What it is
Cash reserve ratio, or CRR, is the proportion of deposits that banks have to hold in the form of cash. It is mandatory and banks need to deposit the same with the Reserve Bank of India (RBI) fortnightly. For instance, currently the CRR is 6%. This means for every Rs100 deposited in the bank, it needs to deposit Rs6 with RBI. In other words, banks cannot lend or use this Rs6 for any purpose.
However, the entire remaining amount of Rs94 can’t be used by the banks for lending. In addition to the CRR, banks also have to set aside a stipulated proportion of the deposits as mandated by RBI.
Banks don’t earn an interest on the funds they deposit with the central bank as CRR.
What is the purpose of CRR
The main purpose is to shelter the risk of the bank’s depositors to an extent and to ensure that a bank maintains some funds in liquid form.
The central bank also uses the CRR to adjust liquidity in the system, the supply of money circulating in the economy. So when there is excess money supply in the market, RBI will increase the CRR to drain out the excess. On the other hand, if the economy is falling short of liquidity, then RBI will decrease the CRR to release more funds in the market. This is thus one of the instruments that the central bank uses to control inflation.
What change in CRR does
When the CRR is increased, the amount of funds that a bank can lend decreases. Banks would thus try to encourage more deposits by increasing the interest rates. Rising interest rate could also dissuade money shoppers (loan seekers) as a higher interest rate means that the cost of money has increased.
However, CRR is not the only factor that influences interest rates. Besides, this is a theoretical concept. Practically speaking, a change in CRR has a major effect on the bank itself, but may not necessarily have a major effect on investors unless a combination of factors facilitate a change in interest rates.