Cash Reserve Ratio is that portion of banks total deposits which Banks have to park with Central Bank (RBI in India). A bank earns its income through lending at higher rates and paying low rate of interest on Deposits.
So any increase in CRR leads to lesser amount of money at disposal of banks, which can be given as advances and loans, thereby sucking liquidity in market. On the other hand, a decrease in CRR implies more money at disposal of banks, and hence more liquidity in market.
Increase in CRR means lesser liquidity, which in turn leads, to higher interest rates, implying fewer new projects, more interest costs for companies and individuals on their outstanding portion of loans (if taken on variable or market linked rate of interest), less spending on luxuries, lesser investments opportunities, etc. this will cause lesser demand and hence prices will come down (i.e. inflation rate will come down).
Thus, an increase in the CRR leads to banks being forced to keep more money with RBI reducing the funds available for lending. As less money is available to the bank to lend there is bias towards increase in rates as per the normal laws of supply and demand. So an increase in CRR will normally result in an increase in interest rates (and vice versa a reduction in CRR will normally result in a reduction in interest rates).
Let us say the RBI increase the CRR. This would mean that banks would have to keep more money with the RBI. This, in turn, would reduce the money available with them, thus bringing down the money supply in the market. A lower money supply would lead to an increase in interest rates.
Over the years CRR has become an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RBI feels that the money supply is increasing and causing an upward pressure on inflation, the RBI has the option of increasing the CRR thereby reducing the deposits available with banks to make loans and hence reducing the money supply and inflation.
Now look at the other side. A reduction in CRR would put more money in the coffers of the banks. As the money supply rises, interest rates decrease.
While the availability of Cash Reserves provides numerous benefits to society and the economy, it also poses a serious drawback in the form of lost interest. Banks do not earn interest on cash reserves, which results in reduced earnings for the bank and for its customers. In a 1992 release, the Federal Reserve estimated this loss to exceed $700 million per year in pre-tax earnings, which represents a loss of roughly 2 percent.
What do we do when interest rates are high?
Well, common sense would dictate that when the interest rates are high, we save, and not spend, money.
On the other hand, lower interest rates act as a disincentive to save money. So, in this case we would spend, and save.
Lower interest rates often boost demand for goods and services. In the short run, this would result in inflation as supply may not be able to match demand. Currently, to control the steeply rising inflation, the RBI twice raised the CRR in the recent past.
The reason why the RBI controls the CRR is that it is an effective and important tool to control inflation.
To put in a nutshell, a higher CRR would mean that there is less money available in the market. So there will be less money with people. This would mean that their demand for goods and services would be low. So the prices would be low.
Let’s make the entire concept, more Understandable, citing an example from routine life.
When you deposit Rupees 100, in a Bank, it gets Rupees 100 & now it can use this Rs 100, to lend others, but they have to put some part of it (as per CRR: say it to be 8%), with RBI, i.e. Rupees 8 with RBI, in this case & they are left with Rs 92, to lend to others.
From the perspective of a borrower
As a prospective borrower, you are the worst hit. The cost of money i.e. interest rates will rise post the CRR hike. You will probably need to settle in for a lower loan amount given the EMI. If you are an existing borrower, as long as the rate of interest on your loan is fixed, you are immune to any rise in interest rates. However, if you have a floating rate loan, then expect either the tenure of the loan or the EMI to jump soon.
- What is CRR?
- What is Scheduled Commercial Bank?
- Examples of Scheduled Commercial Banks
- Case #1: High CRR and SLR
- Case #2: Low CRR and SLR
- Repo Rate
- Reverse Repo Rate
- Bank Rate
- What is the need of all these CRR,SLR,Repo rates?
- What is the problem with CRR?
- How much CRR deposit does RBI have?
- What does SBI want?
- Deputy Governor of RBI
- Timeline of Events
- Mock Questions
What is CRR?
- CRR means Cash Reserve Ratio.
- Banks in India are required to hold a certain proportion of their total deposits with RBI in cash form.
- Right now, CRR is about 4.75% that means if people deposit total Rs.100 in SBI, then SBI would have to deposit Rs.4.75 in RBI.
- This is CRR or Cash Reserve Ratio.
- CRR rule doesnot apply to Non Banking Financial Companies (NBFC), Mutual funds or insurance companies.
What is Scheduled Commercial Bank?
- Scheduled banks are those banks which have been included in the second schedule of the Reserve bank of India act of 1934.
- The banks included in this schedule list should fulfill two conditions.
- The paid capital and collected funds of bank should not be less than Rs. 5 lakhs.
- Any activity of the bank will not adversely affect the interests of depositors [hahaha, does it mean Non-scheduled banks are allowed to adversely affect the interests of depositors !?]
