How do changes in CRR and SLR affect the economy?

First lets see what exactly is CRR and SLR:-

CRR – Cash Reserve Ratio:- You’re a banker, you’ve to keep deposit that much ca$h in RBI.

SLR - Statutory Liquidity Ratio:- You’ve to keep that much gold/ca$h/bonds in your bank.

Lets assume you’re a banker, have 100 Rs. cr.

Out of that you were required to keep aside 1 cr. worth cash, gold etc. in SLR+CRR in Jan’11 as per RBI order.

So you’ve 99 cr. to give as loan and earn interest out of it.

But in Feb’11,  RBI increases both ratios, so you’ve to keep aside 15 cr. in SLR+CRR.

So you only have 85 cr. to give as loan and earn interest out of it. Obviously you’ll charge more interest, when giving loans, to maintain same amount of profit.

How does this affect economy?

1. Well Lower SLR+CRR, means bank can give more money as loan = lower interest rates = cheap loan = more people take loan to start business or building house or buying car = boost in economy
2. HOWEVER, can also lead to inflation, if people have more cash in their hands than the items available for purchase in the market.
3. Higher SLR+CRR = bank can give less money as loan = HIGHER interest rate = it becomes expensive to start a new factory, buy a new house / car/bike. This can curb inflation but may also lead to slowdown in economy,because people wait for the interest rates to go down, before taking loans.

##As described by Mrunal

CDS : Credit default swaps

In simplest form Its buying insurance against a default.

Example

I’m a banker, gave car-loans to dude, but I’m afraid he might not pay back the full money. So I’ll goto some other Bank X who sells Credit default Swaps (CDS).

I’ve to pay regular premium Bank X, but if someday that dudes default on his car-payment, Bank X will pay me the money.

RBI is currently drafting rules for starting a CDS market in India.

These CDS bonds, once issued, can be sold and bought like any other bond or security but only thing is that they are not regulated.

i.e. Bank X sells my CDS to Bank Y. So now Bank Y gets my premium but in case of default by that Dude, Bank Y is supposed to pay me.

# As described by Mrunal

Related Articles 

Related articles

• CDS going wild (forexlive.com)
• Lehman Brothers: a primer on Credit Default Swaps (creditwritedowns.com)
• The depressed market for Greek default recoveries (ftalphaville.ft.com)
• Greek CDS spreads at record; Italy, Spain stable (marketwatch.com)
• Those Greek credit default swaps? (forexlive.com)
• FSA Said to Review Credit-Default Swaps in Market Abuse Probe (businessweek.com)

Credit Crunch – Meaning, Example and Implications

What is Credit Crunch?

In simple words, when you can’t get loans easily, its credit crunch.

Definition: Reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the banks. 

Examples of credit crunch

1. In America, banks were giving housing loans to any swinging dude, without checking his credit-worthiness (like can he really pay back the loan or not?). This lead to mass-defaults after few years. Now bank managers are very cautious and before processing your loan application, they’ll check it 17 times! this is also a sort of credit crunch because you can’t get loans that easily, like you used to get, before the recession.

2. In 3G auction spectrum, telecom companies took 70,000 cr. from Indian Banks to bid in the auction. = lot of money flew out of the system. So for a time being, banks have less money to give as loans to other customers = Credit crunch. (although that didnot happen) but suppose Mukesh Ambani had called up a bank asking for 50000 cr. loan for acquiring a foreign company next morning, Bank manager might have said ‘Sir, sorry we don’t have no money!”

Implications of Credit Crunch

Credit crunch is not good for economy, because

1. A businessman wants to start new factory, but cannot get loans easily = slowdown in economy.
2. A couple wants to buy home, but can’t get home-loan easily = slowdown in real-estate sector.
3. A college kids wants a new bike, but his dad can’t get loan easily = slowdown in automobile sector, but also good from climate-change angle. as people will be forced to use public transport system

If such credit crunch continues for a long time, it’ll lead to job-losses, factories shutting down and finally recession.

But sometimes credit crunch is a necessary evil, when there is too much liquidity (money) in the market.

Too much liquidity = too much money = easy to get loans = people have more money in their hands compared to the items available for purchase = hyper-inflation.

From the previous post about CRR & SLR, we can also say that an (Excessive) increase in CRR and SLR will lead to Credit crunch.

##As described by Mrunal