Retain but reward CRR: Financial Express 8th September 2012

Around R3.25 lakh crore is locked up with RBI as CRR, earning no return. Paying at least 3-3.5% interest would be fairAn interesting issue that has come up for discussion is the relevance of the cash reserve ratio (CRR). CRR is spoken of quite often just before RBI announces its monetary policy as it is a signal of the stance of the central bank on monetary easing. CRR today is 4.75% and there is a section of bankers who feel that this is a drag on the system as it constrains them.The argument goes like this. The Indian banking system gets R100 as deposits. Of this, R4.75 has to be kept aside as CRR and another R23 has to be invested in government paper. The bank is left with R72.25 to work with. Of this, again, 40% goes as priority sector lending, which leaves them with R43.35 to pursue discretionary banking activity. Is this fair enough?While the 40% priority sector credit allocation is inescapable, and given that the buzzword is inclusive growth, it is politically incorrect for bankers to be critical of this component even though the highest level of NPAs reside in this category. The SLR criticism becomes weak because banks are holding on to excess SLR (currently around 28.2%) anyway, meaning thereby that it is still relatively attractive. In FY11, the net return on investments over cost of funds was 206 bps and that on advances was 445 bps. But given the benefits on investing in government paper when reckoning capital adequacy and making provisions on the asset portfolio, investment in SLR securities makes a lot of sense. Therefore, CRR has now become an interesting bone of contention.CRR actually has two purposes. The first is that it is a safety valve of solvency for banks as they need to have a certain prudential level of cash to meet their requirements as well as contingencies. This again is not sacrosanct because some countries have this reserve requirement while others do not. But, intuitively, having it makes sense as it affords comfort to the central bank. What should this level be? Currently, the ratio of cash on hand and balances with RBI is 5.3% of Net Demand and Time Liabilities (NDTL), which means that banks can actually manage, with around 0.5% of NDTL, their cash requirements under normal conditions. This is a matter of discretion for the central bank and is often linked to the second purpose of CRR, i.e. monetary policy.RBI has several means of controlling the growth in credit and one of them is CRR. It is a quantitative measure which ideally is not efficient since it is not market-driven and means tinkering with the market forces. But CRR is very effective because it directly takes out or induces liquidity into the system, thus ensuring success of the monetary policy measure. The analogy can be drawn from the difference between a quota and tariff where a quota works immediately though it may not be efficient in the market sense. Therefore, RBI would love to keep this option open.The open market operation (OMO) is used more frequently by the Federal Reserve, but theoretically an OMO may be good for supplying liquidity but may be ineffective for drawing it out as banks can choose not to buy paper from RBI which is offered to them. Therefore, CRR is more effective than an OMO and, in fact, even more powerful than the repo rate, because while such rates are indicative of what RBI wants, the P&L of banks are affected only to the extent that they borrow or lend to RBI through the repo/reverse-repo windows. Therefore, often changes in the repo rate do not translate into changes in deposit and lending rates as the balance sheets are not directly affected significantly.This means that CRR has to be retained and is an effective tool for RBI. But the other part of the debate is whether banks should be paid interest on these balances as banks bear a cost on their deposits and borrowings, and any impounding of these balances is a setback. A back-of-the-envelope calculation shows that with deposits standing at R62.8 lakh crore, and NDTL at R68.38 lakh crore, around R3.25 lakh crore are locked up with RBI, earning no return. A 1% return would earn the system R3,250 crore and would increase as RBI offers a better rate. In FY11, net profits of banks were around R70,000 crore and 1% return would improve profits by around 4.5% and increase progressively as the return is enhanced by RBI. Banks would naturally see this positively as it improves their profit margin.A counter-argument could be that as banks do not pay anything on demand deposits, which account for around 9% of total deposits, there is actually no implicit loss for banks, though it is also true that money is fungible and matching source with use does not always happen.As can be seen, there are no right or wrong answers here. Retaining CRR is a prudent move to ensure solvency of the realm, especially in times of a crisis. But rewarding banks with a return may not be a bad idea as they are already handicapped with too much pre-emption. Another argument to support this reward can be that if the same amount were to be added as a mandatory second tier of SLR that has to be held to maturity and replenished, banks would still earn a return of around 7% on such paper besides allowing the government to borrow more money. Therefore, going back to paying at least 3-3.5% would be a fair deal.