MBA (FM)- II Semester Funds Management in Banking & Insurance - PowerPoint Presentation

1. MBA (FM)- II SemesterFunds Management in Banking & InsuranceUnit – IIManagement of Primary Reserves

2. Nature of Primary Reserve in Commercial BanksPrimary 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 defense 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.

3. For example, primary reserves work at a commercial bank, assuming a 20% reserve requirement. Suppose, a depositor puts Rs. 500 in bank-A. The bank keeps Rs. 100 of it to meet its primary reserve requirement, then lends the rest (Rs. 400) to other customer, who uses that money to purchase groceries. The grocery store in turn deposits that Rs. 400 in bank-B account. Now, bank-B is required to keep Rs. 80 (20%) of that amount in reserve, then lends the other Rs. 320 as its own excess reserves. When that money is lent out, it in turn goes on deposit at a third bank, and this cycle continues.

4. In this example, that original Rs. 500 becomes Rs. 1220 on deposits in three different banks, which is known as a multiplier effect. The size of the multiplier can be adjusted depending on the amount of money banks must keep on reserve. When the Central Bank requires to increase or decrease reserves, the multiplier changes, which can either pump money into or drain money out of the economy. This is known as contracting or expanding the money supply.

5. 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:1- To maintain sufficient liquidity in the bank with a view to protect it against illiquidity crisis.2- To enable the bank to satisfy the depositors’ claims;3- To perform its expected functions in the community; 4- To meet the establishment charges e.g. computerisation, etc.; 5- To meet the day to day business needs; 6- To comply with the obligation of CRR imposed on it by law.The primary reserve may be classified into two categories:a- Legal Reserve (CRR with the RBI)b- Working Reserve (Cash holdings with itself and with other banks)

6. 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: a- 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. b- Regulatory Functions: It regulates the CRR (4%) within the range of 3% to 15% out of total deposits (TDs).

7. 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: i- Cash in their own vaults and tills ii- Demand Deposits (DDs) with other banks iii- 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:

8. A- 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:1. Banking Habit of the People 2. Nature of Business Conditions 3. Seasonal Factors 4. Cash Reserves held by Other Banks 5. Existence of Clearing House Arrangements B- Internal Factors: are concerned with such factors which are controllable by individual banks. These are: 1. Scale of Operations of the bank 2. Structure of Deposits 3. Size of Deposit Accounts 4. Ownership of Deposit Accounts 5. Location of Banks 6. Size of Secondary Reserves 7. Availability and Cost of Borrowings

9. Functions of Working Reserve: 1. To take care of both regular and exceptional requirements; 2. To satisfy the depositors’ claims; 3. To meet out the day to day business needs; 4. To maintain sufficient liquidity in the bank; 5. To bring a trade- off between the liquidity and profitability; 6. To maintain public confidence, the banks must stand ready at a moment’s notice to pay out cash to their depositors and others

10. Cash Management in Commercial BanksCash management refers to a broad area of finance involving the collection, handling and usage of cash. It involves assessing market liquidity, cash flow and investments. In banking, cash/treasury management is a marketing term for certain services related to cash flow offered primarily to larger banking customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it is more often used to describe specific services such as cash concentration, zero balance accounting, and clearing house facilities. Sometimes, private banking customers are given cash management services. Financial instruments involved in cash management include money market funds, treasury bills and certificates of deposit.

11. An efficient utilisation of cash is a pre-condition for the successful survival of a bank. A bank receives money from customers on various deposit accounts and pays cash to depositors and borrowers and also to those who have transferred their funds by way of their mail or telegraphic communication. There would have been little or no need for cash in the vaults if cash inflow and outflow had been properly synchronized. However, in a banking company where the quantum and character of cash flows is conditioned by the external factors and banker has little say in governing in the cash position, a synchronization of cash inflows and outflows cannot be effectively done.A banker does not know about the individual customers when money is deposited except in case of time deposits. Hence, there is an element of uncertainty. It is, therefore, necessary for a bank to carry a reasonable amount of cash at all times, so that it may promptly satisfy the customers. If it fails to do so it will lose public confidence which may subsequently become the root cause of bank liquidation. However, if the bank keeps excess cash , there is a loss of opportunity

