The term liquidity trap was coined by economist John Maynard Keynes in 1936. A liquidity trap is when there is excess liquidity in the market but the banking sector is unable to invest and there is no demand for credit. This is why the banking sector is forced to further reduce interest rates. When investment is weak, the price of goods and services also increases. 

Banks have large sums of money in their deposits and are not borrowing. This is a problem because banks have to pay interest on the money they have. The state of cash availability in banks and financial institutions is called liquidity apart from the quality or ability of any asset to be converted into immediate expenditure or payable amount. 

In the banking and financial sector, liquidity is also understood as immediately investable capital. Even with low interest rates, there is no demand for credit from the business sector, but rather consumption and investment are reduced, cash hoarding is encouraged and capital is transferred abroad, that is, capital flight. When liquidity in such a market increases, investors are worried that they will not get a return. In such a situation, monetary policy is powerless because it cannot be implemented effectively. 

Nepal Rastra Bank is the regulator of managing bank liquidity in Nepal, so it has a large number of tools to control bank liquidity. Some of the methods are increasing the CRR and SLR ratios, increasing reverse repo, issuing government securities, increasing bank rates, etc. For some time now, there has been a significant decrease in excess liquidity and credit flow.

Deposits kept by the general public in banks, amounts kept by banks in the central bank, financial instruments that are bought and sold in the market, and precious metals such as gold and silver have high liquidity. 

There are some reasons for this which include: Lack of clear explanation of currency liberalization, financial chaos, non-viability of the economy, sluggishness in the capital market, post-covid economic situation etc., unpreparedness of business, trade and industry friendly environment.

In short, unless some security is given to the bank officials, they are less likely to lend. This excess liquidity, which could have driven economic growth under ideal circumstances of the country and monetary situation, is being underutilized mainly due to declining credit activity and increasing burden of non-banking assets, which is currently seen in Nepal. 

Liquidity problem

Despite the country having sufficient cash reserves, banks are struggling to mobilize funds profitably. Economic uncertainty and declining public confidence have brought about and are overshadowing a dramatic slowdown in credit distribution in the country. Borrowers worried over financial instability are reluctant to borrow more, while banks, burdened by a growing default burden, are tightening lending standards. Adding to these problems is the growth of non-banking assets—assets that banks have acquired due to loan defaults, usually real estate, which is also a problem, and the current budget. Even in the past, the idea of ​​opening an asset management company did not work. 

Service vs manufacturing 

Nepal currently has a huge service industry. This is a bright spot. The problem is that lending to the service industry is a struggle fraught with great risks. There is almost always zero physical assets and service industries are always valued by their equity value and their overall brand name and demand. Banks are uncomfortable lending to the service industry as well as the manufacturing industry. One because the assets are always intangible and the other because of the existing NPAs. 

Liquidity management in Nepal in a difficult situation. It would not be an exaggeration to say that economic stability is the main macroeconomic goal of any country, developed or developing. Fiscal policy and monetary policy ensure this, which is not possible without the availability of liquidity and its proper mobilization. The main source of liquidity is deposits received from various agencies and individuals, external remittances and loan recovery. Looking at the current context of Nepal, on the one hand, there is a predominance of consumer credit, and on the other, due to the slowdown in industry and trade, the disposable income of businesspeople and the general public has decreased, which is making it difficult to pay the principal and interest on loans taken from banks. 

The bitter but real question has begun to arise whether the banking sector will find it difficult to manage liquidity due to the country’s excess liquidity and will fall into a liquidity trap. The budget for the fiscal 2025-26 has arrived, there is a liquidity mechanism, monetary policy will come, how will it be addressed? 

In this context, businesspeople had to run their businesses to repay bank loans. Consumers had to increase consumption. At the same time, banks should be aware that they should not delay in formulating short-term, medium-term and long-term strategies to solve the problem of liquidity management.

The country’s banking sector is experiencing a terrible paradox. 

Despite having sufficient cash reserves, banks are struggling to mobilize funds profitably. Economic uncertainty and declining public confidence have led to a dramatic slowdown in credit distribution. Borrowers worried about financial instability are hesitant to take on more loans, while banks burdened by the burden of increasing defaults are tightening lending standards.

Despite having adequate cash reserves, banks are struggling to mobilize funds profitably. Economic uncertainty and declining public confidence have led to a dramatic slowdown in credit distribution. Borrowers concerned about financial instability are reluctant to borrow more, while banks, burdened by growing defaults, are tightening lending standards. The Daily Liquidity Facility (DCF) Procedures of the Nepal Rastra Bank (Second Amendment) Provides detailed information on the procedures and processes to be followed for the DCF and the Overnight Liquidity Facility under the Real Time Gross Settlement (RTGS) system operated by Nepal Rastra Bank. 

