MONEY BANKING MEANING AND FUNCTIONS contd. Secondary Functions contd. As transfer of value, sale and purchase of movable and immovable assets, paper wealth

MONEY &

BANKING

Samir K Mahajan

MONEY: MEANING AND FUNCTIONS

Money is regarded any object which is generally accepted as:

medium of exchange

unit of account i.e. common measure of value

standard of deferred payment

store of value

transfer of value.

Primary Functions

As medium of exchange, money is used as a means of payment.

o As money has ready purchasing power, it facilitates in transacting exchange of goods andservices with minimum effort and time.

MONEY: MEANING AND FUNCTIONS contd.

Primary Functions contd.

As unit of account, money is treated as common measure of value.

o value of all goods and services in exchange can be expressed in terms of money.

o Such expression gives rise to price system in which money act as a means of calculatingthe relative prices as absolute prices of goods and services.


Secondary Functions:

As standard of deferred payment, money can be used in the settlement of debt and futurepayments.

o Loans are advanced and future contracts are settled in terms of money.


Secondary Functions contd.

As store of value, money is hold as an asset in liquid (or cash balance) to use anytime in future.

o This is because money has purchasing power which holds commands over goods andservices all time – at present and in future.

o However use of money as store of value is not without drawbacks. Changes in general pricelevel causes rise and fall in the value of money. When price level rises, value of money fallsand vice versa.


Secondary Functions contd.

As transfer of value, sale and purchase of movable and immovable assets, paper wealthand physical wealth can be made with the help of money.

o Thus, value available in the form of asset can be transferred from one person to anotherwith the use of money.


FORMS OF MONEY IN MODERN TIMES

In modern monetary transactions, the total stock of money or money supply includes the

following:

Metallic money or currency coinso Standard or Full-bodied Coins.o Token coins

Paper money or paper currency

Credit or bank money

FORMS OF MONEY IN MODERN TIMES contd.

Metallic money or currency coins : refers to the coins made out of metal like gold, bronze, silver, copper, nickel.

Standard or Full-bodied Coins are those coins whose face value is equal to its intrinsic (metallic)value.

Token coins have intrinsic (metallic) value less than its face value.

o They generally are of lower denominations are made of cheap metals like nickel andcopper.

o Token coins are used for exchange of small value.


Paper money or paper currency : Paper money consists of currency notes issued by the StateTreasury or the Central bank of the country.


Credit or bank money: Bank demand deposits withdraw-able by issuing cheque has startedfunctioning as money, and cheque are conventionally accepted as a means of payment bythe business community in general.

In short, anything and everything that has served as money is generally

recognized and accepted as means of payments. But all can serve a good

money. Good money should poses the attributes of general acceptability,

cognizability (capable of being known), portability, divisibility, durability,

uniformity, adequacy and stability of value.

LEGAL TENDER AND CONVENTIONAL MONEY

In modern era, currency money and bank money together constitute the total stock of

money or money supply.

Currency money (both currency coins and currency notes) is legal tender money or fiat

money and has general acceptability.

Credit money or bank demand deposits are conventional money and lacks general

acceptability.

FUNCTIONS OF COMMERCIAL BANKS

A commercial bank or simply a bank is a financial institution which deals with money,

accepts deposits, advances loans, and create credits with the sole purpose of earning

profits. Modern banks performs a wide variety of functions. The important functions

of the commercial banks are as follows.

Functions:

Acceptance of Deposits

Advancing of Loans

Credit Creation

Agency Functions

General Utility Services

Samir K Mahajan

FUNCTIONS OF COMMERCIAL BANKS

Acceptance of Deposits: Commercial bank borrows by accepting deposits from the public.

Demand Deposits: are repayable by the bank on demand or may be withdrawn by thedepositors at any time without previous notice to bank through issue of cheque or other

forms

o includes savings deposits (interest bearing) and current account deposits (non-interest bearing) .

Time/term Deposits: These are deposits repayable after a certain fixed time period varying

from seven days to ten years or more.

o are not withdraable by cheque, draft or by other means.o includes fixed deposits, recurring deposits, certificate of deposits.

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FUNCTIONS OF COMMERCIAL BANKS contd.

Advancing of Loans: The commercial banks provide loans and advances to the public invarious forms.

These includes overdraft, cash credit, discounting of bills, loans and advances,consumer loans etc.

Samir K Mahajan

Credit Creation : is the multiple expansions of bank demand deposits.

When a bank advances a loan to its borrower , it does not lend cash buts open a demanddeposit account in the name of the borrower and credits the loan amount to his account.

o The bank allows the borrower to draw upon the bank as and when required thoughcheque.

o Thus whenever a bank grants a loan, it creates an equal amount bank deposits.

o Creation of such derivative demand deposits is called credit creation which results in netincrease in the money stock of the economy.

Banks have the ability to create many times more than their deposits.

The ability of bank to create credit is limited by cash-reserve requirements.


