Previous Year Question

A reduction in the Cash Reserve Ratio (CRR) generally increases the credit-creation capacity of banks. CRR is the prescribed ratio that Scheduled Commercial Banks are required to maintain as cash balances with the RBI on the basis of their relevant demand and time liabilities. Under Section 42 of the RBI Act, 1934, the RBI has the authority to prescribe the CRR.

When the RBI reduces the CRR, banks are required to keep a relatively smaller proportion of their deposit liabilities as reserves with the RBI. Consequently, banks can have more lendable resources available for loans and other permitted banking operations. The RBI has itself described the effect of previous CRR reductions as an augmentation of the lendable resources of banks.

Thus, the normal monetary mechanism can be understood as: CRR falls → lendable funds available with banks rise → lending capacity rises → possibility of credit creation increases. The RBI has also explained that relaxation in bank liquidity requirements can lead to greater credit creation.

Important qualification: An actual increase in bank lending need not automatically occur in exactly the same proportion as the CRR reduction. Actual lending also depends on demand for loans, banks' risk assessment, their capital position and broader economic conditions. However, other things remaining equal, a reduction in CRR increases the capacity for credit creation.