The Finance Ministry (referred to as ‘Ministry’ hereafter), according to media reports, wants the Reserve Bank of India (RBI) to pay interest on the balances of commercial banks held under the Cash Reserve Ratio (CRR). The RBI is reported to have said that it would then run into a loss. In this connection, the Ministry wants to scrutinise its balance sheet to find out whether the claim is justified. An uncharitable view taken by the media is that the Ministry is getting back at the Bank in response to the latter not agreeing to a reduction in the interest rates in the recent policy review.

Interest on CRR balances

It is surprising that the government wants the RBI to pay interest on the balances under CRR, knowing fully well that it would adversely affect the transfer of net income from the central bank to it at the end of the year (Rs 16,000 crore last year). So much for fiscal consolidation!

The reasoning that it would help in reducing the lending rates of banks is not convincing. In a way, the RBI’s transfer of its surplus income assists the government in bearing the interest rate subvention that it is providing to selected sectors.

The question of interest payment was debated for quite some time. The RBI pointed out that it diluted its tightening monetary policy measures. The law was amended to abolish it after giving considerable thought.

I have argued that CRR is not a repressive tax, as claimed by the Western economists but a fee (Nothing for banks to gripe about, Business Line , September 11).The banking system benefits from the licence it gets from the central bank to carry on business, because it mints money through the working of the multiplier.

It is a form of seigniorage enjoyed by the system similar to what the government gets through the printing of currency notes. Hence, the question of paying interest on CRR balances does not arise, as the system is amply rewarded by the power to create money. Obviously, in such matters while the RBI looks at the system, individual banks think in terms of their bottomline.

Autonomy question

During the time when I. G. Patel was Governor (December 1, 1977 to September 15, 1982) there was a reference from the Ministry forwarding a parliamentary question (if I remember well) suggesting that the Annual Report of the RBI might be submitted to Parliament instead of Government.

At the instance of the Secretary’s Department, I examined the issue from the broader point of view of central bank autonomy, taking into account the position obtaining in other countries.

I pointed out that even in the US, autonomy had been eroded in that the Chairman of the Fed had to appear before a Committee of the Congress to justify monetary policy. What was more interesting was that the US Fed had already come to be subjected to public audit with the exemption of its open market operations.

The RBI should trace and study the relative note in its archives with the remarks of the Governor.

It should be prepared for the day when some smart kid in the North Block suggests that it, too, be audited by the Comptroller and Auditor General (CAG) like others in the public sector.

It is the only government body in the country now that has its accounts audited by private auditors and not by CAG.

The position in US

It may indeed be surprising for readers to know that for a long time in the US the government wanted the central bank to pay interest to banks on reserves, but the Fed resisted it saying that it would affect the transfer of surplus income to the Treasury. The law was silent on the matter.

In the wake of the Lehman crisis the Fed agreed to pay interest at 0.25 per cent to help banks. However, it has not helped in raising bank lending.

Banks’ total (seasonally adjusted) cash reserves in the Fed amounted to $1.5 trillion on October 31, of which 93 per cent was excess. Banks’ borrowings from the Fed were a minuscule $1.4 billion.

Besides the reluctance to lend, either due to risk aversion or lack of demand in an atmosphere of pessimism on the future of the economy, banks find the interest of 0.25 per cent on total balances with the Fed more attractive than investment in Treasury Bills (TBs).

The yields on TBs of 4 weeks, 13 weeks, 26 weeks and 52 weeks were 0.06 per cent, 0.09 per cent, 0.15 per cent and 0.17 per cent, respectively, as on November 1, 2012.

During October 2012, the Federal Funds Rate ranged between 0.06 per cent and 0.5 per cent, providing arbitrage opportunities at the lower levels.

The solution may be the non-payment of interest on excess reserves. The Fed Chairman once commented on the possibility of the interest rate on reserves becoming another monetary instrument!

Whether the payment of interest on CRR balances will help in reducing the lending rates or not is a moot question at a time when the non-performing loans and restructured assets are on the rise, calling for increased provisioning.

The banks look at every issue from the point of view of the spread and would like to avail of every opportunity to increase it. There is always the moral hazard of good borrowers paying for the delinquency of the bad ones.

(The author is a Mumbai-based economic consultant. >blfeedback@thehindu.co.in )

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