RBI Act — Cash Reserve Ratio (Section 42)

Section 42 of the Reserve Bank of India Act, 1934 is the statutory engine of the Cash Reserve Ratio (CRR) — the slice of every scheduled bank's deposits that must sit, in cash, with the Reserve Bank. It is at once a prudential safeguard for depositors and the single most powerful lever the RBI has over the volume of credit in the economy. For the judiciary and CLAT-PG aspirant the section repays close reading: it is a tightly drafted fiscal provision whose every limb — the percentage, the base of computation, the fortnightly averaging, the penal-interest cascade and the 2006 deregulation of the rate — has been litigated or examined. This chapter dissects Section 42 sub-section by sub-section, situates it against Joseph Kuruvilla Vellukunnel, Peerless General Finance and the 2023 demonetisation ruling, and shows how CRR sits beside the Statutory Liquidity Ratio in the architecture of Indian monetary law.

What the Cash Reserve Ratio is, and where Section 42 sits

The Cash Reserve Ratio is the minimum fraction of a scheduled bank's net demand and time liabilities (NDTL) that the bank must keep as a balance with the Reserve Bank of India. It is not an investment the bank chooses — it is a statutory deposit commanded by Section 42(1) of the Reserve Bank of India Act, 1934. Because the balance is held in cash with the central bank and (since 2006) earns no interest, the CRR is simultaneously a depositor-protection device, a settlement reserve, and the most direct instrument of quantitative monetary control available to the RBI.

Section 42 falls in Chapter III of the Act — "Central Banking Functions" — the same chapter that houses the RBI's power to act as banker to banks and to the Government. It must be read alongside the broader scheme discussed in our notes on the functions and powers of the Reserve Bank and the introduction to the Act. The conceptual neighbour of the CRR is the Statutory Liquidity Ratio under Section 24 of the Banking Regulation Act, 1949; the two are routinely confused but operate on different statutes and serve distinct ends, a distinction examined later in this chapter.

Crucially, Section 42 applies only to scheduled banks — those entered in the Second Schedule to the Act. A non-scheduled bank's reserve obligation flows instead from Section 18 of the Banking Regulation Act, 1949. The gateway to Section 42, therefore, is inclusion in the Second Schedule, a matter governed by sub-section (6) and discussed below.

Section 42(1): the core mandate

Section 42(1) is the operative charge. In its post-2006 form it requires that "every bank included in the Second Schedule shall maintain with the Bank an average daily balance the amount of which shall not be less than such per cent of the total of the demand and time liabilities in India of such bank as shown in the return referred to in sub-section (2), as the Bank may, from time to time, having regard to the needs of securing the monetary stability in the country, notify in the Gazette of India."

Three features deserve emphasis. First, the obligation runs to a balance maintained with the Bank — i.e. the RBI itself — not to vault cash held on the bank's own premises; CRR is a balance in the bank's current account with the Reserve Bank. Second, the figure is an average daily balance over a fortnight, not a balance to be held every single day at the full rate — a deliberate softening explained in the section on fortnightly averaging. Third, the rate itself is whatever the RBI notifies in the Gazette "having regard to the needs of securing the monetary stability in the country" — language that converts CRR from a fixed statutory ratio into a flexible policy instrument.

The base of computation is the total demand and time liabilities in India as disclosed in the fortnightly return under Section 42(2). In banking practice this is refined into net demand and time liabilities (NDTL), because inter-bank assets are netted against inter-bank liabilities; the precise contours of "liabilities" are set by the Explanation to the section and by RBI circulars, examined separately below.

The 2006 amendment: removal of the floor and the ceiling

Until 2006 Section 42(1) was a fettered power. The sub-section originally fixed a statutory floor — the balance could "not be less than three per cent" of demand and time liabilities — and a companion ceiling restricted the RBI from requiring more than a stated maximum (historically 15 per cent, later 20 per cent) of those liabilities. The RBI could move CRR only within this corridor.

