Imagine a bank account as a treasure chest filled with precious coins and gems. Now, imagine if some of these treasure chests are untouched and unused. This is exactly what happens with dormant bank accounts, where customers forget about their accounts or stop using them. As a result in Feb 2023, Banks in India urged the Reserve Bank of India (RBI) to consider the unclaimed deposits or funds in these dormant accounts as part of their cash reserve ratio (CRR).
Not familiar with this word? Fret not, we have got you covered.
In this blog, we will discuss the cash reserve ratio meaning, the CRR formula, how to calculate CRR , and why it is important for the economy, and the stock market.
What is Cash Reserve Ratio or CRR?
The CRR or Cash Reserve Ratio definition is a specific amount of cash that banks have to keep as a deposit with the Reserve Bank of India (RBI). The percentage of cash is fixed and has to be followed by every bank.
Think of the CRR as a safety net or cushion. This ensures banks keep aside enough money to cover any unexpected losses or withdrawals. Since maintaining a CRR ratio is mandatory, a failure in the maintenance of the CRR ratio may result in penalties. In some cases, the penalty for the default on that particular day will be 3% above the average bank rate.
Thus, by including the unclaimed funds in the dormant accounts in the CRR, banks can unlock this forgotten treasure and use it to strengthen their financial position. It’s a win-win situation. Banks get a boost in their required reserves, and customers get a chance to reclaim their forgotten assets.
So, it’s not just about dormant accounts anymore. It’s about turning forgotten treasure into a valuable resource for the banking system.
What is the Need For Banks To Maintain CRR?
The Reserve Bank of India continually monitors and manages the cash flow in the economy through various monetary instruments, including the Cash Reserve Ratio (CRR). Each scheduled commercial bank is mandated by the RBI to adhere to specific CRR guidelines.
When the CRR rate held with the RBI is high, it can lead to reduced liquidity in the economy. Conversely, a lower CRR may result in higher overall liquidity in the economy.
Adherence to the prescribed Cash Reserve ratio can ensure that banks maintain an adequate reserve of funds, preventing shortages when depositors require funds for personal needs. This effective management of overall liquidity might benefit all scheduled commercial banks.
Now that we have covered what is CRR in banking and the role of CRR in economics, let’s look at how CRR meaning in economics works.
How Does CRR Work?
RBI regulates the money flow in the economy with the help of the CRR ratio; thus, it is an essential part of its monetary policy.
The purpose of the CRR ratio is to ensure the stability of the banking system and control inflation. By mandating banks to keep a certain percentage of their deposits with the central bank, it can control the amount of money that is available for lending in the economy. Thus, RBI can even increase the cash reserve ratio during periods of inflation to limit the issuance of loans.
For example, if the central bank increases the CRR ratio. Then the banks might need to keep a higher percentage of their deposits with the central bank. Resulting in a reduced amount of money that they can lend out to borrowers. Thus, this results in less money being available in the economy, which can help to control inflation.
Conversely, if the central bank decreases the CRR ratio. Then the banks will have to keep a lower percentage of their deposits with the central bank. Resulting in an increased amount of money that they can lend out. This results in more money being available in the economy, which can help to stimulate economic growth.
Overall, the CRR is an important tool. It is used by the central bank to manage the money supply in the economy and maintain financial stability.
What is the Current CRR & its Impact?
The current Cash Reserve Ratio rate is fixed at 4.5%. This means that if XYZ bank receives deposits of 100, it must maintain its 4.5 in the form of liquid assets
The CRR is a powerful tool used by the RBI to regulate the liquidity in the banking system. When the CRR is high, banks are required to hold a more substantial portion of their deposits with the RBI. This, in turn, reduces the funds available for lending to customers, which can lead to higher interest rates for borrowers and a decrease in overall liquidity in the economy.
Conversely, when the CRR means is low, banks may have more funds at their disposal for lending, which can stimulate economic activity by making loans more accessible and affordable.
How is the Cash Reserve Ratio Calculated?
