The peer, who led the Liberals from 1976 to 1988, said that questions over why the claims were not originally investigated further were for the police and not the Liberal Democrats.
The former presiding officer of the Scottish Parliament added that he would not have recommended Sir Cyril for a knighthood if he had known about his behaviour.
Greater Manchester Police and Rochdale Council are investigating claims of physical and sexual abuse by the politician, who served as the MP for Rochdale between 1972 and 1992. He died in 2010.
Police have also announced that they are to investigate claims there was a cover-up of widespread sexual abuse at a school linked to the late politician.
Lord Steel said that he first became aware of the allegations in the late 1970s.
The prompt was an article in Private Eye magazine which centred on accusations surrounding the time before Sir Cyril became an MP.
Lord Steel said that he had confronted Sir Cyril after first reading the article back in 1979.
During that conversation the former MP pointed out that police had investigated the claims and that no further action had been taken, Lord Steel said.
He added: "Now one of the things that should come out now is why no action was taken?
"I think that's a legitimate public interest question. But it's not a question for the Liberal Democrats. It's a question for the police."
He added that, although there had been Westminster gossip about Sir Cyril after the original article appeared, "we're a political party, not a detective agency, and idle gossip is not a basis for any inquiry at all".
He added: "My basic point is that not a single story emerged - not even a rumour emerged - about him misbehaving as an MP.
"If that had happened, of course we would have inquired."
Lord Steel also said he would never have recommended Sir Cyril for his honour in 1988 if he had had "the slightest inkling" of allegations that he abused young men while an MP.
Asked about a claim he had "facetiously" described the behaviour as no different to conduct at many of the UK's public schools, Lord Steel said: "You say it is a facetious remark.
"But it also happens to be true that in those days corporal punishment was permitted.
"The accusation in the  Private Eye version of the report was simply that he was administering corporal punishment to these boys which he should not have been doing."
Yesterday, a former member of Rochdale Young Liberals said that Sir Cyril once groped him in the House of Commons and that he had abused him after recruiting him to the party as a teenager in 1979.
The man, speaking anonymously, said Cyril would suggest they "'go and do some door-knocking' and he would take me out on a drive on the moors above Rochdale".
He said the peer would then start to grope him.
He added: "I was shocked. I just froze. I had never had a sexual experience.
"The first time, it was something alien to me."
The man said he had even been targeted when he was being introduced to someone in the House of Commons.
He added: "Obviously, they didn't see him, they couldn't have done because they wouldn't have allowed it.
"I felt awful. I had nightmares."
The allegations against the late LibDem MP date back more than 30 years.
It is understood that nine people have so far approached police to say they were abused by adults at Knowl View school in Rochdale.
The current Rochdale MP, Labour's Simon Danczuk, has written a book detailing accusations of abuse against Sir Cyril, which is called Smile for the Camera: The Double Life of Cyril Smith.
Mr Danczuk first set out details of the MP's alleged abuse in 2012 during a debate on child sexual exploitation in the Commons.
In 2012 Greater Manchester Police said that Sir Cyril had abused young boys during the 1960s.
Police said that he had used his role as secretary of the Rochdale Hostel for Boys Association to gain access to children.