Daily Current Affairs : 16-September-2023

The Reserve Bank of India (RBI) recently unveiled its plan to gradually phase out the Incremental Cash Reserve Ratio (I-CRR), an important tool in managing liquidity in the Indian banking system. This move by the RBI holds significant relevance to India’s economic landscape, falling under the purview of GS III: Indian Economy. In this essay, we will explore the dimensions of this development, including the RBI’s phased approach, an understanding of I-CRR, its relationship with Cash Reserve Ratio (CRR), and its application during demonetization. We will also delve into the broader context of monetary policy instruments at the RBI’s disposal.

RBI’s Phased Implementation of I-CRR Discontinuation

Smooth Transition

The RBI has adopted a cautious and well-structured approach to discontinuing I-CRR. The rationale behind this phased implementation is to prevent abrupt disruptions in liquidity, which could adversely affect the banking system. This approach ensures a smooth transition from the existing I-CRR framework to a more flexible liquidity management strategy.

Three Stages

The RBI’s plan involves three distinct stages. In the first and second stages, 25% of the impounded funds from banks will be released, providing incremental liquidity to the banking system. In the final stage, the remaining 50% of the balance will be released. This gradual progression is designed to accommodate the increasing credit demands anticipated during the upcoming festival season, ensuring banks have adequate liquidity.

Understanding Incremental Cash Reserve Ratio (I-CRR)

Introduction of I-CRR

I-CRR was introduced on August 10, 2023, requiring banks to maintain a 10% reserve on the increase in their Net Demand and Time Liabilities (NDTL). NDTL represents the difference between a bank’s total demand and time liabilities (deposits) and the deposits it holds as assets with other banks.

Purpose of I-CRR

I-CRR was initially introduced as a temporary measure to manage excessive liquidity in the banking system. Factors contributing to this surplus liquidity included demonetization of Rs 2,000 banknotes, RBI’s surplus transfer to the government, increased government spending, and capital inflows. Excessive liquidity posed risks to both price and financial stability, necessitating effective liquidity management.

Impact on Liquidity Conditions

I-CRR was expected to absorb over Rs 1 lakh crore of excess liquidity from the banking system. Initially, the banking system faced liquidity deficits due to I-CRR, which were exacerbated by GST-related outflows and central bank interventions. However, over time, liquidity conditions stabilized, demonstrating the effectiveness of this tool in managing liquidity.

Cash Reserve Ratio (CRR)

Applicability of CRR

Cash Reserve Ratio (CRR) is the percentage of cash that banks are required to keep in reserves relative to their total deposits. All banks in India, except Regional Rural Banks (RRBs) and Local Area Banks (LABs), must deposit CRR funds with the RBI. RRBs and LABs, however, are exempted from maintaining CRR with RBI but must hold it within themselves in the form of cash, gold, or approved unencumbered securities.

Usage of CRR Funds

Banks are prohibited from lending CRR funds to corporates or individual borrowers, and these funds cannot be used for investment purposes. CRR ensures the security of a portion of a bank’s deposits with RBI in case of emergencies, making this cash readily accessible to customers when they request their deposits.

Role in Inflation Control

CRR plays a vital role in controlling inflation. When there is a threat of high inflation, RBI increases the CRR requirement, forcing banks to hold more money in reserves, thus reducing the money available for lending and curbing excess liquidity in the economy. Conversely, when there is a need to stimulate economic growth, RBI lowers the CRR, allowing banks to provide loans for investment purposes.

Applicability to Non-Banking Financial Companies (NBFCs)

It’s important to note that while commercial banks are required to maintain CRR, Non-Banking Financial Companies (NBFCs) are not subject to this requirement, which differentiates their regulatory framework from that of traditional banks.

The Use of I-CRR During Demonetization: Why RBI Chooses It

Addressing Sudden Liquidity Influx RBI turns to I-CRR in cases of abrupt surges in liquidity, as witnessed during the demonetization period in November 2016. I-CRR allows RBI to manage the specific issue of excess liquidity without disrupting other components of its monetary policy. This precision is crucial during unique events like demonetization.

Speed of Implementation I-CRR can be swiftly implemented. In situations where there is a sudden liquidity surge, such as the return of demonetized currency notes, the central bank may require a tool that can be put into effect promptly.

Temporary Nature I-CRR is typically a temporary measure introduced to absorb excess liquidity temporarily. Once the liquidity situation stabilizes, it can be phased out. In contrast, other tools like Repo Rate, Statutory Liquidity Ratio (SLR), etc., may have a longer-term and slower impact on liquidity.

Effective Management of Unique Situations The use of I-CRR during demonetization allowed RBI to efficiently manage the influx of returned currency notes, preventing unintended consequences on inflation, monetary stability, and economic growth.

Monetary Policy Instruments at RBI’s Disposal

Qualitative Instruments

  • Moral Suasion: Non-binding persuasion and communication to influence banks’ lending and investment decisions.
  • Direct Credit Controls: Regulation of credit flow to specific sectors or industries through RBI directives or credit limits.
  • Selective Credit Controls: Targeted measures focusing on specific types of loans, such as consumer credit, to manage demand in specific economic areas.

