Management of Secondary reserves.pdf
- 1. (FM) – II SemesterMBA Funds Management in Banking & Insurance Unit– II Management of Secondary Reserves
- 2. 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.
- 3. Apart from the high degree of shiftability, a highly liquid earning asset must be free from the money rate risk i.e. the risk arising out of fluctuations in security prices due to variations in interest rates. However, the contractual rate of interest would remain the same regardless of any interest rate fluctuations. Any change in the interest rate will cause a corresponding variation in the market value of securities. For e.g. If the interest rate raises, the market value of securities bearing a fixed contractual interest rate will fall. The longer the period which the instrument has before it matures, the greater will be fall in it’s market price. And hence, the greater the loss to the holder who is forced to convert the instrument into cash. Short period securities are comparatively less sensitive to interest rate fluctuations and therefore carry a low risk.
- 4. 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: i). Call loans to stock brokers and commercial banks; ii). Short term loans to commercial banks; iii). Short term loans against self-liquidating assets or shares of blue chip companies; iv). Investment in government securities, treasury bills, bonds, NSCs, NSS, Kisan Vikas Patras, etc. v). Promissory notes of short period maturity; vi). Discounting of usance bills eligible for rediscounting from the RBI; vii). Short period debentures of companies with a non-questionable credit standing.
- 5. 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: 1- The basic function of sec. reserve is to replenish the primary reserves, while its subsidiary function is to earn a moderate income. 2- It helps a banker to trade off successfully between the liquidity and profitability which are the conflicting goals each other for a bank.
- 6. 3- The banker by holding the sec. reserves in a large proportion can easily meet the risks/hazards of illiquidity. 4- 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. 5- It acts as a reservoir for the bank whose gates are opened or closed as the need for funds arises. 6- It acts as a second line of defense for the safety of the bank as these are easily convertible into cash.
- 7. 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: A- External Factors: a- 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: 1- General State of Economy: a- Prosperity- Lower proportion of funds/TDs in sec. reserves. b- Recession- Higher proportion of funds/TDs in sec. reserves.
- 8. 2- Political Conditions: a- Uncertain Political Conditions: Larger proportionof funds. b- Normal Political Conditions: Lower proportion of funds. 3- Taxation Policy: a- Govt. Securities: Exempt from tax- Larger proportion of funds in secondary reserves. b- Non-Govt. Securities: Not exempt from tax- Lower proportion of funds in sec. reserves. 4- Monetry 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.
- 9. b- Local Factors: These factors are related to the local economy in which the bank is operating. Since deposits and loans are products of economic activity, a banker must familiarise himself with the strengths and weaknesses of the local economy which affect the deposit structure, deposit withdrawals, loans and investments while planning the size of the sec. reserves. The local factors are as follows: 1- Character of the Local Economy: An local economy dominated by agriculture is highly vulnerable to seasonal fluctuations, in such an economy, the bank receives the bulk of deposits twice a year immidiately after the harvest, while withdrawals take place throughout the year. Farmers ask for loans at the time of sowing or before the harvest. Therefore, the bank has to keep a larger portion of funds in the sec. reserves only at certain times.
- 11. 2- Character of the Local Population: 3- Movement of the Local Population: B- Internal Factors: Within the limits of national and local factors, internal factors affect the level of secondary reserves. Internal factors are as follows: 1- Level of the Deposits 2- Ownership of Deposit Accounts 3- Average Size of Bank Accounts 4- Access to Money Market 5- Nature of Bank Loans