Transforming Live, Inventing Future

A Project Report On
CRR HISTORICAL PERSPECTIVE OF RECENT CHANGES AND ITS IMPACT ON BANKS AND ECONOMY
By 1. MUHAMMAD ILYAS 2. RAHEEL KHALID 3. REKHA KUMAR

OFFSITE SUPERVISION AND ENFORCEMENT DEPARTMENT

STATE BANK OF PAKSITAN KARACHI

A Project Report On
CRR HISTORICAL PERSPECTIVE OF RECENT CHANGES AND ITS IMPACT ON BANKS AND ECONOMY
SUBMITTED BY:

1. MUHAMMAD ILYAS (Gomal University D.I.Kan) 2. RAHEEL KHALID (M.Ali Jinnah University Karachi) 3. REKHA KUMARI (Sindh University Jamshoro)
UNDER THE GUIDENCE OF:

JOINT DIRECTOR JAMAL ABDUL NASIR

OFF-SITE SUPERVISION AND ENFORCEMENT DEPARTMENT STATE BANK OF PAKSITAN KARACHI

AUTHORIZATION CERTIFICATE

This is to certify that the project entitled PROJECT TITLE has been carried out by the team under my guidance in partial fulfillment of the degree of Bachelor of Engineering in Computer Engineering / Information Technology of North Maharashtra University, Jalgaon during the academic year 2008 2009(Semester-I) .
Team:

1. Name of the student 1 2. Name of the student 2 3. Name of the Student3

Date: Place:

Guide (Name of Guide)

Head of Department

TABLE OF CONTENTS

CRR Historical Perspective of Recent Changes and its impact on Banks and Economy
The following are the areas which we cover in our Report: 1) History of Cash Reserve Requirements: (1.1)When the need of CRR was arose? (1.2)Objectives of Maintaining CRR. 2) CRR as assurance for depositors: (2.1)How CRR assure depositors of their Deposits? 3) Impact of Changes in CRR on different Sectors of the economy : (3.1)Impact on Banking sector. (3.2)Impact on Stock market. (3.3)Impact on Debt market. 4) Which countries do not follow the practices of Cash Reserve Requirement and what alternative mechanism they use to maintain liquidity in the banking sector? 5) Cash Reserve Ratio in The SAARC countries. 6) CRR as a tool for monetary policy: (6.1)How CRR affect the money supply and inflation in the economy of Pakistan

FIGURE INDEX
Figure Page No.

1.1 1.2 2.1 2.2 : : : N

Figure 1 About Figure 2 About Figure 3 About Figure 4 About : : : Figure N About

History of CRR
The federal reserve system
Structure of Federal Reserve System

History
During the nineteenth century, the United States was plagued by banking panics. These occurred when people suddenly attempted to turn their bank deposits into currency. When they arrived at the banks they found that the banks had an inadequate supply of currency because the supply of currency was fixed and smaller than the amount of bank deposits. Bank failure and economic downturn ensued. After the severe panic of 1907, agitation and discussion led to the Federal Reserve act of 1913 which was to provide for the establishment of Federal Reserve banks to
furnish and elastic currency.

The major purposes of the Federal Reserve System are: y Conducting the nation s monetary policy y Supervising and regulating banking institutions y Maintaining the stability of the financial system y Providing certain financial services to the government and the public

Legal reserve requirement

In the nineteenth century, banks sometime had insufficient reserves to meet depositors demands and this occasionally spiraled into bank crises. Therefore beginning at that time and currently formalized under Federal Reserve regulations, banks are required to keep a certain fraction of their checkable deposits as reserve requirements apply to all types of checking deposits, independent of the actual need of cash on hand. Bank reserves are held either as cash on hand or as deposits with the Federal Reserve. Reserves have a zero yield and the Fed pays no interest on bank deposits. Under Federal Reserve regulations, banks are required to hold a fixed fraction of their checkable deposits as reserves. This fraction is called the required reserve ratio. Bank reserves take the form of vault cash (bank holding of currency) and deposits by banks with the Federal Reserve System. The level of required reserve is generally higher than what banks would voluntarily hold. A prudent banker today, concerned only with assuring customers that the bank has enough cash for daily

transactions, might choose to keep only 5% of the banks checking deposits in reserves.

History of Cash Reserve in Pakistan

It is worth mentioning that two different statutes prescribe the CRR and LAR for financial institutions in Pakistan. While the former requirement is contained in the State Bank of Pakistan Act 1956, the later one is prescribed under the Banking Companies Ordinance, 1962. The practice of parallel two requirements exists in a number of countries and the literature on the subject document it as multiple reserve requirements. The two requirements, however, entail different implications for the banking sector and economy.

