A working reserve is mandatory but insufficient for maintaining normal banking operations. In a simple sense, the bank keeps the assets or securities in the near-cash form to maintain liquidity. They are not included in the statutory or primary reserves and are called secondary reserves.
All bank regulatory committees suggest keeping an adequate secondary reserve to avoid liquidity problems and to continue normal operations.
Meaning of Secondary Reserve of Bank
Reserve that provides protective liquidity for stable cash needs as well as more remote contingencies. Typically, they include treasury bills and other government short-term securities.
According to Peter S. Rose, “The second line of defense to meet the demand for cash and serve as a quick source of funds is the bank’s liquid security holding called secondary reserves.”
Another banking specialist said, “Aggregates of highly liquid earning assets are designated as secondary reserve assets in the banking circle”.
An anonymous banking specialist said, “An asset is said to be highly liquid if it can be converted into cash very quickly without any material loss.”
According to the Dictionary of Banking and Finance, the secondary reserve is “Those assets of a bunk that are convertible into cash on short notice by sale in the open market or by rediscount.”
Conditions of Secondary Reserve Assets
It has been said earlier that secondary reserve is not kept in cash form. Rather, they are kept in such assets, which have easy convertibility into cash to meet the liquidity demand and when necessary.
Some conditions must be satisfied to be considered secondary reserve assets. These conditions are given below;
- convertibility,
- low risk, and
- yield
Secondary reserve assets must be eligible to be converted into cash within a concise period of time without any material loss. Conversion time and the risk of losses from invested money through conversion must be very minimum.
It means that assets have a face value of the worth of $100 must not usually fall below $100 at the time of conversion. But a conversion value of more dun $100 will be preferable.
There are two types of risks associated with the time of conversion of these assets –
- reduction in price, and
- interested buyer for conversion
The above-mentioned limitations should be carefully avoided at the time of conversion. Logically, investors will expect at least some income from their investments. So, the assets kept as secondary reserve must be eligible to cam some profit.
Functions of Secondary Reserve
The functions of the secondary reserve of a commercial bank are described below:
- To avoid a liquidity crisis,
- To earn moderate-income, and
- To trade-off between liquidity and profitability.
The primary reserve of a commercial bank is used to meet the withdrawal needs of the depositors, entertainment expenses for the clients, and various recurring internal expenses. Banks invest in dial-in secondary reserve assets when the primary reserve is surplus.
Liquidity is the ability to satisfy the depositors’ cash demands, installments of the committed loans, repayment to borrowers, and other short-term payments. The primary reserve is the first line of defense against liquidity, and the secondary reserve is the second and most reliable.
Well-managed secondary reserve assets protect the banks from a liquidity crisis. Secondary reserves are kept in high-quality liquid blue chips like treasury bills, bonds, debenture, etc.
Secondary reserve assets prioritize meeting the liquidity needs through the convertibility feature of the assets, and the second priority is to moderate income toward profitability. Thus, the secondary reserve maintains a reasonable balance between liquidity and profitability.
Secondary Reserve Assets
After keeping a reasonable amount of money for the depositors in the primary reserve as liquidity, banks invest the excess amount in different assets as a secondary reserve.
The most common types of secondary reserve assets that are highly convertible with the ability to make moderate yield include, among others, the following:
- Call loans to stock lookers and commercial banks.
- Short-term loans to commercial banks.
- Short-term loans secured against self-liquidating assets or blue chips.
- Investment in treasury bills.
- Promissory notes of short-period maturity.
- Discounting of usance bills eligible for rediscounting from the central bank.
- Short-period debentures of companies of unimpeachable credit standing.
- Certificates of deposits [CDs].
- Government notes and bonds.
- Bonds and securities of government agencies,
- Bond and securities of the government unit.
Factors Determining Secondary Reserve
Factors determining secondary reserves can be of two types –
- Internal factors.
- External factors.
Internal Factors Determining Secondary Reserve
1. Structure of deposit
We have discussed earlier that deposits can be of three types: term, current, and savings. The more the current deposit amount or, the higher the portion of demand deposit nature in savings deposit, the more the secondary reserve requirement will be.
In the case of term deposits, there is little chance to withdraw before maturity. But experience says that banks should always be ready for sudden withdrawal if and when fixed depositors face and need to withdraw.
That’s why secondary reserve should be kept after analyzing the history of the sudden withdrawal experience of large-sized deposits.
2. Ownership of deposit
If a large number of non-business individual savings accounts are there, the requirement of the volume of secondary reserves will be below.
On the other hand, if most deposit accounts are currently opened and owned by businesses & corporate houses /institutions, the volume of secondary reserves will be high.
