Each day we are involved in a number of transactions that involve trading, exchanging, buying, selling, receiving and spending, that are centred around money or other forms of currency . Finance is the spine of the present day economy, and the banks act as the branches of the same. The term ‘bank’ finds its roots in Italy and France and has several functions to perform. Apart from the traditional functions of dealing in money by accepting deposits and advancing loans, a bank has several other functions to perform such as facilitating advances, providing services such as withdrawal, payment, financing trade, and general utility and agency services.
A bank acts as a link between the people who have excess money to spare at any given point of time, and those who are in dire need of the same, thereby helping bridge the wide monetary gap, over time. Banks are increasingly becoming profit maximising institutions in the present with every move directed towards achievement of optimum profit. In their ambition to achieve profit, banks may end up using all their deposits to facilitate loans with a substantial rate of interest. Now, it may so happen that certain -large loans may be advanced in respect of entities which turn to out be Non-Performing Assets (This refers to the condition where interest on a loan or principal due to a bank has remained due for a specified period of time). Such ‘bad loans’ or defaults may occur in any financial system at any point of time, and are problematic for banks as they primarily depend on interest to function. To ensure that banks hit by such NPAs don’t eventually fail and close down, the concept of cash reserves comes into play. This reserve requirement is a regulation put in place by the Central Bank of the country (the Reserve Bank of India, in our case), which provides for holding a certain minimum fraction of the total deposits of a bank as a reserve, instead of lending it out to customers.
The Reserve Bank of India acts as a supervisory body to the Indian banks, by ensuring a certain level of corporate governance, regulating interest rates and fixing statutory pre-emptions such as the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). The CRR and the SLR are used as tools in monetary policy by the RBI to govern the nation’s economy. The following project briefly explains the concepts of Cash Reserve Ratio and Statutory Liquidity Ratio, and the method of calculation of the same in the first segment. Further, it briefly highlights the role of various factors which influence the CRR and the SLR (or the cash reserves held by the bank or with the RBI). The function of the cash reserves as tools of monetary policy is discussed. In the final segment, the implications of the amount of cash reserves held is looked at, in the economy at the national level.
Reserve money, which comprises of the money in circulation in the market, the reserves kept with the bank, and the reserves of the bank maintained with the RBI is a major determinant of the liquidity. Liquidity refers to the availability of liquid assets to the market, the liquid assets being those which can be converted into cash readily, and include money, government bonds, stocks, etc. The Cash Reserve Ratio and the Statutory Liquidity Ratio are determined every year by the Reserve Bank of India and have to be maintained by the commercial and schedule banks, with the RBI. The primary objective behind the maintenance of this cash reserve is to ensure that a bank possesses sufficient liquid assets at any given point of time, so as to avoid a situation of bank failure. The Reserve Bank of India (Amendment) Bill, 2006 laid down the principle of Cash Reserve Ratio as a tool for securing monetary stability in the country, as an Amendment to section 42(1) of the Act. The rate of such can be prescribed by the RBI without any floor or ceiling rate. Hence, the banks are mandatorily supposed to hold a certain percentage of their total deposits , in the form of cash and deposit it with the RBI. It is an instrument that controls the amount that banks can lend out and earn a profit on (in the form of interest). Using this, the RBI can also control the amount of money available in the market, increasing or decreasing the liquidity as per the requirement.
Therefore, this serves the dual purpose of acting as a tool to control liquidity, and hence, inflation, while at the same time, ensuring that the deposit with the RBI is risk-free and may help in avoiding a situation of complete bank failure. For instance, if a bank’s deposit increases by Rs. 1,000, and the CRR is fixed by the RBI at 8%, then the bank will have to deposit an additional Rs. 80 with the RBI, and will be able to lend out only the remaining Rs. 920 as a loan amount. The CRR amount cannot be used by the bank for lending, investment, or any other commercial or economic activity. (Present rate is 4%) Further, a bank is also required to maintain a prescribed minimum portion of its Net Demand and Time Liabilities at the close of business every day, in the form of liquid assets, that is invested in certain approved securities (predominantly Central and State Government securities) at. This ratio of liquid assets to the demand and time liabilities is known as the Statutory Liquidity Ratio, and at present, the RBI is empowered to increase the ratio to a maximum of 40% ( present rate is 22%). Here, it may be noted that in case of SLR, the money is predominantly invested in Central Government securities, thereby enabling the banks to earn some interest on the investment, as opposed to CRR, where the reserve earns no interest at all. Hence, when we look at both CRR and SLR collectively, it is an amount of money that remains ‘blocked’ statutorily, and is unavailable for investment in comparatively higher earning avenues, such as loans or bonds. It undoubtedly limits the resources of the bank to earn and maximize profit, while at the same time, assuring the absence of risk on the amount so deposited by the depositors in the banks, and the banks themselves.
