Cash Reserve Requirement or Cash Reserve Ration (CRR) mandates the banks to hold a certain percentage of the deposit in the form of cash or cash equivalents. Banks can lend the rest of the money to the lenders after maintaining the reserve ratio or requirement. Banks do not normally keep the reserved cash with them; instead they deposit it with the RBI or invest in Government bonds or treasury bills which are considered to be cash equivalents. Cash Reserve Requirement is a very strong monetary tool with some important benefits. They are:
It helps to reduce the liquidity in the financial system. It is a very strong monetary policy tool to check the liquidity in the financial system.
It encourages the banks to invest in the government bonds and treasury bills, which the government sells to borrow money from the market.
It also reduces the risk of banking operation by restricting the lending percentage. Reserved money also helps the banks to cater any sudden liquidity crisis.
The Central Bank uses the Cash Reserve Ratio for the below purposes:
To maintain banks solvency in repaying the customer’s deposits
To control the money supply in the country by changing CRR value
Calculating Cash Reserve Ratio and how it helps to control liquidity:
For example, CRR rate guided by the Central Bank is 4%
Suppose if the bank has a deposit of USD 10000
The reserve to be maintain with Central Bank =USD 10000*4%= USD 400
The amount available for lending =>USD 10000 – USD 400 = USD 960
Now if the CRR is increased to 10%
For the same deposit amount of USD 10000, the reserve to be maintained is = USD 10000 * 10%=USD 1000
The available amount for lending = USD 10000 – USD1000= USD9000
This is how the available amount for the banks to lend can be decreased by increasing CRR.