liquidity.
2. Advance Tax Payments – Corporates’ advance tax payments to the government temporarily reduce banking liquidity. This is because large sums are withdrawn from the banking system for tax payments, but they do return once the government spends the collected taxes, albeit after a delay.
3. Cash Withdrawals – Increased cash withdrawals, especially during the festive season, have drained funds from bank deposits, further contributing to the liquidity crunch. People withdrawing cash from their savings, current, or term deposits lead to a temporary reduction in liquidity within the banking system.

As of last month, India’s liquidity deficit reached approximately ₹1.5 trillion (about $17.7 billion), the largest shortfall in nearly six months.

RBI’s Efforts to Address Liquidity Shortfall

In response to the ongoing liquidity challenges, the RBI has been actively implementing various measures:

• Open Market Operations (OMOs): The RBI has announced bond purchase auctions totalling ₹60,000 crore across three tranches in January and February 2025 to inject liquidity into the system.
• Variable Rate Repo Auction: A 56-day Variable Rate Repo auction worth ₹50,000 crore was conducted on February 7, 2025, to provide short-term liquidity to banks.
• USD/INR Buy/Sell Swap Auction: On January 31, 2025, the RBI conducted a $5 billion USD/INR buy/sell swap auction to further enhance liquidity.

Why Didn’t the RBI Announce Further Liquidity Measures?

During the Monetary Policy Committee (MPC) meeting today, the RBI did not announce any additional liquidity-easing measures. This decision stems from the fact that increasing liquidity could inadvertently stoke inflation. With inflation inching closer to the targeted range, the RBI aims to strike a balance between providing liquidity and maintaining price stability.

Impact of Tight Liquidity

Tight liquidity in the banking system essentially means that the availability of funds is limited. As a result, the cost of funds rises. Even though the RBI has reduced the policy rate, banks continue to face high borrowing costs due to the limited supply of cash. This could make banks more reluctant to lend to the economy, slowing down the flow of credit to businesses and consumers.

In simple terms, banks are caught in a dilemma: while the policy rate is lower, the availability of funds is restricted, preventing a sharp reduction in the cost of money. This scenario could ultimately stifle lending and slow down economic growth, especially in sectors that are sensitive to interest rate changes.

Conclusion

The RBI’s efforts to manage banking system liquidity have been robust, but the underlying challenges remain. Despite interventions like OMOs and repo auctions, a liquidity deficit persists, driven by factors like forex interventions, advance tax payments, and cash withdrawals. Without additional measures, tight liquidity could continue to hinder credit flow in the economy, making it harder for businesses to access funds and slowing down overall economic growth.