The Reserve Bank of India(RBI) had recently released a notification to increase the CRR by 0.5% in two stages. This led to most major banks increasing their lending rates with ICICI bank taking the lead. But what exactly is CRR and why does it have an effect on the lending rates.
CRR or the Cash Reserve Ratio is the amount that the banks have to keep with RBI. This amount is kept as an interest free deposit by the RBI. Increasing the CRR has to main effects - one it constricts the money supply and second that the banks lose out on interests for their deposit with RBI. As more borrowers are running after lesser available money the lending rates are bound to go up.
Apart from CRR, RBI also controls the Repo rate and the reverse repo rate. Both of these are effective controls in the monetary policy. Repo rate is the rate at which the RBI lends the money to the banks while Reverse repo rate is the rate at which RBI borrows the money from various banks. An increase in either of them can lead to an increase in lending rates for the banks. If repo rate is increased borrowing becomes costlier for the banks and they tend to pass the increased costs to the customers. Similarly, if the reverse repo rate increases banks might find it advantageous to deposit the money with RBI which is essentially risk free. The increase in lending rate offsets the risk that the banks have to take.