Sunday, 2 September 2012

Should CRR be phased out?

Reproduced from:

Bankers have always looked at cash reserve ratio (CRR) with skepticism. The reason is that this part of the deposits which the banks have to keep with the Reserve Bank of India does not earn interest.
SBI Chairman Pratip Chaudhuri was quite candid about it. "CRR does not help anybody," he said, "it is locked up in the vault and not ploughed back into the economy … it needs to be phased out as it does not earn any interest income and increases pressure to earn more from remaining resources". The RBI was quick to retort. Deputy Governor K. C. Chakrabarty bluntly remarked that Chaudhuri "has to find some other place" if he could not work within RBI regulations.

The loss of interest on CRR is not the major issue. A more basic question is whether CRR is at all necessary and, if not, should be phased out.
Not all central banks follow the same practice. In the United States, the reserve requirement is in respect of transaction (current) accounts and is at about 10 percent. There is no reserve requirement for time deposits. In the UK, it is voluntary. Even so, banks do keep reserves to have enough liquidity to prevent any sudden increase in cash outflow which can result in a run on the bank. On average it is about 3 percent. In the euro zone, the reserve requirements are at 1 percent.

Generally, central banks in the U.S. and EU do not change the reserve requirements and liquidity is regulated through open market operations. CRR serves two objectives. First, it helps the banks to have enough cash to meet any eventuality. Second, it enables the RBI to regulate liquidity in the banking system and try to control inflation.
Banks in India are also required to invest 23 percent of the deposits in government securities. This ratio, called the statutory liquidity ratio, is also a policy target set by the RBI. This risk-free investment improves the risk quality of banks' assets. In the absence of CRR and SLR, banks can come under unexpected danger as was realised by investment bankers in the U.S. in 2008.

Reserves are necessary. That is why in spite of the absence of compulsion in the UK, banks maintain reserves. Reserve is a precaution. What the level should be is a matter of judgment on the part of the banker. Three percent could be a good enough back-up. Also, both the CRR and the SLR should be stable ratios which can be changed only in exceptional conditions.

Chaudhuri has been concerned about the interest foregone by banks on CRR. In the absence of CRR, banks would, in any case, keep reserves in the cash vault. Hence, reserves up to 3 percent should be interest free; reserves above that level should be eligible for interest payment.

That leaves the RBI with open market operations to control liquidity and the repo to regulate the interest rates. Both are effective instruments and together make a complete package.

The country needs to move towards a situation where Cash Reserve Ratio (CRR) level comes down and that it is used as an instrument of “credit control” only in extraordinary conditions, said C. Rangarajan, Chairman, Economic Advisory Council to the Prime Minister, on Thursday.
As “Open market operations (OMOs) became increasingly major instrument….The role of CRR, as credit control, will come down,”
prior to 1991 CRR was the major instrument of credit control because interest rate was administered and, therefore, OMOs could not be conducted and, therefore, CRR remained the major or the only instrument of credit control available with the RBI.
In fact, at that time, CRR continued to be raised to very high levels because the budget deficits were high and it was being financed by the RBI and, therefore, to contain liquidity growth, CRR needed to be raised to very high levels.
However, said Dr. Rangarajan, “at the time of the banking sector reforms, we took a conscious view to reduce the CRR and, therefore, it has been progressively brought down.”
While speaking on the topic ‘The Indian banking system — some issues’, Dr. Rangarajan said that if the Indian banking system was to remain competitive over time, there should be periodic entry of new banks . “A closed system can only become oligopolistic. The ‘threat’ of entry should not, therefore, be eliminated, and the central bank should lay down entry norms as also decide on who satisfies the criterion of fit and proper,’’ he said.2

The cash reserve ratio (CRR), an instrument of monetary policy, has been in the news recently for two reasons. On September 17, the Reserve Bank of India, while unveiling its mid-quarter monetary policy review, reduced the CRR from 4.75 per cent to 4.50 per cent. The CRR is the proportion of deposits that commercial banks must maintain with the central bank. The 25 basis points cut would release Rs.17,000 crore of primary liquidity and through a process of monetary multiplier several times more.
CRR is one of the two reserve ratios. The other SLR or Statutory Liquidity Ratio is the proportion of demand and time deposits that banks have to keep invested in unencumbered, approved government securities, gold or cash. SLR, now remains at 23 per cent. 

Those who argue that CRR should go are of the view that:
1.  it curbs their ability to lend more. According to them, funds get unnecessarily blocked. 
2. They yield no return also. 
3. Further, compared to mutual funds, non-banking finance companies (NBFCs) and insurance companies, which are not under any compulsion to follow CRR norms, banks are placed in a disadvantageous position. 
4. From the reform perspective, the Narasimham Committee-1 mandated a sharp reduction in the CRR and SLR.

Yet, according to many, the time to do away with these statutory pre-emptions has not yet arrived.
1. It fulfils an important regulatory function in countries such as India where the Open Market Operations (OMO) that central banks use to check liquidity face some structural rigidities.  Central banks rely on CRRs to check inflation by varying money supply. An increase in CRR lowers the multiplier, and, hence, the growth of money supply. The opposite result happens when the CRR is lowered. 
2. Banks ought to view the zero interest on CRR balances as a fee paid to the RBI for its supervisory function. 
3. Banks alone can mobilise low-cost savings and current account deposits. Mutual funds, NBFCs and insurance companies do not have access to such funds. So, banks are not disadvantageously placed in having to meet CRR obligations. 
[C.R.L. Narasimhan, The Hindu].3


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