4. Banking
• Abank is said to be a financial intermediary.
• It stands mid way between the savers and the
users of fund.
• There are different types of bank having some
common and some special functions.
• Banks may be of various types such Central
Bank, commercial banks, development banks,
Cooperative banks, rural banks etc.
• The Central Bank, the commercial banks and
the development banks are of primary
importance.
6. Commercial Banks
• Acommercial bank is a financial intermediary.
• Its central objective is commercial that is, profit making.
• It takes money from a surplus unit by paying a low rate of
interest and lends the same fund to a Deficit unit at a
higher rate of interest and thus makes profit.
• It is said to be a dealer in credit.
• It may be organized privately or by the Government.
• The two primary functions of such a bank are Deposit
function and Loan function.
• Deposits may be of three types: Demand or current, Savings
and Fixed or Time deposit.
8. Commercial Banks
• The funds thus obtained from various classes of people are
pooled together and lend to users of capital.
• Banks do not lend the entire sum of deposit. But a portion is
kept in the form of cash. This is called Cash Reserve Ratio(CRR)
in order to meet the unforeseen demand of some depositors.
• In its loans and advances, banks maintain a diversified portfolio
in order to seek a balance between liquidity and profitability.
• Banks perform some other functions that enhance their yield.
They keep valuables in their custody, collect chequable amounts,
the purchase and sell of shares, debenture, they act as agents of
their customers. Besides they act as trustee and executors of wills,
pay bills of customers.
10. Functions Of A Commercial Bank
• Modern commercial banks perform a
variety of functions and provide a number
of services to their customers.
• They are regarded as departmental-store
banks because they provide a wide variety of
services To their customers.
12. Various functions performed by commercial
banks are as follows
• 1. Acceptance of deposits —People who have
surplus funds with them would like to deposit
these with commercial banks. Banks accept mainly
three types of deposits:
14. Various functions performed by
commercial banks are as follows
• 2. Advancing of Loans — The second primary
function of the commercial banks is to extend
loans and advances. Lending is the most profitable
business of a bank. Banks charge interest from the
borrowers which are more than the interest they pay
to their depositors. Banks these days extend loans and
Advances to their customers in the following ways:
18. Various Functions Performed By Commercial
Banks
3. Facilitation of payments through cheques — Banks have
provided a very convenient system of Payment in the form
of cheques. The cheque is the principal method of payment in
business in recent times. It is convenient, cheap and safe
means of making payments.
4. Transfer of funds — Banks help in the remittance or
transfer of funds from one place to another through The
use of various credit instruments like cheques, drafts, mail
transfers and telegraphic transfers.
5. Agency Functions — Banks provide various agency
functions for their customers. The banks charge
Commission or service charge for such functions. The main
agency functions are:
20. Various Functions Performed By Commercial
Banks
• (i) The commercial banks collect cheques, drafts,
bills of exchange, hundies and other financial
Instruments for their customers.
• (ii) They make and collect various types of
payments on behalf of their customers, such as
insurance premia, pensions, dividends, Interest, etc.
• (iii) The commercial banks act as agents for the
customers in the sale and purchase of securities.
21. Various Functions Performed By
Commercial Banks
• They provide investment services to the companies by
acting as underwriters and bankers for new Issues of
securities to the public.
• (iv) They render agency services of various types,
such as obtaining foreign currency for customers
And sale of foreign exchange on their behalf, sale of
national savings certificates and units of U.T.I.
• (v) The commercial banks act as trustees and
executors. For instance, they keep the wills of their
Customers and execute them after their death.
22. Various Functions Performed By Commercial
Banks
• Miscellaneous Services – Commercial banks provide various
miscellaneous services, such as provision of locker facilities for
safe custody of jewellery and other valuables, issue of travellers
cheques, gift cheques, provision of tax assistance and investment
advice, etc.
• 7. Credit Creation — A very important and unique function of
the commercial banks is that they have the power of credit
creation. In the process of acceptance of deposit and granting of
loans, commercial banks are able to create credit. This means that
they are able to grant more loans than the amount of initial or
primary deposits made by the customers. This function is discussed
below in detail.
• In short, commercial banks perform a large variety of functions in
the modern economics.
23. 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.
• fixed by the Central Bank as a tool in
monetary policy in influencing the volume of
credit
24. Statutory Liquidity Ratio (SLR)
• Refers minimum 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).
• Fixed central bank of a country in order to
control the expansion of bank credit.
25. Legal Reserve Ratio (LRR)
• 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.
