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Saturday, August 13, 2011

The Explainer: Cash Reserve Ratio


In 'The Explainer' this week, I will focus on a not-so-well understood economic term: Cash Reserve Ratio (CRR). The Cash Reserve Ratio (CRR) is used by the RBI to control the supply of money in the economy. The amount of money determines the rates of interest and the prices of different commodities.

What is Cash Reserve Ratio?
In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI an average cash balance, the amount of which shall not be less than three per cent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding 20% of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934.
In simple terms, all scheduled commercial banks must keep a 'certain percentage of their total time and demand liabilities with the RBI'. 

This is all Greek to me. Please explain the definition.
A liability is also called a loan. Here, a liability is simply a deposit account with a bank, i.e. what we call a deposit is called a liability by the bank as it would have to repay us (the money in that account). In other words, a deposit is our LOAN to the bank (and hence the interest paid by the bank).
There are two kinds of liabilities (hereon, we will use the term, 'deposit'): (1) time deposit, and (2) demand deposit.

Explain Time and Demand Deposits.
A Time Deposit is a type of account from which you can withdraw your money ONLY after a specified period of time. An example is a fixed deposit account. Hence, it is also called Term Deposit.
A Demand Deposit is one from which you can withdraw your money on demand. For example, from your Savings or Current account, you can withdraw money at anytime. (Also, you must have observed that an ATM is card is typically issued on these kinds of accounts, though they are also issued on some special types of fixed deposits).

Now, having understood the backgrounder on deposits, let's go further on CRR. 
Under the CRR, every scheduled commercial bank has to keep a certain percentage of such deposits with the RBI. The percentage lower limit is 3% while the upper limit is 20%. The current CRR is 6%. (You can access these data points here.)

How does this affect people like us and the economy in general?
As mentioned earlier, the CRR is used by the RBI to control the supply of money in the market. The amount of money determines the rate of interest and the prices of different commodities.
How does this work?
0.25% roughly equals about Rs8000 crore (Rupees Eight Thousand Crore only).
Let us say the RBI increases the CRR by 0.25%. This would mean that banks would have to keep more money with the RBI (Rs8000 crore will go into the RBI). This would reduce the money available with them. So this brings down the overall money supply in the market. A lower money supply would raise the interest rates (as demand for money is always high).
Now look at the reverse scenario. A reduction in CRR by 0.25% would release Rs 8000 crore into the market. As the money supply rises, the interest rates decrease. 

What do we do when the interest rates are high?
Common sense dictates that when interest rates are high we SAVE money and not Spend it. On the other hand, lower interest rates would make us SPEND more and not Save.
Lower interest rates would boost demand for goods and services. In the short run, this results in inflation as supply may not be able to match consumer demand. 
However, in the last three years, the RBI has raised the CRR from 3% to 6%. A higher CRR would mean that there is less money in the market. So there will be less money with people, which would mean that their demand for goods and services would be low. So the prices would be low. Hence inflation will be low. 

Just think about an increase in CRR of 3% in about three years; over Rs2 lakh crore has been sucked out of the system into the RBI! Though such a large amount has gone out of the system, it still has not brought down the rate of inflation.
As we can see today, inflation is very high and is impacting the common man in a very negative way. The RBI has tried various measures, like raising the CRR, to bring down inflation but to no avail. 
Sometime in the next four weeks, I will write on why the inflation rate is so high and how higher interest rates may impact economic growth in a negative way.

(Please select your reaction to this post; see below.)

20 comments:

Sri Charan said...

I came across a bank which is offering 10.5% interest rate and that too for a short period either 12 months or 21months.
Can u please tell me why they raised the interest rate..

Name of the Bank: Lakshmi Vilas Bank, Chennai

mahak said...

Thank you sir for explaining this in a layman's language. :)

Anonymous said...

neatly explained . .very clear idea is formed in my mind

Anonymous said...

sir can u xplain bt repo,reverse repo

Lovely Krishna said...

Sir just to answer Sri Charan's question,

For every bank there is an associated metric called "Cost of Funds" which basically determines the "Rate of Interest" they can offer to a specific client/customer so that the Bank/FI may make profit out of a loan.

A BIG bank like SBI with presence all over India can have easy access to funds (in the form of deposits/savings/current accounts) when compared to a relatively smaller bank like Lakshmi Vilas Bank. Hence the "Rate of Interest" of smaller banks or NBFCs are higher when compared to BIG banks.

Hope the explanation helps.

Sri Charan said...

thank lovely, this may be only to raise the funds.
one more questions strikes in my mind is can the bank itself change the interest rate or should it get an approval from RBI

Sri Charan said...

@Anonymous:

To my knowledge repo is a Repurchase agreement.
Usually repos are used in short term, unlike futures or forwards.

Something like, i have a security and i sell that to you on an agreement that i will buy it back.

Now for me the agreement is a repo (repurchase agreement).

for you it is a reverse repo.
Hope this can clarify.



Sir, pls validate the post with your comment

Lovely Krishna said...

@ Sri Charan: Banks can change the interest rate from time to time. Indeed banks change only the benchmark interest rate which was earlier called "PLR" - Prime Lending Rate, which is now currently "Base Rate". RBI has made the stipulation for every bank to disclose the Base Rate which basically is the minimum rate at which a bank can provide a loan to a customer. So all the interest rates are linked to "Base Rate", for example a Bank may quote interest rate as Base Rate + 3% (Spread). The spread is generally constant and reset once a year upon mutual consent, however Banks have the liberty to change Base Rate as and when they wish to.

There's no hard and fast rule that Banks change their base rate when RBI hikes interest rates. They may or may not, left to the banks discretion.

Anonymous said...

wt abt SLR...???

Sricharan Myadam said...

@ Anon: Gud one,

Both SLR and CRR should be maintained properly :)

Sir waiting for "The Explainer"

Kakarla said...

thank you sir..

Kamalakar Reddy said...

a very good article about CRR. Previously i don't have knowledge about why banks rise interest rates? why they decrease? now i have some clarity on that.
Thank you bharath sir.
Your articles are very useful to all especially MBA aspirants.

Deep said...

Really informative article sir... Please publish the next part of the series .. Cant wait for it!

Nakul said...

Truly helpful :)

Aditya Kagliwal said...

awsome article... cant find a more simple explaination :)

Goutam said...

the simple language used has struck a chord and the "greek" is decipherable..thank you sir!!

Raj said...

RBI has so many tools for controlling the market CRR, Repo, Base Rate etc., Can you explain me in what scenario which tools is used. I mean when is CRR is used and why can't others be used in that scenario?

Raj said...

As far as I know Base rate is the rate at which RBI lends to Banks. Why is that used as a base for fixing interest on loans?? Eg: I have a bank and I have good deposits with 4% interest. This means if all my costs are covered then can I lend at 6% even if Base rate is 7%?

To put it simply after following all CRR, SLR etc banks still have 65-70 Rs for every 100Rs deposited. Then why do Banks borrow money from RBI and fix lending rates based on the Base rate fixed by RBI. Why is RBI coming into picture?

Elizabeth J. Neal said...

will write on why the inflation rate is so high and how higher interest rates may impact economic growth in a negative way. finances

Boopathi raJA said...

A good read. Thank you sir!