In the world of monetary policy and banking system, one of the most crucial instruments that the central bank makes use of for regulating and controlling the supply of money in an economy is Cash Reserve Ratio (CRR).
But what exactly is CRR, and how does it work? This article will clarify the concept concerning CRR meaning, its functions, and its objectives. Are you ready to explore what is CCR? Let’s begin!
CCR full form is Cash Reserve Ratio, a mandatory requirement that mandates commercial banks to maintain a percentage of their total net demand and time liabilities with the central bank in the form of cash reserves. Commercial banks must hold these cash reserves in the form of deposits or as physical currency with the central bank and are not allowed to be used for the purpose of investment or lending.
The working of CRR involves setting a particular percentage of the total deposit of the commercial bank that needs to be kept as cash reserves with the central bank. The central bank solely responsible for implementing monetary policy determines the appropriate CRR level on the basis of its economic objectives.
If the aim of the central bank is to curb inflation and reduce excessive lending, it raises the CRR. On the other hand, if it aims to stimulate growth within the economy, it lowers the CRR rate.
Once the central bank sets the CRR rate, commercial banks are obligated to keep a specific percentage of their net demand and time liabilities in the form of cash reserves, which must be held in a special account with the central bank.
The Cash Reserve Ratio retains a significant impact on lenders, primarily the commercial banks, which are mentioned below in detail:
A rise in the CRR rate forces commercial banks to keep a higher portion of their deposits as cash reserves reducing the total fund available for lending and restricting the bank's capacity to provide loans to individuals and businesses.
Thus banks become more selective in their practices of lending. This usually leads to decreased availability of credit in the market.
To ensure compliance with the requirements of CRR, banks may also face a shortage of funds. In order to alleviate this, they attract more deposits by raising their interest rates to maintain a sufficient cash reserve. On the other hand, commercial banks also adjust their interest rates for lending based on the basis of the CRR changes of the Central Bank.
With an increase in CRR rate, banks also increase their lending rates to compensate for reduced fund availability affecting the borrowing cost. However, this negatively impacts businesses and several consumers as increased borrowing costs make loans more expensive.
As it becomes mandatory for banks to hold a larger portion of funds as non-earning cash reserves, it adversely affects their profitability due to reduced investment and lending opportunities. This impacts the bank’s income stream as well as overall profitability.
The CRR also affects the money supply in the economy by making it mandatory for banks to keep a portion of their deposits as cash reserves. With the increase in CRR, the bank's lending power decreases, resulting in a contraction of the money supply in the economy.
When the central bank reduces CRR, commercial banks can hold a limited portion of their deposit as reserves leading to a boost in the supply of money.
The CRR also influences the interest rate, as banks usually face a shortage of lendable funds when CRR is increased by the central bank, leaving no other options but to increase the interest rates to attract deposits.
This helps in the conservation of their resources. At the same time, reduced CRR rates may lead to lower banking interest as banks entertain more funds available for lending.
By making it mandatory for banks to maintain a part of their deposit as cash reserves, CRR embellished the resilience and stability of the entire banking system. During the period of financial crisis or sudden withdrawal of deposits, entertaining an adequate reserve may help the banks prevent liquidity crises and meet their obligations.
All these changes concerning money supply and rate of interest triggered by CRR have widespread effects on investment, consumption, price levels, and economic activity. A controlled money supply ensures price stability in the economy, avoiding deflation or runaway inflation.
The current CRR rate is 4.50 % which was last updated on October 2022.
The CRR objectives are primarily related to the achievement of broader goals concerning financial stability and monetary policy. The central bank uses CRR as one of its key financial tools for achieving these objectives, which are explained below in detail:
CRR acts as one of the most significant tools that central banks use to control inflation. By increasing the CRR, central banks can lower excess liquidity and curb pressures on inflation. On the other hand, a decrease in CRR can inject more funds into the economy, stimulating economic growth, although it sometimes raises the risk of inflation if not managed appropriately.
Although there is no particular formula for the calculation of CRR, technically, it is calculated as a percentage of NDTL (Net Demand and Time Liabilities). NDTL refers to the aggregate savings account, fixed deposits, and current account balances that a commercial bank holds.
Therefore as per the current regulations, whatever the aggregate, 4.50% has to be kept with RBI, including all three account categories.
A change in CRR happens due to a plethora of reasons which are mainly linked to the objective of the central bank as well as the prevailing economic conditions. Some of the key factors that result in the changing of CRR include:
The central bank's primary goal is to ensure the stability of trice in the economy and promote sustainable economic growth. For this, it employs various monetary policies, which include CRR.
When inflation is rising, the Central bank increases the CRR in order to reduce excess liquidity in the banking system and control the expansion of credit, thereby curbing inflation. When the central bank assumes that the economy needs a boost, it lowers the CRR for encouraging investment and lending.
A shift in the mobilization of deposits and lending behavior in the banking system also influences the CRR. If the banks accumulate significant deposits, the CRR is adjusted by central bank to manage excess liquidity.
On the other hand, if there is a shortage of funds for lending, the CRR is typically reduced by the central bank to increase the availability of credit.
During an economic recession, the Central bank reduces the CRR for increasing the money supply so that the banks can offer more funds for lending. This stimulates investment and borrowing and supports recovery.
Thus, CRR serves as a critical tool that stabilises the financial system, manages inflation, and brings about a sense of stability to the country's overall economy.