Cash Reserve Requirement (CRR)

Under arrangements embodied in the Pakistan Monetary System and Reserve Backorder, 1947 the Reserve Bank of India was to continue to function till September 1948 as the currency and banking authority in Pakistan after partition of the sub-continent in 1947. Subsection (1) of Section (12) of the said Order, explicitly prescribing CRR for scheduled banks in Pakistan with the Reserve Bank of India, says:
12. (1) Every Pakistan scheduled bank shall maintain with the Bank a balance the amount of which shall not at the close of business on any day be less th an five percent of the demand liabilities, and two percent of time liabilities, of that bank in Pakistan as shown in the latest return made under sub-section(2).

Before partition, Reserve Bank of India was the currency and banking authority in the subcontinent. Sub-section (1) of Section (42) of the Reserve bank of India Act, 1934, prescribing CRR for scheduled banks in India, says, The power to vary the CRR ratio technically rested with the Government since the beginning. However, to highlight it the following provision was added to sub-section (1) of Section (26).
Provided that the requirement of this sub-clause as to the maintenance of balance in the Bank may from time to time by notice published in the official Gazette be varied by the Central Government but so that the balance required to be maintained by any bank shall not at any time be less than the balance required by this sub-clause to be maintained.

The State Bank of Pakistan Act, 1956 replaced the State Bank of Pakistan Order,1948 and requirement of maintaining Cash Reserve was retained. The provision was inserted as sub-section (2) to section (36). Sub-section (1) and (2) of Section (36) of the State Bank of Pakistan Act, 1956, reads as follows;

36. (1) Subject to sub-section (2) every scheduled bank shall maintain with the Bank a balance the amount of which shall not at the close of business on any day be less than five percent of the demand liabilities and two percent of time liabilities of such bank in Pakistan. (2) The requirement of this section as to the maintenance of balances in the Bank may from time to time, by notification in the official Gazette, be varied or, for such period and subject to such condition as maybe specified in the notification, be dispensed with by the Central Government.

Besides conversion of provision to Sub-section and rephrasing the text in State Bank of Pakistan Act, 1956, notable changes need to be mentioned. The 1948 Order had defined schedule banks as banks included in the second schedule of the Order but the SBP Act, 1956 defined scheduled banks as banks included in the list of banks maintained by the State Bank of Pakistan under Sub-section (1) of Section 37. S.A Meenai in this regard says,
it was felt that the second schedule was subject to frequent changes due to inclusion and exclusion of banks and should not, therefore, form part of a permanent statute.

The distinction between demand and time liabilities for the imposition of CRR was removed and uniform ratio imposed on both demand and time liabilities w.e. from 25th July 1963. As for the elimination of distinction S. A. Meenai says,
The earlier distinction obviously stemmed f rom a feeling that demand deposits required a higher cash reserve requirement than time deposits which were less liquid. 11

In 1993 sub-section (2) of Section 36 was omitted vide State Bank (amendment) Ordinance, 1993 (Ordinance XXVIII dated October 5, 1993). Besides this, some other changes were also affected in sub-section (1) of Section 36. After the word Pakistan the words as may be determined by State Bank of Pakistan were added. Similarly the words Five percent were substituted with the words such percentages to facilitate the frequent changes in ratio for the effective implementation of monetary policy without amendments In the permanent statute. Consequently, SBP acquired the power to vary the CRR ratio as a tool of monetary policy. For the sake of continuity the same changes were repeated in new Ordinance, as the Majlis -e-shoora (Parliament) was still not in session. Subsequently, the changes were incorporated in Act by the Majlis-e-shoora (Parliament). After

incorporating all the changes made from time to time in the SBP Act, 1956, CRR is still in force according to Sub-section (1) of Section 36 which says,
36. (1) Every scheduled bank shall maintain with the Bank a balance the amount of which shall not at the close of business on any d ay be less than such percentage of demand liabilities and that of the time liabilities of such bank in Pakistan as may be determined by the State Bank.

In passing it is important to mention some other important changes in the framework. First, the State Bank introduced averaging concept for the maintenance of cash reserves i.e., banks was allowed to maintain CRR on average basis over the weak subject to a daily minimum. The aim Was to introduce some flexibility and thus avoid undue volatility in the money market interest rates. On 22 nd June 1998 the averaging practice was temporarily suspended but restored back with Effect from 5th September 1998. The suspension came along with reduction in CRR to alleviate difficulties of banks facing liquidation of foreign currency deposits. Second, inter-bank items and call money liabilities were excluded from the base for calculation of CRR .

