Banks Ride Rate Arbitrage

Banks borrow At 6.5% from RBI and lend in call money market where rates are 6.75-6.85%

Banks are borrowing from RBI to lend in the money market, taking advantage of a rate arbitrage opportunity. Funds are available at 6.5% from the central bank under its liquidity adjustment facility (LAF) while rates in the call money market, where banks borrow from each other, are at 6.75-6.85%.
"Banks with excess government bonds are resorting to arbitrage deals," said a treasury official of the state-owned Corporation Bank. Banks pledge government securities with RBI to raise shortterm money, and are required to hold gilts as part of their statutory liquidity ratio (SLR). The banking system has 4% excess SLR holding.
However, banks are not buying securities to take advantage of the arbitrage. "Investment in government bonds does not look attractive, but short-term rates look good," said a trader.
Banks will fatten their balance sheets to meet their targets by end March and this is pushing up short-term rates. Certificate of deposits of six months have touched 10%, inching closer to 12-month CD yields at 10.10%. The threemonth commercial paper is in double digits at 10.38% while 6-month CPs are being issued to banks at 10.58%, the highest since June 2009. But these rates are lower than the levels touched in the second half of 2008.
Bankers said there was little buying interest among banks at such rates. "Term deposit rates and CD rates are above 10%. At current rates, I don't know how many investors are willing to pick up commercial papers, even the ones with good credit rating. So volumes remain low," said Manish Saraf, treasury head of Dhanlaxmi Bank.
A slow growth in bank deposits has also tightened liquidity. According to the weekly statistical report published by RBI, bank deposits grew at 10.9% in 2010-11 against 12.1% in the previous financial year. According to Mr Saraf, "The slowdown in deposit growth rate could be due to two reasons. Depositors are holding out in the hope that rates will rise further. Banks are not yet going all out in raising high-cost deposits."
Bankers say, the tightness in liquidity has worked well in the favour of RBI in the monetary policy transmission. "It is a matter of higher demand and less supply, which has led to proper transmission of rates. So it is not the change in interest rates that has affected the transmission of the policy, but sucking out the liquidity in the system which has led to real transmission of rates," said, Moses Harding, head-global markets, IndusInd bank.
RBI has mentioned in its monetary policy report that liquidity is likely to ease by April first week. Close to . 17,000-crore government bonds will be redeemed next week but liquidity will be under pressure mid-March when banks face an outflow due to advance tax. ruchira.roy@timesgroup.com