Cash Reserve Ratio
SYNOPSIS
- Introduction
- Fractional reserve banking system
- Cash Reserve meaning
- What is Cash Reserve Ratio?
- Role of Cash reserve ratio in Banking industry
- Section 18 of Banking Regulation Act
- Requirement of Cash Reserve Ratio
- Impact of increase and decrease
- Current Cash Reserve Ratio
- Conclusion
Introduction
Cash Reserve Ratio called CRR as well is a popular term in banking industry. Cash Reserve Ratio is fixed by government to regularize the market and economy of a country. Every country’s economy is based on its banking industry as it is the place from where money comes and circulates in the market.
Fractional reserve banking system
Cash Reserve Ratio method gives greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves with them. This is called fractional reserve banking.
It is a system in which commercial banks accept deposits from individuals and make loans investments etc. while holding reserve at least equal to a fraction of its deposit liabilities. These reserves are called currency in the bank account of depositor bank having with the central bank. This fractional banking system is prevalent and popular among most countries worldwide.
This system allows a bank to act as financial intermediaries between borrowers and savers and to provide long term loans to borrowers by provide immediate liquidity to depositors.
In the banking industry there can be chances that bank may face bank run or a situation when a large number of people withdraw their money deposited to the bank as they believe that bank is going to shut and they may lose their money.
To deal with such kind of risk and situations governments regulate the banking system by acting as a lender to commercial banks.
 Cash Reserve meaning
Cash Reserve means any amount of money or a business or an individual keeps in hand for meeting short-term and emergency funding needs. It is a type of short-term highly liquid investment that earns a low rate of return.
If an individual, group of individuals, or company having significant cash reserves, it gives them the ability to make a large purchase immediately. The central bank has the legal power to change the CRR any time at its discretion.
As per the market view cash is the most liquid form of wealth, but short-term assets, such as three-month Treasury bills, are considered cash reserves because of their high liquidity and short maturity dates. Thus it is one of the reasons a business may hold cash reserves is to have the necessary liquidity to meet the cost of all expected and unexpected costs.
What is Cash Reserve Ratio?
The cash reserve ratio is also called as a Statutory Reserve Ratio (SRR) because it is a legal requirement for the commercial banks. The Cash Reserve Ratio means a certain percentage of total deposits the commercial banks are required to maintain in the form of cash reserve with the central bank for maintaining its liquidity power.
Efficiency of Cash Reserve Ratio with respect to its impact on the capital market depends on the banking credit share in the credit market. In addition to CRR, the Reserve bank has imposed another kind of reserve called as Statutory Liquidity Ratio (SLR).
·      Objective
The objective of CRR is to prevent the shortage of funds in meeting the demand by the depositor. What should be the amount of reserve to be maintained it depends on the bank’s experience regarding the cash demand by the depositors. Cash reserve is an amount where no interest is paid on the deposit.
Therefore, the commercial banks often keep the reserve low. If there had been no government rules, the commercial banks would keep a very low percentage of their deposits in the form of reserves with the central bank which could cause emergency situations, risky for the banking industry.
·      Functioning
The central bank can change money supply in the economy through CRR. In India Reserve Bank of India keeps the cash reserve of commercial banks and regulate the economy by such cash reserve. On the basis of economy RBI decides whether to increase the money flow in market or to deduct the same.
Market condition plays vital role in deciding the cash reserve ratio. Through these mechanism commercial banks gets stability to work.
Role of cash reserve ratio in banking industry
Cash Reserve Ratio is a crucial monetary policy tool and it is used for controlling money supply in an economy. The amount specified as the CRR is held in cash and cash equivalents. It is stored in bank vaults or parked with the Reserve Bank of India. The motive behind this is to ensure that banks do not run out of cash to meet the payment demands of their depositors.
It can be understood with the help of an example, suppose a commercial bank is having total deposits of Rs.150 million and CRR is 20%. 150×20/100=30, it is the amount which a bank need to reserve with central bank. After deducting 30 from 150 million, it has 120 million in its hand.
Credit of deposit multiplier is equal to five (1/0.20). This means a bank can create, through a credit multiplier a total credit of Rs 750 million (150 x5) or an additional credit of Rs 600 million (120×5).
Same way, if the central bank decides to decrease the supply of money to the market it raises the CRR to 25%. The credit multiplier will be Four now (1/0.25). Here, the commercial bank can only give a loan of Rs. 112.5 million (150 x 0.25 = 37.5 million).
