Need for Cash Balances with Banks
The banking system in any country in the world is the lifeline of its economy. As long as the money the banking system generates is circulated in the economy, the country will be running smoothly and efficiently. However, as soon as this money supply is stopped, it becomes a serious cause for concern. If capital is not provided to any sector in the economy, that sector will suffer and will eventually lead to a massive failure. The ease with which the funds are made available to the people largely depends on the how well banks are able to mobilize deposits in the economy. The primary role of a bank is to take funds that are also called deposits or balances from the people who have excess money. The banks in turn, pool the money and lend it to the people who need these funds. The depositors of money can be individuals, financial and non-financial firms or even State or Central Governments. Deposits are made available on demand in the case of a checking account or with some restrictions in the case of savings accounts.
For the purpose of profits, the banks lend money on the basis of the customers’ deposits. However, all the deposits held by the bank cannot be lent out. A certain part of the deposit needs to be held in reserve. There are certain provisions varying from country to country which specifically mention the ratio of the deposits held by the bank that need to be a part of the reserve.
The financial system of any country provides a mechanism through which the savers in the economy deposit their money and the borrowers have access to those financial resources. There exists a set process through which banks convert these mobilized deposits into available capital to the borrowers.
The domestic deposits of a country are a very reliable source of funds to undertake development activities, which is especially critical to the developing nations. The capital available through the deposits mobilized are also preferred in situations where an economy faces difficulty in raising funds in the international markets. Many studies undertaken all over the world have suggested that banks should fund their loans with customer deposits. This would enable the banks to withstand any liquidity crunch which may arise in the future also would help maintain the stability of the banking system.
Usually when banks resort to raising funds through the open market and not through deposit funding, it is seen as a factor that could negatively impact the financial stability of a country.
Every citizen of a country that makes a deposit in a bank is contributing to the financial stability of the economy.
So many years have passed by, but the most intrinsic operation of any bank still remains the lending and borrowing of money although they engage in a lot many other activities. Lending and borrowing becomes very crucial in driving the economy forward as they act as financial intermediaries in transferring the surplus money from the lenders to the borrowers and secondly supplying the money. As the principle activity involves lending and borrowing, banks need to maintain certain balances in the form of their own capital as well as liquidity. Capital comprises of the funds that they themselves have which may come from their shareholders, the partners in the bank, bank’s sole owner among others. Maintaining liquidity becomes tricky for most of the banks. Although almost every time payments going into the bank equal withdrawals from the bank, sometimes they fall short of liquid money. So in order to avoid default, banks need to have good amount of cash in hand. How much CIH do they need to have brings the central banks into picture and with it, some regulations and legal provisions.
In the wake of two major bank failures Bankhaus Herstatt and of Franklin National Bank in 1974, regulation of banks through laws other than normal company laws came into effect in different countries at different points of time. These were mid-sized banks but started affecting other banks as well. Ultimately this resulted in setting up of a Standing Committee from executive members of G10 countries which came to be known as Basel Committee .The main concern of this committee became regulation of capital in banks. The meeting in 1988 gave birth to Basel Norm-1 where banks are required to hold capital as per this norm:
Basel risk assets ratio = Capital/Weighted Risk Assets.
It went further modification to become Basel –II and Basel III at present which aims to the banking minimum capital requirement. Main purpose of doing this was basically reviewing bank risk exposure and maintaining liquidity in bank and making bank averse to all kinds of financial and operational risk. This is the standard for banks across all the countries in the world other than bank regulations and laws set by the central bank in respective countries.
With regards to a particular country, in order to maintain monetary stability and avoid other financial risk, Reserve Bank of India deploys two tools namely Cash Reserve Ratio and Statutory Liquidity Ratio. From time to time, RBI uses the former to remove excess liquid cash from the economy and infuse money to drive the economy. This at the same time ensures that some money is with RBI and is totally risk free, whereas to control credit growth RBI has deployed SLR which requires bank to maintain a minimum percentage of deposits in the form of cash, gold or other securities at the end of the day with the RBI. If a banking company fails to maintain the minimum value for CRR and SLR, it becomes liable to pay for RBI in respect of that default