The banks have too much money and other people don’t.
One problem with the banking system is that not all of your deposits are in the bank right now.
If everyone who has a deposit in a bank goes and asks for the money back, the bank won’t have it. So, to fix it we came up with a neat solution – a central bank. The central bank is (usually) owned by the government and has the job of ensuring that all the banks have enough money when they need it. [2]
In India the central bank is the Reserve Bank of India (RBI).
All banks in India have an account with the RBI, and required to keep a certain percentage of their assets there, so that when customers need money the bank can take it from its account at the central bank. Beyond that they are more or less free to do what they wish with their money. They can lend to people to buy homes, companies to make investments and so on.
But they can also lend to the RBI if they have too much money. [3]
If a bank feels that it’s not safe enough to lend to anyone, they can put the money in one of the safest places possible – the RBI. And when they do that, other people they normally lend to like companies and households don’t get any money.
That means that loan growth slows down, or stops. A lot of people who could have bought appliances like fridges and washing machines. If people cannot borrow from banks to get home loans, and car loans, they don’t buy those assets.
I don’t blame the banks here. They don’t know if the person they lend to will have a job a year from now. They don’t know if the companies they lend to will have money next year to pay back the loan. It is only natural that they are doing this.
That was exactly what Governor Shaktikanta Das was talking about in his speech yesterday. He said that there was excess liquidity in the banking system, and in simple English that means that banks have too much money.
Caption: Governor Das explains the measures taken by the RBI on 17th April.
This is sort of the opposite of a financial crisis. A financial crisis happens when everyone asks for money at the same time. But here no money is going out of the banks. And that is the main problem.
In July 2019, there was ₹1464 billion of excess liquidity. By December 2019, that number increased to ₹2432 billion. And yesterday on 17th April 2020, there was ₹6993 billion of excess liquidity in the system.
So the RBI did two things to reduce that: They cut the interest rate banks get when they deposit money at the RBI. Then they announced a plan to get money flowing to other financial institutions who need money now.
Those financial institutions are Non Bank Financial Companies (NBFCs) and MicroFinance Institutions (MFIs).
NBFCs are companies that lend money to other companies and people, with their own capital. The key difference between them and banks is that they cannot take demand deposits - money payable when the depositor wants. But they can make loans just like a bank. Another important difference between NBFCs and Banks is that they don’t have access to the RBI’s lending window.
A MFI does similar things, but mostly to low-income populations
When a bank is in trouble, it can go to the RBI and the RBI will lend to it. But that is not true for NBFCs. They aren’t part of that system[4].
Along with that, the NBFCs are having a real hard time now. The people they lend to - salaried workers, companies, and so on have had their incomes devastated because of the pandemic. So they may not pay back the loans. And the NBFCs need money to pay all the other expenses - like loans, salaries to employees and so on.
But given that the NBFCs aren’t making much money now, and unlike banks they can’t borrow from the RBI lending window, where do they get the money from?
The RBI came up with a plan for that. It is called the Targeted Long Term Repo Operation (TLTRO). Basically, the RBI lends to banks with the condition that they lend at least 50% to NBFCs and MFIs.
This means that the RBI gives money to the banks at an interest rate. The banks lend at least half the money to NBFCs and MFIs. The NBFCs and MFIs get some short term respite. At the very least, they get money to pay their short term obligations and don’t go bankrupt.
This was a very important move by the RBI because it ensures that the financial sector gets the money it needs. That means that after the pandemic, we should have NBFCs ready to lend, or at the very least not bankrupt.
The nightmare scenario that nobody wants, but everyone is thinking of in the back of their head is that the NBFCs don’t get any funding, they go bankrupt and at the end of all of this, there is no financial system left.
This isn’t stimulus. It is damage control
[1] Risk Weighted Assets is the technical term.
[2] Huge over-simplification there. The central bank has 3 primary jobs: to ensure a low and stable rate of inflation, to ensure the stability of the financial system, and in times of crisis to lend to the government. There are other things, but these 3 form the majority of their functions.
[3] This is called a reverse repo operation. The RBI sells an asset to the bank (usually government bonds). The RBI gets cash, the bank gets the asset. A few weeks later, the RBI gives a slightly higher amount (called the reverse repo rate) along with the principal amount.
[4] That is because NBFCs can’t issue demand deposits. So that means that there is no chance of everyone asking for the money at the same time. That’s why the RBI doesn’t come to them to help, because they don’t need the help in normal circumstances. But right now, we aren’t facing normal circumstances.