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Monetary policy

Monetary policy






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    Monetary policy Monetary policy Document Transcript

    • Monetary Policy Monetary policy is the process by which the monetary authority of a countrycontrol the supply of money, often targeting a rate ofinterest for the purpose ofpromoting economic growth and stability. The official goals usually include relativelystable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It isreferred to as either being expansionary or contractionary, where an expansionarypolicy increases the total supply of money in the economy more rapidly than usual, andcontractionary policy expands the money supply more slowly than usual or even shrinksit. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.Overview Monetary policy rests on the relationship between the rates of interest in aneconomy, that is, the price at which money can be borrowed, and the total supply ofmoney. Monetary policy uses a variety of tools to control one or both of these, toinfluence outcomes like economic growth, inflation, exchange rates with othercurrencies and unemployment. A policy is referred to as contractionary if it reduces the size of the money supplyor increases it only slowly, or if it raises the interest rate. An expansionary policyincreases the size of the money supply more rapidly, or decreases the interest rate.Furthermore, monetary policies are described as follows: accommodative, if the interestrate set by the central monetary authority is intended to create economic growth;
    • neutral, if it is intended neither to create growth nor combat inflation; or tight ifintended to reduce inflation. Monetary policy is the process by which the government, central bank, ormonetary authority of a country controls (i) the supply of money, (ii) availability ofmoney, and (iii) cost of money or rate of interest to attain a set of objectives orientedtowards the growth and stability of the economy.Trends in Central Banking The central bank influences interest rates by expanding or contracting themonetary base, which consists of currency in circulation and banks reserves on depositat the central bank. The primary way that the central bank can affect the monetary baseis by open market operations or sales and purchases of second hand government debt,or by changing the reserve requirements. If the central bank wishes to lower interestrates, it purchases government debt, thereby increasing the amount of cash incirculation or crediting banks reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans tobanks secured by suitable collateral, specified by the central bank). If the interest rate onsuch transactions is sufficiently low, commercial banks can borrow from the centralbank to meet reserve requirements and use the additional liquidity to expand theirbalance sheets, increasing the credit available to the economy. Lowering reserverequirements has a similar effect, freeing up funds for banks to increase loans or buyother profitable assets. A central bank can only operate a truly independent monetary policy whenthe exchange rate is floating. If the exchange rate is pegged or managed in any way, thecentral bank will have to purchase or sell foreign exchange. These transactions inforeign exchange will have an effect on the monetary base analogous to open marketpurchases and sales of government debt; if the central bank buys foreign exchange, themonetary base expands, and vice versa. But even in the case of a pure floating exchangerate, central banks and monetary authorities can at best "lean against the wind" in aworld where capital is mobile.
    • Accordingly, the management of the exchange rate will influence domesticmonetary conditions. To maintain its monetary policy target, the central bank will haveto sterilize or offset its foreign exchange operations. For example, if a central bank buysforeign exchange (to counteract appreciation of the exchange rate), base money willincrease. Therefore, to sterilize that increase, the central bank must also sell governmentdebt to contract the monetary base by an equal amount. It follows that turbulent activityin foreign exchange markets can cause a central bank to lose control of domesticmonetary policy when it is also managing the exchange rate.  Net Export o The value of a countrys total exports minus the value of its total imports. It is used to calculate a countrys aggregate expenditures, or GDP, in an open economy. o In other words, net exports is the amount by which foreign spending on a home countrys goods and services exceeds the home countrys spending on foreign goods and services. For example, if foreigners buy $200 billion worth of U.S. exports and Americans buy $150 billion worth of foreign imports in a given year, net exports would be positive $50 billion. Factors affecting net exports include prosperity abroad, tariffs and exchange rates.  Trade Deficit o An economic measure of a negative balance of trade in which a countrys imports exceeds its exports. A trade deficit represents an outflow of domestic currency to foreign markets. o Economic theory dictates that a trade deficit is not necessarily a bad situation because it often corrects itself over time. However, a deficit has been reported and growing in the United States for the past few decades, which has some economists worried. This means that large amounts of the U.S. dollar are being held by foreign nations, which may decide to sell at any time. A large increase in dollar sales can drive the value of the currency down, making it more costly to purchase imports.