The Reserve Bank of India (Amendment) Act, 2006 (Act 26 of 2006) rewrote this. It substituted, for the words "three per cent of the total of the demand and time liabilities," the open-ended formula "such per cent ... as the Bank may, from time to time, having regard to the needs of securing the monetary stability in the country, notify in the Gazette of India," and it removed the upper ceiling. The legal effect is that there is today no statutory floor and no statutory ceiling on CRR; the rate is entirely a matter of RBI notification. This was a conscious move to give the central bank unconstrained room to use CRR as a counter-cyclical tool, consistent with the deregulatory thrust of monetary policy after liberalisation.

The same 2006 amendment omitted sub-section (1B), under which the RBI had paid interest to banks on eligible CRR balances. Consequently, with effect from the fortnight beginning 24 June 2006, the Reserve Bank stopped paying any interest on CRR balances maintained by scheduled banks. CRR thus became a true non-remunerated reserve — a feature that sharpens its bite as a liquidity-absorbing instrument and distinguishes it from SLR holdings, which are invested in interest-bearing approved securities.

Section 42(1A): the incremental or additional CRR

Section 42(1A) is a less-noticed but potent supplement. It empowers the RBI, by gazette notification, to require scheduled banks to maintain an additional average daily balance over and above the basic CRR under sub-section (1). This additional balance is computed not on the whole of demand and time liabilities but on the excess of such liabilities over their level on a specified base date — i.e. it bites on incremental deposits.

The device lets the RBI sterilise a sudden surge of liquidity — for instance a large inflow of foreign-currency deposits — without raising the headline CRR rate for the entire deposit base. The notification cannot demand more than the excess itself, so the additional balance is structurally capped at one hundred per cent of the incremental liabilities. Section 42(1A) was, for example, the statutory peg for the incremental CRR the RBI imposed after the 2016 demonetisation deposit surge. Read with sub-section (1), it shows the layered flexibility the legislature has built into the cash-reserve regime: a permanent ratio plus a surgical, deposit-linked top-up.

What counts as "liabilities": the Explanation and NDTL

The percentage is only as meaningful as its base. The Explanation to Section 42 defines "liabilities" for the purpose of the section and, importantly, excludes certain items — chiefly the bank's paid-up capital, its reserves, any credit balance in its profit-and-loss account, and specified borrowings such as loans taken from the RBI, the Exim Bank, NABARD and other notified development financial institutions. State co-operative banks and Regional Rural Banks enjoy further exclusions in respect of loans from their sponsor or apex banks.

Beyond the statutory exclusions, the working concept is net demand and time liabilities. The netting principle allows a bank to set off its assets with the banking system against its liabilities to the banking system, so that inter-bank balances are not double-counted across the system. RBI master directions refine this further — for instance, inter-bank term deposits and term borrowings of original maturity of 15 days and above and up to one year are kept out of "liabilities to the banking system" for CRR purposes, and incremental FCNR(B) and NRE term deposits have at various times been exempted from CRR and SLR by notification under Section 42 read with Sections 18 and 24 of the Banking Regulation Act, 1949.

The point of constitutional and administrative-law interest, foreshadowed in Peerless General Finance and Investment Co. Ltd. v. Reserve Bank of India, is that what is or is not a "liability" for reserve purposes is itself a matter the RBI may shape through directions, and courts have been slow to second-guess that characterisation in the domain of financial policy.

Fortnightly averaging and the daily-minimum discipline

Section 42 measures compliance over a fortnight, defined in the Explanation as the period from Saturday to the second following Friday (both inclusive). The "average daily balance" is the mean of the closing balances held with the RBI on each day of that fortnight. A bank therefore satisfies the section if its average over the fortnight meets the required percentage, even if on individual days the balance dips below the requirement.

This averaging would, unchecked, let a bank run its CRR balance to near zero on most days and make it up with a single large end-of-fortnight deposit — defeating the daily settlement role of the reserve. To prevent this, the RBI prescribes by direction a daily minimum: banks must hold, on each day of the fortnight, a stipulated minimum percentage of the required CRR (the level has historically been set at 90 per cent), while still achieving 100 per cent of the requirement on a fortnightly average. The fortnightly-average mechanism in the statute and the daily-minimum floor in RBI directions together balance operational flexibility for banks against the central bank's need for a stable settlement reserve.

