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FIs have the best of many worlds

T.B. Kapali

ARE the financial institutions having the best of many worlds? It would appear so if the latest Reserve Bank of India draft guidelines on issue of Commercial Paper are any indication.

Even as it is, FIs have access to the retail deposit market but do not suffer from any reserve requirement against such liabilities. They therefore, theoretically, can function as some kind of an external financial market - much like the euro markets.

They can offer more competitive rates on both their funding and lending sides (mainly on the funding side) in the absence of the reserves burden. That is, a higher deposit rate which will still be equal to the reserve-adjusted cost of deposits for banks. On the lending side, though, the rate at which comparative loans are made by conventional banks will set the ceiling at which FIs themselves can make loans.

Therefore, there will prima facie be a reduction in the spreads at which FIs can operate. Higher volumes of business on the back of the advantage of possibly a higher fund base (enabled by more competitive deposit rates) is typically the antidote to such a shrinkage in spreads. The euro markets have typically grown by leaps and bounds in this backdrop.

In the instant case, on top of such an advantage as described above, come the draft guidelines on CPs which talk of permitting the FIs to access the short-term wholesale money markets. CPs could well be a good source of short-term funding for the FIs ena bling them to further expand their lending activities.

The question here from a regulatorial point of view and for the regulator (the RBI) is: how different will borrowing through CPs be different from borrowing in the overnight money markets? The RBI has for long kept the FIs away from borrowing in the over night market. The reason, ostensibly, was to avoid another source of borrowal demand in the overnight markets.

Permitting FIs to borrow through CPs would effectively enable them get over the fact that the overnight market should be a pure inter-bank market.

Another point of interest is about risk management. Here is a policy proposal which could well encourage FIs to deliberately create maturity mismatches in their asset/liability book. Of course, it is not that maturity mismatches cannot be created in the business of financial intermediation. The interesting thing is the RBI itself seeming to create the opportunities for gaps.