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Tata Capital > Blog > RBI Regulations > What is the Cash Reserve Ratio and how does it work?

RBI Regulations

What is the Cash Reserve Ratio and how does it work?

What is the Cash Reserve Ratio and how does it work?

The Reserve Bank of India (RBI), as you know, oversees the flow of money throughout the economy. It has many measures in place to effectively regulate the supply of money into the banking system.

The Cash Reserve Ratio(CRR) is one of those monetary tools the RBI uses to achieve this. It is a mechanism that works according to the RBI’s official guidelines and focuses on managing the financial system's liquidity.

CRR has an inverse relationship with money and investment in the economy, in other words when CRR rises, the circulation of funds reduces hence investments decline and vice-versa. The RBI frequently employs CRR to manage the nation's money supply and to control inflation.

Let’s explore more for a thorough understanding.

Cash Reserve Ratio meaning

The Cash Reserve Ratio or CRR is the least proportion of deposits commercial banks mandatorily must keep with the RBI. These deposits are maintained so the banks have sufficient cash for periods of high demand and unforeseen circumstances.

Cash reserves denote the capital of banks. They deposit this amount in the form of liquid cash, which also preserves the flow of money in the economy.

The RBI determines the aggregate amount and is maintained therein to ensure financial stability. RBI prohibits the utilisation of the reserves for lending or investment purposes by the bank, and these reserves do not carry any interest. The current cash reserve ratioas of 2023is 4.50% effective since May 21, 2022, according to the official website of RBI.

The coverage of the CRR policy does not extend to scheduled commercial banks, regional rural banks, and non-banking financial companies (NBFCs).

Purpose of the Cash Reserve Ratio

The main purpose of CRR is to regulate money circulation in the economy to drive overall liquidity. The additional goals of CRR are:

1. It enables banks to keep a minimum cash reserve, ensuring customers and borrowers can withdraw their money in an emergency. As a result, it keeps the country's liquidity at a fixed level. Furthermore, because the RBI holds that cash reserve, it ensures its safety and security.

2. It helps keep inflation under control. The RBI may raise the CRR during periods of high inflation, preventing banks from making additional loans.

3. CRR make sure that the banks keep their solvency standing. Rather than loaning out the entire cash available with the banks, it reserves some fraction of the balance of total cash available.

4. The cash reserve ratio also affects the base rate below which banks cannot offer loans to any customer.

Working of CRR Ratio

It is imperative to understand the operations of banks to understand the working of the CRR ratio. The main task of banks is depositing money from customers and lending.

1. Lending money is the bank's significant financial goal and by maximising their lending capacity they make a profit. For this purpose, they obtain funds in the form of deposits from their customers.

2. Then, banks lend the same funds to their borrowers at an interest rate that is typically much higher than what they offer to their customers for deposits. The difference in interest rates between loans and deposits represents a bank's profit.

3. If a consumer requests their money back, the bank must have enough cash. Every commercial bank is allowed to take customer deposits for a defined period in exchange for a commitment to pay the depositor a specific interest on it.

4. But to ensure that banks do not utilize all the deposits to offer loans, RBI enforces a cash reserve policy. Therefore, every commercial bank must retain a percentage of their total deposits as a reserve with the RBI.

5. The increase in the Cash Reserve Ratio (CRR) by the Reserve Bank of India reduces the funds available to banks. Thus, the RBI regulates the surplus availability of money within the economy.

However, the cash reserve should not descend below 4% of the total Net Demand and Time Liabilities (NDTL) managed by RBI once every two weeks. It is also important to note that banks do not earn any interest from RBI on their reserves.

The banks cannot use the funds they set aside with the RBI for anything else, including loans. The fundamental goal of the CRR is to ensure that banks never run out of cash and can readily deal with unforeseen financial situations.

How CRR affects the economy?

The Cash Reserve Ratio impacts the Indian economy significantly in the following ways:

1. CRR requires the banks to hold a part of their deposits with the RBI. So, the RBI strategically raises or reduces CRR to supervise cash flow into the banking system and regulate the entire country’s money supply.

2. The Reserve Bank slumps the ability of commercial banks to lend money when there is inflation by raising the CRR level. As a result, the economy's money supply drops substantially. While it has a detrimental impact on the core economy, it controls the level of inflation.

3. However, in need of increased funds, RBI sinks the CRR threshold, enhancing credit prospects for commercial banks. As a result, banks can offer more loans to individuals and businesses. It ultimately improves the money supply and boosts economic productivity.

Bottom line

The Cash Reserve Ratio (CRR) is essential to a country’s monetary policy. Central banks across the globe use it to regulate the money supply within the economy, govern inflation, and uphold financial stability. 

Although CRR controls the lending capacity of banks, NBFCs and some other financial institutions are untouched by its effects. So, if you are looking for loans during high inflation, you do not have to rely solely on the traditional banking system.

Instead, you can turn to Tata Capital, one of the leading NBFCs in the country. We at Tata Capital offer affordable personal loans at attractive interest rates and flexible tenures. Besides, the application process is online and requires minimal paperwork. Visit our website to know more.

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