The margins of banks will be impacted and temporary liquidity mismatches created for some of them after the Reserve Bank of India (RBI) hiked the incremental cash reserve ratio (CRR) to 10% for both deposits and advances which lenders contracted between 19 May and 28 July 2023.

“The latest liquidity sucking measure of RBI will impact our net interest margins (NIM) by 4 to 5 basis points,” Bank of Maharashtra managing director and CEO AS Rajeev told indianbankingnews.com. 

The move will suck out Rs 1.1 trillion of deposits, considering that Rs 11 trillion is the incremental deposits that banks have contracted during this period. 

The liquidity situation, however, may not get too tight. About Rs 0.9 trillion from RBI’s VRRR (variable rate reverse repo) auctions is expected to mature and come into the banking system. This will take care of the immediate liquidity needs of the banks and companies. The existing CRR remains unchanged at 4.5%.

Still, it is an opportunity lost for banks. “The money will move to the RBI without any interest. Banks could have earned an average rate of 9% if they would have used it for loan deployment. The assumed opportunity loss to the banking system could be to the tune of Rs 800 crore,” said Ashutosh Khajuria, chief mentor at Federal Bank. 

The RBI’s new measure is aimed at absorbing surplus liquidity, as indicated by its Governor Shaktikanta Das. The withdrawal of the Rs 2,000 note since May has created additional liquidity in the banking system. It allowed citizens to deposit these notes or exchange them in banks until 30 September. By 31 July, 88% of the Rs 2,000 banknotes valued at Rs 3.14 lakh crore had returned to the banking system, according to the data put out by RBI. 

The level of surplus liquidity in the system has  gone up in recent months also due to RBI’s surplus transfer to the government, pick up in government spending and capital inflows. The overall daily absorption under the liquidity adjustment facility (LAF) was Rs 1.7 lakh crore in June and Rs 1.8 lakh crore in July 2023.

“RBI wanted to bring down the excess liquidity which was to the tune of close to Rs 2 trillion that banks were depositing in the repo window. The incremental hike in CRR is a better move than hiking the repo rate,” Khajuria said.

Despite such surplus liquidity, market response to RBI’s 14-day VRRR auctions was lukewarm. Banks, instead, preferred to place their surplus liquidity in the less remunerative standing deposit facility (SDF).

“If banks had participated in the auctions, they would have earned 6.5% on the government bonds. So, it is an interest earning loss of around Rs 650 crore. But this is a notional loss. The real impact is negligible since the RBI move is only for a short time,” said a senior official from a public sector bank.

Even HDFC Bank’s net interest margin could get impacted due to the RBI’s new move on CRR. 

“HDFC Bank appears more sensitive to the incremental CRR requirement as it would have bloated NDTL (net demand and time liabilities) post its merger with parent HDFC Limited. The bank could have around Rs 5 trillion additional NDTL on 1 July 2023, the effective date of merger. Our broad calculations suggest 5 basis points impact on net interest margin for Q2FY24 for the merged entity assuming the incremental CRR requirement remains effective as announced till 28 July,” ICICI Securities said in a note.

The incremental CRR stands to be reviewed on 8 September, ahead of the festive season and advance tax outflows. 

Some economists say the impact of the RBI’s CRR hike move will hardly be felt by the banks. “Being a temporary measure to restrain excess liquidity, there is unlikely to be any material impact on banks’ profitability or margins. This move was last tapped in wake of the 2016 demonetisation, when the ICRR was pegged at 100%. This time around, the ICRR was considered after banks were reluctant to participate in the VRRR auctions, instead parking funds with the punitive SDF,” said Radhika Rao, chief economist at DBS.

The incremental CRR was the best option at the current juncture, but it was not the only tool available to the RBI to deal with the liquidity overhang. “The ICRR was considered necessary in the background of the liquidity overhang. We considered it desirable in the interest of financial and price stability. It will have an impact on inflation also. It is a purely temporary measure," the RBI Governor said.

The incremental CRR hike of 10℅ is likely to elevate the shorter-end yields, thus keeping the yield curve flatter for a longer period. 

“The incremental CRR hike is a very temporary measure. At most, the RBI could extend it by a month. It is certainly an opportunity loss for banks. I am not reading too much into it as far as the bond market rates are concerned. The standalone impact of a few basis points would be felt on short-term rates in bond markets due to this measure. But it makes it very clear that rate cuts any time soon are off the table, "said PNB Gilts senior executive vice president Vijay Sharma.