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Important Credit Control Tools Of RBI: CRR, Repo and Reverse Repo Rates Research Team | Posted On Monday, March 25,2019, 04:31 PM

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Important Credit Control Tools Of RBI: CRR, Repo and Reverse Repo Rates



What is CRR?

Cash Reserve Ratio is a certain percentage of the bank’s total deposits that banks must maintain with the Reserve Bank of India in the current account. Banks do not have access to this money for any commercial or business activities. If the RBI decides to hike CRR, funds available with banks for disbursal of loans and daily transactions diminish.

CRR is one of the most commonly used tools for credit control. Commercial banks must maintain an average cash balance with the RBI, which should not be less than 3% of total Net Demand and Time Liabilities (NDTL) on a fortnightly basis. So, we can say that CRR is a tool used by the central banks to control liquidity in the banking system.

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SEE ALSO:  What is CRR?

Important Credit Control Tools Of RBI: CRR, Repo and Reverse Repo Rates

Objectives of CRR:

The objectives of CRR are as follows:

  • One of the main objectives of CRR is to make sure banks maintain a minimum ratio of their cash reserves against liabilities, so that there is no shortfall of funds when the banks require excess funds.
  • It is a quantitative tool used by the RBI to control the flow of money into the system.
  • The people make cash transactions and withdrawals through banks. In times of a Cash crunch, the CRR helps banks maintain their position as credit institutions.
  • It is also used by the RBI to send signals on the direction of liquidity, although the RBI does not use it very frequently these days.

How is CRR Calculated?

The most important part of the calculation of CRR is Demand and Time Liabilities (DTL). DTL can be defined as the total volume of liabilities for which the banks must maintain CRR with the RBI. DTL encompasses time liabilities of the bank like current account deposits, savings account deposits, margins held against L/Cs and guarantees, outstanding TT/MT/DD and call money borrowings.

Time liabilities of the bank include fixed deposits, cash certificates, recurring deposits and so on.  However, DTL does not include loans from RBI, refinance from NABARD/NHB, income tax provisions, unrealized gains or losses from any derivative transactions.

Why is CRR kept with RBI?

Banks must maintain a certain percentage of deposits as CRR with the RBI. Currently, all banks must maintain 4% of deposits that must be held in a current account with the RBI (CRR is 4%). When the cash reserve ratio is lowered by the RBI, banks have surplus money to invest in other businesses as the cash reserves needed to be maintained with RBI is low. When there is an increase in money supply, excess funds lead to inflation in the economy. RBI immediately increases the CRR to flush out excess funds in the economy. CRR is a monetary tool to control the overall liquidity in the banking system. Failure to maintain the minimum CRR leads to imposition of penalties on banks.

Why is Cash Reserve Ratio Changed Regularly?

CRR balance is a percentage of the total demand and time liabilities of the bank maintained with RBI. Higher the CRR, lower will be the liquidity in the system. The RBI is empowered to change CRR from 3% to 15%. Funds are maintained as reserves with the RBI for helping banks during an emergency. These deposits do not earn interest. RBI increases CRR as a policy to reduce bank’s liquidity and it reduces CRR when it wants to increase liquidity in the banking system and boost credit.

Cash Reserve Ratio is revised by the RBI from time to time. It is part of the statutory reserves stipulated by the RBI. Statutory reserves include the CRR and the statutory liquidity ratio (SLR). The CRR is maintained with the RBI to ensure banks have sufficient liquidity in order to carry out daily transactions and bank withdrawals of customers. CRR plays an important role in the functioning of the banking system. It also helps banks maintain solvency and liquidity positions.

SEE ALSO:  How is CRR Calculated?

Advantages of CRR:

  • CRR helps commercial banks retain their position of trust and sustain solvency.
  • It helps banks maintain constant liquidity.
  • It works towards having a smooth supply of cash as well as credit in the nation’s economy.
  • Cash reserve ratio is a measure through which the RBI controls and co-ordinates credit flow in the economy.
  • When the reserve bank of India reduces the CRR, a scheduled commercial bank will have the ability to offer more loans like personal loans, car loans, home loans, and other forms of credit to borrowers across India.
  • The CRR helps control inflation. When the CRR is low, the interest rate is low and when the CRR is high, the interest rates are also high.
  • The implementation of the cash reserve ratio is more effective when compared to other monetary instruments like Market Stabilization Scheme (MSS) bonds. Typically, MSS bonds take a lot of time to control liquidity in the country.

What is Repo Rate?

Repo rate is the rate at which the RBI lends to banks against government securities. Repo rate is an instrument of monetary policy. Whenever there is a shortage of funds, commercial banks borrow money from the RBI and have to pay interest on the money borrowed. The rate of interest on the borrowed funds is known as repo rate. Repo rate is currently 6.25%. A reduction in repo rates helps banks get money at a cheaper rate and vice versa. The repo rate in India is similar to the discount rate in the USA.

What is Reverse Repo Rate?

Reverse repo rate is the rate at which the RBI borrows money from the commercial banks. Banks easily lend to the RBI as they know that the money is in safe hands. Banks earn interest by lending to the reserve bank of India. Currently the reverse repo rate is 6%. An increase in the reverse repo rate enables banks keep more money with the RBI and earn good interest and get better returns on surplus deposits. Reverse repo rate is also a monetary tool used by the RBI to control the flow of money in the economy by draining excessive liquidity out of the banking system.

Differences Between Repo Rate and Reverse Repo Rate:

Listed below are the main differences between repo rate and reverse repo rate. The differences help you get a better understanding:

  • The repo rate is always higher than the reverse repo rate.
  • Reverse repo is the rate at which the RBI borrows from the commercial banks operating within the country.
  • When the repo rate is high, there are limited funds available with banks. A high reverse repo rate helps increase liquidity in the banking system. It helps the bank’s sanction loans to customers and earn profits due to availability of funds.
  • While repo rate is used to control inflation, reverse repo rate is used to control money supply in the market.
  • The primary objective of repo rate is to deal with shortage of funds on the other hand reverse repo rate deals with liquidity in the economic system.
  • Repo Rate involves selling securities to RBI with a motive to repurchase in the future at a fixed rate of interest, but reverse repo rate refers to transferring of funds from bank account to RBI account.

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