Explain the components of Legal reserve Ratio.
Commercial banks have to maintain minimum reserves according to the legal reserve requirements in order to control the credit creating power of these banks. They maintain reserves in the following ways:
i. Cash Reserve Ratio (CRR)
The cash reserve ratio (CRR) is the necessary minimum percentage of a bank’s total deposits which is to be kept with the Central Bank. According to the RBI Act, 1934, every commercial bank needs to maintain with the Central Bank a certain percentage of their deposits in the form of cash reserves. By an amendment of the Act in 1962, the Central Bank can vary the CRR between 3 and 15% of the total deposits of commercial banks During inflation, the Central Bank increases the CRR, and thereby, the funds for providing loans with commercial banks decrease. In this process, the flow of credit and the aggregate demand are reduced. Thus, the process of credit creation by the commercial bank is checked and helps control inflation. On the other hand, the RBI reduces the CRR to curb the deflation situation.
ii. Statuary Liquidity Ratio (SLR)
Statutory liquidity ratio (SLR) is the fixed percentage of assets in the form of cash or other liquid assets which a bank must maintain with the Central Bank. The Central Bank can vary the SLR between 20 and 40%. If there is a change in SLR, then the freedom of banks to sell government securities or borrow against them from the Central Bank will get affected.