Transcript II_ 4_Money and Banking

MONEY
&
BANKING
Samir K Mahajan
MONEY: MEANING AND FUNCTIONS
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Money is regarded any object which is generally accepted as:
medium of exchange
unit of account
standard of deferred payment
store of value
transfer of value.
Samir K Mahajan
MONEY: MEANING AND FUNCTIONS contd.
 Primary Functions
o As medium of exchange, money is used as a means of payment. As money has ready purchasing power, it facilitates
in transacting exchange of goods and services with minimum effort and time.
o As unit of account, money is treated as common measure of value. Value of all goods and services in exchange can be
expressed in terms of money. Such expression gives rise to price system in which money act as a means of calculating
the relative prices of goods and services.
 Secondary Functions:
o As standard of deferred payment, money can be used in the settlement of debt and future payments. Loans are
advanced and future contracts are settled in terms of money.
o As store of value, money is hold as an asset in liquid (or cash balance) to use anytime in future. This is because money
has purchasing power which holds commands over goods and services all time – at present and in future. However
use of money as store of value is not without drawbacks. Changes in general price level causes rise and fall in the
value of money. When price level rises, value of money falls and vice versa.
o As transfer of value, sale and purchase of movable and immovable assets, paper wealth and physical wealth can be
made with the help of money. Thus, value available with a person in the form of asset can be transferred from one
person to another with the use of money.
Samir K Mahajan
FORMS OF MONEY IN MODERN TIMES
In modern monetary transactions, In modern era, the total stock of money or money supply includes the following:
 Metallic money or currency coins : Metallic money refers to the coins made out of metal like gold, bronze, silver, copper,
nickel. Coins are of two types such as: Standard or Full-bodied Coins and Token coins.
o Standard or Full-bodied Coins are those coins whose face value is equal to its intrinsic (metallic) value.
o Token coins have intrinsic (metallic) value less than its face value. They generally are of lower denominations are made
of cheap metals like nickel and copper. Token coins are used for exchange of small value.
 Paper money or paper currency : Paper money consists of currency notes issued by the State Treasury or the Central bank
of the country.
 Credit or bank money: Bank demand deposits withdraw-able by issuing cheque has started functioning as money, and
cheque are conventionally accepted as a means of payment by the business community in general.
Samir K Mahajan
LEGAL TENDER AND CONVENTIONAL MONEY
In modern era, currency money and bank money together constitute the total stock of money or money supply.
 Currency money (both currency coins and currency notes) is legal tender money or fiat money and has general
acceptability.
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Credit money or bank demand deposits are conventional money and lacks general acceptability.
Samir K Mahajan
FUNCTIONS OF COMMERCIAL BANKS
A commercial bank or simply a bank is a financial institution which deals with money, accepts deposits, advances loans,
and create credits with the sole purpose of earning profits. Modern banks performs a wide variety of functions. The
important functions of the commercial banks are as follows.
 Acceptance of Deposits: Commercial bank borrows by accepting deposits from the public. These deposits are broadly
classified as time deposits and demand deposits.
o Demand Deposits: Demand Deposits are repayable by the bank on demand or may be withdrawn by the depositors
at any time without previous notice to bank through issue of cheque or other forms. It includes savings deposits
(interest bearing) and current account deposits (non-interest bearing) .
o Time/term Deposits: These are deposits repayable after a certain fixed time period varying from seven days to ten
years or more.. These deposits are not withdrawn able by cheque, draft or by other means. It includes fixed deposits,
recurring deposits, certificate of deposits.
 Advancing of Loans: The commercial banks provide loans and advances to the public in various forms. These includes
overdraft, cash credit, discounting of bills, loans and advances, consumer loans etc.
Samir K Mahajan
FUNCTIONS OF COMMERCIAL BANKS contd.
 Credit Creation : Credit creation is the multiple expansions of bank demand deposits. When a bank advances a loan
to its borrower , it does not lend cash buts open a demand deposit account in the name of the borrower and credits
the loan amount to his account. The bank allows the borrower to draw upon the bank as and when required though
cheque. Thus whenever a bank grants a loan, it creates an equal amount bank deposits. Creation of such derivative
demand deposits is called credit creation which results in net increase in the money stock of the economy. Banks have
the ability to create many times more than their deposits. The ability of bank to create credit is limited by cash-reserve
requirements.
