Tuesday, 17 January 2017

Why I Won't Invest in the FFO of the CPSE ETF - 17Jan2017

Why I Won't Invest in the Further Fund Offer of the CPSE ETF:

The Government of India has come out with a further fund offer (FFO) of the CPSE exchange traded fund or CPSE ETF, which is managed by the Reliance Nippon Life Asset Management Ltd or Reliance Mutual Fund. This FFO opens on 18 January and closes on 20 January 2017 for non-anchor investors. The government wants to raise Rs 4,500 crore (with a green shoe option of another Rs 1,500 crore) from this offer.

Here I briefly analyse of the offer of the units of CPSE ETF and I'm giving my reasons why I will not invest in this further fund offer of CPSE ETF:

1. High Concentration Risk:

There are only ten stocks in the CPSE ETF mutual fund. All of them belong to the public sector known as central public sector enterprises or CPSEs. Top four stocks account for around 74% of total value of the fund. Such high concentration is vulnerable to greater risks and against the principles of diversification. As noted, the performance of the ETF depends mostly on four PSUs (public sector undertakings), namely, ONGC, Coal India, IOC and GAIL.

Even among sectors there's little diversification. Energy sector (oil, gas and minerals) accounts for 77% of the total value, which is not desirable. Financial services is one of the high growth sectors in India, but this ETF has only less than 11% exposure to this sector.

The natural resources sector is not a growth sector in India, though these companies have huge assets and some of them are in monopoly businesses. It's inexplicable how the market regulator SEBI has allowed such an ETF with just 10 stocks, all belonging to the public sector, with high exposure of 77% to natural resources sector.

2. Indian Government Is a Bad Manager:

As is widely known, governments in India are known to arm-twist PSUs to suit their political and social needs, crippling the ability of the management of the companies to deliver decent performance. Every year, the Government forces these companies to declare higher dividends (ignoring the internal needs of the individual companies for capital expenditure) to bridge government's recurring fiscal deficit.

The Comptroller and Auditor General of India (CAG) brings out a yearly report on the central public sector enterprises (CPSEs), pointing out the poor performance and resource allocation of them. PSU stocks have greater political risk.

3. Price Risk:

The FFO will open on 18 January and closes on 20 January 2017 for non-anchor investors. The price for new investors will be based (after 5% discount) on the average price of CPSE ETF during the three days offer period (that is, 18-20 January 2017).

The Reliance Nippon Mutual Fund has indicated the new units of the current offer are likely to be listed on NSE and BSE by 10 February 2017. The new investors in FFO of CPSE ETF will have to bear price risk between the investment date and FFO allotment date for about 20 days.

In between, we've Union Budget on 1st of February, which is expected to give some surprises for stock markets. The NAV of the CPSE ETF is likely to be impacted by this event.

4. Past Performance:

Government of India seems to have timed the FFO of CPSE ETF very well. The last one-year return of the CPSE ETF is 32% as compared to 14% for the Birla Sun Life Nifty ETF fund. This performance has to be seen in the context of minus 20% delivered by this CPSE ETF in one year prior to that. As PSU stocks were beaten down during Jan2015-Jan2016 period, the return of the CPSE ETF looks superior in the last one year. But when you look at the last two years performance, the extra return of the CPSE ETF is not much.

Birla SunLife Nifty ETF
From 17Jan2016 to 17Jan2017
From 17Jan2015 to 17Jan2016
- 20%
- 11%

From 17Jan2015 to 17Jan2017

To use a cliche, past performance of a mutual fund is no guarantee of future performance. It's a different matter whether the current offer will be suitable for new investors.

5. Any Alternatives to this CPSE ETF?

Two mutual funds are available that invest in PSU stocks--they are Invesco India PSU Equity fund and SBI PSU fund. They hold around 20 PSU stocks in their portfolios, with about 50% exposure to natural resources sector. Even these two funds cannot be called as diversified funds.