Thus, the total credit created by the commercial bank will go down to Rs 600 million (15×4), and the additional credit goes down to Rs 450 million (112.5 x 4). A fall in the bank credit of Rs 150 million will have a great impact on the money market.
Section 18 of Banking Regulation Act
Section 18 Banking Regulation Act says that every banking company or a bank, which does not come in scheduled banks, will have to maintain in India a cash reserve either with itself or with the Reserve bank of India by maintaining such amount in by way of net balance in the current account maintained by their name in RBI.
The amount should be a sum equivalent to at least three percent of total of the demand and liabilities of bank in India calculated as on the last Friday of the second preceding fortnight.
It shall submit the same to RBI before the twentieth day of every month a return showing the amount so held on alternate Fridays during a month with particulars of its demand and liabilities in country on such Fridays or if any such Friday is a public holiday under the Negotiable Instruments Act, 1881 (26 of 1881), at the end of business on the preceding working day.
Explanation is attached with this section and section 24 which explain following things:
- Liabilities in India –it is meant that it shall not include-
- The paid up capital, any reserves, any credit balance in the profit and loss account of any such banking company referred above.
- Any advance taken by the banking company from Reserve Bank of India or any Development Bank or Exim Bank, Reconstruction Bank, National Bank or from the Small Industries Bank.
- In case of a Regional Rural bank any loan taken from Sponser Bank.
- Fortnight – it shall mean period from the Saturday to the second following Friday, including both days.
- Net balance in current accounts- it means in case of banking company the excess if any of the aggregate of credit balance in current account maintained by such company in State Bank of India or its subsidiary bank or a corresponding new bank over the aggregate of the credit balances in current account held by the above mentioned banks with such company.
- Computation of liabilities- for such purpose the aggregate of the time liabilities of a banking company to the State Bank of India, a subsidiary bank, a corresponding new bank, a regional rural bank, or any other banking company, a co-operative bank or any other financial institution notified by the Central Government in this behalf, shall be reduced by the aggregate of the liabilities of all such banks to the banking company.
- Co-operative banks- it shall have the same meaning as given to it in clause (cci) of section 56.
Section further states that for the purpose of this section and section 24, may specify from time to time, with reference to any transaction or class of transactions, that such transaction or transactions shall be regarded as liability in India of a banking company and, The decision of the Reserve Bank shall be final if any question arises as to whether any transaction or class of transactions shall be regarded for the purposes of this section and section 24 as liability in India of a banking company.
Requirement of Cash Reserve Ratio
RBI has primary functions-
- To control the supply of money in the economy means how much money is available for the industry
- The cost of credit, what is the price that the economy has to pay to borrow that money.
These two things (Supply of money and cost of credit) are controlled by RBI. These two factors have great impact on the inflation and growth in the economy
The various methods employed by the RBI to control credit creation power of the commercial banks can be classified into two groups-
- Quantitative controls
- Qualitative controls.
Quantitative controls
These are designed to regulate the volume of credit created by the banking system.
 Qualitative Controls
These are designed to regulate the flow of credit in specific uses.
To control inflation and the growth, RBI uses certain tools like CASH RESERVE RATIO, STATUTORY LIQUIDITY RATIO, REPO RATE, and REVERSE REPO RATE
Impact of increase and decrease of CRR
Cash reserve ratio plays a role of tool for reserve Bank of India. RBI uses this tool for its monetary policy to balance between growth and inflation in the capital market. When RBI increases the cash reserve ratio, it curtails the power or ability of bank of giving loans hence flow of money in market decreases.
On the other hand, if RBI decreases the cash reserve ratio Banks can retain more money in their hand and can give more loans and money flow in market will be increased which will have direct impact on economy.
Current Cash Reserve Ratio
Current Cash Reserve Ratio is 4%. Which means every commercial Bank will have to maintain 4% of its total deposits with Reserve Bank of India as per the guidelines given by RBI.
Conclusion
The cash reserve ratio method very effective where the open market operations and bank rate policy proves to be ineffective. Through CRR Reserve Bank provide safety net to banks against bad loans. By reserving cash of a bank it controls lending and crediting power of bank so that they cannot keep lending, here it is important to mention that if a bank face loss due to bad loans this reserve cash helps it.
Banks also maintain their liquidity in form of cash reserve ratio, therefore it is a protection of banks from the unexpected monetary situation. There are countries like Canada, the UK, New Zealand, Australia, Sweden and Hong Kong have no reserve requirements.
