Why CRR should not be abolished

There is a huge tussle of words going on between the Chairman of SBI and the Deputy Governor of RBI on whether the CRR (Cash Reserve Ratio) is needed in India.

Scheduled Commercial Banks are required to maintain with RBI an average cash balance, the amount of which shall not be less than three percent and not exceed twenty percent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis. At present, effective from the fortnight beginning August 31, 2012, the rate of CRR is 4.75 per cent of the NDTL.

With RBI tightening the noose around banks to control liquidity in the market and ease inflation through its monetary policies and strict regulatory guidelines, banks are looking for alternative methods of increasing their funds. And CRR as a policy seems to be the easiest target. 

A higher CRR means banks have to park more money with the RBI and have lesser amount at their disposal to lend and invest. This is sure to result in a liquidity crunch. In spite of depositing sizeable amounts of money in the RBI's vault, banks receive zero interest. 

CRR as a monetary policy tool was devised to control liquidity in the system. Earlier, RBI used to pay interest on CRR in the range of 7-13% (16.5 percent by 1992) and gradually brought it down to 3%. CRR as a policy was not very effective then. It was only in 2007, that RBI decided to bring the interest rate to zero and since then it has been far more effective.

If interest is paid on CRR then it would lead to infusion of more cash into the system, which would make the CRR policy crippled and totally useless.

On the other hand, if RBI heeds to the demands and pays an interest on CRR, then it would surely hike the CRR to adjust the increased liquidity. This would again lead to further crunch in the liquidity situation.

So, before demanding the abolition of CRR altogether banks should consider the serious repercussions this may have on the overall economy and let RBI decide on the future course of action.