A mechanism introduced by the central bank to reduce interest rate volatility has failed to yield desired results with interbank lending rates continuing to see-saw, albeit deposit rates have gone up providing some relief to those who park money in banks.

The Nepal Rastra Bank (NRB), in mid-August, introduced the interest rate corridor to guide short-term market rates and keep all interest rates within a certain band, thereby reducing interest rate volatility.

At the time of the corridor’s launch, interbank lending rate of commercial banks—the interest at which banks borrow money from each other—hovered around 0.4 percent. The weighted average interbank rate has gradually started to climb up since and crossed 4-percent mark in October. But of late, the rate has started falling and stood at 2.03 percent on Sunday.

These swings over the three and a half months indicate a high volatility in interbank rates.

“This is happening because the central bank has not been introducing adequate money market instruments on time to mop up liquidity from or inject liquidity into the banking sector,” Sanima Bank CEO Bhuvan Kumar Dahal told the Post.

Interbank borrowing is generally practiced to manage short-term liquidity problems, such as shortfall in cash reserve ratio—a portion of total deposit that banks must park at the central bank. Such borrowings mature within a week, meaning these loans have to be returned after seven days, although the credit can be rolled over for a longer period.

Although interbank rates are interest rates that banks use to borrow money from or lend money to other banks and do not apply to depositors and borrowers, these rates ultimately affect end-consumers because the banks refer to these rates to determine lending and deposit rates. A hike in interbank rate tends to push deposit and lending rates higher, while a fall in interbank rate lowers pressure on deposit and credit rates.

Rates fluctuate in this manner because higher interbank rate indicates liquidity crunch or shortage of money. On the other hand, low interbank rate indicates higher liquidity or availability of greater funds.

Yet what is surprising is that the interbank rates have lately started falling with the drop in the level of excess liquidity in the banking sector.

In late October, for instance, the interbank rate exceeded 4 percent when the level of excess liquidity stood at around Rs40 billion. This rate has now dipped to around 2 percent, although the level of excess liquidity, according to NRB, has dropped to around Rs 35 billion.

“The interbank rate has fallen because some banks that were facing the liquidity crunch in the past raised fresh deposits from the market,” said Nara Bahadur Thapa, chief of the Research Department at the NRB. The rush to collect fresh money from the market has pushed up institutional deposit rates to as high as 9.5 percent from around 7.5-8 percent at the end of September.

“Also, the government has stopped rolling over some batches of treasury bills, meaning some of the public debt is being repaid,” Thapa said. “This has injected cash into the banking sector.”

A few days ago, the government repaid Rs3.2 billion worth of debt, show the NRB data. The government is repaying debt because it has savings to the tune of Rs195 billion, as it has not been able to implement a very big chunk of capital projects, while revenue collection has remained robust this year.

Among others, a balance of payments surplus recorded in the third month of the fiscal year—as against deficits faced in first two months—has added money to the economy, said Thapa. “On the other hand, India’s decision to ban 500 and 1000 Indian banknotes has reduced flow of money to India because Nepali currency, these days, cannot be easily converted into Indian rupee due to shortage of banknotes of smaller denominations. This has allowed cash to stay in the country, thus reducing pressure on interbank rate,” Thapa added. “So cash, it seems, is evenly distributed among banks. Hence the interbank rate has fallen despite moderate fall in the level of excess liquidity.”

Yet fluctuations seen in interbank rates over the months were not expected following the launch of the interest rate corridor, as the mechanism was introduced to provide clear signals to bankers, policymakers, borrowers and depositors on movement of short-term rates and enable them to make decisions accordingly.