What is Liquidity?
Liquidity is the availability of sufficient funds as and when it is required. Individually, each of one of us is considered to be liquid when we have enough cash with us to spend to meet our necessities. Often the savings are invested in assets for earning higher returns. In order to increase our liquidity in case of our exigencies we sell these assets to mobilize cash. When a number of persons come to the market for selling the same asset the supply increases. The news regarding sale of this particular asset spreads in the market and the holders of this asset get panicky and start selling it at what ever price they get. This process pulls down the price of the asset and the demand side become very weak and even turns to negative. Slowly this spreads to other assets also and the entire market witnesses a crash leading to financial distress. When the savers become illiquid they withdraw money from the banks instead of depositing and start borrowing heavily from banks to increase their liquidity. Consequently banks also lose liquidity and stop lending which adds fuel to the fire.
Liquidity Management
The role of central bank of a country is to ensure enough liquidity in the market. The central bank intervenes in the market in two ways. Firstly they apply monetary measures like reducing the bank rate, reducing CRR and SLR, reducing repo rates etc. The effect of these measures is that the banks get relief through increased funds position. When the central bank reduces the CRR the excess balances maintained with RBI get released to the banks which increase their liquidity. When the SLR is reduced, the banks need to invest less in SLR securities and hence the excess security holdings could be sold in the market. But in a falling market it will not help in reducing liquidity since when every bank approaches the market for selling securities, the demand for securities declines pulling down the price. But the banks get relief from maintaining the future SLR at lower rate and hence that much funds would be available for lending.
Reduction in bank rate and repo rate reduces the cost of borrowings of banks which will enable them to increase their liquidity by borrowing from the central bank. The reduction in the cost of borrowing will lead to reduction in cost of lending and people will increase their borrowing there by lincreasing the liquidity in the market. The recent RBI measures brought down the CRR to 5.5 per cent and SLR to 24 percent and pumped an aggregate amount of Rs.140000 crores. Besides, RBI also released an amount of Rs.25000 crore in the first week of November towards the first tranche of the debt relief package as announced by the government in its current years’ buidget.
Non-monetary Measures
The second method is by building up confidence among the public about the safety of their investments. Generally people easily succumb to roumours and act swiftly without thinking twice. Any bad news will spread faster and speedier than good news. Hence it is much easy to spread damaging news against any institution. The best example is the rumours spread about ICICI Bank recently. The government and central bank come to the rescue of financial institutions in such cases. A statement from the finance minister re-affirming the health of financial institutions in the country can boost the confidence among investors. Similarly central banks come through media and assure the safety of the deposits with banks. Recently the government of
Vanishing Liquidity
Though the market received a whopping Rs.165000 crore by way additional liquidity, the industry continued to face the brunt of liquidity crunch because of reluctance of bankers to extend financial assistance. Now the question is where these funds have gone? Another interesting feature is that the increased liquidity could not help the capital market to withstand the crash due to increased FII activities. I strongly feel that the liquidity should have been pumped through the pension funds and mutual funds so that they could support the market by buying the securities, instead of releasing the banks with the hope of activating lending operations. Now neither the credit portfolio of banks increased nor the industries received the benefits of RBI interventions. I invite readers to probe and come out with their suggestions.
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