We put a lot of faith in our banks. We park all our hard earned money, investments etc. in banks as we trust them. Banks give us a secured feeling that our money is safe with it and we can get our money as and when we require it. We cannot imagine even in our wildest dream that our banks would ever run out of cash. If at all in our dreams the banks get bankrupt, that dream would be a nightmare which would take away our sleep, peace of mind and make us extremely worried. But don’t worry, our RBI has made sure that this nightmare does not become a reality. RBI has drafted few policies to keep a check on various points to counter the danger of bankruptcy of the banks. These measures are like defining the Reserve Ratio, Statutory Liquidity Ratio, Repo Rate, Reverse Repo rate etc. which helps the RBI to keep our Banking system healthy and robust. Today, let us learn more about one such instrument called the Cash Reserve Ratio.
What is Cash Reserve Ratio?
As per the section 42 of the RBI Act, 1934, Cash Reserve Ratio (CRR) is an amount that all commercial banks have to maintain with RBI. RBI publishes the CRR in a timely manner as a percentage of its total net demand and time liabilities (NTDL) relative to the 2nd previous fortnight. As of March 7, 2017, CRR is 4% of NDTL. This basically means that CRR is calculated as specified minimum percentage on the total amount of deposits that commercial banks have from its customers. Commercial banks have to hold this fraction of total deposit of the customer deposits as reserve at RBI, either in cash or as deposits.
CRR is set as per the guidelines of RBI. It is mandatory to maintain the Cash Reserve Ratio requirements as prescribed by the RBI. Banks need to maintain a minimum 95% of the required CRR on a daily basis whereas on an average 100% needs to be maintained fortnightly. Banks failing to maintain the CRR can attract penal charges by RBI. CRR in India has hovered around an average of 5.61% for the last 18 years i.e. from 1999 to 2017. During this period, it reached an all time high of 10.5% in March’ 1999 and touching the all time low in Feb 2013 at 4%.
The chart below shows the trend the CRR rate in India for the 18 years:
How Banking Channel works?
Banks’ primary objective is to lend money. They earn profit from maximizing their lending power i.e. by giving loans. For this, banks source their money from their depositors/customers in the form of deposits. Banks offer deposit schemes to their customers which often attract healthy deposits and they, in turn, lends the same money to its borrowers at a considerably higher rate of interest as compared to the rate of interest offered for deposits. The difference between the rate of interest of deposits and loans is called the profit that a bank earns.
Now consider a scenario, let us assume Mr. Vaibhav has deposited Rs.100 with the bank, and the bank has lent the same Rs.100 to XYZ Pvt. Ltd as a commercial loan on condition to repay the loan back after 2 years. Now after 6 months, Mr. Vaibhav wants Rs.10 to buy a vehicle out of his deposited amount. Now, the bank is in trouble as it does not have the money that Mr. Vaibhav had kept with them. This is exactly the scenario that RBI and in turn every bank wants to avoid. And this is where the Cash Reserve Ratio comes into picture. CRR plays an important role to avoid this kind of scenario. Let us now understand how Cash Reserve Ratio rescues banks from such undesirable circumstances.
As we know that all commercial banks accept deposits from its customer for a certain period by agreeing to pay certain interest on them and use those deposits to give various loans. Now, CRR is that percentage of deposits which all the Commercial Banks are liable to maintain as a reserve with the RBI. The money that is parked at RBI cannot be used by banks to give loans. Let us now consider how CRR works with the above stated example: consider bank CRR is 10%, then banks would have accepted Rs 100 from Mr. Vaibhav, kept Rs 10 as reserve and would have given Rs 90 for loan purposes to XYZ Pvt. Ltd., so when Mr. Vaibhav suddenly demands a fraction of his money, the bank would be having necessary cash to pay him. Thus, the aim of Cash Reserve Ratio is to ensure that the banks never get out of money and can easily make payments of the cash demanded by its depositors.
Why Cash Reserve Ratio is important?
Following are the key reasons why cash reserve ratio is a crucial and regulatory aspect for any bank:
- Cash Reserve Ratio is a crucial monetary policy tool used by RBI.
- It is used to control the supply of money in an economy.
- It aims at healthy banking channel and ensures that banks maintain some liquid funds to meet the demand payments of its customers.
- It is used to control inflation or deflation prevalent in the economy.
- It is used as a tool either to inject money supply in the economy or drain excess funds from the economy.
How Cash Reserve Ratio Impacts Various Economic Domains?
- CRR as Monetary Policy Tool: Cash Reserve Ratio is considered as one of the most crucial and important tool while structuring monetary policies by the RBI for Indian Economy. CRR is effectively used to adjust and control the money supply in the economy. RBI resorts to CRR tool to effectively drain out the excess money out of the economic system by lowering or raising the CRR rates.
- CRR and Banks: As we know CRR and Banking Channel work closely and are interdependent. The CRR and availability of funds with the banks are inversely proportional to each other i.e. when RBI increases the Cash Reserve Ratio, it leads to lesser funds at disposal with banks. Likewise decreased Cash Reserve Ratio means increased funds at disposal with banks.
- CRR and Interest Rates on Loans: When there is increase in Cash Reserve Ratio, the loans become expensive as the banks are forced to keep more money with the RBI, So, the amount of funds available with the bank for disposal are decreased resulting into higher rate of interest as banks have less cash to give for loans and advances. On the other hand when there is decrease in cash reserve ratio the loans become cheaper. This is because the amounts of funds available with the banks for disposal have increased, resulting into lower rates of interest as banks capacity to fund loans and advances increases. The relation between Cash Reserve Ratio and Interest Rates are directly proportional to each other.