Section 42(3): the penal-interest cascade for shortfall

The teeth of Section 42 lie in sub-section (3). If a scheduled bank's average daily balance in any fortnight falls below the prescribed minimum, the bank is liable to pay penal interest to the RBI on the amount of the shortfall. The rate escalates: for the first defaulting fortnight the penal interest is three per cent above the bank rate on the shortfall; if the default continues into the next succeeding fortnight, the rate rises to five per cent above the bank rate for that and each subsequent fortnight of continued default.

The "bank rate" referenced here is the standard rate published under Section 49 of the Act — "the standard rate at which the Reserve Bank is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under this Act." Anchoring the penalty to the bank rate keeps the deterrent proportionate to the prevailing cost of central-bank money.

Section 42(3) goes further where default is persistent or aggravated. If a bank fails to comply despite the penal interest, the RBI may take escalated action — historically including monetary penalties on the bank and its officers and a power to prohibit the defaulting bank from receiving fresh deposits. Penal interest and penalties become payable within fourteen days of a demand notice, and, on continued failure, are recoverable through the certificate procedure — effectively as an arrear of land revenue — under the recovery limb of the section.

Section 42(2): the fortnightly return

Compliance cannot be policed without data, and Section 42(2) supplies it. Every scheduled bank must submit to the RBI a return, signed by two responsible officers, showing for each Friday of the fortnight (or the preceding business day where Friday is a holiday) the amount of its demand and time liabilities, its borrowings from banks, its holdings of cash and approved securities, and its advances and investments in the prescribed form. This return is the very document Section 42(1) refers to when fixing the base of the CRR computation — "the demand and time liabilities ... as shown in the return referred to in sub-section (2)."

Failure to submit the return, or submission of an incorrect return, attracts its own penalty under the section — historically a fine for each day of default — reinforcing that the reporting obligation is independent of, and additional to, the substantive reserve obligation. The return is thus both the measuring instrument and an enforceable duty in its own right.

Entry into and exit from the Second Schedule: Section 42(6)

Because Section 42 binds only banks in the Second Schedule, the power to put a bank in or strike it off is consequential. Section 42(6) gives that power to the RBI. The Bank shall direct inclusion in the Second Schedule of any bank that applies and satisfies the conditions — broadly, that it carries on banking business in India, has paid-up capital and reserves of an aggregate value of not less than the prescribed amount (historically five lakh rupees), and that its affairs are not being conducted in a manner detrimental to the interests of its depositors.

Conversely, the RBI may direct that a bank be excluded from the Second Schedule where it ceases to satisfy these conditions, goes into liquidation, or otherwise ceases to carry on banking business. Scheduling therefore carries both privilege — access to RBI accommodation and to the clearing and settlement system — and burden — the CRR obligation and the supervisory reach of Section 42. The depositor-protection condition in sub-section (6) dovetails with the RBI's wider supervisory powers; the Supreme Court's reasoning on the public-interest character of banking regulation in Joseph Kuruvilla Vellukunnel v. Reserve Bank of India, discussed below, illuminates why the legislature entrusted this gatekeeping to the central bank.

CRR distinguished from the Statutory Liquidity Ratio

Examiners delight in the CRR–SLR distinction, and the two are genuinely different in source, form and purpose. The CRR arises under Section 42 of the RBI Act, 1934; the SLR arises under Section 24 of the Banking Regulation Act, 1949. The CRR is maintained as a cash balance with the RBI and earns no interest; the SLR is maintained by the bank itself, in the form of cash, gold or unencumbered approved securities, and the securities component earns a return.

Functionally, the CRR is primarily a monetary-control instrument — raising it sucks lendable funds out of the system and contracts credit; lowering it does the reverse. The SLR, while it also constrains credit, is principally a prudential-liquidity and (historically) a captive-finance device ensuring banks hold a buffer of liquid, mostly government, paper. A further structural contrast: there is, post-2006, no statutory ceiling on CRR, whereas the SLR is statutorily capped at 40 per cent of NDTL under Section 24. Both ratios bite on the same NDTL base, which is why the RBI's exemptions — such as the FCNR(B)/NRE exemptions noted earlier — are typically issued jointly under Section 42 of the RBI Act and Sections 18 and 24 of the Banking Regulation Act.

