Drivers and Determinants of Liquidity across Sectors and Implications 

for Systemic Risk - A Central Bank Perspective

1. Liquidity is a key focus of international policy debates as liquidity and its drivers are 

of major importance for financial stability. Throughout the global financial crisis 

which began in mid-2007, many banks struggled to maintain adequate liquidity. The 

crisis illustrated how quickly and severely liquidity risks can crystallize and certain 

sources of funding can evaporate, compounding concerns related to the valuation of 

assets and capital adequacy. Essentially, financial crisis highlighted the lack of sound 

liquidity risk management at financial institutions. 

2. We all agree that the complex nature of interrelationships among different markets 

and the uncertainty in the behavior of markets render the task of identifying the 

drivers and therefore the management of liquidity difficult. In the wake of 

accentuated integration, liquidity conditions in one financial market get

transgressed to another financial market, create systemic liquidity stress and 

eventually affect the macroeconomic stability. 

3. There are deep interdependencies between solvency and liquidity. However, it is 

liquidity risk which arises without warning and can be stressful. This is where the 

basic principles of liquidity management are expected to be active and effective. 

However, liquidity risk emanating from any sector, be it from a large corporate or 

arising in equity, G-Sec, money, commodity or forex market, it almost invariably 

culminates in banking sector affecting the macroeconomic liquidity. The enduring 

stress may lead to the loss of confidence and choke inter-bank lending due to risk 

aversion. The adverse impact on monetary conditions drives up stress further with 

systemic implications.

4. Banks are special in the financial system given their ability for multiple credit 

creation. They essentially drive the liquidity in real and financial markets and can 

impact the monetary conditions simultaneously in various sectors. Keeping this in 

view, I would restrict my discussion on drivers of banking liquidity from the 

perspective of a central banker. 

5. We all are aware that liquidity problems in some banks can create stress in the 

funding liquidity in the financial markets. To safeguard from such eventualities, 

BCBS strengthened its liquidity framework by developing two minimum standards 

for funding liquidity: (i) the Liquidity Coverage Ratio (LCR) to ensure that FI has 

sufficient high-quality liquid assets to survive a significant stress scenario lasting for 

one month; and (ii) the Net Stable Funding Ratio (NSFR) with the time horizon of 

one year to provide a sustainable maturity structure of assets and liabilities. 

6. In India interestingly, we have a somewhat unique instrument of Statuary Liquidity 

Reserve (SLR) which requires Banks to hold 23% of the net demand and time 
liabilities (NDTL) in risk free sovereign bonds or in low risk State government 

bonds, it serves the role of a liquidity ratio. Consequently, banks in India seldom face 

liquidity problems. Interestingly, banks are holding almost 30% of their liabilities in 

SLR form as against the mandated 23%. While any excess CRR and SLR gets 

included in LCR, how much of mandatory SLR can be included in LCR is a current 

debate in India. Since SLR is essentially a statutory liquidity reserve, it is justifiable 

to count a large proportion of it towards liquid assets. 

7. This also means that in India, banks and financial institutions (FIs) hold a large part 

of their assets in Government bonds. As a result, liquidity in Government bonds 

markets becomes central from systemic liquidity perspective. Let me elaborate, 

liquidity in Government bonds market is conditioned by host of factors, viz. debt 

management strategy, product design, instrument diversification, market 

microstructure (including trade execution systems, transactions costs) and 

transparency of markets and extending investors’ base. Other drivers that affect 

liquidity are securities that are held to maturity (HTM) by investors, the amounts 

outstanding of benchmark issues, taxes, arrangements for repurchase, clearing and 

settlement practices, as well as development of other allied segments of the market 

such as repo, when issued, short-sale, etc. More importantly, during stressed times, 

the counterparty risks and cash liquidity constraints become important negative 

bearing on trading and liquidity. These are being taken care through CCPs and 

putting in place the appropriate implementation of PFMIs. (Here we may provide 

some data on diversified investor base, instruments etc.)

8. Macroeconomic factors also affect liquidity in Government bonds market, as the size 

of bond market increases with the size of the economy and small size of the market 

limits the range of marketable instruments and their effective tradability. We 

undertake active and passive consolidation of securities to impart liquidity in the 

market. We also have a network of very active primary dealers (PDs) in place which 

impact the liquidity through their market making activities. 

