Amidst the ongoing liquidity tightness in India's banking system, the Reserve Bank of India (RBI) faces the challenge of providing liquidity support to ensure smooth credit flow. While open market operations (OMOs) are a standard tool to infuse primary liquidity, their effectiveness in the current context is constrained due to structural and regulatory challenges.Challenges with OMOsThe effectiveness of OMOs hinges on the ability of banks to tender surplus government securities to the RBI. However, with banks operating close to their minimum Liquidity Coverage Ratio (LCR) requirements, they lack the flexibility to participate in OMOs effectively.For institutional investors like insurance companies and provident funds (PFs), OMOs allow them to tender bonds to the RBI in exchange for cash. However, this liquidity infusion has limited direct impact on the banking system unless bondholders convert their holdings into bank deposits. Consequently, OMOs often result in a sharp fall in government bond yields without a proportional liquidity boost for banks.If institutional investors reallocate the cash to corporate bonds, the banking system could face further disintermediation. This would constrain banks' deposit growth and lead to an equilibrium with lower credit and deposit expansion. Such a scenario disproportionately impacts sectors dependent on bank loans-like SMEs, MSMEs, and retail borrowers-leaving their cost of funds unchanged. Meanwhile, AAA-rated corporates and government bonds benefit from falling yields, exacerbating the gap between high-quality borrowers and the broader economy.The Problem with Rate CutsRate cuts by the RBI are unlikely to achieve their intended impact without addressing systemic liquidity shortages. Banks, burdened with high deposit costs, are unable to pass on rate cuts effectively. Thus, without targeted measures to ease banking liquidity, rate cuts risk being ineffective.A Better Solution: Reforming CRR and LCRTo provide immediate and uniform liquidity relief, the RBI could consider reducing the Cash Reserve Ratio (CRR) or recalibrating LCR requirements. This would directly inject liquidity into the banking system, enabling banks to support credit growth without significant operational adjustments.India is unique in having an additional CRR requirement over and above the global LCR standards. While CRR was historically essential alongside Statutory Liquidity Ratio (SLR) as a monetary tool, its relevance has diminished under the modern LCR framework. Rationalizing or eliminating the CRR requirement could mitigate liquidity risks while simplifying regulatory compliance for banks.Structural Shifts in Asset AllocationA significant factor driving liquidity challenges is the shift in asset allocation patterns. Tax incentives for insurance, PFs, and pension products have diverted investments away from bank fixed deposits toward these vehicles. Unlike banks, which allocate around 75% of their resources to the private sector, these vehicles invest heavily-over 60-70%-in government securities (G-Secs) and State Development Loans (SDLs). This shift has widened the cost of funds between SMEs/MSMEs and the government or PSU sectors, as institutional investments disproportionately favor the latter. As banks' role in funding the government sector diminishes, OMOs alone fail to address systemic liquidity needs effectively.The Way Forward: Innovative MeasuresTo support banking system liquidity and stimulate broader credit growth, the RBI needs to explore new and innovative tools. Beyond CRR reforms, measures like long-term repo operations (LTROs), buy sell forex swaps, or dynamic adjustments to LCR requirements could ensure liquidity flows to sectors that need it most. In conclusion, addressing liquidity tightness in India's banking system requires a multifaceted approach that considers structural shifts, regulatory reforms, and innovative liquidity mechanisms. By realigning policy tools to the evolving financial landscape, the RBI can ensure equitable credit access and support sustainable economic growth.