THE CLEARING CORPORATION OF INDIA LTD.

CALL MONEY MARKET VOLATILITY

Golaka C. Nath* (April 2007)

One of the main objectives of monetary policy is to ensure a stable interest rate structure in the economy which would lead to healthy asset liability management in the banking sector. Banks need to reconcile their short term money management in such a manner that would keep all the expected short term market rates close to the policy reference rates of the central bank. The central bank signals its future actions through monetary policy quarterly and half-yearly reviews. During the last three reviews, the central bank pronounced inflation as the major risk to the economy that has been growing at a considerably higher rate during last three years or so. The inflation has been consistently higher than the central bank target of 5-5.5% which has led to some of the policy measures like hike in Cash Reserve Ratio (CRR) by 150bps in three different actions (recent actions being on February 13, 2007 a two-stage increase of 25 basis points each in the CRR was announced, effective from the fortnights beginning February 17 and March 3, 2007 and on March 30, 2007 a further two-stage increase of 25 basis points

each in the CRR was announced, effective from the fortnights beginning April 14 and April 28, 2007), increase in repo rate making the borrowing from central bank costly for banks, keeping a cap on total absorption of liquidity through Liquidity Adjustment Facility (LAF) to Rs.3000crores per day (March 2, 2007). Other policy actions included increase in risk weights in the case of housing loans (from 50 per cent to 75 per cent), commercial real estate (from 100 per cent to 150 per cent) and consumer credit (from 100 per cent to 125 per cent) and general provisioning requirement for standard advances in specific sectors has been raised to 1.0 per cent of standard advances. The monetary policy stance has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability with immediate monetary measures and to take recourse to all possible measures promptly in response to evolving circumstances. This clearly gives the focus of inflation management as the key policy driver.

*Shri Golaka C. Nath is the Vice President, Economic Research and Surveillance Department, The Clearing Corporation of India Limited

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The central banks action on March 30, 2007 took the market participants by complete surprise as the short term market has been passing through one of the most volatile periods in recent times. However there was little choice left before the central bank but to act to rein in inflation as the same has not been coming down from 6.4% level. The central banks demonstrable and determined policy action on last Friday of the financial year is likely to move the interest rate northward at least by 50bps across the board as the increase in CRR would suck away about Rs.15500crores (last sucking was about Rs.14000crores) from the system which is already getting the life line from the central bank through LAF repo of about Rs.35000crores on daily basis. Further a cut in the remunerative rate on CRR balances from 1% to 0.5% will also drain some amount of cash which was available to the banks as income inflows. The policy action will put the fund managers in banks into corrective action mode and may lead to a long term change in terms of managing short term funds and asset liability mismatches. Inflation control has been put in the main policy domain. The central bank has stated in its announcement on March 30, 2007 that At this juncture, it is important to reinforce the measures already taken for maintaining price stability and anchoring inflation expectations in order to sustain the growth momentum. The role of monetary policy is
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to maintain stability and so contribute to growth on an enduring basis. A central bank would like all short term rates to hover around the policy reference rates as the same is used as the signalling system. When the system has excess funds, it is likely that short term market rates like overnight call, market repo and CBLO would be close to the reverse repo rate. This was very much in line as till recently the central bank absorbed all the excess liquidity and remunerated the same at a relatively higher rate vis--vis the market determined rates of similar type of funds. Banks were provided further comfort of getting to park the funds in second LAF at the end of the day (after the short term markets are closed or nearly closed). Most of the banks used to opt for second LAF as it always provided the last option to banks with a guaranteed support system. This second LAF led to complacency among the fund managers in banks as they were a s s u re d o f g e t t i n g t h e i r m o n e y remunerated at reverse repo rate of 6% if they can not park funds in the call/notice/term/, CBLO or repo market. This might have led to passive management of short term funds in many banks. However, the policy action of the RBI in capping the absorption of Rs.2000crores in the first LAF and Rs.1000crores in the second LAF led the managers to wake up for active funds management. Except in