It clarifies how participating financial institutions can utilize the liquidity facility, the management of collateral, calculation of interest, and the additional charges and actions to be taken in case of default.

It also covers the use of collateral management accounts and settlement accounts, the format of monthly reports and the rules on recovery. In the country, the Nepal Rastra Bank is the bank that sends the required liquidity to the banking system and absorbs it when there is excess.

The procedure was prepared by the central bank with the aim of providing immediate liquidity to banks and financial institutions in case of liquidity shortage while transacting in the Real Time Gross Settlement (RTGS) system. This has been made by exercising the authority granted by Section 110(3) of the Nepal Rastra Bank Act, 2058. In Nepal, credit has not been able to expand because there is currently pressure on businesses to repay loans rather than demand for loans. Central banks manage liquidity in the economy to ensure financial stability and control inflation. 

A detailed overview of why and how they collect excess liquidity, the benefits of this practice, and the costs associated with it shows that: Why do central banks collect excess liquidity? 

Control of inflation

Excess liquidity can lead to high inflation because more money can buy the same amount of goods and services. By collecting liquidity, central banks can help stabilize prices. 

Financial markets are stable: Too much liquidity can result in rising asset prices and increased risk-taking. Reducing liquidity can help maintain market discipline. Promoting sustainable economic growth: By ensuring that liquidity levels are appropriate, central banks can help the economy grow sustainably rather than overly dynamic. 

Managing currency value: Excess liquidity can also weaken a country’s currency. By controlling liquidity, central banks can help maintain or strengthen the value of a currency.

How do central banks raise excess liquidity? 

Open market operations (OMOs): The central bank sells government securities in the open market to absorb excess cash. When financial institutions buy these securities, they pay for them from their reserves, which reduces the amount of money in circulation. 

Interest rate adjustments: By lowering interest rates, central banks can make borrowing cheaper and saving more unattractive, which can lead to lower spending and investment, which in turn reduces liquidity. 

Reserve requirements: Increasing the reserve requirement ratio forces banks to hold a larger portion of their deposits in reserves, which reduces the amount available for lending. This can directly reduce liquidity in the economy. 

Fixed deposits and reverse repos: Central banks can also use instruments such as fixed deposits or reverse repurchase agreements to temporarily absorb liquidity. Banks deposit funds with the central bank for a specified period, reducing the money supply. 

Benefits of liquidity deposits 

Inflation control: Helps maintain price stability, which is important for economic confidence and planning. 

Financial stability: Reduces the risk of asset overvaluations, which can lead to a financial crisis if they become too extreme. 

Promotes responsible lending: By controlling excess liquidity, banks can be encouraged to lend more responsibly, reducing the risk of default. 

Strong currency: A strong national currency can benefit importers and reduce the cost of foreign borrowing. 

Long-term economic growth: By creating a more stable economic environment, central banks can foster conditions that support sustainable growth. As for the costs of liquidity management, they can vary depending on the methods used 

Interest costs: If a central bank raises interest rates, it can increase the cost of borrowing for governments and consumers, which can have a liquidity effect on the economy. 

Opportunity costs: Selling securities or raising reserve requirements can limit the amount of money available for banks to lend, potentially slowing economic growth. 

Administrative costs: Implementing and managing liquidity management operations incurs administrative costs for the central bank. 

Market effects: Aggressive liquidity management can cause market instability or disruptions, which can have broader economic effects. In short, despite the costs of managing excess liquidity, it can also contribute to economic stability, inflation control and sustainable growth.

In short, while there are costs to managing excess liquidity, the benefits in terms of economic stability, inflation control and sustainable growth often outweigh these costs. Therefore, central banks must carefully balance their liquidity management strategies to effectively achieve their monetary policy goals. Collaboration with the business community is essential in resolving the issues raised, including the questions raised regarding the current capital and credit guidelines for liquidity management, 2079. 

It seems that a comprehensive roundtable conference should be held immediately between bankers, businesspeople and the government to arrive at a conclusion on why the banking sector is not enthusiastic about credit investment and why there is no demand for credit despite the significant increase in deposits. The economy is weakening due to increasing dependence on consumption, government revenue and imports. Therefore, for proper management of liquidity, emphasis should be placed on manufacturing and agricultural-oriented investment, and the development of import-substituting industries and exports should be increased.