Agency Functions: Commercial banks also performs agency functions on behalf of the customers/clients which includes
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Collection of cheques, dividends, and interests on behalf of the customers
Payment of rent, insurance premiums on behalf of the customers
Dealing in foreign exchange
Purchase and sale of securities on behalf of the customers
Act as correspondent of their customer
Preparations of Income-Tax returns for their customers
Act as trustee, executor, attorney etc
Samir K Mahajan
FUNCTIONS OF COMMERCIAL BANKS contd.
 General Utility Services: Banks also performs certain general utility services which yields non-interest
income to the banks. Such services includes:
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Safety locker facility
Money Transfer
Travelers' cheques
Gift cheques
ATM facilities
Credit card
Debit card
Accepting bills
Internet banking
Letters of credit
Merchant Banking
o Bancassurance
Samir K Mahajan
CRR, SLR, LRR
CASH RESERVE RATIO (CRR):
Cash Reserve Ratio (CRR) is the minimum fraction of the total deposits of customers which commercial banks have to
hold as reserves either in cash or as deposits with the central bank. The cash reserve ratio is fixed by the Central Bank
as a tool in monetary policy in influencing the volume of credit that can be created by the banking system of a country.
STATUTORY LIQUIDITY RATIO (SLR):
Statutory liquidity ratio (SLR) refers portion of deposits that the commercial banks are required to maintain in the form
of liquid asset such as gold or govt. approved securities (bonds, shares) . Statutory Liquidity Ratio is determined and
maintained central bank of a country in order to control the expansion of bank credit.
LEGAL RESERVE RATIO (LRR) : Legal Reserve Ratio comprises of both CRR and SLR. While the aim of CRR is immediate
liquidity needs, the objective of SLR is two fold : to provide profitability with liquidity.
Samir K Mahajan
Banks
A
B
C
D
------Total
Credit Creation By Commercial Banks
Primary Deposits (Rupees Cash Reserve
in Crores)
(Cash Reserve Ratio = 20
per cent )
1000
200
800
160
640
128
512
104
------------5000
1000
Derivation of Credit Multiplier
can create credit (∆D) can be written as
∆D=∆R [1+ (1-r)2 +(1-r)3 + (1-r)4 + ………….. ]
or, ∆D =(∆R) 1/r
Where ‘r’ stands for Reserve Ratio
∆R stands for initial excess reserve
∆D stands derivative demand deposits
The extent to which the banking system
Credit Creation
/Demand Deposits
800
640
512
408
------4000
Derivation of Credit Multiplier: Illustration
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r = 20 percent = 0.2
Primary deposits = Rs 1000 crores
Initial excess reserves = ∆R = 80 percent of Rs 1000 crores
Derivative demand deposits (=credit creation by banking
system) = ∆D = 800 x (1/ 0.2) = Rs 4000 crores
Samir K Mahajan
FUNCTIONS OF CENTRAL BANK WITH SPECIAL REFERENCE TO RESERVE BANK OF INDIA
The Central Bank (The Reserve Bank of India in India) is the highest monetary authority of a country. It acts as the
regulatory authority of a country's banking system and is the sole provider and printer of notes and coins in circulation. It
also formulates monetary and credit policy of a country. The Central bank of a country perms the following functions:
 Monopoly of Note-Issue: The central bank has the sole monopoly of note issue in almost every country. It mints
currency coins and prints currency notes. In India, the Reserve Bank of India It has the sole right to issue currency notes
of all denominations except one-rupee notes. One-rupee notes had been issued by the Ministry of Finance of the
Government of India.
 Banker, Agent & Adviser to the Government: The central bank acts as the banker, agent and adviser to Government of
India. As banker to the government, central bank provides all those services and facilities to the government which
public gets from the commercial banks. In India, RBI maintains and operates government deposits, advises the
government on all financial matters etc. As agent, it manages government funds, raises loans from the public on behalf
of the government, looks after the management of public debt etc.
