This method was first suggested by Lord J M Keynes, as a method of credit control by the central bank.
With excessive reserves kept by the banks , the two traditional weapons – bank rate policy and the policy of open market operations prove to be ineffective and therefore a more direct and effective method like the CRR is required.
The Reserve Requirement or the Cash Reserve Ratio (CRR) is a central bank regulation employed by most of the world’s central banks
It seta a certain minimum percentage of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.
The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India.
Under the RBI act of 1935 a certain minimum percentage of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the RBI. The RBI can vary CRR from 3% to 15 % of the total demand and time deposits of commercial banks.
The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors.
CRR is a crucial monetary policy tool which influences the country’s borrowing and interest rates by changing the amount of funds available for banks to make loans with. It and is used for controlling money supply in an economy.
RBI uses CRR either to drain excess liquidity or to release funds needed for the growth of the economy from time to time.
An institution that holds reserves in excess of the require amount is said to hold “excess reserves”.
When the central bank raises the reserve ratio
The commercial banks have to keep more money as reserves with the central bank,
This will reduce cash balances of commercial banks
And hence their capacity to create credit will be reduced,
Therefore higher the ratio lower is the amount that banks can use for giving loans.
An increase in CRR leads to contraction of credit
Increase in lending interest rates and a reduction in the money supply in the economy
The RBI uses the CRR to drain out excessive money from the system
This can reduce inflationary pressures.
When the central bank reduces the reserve ratio
The commercial banks have to keep less money as reserves with the central bank,
This will increase cash balances of commercial banks
And hence their capacity to create credit will be increase,
Therefore lower the ratio higher is the amount that banks can use for giving loans.
A decrease in CRR leads to expansion of credit
Decrease in lending interest rates and an increase in the money supply in the economy
The RBI uses the CRR to increase the money supply in the system
This can control recession/deflation..
Therefore when the central bank wants to reduce money supply, CRR will be raised and it will be reduced to expand quantity of money supply.
It is a very effective instrument as it affects the base of credit creation.
Thus we can say that this serves duel purposes i.e.
(a) ensures that a portion of bank deposits is kept with RBI and is totally risk-free,
(b) Enables RBI to control liquidity in the system, and thereby, inflation by tying the hands of the banks in lending money.
Western central banks rarely alter the reserve requirement because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use open market operations [buying and selling government issued bonds] to implement their monetary policy.
Limitations of variable reserve ratio
a] This method proves ineffective when commercial banks have large excessive cash reserves with them.
b] The method proves without an edge even when commercial banks happen to have large foreign funds with them.
c] This method is effective when big changes are made in the reserves of commercial banks, but fails as a weapon to correct marginal adjustments in their reserves.
d] this method is discriminatory in nature ie it discriminates smaller commercial banks with small cash reserves and favours larger commercial banks which are not affected by changes in the cash reserve ratio.
e] this method creates uncertainty as the commercial are constantly under pressure that the central bank may change the reserve ratio.
f] it imposes undue financial burden on commercial banks as no interest is paid on the cash reserves held by them.
g] it is a very powerful and potent weapon of the central bank as its effect on control of credit is immediate and direct.
h] the success of this method depends on the willingness of the borrower which is absent under conditions of depression in the economy.