FINANCING POWER IN INDIA: GENERIC TRENDS

Banks and Infrastructure Finance Companies (IFCs) are the predominant sources of financing of power sector in India. Balance sheet size of many Indian banks and IFCs are small vis-à-vis many global banks. Credit exposure limits of banks and IFCs towards power sector exposure is close to being breached. Any future exposure seems to be severely constrained by balance sheet size, their incremental credit growth and lack of incentives to lend to power sector. The desirability and sustainability of sectoral exposure norms of the banks in the future may be examined in view of the massive exposure of the banks and projected fund requirements for the power sector.

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Further, any downgrade in the credit rating of power sector borrowers would adversely impact the ability of the major NBFCs viz. PFC and REC to raise large quantum of funds at a competitive rate from domestic as well as international capital markets. In such a scenario, the sources of funds available for power sector projects are expected to be further constrained.

Tenor of Funds

The capital intensive nature of power projects requires raising debt for longer tenor (more than 15 years) which can be supported by life of the Power Project (around 25 years). However, there is wide disparity between the maturity profiles of assets and liabilities of banks exposing them to serious Asset Liability Maturity mismatch (ALM). Accordingly, the longest term of debt available from any bank or financial institution is for 15 years (door-to-door) which could create mismatch in cash flow of the Power project and may affect the debt servicing. Options like re-financing are explored to make funds available for the power project for a long tenor.

Though maturity profiles of funds from insurance sector and pension funds are more suited to long gestation power projects, only a minuscule portion is deployed in power sector. Appropriate fiscal incentives need to be explored to channelize savings. New debt instruments and sources of funds viz. Infrastructure Debt Fund, Clean Energy Funds etc. are identified for the purpose of infrastructure financing.

Cost of Funds

Cost of Rupee funding is high as compared to foreign currency funding. In a competitive bidding scenario, higher cost of borrowing could adversely affect the profitability and debt servicing of loan. External Commercial Borrowings (ECBs) for power projects is not well suited due to issues relating to tenor, hedging costs, exposure to foreign exchange risks etc. Project financing by multilateral agencies (World Bank, Asian Development Bank) has been low due to various issues.

While bond offerings are a lower cost option to raise funds vis-à-vis syndicated loans, corporate bond market for project financing is virtually absent in India. The credit rating of the power projects being set up under SPV structure is generally lower than investment criterion of bond investors and there is a need for credit enhancement products.

Specialized Debt Funds for Infrastructure Financing

Creation of specialized long-term debt funds to cater to the needs of the infrastructure sector; a regulatory and tax environment that is suitable for attracting investments is the key for channelizing long-term funds into infrastructure development.

RBI may look into the feasibility of not treating investments by banks in such close-ended debt funds as capital market exposure. IRDA may consider including investment in SEBI registered debt funds as approved investments for insurance companies.

Long tenor debt funds

Insurance Companies, Financial Institutions are encouraged/provided incentives to invest in longer dated securities to evolve an optimal debt structure to minimize the cost of debt servicing. This would ensure lowest tariff structure and maximum financial viability. Option of a moratorium for an initial 2 to 5 years may also reduce tariff structure during the initial years.

Viability Gap Fund

The power projects that are listed under in generation or transmission and distribution schemes in remote areas like North-eastern region, J&K etc and other difficult terrains need financial support in the form of a viability gap for the high initial cost of power which is difficult to be absorbed in the initial period of operation. A scheme may be implemented in the remote areas as a viability gap fund either in the form of subsidy or on the lines of hydro power development fund, a loan which finances the deferred component of the power tariff of the first five years and recovers its money during 11th to 15th year of the operation may be introduced. Any extra financing cost incurred on such viability gap financing should also be permitted as a pass through in the tariff by regulators.

Policy Measures for Take-out financing for ECB Lenders

RBI has stipulated guidelines for Take-out Financing through External Commercial Borrowings (ECB) Policy.