    •  Trade Surplus o An economic measure of a positive balance of trade, where a countrys exports exceeds its imports. A trade surplus represents a net inflow of domestic currency from foreign markets, and is the opposite of a trade deficit, which would represent a net outflow. o When a nation has a trade surplus, it has control over the majority of its own currency. This causes a reduction of risk for another nation selling this currency, which causes a drop in its value. When the currency loses value, it makes it more expensive to purchase imports, causing an even a greater imbalance. o Because a trade surplus usually creates a situation where the surplus only grows (due to the rise in the value of the nations currency making imports cheaper), there are many arguments against Milton Friedmans belief that trade imbalances will correct themselves naturally. Budget Deficit o A financial situation that occurs when an entity has more money going out than coming in. The term "budget deficit" is most commonly used to refer to government spending rather than business or individual spending. When it refers to federal government spending, a budget deficit is also known as the "national debt." The opposite of a budget deficit is a budget surplus, and when inflows are equal to outflows, the budget is said to be balanced. o Government budget deficits can be cured by cutting spending, raising taxes or a combination of the two. Deficits must be financed by borrowing money. Interest must be paid on borrowed funds, which worsens the deficit.
    •  Budget Surplus o A situation in which income exceeds expenditures. The term "budget surplus" is most commonly used to refer to the financial situations of governments; individuals speak of "savings" rather than a "budget surplus." A surplus is considered a sign that government is being run efficiently. A budget surplus might be used to pay off debt, save for the future, or to make a desired purchase that has been delayed. A city government that had a surplus might use the money to make improvements to a run-down park, for example. o When spending exceeds income, the result is a budget deficit, which must be financed by borrowing money and paying interest on the borrowed funds, much like an individual spending more than he can afford and carrying a balance on a credit card. A balanced budget occurs when spending equals income. The U.S. government has only had a budget surplus in a few years since 1950. The Clinton administration (1993-2001) famously cured a large budget deficit and created a surplus in the late 1990’s. Required Reserve Ratio o The portion (expressed as a percent) of depositors balances banks must have on hand as cash. This is a requirement determined by the countrys central bank, which in the U.S. is the Federal Reserve. The reserve ratio affects the money supply in a country. o For example, if the reserve ratio in the U.S. is determined by the Fed to be 11%, this means all banks must have 11% of their depositers money on reserve in the bank. So, if a bank has deposits of $1 billion, it is required to have $110 million on reserve. Discount Rate o The interest rate that an eligible depository institution is charged to borrow short-term funds directly from a Federal Reserve
    • Bank. Different types of loans are available from Federal Reserve Banks and each corresponding type of credit has its own discount rate. o The interest rate used in discounted cash flow analysis to determine the present value of future cash flows. The discount rate takes into account the time value of money (the idea that money available now is worth more than the same amount of money available in the future because it could be earning interest) and the risk or uncertainty of the anticipated future cash flows (which might be less than expected). o This type of borrowing from the Fed is fairly limited. Institutions will often seek other means of meeting short-term liquidity needs. The Federal Funds Discount Rate is determined by the average rate which banks are willing to charge each other for overnight funds. Bond o A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. o Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents. o The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries." o Two features of a bond - credit quality and duration - are the principal determinants of a bonds interest rate. Bond maturities range from a 90- day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.
