Liquidity, systemic importance and the safety net

Detail

1. Why liquidity matters: the NCERT logic

• NCERT (Class 12, Money and Banking): "being able to repay depositors on demand is crucial to the bank's survival".
• Liquidity means having enough cash, or assets that quickly turn into cash, to pay people when they ask.
• Asset-liability mismatch (ALM): the bank's liabilities (money it owes, mainly deposits) can be withdrawn at short notice. Its assets (money owed to it, mainly loans) come back slowly, over years.
• Normal times: only a few depositors withdraw on any day, so the bank copes.

• Stress: a rumour spreads → many depositors withdraw together → the bank cannot recall its loans fast enough → a bank run (a rush of withdrawals that can break even a solvent bank).

• Basel III therefore adds two liquidity rules on top of the capital rules. One covers the short term (LCR, 30 days). The other covers the long term (NSFR, 1 year).

2. High-Quality Liquid Assets (HQLA)

• HQLA: cash and government securities that can be turned into cash quickly, with little loss of value, even in a crisis.
• Level 1 HQLA (counted at full value, with no haircut):
• cash
• excess CRR (cash kept with the RBI above the required Cash Reserve Ratio)
• G-secs (government securities) held above the SLR (Statutory Liquidity Ratio, the share of deposits a bank must hold in safe liquid assets)

• G-secs within the SLR, allowed under the FALLCR carve-out (Facility to Avail Liquidity for LCR: the part of SLR bonds the RBI lets banks count, because banks can borrow against them from the RBI in stress)

• Update (April 2025 circular): Level 1 G-secs must now be valued at no more than their current market value, minus haircuts that match the margins the RBI applies under LAF (Liquidity Adjustment Facility) and MSF (Marginal Standing Facility) [2].

• Level 2 HQLA: certain corporate bonds and equities. They count only after haircuts (a cut in their counted value, because they may sell below price in a crisis).
• Example: Rs 100 crore of eligible corporate bonds with a 15% haircut count as only Rs 85 crore of HQLA.

3. Liquidity Coverage Ratio (LCR): the 30-day test

• Definition: it tests whether the bank can survive 30 days of severe stress using only its own stock of HQLA.
• Formula: LCR = Stock of HQLA ÷ Total net cash outflows over the next 30 days ≥ 100%
• Net cash outflows = expected outflows under stress − expected inflows.

• Expected outflows = each type of liability × its run-off factor (the share of it assumed to leave in a crisis).

• The 100% level has applied since January 2019 (the requirement was phased in before that).

• Worked example:
• HQLA = Rs 120 crore
• Stressed outflows = Rs 200 crore; inflows = Rs 100 crore → net outflows = Rs 100 crore
• LCR = 120 ÷ 100 = 120%, so the bank complies

• If HQLA fell to Rs 90 crore, LCR = 90% → breach

• Revised LCR norms (circular RBI/2025-26/27, 21 April 2025) [2]:

• Retail deposits that can be withdrawn through internet and mobile banking (IMB) get an extra 2.5% run-off factor [2].
• Stable retail deposits: run-off rises from 5% to 7.5% [2].
• Less stable retail deposits: run-off rises from 10% to 12.5% [2].
• Effective 1 April 2026 [2] (NCERT scaffold: effective 1 April 2026, marked "verify current". This is now confirmed).
• Applies to all commercial banks except Payments Banks, RRBs and Local Area Banks [2].

• Why: with UPI and net banking, money can leave at the tap of a phone. Runs are now faster (e.g. Silicon Valley Bank, USA, 2023).

• Worked example of the change:

• A bank has Rs 1,000 crore of stable retail deposits with IMB access.
• Old assumed outflow: 5% = Rs 50 crore. New assumed outflow: 7.5% = Rs 75 crore.
• The bank must hold Rs 25 crore more HQLA to keep the same LCR.

4. Net Stable Funding Ratio (NSFR): the 1-year test

• Definition: it checks that long-term assets are paid for with stable, long-term funding, not short-term borrowing.
• Formula: NSFR = Available Stable Funding (ASF) ÷ Required Stable Funding (RSF) over one year ≥ 100%
• ASF: capital, long-term borrowing and stable deposits, each weighted by how likely it is to stay for one year.

• RSF: assets weighted by how hard they are to sell within one year. Long loans need more stable funding than cash does.

• In force in India from October 2021.

• Purpose: it limits dependence on short-term wholesale money, which disappears first in a crisis.
• Worked example: ASF = Rs 950 crore; RSF = Rs 1,000 crore → NSFR = 95%, a breach. The bank must raise longer-term deposits or bonds, or shift to more liquid assets.

Feature	LCR	NSFR
Horizon	30 days	1 year
Tests	Surviving a sudden run	Structural funding mismatch
Minimum	100% (since Jan 2019)	100% (since Oct 2021)

5. Systemic importance

• Systemic importance: how badly the whole financial system would suffer if one bank failed. It depends on size, links with other banks, how hard its services are to replace, and how complex it is.

