The RBI’s 2025, is a calculated step to rein in surplus liquidity sloshing around in the banking system.
With liquidity at Rs 2.44 lakh crore and banks parking Rs 2.52 lakh crore in the RBI’s standing deposit facility (SDF) as of June 23, the central bank is clearly signaling its intent to keep a lid on excess funds that could stoke inflationary pressures or distort market dynamics.
But this move, while prudent from a monetary policy standpoint, has ripple effects that could squeeze bank margins, nudge fixed deposit (FD) rates, and reshape the cost of funds for lenders already grappling with a slowing credit cycle.
Let’s unpack the context first. The RBI’s VRRR auctions are a tool to absorb excess liquidity when banks have more cash than they can productively deploy.
Unlike the passive SDF, where banks park funds at a fixed 6.25% (50 basis points below the repo rate of 6.75%), VRRR auctions allow the RBI to drain liquidity at market-determined rates, often higher than the SDF rate.
The June 27 auction, with funds reversing on July 4, comes at a time when surplus liquidity has crossed the RBI’s comfort threshold of Rs 2 lakh crore. The central bank’s decision to skip the 14-day main operation further underscores its focus on short-term liquidity management, avoiding any long-term commitment that could lock up funds unnecessarily.
For banks, this move is a double-edged sword. On one hand, the VRRR offers a better return than the SDF, potentially in the range of 6.5% or higher, depending on bidding dynamics. This is a small relief for lenders sitting on idle cash. But the broader implication is less rosy.
Surplus liquidity has kept short-term money market rates, like those for treasury bills and commercial paper, soft. Banks have enjoyed relatively low funding costs as a result, even as deposit growth lags credit growth. The RBI’s liquidity tightening, however, could push these rates up, forcing banks to compete harder for funds. This is where the pressure on FD rates kicks in.
Fixed deposit rates have already been inching up over the past year as banks scramble to attract retail deposits to fund loan growth. With credit growth at around 12% and deposit growth trailing at 10%, lenders have had to sweeten FD offerings, especially for tenures of 1-3 years, where rates for top banks now hover between 6.5% and 7.5%.
If the RBI’s VRRR auctions become a regular feature—a likely scenario if liquidity remains elevated—banks may need to raise FD rates further to lock in stable funds. This is particularly true for smaller private banks and non-banking financial companies (NBFCs), which rely heavily on retail deposits and face stiffer competition from government small-savings schemes offering rates as high as 8.2% for certain tenures.
Rising FD rates, while good for savers, will erode banks’ net interest margins (NIMs). Most banks are already operating with NIMs in the 2.8-3.5% range, and every 25-50 basis-point increase in deposit costs can shave 5-10 basis points off these margins.
Public sector banks, with their larger CASA (current and savings account) ratios of 35-40%, are somewhat cushioned, but private banks, where CASA ratios are closer to 25-30%, are more exposed. The cost of funds, which includes not just deposits but also borrowings and capital market instruments, will also rise as liquidity tightens.
For instance, if money market rates climb by 6.75% or beyond, banks may lean more on costlier sources like certificates of deposit or bulk deposits, further straining their profitability.
There’s another angle to this. The RBI’s liquidity management isn’t just about inflation control; it’s also about nudging banks to deploy funds more efficiently. With surplus liquidity, some lenders have been lazy, parking excess cash in low-yielding government securities or the SDF rather than aggressively lending.
The VRRR, by making idle funds less attractive, could spur banks to lend more, particularly to productive sectors like manufacturing or MSMEs. But this assumes demand for credit picks up, which isn’t a given in an economy where private investment is still lukewarm and global headwinds like slowing exports and geopolitical risks linger.
The RBI’s move also reflects its hawkish tilt. Despite CPI inflation easing to around 5% in recent months, the central bank remains wary of food price volatility and imported inflation from global commodity spikes.
By tightening liquidity, the RBI is preemptively ensuring monetary policy transmission remains effective, ensuring that repo rate signals translate into actual lending rates. But this comes at a cost to banks, which may find their balance sheets stretched as they juggle higher funding costs and tepid loan growth.
In the near term, expect FD rates to edge up, particularly for mid-tenure deposits, as banks respond to tighter liquidity and competitive pressures. Margins will take a hit, especially for banks with weaker deposit franchises.
The RBI’s VRRR is a necessary step to keep the system in check, but it’s a reminder that monetary policy is a blunt instrument—one that stabilizes the economy but leaves banks walking a tightrope. For savers, it’s a silver lining; for bank shareholders, it’s a reason to keep a close eye on those NIMs.