    • Inflation The rate at which the general level of prices for goods and services is rising, and,subsequently, purchasing power is falling. Central banks attempt to stop severeinflation, along with severe deflation, in an attempt to keep the excessive growth ofprices to a minimum.An increase in the money supply may be called monetary inflation,to distinguish it from rising prices, which may also for clarity be called price inflation. The inflation rate is a measure of inflation, or the rate of increase of a priceindex such as the consumer price index. It is the percentage rate of change in price levelover time, usually one year. The rate of decrease in thepurchasing power of money isapproximately equal.Causes of Inflation Historically, a great deal of economic literature was concerned with the questionof what causes inflation and what effect it has. There were different schools of thoughtas to the causes of inflation. Most can be divided into two broad areas: the Demand PullInflation and the Cost Push Inflation. The Demand Pull Inflation is an inflation cause bythe increase in the demand that occurs when the level of the spending exceeds theamond firms are capable of producing. The Cost Push Inflation is an inflation cause bythe decrease in the cost of production that occurs when the vital resource become scarcecausing its price to rise and raising the cost of production of the firms. Demand Pull Inflation o A term used in Keynesian economics to describe the scenario that occurs when price levels rise because of an imbalance in the aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices increase. Economists will often say that demand-pull inflation is a result of too many dollars chasing too few goods. o This type of inflation is a result of strong consumer demand. When many individuals are trying to purchase the same good, the price
    • will inevitably increase. When this happens across the entire economy for all goods, it is known as demand-pull inflation. Cost Push Inflation o A phenomenon in which the general price levels rise (inflation) due to increases in the cost of wages and raw materials. o Cost-push inflation develops because the higher costs of production factors decreases in aggregate supply (the amount of total production) in the economy. Because there are fewer goods being produced (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation).Types of Inflation Other economic concepts related to inflation include: deflation – a fall in the generalprice level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economicgrowth and high unemployment; and reflation – an attempt to raise the general level ofprices to counteract deflationary pressures. 1. Deflation  is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time. Deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases
    • and consumption until prices fall further, which in turn reduces overall economicactivity. Since this idles the productive capacity, investment also falls, leading tofurther reductions in aggregate demand. This is the deflationary spiral. An answer tofalling aggregate demand is stimulus, either from the central bank, by expandingthe money supply, or by the fiscal authority to increase demand, and to borrow atinterest rates which are below those available to private entities. 2. Hyperinflation  occurs when a country experiences very high, accelerating, and perceptibly "unstoppable" rates of inflation. In such a condition, the general price level within an economy rapidly increases as the currency quickly loses real value. Meanwhile, the real values of specific economic items generally stay the same with respect to each other, and in terms of other relatively stable foreign currencies. This includes the economic items that generally constitute the governments expenses.  Hyperinflation occurs when there is a continuing (and often accelerating) rapid increase in the amount of money that is not supported by a corresponding growth in the output of goods and services.  The price increases that result from the rapid money creation creates a vicious circle, requiring ever growing amounts of new money creation to fund government activities. Hence both monetary inflation and price inflation proceed at a rapid pace. Such rapidly increasing prices cause widespread unwillingness of the local population to hold the local currency as it rapidly loses its buying power. Instead they quickly spend any money they receive, which increases the velocity of money flow; this in turn causes further acceleration in prices. 3. Stagflation  a portmanteau of stagnation and inflation, is a term used in economics to describe a situation where an inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. It raises a
    • dilemma for economic policy since actions designed to lower inflation may exacerbate unemployment, and vice versa.  Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when the productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil for an oil importing country. Such an unfavorable supply shock tends to raise prices at the same time that it slows the economy by making production more costly and less profitable. Milton Friedman famously described this situation as "too much money chasing too few goods".  Second, both stagflation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of themoney supply and the government can cause stagnation by excessive regulation of goods markets and labour markets. Either of these factors can cause stagflation. Money Money is any object or record that is generally accepted as payment for goodsand services and repayment of debts in a given socio-economic context or country.Money is historically an emergent market phenomenon establishing a commoditymoney, but nearly all contemporary money systems are based on fiat money. Fiatmoney, like any check or note of debt, is without intrinsic use value as a physicalcommodity. It derives its value by being declared by a government to be legal tender;that is, it must be accepted as a form of payment within the boundaries of the country,for "all debts, public and private". Such laws in practice cause fiat money to acquire thevalue of any of the goods and services that it may be traded for within the nation thatissues it. The money supply of a country consists of currency (banknotes and coins)and bank money (the balance held in checking accounts andsavings accounts). Bank
