FACULTY OF BUSINESS & ECONOMICS

Course: Introduction to Money & Banking

SAHAL UNIVERSITY
BOSASO

Introduction to Money & Banking

 FACULTY OF BUSINESS & ECONOMICS
Course: Introduction to Money and Banking

INTRODUCTION TO MONEY AND BANKING

Course Description

This course explores the practical aspects of money and banking within the economy.
Emphasis is given to the changing role of financial institutions as well as new financial
instruments. Topics will include money creation, the Federal Reserve, economic
stabilization using monetary and fiscal policy as well as the creation of different
international monetary systems and their impact on the global economy.

Understanding money and banking is a necessary component to sound financial

investment. In this course, students will go beyond the traditional description of the
financial markets, introduced in economics courses, to study financial markets and
instruments and their impacts on the economy. In addition, the Federal Reserve Bank
and its ability to manipulate the economy will be investigated.

Course Learning Outcomes

At the completion of the course, students will be able to:

1. Analyze how the banking system works and its impact on society.

2. Communicate with others verbally and in written form the issues facing the monetary
system of the country.

3. Use current technology to track changes occurring in the banking system.

4. Evaluate ethical issues facing the monetary system and its regulators.

Course objective

The objective of this course is to enable students to understand modern financial and
monetary system. The basic terms of money and banking have been explained in simple

Introduction to Money & Banking 1

language with examples. This course will fulfill the basic requirements for
understanding the advanced level subjects of finance in higher classes.

Course Reading list

 Carlin, W and D Soskice (2015) Macroeconomics: Institutions, Instability, And

The Financial System, OUP

 K Matthews and J Thompson (2014) The Economics of Banking, Wiley

 McLeay et at. (2014) Money Creation in the Modern Economy. Quarterly

Bulletin Q1, BoE.

 Mishkin, F (2018) The Economics of Money, Banking and Financial Markets,

Global Edition. Pearson.

 Blanchard, O. Amighini , A. Giavazzi, F. (2017) Macroeconomics: A European

Perspective. Pearson.

Additional reading:

 Kay, J. (2015). Other People’s Money: Masters of the Universe or Servants of the
People? Profiles Books, London

 Neilson, D. H. (2012) Banks as Creators of Money. The Money View, INET.

Introduction to Money & Banking 2

 CHAPTER I - INTRODUCTION TO MONEY AND BANKING

Introduction to Money

The word money is derived from Latin word ‘’Monet’’. Money used in economic
transactions and also serve as medium of exchange.

Money can be defined as “Money can be anything that is generally acceptable as a means
of exchange that at the same time acts as a measure of value.’’ (Crowther)
OR
“Money is anything that is generally accepted in payment for goods and services or in
the repayment of debts”. (Mishkin)

In modern world, money is considered as a basic necessity. The benefit of the discovery
of money is to over comes the problems of barter system in which goods were exchanged
against other goods.

As goods were of different quality and quality, a simple unit of measurement was
necessary for conducting the economic transactions.

With the help of money people can make payments.

Producers buy raw material, plants and heavy machinery with the help of money.

Definitions of Money

Money is the backbone of capitalistic economy everyone according to his capacity

engaged in economic activities.

Individual who owned money has complete right for production decisions and
consumption pattern.

Consumers and producers receive money income in the form of wages, interest etc.

Money is a center of a circle and in capitalist economy money performs the important
function of solving the central problem through price mechanism.

Money is any object or record that is generally accepted as payment for goods and
services and repayment of debts in a given socio-economic context or country.
The main functions of money are distinguished as: a medium of exchange; a unit of
account; a store of value; and, occasionally in the past, a standard of deferred payment.

Introduction to Money & Banking 3

Barter System

During the primitive stages of civilization, human needs were simple and every person
produced all that was needed to sustain life - he gathered his own food, sewed his own
clothes and built his own shelter.

It involved exchange of goods for goods. For example, exchange of rice for shoes by
some individuals. This exchange of goods for goods was known as barter.

In this system of exchange, there were several difficulties and inconveniences.

Difficulties of Barter System

Barter system had certain difficulties which created numerous inconveniences to people.
They are:

Double coincidence of wants. Difficult to get what you need and fine one who
wants what you have.

Indivisibility of some commodities exchanged.

Difficulties to calculate the value of commodities exchanged.

The exchange of services would be far more complicated than the trading of
goods. For example, how to pay for the services rendered by a teacher or a barber
is not easy to decide in a barter system.

In a barter system, it is very difficult to accumulate wealth for future use.
Perishability of some commodities.
Difficulties in transportation of awkward shaped and heavy commodities.
Thus, the difficulties associated with this barter system compelled human beings to give
up this sort of exchange and to look for something easily recognizable and generally
acceptable to all.

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This commonly accepted commodity or thing had to act as a medium of exchange.

This medium of exchange formed the basis for earlier definition of money.

Money may be anything chosen by common approval as a medium of exchange.

Features of Money:

Medium of Exchange: It is accepted as medium of exchange for the settlement of

economic transactions.

Legal Tender: It is used as legal tender for repayment of debts, wages, interest, profit
etc.

Pricing: It is used as standard in the development of pricing mechanism for economic

activities

Unit of Measurement: It is used as accounting measure for different services/things.

Savings: It is used as a tool to save and store purchasing power for future period.

Forms of Money

Along with the development of human civilization, money also changed its form and its
role to meet new challenges for economic prosperity and development of society. Money
evolved itself over the ages starting from animal money to credit cards of today.
Economists have identified the following phases in the evolution of money:
Animal Money
Commodity Money
Metallic Money
Convertible Paper Money
Fiat Money
Bank Money
Super Money
Electronic Money

Introduction to Money & Banking 5
Functions of Money

Money is anything that is widely used as a mean of payments and is generally expectable
in settlement of debts. It is also used in economic transactions or medium of exchange
purpose.

A. Primary Functions:

Medium of Exchange: Money is used as a medium of exchange and the sale and
purchase of different products can be made through money. It is the most important
function of money

Measure of Value: the value of all goods and services are expressed in terms of
money. we measure the value of money in terms of money.

Standard of Deferred Payments: Money also serves as a standard of payment made

after a lapse of time to settle debts and make investments.

Store of Value: Money is the most liquid assets from all the assets therefore it is easier
to store value in the form of money.

B. Secondary Functions:

Instrument for Lending: People save money and deposit it in to banks. The banks
advance these savings as loans to businessmen and earn profit by charging interest.

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Instrument of Economic Policy: Money is the powerful factor to achieve growth,
reduce unemployment and maintain expansion of economic activity.

Tool to Monetary Management: Money is also help in determining the distribution

of wealth among the members of society.

Aids to Production and Trade: It helps in the production of goods and services and
facilitates expansion of trade.

Qualities of Ideal Money

The essential attributes of ideal money are as follows;

 General Acceptability: should be acceptable as a medium of exchange without

any objection by others for goods and services.

 Portability: it can be easily and economically transported from one place to the
other. In other words it possesses high value in small bulk.

 Durability: As money is passed from hand to hand and is kept in reserves it

must not easily deteriorate either in itself or as a result of wear and tear.

 Homogeneity: that is of the same quality so that equal weights have the same
value.

 Divisibility: should be capable of division.

 Malleability: should be capable of being melted and given convenient shapes. It

should be neither too hard and nor too soft.

 Recognizability: a good money material is that it should be easily recognizable

by the eye, ear or the touch.

 Stability of Value: Money should not be subject to fluctuations in value.

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Exercise

Give short answer to following questions:

1. Define money.

2. Write the functions of money.

3. What is barter system?

4. Write down the features of ideal money.

VALUE OF MONEY

Value of money means the purchasing power and capacity to exchange the goods and
services.

“The value of money is what it will buy.”

It refers to the strength of money in the market against which we can buy or sell
something.

Money is a type of asset in an economy which is used to buy good and service and it
serve as store value in an economy.

In daily life, we can observe that mere increase in the supply of money does not make us
rich rather it hurts the purchasing power of consumers.

Kinds of value of money

- The value of money is of two types:-
The internal value of money and
The external value of money.
- The internal value of money means the purchasing power of money over
domestic goods and services.
- The external value of money means the purchasing power of money over foreign
goods and services.

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Theories of value of Money

To know how the value of money is determined, we need to understand the following
theories:
 Quantity Theory of Money
 Cash Balance Approach of the Quantity Theory of Money
 Modern Theory of Value of Money:

A. Quantity Theory of Money

It states that “there is a direct relationship between the quantity of money in

an economy and the level of prices of goods and services sold”.

According to QTM, if the amount of money in an economy doubles, price levels also
double, causing inflation.

So an increase in money supply causes prices to rise (inflation) as they compensate for
the decrease in money's marginal value.

The Theory's Calculations

In its simplest form, the theory is expressed as:

MV = PT (the Fisher Equation)

Each variable denotes the following:

M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services

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Worked example

Given that the quantity of money in an economy is Shs. 1,000,000, its velocity of
circulation is 20 and the number of transactions made are 250. Calculate the general
price level in an economy.

B. Cash Balance Approach of the Quantity Theory of Money

Quantity Theory of Money approach emphasized the medium of exchange functions of

money.

On the other hand, the cash-balance approach was based on the store of value function
of money.

According to cash-balance approach, “the demand for money and supply of

money determine the value of money”.

This approach, considers the demand for money and supply of money at a particular
moment of time.

Since, at a particular moment the supply of money is fixed, it is the demand for money
which largely accounts for the changes in the price level.

As such, the cash- balance approach is also called the demand theory of money.

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Fall in demand for goods and services will reduce the price level and raise
the value of money. Conversely, fall in the demand for money will raise the
price level and will reduce the value of money.

Cash-balance equation

The Marshallian cash-balance equation is expressed as follows:

MV = KPY
Where
M is the supply of money (currency plus demand deposits)
P is the price level
Y is aggregate real income; and
K is the fraction of the real income which the people desire to hold in the form
of money.
Simplified equation: The value of money (1/p) (or, the purchasing power of
money),

Worked example

If M is Rs10,000, Y is $1,00,000 units, K is .5, then the value of money (1/p) will be?

The cash balance states that:

The price level (P) is directly proportional to the money supply (M);

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 The price level (P) is indirectly proportional to the aggregate real income (Y) and
the proportion of the real income which people desire to keep in the form of
money (K);

M and Y being constant, with the increase in K price level (P) falls and with the
decreases in K price level (P) rises;

K and Y remaining unchanged, if supply of money (M) increases, price level (P)
rises and if supply of money (M) decreases, price level (P) falls.

C. Modern Theory of Value of Money:

Milton Friedman said that ‘’the quantity theory is the theory of demand for money.

It is not the theory of output or money income or price level”.

According to Friedman wealth includes the source of income or consumable services.

ASSIGNMENT
Given that the volume of money in an economy is £ 20 billion; total level of transactions
is £ 250 and the transactions velocity of money is 20; calculate the general price level in
the economy. (hint; Quantity theory of money…)

Forms of wealth according to Friedman

In Friedman views, wealth can be held in the following five different forms.

I. Money: It includes currency, demand deposits and time deposits.

II. Bonds: Bonds are defined as a claim for payments that are fixed in nominal
units.

III. Equities: Equities are defined as a claim for payment that are fixed in real units.

IV. Physical goods: It includes inventories of producer and consumer goods.

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 V. Human capital: It includes skills, knowledge and experience possessed by an
individual.

The demand for money according to Friedman

According to Friedman the demand for money is a function of the following factors:

 Rate of returns on shares: if rate of return on shares increases, the demand

for money is decreases and vice versa.

 Rate of return on bonds: If the rate of return on bonds is increased, the

demand for money is decrease and vice versa.

 Liquidity: It means how quickly the assets can be converted into cash the
liquidity of assets also affects the demand of assets.

 Degree of risk: Degree of risk is also affecting demand for an asset.

INFLATION AND ITS TYPES

Inflation is an increase in the general price level of the goods and services in an economy
over a period.

Inflation occurs when general level of prices and cost are rising.

