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What Happens When Cash Reserve Ratio Increases?

IndianMoney.com Research Team | Posted On Thursday, February 28,2019, 03:16 PM

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What Happens When Cash Reserve Ratio Increases?

 

 

What Is Cash Reserve Ratio?

Cash reserve ratio CRR, is the share of a bank’s total cash deposit to be maintained with the reserve bank of India, RBI, at all times. All commercial banks are mandated by RBI to follow CRR guidelines. Cash reserve ratio is adjusted by RBI to control and regulate liquidity in the market. RBI has the authority to set a cash reserve ratio anywhere between 3 to 15%.

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Why Does A Bank Need To Maintain Cash Reserve Ratio?

The Reserve bank of India, RBI, uses cash reserve ratio CRR, as a tool to frame monetary policies to control and regulate liquidity in the market. CRR is one of the critical factors that depicts liquidity. CRR is an indicator of the lending rate.

How Does Cash Reserve Ratio (CRR) Help A Bank?

CRR indicates the percentage of money available at a bank’s disposal for lending. CRR is a tool that is employed by RBI to regulate liquidity in India. If the CRR is low, then the banks can sanction more loans as they have more money at their disposal. If the CRR is high, then the banks can sanction limited loans as they have lesser money at their disposal.

SEE ALSO:  What Is Cash Reserve Ratio

Illustration Explaining The Importance Of Cash Reserve

Ratio:

This is how CRR works: consider the current CRR set by RBI to be 5%. This means, a bank must keep Rs 5 with RBI for every Rs 100 deposits by customers. If the CRR is raised to 6%, then a bank must keep Rs 6 for every Rs 100 deposits. Cash deposit to be maintained with RBI by a bank increases with increase in CRR.

When CRR is increased, then the banks would not have more money at their disposal to sanction loans. When CRR is reduced to say 3%, this means a bank must keep Rs 3 for every Rs 100 deposits with the RBI, thus leaving banks with more money to lend.

Advantages Of Cash Reserve Ratio (CRR)

Below mentioned are the advantages of cash reserve ratio, CRR:

  • CRR helps build and sustain the solvency of a scheduled commercial bank authorized by reserve bank of India.

  • CRR ensures the liquidity in a scheduled commercial bank is regulated at all times.
  • CRR is targeted at providing a smooth cash flow by regulating lending across all scheduled commercial banks in the country.
  • The reserve bank of India controls and co-ordinates lending businesses run by commercial banks through the implementation of CRR.
  • When CRR is reduced, scheduled commercial banks would have more cash at their disposal. This increases lending ability of banks which in turn increases liquidity as the cash flow increases in the country. When CRR is reduced, banks sanction more car loans, personal loans, home loans and so on.
  • At times when market rates are down, CRR helps in absorbing liquidity.
  • CRR is most effective in regulating liquidity. Other monetary instruments like market stabilization scheme MSS, are not that effective and take more time to regulate and control liquidity in the market.
  • The cash reserve ratio plays a crucial role in moderating the economy.

How Does Cash Reserve Ratio (CRR) Work With Banks?

All scheduled commercial banks prefer cash reserve ratio to be as low as possible. This is because scheduled commercial banks must set aside the amounts with RBI at all times. Moreover, banks don’t earn interest on the funds deposited as CRR with RBI. The funds deposited with RBI by scheduled commercial banks would be in an account that works on similar lines to a current bank account in a commercial bank operated by businessmen.

The CRR is calculated as a certain percentage of the net demand and time liabilities NTDL, of each and every bank. NTDL is the sum of current account, fixed deposit, recurring deposits and savings account balances.

SEE ALSO:  Advatages of CRR

What Is The Importance Of Cash Reserve Ratio (CRR) To Banks?

Banks usually want to lend the maximum amount to borrowers and retain as little money as possible for other utilities.

Maximum lending helps commercial banks achieve good profits. However, if a considerable portion of a bank’s money is lent and if there is a high and sudden demand for withdrawals from the customers, then the banks would be left with insufficient funds to facilitate customers’ withdrawal. This is when CRR comes in handy for the banks. RBI has set CRR guidelines in order to prevent banks running short of cash (cash crunch) resulting due to extensive lending.

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The main objective of CRR is to ensure that there is always a small portion of liquid funds against deposits. The next important goal of CRR is to help RBI monitor rates as well as liquidity in the market.

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