    • money, which consists only of records (mostly computerized in modern banking), formsby far the largest part of the money supply in developed nations.Functions of MoneyThe main functions of money are distinguished as: a medium of exchange a unit of account a store of value There have been many historical disputes regarding the combination of moneys functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. One of these arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value: its role as a store of value requires holding it without spending, whereas its role as a medium of exchange requires it to circulate. Others argue that storing of value is just deferral of the exchange, but does not diminish the fact that money is a medium of exchange that can be transported both across space and time. The term financial capital is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender. Medium of Exchange  When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the double coincidence of wants problem. Unit of Account  A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a
    • unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. To function as a unit of account, whatever is being used as money must be:  Divisible into smaller units without loss of value; precious metals can be coined from bars, or melted down into bars again.  Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds, works of art or real estate are not suitable as money.  A specific weight, or measure, or size to be verifiably countable. For instance, coins are often milled with a reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to detect. Store of Value  To act as a store of value, a money must be able to be reliably saved, stored, and retrieved – and be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. Some have argued that inflation, by reducing the value of money, diminishes the ability of the money to function as a store of value.Money Supply In economics, money is a broad term that refers to any financial instrument thatcan fulfill the functions of money. These financial instruments together are collectivelyreferred to as the money supply of an economy. In other words, the money supply is theamount of financial instruments within a specific economy available for purchasinggoods or services. Since the money supply consists of various financial instruments(usually currency, demand deposits and various other types of deposits), the amount of
    • money in an economy is measured by adding together these financial instrumentscreating a monetary aggregate.Types of Money Currently, most modern monetary systems are based on fiat money. However, formost of history, almost all money was commodity money, such as gold and silver coins.As economies developed, commodity money was eventually replaced by representativemoney, such as the gold standard, as traders found the physical transportation of goldand silver burdensome. Commodity Money  Many items have been used as commodity money such as naturally scarce precious metals, conch shells, barley, beads etc., as well as many other things that are thought of as having value.  Commodity money value comes from the commodity out of which it is made.  The commodity itself constitutes the money, and the money is the commodity.  Examples of commodities that have been used as mediums of exchange include:  gold  silver  copper  rice  Salt  Peppercorns  large stones  decorated belts  shells  alcohol  cigarettes  cannabis
    •  candy  etc.  These items were sometimes used in a metric of perceived value in conjunction to one another, in various commodity valuation or Price System economies. Use of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of accountfor the commodity which is being used as money.Representative Money In 1875, the British economist William Stanley Jevons described the money used at the time as "representative money". Representative money is money that consists of token coins, paper money or other physical tokens such as certificates, that can be reliably exchanged for a fixed quantity of a commodity such as gold or silver. The value of representative money stands in direct and fixed relation to the commodity that backs it, while not itself being composed of that commodity.Fiat Money  Fiat money or fiat currency is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold).  Instead, it has value only by government order (fiat).  Fiat money, if physically represented in the form of currency (paper or coins) can be accidentally damaged or destroyed.  However, fiat money has an advantage over representative or commodity money, in that the same laws that created the money can also define rules for its replacement in case of damage or destruction.  For example, the U.S. government will replace mutilated Federal Reserve notes (U.S. fiat money) if at least half of the physical
    • note can be reconstructed, or if it can be otherwise proven to have been destroyed.By contrast, commodity money which has been lost or destroyed cannot be recovered.Coinage  These factors led to the shift of the store of value being the metal itself: at first silver, then both silver and gold, at one point there was bronze as well. Now we have copper coins and other non-precious metals as coins. Metals were mined, weighed, and stamped into coins. This was to assure the individual taking the coin that he was getting a certain known weight of precious metal.  Coins could be counterfeited, but they also created a new unit of account, which helped lead to banking. Archimedes principle: coins could now be easily tested for their fine weight of metal, and thus the value of a coin could be determined, even if it had been shaved, debased or otherwise tampered with.  In most major economies using coinage, copper, silver and gold formed three tiers of coins.  Gold coins were used for large purchases, payment of the military and backing of state activities.  Silver coins were used for midsized transactions, and as a unit of account for taxes, dues, contracts and fealty.  Copper coins represented the coinage of common transaction.Paper money  The advantages of paper currency were numerous:  it reduced transport of gold and silver, and thus lowered the risks;  it made loaning gold or silver at interest easier, since the specie (gold or silver) never left the possession of the lender until someone else redeemed the note;
    •  and it allowed for a division of currency into credit and specie backed forms.  It enabled the sale of stock in joint stock companies, and the redemption of those shares in paper.Commercial Bank Money  Commercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior notice.  Banks have the legal obligation to return funds held in demand deposits immediately upon demand (or at call). Demand deposit withdrawals can be performed in person, via checks or bank drafts, using automatic teller machines (ATMs), or through online banking.  Commercial bank money is created through fractional-reserve banking, the banking practice where banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.  Commercial bank money differs from commodity and fiat money in two ways:  firstly it is non-physical, as its existence is only reflected in the account ledgers of banks and other financial institutions, and  secondly, there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent.  The process of fractional-reserve banking has a cumulative effect of money creation by commercial banks, as it expands money supply (cash and demand deposits) beyond what it would otherwise be. Because of the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by