Purposes of Cash Reserve Requirement

y Bank reserves are kept above the prudent commercial level for an important reason: high reserve requirements enable the Federal Reserve to control the amount of checking deposits that banks can create. y Cash reserve requirements are set high in order to allow the central bank to control the money supply. y Reserve requirement help the Fed conduct its open market operations by ensuring a stable relationship between open market operations and deposits. y Put differently high reserve requirements plus a zero return on resave ensure that banks would want to hold just that legal minimum.

y The supply of bank money will then be determined by the supply of bank reserves (determined by the Fed through open market operations) and by the money supply multiplier (determined by the required reserve ratio). Because the Fed controls both banks reserves and the required reserve ratio, it has firm control over the money supply.

How CRR assures depositor for their deposits

The nature of modern banking is such that the cash reserves at the bank available to repay demand deposits need only be a fraction of the demand deposits owed to depositors. In most legal systems, a demand deposit at a bank (e.g. a checking or savings account) is considered a loan to the bank (instead of a bailment) repayable on demand that the bank can use to finance its investments in loans and interest bearing securities. Banks make a profit based on the difference between the interest they charge on the loans they make, and the interest they pay to their d epositors. Since a bank lends out most of the money deposited, keeping only a fraction of the total as reserves, it necessarily has less money than the account balances of its depositors. The main reason customers deposit funds at a bank is to store savings in the form of a demand claim on the bank. Depositors still have a claim to full repayment of their funds on demand even though most of the funds have already been invested by the bank in interest bearing loans and securities. Holders of demand deposits can withdraw all of their deposits at any time. If all the depositors of a bank did so at the same time a bank run would occur, and the bank would likely collapse. Due to the practice of central banking, this is a rare event today, as central banks usually guarantee the deposits at commercial banks, and act as lender of last resort when there is a run on a bank. However, there have been some recent bank runs: the Northern Rock crisis of 2007 in the United Kingdom is an example. The collapse of Washington Mu tual bank in September 2008, the largest bank failure in history, was preceded by a "silent run" on the bank, where depositors removed vast sums of money from the bank through electronic transfer. However, in these cases, the banks proved to have been insolvent at the time of the run. Thus, these bank runs merely precipitated failures that were inevitable in any case.

In the absence of crises that trigger bank runs, fractional-reserve banking usually functions smoothly because at any one time relatively few depositors will make cash withdrawals simultaneously compared to the total amount on deposit, and a cash reserve can be maintained as a buffer to deal with the normal cash demands from depositors seeking withdrawals. In addition, in a normal economic environment, cash is steadily being introduced into the economy by the central bank, and new funds are steadily being deposited into the commercial banks. However, if a bank is experiencing a financial crisis, and net redemption demands are unusually large over a period of time, the bank will run low on cash reserves and will be forced to raise additional funds to avoid running out of reserves and defaulting on its obligations. A bank can raise funds from additional borrowings (e.g. by borrowing from the money market or using lines of credit held with other banks), or by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of cash or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining cash reserves before they do, triggering a cascading crisis that can result in a full-scale bank run.

IMPACT OF CRR ON THE FINANCIAL FRAMEWORK:

Liquidity and Interest Rates
A CRR cut increases the money multiplier since it leaves a larger fraction of deposits free to be disbursed as credit. This helps to improve the liquidity within the banking system without affecting its monetary base. The CRR cut, could put pressure on banks to find ways and means of investment of funds. CRR hike is used as an important weapon to mop up liquidity. With a rise in CRR the liquidity in the rupee market will go down forcing banks to sell dollars to generate rupee funds. This would drive up rupee in the short term.

