Central bank liquidity and its impact on banks and global economies

Through Abhik Agrawal, Senior Senior Product Manager, Oracle Financial Services

The Covid-19 pandemic has affected all economies, large and small, across the world. Central banks everywhere have handled the situation proactively and have succeeded in injecting a large amount of liquidity into the banks through various means. However, due to the widespread uncertainty caused by the pandemic, banks are reluctant to lend and consumers are reluctant to resort to credit. This article highlights the negative impact that excess liquidity can have on banks and economies if adequate demand is not created.

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WAs the entire world grappled with the pandemic, central banks around the world were better prepared to tackle the economic impact it caused. The experience and lessons learned from previous crises have served to inform central banks’ response to the pandemic. They pushed out a huge amount of liquidity to keep the banks afloat and help the economy as a whole during this time of magnanimous stress.

Here are some common actions central banks take to inject liquidity into banking institutions:

  • Rate cut: Several rounds of rate cuts have been applied by central banks around the world for short-term loans to banking institutions, resulting in excess liquidity between banks. A few central banks even cut rates to zero and below zero levels. The US Federal Reserve cut its key rates for short-term loans from 1% and 1.25% to 0% and 0.25%. Some European banks lowered the rate to negative.
  • Quantitative Easing (QE): Quantitative Easing, a brainchild of the Bank of Japan, is a way of injecting liquidity into the markets through banks. It is now widely used by central banks around the world. QE is part of monetary policy and is effective when short-term rates are close to zero. As part of quantitative easing programs, central banks buy long-term government bonds and other securities and increase the money supply. For example, in response to COVID-19, the U.S. Federal Reserve announced a more than $ 700 billion quantitative easing plan and then bolstered it with a commitment to buy at least $ 80 billion and $ 40 billion. dollars per month in government securities and mortgages respectively. securities.
  • Relaxation of regulatory requirements: In view of the crisis, central banks have relaxed some regulatory requirements in terms of capital and liquidity. The Reserve Bank of India has postponed the NSFR’s continuation directive for six months, from April 1, 2020 to October 1, 2020. The liquidity coverage maintenance ratio has also been reduced from 100% to 80% for a few months.
  • Discount window: A discount window is used by central banks for short-term loans, mainly overnight. Banks have reduced the rate on loans through the discount window and have also increased the term of loans to ensure adequate liquidity with banking institutions. For example, the US Federal Reserve lowered the rate it charges banks for loans at its discount window by 2 percentage points, from 2.25% to 0.25%.
  • International exchange line: The US Fed opened international swap lines, which are essentially an emergency money pipeline, to many central banks, which needed US dollars, and it also cut the rate on existing lines.

There are many other measures taken by central banks targeting direct lending to consumer or securities markets, such as increasing the three-month moratorium period, direct lending to businesses, such as the Consumer Credit Facility, primary market companies of the US Fed, the Money Market Mutual Fund. Ease (MMMFF), etc. (But for this article, I’ll focus on the measures that resulted in direct central bank lending to other banks.)

Actions by central banks to keep banks sufficiently liquidated through the stimulus packages were well on time and much needed, but the surge in liquidity alone is not enough to cope with the situation. It is important that the excess funds with the banks pass into the hands of creditworthy borrowers and that economic activities gradually recover until the pre-pandemic era.

But for several reasons, the liquidity that was pumped into the banking system did not result in proportionate lending:

  • Refusal of banks to lend: Due to the potential negative impact of the pandemic on jobs and businesses, the credit rating of borrowers and the value of collateral against which the bank lends may decline. This makes banks skeptical about lending.
  • Provision for potential losses: Banks set aside more funds for potential losses on existing loans due to the possibility that borrowers’ credit quality will decline due to lower economic activities. A study published in the March 2021 BRI quarterly review shows that the provision for the first half of 2020 was three times compared to the second half of 2019.
  • Less credit request: Many businesses, especially small businesses, have suffered greatly from foreclosure restrictions. The unemployment rate has also increased. This has resulted in uncertain income streams for individuals and businesses, resulting in lower 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 for fear of the pandemic. For many banks, the focus is on ensuring the safety of their staff and carrying out the most essential tasks rather than growing the business.

Banks are sitting on a lot of cash. Although this current level will not be maintained for long, the banks will soon start pumping this money into the economy. However, if this happens without creating adequate demand, it can prove counterproductive for banking institutions and economies in the following ways:

  • Inflation: The push of money supply to banks and the economy in general is likely to increase inflation. If this is not followed by an increase in the growth of supply and demand for credit, the situation may worsen and the economy may sink into stagflation. Stagflation is a condition where inflation rises, but economic growth stagnates.
  • High risk loans: With the accumulation of liquidity and low interest rates, banks may be drawn into high risk loans. This can result in overfunding for existing customers or funding for new customers with poor credit quality. This will have a long-term impact on the overall credit quality of the bank.
  • Postcode battery: In addition to new loans, existing accounts can also switch to non-performing assets (NPA) due to high unemployment rates and losses suffered by businesses due to low economic activity.
  • Currency devaluation: Measures such as quantitative easing to boost liquidity can lead to currency devaluation. As bond yields decline due to quantitative easing, a devaluation of the currency occurs. It may help the country’s exporters as their products would be cheaper in the world market, but it will make the import products more expensive. This happened during the global financial crisis of 2007-2008 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 interest rates are very low but the consumer continues to accumulate money in savings and other accounts and does not wish to invest in any other instrument. This happens when the client anticipates a negative event in the economy and does not want to invest in low yielding bonds, which will result in a loss for him when interest rates in the market rise. A similar situation applies when banks prefer to hold cash rather than lend to customers, as keeping reserves with the central bank gives a higher return.
  • Overheating stock markets: During the pandemic, markets around the world collapsed for the first few weeks, but then hit an all-time high in 4 to 6 months since the start of the pandemic. Many experts claim that this unprecedented run in the stock markets is due to the huge liquidity stimulus injected by central banks around the world. Several experts also cite this as the main reason for the race north of the security markets.
  • Lower net interest margins: The excess liquidity of many banks is placed in low yield accounts. This will have an impact on the banks’ net interest margin (NIM).

There is no doubt that central banks around the world have learned from past crises and provided enough stimulus this time around to keep bank liquidity in a healthy position. However, they should be aware that excess liquidity can cause damage to the overall economy. They must either start absorbing liquidity through tactics such as rate hikes or open market operations at an appropriate time, or continue to push banks to lend using their inflated coffers.

Recently, the situation in a few countries like the United States and the United Kingdom has improved and economic activities are returning to normal. This could indicate that the central banks of some countries will take the necessary steps to suck liquidity from the markets. However, this is unlikely to happen before the first quarter of 2022. Nonetheless, the battle could be longer as financial uncertainty continues to be a major factor in many countries.

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