The guidelines stipulate that the corporate developing the infrastructure project including Power project should have a tripartite agreement with domestic banks and overseas recognized lenders for either a conditional or unconditional take-out of the loan within three years of the scheduled Commercial Operation Date (COD). The scheduled date of occurrence of the take-out should be clearly mentioned in the agreement. However, it is felt that the market conditions cannot exactly be anticipated at the time of signing of document and any adverse movement in ECB markets could nullify the interest rate benefit that could have accrued to the project. Hence, it is suggested that tripartite agreement be executed closure to project COD and instead of scheduled date of occurrence of the take-out event, a window of 6 or 12 months could be mentioned within which the take-out event should occur.

Further, the guidelines stipulate that the loan should have a minimum average maturity period of seven years. However, an ECB of average maturity period of seven years would entail a repayment profile involving door-to-door tenors of eight to ten years with back-ended repayments. An analysis of past ECB transactions indicates that ECB with such a repayment profile may not be available in the financial markets. Further, the costs involved in hedging foreign currency risks associated with such a repayment profile could be prohibitively high. Hence it is suggested that the minimum average maturity period stipulated should be aligned to maturity profiles of ECB above USD 20 million and up to USD 500 million i.e. minimum average maturity of five years as stipulated in RBI Master Circular No.9 /2011-12 dated July 01, 2011.

Combined Exposure Ceilings: RBI exposure norms applicable to IFCs allow separate exposure ceilings for lending and investment. Further, there is also a consolidated cap for both lending & investment taken together.

In project funding, the IFCs are mainly funding the debt portion and funding of equity is very nominal. Therefore, the consolidated ceiling as per RBI norms may be allowed as overall exposure limit with a sub-limit for investment instead of having separate sub-limits for lending and investment. This will leverage the utilization of unutilized exposures against investment. It is well justified since lending is less risky as compared to equity investment. This will provide additional lending exposure of 5% of owned funds in case of a single entity and 10% of owned funds in case of single group of companies, as per existing RBI norms.

UMPP: As each UMPP is likely to cost around Rs.20000 crore and would require around Rs.15000 crore as debt component considering D/E ratio of 75:25. Such a huge debt requirement could not be met with present RBI exposure norms of 25% of owned funds in case of single borrower and 40% in case of group of companies.

So, a special dispensation could be considered by commercial banks for UMPPs in respect of exposure limit as at the time of transferring UMPP all clearances are available, escrow account is opened in favour of developers and PPAs are signed. Considering the above, there is a need to allow relaxed exposure ceilings for funding to UMPPs.

Exposure linked to Capital Funds: RBI Exposure ceilings for IFCs are linked to ‘owned funds’ while RBI exposure norms as applicable to Banks & FIs allow exposure linkage with the total regulatory capital i.e. ‘capital funds’ (Tier I & Tier II capital). Exposure ceilings for IFCs may also be linked to capital funds on the lines of RBI norms applicable to Banks. It will enable to use the Tier II capitals like Reserves for bad and doubtful debt created under Income Tax Act, 1961, for exposures.

Provisioning for Government Guaranteed Loans: RBI norms provide for 100% provisioning of unsecured portion in case of loan becoming ‘doubtful’ asset. Sizeable loans of Government IFCs like PFC and REC are guaranteed by State Governments and not by charge on assets. On such loans, 100% provisioning in first year of becoming doubtful would be very harsh and can have serious implication on the credit rating of IFC. Therefore, for the purpose of provisioning, the loans with State/Central Government guarantee or with undertaking from State Government for deduction from Central Plan Allocation or Direct loan to Government Department may be treated as secured.

Loan-wise Provisioning: As per RBI norms, the provisioning for NPAs is required to be made borrower-wise and not loan-wise if there is more than one loan facility to one borrower. Since Government owned IFC’s exposure to a single State sector borrower is quite high, it would not be feasible to provide for NPA on the total loans of the borrowers in case of default in respect of one loan. Further, the State/Central sector borrowers in power sector are limited in numbers and have multi-location and multiple projects. Accordingly, default in any loan in respect of one of its project does not reflect on the repaying capacity of the State/Central sector borrowers. A single loan default may trigger huge provisioning for all other good loans of that borrower. This may distort the profitability position. Therefore, provisioning for NPAs in case of State/Central sector borrowers may be made loan-wise.

In case of consortium financing, if separate asset classification norms are followed by IFCs as compared to other consortium lenders which are generally banking institutions; the asset classification for the same project loan could differ amongst the consortium lenders leading to issues for further disbursement etc.