30. Essentials of a Sound Banking
System
• A sound banking system promotes all round economic development
of an economy.Agood bank Must have the following features:—
• (a) Adequate Liquidity — A bank must keep sufficient cash in
hand to meet the claim of depositors, Otherwise they would be
insolvent. A bank failure not only affects depositors but banks also.
People Would not more keep funds with bankers. It ensures safety
of a bank. Unless a bank is safe it cannot Render its social services.
• (b) Expansion of banking — Banking facilities should spread
throughout the economy. It must also cover all sections of people
in need of funds and all productive activities. The less-developed
Regions should get more banking facilities than others. Thus,
diffusion of banking offices is essential.
32. Central Bank
• Central Bank may be defined as an
institution charged with the responsibility of
managing the expansion and contraction of
the volume of money supply for general
Economic Welfare.
• The Central Bank is the Apex institution in
the banking and financial structure of the
country.
34. Functions of Central Bank
• Central Bank plays a leading role in organizing,
running, supervising, regulating and developing
the banking and financial structure of the country.
35. Functions of Central Bank
(i) Monopoly of Note Issue :
The Central Bank enjoys the exclusive power of note issue. In India
the RBI issues all notes except Re 1 notes and coins. Re 1 notes are
issued by the Government of India under the guidance of RBI. The
currency notes issued by the Central Bank are declared unlimited
legal tender throughout The country. The Central Bank has to keep
reserve of Gold, Silver and foreign securities for issuing notes.
(ii) Banker,Agent,Advisor To The Government :
The Banking A/c of the government both central and state are
maintained by the Central Bank as the commercial bank does for its
customers. As a banker and to the government it helps the government in
short term loans and advances for temporary requirements and floats
public loans For the government.
38. Functions of Central Bank
(iii) Banker’s Bank :
• All commercial banks keep part of their cash balances as
deposits with the Central Bank of the country. This is either
because of convention or legal compulsion. The commercial banks
regularly Draw currency during the busy season and paying in
surplus during the slack season. Part of these balances are meant for
clearing purposes i.e.; all commercial banks keep deposit account
with the Central Bank. The deposit balances of the Central Bank
is considered as cash reserves for General purpose.
• Under the Banking Regulations Act of 1949, the Central Bank
of India have been empowered with the right to supervise and
control the activities of various scheduled commercial banks.
These powers are related to licensing, branch expansion, liquidity of
assets and methods of working of The Bank.
40. Functions of Central Bank
(iv) Clearing House Facility :
• By virtue of its unique position in dealing with domestic and
foreign funds the Central Bank has a Special position for
conducting:
• (a) Clearing house operation
• (b) Interbank transfer of funds
• (c) Settlement of accounts.
• Clearing house facility means providing an opportunity to member
commercial banks to settle Their claims on each other mutually E.g.:
Indian Bank has to pay to SBI a sum of` 2 lakh and SBI has to pay
to Indian bank`1,50,000.This can be settled with a check of `50,000
by Indian Bank On the RBI in-favour of SBI. As a result Indian
Banks accounts will be debited and SBI’s account will be credited.
42. Functions of Central Bank
(v) Custodian of Foreign Exchange Reserves :
• Under this system the RBI controls both receipts and
payments of foreign exchange. A country Have In its
foreign trade favourable or unfavourable balance.
• Favourable balance helps to bring foreign exchange to the
country while unfavourable balance means paying foreign
exchange out. As custodian of Foreign Exchange, Central
Bank keeps a constant watch on the same so that the value of
the home currency does not rise or fall adversely In relation to
foreign currency.
• During times of emergency the Central Bank may impose
restrictions to control on buying or selling Of foreign
currencies in the market.
44. Functions of Central Bank
• (vii) 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
46. Credit Control
(vii) Credit Control
• In order to ensure price stability and Economic
growth of a country, the Central Bank
undertakes The responsibility of controlling
credit.
• The Central Bank ensures price stability and
avoids inflationary And deflationary tendencies
by several monetary methods such as regulation
of Bank rate, open Market operation, change
invariable reservation, etc.
47. Credit Control by Central Bank
• Credit money created by commercial banks and other non-banking financial
institutions constitutes A significant portion of total money supply In an
economy.
• Their shortages and excesses may have profound impact upon an economy.
• The flow of credit should be regulated in such a way that they may raise or fall
according to the Needs of an economy. This is what we generally means by credit
control.
• This is done by the central bank in its role of a banker’s bank.
• The objective of credit control is generally two fold.
• A central bank may encourage member banks to expand credit, known as
expansionary monetary policy, which is adopted to lift an economy out of
depression and unemployment.