Quantitative Instruments

  • Cash Reserve Ratio (CRR): A portion of a bank’s deposits held as cash reserves with the RBI, affecting the funds available for lending.
  • Repo Rate: The interest rate at which RBI lends short-term funds to commercial banks, influencing their borrowing costs and lending rates.
  • Reverse Repo Rate: The interest rate at which banks can park excess funds with the RBI, setting a floor for short-term interest rates and managing liquidity.
  • Bank Rate: The rate at which RBI provides long-term funds to banks and financial institutions, impacting long-term money market rates.
  • Open Market Operations (OMOs): RBI’s buying or selling of government securities in the open market, affecting money supply and banking system liquidity.
  • Liquidity Adjustment Facility (LAF): Comprises the repo rate and reverse repo rate, used by banks for short-term liquidity needs and daily liquidity management.
  • Marginal Standing Facility (MSF): The rate at which banks can borrow overnight funds from RBI using government securities as collateral, serving as a secondary funding source.
  • Statutory Liquidity Ratio (SLR): A percentage of a bank’s net demand and time liabilities (NDTL) to be maintained in approved securities.

Important Points:

RBI’s Phased Implementation of I-CRR Discontinuation:

  • RBI plans to eliminate Incremental Cash Reserve Ratio (I-CRR) gradually.
  • Three stages: 25% of impounded funds released in first and second stages, remaining 50% in the third.
  • Ensures liquidity for banks during the festival season.

Understanding Incremental Cash Reserve Ratio (I-CRR):

  • I-CRR introduced to manage excess liquidity.
  • It requires banks to maintain 10% reserve on the increase in Net Demand and Time Liabilities (NDTL).
  • Initial impact caused liquidity deficits but eventually stabilized.

Cash Reserve Ratio (CRR):

  • CRR is a percentage of cash banks must keep in reserves.
  • Applicable to all banks except Regional Rural Banks (RRBs) and Local Area Banks (LABs).
  • CRR funds cannot be lent or used for investment; they secure customer deposits.

I-CRR During Demonetization: Why RBI Chooses It:

  • I-CRR used during sudden liquidity surges, like demonetization.
  • Swift implementation; temporary measure.
  • Efficiently manages influx of returned currency notes.

Monetary Policy Instruments at RBI’s Disposal: Qualitative Instruments:

  • Moral Suasion, Direct Credit Controls, Selective Credit Controls influence bank decisions.

Quantitative Instruments:

  • CRR affects lending capacity.
  • Repo Rate, Reverse Repo Rate influence borrowing costs.
  • Bank Rate impacts long-term money market rates.
  • Open Market Operations (OMOs) affect money supply.
  • Liquidity Adjustment Facility (LAF) manages short-term liquidity.
  • Marginal Standing Facility (MSF) provides overnight funds.
  • Statutory Liquidity Ratio (SLR) requires maintaining approved securities.
Why In News

The Reserve Bank of India (RBI) has unveiled its strategic roadmap for phasing out the Incremental Cash Reserve Ratio (I-CRR), a move aimed at gradually freeing up the funds held by banks as part of this reserve requirement in a systematic manner. This gradual elimination process is designed to ensure a smooth transition for financial institutions and maintain stability in the banking sector throughout the implementation.

MCQs about I-CRR and CRR in Indian Banking

  1. What is the primary purpose of the Incremental Cash Reserve Ratio (I-CRR) introduced by RBI?
    A. To encourage banks to lend more to individuals and corporates.
    B. To manage excess liquidity in the banking system.
    C. To increase the interest rates on loans.
    D. To stimulate economic growth.
    Correct Answer: B. To manage excess liquidity in the banking system.
    Explanation: The I-CRR was introduced by RBI to control and manage excess liquidity in the banking system.
  2. What is the primary function of Cash Reserve Ratio (CRR) in the banking system?
    A. To generate interest income for banks.
    B. To encourage banks to invest in government securities.
    C. To maintain a portion of deposits as reserves with RBI.
    D. To promote lending to the corporate sector.
    Correct Answer: C. To maintain a portion of deposits as reserves with RBI.
    Explanation: CRR requires banks to maintain a portion of their deposits as reserves with RBI to ensure the security of customer deposits and manage liquidity.
  3. When might the RBI choose to implement the Incremental Cash Reserve Ratio (I-CRR)?
    A. During periods of economic recession.
    B. To stimulate economic growth.
    C. In cases of abrupt surges in liquidity.
    D. During demonetization events.
    Correct Answer: C. In cases of abrupt surges in liquidity.
    Explanation: The RBI uses I-CRR during sudden liquidity surges, such as during demonetization or other unique events.
  4. Which of the following is NOT a quantitative monetary policy instrument used by RBI?
    A. Cash Reserve Ratio (CRR)
    B. Repo Rate
    C. Selective Credit Controls
    D. Statutory Liquidity Ratio (SLR)
    Correct Answer: C. Selective Credit Controls
    Explanation: Selective Credit Controls are a qualitative instrument, while the other options are quantitative monetary policy instruments .

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