Examples of Scheduled Commercial Banks
|Public Sector||Private Sector|
|Majority of stake is held by the government.||Majority stakes are held by private players.|
Case #1: High CRR and SLR
Suppose total deposit deposited in (by you and me) State Bank of India =Rs.100
|CRR: 15%SBI has to park this much amount of total deposit in RBI, without getting any interest.||-15|
|SLR: 38%SBI has to park this much amount of total deposit, in Government securities / treasury bonds. SBI earns around 7.5% interest rate on this investment.||-38|
|Money left with SBI||100-15-38=Rs.47|
Case #2: Low CRR and SLR
|CRR: 4.75%SBI has to park this much amount of total deposit in RBI, without getting any interest.||-4.75|
|SLR: 23%SBI has to park this much amount of total deposit, in Government securities / treasury bonds. SBI earns around 7.5% interest rate on this investment.||-23|
|Money left with SBI||100-4.75-23=Rs.72.25|
In either case, as long as you’re running a bank, you’ll have some input costs such as
- Salary to Bank PO , Clerks, peons and security guards (With rusted guns)
- Office rent
- ATM machine’s electricity and maintenance.
- Newspaper advertizements.
To pay above salary and bills, SBI would need to maintain certain amount of profit margin, no matter what RBI does with CRR,SLR or Repo Rate.
In Case#1, when SBI has only Rs.47 in the hands, what can it do to keep the profit margin same?
Obviously SBI will have to increase the interest rates on car,home,bike,business loans given to customers.
In case#2, when SBI has Rs.72, what can it do? Here the situation is not that bad.
So, SBI chief would decrease the interest rates on car,home,bike,business loans to seduce more customers. We already discussed this- SBI has more money so it can cut down interest rates and suffer temporary reduction in profit, in order to seduce more customers (compared to ICICI) So once SBI has reduced the interest rates, other banks will need to reduce their interest rates, to stay in the competition.
Let’s continue assuming the Case#2, that SBI has only Rs.72.25 left in its locker.
- SBI chief comes to know that recently Samsung Company has launched Galaxy S3 mobile so plenty of youngsters may want to buy it because of the advertisements that appear on TV channels 24/7
- Thus there will be demand for more personal loans (EMI) or credit card based shopping. But SBI got only Rs.72.25.
- So SBI chief would borrow some more money from RBI @8% interest rate and then re-lend this money to customers as personal loan @16% (and thus making a killing profit of 16-8=8%)
- or he can supply money to customers for Credit Card shopping, and in that case he can earn interest rate anything between 16-37% or even more (depending on hidden terms and conditions of credit card.)
- This 8% : the rate @which RBI lends short term loans to clients, is called Repo Rate.
Reverse Repo Rate
- As the name suggests, Reverse repo rate is “reverse” of Repo rate.
- So, if SBI chief feels there is not enough demand for loans and most of those 72.25 Rupees are sitting idle, he’ll deposit some of that cash, in RBI.
- RBI will pay SBI chief 7% interest rate on such deposit.
- Thus, Reverse repo rate is the interest rate which RBI pays its clients* for their short-term deposits.
- Note: Reverse Repo Rate is automatically kept 1% less than Repo rate according to new RBI rules. [Since Nov.2010, Reverse Repo rate is constantly 1% less than Repo].
Why would SBI chief put his money in RBI?
Because on your normal savings account in SBI, the chief pays you around 4% interest rate, while RBI is giving him 7% Reverse repo rate, so he’s making a profit of 3%.
- Bank rate is the interest rate which RBI charges from its clients* for their LONG-term loans.
- Recall that Repo Rate = RBI charge that much interest from its clients on SHORT term loans.
*Who’re the clients of RBI?
- Union Government
- State Government
- NABARD (through that money goes to Microfinance companies and Regional Rural Banks)
- Commercial Banks (SBI, ICICI etc)
- Non Banking Financial Companies (NBFC) like Muthoot Finance and Mannapuram Gold Loans.
(^list is not exhaustive.)
- Bank Rate, Repo Rate and Reverse Repo Rate applies to all Clients of RBI.
- The CRR,SLR applies to Commercial Banks. (including Urban Cooperative banks but excluding Regional Rural Banks)
What is the need of all these CRR,SLR,Repo rates?
- RBI’s main job = control inflation by controlling money supply in the market.
- Too much money in the market =easy to get loans= not good. Because It’ll create inflation. [Demand Pull]
- Too less money in the market= again not good, because businessmen find it hard to get loans, thus input cost of production increases= not good for economy either and it’ll create inflation. [Cost push]
- Therefore, RBI will increase/decrease these CRR, SLR and Repo Rates according to the situation in order to adjust the money supply in market and thus control inflation. [Monetary policy]
- Nowadays RBI doesn’t touch Bank rate much and mostly relies on Repo rate to control the money supply.