To Sum Up:

Investments in equities have to be made based on one's risk appetite, one's asset allocation, long term orientation, future expected performance of the fund (a basket of stocks underlying the CPSE ETF), and diversification potential of the underlying stocks in the ETF. Due to the above reasons, the FFO of CPSE ETF may not be suitable to most of the investors.

As buying the underlying stocks by large institutional investors involves high impact cost, such large investors, like, EPFO, LIC of India and other insurers may be tempted to invest in this ETF.

The managers to the offer are marketing the FFO of the CPSE exchange traded fund with the following reasons: there is a 5% discount to investors; the ETF is eligible for Rajiv Gandhi Equity Savings Scheme; invests in ten so-called "Maharatna" and "Navratna" companies; the ETF is outperforming Nifty 50 index; low expense ratio of 0.065%; and 4% dividend yield of the CPSE Index.

All these reasons do not outweigh the risks involved in the CPSE ETF, like, high concentration risk, perceived mismanagement and unnecessary interference by the government and high exposure to natural resources stocks.

If one is positive about the future performance of the underlying stocks, one might take a small exposure to the further fund offer of the CPSE ETF. Before you take a decision on investing, you better read the following web links:

Read More:


EPFO - Employees Provident Fund Organisation
BSE - Bombay Stock Exchange
NSE - National Stock Exchange

Disclosure: Don’t own any units in the above ETF. But I own a few shares in a few PSUs.

Disclaimer: The brief analysis provided here is only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets. He blogs at:

Friday, 2 December 2016

Primer on Market Stabilisation Scheme and Liquidity Management-VRK100-02Dec2016

Primer on Market Stabilisation Scheme 

and Liquidity Management

After a gap of six to seven years, MSS has become a buzzword in the financial space once again. Government of India today, based on the recommendation of the  Reserve Bank of India, raised the MSS ceiling for financial year 2016-17 to Rs 600,000 crore from Rs 30,000 crore fixed earlier. The steep increase in MSS ceiling is necessary as banks have been receiving large amount of deposits following the currency ban on Rs 500 and Rs 1,000 bank notes with effect from November 9th.

So what is MSS? Simply put, MSS is an acronym for market stabilisation scheme. MSS is used by country's central bank RBI as a monetary policy instrument for liquidity absorption and/or injection. RBI already uses other tools like LAF Repo, Reverse Repo and CRR. Why doesn't RBI use these tools instead of MSS? What is the impact of MSS on fiscal deficit?  I will try to answer them in this write-up.

1. What is MSS?

The Market Stabilisation Scheme (MSS) in an innovative sterilisation tool  introduced by the RBI in 2004. It basically deals with the liquidity impact of surging capital flows, such as foreign direct investment (FDI) and foreign portfolio flows (FPI).

The MSS is an instrument for active liquidity and monetary management, in addition to other tools such as LAF repo rate, reverse repo rate and bank rate. It has enabled RBI to conduct exchange and monetary management operations in a flexible and stable manner.

2. Why did the Government increase the MSS ceiling steeply and suddenly?

The Government of India today raised the MSS ceiling to Rs 600,000 crore for the financial year 2016-17 from Rs 30,000 crore fixed earlier. The steep raise was expected for the past one or two weeks following the flood of money into bank deposits due to the currency ban on 8 November 2016.

This MSS instrument was used by RBI between 2004 and 2010 to first absorb liquidity of FII (now FPI) inflows into Indian securities and later inject liquidity into the financial system post the global financial crisis (GFC) that started in 2008. After the Lehman Brothers crisis, RBI started unwinding/de-sequestering of the MSS securities and released liquidity into the banking system, without expanding its balance sheet. The MSS outstanding balance has remained zero since 28 July 2010 till yesterday.

