Chaudhri, Fateh M.

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RESEARCH REPORT SERIES 
No. 47 
A Study of Scheduled Banks Response to Cost 
of Alternative Sources of Funds.. 
By 
Fateh M. Chaudhri 
PAKISTAN INSTITUTE OF DEVELOPMENT ECONOMICS 
O L D S I N D A S S E M B L Y B U I L D I N G 
B U N D E R R O A D , K A R A C H I 
P A K I S T A N 
No. 47 
A Study of Scheduled Banks Response to Cost 
of Alternative Sources of Funds.. 
By 
Fateh M. Chaudhri 
The Research Reports of the Pakistan Institute of 
Development Economics are circulated to inform interested 
persons with regard to research progress at the Institute. 
These reports may be freely circulated but they are not to 
be quoted without the permission of the author.. Work on 
this manuscript is still in progress; comments are invited 
to improve the final version. 
February 1966 
PAKISTAN INSTITUTE OF DEVELOPMENT ECONOMICS 
OLD SIND ASSEMBLY BUILDING 
BUNDER ROAD, KARACHI-1 
(PAKISTAN) 
A. STUDY OF SCHEDULED -BANLS RESPONSE TO COST 
UF ALTERNATIVE SPURGES OF FUNDS 
by 
-r 
Fc t eh li. Chaudhri 
I. INTRODUCTION 
Our aim in this paper is r. limited one. We wish to 
study, (a) what weight the Pakistani bankers assign to cost 
factors in acquiring short funds from alternative sources of 
supply and (b) how good substitute are these alternative sources 
of supnly of funds for scheduled banks in Pakistan. V.e have 
chosen for our study the two short money markets existing in 
Pakistan; namely, the call money market and the discount window 
of the State Bank of Pakistan. 1/ 
Dr. Porter has also tested the hypothesis how net free 
reserves (defined as excess reserves minus scheduled banks 
borrowings from the State Bank of Pakistan) are influenced by 
the relation of the call rate with the discount rate . He thinks 
that scheduled banks in the aggregate respond in some fashion 
to the spread between the discount rate andthe call rate, he 
considers the spread between these two as the critical variable 
in explaining scheduled banks' borrowings from the State bank of 
Pakistan. This assumes that the funds available in the inter-bank 
call money market and- from the State Bank of Pakistan are very 
good substitutues. We wish to state more explicitly how good 
substitutes are these alternative sources of short funds and how 
much 'critical' is the spread between the call rate and the 
discount rate in explaining scheduled bank behaviour pattern. o/ —-— " " " . ——— • "*" 
'rTlie author is a research economist at the Pakistan Institute 
of Development economics. He wishes to express his indebted-
ness to I j t. Abdur Rahman, a friend and colleague at the 
Institute, for his helpful suggestions on the design of this 
study. He also wishes to thank Lr. Qazi Lholiquzzoman Ahmad, 
Staff Economist, for providing computational help. The author, 
however, remains fully responsible for any remaining errors 
and for the points of view put-forth here. 
X/Porter, Richard. C,: Liquidity and Lending: Volume of bank 
Credit in Pakistan, Karachi, Pakistan Institute of Development 
Economics, 1963, Section: XII. 
- 2 -
In our opinion it would be more illuminating if we compared 
the relative cost of clternative sources of funds, i.e. the 
call rate and the discount rate, in such a way that variations 
in cost not only explained the v&riations in the level of 
scheduled banks.borrowings from the State Bank of 
Pakistan and the inter-bank call money market but also showed 
the strength of relationship between the changes in the 
relative position of these rates and the changes in the level 
of funds transacted in the two short money markets. This, we 
intend to do with a methodology to be outlined is section 
IV below. 
II. Thh HYPOTHESIS 
^ince both the inter-bank call money market and the 
discount window of the i>tate Bank of Pakistan are generally 
assumed to offer funds to scheduled banks fox" short run purposes 
and banks in need of funds may have access to both the markets, 
our hypothesis is that scheduled banks behaviour pattern, in 
obtaining funds, as rational operators aiming at minimising 
costs, is highly sensitive to the cost of alternative sources 
of funds even in an under-developed short money markets 
like that of Pakistan. In other words we expect a positive 
relationship between an increase in the rate of interest in 
one market ana the increase of funds transacted in the other, 
i^ lso we exoect a strong ana significant relationship between 
the two series of funds transacted and the interest rates 
charged. 
To test this hypothesis and to have a better perspective 
of scheduled banks operational behaviour, we shall simply 
compute and study the elasticity of substitution^, 
bfetwe'an funds borrowed from the State Bank of Pakistan 
ana the call money market. This will also permit us to see 
how much -variations in the relative level of borrowings from 
the State Bank of Pakistan and the call money market can be 
- 3 -
explained by variations in tne relative position of the two 
rates — i.e. the call rate and the discount rate. 
III. POLICY IHPLICATlUu • OF Trih STUDY 
The policy implication of t-,is study is that if the 
elasticity of substitution, e, is found to be high and the 
coefficientyof determination between the relative position 
of the two rates and the level of funds transacted in the two 
markets is also high, then by maneouvering one rate in one 
market, the amount of funds transacted in the other would be 
affected in a predictable fashion and the same may, therefore, 
be influenced in the desirable direction. 
IV. hhlKODOIOGY OF Thx, STuDY 
Let us designate : 
'•4c quantity of funds transacted in the call money 
market ; 
4d quantity of funds borrowed from the State bank 
of Pakistan; 
Pc the average rate of interest in the call 
