The Cash Reserve Ratio or CRR is one of the several monetary policy tools employed by the Reserve Bank of India to maintain the country’s economy. As the apex bank of the nation, the RBI oversees managing the cash flow to commercial banks, non-banking financial companies (NBFCs) and other lenders, who in turn supply money to the rest of the country.
What Is Cash Reserve Ratio?
Cash Reserve Ratio is a percentage of cash that all banks need to retain as a deposit with the RBI. This proportion is fixed and adjusted periodically. However, banks do not get any interest on this reserve money kept with the RBI and it cannot be utilised for investment or lending purposes.
How Is Cash Reserve Ratio calculated?
There is no formula for computing CRR. It is calculated as a proportion of Net Demand and Time Liabilities (NDTL). These include the aggregate savings account, current account and fixed deposit balances held by a bank. Whatever the total NDTL amounts to for each bank, 3% of this sum must be retained with the RBI, as per the current reserve requirements.
Significance of Cash Reserve Ratio
Banks earn profits from the interest incurred on loans. If they were to lend out a majority of their capital, they could easily maximise their profits. But, this could lead to a financial crisis. They would struggle if customers wanted their money back in times of need. Therefore, the prime objective of the CRR is to have some form of liquid cash against deposited funds, so that banks do not run out of money when depositors seek to make withdrawals.
The Cash Reserve Ratio helps to control inflation and the market interest rates. Apart from the CRR, the RBI uses other monetary tools such as the Statutory Liquidity Ratio (SLR), repo rate, reverse repo rate, open market operations, etc. to steer the economy. CRR rates are increased or reduced from time to time in response to the changing financial situation.
During high levels of inflation, the RBI increases the CRR to reduce the excess cash flow in the market. As a result, banks need to deposit more money with the RBI and keep lesser capital for themselves. Hence, they are left with insufficient funds for lending, investing and other credit requirements.
On the other hand, if the CRR is reduced, it suggests the RBI wants to inject liquidity into the economy by supplying more money in the market. In this case, banks can easily extend loans to industries and businesses for investment.
CRR directly influences the market interest rates since cash supply and interest rates are inextricably linked.
Benefits of Cash Reserve Ratio
A competent Cash Reserve Ratio offers numerous advantages such as:
- CRR assists in managing liquidity by supplying capital as per the demands of the economy.
- CRR is influenced by the amount of money available in the financial market. When there is high inflation, the RBI raises the CRR to reduce the circulation of excess funds. Similarly, when there is limited money in the market, the RBI lowers the CRR to boost the economy.
- It strengthens and maintains the solvency position of commercial banks.
- It consistently maintains the liquidity system in all commercial banks.
- It enables the RBI to control and co-ordinate the credit held by banks, resulting in a smooth supply of cash and credit in the economy.
- Commercial banks offer more loans to borrowers when CRR is lowered increasing the flow of cash to the general population.
- When the market rates fall sharply, CRR helps to improve the declining rate by absorbing liquidity.
- CRR plays a positive role in moderating the financial climate when the currency is in surplus.
- Exercising CRR proves more effective than using other monetary instruments such as Market Stabilisation Scheme bonds, which take a long time to regulate the economy.
Effects of Cash Reserve Ratio
The Cash Reserve Ratio affects our economy in the following ways:
- CRR enables the RBI to oversee interest rates and liquidity in the country.
- An increase in CRR limits the lending capacity of banks resulting in additional deposit accounts and higher interest rates. This discourages borrowers from seeking loans because higher interest rates mean higher loan costs.
- For depositors, who have made stock investments in a bank, a higher CRR rate means lesser margins for the bank.
- When the CRR is reduced, banks have more capital available for investing and lending. They can offer loans at a lower rate of interest.
- A fall in the CRR results in increased cash flow, more investments and better economic growth.
CRR is an essential monetary policy instrument used by countries around the world. The CRR rate varies for nations depending on their respective central bank mandate. The stipulated reserves are held in the form of deposits with the central bank (like RBI in India) or housed in bank vaults. CRR is an important indicator of the economy’s health and depositors need to understand its different aspects to make sound financial decisions.