In a bid to ease the liquidity constraints of the banking sector the Central Bank last week told banks through an official circular that they can borrow one month’s liquidity requirement from the Central Bank.

Earlier banks were allowed to borrow funds from the Central Bank daily using the over-night reverse repurchase window on which the Central Bank had imposed a penal rate if banks exceeded the prescribed number of times it can be accessed each month.

The Central Bank will now allow commercial banks to borrow one month’s requirement at one go instead of daily.

"There is a crisis of confidence and local banks are reluctant to lend to one another so Central Bank’s recent directive will go a long way to give the market liquidity which has been short due to the defense of the exchange rate," a dealer said.

He said that by allowing banks to borrow their liquidity requirement for a month, it would help stabilize the interest rates and reduce the volatility in the money market.

"Despite the erosion of rupee liquidity due to the defense of the exchange rate, the Central Bank is at the same time providing enough liquidity," another dealer said, adding that the regulator had always made adequate adjustments to ensure liquidity in the money market.

The money market on Monday was short by about Rs. 8 billion from the Rs. 12 billion short position it held last Wednesday.

Dealers said this was because of the weekly change in the reserves held with the Central Bank.

Missing the point…

Some dealers said that the Central Bank circular allowing banks to borrow one month’s liquidity requirement would allow banks to use these funds to invest in Treasury instruments without risking lending to each other.

"We could sit back and relax and make a decent gain," a dealer said.

If this is the case, while the Central Bank has taken steps to improve liquidity it still does not address the issue of banks’ falling confidence in each other.

Dealers opine that current lending rates would most likely persist well into the festive season in April as they brace for the pressure on liquidity to intensify.

Falling asset values

According to dealers, rupee liquidity is concentrated with a few banks and these banks are reluctant to lend to other banks and non-bank primary dealers primarily as a result of the fall in asset values.

"Commodity prices have fallen, Currency assets have fallen by about 20 to 30 percent against the dollar compared to last year and some property markets have almost halved so the asset values of some banks have fallen and as a result banks holding enough cash are reluctant to lend to these institutions," a dealer said.

"While Sri Lanka’s banking system is to some extent immune to the global financial crisis, falling commodity prices and equity values have to a little extent affected the liquidity situation in the country, but for the most part it is the fall in domestic assets and confidence issued caused by the recent scandals in the financial system.

"A property market was created not out of necessity, and in times such as these, when investors have low confidence in the non-bank financial system they prefer to hold their assets in liquid forms such as in Treasury bills and fixed deposits.

"So banks who are exposed to property assets, loans attached to such assets and inter- group lending are now finding it difficult to borrow from other banks," he said.

The performance of NPLs…

Dealers said that banks are expecting their Non Performing Loans to increase by about 2 percent for 2009 under the prevailing economic climate.

"There is a concern about the ability of some banks to repay their loans as their exposures to illiquid assets increase.