By Abhik Agrawal, Senior Principal Product Manager, Oracle Financial Services
The Covid-19 pandemic has impacted all the economies, big or small, across the globe. Central banks everywhere have been proactively dealing with the situation and have successfully pushed a large amount of liquidity to the banks through various means. However, due to widespread uncertainty caused by the pandemic, banks are reluctant to lend, and consumers are hesitant to avail credit. This article highlights the adverse impact that surplus liquidity may have on the banks and economies if adequate demand is not created.
While the whole world has grappled with the pandemic, central banks across the world were better prepared to fight the economic impact it caused. The experience and lessons learned from previous crises served to inform central banks’ response to the pandemic. They pushed a huge amount of liquidity to keep the banks afloat and help the overall economy in this time of magnanimous stress.
Here are a few common measures taken by central banks to push liquidity into the banking institutions:
- Rate cut: Several rounds of rate cuts were applied by central banks across the globe for short-term lending to banking institutions, resulting in a liquidity surplus across banks. A few central banks even reduced the rates to zero and sub-zero levels. The U.S. Federal Reserve reduced its benchmark rates for short-term lending from 1% and 1.25% to 0% and 0.25%. Some European banks brought down the rate to negative.
- Quantitative easing (QE): Quantitative easing, a brainchild of the Bank of Japan, is a way of pushing liquidity into the markets through banks. It is now widely used by central banks across the globe. QE is a part of monetary policy and is effective when short-term rates are near zero. Under QE programs central banks purchase long-term government and other securities and increase the supply of money. For example, in response to COVID-19, the U.S. Federal Reserve announced a quantitative easing plan of more than $700 billion and subsequently enhanced it by a commitment to buy at least $80 billion and $40 billion a month respectively in government- and mortgage-backed securities.
- Relaxing regulatory requirements: Given the crisis, central banks relaxed a few capital and liquidity regulatory requirements. The Reserve Bank of India deferred the NSFR maintenance guideline by six months, from April 1, 2020 to October 1, 2020. The maintenance of liquidity coverage ratio was also brought down from 100% to 80% for a few months.
- Discount window: A discount window is used by central banks for short-term, mostly overnight, lending. Banks have cut the rate of lending through the discount window and have also increased the tenure of lending to ensure adequate liquidity with banking institutions. For example, the U.S. Federal Reserve lowered the rate that it charges banks for loans from its discount window by 2 percentage points, from 2.25% to 0.25%
- International swap line: The U.S. Fed opened international swap lines, which are essentially an emergency pipeline of money, to many central banks, which needed U.S. dollars and it has also cut the rate on the existing lines.
There are many other measures taken by central banks targeted towards direct lending to the consumer or security markets like increasing the moratorium period by three months, lending directly to corporates, such as the Primary Market Corporate Credit Facility by the U.S. Fed, Money Market Mutual Fund Facility (MMMFF), etc. (But for this article I’ll focus on the measures which resulted in central bank’s direct lending to other banks.)
The actions of central banks to keep the banks sufficiently liquidated through the stimulus packages were well in time and much needed, but the liquidity push alone is not sufficient to tackle the situation. It is important that the surplus fund with the banks goes into the hands of creditworthy borrowers, and the economic activities gradually re-instate to the pre-pandemic era.
But for several reasons the liquidity that was pushed into the banking system didn’t result in proportionate lending:
- Banks unwillingness to lend: Due to the potential negative impact of the pandemic on employment and people’s businesses, there are chances that the credit rating of borrowers and the value of collaterals against which the bank lends may go down. This makes banks skeptical of lending.
- Provision for potential losses: Banks are setting aside a larger amount of funds for potential losses in existing loans due to the possibility that the credit quality of borrowers will decline as the result of lesser economic activities. A study published in the March 2021 BIS quarterly review shows that the provision for the first half of the year 2020 was three times as compared to the second half of the year 2019.
- Less demand for credit: Many businesses, especially small businesses, suffered immensely due to lockdown restrictions. The unemployment rate also increased. This has given rise to uncertain income streams for individuals and corporates, resulting in a decline in the demand for credit.
- Operational issues: Banks in many European countries and countries like India, which are facing the second or third wave of the pandemic, are not adequately staffed due to restrictions imposed by local authorities or absenteeism due to fear of the pandemic. The focus for many banks is on the safety of their staff and performing the most essential duties rather than growing the business.
Banks are sitting on a large amount of liquidity. Although this current level may not be maintained for long, and at some point soon banks will start pushing this money into the economy. However, if it happens without creating adequate demand, it may prove to be counterproductive to the banking institutions and the economies in the following ways:
- Inflation: The spurt of the money supply to the banks and the general economy will likely increase inflation. If the same is not followed by an increase in credit supply and demand growth, the situation may get worse, and the economy may fall into stagflation. Stagflation is a condition where inflation increases, but economic growth is stagnant.
- High-risk lending: With liquidity piling up and low interest rates in place, banks may be enticed towards high-risk lending. This can result in overfunding to existing customers or funding to new customers with low credit quality. This will have a long-term impact on the bank’s overall credit quality.
- NPA pile-up: Apart from new lending, the existing accounts may also slip into nonperforming asset (NPA) due to high unemployment rates and losses to businesses caused by low economic activity.
- Currency devaluation: Measures like quantitative easing to push liquidity may result in the devaluation of currency. As the bond yields decrease due to quantitative easing, currency devaluation occurs. This can help the country’s exporters as their products would be cheaper in the global market, but it will make import goods more expensive. This happened during the 2007-2008 global financial crisis with the USD index, which fell more than 5% after the first round of quantitative easing.
- Liquidity trap: A liquidity trap is a situation where the interest rates are very low but the consumer continues to hoard cash in savings and other accounts and does not want to invest in any other instrument. This happens as the customer foresees a negative event in the economy and does not want to put money in low-yield bonds, which will result in a loss to them when the interest rates in the market increase. A similar situation applies when banks prefer to keep liquidity rather than lending to customers because keeping reserves with the central bank gives a higher return.
- Overheating of stock markets: During the pandemic markets across the globe crashed for the initial few weeks, but then they reached an all-time high in 4-6 months from the start of the pandemic. Many experts say that this unprecedented run in the stock markets is due to the enormous liquidity stimulus injected by central banks across the globe. Several experts also list this as the main reason for the northward run of security markets.
- Lower net interest margins: The excess liquidity for many banks is placed in low-yielding accounts. This will impact the net interest margin (NIM) of the banks.
There is no doubt that central banks across the globe learned lessons from past crises and provided enough stimulus this time to keep the liquidity of the banks in a sound position. However, they must be cognizant of the fact that excess liquidity may cause damage to the overall economy. They must either start absorption of liquidity through tactics like rate hikes or open market operations at an appropriate time or keep nudging the banks to lend using their swelling coffers.
Recently the situation in a few countries like the U.S. and UK has improved and economic activities are returning to normal. This might indicate that the central banks in certain countries will take necessary actions to suck liquidity from the markets. However, this is not likely to happen before the first quarter of 2022. Still, the battle could be longer as financial uncertainty continues to be a major factor in many countries.