The Cash Reserve Ratio (CRR) can be calculated as a percentage of a bank’s net demand and time liabilities (NDTL). The NDTL includes all deposits held by a bank. Including payable on demand, such as current and savings accounts, as well as time liabilities, such as fixed deposits (FDs) and recurring deposits (RDs).
(Read more about FD Vs RD for better understanding)
The cash reserve ratio formula is as follows:
CRR = (Amount of cash reserves held by the bank with the central bank) / (Net Demand and Time Liabilities)
For example, if a bank has net demand and time liabilities of Rs. 100 crore, and it is required to maintain a CRR of 4%, it will have to maintain cash reserves of Rs. 4 crores with the central bank.
The CRR is set by the central bank, such as the RBI. Thus, it can be changed periodically to suit economic conditions. The central bank typically sets the CRR as a tool to manage the money supply in the economy and control inflation.
Why is the Cash Reserve Ratio Changed Regularly?
The ratio is changed regularly by the central bank, such as the Reserve Bank of India (RBI), for several reasons. Here are some of the main reasons why the CRR is changed:
- Controlling Inflation: One of the main reasons why the CRR is changed is to control inflation. If there is too much money available in the economy, it can lead to inflation. By increasing the CRR ratio, the central bank can reduce the amount of money available for lending, which can help to control inflation.
- Stimulating Economic Growth: Conversely, if the economy is in a recession or is experiencing slow growth, the central bank may decrease the CRR ratio to increase the amount of money available for lending. This can help to stimulate economic growth by increasing investment and consumption.
- Managing Liquidity: The central bank may also change the CRR to manage liquidity in the banking system. If there is a shortage of liquidity in the banking system, the central bank may decrease the CRR to increase the amount of money available for lending.
- Maintaining Financial Stability: The central bank may also change the cash reserve ratio to maintain financial stability in the banking system. By requiring banks to maintain a certain level of cash reserves, the central bank can ensure that banks have enough funds to meet their obligations and prevent bank failures.
How Does the Cash Reserve Ratio Affect the Economy?
An increase or decrease in the cash reserve ratio affects the economy. Let’s understand how.
- Relationship Between CRR and Money Supply: Cash Reserve Ratio has a direct relationship with the money supply in the economy. The central bank requires banks to keep a higher proportion of their deposits as cash reserves when it increases the CRR. Banks are required to potentially keep a lower proportion of their deposits as cash reserves when the CRR is decreased.
- Impact of CRR on Inflation: CRR has an impact on inflation as it affects the money supply in the economy. Increasing the CRR may reduce the amount of money banks have to lend out to borrowers, which in turn decreases the demand for goods and services. When banks decrease the CRR, they may have more money to lend out, which can lead to an increase in the demand for goods and services and higher inflation.
- Effect of CRR on Interest Rates: The cash reserve ratio also affects interest rates in the economy. Increasing the CRR results in banks having less money to lend out. Lenders may then try to compensate for the reduced availability of funds by increasing interest rates. Therefore, banks can have more money to lend out. This can lead to a decrease in interest rates as lenders compete for borrowers when they decrease the CRR.
Examples of CRR Implementation in Various Economies
Many central banks around the world use CRR as a tool to manage the money supply and control inflation.
For example, in India, the Reserve Bank of India (RBI) sets the CRR for banks. In the United States, the Federal Reserve does not use Cash Reserve Ratio. However, it does use a similar tool called the reserve requirement. Thus, this tool requires banks to hold a certain amount of reserves in the form of cash or deposits.
The European Central Bank also has a reserve requirement system in place for banks in the Eurozone. In China, the People’s Bank of China uses a reserve requirement ratio to manage the money supply.
Advantages of CRR
Central banks use the Cash Reserve Ratio (CRR) to manage the money supply and maintain financial stability in the economy. Some of the advantages of CRR are:
- Controlling Inflation: By increasing the CRR, the central bank can reduce the amount of money available for lending, which can help to control inflation. This is because when there is less money available for lending, the demand for goods and services in the economy decreases, resulting in lower prices and lower inflation.