5a. Global Systemically Important Banks (G-SIBs)

• G-SIBs: banks whose distress would disrupt the global financial system.
• The Financial Stability Board (FSB) publishes the list every year.
• G-SIBs must hold 1-3.5% extra loss-absorbing capital (the exact figure depends on their bucket) plus TLAC (Total Loss-Absorbing Capacity: debt that can be written down or turned into equity if the bank fails, so creditors bear the loss and taxpayers do not).
• No Indian bank is on the G-SIB list.

5b. Domestic Systemically Important Banks (D-SIBs)

• D-SIBs: banks whose failure would seriously disrupt India's financial system.
• RBI D-SIB framework: 2014. Banks are placed in buckets by their systemic-importance score. A higher bucket means a higher capital add-on.
• They hold additional CET1 (Common Equity Tier 1: the purest capital, mainly shareholders' equity and retained profits). This comes on top of the capital conservation buffer [3]. They also face closer supervision.
• Added to the list: SBI (2015), ICICI Bank (2016), HDFC Bank (2017).
• Latest list (RBI press release, 13 November 2024) [3]:

Bank	Bucket	Additional CET1 (% of RWAs)
SBI	4	0.80% (0.60% until 31 March 2025)
HDFC Bank	2	0.40% (0.20% until 31 March 2025)
ICICI Bank	1	0.20%

• The higher surcharges for SBI and HDFC Bank apply from 1 April 2025 [3]. (The NCERT scaffold figures of 0.80% / 0.40% / 0.20% match.)

• The list is reviewed every year using bank data as of 31 March [3].

• Worked example: if a D-SIB has risk-weighted assets (RWAs) of Rs 10 lakh crore, a 0.80% surcharge means Rs 8,000 crore of extra CET1 above the normal minimum and buffers.

• RWAs are the bank's assets, each weighted by how risky it is.

5c. Too big to fail (TBTF) and moral hazard

• Too big to fail: the belief that the government will not let a giant bank fail, because the damage would be too great.
• The chain:
• Markets expect a rescue → they lend to the big bank cheaply, which acts as an implicit guarantee
• Cheap funding → the bank grows bigger and takes more risk

• This is moral hazard: taking more risk when you are protected from the consequences

• The policy answer: D-SIB/G-SIB surcharges (make size costly), TLAC and bail-in (make creditors share losses), and tighter supervision.

6. Prompt Corrective Action (PCA)

• PCA: an RBI framework that places automatic, rising restrictions on a weak bank before it fails, like an early-warning system.
• Introduced 2002. Revised framework from 1 January 2022.
• Triggers (indicators):
• Capital: CRAR (Capital to Risk-weighted Assets Ratio) and CET1
• Asset quality: net NPA ratio (bad loans after provisions, as % of net advances), with risk thresholds at 6%, 9% and 12%

• Leverage: the Tier 1 leverage ratio (Tier 1 capital ÷ total exposure, without risk weights)

• Worked example: net NPA = 7.5% → breaches Risk Threshold 1 (6%). If it rises to 10% → Threshold 2 (9%). At 13% → Threshold 3 (12%), which brings the harshest curbs.

• Restrictions grow with the threshold breached: limits on dividends, branch expansion, lending, and management pay.
• History: 11 PSBs were under PCA in 2017-18. All exited by September 2022, with Central Bank of India the last.
• PCA now also applies to NBFCs and UCBs (verify current).

7. Deposit insurance: DICGC

• Deposit insurance: protects depositors, up to a set limit, if a bank fails or is placed under restrictions.
• Provider: DICGC (Deposit Insurance and Credit Guarantee Corporation), set up under an Act of 1961 and in its merged form from 1978. It is a wholly owned subsidiary of the RBI.
• Cover: Rs 5 lakh per depositor per bank, "in the same right and capacity", from 4 February 2020. The limit was Rs 1 lakh from 1993.
• The Rs 5 lakh covers principal and interest together [4].
• "Same right and capacity": all accounts one person holds in the same role are added together. Accounts held in a different role (individual, partner, trustee, or a joint account with a different order of names) each get a separate Rs 5 lakh cover [4].

• Worked example: Ravi holds Rs 4 lakh in savings and Rs 3 lakh in an FD, both in his own name, in Bank X. Total = Rs 7 lakh, but he is covered only up to Rs 5 lakh. A joint account "Ravi & Meena" in the same bank is covered separately.

• Who is covered: commercial banks (including foreign bank branches), RRBs, LABs and cooperative banks [4].

• Not covered: NBFCs and PACS (primary agricultural credit societies) [4]. Also excluded: deposits of foreign governments, deposits of central and state governments, inter-bank deposits, and deposits received outside India [4].
• Who pays the premium: the insured bank bears it entirely. It cannot pass it on to depositors [4].
• DICGC (Amendment) Act 2021: interim payment within 90 days of the RBI placing restrictions on a bank. Depositors no longer wait for liquidation. This was the lesson from PMC Bank (2019), where depositors were stuck for years.
• Premium: from flat rate to risk-based.
• Since 1962, DICGC charged a flat premium, currently 12 paise per Rs 100 of assessable deposits [5].
• Risk-Based Premium (RBP) framework, effective 1 April 2026 (announced 6 February 2026; approved by the RBI Central Board on 19 December 2025) [5]. (NCERT scaffold: "move to risk-based premiums (verify current)". This is now in force.)
  • Two models: Tier 1 for scheduled commercial banks (excluding RRBs); Tier 2 for RRBs and cooperative banks [5].
  • Better-rated banks get up to a 33.33% cut from the risk model, plus a vintage incentive of up to 25% for banks that have paid premiums for longer [5].
  • LABs and Payments Banks stay at the standard rate. UCBs under regulatory action stay at the card rate [5].