    • the countrys central bank. That multiple (called the money multiplier) is determined by thereserve requirement or other financial ratio requirements imposed by financial regulators. Digital money  Digital currencies gained momentum in before the 2000 tech bubble. Flooz and Beenz were particularly advertised as an alternative form of money. While the tech bubble caused them to be short lived, many new digital currencies have reached some, albeit generally small userbases.  Most digital currencies are simply fiat currencies parleyed across a digital medium. However, protocols like Bitcoin allow money to only exist in cyberspace which allows for some classic limitations to be lifted.  Never before has the sending of money across a geographical divide not required the trust of a third party which of course then is susceptible to regulatory capture.  New forms of currency coming to fruition this very day allow for the free exchange of wealth across distances. Bank A bank is a financial institution and a financial intermediary that accepts depositsand channels those deposits into lending activities, either directly by loaning orindirectly through capital markets. A bank is the connection between customers thathave capital deficits and customers with capital surpluses. Due to their influence within a financial system and an economy, banks aregenerally highly regulated in most countries. Most banks operate under a system knownas fractional reserve banking where they hold only a small reserve of the funds depositedand lend out the rest for profit. They are generally subject to minimum capitalrequirements which are based on an international set of capital standards, known as theBasel Accords.
    • Banking Standard activities  Banks act as payment agents by conducting checking or current accounts for customers, paying cheques drawn by customers on the bank, and collecting cheques deposited to customers current accounts.  Banks also enable customer payments via other payment methods such as Automated Clearing House (ACH), Wire transfers or telegraphic transfer, EFTPOS, and automated teller machine (ATM). Banks borrow money by accepting funds deposited on current accounts, by accepting term deposits, and by issuing debt securities such as banknotes and bonds.  Banks lend money by making advances to customers on current accounts, by making installment loans, and by investing in marketable debt securities and other forms of money lending.  Banks provide different payment services, and a bank account is considered indispensable by most businesses and individuals.  Non-banks that provide payment services such as remittance companies are normally not considered as an adequate substitute for a bank account. Channels  Banks offer many different channels to access their banking and other services:  Automated Teller Machines  A branch is a retail location  Call center: A call centre or call center is a centralised office used for the purpose of receiving or transmitting a large volume of requests bytelephone. An inbound call centre is operated by a company to administer incoming product support or information inquiries from consumers. Outbound call centers are operated for telemarketing, solicitation of charitable or political donations and debt collection. In addition to a call centre, collective handling of letter, fax, live chat, and e-mail at one location is known as a contact centre.
    •  Mail: most banks accept cheque deposits via mail and use mail to communicate to their customers, e.g. by sending out statements  Mobile banking is a method of using ones mobile phone to conduct banking transactions  Online banking is a term used for performing multiple transactions, payments etc. over the Internet  Relationship Managers, mostly for private banking or business banking, often visiting customers at their homes or businesses  Telephone banking is a service which allows its customers to perform transactions over the telephone with automated attendant or when requested with telephone operator  Video banking is a term used for performing banking transactions or professional banking consultations via a remote video and audio connection. Video banking can be performed via purpose built banking transaction machines (similar to an Automated teller machine), or via a video conference enabled bank branch clarification.Product  Retail Banking  Checking account  A transactional account is a deposit account held at a bank or other financial institution, for the purpose of securely and quickly providing frequent access to funds on demand, through a variety of different channels.  Transactional accounts are meant neither for the purpose of earning interest nor for the purpose of savings, but for convenience of the business or personal client; hence they tend not to bear interest. Instead, a customer can deposit or withdraw any amount of money any number of times, subject to availability of funds.
    •  Savings account  Saving account are accounts maintained by retail financial institutions that pay interest but cannot be used directly as money in the narrow sense of a medium of exchange (for example, by writing a cheque).  These accounts let customers set aside a portion of their liquid assets while earning a monetary return.  For the bank, money in a savings account may not be callable immediately and in some jurisdictions, does not incur a reserve requirement, freeing up cash from the banks vault to be lent out with interest. Money market account  A money market account (MMA) or money market deposit account (MMDA) is a financial account that pays interest based on current interest rates in the money markets.  Money market accounts typically have a relatively high rate of interest and require a higher minimum balance (anywhere from $1,000 to $10,000 to $25,000) to earn interest or avoid monthly fees. The resulting investment strategy is therefore similar to, and meant to compete with, a money market fund offered by a brokerage. The two account types are otherwise unrelated. Certificate of deposit (CD)  A certificate of deposit (CD) is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions.  CDs are similar to savings accounts in that they are insured and thus virtually riskfree; they are "money in the bank".