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times of shortages, banking system used to park nearly Rs.15000crores daily through reverse repo window under LAF. The central bank has taken a cue from the policy action of other global central banks and its press release on March 30, 2007 states Globally, the process of withdrawal of accommodation in monetary policy is being vigorously pursued. Short Term Market Dynamics Introduction of LAF as a policy measure to moderate short term money acted as a deterrent to higher volatility in short term interest rates that have an important bearing on banks asset liability

long term assets that provide them with a decent and lucrative margin. Accessing overnight call market was once the most convenient method of raising substantial resource before the RBI brought policy regulations restricting the quantum of lending and borrowing linking the same to the new owned funds/net worth of the participants. Further, phasing out nonbanks from the call market also brought about much needed discipline and robustness to the market. This policy move by the central bank led towards a collateralised market environment. Chart1 gives the marked shift to short term collateralised market.

Chart-1: Short Term Market Distribution (Jan 2004-Mar 2007)

100% 90% Ma rke t S ha re (% ) 80% 70% 60% 50% 40% 30% 20% 10% 0% Y2004 Y2005 Year CallVol CBLOVol RepoVol Y2006 Y2007

management. The central bank would like to see a stable interest rate regime in the economy with lower level of volatility. Some banks regularly access short term markets to borrow heavily to fund their

The call market that used to dominate the short term segment has been declining steadily in terms of market share while CBLO has increased its share substantially. Market repo has also shown a decline over

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Chart 2: Short Term Market Rates (March 1 - March 15, 2007)

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the years as market participants preferred a transparent and efficient price discovery mechanism. This has brought down the systemic risk as market started to shift to a collateralised and guaranteed environment. The short terms which remained more or less close to the policy rates for a very long period of time (except temporarily moving way above the policy rate corridor) started showing a little different trend after the RBI decided to restrict LAF reverse repo amount to Rs.3000crores effective March 5, 2007. This action moved the short terms rate to lower levels before the market moved to a shortage mode due to advance tax outflows of Rs.35000crores on March 15, 2007. Chart-2 shows how the short term rates dived downward due to the policy change. The removal of comfort led to active management of short funds by some banks which were heavily relying on RBI liquidity absorption programme on daily basis.
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However, once the shortages set in due to advance tax outflows and the declaration of proposed bank strike by public sector bank employees (later withdrawn) just before the closing of books of accounts led to panic in the market. This prompted the RBI to go for infusion of liquidity to the system by way of repo under LAF and the amount of support was close to the advance tax outflows. However, the support from the RBI was only available against eligible SLR securities. The banks holding excess SLR securities (typically PSU banks) got the liquidity from the RBI at the repo rate of 7.5% and decided to either use the funds for internal balance sheet management or on-lending the same in other comparable markets. The shortage of liquidity coupled with lack of availability of excess SLR with some banks led to rates moving to unusual levels of 80%. Chart-3 gives the short term rate movement during the last fortnight of the

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Chart 3: Short Term Market Rates (March 16 - March 30, 2007)

51.00 46.00 41.00 36.00 31.00 26.00 21.00 16.00 11.00 6.00
0 6307 1 0 7307 1 0 8307 1 0 9307 2 0 0307 2 0 1307 2 0 2307 2 0 3307 2 0 4307 2 0 5307 2 0 6307 2 0 7307 2 0 8307 2 0 9307 3 0 0307

Ra te (% )

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financial year 2006-07. The collateralised markets behaved in a much better and disciplined way while the overnight call market moved to unusual levels. The movement of call rates outside the policy rate corridor has led to many issues that will have far reaching consequences in the balance sheet of banks specifically the banks that have huge interest rate swaps outstanding. Most of the swaps are linked to MIBOR and all old contacts have been designed keeping in mind the stable call rate due to unlimited support by the RBI in terms of monetary absorption in reverse repo window. Putting a restriction on LAF reverse repo support has led to the overnight rates coming down by about 50bps and the banks receiving floating rate suffered good amount of loss. This syndrome is likely to continue for some time in near future as the removal of comfort by RBI is a structural change.