• Worked example: a bank with Rs 10,000 crore of assessable deposits pays 0.12% = Rs 12 crore at the flat rate. With the full 33.33% risk-model discount, it pays about Rs 8 crore.

• Moral-hazard concern: insured depositors stop checking how safe their bank is. Risk-based premiums partly answer this by charging risky banks more.

8. Bail-out vs bail-in

• Bail-out: outside money rescues the bank. This is usually taxpayer money or a rescue directed by the state.
• Bail-in: the bank's own creditors, and sometimes depositors, absorb the losses. Their claims are written down or turned into shares.

Bail-out (outside money)	Bail-in (creditors and depositors bear losses)
Yes Bank Reconstruction Scheme (March 2020): capital led by SBI	FRDI Bill 2017: its bail-in clause caused depositor panic; withdrawn 2018
Lakshmi Vilas Bank merged into DBS India (2020)	Cyprus (2013): large deposits converted into equity
	AT1 write-downs as contractual bail-in: Yes Bank (2020), Credit Suisse (2023)

• AT1 bonds (Additional Tier 1 bonds): perpetual bonds that count as bank capital. Their terms allow them to be written off when the bank is in trouble. This is a bail-in agreed in advance by contract.
• The trade-off:
• Bail-out protects stability now, but it costs taxpayers and increases moral hazard.
• Bail-in protects taxpayers, but it can frighten depositors and set off runs (the FRDI episode).

Prelims Hooks

• LCR = HQLA ÷ net cash outflows over 30 days ≥ 100% (since Jan 2019). NSFR = ASF ÷ RSF over one year ≥ 100% (since Oct 2021). Trap: the LCR horizon is 30 days, not one year.
• FALLCR lets banks count part of their SLR G-secs as Level 1 HQLA. Level 2 assets (corporate bonds, equities) count only after haircuts.
• Revised LCR (from 1 April 2026): an extra 2.5% run-off on retail deposits reachable through internet and mobile banking. Stable deposits go from 5% to 7.5%; less stable from 10% to 12.5% [2].
• D-SIBs (2024 list): SBI (bucket 4, 0.80%), HDFC Bank (bucket 2, 0.40%), ICICI Bank (bucket 1, 0.20%) additional CET1, from 1 April 2025 [3]. No Indian bank is a G-SIB.
• DICGC is a wholly owned subsidiary of the RBI. Cover is Rs 5 lakh (principal + interest) per depositor per bank, from 4 February 2020. The premium is paid by the bank, not the depositor [4].
• DICGC covers RRBs, LABs, cooperative banks and foreign bank branches. It does not cover NBFCs or PACS.
• Risk-based deposit insurance premium replaced the flat 12 paise/Rs 100 rate (in use since 1962) from 1 April 2026 [5].
• PCA triggers: CRAR, CET1, net NPA (6%/9%/12%) and the Tier 1 leverage ratio. Trap: profitability (RoA) is not a trigger in the 2022 framework.
• DICGC (Amendment) Act 2021: interim payment within 90 days of RBI restrictions, after PMC Bank.
• FRDI Bill 2017 was withdrawn in 2018 over its bail-in clause. The Yes Bank rescue in 2020 was a bail-out led by SBI.

Mains Points

• Digital runs change liquidity rules: UPI and mobile banking let deposits leave in hours, not days, as in the SVB collapse of 2023. The RBI's extra 2.5% run-off on digitally accessible deposits [2] makes banks hold more HQLA. The trade-off: more HQLA means more idle money in G-secs and less lending, so credit may cost more.
• Too big to fail vs competition: D-SIB surcharges (SBI 0.80%) [3] make size costly and reduce moral hazard. Market belief in a state guarantee, especially for PSBs, still gives them cheap funding. Credible resolution (bail-in tools, TLAC-type buffers) is the missing piece after the FRDI Bill was withdrawn.
• Deposit insurance design: the Rs 5 lakh cover and the 90-day interim payment protect small savers and prevent panic (the PMC lesson). But a flat premium made safe banks subsidise risky ones. The 2026 risk-based premium [5] brings back market discipline. Gaps remain: NBFC and PACS depositors, and the cover limit compared with rising average deposit sizes.
• PCA as a pre-emptive tool: 11 PSBs under PCA (2017-18) cleaned up and all exited by September 2022. This shows rule-based early action works. Critics said PCA curbs on lending hurt credit to MSMEs during a slowdown, which is a stability vs growth trade-off. Extending PCA to NBFCs and UCBs closes gaps in regulating the shadow banking sector (lenders outside the banking system, such as NBFCs).