Samir K Mahajan

Agency Functions: Commercial banks also performs agency functions on behalf of the customers/clients which includes

Collection of cheques, dividends, and interests on behalf of the customers

Payment of rent, insurance premiums on behalf of the customers

Purchase and sale of securities on behalf of the customers

Act as correspondent of their customer

Preparations of Income-Tax returns for their customers

Act as trustee, executor, attorney


Samir K Mahajan

General Utility Services: Banks also performs certain general utility services whichyields non-interest income to the banks. Such services includes:

Safety locker facility Money Transfer Travelers' cheques Gift cheques ATM facilities Dealing in foreign exchange


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Credit card Debit card Accepting bills Internet banking Letters of credit

Merchant Banking

Bancassurance

CRR, SLR, LRR contd.

CASH RESERVE RATIO (CRR): is the minimum fraction of the total deposits of customers whichcommercial banks have to hold as reserves either in cash or as deposits with the central bank.

o fixed by the Central Bank as a tool in monetary policy in influencing the volume of credit

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STATUTORY LIQUIDITY RATIO (SLR): refers minimum portion of deposits that the commercialbanks are required to maintain in the form of liquid asset such as gold or govt. approvedsecurities (bonds, shares).

o fixed central bank of a country in order to control the expansion of bank credit.



LEGAL RESERVE RATIO (LRR) comprises of both CRR and SLR. While the aim of CRR is immediateliquidity needs, the objective of SLR is two fold : to provide profitability with liquidity.


Derivation of Credit Multiplier can be

written as

∆D=∆R [1+ (1-r)2 +(1-r)3 + (1-r)4 + ………….. ]

or, ∆D =(∆R) 1/r

Where ‘r’ stands for Reserve Ratio

∆R stands for initial excess reserve

∆D stands derivative demand deposits

The extent to which the banking system

Derivation of Credit Multiplier: Illustration

o r = 20 percent = 0.2

o Primary deposits = Rs 1000 crores

o Initial excess reserves = ∆R = 80 percent of Rs 1000 crores =800

o Derivative demand deposits (=credit creation by banking

system) = ∆D = 800 x (1/ 0.2) = Rs 4000 crores

Credit Creation By Commercial Banks

Banks Primary Deposits (Rupees in

Crores)

Cash Reserve

(Cash Reserve Ratio = 20 per

cent )

Credit Creation /

Derivative Demand

Deposits

A

B

C

D---

---

---

1000

800

640

512---

---

---

200

160

128

104---

---

---

800

640

512

408---

---

---

Total 5000 1000 4000

Samir K Mahajan

FUNCTIONS OF CENTRAL BANK WITH SPECIAL REFERENCE TO RESERVE BANK OF INDIA

The Central Bank (The Reserve Bank of India in India) is the highest monetary authority of a country. It acts as theregulatory authority of a country's banking system and is the sole provider and printer of notes and coins in circulation.It also formulates monetary and credit policy of a country. The Central bank of a country performs the followingfunctions:

Monopoly of Note-Issue: The central bank has the sole monopoly of note issue in almost every country. It mintscurrency coins and prints currency notes. In India, the Reserve Bank of India It has the sole right to issue currencynotes of all denominations except one-rupee notes. One-rupee notes had been issued by the Ministry of Finance ofthe Government of India.

Banker, Agent & Adviser to the Government: The central bank acts as the banker, agent and adviser to Governmentof India. As banker to the government, central bank provides all those services and facilities to the governmentwhich public gets from the commercial banks. As banker, RBI maintains and operates government deposits, Asagent, it manages government funds, raises loans from the public on behalf of the government, looks after themanagement of public debt etc. As adviser, advises the government on all financial matters etc.

Banker's Bank: Central bank is the bank of banks. It is the custodian of cash reserves of commercial banks. It givesthem advice on financial and economic matters and regulate banking activities such relating to licensing of banksand their branch expansion; management and methods of working of the banks; amalgamation, acquisition of banksetc. Samir K Mahajan

Lender of Last Resort: Central bank provides security to their cash reserves, gives them loan and accommodation at thetimes of emergency and thus act as the lender of the last resort. The Reserve Bank provide financial assistance to thescheduled banks by rediscounting their eligible bill, and through loans and advances against approved securities.

Credit Control: The central bank of the country regulates bank credit and thus money supply in economy in order toensure internal price stability and promote economic growth and thus, avoids inflationary and deflationary tendencies inthe country. The monetary authority use of various quantitative (such as bank rate, open market operation, cash reserveratio, repo and reverse repo) and qualitative techniques (such as margin requirements, moral suasion, appeal etc) toeffectively control and regulate credit in the country.

Custodian of Country’s Reserves of Foreign Currencies: Central bank is the custodian of the foreign currency obtainedfrom various countries. It maintains and stabilizes the external value of the domestic currency , and thus administersexchange controls and other restrictions imposed by the government, and manages the foreign exchange reserves.

FUNCTIONS OF CENTRAL BANK contd.

Samir K Mahajan

Clearing House FunctionAll the commercial banks have their accounts with the central bank. Therefore, central bank settles the mutualtransactions of banks and thus saves all banks contacting each other individually for setting their individual transactions,and claims. In this way; the unnecessary cash transactions between individual banks are avoided.

