Cash Reserve Ratio is one of the many monetary policy tools that RBI uses to control the money supply in the economy.
RBI is the central bank of our country which manages the money supply to various other commercial banks, NBFCs and other lenders, which ultimately supply money to the rest of the country. The Cash Reserve Ratio or CRR is a crucial financial instrument set by the central banks of any country. It influences the flow of money in the market and even controls inflation. When the CRR rises, banks must stash more funds with the central bank, curbing their lending and investment capabilities. Conversely, when the CRR drops, banks release funds, fostering more lending and potentially boosting inflation
What is the Cash Reserve Ratio?
the Cash reserve ratio is a certain percentage of cash that all banks have to keep with the RBI as a deposit. This percentage is fixed by the RBI and is changed from time to time by the central bank itself.
Currently, the CRR is fixed at 4.50%. This means that for every Rs 100 worth of deposits, the bank has to keep Rs 4.5 with the RBI.
Objectives of CRR
- CRR aids in the control of inflation. In an inflationary climate, the RBI can raise the CRR to deter banks from lending more.
- CRR also assures that banks have a minimum level of funds available to customers, even in times of high demand.
- The CRR serves as the loan’s reference rate. Banks cannot offer loans at rates lower than the basic rate for lending.
- Since the CRR regulates the money supply, it stimulates the economy whenever necessary by lowering the Cash Reserve Ratio.
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 flow of money in the economy. 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 are 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 gain access to the funds. This includes fixed deposits, time liabilities portion of savings bank deposits and staff security deposits.
The liabilities of a bank include call money market borrowings, certificates of deposit and investment in deposits in other banks. In short, the higher the Cash Reserve Ratio, the lesser is the amount of money available to banks for lending and investing.
NDTL = Demand and time liabilities (deposits) with public sector banks and other banks – deposits with other banks (liabilities)
How is the Cash Reserve Ratio Calculated?
There is no cash reserve ratio formula. In technical terms, CRR is calculated as a percentage of Net Demand and Time Liabilities (NDTL).
NDTL for banking refers to the aggregate savings account, current account and fixed deposit balances held by a bank. So whatever is the aggregate amount, according to current regulations, 4.50% of the aggregate balances of all these three categories have to be kept with the RBI.
How does CRR affect the economy
Cash Reserve Ratio (CRR) is one of the main components of the RBI’s monetary policy, 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 flow of money in the economy.
For this, RBI increases the CRR, lowering 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 wants to pump funds into the system, it lowers the CRR, which increases the loanable funds with the banks. The banks in turn sanction a large number of loans to 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.
Difference Between CRR and SLR
SLR | CRR |
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Why is Cash Reserve Ratio changed regularly
As per the RBI guidelines, every bank is required 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. The RBI can change this ratio from time to time at 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 maximum amounts, to make higher profits and have very little cash with them. An unexpected rush by customers to withdraw their deposits will lead to banks being unable 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. While ensuring liquidity against deposits is the prime function of the CRR, it has an equally important role in controlling the 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 cash in the economy leads to the RBI raising interest rates to bring down inflation, while the scarcity of cash leads to the RBI cutting interest rates, to stimulate growth in the economy.
Thus, as a depositor, it is good for you to know of the CRR prevailing in the market. It ensures that regardless of the performance of the bank, a certain percentage of your cash is safe with the RBI.
FAQs
How does the CRR keep inflation under control?
The Cash Reserve Ratio carries a direct impact on the country’s level of liquidity. You can think it is a money supply valve held by the RBI in order to regulate inflation. In the event of increased inflation, the RBI may raise the Cash Reserve Ratio requirements in order to decrease banks’ lending capability and, therefore, lower inflation.
What happens when the cash reserve ratio increases?
As a result, increasing the CRR reduces the money supply, raises interest rates on home loans, vehicle loans, and other loans, and increases demand for money in the interbank market, lowering inflation.
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