Definition: The Cash Reserve Ratio refers to a certain percentage of total deposits the commercial banks are required to maintain in the form of cash reserve with the central bank.
The objective of maintaining the cash reserve is to prevent the shortage of funds in meeting the demand by the depositor. The amount of reserve to be maintained depends on the bank’s experience regarding the cash demand by the depositors. If there had been no government rules, the commercial banks would keep a very low percentage of their deposits in the form of reserves.
Since cash reserve is non-interest bearing, i.e. no interest is paid on the deposits, therefore, the commercial banks often keep the reserve below the safe limits. This might lead to a financial crisis in the banking sector. Thus, in order to avoid such uncertainty the central bank imposes a cash reserve ratio or CRR on commercial banks. The central bank has the legal power to change the CRR any time at its discretion. The cash reserve ratio is a legal requirement and therefore it is also called as a Statutory Reserve Ratio (SRR).
Through a cash reserve ratio, the central bank can change money supply in the economy. Such as, when the economy demands a Contractionary Monetary Policy the central bank will raise the CRR. On the other hand, when the economic conditions, demand for an Expansionary Monetary Policy the central bank cuts down the CRR. The effect on the supply of money and credit due to the change in CRR is explained below:
Suppose a commercial bank has total deposits of Rs 150 million and CRR is 20%. It means a bank can loan Rs 120 million (150*20/100 = 30 million), and the credit of deposit multiplier is equal to Five (deposit multiplier, Dm = 1/CRR = 1/0.20). This means a bank can create, through a credit multiplier a total credit of Rs 750 million (150 *5) or an additional credit of Rs 600 million (120*5).
Now, if the central bank decides to curb the supply of money to the public raises the CRR to 25%. The credit multiplier will go down to Four (1/0.25). By doing so, the commercial bank can now only give a loan of Rs. 112.5 million (150 * 0.25 = 37.5 million). Thus, the total credit created by the commercial bank will go down to Rs 600 million (150*4), and the additional credit goes down to Rs 450 million (112.5 * 4). A fall in the bank credit by Rs 150 million will have a great impact on the money market.
The cash reserve ratio method is more handy and effective where the open market operations and bank rate policy proves to be ineffective. However, its efficiency with respect to its impact on the capital market depends on the banking credit share in the credit market. In addition to CRR, the central bank has imposed another kind of reserve called as Statutory Liquidity Ratio (SLR).