 Banker's Bank: Central bank is the bank of banks. It is the custodian of cash reserves of commercial banks. It gives them
advice on financial and economic matters and regulate banking activities such relating to licensing of banks and their
branch expansion; management and methods of working of the banks; amalgamation, acquisition of banks etc.
Samir K Mahajan
FUNCTIONS OF CENTRAL BANK contd.
 Lender of Last Resort: Central bank provides security to their cash reserves, gives them loan and accommodation at the
times of emergency and thus act as the lender of the last resort. The Reserve Bank provide financial assistance to the
scheduled banks by rediscounting their eligible bill, and through loans and advances against approved securities.
 Credit Control: The central bank of the country regulates bank credit and thus money supply in economy in order to
ensure internal price stability and promote economic growth and thus, avoids inflationary and deflationary tendencies in
the country. The monetary authority use of various quantitative (such as bank rate, open market operation, cash reserve
ratio, repo and reverse repo) and qualitative techniques (such as margin requirements, moral suasion, appeal etc) to
effectively control and regulate credit in the country.
 Custodian of Country’s Reserves of Foreign Currencies: Central bank is the custodian of the foreign currency obtained
from various countries. It maintains and stabilizes the external value of the domestic currency , and thus administers
exchange controls and other restrictions imposed by the government, and manages the foreign exchange reserves
Samir K Mahajan
FUNCTIONS OF CENTRAL BANK contd.
Clearing House Function
All the commercial banks have their accounts with the central bank. Therefore, central bank settles the mutual
transactions of banks and thus saves all banks contacting each other individually for setting their individual transactions,
and claims. In this way; the unnecessary cash transactions between individual banks are avoided.
Other Functions
Besides the traditional central banking functions, Central Bank (RBI)also performs a variety of promotional and
developmental functions.
 It collects and publishes statistical information relating to banking, finance, credit, currency, agricultural and industrial
production, etc.
 It also publishes the results of various studies and review of economic situation of the country in its monthly bulletins
and periodicals.
Samir K Mahajan
METHODS OF CREDIT CONTROL BY CENTRAL BANK WITH SPECIAL REFERENCE TO MONETARY POLICY OF RBI
Credit control policy or monetary policy may be defined as that branch of economic policy of public authority which is
concerned with the regulation of the supply, the costs and the directions of credit. The monetary and credit policies in
India is prepared and effectuated by the Reserve Bank of India. The major objectives RBI monetary policy are:
o Economic growth with price stability
o Equitable distribution of credit in different sectors and in different sections of the society
o Stability of external value of its currency
Central bank of a country can control credit by following two methods such as quantitative credit control and qualititative
credit control.
 Quantitative /General Credit Controls: Quantitative controls are used to expand or contract the total quantity (overall
size) of credit in an economy. These are, thus, used to regulate and adjust the total quantity of derivative deposits
created by the commercial banks in general.
o Bank Rate (or Discount Rate) Policy : The bank rate is the rate at which the central bank lends funds to commercial
banks a lender of last resort against approved securities or eligible bills of exchange. During inflationary tendencies,
the central bank may increase bank rate and consequently, lending rates by bank on loans and advances also move
up, borrowing from banks becomes expensive and is discouraged and, as a result, monetary expansion decreases.
During deflationary tendencies, bank rate may be decreased.
Samir K Mahajan
CREDIT CONTROL BY CENTRAL BANK contd.
o Open Market Operation: Open market operation refers to buying and selling of approved securities by the Central Bank
with a view to influencing money supply in the economy. During inflationary tendencies, the central bank sells
securities to the public and banks. As a result, a portion of purchasing power of the public and commercial banks' cash
flows goes to the central bank. With reduction in deposits, lending power of banks decreases which leads to reduction
in credit expansion. The central bank purchase securities during falling prices (i.e. deflationary).
o Cash Reserve Ratio: The proportion of primary deposits which the banks are legally required to keep with the central
bank is termed legal cash reserve ratio (CRR) . If the cash reserve ratio is raised, the lending power of commercial banks
will contract accordingly. This will cause fall in money expansion in the economy and is followed during rising prices or
inflationary tendencies. A decrease in ratio has an opposite effect and may be followed during deflationary tendencies.
o Statutory Liquidity Ratio: Statutory liquidity Ratio (SLR) refers to the amount of assets which banks are legally required
to hold in the forms of cash in hand, government and approved securities. The increase in SLR causes a fall rate of
credit expansion and decrease in SLR causes a rise in the rate of credit expansion.
