Source: The post CRR below 4% might be risky for India’s banking system has been created, based on the article “Managing liquidity: No case for CRR cuts” published in “Business Standard” on 22nd January 2025
UPSC Syllabus Topic: GS Paper3- Economy-Banking
Context: The article explains the current liquidity deficit in India’s banking system, the role of the CRR in managing liquidity, and why further reduction in CRR is risky. It suggests alternative methods to address liquidity without reducing CRR below 4%.
Why is there a liquidity deficit in the banking system?
- The banking system entered a liquidity deficit in December 2024, with the shortfall reaching ₹2.36 trillion by January 20, 2025.
- Government cash balances with the RBI increased, reducing liquidity.
- In December 2024, the RBI reduced the cash reserve ratio (CRR) in two tranches of 25 basis points each, bringing it to 4% of net demand and time liabilities (NDTL). This move released ₹1.16 trillion into the banking system. However, bankers have since suggested further CRR reductions, which require caution.
- Net surplus durable liquidity fell from ₹4.20 trillion (July 26, 2024) to ₹64,350 crore (December 27, 2024).
- Forex reserves dropped by $14 billion between December 27, 2024, and January 10, 2025, likely causing a durable liquidity deficit.
What is the role of the CRR in liquidity management?
The CRR serves two main purposes:
- Stabilizing short-term interest rates:
- CRR balances help banks settle payment obligations and reduce overnight liquidity pressure.
- It mitigates volatility in the inter-bank call money rate.
- Addressing sudden liquidity shocks:
- CRR is a tool to address liquidity needs quickly, especially during financial upheavals, as seen during the 2008 financial crisis and the Covid-19 pandemic.
Why should the CRR not be reduced further?
- CRR is already at a critical level (4%): Historically, the CRR has not fallen below this level except during crises, such as the COVID-19 pandemic in 2020, when it was briefly reduced to 3%.
- Temporary liquidity issues: The current deficit of ₹2.36 trillion is partly due to short-term factors like increased government cash balances and RBI’s forex interventions.
- Alternative tools exist: The RBI can use the Liquidity Adjustment Facility (LAF) to address short-term liquidity needs instead of reducing the CRR. Additionally, durable liquidity can be injected through Open Market Operations (OMOs), though cautiously, as large OMOs may distort bond yields and increase interest rate volatility.
- Market stability risks: Reducing CRR further could destabilize short-term interest rates and reduce banks’ flexibility in managing reserves.
Question for practice :
Evaluate why reducing the CRR below 4% might be risky for India’s banking system, considering the current liquidity deficit and alternative tools available.
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