Introduction to Cash Reserve Ratio (CRR) and How Does it Work?

Money

Introduction to Cash Reserve Ratio (CRR) and How Does it Work?

By Jupiter Team · · 6 min read

The Reserve Bank of India (RBI) is the apex bank of the country. It manages the supply of money to other commercial banks and largely controls the flow of money in the economy.

To do so, the RBI makes use of the various monetary tools it has at its disposal, one of them being the Cash Reserve Ratio or CRR.

The RBI extensively uses CRR to maintain inflation levels and manage the supply of money and liquidity in the country.

The CRR is inversely proportional to the supply of money and investment in the economy.

What is Cash Reserve Ratio (CRR)?

Since the RBI is the Central Bank, it requires all banks to maintain a certain portion of their deposits in the form of cash.

This portion or percentage of liquid cash is to be maintained with the RBI and is referred to as the Cash Reserve Ratio or CRR. The bank earns no interest out of this cash deposit and cannot use it for lending or investing.

How does CRR work?

Let us understand the working of CRR in banking with the following scenario. Assume that the RBI wants to manage the excess flow of money in the economy.

To do so, it will increase the CRR because that would mean that the scheduled banks will need to keep aside more of their deposit with the RBI.

Every scheduled bank must maintain not less than 4% of the total NDTL (Net Demand and Time Liabilities) as cash balance with the RBI. This has to be revisited every fortnight.

Let us look at an example. If the CRR is 4%, then banks must put aside INR 4 every time there is an increase in their deposits by INR 100. And this equation must be maintained within a fortnight.

NDTL is the total net demand and time liabilities (or deposits) that banks hold. Demand deposits are liabilities that need to be paid on demand and time deposits are those that need to be paid back on a certain date, mostly on maturity.

These cannot be withdrawn by depositors immediately, unlike demand deposits.

At the outset, it might seem simple to maintain 4% of your deposits with the RBI. However, the implications of this equation are profound. The CRR is calculated keeping several factors in mind.

Now, let’s find out what really goes into it.

How is CRR calculated?

We already know that the CRR of a bank is calculated as a percentage of the NDTL. The NDTL, on the other hand, is the total demand and time liabilities with public sector banks and other banks excluding the deposits in other banks.

Typically, a bank’s liabilities are as follows:

  • Demand liabilities like demand drafts (DDs), current deposits, cash certificates, and so on
  • Time liabilities like fixed deposits (FDs), gold deposits, and much more
  • Others like dividends, deposit interest, and so on

So, the formula for CRR is

CRR = (Cash/NDTL) x 100

What is the importance of CRR in banking?

The reason why most banks encourage customers to open a bank account or make deposits is so they can lend to other customers. Banks prefer to lend more and keep limited cash in the bank for miscellaneous expenses.

Why do they do that? The answer is simple — profits. If they lend more, banks can earn more profits in the form of interest. However, the flip side is that if a bank uses a large portion of its funds to lend to borrowers, then it will be unable to meet a sudden demand for withdrawals because it would have lent it all.

To avoid this, the RBI mandates a CRR for banks. Therefore, CRR in banking plays an instrumental role in ensuring that banks do not face a shortage of funds in times of need. CRR also plays a role in enabling the RBI to allocate rates and general liquidity in the country.

Objectives of Cash Reserve Ratio (CRR)

  • It ensures that customers and borrowers always have funds to withdraw in times of need by enabling banks to maintain a minimum cash reserve. So, it maintains a certain level of liquidity in the country. Moreover, since that reserve of cash is held by the RBI, it is safe and secure.
  • It plays a role in containing inflation. During times of high inflation, the RBI can increase the CRR and that will discourage banks from lending more.
  • The base rate or the rate below which banks cannot lend to any borrower is also influenced by the CRR.

Current Cash Reserve Ratio (CRR) rate

Like we discussed earlier, the CRR is an important tool of RBI. It is a critical component of its monetary policy, and the RBI keeps revisiting the rate depending on the situation in the economy. The current CRR stands at 3%.

Why is CRR changed regularly?

We already know how the CRR plays an instrumental role in maintaining the liquidity of banks and the economy.

However, sometimes banks, in their pursuit of profits tend to over-lend. This causes an increase in cash or liquidity in the economy and a possible increase in inflation levels.

The RBI uses the CRR to maintain this stability in the economy. By raising the interest rates, the RBI reduces bank lending and inflation.

On the other hand, if there is too little cash in the economy, then the RBI slashes interest rates to enable growth in the economy.

Moreover, as a depositor, having a general idea of the current CRR will keep you confident that a small portion of your cash resides safely with the RBI.

While reading through this article, you may have wondered how the CRR is different from the Statutory Liquidity Ratio (SLR)? Let’s find out.

The difference between CRR and SLR

Both CRR and SLR make crucial parts of the RBI’s monetary policy. The differences between the two are highlighted in the table below:

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

It refers to the percentage of cash that banks must hold 

It refers to the percentage of liquid assets that include government securities, gold, and others apart from cash  

It does not enable banks to earn interest

It permits banks to earn interest 

It is used by the RBI to maintain and manage liquidity in the system

It is used to maintain the solvency of banks and financial institutions and to organize credit development

The cash reserve is kept with the RBI on behalf of the banks

The liquid assets are kept with the bank themselves 

It is used to manage inflation or the purchasing power of money

It is used to encourage banks to invest in government securities 

How does CRR help in controlling inflation?

When inflation is high, the government needs to step in and curtail the flow of money within the economy. That is when the government decides to increase the CRR.

As a result, banks will now need to park more funds with the RBI and that will leave with them little to lend.

Conversely, when there is a dearth of money, the government needs to stimulate some cash flow. That is when it decides to lower the CRR.

This move drives banks to lend more to individuals and encourages businesses and industries to invest. A low CRR can also boost the growth of the economy by leading to more development.

This relationship between the CRR and the economy can also be looked at from another perspective.

What happens when CRR decreases?

When the CRR is decreased, it has an impact on the following.

Interest rates

When the Central Bank or RBI reduces the CRR, then banks will have more cash to lend and to invest because they need to keep a smaller reserve with the RBI. With excess funds, the interest rates on loans will drop.

Inflation

A lower CRR means more cash in the banking system. More funds will translate to higher levels of inflation because there is more money but few goods in the market.

However, a reduction in the CRR also extracts money from the system so there is a limited supply. This, in turn, leads to a drop in inflation.

What happens when CRR increases?

Now, let us understand the consequences of a rise in the CRR. A higher ratio will force the banks to keep larger reserves for cash and will face a dearth of funds for other purposes.

Moreover, banks do not receive any interest on the funds parked with the RBI.

In their bid to earn interest, banks will try to raise interest rates for most of their consumer products like personal loans, car loans, and home loans.

A higher interest rate will mean more expensive equated monthly installments (EMIs). So, increasing the CRR will lead to an increase in the interest rates of loans.

It is important to understand what role the CRR plays in your life. It can impact your financial decisions in many ways.

It reflects the financial situation of the economy and guides you to make informed decisions. You may use the CRR to decide whether you would like to invest your funds, deposit them in the bank, or borrow from the bank.

At every important financial juncture, review the CRR and SLR to determine the condition of the economy.

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