- By Utkarsh Shukla
Liquidity within the banking system refers to the simple access to liquid funds that are needed for operations and financial needs, but it became difficult to access these funds due to several factors, such as record borrowing from the central bank and significant outflows of money from tax payments. The largest liquidity shortfall in more than four years had been experienced by the Indian banking system.
Liquidity deficit in the system
Liquidity deficit in the banking system refers to a situation where banks do not have enough cash or other liquid assets to meet their short-term obligations. Recently, the liquidity shortfall reached a shortfall of $17.67 Billion on September 18, 2023. This is believed to be the highest single-day deficit after April 23, 2019. The major contributor is considered to be the borrowing by the banks, with a record $23.7 Billion borrowed from the Central Bank’s marginal standing facility window. A liquidity deficit in the system can have a negative impact on banking stocks, Bank Nifty, Nifty, and other stocks. This is because banks are more sensitive to liquidity conditions than other sectors. When there is a liquidity deficit, banks have to borrow more money at higher interest rates to meet their funding needs. This can lead to a decline in their profitability and make them more vulnerable to financial shocks.
The Major factors
The factors to play are advance tax payments, followed by substantial outflows towards the Goods and Services Tax, expected to total up to $30 Billion. Also, it is believed that the portion of the available funds is locked in the Cash Reserve Ratio.
Some general factors due to which liquidity deficit occurs in the system are: -
· Increased demand for loans: When companies and individuals borrow from banks, the banks' liquidity reserves drop. This can happen if there's an unforeseen boost in demand for loans, similar to during a period of economic expansion.
· Decrease in deposits: When people withdraw money from their bank accounts, the banks' liquidity reserves drop. This can be if there's a loss of confidence in the banking system or if there's an unforeseen boost in demand for cash, similar to during a natural catastrophe.
· Mismatched maturities: Banks frequently advance out cash for longer ages of time than they admit deposits. This means they may have to adopt money in the short term to meet their obligations. However, if there is a sudden increase in interest rates, banks may borrow money at an expensive rate.
· Geopolitical issues: Geopolitical effects can also result in a liquidity deficiency in the banking system. For illustration, if there's a war, like the recent Russia- Ukraine war or a trade embargo, this can disrupt the system and lead to a drop in deposits. Also, if there's a loss of confidence in the global economy, this can lead to a decrease in foreign investment, which can also set downcast pressure on the banking system's liquidity reserve.
Impact on banking stocks
Banking stocks are likely to be the most affected by a liquidity deficit. This is because banks are the largest borrowers in the system and they rely heavily on short-term funding. When there is a liquidity deficit, banks have to offer higher interest rates on deposits to attract liquidity. This can lead to a decline in their net interest margins (NIMs). Additionally, a liquidity deficit can make it difficult for banks to lend to businesses and consumers, which can also hurt their profitability.
Impact on Bank Nifty
Bank Nifty is an index that tracks the performance of the top 12 banking stocks in India. As a result, it is highly sensitive to the performance of banking stocks. When there is a liquidity deficit, Bank Nifty is likely to underperform the broader market.
Impact on Nifty and other stocks
The impact of a liquidity deficit on Nifty and other stocks will depend on the severity of the deficit and the overall state of the economy. If the liquidity deficit is severe and prolonged, it is likely to weigh on the performance of all stocks, including Nifty stocks. However, if the liquidity deficit is mild and temporary, the impact on Nifty and other stocks may be muted.
Central bank stepping in
The Central Bank (RBI) steps in and is believed to ease the incremental Cash Reserve Ratio imposed on banks in August. It is also planned to release 25% of the funds on September 23rd and the remaining on 7th October. However, the inflows are not expected till the end of September and the situation will remain the same due to Rupee depreciation pressures and risks of inflation.
Impact on the Capital Market as a whole
The impact of the liquidity deficit on the capital market is likely to be more persistent in the short term. However, if it is there in the long term, the market is going to be severely impacted.
Lower Investments: Lower investments are being made in numerous sectors of the economy. Due to a lack of liquidity, companies are raising less money through IPOs than in the past. This is because investors are more cautious about investing in new companies when there is a liquidity shortfall.
Stock prices decline: Stock prices have been declining in recent months due to several factors, including liquidity deficiency. Investors are selling their stocks to raise cash.
Further volatility: The capital request has become difficult to predict as a result of the lack of liquidity. This is because investors are more likely to sell their equities if they are worried about an extreme liquidity shortage.
Authentic statistical facts in relation to stock markets with regards to liquidity deficit in the banking sector:
Bank Nifty underperformance: The Bank Nifty index has underperformed the Nifty index by over 10% since August 2023, when the liquidity deficit in the Indian banking system began.
Increased short-term interest rates: The overnight inter-bank call money rate has risen from 5.4% to 6.75% in recent weeks, due to the liquidity deficit.
Decline in banking sector profitability: The net interest margins (NIMs) of Indian banks have declined in recent quarters, due to the increase in short-term interest rates.
Outflows from banking sector mutual funds: There have been significant outflows from banking sector mutual funds in recent months, as investors have become concerned about the impact of the liquidity deficit on the sector.
Underperformance of small and mid-cap banking stocks: Small and mid-cap banking stocks have underperformed large-cap banking stocks in recent months, due to their higher exposure to the liquidity deficit.
These statistical facts suggest that the liquidity deficit in the Indian banking sector is having a negative impact on stock markets. Banking stocks and Bank Nifty are underperforming the broader market, and there have been outflows from banking sector mutual funds. Additionally, small and mid-cap banking stocks have underperformed large-cap banking stocks.
Conclusion
The average daily trading volume in Bank Nifty futures and options has declined by over 20% since August 2023.
The share prices of most major banking stocks have fallen by more than 5% since August 2023.
The Nifty Bank index has a correlation of 0.75 with the Nifty index, which means that it is highly sensitive to the performance of the broader market. However, the correlation has declined in recent months, suggesting that Bank Nifty is becoming more decoupled from the broader market.
This suggests that the liquidity deficit in the Indian banking sector is having a significant impact on stock markets. Banking stocks and Bank Nifty are underperforming the broader market, and there has been a decline in trading volumes. Additionally, Bank Nifty is becoming more decoupled from the broader market, which suggests that it is becoming more susceptible to its own factors, such as the liquidity deficit.
To address the lack of liquidity in the banking sector, the government and the Reserve Bank of India (RBI) are implementing several actions. However, it's crucial to remember that the short-term effects of the liquidity shortage on the capital market are likely to continue. Investors are encouraged to exercise caution and conduct independent research before investing in the capital market.
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