3. Will the Government use MSS money absorbed by RBI?

Issue of MSS bills/bonds by RBI leads to accretion of government deposits with the RBI, but they remain sterilised in the sense the government cannot use these MSS funds for its expenditure purposes. Amount raised under MSS will be kept in MSS cash account, which is separate from the normal cash account of the Central Government maintained with the RBI. Basically, RBI impounds these MSS funds.

4. What is the impact of issue of MSS securities on country's fiscal deficit?

The Market Stabilisation Scheme is backed by a corresponding equivalent amount of cash balances with the RBI. Amounts raised from MSS bills/bonds will not enter the Consolidated Fund of the Central Government.

As the funds raised under MSS would remain hoarded by the RBI in its books, there is no impact on the fiscal deficit of the Centre.

After MSS unwinding/de-sequestering, the money will be transferred from MSS cash account to the normal cash account of the Government. With the unwinding of MSS bills/bonds, the government will be able to use the money for its expenditure.

Interest due on MSS securities will be paid by the Central Government--to this extent MSS will impact the fiscal deficit of the government.

5. What type of instruments are issued under MSS?

Under the MSS, RBI issues dated securities and Treasury bills by way of auctions--either multiple price auction or uniform price auction up to a limit mutually agreed upon between the Government and RBI. They are marketable government securities eligible for statutory liquidity ratio (SLR), repo and LAF.

Today, the RBI issued 28-day cash management bills (CMBs) worth Rs 20,000 crore under the MSS, after raising the MSS ceiling for FY 2016-17 to Rs 600,000 crore.

6. What is the difference between LAF and MSS?

The Liquidity Adjustment Facility (LAF) is basically used for day-to-day liquidity management, while the MSS is used for semi-durable and durable mismatches.

The LAF is used for short-term liquidity purposes, whereas the MSS is used for funds of medium or long term nature. For greater transparency and stability in the financial markets, the RBI releases an indicative quarterly schedule for issuance of Treasury bills and dated securities.

7. Who will invest in MSS bills/bonds?

The participants in the auction of MSS bills/bonds are commercial banks, cooperative banks, financial institutions such as insurance companies, primary dealers, etc.

8. What other types of policy tools are used by RBI in its liquidity management?

LAF: The Liquidity Adjustment Facility (LAF) introduced in June 2000 is the primary tool used by the RBI for liquidity absorption (reverse repo) and injection (repo) for day-to-day purposes. It is generally used for temporary purposes, not for liquidity of enduring nature. The LAF enables the RBI to modulate short-term liquidity ensuring overnight call money rates move in the LAF corridor (between repo and reverse repo rates). The LAF repo rate has emerged as the policy signalling rate.

OMO: With open market operations, RBI purchases and sells government securities. It is the main instrument of sterilisation used by the RBI. OMO sales entail the permanent absorption of the liquidity.

Centre's surplus balance with RBI: The Central Government's surplus balance kept with the RBI also work as an instrument of sterilisation. As the RBI Act does not permit RBI to pay interest on such balances, these balances are invested in government securities held with the RBI. 

CRR: Cash reserve ratio (CRR) is considered a blunt instrument for impounding liquidity of the banking system. Currently, CRR is kept at 4%. On 26 November 2016, RBI imposed an incremental CRR of 100% on increase in bank balances between 16 September 2016 and 11 November 2016. This additional CRR is a temporary step to manage excess liquidity arising from currency ban.

MSF: Marginal standing facility was introduced by the RBI in 2011. The MSF is an additional window provided by RBI to banks, so that the latter can borrow overnight funds from the RBI against their excess SLR (statutory liquidity ratio) holdings. MSF scheme is similar to the LAF-Repo scheme. The difference between MSF and LAF-Repo is that under MSF, banks will have to pay higher rate of interest to RBI for their borrowings as compared to LAF-Repo.

In addition to the above (MSS, LAF, OMO, Centre's surplus balance, CRR and MSF), RBI also uses SLR and bank rate as monetary policy tools.

