CASH RESERVE RATIO- ALL YOU NEED TO KNOW
The cash reserve is the amount of capital a bank has. The Cash Reserve Ratio (CRR) is the percentage of total deposits a bank must have in cash to operate risk-free. The Reserve Bank of India decides the amount and is kept with them for financial security. The bank cannot use this amount for lending and investment purposes and does not get any interest from the RBI. CRR applies to scheduled commercial banks, while the regional rural banks and NBFCs are excluded.
CRR calculated
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, 3% of the aggregate balances of all these three categories have to be kept with the RBI.
Key objectives of the Cash Reserve Ratio
- CRR helps control inflation. In a high inflation environment, RBI can increase CRR to prevent banks from lending more.
- CRR also ensures banks have a minimum amount of funds readily available to customers even during huge demand.
- CRR serves as the reference rate for loans. Also known as the base rate for loans, the banks cannot offer loans below this rate.
- Since CRR regulates the money supply, it boosts the economy whenever required by lowering the Cash Reserve Ratio.
Effect of Decrease in Cash Reserve Ratio
- Effect on interest rates: When the cash reserve ratio is decreased by the RBI, banks will have more money to invest in other businesses since the amount of funds that needs to be kept with the RBI is low. This shows that banks will have an excess of funds and hence, there will be a decline in the interest rates that are charged on loans.
- Effect on inflation: When the cash reserve ratio is minimised, commercial banks will have more funds and hence, the money supply of the banking system will increase. When there is a rise in the money supply, excessive funds will result in high inflation.
When the CRR is minimised, funds are drawn out from the economic system excessively and then the money supply is affected negatively wherein there is a shortage of funds. Since the money supply has declined in this situation, the inflation also reduces.
Advantages of Cash Reserve Ratio (CRR)
- CRR aids in the management of total liquidity by spreading money circulation throughout the economy.
- It makes sure the liquidity system of scheduled commercial banks is consistently maintained well.
- CRR assists commercial banks in strengthening and maintaining their solvency.
- It assures that the liquidity system in all commercial banks is consistent and adequately maintained.
- Through the implementation of a cash reserve ratio, the Reserve Bank of India can control and coordinate the credits that are by commercial banks.
- Commercial banks can give additional advances to borrowers when the CRR rate is cut by the RBI, which enhances the flow of cash to the general population.
- It works towards having a smooth supply of cash as well as credit in the nation’s economy.
- CRR plays a positive role in alleviating the financial climate when the currency is in surplus.
- When market interest rates go down intensely, the cash reserve ratio acts as a very good liquidity absorption instrument. This functioning of the instrument will help in improving the declining rates.
Investors should keep themselves aware of how CRR works and how it affects interest rates, inflation, and other monetary factors. This helps in making sensible decisions regarding borrowings and savings. It can also help in timing an investment.