• Cash Reserve Ratio (CRR)

    When you make banking transactions, you would have come across the term ‘cash reserve ratio (CRR)’ several times. Have you wondered what it means? Cash reserve ratio is described as a particular percentage of cash deposits that must be maintained by every bank in India as per the requirements of the Reserve Bank of India (RBI).

    It is a regulation that is implemented by the central bank of almost every nation. It refers to the minimum quantity of reserves that needs to be retained by every commercial bank. In our country, the Reserve Bank of India functions as the chief central bank.

    The RBI provides a specific CRR for each commercial bank in the nation. Each bank will be asked to retain a specific amount of its deposits in the current account of the central bank. The RBI has the authority to set the cash reserve ratio between 3% and 15%. However, the RBI does not have any ceiling on setting the CRR since 2006.

    The cash reserve ratio in India is presently 4% (as on 4 October 2016).

    Definition of Cash Reserve Ratio (CRR)

    Cash reserve ratio (CRR) is generally defined as a particular minimum amount of deposits that needs to be maintained as a reserve by every commercial bank in India according to the requirement of the RBI. The CRR will be fixed as per the rules and regulations of the RBI.

    Why Does a Bank Need to Maintain Cash Reserve Ratio (CRR)?

    The Reserve Bank of India constantly works towards monitoring the cash flow in the entire economy of the nation. It has several monetary tools and instruments in order to control and manage the economy in terms of different aspects. One of these important monetary instruments is the cash reserve ratio. The RBI wants every bank in India to adhere to the specific CRR rules provided to each bank.

    When every bank maintains the necessary CRR, the overall liquidity will be administered and managed thoroughly. This, in turn, will benefit each bank also. A bank will always have the right amount of cash and not fall short of funds when depositors or customer require funds for their various personal needs. This is a very good advantage for any bank’s operations.

    However, one needs to note that when the CRR maintained with the RBI is high, the liquidity will be low in the economic system. It works vice versa wherein the lower the CRR maintained with the RBI, the higher will be the overall liquidity of the financial system.

    How Does Cash Reserve Ratio (CRR) Help a Bank?

    When a bank has a sufficient amount of funds to provide to its depositors by maintaining the right CRR, the bank earns an excellent reputation among the public and it also earns a good name in the entire banking industry. It also gets recognised by the Reserve Bank of India for consistently keeping the required quantity of readily accessible money in the bank.

    Illustration Explaining the Importance of Cash Reserve Ratio (CRR)

    We can take a look at a small and basic illustration to understand the significance of a bank maintaining the cash reserve ratio. It serves as an outstanding tool to the RBI for maintaining liquidity.

    If an individual deposits or invests Rs.10,000 in a certain commercial bank, then the deposits of that particular bank will rise by Rs.10,000.

    If we assume that the cash reserve ratio of a particular bank is 12%, then it will be necessary for that bank to hold an extra amount of money worth Rs.1,200 with the Reserve Bank of India. In this case, this commercial bank will be entitled to utilise only Rs.8,800 for lending to customers or for investments. Lending to customers can be in the form of offering personal loans, car loans, home loans, two-wheeler loans, etc.

    Advantages of Cash Reserve Ratio (CRR)

    • Cash reserve ratio assists in building and sustaining the solvency position of any scheduled commercial bank.
    • It makes sure the liquidity system of scheduled commercial banks is consistently maintained well.
    • It works towards having a smooth supply of cash as well as credit in the nation’s economy.
    • Through the implementation of a cash reserve ratio, the Reserve Bank of India can control and coordinate the credits that are by commercial banks.
    • When the Reserve Bank of India reduces the cash reserve ratio, a scheduled commercial bank will have the ability to offer more loans such as personal loans, car loans, home loans, and other forms of credit to borrowers across the nation. This, in turn, will raise the flow of cash to the public.
    • When market interest rates go down intensely, the cash reserve ratio acts as a very good liquidity absorption instrument. This functioning of the instrument will help in improving the declining rates.
    • The implementation of the cash reserve ratio is more effective when compared to relying on other monetary instruments such as Market Stabilization Scheme (MSS) bonds. Typically, MSS bonds take a lot of time in controlling the liquidity system in the country.
    • The cash reserve ratio plays a positive role in moderating the financial environment whenever there is a surplus rupee situation.

    How does Cash Reserve Ratio (CRR) Work with Banks?

    In the context of cash reserve ratio, banks prefer when it is low. This is because commercial banks need to keep this ratio of funds with the Reserve Bank of India without earning any interest on these funds. The money is kept for free.