    •  CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for banks and by the National Credit Union Administration (NCUA) for credit unions. They are different from savings accounts in that the CD has a specific, fixed term (often monthly, three months, six months, or one to five years), and, usually, a fixed interest rate.  It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest. Individual retirement account (IRA)  An Individual Retirement Account is a form of retirement plan, provided by many financial institutions, that provides tax advantages for retirement savings in the United States as described in IRS Publication 590, Individual Retirement Arrangement (IRAs).  The term IRA encompasses an individual retirement account; a trust or custodial account set up for the exclusive benefit of taxpayers or their beneficiaries; and an individual retirement annuity, by which the taxpayers purchase an annuity contract or an endowment contract from a life insurance company. Credit card  A credit card is a payment card issued to users as a system of payment. It allows the cardholder to pay for goods and services based on the holders promise to pay for them.  The issuer of the card creates a revolving account and grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or as a cash advance to the user.
    •  Debit card  A debit card (also known as a bank card or check card) is a plastic card that provides the cardholder electronic access to his or her bank account(s) at a financial institution.  Some cards have a stored value with which a payment is made, while most relay a message to the cardholders bank to withdraw funds from a payees designated bank account.  The card, where accepted, can be used instead of cash when making purchases. In some cases, the primary account number is assigned exclusively for use on the Internet and there is no physical card. Mortgage  A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan. However, the word mortgage alone, in everyday usage, is most often used to mean mortgage loan.  The word mortgage is a French Law term meaning "death contract", meaning that the pledge ends (dies) when either the obligation is fulfilled or the property is taken through foreclosure. Home equity loan  A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. Home equity loans are often used to finance major expenses such as home repairs, medical bills or college education. A home equity loan creates a lien against the borrowers house, and reduces actual home equity.
    •  Mutual fund  A mutual fund is a type of professionally managed collective investment vehicle that pools money from many investors to purchase securities.  While there is no legal definition of the term "mutual fund", it is most commonly applied only to those collective investment vehicles that are regulated and sold to the general public.  They are sometimes referred to as "investment companies" or "registered investment companies." Most mutual funds are "open-ended," meaning investors can buy or sell shares of the fund at any time. Hedge funds are not considered a type of mutual fund. Personal loan  In finance, unsecured debt refers to any type of debt or general obligation that is not collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment.  In the event of the bankruptcy of the borrower, the unsecured creditors will have a general claim on the assets of the borrower after the specific pledged assets have been assigned to the secured creditors, although the unsecured creditors will usually realize a smaller proportion of their claims than the secured creditors. Time deposits  A time deposit is a money deposit at a banking institution that cannot be withdrawn for a certain "term" or period of time (unless a penalty is paid).  When the term is over it can be withdrawn or it can be held for another term. Generally speaking, the longer the term the
    • better the yield on the money. In its strict sense, certificate deposit is different from that of time deposit in terms of its negotiability. CDs are negotiable and can be rediscounted when the holder needs some liquidity, while time deposits must be kept until maturity.  The opposite, sometimes known as a sight deposit or "on call" deposit, can be withdrawn at any time, without any notice or penalty: e.g., money deposited in a checking account or savings account in a bank. ATM card  An ATM card (also known as a bank card, client card, key card, or cash card) is a card issued by a financial institution, such as a bank, credit union, or building society, that can be used in an automated teller machine (ATM) for transactions such as: deposits, withdrawals, obtaining account information, and other types of transactions, often through interbank networks.  It can also be used on improvised ATMs, such as merchants card terminals that deliver ATM features without any cash drawer (commonly referred to as mini ATMs). These terminals can also be used as Cashless scrip ATMs by cashing the fund transfer receipt at the merchants Cashier. Current Accounts  A current account is the form of transactional account found in the United Kingdom and other countries with a UK banking heritage; a current account offers various flexible payment methods to allow customers to distribute money directly to others.  Most current accounts come with a cheque book and offer the facility to arrange standing orders, direct debits and
    • payment via a debit card. Current accounts may also allow borrowing via an overdraft facility. Business (or commercial/investment) banking  Business loan  In finance, a loan is a debt evidenced by a note which specifies, among other things, the principal amount, interest rate, and date of repayment. A loan entails the reallocation of the subject asset(s) for a period of time, between the lender and the borrower.  In a loan, the borrower initially receives or borrows an amount of money, called the principal, from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount.  The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants.  Acting as a provider of loans is one of the principal tasks for financial institutions. For other institutions, issuing of debt contracts such as bonds is a typical source of funding.  Capital raising (Equity / Debt / Hybrids)  The Stock Exchange provide companies with the facility to raise capital for expansion through selling shares to the investing public.