Inflation arises when money income is expending more than proportionate to income
earning activity.

Classification of Inflation

Inflation can be classified on the following basis:

a. Inflation based on Causes: Inflation can be classified on the basis of causes as:
(demand pull and cost push inflation)

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 Demand Pull Inflation: Demand pull inflation arises in an economy when
the demand for goods and services is increased but on the other hand supply
of goods and services decreases and the general price level rises.

There are many factors that cause the demand pull inflation:
 Increase in money supply
 Increase in the demand for goods and services
 Increase in the income level
Cost Push Inflation: Cost push inflation arises when the cost for
production and operations increases.
There are many factors that create cost push inflation:
 Increase in wages.

 Increase in cost of raw materials.

 Increase in the cost of important components.

b. Inflation based on Employment

Inflation can be classified on the basis of employment as;

Partial Inflation: According to J. M. Keynes, when the general price level

increases partly due to an increase in the cost of production of goods and
partly due to rise in supply of money before full employment stage is called
partial inflation.

Full Inflation: It arises when the economy has reached at level of full
employment. Increase in money supply and general price level also increase,
but without any increase in production and employment.

C. Inflation based on Degree of Control

Inflation can be classified on the basis of control as:

Open Inflation: In open inflation, general price level rises day by day and gets
out of control for the government.

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 Suppressed Inflation: In this type of inflation government should take steps
and measures to control in the rise in general price level through different
methods like rationing.

d. Inflation based on Rate of Inflation

Inflation on the basis of rate of inflation can be classified as under:

- Creeping Inflation: situation where the general price rises with slow rate. i.e.
price level rises up to a rate of 2% per annum.

- Walking Inflation: in situation the general price level is increased at lesser

level as compared to the creeping inflation. price level rises approximately 5%
annually.

- Running Inflation: In running inflation situation the general price level rises
approximately 8% to 10% annually.

- Hyperinflation: Keynes calls hyperinflation as the final stage of inflation that

type of inflation arises after the level of full employment attained, but price level
increases rapidly.

Other Types of Inflation:

Monetary Inflation: Monetary inflation arises in an economy due to rapid increase in

money supply.

Budgetary Inflation: When government of a country overcome the budget deficit

through lending and insurance of new currency, that behavior increase the purchasing
power and also create rise in the general price level that leads to inflation.

Profit Induced Inflation: Profit induced inflation arises, when the business in
monopoly position they increase their rate of profit on their production, they may cause
inflation in an economy.

Remedies/Solutions for Inflation

It is the main duty or objectives of every government to take proper measures and steps
to control the inflation.

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Two major tools to control the inflation are:

 Monetary policy and

 The fiscal policy;

Monetary Policy

Monitory policy influences the economy through change of money supply and
availability of credit.

Monetary policy is set by the central bank of a country who adopts following
methods to control the money supply i.e.

Variation in reserves requirements of commercial banks.

Variation in bank rates for lending.
Variation in margin requirements for banks.
Credit rationing for allocating capital in various sectors.

Fiscal Policy

It is the budgetary policy of the government related to the public finance taxes,
borrowing and deficit financing.

Fiscal policy states the change in the spending and taxes to stimulate the
economy by the government.

The main fiscal measure is:

- Changes in taxation by lowering tax rates and increasing consumption

- Public borrowing is curtailed, and funds are saved

- Control of budget deficit is achieved, and the deficit financing is reduced

Introduction to Money & Banking 16

 - Adopting a general austerity policy by reducing govt. expenditures

Other Measures:

i. Some other measures taken by the government to overcome the inflation are as
follows.

ii. Control of smuggling as it reduces supply of goods in country.

iii. Provisions of subsidies to needy sections of society.

iv. Population control to reduce the aggregate demand.

v. Encourage simple living to reduce demand for expensive items.

vi. Direct control on the prices of essential items by the government.

vii. Encourage Sunday and Friday markets to offer discounts.

DEFLATION

Deflation is opposite to the term inflation.

Deflation is that state of the economy where the value of money is rising, or prices are
falling.

Causes of Deflation:

Level of investments decreases negatively affecting the economy as the demand

for goods fall down.

Decrease in the people income also cause deflation in the economy. Due to
reduction in the income level the demand for goods and services decreases that
leads to decrease in price level.

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 Increase in supply affects demand of goods negatively and the price level falls
down.

Remedies for Deflation

- To increase exports for achieving higher incomes and price support

- Central bank should reduce interest rate for increasing the level of lending in
economy.

- To encourage the private sector investments by giving tax

exemptions/credits/rebates.

- To encourage the people for consumption by offering discounts.

STAGFLATION

Stagflation is the co-existence of inflation and unemployment.

It is a process in which the economy faces the serious problems at the same time i.e.
unemployment and increase in prices.

Stagflation involves inflationary rise in prices and wages at the same time.

The people are unable to find jobs and firms are unable to find customers for what their
plants can produce.

Causes of Stagflation

There are many causes that help to create stagflation in an economy.

The decrease in the supply of goods occurs due to the following factors:
Cost of resources is increased due to lesser supply
Shortage of labor due to changes in technology
Introduction to Money & Banking 18
 Rise in taxes especially indirect taxes

Remedies for Stagflation

 Encourage development programs especially infrastructure related.

 Encourage training programs for labor force.

 Reduce taxes on goods and services.

 Increase in labor supply and ensure minimum wages

 Providing raw material at lower rates to the industry.

DEPRECIATION AND DEVALUATION OF MONEY

There are two types of decrease in the value of a currency:

A. Devaluation of Currency: Is the legal reduction of country’s value of currency in

relation to other currencies.

Government takes devaluation of currency against other currencies for the improvement
of trading positions.

B. Depreciation of Currency: Is the fall of value of the country’s currency in relation

to other country’s currencies.

Market driven devaluation does not arise by the government, but it arises due to the
market position

Effects of Depreciation/Devaluation

- Following are the effects of depreciation and devaluation of currency:

- The imports tend to be more expensive and exports tend to cheaper.

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 - Discourages the investors for making investment in that country whose currency
devalued rapidly.

- Makes the country currency less attractive at international level.

- Devaluation exports increases and imports decrease, that make the balance of
payment favorable.

- The increase in exports and decrease in imports reduced the current account
deficit.

Exercise:
1. What is meant by stagflation?
2. What do you know about the term devaluation of money?
3. Enlist any three types of inflation?
4. What is cash balance approach?
5. Difference between depreciation and devaluation of money.

Introduction to Money & Banking 20

 CHAPTER II - FINANCIAL ASSETS

Financial asset

A financial asset is a documentary claim that has a monetary value.

In capitalism, markets offer a mechanism to trade goods and services among the buyers
and sellers at an agreed price.

There are many types of markets in an economy; fruits markets, cloth markets,
commodity markets, auto markets etc.

The financial market is also a kind of market that coordinates the activities of all other
markets.

The financial market is a mechanism to trade financial assets among the buyers and
sellers at a mutually agreed price.

Types of Financial Assets

There are different types of financial assets traded in financial market;

 Shares are the certificates usually bought on a stock exchange that represent the
claim of ownership in a company.

 Bonds are the certificates through which investors provide funds to the
businesses at an interest rate for a specific period.

 Commercial papers are short term investment instruments redeemable at

maturity and are purchased by the buyers in order to provide funds to the
businesses at an interest rate.

 Futures are the financial assets that derive their value from an underlying asset
whose price is agreed at present and settlement is made in future.

 Treasury Bills are the investment tolls offered by the government for short
term financing requirements that carry an interest rate and are redeemable on
maturity.

 Cheque is a modern banking tool that is used to settle outstanding liabilities

through bank accounts.

 E-Certificates are offered by the modern online form of businesses for investing
funds in their projects.

Introduction to Money & Banking 21

FINANCIAL MARKETS

After going through the various types of financial assets, now, we are able to understand
the working of financial markets.

Classification of Financial Markets

These financial markets can be understood in several different ways as highlighted

below:

A. Classification by Nature of Claim:

Debt market is a market where debt instruments like bonds, debentures, term
finance certificates are traded among the buyers and sellers.

Equity market is a market where the equity instruments like common shares,
preferred shares etc. are traded among the investors.

B. Classification by Maturity of Claim.

Money market is a market for trading the short-term financial assets like trade
notes, commercial papers, treasury bills etc. in an economy.

Capital market is a market where the long-term maturity bearing financial

assets like shares, bonds, certificates are traded among investors.

C. Classification by Seasoning of Claim.

Primary market is a market where a financial asset is offered first time for
trading in the financial system.

Secondary market is a market where the trading of financial asset is carried on

after its launching in the primary market.

D. Classification by Delivery

Cash or spot market is financial market where the financial assets are traded
on spot without involving any reference to future price or delivery.

Derivative market is a market that involves the trading of financial assets

whose delivery is expected in future.

E. Classification by Product Type

Commodity market is a type of financial market in which the future contracts

for metals, oil, gas and crops are bought & sold by the investors.
Introduction to Money & Banking 22
 Forex market is a financial market that involves the trading of different
currencies of the world in order to earn profit.

Equity market is a market where the shares are bought and sold in order to
earn capital gains and dividends.

Difference between Money and Capital Markets

Money Market Capital Market

Definition:
Money market used for short term Capital markets are used for long term
borrowings borrowing.
Time period:
Money market lending and borrowing In capital market lending and borrowing
is for short time one year or less is made for more than one year.
than one year.
Instruments:
Commercial papers, Repurchase Stock, shares, debentures, bonds, and
agreement, Certificate of deposit and government securities.
treasury bills
Institutions:
Central bank, commercial bank, Stock exchange, commercial banks, and
National financial institutions. insurance companies etc.
Risk:
In money market risk factor is very In capital market risk factor is more as
small because time period is less than compared to money market the reason
one year. behind this is the time period.
Merit:
Increases liquidity of funds in the Mobilization of saving in the economy.
economy.
Purpose:
To fulfill short term credit needs of To fulfill long term credit needs of the
the business. business.
Return on investment:
Return on money market less as Return on capital market is Comparatively
compared to capital market. high.

Introduction to Money & Banking 23

Foreign Exchange Rate

Foreign exchange rate also known as FX rate or forex rate is a ratio between the
values of two country currencies. $1 = sos 26000

Exchange rate tells the value of domestic currency in terms of foreign currency.

Exchange rate is the price of the currency of a country can be exchanged for the number
of currency of another country.

Foreign exchange situation of a country tells us about the financial position of a country.

Theories of Foreign Exchange Rate

Economic experts have developed the theories of exchange rates to explain how the
foreign exchange rate among different currencies is established. Two of these theories
are discussed below:

 The Purchasing Power Parity Theory: Purchasing power parity theory is

(PPP) which states that exchange rate of two currencies are in equilibrium when
the purchasing power is same in each of the two countries. The purchasing power
parity theory is based on the law of one price

 The Balance of Payment Theory: it is also known general equilibrium theory

of exchange rate.
According to this theory, the exchange rate of a currency depends upon the demand
and supply of that currency in a region or country. The demand of foreign currency
arises from the debit side of balance of payment.

Other Factors that Influence the Rate of Exchange

There are many other factors that influence the exchange rate:

Inflation rate affects the value of a currency in an economy thereby affecting

the determination of exchange rates.

Interest rate also has an impact on the level of investments in an economy and
explains the level of investments in an economy. .

Political stability affects the inflows and outflows of investments in an

economy.

Recession negatively affects the value of a currency as industrial production and

demand is down.
Introduction to Money & Banking 24
 Industrial position: The structure and performance of the industrial sector
also affects the rate of exchange as investments are made or withdrawn on the
basis of economic performance.

TRADE CYCLE

A trade cycle is composed of periods of good trade, characterizes by

o Rising prices

o Low employment percentages,

o Shifting with periods of bad trade,

o Characterized by falling prices and

o High unemployment percentages.

Phases of the Trade Cycle

There are four phases that involves in the construction of trade cycle. These are as under

Recovery: is a turning phase in which economy moves toward boom or peak.

