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The RBI's move to cut cash reserve ratio by 50 basis points can aid the net interest margins of banks in the coming quarters. This will also improve liquidity in the financial system, thus easing short-term borrowing rates for both banks and companies.
Benefit from CRR cut
Cash reserve ratio (CRR) is that proportion of cash that a bank has to compulsorily deposit with the RBI. A lower CRR means more funds with banks. Banks do not receive any interest on the cash reserve ratio that they park with the RBI.
The cut in CRR will improve net interest margins (NIM) of banks in two ways. One, the liquidity available for banks will improve. To that extent, banks need not borrow funds from the market at high rates.
Two, by deploying this additional liquidity into productive assets – whether through lending or through investments – the banks can improve their interest income. For instance, if banks decide to invest the additional Rs 32,000 crore that this CRR cut will release, into government bonds, they will see a 4 basis-point increase in their NIM.
The hike in NIM can be even higher if they lend the money. In fact, the additional money released will add as much as Rs 1.5-1.6 lakh crore into the broad system (called M3), if one takes in to consideration the multiplier effect. This too, can result in higher interest income for banks.
Tight liquidity
The CRR comes after the RBI's efforts, since November 2011, to infuse money through bond buybacks (open market operations) did not ease liquidity situation. Banks have been borrowing heavily through the repo window in the last two months.
RBI's intervention in the foreign exchange market to contain the declining rupee against the dollar was also sucking out liquidity.
For instance, the RBI had sold dollars worth Rs 19,600 crore until November 2011 and thus took away rupees in the system. On the other hand, it resorted to bond buybacks (which will infuse rupees) only to the tune of Rs 10,000 crore till end of November.
Following this reserve ratio cut, the RBI is likely to resort to further bond buybacks to bring liquidity levels to its comfort zone of 1 per cent of time and demand liabilities (essentially deposits and borrowings of banks). This ratio currently stands at 2 per cent.
Rate cut needed
The central bank is likely to look out for clear signs of slowing inflation, especially in the manufacturing space and also watch for any rise in administered price levels in oil, coal and electricity before resorting to rate cuts.
Banks have seen a moderation in credit growth as a result of lower demand for credit from companies.
The share of banking credit to companies fell from 57 per cent during April-December 2010 to 46 per cent in the April-December 2011 period.
They appear to have lost out to the non-banking sector. Companies have been borrowing through channels such as the commercial paper, external commercial borrowing, FDI and NBFCs. Only a rate cut can bring these borrowers back into the banking system.
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