Cash reserve ratio has lost its relevance

The cash reserve ratio (CRR) has lost all relevance, especially after the stringent rules laid down under Basel III norms. Which is why the country’s topmost commercial banker is reported to have advocated abolishing the CRR.

Unfortunately, her timely and sage advice does not seem to have been considered by the authorities.

CRR, as widely understood, is the amount of cash held by commercial banks in relation to their deposit liabilities.

Cash should include cash in the bank’s vaults and deposits with the Reserve Bank of India. In India, cash, for CRR purposes, means only the deposits with the RBI and not cash held in banks’ vaults. Deposit liabilities would generally mean deposits held by the public with banks.

In India, the RBI has included virtually all external liabilities, including FCNR (B) and NRE deposits (payable in foreign currency) and call money borrowings, etc. Commercial banks are expected to maintain 4 per cent of their total outside liabilities, excluding some dues to the RBI and a few other government agencies, in the form of deposits with the RBI.

The two original objectives for which CRR is stipulated worldwide were: (a) banks should have sufficient cash at all times to meet the payment demands of their deposit customers; and (b) it is a tool of monetary policy to control money supply in the economy.

Both the objectives are not relevant these days. In fact, central banks of countries such as the UK, Canada, Australia, New Zealand and Sweden reportedly do not prescribe CRR.

CRR as a bulwark against a ‘run’ on a bank is an outdated concept. However, a few decades ago, there were reports of depositors clamouring for withdrawal of money from a commercial bank in India. The bank was stable and sound, but some rumours allegedly spread about its financial health.

The RBI acted promptly and had its own currency chests and those of State Bank of India kept open 24/7 on all days, including Sundays, and supplied cash to the affected bank. The panic subsided in a short period and normalcy was restored.

In a panic situation, the own CRR of a bank would be of no use. It could, at best, meet the demands of public depositors to the extent of about 10 per cent (depending on the component of non-public deposits in the total portfolio). Usually, depositors would demand their money back prematurely only when they suspect the financial soundness of a bank.

The financial strength of a bank in India is monitored keenly by the RBI. Of course, there are always unscrupulous bankers who mask the financial weakness of a bank using various ruses.

In such a situation, the RBI has always acted swiftly, either by reassuring depositors or by ordering a moratorium on withdrawals by depositors of the bank concerned and engineering a merger with a sound bank.

So far, the RBI has always ensured that the depositors of a financially broke commercial bank do not suffer.

CRR could thus be justified only in relation to the second objective, namely, as an instrument to control money supply in the economy.

This is based on the notion that banks create money with the deposits. For example, when a bank gets a deposit of ₹100 and lends it to a business, the latter uses the money to pay for expenses. The recipient of the money, in turn, deposits the money back into the banking system and boosts money supply in the economy. By impounding a portion of the deposits as CRR, the capacity of banks to create additional money is curtailed.

But the extent of CRR in many countries is less than 5 per cent and central banks have not resorted to increasing this percentage to control money supply in times of need. They resort to other tools such as open market policies to mop up surplus money supply.

Another related issue is that the capacity of the banking system to lend has been, for long, determined by the ability to attract deposits from the public, irrespective of basic financial strength as represented by the equity capital base.

This led to some international banks collapsing under the weight of their debt (deposit) burden when their loans turned sour.

Strangely, till the early 1990s, there was no minimum capital requirement for banks in relation to their deposits: on the other hand, banks insisted that borrowers had some minimum capital vis-à-vis borrowings. The dichotomy was sought to be resolved by the rules developed by the Bank for International Settlement (BIS) based in Basle, Switzerland. All countries have adopted these rules, commonly known as the Basel norms .

What started as the need for minimum capital for a given level of borrowings (mainly deposits) morphed into a ratio of capital to assets of the banking system. Thus evolved CRAR or capital to risk-weighted assets ratio.

Since many international experts got into the act, they made it as complex as possible. The word ‘capital’ was stretched to include even a category of loans.

As for assets, the full amount was not taken, but only a portion depending on their riskiness. And the risk of loans (the major component of assets) was measured either by credit rating agencies or by the banks themselves.

The rating agencies’ capacity and integrity was severely called to question during the financial meltdown in advanced countries of the West during 2007-08. Reliance on a banks’ own risk assessment for calculating the capital base can never be foolproof.

The situation made even The Economist claim, in exasperation, in April 2014, “Although elegant in theory, it (CRAR) proved badly flawed in practice.”

After the events of 2007-08, the BIS decided to superimpose one more requirement on international banks under Basel III norms.

A new ‘leverage ratio has been introduced to take effect from 2017-18. The Economist endorsed this concept, saying “Leverage is a simpler, if cruder, measure of banks’ riskiness’.”

The RBI has asked banks in India to adopt the leverage ratio. Banks should have a minimum equity capital of 4.5 per cent of their total assets and off-balance sheet items such as guarantees, letters of credit, etc by 2017-18.

This means the conventional debt-equity ratio of a commercial bank should not be higher than 21:1. Although this is much higher than what banks insist on with regard to business concerns borrowing from them — a maximum of about 4 — the fact is that banks and financial institutions do have larger borrowings and debt component would include contingent liabilities.

After the introduction of leverage ratio, the capacity of the banking system to inject additional money into the economy would beseverely circumscribed by the aggregate equity capital of all banks in an economy.

To conclude, CRR is well past its ‘sell by’ date and by abolishing it, the RBI will save the time and manpower of various commercial banks.

The writer was formerly deputy managing director, SBI