Capital Adequacy Ratio (CAR): Prudential Norms relating to requirement of capital adequacy are not applicable to Government owned IFCs. However, on the other side, it has been prescribed as an eligibility requirement for an Infrastructure Finance Company (IFC) being 15% (with minimum 10% of Tier I capital). Accordingly, Government owned IFCs are also required to maintain the prescribed CAR. Considering the better comfort available in case of Government owned IFCs, it is felt that RBI may consider stipulating relaxed CAR requirement for Government owned IFCs. It will help such Government owned IFCs in better leveraging.

Risk Weights for CAR: RBI prudential norms applicable to IFCs require 100% risk weight for lending to all types of borrowers. However, it is felt that risk weight should be linked to credit rating of the borrowers. On this premise, a 20% risk weight may be assigned for IFC’s lending to AAA rated companies.

Similarly, in case of loans secured by the Government guarantee and direct lending to Government, the IFCs may also assign risk weight in line with the norms applicable to banks. Accordingly, Central Government and State Government guaranteed claims of the IFC’s may attract ‘zero’ and 20% risk weight respectively. Further their direct loan/credit/overdraft exposure to the State Governments, claims on central government will attract ‘zero’ risk weight. It may be mentioned that RBI vide its letter dated 18.03.2010 advised PFC and REC that State Government guaranteed loans, which have not remained in default for more than 90 days, may be assigned a risk weight of 20%.

ECB: As per extant ECB Policy, the IFCs are permitted to avail of ECBs (including outstanding ECBs) up to 50% of their owned funds under the automatic route, subject to their compliance with prudential guidelines. This limit is subject to other aspects of ECB Policy including USD 500 million limit per company per financial year. These limits/ceilings are presently applicable to all IFCs whether in State/Central or Private Sector.

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Government owned IFCs are mainly catering to the funding needs of a single sector, like in Power sector where the funding requirements for each of the power project is huge. These Government owned IFCs are already within the ambit of various supervisory regulations, statutory audit, CAG audit, etc. It, is, therefore, felt that the ceiling of USD 500 million may be increased to USD 1 billion per company per financial year for Government owned IFCs. Further, the ceiling for eligibility of ECB may also be increased to 100% of owned funds under automatic route for Government owned IFCs to enable them to raise timely funds at competitive rates from foreign markets. Thus, these measures will ensure Government owned NBFC-IFCs to raise timely funds at competitive rates thereby making low cost funds available for development of the infrastructure in India.

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Recapitalisation and Demonetisation. Is the link exaggerated?

What has been witnessed in the aftermath of demonetisation is the declining yield on Government securities, and as a consequent of which treasury gains for public sector banks have already surpassed capital infusion. With a sluggish economy, high levels of stressed assets and eroding bottom-lines, banks have been pushed to the corner to regulate lending. The aim of recapitalisation, and/or capital infusion is geared towards shoring up the lending capacities of banks, public sector banks in this case as countenance  against these erosions. To understand what recapitalisation is, let us take a jaunt to Indradhanush 2015, the seven colours or A2G meant for reviving the banking industry in the country. The seven colours talked about are: Appointments, Bank Board Bureau, Capitalisation, De-stressing PSBs, Empowerment, Framework of Accountability, and Governance reforms. The third colour, i.e. capitalisation (Capital Infusion or Recapitalisation) is an exercise to estimate the capital requirements based on credit growth rate of 12% for the current year and 12 to 15% for the next three years depending on the size of the bank and their growth ability. It has been presumed that the emphasis on PSBs financing will reduce over the years by development of vibrant corporate debt market and by greater participation of Private Sector Banks. Based on this exercise, it is estimated that as to how much capital will be required this year and in the next three years till FY 2019, despite the banks being under a lot of stress and still adequately capitalised and meeting all Basel-III and RBI norms. It must be noted that under Basel III, a bank’s tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5%. The capital conservation buffer recommendation is designed to build up banks’ capital, which they could use in periods of stress; where tier-1 capital is the core capital and includes equity and disclosed reserves, while tier-2 capital are hybrid capital instruments, loan-loss and revaluation reserves as well undisclosed reserves.

