Restrictions on overnight window could spark contraction in bank balance sheets

• CT CLSA says foreign banks operate with surplus liquidity, estimated at around Rs.200bn 
• Restrictions aimed at redirecting this money to domestic units with liquidity deficits 
• This has potential to bring rates down, provided effective participation by both parties
• Central Bank between devil and deep blue sea on cutting rates as inflation impulses still persist 

While a more active interbank market is intended by the Central Bank when it announced certain limitations into commercial banks’ access to dual standing windows effective from January 16, its effective implementation and thereby its lateral objective of easing market interest rates would depend entirely on participation in the scheme by both parties—one holding excess liquidity and other with a deficit. 

Should the banks fail to participate in the scheme announced, the Colombo-based equity brokerage CT CLSA Securities showed that the move could risk a contraction in the balance sheets of the overall banking sector. The Central Bank earlier this week announced plans to limit the commercial banks’ access to its Standing Deposit Facility (SDF) to five times a month while restricting the borrowings from its Standing Lending Facility (SLF) window to 90 percent of a bank’s mandatory reserve requirement in a given day.   

The move was aimed at reactivating the interbank market, whereby the banks would be nudged to trade between them based on liquidity statuses, while discouraging them to use the SDF and SLF every time.

According to a brief analysis by CT CLSA Securities, the restrictions on accessing the SDF window are aimed at reducing the return generated via the SDF by those banks that park their excess liquidity there. 

The banks can earn 14.5 percent on the funds they park under the SDF while those that require liquidity from the SLF window are charged at 15.5 percent—the two rates together make the Central Bank’s key policy rates. 
While the terms used to identify these key policy rates may vary based on the jurisdiction, these are the key policy tools at the disposal of any central bank in the world to control the pace of money supply and thereby the pace of inflation. 

When inflation proved to be more entrenched last year from earlier expectations of it being transitory, predominantly due to the global energy and commodities price boom, the central banks around the world, with the exception of China and Japan, tightened their monetary policies by raising their key rates. 

CT CLSA in its study found that the local units of foreign banks operating in Sri Lanka mostly operate with excess liquidity, which they park under the SDF. The restrictions that would come into play would compel these banks to redirect their surplus funds, which are estimated at Rs.200 billion to the domestic banking system. 

On the other hand, the domestic banks that have a deficit in their liquidity can make up for any difference in meeting their daily liquidity requirements by accessing this Rs.200 billion from foreign banks. CT CLSA estimates that based on the restrictions announced, the domestic banks could borrow from the SLF only up to Rs.339 billion, which is the equivalent of the 90 percent of their reserve holding of Rs.377 billion at present, resulting in a shortage of about Rs.200 billion, the amount of which can be met from directly borrowing from foreign banks, which operate with excess rupee liquidity. 

This move, if works as expected, has the potential to put downward pressure on market interest rates but requires the commitment and desire from both parties, CT CLSA said. 

“Failure of this could lead to the contraction of the balance sheets of the overall banking sector,” CT CLSA opined. This week’s circular announcing these restrictions is a follow through by the Central Bank, which said in November that it would intervene in the interbank market, if necessary, to bring down the market rates. 

The Central Bank is currently placed between the devil and the deep blue sea, as it can no longer continue its tight monetary policy without prolonging suffocating the economy while any pull back could stoke inflationary impulses, as the prices still remain at red-hot levels.