Further, when the rates started moving to unusual levels, banks paying MIBOR would have been suffering huge losses. Since the swap market is purely OTC, it would not be possible to ascertain the quantum of such losses at present. The call market, a pure telephone market till recently, witnessed some interesting change in terms of infrastructure. After the introduction of NDS-Call, the quote driven platform for dealing in call money, market participants increasingly started using the new system and volumes started moving to this platform from the telephone market. In the time of high volatility in call rates, market participants preferred to use the new system for negotiation as it provides them the option of seeing all the rates given by their respective counter parties as well as viewing the movement in the market on real time basis. Chart-4 gives the increasing market

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Chart-4: Share of NDS-Call

Market Share (%)

60.00 50.00 40.00 30.00 20.00 10.00 0.00 0 3- 10 - 0 6 1 4 - 11 - 0 6 1 2- 12 - 0 6 0 9- 01 - 0 7 2 0 - 02 - 0 7 2 0- 03 - 0 7

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share of NDS-Call system after its introduction in Sep06. Volatility in Short Term Rates The short term has been going through a most volatile phase at present. Till recently

and hence the short term rates were very close to the reverse repo rate except in times of shortages when the market moved to the upper end of the corridor. Chart-5 gives the short term rates movement during Jan04 and March 15, 07.

Chart 5: Short Term rate movement (Jan'04- Mar 15, '07)

18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 01- 07- 2006 01- 03- 2004 01- 07- 2005 01- 05- 2004 01- 07- 2004 01- 09- 2004 01- 09- 2005 01- 11- 2005 01- 01- 2006 01- 01- 2004 01- 11- 2004 01- 01- 2005 01- 03- 2005 01- 05- 2005 01- 03- 2006 01- 05- 2006 01- 09- 2006 01- 11- 2006

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the market was a stable one as rates hovered around the policy rates. Since Jan 2004, the market remained mostly in surplus mode
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This was possible earlier because of the central bank comfort provided to banks. The volatility of the short term rates

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increased significantly after March 15, 2007 when the market went into deficit mode. Till that time, the market witnessed lesser degree of volatility as can been in Chart-6.

composition. In the lending side, public sector banks contribute 77% to the volume followed by private banks with about 11% and cooperative banks with about 8%. Foreign banks and primary dealers

Chart 6: Volatility in Short Term Market(Jan'04 - Mar15,'07)

2.50 Volatility (%) 2.00 1.50 1.00 0.50 0.00
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The volatility went up significantly during the last fortnight of March07 as can be seen in Chart-7. Call Market Composition The call market has a very interesting
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contribute only 4%. However, in the borrowing side, foreign and private sector banks together contribute about 74% of the volume followed by primary dealers and public sector banks with about 14% and 13% of the market. Cooperative banks

Chart -7: Volatility in Short term market (Mar 16 - Mar 30, 2007)
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hardly borrow from the market. Concluding Remarks The short term market in recent times has seen one of its worst phases. Overnight rate has reached 80% - the highest since 1997. Hopefully, the market may take little time to comeback to its usual level anchoring around the policy rates. However, the draining of another Rs.15500crores from the system may bring another round of short term volatility in the market. The same is not likely to affect banks having excess SLR securities as they would use the same in RBI repo window under LAF to get

the funding at 7.75%. However, the banks which have little or no excess SLR security would face the heat more. Credit disbursal is likely to come down as the cost of funds would go up. This may also bring in additional non-performing assets in the books of the banks as some of the borrowers would find it difficult to service the loans even after adjustment in terms of elongating the maturity of the loan. Most of the bankers are keeping their fingers crossed hoping the usual March syndrome would pass off peacefully without affecting their balance sheet.

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