Money in the bank: Debate over cash reserve ratio's utility grows

Indians are flocking to invest in stocks, putting pressure on banks which need to strike a balance between deposits and loans

Is the cash reserve ratio (CRR) a deadweight on banks? Of every Rs 100 raised by banks in deposits, Rs 4.50 is locked up and it earns nothing by way of interest. The CRR framework is in the spotlight because one, a good number of folks now opt to park their monies in bourse-linked investments. In this financial year, Rs 603,280 crore moved in to mutual funds (MFs) compared Rs 354,701 crore in FY24; deposit growth in the same period (incremental) is at Rs 846,980 crore (Rs 2,431,312 crore). And two, banks’ credit-deposit (CD) ratio is in the high seventies because deposits are trailing credit.

So, is the CRR to be re-looked at?

Two senior bankers concur that there’s a case to reverse the 50 basis points hike in the CRR given effect to during the pandemic; it would bring down the figure to 4 per cent (and take care of the CD ratio aspect). They are Dinesh Kumar Khara, who recently stepped down as State Bank of India’s chairman, and S S Mundra, former deputy governor, Reserve Bank of India (RBI). But beyond this, they will not put a gun to the CRR.

As Khara views it, “this (any tinkering with CRR) will not address the issue relating to the preference for stock market instruments for asset allocation. As for some holding the view that the CRR is making banking as a business unviable, well, that I think is an exaggeration.” Mundra has it that people’s interest in equities and other assets over deposits, “to my mind would only continue to gain momentum”. That in any case, funds invested in the stock markets or in MFs ultimately remain within the banking system. “What distinguishes a winner bank is the superior ability to get and maintain settlement accounts. And thus, have the benefit of low-cost transition funds.”

‘Time-tested tool’

Mridul Saggar, professor at Indian Institute of Management Kozhikode and a former RBI executive director and past member of the Monetary Policy Committee, has stronger words: “CRR is one of the oldest, time-tested and powerful monetary tools, and keeping it in the armoury is sensible. It’s not very useful, and in fact sterile, to debate about it being remunerated by the central bank. Interest on CRR will only raise the calibrated reserves that are to be impounded for monetary control. No wonder, the late S S Tarapore (deputy governor at RBI) considered it as a central banking sin.”

Defence of the CRR in its current avatar apart, the preference for capital markets over bank deposits was flagged in a paper on ‘Bank Deposits: Underlying Dynamics’ in a May 2019 Bulletin by RBI staffers. It noted: “There is growing popularity of MFs and other stock market instruments… Consequently, opposing movements between Sensex returns and deposit growth are indicative of substitution effects.” It also referred to “the widening wedge between credit and deposit growth triggering concerns about a structural liquidity gap in the system, which can throw sand in the wheels of the financial intermediation process through which deposits are converted into productive investments by way of lending, thereby greasing the wheels of the economy.”

Five years on, these issues are upon us again.

M V Rao, chairman of Indian Banks’ Association (IBA), last month made a case for intervention from the authorities to tackle the preference for equities and MFs. Even though he did not spell its terms, Rao (he helms Central Bank of India as a banker) was of the view that if the trend of investors preferring avenues other than deposits were to hold, systemic risks could arise. Again, while he did not put it in so many words, the following has been voiced in private by senior bankers: What if the MF business were to become so big that top-notch firms queue up at their door over banks? They have no end-use monitoring of funds like banks and their pricing would be much finer given that MFs have no CRR or statutory liquidity ratio requirements – it is 18 per cent for banks which have to be invested in government securities.

“Going forward, banks can’t dictate to customers. We have to evolve and ensure that higher returns are given to depositors,” Rao said at the annual FICCI-IBA event held last month. He added: “The involvement and active participation of the government and regulators is required so people put money in deposits, which helps the economy, rather than putting the money into the market where risks are involved”.

That the deposit-side of the story has still some catching up to do is evident from another detail.

Banks are tapping certificates of deposit (CD) – an instrument issued to raise funds from large investors – in a big way. These issuances were nearly Rs 10 trillion in FY24 from Rs 2.90 trillion in FY22, a jump of 3.3 times. In Q1 FY25, CD issuance increased by 66 per cent to Rs 2.65 trillion compared to Rs 1.60 trillion in Q1 FY24, said SBI Research in a report. Banks were also active in the securitisation market: Volumes touched Rs 8,500 crore in the Q1 FY25; it was Rs 10,000 crore in FY24. (Securitiation is selling assets to generate liquidity.)

Incidentally, the merger of the HDFC twins also had a key impact on deposit demand over the last couple of years due to reserve requirements on a higher base. Further, given that the maturing bonds of HDFC Ltd need to be substituted by deposits at the Bank, this demand pressure continues.

Now, why can’t banks raise deposit rates to tide over their slack growth?

“You have to see it from banks’ margin point of view. The recent curbs placed on unsecured lending and better working capital management by companies have resulted in yield pressures. Also, when the rate-reduction cycle starts, the loan book will be re-priced way ahead of the deposit book,” says Gurumurthy R, independent director, Arka Fincap. He has a different take on the CD ratio though: It has gone up in recent years to the high seventies even as the average capital adequacy ratio in the banking system has moved northwards by 6-7 per cent (to the mid-teens) over the decade. “Effectively, more lending is covered by equity as against deposits; which is not a bad outcome at all.”

 

Relooking CRR

Are there innovative ways to look at the CRR?

“It (CRR) can be made of the SLR (a special carve out) and banks can earn interest if it has to be kept. It is idle money for the system, not put to any use as of now,” says Madan Sabnavis, chief economist, at Bank of Baroda.

Ravi Duvvuru, partner at Duvvuru & Reddy LLP and member of the advisory group to the Regulatory Review Authority 2, says it should be remembered that deposit insurance limits are still low in India as compared to other countries. That the RBI has to factor in financial stability risks and monetary policy transmission issues before making any change in the CRR framework. Instead of re-looking at the framework, Duvvuru recommended that CRR balances be considered for the liquidity coverage ratio.” The LCR is a measure that requires banks to maintain a certain amount of high-quality liquid assets. “This would help the liquidity position of banks to support credit growth while keeping monetary policy objectives in place”.

The whiff of cash is always interesting.