Cash deposit ratio plays a crucial role in banking operations. The banks try to fine-tune it. They do not want to hold more than necessary cash reserves because in that case they lose some of the profit, which they can otherwise earn. Similarly, they cannot afford to have a lower than necessary cash reserve ratio because that can result in their failure to meet their payment obligations. If a bank false to honor its commitment to pay in time, the customers lose confidence in its ability (or willingness) to pay. As a result, all of them rush to the bank and demand payment. And the bank, by the very nature of its balance sheet, is never able to meet this demand in full. It can go bankrupt. It is, therefore, helpful to note the factors that determine critical cash deposit ratio, which a bank tries to maintain.
1. The first factor, which determines the cash deposit ratio of a bank, is its size and branch network. A big bank is likely to have proportionately larger number of customers also. Consequently, a large proportion of cheques and cash payments is received by its own customers. It, therefore, suffers from a smaller cash leakage and can afford to maintain a lower cash deposit ratio. Similarly, a bank with a large number of branches can transfer cash from one branch to the other and average out demand for cash. As a result, it can afford to have a lower cash deposit ratio on this count as well.
2. The cash deposit ratio, which a bank must maintain, also depend upon the banking habits of its clients. Normally speaking, when a bank is located in big trade and manufacturing centers, its clients are more likely to make payments to each other through book entries in their bank accounts rather than use hard cash.
3. Apart from the location of the banking offices, the stage of economic development of the country also lays an important role in the determination of cash deposit ratio of the banking system. It is expected that with economic growth, people develop banking habits and the incidence of cash leakage declines.
4. A significant component of economic growth of a country is the development of its financial system. A large volume and variety of financial instruments are an integral part of a developed financial system. The markets for financial instruments, including specialized markets for some categories of them become highly integrated and sensitive to changes in yield rates and the like. This phenomenon is accompanied with the growth of specialized financial institutions also. The net result is that on account of the availability of a larger number of effective substitutes of cash, the need by banks to maintain a high cash deposit ratio is reduced.
5. Legal provisions, such as the measures taken by the central bank of the country, play a crucial role in forcing the banking system to maintain a higher than necessary cash deposit ratio. However, they may be able to side step these provisions to some extent by resorting to window dressing. Window dressing refers to the practice of the bank in managing their asset portfolio in such a manner that, while normally maintaining a low cash deposit ratio, they have a high ratio at those points of time for which they are to draw their balance sheets. For example, the banks may be required to maintain 8% cash deposit ratio but the market conditions, the strength of the financial system and other factors may enable a bank to do its business successfully with only 6%. Further suppose, it is to report to the central bank of the country its cash deposit ratio as at the close of every Friday. in that case, it tries to manage its affairs in such a way that it has adequate cash balances at the close of each Friday, but not at other points of time. This it may do by arranging the flow of discounting of bills, money at call and short notice and the like.