- Stabilizing the Financial System: The CRR can help to stabilize the financial system by ensuring that banks have enough cash reserves to meet their obligations. By requiring banks to maintain a certain level of cash reserves, the central bank can prevent bank failures and maintain financial stability in the banking system.
- Maintaining Liquidity in the Banking System: The CRR can also help to maintain liquidity in the banking system. By requiring banks to keep a certain proportion of their deposits as cash reserves, the central bank can ensure that there is enough liquidity in the banking system to meet the demand for funds.
Disadvantages of CRR
Let’s review some of the limitations of the cash reserve ratio.
- Reduced Profitability for Banks: The central bank requires banks to hold a larger portion of their deposits as cash reserves when it increases the CRR. This can result in reduced profitability for banks, as they have less money available for lending and earning interest.
- Limitations in Implementation: The CRR is a blunt instrument that can have unintended consequences. For example, increasing the CRR during a period of economic growth can slow down the economy by reducing the availability of credit. Reducing the CRR during a period of economic downturn can lead to an increase in inflation.
- Impact on Credit Availability: Increasing the CRR can reduce the amount of money available for lending by banks, which in turn can decrease the availability of credit in the economy. Credit money can increase when CRR is increased, resulting in increased availability of credit in the economy. This may directly impact the country’s economic growth, businesses, and individuals to obtain loans.
Difference Between CRR and SLR
Like the CRR ratio, we have the SLR ratio abbreviated as Statutory Liquidity Ratio. Commercial banks in India define this particular ratio as the deposit that they must maintain with the RBI in the form of gold, cash, and other securities. The RBI uses the CRR and SLR ratio to curb inflation and boost economic growth.
CRR vs SLR
Now, let’s have a look at its key differences.
|Parameters||CRR (Cash Reserve Ratio)||SLR (Statutory Liquidity Ratio)|
|Definition||CRR refers to the amount of cash that commercial banks must keep in reserve with the central bank of the country.||SLR is the percentage of deposits that banks must maintain in the form of liquid assets such as cash, gold, or government securities.|
|Purpose||It helps the central bank to regulate the money supply and inflation in the economy.||It helps to maintain the solvency of the banks and ensure their stability.|
|Applicability||Applicable only to demand deposits and not to time deposits.||Applicable to both demand and time deposits.|
|Interest||The central bank may not pay any interest on the funds kept as reserves.||Banks earn some interest on the funds kept as SLR investments.|
|Penalty||Banks might need to pay a penalty for not maintaining the required Cash Reserve Ratio.||Banks have to pay a penalty for not maintaining the required SLR.|
|Control||The central bank has direct control over the Cash Reserve Ratio.||The central bank has indirect control over the SLR, as it can only control the availability of eligible securities.|
We hope this helps!
To Wrap it Up….
In conclusion, the Cash Reserve Ratio (CRR) is an important tool of monetary policy used by central banks to regulate the money supply in an economy. The cash reserve ratio is an essential tool in the hands of central banks to manage the money supply in the economy, control inflation, and ensure financial stability. Its importance can be seen from the fact that it is used by most central banks around the world. However, it is important to strike a balance between the need to control inflation and the need to ensure adequate credit availability to promote economic growth.
As always, please do your own research and/or consult a financial advisor before investing.
CRR full form in accounts is Cash Reserve Ratio. The meaning of CRR is the percentage of a bank’s total deposits that it must maintain as cash with the central bank. It is a monetary policy tool used to control the money supply in the economy.
To define CRR objective, it ensures financial stability and control inflation by regulating the amount of funds banks hold with the central bank, thereby influencing liquidity in the banking system.
By definition of cash reserve ratio, by reducing the amount of money banks can lend, curbing excess liquidity and lowering overall demand, which helps stabilize prices.
CRR is maintained with RBI to ensure financial stability, control liquidity, and facilitate monetary policy implementation.
Repo (Repurchase Agreement) is a short-term borrowing mechanism where banks borrow funds from the RBI by selling securities. Reverse repo is the opposite, where banks lend funds to the RBI in exchange for securities. Read more about Repo rate vs Reverse repo blog.
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