Cash Reserve Ratio

Cash Reserve Ratio

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Cash Reserve Ratio

The share of a commercial bank’s total deposit which the Reserve Bank of India (RBI) mandates to be maintained at the respective bank in the form of liquid cash is known as Cash Reserve Ratio or CRR. It is a tool used to control the liquidity of finances in the banking system and is set according to the guidelines stated by the RBI. This article talks about Cash Reserve Ratio and the various aspects of the same.

Objectives of CRR

Cash Reserve Ratio, or CRR, is considered as one of the reference rates when it comes to determining the Base Rate. Base Rate may be defined as the minimum lending rate that is set and determined by the Reserve Bank of India (RBI). It should be noted that no bank is permitted to lend funds below this standard rate. In order to ensure the transparency of lending and borrowing in the credit market, the Base Rate has been fixed at a specific predetermined value. It also plays a vital role in cutting down the cost of lending of banks. This, in turn, would help banks to extend more affordable loans.

Therefore, the main objectives of the Cash Reserve Ratio are as follows.

  • The Cash Reserve Ratio ensures that the Central Bank has a part of the bank’s deposit. Therefore, part of the deposit is safe.
  • Another objective of CRR is to maintain inflation and to keep it under control. The RBI increases the CRR in order to lower the bank’s loanable funds during high inflation in the economy.

Working

The amount of money that would available with banks would reduce when the RBI decided to increase the value of Cash Reserve Ratio (CRR). This way, the Reserve Bank of India controls the excess supply of money in the economy. The RBI has mandated scheduled banks to maintain a cash balance with the latter itself. However, the cash balance that is kept should not drop below 4% of the total Net Demand and Time Liabilities (NDTL). The Central Bank would execute this on a fortnightly basis.

The primary objective of any bank is to lend funds. They would earn a profit by maximising their lending power, which is achieved by sanctioning loans. For this purpose, banks source money from their users in the form of deposits. These banks offer deposit schemes to customers who often brings in healthy deposits. Then, they lend the same money to its borrowers, generally, at a considerably higher rate of interest when compared to the same offered for deposits. The profit earned by a bank is the difference between the rates of interest in loans and deposits.

CRR comes into the picture to ensure that the bank does not run out of funds in case the customer requires their funds back. It is known that every commercial bank accepts deposits from customers for a particular period by agreeing to pay a specific interest for the funds. These deposits are often used to give out many loans. Therefore, CRR is the percentage of the deposits which every commercial bank is liable to maintain as a reserve with the Central Bank. The funds reserved with the RBI cannot be used for any other purpose by the bank, including loans. The main aim of the Cash Reserve Ratio is to ensure that banks never run out of money and may easily make payments of the funds demanded by the relevant depositors.

Importance

The following are the reasons why CRR is considered a crucial and regulatory aspect for every commercial bank.

  • CRR is a vital monetary policy tool used by the RBI.
  • It aims to form a healthy banking channel and ensure that banks maintain a certain amount of liquid funds to meet the demands of their customers.
  • It controls the supply of money in a country’s economy.
  • It is used to maintain and control inflation or deflation, whichever is prevalent in a country’s economy.
  • It is used to inject funds into an economy or to drain excess funds from an economy.

Impact of CRR

In this section, we are going to take a look at the impact of CRR on various segments of the market.

Real Estate

With an increase in CRR, liquidity of funds in the market would be less. This means that investors would not be looking forward to purchasing real estate nor be inclined to take on a home loan due to the high rates of interest. Moreover, the construction sector would be in a slowdown as multiple construction companies would face scarcity of work as the demand would be less, and as they would require to borrow funds at higher rates. Therefore, construction companies would be reluctant to take on work that would increase their overhead costs.

Investments

Investments generally translate to injecting money in the economy. When CRR increases, there might be a shortage of funds in hand to invest. This would cause a slack and slowdown with respect to investments. Hence, resulting in the economy in itself slowing down.

Exports and Imports

The increase in CRR often means higher interest rates. This makes industries restrict their production of products and services and in turn, will deploy lesser amounts into production and expansion plans. This would cause people to switch to foreign goods and services to obtain their desired products, increasing and decrease in imports and exports respectively. Therefore, implying downward pressure on a country’s GDP.

Equity and Commodity Market

An increase in CRR would result in lesser investment in the equity market. This would affect the commodity market, as well. This would be due to the limited availability of funds for investments. Moreover, the main goal of an ordinary citizen is to save more than invest.

Common Public

Increase in CRR may result in higher rates of interest. Hence, the buying capacity of the public would decrease as it would discourage spending. When rates of interest are high, the loans would also be expensive. However, an existing borrower need not worry as neither EMI nor the tenure of their loan would be affected. With floating interest rates, one can expect their EMI or the tenure of the loan to increase at any given time.

Stock Market

With the increase in CRR, the impact on the stock market would be seen negatively. This means that there would be a decline in the prices of the stocks. A slowdown in many sectors such as engineering, manufacturing, banking, and so on would result negatively as there would be a decline in the prices of the stocks of these companies. Therefore, the stock market would face a hit with the increase in the CRR.

Statutory Liquidity Ratio vs Cash Reserve Ratio

Both, Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), are components of monetary policy in India. However, there are a few critical differences amongst them. The following table gives an idea of the dissimilarities.

Cash Reserve Ratio (CRR)Statutory Liquidity Ratio (SLR)
The CRR requires every commercial bank to maintain only cash reserves with the RBI.In the case of SLR, every commercial bank is asked to have reserves in terms of liquid assets. This would include both cash and gold.
Banks do not earn any return on money reserved as CRR.Banks earn a certain amount of return on money reserved as SLR.
In CRR, the particular cash reserve is maintained by banks with the Reserve Bank of India (RBI).In the case of SLR, the securities kept with the banks themselves are required to be maintained in the form of liquid assets.
The Central Bank, the RBI, controls the liquidity in the Banking System with the help of CRR.SLR is used as a tool to control a bank’s leverage for credit expansion.

 


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