Cash and Balances with RBI

Behaviour of Banks with regard to cash and Balances
To understand the behaviour of banks with regard to cash and balances, first we need to understand what cash is how it is related with RESERVE BANK OF INDIA. Also how it impacts banks and economy.
Cash Reserve Ratio is the amount of money which Banks have to keep with Central Bank. A bank earns its money by giving out loans at higher rates and paying low rate of interest on savings and Deposits.
So any increase in cash Reserve Ratio leads to lower amount of money with the banks, which can be given as loans, thereby lessening the liquidity in market. On the other hand, a decrease in CASH RESERVE RATIO implies more money with the banks, and hence more liquidity in the economy.
Increase in Cash Reserve ratio means lesser liquidity, which leads to:

  1. Higher interest rates.
  2. More costs for the companies and individuals on their outstanding loans if taken on variable or market linked rate of interest.
  3. Less spending on luxuries items and goods
  4. Lesser investments opportunities.
  5. Lesser new projects, etc.

This will cause lower demand and prices will come down and eventually inflation will also come down.
Thus, an increase in the CASH RESERVE RATIO means banks are forced to keep more money with Reserve Bank of India and thereby reducing the money available for lending. As less fund is available to the bank to give loans, there is tendency towards increase in rates as per the laws of supply and demand. So an increase in CASH RESERVE RATIO will normally result in an increase in interest rates and vice versa a reduction in CASH RESERVE RATIO will normally result in a reduction in interest rates.
Let us say the RESERVE BANK OF INDIA has increased the CASH RESERVE RATIO. This could mean that banks would have to keep more money with the RESERVE BANK OF INDIA. This would lessen the money available with the banks, thus bringing down the money supply in the market. Lesser money supply will lead to an increase in interest rates.
CASH RESERVE RATIO is one of the important and effective tools for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RESERVE BANK OF INDIA feels that the money supply is increasing and causing an upward pressure on inflation, the RESERVE BANK OF INDIA has the choice of increasing the CASH RESERVE RATIO thereby reducing the deposits available with banks to make loans and hence reducing the money supply and inflation.
On the other hand, a reduction in CASH RESERVE RATIO would put more money in the vaults of the banks. As more money flows into the economy, interest rates will decline.
While the availability of Cash Reserves provides lots of benefits to market and economy, it also poses a serious drawback in the form of lost interest. Banks do not earn interest on cash balances which would results in reduced earnings for the bank and for its customers.
At present, the domestic economy is dealing with a situation of excess liquidity. Liquidity has gone up due to money coming in from foreign investors. This excess liquidity is one of the reasons for the higher inflation, and a hike in the CASH RESERVE RATIO will help in drawing out some of the excess liquidity from the system, which will balance out the whole system.
It also has impact on credit growth, the credit off-take in the retail category was quite low. It has grown up during the last couple of months due to the festival season and a number of attractive offers floated by banks. The rise in the CASH RESERVE RATIO will have some effect on credit growth.
A bank meets its cash flow obligations by efficient liquidity management. This becomes increasingly difficult owing     to uncertainties in the external events and the behaviour of other financial agents. Nevertheless, cash and reserve balances is of utmost importance since a liquidity crunch at any specific institution can have system wide repercussions. With the economy burgeoning, it has posed a formidable challenge for the banks to manage the complexity of its cash and reserves.
Cash Balances with RBI: A major source of the cash balance at RBI is the Government of India and the other central banks. They maintain their cash balances in form of deposits with RBI. This is done in order to manage fluctuations in its receipts and expenditures. Government account is far more volatile because of the typical nature of government businesses. For instance, advance tax flows come to the government account in every quarter which leads to a sudden rise in the cash balances and the deposits with RBI. This tax collection is then spent over a period of time leading to balances swinging from one extreme to the other. This leads to huge volatility particularly in money markets (explained later).
The reduction in government balances helps to bring the LAF (liquidity adjustment facility) operations into the zone of comfort. The LAF is the window through which banks park money with RBI when they are in surplus and borrow whenever they face a cash crunch.
Whenever the government is scheduled to spend money on heavy projects, a major part of this spending is financed by the cash balance with the reserve bank, while the rest could be funded by another trillion rupees in expected revenues.
A bank meets its cash flow obligations by efficient liquidity management. This becomes increasingly difficult owing     to uncertainties in the external events and the behaviour of other financial agents. Nevertheless, cash and reserve balances is of utmost importance since a liquidity crunch at any specific institution can have system wide repercussions. With the economy burgeoning, it has posed a formidable challenge for the banks to manage the complexity of its cash and reserves.
A major source of the cash balance at RBI is the Government of India and the other central banks. They maintain their cash balances in form of deposits with RBI. This is done in order to manage fluctuations in its receipts and expenditures. Government account is far more volatile because of the typical nature of government businesses. For instance, advance tax flows come to the government account in every quarter which leads to a sudden rise in the cash balances and the deposits with RBI. This tax collection is then spent over a period of time leading to balances swinging from one extreme to the other. This leads to huge volatility particularly in money markets (explained later).
The reduction in government balances helps to bring the LAF (liquidity adjustment facility) operations into the zone of comfort. The LAF is the window through which banks park money with RBI when they are in surplus and borrow whenever they face a cash crunch

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