Samir K Mahajan
CREDIT CONTROL BY CENTRAL BANK contd.
o Repo and Reverse Repo by RBI : 'Repo' transactions are conducted by RBI in money market to manipulate short-term
interest rate, and to manage liquidity levels/short term capital.
When RBI conduct a Repo, commercial banks sell approved securities to RBI with a repurchase or buy back
option on a specified time and price. Thus, with Repo, RBI lends money to the banks and thus, inject extra
liquidity into the money market. Repo rate is the discount rate at which commercial banks sells government
securities to RBI with a buy back option.
When RBI conduct a Reverse Repo, Commercial Banks buys approved securities from RBI with a to resale
agreement at future date and specified price. Thus, with revers Repo, RBI borrows money from commercial
banks and thus, absorb excess liquidity from the money market. Reverse Repo rate is the discount rate at which
commercial banks purchases government securities with a resale option.
Samir K Mahajan
CREDIT CONTROL BY CENTRAL BANK contd.
 Qualitative /Selective Credit Controls
The qualitative measures do not regulate the total amount of credit created by the commercial banks but certain
particular credit or loans which creates economic instability. Therefore, qualitative measures are known as the selective
measures of credit control.
o Fixation of Margin Requirements: Margin Requirements is the difference between the value of the securities and the
loan. When the Central Bank prescribes higher margin the borrowers can obtain less amount of credit on his stock and
vice-versa.
o Rationing of Credit: Under the rationing of credit, the Central Bank fixes a maximum limit for loans that a commercial
bank can provide to different sectors of the economy.
o Directives : The Central Bank issues directives from time to time to follow its credit policy and the commercial banks
abide. The directives may be in the form of written orders, warnings or appeals, etc.
o Moral Suasion: Under this method, the Central Bank merely uses its moral influence on the commercial banks. It
includes the advice, suggestion request and persuasion with the commercial banks to co-operate with the Central
Bank. If the commercial banks do not follow the advice extended by the Central Bank, no penal action is taken against
them.
Samir K Mahajan
CREDIT CONTROL BY CENTRAL BANK contd.
o Publicity: Under this method, the Central Bank gives wide publicity to its credit policy through its bulletins. By this,
the Central Bank educates the general public regarding the monetary policy and its objectives. The commercial
banks are guided as well.
o Direct Action: The Central Bank uses direct action act against the banks which does not comply with its
instructions. No commercial bank can afford to go against the wishes of the central bank with regard to policy
matters, as the central bank has wide powers even to stop banks' operations.
Samir K Mahajan
CLASSIFICATION OF MONEY BY RESERVE BANK OF INDIA
 M1 ( Narrow Money/High Powered Money) = Currency ( coins and notes) with public + Demand deposits (Current
Deposits and Demand Liabilities Portion of Savings Deposits ) with the Banking system + Other deposits with RBI
M2 = M1 + Time Liabilities Portion of Savings Deposits with the Banking System + Certificate of Deposit (CDs)
issued by Banks + Term Deposits of residents with a contractual maturity of up to and including one year with the
Banking System (excluding CDs)
 M3 (Broad Money)= M2 + Term Deposits of residents with a contractual maturity of over one year with the Banking
System + Call/Term borrowings from 'Non-depository Financial Corporations by the Banking System
 M4 = M3 + All deposits with post office savings banks (abolished)
Samir K Mahajan
As on Aug. 29, 2014
Ratios and Rate (in percent)
RBI
Cash Reserve Ratio
Statutory Liquidity Ratio
4.00
22.00
Repo Rate
8.00
Reverse Repo Rate
7.00
Bank Rate
9.00
Samir K Mahajan