Impact on inflation
As from the above Para we have understood that how these ratio reduce or increase the money supply in the system and we know if more person is demanding few goods then price of goods tends to increase and its called inflation so when central bank reduce these ratios then money supply in market increases and inflation is rises further but in present case this is not the correct and right relation. The Increase in CRR will squeeze 36000 crore from market, so less money will chase few things means less demand so it will reduce inflation. At the time of depression the reduction of these ratios is to maintain liquidity without

disturbing inflation much. While marked is falling and each and every commodity rate going downwards. In these situations after increasing of money supply inflation rate does not goes up as the demand is slow and reduction in commodity prices will nullify the impact of increase in money supply and have less inflationary effects

IMPACT ON STOCK MARKETS

A hike in CRR leading to rising interest rates has several implications including Slowing down the overall growth in the economy; this effectively means that demand for goods and services, and investment activity, gets adversely impacted. Apart from the fact that overall growth is impacted, companies take a hit on account of higher interest costs that they have to bear on their outstanding loans. Since some investors tend to leverage and invest in the stock markets, higher interest rates increase expectation of returns from the stock markets; this has the impact of lowering current stock prices. So, from a short term perspective, higher interest rates should adversely impact stock market sentiment. From a long term perspective however our expectations of returns from the stock markets remains unchanged. As mentioned earlier, central bank move to tame inflation over the long term augurs well for long term economic growth. This will ultimately benefit well-managed companies.

IMPACT ON DEBT MARKET

An increase in the CRR indicates a liquidity crunch with the bank and to compensate for the crunch it hikes interest rates. Therefore, an increase in the CRR and the repo rate create paucity of liquidity in the debt market. One of the fall outs of such a move is that the yield of a bond increases as the bond's price decreases .This helps judicious investors. Thus increase in CRR: Increase in bond yields y Fall in interest rates on deposits y Rise in interbank call rate y Rise in interests rates on loans However, existing investors in debt oriented funds may take a one time hit; but at the same time, since overall interest rates are higher, from here on, such funds will yield higher returns. Although the interest rates have risen quite a bit, it may still not be the best time to lock in all your money in long term debt instruments. Short term Fixed Maturity Plans (FMPs), which can yield an annualized return of about 8% on a post tax basis for a three month deposit or well managed Monthly Income Plans (MIPs) offered by mutual funds are attractive in view of rising interest rates. The low risk option with a quarterly dividend option can also be exercised. With higher interest rates and possibly lower stock prices, MIPs could yield an attractive post tax return. With CRR hike the interest rates rise and if one looks at three-month commercial paper rates, you have gone from around 7 to 9.5, so the market is already tightening. y Impact on bond yields: A hike in CRR aimed at controlling inflationary pressures. Thus bonds are expected to experience some elevation due to CRR and Repo rate hikes. y Rise in lending rates: Buying a home or a car or seeking a personal loan for an overseas trip may pinch a lot more with the rise in cash reserve ratio as most bankers feel that it is imperative that lending rate s will shoot up further, at least, by another 25-50 bps.

Impact on government securities: The rise in G-sec yields was limited as compared to the other segment of the bond market. This was mainly on account of the continued incremental Statutory Liquidity Ratio (SLR) requirement of the banks and buying by other large institutional investors. The government securities market started the month on a positive note with the yield on ten-year bond falling to 7.38% levels against the previous month close of 7.43%. The hike Cash Reserve Ratio (CRR) leads to a sharp rise in yield on ten -year G-sec. A CRR hike has a negative impact on Liquidity Adjustment Facility (LAF). It tends to tighten the LAF causing LAF balances to fall. The government securities market remained volatile for most part of the month after CRR hike. The market saw good buying at these levels due to the investment demand and lower than expected inflation numbers. The ten-year yield gradually softened to the levels of 7.59%before closing the month at 7.62%. The liquidity remained strained for most part of the month. The impact of CRR hike was seen immediately after the announcement.

IMPACT ON FOREIGN EXCHANGE MARKETS Rise in reserve requirements: When central bank decides to raise the reserve requirements the amount of money available with banks for investment falls short. This causes an increase in supply of bonds and reduction of bond price. Thus, causing a rise in the rate of interest. Higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced. A rise in CRR raises the demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate i.e. the value of the domestic currency is now higher relative to foreign currencies. A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease. The rupee went through a volatile day before ending slightly weaker against the dollar. Cut in reserve requirements: If central bank decides to lower reserve requirements, this will cause banks to have an increase in the amount of money they can invest. This causes the price of investments such as bonds to rise, so interest rates must fall. When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower interest rates lead to higher rates of investment. A cut in CRR lowers the demand for domestic currency and the demand for foreign currency rises, thus causing a decrease in the exchange rate i.e. the value of domestic currency falls in relation to foreign currency. A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase. Since bond prices rise, an investor will sell his domestic bond, exchange rupees for foreign currency, and buy a foreign bond. This causes the supply of rupees on foreign exchange markets to increase and the supply of foreign currency on foreign exchange markets to decrease. This causes the domestic currency to become less valuable relative to the foreign currency. The lower exchange rate makes domestic produced goods cheaper and foreign produced goods more expensive in foreign country, so exports will increase and imports will decrease causing the balance of trade to increase.