Earlier, RBI used policy tools such as, prescribing deposit and lending rates of commercial banks, selective credit control (SCC) over sensitive commodities and sector-specific standing facilities. But over the years, it had stopped using them.

9. Who will bear these costs of sterilisation?

a) In case of cash reserve ratio (CRR) and incremental CRR, banks bear the costs as RBI doesn't pay any interest on such CRR balances.

b) Government of India bears the cost of interest in the case of MSS.

c) In case of LAF window, RBI bears the costs.

So the costs are shared among all the three players. Of course, the costs borne by RBI will reflect in its balance sheet by way of lower transfer of surplus to the government.


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Additional Information:

What are the indicators of liquidity in the Indian financial system?

a) Outstanding balances under LAF (repo and reverse repo) on a specific date
b) Outstanding balances under MSS on a specific date
c) Central government's surplus with the RBI on a specific date

Related articles:

Disclosure:  The author has a vested interest in the financial markets.

Disclaimer: The author is a CFA Charterholder (USA) and an investment professional. The views are personal. His views should not be construed as investment advice. Before making any investments, you are advised to consult your registered financial advisor. The author will in no way responsible for the decisions taken by readers.

Wednesday, 6 January 2016

Understanding Real Effective Exchange Rate-VRK100-06Jan2016

Understanding Real Effective Exchange Rate

A nominal effective exchange rate (NEER) is calculated as a geometric weighted averages of exchange rates of domestic currency in terms of a foreign currency.  

The real effective exchange rate (REER) can be defined as the weighted average of nominal effective exchange rates (NEER) that have been adjusted for relative price levels or interest rate differentials.  

Traditionally, India’s central bank Reserve Bank of India (RBI) was using REER for managing rupee exchange rate. That was till 1997. But since 1997, RBI changed its stance as REER takes care of only merchandise trade and does not consider services. And from 1997, RBI had shifted its exchange rate policy to ‘control of excess volatility,’ as stated officially time and again.

The official policy stance of RBI for long has been ‘containing exchange rate volatility.’ RBI also wants Indian exchange rate to be competitive for India’s trade against other countries. Some argue rupee’s exchange rate should have been 71-72 versus USD, as against the actual 66.83 as on today, that is, 06Jan2016—based on USD-INR interest rate differentials.

However, the exchange rate of the rupee is by and large market-determined, subject to RBI’s market intervention through sale and purchase of US dollars in foreign exchange market.

A country’s exchange rate depends on a number of factors like elasticity of exports and imports, import intensity of exports, relative prices of domestic and global products, and others. In terms of REER, there has been a rupee appreciation of 3.7% in 2015-16 (April-October) compared to 2014-15 (April-October).

Increase in indices (NEER and REER) indicates appreciation of rupee and vice versa. REER figures are based on Consumer Price Index - CPI (combined).

If the REER is more than 100, then the rupee is “overvalued” and is expected to depreciate. If REER is less than 100, the rupee is “undervalued” and is expected to appreciate in future. But in a practical sense, nobody in foreign exchange markets takes REER very seriously, as fundamentals could take a very long time to adjust in financial markets. RBI too follows a variety of metrics (most of them are not known to the public) to control what it calls ‘excess exchange rate volatility.’

Countries with highest trade weights in RBI’s 36-country REER index (2013-14) are Euro area (highest at 12.69%), UAE, China, USA, Saudi Arabia, Switzerland, Hong Kong, Singapore and Indonesia.

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Saturday, 24 October 2015

Seven Reasons why Gold Monetization Scheme will be a Spectacular Failure-VRK100-24Oct2015

Why Gold Monetisation Scheme 2015 will be a spectacular failure

Indians simply love gold--there is no rationale or logic--the buying decision is more of a psychological or emotional one. The same is true across the globe except in the US or a few other nations.

We love something tangible such as gold--we can feel it, touch it, kiss it, display it or wear it. You can also lend it or borrow money against gold ornaments. Gold as a financial asset is not very successful in India.

