How does the Cash Reserve Ratio Work?
The cash reserve ratio is a way for the RBI to maintain a certain level of liquidity or money flow in the economy. Let us say that the RBI thinks that the liquidity is very high in the economy. Besides, the excess money flow is also causing inflation, as people have more money in their hands and therefore they are increasing the demand for goods and services.
In such a case, the RBI can increase the CRR, thereby making it necessary for banks to hold a higher percentage of their deposits as liquid cash with the RBI. As banks will not be able to either lend or invest these funds, the supply of money or liquidity will be reduced in the economy.
Conversely, when the RBI thinks that the liquidity is on the lower side in the economy, it can reduce the CRR, which will allow banks to maintain a lower percentage of their deposits as CRR. Hence, they will be able to lend and invest more, which will increase liquidity.
How is the Cash Reserve Ratio Calculated?
The cash reserve ratio (CRR) is calculated as a percentage of a commercial bank's net demand and time liabilities (NDTL). The funds calculated by this percentage must be maintained as liquid cash with the central bank, that is, the RBI.
Now, what are a bank's net demand and time liabilities (NDTL)?
a) Demand Liabilities: Those deposits of a commercial bank, which are payable on demand, are called its demand liabilities. Savings accounts and current accounts are examples of demand liabilities. When you have such accounts with a bank, you can demand their withdrawal anytime. Hence, they are called “demand” liabilities.
b) Time Liabilities: Those deposits which can be redeemed only at the end of a fixed term (e.g., fixed deposits or FDs and recurring deposits or RDs) are called “time” liabilities. As a depositor, you cannot withdraw such deposits anytime you want.
c) Certain Exemptions: By adding the demand and time liabilities of a bank, we will arrive at its “Gross Demand and Time Liabilities.” From this number, to arrive at net demand and time liabilities, we need to deduct certain exemptions, like inter-bank deposits and any other exemptions specified by the RBI.
Having calculated a bank’s NDTL, we need to apply the CRR specified by the RBI to calculate the amount of funds to be maintained by the bank with the RBI as liquid cash.
Read Also: What is Quantitative Easing?
Objectives of CRR
There are several objectives of the cash reserve ratio, which are described below:
a) Maintaining a certain level of liquidity: CRR helps the central bank maintain a certain level of liquidity in the economy. If the liquidity is high, the RBI can increase CRR, which will leave lesser funds with banks for them to lend. On the other hand, if the liquidity is low, the RBI can decrease CRR, thereby permitting banks to lend more and increasing the liquidity.
b) Maintain a certain level of inflation: The supply of money affects the level of inflation in an economy. If the money supply is higher, inflation is likely to be high. To curb inflation, the RBI can decrease the money supply by increasing the CRR. Conversely, if the money supply is too low, people may have less money in their hands to buy goods and services. Hence, the RBI can reduce the CRR to increase the money supply.
c) Works as the base rate of loans: CRR also works as the base rate of loans provided by commercial banks. Banks cannot lend below this rate. Hence, by tweaking CRR, the RBI can also change the rate at which commercial banks provide loans to their customers.
Difference Between CRR and SLR
For a central bank, Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) are important tools of its monetary policy. However, there are key differences between these rates, which are explained below:
Criteria
| Cash Reserve Ratio (CRR)
| Statutory Liquidity Ratio (SLR)
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Meaning
| The CRR refers to the amount of cash reserves commercial banks need to maintain with the RBI.
| The SLR indicates the amount of liquid assets, which banks are asked to maintain that are in the form of cash, government securities, and gold.
|
Objective
| The objective of the CRR is to maintain a certain level of liquidity in the economy.
| The objective of the SLR is to maintain the solvency of commercial banks. As banks are required to keep a certain percentage of their NDTL as liquid assets, they can meet their short-term obligations easily. Besides, the SLR also helps the RBI in maintaining a desired level of liquidity in the economy.
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Interest Income
| Banks do not earn any interest on the funds they maintain as CRR.
| Banks earn interest income on the funds they maintain as SLR.
|
Where are the funds parked?
| Banks have to maintain a certain level of cash with the RBI as CRR under the regulations.
| Banks have to keep a certain level of liquid assets with themselves as per the regulations regarding the SLR.
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Why are Changes Made to the Cash Reserve Ratio Regularly?
The central bank or the RBI keeps on changing the CRR regularly for multiple purposes. For example, it can change the CRR to ensure that commercial banks do not lend excessively. Suppose banks start lending too much. In such a situation, if for some reason, customers start rushing to withdraw their deposits, banks may not have sufficient funds to repay those deposits to their customers.
Hence, CRR helps the RBI maintain a certain level of liquidity and stability in the economy. When banks lend excessively, it can increase the money supply, which can cause inflation. To deal with it, the RBI can increase the CRR, which will require banks to maintain a higher percentage of their deposits as liquid cash, thereby reducing their ability to lend and curbing inflation.
Conclusion
If you have a trading account and participate in the Indian stock market, you should thoroughly learn the concept of the cash reserve ratio. This ratio impacts the entire economy through banks. When banks have a lot of liquidity, they can easily extend loans to borrowers. However, the RBI can increase the CRR to curb the money supply, which can make banks lend less. As banks lend less, it can impact economic growth. If the economic growth declines, it may cause stock prices to fall, too. Hence, for an investor, it is very important to understand how the changes in the CRR impact the economy in general and the stock market in particular.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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