Cash Reserve Ratio

What is a Cash Reserve Ratio?

The cash reserve ratio (CRR) is a regulation set by the central bank requiring commercial banks to hold a certain percentage of their deposits as reserves. This minimum amount of cash reserves must be kept either in the bank's vault or deposited with the central bank.

The CRR is calculated as a percentage of the bank's total deposits, including current deposits, savings accounts, and fixed deposits. These reserves are crucial for ensuring that banks possess enough liquidity to meet customer demands and manage liquidity problems.

Under the CRR, banks cannot use these reserves for lending to corporations or individual borrowers, nor can they use the funds for investment purposes. Additionally, banks do not earn any interest on the money held as required cash reserves. This measure is part of the central bank's broader monetary policy to manage the money supply and control inflation in the economy.

Cash Reserve Ratio Explained

When the central bank decides to increase the cash reserve ratio (CRR), it effectively reduces the amount of money that commercial banks have available for lending and investment purposes. This is a strategic move by the regulator to control the excess flow of money in the economy and manage liquidity. The CRR is the percentage of a bank's total liabilities that must be maintained as cash reserves with the central bank.

The liabilities for these purposes include all the demand and time deposits that banks hold, as well as call money market borrowings. Demand deposits encompass liabilities that the bank must pay on demand, such as current deposits, demand drafts, balances in overdue fixed deposits, and the demand liabilities portion of savings bank deposits. Time deposits are funds that need to be repaid on maturity, where the depositor cannot withdraw these funds immediately; this includes fixed deposits, the time liabilities portion of savings bank deposits, and security deposits.

Commercial banks must maintain a minimum CRR with their compliance typically evaluated on a fortnightly basis. For instance, in January 2025 the CRR in India was set at 4% while in China it stood at 9.5% for big banks. This requirement ensures that banks have enough liquidity to meet customer demands while also controlling the money flow in the financial system.

Objectives of Cash Reserve Ratio

1. Security of Bank Deposits. The CRR ensures that a portion of a bank's deposits is held with the central bank, such as the Federal Reserve or the European Central Bank. This requirement secures a part of the bank's reserves, contributing to the overall stability of financial institutions and the banking system.

2. Managing Money Supply and Inflation Control. Another critical objective of the CRR is to manage money supply and control inflation. During periods of high inflation, central banks may raise the CRR. When the cash reserve requirement ratio is increased, banks have less money available for lending. This reduction in available funds helps to squeeze the money flow in the economy, reducing investments and consumer spending, which in turn helps bring down inflation.

How Is the Reserve Ratio Determined?

The required cash reserve ratio is a critical component of a country's monetary policy and is determined by the central bank. In the United States, the Federal Reserve System, specifically the Board including representatives of Federal Reserve Banks, set the reserve requirement ratio. This ratio mandates the proportion of depositors' balances that depository institutions, including commercial banks, must hold as bank reserves either in their vault or on deposit at a Federal Reserve Bank. As of January 2025, the reserve requirement level in the US is 0%.

Most central banks, such as the European Central Bank and the Federal Reserve, adjust the reserve requirement ratio based on various economic indicators to control inflation, manage liquidity, and ensure the stability of financial institutions. These adjustments can influence the amount of money available for lending and investment by banks, thereby impacting the overall money supply and interest rates.

In setting the reserve ratios, central banks consider factors such as the current economic conditions, growth rate, inflation levels, and the overall health of the banking system. By altering the reserve requirements, central banks can either pump funds into the economy to stimulate growth or withdraw liquidity to control inflation, thus ensuring that banks maintain adequate reserves held to meet depositor demands and manage liquidity problems efficiently.

Example

Consider a commercial bank with total net transaction accounts and time deposits amounting to $1 billion. If the central bank sets the cash reserve ratio (CRR) at 5%, the bank must maintain $50 million as reserve balances with the central bank. This means that out of the $1 billion in deposits held, the bank cannot use $50 million for lending or investment. This CRR requirement ensures banks have enough liquidity to meet depositor demands and manage liquidity effectively, especially during periods of higher inflation, while also supporting the central bank's broader monetary policies aimed at controlling the money supply and interest rates.