Cash Reserve Ratio (CRR) falls among RBI monetary policies. RBI uses this monetary tool to curb liquidity risks and regulate cash flow in the Indian economy. Cash Reserve Ratio requires banks to keep a certain percentage of their share as a deposit that is to be maintained by the RBI as a reserve in form of liquid cash.
To know the ins and outs of CRR (Cash Reserve Ratio), go through the following sections.
Table of Contents
What Is Cash Reserve Ratio and How Does It Affect the Economy?
The cash reserve ratio is a percentage of cash that a bank must keep in reserves against its total deposit. The Reserve Bank of India uses CRR in order to ensure robust financial management which regulates liquidity and slows investment.
Cash Reserve Ratio (CRR) is a key component of the monetary policy of RBI. Besides regulating the inflation level, it also manages cash supply and liquidity; hence has a significant impact on the Indian economy. The higher the CRR rate, the lower the liquidity with all banks.
However, it is important to note that the CRR amount cannot be lent to individual borrowers or business bodies, and neither the amount can be used for investment purposes. Further, financial institutions do not earn any interest on the cash that is parked with RBI.
This monetary tool applies to all commercial banks. However, it does not apply to RRB (Regional Rural banks) or NBFCs. CRR influences the pattern following which banks extend credit options. It plays an important role for both financial institutions and depositors.
Importance of Cash Reserve Ratio
RBI increases the CRR if the inflation level is high. In this scenario, banks cannot lend funds which in turn lowers the investment spree and reduces the cash flow in the economy. Conversely, RBI lowers the CRR rate when there is a need to inject funds into the financial market. It helps banks offer loans to borrowers, industries or business bodies. Reducing the reserve cash ratio improves cash flow and strengthens the economy.
Maximum lending will help banks achieve higher profitability. However, in pursuit of making more profit, banks might lend out maximum money and face a cash crunch. If there is a higher rate of withdrawal in such situations, banks will not be able to cater to the repayment needs of customers. This is where CRR proves to be extremely effective. RBI fixes this monetary tool to mitigate such scenarios and ensures that banks always have a fraction of all deposits.
Objectives of Cash Reserve Ratio
Here are the major objectives of Cash Reserve ratio.
- The main objective of the Cash Reserve Ratio (CRR) is to control inflation. RBI, in a high inflation scenario, increases the cash reserve ratio to stop banks from lending.
- CRR is implemented to ensure that the banks never run out of cash to cater to the payment demands of depositors. In simple words, it works as a safety net for depositors. Regardless of the bank’s performance, it ensures the depositors that a percentage of their cash is secured with RBI.
- This monetary tool is also used as a reference rate for loans, which is termed as the base rate.
- It also ensures that banks have a minimum amount of money that can be extended to customers during massive demand.
- CRR regulates cash flow and boosts the economy.
- Besides ensuring liquidity, CRR has an equal role in regulating interest rates levied by banks on the loan. By adjusting liquidity, the Reserve Bank of India regulates short-term volatility.
Advantages of Cash Reserve Ratio
Let’s have a look at the advantages of Cash Reserve Ratio.
- The cash reserve ratio ensures a consistent and regulated liquidity system in every commercial bank.
- It also absorbs liquidity when the interest rate prevailing in the market drops drastically, thereby helping in uplifting the declining rate.
- CRR aids commercial banks to sustain their solvency position.
- As RBI controls the credit that banks must have through the CRR rate, it helps to ensure a seamless cash supply in the economy.
As a depositor, it is imperative to know the prevailing CRR.
Difference between Statutory Liquidity Ratio Vs Cash Reserve Ratio
|Statutory Liquidity Ratio||Cash Reserve Ratio|
|SLR (Statutory Liquidity Ratio) encompasses liquid assets (bonds, gold, government securities etc.)||As the name suggests, the cash reserve ratio includes only cash reserves.|
|Banks do earn interest on assets reserved as SLR.||Banks do not earn any interest on the fund parked as CRR.|
|In SLR, securities are maintained by the financial institutions themselves.||CRR amount is kept with the RBI.|
|This monetary tool is used to regulate the leverage of banks for credit expansion.||CRR, on the other hand, regulates liquidity in the banking system|
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Frequently Asked Questions
Why is Cash Reserve Ratio (CRR) changed periodically?
CRR caters to the dynamics of the economy. Hence, depending on the flow of cash in the Indian economy, RBI has to change the cash reserve ratio at regular intervals. A slight change in the CRR will impact the economy.
What is the formula used for evaluating the cash reserve ratio?
CRR is evaluated as a percentage of the bank's net demand liabilities and time liabilities. The formula used for cash reserve ratio is-
Cash reserve ratio (CRR) = (Liquid cash / NDTL) * 100
Why do individuals avoid borrowing from banks when CRR is increased?
Banks have low lending capacity when RBI increases the cash reserve ratio. Low lending potential prompts banks to raise the interest rate. Higher interest rate results interest payments and loans to be on the expensive side. Hence, borrowers avoid applying for a loan when CRR is increased.