Commercial Banks earn interest from lending money, So, they want to lend the maximum possible amount. However, there is a limit to credit creation by banks and this is determined by Legal Reserve Ratio, which is fixed by Central Bank.
Legal Reserve Ratio:-
According to Legal reserves requirements, commercial banks are obliged to maintain reserves.
It is a very quick and direct method for controlling the credit-creating power of commercial banks.
Commercial Banks are required to maintain reserves on two accounts:
1. CRR (Cash Reserve Ratio)
2. SLR (Statutory Liquidity Ratio)
An increase in the LRR decreases the cash reserves with the commercial banks decreasing its capacity of lending.
A decrease in the LRR increases the cash reserves of commercial banks, increasing it’s lending capacity.