To know about stock market instruments

1. (FM) – II SemesterMBA
Funds Management in Banking & Insurance
Unit– II
Management of Secondary Reserves

2. Nature of Secondary Reserves:
The secondary reserves are the aggregate of highly liquid earning
assets which can be converted into cash quickly.A commercial bank
generally relies on highly liquid earning assets to meet its expected and
unexpected financial needs because it cannot afford to hold a larger
proportion of funds in the vault for the purpose of maintaining liquidity
in the bank with a view to protect it from illiquidity crisis or day to day
business needs.
The main purpose of holding the secondary reserve is to provide
adequate liquidity to funds without adversely affecting the profitability
of a bank. Therefore, it must comprise such assets which yield some
income to the bank and at the same time are highly liquid. An asset is
said to be highly liquid if it can be converted into cash very quickly
without any material loss. The secondary reserves include such assets
which fulfill the three conditions of shiftability, low risk and yield.

3. Apart from the high degree of shiftability, a highly liquid earning asset
must be free from the money rate risk i.e. the risk arising out of
fluctuations in security prices due to variations in interest rates.
However, the contractual rate of interest would remain the same
regardless of any interest rate fluctuations. Any change in the interest
rate will cause a corresponding variation in the market value of
securities.
For e.g. If the interest rate raises, the market value of securities bearing
a fixed contractual interest rate will fall. The longer the period which
the instrument has before it matures, the greater will be fall in it’s
market price. And hence, the greater the loss to the holder who is
forced to convert the instrument into cash.
Short period securities are comparatively less sensitive to interest rate
fluctuations and therefore carry a low risk.

4. Secondary reserves must yield income but for the sake of income the
liquidity attribute should not be forgone. Keeping in view the three
characteristics of the secondary reserve i.e. shiftability, low risk and yield,
the following types of assets may be grouped in the category of
secondary reserve:
i). Call loans to stock brokers and commercial banks;
ii). Short term loans to commercial banks;
iii). Short term loans against self-liquidating assets or shares of blue chip
companies;
iv). Investment in government securities, treasury bills, bonds, NSCs, NSS,
Kisan Vikas Patras, etc.
v). Promissory notes of short period maturity;
vi). Discounting of usance bills eligible for rediscounting from the RBI;
vii). Short period debentures of companies with a non-questionable
credit standing.

5. Functions of Secondary Reserves in Commercial Banks:
If a commercial bank has a surplus in the primary reserves on account of
heavy cash inflows in different accounts, it is invested in the sec. reserve
assets so that in times of need they can be converted into cash quickly.
They are primarily designed to strengthen bank’s liquidity. The following
are the functions of sec. reserves:
1- The basic function of sec. reserve is to replenish the primary reserves,
while its subsidiary function is to earn a moderate income.
2- It helps a banker to trade off successfully between the liquidity and
profitability which are the conflicting goals each other for a bank.

6. 3- The banker by holding the sec. reserves in a large proportion
can easily meet the risks/hazards of illiquidity.
4- It provides safety to the bank in the event of unexpected heavy
withdrawals as a banker can quickly convert the sec. reserve assets into
cash.
5- It acts as a reservoir for the bank whose gates are opened or closed
as the need for funds arises.
6- It acts as a second line of defense for the safety of the bank as
these are easily convertible into cash.

7. Factors Influencing Secondary Reserves:
A banker must keep in mind both internal and external factors
while deciding the level of secondary reserves for his bank,
which are as follows:
A- External Factors:
a- National Factors: While planning the sec. reserve
requirements, a banker must keep himself update of national
developments and assess their impact on deposits and loans.
The national factors are as follows:
1- General State of Economy:
a- Prosperity- Lower proportion of funds/TDs in sec. reserves.
b- Recession- Higher proportion of funds/TDs in sec.
reserves.

8. 2- Political Conditions:
a- Uncertain Political Conditions: Larger proportionof funds.
b- Normal Political Conditions: Lower proportion of funds.
3- Taxation Policy:
a- Govt. Securities: Exempt from tax- Larger proportion of funds
in secondary reserves.
b- Non-Govt. Securities: Not exempt from tax- Lower proportion
of funds in sec. reserves.
4- Monetry Policy: If RBI raises present 19%SLR by 2% then the
banks will divert their funds from loans and investments to
secondary reserves to satisfy this legal requirement.

9. b- Local Factors: These factors are related to the local economy
in which the bank is operating. Since deposits and loans are
products of economic activity, a banker must familiarise
himself with the strengths and weaknesses of the local
economy which affect the deposit structure, deposit
withdrawals, loans and investments while planning the size of
the sec. reserves. The local factors are as follows:
1- Character of the Local Economy: An local economy
dominated by agriculture is highly vulnerable to seasonal
fluctuations, in such an economy, the bank receives the bulk of
deposits twice a year immidiately after the harvest, while
withdrawals take place throughout the year. Farmers ask for
loans at the time of sowing or before the harvest. Therefore,
the bank has to keep a larger portion of funds in the sec.
reserves only at certain times.

11. 2- Character of the Local Population:
3- Movement of the Local Population:
B- Internal Factors: Within the limits of national and
local factors, internal factors affect the level of
secondary reserves. Internal factors are as follows:
1- Level of the Deposits
2- Ownership of Deposit Accounts
3- Average Size of Bank Accounts
4- Access to Money Market
5- Nature of Bank Loans