Boom or Peak: The highest level in trade cycle is called boom or peak. This
stage is also known as prosperity stage.

Depression: In this phase, the economic activities fall that leads to decrease in
production.

Recession: is the decline in the economic boom. Is in form of fall in production,

rise in prices, and increase in costs of production.

Introduction to Money & Banking 25

Diagrammatically – phases of the trade cycle

Factors Affecting Trade Cycle

The theories of trade cycle explain the causes and possible remedies for managing the
trade cycle in an economy.

 Money Supply

 Aggregate Demand

 Level of Investments

 Political Situation

 Uncontrollable Natural Events: Sometimes, earthquakes, epidemic or unusual

flood

MONEY MARKET

Definition and meaning

Following definitions will help us to understand the concept of money market.

According to Crowther, "The money market is a name given to the various firms and
institutions that deal in the various grades of near money."

According to the RBI, "The money market is the centre for dealing mainly of short
character, in monetary assets; it meets the short term requirements of borrowers and
provides liquidity or cash to the lenders.

Introduction to Money & Banking 26

According to Nadler and Shipman, "A money market is a mechanical device through
which short term funds are loaned and borrowed through which a large part of the
financial transactions of a particular country or world are degraded.

A money market is distinct from but supplementary to the commercial banking

system.“

These definitions help us to identify the basic characteristics of a money market. A

money market comprises of a well-organized banking system

Functions of Money Market

Money market is an important part of the economy. It plays very significant functions.
As mentioned above it is basically a market for short term monetary transactions.
The major functions of money market are given below:-

 To maintain monetary equilibrium

 To promote economic growth:

 To provide help to Trade and Industry

 To help in implementing Monetary Policy

 To help in Capital Formation

Questions

1. Define exchange rates.

2. Define money market?

3. What do you know about capital market?

4. Enlist any three financial assets?

INTERNATIONAL MONETARY SYSTEM

International Monetary System

The international monetary system is a set of agreed rules and frameworks that
determine the flow of funds among the different nations.

These rules help to set the foreign exchange rate for different currencies of the world.

Introduction to Money & Banking 27

As the global trade and investments occurs among different nations, the exchange of one
currency against the other requires setting commonly agreed rules.

Types of foreign exchange rate system

There are three types of foreign exchange rate system in the world:

Fixed Exchange Rate System: is also known as pegged exchange rate

system. Exchange rate for currency is fixed by the government of a country. The
basic purpose of adopting this system is to maintain the stability in foreign trade.

Floating Exchange Rate System: (flexible exchange rate system),the

exchange rate is determined by the forces of demand and supply of different
currencies in foreign market.

Value of national currency is allowed to move freely with respect to the demand
and supply of other currencies.

Managed Floating System: In managed floating system, the exchange rate is

determined by the forces of market (demand and supply) and interventions of the
government or central bank.

In this system the government and central bank intervenes in the foreign exchange
market to restrict the fluctuation in the exchange rate within certain limits.

International Monetary Fund (IMF)

During the early years of the 20th century the world suffered though the great
depression.

This happened during 1930 and World War I & II has weakened the international
payments system.

In July 1944, 730 delegates from the 44 major countries met at the Mount washing
hotel.

The primary purpose of that conference was about the establishment of an

institution that take care of the international finances on the other hand
that institution could help the member countries during any emergency or
crises.
The institution will work like a bank.

Formation of the IMF

During the Bretton Wood Conference, a lot of agreements were signed to establish

Introduction to Money & Banking 28

  General Agreement on Tariffs and Trade (GATT),

 the International Bank for Reconstruction and Development (IBRD) and

 the International Monetary Fund (IMF).

The international monetary fund was founded on 27thDecember 1945 by an agreement

signed by the 29 member countries.

The IMF started their financial operations on 1stMarch 1947.

The establishment purpose of IMF was to give financial assistance and overcome the
crises in any member country.

The IMF has approximately 188 member countries.

How IMF Works?

The member countries deposit some amount of money as subscription fee.

The member countries are also responsible for the rules and regulations made by the
organization IMF.

The basic function of the establishment of the international monetary funds was to help
out those countries that face financial crises.

IMF lend loan to these countries on some low interest policies.

The decision making in the IMF is done by the board of governor considered as general
body of IMF.

Functions of IMF:

To Promote Exchange Stability

Borrowing Facility: IMF provides borrowing facility to the member countries.

If member countries face any problem or crises.

Balance of Payment Stability

Technical assistance: providing services of experts to the members of IMF on

economic and financial matters.

International monetary cooperation: IMF also helps to establish monetary

cooperation between member countries.

Introduction to Money & Banking 29

Economic and Political Limitations of IMF

A. Dominance of Major Economies

 Influence of the United States and European countries

 Power imbalances in decision-making processes

B. Conditionality and Policy Impositions

 Stringent conditions attached to loans and assistance

 Criticism of policy prescriptions and their impact on sovereignty

C. Political Interference

 Allegations of political bias and manipulation

 Influence of major shareholders in shaping IMF policies

Environmental Considerations

A. Inadequate Focus on Environmental Issues

 Insufficient consideration of environmental impacts in policies

 Inadequate support for sustainable development and climate change initiatives

B. Financing of Fossil Fuels

 Criticism of IMF support for fossil fuel projects

 Failure to align with international climate commitments

QUESTIONS

1. What is the IMF and what is its purpose?

2. How does the IMF provide financial assistance to countries?

3. What are the conditions attached to IMF loans?

4. How does the IMF make decisions and who has the power to influence those
decisions?

Introduction to Money & Banking 30

 5. What role does the IMF play in global economic governance?

6. How does the IMF address economic crises and financial stability?

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

(IBRD)

International bank for Reconstruction and Development is also known as the World
Bank.

IBRD was established in 1944 and became operational in 1946 as the original institution
of the World Bank group.

The IBRD head quarter is in Washington DC, USA and approximately 15000 staff from
the member countries.

The structure of IBRD is like cooperative society that is operated for the benefits of 188
member countries.

All powers of the bank are vested in its board of governors. The board meets annually in
annual board meeting.

Objectives of IBRD

 To assist the member countries.

 To promote foreign investment.

 To promote balanced growth of international trade.

 To provide loans for reduce poverty

Membership

All the IMF members are also members of IBRD.

A country to want to hold its membership must subscribe to the charter of the bank.

If any country wants to resigns its membership that country pay back all loans with
interest to IBRD.

IBRD Fund Sources

Introduction to Money & Banking 31

 Member countries contribute according to their Quota in IMF, that contribution
is a source of fund for IBRD.

Sometimes IBRD raises their funds through selling of bonds in the international
capital market and increased their funds.

IBRD advance loans to the member countries and received back loan amount
with interest as well, that also helps IBRD to raise their funds.

IBRD Role in Somalia

IBRD has helped Somalia many times and provided loans and technical assistance for;

 Poverty reduction

 Social development

 Infrastructural development

 Capacity development of govt. institutions

ASIAN DEVELOPMENT BANK (ADB)

The Asian Development Bank (ADB) is a regional development bank established on

December 19, 1966 with an authorized capital of 58 billion dollars.

Is headquartered in Manila, Philippines.

The basic purpose of ADB is to promote social and economic development.

Sources of Finance

ADB raises fund through bond issues in the world capital markets.

Member’s contribution as subscription fee and raises the funds of ADB.

ADB raises fund through lending operation, and the repayment of loans.

CASE STUDY - ADB and Pakistan

ADB remains one of the largest development partners and has provided more than 23
billion dollars in loans and over 531 million dollars in grants.

Introduction to Money & Banking 32

The ADB has helped Pakistan many times and has provided technical and financial
assistance in the following sectors:

 Educational sector development

 Energy and health sector development and capacity development

 Industry and trade development

 Information and communication technology

 Public sector financial and technical management

 Social protection and poverty alleviation

 Transport and water infrastructure development

 Agriculture sector development

 Development of capital markets

Short Questions:

1. What do you know IMF?

2. Write three objectives of IBRD.

ISLAMIC DEVELOPMENT BANK (IDB)

The Islamic development bank (IDB) is a multilateral development financing institution

located in Jeddah, Saudi Arabia.

It was founded in 1973 by the finance ministers at the Islamic conference (now called
the Organization of Islamic Cooperation OIC)

with the support of the King Faisal of Saudi Arabia and started its activities on 20
October 1975.

IDB Groups

IDB has group of five entities;

Islamic Development Bank (IDB)

Introduction to Money & Banking 33

 Islamic Research and Training Institute. (IRTI)

Islamic Corporation for Development of the Private Sector. (ICD)

Islamic Corporation for Insurance of Investment and Export Credit (ICIEC)

International Islamic Trade Finance Corporation. (ITFC)

Functions of IDB:

i. To invest in economic and social infrastructure projects in member countries.

ii. To provide loans to private and public sector for the financing of productive
projects.

iii. To assist in the promotion of foreign trade.

iv. To provide technical assistance for economic growth in members countries.

v. To conduct operations according to the principles of Shariah i.e. Islamic law.

vi. To corporate with all international institutions having similar purpose.

vii. To participate in the productive projects in the member countries. To promote

savings and investments

ASIAN INFRASTRUCTURE INVESTMENT BANK (AIIB)

The Asian Infrastructure Investment Bank (AIIB) is a multilateral development

bank.

It aims to support the building of infrastructure in the Asia-Pacific region.

The bank was proposed by China in 2013 and the initiative was launched at a ceremony
in Beijing in October 2014.

Functions of the AIIB

 Development of physical infrastructure in emerging economies

 Financing for large scale investment projects in low to medium income countries

 Enhancing trade and bilateral cooperation among member countries

 Development of modern technological networks for emerging economies

Introduction to Money & Banking 34

  Providing equity and debt support for large scale infrastructure projects

Questions:

1. Differentiate between AIIB and ADB.

2. Write any three functions of IDB.

3. Briefly explain IDB.

4. Briefly explain the organizational structure of ADB.

Introduction to Money & Banking 35

 CHAPTER III – BANKING

Introduction to Banking

The banking system is a lifeline of an economy and as it plays very important role in the
development of any country.

Banking sector have a significant influence in supporting economic development

through financial services.

A bank is an institution which accepts deposits and lends advances.

It accepts deposits from general public and institutions and lend money to the eligible
investors for productive purposes.

Definition

A general definition of a bank is “Bank is an institution which gets loans to lend and, in
this way, creates credit”.

A bank is an intermediate party between the borrower and lender. It borrows from one
party and lends to another”.

Generally, a bank performs the following functions:

Acceptance of deposits.

Advancement of loan.

Issues and pays cheque.

Transfer money from one place to another.

Banking plays an important role in economic growth of any country.

Major Development for a country depends on banking sector as bank maintain the
currency value and stability of foreign exchange.

People trust banks and deposit their surplus money in bank accounts which banks used
it for investment and making loans to needy.
Functions of Bank

 Acceptance of deposits: Banks accepts money from the people in the form of
deposits which are usually repayable on.

Introduction to Money & Banking 36

  Advancing money: The funds collected as deposits are then given as loan to
the businesses and individuals as per their requirements.

 Agency Services: The agency services include transfer of funds from one
account to another, regular periodic payments, collecting cheques, managing
investment accounts etc. The banks charge fee to their clients for performing
these services.

 Utility Services: The utility services offered by a bank include services

accepting utility bills payments, Govt

Banks are useful in following ways:

Money deposits in banks is safe and other precious good and documents in bank
locker.

Banks provide credit facilities to needy people.

Bank encourage the habit of saving by offering interest against deposited money.

Bank provides safe way of transferring money from one place to other.

Foreign trade constantly increases through banks.

EVOLUTION OF BANKING

Different banking experts have different opinion about the beginning of word “Bank’’.

The word bank is derived from Italian word “Banque’’.

Whereas German experts says that it is originated from German word “Back” It
denoted to a bench for keeping, lending and exchange of money or coins in the market
place by money lender and money exchangers.

Stages of evolution of banking

There are three stages of evolution of banking:

Merchants were first inventor of the banking system as they were considered as
trustworthy and responsible people because of their strong financial background
and repute of dealings in money.

