I think, most of us already know that banks earn money by taking deposits and lending money. In simple terms, banks takes deposits from public and lends to public. The difference in interest rates is what helps them to sustain. For example- I invested a sum of money in Fixed Deposit (FD) in SBI bank for 1 year at an interest rate of 9% and than I took a car loan @10.5%, So the difference between lending and deposits (i.e 10.5% – 9%) is what banks earns. Here, we have assumed a very basic model excluding all the transaction and other costs involved.
Here, We shall try to learn common banking terminologies through series of articles in a simple way.(Please note that here for all practical purpose “Banks” means Public sector banks (PSB)).
Have you ever wondered what actually happens with the money that you deposit in bank? Lets take an example to understand the functioning of banks.
Suppose you deposit Rs 100 with the bank, on receiving money, bank will first keep aside Rs 4 as CRR (Cash Reserve ratio), CRR is a term which we hear in news so many times, bankers, industrialists talk about CRR, so this is a liquidity tool used by RBI to pump or suck money from the system. PLEASE NOTE, CRR IS NON INTEREST BEARING i.e Banks do not get any interest on this amount it keeps with RBI and also CRR is most liquid, maintained in Cash form with central bank.
So, we are left with Rs 96 which banks have to deploy efficiently so that it can repay the depositor Rs 100 (with interest too!).
What Is Cash Reserve Ratio (CRR)?
In India banks are required to deposit a certain percentage of their total deposits with RBI in the form of cash. This minimum amount which banks need to deposit is stipulated by the RBI and is known as Cash Reserve Ratio (CRR).
But wait, before they do that, they have to deposit another Rs 23 (23% of Rs 100) in government securities and holdings (this is called SLR-statutory liquidity ratio), Banks are paid very less interest on SLR compared to other interest bearing asset categories. SLR is used by central bank to regulate Credit expansion and money supply.
What Is Statutory Liquidity Ratio (SLR)?
In India banks are required to deposit a certain percentage of their total deposits with RBI in form of gold, cash or other approved securities.
So, now we are left with Rs 73 ( Rs 96 – Rs 23) , Banks have to deploy this Rs 73 effectively to pay the depositor as well as earn money to make profits as well.
Now, out of this Rs 73 , 40% (i.e Rs 29) have to be given to Priority sector (Agriculture), We all know general fate of Agricultural loans and also margin on these loans are too small for banks for comfort!
So, in the end a banker is left with Rs 44 , this he can use for real commercial lending (CORPORATE + RETAIL LOANS) ensuring he gives Rs 100 to the depositor with interest, earn profit and distribute dividend to the shareholders and plough back enough profit to balance sheet for future expansion!
(Note – We have used current CRR and SLR rates above, these rates are constantly reviewed by RBI)
Soon will discuss CRR and SLR in detail to give you a clear understanding on these terms.