- CRR and SLR are also not changed as frequently as Repo rate.
- And Reverse repo rate is automatically kept 1% less than Repo rate, so that makes Repo rate the “most frequently used tool” in RBI’s monetary policy, in last two years.
- Apart from that, CRR,SLR and Repo Rate also help those competitive magazine wallas to fill up pages with ridiculously unimportant data tables to make your life more miserable.
What is the problem with CRR?
- CRR serves two purposes
- Control money supply in the market
- Acts like the ‘library deposit’, so if your bank goes broke / doesn’t play by the rules then RBI can use its CRR deposit to temporarily fix things.
- Earlier, RBI had to pay interest rates on CRR deposits.
- But in 2007, Government amended the RBI act so now RBI doesn’t have to pay any interest on the CRR deposits.
- Obviously the SBI, ICICI etc wouldn’t like it because their money is sitting idle in the lockers of RBI without earning any interest.
- They want CRR provision to be deleted.
How much CRR deposit does RBI have?
In July 2012 [all approximate numbers]
|Total Deposits in all Scheduled Commerical banks (SBI,ICICI etc)||65 lakh crores|
|CRR: 4.75%Banks have to keep this much amount of total deposits in RBI.||65 lakh crores x 4.75%=around 3 Lakh crores sitting idle in RBI lockers.|
|Interest earned by SBI/ICICI etc on CRR deposits made in RBI||3 lakh crores x 0% = Rs.0|
- If SBI/ICICI etc. could lend these 3 lakh crores (CRR deposits) to customers @10%, they could easily earn Rs.30,000 crores in interest payment.
- Thus, CRR makes a huge difference in the profit of banks.
- UK, Canada, Sweden, Australia and New Zealand donot have CRR system in any form.
- In USA, there is graded system i.e. small banks don’t need to maintain any CRR with their central bank. While “big” banks would need to maintain CRR Deposit according to their size.
- Side Question: How “big“? Answer: no need to do Ph.D on that question trail.
- By the way, USA’s RBI (Central Bank) is known as Federal Reserve system and commonly known as “Feds”. So sometimes while randomly surfing through BBC/CNN you might come across lines like “Market boomed /crashed after Feds cut down the rates” they’re talking about USA’s RBI changing their repo, SLR etc. rates
- Interestingly, USA’s RBI (Feds) pays interest on the CRR deposits, while India’s RBI doesn’t pay any interest on CRR deposits.
What does SBI want?
Recently SBI Chairman Pratip Chaudhari said that
- CRR does not help anyone and it is unfair to apply it only on banks.
- Even if CRR is required why should it be on banks alone? There are a number of institutions that raise funds from the public – insurance companies, mutual funds and NBFCs so CRR should be applicable to all.
- Because of CRR, every year we lose Rs. 3,500 crore.
- In India, Businessmen get loan @11 per cent while that for a Chinese equipment manufacturer gets loan in his country for only 4 per cent. So CRR= less money in market= higher interest rate= increases the input cost of Indian products.
Deputy Governor of RBI
On SBI chief Pratip Chaudhari’s demand for removal of CRR, the Deputy Governor of RBI K C Chakrabarty, replied that
if the SBI Chairman is not able to do business as per our regulatory environment, he has to find some other place.
On this [rude] comment of Chakrabarthy, SBI chief Pratip Chaudhari replied,
(doesn’t matter what anyone says) I wanted to start a debate on CRR in the public domain, so let that debate happen.
Timeline of Events
|Early 90s||CRR used to be as high as 15% and SLR used to be as high as 38.5%, thus making life of businessmen and aam juntaa difficult.|
|1992||RBI introduces system of Repo rate.|
|1996||RBI introduces the system of Reverse Repo Rate|
|1999||RBI starts paying interest rates to banks, on CRR deposits.|
By the way, during this time,
Q1. Which of the following statements are incorrect?
- The NBFCs are required to maintain CRR deposits with RBI.
- RBI pays interest rates on CRR deposits.
- An Increase in CRR would decrease the liquidity from the market.
- At present, Bank Rate > Repo Rate > Reverse Repo Rate.
Q2. Which of the following statements are correct?
- Repo rate is the interest rate paid by RBI to banks on short term deposits.
- A decrease in repo rate will increase the home loan interest rates.
- HDFC is a Non-scheduled Commercial bank.
- SLR is always 20% higher than CRR.
Q3. What were the steps taken by RBI in its monetary policy during 2011 to control inflation in India. Do you think RBI achieved its objective? Give reasons to justify your stand. (Mains)
Q4. If you were the RBI Governor, what steps would to take regarding the CRR issue?(interview)<
- Indian Economy by Ramesh Singh (Tata McGraw hill Publication)