Variable Cash Reserve Ratio in Underdeveloped Countries

                                                         1.      Introduction

The central bank of a country has the responsibility of controlling the volume and direction of credit in the country. Bank credit has become these days an important constituent of the money supply in the country. The volume and direction of bank credit has, therefore, an important bearing on the level of economic activity. Excessive credit will tend to generate inflationary pressures in the economy, while deficiency of credit supply may tend to cause depression or deflation. Lack of the availability of cheap credit may also hinder economic growth and development. At times of depression, there is a need to expand credit and at times of boom there is need to contract credit. For promoting economic development, expansion of cheap credit (credit at low rates of interest) is desirable. In order to prevent booms and depressions (i.e., to maintain economic stability) and to promote economic growth, central bank seeks to control credit in accordance with the needs of the situation. There are basically there methods of credit control as a quantitative methods like changing bank rate, open market operation and the changing cash reserve ratio. The changing cash reserve ratio is a monetary tool to vary the quantity of credit is to change the required cash reserve ratio. By law, banks have to keep a certain amount of cash reserves with central bank as reserve requirement against demand and time deposits. In another way, the method of variable cash reserve ratio or changing minimum cash reserves to be kept with the central bank by the commercial banks is comparatively new method of credit control used by the central banks. This method was first adopted by the Federal Reserve System of the U.S.A. in 1935 in order to prevent injurious credit expansion or contraction. While the bank rate policy and the open market operations, due to their limitations, are appropriate only to produce marginal changes in the cash reserves of the commercial banks, the method of cash reserve ratio is a more direct and more effective method in dealing with the abnormal situations when, for example, there are excessive reserves with the commercial banks on the basis of which they are creating too much credit, leading to inflationary situation.

Suppose the commercial banks keep 10% of their cash reserve with central bank. This means Rs. 10 reserves would be required to support Rs. 100 of deposit and the credit multiplier is 10 (i.e. 1/10% =10). To check inflation, the central bank raises the cash reserve ratio from 10% to 12%. As a result of the increase in the cash reserve ratio, the commercial banks will have to maintain to greater cash reserve of Rs. 12 instead of Rs. 10 for every deposit of Rs. 100 and they will now decrease their lending to get the additional 2 % cash. The Credit multiplier will fall from 10 to 8.3 (i.e., 1/12%=8.3). On the other hand, to check deflation, the central bank may reduce the cash reserve ratio from 10% to 8% and thus make available 2% excess cash reserves to the commercial banks which they utilize to expand credit. The credit multiplier will then rise from 10 to 12.5 (i.e. 1/8=12.5%).

 

2.      Significance of Variable Cash Reserve Ratio

Changes in the cash reserve ratio is a powerful method for influencing not only the volume of excess reserves with the commercial banks, but also the credit multiplier of the banking system. The significance of this method lies in the fact that increase (or decrease) in the minimum cash reserve ratio(CRR), by reducing (or increasing) the base of the cash reserves of the commercial banks (or increase) their potential credit creation capacity Thus, a change in reserve requirements affect the money supply in two ways.

a.       It changes the level of excess reserves

b.      It changes the credit multiplier.

 

3.      Central Bank Practice , Policy and Provision

3.1. Provision Relating to Compulsory Reserve Requirement

·         According to Nepal Rastra Bank Directives 2076/77, it shall be mandatory for Class "A" institutions licensed by this bank and for the "B" and "C" classes institutions licensed by this Bank and accepting the current /calls accounts to be maintained a deposit of 4 percent point of the total deposit liabilities at the Bank. There will be minimum 70 percent point of everyday reserve requirement that must be followed by Class A, B and C.

·         For the purpose of calculation of compulsory reserve to be maintained  the following procedures shall be followed

o   The compulsory reserve shall be examined on weekly basis (from every Sunday to Saturday).

o   The compulsory reserve shall be examined against the average weekly balance of deposit liabilities of immediately preceding two weeks. In the case of full holidays in any week, the average deposit of immediately preceding week shall be considered.

o   For the purpose of calculation compulsory reserve, the weekly average of total deposit liabilities and balance held with this Bank shall be determined 360 by aggregating the total amount of daily balances from Sunday to Saturday and dividing the same by the figure seven. In doing so, if any holiday falls in the week, the balance of the preceding day shall be considered as the balance for the day.

o   There will be minimum 70 percent point of everyday reserve requirement.

o   For this purpose, the particulars relating to each Sunday to Saturday (in the case of holiday, the previous day's balance has to be mentioned) shall be compulsorily submitted to the concerned Supervision Department of this Bank in the prescribed format referred to in Directives Form No. 13.11, within seven days from the date of the end of the week

 

3.2 Other Provisions

In order to render the functioning of the licensed institution well-managed, easy and convenient, the institutions of class 'A', 'B' and 'C' licensed from this Bank, other than the market-makers, may also make payment of the principal and interest of government bond and make a claim to this Bank for reimbursement thereof. For the period of non-receipt of reimbursement of the amount of payment of principal of Government of Nepal securities from this Bank to the licensed institution, the said amount shall also be calculated in the ratio of compulsory reserve. Moreover, in the event where the principal amount could not be paid to the concerned banks and financial institution for the reason of falling a public holiday, the said principal amount shall, for the duration of the said holiday, be calculated in the compulsory reserve ratio to be maintained at this Bank.

 

4.      Strength Weakness Assessment of Variable Cash Reserve Ratio

The following is an assessment table of variable cash reserve ratio as method of credit control, is very popular in the underdeveloped countries.

