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What role reserves and surplus play in a Banks functioning

Accumulation of surplus fund in a bank reflects its strength and safety. Excess reserve of a bank shows its
liquidity strength and acts as insurance against sudden/unexpected withdrawal of funds. However, sometimes
surplus of funds shows poor liquidity management because of either poor portfolio management or poor
payment infrastructure. Some reserves banks have to maintain willingly, so that monetary policy would not be
affected adversely by losing control of growth and inflation. For a laymen, surplus appears as a reserve which
acts as protection if bank would face unusual losses anytime in future. Some people see surplus funds as funds
accumulated for meeting temporary needs while others view surplus funds as funds set aside as permanent
addition to guarantee funds. Most people agree with the notion that surplus funds act as a buffer or reserve
which can use in in event of losses. However, surplus and reserve are two completely different terms. A bank
might go insolvent temporarily even if it has huge surpluses. Surplus accts as buffer in certain cases when
certain assets fails to materialize themselves. Lets say a bank has Rest 100 with Rs 20 as surplus fund, if a
dishonest bank officer or clerk disappeared with Rs 15 cash, the bank is still left with its capital intact with
additional cash of Rs 5. Had the bank possesses no surplus fund, the capital would have been impaired to the
extent of Rs 15 and the result would have been a necessary reorganisation of the organization due to reduction of
capital.
There are two types of reserve: Excess reserve and voluntary reserve. Voluntary reserves are reserves kept
by banks for precautionary motives. The reason why banks keep voluntary reserves, arises from a desire to selfinsure and can vary dependent on the uncertainty of payment flows. In time of market stress, reserves are highly
liquid and safe asset, often in such circumstances counterparty demand increases. Excess reserves on the other
hand are reserves that exceed the voluntary amount of reserve banks need. Important to remember that in
aggregate the amount of reserves in the system is determined by central banks balance sheet.
There are two types of bank reserves in terms of form. One of them is physical cash stored by banks in their
vaults and another one is the deposit balances held by commercial banks at central bank.Not only for unforeseen
contingencies banks need reserves but also , banks need reserves because in daily business they need pay other
banks in the banking system. Whenever a depositor at one bank sends money online or pay to someone by
cheque , whose bank is different, to make the payment completed , the first bank need to settle with the second
bank. Hence,the reserves also can be called as payment assets or clearing balances.

If market has huge reserves, then it depends on the discretion of the banks whether they lend the surplus
funds to central bank or not. Central bank cant force commercial banks to lend funds; hence central bank
normally weakens the interest rates. Surplus has also implications on exchange rate especially at the time of
currency crisis. Excess reserves may land into theforeign markets if the public prefers to hold some of its
liquidity in foreign currency. It will put (further) downward pressure on the domestic currency and could have
knock-on effects on inflation. At the same time, in a situation of continuing surplus reserves, the central bank is
a net debtor with the market and is likely to have problems refinancing its short-run borrowing. Its
counterparties are unlikely to participate in these operations unless the central bank raises interest rates, both to
make its refinancing possible and to prevent an even steeper depreciation of the currency.
If required to do so for monetary policy purposes, the banks will hold a proportion of their deposit liabilities at
the central bank in either remunerated or unremunerated form.Obviously, these required bank reserves are
more costly to the banks if they are unremunerated. If the central bank chooses to pay a rate of return to the
banks this can be at a market or sub-market rate of interest. The cost of required reserves will also depend on
their coverage, namely how much of the banks liabilities are actually included. For example, they may or may
not include foreign currency liabilities; or, the central bank may choose to exempt liabilities over a certain
maturity, say two years for example. Thus, the size of these holdings is determined by the central bank and
varied from time to time when the authorities wish to adjust monetary conditions. For example, an increase
(decrease) in required reserveswill reduce (increase) the liquidity of the banking system. In practice, however,
there may belimits to the frequency with which reserve requirements can be changed, and so fine tuning of
Short-term swings in liquidity will have to be approached in a different way. The advantageof reserve
requirements as a liquidity device is that they require little in the way ofinfrastructure to implement. The central

