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Should CRR be phased out?

An analyst asks whether CRR is necessary

DH Pai Panandiker
BANKERS have always looked at cash reserve ratio (CRR) with scepticism. 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 KC 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 US and EU do not change the reserve requirements and liquidity is regulated through open market opera-
tions. 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 US 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.
DH Pai Panandiker is president of the RPG Foundation.