9. Reserve money which includes currency in circulation and reserves, plays a crucial 

role in the determination of liquidity. Currency in circulation that comprises 

currency with the public and cash in hand with banks, is another autonomous driver 

of banking liquidity. While the public’s demand for currency is driven by a number 

of factors such as real income, price level, the opportunity cost of holding currency 

and the availability of alternative instruments of transactions, the demand for 

reserves by banks depends on the requirements for the maintenance of daily CRR 

and to meet payment obligations. 

10. Other autonomous drivers of liquidity include government cash management and 

foreign exchange management. In its role as the banker to the government, the 

Reserve Bank’s cash management operations involve provision of liquidity to tide 

over temporary deficit of the government as also facilitate investment of the 

temporarily surplus cash balances of the government. Big ticket borrowings, bunchy 
redemptions and sudden large changes in government cash flows due to 

quarterly/annual bullet tax receipts/spending can cause sudden changes in liquidity 

conditions. If central bank does not support the smoothening of liquidity, it can 

result in money market tightness. If left unaddressed, it can lead to systemic risk. 

11. Further, in order to prevent the excessive volatility of the exchange rate, the Reserve 

Bank, at times, intervenes in the forex market which has, in the same way,

implications for domestic rupee liquidity. 

12. The stress in liquidity conditions is also reflected in market liquidity indicators like 

bid-ask spread, turnover, impact cost and average number of trades (Table on 

market liquidity indicators may be provided). 

13. In India, the key indicators of macroeconomic liquidity include LAF and monetary 

and credit aggregates. In terms of price, they include policy interest rates and the 

term structure of interest rates. Keeping in view the availability and growth of 

macroeconomic liquidity and its impact on the Reserve Bank’s policy objectives of 

price stability, growth and financial stability, the Reserve Bank tighten or ease the 

price of liquidity under the LAF at which commercial banks can fund their liquidity 

requirements. Macroeconomic liquidity is closely related to balance sheet liquidity 

in India since the Reserve Bank accepts only SLR securities for the purpose of LAF 

repo operations. Market liquidity is also an important consideration in the provision 

of liquidity under LAF as the securities chosen for overnight liquidity management 

need not necessarily be liquid; being eligible for LAF, imparts liquidity to these 

securities. 

14. In a nutshell, the unanticipated liquidity drain from the banking system which could 

have implications for systemic risk arising out of government uneven cashflows/

capital flows/ currency is offset by the provision of central bank liquidity through 

LAF on a day-to-day basis. Over and above, LAF framework is ably supported by 

open market operations, market stabilization schemes, and cash reserve ratio to 

maintain orderly liquidity conditions in the money market in times of significant 

volatility emanating from autonomous flows so as to facilitate effective monetary 

transmission.

15. The period of the onset of the financial crisis in September 2008 presents an 

example from the Indian experience on the interaction between macroeconomic and 

funding liquidity. Initially, the banking sector in India was not affected by the global 

turmoil as it hardly had any direct exposure to the US subprime assets. However, 

with the drying up of the external sources of funding for corporates, mutual funds 

that depended on corporates for bulk funding faced redemption pressures from the 

corporates. This, in turn, translated into funding liquidity problems for NBFCs as 

mutual funds were important source of funds for NBFCs. Thus, the pressure for 

funding liquidity needs of corporates, NBFCs and mutual funds came to rest on the 

banks. To ensure systemic stability and meet credit demand, the Reserve Bank had 
to step in with liquidity augmenting measures such as cuts in CRR, open market 

purchases, unwinding of MSS and increase in refinance facilities. Unlike advanced 

economies such as the US and the UK, that had direct exposure to non-bank market 

participants, the Reserve Bank channelized the central bank money to meet funding 

requirements of non-bank players entirely through the banking system. This helped 

the market participants to meet their liquidity requirements.

16. In conclusion, I must emphasize that liquidity shortages arising in various sectors 

but culminating in banking sector have the potential to lead to failure of institutions. 

Through spill over and contagion effect this could give rise to concerns about 

systemic stability and impinge on the real economy. This necessitates injection of 

central bank liquidity. As I explained, macroeconomic liquidity and funding liquidity 

are closely related through the central bank’s role in the provision of settlement 

balances.

17. High public debt, large sized government borrowing programs and uncertain 

government cash flows exacerbate volatility in liquidity conditions. It becomes 

essential for public policy to ensure that public finances are better managed, sound 

debt management strategies are adopted to avoid liquidity spikes and buffers are 

built by financial institutions to cope with sharp changes in liquidity conditions and 

consequent systemic risk. 

Thank You.