RBI’s cash reserve stunner was a V3R prod for banks

The market believes that the incremental cash reserve ratio was a strong signalling mechanism used by RBI to send the message that it was not pleased with the response of banks to variable reverse repo rate auctions.
The market believes that the incremental cash reserve ratio was a strong signalling mechanism used by RBI to send the message that it was not pleased with the response of banks to variable reverse repo rate auctions.


  • RBI’s shock imposition of an incremental cash reserve ratio was a sharp message for lenders that preferred to sit on excess funds instead of joining variable reverse repo rate (V3R) auctions.

The Reserve Bank of India (RBI) has always maintained that it has several instruments at hand to address issues relating to monetary conditions. While market sentiment is guided largely by its policy rate actions, it has often surprised by using these tools from time to time. There was, for instance, the innovative Standing Deposit Facility (SDF) introduced to absorb overnight liquidity without involving government securities (GSecs), which made it better than its overnight reverse repo window.

More recently, RBI’s incremental cash reserve ratio (ICRR) was a master-stroke; it shocked the market and hence was potent. This was an instrument long forgotten as being part of the monetary policy toolkit, although it had resurfaced during demonetization when banks were inundated with deposits. A 100% ICRR was imposed in November 2016 and withdrawn subsequently once conditions stabilized. Back then, the situation was quite singular, as the system was in a state of turmoil with people rushing to deposit their currency notes. However, it was not a systemic shock that led to its recent deployment. Rather, it was for its utility as a conventionally unconventional regulatory tool when ‘all else fails.’

The market was taken by surprise. It was believed that liquidity management would be done through RBI’s variable rate repo (V2R) and variable reverse repo rate (V3R) auctions, as this was emphasized repeatedly by it as part of its efforts to guide liquidity. The V2R auctions were meant to provide liquidity and V3R to absorb it from the system through tenures that could go up to 28 days. The two tools were quite innovative, as they came as improvements over standard open market operations (OMOs).

An OMO is used by RBI to either buy or sell GSecs from or to banks in order to supply or absorb liquidity. OMOs, however, have a strong element of permanency in the sense that they involve transactions that result in a permanent removal or provision of liquidity as securities are bought and sold. In the case of V2R or V3R, however, there is only temporary liquidity infusion or absorption.

The market believes that the ICRR was a strong signalling mechanism used by RBI to send the message that it was not pleased with the response of banks to V3R auctions. It may be recalled that RBI had been carrying out V3R auctions for longer durations of 14 or 28 days. However, even when liquidity was in surplus, bank participation was low. The reason was quite straight-forward. Banks did not want to lock-in funds for durations so long and preferred parking their surplus funds up to 4 days. Once funds are locked in for 28 days, say, then any sudden shortage in liquidity would force them to borrow through RBI’s marginal standing facility (MSF) at 6.75% (the current rate) or from the call market at varying and potentially higher rates than they get at V3R auctions. Such a liquidity crunch could arise from bulky tax payments or a sudden increase in credit demand. This made the V3R less attractive.

A way out for RBI was to impose a ICRR that at one stroke impounded 1 trillion. While this served the central bank’s liquidity absorption goal, banks stood to lose, as the mandatory cash reserves of banks held with RBI do not earn interest. If these surplus funds had been invested in V3R for 14 days, banks could have earned up to 6.49%, the cut-off rate set through these auctions. This interest loss served as a strong signal to the market to take cues from the central bank’s moves, else it would take stern measures to regulate liquidity that they may find punitive.

Data shows that surplus liquidity, which was above 2 trillion on a daily basis, fell sharply after the ICRR was invoked to less than 1 trillion, and also, on occasion, to a deficit, which meant banks had to borrow from the MSF window.

The central bank has now announced the ICRR’s withdrawal in three tranches. This isn’t a surprise, since liquidity has normalized. Interestingly, on the day of the withdrawal announcement, the V3R auction for 28 days again elicited a weak response, with banks bidding to park just 186.7 billion as against the notified amount of 500 billion. They were still not willing to deploy their lower surpluses, given the advance tax payments that were due. During this period of one month, short-term bond yields were largely stable, while the yield on the 364-day T-Bill went up by up to 10 basis points and on the 10-year bond by around 5, implying that there was little market disruption.

One justification for mopping up excess liquidity is that such surplus money stokes inflation. This argument can be contested because if there is 2 trillion being invested by banks in, say, the SDF or V3R (for shorter durations), there is no credit being generated. Still, sentiment does get impacted on account of such surpluses, as inflationary expectations can become self-fulfilling.

So what is one to make of all this? The message is that besides OMOs and V3R auctions, there is one more instrument that can be selectively used to manage liquidity. Second, banks would be better advised to lock into longer-term V3R auctions where they can earn 6.49% rather than nil on ICRR. Third, we can expect RBI to resort to temporary measures to manage liquidity conditions that do not warrant the use of OMOs. The cash reserve ratio (CRR) may be a permanent feature of banking, but an ICRR that is temporary in nature could also serve the central bank’s purpose if need be.

Madan Sabnavis is chief economist at Bank of Baroda and author of ‘Corporate Quirks: The Darker Side of the Sun’

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