Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Is there a two tier inter bank market in India?

Update October 13, 2011:

After I posted this yesterday, the RBI published the results of the Reverse Repo auction yesterday showing that there was no money parked with the RBI yesterday. Possibly, the top tier banks are also now cash deficit in the aggregate, and they do not have any surplus to deposit with RBI. Or perhaps, the two tier market is de-tiering. I do not know.

Original post (October 12, 2011):

In a well functioning inter bank market, cash surplus banks lend to cash deficit banks and only the aggregate cash surplus or deficit of the banking system is absorbed by the central bank’s liquidity operations (repo or reverse repo). In a two tier market, there is a top tier of healthy banks that lend to and borrow from each other, but this tier refuses to lend to the second tier of banks whose financial health is suspect. In such a market, if the top tier banks in the aggregate have a cash surplus, they would not lend it to the second tier banks, and would instead park the surplus with the central bank. If the second tier banks have a cash deficit, they would be borrowing from the central bank because they are unable to borrow from anybody else. The central bank would thus be partially supplanting the inter bank market. A two tier market is of course better than a complete seizure of the inter bank market where there is no inter bank market at all and all cash surpluses are parked with the central bank which on-lends it to the deficit banks. After 2008, this progression from a normal inter bank market to a non existent one is well known and understood.

What I am worried about is whether there is a two tier inter bank market in India today. Since the end of last month, we have been seeing the odd situation of some banks parking cash with the RBI at 7.25% while other banks are borrowing from the RBI at 8.25%. If there is no tiering of the banking system, this does not make sense. The surplus bank could lend to the deficit bank at 7.75% and both banks would be better off. The surplus bank would earn ½% more than what the RBI pays, while the deficit bank would reduce its borrowing cost by ½%. That this is not happening suggests that the surplus bank does not have confidence in the solvency of the deficit banks and prefers a safe deposit with RBI. Put differently, there are some banks who are able to borrow only from the central bank as other banks are unwilling to lend to them.

When I started observing this phenomenon at the end of September, my first reaction was that it was due to the distortions caused by the half yearly closing on September 30. When it lasted beyond that, I thought that this was just the effect of the holiday season (Durga Puja and Dussehra). But all that is now over and still the phenomenon persists. Are some bankers worried about the solvency of their fellow bankers?

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