Government and regulatory authorities say gold is an unproductive asset. But most of the Indian public doesn’t buy this argument. Their lust for gold is enormous; nobody can change the views of the people.

Government’s sermons on discouraging Indians to buy physical gold won’t work. Indians see it as a highly liquid asset—though they get shortchanged routinely by gold merchants and jewelers in the form of less weight, higher rates, making charges and others.

Governments have no business to tell people what they want to buy or consume. They can’t say gold is undesirable for you. People are intelligent enough to make their own choices.

Many believe gold is a safe instrument in times of crises, war or other disasters. There is no point in fighting such views. Humans love for gold will continue forever—its demand may wane or rise depending on factors such as central bank policies, government fiscal policies, interest rates or financial crises.

Many Indians are wary of governments or their schemes. Because such schemes involve a lot of paper work and/or seen as a waste of time. Physical gold works as an insurance against the failure of governments in protecting people’s interests.

Gold may not have any intrinsic value, but as an insurance against the ineffective monetary policies of global central banks, physical gold acts as a perfect hedge in one’s portfolio as part of asset allocation.

P.Chidambaram, when he was finance minister, officially imposed several curbs on gold imports. As per official numbers, gold imports declined for some time. But gold smuggling has gone up. Net-net, the impact of gold curbs on India’s current account deficit is only minimal. The gold smuggled will reflect elsewhere in India’s imports.

Once the government loosens its curbs, Indians will buy more gold in a resurgent way. The suppressed demand for gold may rear its head in future.

Gold Monetisation Scheme 2015:

With a view to mobilizing physical gold from Indians, the Government of India last month launched a scheme named Gold Monetisation Scheme 2015, to be implemented by scheduled commercial banks across India.

In the words of the government, the objective of the scheme is “mobilizing the gold held by households and institutions in the country and to putting this gold into productive use.

India’s central bank Reserve Bank of India, a few days back, issued directions to banks on the implementation of the scheme.

Seven reasons why Gold Monetisation Scheme 2015 will be a spectacular failure:

1) Any government scheme comes with a lot of stupid and bureaucratic rules. Though GMS 2015 is a slight improvement over the old gold deposit scheme, the new scheme has its own share of complexity. If anything can’t be explained in one minute to a user, the product is bound to fail.

2) As the RBI circular on GMS shows, the product involves a lot of costs for banks. These high costs will deter banks from offering this product with a lot of enthusiasm—unless the Modi government batters this product on bankers’ heads the way it had successfully done with the Jan Dhan Yojana. Deposits under the Gold Monetisation Scheme will attract CRR and SLR—the statutory requirements of Reserve Bank of India.

3) Let us come to the user. Gold is the easiest conduit for black money in India. All the government’s evangelistic zeal for GMS 2015 will make users wary of its ultimate intentions. I mean the suspicion is that Modi government will try to target black money holders in the name of GMS. Indians are completely put off by moralizing (from the likes of P. Chidambaram and Arun Jaitley) which describe gold as unproductive. Most Indians including the poor hold gold as it’s highly liquid.

4) Indians have enormous lust for gold and gold ornaments. These gold bugs will not like their gold ornaments being melted into gold bars. This is the most deterrent factor of this product for the end user.

5) Banks may offer only two percent annual interest on this product. As such it’s not worth going for a product that offers very low interest. Under the current market conditions, there are a plenty of products that offer higher interest.

6) There are only 331 Assaying and Hallmarking Centres in India—and most of them are concentrated in South India. This number is too small for the success of this product.

7) Know-your-customer (KYC) rules are applicable for this scheme. When they hear KYC, more than 50% of the public will run away from the product! Without doubt, KYC is the most dreadful word in India right now!

Written with malice and jaundiced eyes against all governments:

Copyright © RamaKrishna Vadlamudi—24 October 2015.

