Liquidity Crisis and its management: Perspective of Nepal

Narayan Prasad Pokhrel1

Introduction Bank liquidity is sum of Cash in hand, Balance with central bank, foreign currency in hand, balance held abroad, cash in transit and short term investments. Banks generally face liquidity shortfall due to collecting short term deposits and investing these funds in long-term and illiquid assets, such as loans. Banks may be vulnerable to liquidity shocks arising mainly from the liability side of their balance sheets. If a large fraction of depositors demand cash, the bank may need to liquidate loans. Since this may entail a loss of value, a liquidity shortage may turn into a solvency crisis. Mechanisms that banks can use to ensure against liquidity crisis Self-insure against liquidity shocks on the liability side of the balance sheet, by holding a buffer of liquid assets on the asset side. Co-insure in the interbank market Lender of Last Resort (LOLR) General refinancing and Special refinancing.

Determinants of Liquidity buffers The costs of keeping a stock of liquid assets of a particular size are weighed against the benefit of reducing the chance of being out of stock. The key prediction of various theories is that the size of the liquidity buffer should reflect the opportunity cost of return foregone from holding liquid assets rather than loans. It should also relate to the distribution of liquidity shocks the bank may face, and in particular to the volatility of the funding basis as well as the cost of raising funds (eg in the interbank market) at short notice. A demand function for excess reserves that depends both on the distribution of the deposits withdrawals, the external cost of finance (penalty rates applied by the central bank) and the impact of regulation. Banks hoard liquidity during periods of economic downturn, when lending opportunities may not be as good and that they run down liquidity buffers during economic expansions when lending opportunities may have picked up.When the central bank attempts to stimulate the economy with a reduction in the interest rate and a corresponding increase in the monetary
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Assistant Director, Research Department, NRB

2 base, the effects are only transmitted with a lag, since banks appear to keep the additional liquidity on their balance sheets. Banks appear to hold smaller (larger) amounts of liquidity, relative to both total assets and total deposits, in periods of stronger (weaker) economic growth. In other words, banks appear to build up their liquidity buffers during economic downturns and draw them down in economic upturns. BFIs retaliate to restore their behavior on receiving emergency liquidity assistance from central bank (i.e. Lender of Last Resort facility from central bank) and liquidity buffer motive. Interplay between macroeconomic conditions and bank liquidity Bank liquidity buffers are countercyclical. In other words, banks appear to build up liquidity buffers in periods of weak economic growth and draw buffers down in periods of strong economic growth. Banks appear to hold larger buffers when short term rates are low and smaller buffers when short term rates are high. Various windows available at NRB for liquidity Repo Maximum period of repo auction is 28 days. Maximum period of repo auction has been reduced from existing 45 days by considering the comfortable liquidity situation of money market. Conduct of repo and reverse repo auction against the collateral of development bonds in addition to treasury bills has been continued. Standing Liquidity Facility (SLF) Monetary Policy 2012/13 has incorporated new provision to provide standing liquidity facility (SLF) at the bank rate (currently bank rate is 8%). The existing provision of determining SLF rate by adding 3 percentage penal rate on weighted average of 91-days treasury bills rate or prevailing bank rate, whichever is higher, has been repealed. SLF facility is provided against collateral of government securities. Outright purchase
For medium term liquidity management, NRB conducts outright purchase of government securities (T-bills). Maturity period of outright purchase is equals to maturity period of T-bills.

General refinancing Against the collateral of good loans of BFIs, general refinancing facility is provided to BFIs for maximum period of six months. Purpose of general refinancing is to extend productive sector credit. Ceiling of general refinancing is maximum of 40% of core capital or 80% or good loan of BFIs.

3 Refinancing facility for liquidity management purpose Against the collateral of good loans of BFIs, NRB provided this facility maximum up to 120 days especially to pay depositors only. Ceiling for this facility was maximum of 60% of core capital or 80% of good loan of BFIs. This facility has been discontinued since 18 Nov. 2011. Lender of Last Resort (LOLR) facility This facility is provided to BFIs against the collateral of good loan and physical assets of BFIs for maximum period of one year specifically to pay only to depositors. NRB uses discretion for other term and conditions of this facility. Way forward Interest rate, especially short term interest rate, largely depends on the liquidity situation in financial system. The volatility in interest rate is the reflection of the liquidity situation. Short term interest rate is highly volatile in Nepal. Such a high volatility not only increases the risk to financial sector stability but also increases risks and uncertainty in other business and industrial activities. Though it is very difficult to pinpoint the optimum level of interest rate, it would be appropriate to guide short term interest rate within an acceptable band defined by ceiling and floor rates. Apart from the rule based instruments, OMOs have been conducted to hit the operating target (Excess liquidity) as indicated by LMFF. LMFF is not sufficient to assess and forecast weekly liquidity position due to lack of information on currency held by the counterparties on weekly basis, lack of detailed schedule of governments expenditure and revenue flows and other structural factors such as unavailability of weekly balance sheet in stipulated time etc. Therefore, OMO has not been that much effective to manage the short-term liquidity and thereby stabilize the short-term interest rates.

Conclusion Since liquidity buffers are countercyclical in nature, shooting proper liquidity regulation is tough to the central banks. During the economic downturns, lowering interest rate and widening monetary base with intention of boosting economy through investment channel, shows bank and financial institutions investing less and hoarding more liquidity buffers. So, proper liquidity management tool is to initiate interest rate corridor, so that, Standing deposit facility will be provided at floor rate and Standing liquidity facility will be provided at ceiling rate. Implementation of base rate system by NRB is welcome step, apart from this, NRB should implement proper shooting of open market operations, and timely implementation of interest rate corridor at the cost of standing deposit facility for short term market interest rate stability so that some liquidity windows of NRB could be closed.