Banking terms often in news: Cash Reserve Ratio

In the next few articles we will understand various banking terms which are often in news from a generalist point of view..

Cash Reserve Ratio(CRR):

  • About:
    • CRR is the minimum proportion of the deposits that are to be kept by the commercial banks as reserves.
    • It may be kept either in cash or as deposits with the central bank(RBI in case of India).
    • Its value is set according to the guidelines of central bank (RBI).
    • It is a vital part of the Monetary policy of the RBI.
  • Purpose:
    • To ensure that banks do not run out of cash for fulfiling the payment demands.
  • Significance:
    • This is an instrument which is used by the central bank to regulate the money supply in the economy.
    • This has a bearing on the inflation indicators (CPI/WPI-to be covered later).
    • This affects the savings, investment and eventually the economic growth of the country.
  • Conceptual understanding:
    • If CRR increases:
      • means greater deposits to be held as reserves.
      • thus, there is lesser cash to be given as loan/credit.
      • interest rates will increase.
      • this would reduce the liquidity in the economy.
      • thus, inflation ‘may’ reduce.
      • also, due to lesser availability of credit, investment would reduce.
      • this ‘may’ affect the economic growth negatively.
    • If CRR decreases:
      • lesser deposits as reserves.
      • greater credit availability.
      • interest rates will decrease.
      • more liquidity.
      • inflation growth rate may increase.
      • investment could increase with greater availability of credit.
      • Economic growth rate may increase.
  • Current CRR in INDIA: 4%. This means 4% of the deposits of the banks is to be withheld as reserves.
  • Contention:
    • No interest to be paid to the banks for resereves under CRR after amendment to the RBI act in 2007. Bankers, thus, demand the deletion of the CRR.
    • SBI’s critique of the CRR:
      • Loss of around Rs.3500 crores because of CRR.
      • Not only bankers but also other institutions like NBFCs(Non-Banking Financial Company) which raise public funds must be covered under the ambit of CRR.This is seen as unfair in nature.
      • CRR in itself reduces the credit availability(lesser or more, some amount would be withheld with the central bank)–>this increases the interest rates on loans–>thus, creating a negative impact on investment and growth.
  • Should it be removed?:
    • This could be a gradual and phased process.
    • Even now, CRR is used by the central bank as an importan tool to contol inflation.
    • It lowers the multiplier effect* and thus, the growth of money supply.

*multiplier effect: expansion of country’s money supply with ability of banks to lend.

 

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