bank needs timely information on the size of banks balance sheets, but with modern monetary instruments there
is no need for a liquid inter-bank market as such. In India Central bank ie. RBI manages money flow in
economy by controlling reserves. It does so by asking bank to maintain CRR and SLR .Using CRR it forces
commercial banks to keep certain %age of depositors money in cash reserves.
Bank reserves or central bank reserves are banks' holdings of deposits in accounts with their central bank. The
some central banks set minimum reserve requirements, which require banks to hold deposits at the central bank
equivalent to a specified percentage of their liabilities such as customer deposits.
United States is the first country to have reserve requirements against the deposits and then it was adopted by
many more countries. Money which a bank holds as reserve cannot be lent out and also it does not earn any
interest. Hence, banks have no incentive to keep more reserves than minimum requirement level specified by
central bank and their liquidity needs. The under developed countries dont offer a large basket of marketable
financial assets which is found in developed or industrial economies, hence in under develop countries holding
reserves provides liquidity. The greater the amount of reserve which banks hold as deposit liabilities the lesser is
their capacity of banking system to expand credit. When the minimum requirement of reserve falls, banks have
to either contract credit or obtain additional reserves either by selling assets such as foreign exchange or
government securities to central banks or borrow from central banks. An individual bank may obtain reserves at
the expense of reserves of other bank but it does not strengthen the credit potential of banking system.
In relation to bookkeeping the term is a misnomer. Reserves are ordinarily part of the equity of the company and
are therefore liabilities. Bank reservesare part of the bank's assets. In a bank's annual report, they are referred to
as cash and balances at central banks.
The following scenario illustrates how the reserve ratio requirement relates to bank lending. Suppose a bank has
$100,000,000 in demand deposits and $10,000,000 in reserves, which is just enough to meet the reserve ratio of
10%. The bank plans to issue mortgage loans totalling $5,000,000 for a new housing development.
BORROWING RESERVES WHEN NEEDED: Assume the first loan is for $1,000,000. The immediate effect
of the loan is to increase the bank's assets and liabilities by that amount, without affecting its reserves or capital.
When the borrower spends the $1,000,000, if the proceeds are deposited in other banks, the lending bank loses
that much in reserves to other banks but it no longer has that deposit liability. However the bank's original
demand deposits of $100,000,000 have not changed, and they are now backed by only $9,000,000 in reserves.
The bank must therefore acquire $1,000,000 more in reserves to meet the 10% reserve requirement.
Other banks now have $1,000,000 in new deposit liabilities, as well as new reserves of the same amount. Since
they only need $100,000 of those reserves to back their new deposits, they could use the remaining $900,000 to
back additional lending of their own. But let's assume they have no good lending opportunities at the time, and
therefore offer to lend the excess reserves in the Fed funds market. The lending bank could borrow the excess
reserves, which would still leave it $100,000 short of what it needs.
THE BANK CAPITAL AND SURPLUS: For the purpose of protection of note holders and depositors in case of
bank failures and consists of the requirement that banks shall accumulate and maintain an adequate capital and
surplus. The funds contributed or guaranteed by the stockholders or proprietors of the institution at the time of
its foundation, and by surplus is meant an additional fund accumulated from the profits of the bank after it has
engaged in business. In the case of joint-stock institutions the capital is usually accumulated by the sale of
certificates of the denominations one hundred or one thousand dollars, the possessors of which acquire in return
for their contributions a right to share pro rata in the profits and government of the institution. The capital of
private banks is contributed directly by the proprietors. The surplus is ordinarily accumulated by setting aside or
reserving a certain amount or proportion of the annually accruing profits until the total sum reaches a specified
aggregate. The law regulating the Imperial Bank of Germany provides that twenty per cent of the profits
annually accruing, in excess of a four and one-half per cent dividend to be paid to stockholders, shall be reserved
until the total amount reaches one-fourth of the total capital.

The statutory regulations regarding the amount of capital of banks are far from uniform. The National
Banking Act of the United States limits the indebtedness of banks to the amount of their capital stock, but
defines indebtedness in such a way as to exclude the notes in circulation, bills of exchange or drafts drawn
against money actually on deposit to their credit or due to them, and liabilities to stockholders for dividends and
surplus profits. The German bank act of 1875 limits the interest-bearing deposits of the Imperial Bank to the
amount of its capital and surplus. In England and France the statutes do not fix any relation between the debts
and the capital of banks, but special laws have been passed from time to time providing for an increase in the
capital of their respective banks.
Surplus liquidity occurs when cash flows into banking system continuously and is more than the
withdrawals of liquid assets from market. This is reflected in holdings of reserves in excess of the central
banks required reserves. Surplus liquidity is widely seen in many countries around the world. In past , it was
seen often in Soviet, wartime and transitional countries. Transitional economies often attract huge funds as
economy opens up to privatisation. The result of inflow of funds on liquidity is often made troublesome by
central bank sintervention in the foreign exchange market especially domestic currency is under upward
pressure . Specially in the wartime economy, consumption is decreasedand large amounts of savingsget
accumulatedunless until goods and services made available widely. Soviet-style economies have displayed
widespread shortages and administered prices. Hence a situation of repressed inflation is created, where prices
are too low relative to the amounts of moneystock, there by people with excess real balances are left. The
importance of surplus liquidity for central banks is as below: (1) the transmission mechanism of monetary
policy; (2) intervention of central bank in the money market, and (3)thebalance sheet and income of Central
bank.