IMPACT ON DIFFERENT INDUSTRIES Impact on Banking Industry

Interest rate hike: A hike in CRR would suck out liquidity from the system.. Earlier, banks would park in idle cash at the repo auctions. However, with the rise in CRR, the idle cash is likely to reduce, there by eating into the treasury returns. However, a hike in interest rates is not ruled out after this move. But for competition, the country would surely witness a rate hike. The cut in the bank rate is a signal for reducing lending rates. However the impact may be limited due to the following reasons: (a) A floor of 4 per cent on the savings deposits reducing the flexibility for cutting prime lending rates (PLR) (b) Competition from the Governments small saving schemes with administered interest rates leave little room for bank deposit rates to come down (c) High intermediation costs of banks, which are mainly influenced by their operating costs keeping spreads and therefore lending and deposit rates sticky; and (d) High cost of fund mobilization, with an average of cost 7 per cent for PSBs, the largest mobilizes of deposits. This would at best give the banks room for cutting their PLRs marginally by 10 to 15 bp, the margin by which the reserve adjusted cost of funds would go down. Any cut in the lending rates are going to put pressure on the profitability of the banks as it would impact their margins.

Impact on domestic deposits

Impact of cut in reserve requirements The likely impact of the bank rate and CRR cut on deposits via deposit rate changes is also going to be marginal. In absence of variable rate term deposits, banks have little room to cut deposit rates, as it can lead to money flowing in to mutual funds or small saving schemes. Besides the scope for a cut is limited by the impact on lending rates i.e. a cut by 10 to 15 bp. Impact of rise in reserve requirements The move will benefit the fixed deposit investors as banks are likely to raise the interest rates on term money. But the flip side is that consumer loans and housing loans will now become costlier.

Impact on foreign deposits

Foreign currency deposits were earlier exempt in calculation of CRR, but will now be counted for the same. This means that banks with relatively bigger corpus of foreign deposits, in proportion to domestic deposits, would need to put away more funds toward CRR and hence cost of funds from such deposits would go up. This would require banks to rationalize interest rates on foreign deposits, which traditionally had more aggressive interest rates. Smaller foreign banks which have borrowed heavily from their parent banks will be hit harder. Among all bank groups, foreign banks, witnessed the largest reduction in their intermediation costs (difference in interest income and expenditure) by 38 bp in FY00. The repeal of CRR exemptions can alter this scenario.

Impact on common man

Changes in CRR affect the common man a lot. As CRR increases the money supply in the market decreases and interest rate increases and banks are expected to pass on the burden to the common man. Hike in reserve requirement y Higher returns from debt oriented i nstruments due to higher interest rates. y Loans would become costly as the banks would change a higher rate of interest. As long as the rate of interest on the loan is fixed the borrower would be immune to any rise in interest rate. However if he has a floating rate loan then either the tenure of the loan or the EMI would increase.

The WPI which is the index of wholesale prices takes some time to show up in CPI numbers. Thus we can except a movement in CPI to follow the downturn of the WPI by a few months. Further the CPI places a much greater emphasis on food(46% weight in CPI as opposed to 15% in WPI). Therefore the CPI tends to be less interest rate sensitive and more affected by supply side movements than the WPI. In other words the problem of inflation has partly already been solved and the portion remained cant be solved through monetary tightening since the CPI is affected by non monetary measures for more than by monetary measures.

From the perspective of a borrower

As a prospective borrower, you are the worst hit. The cost of money i.e. interest rates will rise after the CRR increase. You will probably need to settle in for a lower loan amount given the EMI. If you are an existing borrower, as long as the rate of interest on your loan is fixed, you are immune to any rise in interest rates. However, if you have a floating rate loan, then expect either the tenure of the loan or the EMI to jump soon.

CENTRAL BANKS WITH NO CASH RESERVES

Introduction: Central banks by definition are the sole issuers of central bank money, which consists of banknotes and deposit balances held by depository institutions at central banks. This feature provides them the power to implement monetary policy by influencing liquidity in their banking systems in order to achieve their policy (interest rate) targets and thus promote their long-term objectives. Reserve requirements are the minimum percentages or amounts of liabilities that depository institutions are required to keep on hand in cash (vault cash) or as deposits with their central banks (required reserve balances).

