Cash Reserve Ratio (CRR): Meaning, How it Works And its Impact on Depositors
All commercial banks in India maintain a specific percentage of total bank deposits as per the guidelines of the Reserve Bank of India (RBI) known as the Cash Reserve Ratio (CRR). This helps reduce liquidity risks.
Read on to get an in-depth understanding of the Cash Reserve Ratio, its importance and impact on interest rates, what happens when CRR increases or decreases and what is the current CRR. Read on!
What is Cash Reserve Ratio?
The cash held as reserves against total bank deposits is termed as Cash Reserve Ratio (CRR). The RBI keeps a particular percentage of money with commercial banks in this system. The sum of money is sent chiefly directly to the central bank, but it is often preserved in the bank’s locker.
Banks can neither use CRR money on investing activities nor lend it to the borrowers or loanees. Nevertheless, RBI uses the CRR ratio as a quantitative instrument to normalise inflation or deflation in the country.
The formula for computing CRR is:
Cash Reserve Ratio (CRR) = Reserve Requirement x Bank Deposits
Objectives of Cash Reserve Ratio
The base rate is the minimum lending rate set by the RBI below which banks are prohibited from lending money. The Cash Ratio Reserve acts as a reference for setting this base rate.
It helps establish transparency in the banking sector’s borrowing and lending activities and gives banks the ability to provide affordable loan options.
Apart from these two objectives, some of the other main objectives of CRR are:
- It ensures that a fraction of the bank’s deposits are secured with the RBI to maintain solvency.
- It regulates the cash flow in the economy. The policies decided by the RBI determine how much money will flow into the economy.
- CRR helps keep inflation within limits. For instance, when inflation gets high, RBI increases the CRR to reduce the ability of banks to sanction loans. This results in the reduction of market liquidity, which helps bring down inflation.
- CRR helps during liquidity crunches in the market. During these periods, RBI reduces the CRR so that banks can lend more money to people to balance the economy.
How Does Cash Ratio Reserve Work?
The RBI helps in controlling the cash flow through the economy via Cash Reserve Ratio. When RBI increases the CRR, the banks end up with less available funds.
Currently, the cash balance to be maintained by a bank with RBI needs to be more than 4.5% of NDTL (Net Demand and Time Liabilities). This means that for every Rs. 100 of deposits that a bank owns, it must hold Rs. 4 in cash readily available for withdrawals.
NDTL consists of deposits made in banks by the general population and other balances. The demand portion comprises all liabilities the bank must pay upon demand. For example, demand drafts, overdue fixed deposits, current deposits, etc., are demand deposits.
Time liabilities comprise all liabilities which must mature before repayment. The depositor cannot withdraw the money before the maturity date. Examples of these are fixed deposits and staff security deposits.
How is Cash Reserve Ratio Calculated?
The Cash Reserve Ratio is set by the RBI. The Cash Reserve Requirement is calculated as a percentage of the NDTL. The total balance of all fixed deposits, savings accounts and current accounts is considered a part of the NDTL for banks.
For instance, let us assume that the CRR is set at 5% and the NDTL of a bank is Rs. 100 crore.
The Cash Reserve Requirement for the bank would be: Rs. [(5 / 100) x 100 crore)] = Rs. 5 crore
Hence, the bank would have to keep Rs. 5 crore of its deposits with the RBI. This amount would be unavailable to the bank for investment and lending.
Why Does a Bank Need to Maintain CRR?
- Reserve Bank of India focuses on controlling liquidity in the financial banking system. It maintains the cash flow of the whole country by using various financial instruments to uphold the economy. CRR is one such instrument.
- Maintaining CRR in a systematic way will control the liquidity of the country. Nevertheless, it can be beneficial for the commercial banks, too, as by no means they will suffer from fund shortages.
- Another vital reason to maintain CRR is that it controls inflation in the economy. In case of a sudden rise in the price of products, the RBI increases CRR to lower the money flow and investment, thereby lessening inflation.
- In the economic system, Cash Reserve Ratio is inversely related to the country’s liquidity. It means when a high level of CRR is reserved with RBI, economic liquidity will get reduced. Similarly, a low level of CRR kept with RBI will raise liquidity.
