Nature & Functions of Primary & Secondary Reserves

27th September 2022 0 By indiafreenotes

Nature of Primary Reserve in Commercial Banks Primary reserve refers to absolutely non-earning liquid assets held by a commercial bank.

It is an aggregate of cash holdings by a bank with itself, the balance with the central bank and the demand deposits (DDs) with other commercial banks.

Primary reserves are the minimum amount of cash required to operate a bank. They include the legal reserves that are deposited with the Central Bank (i.e. RBI in case of India) or other correspondent bank. Cheques that have not been collected are also included in this amount as well. They are kept in order to cover unexpected major withdrawals or runs of withdrawals. They serve as a defence against substantial reduction in liquidity. These reserves must be kept more liquid than secondary reserves, which may be invested in marketable securities such as treasury offerings/bills

Purpose of Primary Reserve:

From the liquidity point of view, the main purpose of primary reserve is not only to play the role of first day to day business needs but also to comply with the obligation imposed on it by law. The other purposes are as follows:

  • To maintain sufficient liquidity in the bank with a view to protect it against illiquidity crisis.
  • To enable the bank to satisfy the depositors’ claims;
  • To perform its expected functions in the community;
  • To meet the establishment charges e.g. computerisation, etc.;
  • To meet the day to day business needs;
  • To comply with the obligation of CRR imposed on it by law.

The primary reserve may be classified into two categories:

  • Legal Reserve (CRR with the RBI)
  • Working Reserve (Cash holdings with itself and with other banks)

Types:

Legal Reserve: It is the portion of primary reserve which the law requires a bank to maintain. It is calculated on the basis of average deposits outstanding on the bank’s books over a short period, i.e. one or two weeks. Banks deals in public money and attracts public deposits on the promise that deposit holders will get back their money on demand.

The government has the responsibility to ensure sufficient liquidity in the banking system so that the depositors’ claims are met in full, as promised.
There are two main functions of legal reserve:

  • Primary Functions: To serve as a powerful tool in the hands of RBI to offset the supply of money; to curve the inflationary pressures; to restrict the lending and investment activities of banks; to take the economy out of depression.
  • Regulatory Functions: It regulates the CRR (4%) within the range of 3% to 15% out of total deposits (TDs).

Working Reserve: Since the legal reserve only cannot overcome the illiquidity crisis, banks have to carry cash reserves in excess of the legal minimum reserve in order to meet the depositors’ claims, to satisfy credit needs of the community and to provide protection against the unforeseen withdrawals.

This excess cash reserves held by the banks to fulfill the day to day business needs is designated as working reserve. It consists of:

  • Cash in their own vaults and tills
  • Demand Deposits (DDs) with other banks
  • Excess reserve with the Central Bank (RBI)

There are various factors which influence the level of working reserve which may be categorised into two groups, namely, external factors and internal factors:

External Factors: Refer to environmental factors which exert their influence alike on all banks and which are beyond the control of the bank management.

These are:

  • Banking Habit of the People
  • Nature of Business Conditions
  • Seasonal Factors
  • Cash Reserves held by Other Banks
  • Existence of Clearing House Arrangements

Internal Factors: are concerned with such factors which are controllable by

  • Individual banks. These are:
  • Scale of operations of the bank
  • Structure of deposits
  • Size of deposit accounts
  • Ownership of deposit accounts
  • Location of banks
  • Size of secondary reserves
  • Availability and cost of borrowings

Secondary Reserves:

Nature of Secondary Reserves:

The secondary reserves are the aggregate of highly liquid earning assets which can be converted into cash quickly. A commercial bank generally relies on highly liquid earning assets to meet its expected and unexpected financial needs because it cannot afford to hold a larger proportion of funds in the vault for the purpose of maintaining liquidity in the bank with a view to protect it from illiquidity crisis or day to day business needs.

The main purpose of holding the secondary reserve is to provide adequate liquidity to funds without adversely affecting the profitability of a bank. Therefore, it must comprise such assets which yield some income to the bank and at the same time are highly liquid. An asset is said to be highly liquid if it can be converted into cash very quickly without any material loss. The secondary reserves include such assets which fulfill the three conditions of shiftability, low risk and yield.

Secondary reserves must yield income but for the sake of income the liquidity attribute should not be forgone. Keeping in view the three characteristics of the secondary reserve i.e. shiftability, low risk and yield, the following types of assets may be grouped in the category of secondary reserve:

Call loans to stock brokers and commercial banks;

  • Short term loans to commercial banks;
  • Short term loans against self-liquidating assets or shares of blue chip companies;
  • Investment in government securities, treasury bills, bonds, NSCs, NSS, Kisan Vikas Patras, etc.
  • Promissory notes of short period maturity;
  • Discounting of usance bills eligible for rediscounting from the RBI;
  • Short period debentures of companies with a non-questionable credit standing.

Functions of Secondary Reserves in Commercial Banks:

If a commercial bank has a surplus in the primary reserves on account of heavy cash inflows in different accounts, it is invested in the sec. reserve assets so that in times of need they can be converted into cash quickly. They are primarily designed to strengthen bank’s liquidity. The following are the functions of sec. reserves:

  • The basic function of sec. reserve is to replenish the primary reserves, while its subsidiary function is to earn a moderate income.
  • It helps a banker to trade off successfully between the liquidity and profitability which are the conflicting goals each other for a bank.
  • The banker by holding the sec. reserves in a large proportion
    can easily meet the risks/hazards of illiquidity.
  • It provides safety to the bank in the event of unexpected heavy withdrawals as a banker can quickly convert the sec. reserve assets into cash.
  • It acts as a reservoir for the bank whose gates are opened or closed as the need for funds arises.
  • It acts as a second line of defense for the safety of the bank as
    these are easily convertible into cash.

Factors Influencing Secondary Reserves:

A banker must keep in mind both internal and external factors while deciding the level of secondary reserves for his bank, which are as follows:

  • External Factors:

National Factors: While planning the sec. reserve requirements, a banker must keep himself update of national developments and assess their impact on deposits and loans. The national factors are as follows:

Prosperity: Lower proportion of funds/TDs in sec. reserves.

Recession: Higher proportion of funds/TDs in sec. reserves.

Political Conditions:

  • Uncertain Political Conditions: Larger proportion of funds.
  • Normal Political Conditions: Lower proportion of funds.

Taxation Policy:

  • Securities: Exempt from tax- Larger proportion of funds in secondary reserves.
  • Non-Govt. Securities: Not exempt from tax- Lower proportion of funds in sec. reserves.

Monetary Policy:

If RBI raises present 19%SLR by 2% then the banks will divert their funds from loans and investments to secondary reserves to satisfy this legal requirement.