The following six countries implement monetary policy without reserve requirements . The six countries consist of
1. Australia 2. Canada 3. Denmark

4. New Zealand 5. Norway 6. Sweden.

They explain how our banking system operates, withoout the absence of any monetary reserves: The central banks of these six countries make interbank payment settlement accounts available to depository institutions subject to certain rules. They provide standing facilities with interest charges and the lending interest rate sets an upper bound on the market interest rate. These central banks also pay interest on end-of-day account surpluses, and that interest rate forms a lower bound on the market rate Thus, len ding and deposit rates form a corridor for the target overnight interest rate. In addition to imposing rules for settlement accounts and providing standing facilities, most of these central banks influence the aggregated settlement balances in the banking systems mainly through open market operations. Heres a flow chart helpfully provided by the researcher. It shows (on the left) the monetary Reserve Requirement system used in 24 of 30 OECD countries. Australias no monetary reserves banking system is circled on the right (click to enlarge):

Source: US Federal Reserve, FEDS, Reserve Requirement Systems in

OECD Countries Now, its very important to make a clear distinction here. We need to remember that there are actually two basic concepts of what a ba nking reserve actually is. One is monetary reserves thats what the US Feds paper we are discussing is all about. The other is capital reserves. Now, Australias banking system does have capital reserves. It is a condition of Australias decision (January 2008) to adopt the Basel II Capital Adequacy framework. It is regulated in Australia by the Australian Prudential Regulation Authority (APRA), under Prudential Standard APS 110 Capital Adequacy. So if our banks have capital reserves, does that mean everything is ok? Not if you are a customer with a cash deposit in the bank. The problem here is this. Capital reserves relate to the question of the banks capacity to absorb investment losses. It is a kind of reserve that is meant to protect shareholders in the bank, against the bank making losses on its investments. That is why the capital reserve requirement is essentially composed of a % of shareholder funds, that are held against the value of the banks risk-weighted assets. Monetary reserves, on the other hand, relate more directly to the question of the banking systems capacity to absorb a run on customer deposits. That is, a good old fashioned bank run, where people lose confidence in the safety of the bank/s, and try to withdraw their cash en masse. In the six countries including Australia that have zero monetary Reserve Requirements, essentially the central bank is the ultimate backstop.

CRR RATES IN THE SAARCCOUNTRIES

COUNTRY
PAKISTAN INDIA SRILANKA BANGLADESH NIPAL BHUTAN AFGHANISTAN MALDIVES

CASH RESERVE RATIO

5% 6% 10% 6% 5.5% 17% 8% 5.64%

NOTE

IMPACT OF CHANGES IN CRR ON BANKS AND ECONOMY OF PAKSITAN  IMPACT ON LIQUIDITY  IMACT ON MONEY SUPPLY CRR changes and its Effect on Liquidity and Money Supply (2010)
In FY 2010 the Cash Reserve Requirement remains unchanged because State Bank had to ensure the sufficient liquidity to grow the Financial sector. State Bank of Pakistan use Open Market Operations as its major tool for controlling inflation. In 2010 the inflation rate was 13.6 % as compared to the inflation rate of 20.3% in 2009 which shows that the Central Bank of Pakistan effectively used its Monetary policy to control inflation to some extent.

CRR changes and its Effect on Liquidity and Money Supply (2008-2009)
In FY09 liquidity management was a big challenge because there was uncertain variability in interbank liquidity. Despite various measures taken, the banking sector had sufficient liquidity up to June CY08, given that: (1) the banks deposit base increased by Rs 333.5 billion (8.7 percent) during H1-CY08; (2) the excess liquidity over and above the required amount (of CRR and SLR) averaged around 6.0percent of the demand and time liabilities (DTL) of the banking system; (3) and the liquidity spread (gap between overnight