    •  Mezzanine finance  Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a companys assets which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.  Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of it being an unsecured, subordinated (or junior) obligation in a companys capital structure (i.e., in the event of default, the mezzanine financing is only repaid after all senior obligations have been satisfied).  Additionally, mezzanine financings, which are usually private placements, are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield market; as such, they involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or more senior lenders. Project finance  Project finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of its sponsors.  Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks or other lending institutions that provide loans to the operation.
    •  They are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling.  The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets and are able to assume of a project if the project company has difficulties complying with the loan terms. Revolving credit  Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit.  Credit cards are an example of revolving credit used by consumers.  Corporate revolving credit facilities are typically used to provide liquidity for a companys day-to-day operations. They were first introduced by the Strawbridge and Clothier Department Store. o Typical characteristic  Case study is required  The borrower may use or withdraw funds up to a pre-approved credit limit.  The amount of available credit decreases and increases as funds are borrowed and then repaid.  The credit may be used repeatedly.  The borrower makes payments based only on the amount theyve actually used or withdrawn, plus interest.
    •  The borrower may repay over time (subject to any minimum payment requirement), or in full at any time.  In some cases, the borrower is required to pay a fee to the lender for any money that is undrawn on the revolver; this is especially true of corporate bank loan revolving credit facilities. Risk management (FX, interest rates, commodities, derivatives)  Risk management is the identification, assessment, and prioritization of risks (defined in ISO 31000 as the effect of uncertainty on objectives, whether positive or negative) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.  Risks can come from uncertainty in financial markets, project failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of uncertain or unpredictable root-cause.  Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards.  Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial
    • processes, financial portfolios, actuarial assessments, or public health and safety.  The strategies to manage risk typically include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the potential or actual consequences of a particular risk.  Certain aspects of many of the risk management standards have come under criticism for having no measurable improvement on risk, whether the confidence in estimates and decisions seem to increase. Term loan  A term loan is a monetary loan that is repaid in regular payments over a set period of time. Term loans usually last between one and ten years, but may last as long as 30 years in some cases. A term loan usually involves an unfixed interest rate that will add additional balance to be repaid.  Term loans can be given on an individual basis but are often used for small business loans. The ability to repay over a long period of time is attractive for new or expanding enterprises, as the assumption is that they will increase their profit over time.  Term loans are a good way of quickly increasing capital in order to raise a business’ supply capabilities or range. For instance, some new companies may use a term loan to buy company vehicles or rent more space for their operations. Cash Management Services (Lock box, Remote Deposit Capture, Merchant Processing)
    • Risk and capital Banks face a number of risks in order to conduct their business, and how wellthese risks are managed and understood is a key driver behind profitability, and howmuch capital a bank is required to hold. Some of the main risks faced by banks include: Credit risk: risk of lossarising from a borrower who does not make payments as promised. Liquidity risk: risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). Market risk: risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. Operational risk: risk arising from execution of a companys business functions. Macroeconomic risk: risks related to the aggregate economy the bank is operating in. The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted (see risk-weighted asset).Types of Banks Banks activities can be divided into retail banking, dealing directly withindividuals and small businesses; business banking, providing services to mid-marketbusiness; corporate banking, directed at large business entities; private banking,providing wealth management services to high net worth individuals and families; andinvestment banking, relating to activities on the financial markets. Most banks areprofit-making, private enterprises. However, some are owned by government, or arenon-profit organizations.