• It may restrict credit-creating power of banks and non-banks which is known
as restrictive policy to fight inflation and to achieve financial stability In the
context of growth with stability a central bank is to deal with both aspects-
increasing credit Flow for more investment and, at the same time, restrict flow of
credit so that it may not generate inflation.
49. Credit Control
• Central bank of a country can control credit by following
two methods such as
• Quantitative Credit Control
• Qualitative Credit Control.
• Quantitative /General Credit Controls:
regulate (expand or contract) the total quantity of credit
(vis-à-vis derivative demand deposits ) created by
commercial banks in an economy.
• Qualitative /Selective Credit Controls:
do not regulate the total amount of credit created by
commercial banks but certain particular (selective) credit
which creates economic instability.
50. Quantitative /Genera Credit Controls
• 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 lending rates by bank on
loans and advances also move up, borrowing from
banks becomes expensive and is discouraged and,
monetary expansion decreases During deflationary
tendencies, bank rate may be decreased.
52. 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, central bank sells
securities to the public and banks 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).
54. 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).
• during rising prices or inflationary tendencies If
CRR is raised, the lending power of commercial
banks will contract accordingly.
• This will cause fall in money expansion in the
economy A decrease in ratio has an opposite
effect and may be followed during deflationary
tendencies.
56. 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 decrease in SLR causes a rise in the
rate of credit expansion.
58. 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.
• 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 sell government securities to RBI with a buy
back option.
60. Repo and Reverse Repo by RBI
• When RBI conduct a Reverse Repo,
Commercial Banks buys approved securities
from RBI with a to resale agreement at future
date and specified price.
• 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.
61. Qualitative /Selective Credit Controls
• 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.
62. Qualitative /Selective Credit Controls
• 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.
63. Qualitative /Selective Credit Controls
• 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.
• 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.
65. Qualitative /Selective Credit Controls
• Publicity: the Central Bank gives wide publicity to its
credit policy through its bulletins.
• educates the general public regarding the monetary policy and
its objectives.
• The commercial banks are guided as well.
• Direct Action: The Central Bank uses direct action 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.
68. 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)
70. Stabilization Policies
• Economic policies undertaken by governments to
counteract business-cycle fluctuations and prevent
high rates of unemployment and inflation. The two
most common stabilization policies are fiscal and
monetary.
• Stabilization policies are also termed countercyclical
policies, meaning that they attempt to "counter" the
natural ups and downs of business "cycles."
Expansionary policies are appropriate to reduce
unemployment during a contraction and contractionary
policies are aimed at reducing inflation during an
expansion.
71. Stabilization Policies
• Stabilization policies are government actions,
especially fiscal policy and monetary policy,
designed to fix the unemployment and inflation
problems created by business-cycle instability.
During periods of high or rising unemployment
associated with a business-cycle contraction, the
appropriate action is to stimulate the economy through
expansionary policies.
• During periods of high or rising inflation associated
with a business-cycle expansion, the appropriate
action is to dampen the economy through
contractionary policies.
73. Fiscal and Monetary Policies
• The two most frequently used stabilization policies are fiscal
policy and monetary policy.
• Fiscal Policy: This policy makes use of government
spending and/or taxes, the two components of the
government's "fiscal" budget. When government increases
or decreases spending, especially by changing the quantity
of gross domestic product purchased, then aggregate
production, employment, and national income are also
affected. Government can change the amount of taxes
collected from the public, as well, which then affects the
amount of income available to purchase gross domestic
production, employment, and national
product. This also triggers changes in aggregate
income.
75. Fiscal and Monetary Policies
• Monetary Policy: This policy involves the total
amount of money in circulation throughout the
economy, as well as interest rates in financial
markets. By changing the amount of money in
circulation, the public has more or less of an
ability to purchase gross domestic product, which
then triggers changes in overall economic activity.
Money supply changes also invariably cause
changes in interest rates, which subsequently
affect the willingness and ability to borrow the
funds used for expenditures.
77. Expansionary and Contractionary
Policies
• Stabilization policies can be either
expansionary or contractionary, depending on
whether the most pressing problem is excessive
unemployment or excessive inflation.
Expansionary Policy: This policy is designed to
stimulate the economy and to reduce
unemployment by countering or preventing a
business-cycle contraction. Expansionary fiscal
policy is an increase in government spending
and/or a decrease in taxes. Expansionary
monetary policy is an increase in the money
supply and/or a decrease in the interest rate.
