Here’s what you need to know about banks’ cash reserve ratio

The cash reserve ratio (CRR) often comes up in the monetary policies. It ensures consumers financial security. Know the meaning, objectives and formula.

Economies are usually volatile. They fluctuate depending on several internal and external factors. Banks and their ability to lend money are especially susceptible to these factors. Proper regulation and financial management can help avoid bumps in banking operations and maintain enough liquidity.

Central Bank use CRR to eliminate such risks and regulate the money supply in the market. CRR impacts banks and financial institutions in how they offer loans and other credit products.

What Is CRR?

The Cash Reserve Ratio (CRR) is the percentage of total deposits a bank must have in cash to operate risk-free.

A bank cannot use this amount for lending and investment purposes. CRR applies to scheduled commercial banks, while the regional rural banks and NBFCs are excluded.

For example, if the CRR stands at 6%, a bank must deposit $6 for every $100 raised in deposits.

Key objectives of CRR

Following are the critical objectives of the Cash Reserve Ratio.

- CRR helps control inflation. In a high inflation environment, central banks can increase CRR to prevent banks from lending more.

- CRR also ensures banks have a minimum amount of funds readily available to customers even during huge demand.

- CRR serves as the reference rate for loans. Also known as the base rate for loans, the banks cannot offer loans below this rate.

- Since CRR regulates the money supply, it boosts the economy whenever required by lowering the CRR.

How does CRR control inflation?

The CRR directly impacts the level of liquidity in the country's economy. One can assume it is a money supply valve the central bank holds to control inflation.

In case of higher inflation, the central bank can increase the CRR requirements to reduce the banks' lending capacity, thereby lowering inflation.

How is CRR calculated?

The Cash Reserve Ratio is calculated based on the bank's net demand and time liabilities (NDTL).

Net demand and time liability can be defined as the total deposits of the bank with the public or other banks minus the deposits of other banks. Liabilities such as current deposits, cash certificates, demand drafts, fixed deposits (FDs), gold deposits, dividends etc., constitute NDTL.

Here is a simple expression to calculate the cash reserve ratio:

CRR = (Liquid Cash/NDTL) * 100

Why does CRR keep changing?

Central banks keep changing the CRR for consumers' safety and a smooth economy. Moreover, the central banks can also increase or decrease the CRR to meet its other requirements, such as supplying money to boost the economy.

Knowing how CRR works for banks and financial institutions can help you make informed decisions and choose when to go for a suitable financial product. The CRR is a safety net for the customers and is an integral part of central banks’ monetary policies.

Source: IDFC FIRST Bank