Introduction to Money & Banking 37

 Goldsmiths, were also considered as the trustworthy people due to their strong
financial position and heaving safe places or strong iron safe for the safety of
valuable metals.

Money Lenders, lend their excess money or own resources to the people who
need money by charging interest against loan.

KINDS OF BANKS

With the increase in population and people interest in banking sectors the banks
perform many other different functions to facilitate different economic sectors.

By increasing demand of banks, it becomes difficult for banks to perform all functions
properly.

So, banks are divided into different types based on their functions:

Central Bank: Its main function is to regulate the monetary policy and to control
the working of all commercial bank for the proper regulation of monetary and
economic policy. A central bank has sole authority of issuing currency.

Commercial Bank: A commercial bank main objective is to earn profit by lending

to the eligible businesses. Bank receives deposits from people and pay interests and
lends apportion of those deposits to the people who need it and charge high interest.

Introduction to Money & Banking 38

 Exchange Bank: Exchange bank provides foreign exchange to importers and
exporters of country. Main functions of exchange bank are as: discounting of foreign
bills, helping import and export trade and transfer of money from one country to
another.
Industrial Bank: These banks are established for the promotion of industrial
sector of country.

Mortgage Bank: These banks provide financing for buying property i.e. houses,
flats, shops, etc.

Investment Bank: Investment banks are a bank which deals in sale and purchase
of securities and financing long term projects against higher interest rates.
Agriculture Bank: Agriculture banks are formed for the development of
agriculture sector by providing finance for the purchase of machinery and other
tools.

Consumer Bank: It is the modern form of bank. It provides loan for purchase of
consumer goods. The basic purpose is to provide short term loans for basic
consumer goods i.e. electronics items.

Foreign Bank: Foreign bank are owned by foreign based shareholders and they
provide services in another country.

Domestic Bank: These are owned by local shareholders and provide services in
their own country of origin as commercial or other type of bank.
Consumer Bank: It provides loan for purchase of consumer goods. The basic
purpose is to provide short term loans for basic consumer goods i.e. electronics
items.

Foreign Bank: Foreign bank are owned by foreign based shareholders and they
provide services in another country.

Domestic Bank: These are owned by local shareholders and provide services in
their own country of origin as commercial or other type of bank.

Credit Instruments

Credit instrument is a document which is used as an evidence of debts.

It is issued to meet the deficiency of money, because currency money and metallic
money are not enough to meet the modern business requirements.

It provides a written proof for future references and acts as money for buying and selling
purposes. It may specify the payment process and parties involves in it.

Cheque, bill of exchange, and bank draft etc. are used as credit instruments.
Introduction to Money & Banking 39
Features of Credit Instruments

 It is a written evidence of transaction

 It is used as a substitute of money

 It should be unconditional

 It reduces risk of theft.

 Credit instruments facilitates large size trade.

Questions

1. Explain the different kinds of banks.

2. Define the credit instruments

3. What are the features of credit instruments?

CHEQUE

Cheque is a credit instrument used in the banking system.

It is a form of money through which payments can be made to other parties through the
banks.

Banks issue cheque books to their customers for using them instead of dealing in cash.

“Cheque is a bill of exchange drawn on a specified bank and not expressed

to be payable otherwise than on demand’’

Introduction to Money & Banking 40

PARTIES OF A CHEQUE

Drawer: A drawer is the person who draws cheque upon a bank. He is account
holder of the bank who uses a cheque to withdraw amount from its accounts. The
one who sign the cheque is drawer who directs the bank to pay certain amount.

Drawee: A drawee is the branch of bank upon which cheque is drawn for
payment. It is the party to whom customers order to pay specific amount in the
name of person written on cheque or to the bearer of cheque.

Payee: A payee is the person who receives the payment from bank against cheque.
He might be drawer itself or any third party whose name is written on cheque.
Other parties involved in cheque are;

Holder: Holder is the person who has legal authority to receive amount of cheque.
This person may be bearer or any other party.

Endorser: Endorser is the person who transfers the rights of a cheque to other,
transfer of rights is also called endorsement.

Endorsee: An endorsee is that person to whom endorser transfer the rights of

cheque

Introduction to Money & Banking 41

Elements of Cheque

 Name of bank is written on the cheque.

 Cheque number is printed on the cheque in a series.

 The name of the person to whom cheque is to be paid is written on it. If cheque is
drawn by account holder itself, it should be write self.

 Date should be mentioned on cheque

 Amount to paid write in figures and in words clearly.

 Account number is also printed on the cheque.

 At the end name of account holder is written where drawer sign the cheque.

Requirements of a Valid Cheque

Cheque must be in written form. An oral order cannot be constituted by bank.

A cheque should be drawn on specified branch with whom drawer has account.

Cheque cannot be payable conditionally. It should be unconditional to pay a

certain amount written on cheque.

Cheque cannot be accepted without signature of account holder and date.

Validity period of cheque must be checked as postdated cheque cannot accepted

by bank.

The drawer must direct the bank for the mode of payment, i.e. by making the
cheque ‘’bearer’’, ‘’crossed’’ or ‘’order’’.

Types of Cheque

There are four basic kinds of cheque.

Order Cheque: Order cheque is payable to particular person. The name of payee
must be clearly written on cheque. The order cheque is only paid by bank to payee if
the bank is satisfied about the identity of payee.

Open Cheque: Open cheque is one against which cash is received over the
customer. The holder of cheque can receive payment of transfer to any third party
by signing on the back of the cheque.
Introduction to Money & Banking 42
 Bearer Cheque: Bearer cheque is the cheque which is paid to the bearer of the
cheque. A bearer cheque does not need endorsement.

Crossed Cheque: Holder of crossed cheque cannot cashed at counter of the bank.

The payment of crossed cheque is only made by credited the amount in the account of
payee whose name is written on cheque. Two parallel lines are drawn across top left
corner of the cheque.

Crossing of a cheque

A cheque is an unrestricted order, drawn on a particular banker and is always payable

on claim.

In case of a bearer cheque, the paying banker need not ask for the identification of the
holder of the cheque.

Although, in the latter case, there is some risk involved. The cheque might have fallen in
the hands of a wrong person.

To avoid the payments made to wrong persons, the drawer may give a ‘instruction’ to
the paying banker to pay the amount of the cheque through a banker only.

Such an instruction is called a ‘crossed cheque’, without the crossing cheques are
called ‘open cheques’.

Introduction to Money & Banking 43

The crossing on a cheque is proposed to guarantee that its payment is made to the right
payee of the cheque.

Types of Crossings on Cheques

Broadly, Crossings on cheques can be categorize into two types-

 General Crossing and

 Special Crossing.

A. General crossings
It is general crossing where a cheque bears across its face an addition of the words “and
company” between two parallel sloping lines, or two parallel transverse lines simply,
either with or without the words ‘not negotiable’.

Where a cheque is crossed generally, the paying banker will pay to any banker.
Conditions for crossings The lines must be;

- On the face of the cheque,

- Parallel to each other,
- Sloping lines (i.e. transverse).

Inclusion of the words ‘and company’ is immaterial and of no special consequences.

In general crossing, the cheque must be presented to the paying banker and not by the
payee himself at the counter

Sample

Introduction to Money & Banking 44

Two types of words in General Crossing

1. Not Negotiable crossing – Clear indication to the banker that the bank has to
be very careful while making payments on the cheque.

2. Account Payee crossing – when a cheque is crossed “account payee only”,

payment should be credited by the bank only to the account of the payee.

B. Special Crossing

Where a cheque bears across its face an addition of the name of a banker, either with or
without the words "not negotiable" that addition comprise a crossing and the cheque is
considered as crossed specially and to that banker.

Dishonoured cheques

A cheque falls under the dishonoured category when a payee cannot successfully deposit
the payer’s cheque.

A payer is the one who issues a cheque to the payee. The payee deposits this cheque in
the bank.

Introduction to Money & Banking 45

If the bank refuses to pay the amount mentioned on the cheque, the cheque is
dishonoured.

The payee must inform the payer of the dishonoured cheque and ask them to inquire
about its reason.

If the payer believes the cheque will be honoured a second time, they can resubmit it
within three months after the date on it. However, if the cheque bounces again, the
payer can face legal action.

NOTE: The payee could file a case if the amount specified in the payer’s cheque was for
the discharge of a debt. No legal action can be taken if the cheque was given as a gift or
for lending money.

Why do cheques get dishonoured?

Cheques can be dishonoured for a no. of reasons. Some of them are as below

Insufficient funds: Lack of cash in the account is one of the most common
reasons for dishonoured cheques. The bank cannot execute the transaction if you
do not have the required funds in your account

Mismatched signature: Cheques are among the few payment methods that still
rely on signatures. Signatures are, in fact, a key component of cheques. If the
payer’s signature does not match the recorded signature with the bank, the bank
will reject the cheque.

The date on the cheque: Date is an essential feature in cheques. Any

discrepancy or fault with it can result in dishonoured or disapproved cheques. The
most common problem with dates on cheques is that they can be distorted or
outdated. Ensure that you check it thoroughly before depositing or offering a
cheque.

Damaged cheque: The bank will not accept any cheque in damaged, ripped, or
poor condition. Banks also reject cheques if the details are unclear or there are too
many stains on them

Overwriting: Overwriting anything on cheques can lead to rejection. Banks reject

them because it appears suspicious.

While IDFC FIRST Bank closely analyses the cheques it receives, the bank does not
scrutinize mistakes.

Writing errors are common, so you will not be charged for an honest mistake. However,
penalties will apply if the same mistakes are repeated countless times

Introduction to Money & Banking 46

CREDIT CREATION

Credit creation is the major function of a commercial bank. A bank can create credit by
advancing loans to a person and it results in increase in money in circulation.

Usually, a bank acts as a factory for the manufacturer of credit in a modern economy.

The process of credit creation is the central pillar of modern economies and therefore
banking has got a key position in the modern economic system.
Without credit creation through banks, the economic transactions in a modern economy
will be reduced by at-least 70%-80%.

Methods of Credit Creation

By Loan: Bank provides loan facility to customer against securities. Bank do not
provide loan in form of cash.

Discounting of Bills: Banks creates credit through discounting of bills of

exchange. When bank discount bill it credits the amount in customers account who
draws through cheque

Through Investment: A bank creates credit by making investment by

purchasing government securities and payment is made through cheque to central
bank.

Sources of demand deposits for credit creation

Demand deposits mount in two ways:

- When the customer deposits currency with commercial banks, and

- When banks advance loans, discount bills, provide overdraft facilities and make
deposit investments through bonds and securities.

The first type of demand deposits is termed “primary deposits”. Banks play a passive
play in introducing them. The second type of demand deposits is termed as “derivative
deposits”. Banks actively create deposits.

As per Withers, Banks can generate credit by introducing a deposit, every time they
advance a loan.

Limitations of credit creation

i. Credit creation depends upon the amount of deposits.

Introduction to Money & Banking 47

 ii. Banking habits of the people are well developed; it will lead to expansion of
credit.

iii. Loans are sanctioned by banks against some security. If enough securities are
available, then credit creation will be more and vice versa.

iv. If the entire commercial banks, follows a uniform policy regarding CRR, this
credit creation would be smooth.

v. If the liquidity preference of the people is high, the credit creation will be less and
vice versa.

vi. If business conditions are bright then demand for credit will be more.

vii. Customers should be willing to borrow from the banks to facilitate credit
creation.

Process of credit creation

The process of credit creation can be studied in two parts:

- Single Banking System

- Multiple Banking System

a. Credit Creation in a Single Banking System: It means there is only one bank in
the country. All transactions are done by this bank only. There can be two basis of credit
creation.

b. Basis of Credit Multiplies

Basis of Credit Multiplies:

 Suppose a person deposits Rs.10000 in a bank. (credit deposit)

 Cash ratio of 10% and the remaining balance is given out as a deposit.

 Three banks involved; A, B, and C.