79. Expansionary and Contractionary
Policies
• Contractionary Policy: This policy is designed to
dampen the economy and to reduce inflation by
countering or preventing the inflationary excesses of
a business-cycle expansion. Contractionary fiscal
policy is a decrease in government spending
and/or an increase in taxes. Contractionary
monetary policy is a decrease in the money supply
and/or an increase in the interest rate.
80. A Graphical Illustration
• This graph illustrates the goal of stabilization policies. The
red line is the "natural" business cycle. Rising and falling
around the blue long-run trend line. But it rises and falls
too much, causing inflation and unemployment.
• Stabilization policies can achieve this result by countering
business cycle ups and downs. When unemployment rises
with a business-cycle contraction, expansionary policies are
appropriate. When inflation worsens with a business-cycle
expansion, contractionary policies are appropriate. Once
countercyclical. Contractionary policies counter
and expansionary policies counter
again, note that stabilization policies are a
an
a
expansion
contraction
82. Impossible Trinity
• The Impossible Trinity is a simple rule with
deep implications. It was first uncovered by
Nobel Prize-winning economist Robert
Mundell in the early 1960s.
• The rule is that a country cannot have an
independent monetary policy, an open capital
account and a fixed exchange rate at the
same time.
84. Impossible Trinity
It is not possible for a country to maintain all three
of the following:
1) free capital flows
2) a fixed exchange rate
3) independent monetary authority
86. Impossible Trinity
• You can have any two of those three
conditions. You can even have only one or
none if you like. But you can’t have all three at
the same time.
• Understanding and using the Impossible
Trinity works wonders if you can spot the
right conditions and set up your trades in
advance of the inevitable policy failures of the
central banks.
87. Independent Monetary Policy
• The first part of the Impossible Trinity is an
independent monetary policy.
• This simply means that your central bank
can set rates where they want without
regard for what other central banks are
doing. If you want to ease to help your
economy, and another central bank wants to
tighten to prevent inflation, that’s fine. Each
central bank does its own thing.
88. Independent Monetary Policy
• Control over interest rates
• Adjusted to suit the specific needs of the
economy
• If the economy is in a recession or a slow
down, interest rates can be lowered to give
the economy a boost.
• If the economy is overheating or in a bubble
with too high inflation, interest rates can be
raised
89. Open Capital Account
Free Capital Movement
• The second part of the Impossible Trinity is
the open capital account.
• This refers to the ability of investors to get
their money in and out of a country quickly
and easily.
90. Open Capital Account
Free Capital Movement
• Freedom to move money to other countries
and invest easily
• Governments want to make easy for
companies to invest in their country, setting
up factories and employing people
• Making global movement as easy as
possible, money can move to the places
where it is needed the most and can make the
best return
92. Fixed Exchange Rate.
• The third part of the Impossible Trinity is a
fixed exchange rate.
• This simply means that the value of your
currency in relation to some other currency is
pegged at a fixed rate.
93. Fixed Exchange Rate
• A currency’s value is fixed against the value of
another single currency
• Used to stabilize the value of a currency against
the currency it is pegged to Makes trade and
investments between the two currency areas
easier and more predictable
• Reduces volatility and fluctuations in relative
prices
• Eliminates exchange rate risk by reducing the
associated uncertainty
• Useful for small economies
95. Impossible Trinity
• The diagram below represents the
Impossible Trinity. In this schematic, the
open capital account is labelled “A”, the fixed
exchange rate is labelled “B,” and the
independent monetary policy is labelled “C.”
• The theory of the Impossible Trinity is that
it is impossible for a country to achieve
A+B+C at the same time. Any country that
attempts this is doomed to fail:
97. Impossible Trinity
• The Impossible Trinity is a tool to separate
countries with good policies from those with
bad policies. It is also a tool used to make
accurate forecasts based on the sustainability
of those policies.
98. Impossible Trinity (examples)
1)U.S. allows free flow of capital & maintains
monetary authority but does not have a fixed
exchange rate
2)Hong Kong has a fixed exchange rate &
allows free flow of capital but does not have
independent monetary authority
3)In the past, China had a fixed and
maintained monetary authority but did not
allow the free flow of capital
100. References
• Engineering EconomicAnalysis –NPTEL
http://nptel.ac.in/courses/112107209/
• Engineering Economics
http://www.inzeko.ktu.lt/index.php/EE
• Fundamentals of Economics and Management
Institutes of Cost Accountants of India www.icmai.in
• Modern Economics : Dr. H. L.Ahuja
• Principles for Macro-economics- C Rangarajan
