The solution for addressing the issue, as put forward by the RBI in the same report gives us some interesting insights. It says that
“Some policy actions that would result in integration of the government securities yield and swap rates include progressive reduction in SLR, more flexibility with regard to short sale, securities financing arrangements and more open regime in respect of arbitrage between the curves.”
The SLR or Statutory Liquidity Ratio requires banks to hold 24% (as per extant regulations) of the Net Demand and Time Liabilities in government securities. Restrictions can depress prices. Depressed price would mean higher yields.
Are there other reasons?
The RBI presents another generic reason in the same report. It says that a “ lack of significant participation by large players such as public sector banks, mutual funds and insurance companies” is one of the reasons for rigidity in the derivatives market.
I would like to offer a more detailed explanation.
Because of their very limited branch networks in India, foreign banks use inter-bank borrowing to a disproportionately large extent. Foreign banks as a group have less than 10% of India’s banking business. However, as per data published by CCIL (and available at its website ), foreign banks have had a 22.49% share of inter-bank call money borrowing over a 58 week period upto 24th April 2009(week ended 14th March 2008 to the week ended 24th April 2009). Foreign banks as a group would largely be price takers# in this market as their ability to make prices is limited by their large presence on the borrowing side in comparison to their smaller presence (a share of 11.54% of the lending side over the same 58 week period@) on the lending side.
However, foreign banks as a group would generally be price makers in the MIBOR-linked OIS market, as they have a very large presence on both sides of this market. Over the same 58 week period foreign banks had a 79.45% of the market share on the buy swaps side, and 80.25% of the market share on the sell swaps side. While a significant portion of the swap market volumes are on account of trading, the supremacy of the foreign banks in India’s MIBOR-linked OIS market gives allows them to be price makers.
It would be only be convenient for the foreign banks if the swap curve (for the MIBOR-linked OIS) is below the government securities curve. As then they will be able to swap their inter-bank call money borrowings into a fixed rate lower than the fixed interest rate paid by the sovereign on its borrowings!
Other entities that are largely borrowers in the inter-bank call money market (like primary dealers) SHOULD join the free ride!
Do you have any other reasons?
# The NSE overnight MIBOR is a polled rate. And though foreign banks are almost always net-borrowers, they are among the contributors to the poll. So, foreign banks do participate in the fixing of the MIBOR. Considering, that the MIBOR is an offer rate, only banks who lend, or both lend and borrow (without a significant bias towards the latter) should be contributors. If you go to a fruit market, should you as a buyer (only buying and no selling) of oranges be asked about what the offer rate for your oranges should be when you have no oranges to sell (a similar question for the bid rate would be meaningful)?
@ the share of foreign banks in net-borrowings in the call money market would be even bigger.