3. Size of the deposit account
The small secondary reserve will be maintained when most depositors have a smaller bank account.
4. Nature of Bank Loan
Sometimes, money is required to provide the Ioan installments of the loans sanctioned to the borrowers, maybe shortly, not now.
The bank must keep the money as a secondary reserve to fulfill this demand. The amount of secondary reserve will be higher for a higher volume of loan installments due to be provided within a short span of time.
5. Maturities and Diversification of Investment Portfolio
Banks invest using a well-thought-diversified mix of portfolios of securities to increase income. The longer the terms of the securities and the more attractive the portfolio mix is, the more secondary reserve will be required.
6. Access to the Money Market
The commercial banks’ winch operates most of the transactions in the money market. It can create an image, and goodwill can easily collect the necessary amount of money from the money market, and as such low volume secondary reserve is not a problem for these hanks.
External Factors Determining Secondary Reserve
As the determinants of the secondary reserve, external factors can the of two types;
- Local factors
- National factors
Local Factors Determining Secondary Reserve
1. Movement of the local population
Large depositors can migrate from one place to another to find better business opportunities or other purposes. If large migration occurs, the demand for cash from the bank clients becomes smaller, and the need for maintaining higher secondary reserve does not arise.
On the other hand, the cash demand of the bank clients will be higher when many depositors have transferred their deposits as clients come through migration. Ami is such, a higher amount of secondary reserves will have to be kept in the binks of these localities.
2. The character of the Local People
If the businessmen are fewer in number among the local people and the amount of withdrawals from the bank is lower, the bank will keep a lower amount of secondary reserve.
On the other hand, many people in a locality are engaged in business activities and frequently withdraw money from the bank. The bank should maintain a higher volume of the secondary reserve.
3. The character of the Local Economy
If the local economic condition is good, the number of bank transactions will be higher. In this case, the necessity of maintaining a higher secondary reserve is imperative.
National Factors Determining Secondary Reserve
1. National Economic Condition
When the country’s overall economic condition is very much encouraging & favorable, demand for investible funds will be much higher. Banks must keep a higher volume of secondary reserves to meet such augmented fund demand.
2. Political condition
A stable political condition is conducive to a country’s domestic and international trade, commerce, and industry. Rapid economic development occurs in a country where both the government and the opposition party keep their respective promises.
Eventually, the number of deposits and demand for loans for the increasing volume of investments will rise. Banks, therefore, will have to maintain a relatively higher volume of the secondary reserve.
3. Monetary Policy
If the government for huge development activities causes inflation in the economy by changing the monetary policy, deposits will increase.
In this case, the small secondary reserve can serve the purpose. Again, if the government decreases the interest rate, the public will withdraw more deposits, and demand for a bank loan will also increase. In this case, banks should maintain a higher volume of the secondary reserve.
4. Taxation Policy
By taxation policy, export and import will also increase if the tax rate is decreased. Resultantly, the country’s domestic trade gets new mobility in these circumstances.
The demand for bank loans is likely to be increased, and more withdrawals for higher doses of the investment may be observed.
In this situation, if banks don’t maintain higher secondary reserves, they (banks) have to face difficulties. The reverse will be the situation for the higher rate of the tax rate.
Primary Reserve Vs. Secondary Reserve
The main objective of both primary and secondary reserves is to maintain the best possible liquidity. Though both types of reserves are meant for maintaining adequate liquidity, there remain some similarities and dissimilarities between the two designated reserves.
The key differences between these two types of reserves are;
| Points of Difference | Primary Reserve | Secondary Reserve |
|---|---|---|
| 1. Objective | Liquidity only | Liquidity plus some yield |
| 2. Forms | Available in cash only | Available in securities and bonds, etc |
| 3. Location | – Bank’s vault. – In the Central bank, or – As current deposits in sister banks | With the security and bond-issuing corporations/institutions |
| 4. Extent of Liquidity | Up to 100% | Highly liquid but less than 100% |
| 5. Rate of Yield | No earning capacity at all | Have some earning capacity |
| 6. Types | Two types; Statutory and Working reserve. | Securities are termed as blue chips, but no need to classify |
| 7. Quantity | Relatively smaller compared to the secondary reserve | The amount of secondary reserve is about 3 or 4 times higher than the primary reserve |
| 8. Line of Defense | The first line of defense | The second line of defense |
| 9. Liquidity Readiness | Instant without loss of time | Takes little time for conversion |
| 10. Need for Shift ability | As already cash -no need to change | Required to be converted into cash. |
| 11. Level of Risk | Almost zero | Insignificant risk involved |
| 12. Need for marketization | As there is already cash -there is no need for marketization | It needs to be marketed, but as blue chips, Toady’s marketization is possible. |
