Primary Reserve of Bank
Generally, the primary reserve is related to the central bank. Commercial banks keep a certain portion of their time deposits to the central bank. The central bank warns, punishes, and fines such banks if they do not maintain this amount of money at the central bank.
In exchange for maintaining the reserve at the central bank, commercial banks enjoy loan advantage as lenders of the last resort advice and other opportunities from the central bank. Sometimes, banks can keep this money in their own vault with the central bank’s approval. Hence, the primary reserve can be defined as:
- Aggregate cash holdings by commercial and central banks are designated primary reserves.
- Primary reserve refers to absolutely non-earning liquid assets held by a commercial bank.
- What is the Primary Reserve of Bank?
- Constituents or Primary Reserve
- Functions of Primary Reserve
- Types of Primary Reserve
- Factors Determining Legal Reserves
- Factors Determining Working Reserves
- Internal Factors Factors Determining Working Reserves
- External Factors Factors Determining Working Reserves
- National Factors Factors Determining Working Reserves
What is the Primary Reserve of Bank?
Reserves intended to meet working capital needs, legal requirements and a caution against unanticipated withdrawals or loan demand.
According to another bank specialist Peter S. Rose: “The first asset item normally listed on a bank’s report of condition is cash and deposits due from banks. The item, which includes cash held in the bank’s vault, any deposits the banks have placed with other banks (Correspondent deposits), cash items in the process of collection (mainly uncollected checks), and the hanks reserve account held with the Federal Reserve bank in the region is often labeled primary reserves”.
According to the Dictionary of Banking and Finance: “Those balances on deposit with other banks, which are immediately available for the payment of a bank consisting of cash liabilities.
Constituents or Primary Reserve
The central bank does not keep the primary reserve in cash form. It can be kept in various forms. Constituents of the primary reserve are as follows:
- Cash in Hand: Cash in hand constitutes all the paper currencies and coins stored in the vault of a commercial bank on a particular date.
- Balance With Central Bank: The money lying in the central bank on a particular date as the balance of the reserve account is called balance with the central bank.
- Demand Deposit With Other Bank: A bank often keeps money in the form of a current deposit in another commercial bank in any arrangement of mutual benefit to maintain liquidity. The balance lying in other sister commercial hanks as demand deposit on a particular date falls in this category.
Functions of Primary Reserve
Some unique functions of primary reserve make it different from other types of reserves. These functions are indicated below:
- Protect from a possible liquidity crisis.
- Plays the role of the first line of defense.
- Enables the bank to satisfy depositors’ claims instantaneously.
- Enables to perform the expected function of the community.
- Enables the bank to meet the establishment expenses.
After maintaining statutory reserve requirements, the main function of the primary reserve after fund collection is to prevent a liquidity crisis. Banks with liquidity crises face a bad reputation in the market.
The primary reserve is the first line of defense for any commercial banks, domestic or foreign. If a bank fails to fulfill clients’ expectations, they (clients) become skeptical about the capacity of payment of the bank.
On the other hand, clients expect cash when they present checks for withdrawing money. An adequate primary reserve is imperative to avoid this kind of adverse situation.
On the other hand, the bank participates in different social welfare programs by preserving the environment, cultural development, and providing educational aid.
If a bank fails to disburse the necessary amount for a previously committed social claim or approved loan due to a cash crisis, its goodwill will undoubtedly decline.
A bank must keep an adequate primary reserve to protect from such embarrassment. There are various daily and monthly expenditures of banks.
Money is needed to bear the rental expenses, electricity bill, telephone bill, gas bill, etc.. A bank also loses its goodwill if it fails to pay these bills.
So, with the help of primary reserve, a bank also bears administrative expenses.
Types of Primary Reserve
Generally, the primary reserve can be of two types which may be seen in the following figure:
The deposit portion that must be kept compulsorily in cash by the bank regulatory authority is called legal reserve.
The percentage of total deposits determines this reserve – such percentage usually ranges from 2% to 7%. This rate varies from country to country and in the same country from time to time.
The amount over legal reserve lying as current deposits in other sister banks or excess reserve kept in the central bank may also be known as working reserve. The working reserve plays an active role in meeting daily liquidity crises and paying off liabilities.
Factors Determining Legal Reserves
A bank’s money position, especially the size of its legal reserve account at the central bank, is influenced by a long list of factors, some of which are included in the following table.
Controllable Factors Increasing Legal Reserves
- Selling securities.
- Receiving interest payments on securities.
- Borrowing reserves from the Central bank.
- Purchasing Treasury bills/notes/ bonds funds from other banks.
- Selling securities under a repurchase agreement (RP).
- Selling new CDs. Eurocurrency deposits or other deposits to customers (With the new funds coming into the bank’s reserve account by check or by wire).
Controllable Factors Decreasing Legal Reserves
- Purchasing securities.
- Making interest payments to investors holding the bank’s securities.
- Repaying a loan from the central bank.
- Selling Treasury bills/notes/ bonds funds to other institutions in need of reserves.
- Security purchases under a repurchase agreement.
- Receiving into the bank’s vault currency and com shipments from the central bank.
Noucontrollable Factors Increasing Legal Reserves
- Surplus position at the local clearinghouse due to more def-idled checks in its -favor than checks drawn against it.
