Stock / Share Market
by 5paisa Research Team Last Updated: 2022-11-25T15:48:54+05:30

Introduction

The Reserve Bank of India (RBI) is the bank of banks. This central monetary authority controls the supply of money in the economy. RBI’s monetary policy committee designs and implements economic and monetary policies to control factors that directly affect price stability and economic growth. 

All the banks in the country are the source of monetary transactions and hence they must adhere to RBI regulations. The RBI aims for economic growth by changing the money markets depending on the market conditions. The monetary policy uses financial instruments to control money flow in the economy. These instruments include Cash Reserve Ratio, Statutory Reserve Ratio, Bank rate policy, repo rate, and reverse repo rate, among others. This article discusses the Cash Reserve Ratio meaning, how it works, and how it is calculated.
 

The Cash Reserve Ratio definition (CRR)

According to the CRR meaning, the Cash Reserve Ratio is the percentage of customers’ cash deposits that a commercial bank must keep with the RBI in the form of reserves or cash. It is an important tool that controls liquid cash flow in the economy while managing inflation. 

 

How does Cash Reserve Ratio work?

Currently, the Cash Reserve Ratio is 4% for all commercial banks. This implies that banks must deposit 4% of their liquid assets with the RBI. The RBI can increase or decrease this rate depending on the economic conditions and regulatory policies. When the CRR is reduced it reduces the cash with the banks that can be lent to businesses. This reduces the total cash flow in the economy. 

Businesses will not have enough funds to invest and hence there will be a control in prices and inflation. On the other hand, if the CRR is reduced banks will have more liquidity. They can lend more to businesses allowing for higher liquidity circulating in the economy to boost economic activity and growth. 
 

How is Cash Reserve Ratio calculated?

According to the CRR definition, it is calculated as a percentage of the bank’s Net Demand and Time Liabilities (NDTL). The bank's liabilities can be:

1.    The demand liabilities of the bank are all liabilities that the banks must pay when demanded. They include current deposits, demand drafts, balance in overdue fixed deposits, and demand liabilities of the savings bank deposit.

2.    Deposits where the depositor cannot withdraw deposits immediately or, rather, have to wait till they mature are Time deposits. These include fixed deposits, staff security deposits, and the time liabilities portion of the savings bank deposits.

3.    Other liabilities could take the form of call money market borrowings, certificates of deposit, interest deposits in other banks, dividends, etc.

 A simple formula to calculate CRR is

 CRR = (Liquid Cash/ NDTL ) *100
 

Objectives of CRR

CRR plays an important role in the balance and growth of an economy.

1.    CRR secures customers’ funds with the banks. It ensures that the funds are available in case of a surge in demand.

2.    CRR makes sure that the banks maintain minimum liquidity.

3.    CRR helps control inflation. If inflation is high, an increase in CRR reduces liquidity and reduces lending.

4.    It serves as a reference rate for lending by banks. Banks cannot lend at rates lower than the CRR and thus become transparent in their loan schemes.

5.    A reduction in the CRR boosts lending that helps businesses and the economy grow.
 

Difference between CRR and SLR

The Statutory Liquidity Ratio is the ratio of liquid assets to the time and demand liabilities that need to be maintained by any bank. These liquid assets need not be cash-only, but can be in the form of other liquid assets like gold, government securities, bonds, and precious metals. The key differences between CRR and SLR are as below.

SLR

CRR

 

Liquid assets can be in the form of gold, precious metals, bonds, and government securities.

 

 Liquid assets need to be in cash.

 

The liquid assets can be maintained with the bank.

 

The liquid asset needs to be with RBI.

 

The current SLR is 18%

 

 

The current CRR is 4%

 

Banks earn interest on the funds that are marked as SLR.

 

 

Banks do not earn interest on CRR funds.

 

RBI uses SLR to maintain the bank's solvency and ensure credit leverage.

 

 

RBI uses CRR to control liquidity in the banking system of an economy.

 

Why is Cash Reserve Ratio changed regularly?

A bank has liquid money in the form of cash, securities, bonds, and precious metals. As per RBI regulation, the bank must maintain a ratio of these liquid securities in cash with the RBI. This cash can also be currency stored in a safe or chest. The ratio changes from time to time so that the RBI can regulate the cash that is circulating in the economy.

In situations with a sudden demand for liquidity, the bank should have enough cash to meet this demand. CRR ensures liquidity to make the repayments. Regular updating ensures banks have enough liquidity depending on the economic scenario.

CRR also plays an important role in controlling liquidity and volatility. By raising interest rates, liquidity is brought down, making loans expensive and by reducing rates they improve liquidity and banks can lend easily, boosting the economy.

The Cash Reserve Ratio is an important term that every person needs to be well acquainted with. It has a direct or indirect effect on our everyday financial transactions. One can see the ripple effects of CRR on loan rates, equity and commodity markets, imports and exports, foreign exchange, real estate market, and even the Gross Domestic Product (GDP) which indicates the rate at which the economy is growing.  
 

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