My Turn

On bank illiquidity, T-bills and savings

Contrary to the excess liquidity that characterised Malawi banks in recent years, recently illiquidity has forced many to resort to borrow from the discount window despite the punitive rates and offer unsustainably high deposit interest rates.

Banking involves mobilising funds from savers and lending it to those who need it. While lending, banks must remain liquid enough to meet cash withdrawals by their depositors. Banks meet these by (i) keeping a certain fraction of their deposits in liquid assets (assets that can be quickly converted into cash) while lending the rest, and (ii) continuously accepting deposits.

The law of large number is at work here; since banks generally have large number of depositors, under normal circumstances, the probability that most or all would want to withdraw their deposits at the same time is low. Banks can thus lend part of the deposits without becoming illiquid. Deposit mobilisation is thus a key aspect of sustainable liquidity.

Some banks may be prudent enough to do both. But, it cannot be taken for granted. So, regulation comes in to protect public interest by, among other things, requiring banks to keep a certain fraction of their deposits in liquid assets and to buy deposit insurance. While the RBM can impose a liquidity requirement on banks, it usually does not force them to mobilise deposits. Savings could be held in various forms: in-kind (e.g. crops, livestock, jewellery, real property), cash, bank deposits, shares, etc. So, savers need to be encouraged to deposit their savings in banks through various incentives including easy and convenient access to banks, reasonable interest rates, and compulsory deposit insurance.

The RBM defines the ‘liquid asset’ and where and how it should be kept. A narrow definition uses only cash with the RBM while a wider definition includes T-bills and other assets that are maturing quickly. The definition adopted has important implication on banks’ liquidity and costs and the interest rates they charge.

For example, if it consists of only cash with the RBM (as is the case in Malawi), then banks earn no return on it while incurring deposit interest expenses on them. Banks thus have to compensate for the forgone interest income through higher lending interest rate on the amount they lend. 

That bank liquidity depends not only on the level of the liquidity reserve ratio (LRR) but also on the definition of liquid assets adopted and the extent to which banks engage in sustained mobilisation of savings has important policy relevance. Yet, what is being suggested as a solution to the current liquidity problem is narrow and one-sided; narrow because it only focuses on reducing the LRR, and one-sided because it seeks solution only from the RBM, not considering what banks could and should do.

The other area is promoting savings mobilisation. This ensures continual inflow of liquidity to banks and brings banks to be part of the effort to ensure sustainable liquidity. This requires inculcating a savings culture and encouraging people to hold bank deposits. These require both policy and bank level measures.

Thus, the policy stance and practice in these areas need to be re-examined and appropriate measures undertaken.

Expanding the outreach and reliability of deposit taking institutions and providing incentives to encourage not only savings but also their flow to banks are crucial. Keeping interest rates on deposits so low for a long time was somewhat myopic. Offering deposit interest rates that offer reasonable incentive will serve banks well since savings cannot be increased overnight. It requires a change in consumption habits which does not happen quickly. It is precisely for this reason that countries that want to encourage domestic savings mobilisation put a floor on deposit interest rates to prevent them from being too low. Increasing savings in times of inflation requires stronger incentives as stocking consumer items may be more appealing.  – The author is UNDP’s economics adviser.

Related Articles

Check Also
Close
Back to top button