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Banking Instruments – Cash Reserve Ratio

Banking Instruments – Cash Reserve Ratio

Banks in the Indian economy can manage inflation at a desired level and control and monitor money flow in the banking system by changing the CRR rate.

The Reserve Bank of India has made it essential for all banks to keep a portion of their deposits in cash to distribute it to customers in an emergency. The Cash Reserve Ratio is the ratio of the percentage of cash required to be retained as a reserve to the bank’s total deposits in the Indian economy  . The CRR is kept in your bank’s vault or transmitted immediately to the RBI. The banks are not paid interest on the money held in the RBI’s CRR account.

CRR’s Objectives

CRR is kept with the RBI as part of a bank’s deposit, ensuring safe money. CRR makes it easy for clients to get their money back if they want it.

CRR is in charge of keeping inflation under control. When the economy is experiencing significant inflation, the RBI raises the CRR to ensure that banks have more money in reserve, allowing them to lend less money in the future.

Importance

The Cash Reserve Ratio is a tool for managing overall liquidity in the Indian economy by circulating cash. These are some of the benefits of maintaining the cash reserve ratio:

  • CRR ensures that the liquidity system in all commercial banks is stable and well maintained.
  • The solvency position can be built and tolerated when the CRR is maintained in a bank.
  • If the RBI lowers the CRR rates, it will help borrowers because the bank can issue more advances.
  • The RBI controls and coordinates the credit maintained by banks through the CRR rate to ensure an easy supply of cash and credit in the economy.
  • The cash reserve ratio is a significant consideration for both banks and depositors. When a bank maintains the required CRR rate, depositors do not have to be concerned about the quantity of their deposits because the Reserve Bank of India keeps a portion of them safe as a reserve.

Calculating the CRR Rate

(Reserve Ratio / Bank Deposits) * 100% = Cash Reserve Ratio

Cash Reserve Percentage * Bank Deposits = Reserve Requirement

Where,

Reserve Requirement = The cash reserve that a bank must hold with the central bank is the reserve requirement.

The term “bank deposits” refers to the bank’s total deposits. 

Impact of CRR have on the Indian economy

The Cash Reserve Ratio (CRR) is a key component of the RBI’s monetary policy, which controls the country’s money supply, inflation, and liquidity. The lower the CRR, the less liquidity with the banks, and vice versa in the Indian economy. Attempts are undertaken to limit money flow in the Indian economy when inflation is strong. As a result, the RBI raises the CRR, reducing the loanable funds available to banks. Hence, the supply of money in the economy shrinks. This also aids in the reduction of inflation.

When the RBI needs to inject funds into the system, it reduces the CRR, which increases the amount of money available to banks. As a result, banks provide a significant number of loans to businesses and sectors for various purposes. It also expands the entire money supply in the economy.

Raising the Cash Reserve Ratio

Banks will have minimal finances when the cash reserve ratio is raised because they must keep large sums of cash on hand with the Reserve Bank of India. As a result, banks will be unable to use their funds for other objectives. You should also remember that the RBI does not pay interest on CRR holdings. As a result of not obtaining any interest, banks have decided to boost interest rates. They’ll have no choice but to hike the rates on their credit products. When interest rates rise, the borrowers’ equated monthly installments (EMIs) will also increase. The interest rate on your loan will skyrocket.

Why is CRR updated frequently?

We already know how the CRR helps banks and the economy keep their liquidity. On the other hand, banks tend to over-lend in their search for profits. This results in a rise in cash or liquidity in the Indian economy and an increase in the rate of inflation. The RBI uses the CRR to keep the economy stable. The RBI limits bank lending and inflation by hiking interest rates. When there is little cash in the economy, on the other hand, the RBI lowers interest rates to help the economy thrive. Furthermore, as a depositor, knowing the current CRR will give you peace of mind that a bit of your money is secure with the RBI.

Penalties

In the event of a failure to maintain the CRR, the following penalty interest is charged:

If the CRR requirement is not met daily, which is currently 95% of the total CRR requirement, penal interest will be charged at a rate of 3% per annum above the bank rate by which the amount maintained short of the prescribed minimum on that day, and if the shortfall continues on the following day/s, penal interest will be charged at a rate of 5% per annum above the Bank Rate on the amount by which the amount-maintained falls short of the prescribed minimum

Conclusion

Cash Reserve Ratio is necessary to regulate excess money flow and accommodate unforeseen deposit demand. It also benefits depositors because their deposit ratio is safe with the RBI. These are essential for the government to safeguard and develop our country to better the  Indian economy.