- Effects of CRR on Inflation and Deflation: Over the years, Cash Reserve Ratio has become an effective and important tool for directly regulating and controlling the money supply in the economy. When the CRR increases, there is a rise in the rate of interest so the bank’s lending capacity is reduced. This implies fewer new projects, new and existing loans with floating rate of interest to become expensive, less investment opportunities, less spending on luxuries etc. This will cause the prices to come down i.e. the inflation will come down. On the other hand, in deflation, when the RBI reduces CRR, the money is pumped into the economy via banking channels and thus the spending capacity increases and the deflation is curbed.
- CRR and Value of Money: When inflation decreases, the value of the money is depreciated and in the times of deflation, the value of the money increases. So when the government wants to curb inflation or deflation and correspondingly increase or decrease the value of money, it can be done by injecting or draining out money from the economy. This can be attained with the help of cash reserve ratio as we have seen CRR helps forming monetary policies of the economy.
Impact of Cash Reserve Ratio On Market
Let us have a holistic look at impact of Cash Reserve Ratio on various segments of the market when the CRR is increased.
Exports and Imports:
Increase in CRR means higher interest rates. This will make industries restrict their production of products and services as they will deploy lesser amount in production and expansion plans. This means the people will switch to foreign goods and services to get their desired products, resulting in increase in imports and decline in exports. Thus, putting downward pressure on the GDP.
Impact on Investments:
Investments mean injecting money in the economy. With the increase in CRR, there would not be enough cash in hand to do investments. So, there will be a slack and slowdown in investments resulting in slowing down of the economy.
Impact on Equity and Commodity Market:
An increase in the CRR would result in less investment in the equity market as well as Commodity market due to limited availability of funds for investments. Also, the primary goal of common people is to save more than invest.
Impact on the Bond Market:
An increase in CRR will result positively on the Bond Market as long term yield would be beneficial when considering investing in Bonds.
Impact on Real Estate:
With hike in CRR there would be less of liquidity in the market. This means that the investors would not be keen into buying real estate or would not be inclined to borrow home loan because of high rate of interest. Also construction sector would slowdown as construction companies would be apprehended to do work as the demand would be less plus they would need to borrow funds at higher rates. Thus, construction companies would be reluctant to increase their overhead costs.
Impact on Automotive Sector:
Automotive sector will also face a slowdown as manufacturers would be reluctant to manufacture as the demand will decrease due to higher lending rates. Also, the manufacturer would have to borrow funds at higher rates.
Impact on Stock Market:
With hike in the CRR, the impact on stock market would be seen in a way that there would be decline in the prices of the stocks. A slowdown in various sectors like the manufacturing, engineering, banking etc would result in decline in the prices of stocks of these companies. Therefore, the stock market would face the impact of increase in CRR.
Impact on common public:
Rise in the CRR would result in high rate of interest. So, the buying capacity of the public would decline as everyone would be in the mindset to do more saving rather than spending. Also when rate of interest are high, the loans would be expensive i.e. individual prospective borrowers would have to settle down for a lower loan amount for a given EMI. But if you are an existing borrower, then you need to worry as neither EMI nor the tenure of your loan would be affected, in case of fixed interest but with floating interest rates, you can expect your EMI or the tenure of the loan to rise anytime soon.
Should CRR be Abolished or Not?
There are various views regarding the abolishment of CRR from the banking structure. Let us understand both sides.
Arguments in favor of abolishing CRR:
- RBI does not pay any interest on the humongous amount of cash that is created and deposited into the vaults every day. CRR, in this case acts like a tax on the banking channel unlike mutual fund companies or non banking companies who do not have to maintain CRR. So, banks consider it as a disadvantage.
- Many bankers believe and are of an opinion that if the CRR is abolished, it would allow the banks to lower their lending rates as more liquid cash will be available with the bank for its disposal to its customers.
- As maintaining CRR is obligatory, many bankers believe that the amount that is kept with RBI as CRR is the loss to the banking sector as the banks have to part away from this fund.
- In India, there is uniformity in the rate of CRR across all banks. While in many developed countries, CRR is no longer used as the tool to control inflation or create slabs for charging CRR depending on the deposits received by the banks.
Arguments against abolishing CRR:
- CRR is an umbrella that can protect us from various financial losses. CRR is a safety system to protect all banks from any unforeseen adversities like global crisis or to face the demand from depositors.
- If CRR is abolished there would not remain any check over the banks, thus endangering the bank customers.
- Also another important aspect is that with rising non-performing assets (NPAs) of commercial banks, decline in current accounts, large public borrowing and more, Indian economy is facing a risk of financial downturn. In such a scenario, it is helpful to maintain CRR as it helps in strengthening and protecting the banking system.
- Also having a sound Cash Reserve is still considered as an important aspect along with the sound financial condition of the bank.
Thus, Cash Reserve Ratio is a tool to safeguard depositors. CRR cannot be abolished till all commercial banks in India attain zero non-performing assets along with a considerable financial backup to mitigate threats of financial breakdown in the economy.
To summarize, we can say that Cash Reserve Ratio is one of the important tools used by RBI to maintain liquidity in the economy, drain excess funds from the economy or inject liquidity in the economy, rein in inflationary situation etc. Cash Reserve Ratio gives immense control and regulatory authority to the RBI over money supply in the economy ensuring that the banks do not run out of cash and meet the demand payments of its customers.