Functioning of Banks – Zaid Writings

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The banking system of India consists of the central bank (Reserve Bank of India – RBI), commercial banks (ex. SBI, BOB, Union – Public banks) (ex. HDFC, ICICI, Kotak – Private banks), cooperative banks (ex. Surat Peoples Coop Bank Ltd) etc.

Source: IBEF

Public sector bank’s contributes 70%+ of the total banking sector assets. Private sector bank’s contribution rose till FY18. After the “Yes bank saga”, generally people want to deposit their savings in public sector banks for the same reason of safety.

Let’s address how the banking system works in India…

Balance Sheet of Indian Banking System

Source: CNBC

CRR & SLR is 4% & 18.25% respectively (as on March, 2020) (Source: RBI)

The RBI mandates that banks must maintain a minimum CRR of 4% of Net Demand and Time Liabilities (NDTL) i.e. clients deposit which turns out to be ₹5.2 trillion (130*4%).

The RBI mandates a minimum SLR of 18.25% of NDTL, and sufficient HQLA (High-Quality Liquid Assets) to cover 30 days of expected outflows. Banking outflows, and hence HQLA, is not a static percentage of NDTL – it depends on the type and tenor of banking deposits and loans. For now, let’s assume that the banks have to maintain 23% (add 5% to the SLR i.e. 23% for Banking outflows & HQLA adjustment) of NDTL which comes out to be ₹29.9 trillion (130*23%).

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What if sometime SLR is in surplus & CRR is in deficit? Or the other way around?

The RBI’s Liquidity Adjustment Facility (LAF) window merely allows banks to convert one form of statutory reserve to another.

In case of a CRR shortfall, banks can convert excess SLR/ HQLA into CRR at the RBI’s LAF repo window. They effectively pay the LAF policy repo rate for this transformation, currently set at 4.4% (April 2020).

Likewise, banks can convert surplus CRR balances into SLR/ HQLA at the RBI’s LAF reverse repo window, earning them the LAF policy reverse repo rate of 4% (April 2020).

The banking system does not borrow clean funds from (or lend clean funds to) the RBI. The LAF repo and reverse repo windows only allows the system to transform excess SLR/ HQLA into CRR and vice versa.

Credit Creation

What if an eligible borrower seeks a fresh loan of ₹10 trillion, much higher than the ₹7.9 trillion of excess statutory reserves with banks. Can the banking system provide this loan?

Let me share you the way through which the banking system creates money:

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& this goes on…

Person A deposits ₹1000 in the bank. Bank keeps ₹200 reserves & lends the remaining ₹800. Person B borrows that ₹800 where bank credits the account of Person B by the same amount. Now, after keeping 20% reserve of ₹800, the bank lends ₹640 & the cycle goes on!

Banks create money (credit from every deposit they gain) and as lending creates deposits, with every loan disbursed, the need for statutory reserves goes up.

The banking system does not need liquidity surpluses to disburse fresh loans, because fresh loans create their fresh deposits. Bank lending creates fresh money to chase goods and services.

Other ways to maintain the liquidity

Summary of –

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Zaid Munshi

Zaid Munshi

Zaid started his journey in the Indian market in April 2018. He is always keen to understand the business and check whether the business is worth investing or not.
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