Banks are commercial institutions that seek to maximise profit by lending money at a higher rate of interest than they offer on deposits. Banks can also enhance their profits by lending all the money available with them in the form of deposits, however, as we have seen earlier, that is not possible, since they have to meet the cash requirements of their customers and provide the depositors with their money. Failure to do this will lead the reputation of the bank to suffer and it will end up going into liquidation. So, one would assume that a safer alternative would be to maintain a large portion of their deposits as reserves, instead of lending it out. But if the banks barely lend out any money, they will earn meagre profits and there are chances of them going into losses. Therefore, it is essential that they strike a balance between maintaining the profitability and the liquidity of the deposits. Following are some of the factors which may influence the size of reserves to be maintained by the banks:
(a) Size Of Deposits & Nature Of Account- If the customers of a bank deposit large amount of cash, then the bank is obliged to maintain a larger reserve, since the cash may be demanded by the depositor at any point of time. In contrast, if a bank has a large number of deposits, with smaller amounts, it won’t have to maintain a large cash reserve. Further, a major deposit in the current account calls for larger reserves to be maintained by the bank, while with majority of the deposits in the savings account, a bank can afford to maintain smaller cash reserves.
(b) Legal Requirements- As we have seen in the previous section, one of the major factors that influence the cash reserves maintained by the banks is the statutory requirement of adhering to a minimum reserve amount to be deposited with the RBI. The Cash Reserve Ratio fixed by the RBI is 4% at present, while the Statutory Liquidity Ratio lies at 22%.
(c) Nature Of Clients & Use Of Credit Instruments- If a substantial number of the clients of a bank are industrialists, brokers, businessmen and the like, the banks will have to maintain large cash reserves, since these classes may demand huge loans at any time for investment or business purposes. Also, if the public at large is well versed with and does indulge in the use of cheques, credit cards, etc, the banks don’t have to worry about maintaining a large reserve of liquid assets.
(d) Presence Of Clearing House Facility & Other Banking Facilities- If the clearing house facility[ is not available, then each transaction will be cash-based thereby necessitating the presence of a larger cash reserve. Further, if the banking network is well developed, most of the transactions (inflow and outflow) will take place through cheques, hence paving the way for maintenance of a smaller cash reserve. (e) Rural or Urban Areas & Developed or Under-Developed Nations- Banks located in rural areas keep comparatively less cash reserves than their counterparts in bigger towns and cities, since the demand for cash is seasonal in nature in villages, owing to their involvement in agriculture as a primary source of income. Further, in under-developed nations, a larger cash reserve is maintained, since most of the transactions are completed with the use of cash, and no credit, which is unlike the situation in developed countries.
The amount of cash reserves to be maintained as per the RBI norms is the result of a number of factors, and in turn, affects the market at various levels. It works like the cogs of a wheel, each decision affecting the next, and it is all one giant cycle. It all boils down to this, that the factors governing cash reserves are also the resultant or after-effects of the cash reserve policy-therefore, the cause is also, somewhere or the other, the effect. The Reserve Bank of India fixes the amount of cash reserve to be maintained, so that banks don’t end up lending all the deposits, and some day, end up insolvent owing to lack of cash in hand to return to the depositors. To avoid this situation, but at the same time, to ensure that the banks maximize their profits, a balance has to struck between the two, so as to determine an ideal reserve ratio.
Hence, this is tool or instrument of monetary policy used by the RBI to control the flow of money in the market, with far-reaching implications. When the RBI prescribes a higher reserve ratio, the banks are supposed to set aside a higher percentage of their total deposits for non-lending and non-investment purposes. This leaves the bank with limited cash to lend to its customer base, and chances of earning profit (in the form of interest) decrease. To emerge from this situation, banks increase the rates of interest on the loans. Further, since the cash available in the form of loans is limited, all the firms looking to borrow and invest money elsewhere may not have access to the required cash. This limited amount of money present in the market affects everything in the market and the economy slows down. With the economy constantly decelerating and the interest rates on a rise, the public might end up consuming lesser goods and services than usual (assuming that the public used to take a loan for fulfilling certain needs).