12. Earnings which it would have obtained by investing in alternative uses.Thus, a banker faces with a dilemma:“Should he prefer liquidity to profitability or profitability to liquidity”. In actual practice, bankers have been found to keep excess cash to avoid the risk of running out of it because of the uncertain behaviour of the customers. On the basis of their past experience, they decide the proportion of deposit liabilities to be held in cash without examining whether such a cash level is really the optimal level. They do not realize that by holding more than necessary cash for the safety and liquidity of the bank, they are cutting into the margin of the banks' profitability.Therefore, the basic issues involved in cash management in a bank are: 1- The management has to keep the cash balance at the lowest possible level in order to avoid the loss of opportunity income. 2- At the same time, a low cash level will mean a greater risk of running out of cash and a higher cost of replenishment.

13. The prudence in the management of cash lies in striking a satisfactory balance between the two factors. A banker has to determine the minimum cash level which just sufficient to meet the needs of day to day transactions. In India, there is considerable scope for economizing on the use of till money. Most of the bankers prefer to keep cash far in excess of their actual requirements in or to avoid the risk of running out of it.For effective management of cash, the bank management should involve branch managers who are in a better position to determine the optimum level of cash than anybody making a decision for them from a far-off place. Branch managers are well acquainted with the specific problems arising out of the banking habits of their clients. If any heavy withdrawals are to be made, this fact too is known to them in advance.The district level managers should be asked to transmit weekly/periodically information relating to cash receipts, cash payments and similar other information branch-wise to the Head Office. Each branch manager may be asked to compile the day-to-day information on cash receipts from customers, cash payments and

14. Related information in the following form and send it to the district level manager. 1- Cash receipts from the customer. 2- Cash receipts by way of remittances from the head office/central cash centers or withdrawals from the current accounts maintained by the branch in other banks; 3- Routine cash payments to customers; 4- Payments in the form of remittances to the head office/central cash centers or to the current account of the branch in other banks; 5- The amount of cash receipts utilised for the purpose of making everyday cash payments.

15. Routine cash receipts from customers and by way of remittances from the head office/central cash centr or withdrawals from the current accounts of the branch in other banks are to be shown separately. Similarly, routine cash payments to customers and payments in the form of remittances to head office/central cash centres or to the current accounts of the branch in other banks are to be shown separately. The routine cash payments do not include cash payments to fixed depositors and other large cash payments made on a regular basis, which are known well in advance to the branch manager. The branch manager should be instructed to maintain a separate register of maturity schedules of all the fixed deposits and a separate record of all account- holders who regularly make heavy withdrawals of cash from the branch.

16. In fact, the entire cash receipts of a bank cannot be utilised on the same day. A branch manager from his past experience knows how much of the cash receipts may be used to make that day’s payments. On this basis, the amount of cash receipts being utilised for making that day’s payments is worked out and is entered on the chart. The district level manager compiles the daily information received from different branches of the district and prepare a consolidated branch- wise weekly information in the Chart.The head office would analyse the data and determine the optimal cash levels for each branch monthly or yearly in the following manner: 1-Cash receipts used for making every payments would be subtracted from cash payments to determine the amount of excess cash payments; 2- The resulting figure would be the optimum level of cash in a branch 3- The amount of maturing fixed deposits and prominent cash payments known in advance should added to the excess cash payments.This analysis would enable the head office to identify surplus and deficit branches and arrange funds to meet the deficit branches.

17. BranchesCash Receipts from CustomerCash received by way of remittances from HO/Central Cash centre or withdrawals from current A/c maintained by the branch with other banksRoutine cash payments to customersPayments in the form of remittances to HO/Central cash centre or to the current A/C of the branch in other banksAmount of cash receipts utilised for making every day cash paymentsBranch 1Branch 2Branch 3Branch 4Branch 5Branch 6Branch 7Branch 8Branch 9Branch 10Branch-wise Weekly Information Chart