20 Dec 2016 15:16 IST

All you wanted to know about: Cash reserve ratio

The RBI uses CRR as an instrument to deal with the deposit surge during demonetisation

Earlier this month, India’s new Monetary Policy Committee sprang a surprise by not announcing any cut in the official interest rate. But bankers, usually prone to complaining about this, took the announcement well. “Oh well! So what if we didn’t get a rate cut, at least RBI has withdrawn the excess CRR requirement,” they said.

What is it?

Banks are glad about a lower CRR because the Cash Reserve Ratio is money that banks park with the RBI for free, without receiving any interest on it. The CRR, now at 4 per cent, is calculated as a percentage of each bank’s net demand and time liabilities (NDTL). NDTL refers to the aggregate savings account, current account and fixed deposit balances held by a bank.

The CRR has been in the news because the RBI has been using it as an instrument to deal with the deposit surge during demonetisation. Since November 8, banks had been receiving a tidal wave of deposits due to the intake of old currency notes. On November 26, the RBI decided to mop up some of the sudden riches of banks by hiking its CRR requirement from 4 per cent to 100 per cent of incremental deposits, on a temporary basis. In its policy review it restored the status quo.

Why is it important?

When banks source deposits from us, their primary objective is to lend to earn a ‘spread’. Left to themselves, banks may like to maximise their lending and keep their idle cash at a minimum so that profits are higher. But if much of the funds are lent out and there’s a sudden rush to withdraw, banks will struggle to meet the repayments.

It is to avoid this situation that the RBI specifies both a CRR and an SLR (Statutory Liquidity Ratio) for banks. The CRR (4 per cent of NDTL) requires banks to maintain a current account with the RBI with liquid cash. The SLR (20.75 per cent of NDTL) requires banks to invest in safe and quickly saleable assets such as government securities.

While ensuring some liquid money against deposits is the primary purpose of CRR, its secondary purpose is to allow the RBI to control liquidity and rates in the economy. In the short term, interest rates swing up or down depending on how much liquidity is available for lending. Too much money leads to a collapse in rates, and too little, a spike.

With demonetisation sucking cash out of the economy and putting it in the hands of banks, market interest rates fell sharply from nearly 7 per cent on November 8 to 6.2 per cent by the end of the month. The RBI seems to have hiked CRR requirements end-November so that market rates wouldn’t plummet below its policy repo rate, which was pegged at 6.25 per cent.

But this move, now withdrawn, was negative for banks, as they were still paying depositors an interest, while earning no interest on their high CRR balances.

Why should I care?

As a depositor, the CRR and SLR requirements together ensure that a fourth of your deposits with Indian banks remain secure, even if banks make poor lending decisions.

If you are a bond market investor, it is as important to watch the CRR and SLR requirements of the RBI as it is to watch its repo rate actions. It is liquidity that decides the short-term direction of interest rates in the market.

If you are an investor in bank stocks, a higher CRR means lower margins for the bank and vice versa.

The bottomline

The repo rate isn’t the only astra the RBI wields in its battle to control interest rates.

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