Public Sector Banks Lending, Demonetisation and RBI Norms: an adumbration

How far is it true that in the current scheme of things with stressed assets plaguing the Public Sector Banks on one hand and the recent demonetisation rendering bills of Rs. 500 and Rs. 1000 legally invalid has fuelled once again the debate of these public banks with excess deposits or surplus liquidity in their kitty are roaring to go on a relentless lending, thus pressurising the already existing stressed assets into an explosion of unprecedented nature hitherto unseen? Now, that is quite a long question by a long way indeed. Those on the civil sector spectrum and working on financials leave no stone unturned in admitting that such indeed is the case, and they are not to be wholly held culpable for India’s Finance Minister has at least on a couple of times since the decision to demonetise on 8th November aided such a train of thought by calling upon banks to be ready for such lending to projects, which, if I were to speculate would be under project finance and geared towards the crumbling infrastructure of the country. Assuming if such were the case, then, it undoubtedly stamps a political position for these civil actors, but it would hardly be anything other than a cauldron, since economics would fail to feed-forward such claims.

So, what then is the truth behind this? This post is half-cooked, for it is as a result of an e-mail exchange with a colleague of mine. The answer to the long question above in short is ‘NO’. Let us go about proving it. Reserve Bank of India in no different manner has been toying the switch of a flip-flop in policy makeovers in the wake of demonetisation. But, what the Central Bank and the Regulator of India’s monetary policy has done increase Cash Reserve Ratio (CRR) by 100% of net demand and time liabilities (NDTL),  which is the difference between the sum of demand and time liabilities (deposits) of a bank and the deposits in the form of assets held by another bank. Formulaically,

NDTL = demand and time liabilities (deposits) – deposits with other banks.

The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy. towards the end of November, the RBI hiked the incremental CRR by 100%. The incremental cash reserve ratio (CRR) prescribes the reserve ratio based on the extent of growth in resources (deposits). It im­mobilises the excess liquidity from where it is lodged (the banks which show high growth), unlike the average ratio which impounds from the banks which are slow-growing as well as banks which are fast-growing. It also avoids the jerkiness of the average ratio. This means it has literally mopped the surplus liquidity that has gone into the banks as deposits in the wake of demonetisation. So, banks do not have capital to lend.  There is a formula on how much a bank could lend. It is:

Lending = Deposits – CRR – SLR (statutory liquidity ratio) – provisioning

; SLR is the amount of liquid assets such as precious metals (Gold) or other approved securities, that a financial institution must maintain as reserves other than the cash.

SLR rate = (liquid assets / (demand + time liabilities)) × 100%

As of now, the CRR and SLR rates are 4% and 23% respectively. Hence, the bank can only use 100-4-23= 73% of its total deposits for the purpose of lending. So, with higher CRR, banks can give less money as loan, since with higher interest rates, it becomes expensive to lend. This can curb inflation (and this is one of the main arguments of pro-demonetisation economists), but may also lead to slowdown in economy, because people wait for the interest rates to go down, before taking loans.

Moving on, what civil actors perceive, and not totally wrongly is that in the wake of demonetisation, deposits going into the banks are some form of recapitalisation, or capital infusion, which is technically and strictly speaking, not the case. For capital infusion in India happens through a budgetary allocation, and not this route. The RBI even came out with reverse repo, so that banks could purchase government securities from the RBI and thus lend money to the regulator. Thereafter, CRR was raised to 100, which, though incremental in nature would be revised 2 days from now, i.e. on the 9th. This incremental CRR is intended to be a temporary measure within RBI’s liquidity management framework to drain excess liquidity in the system. Though, the regular CRR would be 4, this incremental CRR is precisely to lock down lending going out from surplus deposits/liquidity as a result of Demonetisation. This move by the RBI was necessitated by the fact it at present holds Rs. 7.25 lac crore of rupee securities (G-Secs and T-Bills) and will soon run out of options of going in for reverse repo options, where it sells G-Secs in return for cash from banks, which have surplus deposits. These transactions have been reckoned at rates between 6.21% – 6.25%. There are expectations that the volume of deposits will increase by up to Rs. 10 lac crores by December due to demonetisation. The present equation of Rs. 3.24 lac crore impounded due to CRR and Rs. 7.56 lac crore to be used as open market option (OMO) or reverse repo options broadly covers this amount, leaving no extra margin.

There are two implications out of this:

One being, as the level of deposits keep increasing, banks may have to park the increments as CRR with RBI, which will affect their profit and loss (P&L). The expectation till today morning, i.e. the 7th December, 2016 had been that the RBI would lower the repo rate aggressively by 50 basis points (bps), which it did not do. This surely is deferred till stability due to demonetisation is achieved in the system. The other being on interest rate transmission. Banks could have delayed cutting their lending rates given that they had promised at least 3-4% interest rate to savings account depositors, and not be receiving any interest on the deposits impounded for CRR, which they haven’t as on individual levels, they have been cutting lending rates to approach RBI’s. This culminates into liquidity to tighten and send bond yields on a northward blip, and this is where lending would shrink automatically. Hence the banks cannot go after relentless lending, either in the wake or otherwise of demonetisation. QED.