Also Read: Prime Lending Rate, MCLR, RBI Base Rate & How Do These Rates Work
Effects of Cash Reserve Ratio
Cash reserve ratio has a significant impact on India’s economy. The following pointers outlines its effects:
1. CRR’s Effect on Economy
One of the best financial instruments followed by the RBI to control inflation, supply of money, cash flow etc., is the Cash Reserve Ratio (CRR). If the level of CRR increases, the amount of liquidity decreases and vice-versa.
In case of inflation, the Reserve Bank of India enhances the CRR level alongside diminishing the borrowing funds of commercial banks. In turn, it lessens the money supply in the economy. Although it causes adverse effects on the country’s core economy, it still controls the burden of inflation.
Likewise, when RBI figures out some funds are needed desperately, they reduce the CRR level, enhancing credit facilities for the commercial banks. This enables banks to offer more and more loans to borrowers and businesses. Thus, money supply and productivity in the economy get better.
2. Cash Reserve Ratio’s Effect on the Interest Rate
When the cash reserve ratio increases, banks reduce the flow of funds. As a result, this will make people keep more deposits in their bank accounts. It will make banks increase the rate of interest, thereby disallowing borrowers from applying for credit. Point to be noted that interest rates are directly related to loan expenses.
So, if the interest rate is higher, loan expenses will also increase. Now let’s check what happens when the cash reserve ratio increases or decreases.
3. Effect of Increase in CRR
The following effects will occur when CRR increases:
- Banks will have to keep fewer funds and resources when CRR is raised.
- Commercial banks will keep inadequate funds since RBI asks them to hold large liquid cash.
- Banks will be forced to increase interest rates on credit items like home loans, car loans, personal loans, etc.
- An increase in interest rate will also raise the Equated Monthly Instalments (EMIs).
4. Effect of Decrease in CRR
The following effects will occur when CRR decreases:
- When CRR decreases, the supply of money will increase due to more funds from commercial banks.
- A rise in the money supply will increase the chance of causing inflation.
- If CRR decreases, a reduction of funds will occur in the economy, and the supply of money will be affected.
Difference between Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
The major differences between Cash Reserve Ratio and Statutory Liquidity ratio are as follows:
| Prospect | CRR | SLR |
| Meaning | CRR is a certain portion of the money that the commercial banks keep as a reserve with the central bank. | SLR refers to the funds that banks require to maintain their liquid assets like cash, securities. etc. |
| Form | Cash and cash equivalents | Liquid Assets |
| Use | To eliminate excess fund from the economic system | Ensuring creditworthiness of commercial banks. |
| Control | Central Bank or RBI (Reserve Bank of India) | Bank itself |
| Returns | Banks earn no interest as a return on the fund in case of CRR. | Banks earn interest as a return on the funds in case of SLR. |
Also Read: What Is The Difference Between Secured And Unsecured Loans?
Final Word
CRR or Cash Reserve Ratio determines the percentage of deposits held by the commercial banks as reserves. Central Banks use CRR to control the interest rates and lending rates of a country by adjusting money whenever necessary.
FAQs
Ans: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are both important concepts in banking. While CRR is the reserve that banks maintain with the RBI, SLR is the reserve that the banks must maintain themselves before offering credit. Moreover, banks must maintain SLR in the form of cash, gold and other securities, unlike CRR, which must be held as cash.
Ans: The current cash reserve ratio set by the RBI is 4.50%. The RBI keeps on changing this value based on various factors.
Ans: The CRR is set and maintained by the Reserve Bank of India. They keep on changing the CRR on a fortnightly basis.
Ans: The main objective of SLR is to maintain liquidity of the banks. Apart from that, it also helps in controlling inflation and credit flow and maintaining solvency in banks.
Ans: The Cash Reserve Requirement is calculated as the CRRs percentage of the NDTL. For instance, let us assume that the CRR is at 4% and the NDTL of a bank is Rs. 200 crore.
The Cash Reserve Requirement for the bank would be: Rs. [(4 / 100) x 200 crore)] = Rs. 8 crore
When RBI increases the CRRR, banks are left with fewer funds to sanction loans and make investments. The reduced cash flow helps in bringing down inflation.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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