MUMBAI: In a significant move to try and combat rising interest rates, the government has restored interest payments on the bank balances that commercial banks need to keep with the Reserve Bank of India (RBI). The level of this cash reserve, stipulated by RBI from time to time, is the cash reserve ratio (CRR).
This has been done with a view that the banks would then pass on some of that interest benefit to their consumers, both individuals as well as corporations, thus reducing borrowing costs, a finance ministry official, who did not want to be named, told Mint.
But the move is unlikely to pay off unless the RBI plays along. Sources close to the central bank, who didn’t want to be named, said the bank would not pay interest on the CRR balance as it believes the payment is no longer mandatory.
Banks are required to keep 5.5% of their deposit liabilities with the central bank as a cash reserve. Under the law, however, the minimum cash balance to be kept with RBI is 3% and banks earn interest over and above this. This means that they are eligible to earn interest on the additional 2.5% of their cash reserves parked with RBI.
Until last June, the commercial banks were earning a 3.5% interest rate on that part of the cash reserve above 3% kept with RBI.
But the government amended the Reserve Bank of India Act in June and abolished the 3% minimum cash balance floor as well as the provision of interest payment on the remaining cash balance.
However, on 9 January, while formally notifying the amendment, a process by which the amendment comes into effect, the government quietly dropped the relevant section of the Act that deals with CRR. So, according to the government, the 3% floor of CRR stays as does the provision for interest payment on the remaining cash balances kept with RBI.
Prima facie, the government’s decision could boost the banks’ interest income and thus profitability. Finance ministry sources say the change in thinking was spurred by the idea that consumers will benefit as banks will likely pass on some of the interest income to their own borrowers.
The banking system has a deposit base of about Rs24,00,000 crore. At a 3.5% interest rate on the deposits—Rs60,000 crore will be eligible for interest—the banking industry will earn more than Rs2,000 crore interest on their cash balance kept with RBI.
“This will not make a huge impact on their balance-sheet, but certainly give them a cushion while pricing their loans,” said a source familiar with the matter.
According to sources, the government wanted to abolish the floor for CRR, but never wanted to deny payment of interest to the banks. Since the amended RBI Act did both, the government had no option but to use its discretion to drop the whole item while notifying the amended Act. As a result, until such time the government notifies the amendment specifically in relation to cash reserve ratio, the 3% floor for CRR and the provision for interest payment will remain. “We are not in a hurry to notify that,” finance ministry sources said.
The RBI, however, has not been in favour of paying any interest on cash balances as it feels that the interest payments release part of the cash balance that is kept with the central bank. The RBI is of the opinion that this process actually reduces the effectiveness of CRR, which is being used by the bank as a monetary management tool.
Traditionally, RBI raises the cash reserve requirement to tighten the monetary policy. In December, RBI hiked banks’ CRR from 5% to 5.5% and sucked out Rs13,000 crore from the banking system.
With RBI privately baulking, officials at the finance ministry are questioning the central bank’s logic.
“On what basis can the central bank stop interest payment? Even if it wants to tighten liquidity now, what about interest payment for the cash balance kept last year between June and December?” asked the finance ministry official.
An RBI spokesperson did not comment on the matter.
RBI has been paying interest on the additional cash balances (beyond the minimum 3%) since 1973.
According to the terms of Section 42(1) of the RBI Act, RBI could prescribe cash balance for banks between 3% and 20% of their deposits. The cash balance has all along been viewed as a punitive tax on the banking system, adversely impacting the profitability of banks.