Understanding CRR and SLR: RBI's monetary policy instruments

6 Jan 2021  Read 584 Views

For banks, profits are created by lending and investing. In pursuit of this goal, banks could lend considerable amounts to earn higher profits and thus possess less liquid cash with them. Banks are also responsible for the influx of money in the economy as the amount of credits they lend, and the amount that gets deposited with them affects the money supply in the economy.

To avoid giving the banks such direct control over the economy’s money supply, the Reserve Bank of India (RBI) implemented various monetary policy instruments that help regulate the money supply. Hence, to keep track of the banks’ reserve, the RBI implements these monetary policy instruments that control and regulate any discrepancies in the money supply, solvency of banks, bank credit, and inflation in the market. Among these instruments are the CRR and SLR.

Let’s take a detailed look into CRR and SLR and understand their significance.

What is Cash Reverse Ratio (CRR)?

CRR is a certain proportion/percent of all commercial bank’s total deposits that need to be maintained in the form of liquid cash as per RBI’s (Reserve Bank of India) guidelines. This certain proportion is fixed and changed from time to time by the RBI. 

Here are the main objectives of the CRR:

  • The main aim of CRR is to offer some liquid cash against the depositor’s money so that the bank does not fail to meet the depositor’s cash requirements. 

  • CRR ensures that a certain proportion of liquid cash is secure with commercial banks in case of emergency repayments.

  • During high inflation in the economy, RBI raises the CRR percentage for the commercial banks and reduces the bank’s loanable fund that helps to keep inflation under control. 

How Does CRR Work?

When there is an excess cash flow in the economy, RBI steps in to control the excess cash flow and decides to increase the CRR that reduces the available money with the commercial banks.

The cash balance that is to be maintained by commercial banks with the RBI should not be less than 4% of the total NDTL, which is the Net Demand and Time Liabilities. It is done on a fortnightly basis.

NDTL = Deposits( Demand and Time Liabilities) with public and other banks

NDTL is referred to as the total demand and time liabilities held by the commercial banks. That includes deposits of general people and the balances held by the commercial banks with other banks. 

Time deposits consist of deposits which need to be repaid on maturity and where depositors cannot withdraw money immediately. Instead, the depositor is required to wait for a certain period to get access to their funds.

How Does the CRR Affect the Economy?

CRR is one of the important components of RBI’s monetary policy used to regulate and control the money supply, level of inflation, and liquidity in the economy.

In short, if the CRR is high, that means a lower amount is available to the banks for investing and lending. Banks are mandated to keep more money with the RBI and less with themselves.

If the CRR is low, that means RBI is trying to infuse liquidity in the economy by leaving more money to the commercial banks for lending and investing.

CRR does impact the interest rate as the money supply directly correlates with the interest rate in the economy. It further boosts the growth of the economy.

What is Statutory Liquid Ratio (SLR)?

The Reserve Bank of India has mandated every commercial bank to keep a certain proportion of deposits in the form of liquid assets, gold, or other securities excluding the CRR (Cash Reserve Ratio), which is called the SLR. 

The upper limit of SLR is 40%, and the lower limit is 23%. This limit is fixed by the RBI and is changed from time to time.

Here are the main objectives of SLR:

  • When the cash reserve ratio goes up, the bank/financial institutions can face over-liquidity. In this situation, RBI employs SLR regulation to control the bank credit. SLR ensures that there is solvency in the commercial banks and that banks invest in government securities.

  • During inflation, RBI raises SLR to control the bank credit. Similarly, at the time of recession, RBI decreases the SLR to increase the bank credit.

How Does SLR Work?

Every commercial bank has a certain proposition of their NDTL(Net Demand and Time Liabilities) in the form of cash, gold, and other securities by the end of the day. The ratio of these liquid assets with demand liabilities is called SLR.

RBI has the authority to increase this ratio by up to 40%. An increase in this ratio enables banks to inject money into the economy. 

RBI also regulates the money and price stability in the economy through SLR.

How Does SLR Affect the Economy?

If the SLR rises, it restricts the bank's lending capacity and controls inflation by soaking the liquidity from the market. Consequently, banks can have less accessible money to lend, and they can charge higher interest rates on loans to keep up with their profit margin. To avoid this scenario, RBI regulates SLR that ensures the banks' solvency and further regulates the cash flow in the economy. 

Difference Between CRR and SLR

Here are some important differences between CRR and SLR:

Cash Reserve Ratio

Statutory Liquid Ratio

CRR only requires to have a cash reserve ratio with RBI

For SLR, banks are asked to keep the certain proposition of liquid assets in the form of gold and cash by RBI.

Banks don’t earn returns on the money parked as CRR with RBI under CRR requirements.

Banks earn returns on money parked as SLR.

RBI controls the liquidity in the banking system with CRR.

SLR is employed to manage the bank’s leverage for credit growth.

Cash reserve is maintained by the bank with RBI.

Securities are kept with the banks themselves, which they need to maintain in the form of liquid assets.

Final Thoughts

The common man is usually in the habit of keeping some amount of cash as emergency funds. Similarly, commercial banks also keep a certain proportion of the deposits in cash and liquid assets like gold and other securities with the Reserve Bank of India.

The RBI controls these reserves to avoid excessive money supply in the market or inflation in the economy. CRR and SLR help RBI to establish this control, which further enables it to boost the economic growth of the country.

About the Author: Divyanshu kumar | 44 Post(s)

Divyanshu is currently pursuing a Master's degree in Financial economics. Growing up, he has always been interested in codes and numbers which he has gradually learnt to express in words too.

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