Please read the following links for full details of the scheme:

1) Government of India notification on GMS 2015:

2) RBI circular on GMS 2015:

Disclosure: Gold does not form part of my asset allocation—that is to say I don’t own gold in any form.

Disclaimer: The author is an investment professional. The views are personal. His views should not be construed as investment advice. Before making any investments, you are advised to consult your registered financial advisor. The author will in no way responsible for the decisions taken by readers.

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Thursday, 12 March 2015

Weak Monetary Policy Transmission-VRK100-12Mar2015

Why is monetary policy transmission (MPT) slow in India?

(Please see comments below)

Downward stickiness of lending rates: Whenever Reserve Bank of India (RBI) decreases policy rates, banks do not pass on the benefit of lower interest rates to borrowers immediately. The pass-through of policy rates to lending rates is rather slow. Why?

Bank deposit rates are fixed, not floating. When interest rates decline, deposits contracted at higher rates in the past continue to enjoy those rates till maturity. So, banks' cost of funds will not come down immediately.

In contrast, when banks cut lending rates, they have to cut rates on all loans with immediate effect. Most of the bank loan rates are floating. In addition, Indian banks are suffering from a high share of bad loans.

Interest rates are set by the government on small savings, which restrict the reduction in bank deposit rates.

Persistence of large market borrowing programme of the governments hardens interest rate expectations and complicates the transmission. 

When RBI decreases policy interest rates, the banks are slow to decrease lending rates. But when RBI raises policy rates, they are quick to increase lending rates. This divergent response of banks to RBI policy rate changes decreases the effectiveness of RBI’s monetary policy transmission.

The introduction base rate system of loan pricing in banks in July 2010 has not helped matters much. 

Many experts are of the view that banks are protecting their margins by not passing on the benefits of lower interest costs, immediately, to borrowers.

What India needs right now to make the monetary policy transmission more effective is more competition in the banking system. But the RBI and the Indian government are very reluctant to issue new bank licenses.

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Friday, 29 August 2014

India's First Quarter GDP Surges-VRK100-29Aug2014

India’s real gross domestic product (GDP) in April-June (first quarter of 2014-15) surged by 5.7 percent over the first quarter GDP of 2013-14. This is quite positive for the economy and a great relief for the Central Government. The GDP measures a country’s national income and is the total value of all goods produced and services provided within a country. After clocking sub-5 percent growth rates for almost all quarters in the last two years, the GDP growth crossed 5 percent in the latest quarter.

The GDP at factor cost is Rs 14.38 lakh crore in the first quarter of 2014-15. And the GDP at current market prices is Rs 28.43 lakh crore. The surge in the first quarter GDP is led by finance, insurance, real estate and business services (10.4% growth over first quarter of 2013-14); electricity, gas and water supply (10.2% growth); community, social and personal services (9.1% growth); and construction (4.8% growth).

A substantial part of the increase in GDP growth can be attributed to the previous UPA government. The former finance minister P Chidambaram took several steps to revive the economy, though his methods are questionable. The current account deficit was brought under control through some blunt measures, such as, curbing gold imports and raising interest rates. The UPA government controlled the fiscal deficit also, though with the help of some creative accounting, extracting special dividends from cash-rich public sector enterprises and postponing expenditures to the next year.

The surge in GDP growth is a positive for Indian stocks. Global stocks too have been on the upswing for several years though the outlook for the economies of the US, eurozone and China is not very rosy. Prices of crude oil and some other commodities are in decline in recent months—a positive for India.

On expectations of higher growth from the new government, foreign investors have invested heavily in Indian stock and government bond markets this year.

Now the speculation will shift to a possible upgrade in India’s sovereign rating. There have been some rumours that the rating agencies, such as, Standard and Poor’s and Moody’s may consider raising India’s rating. If it happens it will be a boost not only for India’s economy but also for Indian stocks.