 Then the process will be;

Introduction to Money & Banking 48

Process of Credit Creation – table

Round Primary CRR 10% Loans or

Deposits Secondary
Deposits
First 10,000.00 1,000.00 9,000.00

Second 9,000.00 900.00 8,100.00

Third 8,100.00 810.00 7,290.00

Total 27,100.00 2,710.00 24,390.00

It is clear from the above table that total created credit will be Rs.27100.00, out of which
Rs.2710.00 will be kept by bank as CRR and the remaining Rs.24390.00 will constitute
loans.

Credit Equation & Credit Multiplies: alike

Cash Reserve Ratio (r) = Primary Deposit (P)

Total Deposit (D)

Total Increase in Bank Deposit = Primary Deposit in the First Round + Secondary
Deposit in the 2nd Round + + Secondary Deposit in 9th Round

ΔD = ΔP + ΔP (1 – r) + ΔP (1 – r) 2 +…………..+ ΔP (1 – r) n

Credit creation by multiple banking system: In real world, there is not only one
bank in economy, rather there are many banks functioning therein.

A large single bank cannot create more credit than its excess reserve but multiple
banking systems can create many times more credit than its primary deposits.

Questions

1. What is credit creation? Write down the various source of credit creation.

2. What are the limitations of credit creation?

3. Define the methods of credit creation.

Introduction to Money & Banking 49

BANK CREDIT ANALYSIS

Primary function of a bank is to receive deposits and advances loans.

Credit analysis by a lender is used to determine the risk associated with making a
loan.

Regardless of the type of financing needed, a bank or lending institution will be

interested in both your business and personal financials.

While giving credit to a person or business, a bank conducts the credit analysis in order
to make the appropriate lending decisions.

Factors of Credit Analysis

Credit Analysis is governed by the “5 Cs:” character, capacity, condition, capital and
collateral.

Character: Banks need to know the borrower and guarantors are honest and have
integrity.

Capacity (Cash flow): The banks want to know that a business is able to repay
the loan. The business should have sufficient cash flow to support its business
expenses and debts comfortably

Condition: The lender will need to understand the condition of the business, the
industry, and the economy, which is why it is important to work with a lender who
understands the particular industry.

Capital: The bank will ask what personal investment you plan to make in the
business. Not only does injecting capital decrease the chance of default, but
contributing personal assets also indicates that a person is willing to take a
personal risk for the sake of his business.

Collateral: A banker will consider the value of the business’ assets and the
personal assets of the guarantors as a secondary source of repayment. Collateral is
an important consideration, but its significance varies depending on the type of
loan.

Important Terms Used in Bank Credit

 Pledge: Pledge means actual delivery of rights as well as possession of goods as

security against loan. Subject of pledge is returned to the customer when he has
been paid. In case of nonpayment bank has right to sell security to recover its
losses.

Introduction to Money & Banking 50

  Mortgage: It is a written agreement between mortgager and mortgagee. Customer
transfer legal rights of property to bank but possession of goods is remains with
customer.

 Lien: It is a right of the bank to retain the possession of property against loan until
customer repay loan along with interest.

 Hypothecation: Under hypothecation neither ownership nor possession of goods

transfer to bank. It is just an agreement between banker and customer but in case
of failure of repayment bank approach court of law to receive full rights of selling
the hypothecated property.

Bank Advances

A bank advance is provided to a borrower for meeting small level financing needs.

These advances are usually payable within one to three months period and carries
interest rate along with other terms and conditions.

The advances are classified as running finance, cash finance, and short-term demand
finance.

a. Running/Revolving Finance

Running finance is a short-term loan facility from commercial banks to its account
holders.

If account holder bill are greater than its account balance he requested bank manager to
overdraw his account by specific amount for short period.
Features of Running Finance

Features of Running Finance are;

Current account holder: Running finance facility is only provided to his current
account holders.

Contract: Contract is made between bankers and its account holder on the
maximum amount.

Security: In running finance most of the time personal security is taken as

security against overdraft facility. It is in form of credit worthiness of account
holder and sometime bank may demands security in form of another financial
asset.

Withdrawal rule: Account holder can withdraw access amount at full or in

installments.

Introduction to Money & Banking 51

 Time period: Time period for running finance is short may be number of days
30-90.

Interest: Bank charges interest on the amount which is withdrawn in access.

Benefits of Running Finance

i. Easy Access to Funds: Sometime account holder makes payments but balance
in account is not enough, so he requested bank to allow him to withdraw access
money for short period due to which it manages money.

ii. Timely payments Timely payments are made from bank accounts even balance
is not enough due to overdraft facility.

iii. Minimize paperwork In running finance paperwork is reduced as compared

to other advancing facilities offered by bank.

Limitations of Running Finance

Following are the limitations of running finance;

i. Current account holder; Running finance facility is only availed by current

account holder. All other account holder is excluded.

ii. Higher interest; Interest rate is higher as compare to other borrowing

facilities/schemes is charged.

iii. Reduction of limit; Overdraft facility is a temporary advance facility. There is a

risk of decrease in limit of access borrowing from account may also reduce if the
performance of company is not good.

b. Cash Finance

Cash finance is also known as cash credit.

It is process through which bankers allow its customer to borrow certain sum of money
up to limit fixed by commercial banks.

Security should be provided by customers against such loans. As compared to running

finance, cash finance is issued for longer period.

Mostly banks provide cash finance facility to current account holders. Bank allows
customers to withdraw either in lump sum or installments.

Introduction to Money & Banking 52

Features of Cash Finance

Current account holder; Cash finance facility is provided to current account

holder only.

Time period; Time period for cash credit is not as long but its time period is more
than running finance.

Interest/Mark Up: Bank charges interest against amount withdrawn. If customer

does not withdraw up to allowed limit.

Separate Cash Finance Deposit Account: Bankers do not gave amount in form
of cash. It open new account with the name of cash finance deposit and transfers
amount in that account and customer withdraw money through cheque in lump
sum or installments.

Security; Bank provides cash finance facility against security.

Repayment of loan; Loan may be repaid in lump sum or in installment within

due date as per the agreed terms and conditions.

Limitations of Cash Finance

Limitations of cash finance are;

i. Time period; Time period for cash finance is short for further loan customer
has to renew his deposit by bank.

ii. Interest/mark up; Customer must pay interest if he used only little amount of
loan than pay interest on half or quarter amount.

iii. Current account holder; Cash finance facility is only provided to current
account holders. Other account holder like saving and fixed deposits should not
avail this facility.

C. Demand Finance

Demand finance is formal form of bank loan. Bank advances large amount for fixed
period. Loan is repaid after fixed time period or on demand.

Features of Demand Loan

Nature of Deposit; As compare to running finance and cash finance, demand

loan is granted to all account holders who wanted loan.

Introduction to Money & Banking 53

 Securities: Acceptable securities against loan are government securities, and
tangible goods etc.

New Account: Bank never gave money to customer while advancing loan. It open
separate new account in the name of customer and customer can withdraw amount
through cheque which helps in credit creation.

Time period: Demand loan is repayable on demand. It depends on the terms and
conditions of the bank.

Interest: Interest is paid on whole/full amount of loan doesn’t matter either

customer withdraw whole amount or not.

Purpose of Demand Loan: Usually, the purpose of demand finance is to meet

the requirements of working capital.

Comparison among running finance, cash finance and demand finance

Feature Running Finance Cash Finance Demand Finance

Time Time period for Cash finance is also Demand finance is

period running Finance short time but more issued for a longer
if very short as than running finance. period.
number of days.
Interest Interest is only Interest is paid on Interest is charged
paid on amount amount withdrawn if on full amount of
drawn. withdrawn amount is loan.
very little than bank
charges interest on
quarter or half amount.
Type of It is only provided It is only provided to Demand finance is
Account to current current account issued to all
account holders. account holder not
holder. restricted to
current accounts.
Renewal At maturity At maturity it also Demand finance
renewal facility is renewed as running cannot be renewed.
available. finance at customers New request should
request. be made.
Security Personal security Personal and material Material security is
is enough security against loan. required.

Introduction to Money & Banking 54

Questions

1. Write a detail note on running finance.

2. Write about characteristics of cash finance.

3. Detail note on principle of bank lending.

4. What is credit analysis?

Introduction to Money & Banking 55

 CHAPTER IV - BANK SERVICES - RETAIL BANKING

Bank services

Different Types And Services Offered To A Customers – The different products in a bank
can be broadly classified into:

 Retail Banking.

 Trade Finance.

 Treasury Operations.

Retail Banking

Retail Banking is one of the biggest shock absorbers in the banking system. If one were to
closely study the Banking sector, one would observe that retail bank failures seldom
happen. The reason for proliferation of retail banking is twofold.

The principle of spreading the eggs in multiple baskets is the core philosophy of retail. The
probability of all multiple loans failing together at the same time is less than a big loan
failing occasionally
On the retail liability side, the retail portfolio generates low cost deposits which mean
chasing current and savings accounts.

The credit card business is also a lending business, in addition to fees generated by way
of annual maintenance charges and other service charges.

Private banking business is also similar to retail banking, except for the ticket size.

Retail Banking and Trade finance operations are conducted at the branch level while
the wholesale banking operations, which cover treasury operations, are at the head
office or a designated branch.

Retail Banking:

• accepting Deposits (major focus)

• Loans, Cash Credit and Overdraft

• Negotiating for Loans and advances

• Remittances and payments

Introduction to Money & Banking 56

• Book-Keeping (maintaining all accounting records)

• Receiving all kinds of bonds valuable for safe keeping

Trade Finance:

 Issuing and confirming of letter of credit.

 Drawing, accepting, discounting, buying, selling, collecting of bills of exchange,
promissory notes, drafts, bill of lading and other securities.

Treasury Operations:
 Buying and selling of bullion, Foreign exchange.
 Acquiring, holding, underwriting and dealing in shares, debentures, etc.
 Purchasing and selling of bonds and securities on behalf of constituents.

Customer Relationship Management (CRM)

Customer relationship management (CRM) is the combination of practices, strategies

and technologies that companies use to manage and analyse customer interactions and
data throughout the customer lifecycle, with the goal of improving customer service
relationships and assisting in customer retention and driving sales growth.

CRM systems compile customer data across different channels, or points of contact
between the customer and the company, which could include the company's website,
telephone, live chat, direct mail, marketing materials and social media.

CRM systems can also give customer-facing staff detailed information on customers'
personal information, purchase history, buying preferences and concerns.

Question: What is the Importance of Customer Relationship Management

CRM?

Importance of CRM
 A CRM system consists of a historical view and analysis of all the acquired or to be
acquired customers.

 CRM contains each and every bit of details of a customer, hence it is very easy for
track a customer

 In CRM system, customers are grouped according to different aspects according to

the type of business

Introduction to Money & Banking 57

 A CRM system is not only used to deal with the existing customers but is also useful
in acquiring new customers.

 The strongest aspect of Customer Relationship Management is that it is very cost-

effective.

 All the details in CRM system is kept centralized which is available anytime on
fingertips.

 Efficiently dealing with all the customers and providing them what they actually
need increases the customer satisfaction.

Banking Products

Common Banking Products Available

 Credit Card:
 Debit Cards:
 Automated Teller Machine:
 Electronic Funds Transfer (EFT):
 Telebanking:
 Mobile Banking:
 Internet Banking:

Introduction to Money & Banking 58

For example edahab, EVC, T-plus by sombank etc.

Questions: What are the benefits of internet banking?

Introduction to Money & Banking 59

Questions: What are the benefits of internet banking?

Introduction to Money & Banking 60

Types of Deposit Accounts

A deposit account is an account at a bank that allows money to be held on behalf of the
accountholder. The account holder retains rights to their deposit.
Deposit accounts are of classified into two broad types:
 Demand Deposits
 Term Deposits

Demand Deposits

Demand Deposits by definition are deposits that can be withdrawn by customers on

demand, while

Term deposits are deposits that can be withdrawn after a specified period of time.
Term deposits are also known as fixed deposit.

