The Nepal Rastra Bank introduced a standing deposit facility (SDF) in February this year, enabling banks and financial institutions to deposit their excess liquidity at the central bank to earn a 3 percent interest rate.

Excess liquidity of a bank is the money left after extending loans and maintaining regulatory requirements out of total financial resources, mainly deposits. It is the balance after settling all transactions, including deposits inflows and credit outflows.

Previously, banks and financial institutions with liquidity surplus used to keep it idle at their vaults or NRB in interest-free accounts if not borrowed by other banks. Generally, every day, banks compete to borrow and lend to each other to manage their liquidity. Banks with liquidity deficit try to borrow by paying minimum interest from banks having liquidity surplus. The interbank rate goes down when lending pressure increases, and it goes up when borrowing pressure increases in the interbank market.

The interbank market remains inactive when the banking sector faces liquidity overhang or liquidity drain for a long time. For instance, banks do not borrow from each other when they have enough liquidity. In this case, the interbank transaction rate remains negligible or very low. On the other hand, they do not get liquidity from the interbank market or transact at a very high rate when they face liquidity problems. In this way, the interbank rate becomes volatile with a small change in liquidity, if the central bank does not intervene in the money market.

The new provision allows banks to keep their excess liquidity at NRB as SDF for a three percent interest rate if they are not getting more from interbank transactions. Thus, it ensures that banks do not require transacting with each other for a below three percent interest rate even during liquidity overhangs.

The ultimate objective of introducing SDF is to maintain the lower bound of the interest rate corridor, as the current monetary policy has set the SDF rate equivalent to the lower bound of the interest rate corridor. The upper bound of the corridor is set at 6.5 percent, for which monetary instruments are already in place to maintain the rate. At present, the optimal monetary policy choice is to keep the interbank rate around the policy rate, which is currently fixed at 5.5 percent.

The money market is expected to remain vibrant and dynamic under the interest rate corridor framework. Banks knock on the NRB door to place excess liquidity as SDF if not getting more from interbank transactions. On the other hand, banks having liquidity shortfall, borrow from NRB, paying interest equivalent to policy rate or bank rate depending on the duration of liquidity need if they are not getting cheaper rate from the interbank market. In this way, the interbank transaction rate is expected to remain between the corridors.

The main reason for adopting the interest rate corridor policy is to maintain the interbank rate low and stable so as to stabilise the deposit and credit interest rates. This promotes saving mobilisation, enables the business environment and improves banking practices.

On the saving side, NRB does not allow banks and financial institutions to offer interest rates on savings accounts below the SDF rate. As a result interest rates on savings accounts cannot go below SDF rate even at a time of liquidity overhang. So, it protects savers’ interests. On the credit side, when short-term and saving interest rates become more stable, credit interest rates become more stable. This encourages creditors to borrow more. It generally persuades creditors with fixed interest rates. Finally, financial institutions do not reverse interest rates massively as the central bank remains the doorkeeper to provide liquidity and accept deposits when needed. Thus, interest rates become more stable under the interest rate corridor policy.

However, maintaining an interest rate corridor is challenging and also expensive. Banks and financial institutions bear the cost of sustaining the upper-bound corridor, which pays interest on borrowings from NRB. The Nepalese banking sector experienced this situation for a couple of years until the beginning of Covid-19.

On the other hand, the central bank has to bear the cost of maintaining the lower-bound corridor, thereby paying interest expenses on SDF or deposit collection. It happens at a time of liquidity overhang owing to credit slackness. The Nepalese banking sector has experienced adequate liquidity in the last few months due to credit slowdown compared to deposit growth. As a result, average saving and credit interest rates have reduced substantially compared to the previous year, while the average interbank rate has been recorded below three percent in recent months.

It is unlikely for the interbank rate to remain below three percent under the interest rate corridor mechanism where unlimited SDF is available for banks and financial institutions to park their excess liquidity. This calls for further reforms in monetary policy operation to maintain the corridor effectively.

NRB currently offers SDF only twice a week. As banks do not have the opportunity to park their excess liquidity on other days, they may transact liquidity below three percent rather than keeping idle. To maintain the lower bound of the corridor effectively, it is desirable to allow them to utilise the SDF every day. Moreover, banks and financial institutions must maintain some regulatory requirements to become eligible for SDF to relax gradually.

Finally, monetary policy should be forward-looking and more dynamic under the interest rate corridor framework. If liquidity overhangs continue owing to a weak credit demand at a low level of interest rates, monetary tightening, such as increasing CRR, maybe a policy option to protect savers. The policy should address credit bottlenecks through different measures rather than continuing an accommodative policy stance. On the other hand, monetary policy should be relaxed to encourage credit expansion when borrowing from the central bank remains persistent during low credit growth.