However, rainfall from India’s South-West monsoon is deficient in several parts of the country, which may negatively impact agricultural production and livelihoods of millions. The Reserve Bank of India is still battling with inflationary pressures, especially, food inflation.

We also need to watch how the new NDA government led by prime minister Narendra Modi will revive the moribund manufacturing sector and create millions of jobs for India’s restless youth. As far as infrastructure sector is concerned, several measures have been taken in the past three months to revive road and other projects. Indians are hoping for a better future.

Related Articles:

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Abbreviations: NDA – National Democratic Alliance, UPA – United Progress Alliance
Data source: Central Statistics Office, GoI.

Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

Connect with him on twitter @vrk100

Monday, 11 August 2014

What is Liquidity Coverage Ratio?-VRK100-11Aug2014


Banks, across the globe, have to maintain liquidity coverage ratio (LCR) as part of the Basel III norms. These norms are prescribed by the Bank for International Settlements. BIS a global body that acts as a bank for central banks.

Liquidity coverage ratio is the proportion of highly liquid assets that a bank should maintain to meet its liquidity needs in a 30-calendar day period. The LCR is calculated as a ratio of high-quality liquid assets to the total net cash outflows over the next 30 calendar days.

The LCR enables a bank to withstand any financial shocks, such as a run on its deposits, a credit rating downgrade or derivative-linked shocks. These global norms are being introduced effective 1st of January, 2015 (see table above).

The 2007/2008 global financial crisis forced central banks to adopt more stringent liquidity requirements—in the form of the liquidity coverage ratio and net stable funding ratio—to manage liquidity risk in a better manner.

Let us discuss the background and more details of this liquidity coverage ratio.


During the 2007/2008 global financial crisis, banks and other financial institutions mismanaged their liquidity requirements. The collapse of Lehman Brothers drove home the importance of liquidity in the banking system. Banks could not liquidate their assets, leading to severe stress in the money markets.

Liquidity risk arises when securities cannot be purchased or sold without a significant loss in value. This risk is most acute in periods of unusually high market stress as happened during the global financial crisis.

With a view to managing such liquidity risks, the Basel Committee on Banking Supervision (BCBS) has introduced new measures, including the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The NSFR requires banks to fund their assets with more stable sources of funding—providing sustainable maturity structure of assets and liabilities over long term.

What is the need for an LCR?

Once LCR is implemented, banks will be in a better position to meet short-term emergency liquidity (cash) needs. The LCR bolsters a bank’s ability to withstand any financial and/or economic shocks in the short term. It will also reduce the risk of spillover from the financial sector to the real economy.

The Liquidity Coverage Ratio is a key component of the Basel III framework. Basel III norms are global regulatory standards on bank capital adequacy and liquidity endorsed by the G20 Leaders.

The LCR enhances the short-term resilience of banks to potential liquidity disruptions by ensuring that they have sufficient high-quality liquid assets to survive an acute stress scenario lasting for 30 days.

The stress scenarios may include: a run on the bank deposits; a bank losing its ability to raise unsecured funds; a credit rating downgrade; market-related stress and derivative-linked shocks.

How to Calculate the LCR?

As mentioned above, the liquidity coverage ratio is the proportion of highly liquid assets that a bank should maintain to meet its liquidity needs in a 30-calendar day period. The LCR is calculated as a ratio of high-quality liquid assets to the total net cash outflows over the next 30 calendar days.

The LCR has two components: the value of the stock of high-quality liquid assets (HQLAs) and total net cash outflows.

LCR = Stock of HQLA / Total net cash outflows over the next 30 calendar days

The LCR should be equal to or greater than 100 percent.

Banks, across the globe, have to maintain this LCR from 1 January 2015. With effect from 1 January 2015, the LCR will be 60% and rising in equal steps of 10% every year to reach the minimum of 100% LCR on 1 January 2019 as given below:


Minimum LCR

Effective 1 January 1, 2019, the LCR should be minimum 100% (that is, the stock of HQLA should at least equal total net cash outflows) on an ongoing basis. However, during periods of financial stress, banks may use their high-quality liquid assets to tackle liquidity issues and thereby falling below 100 percent.

