How do banks manage liquidity to ensure they meet their obligations while earning a profit?
Credit Creation is explained by taking an imaginary but relevant example. As is the case in the real world, we take a situation of multiple banking systems. We presume many commercial banks such as HDFC Bank, PNB, Axis Bank, etc. are in the country. It is assumed that minimum legal cash reserve ratiRead more
Credit Creation is explained by taking an imaginary but relevant example.
- As is the case in the real world, we take a situation of multiple banking systems. We presume many commercial banks such as HDFC Bank, PNB, Axis Bank, etc. are in the country.
- It is assumed that minimum legal cash reserve ratio is 20%. Thus, each bank is required to keep 20% of its deposits in the form of cash reserves with it.
- Excess (over 20%) cash reserve is used in extending loans and advances.
- One particular bank, say Axis Bank, receives a cash deposit of ₹100,000 from its customers.
- Axis Bank keeps a cash reserve of ₹20,000 (20% of ₹100,000) and gives a loan of ₹80,000 (₹100,000 – 20,000 = ₹80,000) to one of its customers. This is the first round of credit creation.
- This borrower uses the amount for purchasing goods from some trader. He pays by drawing a check on PNB. He will deposit this check in PNB to be collected from Axis Bank on his behalf. The whole amount is transferred to PNB.
- Since PNB is obliged to keep 20% as CRR, it keeps ₹16,000 with it and has an excess of ₹64,000. This is the second round of credit creation.
- In the third round, the businessman uses this amount to purchase from a manufacturer by issuing a check. The manufacturer has his account in BOB, he will deposit this check and get the money transferred to his bank account. In the next round, BOB will keep ₹12,800 as CRR and transfer the remaining ₹51,200. This process goes on.
1. Maintaining Adequate Reserves: Banks are supposed to maintain an absolute amount of cash reserves under the respective regulation-such as Cash Reserve Ratio or CRR. The reserves offer capacity for any cash claims that may occur in an unusual way from their depositors. Despite the fact that maintaRead more
1. Maintaining Adequate Reserves: Banks are supposed to maintain an absolute amount of cash reserves under the respective regulation-such as Cash Reserve Ratio or CRR. The reserves offer capacity for any cash claims that may occur in an unusual way from their depositors. Despite the fact that maintaining such reserves generates no interest, they provide liquidity for money at the bank’s end.
2. Asset/Liability Mismatch Management: They control their asset (loans and investments) and liability maturity profile to storage the inflow from the maturity of asset liability outflow thus minimizing the factor of liquidity risk.
3.Lending and Interbank Market: Also, banks can borrow from other banks in the interbank market or rely on short term funding instruments like repos if funds are immediately required. It would thus enable the servicing of their short term liabilities without compelling the sale of long term assets that would fetch high prices in the market.
4. Liquidity Pool: They possess a pool of HQLAs that can be sold easily at any time, amongst which are government bonds ,inter alia to allow the generation of cash in case of a thick of liquidity.
5. Diversification of funding source: The use of funding by banks reduces on distinct sources of funding for instance retail deposits, wholesale funding, bonds and yet reduces the risk of a short supply of liquidity.
6. Profitability through Lending and Investments: The liquidity that banks establish with regard to income earning activities for loans and securities would guarantee that liquid assets are properly utilized to generate profits without compromising on the capacity to meet its obligations.
This strategic management ensures availability of liquidity and profitability with reduction of the probability of high liquidity.
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