A decrease in overall consumption will influence the production to slow down, which in turn will have a direct effect on the Gross Domestic Product of the country. Now, since the production has decreased, people will look at foreign markets to purchase products. This will lead an increase in imports, while the exports will be facing a downward trend. There will be a surplus of imports over exports, further leading to fall in the GDP of the nation. All of this will end up in a situation of deflation. Now, considering the opposite case, where the cash reserve ratio is very low. Firstly, such a situation would allow the banks to lend a larger amount as loan, accompanied with the chance to earn a greater interest. However, this seldom happens, as we will see. Further, this is associated with the risk of bank failure. Secondly, when the amount of cash increases and the demand for the same does not significantly chance, it is accompanied by a drop in the rates of interest. This would also make savings (deposits) an unappealing option.
When there is surplus money in circulation and suddenly people are richer, they would want to spend more. However, the goods and services available in the market don’t increase all at once, since they are limited. Hence, the firms providing the goods and services increase the prices of the same, without actually adding any value to the product. This situation is known as inflation, and though it may be seemingly harmless, it is harmful in the long run, as incomes of people rise slower than the prices of commodities. Everything is priced at a price way above its value and people whose incomes haven’t risen in proportion, are unable to afford what they used to be able to in the past, anymore.
The RBI is free to prescribe the rate of the CRR and any rate above 3% can be used as an instrument to curb the money supply in the economy. However, the role of the CRR extends to much more than just that. It was also used as a tool to regulate NRI deposit flows in the 1990s. In the more recent times (post 2004), when there was a major inflow of foreign capital and the RBI amassed huge forex reserves, the CRR transformed into an instrument to sterilize the rupee resources released from purchase in dollars. The CRR was initially the most favored instrument to regulate the monetary policy, however the Narasimhan Committee (1991) recommended its reduction, and as a result, the it reduced from above 15% to around 4.5% by 2003. CRR performs the function of a tax that increases their transaction costs, banks are in favor of reducing it to the then minimum requirement of 3%.
In the face of inflation which was high at around 8% at that time, the RBI still decided to bring the rate further down, and it is 4% at present. Similarly, the SLR could also be looked upon as a instrument with multiple functions. The minimum requirement was 25% in this case, and has been known to touch 38% around 1991. As per the recommendations of the Narasimhan Committee, the rate was brought down to 25% by 1997, and at present, the RBI has the freedom to fix the SLR level as well as the CRR. When in the period between 2004 and 2008, non-performing asset (NPA) levels dropped, it was safely decided by the banks to shift more in favor of credit instead of SLR investments. However, in the light of the current post-global crisis and emergence of NPAs yet again, banks are taking solace in SLR investments. In the recent past, RBI Deputy Governor, Anand Sinha implied that the SLR provision would be slightly modified so as to ensure that it fulfills its function of acting as a cushion against threats of liquidity to bank operations. Below is a graphical depiction of the rates of CRR and the SLR since 2008 till June 2014
It has been shown above that banks as commercial institutions perform a variety of functions, that revolve around money. They also have to achieve an equilibrium between optimum profit and fulfilling statutory reserve requirements. The Central Bank of a country, the RBI in India, usually governs the commercial banks, and imposes controls in the form of interest rates and minimum cash reserves to be maintained. The project also mentions how these cash reserves are calculated and why it is essential to maintain them. Further, the RBI uses these controls as tools to implement its monetary policy and to check that the market functions properly. It can hence control the amount of money available for circulation in the market, and increase or decrease it as per the requirement, so as to avoid cases of inflation or deflation. We have seen that a number of factors influence the cash reserves to be maintained and its implications. What goes around, comes around- in the same way, a particular set of factors (such as state of development, banking norms, etc) may influence the amount of cash reserve, which in turn, determines the market conditions and the economy at the national level. This in turn affects the citizens of the country and their way of living, development of the nation, etc, which influences the cash reserve. Hence, all that arises in the banking sector culminates here too.
A professional writer will make a clear, mistake-free paper for you!Get help with your assigment
Please check your inbox
I'm Chatbot Amy :)
I can help you save hours on your homework. Let's start by finding a writer.Find Writer