Tools for Managing Liquidity In The Money Market

Reserve Requirements:
Reserve requirements are of two types: (i) cash reserve requirements and (ii) statutory liquidity ratio (SLR). They are techniques of monetary control used by the Reserve Bank to achieve specific macro-economic objectives. CRR refers to the cash that banks have to maintain with the Reserve Bank as a certain percentage of their total demand and time liabilities (DTL) while statutory liquidity ratio refers to the mandatory investment that banks have to make in government securities.

The statute governing the CRR under section 42(1) of the Reserve Bank of India Act requires every bank in the second schedule to maintain an average daily balance with the Reserve Bank of India, the amount of which shall not be less than 3% of the total demand and time liabilities. CRR is an instrument to influence liquidity in the system as and when required. SLR is the reserve that is set aside by the banks for investment in cash, gold, or unencumbered approved securities. It is mandatory under section 24(2A) of the Banking Regulation Act, 1949, as amended by the Banking Laws (Amendment) Act, 1983 for banks to maintain this reserve. The reserve is supposed to provide a buffer in case of a run on the bank.

The CRR has been brought down from 15% in March 1991 to 4.75% in October 2002 and 4.5% in April 2003 while the SLR was brought down from its peak of 38.5% in April 1992 to 25% on October25, 1997. Thus, till the early 1990s, both the CRR and SLR were preempting around 63.5% of the incremental deposits. Even though the SLR has been brought down to 25%, most banks currently hold a volume of government securities higher than required under the SLR as the interest rate on government securities is increasingly market-determined.

The daily minimum CRR was reduced from 85% to 65% to enable a smooth adjustment of liquidity between the surplus and the deficit segment and better cash management to avoid a sudden increase in the overall call rates.

The Reserve Bank has announced that it would like to see the CRR level down to 3%. The key constraint in reducing the CRR is the continuing high level of fiscal deficit which cannot be financed entirely by the market and, therefore, requires substantial support by the Reserve Bank.

A cut in CRR increases the liquidity in the economy. It also means lower cost for the banks which translates into lower prime lending rates. It also sets a broad direction for interest rates in the future. Since October 2001, the interest rate paid on eligible balances under CRR was linked to the bank rate. From August 11, 2001, the inter-bank term liabilities with an original maturity of 15days and up to one year were exempted from the prescription of minimum CRR requirement of 3%. The CRR will continue to be used in both directions for liquidity management in addition to other instruments.

Interest Rates:
Interest rate is one of the distinct monetary transmission channels. An administered interest rate structure was the central feature of the Indian monetary and credit system during the 1980s. The rationale behind the administered rate structure was to enable certain preferred or priority sectors to obtain funds at concessional rates of interest. This brought about an element of cross-subsidization resulting in higher lending rates for the non-concessional commercial sector. The deposit rates also had to be maintained at a low level. This system became complex with the proliferation of sectors and segments to which concessional credit was to be provided.