The term fixed refers to the term of the deposit which is fixed in nature
Savings Account
Savings account is the most popular type of demand deposit. Savings Account provides
deposit services to individuals.

Introduction to Money & Banking 61

 Demand Deposits

Banks pay a nominal interest rate (3-4% pa) on this account. The savings account can be
with a cheque facility or without a cheque facility.
Depending on whether it is with or without cheque facility, the minimum balance that is
to be maintained in the account varies. There are restrictions on the number of
withdrawals from this account.

NOW Account: The Negotiable Order of Withdrawal(NOW) is a deposit account that

pays interest on which cheques may be written and is a product unique.

• NOW accounts are interest-bearing, and cheques may be written on them, but legally
they are not interest-bearing checking accounts.

• NOW accounts are interest-bearing transaction account that combines the payable on
demand feature of cheques and investment feature of savings accounts. A NOW account
is functionally an interest paying checking account.

• Super NOWs (SNOW): These deposits offer flexible money market interest rates but
accessible via cheque or preauthorized draft to pay for the goods and services.

NOWs and SNOWs. SNOWs were eligible for federal deposit insurance and subject to
reserve requirements. To sum up, savings deposits have following characteristics:

They do not have fixed maturity.

Deposits can be set up periodically to cover over-withdrawals (drawing in excess of
the balance available).

They provide transaction funds by means of limited cheque -writing privileges

• Money Market Account: These accounts are known as MMA or MMDA accounts.

• Money market account is a deposit account offered by a bank, which has a relatively
high rate of interest and typically requires a higher minimum balance to earn interest or
avoid monthly fees.

• The resulting investment strategy is therefore similar to, and meant to compete with, a
money market fund offered by a brokerage, which is considered almost as safe as
savings.

Introduction to Money & Banking 62

 Types of Deposit accounts

Accounts The Deposit Products offered by the bank are broadly categorized into the
following types:

Savings Bank Account

Current Account
Term Deposits
Joint Accounts
A. Savings Bank Account

• Obtaining funds held in a Savings Account may not be as convenient as a Demand

Account. For example, one may need to visit an ATM or bank branch, instead of writing
a cheque or using a debit card. This transference is so easy that savings accounts are
often termed as near money.

• Money can beat anytime but the maximum cannot go beyond a certain limit.

• There is a restriction on the amount that can be withdrawn at a particular time or during
a week. If the customer wishes to withdraw more than the specified amount at any one
time, he has to give prior notice.

• Interest is allowed on the credit balance of this account. The rate of interest is less than
that on fixed deposit. This system greatly encourages the habit of thrift or savings.

The process of opening a Savings Account

The rules governing the process of opening a Savings Account are:

1. Photograph: The bank is required to obtain 2 recent photographs of the person/s

who is/are authorized to operate the account. The purpose is to check the identity of the
person/s the account.

• In case of minors, the photograph of the guardian has to be produced while opening the
account.

2. Identification and Address: The bank must collect a complete proof of address
while opening the bank account.

A recent copy of any of the following documents is acceptable: telephone bill, electricity
bill, ration card, passport, driving license.

Introduction to Money & Banking 63

3. PAN/GIR: The bank is required to obtain Permanent Account Number (PAN) or
General Index Register (GIR) number or alternatively obtain declaration in Form no.60
or 61 as per the income Tax Act (Vide Section 139-A) from the person/s opening the
account.

4. Minimum Balance: The account holder is required to maintain minimum balance

in the account, as specified by the bank from time to time, separately for computerized
and non-computerized branches and also depending on whether the account holder
wants to avail the cheque book facility or not.

5. Issue of cheque book is subject to satisfactory operation in the account. Passbook

is provided to customer and updated periodically.

6. Specimen signature of the client has to be obtained along with the documents so
as to facilitate verification during withdrawal.

Advantages Savings deposit account

Savings deposit account is very popular among the general public because of the
following advantages:
 A savings deposit account can be opened with little sum of money: It helps the
people of small means to save for their future

 The balance lying in the savings account earns some interest: The customer is
benefited as his money grows with the bank.

 The money lying with the bank is quite safe. There is no fear of theft.

 The money can be withdrawn concurrently from the saving account.

 The customer may get the cheque book facility in order to facilitate payment to
third parties by issuing cheques.

B. Current Account

Current Account: Is defined as "a form of demand deposit wherefrom withdrawals

are allowed any number of times depending on the balance in the account up to a
particular agreed amount and shall also be deemed to include other deposit accounts
that are neither savings deposit nor term deposit."

Current Accounts are designed to meet the needs of such sections of the public who
operate their account regularly and frequently. i.e. traders, businessmen, corporate
bodies or the like who receive money and make payments very often.

Introduction to Money & Banking 64

Unlike Savings Accounts where the primary reason for depositing money is
to generate interest, the main function of a Demand Account is
transactional and therefore most providers either pay no interest or pay a
low level of interest on credit balances.

Requirements to open up an account

 The bank requires satisfactory introduction of the person, opening the account by
a person acceptable to the bank.

 The bank is required to obtain 2 photographs of all the person/s who is/are
opening and operating the account.

 The bank is required to obtain Permanent Account Number (PAN) or General

Index Register (GIR) number or alternatively obtain declaration in Form no.60
or 61 as per the income Tax Act

 The bank will provide to the prospective customers details of the documents
required for identification of the person, opening the account in addition to a
satisfactory introduction.

 Minimum balance as stipulated from time to time is required to be maintained by

the customers

 The bank usually does not pay interest on the balance in the current account.

 The applicant (i.e. account opener) should declare in the Account Opening Form
or separately that he is not enjoying any credit facility with any bank

The bank charges service charge on the following services offered to the customers:

1. Ledger folio used

2. Cheque books issued
3. Non-maintenance of minimum balance
4. Return of cheques, etc.

Statement of Account is provided to the account holder monthly or more frequently as

per the arrangement.

Stop Payment facility — The bank will accept stop payment instructions from the
depositors in respect of cheques issued by them (subject to maintenance of required
balance). Charges as specified will be recovered from the customer.

Closing of the Accounts: While dosing the Current Account, the account holder should
return all the unused cheques to the bank.

Introduction to Money & Banking 65

Note:
1. These deposits are also known as demand deposits. These deposits can be withdrawn
at any time.
2. Generally, no interest is allowed on current deposits, and in case, the customer is
required to leave a minimum balance undrawn with the bank.
3. Cheques are used to withdraw the amount.

Question: what are the advantages of Current Deposit Accounts?

Advantages of Current Deposit Accounts

The customer derives the following advantages from current accounts:-

It enhances business transaction: - Demand deposits are treated at par (similar) with
cash. They constitute cheque currency.

It decreases circulation of legal tender money. This decreases the printing cost of
currencies.

It minimizes the risk and inconveniencies of carrying of huge money.

Businesspersons have to receive and make a large number of payments every day. It
facilitates Payment. There is no restriction on the number of cheques or on the amount
to be drawn at a time by on cheque.

It strengthens the credit system: - Cheques save the use of legal tender money, which
in turn save the reserve of the bank.

It Facilitates Overdraft Loans. The banks allow overdraft facilities to the current
account holders.

C. Term Deposit Account/ Fixed Deposit account

Term Deposit Account also known as Fixed Deposit account.

A Fixed Deposit is defied as " a deposit received by a bank for a fixed period and which is
withdrawable only after expiry of a said fixed period and also includes deposits such as
recurring, cumulative, annuity, reinvestment deposits, cash certificates and so on."

The deposits received by the bank for a fixed period withdraw able after the expiry of the
fixed period and include deposits such as recurring, fixed, etc.

Term Deposits can be opened by individuals, partnership firms, private / public ltd.
Companies, Institutions/Societies/Trusts etc.

Introduction to Money & Banking 66

 Requirements to open up an account

The bank requires satisfactory introduction of the person, opening the account by a person
acceptable to the bank.

The bank is required to obtain 2 photographs of all the person/s who is/are opening and
operating the account.

The bank is required to obtain Permanent Account Number (PAN) or General Index
Register (GIR) number or alternatively obtain declaration in Form no.60 or 61 as per the
income Tax Act

The bank will provide to the prospective customers details of the documents required for

Identification of the person, opening the account in addition to a satisfactory introduction.

Interest: Interest is paid on fixed deposits at a rate determined by individual banks.

Interest is normally paid on maturity of the deposit which means on completion of the
term.

Premature withdrawals are allowed unless specified otherwise, at the rate of interest
applicable for the period for which the deposit has run ruling on the date of deposits,
subject to penalty if any prescribed by the bank.

Maturity: On maturity of the term deposit, the account holder can withdraw the amount
with interest or renew the deposit for another specific term.

QUESTION: Explain the advantages of fixed or term deposits

Advantages of fixed or term deposits

Advantages of fixed or term deposits are:

 The rate of interest on fixed deposits is higher than that allowed on savings
deposit account.

 It enables to depositors to get loans from the bank up to 90% of the fixed deposit

 Even though, it is not withdrawn on demand, depositors are allowed to enact

their deposit receipts before maturity by forfeiting a part of the interest accrued
on the deposit, with the agreement of the bank.

D. Joint Accounts
Joint Accounts: Deposit accounts can be opened by an individual in his own name or
by more than one individual subject to maximum of four persons, known as Joint
Account.

Introduction to Money & Banking 67

SB Account can be opened by a minor jointly with natural guardian or with mother as
guardian.

ADVANCING LOANS

Retail lending is a function of banks and is issued to individuals for personal or

commercial, consumption.

There are two types of loans: secured loans and unsecured loans.

a. Secured loans are loans that are secured by collateral. The lender will take a
security interest in your property.

If the person taking the loan does not pay the loan back, the lender has the right to seize
the collateral. Banks do not lend you more than 100% of the value of your collateral and
will usually lend you only 60% to 80% of its value.
b. Unsecured loans, as the name implies, are loans that are not secured by any
collateral.

Secured loans
This definition highlights two essential features of secured advances

Advances must be made against tangible security.

Market value of security must not be less than the amount of loan granted.

Types of Securities: there are two types of security

1. Primary Security: Asset which has been bought with the help of bank finance.

2. Collateral Securities: In narrow sense collateral securities can be said as

securities deposited by third party to secure advance for the borrower and in
wider sense – any type of security on which the creditor has a personal right of
action on debtor in respect of advance.

Forms of Loans

Loans are made against personal security, gold and silver, stocks of goods and other
assets. The most common ways of lending by commercial banks are:
 overdraft facilities: In this case, the depositor in a current account is allowed
to draw over and above his account up to a previously agreed limit. Suppose a
businessman has only $30,000/- in his current account in a bank but requires $
60,000/- to meet his expenses. He may approach his bank and borrow the
additional amount of $30,000/-. The bank allows the customer to overdraw
additional money. The bank, however, charges interest only on the amount
overdrawn from the account.

Introduction to Money & Banking 68

  Cash Credit: Under this account, the bank gives loans to the borrowers against
certain security. But the entire loan is not given at one particular time, instead
the amount is credited into his account in the bank; but under emergency cash
will be given. The borrower is required to pay interest only on the used amount.
 Discounting Bills of Exchange: This is another type of lending which is very
popular with the modern banks. Banks provide short-term finance by discounting
bills that is, making payment of the amount before the due date of the bills after
deducting a certain rate of discount.
 The holder of a bill can get it discounted by the bank, when he is in need of
money. After deducting its commission, the bank pays the present price of the bill
to the holder.

 Money at Call: Bank also grant loans for a very short period, generally not
exceeding 7 days to the borrowers Against collateral securities like stock or equity
shares, debentures, etc., offered by them. Such advances are repayable
immediately at short notice hence; they are described as money at call or call
money.

 Term Loans: They are loans granted for a fixed period of time. A term loan has
a set maturity date and usually has a fixed interest rate. It has fixed periodic
(Scheduled) payment. Term loan can be classified as:
- Short-term loans: A short-term loan is a type of advance offered for
duration up to 12 months.
- Intermediate-term loans: Financial institutions generally classify
intermediate or mid-term loans as the ones that come usually with a tenor
ranging between 1 to 5 years.
- Long-term loans: Available at attractive term loan interest rates; long-
term loans come with an extended tenor that can reach up to 25 years.