Other FunctionsBesides the traditional central banking functions, Central Bank (RBI)also performs a variety of promotional anddevelopmental functions. It collects and publishes statistical information relating to banking, finance, credit, currency, agricultural and industrial

production, etc. It also publishes the results of various studies and review of economic situation of the country in its monthly bulletins

and periodicals.

FUNCTIONS OF CENTRAL BANK contd.

Samir K Mahajan

METHODS OF CREDIT CONTROL BY CENTRAL BANK WITH SPECIAL REFERENCE TO MONETARY POLICY OF RBI

Economic policy of public authority comprises of fiscal policy and monetary policy.

Credit control policy or monetary policy is concerned with the regulation of the supply, thecosts and the directions of credit.

The major objectives RBI monetary policy are:

o Economic growth with price stability

o Equitable distribution of credit in different sectors and in different sections of the society

o Stability of external value of its currency

Samir K Mahajan

METHODS OF CREDIT CONTROL contd.

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.

Samir K Mahajan


Quantitative /General Credit Controls

o Bank Rate (or Discount Rate) Policy

o Open Market Operation:o Cash Reserve Ratioo Statutory Liquidity Ratioo Repo and Reverse Repo by RBI

Samir K Mahajan

Qualitative /Selective Credit Controls

o Fixation of Margin Requirementso Rationing of Credito Directiveso Moral Suasiono Direct Action


Quantitative /Genera Credit Controls

o Bank Rate (or Discount Rate) Policy : The bank rate is the rate at which the central bank lendsfunds to commercial banks a lender of last resort against approved securities or eligible bills ofexchange.

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.

Samir K Mahajan

o Open Market Operation: Open market operation refers to buying and selling of approvedsecurities 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).

CREDIT CONTROL BY CENTRAL BANK contd.

Samir K Mahajan

o Cash Reserve Ratio: The proportion of primary deposits which the banks are legallyrequired 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 deflationarytendencies.


Samir K Mahajan

o Statutory Liquidity Ratio: Statutory liquidity Ratio (SLR) refers to the amount of assets whichbanks are legally required to hold in the forms of cash in hand, government and approvedsecurities.

o The increase in SLR causes a fall rate of credit expansiono decrease in SLR causes a rise in the rate of credit expansion.


Samir K Mahajan


o Repo and Reverse Repo by RBI : 'Repo' transactions are conducted by RBI in moneymarket to manipulate short-term interest rate, and to manage liquidity levels/shortterm 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 moneymarket.

repo rate is the discount rate at which commercial banks sell government securities to RBIwith a buy back option.

Samir K Mahajan


o Repo and Reverse Repo by RBI contd.

When RBI conduct a Reverse Repo,

Commercial Banks buys approved securities from RBI with a to resale agreement atfuture date and specified price.

with revers Repo, RBI borrows money from commercial banks and thus, absorb excessliquidity from the money market.

Reverse Repo rate is the discount rate at which commercial banks purchases governmentsecurities with a resale option.

Samir K Mahajan

Qualitative /Selective Credit Controls

o Fixation of Margin Requirements: Margin Requirements is the difference between the value of the securities and the loan.

When the Central Bank prescribes higher margin the borrowers can obtain less amount of credit on his stock and vice-versa.


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o Rationing of Credit: Under the rationing of credit, the Central Bank fixes a maximum limit for loans that a commercial bank can provide to different sectors of the economy.


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o Directives : The Central Bank issues directives from time to time to follow its credit policy andthe commercial banks abide. The directives may be in the form of written orders, warnings orappeals, etc.

o Moral Suasion: Under this method, the Central Bank merely uses its moral influence on thecommercial banks. It includes the advice, suggestion request and persuasion with thecommercial banks to co-operate with the Central Bank. If the commercial banks do not followthe advice extended by the Central Bank, no penal action is taken against them.


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o 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.

o Direct Action: The Central Bank uses direct action against the banks which does not complywith its instructions.

No commercial bank can afford to go against the wishes of the central bank with regard topolicy matters, as the central bank has wide powers even to stop banks' operations.


Samir K Mahajan

CLASSIFICATION OF MONEY BY RESERVE BANK OF INDIA

M1 ( Narrow Money/High Powered Money) = Currency ( coins and notes) with public + Demand deposits (CurrentDeposits 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 theBanking System (excluding CDs)

M3 (Broad Money)= M2 + Term Deposits of residents with a contractual maturity of over one year with the BankingSystem + Call/Term borrowings from 'Non-depository Financial Corporations by the Banking System

M4 = M3 + All deposits with post office savings banks (abolished)

Samir K Mahajan

RBI

Cash Reserve Ratio 4.00 (w.e.f 09/02/2013)

Statutory Liquidity Ratio 21.50% (w.e.f. 07/02/2015)

Repo Rate 7.25% (w.e.f. 02/06/2015)

Reverse Repo Rate 6.25% (w.e.f. 02/06/2015)

Bank Rate 8.25% (w.e.f. 02/06/2015)

Samir K Mahajan

Documents

MONEY BANKING MEANING AND FUNCTIONS contd. Secondary Functions contd. As transfer of value, sale and purchase of movable and immovable assets, paper wealth