Rationale for imposing CRR

B. Venkatesh

THE Reserve Bank of India cut the cash reserve ratio (CRR) by 2 per cent to 5.5 per cent in its recent credit policy. What is CRR?

CRR is the amount the commercial banks need to maintain with the RBI. The amount is based on a fixed percentage computed on each bank's total time and demand liabilities. A CRR of 7.5 per cent means that the banks need to set aside Rs 7.5 for every Rs 100 they receive in deposits.

The CRR imposes a cost on the banking system. This is because banks do not receive more than 6.5 per cent interest on the CRR, while they earn higher returns if the money is lent to customers or invested in bonds.

Why does the RBI impose the CRR? The reason is that banks may otherwise lend more than they can handle. This follows from the principle of the credit multiplier, which is the process by which banks create loans that are a multiple of the deposits they receive. For instance, if a bank receives deposits worth Rs 100, a credit multiplier of 10 means that it can convert these deposits into loans worth Rs 1,000 (Rs 100 times 10).

The credit multiplier is the inverse of the CRR. That is, if the CRR is 7 per cent, the credit multiplier is 14, which is 100 divided by 7. The lower the CRR, the higher the credit multiplier.

Now, if no CRR limits are imposed on banks, they may lend as much as they receive in deposits. The problem comes when depositors want to withdraw their money. What will the banks do? They cannot pay all their depositors because their money will be in the form of loans.

A CRR helps in such cases. Since banks need to set aside a portion of their deposits as CRR, there is a limit on how much money it can lend to its customers. Such a limit helps in maintaining stability in the banking system.