money market during a certain period; 
• Pd the discount ra'ye during that period ; . 
The elasticity of substitution, e, between the funds 
borrowed from the btate hank of Pakistan ana the call money 
market may then be defined by the following relationship: 
(Qc/Qd) = L (Pd/Pc)6 or 
log (Qc/Qd) = log a + e log(Pd/Pc) 
'hen log (Pd/Pc) is regressed on log(4c/Qd), the 
elasticity of substitution, e, and some residual is found. 
The double-log form of th ti ir^grBSSion is ccpT^ i^ opr^ io. te to find 
elasticity over the whole range ana is likely to give 
satisfactory fit to the data in our case. 
V. LliPIRIGiiii uSTII-ii/fhS 
Regression between log (Pd/Pc) and log (Qc/Qd) yielded 
the following coefficients of the equation : 
logUc/vid) = -. 104660 + 1.568188 log (Pd/Pc) 
( . 1 9 2 ) 
R = .946 
The coefficient of log (?d/Pc), = 1.5O168, is the 
elasticity of substitution, e, between funds transacted 
in the inter-bank call money market and funds borrowed from 
the State bank of Pakistan, i'he figures in.the parenthesis, 
.192 , indicates its standard error. The coefficient means 
that an increase in the ratio of discount rate to call rate 
by 1 per centage point would give rise, ceteris paribus, to 
the ratio of call money funds to discount window funds by 
1.57 percentage points, bign of the elasticity coefficient 
is also consistent with our hypothesis of a positive relation 
ship between changes in the rate of interest in one market an 
the changes in the amount of funds transacted in the other 
market -- i.e. if the ratio of Pd to Pc goes up by 1 per cent 
the ratio of Qc to Qd goes up by 1.57 per cent.' 
The coefficient of correlation between the ratio of 
interest rates and the ratio of funds transacted in the call 
money market and the discount window of the State Bank of 
Pakistan was found to be very high, (R = .973) and 
significant at 1 % level of the significance test. 
2 
The coefficient of determination, (R = .94b), was 
therefore, also very high. It means that variations in the 
quantity of funds transacted 'exploined'^with the variations 
in the relative cost of funds are very high-- i.e. about 
95 oer cent. In other words, factors other than the cost 
of funas are not important determinants for the.amount of 
funds transacted in the two markets,. 
To be able to test the presence of autocorrelated 
disturbances, the burbih - Vatson statistic, d, was 
calculated and found to be, d = 1.47. Por 3b observations 
and one explanatory variable, the Durbin-Vatson upper bound 
du is equal to 1.32 at 1 -,o level of significance. Since the 
figure for our d is greater than du the hypothesis of a 
random disturbances in favour of a- positive autocorrelation 
cannot be rejected -- i.e. there is no evidence of . 
autocorrelation among the residual terms. 
V. Ci:.Cho8lUi,S 
The findings are quite significant in view of the 
fact that the call money market is not very well developed 
and is alleged to suffer from rigidities and imperfections. 
Our finding of a high elasticity of substitution between 
the call money and the discount money, depending mainly on 
the cost of two sources of funds, does not support the 
assertion, often made, that the existing interest rate 
structure and scheduled banks behaviour pattern are 
insensitive. _he high elasticity of substitution, e , 
further repudiates the assertion that ' in the absence 
of a well developed short money market ana extensive chain 
of commercial banks, the efficiency of the. bank rate is 
2/ 
rather limited' . 
Let it be remembered h ere tLa t the extent of activity 
in the call money market has increased from an average 
quarterly transaction of about 15-0 million rupees in 1954 
to about 47.5 million rupees in 19^4* 1 ith such an enormous 
increase in the activity, the price of transactions in the 
call money market has become a sensitive indicator of 
scheduled banks behaviour ana the money market position 
in general. In any analysis of the money market and 
scheduled banks operational behaviour, this fact must be 
giv^n due recognition, Lecisions based on the assumption 
of insensitivit3'_ of scheduled brnks behaviour to cost 
factors would, therefore, be misleading because such 
an assumption does not stand the empirical test devisee 
above. 
7j Heenai, S.a ., i.n Appraisal of the Credit and xionetary 
situation in Pakistan, Karachi, The State hank 
of Pakistan, p. 129-
11 ppendix : 
Suui.GiiS OF DaTa 
Quarterly data on the reallocation of funds through 
the call money market were obtained from the liabilities side 
of the beekly statements of scheduled banks in Pakistan as 
given in the State Bank of Pakistan, Bulletin, table 
captioned :" Scheduled Banks in Pakistan : Weekly 
Oonsolidated Position". We took the sum of interbank 
deposits and interbank borrowings. 
Data on scheduled banks borrowings from the State 
Bank of Pakistan are also given in the above table of the i i 
Bulletin. 
Call money rate arc quoted in the State Bank of 
Pakistan, Report on Currency and Finance-, in the table 
titled: "Inter-bank Call honey Rates (karachi)" and the' 
Bulletin, table related to "Selected economic Indicators". 
The discount rate (i.e. the rate applicable to 
borrowings from the State bank of Pakistan) remained 
constant at 3 c/o till January, 1959 when it was raised to 
4 )o ana remained there during the period covered by our 
study. Later, in June, 1965, it was raised to 5 but our 
study does not extend to that point of time. 

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A study of scheduled banks response to cost of alternative sources of funds

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A study of scheduled banks response to cost of alternative sources of funds

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