- Credit from cash letters sent to the central bank, listing drafts received by the bank.
- Deposits made by the Govt into a tax and loan account held at the bank.
- Credit received from the central bank for checks previously sent for collection (Deferred availability items, which the Govt credits to the bank’s reserve account each day according to a fixed schedule).
Noncontrollable Factors Decreasing legal Reserves
- Deficit position at the local clearinghouse due to more checks being drawn against the bank than in its favor.
- Calls of funds from the bank’s tax and loan account by the Govt.
- Debits received from the central bank’s reserve account.
- Withdrawal of large deposit accounts (such as CDs and Eurodollar deposits), often immediately by wire.
Factors Determining Working Reserves
Determining factors of working reserves can be of two types;
- Internal factors.
- External factors.
Internal Factors Factors Determining Working Reserves
Internal factors that determine the volume of working reserves are discussed below:
1. Level of Bank Operation
According to the variation of the level of operation, bank deposits may be medium or small. If the number of such deposits and the level of other bank operations are high, the volume of working reserves will be high.
But, if the level of bank operation is medium or low, the level of the working reserve will be lower accordingly.
2. Structures of Deposits
There are normally three types of deposits. Those are time, current, and savings deposits.
The more the amount of the current deposit or the higher the portion of the deposit in the savings deposit account, the more the working reserve is required. In the case of time deposits, usually, there is no demand for working reserves before maturity.
But from practical experiences, it is found that banks should always be ready to meet up unexpected demands. And for this reason, working reserves need to be maintained after monitoring the past trend.
3. Size of Deposit Account
Suppose the depositor accounts are large in number but small in size. In that case, working reserves are required to be a lower amount than in the situation where depositor accounts are fewer in number but larger in size.
4. Ownership of Deposit Accounts
A lower working reserve must be maintained if non-business individual savings accounts are greater in the deposit mix. On the other hand, if most deposit accounts are current accounts opened and owned by business institutions, a higher level of working reserves must be maintained.
5. Size of Secondary Reserve
Assets kept in secondary reserve act as the earning source but the higher the number of assets kept in “easily convertible to cash” form, the lower the requirement of the working reserve will be and vice versa.
6. Willingness and Experience of Adjustment of Working Reserves
If large cash demand cannot be met by holding a regular working reserve, three alternative ways remain. These are;
- Seek help from the central bank as the lender of the last resort;
- Take a temporary loan from other sister banks on mutually beneficial terms; and
- Meet the demand by converting debentures or other secondary reserve assets into cash
7. Variations in the Size of Current Accounts of Other Banks
When a bank maintains other banks’ large-sized current accounts, it has to keep more working reserves to meet the sudden demand from such banks.
External Factors Factors Determining Working Reserves
External determining factors of working reserves are of two types:
- National factors, and
- Local factors.
Local Factors Factors Determining Working Reserves
1. Location of the Bank
Based on the level of development of trade & commerce and financial activities, banks may be located in three places – developed, semi-developed, and underdeveloped. Banks in developed locations need to keep a higher amount of working reserves.
On the other hand, banks in underdeveloped locations require a lower amount of working reserve. Thus, the working reserve of banks differs according to the differences in the development of the bank/branch’s location.
2. Variations of Banking Habits of the Clients
If the clients are highly accustomed to banking activities, that is, every transaction is done through the bank with the help of a check or electronic method, working reserves should be high.
3. Conditions of Business of the Locality
The plate where trade & commerce is developed, people tend to withdraw frequently. As a result, banks in these localities should keep a higher amount of working reserves.
On the other side, the location that is not so developed in trade & commerce, banking transactions, and working reserves will be relatively lower in the branches located ill those places.
4. Seasonal Influenced
The weather condition highly influences financial activities in various seasons. If seasoned trade & commercial activities occur in bulk and religious-cultural ceremonies are celebrated, bank clients may require to withdraw large deposits.
To satisfy these clients’ demands, more working reserves will be required. On the other hand, in a slack business season, banks can keep lower working reserves.
5. Location of Other Banks
Transactions of a bank will increase if there are few or no bank branches in the locality. The size of the deposits and withdrawals naturally be larger in this case. As a result, the bank has to maintain a higher amount of working reserve.
In some cases, the low working reserve may be maintained where the opportunity of taking loans from other neighboring banks exists.
6. Volume of Working Reserves of Other Banks of the Area
If most of the banks/ branches in an area keep a high volume of working reserves, the bank in question in the same locality, to be effectively competitive, will have to maintain a higher volume of the working reserve.
National Factors Factors Determining Working Reserves
1. Availability and Cost of Borrowing
Suppose loans with lower interest rates and easy conditionalities are available from the money market, competitor banks, or financial institutions within a short period. In that case, banking operations can be managed with low working reserves.
2. Condition of National Economy and Commerce
Better business condition at the macro level makes business people execute many transactions with the bank. A higher volume of working reserves may be required in such a situation, while a lower volume of reserves may serve the purpose in the opposite situation.
3. Efficiency of Clearing House
The lower working reserve will be sufficient when efficient & quick clearing house transactions are possible.
But while the traditional method followed in the clearinghouse requires relatively more time to settle a transaction, a higher volume of working reserve needs to be maintained; otherwise, banks will most likely face the embarrassing situation of fund shortage.