After excluding the internal profit generation which is going  to be available to PSBs (based on the estimate of average profit of the last three years), the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about huge amount of Rs.1,80,000 crore.

Out of the total requirement, the Government of India proposes to make available Rs.70,000 crores out of budgetary allocations for four years as per the figures given below:

(i) Financial Year 2015 -16 Rs. 25,000 crore
(ii) Financial Year 2016-17 Rs. 25,000 crore
(iii) Financial Year 2017-18 Rs. 10,000 crore
(iv) Financial Year 2018-19 Rs. 10,000 crore
Total  Rs. 70,000 crore

According to the document itself, PSB’s market valuations will improve significantly due to (i) far-reaching governance reforms; (ii) tight NPA management and risk controls; (iii) significant operating improvements; and (iv) capital allocation from the government. Improved valuations coupled with value unlocking from non-core assets as well as improvements in capital productivity, will enable PSBs to raise the remaining Rs. 1,10,000 crore from the market.  Moreover, the government is committed to making extra budgetary provisions in FY 18 and FY 19, to ensure that PSBs remain adequately capitalized to support economic growth. The banks can raise capital from the capital markets as well be availed of tranche facilities running over three tranches, and nowhere is there any mention of such budgetary allocations meant for capital infusion or recapitalisation on the substitute for the process of demonetisation. Before moving on to demonetisation, it must be remembered that capitalisation, recapitalisation or capital infusion (the first two are generally used interchangeably and depends on who the user is, with the former lying squarely with the banks, while the latter with academics, if that wasn’t too generic a distinction, I be forgiven!) is through budgetary allocations. Let us underline this.

Demonetisation is when the Central Bank, RBI in our case strips the bill of its legal tender. What happened post November 8 was stripping bills of Rs. 500 and Rs. 1000 of their legal tender, thus rendering them invalid.

Almost everyone seems to be collaging demonetisation and black money, terror funding, illicit and counterfeit money flows. Not that there isn’t correlation between these, but the whole of argumentation is getting reducible to these aspects and what seems to be totally sent to oblivion is tax evasion. Though, some talks do touch upon these, many of these commit the folly of citing tax havens like Mauritius and Singapore and black money hoarded and channeled through there. A populist line of thought, without considering the fact that a recently concluded tax treaty between India and Mauritius has choked the tax haven significantly. One with Singapore is in the pipeline, and once that gets concluded, the two tax havens would then need to seep through populist discourse as no longer the culprits before the narrative changes sense. A tall order from a half-baked recipe.

On the other hand, even if terror funding is caused by higher denominations, one shouldn’t belittle other ingenious ways of carrying out the same. Though, flushing the economy of higher denominations could trickle down to curbing such illicit fundings, the government should not be gung-ho over this as the be-all end-all to choke such flows, for such denominational crushes would only exaggerate Kosher funds, funds through oil economics, extortion and crucially politically-motivated funds slipping through religiously-fundamentalist and right-wing techno geeky consortiums.

So, whether the move is short-term distress or long-term satisfactory should not be decided on subjectivities, but rather on economic complexities, the answers to which sadly the Government doesn’t have at the moment and no wonder crying foul over any resistances to its move. The same goes true for even those calling the government to dock, for the problem is economics should not be totally (read: wholly) studied sociologically anymore, but all the more importantly, sociology needs to be studied as a consequence of economics, and once the order goes for a tailspin, its only fertile for such sentimental concerns, not that anythings wrong with such concerns, but for the fact these have tendencies to become authoritarian. By authoritarian, what is meant is surely Prime Minister’s grand designs. Unlikely entities in the form of Ratings Agencies is stifling PM’s grand designs. But, all of that could change. With demonetisation of notes and GST, hopefully not this quarter but over the next six-seven quarters, there will be an improvement in the fiscal debt-to-GDP ratio by virtue of expansion of denomination, and improvement in the fiscal tax-to-GDP ratio by virtue of better tax collection. Meaning, a possible upgrade from Baa2 (Moody’s) and BBB- (S&P), a notch over the junk. Consequentially, it’d mean all the big three seeing this war on people capitalistically profitable. a sort of double bind, ain’t it? And, here I am guilty of parsimonious arguments, for reasons that most of these are in liberal supply on the media. So, the basis is to look out at connectors and/or disconnectors between recapitalisation and demonetisation, which is still within approaching distance from here on.