 Consumer Credit: Banks also grant credit to households in a limited amount to

buy some durable consumer goods such as television, sets, refrigerators, etc., or
to meet some personal needs like payment of hospital bills etc

PERSONAL-LOANS

Personal loans are issued to individuals for meeting expenses like marriages,
hospitalization expenditure, cost of holidays etc. A brief description of this type of loan
is given below:

Personal loan is available for both Salaried & Self-employed individuals including
manufacturers, traders, professionals etc

No security, collaterals or guarantors required. This is an unsecured loan given only on

the basis of one's financials.

Introduction to Money & Banking 69

No Question asked or Free usage - The amount received through personal loan can be
used for any purpose, it may be for purchases, gifts, house renovation, festival
celebration or else.

One can repay the loan according to his/her repaying capacity ranging from 12 - 60
months.

Eligibility: This type of loan is extended to customers who are above the age of 18, and
who have sufficient loan repayment power. These loans are usually not granted to
individuals who are due to retire in 1 or 2 years' time.

Eligibility Criteria to get a bank loan

1. Age: A Minimum age of Applicant: 21 years while applying for loan. Maximum age of
Applicant at loan maturity should be 60 years in case of salaried or retirement age
whichever is earlier and 65 years in case of businessman.

2. Income: Minimum Annual Income should be considered and taxable income.

3. Stability

a. The minimum stay at current residence should be 2 years for salaried and self-
employed individuals.
b. The minimum years in continuous employment / business should be 2 years Notes for
salaried individuals and 5 years for self-employed individuals.
c. Either residence or office of the applicant should be owned.
d. The applicant must have a landline telephone connection at home running from the
last six months.
Cont.
4. Loan Amount: One can avail loans ranging from what he/she need depending on
your eligibility, income and repayment capacity.

5. Time frame: Personal loans are granted for period not more than twenty four
months.

6. Rate of Interest: The rate of interest charged is usually high and would vary from
one bank to the other. It varies from 12% - 36% depending upon the person's profile and
the bank's criteria.

7. Documentation

Introduction to Money & Banking 70

LOAN PROCESS

A normal loan process takes 7 to 10 days from application submission to disbursement.

We can understand this process as follows:
i. Day 1- Loan Application complete with all documents login with the bank.
ii. Day 2 - Day 3: Verification of documents, office, residence.
iii. Day 4 - Day 6: Credit Appraisal and decision if other verifications are positive,
Approval.
iv.Day 7 Disbursal

Payment Services

An important service offered by banks is that they offer facilities that enable customers
to make payments.

A payment system can be defined as any organized arrangement for transferring value
between its participants.

Heffernan (2005) defines the payment systems as a by-product of the intermediation

process, as it facilitates the transfer of ownership of claims in the financial sector.

These payment flows reflect a variety of transactions: for goods and services as well as
financial assets.

Some of these transactions involve high-value transfers, typically between financial

institutions. However, the highest number of transactions relates to transfers between
individuals and/or companies.

Payment Services - Cont.

Note that the importance of different types of cashless payments varies from country to
country is discussed as follows:

A. Cheques: are widely used as a means of payment for goods and services. If
individual A buys goods and gives a cheque to individual B, it is up to B to pay the
cheque into their own bank account. Individual B‟s bank then initiates the
request to debit individual A‟s account. Individual A‟s bank authorizes (clears)
the cheque and a transfer of assets (settlement) then takes place. Cheque
payments are known as debit transfers because they are written requests to debit
the payee’s account.

B. Credit transfers: are payments where the customer instructs their bank to
transfer funds directly to the beneficiary's bank account. Consumers use bank
credit transfer payments to pay invoices or to send payment in advance for
products ordered.

Introduction to Money & Banking 71

 C. Standing orders: are instructions from the customer (account holder) to the
bank to pay a fixed amount at regular intervals into the account of another
individual or company. The bank has the responsibility for remembering to make
these payments. Only the account holder can change the standing order
instructions.

Letters of Credit Services

A letter of credit is a document issued by a banker, authorizing some other banker to

whom it is addressed, to honor the cheques of a person named in the document, to the
extent of a sated amount in the letter and to charge the same to the account of the
guarantor of the letter of credit.

Letters of credit may be either personal or commercial. Personal Letters of credit is

usually a clean one i.e. no trade document is attached, whereas, commercial letters of
credit is a documentary letter of credit.

Letter of credit has 4 parties:

the customer,

the issuing bank,

the advisory bank and

the seller.

The customer may be the debtor or the one who buy on credit. The issuing bank is the
one that guarantees the credit sale through the letter. The advising bank is the bank that
accomplishes payment to the seller on behalf of the issuing bank. The last party is the
beneficiary, who sells goods on credit.

Factors considered in choosing the bank that is best for you:

The choice of bank may depend upon the following factors:

Location of Bank
Facilities provided by banks
Interest rates
Flexibility
Service time
Number of branches and ATM center
Customer care

Introduction to Money & Banking 72

 CHAPTER V - CENTRAL BANK AND BALANCE SHEET OF
COMMERCIAL BANKS

Introduction to Central Bank

A central bank is an independent institution that manages a state currency money

supply and interest rates.

The goal of central bank is to stabilize the national currency by keeping unemployment
low and inflation at lowest possible levels.

A central bank has authority to supervise the activities of the commercial bank.

Definitions

“Central bank is defined as an institution charged with the responsibility of managing

the expansion and contraction of the volume of money in the interest of the general
public welfare’’ (R. P. Kent)

“A central bank is to help, control and stabilized the monetary and banking system’’
(Hawtrey)

“A bank which controls credit”. (W. A. Shaw)

In simple words central bank is the bank which controls the monetary policy and
regulates the banking sector in a country.

It is owned by the government of country in which it established. Central bank has sole
authority of note issue.

It makes policies for commercial banks and give advices to government which in
important for economic development.

Functions of a Central Bank

Sole Authority of Currency Issuance: A central bank has sole right to issue
currency in a country. There are two principles used by a central bank while issuing
currency;
 Fixed Fiduciary System: It means the currency issuance criterion is fixed. A
central bank can issue currency up to a certain fixed limit.

Proportional System: It means issuance of currency according to the economic

requirements of a country.

Introduction to Money & Banking 73

 Bank of Government: A central bank acts as a banker of government. The govt.
makes deposit with the central bank. It provides loan to government for different
developing purpose.

Authority to Regulate Commercial Banks: Central bank keeps a proportion of

the deposits of all registered commercial banks. The central bank controls the
working of all the commercial bank.

Regulator of Foreign Exchange: A central bank manages the foreign exchange

rate and maintains the value of local currency in foreign market.

Custody of Monetary Reserves: Monetary reserves are kept by central bank, it

either in form of Gold, Silver or foreign currency. The purpose of making reserve is
to maintain the value of local currency.

Clearing House: A central bank acts as a clearing agent for all the commercial
bank by settlement of their mutual obligations.

Lender of Last Resort for Banks: A central bank acts as a lender of last resort to
other banks which means if any commercial bank faces liquidity problem central
bank provides help in form of rediscounting of bills or in the form of loan.

MONETARY POLICY

The primary function of the central bank is to regulate and control money supply in the
country to achieve the targets of economic policy set by the government.

For this purpose, the central banks develop monetary policy and determine the
policy/bank rate for the banking sector that affects all economy.

Definitions:

“Monetary policy is the attitude of the political authority towards the monetary system
of the community under its control”. (Paul Einzing)

“It is a policy of central bank to control the supply of money with the aim of achieving
macroeconomic stability’’ (Harry G. Johnson)

Objectives of Monetary Policy

Promoting High Employment: The objective of monetary policy is not only to

maintain the money value and employment but also create more employment
opportunities with the help of responsive private sector investments.

Introduction to Money & Banking 74

 Economic Development: The objective of policy is to regulate the credit to
ensure their effective and productive use in different sectors of economy.

Maintain Price Stability: One of the objectives of the monetary policy is to

maintain stable price level to avoid inflation and deflation situation in an economy.

Exchange Rate Stability: It means to maintain the stability of exchange rate as

it affects the prices of imports and exports in a country.

Investment Increased: Through changes in interest rates in the monetary policy

a central bank encourage both private and public sectors for investment which is
helpful for the growth of economic development.

Instruments of Monetary Policy

There are following two methods that control monetary policy.

A. Quantitative Controls:

Change in Bank/Policy Rate: A policy or bank rate refers to the rate at which
central bank rediscounted the bills of commercial bank. A central bank may
change the policy rate for increasing or decreasing the flow of money for the
commercial banks.

Open Market Operations: It means sale and purchase of securities in the

financial market. When central bank wants to increase the volume of money it
purchases securities from open markets and for reduction of volume of money
supply, the central bank sales the securities.

Change in Reserve Ratio: Central bank affects the supply of money by

changing the reserve ratio. Every bank has to maintain the specific reserve ratio
(in the form of cash) with central bank. A central bank may increase or decrease
the reserve ratio to change the money supply in the economy.

Credit rationing: This method of credit is used by central bank is case of

financial crisis. The central bank fixed the rationed credit ratio for each bank and
also specifies its sector-wise allocation in the economy.

B. Qualitative Controls

Margin Requirements: It is the difference between value of securities and the

value of loan advanced by the central bank. The rate of margin may affect the
amount of loans disbursed by a commercial bank.

Direct action If commercial banks do not follow the directions and orders of the
central bank then the central bank may take direct action in the following situations;
Introduction to Money & Banking 75
  By refusing to discount bills

 Does not provide the facility of clearing house.

 May increase the cash reserve ratio.

 May charges fine or penalties

Moral Persuasion: A central bank advises the commercial banks not to involve in
any illegal activities and should work in best way i.e. issuance of loans only for
productive or investing purpose.

Publicity for Awareness: Central bank published the policies and function
through media which enables the people and other banks to understand the
economic condition of the country

QUESTIONS

1. Define the role of central bank in developing economy.

2. What is meaning of central bank? Discuss the various functions of central bank.

3. Define central bank. Discuss the role of central bank in developing economy of a
country.

THE BALANCE SHEET OF COMMERCIAL BANKS

Commercials banks are institutions established to provide banking services to

businesses, allowing them to deposit funds safely and to borrow them when necessary.

Total bank assets equal total bank liabilities plus bank capital.
TA = TL+ C

Banks obtain funds from individual depositors and businesses, as well as by borrowing
from other financial institutions in financial markets.

The difference between a bank’s assets and liabilities is the bank’s capital, or net worth.
TA = TL+ C
A – L =C

 Net worth is the value of the bank to its owners.

A bank’s profits come from both service fees and from the difference between what it
pays for its liabilities and the return it receives on its assets.
Introduction to Money & Banking 76
Table 12.1 shows a consolidated balance sheet for all the commercial banks in the U.S. in
January 2013.

Assets: Uses of Funds

The asset side of the balance sheet shows what banks do with the funds they raise.

Assets are divided into four broad categories:

 Cash,

 Securities,

 Loans, and

 All other assets.

In winter of 2012/13, bank assets were equivalent to about 82 percent of one year’s GDP
of $16 trillion.

Cash Items
Cash asset are of three types:

Reserves - the most important.

 Regulations require a certain percent of cash held in reserves.

 Include the cash in the bank’s vault, vault cash, and bank’s deposits at the Federal
Reserve System.

 Cash is the most liquid of the bank’s assets.

Cash items in process of collection.

The uncollected funds from checks.

Balances of the accounts that banks hold at other banks.

Small banks have accounts at large banks - correspondent bank deposits.

In January 2013, banks held about 13% of their assets in cash.

Up until the financial crisis of 2007-2009, banks held about 3%.

Banks want to minimize cash holdings because they earn less on cash.

Securities
Introduction to Money & Banking 77
Securities are the second largest component of bank assets.

Banks cannot hold stocks, so these are only bonds.

