What is CRR?

Indian banks are required to hold a certain proportion of their deposits as cash. In reality they don’t
hold these as cash with themselves, but with Reserve Bank of India (RBI), which is as good as
holding cash. This ratio (what part of the total deposits is to be held as cash) is stipulated by the RBI
and is known as the CRR, the cash reserve ratio. When a bank’s deposits increase by Rs100, and if
the cash reserve ratio is 10, banks will hold Rs10 with the RBI and lend Rs 90. The higher this ratio,
the lower is the amount that banks can lend out. This makes the CRR an instrument in the hands of a
central bank through which it can control the amount by which banks lend. The RBI’s medium term
policy is to take the CRR rate down to 3 per cent.

What does a hike in this rate mean?

The hike in CRR from 4.5 to 5 per cent will increase the amount that banks have to hold with RBI. It
will therefore reduce the amount that they can lend out. The move is expected to shift Rs 8,000 crore
of lendable resources to RBI. In the past few months the money that banks have available for giving
out as credit is greater than the amount they have been lending out. This has led to “an overhang of
liquidity” in the system. The objective of the CRR hike is to “mop up” some of the “excess liquidity” in
the system.

Will this mean a rise in interest rates on my deposits and home loans too? By when and by how
much?

The hike in CRR is not likely to lead to an immediate increase in interest rates. There is excess
liquidity in the system even after a higher amount is deposited with RBI as reserves.

Unless the demand for credit picks up to the extent that the money is all lent out, banks will not have
an incentive to raise interest rates.

The inflation rate may continue to be high, the economy may also continue to witness growth which
will keep the demand for credit high, and international trends are for rates to move up. This means
that sooner or later interest rates will go up. The first rates to get impacted are yields on government
bonds. We have already seen this happening. If the inflation rate keeps rising, RBI may raise the ‘repo
rate’, the short term rate at which banks park excess funds with the RBI. This makes it less attractive
for banks to lend.

Further, RBI may raise the bank rate, the rate at which it lends to banks.

The present banking system is called a “fractional reserve banking system”, as the banks are required
to keep only a fraction of their deposit liabilities in the form of liquid cash with the central bank for
ensuring safety and liquidity of deposits. The Cash Reserve Ratio (CRR) refers to this liquid cash that
banks have to maintain with the Reserve Bank of India (RBI) as a certain percentage of their demand
and time liabilities. For example if the CRR is 10% then a bank with net demand and time deposits of
Rs 1,00,000 will have to deposit Rs 10,000 with the RBI as liquid cash.
How is CRR used as a tool of credit control?
CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of bank deposits,
however over the years it 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.

Does RBI impose on penalty on banks for defaulting on CRR deposits?

The RBI has the authority to impose penal interest rates on the banks in respect of their shortfalls in
the prescribed CRR. According to Master Circular on maintenance of statutory reserves updated up to
June 2008, in case of default in maintenance of CRR requirement on daily basis, which is presently
70 per cent of the total CRR requirement, penal interest will be recovered at the rate of three 3% per
annum above the bank rate on the amount by which the amount actually maintained falls short of the
prescribed minimum on that day. If shortfall continues on the next succeeding days, penal interest will
be recovered at a rate of 5% per annum above the bank rate. In fact if the default continues on a
regular then RBI can even cancel the bank’s licence or force it to merge with a larger bank.

Does CRR apply to all scheduled banks?

The CRR is applicable to all scheduled banks including the scheduled cooperative banks and the
Regional Rural Banks (RRBs). The present level of CRR is 6.5%. Previously, there was a floor of 3%
and ceiling of 20% on the CRR that could be imposed by the RBI; however since 2006 there is no
minimum or maximum level of CRR that needs to be fixed by the central bank of India. At present, the
RBI does not pay any interest to the banks on the CRR deposits. Prior to 1962, a separate CRR was
fixed in respect of demand and time liabilities, however after 1962 the separate CRRs were merged
and one CRR came into effect for both demand and time deposits of banks with RBI.

CRR i.e. CASH RESERVE RATIO is the percentage of Deposits with the Bank which are to be
maintained in the form of cash or reserves with Reserve Bank of India(RBI) . This will ensure
sufficient amount at the disposal of the bank to cater to the withdrawals by the depositors on
demand. Now comes your question as to the role of CRR in controlling inflation. Always
remember that when banks lend money to people, new money is created. The Bank lends
this money out of deposits with the bank . Example say A has deposited 50000 in the bank,
now bank lends this 50000 to B who needs it to make payment to C for purchasing goods
from C. Now 50000 in the hands of C is new money. Now if C deposits this money in his
bank, the same process will be repeated again and when C?s bank will lend money to D who
needs it make payment to E which E deposits in his bank, new money will be created which
will now be in the hands of E. Now just see how much money is created , A?s deposits with
his bank, 50000 + C?s deposits with his bank, 50000+ E?s deposits with his bank,50000. It
totals upto 150000.
This process by which the initial money of 50000 multiplied into 150000 is called CREDIT
EXPANSION. Inflation is excess of the purchasing power over the value of goods and services
that could be bought with that money. When CREDIT EXPANSION takes place, the purchasing
power in the economy increases like we saw in the example above. Thus when RBI increases
the CRR ratio, the capacity of banks to lend money decreases and thus the volume of credit
expansion decreases thus the purchasing power is controlled to that extent. This method of
controlling inflation adopted by the RBI to control inflation is called a MONETARY MEASURE.
Thus whenever banks lend money new money is created. Thus it is the lending capacity of
the banks which the CRR aims to control.