Cash Reserve Ratio (CRR) is the share of a bank’s total deposit that is mandated by the Reserve Bank of India (RBI) to be maintained with the latter in the form liquid cash.
Objectives of Cash Reserve Ratio
In order to determine the base rate, the Cash Reserve Ratio acts as one of the reference rates. Base rate means the minimum lending rate which is determined by the Reserve Bank of India (RBI) and no bank is allowed to lend funds below this rate. This rate is fixed to ensure transparency with respect to borrowing and lending in the credit market. The Base Rate also helps the banks to cut down on their cost of lending so as to be able to extend affordable loans.
Apart from this, there are two main objectives of Cash Reserve Ratio:
1. Cash Reserve Ratio ensures that a part of the bank’s deposit is with the Central Bank and is hence, safe
2. Another objective of CRR is to keep inflation under control. During high inflation in the economy, RBI raises the CRR to lower the bank’s loanable funds.
How does Cash Reserve Ratio work?
When the RBI decides to increase the Cash Reserve Ratio, the amount of money that is available with the banks reduces. This is the RBI’s way of controlling the excess supply of money. The cash balance that is to be maintained by scheduled banks with the RBI should not be less than 4% of the total NDTL, which is the Net Demand and Time Liabilities. This is done on a fortnightly basis.
NDTL refers to the total demand and time liabilities (deposits) that is held by the banks. It includes deposits of the general public and the balances held by the bank with other banks. Demand deposits consist of all liabilities which the bank needs to pay on demand like current deposits, demand drafts, balances in overdue fixed deposits and demand liabilities portion of savings bank deposits.
Time deposits consist of deposits that need to be repaid on maturity and where the depositor can’t withdraw money immediately; instead, he is required to wait for a certain time period to access the funds. It includes fixed deposits, time liabilities portion of savings bank deposits and staff security deposits. The liabilities of a bank include call money market borrowings, certificate of deposits and investment in deposits other banks.
In short, higher the Cash Reserve Ratio, lesser is the amount of money available to banks for lending and investing.
How does CRR affect the economy?
Cash Reserve Ratio (CRR) is one of the components of the monetary policy of the RBI which is used to regulate the money supply, level of inflation and liquidity in the country. The higher the CRR, the lower is the liquidity with the banks and vice-versa.
During high levels of inflation, attempts are made to reduce the money supply in the economy. For this, RBI increases the CRR, sucking the loanable funds available with the banks. This, in turn, slows down investment and reduces the supply of money in the economy. As a result, the growth of the economy is negatively impacted. However, this also helps bring down inflation.
On the other hand, when the RBI needs to pump funds into the system, it lowers CRR which increases the loanable funds with the banks. The banks thus extend a large number of loans to the businesses and industry for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
Why is Cash Reserve Ratio changed regularly?
In accordance with the RBI guidelines, every bank is decreed to maintain a ratio of their total deposits that can also be held with currency chests. This is considered to be the same as it is kept with the RBI. This ratio can be changed by the RBI from time to time in regular intervals. When this ratio is changed, it impacts the economy.
For banks, profits are made by lending. In pursuit of this goal, banks may lend out to the max to make higher profits and have very less cash with them. In such a scenario, if there is an unexpected rush by the customers to withdraw their deposits, the banks will not be in a position to meet all the repayment needs. Therefore, CRR is vital to ensure that there is always a certain fraction of all the deposits in every bank, kept safe with them. RBI curbs these issues with the help of the CRR.
While ensuring liquidity against deposits is the prime function of the CRR, it has an equally important role in controlling interest rates in the economy. The RBI controls the short-term volatility in the interest rates by adjusting the amount of liquidity available in the system. Too much availability of cash leads to the fall in rates while the scarcity of it leads to a sudden rise in rates, both of which are unhealthy for the economy.
Thus, as a depositor, it is good for you to know of the CRR prevailing in the market that ensures that regardless of the performance of the bank, a certain percentage of your cash is safe with the RBI.
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