High-Quality Liquid Assets (HQLA):

Liquidity of an asset indicates the ability and ease with which it can be converted to cash. Liquid assets are those that can be converted to cash quickly in order to meet financial obligations. Liquid assets include cash, reserves kept with central bank and sovereign debt.

To remain viable, banks must have enough liquid assets to meet its near-term obligations, such as withdrawals by depositors.

Banks must hold a stock of HQLA to cover the total net cash outflows over a 30-day period under the prescribed stress scenario. These HQLAs must be unencumbered—that is free of any legal, regulatory or contractual restrictions.

The HQLA should have the fundamental characteristics of low risk; ease and certainty of valuation; low correlation with risky assets; and listed on a developed and a recognized exchange. And their market-related characteristics should be:  active and sizeable market; low volatility; and flight to quality.

Level 1 and Level 2 Assets:

HQLA consist of Level 1 and Level 2 assets. Level 1 assets generally include cash, reserves kept with central bank, and certain marketable securities backed by sovereigns and central banks, among others. These assets are typically of the highest quality and the most liquid, and there is no limit on the extent to which a bank can hold these assets to meet the LCR.

Level 2 assets are comprised of Level 2A and Level 2B assets. Level 2A assets include, for example, certain government securities, corporate debt securities (including commercial paper) and covered bonds.

Level 2B assets include lower rated corporate bonds, residential mortgage backed securities (RMBS) and equities that meet certain conditions. Level 2 assets may not in aggregate account for more than 40% of a bank’s stock of HQLA. Level 2B assets may not account for more than 15% of a bank’s total stock of HQLA.

Level 2A and Level 2B assets are subject to haircuts ranging from 15% to 50%.

Total net cash outflows:

The term total net cash outflows  is defined as the total expected cash outflows minus total expected cash inflows in the specified stress scenario for the subsequent 30 calendar days. Total expected cash outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down.

Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables by the rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of total expected cash outflows.

Total net cash outflows over the next 30 calendar days =

 Total expected cash outflows – Min {total expected cash inflows; 75% of total expected cash outflows}

Frequency of calculation and reporting:

The LCR should be used on an ongoing basis to help monitor and control liquidity risk. The LCR should be reported to central banks at least monthly. However, central banks may increase the frequency to weekly or even daily at their discretion. The time lag in reporting should be as short as feasible and ideally should not surpass two weeks.

The LCR versus the SLR in the Indian context:

The Reserve Bank of India (RBI) issued the liquidity coverage ratio guidelines for Indian banks on 9 June 2014. These are more or less in line the norms prescribed by the Basel Committee on Banking Supervision.

Indian banks will have to maintain this LCR over and above the statutory liquidity ratio (SLR) prescribed by RBI. As the assets kept for LCR purpose are unencumbered, those assets will be outside of the SLR obligation.

While the purpose of LCR is to meet the short-term liquidity requirements, the purpose of SLR is long-term in nature. The SLR mainly serves three purposes in India:

o  It serves as a solvency cushion for banks (ultimately, bank depositors) against any emergencies –like liquidity crisis, bank failures, etc
o  It is used by the Central Government to raise money (government borrowings) cheaply from banks
o  RBI uses it as a monetary policy tool to infuse (absorb) liquidity into (from) the banking system

With effect from 9 August 2014, the RBI cut the SLR for Indian banks by 50 basis points to 22 percent of net demand and time liabilities (NDTL). The latest SLR cut is expected to help Indian banks in meeting the new LCR norms.

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Disclaimer: The author is an investment analyst with a vested interest in the Indian stock markets. This is for information purposes only. This should not be construed as investment advice. Investors should consult their own financial advisers before taking any investment decisions. The author blogs at:

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