Page 203 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Indian Financial System

Notes A major function of primary reserve is to maintain liquidity in the bank with a view to protecting
it against illiquidity crises. It enables the bank to satisfy the depositors claims immediately to
perform its expected crisis. The primary reserve plays the role of first day-to-day business needs
but to comply with the obligation imposed on it by law. The primary reserve may be divided
into:
1. Legal Reserve
2. Working Reserve
The legal reserve represents that portion of the primary reserve, which the law requires a bank
to maintain. The reserves are computed on the basis of the average deposits outstanding on the
bank's books over a short period (one or two weeks). Since the bank is a dealer in public money
and attracts public deposits on the premise that the deposits on the premises that the depositors
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. The
law prescribes the minimum percentage of deposits, which a commercial bank has to carry with
the central bank. By changing the reserve requirements, the central bank can regulate the
magnitude of credit. In order to curb inflationary trends, banks may raise the reserve requirements
and restrict the lending and investment activities of banks. Similarly the legal reserve weapon
may be used along with other control techniques to take out economy from the possibility of
depression, which is another undesired situation to keep the nation on growth track.
The regulatory function of legal reserve involves three steps by the government of the central
banking authority:
1. Defines those particular types of assets which can be counted towards the legal reserve
requirements. According to RBI the two types of assets- Cash in hand and balance with RBI
are considered eligible for legal reserve purpose.
2. Regulates the rupee volume of the legal reserve maintainable by banks. In India, this is
the main function of the RBI.
3. Requires banks to hold legal reserves equal to at least some stated fraction of their deposit
liabilities.

Statutory Provisions Regarding Cash Holdings

The RBI Act, 1984 empowered RBI to require scheduled banks to keep with it not less than 5
percent of their demand liabilities and 2 percent of their time liabilities. RBI announces its CRR
policy for the year such that the banks can coop up with the maintaining of adequate Cash
Reserve Ratios to prevent illiquidity.

Working Reserve – Nature and Functions

Commercial Banks have to carry cash reserves in excess of the legal minimum reserve to meet
the depositors claims, satisfy the credit needs of the community and provide protection against
unforeseen withdrawals. This excess cash reserves held by the commercial banks to fulfill day to
day business requirements is designated as working reserve.

This consists of:
1. Cash in their own vaults.
2. Demand deposits with other banks
3. Excess reserve with the central bank.

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