They are split between:

 U.S. government and agency securities (14.3% of assets), and

 Other securities (state and local government bonds) (6.6% of assets).

Securities

About half of all securities are mortgage-backed.

A sizeable portion are very liquid - can be sold quickly if the bank needs cash.

 Securities are therefore sometimes referred to as secondary reserves.

The share of securities in banks assets has varied around 20% from 1973 to 2013.

Loans

Loans are the primary assets of modern commercial banks, accounting for well over
one-half of assets.

Loans can be divided into five categories:

 Business loans called commercial and industrial (C&I) loans;

 Real estate loans, including both home and commercial mortgages and home
equity loans;

 Consumer loans, like auto and credit card loans;

 Interbank loans; and

 Other types, including loans for the purchase of other securities.

Loans

The different loan types differ in their liquidity.

The primary difference in various kinds of depository institutions is their composition of

loan portfolios.

 Commercial banks make loans primarily to businesses.

Introduction to Money & Banking 78
  Savings and loans provide mortgages to individuals.

 Credit unions specialize in consumer loans.

Loans

Up until the financial crisis, commercial banks became more involved in the real estate.

 The rise of the commercial paper market made securities debt finance more
convenient for large firms.

 The creation of mortgage-backed securities (MBS) meant that banks could sell
the mortgage loans they made, which reduced the risk of illiquid assets.

Since the financial crisis, banks seem to have reduced their real estate exposure.

LIABILITIES: SOURCES OF FUNDS

Banks get funds from savers and from borrowing in the financial markets.

To entice individuals to put funds into their bank, institutions offer a wide range of
services.

There are two types of deposit accounts:

 Transaction accounts - checkable deposits, and

 Non-transaction accounts.

Checkable Deposits

Demand deposits make up the largest component of checkable deposits.

Financial innovation has reduced the importance of checkable deposits in the day-to-
day business of banking.

 Checkable deposits plummeted from 40% of total liabilities in the 1970s to less
than 10% in 2012.

 They have a low return for consumers

 To meet consumer demand, banks created innovative accounts that earned more
interest, but could also be easily transferred to checkable deposits.

When choosing a bank, make sure to ask questions.

Introduction to Money & Banking 79
  What are the fees?

 How easily can I reach a person?

 How is the customer service?

And if choosing an internet bank, make sure they are a U.S. bank and are FDIC insured.

Non-transaction Deposits

In 2013 non-transaction deposits accounted for more than half of fall commercial bank
liabilities.

Savings deposits were popular for may decades, but less so today.

Time deposits are certificates of deposit (CDs) with a fixed maturity.

 Large CDs are greater than $100,000 in face value and are negotiable - they can
be bought and sold in financial markets.

 Large CDs have an important role in bank financing

Borrowings

Borrowing is the second most important source of bank funds.

 Accounts for somewhat less than 15% of bank liabilities.

Banks can borrow by:

 Borrowing from the Federal Reserve, which is rare, or

 Borrowing from other banks.

Borrowings

Banks with excess reserves will lend their surplus funds to banks that need them though
an interbank market called the federal funds market.

The lending bank must trust the borrowing bank as these loans are unsecured.

Commercial banks will also borrow from foreign banks.

Banks finally can borrow using an instrument called a repurchase agreement, or repo.

Introduction to Money & Banking 80

  A short-term collateralized loan in which a security is exchanged for cash.

 The parties agree to reverse the transaction on a specific future date, typicaly the
next day.

BANK CAPITAL AND PROFITABILITY

Remember that net worth equals assets minus liabilities.

Recall: C(net worth) = A - L

Net worth is referred to as bank capital, or equity capital.

We can think of capital as the owners’ stake in the bank.

Capital is the cushion banks have against a sudden drop in the value of their assets or an
unexpected withdrawal of liabilities.

 It provides some insurance against insolvency.

An important component of bank capital is loan loss reserves:

Loan loss reserves are an amount the bank sets aside to cover potential losses from
defaulted loans.

At some point the bank gives up hope a loan will be repaid and it is written off, or erased
from the bank’s balance sheet.

At this point, the loan loss reserve is reduced by the amount of the loan that has
defaulted.

The ratio of debt to equity in the U.S. banking system was about 7.7 to 1 in January
2013.

Although that is a substantial amount of leverage, it is nearly 25% below the average
commercial bank leverage ratio that prevailed prior to the financial crisis of 2007-2009.

 Debt-to-equity ratio for nonfinancial business in the U.S. is less than 1 to 1.

 Household leverage is roughly 1/3 to 1.

Leverage increases risk AND expected return.

One of the explanations for the relatively high degree of leverage in banking is the
existence of government guarantees like deposit insurance.

Introduction to Money & Banking 81

These government guarantees allow banks to capture the benefits of risk taking without
subjecting depositors to potential losses.

There are several measures of bank profitability.

Return on assets (ROA).

ROA is the bank’s profit left after taxes divided by the bank’s total assets.

It is a measure of how efficiently a particular banks uses its assets.

This is less important to bank owners than the return on their own investment.

The bank’s return to its owners is measured by the return on equity (ROE).

This is the bank’s net profit after taxes divided by the bank’s capital.

ROA and ROE are related to leverage.

One measure of leverage is the ratio of banks assets to bank capital.

Multiplying ROA by this ratio yields ROE.

Bank Capital and Profitability

Prior to the financial crisis of 2007-2009, the typical U.S. bank has a ROA of about 1.3%.

For large banks, the ROE tends to be higher than for small banks, suggesting greater
leverage, a riskier mix of assets, or the existence of significant economies to scale in
banking.

The poor performance during the crisis and moderate returns after, suggests their high
returns were at least partly due to more leverage or a riskier mix of assets.

The final measure of bank profitability is net interest income.

This is related to the fact that banks pay interest on their liabilities and receive interest
on their assets.

Deposits and bank borrowing rate interest expenses; securities and loans generate
interest income.

The difference between the two is net interest income.

Net interest income can also be expressed as a percentage of total assets to yield: net
interest margin.

Introduction to Money & Banking 82

This is the bank’s interest rate spread - the weighted average difference between the
interest rate received on assets and the interest rate paid for liabilities.

Well-run banks have a high net interest income and a high net interest margin.

If a bank’s net interest margin is currently improving, its profitability is likely to

improve in the future.

It is safe to assume that depository institutions will be with us for some time.

There are three basic types of depository institutions: commercial banks, savings
institutions, and credit unions.

Not all these depository institutions are likely to survive the financial innovations and
economic upheaval of the coming decades.

OFF-BALANCE-SHEET ACTIVITIES

To generate fees, banks engage in numerous off-balance-sheet activities.

Lines of credit - similar to limits on credit cards.

• The firm pays a bank a fee in return for the ability to borrow whenever
necessary.

• The payment is made when the agreement is signed and firm receives a
loan commitment.

• When the firm has drawn down the line of credit, the transaction appears
on the bank’s balance sheet.

Letters of credit

• These guarantee that a customer of the bank will be able to make a

promised payment.

• Customer might request that the bank send a commercial letter of credit
to an exporter in another country guaranteeing payment for the goods on
receipt.

• In return for taking this risk, the bank receives a fee.

Standby letter of credit

• Standby letters of credit are letters issued to firms and governments that
wish to borrow in the financial markets

• They act as a form of insurance.

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These activities expose a bank to risk that is not readily apparent on their balance sheet.

By allowing for the transfer of risk, modern financial instruments enable individual
institutions to concentrate risk in ways that are very difficult for outsiders to discern.

Small stores act as financial intermediaries to provide loans to people who cannot
borrow from mainstream financial institutions.

The most common type of loan is a payday loan.

They are very expensive and appeal only to those who cannot get credit elsewhere.

Laws are changing to rein in payday lending practices

Bank Risk: Where It Comes from and What to Do about It

The bank’s goal is to make a profit in each of its lines of business.

•They want to pay less for the deposits they receive than for the loans they
make and the securities they buy.

In the process of doing this, the bank is exposed to a host of risks:

 Liquidity risk,

 Credit risk,

 Interest-rate risk, and

 Trading risk.

Liquidity Risk

Liquidity risk is the risk of a sudden demand for liquid funds.

Banks face liquidity risk on both sides of their balance sheets.

 Deposit withdrawal is a liability-side risk.

 Things like lines of credit are an asset-side risk.

Even if a bank has a positive net worth, illiquidity can still drive it out of business.

In the past, the common way to manage liquidity risk was to hold excess reserves.

 This is a passive way to manage liquidity risk.

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  Holding excess reserves is expensive, because it means forgoing higher rates of
interest than can be earned with loans or securities.

There are two other ways to manage liquidity risk.

The bank can adjust its assets or its liabilities.

Liquidity Risk

On the asset side a bank has several options.

The easiest option is to sell a portion of its securities portfolio.

 Most are U.S. treasuries and can be sold quickly at relatively low cost.

 Banks that are particularly concerned about liquidity risk can structure their
securities holdings to facilitate such sales.

A second possibility is for the bank to sell some of its loans to another banks.

• Banks generally make sure that a portion of the loans they hold are
marketable for this purpose.

Another way is to refuse to renew a customer loan that has come due.

• However this is bad for business.

• The bank can lose a good customer.
• Reducing assets lowers profitability.

Liquidity Risk

Bankers prefer to use liability management to address liquidity risk.

Banks can borrow to meet any shortfall either from the Fed or from another bank.

The bank can attract additional deposits.

 This is where large certificates of deposits are valuable:

 They allow banks to manage their liquidity risk without changing the asset side of
their balance sheet.
In the financial crisis of 2007-2009, banks could neither sell their illiquid assets nor
obtain funding at a reasonable cost to hold those assets.

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When the interbank lending and wholesale money markets dried up, many banks faced
a threat to their survival.

Credit Risk

Credit risk is the risk that a bank’s loans will not be repaid.

Banks use a variety of tools to manage credit risk:

Diversification, where banks make a variety of different loans to spread the risk.

Credit risk analysis, where the bank examines the borrower’s credit history to determine
the appropriate interest rate to change.

Diversification can be difficult for banks, especially if they focus on a certain type of
lending.

 If a bank lends in only one geographic area or one industry, it is exposed to

economic downturns that are local or industry-specific.

 It is important that banks find a way to hedge these risks.

Credit risk analysis produces information that is very similar to the bond rating systems

 Banks do this for small firms wishing to borrow, and credit rating agencies
perform the service for individual borrowers.

 The result is an assessment of the likelihood that a particular borrower will

default.

In the financial crisis of 2007-2009, banks underestimated the risks associated with
mortgage and other household credit.

A bank’s capital is its net worth - a cushion against many risks, including market risk.

Market risk is the decline in the market value of assets.

The larger a bank’s capital cushion, the less likely it will be made insolvent by an adverse
surprise.

In the financial crisis of 2007-2009, banks were too leveraged - they had too many
assets for each unit of capital.

Mark-to-market accounting rules require banks to adjust the recorded value of the
assets on their balance sheets when the market value changes.

Introduction to Money & Banking 86

  When the price falls, the value is “written down” and writedowns reduce a bank’s
capital.

Banks don’t like to hold a large capital cushion because capital is costly.

The more leverage the greater the possible reward for each unit of capital and the
greater the risk.

Interest-Rate Risk

A bank’s liabilities tend to be short-term, while assets tend to be long term.

The mismatch between the two sides of the balance sheet create interest-rate risk.

When interest rates rise, banks face the risk that the value of their assets will fall more
than the value of their liabilities, reducing the bank’s capital.

Rising interest rates reduce revenues relative to expenses, directly lowering a bank’s
profits.

The term interest-rate sensitive means that a change in interest rates will change the
revenue produced by an asset.

For a bank to make a profit, the interest rate on its liabilities must be lower than the
interest rate on its assets.

 The difference in the two rates is the bank’s net interest margin.

When a bank’s liabilities are more interest-rate sensitive than its assets, an increase in
interest rates will cut into the bank’s profits.

END

Mr. Lubega Antonny

[email protected]

Introduction to Money & Banking 87