RBI Policy: Incremental CRR

Subject: Economy

Section: Monetary Policy

In News: RBI announced that all scheduled banks will have to maintain a 10% incremental cash reserve ratio (ICRR) from August 12.

Key Points:

The ICRR of 10% will be on the increase in the banks’ net demand and time liabilities (NDTL) between May 19, 2023, and July 28, 2023.
The measure is intended to absorb the surplus liquidity generated by various factors including the return of ₹2,000 notes to the banking system.
- The recent jump in liquidity was aided by a pickup in government spending, sustained foreign inflows, and the effect of high-value currency withdrawal.
- RBI’s foreign exchange purchases in response to a higher-than-expected Balance of Payments (BoP) surplus have also added to the rupee liquidity
RBI Governor noted that it is a temporary measure for managing the liquidity overhang along with helping reduce inflation.
The liquidity may be released before the festive season.
The net impact of the incremental CRR, as per RBI’s internal calculation, will be a little over ₹1 lakh crore. Normally banks can park excess funds through the standing deposit facility (SDF) or reverse repo. With ICRR that much interest loss will be experienced by the banks
The effective CRR for the period concerned now becomes 14.5% (4.5%+10%).

Effect of ICRR:

Shares of banks fell after the announcement with the Bank Nifty index falling over 1%.
A critical reason behind weakness in banking stocks is that the RBI’s decision on ICRR is expected to cause interest loss for banks
The immediate impact of RBI absorbing liquidity via ICRR will be an increase in the money market rates for borrowers including NBFCs or corporates.
Banks will face lower profit margins as it will affect their Net interest margin NIMs (3-4 bps).
Tighter liquidity conditions in the banking system could lead to some upward pressure on both credit and deposit rates.

What is standing deposit facility (SDF)?

The standing deposit facility is a collateral-free liquidity absorption mechanism implemented by the RBI with the intention of transferring liquidity out of the commercial banking sector and into the RBI.
It enables the RBI to take liquidity (deposits) from commercial banks without having to compensate them with government securities.
The SDF is significant because it was created to give the Reserve Bank the ability to handle unusual circumstances when it must absorb large quantities of liquidity.
In the past, the RBI has experienced issues with liquidity absorption due to events like the global financial crisis and demonetization.
SDF allows banks to deposit money with the RBI on an overnight basis. But the RBI has the option, should the need arise, to absorb liquidity for longer tenors under the SDF with proper pricing. The SDF scheme is open to all participants in the liquidity adjustment facility (LAF).

How is SDF different from reverse repo facility?

RBI employs reverse repo rate and SDF to remove excess liquidity from the system. In contrast to SDF, reverse repo operations require the RBI to deposit collateral in the form of government assets in order to borrow money from commercial banks.
Under the current liquidity system, the Reserve Bank has discretion over liquidity absorption through reverse repos, open market operations, and the cash reserve ratio. SDF, on the other hand, will allow banks to store surplus liquidity with the Reserve Bank at their discretion.