Do you ever wonder how banks manage the funds we deposit? Or why do RBI regulations require that banks not lend every fund or rupee they receive as deposits? Well, it brings us to the Cash Reserve Ratio (CRR) requirement that every bank in India has to follow.
Understanding the CRR is crucial as it significantly affects the inflation rate and our economy. In this blog, we will talk about the CRR, including how it works, its significance and more.
What Does the Cash Reserve Ratio Mean?
Cash Reserve Ratio is a mandatory requirement where commercial banks must hold back a certain percentage of their total net demand and time liabilities at the central bank in cash. India’s central bank, the Reserve Bank of India (RBI), requires that all commercial banks maintain their cash reserves as deposits or currency within the bank or in its head office, with no ability to use such a reserve for either investment or granting loans.
In addition, the CRR rate is subjective as it changes on the basis of RBI’s monetary policy and directly impacts the amount the banks can lend. For instance, if the CRR is fixed at 4%, it indicates that for every deposit of ₹100, the bank must keep ₹4 with itself as cash and lend the remaining ₹96.
The CRR was last increased to 4% from 4.5% by the RBI’s monetary policy committee (MPC) on December 6, 2024, to infuse liquidity into the Indian banking system.
How Does the Cash Reserve Ratio Work?
After understanding the Cash Reserve Ratio meaning, you must learn how it works. Cash Reserve Ratio involves fixing a particular percentage of the total deposit of a commercial bank established in the form of cash reserves with the central bank. The RBI determines the appropriate CRR level based on monetary policy considerations.
If the central bank aims to reduce inflation and excessive lending, it raises the Cash Reserve Ratio. Conversely, if the growth in the economy is on the central bank’s agenda, it lowers the Cash Reserve Ratio. Once the RBI sets the CRR rate in the country, all commercial banks will have to set aside a certain percentage of their net demand and time liabilities as cash reserves with the central bank.
What is the Significance of the Cash Reserve Ratio?
After learning what is CRR, the following pointers highlight the significance of the Cash Reserve Ratio:
Monetary Policy Tool
The Cash Reserve Ratio is a crucial monetary policy instrument used by the Reserve Bank of India to manage the money supply in the economy. The RBI adjusts the Cash Reserve Ratio to impact the lending rate, control inflation, stabilise economic growth and ensure proper liquidity management.
Liquidity Management
The Cash Reserve Ratio ensures that banks keep a percentage of their deposits in cash or highly liquid instruments with the RBI, which helps manage liquidity in the banking system. The higher the CRR, the less money is available for lending by banks, reducing liquidity. Conversely, a lower CRR increases the amount of funds available for lending, increasing liquidity in the economy.
Inflation Control
Cash Reserve Ratio is a significant tool in controlling inflation. In times of high inflation, the RBI increases the CRR to lend less money. Such action curbs excess liquidity in the economy, which decreases lending and economic activities. This maintains stable prices, restricting inflation from skyrocketing.
Financial System Stability
By requiring banks to maintain a part of their deposits as a reserve, CRR ensures the stability of the entire financial system. It serves as a cushion against the threat of bank runs and provides banks with sufficient liquidity to face withdrawal pressures from depositors, enhancing confidence in the banking sector.
Consumer Protection
The Cash Reserve Ratio indirectly guards consumers through reserve requirements. This means that a bank has to maintain sufficient reserve levels to support liquidity during short-term crises. In this way, consumers’ funds remain safe and ready for use.
Economic Stability
The CRR is important for maintaining economic stability. By controlling the amount of money that banks can lend, the CRR influences the overall economic activity. A balanced CRR can encourage sustainable growth by preventing excessive credit expansion that may lead to economic bubbles or recessions.
What is the Procedure to Calculate Cash Reserve Ratio?
The Cash Reserve Ratio is determined as a percentage of the net demand and time liabilities. It encompasses all the bank deposits, including demand deposits like current and saving accounts, and time liabilities such as fixed deposits (FDs) and recurring deposits (RDs).
The formula for determining the CRR is:
Cash Reserve Ratio = amount of cash reserves held by the bank with the central bank / Net Demand and Time Liabilities
For example, suppose a bank has net demand and time liabilities amounting to ₹100 crores, and the RBI requires a 4% Cash Reserve Ratio. In this case, the bank must maintain ₹4 crores in cash with the central bank.
The Reserve Bank of India is responsible for setting the CRR. This can change over time due to economic conditions. Generally, the RBI utilises the CRR as a tool to check the money supply within the economy and control inflation.
What is the Impact of CRR on the Indian Economy?
Now that we have explained what is Cash Reserve Ratio, we will highlight its impact on the Indian economy. The following points highlight CRR’s impact on the Indian economy:
Impact on Supply of Money
The CRR significantly influences the money supply in the economy by requiring banks to maintain a portion of their deposits as cash reserves. An increase in the CRR reduces banks’ lending capacity, leading to a contraction in the overall money supply. Conversely, when the central bank lowers the Cash Reserve Ratio, banks can lend out a large share of their deposits as loans, increasing the money supply.
Influence on Interest Rates
The CRR also affects interest rates. When the central bank raises the CRR, banks experience a shortage of funds available for lending, often resulting in higher interest rates to attract more deposits. This strategy helps banks conserve their resources. On the other hand, a decrease in the Cash Reserve Ratio can lead to lower interest rates as banks have more funds available for lending.
Resilience and Stability
By requiring banks to hold a portion of their deposits as cash reserves, the CRR enhances the resilience and stability of the banking system. In times of financial crisis or sudden deposit withdrawals, maintaining adequate reserves enables banks to prevent liquidity crises and fulfil their obligations effectively.
Overall Impact on the Economy
Changes in money supply and interest rates driven by adjustments to the Cash Reserve Ratio have far-reaching effects on investment, consumption, price levels, and overall economic activity. A well-regulated money supply promotes price stability, helping avoid deflation and runaway inflation in the economy.
Why Does the Cash Reserve Ratio Change Regularly?
CRR is adjusted for various reasons, primarily linked to the central bank’s objectives and current economic conditions. The key factors influencing changes in the Cash Reserve Ratio include:
Monetary Policy Objectives
The Reserve Bank of India aims to maintain price stability and foster sustainable economic growth through various monetary policies, including adjustments to the Cash Reserve Ratio. When inflation rises, the central bank increases the CRR to reduce excess liquidity in the banking system and control credit expansion, curbing inflation. Conversely, the RBI may lower the CRR requirement to encourage investment and lending if the economy requires stimulation.
Changes in Banking System Dynamics
Shifts in deposit mobilisation and lending behaviour within the banking system also affect the CRR. The central bank may adjust the CRR to manage excess liquidity if banks accumulate substantial deposits. Conversely, if there is a shortage of funds available for lending, the central bank typically reduces the Cash Reserve Ratio to enhance credit availability.
Economic Growth and Stimulus
During periods of economic recession, the central bank often lowers the CRR to increase the money supply, enabling banks to provide more funds for lending. This approach stimulates investment and borrowing, supporting economic recovery.
Final Thoughts
The Cash Reserve Ratio is a fundamental component of the Reserve Bank of India’s monetary policy, playing a vital role in maintaining liquidity and stability within the banking system. By mandating that banks hold a specific percentage of their deposits as reserves with the RBI, the Cash Reserve Ratio effectively regulates the money supply and influences interest rates.
By understanding its implications, you can better navigate the complexities of monetary policy and its impact on the broader economy.
