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In a swift move, the Reserve Bank of India (RBI) raised the Cash Reserve Ratio (CRR) to 100% specifically on deposits received by banks between 16th September and 11th November,2016.

What prompted the regulator to take this drastic step?

The RBI controls the flow of money and cost of credit in the economy. Business enterprises need to borrow money to fund their expansion activities. The interest rates are dependent on the total money supply in the economy. If there is a liquidity crunch, interest rates soar as there is a huge demand for money and few lenders. The RBI has powers to tweak the money supply using a few tools so that interest rates are stabilised. The dangers of soaring interest rates are well known.

 

Tools used by the RBI

Statutory Liquidity Ratio (SLR): Banks are required to invest 20.75% of Net Demand and Time Liabilities in specified Central and State Government Securities, Treasury Bills and Government guaranteed Bonds. Banks earn interest on these investments.

Cash Reserve Ratio (CRR): Of the total deposits held by a bank, 4% has to be mandatorily parked in a Current Account with the RBI. Banks cannot use this money whatsoever. There is no income derived from this.

Repo Rate: Banks can borrow from the RBI for tenures ranging from overnight upto 14 days. The rate of this temporary loan is determined by RBI. Currently, the Repo rate is pegged at 6.25%. For the Banks, this rate becomes their base rate above which they are free to lend to corporate and individual customers for their short term needs.

Reverse Repo Rate: The converse of the above is true for Reverse Repo Rate. In this case, RBI borrows from Banks at a specified interest rate to suck out the excess liquidity from the system. Currently the Reverse Repo Rate is 5.75%.

 

Using the above tools, the RBI either infuses or pulls out money from the economy. But why was the CRR so drastically imposed on specific deposits?

In the aftermath of the demonetization announcement, people scrambled to either exchange or deposit their currency of the cancelled Rs.500/- and Rs.1,000/- denominations into their bank accounts. Cash deposits poured in. Banks grabbed this opportunity to invest a part of this in Government bonds and earn some quick income. The demand for these bonds soared drastically. This led to a rally which resulted in the yield of the benchmark 10-year bond crashing more than 50 basis points (One basis point is equivalent to 0.01%). The yield hit a new seven-year low to 6.23% in no time.

After assessing the situation, the RBI decided to prop up the yield of the 10-year bond by plugging this opportunity.  All deposits received by banks from 16th September to 11th November shall necessarily have to be placed with the RBI as CRR.

This has resulted in a whopping Rs.3.24 trillion getting pulled out of the monetary system. Banks will earn nothing from this move as the CRR is interest-free. While the RBI has assured that this move is temporary and shall be reviewed on or before December 9th. Bankers are wary of the move as it has a definitive impact on the next interest review due.

As expected, the stock markets dumped bank stocks post this announcement. Since the CRR does not earn any interest for the Banks, the interest payable to their customers has to come out of their pockets without any corresponding revenue. This will have an impact on profits in the coming quarters.

More on this follows soon, in subsequent articles. So keep coming back to this blog!

 

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