weighted average call and repo rates) exhibited normal trends. While banks faced some liquidity constraints in subsequent weeks, as evidenced by more frequent visit to the discount window, with higher amounts raised , the liquidity position of the banking system continued to be strong during July and August CY08 , as indicated by the excess liquidity with banks, of around 5.5 percent of DTL (on average) during these months, with regular trends observed in other liquidity indicators. Notwithstanding, while the decline in the deposits of the banking system in July was seen as a regular phenomenon,37 the magnitude of the decline and its continuation in August and September, was the first indication of an irregular develop ment. The decline in growth in deposits, in the presence of strong credit demand from the Public Sector Entities (PSEs) and the private sector, was therefore construed to be one of the major factors contributing to liquidities trains in the banking sector in ensuing weeks. The other factor which impinged on the liquidity position, was the surge in global commodity prices with consequent impact on the external current account and the fiscal deficit, and finally on the foreign exchange reserves with the central bank. The monetary impact of this huge reduction in FX reserves is clearly visible from the contraction in NFA of the banking system, which saw a reduction of Rs 346.4 billion during July-November 15, CY08, compared with contraction of only Rs 23.1 billion over the same period last year. This was then the underlying factor which caused liquidity pressures in the banking sector. As the first line of defense in case of liquidity strains, excess liquidity held by banks declined to Rs 79.1 billion (2.1 perce nt of DTL) by the last week of September, CY08, in comparison with Rs 145.6 billion in the preceding week. Bank-wise data shows that all banks were compliant with the minimum liquidity reserve requirements during this week. During the same week, the liquidity spread in the money market also inched up to 443 bps, compared to 333 bps in the previous week. The liquidity situation at this stage was further complicated by the seasonal demand for withdrawals due to the Eid-festival, and arise in the CIC/Deposit r atio , indicating a certain degree of dollarization in the economy, resulting from the weakening of the domestic exchange rate against the US$. In the first working week after Eid, banks witnessed unexpected deposit withdrawals due to rumors in the market regarding the potential impact of the global crisis on the financial position of a few banks. Specifically, the demand liabilities of the banking system saw a reduction of Rs 80.8 billion during the period from the last week of September to the second week of October (two weeks), while liquidity spreads reached 2990 bps as of October 4, 2008 .

To inject the liquidity in the financial sector State Bank of Pakistan conduct its Open Market Operations along with another tools of monetary policy i.e. Discount Rate and our area of concern CRR and SLR. State Bank of Pakistan permanently injected around Rs. 270 billion by reducing Cash Reserve Requirement by 400bps to 5 percent. The easing of the liquidity by the SBP in Oct 2008 has helped the market conditions co nsiderably in an improved excess reserve position of the banks. In the third quarter of FY09, these excess reserves continued to increase on account of the slowdown in private sector credit. Excess reserves increased from a low of 2.1 percent (Rs 79 billio n) as on September 30, 2008 to 13.24 percent (Rs 543.97 billion) of the TDL by June 09. (Excess Liquidity is defined as the surplus holdings of government securities/cash over and above the minimum CRR/SLR). The increase in money supply due to reduction in Cash Reserve Requirement along with other monetary policies the inflation rate also increased. The inflation rate in year 2009 was increased to 20.3% from 11.9% of the last year.

CRR changes and its Effect on Liquidity and Money Supply (2007-2008)
There was a state of great anxiety and uncertainty in the global financial system originating from the subprime mortgage market in mid-2007 shifted gears in September 2008, from being a liquidity crisis in the initial phase to a full blown solvency crisis one year later. Concurrent developments in Pakistan have been such that the financial sector has not been directly impacted by the ongoing events in advanced countries, although the economy has had build-up of pressures of its own, emanating from the weakening macroeconomic environment. Notably, Pakistan has been impacted most severely by the unprecedented rise in commodity prices which peaked in mid-CY08. Government borrowing from SBP remained the main source of liquidity injection in the market. In line with tight monetary policy stance, SBP mopped

up this excess liquidity permanently through revision in SLR on May 22, 2008 and CRR on three occasions; a) August 1, 2007: Weekly average of 7 percent (subject to daily minimum of 6 percent) of total Demand Liabilities (including Time Deposits with tenor of less than 1 year); and Time Liabilities(including Time Deposits with tenor of 1 year and above) will not require any CRR. b) January 31, 2008: Weekly average of 8percent (subject to daily minimum of 7percent of total Demand Liabilities (including Time Deposits with tenor of less than 1 year)and Time Liabilities (including Time Deposits with tenor of 1 year and above) will not require any CRR. c) May 22, 2008: Weekly average of 9percent (subject to daily minimum of 8 percent) of total Demand Liabilities(including Time Deposits with tenor of less than 1 year) and Time Liabilities (including Time Deposits with tenor of 1 year. The above changes in the Cash Reserve Requirement by the State Bank of Pakistan are to drain the money supply to some extent from the financial institutions. The inflation rate increased to 11.9% in 2008 as compared to the inflation rate of 2007 as 7.7%.