    The CRR is computed as a percentage of the net demand and time liabilities (NDTL) of each bank. NDTL is described as the total of the current account, fixed deposit, and savings account balances.

    What is the Importance of Cash Reserve Ratio (CRR) to Banks?

    You should understand that banks allow customers to open deposits mainly for lending to make a ‘spread’. Banks would generally like to lend maximum amounts to borrowers and retain very little money in the bank for other purposes.

    Maximum lending will help banks in achieving high profits. However, if a major portion of a bank’s money is used for lending, and if there is a high and sudden demand for withdrawals, then the bank will not have enough funds to repay comfortably. This is where the cash reserve ratio comes into the picture. The CRR is fixed by the RBI to banks in order to stay away from such situations where the bank has a shortage of funds for repayment due to excessive lending.

    The chief goal of the CRR is to make sure that there are always small portions of liquid funds against deposits. The other next important goal of the CRR is to enable the RBI administer rates as well as overall liquidity in the nation.

    How Does Cash Reserve Ratio Affect Depositors?

    As a depositor, you may wonder how the cash reserve ratio will affect you personally. You may think that you really not have to care about the CRR as it is only for banks and other financial institutions. However, this is not true. When your bank meets the CRR requirements sincerely, a portion of your deposits will remain absolutely safe. You will not have to worry even if banks make any wrong decision.

    Assume you are someone who has invested in bank stocks, then a higher CRR will indicate that your bank will have lower margins.

    How Does Cash Reserve Ratio (CRR) Help in Managing Money Supply of the Economy?

    As already discussed, cash reserve ratio assists in spreading the circulation of money throughout the economy in order to manage the overall liquidity. It is fixed according to the money supply in the financial market. When there is a rise in the supply of money, the RBI will instantly raise the CRR in order to remove the unnecessary funds. On the other hand, when there is a shortage of liquidity or when there is a decrease in the supply of money, the RBI will increase the CRR mainly to let out more money into the market in order to meet demand healthily.

    Impact of Cash Reserve Ratio (CRR) on Interest Rate

    If there is an increase in the cash reserve ratio, a bank will a low lending capacity in terms of funds. Hence, banks will ask more people to open deposits in their bank accounts. Banks will also raise the interest rate and this step will discourage borrowers from applying for loans due to the increased interest rate. This is because high-interest rates indicate higher loan expenses.

    Background Regarding Cash Reserve Ratio (CRR)

    The Reserve Bank of India has specific monetary activities to build and preserve financial stability by utilising exclusive monetary techniques. These monetary activities constantly work on financial elements such as interest rates, supply of money, price stability, credit availability, etc. in order to have a smooth balance of payment system. These operations also assist in having a steady exchange rate and a decent economic growth.

    These monetary techniques also help in controlling one of the most important aspects of the economy, which is inflation. Inflation tends to fluctuate on a regular basis without any fixed format. An inflation refers to a steady rise in the price level of both products and services in the economy of the nation. It is assessed over a particular period of time.

    The central bank of India has a monetary policy in place just like in any other nation. The monetary policy aims at organising and administering the money supply in the economy. This is done by regulating and managing interest rates of various forms of credit. The RBI implements the monetary policy primarily to enhance price stability as well as to attain positive economic growth in the nation.

    The well-planned monetary policy designed and implanted by the RBI has a number of monetary instruments. Each instrument plays its unique role in shaping the economy of the country. One such monetary instrument is cash reserve ratio (CRR). The other monetary instruments include statutory liquidity ratio, open market operations, credit ceiling, moral suasion, bank rate policy, repo rate, credit authorisation scheme, and reverse repo rate.

    Monetary Rates and Ratios Implemented by the Reserve Bank of India

    Among the above-mentioned monetary instruments, there are mainly ratios and rates that are utilised by the Reserve Bank of India to control growth as well as inflation in the country. The ratios include cash reserve ratio and statutory liquidity ratio. Meanwhile, the rates are mainly of 2 types and they include repo rate and reverse repo rate.

    Repo rate refers to the rate at which the Reserve Bank of India provides credit to commercial banks when they are in need of funds due to any shortage. This rate helps monetary authorities to administer inflation extensively. On the other hand, the reverse repo rate is described as the rate at which the Reserve Bank of India borrows funds from the country’s banks.

    Repo rate is fixed by the RBI and this rate can be described as the cost of credit for any bank. This is a benchmark rate below which short-term interest rates will not go. If the repo rate is very high, then the expenses for short-term funds will also be very high and vice versa. This indicates that when the repo rates are higher, the economic growth may get affected negatively. It may also get slower. On the other hand, when the repo rate is low, the growth of the economy can improve efficiently.

