Cash Reserve Ratio is one of the many monetary policy tools that RBI uses to control the money supply in the economy.
RBI is the central bank of our country which manages the money supply to various other commercial banks, NBFCs and other lenders, which ultimately supply money to the rest of the country. Let's read on further to understand what is the cash reserve ratio, CRR meaning and what is the rationale behind having it.
In simple terms, the Cash reserve ratio is a certain percentage of cash that all banks have to keep with the RBI as a deposit. This percentage is fixed by the RBI and is changed from time to time by the central bank itself.
Currently, the CRR is fixed at 4.50%. This means that for every Rs 100 worth of deposits, the bank has to keep Rs 4.5 with the RBI.
The Cash Reserve Ratio's critical objectives are as follows-
There is no cash reserve ratio formula. In technical terms, CRR is calculated as a percentage of Net Demand and Time Liabilities (NDTL).
NDTL for banking refers to the aggregate savings account, current account and fixed deposit balances held by a bank. So whatever is the aggregate amount, according to current regulations, 4.50% of the aggregate balances of all these three categories have to be kept with the RBI.
The cash reserve ratio means the main aim is to provide some sort of liquid cash against depositors’ money so that the bank does not run out of cash to meet depositors’ requirements. There are more rules and regulations to this.
Banks earn money from the loans they lend to us and the interest we pay to banks on the same. In an ideal situation, banks would want to lend as much as they can to earn more profits.
However, this is problematic because if the banks lend out most of the funds they have, in an unlikely circumstance when there is a sudden withdrawal rush by the customers, banks will struggle to meet the requirements.
Cash reserve ratio has other purposes as well. One of them is to control liquidity and interest rates in the economy. Do remember that CRR is just one of the tools and cannot be responsible for controlling the liquidity situation alone.
There are other tools like statutory liquidity ratio (SLR), repo rate, reverse repo rate, open market operations and a few others. A liquidity crunch could happen due to many reasons, which could be domestic or global. CRR rates have been relaxed or hiked time and again to suit the prevailing economic conditions.
The important thing to note here is that banks do not receive any interest on the money they park with the RBI under CRR.
If the CRR is too high, it means that the banks are mandated to keep more money with the RBI and less with themselves. Meaning that they have less money to lend or to meet depositor requirements. This ultimately indicates that liquidity in the economy is low.
The reverse is also true. If CRR restrictions are being relaxed, this means RBI is trying to infuse liquidity into the economy by leaving more money with the banks.
Since the money supply has a direct correlation with interest rates in the economy, it is safe to assume that CRR does have an impact on interest rates.
Banks have been mandated by the Reserve Bank of India (RBI) to maintain a fixed amount of cash as a part of the cash reserve ratio (CRR).
We have already explained above what the term means, what it entails and the percentage itself. Since this is mandatory, if banks fail to maintain the required CRR limit, RBI has specified penalties for the same.
In case a bank fails to maintain its CRR, which is 3% of NDTL in this case, such a bank will have to pay fines to the RBI because of that default. The penalty for the default for that particular day is charged at 3% per annum above the bank rate. It is charged on the shortfall.
In case the bank continues to default to the next working day as well, RBI may increase this penalty to 5% per annum above the bank rate. This is also charged on the shortfall and for the concerned number of days of the shortfall.
Both the CRR and the SLR are critical components of monetary policy. However, there are some distinctions between them.
The table below provides an example of the differences-