With demonetisation has come massive exchanging of old currency for new denominations of Rs. 2000 and Rs. 500 on one hand and depositing old currency in accounts till 30th of December 2016. The deposits have spiked and banks are faced with surplus liquidity, which they are finding hard to find avenues to disburse, say in the form of investments. The cause, which has been reactionary has left the effect no less reactionary, and the culpability lies squarely with planning and implementation of the scheme. Well, thats a different matter, and thus at best put aside. But, the fractures within the social fabric caused due to this lack of implementation has had fatalities that have been extremely costly. As the Financial Express was prescient in noting, there was ecstasy with deposits rising just at beginning of the busy season. Consumerism had shown strong signs in the period leading to Diwali and the good times were to come along supported by banks, which were running tight on deposits. In fact, RBI has been supplying funds through OMOs all through, and it is against this background that banks became ecstatic as deposits rolled in. Most households were in a panic mode and were just keen on getting rid of old notes safely and, hence, most of this money went into savings deposits. The consequences were significant. First, banks automatically started lowering the deposits rates as they no longer had to wait for RBI to announce changes in the repo rate. This also meant that the lending rates could be reduced without a prod, which was a win-win situation for the system. The transmission mechanism became smooth under the compulsion of market forces. In fact, some sections of the market believed that RBI need not lower the repo rate in the December policy, as circumstances have already delivered the result unobtrusively. Banks were also pepped up as the G-Sec yields had crashed with the 10-years paper going down to 6.3% with sentiment providing a guidance of sub-6%. This meant there were capital gains to be had, which would prop up income and banks would be better able to manage provisioning for their NPAs. But, the downside is that the banking sector does not have the capacity to absorb so much of liquidity, and with a low demand for credit, the alternative is to approach G-sec (Government Securities) market. Now, the catch. With stringency to the fiscal target, having additional paper in the primary segment would be self-defeating, and thus another turn, which happens to be the secondary segment for banks to target. This has led to the yields coming down sharply. Given that banks have been paying a minimum of 4% interest on deposits, a positive net return is what they would have wanted. The reverse repo window has been used widely to park these funds where the return could go to 6.25%, which would just about cover their operating cost to assets ratio of 2-2.5%.However, RBI has limited G-Secs in its balance sheet, which is around R7.5 lakh crore, and in case deposits do shoot up to R10 lakh crore, it would not be possible to satiate the market. One option is seeking recourse to MSS bonds (market stabilisation bonds), which have been used in the past when money supply increased mainly due to the influx of foreign currency in the system leading to sharp appreciation in currency. But given the quantum involved (between Rs. 5-10 lakh crore ultimately if the target is reached and cannot be used for lending), this would push up government debt substantially. In fact, it will also add directly to the fiscal deficit, which is not acceptable.

So, what has the RBI proposed? Locking in liquidity on an ex-post basis. It has increased 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.
Formulaically,

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.

To reiterate: This move by RBI was necessitated by the fact that the central bank at present holds Rs 7.56 lakh crore of rupee securities (G-Secs and T-Bills) and will soon run out of options of going in for reverse repo auctions, 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 Rs10 lakh crore by December because of the demonetisation scheme. The present equation of Rs3.24 lakh crore impounded by CRR and Rs7.56 lakh crore to be used as open market option (OMO) or reverse repo auctions 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 had been that the RBI would lower the repo rate aggressively in the December policy by 50 basis points (bps), i.e. today, 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 rates. This culminates into liquidity to tighten and send bond yields on a northward blip, and this is where lending would shrink automatically. And, that is the connector spoken about above, where when the lending spigots are tightly controlled due to tightening of liquidity, the logic behind capital infusion, which anyways comes in through budgetary allocations gets defeated. The real constraining factor could arise when Large Exposure Framework (LEF) gets kickstarted next financial year confining banking sector’s exposure to highly leveraged corporates through a cap scanning risk environs along the way. But, these consequences are still in a speculative realm, though definitely geared to life via demonetisation. 

 

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.
Formulaically,

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.