Mumbai: The Reserve Bank of India (RBI) may allow commercial banks to borrow money from its daily lending window by pledging top-rated corporate bonds as collateral, in addition to government securities, according to three bankers aware of the development.
If approved, the move will improve liquidity in corporate bonds and also assist in liquidity management. It would expand the universe of eligible securities which could serve as collateral for borrowing from RBI’s liquidity adjustment facility (LAF).
This expansion would help banks that do not hold government securities over and above the mandated 21.25% of deposits as they could use their corporate bond holdings to borrow cheaply from the LAF to meet liquidity mismatches.
“This was one of the suggestions made by market participants to RBI at various fora in the context of improving liquidity and developing the corporate bond market,” said one of the three bankers cited above.
All three spoke on condition of anonymity.
“It was also suggested in the light of liquidity shortage that the banking system will face during the FCNR redemptions period,” the first banker added.
FCNR, short for Foreign Currency Non Resident, is an account that can be maintained by non-resident Indians in foreign currency.
Around $25 billion of three-year FCNR deposits raised by banks in 2013, at a time of immense pressure on the rupee that fell to a record low in August that year, are due to mature in September-November 2016.
The redemption of the FCNR deposits could lead to outflows to the tune of about $20 billion as most deposits will not be rolled over, RBI governor Raghuram Rajan had said earlier this month.
To be sure, it’s not clear if and when RBI would allow borrowing against corporate bonds.
An e-mail sent on Thursday to the RBI’s spokesperson seeking comment remained unanswered.
“This is going to be an incentive for people to buy corporate bonds and use (them) to borrow from LAF. We will have to see in what manner and form they (RBI) shape this. But we could see some increase in trading volume of corporate bonds. Sentimentally, it will improve the yields,” said Ajay Manglunia, executive vice-president and head (fixed income markets) at Edelweiss Securities.
RBI, at present, accepts only government securities and state development loans as collateral under LAF. The central bank conducts daily repo and reverse repo auctions through which it infuses and drains liquidity at a fixed rate.
RBI also conducts a variable repo auction through which it infuses liquidity at a cut-off rate arrived from the bids it receives at different rates. However, the cost of borrowing from RBI is largely around the repo rate of 6.50% for banks and is the cheapest source.
Bilateral repos between market participants using corporate bonds was allowed by RBI in 2011. But transactions have been scarce and sporadic. Corporate bond repos were allowed to facilitate greater transparency in the pricing of bonds in the absence of a vibrant secondary market for corporate securities.
With the central bank stepping in to do repos with banks, it would encourage market participants to enter into bilateral trades as well.
In entering into a repurchase agreement, the lender applies a “haircut”, which is the difference between the market value of the collateral and the loan amount, to cover the risk involved in the collateral. Bankers said that in the absence of a standardized formula or a precedent, calculating a haircut for corporate bonds is difficult. This has been the main reason for the tepid response to bilateral repos.
Once RBI enters as a counter-party, bankers believe that the risk perception associated with a corporate paper will be more clear.
“Unlike in advanced economies that have a deep corporate bond market, in India, there is no standardized process to arrive at haircuts while doing repos. Perhaps with the central bank stepping in, there could be some indication of pricing, haircuts and how to perceive risk in repo transactions,” said the second banker.
Given that the underlying corporate bond has an inherent credit risk attached to it, the RBI may have to price it differently compared with its current variable repo as haircuts will have to be applied.
Another way through which the RBI can conduct a corporate bond repo is to allot only a certain percentage of the total demand that the bank makes in order to cover for the risk of the collateral.
“The pricing has to be different as the nature of the collateral is different. Also the repo window should be separate from the current LAF that they have as it is not prudent to merge an SLR (statutory liquidity ratio) and non-SLR collateral within a single window,” said the banker.
SLR is the portion of deposits that banks require to invest in government bonds. At present, SLR is 21.25%.
As of 31 March, outstanding corporate bonds stood at Rs.20.19 trillion, according to data from capital markets regulator Securities and Exchange Board of India (Sebi). Of the total issuance of corporate bonds in fiscal 2016, more than 60% were AAA-rated, estimates primary market tracker Prime Database.
Within the AAA-rated population, the largest issuers of bonds are public sector units such as Power Finance Corp., Rural Electrification Corp. and non-banking finance companies such as HDFC and LIC Housing Finance.
“This is going to be an incentive for people to buy corporate bonds and use to borrow from LAF,” said Ajay Manglunia, executive vice president and head of fixed income markets at Edelweiss Securities. “We will have to see in what manner and form they (RBI) shape this. But we could see some increase in trading volume of corporate bonds. Sentimentally it will improve the yields.”
Although top-rated corporate bonds are widely held among many investors, the proportion held by banks would not be sizeable, said bankers.
“While definitely this is a start, AAA-rated corporate bonds do not suffer from liquidity issues as much as lower rated papers do. So the RBI stepping in to do repos in top-rated bonds will not have a big impact,” said the third banker.
The corporate bond market is largely illiquid as the secondary market turnover is fragmented and thin. Although corporate bond issuances have surged over the last five years, the daily average volume of secondary trades hasn’t increased.
For instance, corporate entities borrowed Rs4.58 trillion through bond sales in fiscal 2016, according to data from Sebi. However, the daily average secondary market volume hasn’t exceeded Rs.5,000 crore.
Many factors contribute to the thin trading. Large investors in corporate bonds such as insurance companies, pension funds and even banks typically buy them to hold for maturity. Corporate bonds with ratings below AAA are rarely traded, bankers said.