Duvvuri Subbarao, the governor of the Reserve Bank of India (RBI), has come in for criticism from all quarters for not acting as per the wishes of the government and cutting the repo rate. Repo rate is the interest rate at which the RBI lends to banks and sets the benchmark for interest rates charged by banks to its customers.
Nevertheless, Subbarao did cut the cash reserve ratio (CRR) by twenty five basis points (one basis point equals one hundredth of a percentage) to 4.25%. This will come into effect from November 3, 2012. Cash reserve ratio is the proportion of their deposits that the banks need to maintain with the RBI. When the CRR is cut that means the banks have to place a lesser proportion of their deposits with the RBI. This releases more money into the financial system. The CRR cut of 25 basis points is expected to release Rs 17,500 crore into the financial system.
Reacting to this move Pratip Chaudhuri, the Chairman of the State Bank of India(SBI) said “I still hold that CRR is a waste for the economy.” For anyone who understands the basics of banking, and presuming that the chief of the largest bank in the country does, this is a statement that should not have been made. Let’s try and understand why.
Banks first appeared on the scene somewhere in the twelfth and thirteenth century in Italy. The earliest banks were essentially banks of deposits. The Italian cities were the biggest trade centres in the world and had merchants who were earning a lot of money. They needed safe institutions which could store this wealth. And that is how banks emerged.
Merchants deposited their money in the form of gold and silver coins and bars with these banks for safekeeping. The bank in return issued a receipt against this deposit. The receipt could be shown when the deposited coins or bars were to be withdrawn. Hence, the earliest banks were “banks of deposits” or “store houses of wealth”. Banks charged a certain fee for this service.
Gradually some of these banks developed a reputation for being honest in their dealings. Something very remarkable emerged from this. Earlier when a merchant had to pay another merchant, he had to go to the bank withdraw a portion of his deposited wealth and pay the other merchant. This was a time consuming activity.
Gradually, merchants who had deposited their wealth with these banks simply started transferring the receipts issued by these banks when they had payments to make instead of going to the bank showing their receipt and withdrawing their coins or bars to pay each other.
If the other merchant to whom the payment was being made immediately needed the money he could simply go to the bank, show the transferred receipt and withdraw that money. What had effectively happened was that these receipts issued by some of the earliest Italian banks had started functioning as “paper money”.
Evolution of banking did not stop at this and after sometime the next level emerged. In sometime people running these banks also figured out that their depositors do not all come on the same day asking for their deposits back. So in the intermittent period they could lend this money out to others. This could be done by actually handing out gold and silver coins and bars that had been deposited or by simply printing fake receipts which looked exactly like original receipts and giving them to people who needed the money and charging a fee for doing so. The fake receipts did not have any gold or silver backing them. The bankers were able to do this simply because all their customers did not arrive on the same day demanding their money back.
A similar trend seems to have played out in London in the seventeenth century where merchants took to depositing money with the goldsmiths. This happened after King Charles I seized around £130,000 in bullion, deposited by the city merchants at the Tower of London in 1640.
Like the Italian bankers the London goldsmiths also figured out that they could keep lending the gold that was deposited or simply issue fake receipts, and make more money in the process. As Hartley Withers writes in his all time classic The Meaning of Money:
The original goldsmith’s note was a receipt for metal deposited. It took the form of a promise to pay metal, and so passed as currency. Some ingenious goldsmith conceived the epoch-making notion of giving notes, not only to those who had deposited metal, but to those who came to borrow it, and so founded modern banking.
This is how banks which started just as banks of deposits got into the lending business as well. And this is how banks primarily operate to this day at their very basic level. Much of the money deposited in banks is lent out with a certain portion of the deposits being retained. This in technical terms is referred to as the fractional reserve banking system.
What the fractional reserve banking system also did was it allowed the banks to create money out of thin air. Let us try and understand how this happens through an example.
Rs 100 is deposited in a bank. The cash reserve ratio is assumed to be at 4.5%. This means that the bank will have to deposit Rs 4.5 with the central bank (i.e. the RBI in the Indian case) and the remaining Rs 95.5 can be lent out. It thus manages to create an asset from someone else’s money. And we also have a situation here were the money supply has increased by Rs 195.5 (Rs 100 money deposited with the bank + Rs 95.5 loan given by the bank).
The Rs 95.5 lent out is spent and again ends up being deposited into another bank. On this bank needs to maintain 4.5% of Rs 95.5 as a reserve and the remaining it can lend out. Hence Rs 4.2975 is deposited with the central bank and the remaining Rs 91.2025 (Rs 95.5 – 4.5% of Rs 95.5) is lent out.
The Rs 91.2025 is spent and ends up with another bank. This bank will now have to deposit 4.5% of this amount with the central bank and can lend out the remaining money. And so the cycle continues. So the banks can keep creating money out of thin air and the money supply can keep going up. In this very simple example, a Rs 100 deposit can lead to an increase in money supply of Rs 2222.22 (the loans evolve into a geometric series which can be summed).
When the central bank cuts the cash reserve ratio. It leads to two things. The banks need to maintain a lower amount with the RBI against the deposits they have already got. This releases more money into the financial system which banks can go ahead and lend.
Other than this the banks need to deposit a lower proportion of their future deposits with the central bank. So if the CRR is cut to 4.25% from 4.5%, a bank now needs to deposit only Rs 4.25 of every Rs 100 deposit that it gets, with the RBI. It had to deposit Rs 4.5 earlier. This in turn means it has a greater amount of money to lend.
And as can be understood from the above example it will also help banks to create more money out of thin air. At a CRR rate of 4.25%, the money supply can increase by Rs 2353, for every Rs 100 that is deposited with the banks, as per the example explained earlier. This is an increase of 5.88% from the Rs 2222.22 created earlier.
This is a very simple example but what it shows clearly is that for the central bank or the RBI in our case, the CRR is a tool which allows it to control the amount of money supply that it wants the banks to create. So when the RBI cuts the CRR like it did yesterday, the broader signal is that it wants a greater proportion of deposits to remain with the banks so that they can lend more and thus create money out of thin air.
But at the same time it has not cut the repo rate or the rate at which it lends to the banks. This is an indication that while it wants banks to lend more, it wants them to do so judiciously and not go hammer and tongs at it. Given this the statement made by the SBI chief that CRR does not matter is immature to say the least. It is one of the important tools that RBI has in its arsenal.
The article originally appeared on www.firstpost.com on October 31, 2012. http://www.firstpost.com/economy/by-calling-crr-a-waste-sbi-chief-questions-banking-history-509290.html
(Vivek Kaul is a writer. He can be reached at [email protected])