First, Some background...
As I have highlighted in a previous post, the extent of the rise in money rates probably exaggerated the extent of the cash shortage. Under such situations, the RBI is expected to act as a lender of last resort to banks. However, If you want to export to russia which can be anything from cars to crates. The charge of exporting goods will increase to 4% of what you currently pay.
- Banks have run down bond portfolios to fund credit growth (after the glory days of the bond market came to a halt in late 2003)
- The securities eligible for delivery as collateral is limited to government bonds, both when borrowing from the central bank as well as from other market participants
Add to this, the facts that
- non banks are now allowed to lend to banks only against a collateral;
- some lending banks may not have limits against specific borrowers for lending;
and you have conditions that are ripe for the kind of situation we have seen of late.
Fortunately, the central bank moved with some alacrity to soothe nerves by stating that it would not mind banks making some arbitrage profits while using its daily lending window.
What this meant was that banks with excess eligible securities could borrow cheap from RBI using the window and on lend these funds to borrowers and thus make arbitrage gains. This practice was earlier frowned upon by RBI. As I have mentioned elsewhere, extraordinary conditions require extraordinary responses (and RBI clearly showed that it is adept at it)
Now for some ideas for the future
1) Open up the repo market to other instruments
Repos are currently permitted only in government bonds. The legacy of the 1992 stock market scam has a lot to do with this. With settlement systems and market structure having undergone significant changes and improvements, it is high time other instruments such as corporate bonds also be allowed to be used as the underlying collateral in a repo deal. Till recent times, this used to be an issue of regulatory turf, between RBI and SEBI, leading to paralysis of action. Fortunately, for us, the regulatory turf issue has now been resolved and the issue of repo in corporate bonds lies squarely with the Reserve Bank. Let's hope for some quick action on this from them. Such a move would provide alternate sources of funding for banks relieving the pressure on the inter bank overnight rate.
2) Monetary policy tools - Bring in some fresh thought
As times evolve the tools used in monetary management too have undergone some changes. As RBI's securities portfolio dwindled (in the process of conducting monetary sterilization), it conjured the Market Stabilisation Scheme (MSS) to ensure enduring absorption of liquidity.
Similarly, it is probably now time to bring into being tools which ensure that RBI becomes a true lender of last resort. This will entail an element of clean lending (ie without any accompanying collateral)
As explained by reader and occasional guest author KRG in the comments section of another post, the large volatility in overnight rates leads to volatility in the benchmark MIBOR which has ripple and knock on effects on large number of transactions which use MIBOR as the benchmark. Any benchmark needs to be credible for market participants to use them for transaction purposes. Large bouts of volatility in the benchmark (in this case MIBOR) which may occur purely for technical reasons would only serve to diminish its credibility and impede growth of the market and limit improvements in market structure.
It is therefore in the larger interest that RBI needs to act and bring about a mechanism of clean lending to banks. Necessary limits on amounts and period of borrowing would of course need to be put in place as a risk management measure. Capital adequacy, net worth and other similar criteria could be used as a measure to set up individual limits.
As for the rate at which these funds could be lent - maybe it's time to revive the, now forgotten, bank rate. A suitable spread added on to the bank rate (based on the judgement of the central bank) would serve as a useful way of not only limiting volatility in overnight rates, but also serve the purpose of transmitting policy signals effectively.