    Reverse repo rate is the opposite of a repo rate. In the case of the reverse repo rate, banks are willing to offer credit to RBI as they can be sure that their funds will be safe in the hands of the RBI.

    Among the 2 ratios, we have already discussed the meaning of cash reserve ratio. The other ratio is statutory liquidity ratio (SLR), which refers to a specific amount of funds that is invested in gold and securities that are approved by the government. These securities can be both state government securities and central government securities. SLR is the minimum reserve of funds that needs to be kept by every commercial bank in India according to RBI regulations.

    Effect of Decrease in Cash Reserve Ratio

    • Effect on interest rates: When the cash reserve ratio is decreased by the RBI, banks will have more money to invest in other businesses since the amount of funds that needs to be kept with the RBI is low. This shows that banks will have an excess of funds and hence, there will be a decline in the interest rates that are charged on loans.
    • Effect on inflation: When the cash reserve ratio is minimised, commercial banks will have more funds and hence, the money supply of the banking system will increase. When there is a rise in the money supply, excessive funds will result in high inflation.

    When the CRR is minimised, funds are drawn out from the economic system excessively and then the money supply is affected negatively wherein there is a shortage of funds. Since the money supply has declined in this situation, the inflation also reduces.

    Effect of Increase in Cash Reserve Ratio

    When the cash reserve ratio is raised, banks will have very limited amount of funds because they are asked to retain huge amounts of cash in hand with the Reserve Bank of India. Hence, banks will not have any money to use for other purposes. You also need to remember that the RBI does not pay any interest on balances of the CRR.

    Now, since banks are not able to receive any interest, they decide to raise the interest rates. They will be forced to raise the interest rates for their loan products such as personal loans, car loans, home loans, two-wheeler loans, etc. When interest rates are increased, even the equated monthly installments (EMIs) of the borrowers will increase. Your loan costs will rise pretty intensely.

    Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

    As discussed, cash reserve ratio (CRR) and statutory liquidity ratio (SLR) are two important ratios that support the Reserve Bank of India in managing the liquidity of the economy. Other than the cash reserve ratio, a bank is mandated by the RBI to invest money in a specific amount of deposits in particular securities that are approved by the government. These can be in the form of gold and central and state government securities. There is a big difference between the CRR and the SRR. When banks maintain the SRR, they do earn a particular amount on it. When banks keep money in the CRR, they do not earn anything on it.

    The Reserve Bank of India will alter the levels of both CRR and SRR on a regular basis in order to manage bank credit extensively. These 2 ratios also assist in upholding the solvency of scheduled commercial banks. Bank solvency refers to a bank’s ability to handle its short-term, middle-term, and long-term financial responsibilities. Bank solvency also refers to a bank’s capability to handle its responsibilities when there is liquidation or when a particular operation gets terminated.

    How does the Statutory Liquidity Ratio (SLR) Affect You as An Investor or Depositor?

    In case you are unsure if the SLR has an impact on you as an investor, we can tell you that the answer is yes. When the statutory liquidity ratio is high, it is good for banks in one way as their funds will be safe with the Reserve Bank of India and these funds can also be redeemed anytime. However, their ability to lend will be controlled due to lack of availability of credit. Hence, banks will resort to raising their lending rates in order to resolve their lending situation.

    Comparison between Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

    • A bank needs to maintain the cash reserve ratio with the Reserve Bank of India and on the other hand, it needs to maintain the statutory liquidity ratio with the bank itself.
    • The cash reserve ratio can be maintained in the form of cash. Meanwhile, the statutory liquidity ratio can be in the form of precious metals like gold, cash, securities, etc.
    • The CRR assists in administering the overall liquidity in the Indian economy as opposed to the SRR that manages and organises the credit development of the economy.
    • The CRR works towards taking care of the purchasing power of money. The SRR mainly works towards encouraging banks to invest funds in government securities.

    To have a successful and smooth borrowing and investing experience, you can keep a track on the cash reserve ratio on a regular basis. You can read news about the CRR and its changing trends in the market. You may also read numerous articles and blogs regarding CRR that are available online in order to widen your knowledge about the concept.

    When you are aware of how the CRR works and how it affects interest rates, inflation, and other monetary aspects, you can make sensible decisions about your loan or savings deposit. You can pick the right time to invest your funds in a loan product or to deposit funds in a bank account according to the prevailing CRR. You can keep yourself updated about the drifts in both the CRR and the SLR to understand the liquidity situation of the nation’s economy.

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