CRR changes and its Effect on Liquidity and Money Supply (2005-2006)
During July 2006, the SBP has raised the Statutory Liquidity Requirements (SLR) from 15 to 18percent of the total time and demand liabilities effective 22nd July 2006. Further the SBP has also introduced for the first time separate Cash Reserve Requirements (CRR) on demand and time liabilities. Specifically, the SBP has set CRR of 7 percent (weekly average) on total

demand liabilities and 3 percent of total time liabilities. Moreover, the SBP has also revised the definition of time and demand liabilities to be used for calculating these requirements. Certainly, the decision was in line with the continued tight monetary posture and was expected to drain excess liquidity from the Money market. In Pakistan, the demand liabilities constitute 88 percent of the t otal net TDL of the banking system. As such, it was expected that the increased CRR requirements on demand liabilities would result in the substantial draining of liquidity from the interbank market. This was because banks usually keep excess liquidity with SBP well above the required level in order to keep a cushion against any sharp increase in the TDL through the remaining days of the week. On this basis, it was estimated that banks would keep a similar spread between the required and actual liquidity requirement, therefore it was anticipated that interbank liquidity may fall by up to Rs 40 -45 billion. However, as an immediate response, the banks took the advantage of their excessive holding of government securities for SLR by converting securities into cash balances with the SBP. In specific terms, at end of the week prior to the changes in reserve requirements ending on July 15, 2006, the banks investments insecurities for SLR purpose was 23.2 percent of total TDL; over 8 percentage points higher than the required S LR. However, the banks reserves in the form of cash or other deposits for CRR purpose was 7 percent of total TDL; only 2 percentage points higher than the required CRR of 5 percent during that period. During the next week ending on July 22,2006, when the new requirements were in place, the commercial banks cash balances with the SBP increased by Rs 51.3 billion while banks holding of securities registered decline of Rs 49.4 billion. As a result, while the liquidity ratio remained more or less unchanged; the share of securities in total liquidity maintained declined from 75.7percentat end week July 15, 2006 to 68.6percent at end week July 22, 2006.However, the actual impact of this measure can be seen from declining difference between the required and actual liquidity . Specifically, at end week July 15,

2006 the liquidity maintained by commercial banks was Rs 282.6 billion higher than the required liquidity. Later, it reached at Rs 168.2 billion at end week July 22, 2006; depicting a declin e of Rs 114 billion during awake.

CRR changes and its Effect on Liquidity and Money Supply (1999-2000)
The following are the changes State Bank of Pakistan made in Cash Reserve Requirement in FY2000
y Effective from 30th December, 2000 and up to 5th January, 2001, every scheduled bank shall maintain with SBP an average balance of 5% of its total Time & Demand Liabilities in Pakistan worked out on weekly basis provided that the amount of balance shall not at the close of business on any day be less than 3% of the total Time & Demand Liabilities in Pakistan. After 5th January, 2001 Effective from 16th December, 2000 every scheduled bank shall maintain with SBP an average balance of 5% of its total Time & Demand Liabilities in Pakistan worked out on weekly ba sis provided that the amount of balance shall not at the close of business on any day be less than 4% of the total Time & Demand Liabilities in Pakistan. Effective from October 7, 2000 every scheduled bank shall maintain with State Bank an average balance of 7% of its total Time & Demand Liabilities in Pakistan worked out on weekly basis provided that the amount of the balance shall not at the close of business on any day be less than 6% of the total Time & Demand Liabilities in Pakistan .

The higher than expected demand for cash and the rebound in private credit complicated the conduct of monetary policy. With a continued increase in the cash-to-deposit ratio the targeted growth in reserve money in the program proved excessively tight. Furthermore, while discount and Treasury bill rates were raised in the fall of 2000 by about 360 basis points, banks generally did not raise deposit rates and with booming credit demand, were faced with liquidity crunch at year-end. To ease the crunch while observing the performance criteria on central bank net domestic asset (NDA) at year end, the SBP took several steps in December 2000. It gave banks the option to convert into T-bills part of the reserves freed up with the reversal in early Dec 2000 of the weekly reserve requirement (CRR) from 7 percent to 5 percent, allowed

banks to convert temporarily the rupee counterpart of the foreign currency deposits of non-resident institutional investors held with the SBP into T-bills, reduced the daily CRR from 4 percent to 3 percent and waived it on December 31, 2000; and closed the discount win on Dec 30, 2000. While the NDA target was thereby met with a comfortable margin, we recognize that the underlying monetary stance was more expansionary than indicated by the artificially depressed reserve money stock at end-year and that correcting for the above described operations indicate a reserve money expansion in the order of the 15 percent for the year, primarily driven by increased demand for cash.

CONCLUSION

SUGGESSTIONS:

REFFERENCES: