Al 13 - chapter 7

Economics
Chapter-7
Grade 13
Lecturer – S. M. Irshad
BA in Social Sciences (OUSL)
MA in Economics (KU) India, in progress
Diploma in Governance, Democratization &
Public Policy (CISS).
E-mail – irshad.sahabdeen@yahoo.com
1

7. Student analyses the contribution of
monetary and banking system to the
economic process.
• 7.1 Investigates the concept of money, types of money and
functions of money.
• 7.2 Presents the factors determining the demand for
money.
• 7.3 Analytically examines the supply of money in Sri
Lanka.
• 7.4 Classifies the financial system of Sri Lanka.
• 7.5 Investigates the functions of commercial banks in the
banking system.
• 7.6 Investigates the role of the Central Bank as the apex
financial institution in Sri Lanka.
2

What is Money?
• Anything which is widely accepted in exchange for goods,
or in settling debts, can be passed on , has the character of
money as means of payments.
• As a means of payment money is an entity which is
transferred when a payment is made, as such it acts as a
medium of exchange.
“Money is a good servant ‘but a
bad master” .– English proverb -
3

Origins of Money
• The word money derives from Latin Moneta, the 1st roman
coinage was minted at the temple of Juno Moneta in 334bc.
Before the coinage, various objects such as cattle, pigs,
teeth and cowries shells had been used as money.
• For most of its history money has taken the form of coins
made of precious metals. The money thus, had intrinsic
value. many of the units of modern money recall their
origin in amounts of precious metal; e.g. – sterling pound ₤
= Roman Pound (12 Ounces of Silver), this symbol stands
for L = Libra- a pound in Latin.
4

Characteristics of Money
• Acceptability – the most important attribute of money is
that its readily acceptable and it’s the convenient type of
medium to buy or exchange.
• Durability – money should not wear quickly, its hard
wearing, can be kept in many forms such as paper money
and coins. The chief form of money in a modern society,
which is bank deposits, suffers no physical depreciation
whatsoever.
• Divisibility – this is another thing that camels, pigs and
teeth, cannot be divided into smaller units, but in the
modern world money can be divided.
5

• Portability – commodity money even coins suffer from
disadvantage that may be difficult to transport. A bank
deposit is a very convenient one because its in electronic
from.
• Stability of value – money should retain its value. This was
little possible in past but in the modern world money was
affected by inflation, which cannot maintain its value
continuously.
• Difficult to forge – once a society uses money which has
only exchange value and not intrinsic value, it is essential
that the possibilities for fraud and counterfeit be kept to a
minimum.
6

Types of Money
• Currency Type - the bank notes, paper money and coins
issued by the monetary authorities that from part of any
economy’s money supply. The term currency is often used
interchangeably with the term cash in economic analysis
and monetary policy.
• Bank Money – it means bank deposits which are used as
money. In other way the deposits in an account where
they are subject to withdrawal by cheque.
• Near Money/Quasi Money – it means anything that can
be readily turned into money at a known value
predominantly savings accounts, bonds, bills of exchange,
highly liquid assets etc.
7

• Money Substitutes – it means the things that serve as
temporary media of exchange but are not stores of value.
Credit cards are good examples. with a credit cards,
money transactions can be made without either cash or
cheuqe. But the evidence of credit, in terms of the credit
slip you sign, is not money because it cannot be used to
effect further transactions.
• Electronic Money – it’s a plastic card or software
product on which physical money is stored electronically
to be used in transactions and as it is used for transaction
its value gradually falls. It consists of e-sign or digi cash –
withdrawals from ATM, e-purse – ATM Card.
8

Functions of Money
• Medium of Exchange – money facilitate the goods and
services in the economy. Workers accept money for their
wages because they know that money can be exchanged
for their needs.
• If there is no money, then people exchange by barter
system. Here we exchange commodity for commodity. If
you have chicken but you need shoes then you must
exchange your chicken someone who has shoes. Then
only you fulfill your needs.
• For classical economists This is known as double
coincidence of wants.
9

• Unit of Account – as a unit of account, money is the basic
unit for measuring economic value. In Sri Lanka, for
example, virtually all prices, wages, asset values, and debts
are expressed in rupees. Having a single uniform measure of
value is convenient.
• For example, pricing all goods in Sri Lankan rupees , instead
of some good being priced in other currencies, some in yen,
gold, some in general motors shares simplifies composition
among different goods.
• The medium of exchange and unit of account functions of
money are closely inked. because goods and services are
most often exchanged for money and expressing economic
values in money terms is natural.
10

• Store of Value - as a store of value money is a way of
holding wealth. An example a beggar keeps his life's savings
in cash under the mattress. in the next minute he spends
money after receiving. He is using money as a store of value
for that short time.
• In most cases money functions as a medium of exchange or
unit of account, but any asset, eg – stocks, bonds, real estate
can be a store of value.
• Why do people use money as a store of value? Because
moneys usefulness as a medium of exchange makes it
worthwhile to hold, even though its return is relatively low.
11

• Standard of Differed Payments – this is always linked
with future. Eg –shipments and agreements, contracts
which usually receives the payments in the future years.
So money can be used over time for deferent payments.
12

Value of Money
• Intrinsic Value – this means the value of the material
content of money itself. For example, when gold coins
were used in the past they had an intrinsic value
equivalent to the face value of the coin.
13

• Extrinsic Value – the extrinsic value means the face value
of money. Nowadays the extrinsic value of money is much
higher than the intrinsic value.
• For example, a Rs. 2000 note is worth more than the piece
of paper use to print that note.
• We call this kind of money as token money. people accept
token money despite its low intrinsic value because the
government has made it legal tender.
14

Demand for Money
• Why do people hold money? When a person holds the
wealth in the form of money he cant earn money,
however the reason for keeping wealth in the form of
money is liquidity. Higher the demand for good and
services , higher will be the demand for money.
• John Maynard Keynes distinguished 3 different
reasons for people to hold money. These were:
 Transactions Demand - MDT
 Precautionary Demand - MDP
 Speculative Demand - MDS
15

Transactions Demand
• The amount of money that people want to keep
for their day to day transaction is called
transaction demand for money. Households and
firms hold a certain amount of money, because of
its usefulness as a generally accepted medium of
exchange. since money is a medium of exchange,
it is required for everyday transactions.
• There is a problem between receipts of money
and payment of money, for consumption people
demand for money. Consumption occurs
continuously in all times, the MDT relates to the
fact that our receipt of money income does not
match our expenditure.
16

Demand for money transaction motive
shows a positive relationship.
17

Precautionary Demand
• This is the amount of money people want
to hold to meet their unforeseen or
unplanned emergencies relating to time
interval of receipts of income and
payments.
• In other words MDP, arises because
individuals and firms are uncertain about
the degree to which payments and
receipts will be occur.
• E.g. sickness, accidents, loss of
employment.
18

Demand for money precautionary
motive shows a positive relationship.
19

Speculative Demand
• Some people wants to hold money in order to
buy financial assets such as shares, bonds to
earn money as income , interests. major
determinant for this demand is the interests
rate. Interest rate is cost of holding money.
When wealth is kept in the form of money
rather than other assets, people will lose the
interest rates as earning.
• So higher the rate of interest, the lower will be
the demand fro money and lower the interest
rate , greater will be the demand for money. This
shows a inverse/negative relationship between
interest rate & demand for money. 20

Demand for money speculative motive
shows a inverse (negative or positive)
relationship.
21

The Money Supply
• This means the total stock of money issued by a monetary
authority, and supplied to the general public. Money
supply can be classified in to different components based
on its function and degree of liquidity. Liquidity means
the degree of ease by which a financial asset can be
converted into a form readily accepted as payment for
goods and services. The most liquid form of money is
cash/currency.
• The central bank estimates the aggregates of different
stock of money. These are based on different concepts of
money supply. These are called monetary aggregates.
22

• The central bank of Sri Lanka has changed the definition of
money supply from time to time taking into account the
changes in the financial sector of the of the country and
changing financial instruments.
• The central bank of Sri lanka is the provider for the
monetary aggregates for the economy. these were;
I. Base money / High powered money
/Reserve money supply
II. Narrow money supply.
III. Broad money supply.
23

Monetary Aggregates
1. M1 = Narrow Money
Supply
2. M2 = Broad Money Supply
3. M2b = Consolidated Broad
Money supply
4. M4 =Very Broad Money
Supply
24

Narrow Money Supply – M1
• Narrow money supply consists of currency held by public
and demand deposits held by public with commercial
bank at a given period of time.
NMS = Notes and coins with the
public + Deposits of public with
commercial banks.
M1= C + D D
26

Broad Money Supply – M2
• BMS consists of notes and coins (currency) held by public,
demand deposits held by public, and time and saving
deposits held by public with domestic banking units of
commercial banks.
BMS = M1+ Time and savings deposits of
the public with commercial banks.
M2 = M1 +TSD
• Therefore M2 is the sum of M1 and quasi money.
M2 = M1+ Quasi Money.
29

Consolidated Broad Money Supply –
M2b
• According to CBSL, M2b consists of currency held by public,
demand deposits held by public and time and saving
deposits held by public in domestic saving units(DBUs) and
offshore banking units (OBUs) of commercial banks.
CBMS = M1 + time saving deposits held by
public with DBUs and OBUs of
commercial banks.
M2b = M1 + time and savings deposits of
OBUs of commercial banks in foreign
currency
30

Very (Extremely) Broad Money Supply
– M4
based on financial survey.
• This financial survey incorporates the operations of
licensed specialized banks and finance companies (RFCs)
in addition to licensed commercial banks to the
consolidated broad money supply.
M4 = M2b + Time and Savings Deposits of
the public with Licensed Specialized
Banks + Deposits of Residents with
Registered Financial Institutions.
M4 = M2b + RDLSB +RDFC
31

Base or Reserve Money
• The monetary base (also base money, money
base, high-powered money, reserve money, or
narrow money) in a country is defined as the
portion of the commercial banks' reserves that are
maintained in accounts with their central
bank plus the total currency circulating in the
public (which includes the currency, also known
as vault cash, that is physically held in the banks'
vault).
• Base money can be analyzed in two ways.
• Using Central Bank liabilities.
• Using Central Bank Assets
32

Determinants of Base Money
Supply
1. Net lending to the government by
the Central Bank.
2. Net foreign assets of the Central
Bank.
3. Other net assets of the central
bank.
4. Lending to commercial banks by
the Central Bank.
33

Base Money (Reserve) Components
• Components of high powered money are as follows.
i. Currency outstanding:
• Currency held by public (CP).
• Currency with commercial banks
(CKB).
ii. Commercial banks deposits with
the central bank(SR/RR).
iii. Government agencies deposits
with central bank (DOI).
34

Net Foreign Assets
(based on M2b)
• They are the external assets (net) of central bank and
commercial bank (including outward bills) so they include,
1. External/ foreign assets of the
monetary authority – CBSL
2. External/ foreign assets of the
commercial banks ( external assets in
DBUs & OBUs).
• Net foreign assets based on financial survey – M4, will
include external assets of licensed specialized banks –
LSBs & registered finance companies – RFCs in addition to
the above 2.
36

Net Domestic Assets
(based on M2b)
• The net domestic assets of the central bank (based on M2b)
consists;
1. The net credit extended by the banking
system (CBSL and Commercial Banks)
to the government.
2. Credit to the public corporation by
banks particularly commercial banks
3. Credit to the private sector by banks.
37

Money Multiplier
• Money multiplier is the ratio between money supply and
high powered money. Therefore multiplication of high
powered money and money multiplier is the money
supply. The relationship of money supply, high powered
money, and money multiplier can be
• shown by the following equations;
38
MoneyBase
SupplyMoney
MM
H
M
K



• Money multiplier is always a value greater than one.
• Factors that influence the money multiplier can be
identified using the formula below.
39
REC
C
K
Ratio
Multiplier
Money



1
•According to the above
formula the factors that
influence money multiplier
can be shown as
• Legal tender (c)
• Excess reserve ratio (E)
• Statutory reserve ratio (R)

• Commercial banks carry out their business activities to achieve two
main objectives below.
1. • to maintain liquidity
2. • to maintain profitability
• There is a conflict between these two objectives. According to the
instructions of the Central Bank commercial banks must maintain a
certain percentage of its deposits as a reserve. This ratio is known as
statutory reserve rate. Central Bank changes this ratio from time to
time. The statutory reserve of commercial banks are known as " excess
reserves " and it can be found as follows.
41

• Excess reserve = Current money reserve -
Statutory reserve
• Surplus reserve is decided on the following factors
1. The demand for loans
2. Selection of commercial bank between liquidity and
profitability.
3. Monetary policy of the Central Bank
• Deposit multiplier is the number of times of extension
of deposit or creation of credit and bank deposit
extensions multiplier shows how many times deposits
are created compared to the increase in reserves.
42

• Deposit multiplier is equal to the difference of statutory
reserve ratio Bank deposit expansion
multiplier=1/Statutory reserve ratio = 1/r
For example : Bank deposit multiplier (K) = 1/r
if r =10% deposit multiplier=1/10%=10
• Profitability decreases when liquidity is maintained and
liquidity decreases when profitability is maintained Since
there is a conflict between the above mentioned aims, it is
important to maintain
• assets to ensure a balance between these aims. Increasing
deposits above the existing deposit by lending the surplus
reserve of commercial banks is called "creation of credit“.
Though it is easy to create money when only one bank
functions in monopoly, it is impossible for a single bank in
the banking system to create money.
43

Determinants of money supply
• Main determinants of the supply of money are (a) monetary base
and (b) the money multiplier. These two broad determinants of
money supply are, in turn, influenced by a number of other factors.
Various factors influencing the money supply are discussed below:
1. Monetary Base:
• Magnitude of the monetary base (B) is the significant determinant
of the size of money supply. Money supply varies directly in
relation to the changes in the monetary base.
• Monetary base refers to the supply of funds available for use either
as cash or reserves of the central bank. Monetary base changes due
to the policy of the government and is also influenced by the value
of money.
2. Money Multiplier:
• Money multiplier (m) has positive influence upon the money
supply. An increase in the size of m will increase the money supply
and vice versa. 44

3. Reserve Ratio:
• Reserve ratio (r) is also an important determinant of money supply.
The smaller cash-reserve ratio enables greater expansion in the
credit by the banks and thus increases the money supply and vice
versa.
• Reserve ratio is often broken down into its two component parts;
(a) excess reserve ratio which is the ratio of excess reserves to the
total deposits of the bank (re = ER/D); (b) required reserve ratio
which is the ratio of required reserves to the total deposits of the
bank (rr = RR/D). Thus r = re + rr. The rr ratio is legally fixed by the
central bank and the re ratio depends on the market rate of interest.
4. Currency Ratio:
• Currency ratio (c) is a behavioral ratio representing the ratio of
currency demand to the demand deposits. The effect of the
currency ratio on the money multiplier (m) cannot be clearly
recognized because enters both as a numerator and a denominator
in the money multiplier expression (1 + c/r(1 +t) + c). But, as long
as the r ratio is less than unity, a rise in the c ratio must reduce the
multiplier. 45

5. Confidence in Bank Money:
• General economic conditions affect the confidence of the public
in bank money and, thereby, influence the currency ratio (c)
and the reserve ratio (r). During recession, confidence in bank
money is low and, as a result, c and r ratios rise. Conversely,
during prosperity, c and r ratios tend to be low when
confidence in banks is high.
6. Time-Deposit Ratio:
• Time-deposit ratio (t), which represents the ratio of time
deposits to the demand deposits is a behavioral parameter
having negative effect on the money multiplier (m) and thus on
the money supply. A rise in t reduces m and thereby the supply
of money decreases.
11. Seasonal Factors:
• Seasonal factors have negative effect on the money multiplier,
and hence on the money stock. During holiday periods, the
currency ratio (c) will tend to rise, thus, reducing the money
multiplier and, thereby, the money supply.
46

7.Value of Money:
• The value of money (1/P) in terms of other goods and services has positive
influence on the monetary base (B) and hence on the money stock.
8. Real Income:
• Real income (Y) has a positive influence on the money multiplier and hence
on the money supply. A rise in real income will tend to increase the money
multiplier and thus the money supply and vice versa.
9. Interest Rate:
• Interest rate has a positive effect on the money multiplier and hence on the
money supply. A rise in the interest rate will reduce the reserve ratio (r),
which raises the money multiplier (m) and hence increases the money
supply and vice versa.
10. Monetary Policy:
• Monetary policy has positive or negative influence on the money multiplier
and hence on the money supply, depending upon whether reserve
requirements are lowered or raised. If reserve requirements are raised, the
value of reserve ratio (r) will rise reducing the money multiplier and thus the
money supply and vice versa.
47

The Quantity Theory of Money
• The QTM, one of the oldest economic theories
,dating back to 500 years before.
• The theory says that increases in prices are
caused solely by increase in the money supply. In
other words increase in price is caused by increase
in money supply. That means price level is directly
proportional to money supply.
• In this case we assume that constant fraction (k)
and the real level of national income (Y), are both
constant. Then;
M = aP
48

• Where ‘a’ is the constant fraction of
real national income level (k Y) or (Y/
V). If the money supply in the
economy-M increases, then so the
price level – P, also must increase. In
the crudest form of monetarism, M
and P will change by the same %
level. So a 10% increase in the money
supply will increase prices by 10%.
• Advocates of the quantity theory of
money are called as monetarists and
they believe that inflation I caused by
solely by increases in the money
supply called Monetarism. 49

Equation of Exchange
• This theory distinguishes between the real and the
money side of the economy. The most famous
formulation of the equation was made by Irvin Fisher,
an American economist during the late 90s and mid
of the 20th century.
• This states; Ms V ≡ P T (i)
Where Ms = the quantity of money
V = the velocity of circulation of each unit of money
P = the price level
T = the volume of transaction
50

• According to fisher, V, is the number of times the money
supply changes hands over a period of time, such as a
year. P, is the average price of each transaction made in
the economist, is the total number of transactions made
over a period of time.
• Assume that there is $ 100, of money (M) in circulation in
the economy. On average each, $1 changed hands 4 times
(V) during the year.
• So w know that $400 must have been spent during the
year (M x V). If the average price of each transactions (P)
was $2, there must have been 200 separate transactions
(T) take place over a year and each transaction was for
an average of $5, then the total amount spent was $500.
51

Velocity of Circulation of Money
• The velocity of circulation of money is the average number
of times a unit of money changes hands over a period of
time. For instance, a $10 note may change hands 50 times
a year.
• One factor which determines the velocity of circulation is
the way which households receive money and make
purchase.
• The VC of broad money will tend to fall if there is a change
from paying workers once a week to once a month.
Households will now hold money for longer periods of
time to cover expenditure later in the month.
52

• The increased use of money substitutes ,
such as credit cards, will also reduce the
velocity of circulation of money itself.
Instead of making separate money
transactions , the card holder will make
one transaction at the end of the month to
the credit card company. On the other hand
, increased use of cheuqes and credit and
debit cards will tend to lead to an increase
in the velocity of circulation of notes and
coins (M0).
53

The Financial System in
Sri Lanka
• The financial system of Sri Lanka consist if
array of institutions. These institutions can
be divided in to below broad categories.
1. The monetary authority – the central bank
of Sri Lanka.
2. Commercial banks
3. Non-Monetary financial institutions – e.g.
development banks, savings banks ,
financial companies.
54

• The financial system has undergone considerable change
since the launch of economic liberalization in 1977.
financial deregulation was a major component of these
reforms. The government control over the financial
system has been greatly reduced under these reforms.
This paved the way for increased privet sector
participation in financial activities.
• The financial system consist the central bank of Sri Lanka
as the apex financial institution, other regulatory
authorities, financial institutions, markets, instruments,
payment and settlement system, a legal framework and
regulations.
55

• The financial system carried out a vital
role in the economy of Sri Lanka , which
includes the financial intermediation
function of borrowing from surplus units
and lending to deficit units. The legal
framework and regulators are needed to
monitor and regulate the financial system.
56

• The financial system in Sri Lanka comprises the major financial
institutions, namely the Central Bank of Sri Lanka, licensed
commercial banks (LCBs), licensed specialized banks (LSBs),
registered finance companies (RFCs), specialized leasing companies
(SLCs), primary dealers (PDs), pension and provident funds, insurance
companies, rural banks, merchant banks, unit trusts and thrift and
credit co-operative societies, the major financial markets, such as the
foreign exchange market, money market, capital market and the
informal financial market ; and the financial infrastructure which is the
legal framework related to the financial system and the payment and
settlement.
• The banking sector in Sri Lanka, which comprises LCBs and LSBs,
dominates the financial system and accounted for 56.3 per cent of the
total assets of the financial system as at end June 2009. Banks play a
central role within the financial system, as they have the capacity to
provide liquidity to the entire economy.
• Banks are also responsible for providing payment services, thereby
facilitating all entities to carry out their financial transactions. On the
other hand, banks can create vulnerabilities of systemic nature, partly
due to a mismatch in maturity of assets and liabilities. Therefore, the
soundness of banks is important, as it contributes towards maintaining
confidence in the financial system and any failure may have the
potential to impact on activities of all other financial and non-financial
entities.
57

• In terms of the asset base and the magnitude of services provided, the
LCBs are the single most important category of financial institution
within the banking sector. As at end June 2009, the LCBs dominated
the financial system with a market share of 47 per cent of the entire
financial system's assets and 84 per cent of the banking sector's assets.
Therefore, the health of the financial system depends to a large extent
on the soundness of the financial institutions, particularly the LCBs.
• As at end June 2009, the banking sector comprised 22 LCBs and 14
LSBs. Even though a large number of licensed banks exist in the
country, the stability of the financial system is primarily dependent on
the performance and financial strength of the six largest LCBs,
consisting of the two state banks and the four largest domestic private
commercial banks. These six banks, which are generally, referred to as
the Systemically Important Banks (SIBs), represented 76.6 per cent of
the LCB sector assets and 64 per cent of the banking sector assets.
• The LSB sector represented 9 per cent and 16 per cent of the entire
financial system's assets and banking sector's assets, respectively. The
systemic importance of the LSB sector is relatively low in comparison
to the LCBs, both in terms of size and their impact on the financial
system, as it does not play an intermediary role in the payment cycle.58

Financial Institutions
• Financial institutions act as financial intermediaries. That
is they accept deposits from the surplus units and lend
such money to deficit units. Thus, institutions which
channel funds from people and institutions wishing to
lend to those wishing to borrow are called financial
institutions. Some of the financial institutions involve in
banking activities and some do not.
59

60
Total Assets and Deposit Liabilities of the Main Institutions in the Financial
System
as at end September 2012 ( a )
Assets Deposits
Financial Institution
Rs.
bn.
%
Share
Rs.
bn.
%
Share
Central Bank of Sri Lanka
1,356.
6
15.4 n.a n.a
Institutions Regulated by the Central Bank
5,608.
7
63.7
3,698.
8
98.0
Deposit Taking Institutions
5,344.
6
60.7
3,698.
8
98.0
Licensed Commercial Banks
4,207.
4
47.8
2,927.
2
77.6
Licensed Specialized Banks 708.8 8.0 539.2 14.3
Licensed Finance Companies 428.4 4.9 232.4 6.2
Other Financial Institutions 264.1 3.0 n.a. n.a.
Primary Dealers 128.5 1.5 n.a. n.a.
Specialized Leasing companies 135.6 1.5 n.a. n.a.

61
Institutions not Regulated by the Central Bank
1,842.
2
20.9 74.2 2.0
Deposit Taking Institutions 84.2 1.0 74.2 2.0
Rural Banks (b) 76.9 0.9 67.9 1.8
Thrift and Credit Co-operative
Societies (b)
7.3 0.1 6.3 0.2
Contractual Savings Institutions
1,690.
2
19.2 n.a n.a
Employees' Provident Fund
1,108.
0
12.6 n.a. n.a.
Employees' Trust Fund 154.3 1.8 n.a n.a
Approved Private Provident
Funds (c)
110.3 1.3 n.a n.a
Public Service Provident Fund 31.3 0.4 n.a n.a
Insurance Companies (d) 286.6 3.3 n.a n.a
Other Financial Institutions 67.8 0.8 n.a n.a
Stock Broking Companies (e) 18.2 0.2 n.a n.a

Continued………..
62
Unit Trusts/ Unit Trust
Management Comapnies (e)
24.4 0.3 n.a n.a
Market Intermediaries* (e)(f) 22.8 0.3 n.a n.a
Credit Rating Agencies (e) 0.2 0.0 n.a n.a
Venture Capital Companies 2.1 0.0 n.a n.a
Total Assets
8,807.
5
100.0
3,773.
0
100.0
Source: Central Bank of Sri Lanka
(a) Provisional
(b) Registered with the Department of Co-operative Development
(c) Registered with the Department of Labour
(d) Regulated by the Insurance Board of Sri Lanka
(e) Regulated by the Securities and Exchange Commission of Sri Lanka
(f) Market Intermediaries include Underwriters, Margin Providers and
Investment Managers.
* Excluding the assets of Licensed Banks, Licensed Finance Companies and
Specialised Leasing Companies which are registered as Market
Intermediaries
n.a. - Not applicable

Financial Intermediaries
• In the absence of financial intermediation, direct
transaction, between surplus units and deficit units
took place. That is surplus and deficit units meet to
fulfill their financial needs. A person with surplus funds
may want to lend those funds in order to maintain
ultimate objective of safety, liquidity and expected
return. On the other hand deficit units try to minimize
their deficit through borrowing from the surplus units.
63

Banking & Non-Banking
Institutions
• Banks refer to a financial intermediary which takes
deposits from people or business which wish to save
and lend such money to people or business which
wish to borrow. Banking institutions are those
institutions which can influence the money supply.
That is those who hold the responsibility to issue
components of money supply. In short those which
are engaged in banking activities.
64

Non Banking Institutions
• Non banking institutions area all the financial
intermediaries which are not engaged in banking
activities , that is influence the money supply. However ,
at present commercial banks diversified their activities
into leasing, direct financing of projects and supply
money for share capital and so on without concentrating
just on traditional banking. Due to this , its practically
difficult to differentiate commercial banks from other
financial institutions.
65

Commercial Banking in Sri Lanka
• Commercial banks are financial intermediaries which
link those who have surplus funds(savings), and those
who have shortage of fund. They undertake many from
the general public , on non-interest bearing demand
deposits and interest bearing savings and term deposits
and uses this money for lending (loan and advances),
investments or other operations.
• Only Com. Banks can maintain demand deposits. Any
banks which maintain demand deposits are known as
com. Banks. So they have the ability to do credit creation.
It is necessary for all commercial banks to obtain license
from the monetary board of CBSL to commence their
operation. Their minimum capital requirement is Rs.
2500 Million.
66

• There are 23 LCBs operating in Sri Lanka including 11
domestic banks and 12 foreign banks.
• Domestic banks including 2 largest states banks and 9
privet banks.
• State Banks – Bank of Ceylon, Peoples Bank.
• Domestic privet banks – Commercial Bank of Ceylon, HNB,
Nation Trust, NDB, PABC, Sampath Bank, Seylan, Union
Bank, DFCC Vardhana.
• Foreign banks – Citi Bank, Deutche bank, Habib bank,
HSBC, Indian Bank, Indian Overseas Bank, MCB, Public
Bank Berhad, Standard Charted Bank, State Bank of India,
Union Bank-Pakistan.
67

Functions of Commercial Banks
• Issue of Bank Notes – promissory notes issued by a
banker and payable to bearer on demand.
• Processing of Payments by way of telegraph
transfer, internet banking.
• Issuing Bank Darts and Cheuqes.
• Accepting Money on Term Deposits and lending
money by way of overdraft, installment loans.
• Providing Documentary and standby letters of
credit (trade finance), guarantees, performance
bonds, securities underwriting commitments and
other forms of balance sheets.
• Providing High Security for documents and other
items and exchange of currencies.
68

• Credit Quality Improvement- bank lend money to
ordinary and commercial personal borrowers , but are
high quality borrowers. 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.
• Netting and Settlement of Payments – bank act as both
collection and paying agents for customers, participating
in interbank clearing and settlement systems to collect,
present, be presented with , pay payment instruments,
since inward and outward payments offset each other.
69

Credit Creation
• Credit creation or credit multiplier is the ability of
the commercial bank system to create new bank
deposits and hence increase the money supply.
commercial banks accept deposit of currency from
the public and some of this money retained by the
banks to meet day to day withdrawals. The
remainder of the money is used to make loans or is
invested. When a bank on lends, it creates additional
deposits in favor of borrowers.
• The amount of new deposits the banking system as a
whole can create depends on the magnitude of the
reserve asset ratio.
70

• For instance, if the banks are assumed to operate with a 50%
reserve asset ratio, the bank 1 receives Rs. 100 million from
the public. Then it keeps Rs. 50 m, for liquidity purpose and
on lends Rs. 50 m.
• This Rs. 50 m, when spent or deposited with bank 2; bank 2
keeps Rs 25 m as part of its reserve assets and on lends Rs.
25 m, and so on. Thus, as a result of an initial deposit of Rs.
100 m, the banking system has been able to create and
additional Rs. 100 m, of new deposits.
• Since the bank deposits constitute a large part of the money
supply, the ability of the banking system to create money
makes it a prime target for the application of monetary
policy as a means of regulating the level of spending in the
economy.
71

The Concept of Central Bank & The
System of Central Banking.
• THE CENTREL BANK – is an agency empowered by the
government,
• To manage a country's monetary and financial institutions,
• To issue and maintain the domestic currency,
• To handle the official foreign exchange reserves. It is
primarily the bank for banks.
• The main responsibility of the central bank is to conduct
monetary policy. Monetary policy can be defined as the
use of the central banks power to control the domestic
money supply, to influence the supply of credit and
interest rates and ultimately the level of real economic
activity.
72

Central Banking System
• The central bank itself does not directly conduct the
monetary policy. It has given this function to a supreme
institution that is known as the central bank. in all our
currency notes you may see the words ‘central bank of Sri
Lanka”. This bank has the sole authority to issue currency
notes and coins. No other government agency or privet
organization has this power.
• There are similar central banks in other countries. Examples
are the Bank of England, the Federal Reserve Bank of USA,
Bundusbank in Germany, the Reserve Bank in New
Zealand.
73

Other Functions of the Central Banks.
• To function as the economic advisor to the government.
• To maintain government accounts.
• To manage the public debt.
• To supervise commercial banks and other financial
institutions.
• To act as the lender of last resort to commercial banks when
there is a financial crisis.
• To develop the financial sector.
• To conduct periodic view of the economy and to disseminate
such in formations. 74

The Central Bank of Sri Lanka
75
The Vision
“A credible and dynamic central bank contributing to the
prosperity of Sri Lanka.”
The vision clearly indicates that the Bank is deeply committed to
contributing to the prosperity of Sri Lanka. The term prosperity has a
wide connotation: enhancement of the quality of life of people through
sustainable wealth creation and inclusion of all segments of the society
in enjoying the benefits of development.

INTRODUCTION
• The government established the Central Bank of
Sri Lanka (then Central Bank of Ceylon), in
1950. before that, a mechanism known as the
Currency Board System managed the money
supply. Under that system, the money supply was
totally dependent on the foreign exchange
reserves. In the meantime, the Ceylon rupee was
liked with the Indian rupee, which was considered
the reserve currency. Therefore, the currency
board did not have any control over the
currency issue, credit creation or the value of
domestic currency. Under the circumstances, the
government realized that the establishment of a
Central Bank was needed to meet the growing
financial needs of the post independent economy.
76

• The CB was set up under the monetary law act no. 58 of
1949. this act was based on sessitonal paper (no. XIV –
1949) titled “report on the establishment of a Central
Bank for Ceylon”. Mr. John Exter, then a Senior Vice
President of the Federal Reserve Bank of New York,
prepared it. The government obtained his services for
this purpose. Since then, the central bank has expanded
its functions to reach the present status.
•
77
Mr. John Exter
Former Governor of
Central Bank
1950 - 1953

The new Central Bank complex in
Colombo fort, Sri Lanka
78

79
Headquarters Colombo
Established 1950 August 28
Governor Ajith Nivard Cabraal
Central bank of Sri Lanka
Currency Sri Lankan Rupee
ISO 4217 Code LKR
Website www.cbsl.gov.lk

Central
Bank of Sri Lanka
• Banks
• Finance Companies
• Leasing Companies
• Primary Dealers
• Money Market
• Foreign Exchange
Market
• Government
Securities Market
Securities &
Exchange
Commission of
Sri Lanka
• Stock Brokers/
Dealers
• Unit Trusts
• Investment
Managers
• Margin Providers
• Underwriters
• Stock Market
• Listed Corporate
Debt Market
• Automated
Trading System
• Debt Trading
System
Insurance Board of
Sri Lanka
• Insurance
Companies
• Brokers
• Loss Adjusters
Co-operative
Departments,
Department
Social Services,
Samurdhi
Authority
• Co-op rural
Banks
• Thrift &
Credit Co-op
societies
• Microfinance
Institutions
• Samurdhi
Banking
Societies
80

Objectives of the Central Bank
• In terms of monetary law act, until recently, the central
bank was expected to fulfill the following objectives;
1. To stabilize the domestic values of rupee
2. To preserve the external values of the rupee
3. To promote production, employment and
real income, and
4. To encourage and promote the full
development of the productive resources.
81

• In the past, most of the countries were adopted a similar
objectives for the central banks and over the times they
realized that the objectives of the central bank are too
diverse. It is generally accepted now that the central
bank’s main objective should be to maintain price
stability in the economy. That is to maintain a low
inflation rate. Every country should maintain the inflation
very low.
• In Sri Lanka, the government introduced some of the
major changes recently with regard to the objectives of
the central bank. recently these changes were contained
in the Monetary Law (Amendment) Act, No. 22 of 2002.
the parliament of Sri Lanka passed this act in December
2002. according to this act, the main objectives of the
central bank are;
• Economic and Price Stability
• Financial System Stability. 82

• Meanwhile, a consensus had developed internationally that a
central bank's primary goal should be the maintenance of
price stability. As price stability is crucially dependent on
stable macroeconomic conditions, one of the core objectives of
the CBSL was therefore specified as "economic and price
stability". Furthermore, as the experience of other countries
has demonstrated, the stability of the financial system is
crucial in improving the resilience of the economy.
• Hence, financial system stability was also identified as a core
objective of the CBSL. The two objectives are correlated and
complement each other. Ensuring financial system stability is
of prime importance, as monetary policy is transmitted
through financial intermediaries (institutions) to achieve
price stability. Hence, the two objectives are in harmony and
this enables the Central Bank to perform its main functions
more effectively. The CBSL has been given a high degree of
autonomy to achieve its objectives. In this task, the Bank
closely liaises with the Ministry of Finance in making policy
decisions and the Secretary to the Ministry of Finance is a
member of the Monetary Board, which is the governing body
of the CBSL.
83

ECONOMIC & PRICE STABILITY
• Price stability safeguards the value of the currency in
terms of what it will purchase at home and in terms of
other currencies. Price stability or stable prices means
low inflation. Experience has shown that the economy
performs well when inflation is low and is expected to be
low. Interest rates are also low in these conditions.
• Such an environment allows an economy to achieve its
growth potential and fosters high employment. Free
from the disruptive effects of high and variable inflation,
both consumers and producers make economic decisions
with confidence. Low inflation or price stability fosters
sustainable long-term economic growth and
employment. The Central Bank uses monetary policy
measures to control inflation. 84

FINANCIAL SYSTEM STABILITY
• A stable financial system creates a favorable environment for
depositors and investors, encourages efficient financial
intermediation and the effective functioning of markets, and
hence, promotes investment and economic growth. Financial
system stability means the effective functioning of the financial
system (financial institutions and markets) and the absence of
banking, currency and balance of payments crisis.
• Financial instability is caused by bank failures, excessive asset
price volatility, and collapse of market liquidity or a disruption
to the payments system. Financial system stability requires a
stable macro-economic environment, effective regulatory
framework, well organized financial markets, sound financial
institutions and safe and robust payments infrastructure.
• The maintenance of financial stability entails the prevention,
detection and reduction of threats to the financial system as a
whole, through the surveillance of markets and financial
institutions, oversight of the payments system and crisis
resolution.
85

CORE FUNCTIONS
• In order to achieve its core objectives as well as to discharge its
responsibilities as economic advisor and banker to, and agent of the
GOSL, the CBSL undertakes the following functions.
Core functions
• Economic and Price Stability
• Financial System Stability
Ancillary to core functions
• Currency Issue and Management
Agency functions
• Employees' Provident Fund Management
• Foreign Exchange Management
• Public Debt Management
• Regional Development
• Financial Intelligence
• Provincial Office Monitoring
86

Monetary Policy: Targets, Instruments &
Indicators.
• FINAL TARGETS – these are the final targets of the CBSL,
these include promotion of economic growth, control of
inflation, creation of employment, and reduction of
foreign exchange deficits. In general these are the broad
objectives of all macroeconomic policies.th CB’s are
expected to design their monetary policy to achieve these
targets.
• INSTRUMENTS – a CB cannot directly involve in achieving
the final targets. Fro instance, it does not have the capacity
to directly raise the economic growth and employment
creation or to control consumer prices. So they can use
various policy instruments to influence economic
activities and to achieve the final targets, such as open
market operations, statutory reserve requirements , moral
suasion, and credit ceilings. It s important to note here is
that a CB has a number of policy instruments in its hand to
influence the economy. 87

• INTERMEDIATE TARGETS – these targets are standing
between final targets and policy instruments. So we call
them as intermediate targets. This target is very
important in conducting monetary policy. The CBSL uses
a monetary targeting framework for monetary
management. For this purpose, the bank has specified
certain intermediate targets. These targets include the
money supply and interest rates.
• They are aggregate or totals of the following versions of
money supply; Narrow money (M1), Broad money (M2),
consolidated broad money (M2b) and very broad money
(M4).it is not easy to control the money supply, because it
ahs many deferent components. So, the CB should select
the most suitable monetary aggregate. In Sri Lanka, M2 is
widely used for monetary policy purposes.
88

MONETARY POLICY INSTRUMENTS
• The Central Bank possesses a wide range of tools to be
used as instruments of monetary policy. The main
monetary policy instruments currently used are (a) policy
interest rates and open market operations (OMO) and (b)
the statutory reserve requirement (SRR) on commercial
bank deposit liabilities.
• Policy Interest Rates and Open Market Operations
(OMO)
• At present, the Central Bank conducts its monetary policy
under a system of active. Open Market Operations. The key
elements of the system are (i) an interest rate corridor
formed by the main policy rates of the Bank i.e. the
repurchase rate and the reverse repurchase rate, (ii) a
daily auction either to absorb or inject liquidity, (iii) a
standing facility at interest rates at the bounds of the
corridor and (iv) outright transactions. 89

• The main instruments to achieve the path of the reserve
money targets are the repurchase rate and the reverse
repurchase rate of the Central Bank which form the lower
and upper bounds for the comparable overnight interest
rates in money markets. These rates, which are the Bank's
signaling mechanism on its monetary policy stance, are
reviewed on a regular basis, usually once a month, and
revised if necessary.
• A daily auction is conducted either to absorb liquidity
through repurchase transactions, if there is excess
liquidity, or to inject liquidity through reverse repurchase
transactions, if there is a shortage of liquidity and thereby
to maintain overnight interest rates stable around a level
considered consistent with the path of reserve money
targets. The auction is on a multiple bid, multiple price
system. Participants could make up to three bids at each
auction and the successful bidders would receive their
requests at the rates quoted in the relevant bid.
90

• Standing facilities are available for those participating institutions
which were unable to obtain their liquidity requirements at the daily
auction. That is, even after the daily auction, if a participant has excess
money he could enter into a repurchase transaction under the standing
facility. Similarly, if a participant needs liquidity to cover a shortage, he
could borrow funds on reverse repurchase basis under the standing
facility. Accordingly, these facilities help containing wide fluctuations in
interest rates.
• Outright transactions are conducted at the discretion of the Central
Bank to address long Term liquidity issues. If a relatively large liquidity
surplus exists and is likely to persist for a long period it is absorbed by
selling Treasury bills outright out of the holdings of the Central Bank,
and if a sufficient stock of Treasury bills is not available, by issuing the
Central Bank's own securities. Similarly, a long term liquidity shortage
would be removed by purchasing Treasury bills and bonds in the
secondary market and buying Treasury bills in the primary market.
There also exists another policy rate known as the Bank Rate.
• It is the rate at which the Central Bank provides credit to commercial
banks as a lender of last resort. These are collateralized loans and
government securities are accepted as collaterals. The Bank rate is
usually a penalty rate and it is higher than other market rates.
Therefore, at present this rate is just an indicative rate as commercial
banks can borrow from the Central Bank at the reverse repurchase rate
which is less than the Bank rate. 91

Statutory Reserve Requirement (SRR)
• The statutory reserve ratio (SRR), i.e., the proportion of
the deposit liabilities that commercial banks are
required to keep as a cash deposit with the Central
Bank, also has been widely used to influence money
supply in the past.
• However, the reliance on SRR as a day to day monetary
management measure has been gradually reduced with
a view to enhancing market orientation of monetary
policy and also reducing the implicit cost of funds which
the SRR would entail on commercial banks. Under the
MLA, commercial banks are required to maintain
reserves with the Central Bank at rates determined by
the Bank. At present, demand, time and savings
deposits of commercial banks denominated in rupee
terms are subject to the SRR.
92

• Credit operations with banking institutions –
the central bank is the lender of last resort
facility; under this facility the CB gives
emergency loans to commercial banks which are
in distress. Other credit facilities provided by the
central bank to commercial banks and other
financial institutions. These includes refinance
facilities.
• Quantitative controls on credit – the CB is
imposing maximum maturity for commercial
bank loans and advances. They limit or stop the
expansion of new loans and advances and also
include fixing of maximum values for ratios of
capital and surpluses to assets and impose
minimum deposit margins for letters of credit.
93

• Operations in foreign exchange – the
central bank has the power to operate the
following tasks,
1. External Reserve
Management
2. Exchange Rate Management
3. Exchange Control
Regulations
94

Moral Suasion
• The central bank could use its influence to persuade
commercial banks to adopt a desired course f action. This
is an informal way of adopting g monetary policy. It is not
explicitly indicated as a monetary policy tool, and thus, it
has no legal backing.
• With the opening up of the economy since 1977, the
direct monetary policy instruments that had been used
earlier became undesirable for the market oriented
economic system, and therefore, the central bank has
placed increased reliance on indirect instruments in the
last 2 decades. Accordingly direct controls such as
quantitative ceilings, refinance facilities were abandoned.
The open market operations and statutory reserves are
used a major instruments at present.
95

The OMO’S
• The OMO’s are known as buying or selling government
securities by the CB to control the money supply and
interest rates. Fro example, the CB can reduce the money
stock by ceiling securities to the general public, in
exchange for money. Conversely, it can increase the
money supply by buying securities in exchange for
money. The central bank conducts OMO in 3 ways.
I. Outright buying or selling of
government securities by the central
bank
II. Temporary buying or selling of
government securities
III. Purchasing or selling of CB securities
to inject or absorb liquidity. 96

Temporary buying or selling of government
securities
• These transactions are conducted repurchase (repo)
and reserve repurchase (reserve repo) windows of the
central bank.
• Commercial banks and primary dealers can invest their
surplus funds temporarily (mostly overnight) in
treasury bond and treasury bills held by the CB
through the repurchase window. thus can obtain funds
temporarily from the CB against the collateral of
treasury bills and bonds through the reserve
repurchase window.
• The CB uses the reserve repurchase and reserve rates
to convey policy signals to the market. The repo rate is
the rate offered by the CB for temporary investment in
government securities, while reserve repo rate is the
arte charged by the CB for temporary lending.
97

• The repo and reserve repo rates are the lending
indicative short term interest rates in the money
market. therefore they are also known as the
policy rates. Depending on the liquidity
conditions in the market, the central bank will
decide whether to inject liquidity to the market
or absorb liquidity from the market.
• This is achieved by changing the repo and
reserve repo rates, which influence market
participants to access the CB’s secondary
window, thus changing market liquidity. The
repo and reserve repo rates are generally
operate as a floor and ceiling respectively for all
market rates, thus preventing excessive volatility
in call rates.
98

• The CB move to more active OMO from march 2008. a
key feature of the new system is conducting of a
auction of a daily basis. The CB decides the volume of
liquidity to be injected or absorbed daily, based on the
monetary policy stance and market liquidity situation.
The bank’s repo and reserve repo rates form an
interest rate corridor. Standing facilities are available
to the participants at these rates.
• In recent times, the CBSL reduced its policy rates. This
was facilitated by factors like a reduction in inflation,
better monetary management, low government
borrowings, high liquidity in the money market,
relative stability in the foreign exchange market and
downward movement in international interest rates.
So, the CB reduced its repo and reserve repo rates by
225 basis points in 3 steps in January, May and August
in 2003.
99

Financial Market in Sri Lanka
• The Financial Market, which is the market for credit and capital,
can be divided into the Money Market and the Capital Market.
• The Money Market is the market for short-term interest-
bearing assets with maturities of less than one year, such as
Treasury bills, commercial paper, and certificates of
deposits. The major task of the Money Market is to facilitate
the liquidity management in the economy. The main issuers in
the Money Market are the Government, banks and private
companies, while the main investors are banks, insurance
companies and pension and provident funds.
• The Capital Market is the market for trading in assets for
maturities of greater than one year, such as Treasury bonds,
private debt securities (bonds and debentures) and equities
(shares). The main purpose of the Capital Market is to
facilitate the raising of long-term funds. The main issuers in
the Capital Market are the Government, banks and private
companies, while the main investors are pension and provident
funds and insurance companies.
100

• The Financial Market can be also be classified according to
instruments, such as the debt market and the equity
market. The debt market is also known as the Fixed
Income Securities Market and its segments are the
Government Securities Market (Treasury bills and bonds)
and the Private Debt Securities Market (commercial paper,
private bonds and debentures). Another distinction can
also be drawn between primary and secondary markets.
The Primary Market is the market for new issues of shares
and debt securities, while the Secondary Market is the
market in which existing securities are traded.
The Central Bank through its conduct of monetary policy
influences the different segments of the Financial Market
in varying degrees. The Central Bank's policy interest
rates have the greatest impact on a segment of the Money
Market called the inter-bank call money market and a
segment of the Fixed Income Securities Market, i.e. the
Government Securities Market. The Central Bank may also
intervene in the inter-bank Foreign Exchange Market,
which is closely connected to the Money Market.
101

The Financial Market in Sri Lanka
Financial
Markets
Money
Market
Call Money
Market
Treasury Bill
Market
Commercial
Paper Market
Foreign
Exchange
Market
Capital
Market
Equity Market
Treasury
Bond Market
Corporate
Bond Market
102

FINANCIAL INSRUMENTS
•
Deposits are sums of money placed with a financial institution, for
credit to a customer's account. There are three types of deposits -
demand deposits, savings deposits and fixed or time deposits. Demand
deposits are mainly used for transaction purposes and for the
safekeeping of funds. Funds can be withdrawn on demand. Demand
deposits do not earn interest, but banks provide a number of services
to demand deposit- holders like cheque facilities, standing orders,
Automated Teller Machine (ATM) cards and debit cards to facilitate
withdrawals and payments.
• Savings deposits earn interest, which may be calculated on a daily,
weekly, monthly or annual basis. Funds may be withdrawn from
savings accounts at any time. However, if the number of withdrawals
exceeds four in any month, interest will not be paid for that particular
month. Financial institutions issue pass-books or statements detailing
transactions to savings deposit holders and also provide services such
as ATM and debit cards. Fixed or time deposits are funds placed at
financial institutions for a specified period or term. Fixed / time
deposits earn a higher rate of interest than savings deposits. Fixed /
time deposits can be for short, medium or long term. Funds can only be
withdrawn before the maturity date with prior notice and a penalty
may be imposed. A fixed / time deposit holder has a facility to borrow
funds from the financial institution using the deposit as collateral.
103

• Loans
A loan is a specified sum of money provided by a lender, usually a financial institution, to a
borrower on condition that it is repaid, either in installments or all at once, on agreed dates
and at an agreed rate of interest. In most cases, financial institutions require some form of
security for loans.
•
Treasury Bills and Bonds
Treasury bills are government securities that have a maturity period of up to one year.
Treasury bills are issued by the Public Debt Department of the Central Bank, on behalf of the
Government of Sri Lanka, under the provisions of the Local Treasury Bills Ordinance.
Treasury bills are issued in maturities of 91 days, 182 days and 364 days. Treasury bills are
zero coupon securities and are sold at a discount to face value, which is paid at maturity. The
difference between the purchase price and the face value is the interest income to the owner.
Treasury bills are considered liquid assets as they can be easily sold in the secondary
market and converted to cash. Treasury bonds are medium and long-term government
securities and are issued in maturities ranging from 2 years to 20 years. Treasury bonds are
issued by the Public Debt Department of the Central Bank, on behalf of the Government of
Sri Lanka, under the provisions of the Registered Stocks and Securities Ordinance. Treasury
bonds are interest-bearing securities, with interest paid bi-annually. Treasury bills and
bonds are guaranteed by the Government and are the safest of all investments, as they are
default risk free. Treasury bills and bonds are tradable securities which are sold by auction
to Primary Dealers, who in turn market the securities to the public. The yields on Treasury
bills and bonds are market determined and the market is both active and liquid. From 2004,
Treasury bills and bonds are issued in scrip-less (paperless) form and transactions are
recorded electronically in the "Lanka Secure" system of the Central Bank.
104

• Repurchase Agreements
Repurchase agreements (Repo) are arrangements which involve the sale, for cash, of
securities (usually government securities) at a specified price with a commitment to
repurchase the same or similar securities at a fixed price on a specified future date.
The difference between the sale price and the repurchase price is the interest income.
The agreement is called reverse repo when viewed from the perspective of the
securities buyer. A repo is similar to a loan that is collateralized by the securities
underlying the agreement. Most repos are very short-term money market
instruments.
Commercial Paper
Commercial papers (CPs) are short-term, non-collateralised (unsecured) debt
securities issued by private sector companies to raise funds for their own use, by
banks and other financial intermediaries. CPs are generally issued by creditworthy
(high-rated) institutions in large denominations and have additional bank guarantees
of payment. CPs are usually sold at a discount, although some are interest bearing.
Corporate Bonds and Debentures
Corporate bonds are medium or long-term securities of private sector companies
which obligate the issuer to pay interest and redeem the principal at maturity.
Corporate bonds that are not backed by a specific asset are called debentures.
Debentures are unsecured, medium or long term, interest-bearing bonds issued by
private sector companies, banks and other financial institutions that are backed only
by the general credit of the issuer. Debentures are usually issued by large, well-
established institutions. The holders of debentures are considered creditors and are
entitled to payment before shareholders in the event of the liquidation of the issuing
company.
105

• Asset-backed Securities
Asset-backed securities (ABS) are bonds collateralized (secured) by mortgages, loans,
or other receivables. Typically, the issuing institution sells mortgages, loans, installment
credit, credit card or other receivables to a trust or a special purpose vehicle (SPV) that
in turn sells ABSs to the public. ABSs are interest- bearing instruments and are often
enhanced through the use of guarantees or insurance.
Financial Leases
Financial leases are accommodations provided to finance the purchase of capital or
durable equipment in which the legal owner (lesser) lends the equipment to the lessee
for payments that cover the full principal and interest cost. The lessee receives all
benefits from the use of the asset and incurs the costs associated with its ownership,
such as maintenance, insurance and taxes. Legal ownership of the equipment passes to
the lessee when the loan principal and interest payments are settled in full.
Shares
Shares are securities representing a portion of the ownership of a company that are a
claim on the company's earnings and assets. Shareholders are paid dividends which are
a percentage of the profits of the company.
Financial Derivatives
A financial derivative is a financial instrument that is linked to another specific financial
instrument, indicator or commodity and through which specific financial risks (such as
interest rate risk, foreign exchange risk, equity and commodity price risk) can in their
own right, be traded in financial markets. The value of a financial derivative comes from
the price of an underlying item such as an asset or index. Financial derivatives can be
used for risk management, hedging (protecting) against financial losses on commercial
transactions and financial instruments and arbitrage between markets and speculation.
There are two distinct classes of financial derivatives - forwards and related
instruments, and options. The most common forward instruments are forward
contracts, futures contracts, forward rate agreements (FRAs) and interest rate swaps
(IRS). Financial derivatives are traded over- the- counter, in which case they are
customized and can be purchased from financial institutions or are standardized
products which are traded on organized exchanges. Although, financial derivatives are
still not widely used in Sri Lanka, the market for forward contracts, FRAs and IRS is
starting to develop.
106

• Payment and Settlement Infrastructure -
One of the most important functions of the financial system is to
ensure safety and efficiency in payments and securities transactions.
Financial infrastructure refers to the different systems that provide
for the execution of both large-value and small-value payments.
Payment and settlement systems enable the transfer of money in the
accounts of financial institutions to settle financial obligations
between individuals and institutions.
The main payment, clearing and settlement systems in Sri Lanka are
• Cheque Imaging and Truncation System (CIT), the inter-bank cheque
clearing system
• operated by Lanka Clear Ltd.
• Sri Lanka Inter-Bank Payment System (SLIPS) operated by Lanka
Clear Ltd.
• Lanka Settle, comprising the Real Time Gross Settlement System
(RTGS) and the
•
• Scripless Securities Settlement Systems (LankaSecure) operated by
the Central Bank of Sri Lanka.
107

Regulation and Supervision of Banks
•
The regulatory and supervisory framework for Banks is specified mainly in the
Banking Act, Monetary Law Act and the Exchange Control Act. The Central Bank
issues banking licenses for two categories of banks, namely Licensed
Commercial Banks and Licensed Specialized Banks (which are savings and
development banks). The main difference between a Licensed Commercial Bank
and a Licensed Specialized Bank, is that the former is permitted to accept
demand deposits from the public (operate current accounts for customers) and
is an Authorized Dealer in foreign exchange which entitles it to engage in a
wide-range of foreign exchange transactions, whereas the latter is permitted to
limited engagements in foreign exchange with Central Bank’s approvals.
The laws empower the Central Bank to undertake the following:
• Licensing of new commercial and specialized banks.
• Issue prudential directions, determinations and orders to banks, under the
statutes.
• Conduct Continuous Supervision and Examination of banks.
• Enforce regulatory actions and the resolution of weak banks.
•
The regulatory and supervisory function relating to banks licensed by the
Monetary Board is carried out by the Bank Supervision Department of the
Central Bank. The supervision of banks is based on the internationally accepted
standards for bank supervision set out by the Basel Committee for Banking
Supervision.
108

• Under the continuous supervision/surveillance system, the financial condition of
Licensed Commercial Banks and Licensed Specialized Banks is monitored on the
basis of periodic information provided by banks on their operations. The periodic
information includes weekly interest rates of deposits and advances, monthly
returns on assets and liabilities, income and expenditure, classified advances and
provisioning for bad and doubtful debts, statutory liquid assets, quarterly returns
on capital adequacy, investments in shares, accommodation granted to related
parties, interest spreads, foreign currency exposures, maturity gap analysis and
annual returns on audited financial statements and abandoned properties.
An Internal Supervisory Rating system of banks is in place, taking into
consideration of quantitative measures such as Capital Adequacy, Asset Quality,
Management, Earnings and Liquidity (i.e. CAMEL model components) and other
qualitative measures such as assessment of bank's compliance with statutory
requirements, applicable laws and regulations, internal controls and the
standards of corporate governance, in order to categorize them under different
risk ratings and take necessary regulatory and supervisory actions to improve the
positions of weaker banks.
In terms of the provisions of the Banking Act and the Monetary Law Act, all
Licensed Commercial and Specialized Banks are subject to statutory
examinations, at least once in two years. A new approach to examination of banks
has now been adopted - the risk based examination process, which focuses on
identification of banking risks, the management of these risks and the assessment
of adequacy of resources to mitigate these risks. Matters relating to non-
compliance with prudential requirements and any weaknesses and deficiencies in
the financial condition, controls and systems of a bank are brought to the notice of
its Board of Directors, by the Central Bank to ensure that corrective action is
taken by the bank.
109

• Licensed Commercial Banks and Licensed Specialized Banks
are also required to publish their quarterly and annual
audited financial statements, including key performance
indicators, in the newspapers, in all three languages, within
two months of the end of each period.
Common Banking Forum - The Governor holds monthly
meetings with the Chief Executive Officers of licensed banks,
which serves as a forum for the exchange of views on issues
and policies relating to banking operations and the financial
sector.
Bank Directors’ Symposium – The Central Bank conducts
annually the Bank Directors’ Symposium with the view of
updating and sharing the new developments in the
regulatory and the banking business reforms with bank
directors in order to ensure banks’ resilience to the
challenging environment.
Public Awareness - The Central Bank conducts public
awareness programmes on the banking and financial system
with regular notices in the newspapers, Radio and TV
commercials/programmes to advise the public to assess and
to be cautious of the risks and returns on their transactions
with financial institutions as well as investing in prohibited
schemes.
110

Regulation and Supervision of Finance
Companies
•
The regulation and supervision of Licensed Finance Companies is
governed by the Finance Business Act. The Finance Business Act No
42 of 2011 was enacted on 09.11.2011 repealing and replacing the
Finance Companies Act No 78 of 1988 to strengthen the regulation
and supervision of Licensed Finance Companies and to curb
unauthorized finance businesses. The Department of Supervision of
Non-Bank Financial Institutions of the Central Bank carries out the
regulatory and supervisory functions in respect of Licensed Finance
Companies, with the objective of ensuring that these institutions
comply with the minimum prudential requirements stipulated by the
Central Bank. These functions are carried out mainly through off-site
surveillance and on-site examinations. The directions and rules issued
under the provision of the Finance Business Act cover minimum
capital adequacy and liquidity requirements, deposits, provisioning
for bad and doubtful debts, single borrower limits and limits on equity
investments. Matters relating to non-compliance with prudential
requirements and any weaknesses and deficiencies in the financial
condition, controls and systems of a finance company are brought to
the notice of its Board of Directors, by the Central Bank to ensure that
corrective action is taken by the finance company.
111

• The Central Bank also conducts investigations into the
affairs of institutions, which are allegedly engaged in
finance business, without legal authority. These
unauthorized institutions are taking money from the
public either as deposits or in a manner akin to deposits
by calling them other names, such as investments, credit,
borrowings or placements. Appropriate action is taken
against such unauthorized institutions that contravene
the provisions of the Finance Business Act. Legal action is
also instituted against entities that fail to provide
information for investigations to ascertain whether such
companies are conducting finance business.
The Central Bank conducts a public awareness
programme through notices, posters and publications to
inform the public of authorized financial institutions and
to warn them of unauthorized persons / entities that
engage in finance business.
112

Maintaining Stability in Money and Foreign
Exchange Markets
•
The Central Bank is responsible for maintaining stability in the money
and foreign exchange markets
Inter-bank Call Money Market
The inter-bank call money market is an overnight market and mainly
serves commercial banks in meeting their immediate liquidity needs
and reserve deficiencies. Hence, an important task of the call money
market is to facilitate liquidity management in the inter-bank market.
Therefore the orderly and stable functioning of the inter-bank call
money market is important to minimize liquidity risk in the banking
system as a whole. The stability of the market is supported by the
provision of Repurchase (Repo) and Reverse Repurchase facilities by
the Central Bank at its policy interest rates. The policy interest rates of
the Central Bank - the Repo Rate and Reverse Repo Rate provides
lower and upper bound respectively for the formation of interest rate
corridor for the inter-bank call money market. Thus the corridor
limits the potential large fluctuations in the short-term market
interest rates.
113

• Changes in the Central Bank's policy interest rates have an immediate
effect on interest rates in the inter-bank call money market. Changes
in the call market rates could lead, within a very short period, to
changes in other short-term money market interest rates, such as the
yield on Treasury bills, commercial paper and the short-term lending
rates of commercial banks. These changes could, with a time lag, affect
the medium-term lending and deposit rates of banks, as well as other
market yields. The inter-bank market and makes frequent adjustment
to the liquidity in the banking system.
• Frequent fluctuations of interbank call rates even to the boarders of
policy rate corridor is not desirable as such changes could inflict
larger volatility in other market rates/prices which uses interbank call
rate as the benchmark. Central Bank generally prefers market
liquidity to be at levels that facilitate minimal fluctuation in the
overnight call market rate. Slight shortage in market liquidity makes it
easier for the central banks to steer the interest rates as the
borrowing banks would have to borrow on the conditions of the
Central Bank. Surplus liquidity will not require commercial banks to
stick to such conditions. As such the Central Bank conducts its open-
market operations by way of Repo or Reverse Repo auction for a
determined amount, in order to inject or absorb liquidity to and from
the market and to reduce undesirable fluctuations in the interbank
call money market rate. The magnitude of the Central Bank
intervention depends on the overall liquidity excess or shortfall,
prevailing interest rate level well as the macroeconomic environment
of the country.
114

• The daily inter-bank call money market transactions
averaged Rs.13.1 billion in 2012.
Treasury Bill Market
The Treasury bill market is another segment of the
Money Market. Treasury bills are highly liquid money
market instruments that provide financial institutions
with an alternate source of liquidity and investment.
Furthermore, interest rate movements in the Treasury
bill market provide a benchmark for the short-term credit
market. Hence, changes in the volumes and rates in the
Treasury bill market affect the cost, profitability and
liquidity of financial institutions. Secondary market
transactions in Treasury bills amounted to Rs. 2472
billion for outright transactions and Rs. 13,916 billion for
repurchase transactions at the end of December 2012.
Treasury bills are also the main securities used as
collateral by the Central Bank in the conduct of its open
market operations.
115

• Foreign Exchange Market
The domestic foreign exchange market in Sri Lanka is two-
fold, namely, the client or retail market and the inter-bank or
wholesale market. Retail market includes transactions
involving individual or institutional customers while the inter-
bank market is mainly organized among authorized dealers in
forex market, which comprises all licensed commercial banks.
The Inter-bank market helps to manage liquidity within the
banking system through currency conversion.
There are two main functions in foreign exchange market, one
is to convert currency of one country into a currency of
another and second is to help minimize the risks arising from
changes in the exchange rate through various derivative
products. Above features of the foreign exchange market
facilitate funding imports, converting export proceeds and
other foreign currency transactions.
The main risk in the foreign exchange market is the volatility in
the exchange rate, i.e., undue fluctuations in the rate at which
one currency is converted in to another currency. If the
volatility is excessive it would create an instability in the
foreign exchange market and thereby would affect the value of
foreign currency assets and liabilities. There are derivative
instruments available in the foreign exchange market such as
swaps, options and forwards which help minimize the risk of
exchange rate volatility.
116

• Transactions in the foreign exchange market are carried out in
the spot market and the forward market. Spot market is the
market for immediate delivery of purchases/sales of a foreign
currency on the same day (Cash basis), the next business day
(Tom basis) or within two business days (Spot basis). The
forward market is for the purchase/sale of a foreign currency at
a price specified now with the delivery and settlement at some
future date exceeding two business days. The domestic inter-
bank foreign exchange transaction volumes in 2012 totaled to
US dollars 13,420 million while the daily average transaction
volume in 2012 was recorded as US dollars 55mn.
Sri Lanka had a floating exchange rate system since 2001 which
allowed the independent adjustment of the exchange rate
according to the market forces of demand and supply. On 9th
February 2012, the exchange rate policy of the country was
changed, which resulted in the conduct of interventions in the
market for the purpose of curbing excess volatilities using
quantities instead of price targets. The Central Bank of Sri
Lanka closely monitors the activities in the domestic foreign
exchange market to ensure a smooth functioning of the market.117

REVIEW QUESTIONS
1. What is barter system? Explain.
2. What are the main functions of money?
3. What are the characteristics of money?
4. What are monetary aggregates? Explain.
5. What is known as money supply. Explain with its
determinants.
6. What are the determinants of base money? Explain.
7. Define the quantity theory of money and the equation
of exchange.
8. Explain briefly what are commercial banks and their
functions.
118

9. Why the concept of central banking is so important?
10. Discuss the establishment of the central bank of Sri
Lanka since independence.
11. What are the major goals of the CB?
12. Explain how a CB can use intermediate targets in
conducting monetary policy.
13. What are the monetary policy instruments of the CB?
14. The CBSL is playing a major role in the Sri Lankan
economy, critically analyze this statement.
15. Should the CBSL remain independent? Argue this
statement from both sides.
16. Discuss the importance of the financial market in Sri
Lanka.
119

References
Prof. S. S. Colombage.” Principles of Macroeconomics”
2006. The Open University Press, Nugegoda, Sri Lanka.
Richard G. Lipsy,” An Introduction to Positive Economics”
7th Low Price Edition ,1989, Butler & Tanner Ltd, London.
Robert J. Gordon," Macroeconomics” 3rd Edition,1984, Little
Brown & Company Canada Ltd, USA.
Robert H. frank, Ben S. Bernake, ”Principles of
Macroeconomics”, 2001. McGraw-Hill Companies Inc, New
York.
David. W. Pearce," The Dictionary of Modern Economics”
2nd Low Price Edition, 1985, Anchor Brendon Ltd. UK.
Prasadini Dharmawardena, GCE A/ L Economics – New
Complete Text Books for grade 12 & 13, ESL Publishers.
Central Bank Reports 2009, 2010, 2011, 2012,Recent
Economic Development Reports from 2008, 2009, 2010,
2011, and 2012, Economics and Social Statistics form 2010,
2011, 2012.The Central Bank of Sri Lanka.
• For more details visit the Central Bank Official Website -
www.cbsl.gov.lk
120

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