 

4.1. Strength or Significance of Variable Cash Reserve Ratio

·         The narrow market for government securities limits the effectiveness of open market operations in a narrow market even a small sale of government securities will lead to significant fall in their prices. The method of variable cash reserve ratio, on the other hand, is more direct and drastic in its effects without any unfavorable repercussion on the prices of the government securities.

·          Most of the commercial banks enjoy an excess liquidity. A rise in the bank race or an increase in the sale of government securities may not succeed in mopping up excess liquidity. In such a situation, the use of more direct method like the variable cash reserve ratio may prove more effective in siphoning off the surplus liquidity.

·         To avoid discriminatory effect of the use of variable cash reserve ratio, the central banks in some underdeveloped countries have decided to enforce additional reserve requirements against any future increase in deposits. The additional reserve requirement, which can be raised to 100% will effectively limit the credit creating capacity of the commercial banks which keep excess liquidity.

·         In reply to the criticism that the impact of variable cash reserve ratio is too drastic, it may be argued that the drastic effects may be avoided if reserve requirements are changed with due notice and by small degrees.

·         The use of variable cash reserve ratio as a stabilization device is more effective that other quantitative credit control methods on the ground that bank lending is directly related to the liquidity ratio of liquidity ratios of the banks.

 

4.2. Limitations of Variable Cash Reserve Ratio

·         This method is not effective when the commercial banks keep very large excessive cash reserves. In such a case ever if cash reserve ratio is raised, ample reserves remain after satisfying the minimum requirements.

·         This method is not effective when the commercial banks happen to possess large foreign funds. Thus, even if the central bank reduces the reserves by raising the cash reserve ratio, these banks will continue to create credit on the basis of the foreign funds.

·         This method is appropriate only when big changes in the reserves of the commercial banks are required. It is not suitable for marginal adjustments in the reserves of the commercial banks.

·         The effectiveness of this method also depends upon the general mood of the business community in the economy. A decrease in the cash reserve ratio may not be able to expand credit during depression because of low future expectations of the investors.

·         This method is discriminatory in nature. It discriminates in favor of the big commercial banks which, because of their better position, are not much affected by the changes in the cash reserve ratio as compared with small banks.

·         Frequent changes in the cash reserve are not desirable. They create conditions of uncertainty for the commercial banks.

·         This method affects only the commercial banking system of the country. The non-banking financial institutions are not required to maintain cash reserves with the central bank.

·         It is the most direct and immediate method of credit control and therefore has to be used very cautiously by the central bank. A slight carelessness in its may produce harmful results for the economy.

·         This is method may have depression effect on the securities market. The higher cash reserve requirements may lead the commercial banks to sell the securities in hand which, in turn, will reduce their prices in the market.

 

5.      Summary and Conclusion

Despite the limitations, the variable cash reserve ratio is a useful method of credit control. It assumes special significance in the underdeveloped countries where the bank rate and open market operations are not so effective because of a number of limitations. However, this method is to be used with utmost care and discretion. As De Kock says, "While it has some technical and psychological limitations which prescribe that it should be used with moderation and discretion and only under obviously abnormal conditions."

6.      Reference

 

·         Paul, R.R. (1992).Monetary Economics. Kalyani Publishers, pp (45B-47B)

 

Online Reference

Nepal Rastra Bank                                           www.nrb.org.np

Federal Reserve Board                                     www.federalreserve.gov

 

 

 

 

 

 

 

 

Notes

1. The 13.1 form according to NRB directives is shown below.

Weekly statement relating to compulsory reserve to be maintained by the licensed institutions of “A”, “B”, and “C” classes

                                                                                                            Rs in thousands

Total Deposit liability (A)

 

 

Gross cash in transit (G)

 

 

 

 

 

 

CRR calculation as per preceding weeks before two weeks

Amount

CRR to be maintained for two weeks

Deposit with Central Bank©

Deposit at current account with class A licnesed Bank(D)

Cash Deposit at Note Fund(1)

Amount withdrawn from note fund(2)

other(3)

Net cash on transit(1-2+3)

Amount of payment for principal of government bond and saving bond(f)

Total Amount(B)=C+D+G+F

Complusory Reserve % (H)=B/M

Daily Reserve Requirement

Detail of total Amount borrowed (N)

Sunday

 

Sunday

 

 

 

 

 

 

 

 

 

 

 

Monday

 

Monday

 

 

 

 

 

 

 

 

 

 

 

Tuesday

 

Tuesday

 

 

 

 

 

 

 

 

 

 

 

Wednesday

 

Wednesday

 

 

 

 

 

 

 

 

 

 

 

Thursday

 

Thursday

 

 

 

 

 

 

 

 

 

 

 

Friday

 

Friday

 

 

 

 

 

 

 

 

 

 

 

Saturday

 

Saturday

 

 

 

 

 

 

 

 

 

 

 

 

Sunday

 

 

 

 

 

 

 

 

 

 

 

Monday

 

 

 

 

 

 

 

 

 

 

 

Tuesday

 

 

 

 

 

 

 

 

 

 

 

Wednesday

 

 

 

 

 

 

 

 

 

 

 

Thursday

 

 

 

 

 

 

 

 

 

 

 

Friday

 

 

 

 

 

 

 

 

 

 

 

Saturday

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Average (M)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Signature of the officer submitting the statement……..

Name ……….

Designation ……………




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