    • Types of retail banks Commercial bank: the term used for a normal bank to distinguish it from an investment bank. After the Great Depression, the U.S. Congress required that banks only engage in banking activities, whereas investment banks were limited to capital market activities. Since the two no longer have to be under separate ownership, some use the term "commercial bank" to refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses. Community banks: locally operated financial institutions that empower employees to make local decisions to serve their customers and the partners. Community development banks: regulated banks that provide financial services and credit to under-served markets or populations. Credit unions: not-for-profit cooperatives owned by the depositors and often offering rates more favorable than for-profit banks. Typically, membership is restricted to employees of a particular company, residents of a defined neighborhood, members of a certain labor union or religious organizations, and their immediate families. Postal savings banks: savings banks associated with national postal systems. Private banks: banks that manage the assets of high net worth individuals. Historically a minimum of USD 1 million was required to open an account, however, over the last years many private banks have lowered their entry hurdles to USD 250,000 for private investors. Offshore banks: banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks.
    • Savings bank: in Europe, savings banks took their roots in the 19th or sometimes even in the 18th century. Their original objective was to provide easily accessible savings products to all strata of the population. In some countries, savings banks were created on public initiative; in others, socially committed individuals created foundations to put in place the necessary infrastructure. Nowadays, European savings banks have kept their focus on retail banking: payments, savings products, credits and insurances for individuals or small and medium-sized enterprises. Apart from this retail focus, they also differ from commercial banks by their broadly decentralized distribution network, providing local and regional outreach—and by their socially responsible approach to business and society. Building societies and Landesbanks: institutions that conduct retail banking. Ethical banks: banks that prioritize the transparency of all operations and make only what they consider to be socially-responsible investments. A Direct or Internet-Only bank is a banking operation without any physical bank branches, conceived and implemented wholly with networked computers.Types of investment banks Investment banks "underwrite" (guarantee the sale of) stock and bondissues, trade for their own accounts, make markets, provide investmentmanagement, and advise corporations on capital market activities such asmergers and acquisitions. Merchant banks were traditionally banks which engaged in trade finance. The modern definition, however, refers to banks which
    • provide capital to firms in the form of shares rather than loans. Unlike venture capital firms, they tend not to invest in new companies.Both combined Universal banks, more commonly known as financial services companies,engage in several of these activities. These big banks are very diversified groups that,among other services, also distribute insurance— hence the term bancassurance, aportmanteau word combining "banque or bank" and "assurance", signifying that bothbanking and insurance are provided by the same corporate entity.Other types of banks Central banks are normally government-owned and charged with quasi- regulatory responsibilities, such as supervising commercial banks, or controlling the cash interest rate. They generally provide liquidity to the banking system and act as the lender of last resort in event of a crisis. Islamic banks adhere to the concepts of Islamic law. This form of banking revolves around several well-established principles based on Islamic canons. All banking activities must avoid interest, a concept that is forbidden in Islam. Instead, the bank earns profit (markup) and fees on the financing facilities that it extends to customers.Banks in the EconomyEconomic functionsThe economic functions of banks include: 1. Issue of money, in the form of banknotes and current accounts subject to check or payment at the customers order. These claims on banks can act as
    • money because they are negotiable or repayable on demand, and hence valued at par. They are effectively transferable by mere delivery, in the case of banknotes, or by drawing a check that the payee may bank or cash.2. Netting and settlement of payments – banks act as both collection and paying agents for customers, participating in interbank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. This enables banks to economize on reserves held for settlement of payments, since inward and outward payments offset each other. It also enables the offsetting of payment flows between geographical areas, reducing the cost of settlement between them.3. Credit intermediation – banks borrow and lend back-to-back on their own account as middle men.4. Credit quality improvement – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the banks assets and capital which provides a buffer to absorb losses without defaulting on its obligations. However, banknotes and deposits are generally unsecured; if the bank gets into difficulty and pledges assets as security, to raise the funding it needs to continue to operate, this puts the note holders and depositors in an economically subordinated position.5. Asset liability mismatch/Maturity transformation – banks borrow more on demand debt and short term debt, but provide more long term loans. In other
    • words, they borrow short and lend long. With a stronger credit quality than most other borrowers, banks can do this by aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions (e.g. withdrawals and redemption of banknotes), maintaining reserves of cash, investing in marketable securities that can be readily converted to cash if needed, and raising replacement funding as needed from various sources (e.g. wholesale cash markets and securities markets).6. Money creation – whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of virtual money is created.