Judicial treatment: the public-interest foundation of RBI's reserve powers

Section 42 has itself generated little reported litigation — a tribute to its precise drafting and to banks' incentive to comply rather than incur escalating penal interest. Its legitimacy, however, rests on a body of case law affirming the Reserve Bank's authority over banking in the public interest. The foundational decision is Joseph Kuruvilla Vellukunnel v. Reserve Bank of India, AIR 1962 SC 1371, where a Constitution Bench, in the context of the winding-up of the Palai Central Bank, upheld the RBI's regulatory powers and held that banking is a business clothed with public interest in which the protection of depositors and the stability of the financial system justify special statutory controls and a wide margin of deference to the central bank's expert judgment.

That deference was reinforced in Peerless General Finance and Investment Co. Ltd. v. Reserve Bank of India, (1992) 2 SCC 343, where the Supreme Court upheld RBI directions requiring a residuary non-banking company to treat depositors' subscriptions as liabilities and to maintain corresponding deposits, observing that in matters of financial and economic policy the RBI is fully competent and that courts should be slow to substitute their own views. The reasoning bears directly on Section 42: if the RBI may, in the public interest, dictate how liabilities are characterised and reserved against, the statutory CRR — a far more orthodox reserve requirement — stands on firm constitutional ground against challenges under Article 19(1)(g).

CRR as a monetary-policy instrument and the demonetisation context

The 2006 deregulation of the rate transformed CRR into a fully flexible lever, and the courts have repeatedly recognised the breadth of the RBI's monetary-policy discretion. In Vivek Narayan Sharma v. Union of India, (2023) 3 SCC 1 — the demonetisation judgment — a Constitution Bench, by 4:1, upheld the 2016 demonetisation of ₹500 and ₹1000 notes under Section 26(2) of the RBI Act, emphasising that decisions in the domain of economic and monetary policy attract a high degree of judicial restraint and that the RBI and Central Government operate within a carefully calibrated statutory scheme.

Although Vivek Narayan Sharma concerned the note-issue power under Section 26 rather than the reserve power under Section 42, its institutional logic is directly relevant: the same deference that shields a demonetisation decision shields the RBI's discretion to set, and to alter at short notice, the CRR percentage "having regard to the needs of securing the monetary stability in the country." The post-demonetisation deposit surge also illustrated Section 42(1A) in action, when the RBI briefly imposed an incremental CRR to absorb the flood of fresh deposits — a textbook deployment of the additional-balance power. The interplay between the note-issue function, discussed in our notes on the issue of bank notes, and the reserve function under Section 42 shows the CRR as one instrument within an integrated monetary-management architecture.

Exam pointers and common traps

Several recurring snares trip up candidates. First, do not state a numerical floor or ceiling for CRR: since the 2006 amendment there is neither a minimum nor a maximum statutory rate — a question premised on a "3% to 20%" band tests pre-2006 law. Second, remember that CRR is non-remunerated; the RBI pays no interest on CRR balances since the fortnight beginning 24 June 2006, when sub-section (1B) was omitted. Third, keep the statutory homes straight: CRR is Section 42 of the RBI Act, SLR is Section 24 of the Banking Regulation Act. Fourth, the penal-interest cascade is 3 per cent above bank rate in the first defaulting fortnight, escalating to 5 per cent above bank rate on continued default — anchored to the Section 49 bank rate, not the repo rate. Fifth, the compliance period is a fortnight (Saturday to second following Friday) measured on an average-daily-balance basis, subject to the RBI's daily-minimum direction. Mastery of these five points, together with the Joseph Kuruvilla Vellukunnel, Peerless and Vivek Narayan Sharma line of authority and the broader scheme in our Banking Regulation and RBI Act hub, covers the great majority of what is asked on Section 42.