By Ajeet Kumar, MA Economics
This is a concise notes on Money and Banking useful for Economics students.
Money: Money is anything that is generally
acceptable as a means of payment in the settlement of all transactions,
including debt. General acceptability as the common means of payment is the
sine qua non. All other attributes of money are derived from this basic
attribute (i.e. general acceptability) of money. Money is a social convention.
Barter: Barter refers to the system in which one
commodity is exchanged for another.
DIFFICULTIES OF BARTER:
Lack of “Double
coincidence of wants”: Double
coincidence of wants is necessary in barter exchange, because each party must
have what the other party wants and must be willing to trade at terms (e.g.
time of exchange, quantity of goods) suitable to both.
Difficulty of sub-division
of discrete goods:
When the goods involved in exchange are of different values and are discrete
goods such as axe and elephant, the goods can not be sub-divided to them of
equal worth. Thus, exchange can not be possible without sacrifice of the
condition of equivalence in exchange.
Absence of common measure
of value: There is no common standard to measure
the values of goods in barter. At what rate a commodity should be exchange for
another? this problem can not be successfully solved in barter exchange. Barter
suffers from the problem of common unit of account.
Difficulty of store of
value: The goods of perishable nature can not
be stored for long. They will be destroyed after passage of time. For examples:
rice, bread, books etc.
FUNCTIONAL
DEFINITION OF MONEY: (in couplet form)
Money is a matter of functioning four:
A medium, a measure, a standard, a
store.
Medium of exchange: The basic function of money is that it
acts as a medium of exchange. The exchange can appear during any kind of
economic activities such as consumption or production. When a consumer buys a
commodity, he makes payment in form of money to seller (exchange for
consumption). Similarly, a producer makes factor payments such as wages and
salaries, rent, interest, and profits to the factors of production in form of
money (exchange for production). Without money such exchange function
will become very difficult. Money facilitates exchange. It speeds the exchange
and helps in specialization which in turn increases the productivity.
Consumer’s satisfaction is increased many-fold because of money.
Measure of value: Money serves as a common unit of
account or measure of value in terms of which the values of goods
and services are expressed. Money makes possible meaningful accounting system.
Because of this attribute of money, the advancement of society (and of
Economics as science) has become possible.
What is meant by price of a commodity? The price of a commodity refers to the
value of the unit-commodity. Since the price of a commodity is expressed in
terms of money, so money measures the value of a commodity.
Standard of deferred
payments: It is not necessary that the factor
payments or payments for commodities will be made at the very moment when the
deals take place between two parties. The payments may be deferred. For
example, retirement pensions; payment of salaries etc. are given after a
stipulated time period. The deferment of payments is possible because of money.
But the value of money changes over time so it can not be considered as a
very good standard of deferred payments. The value of money is decided by a
number of social and psychological factors. The value of money is not an
intrinsic phenomenon.
Store of value: Any assets which can continue to hold
its value in future can be said to have store value. There are various kinds of assets like metal,
grain, land, etc which can be stored because they have their values in future.
But money is the asset which has uniqueness in its store-value in the sense
that it alone is perfectly liquid.
NOTE: Significance of money can be
explained by help of its functional roles.
Liquidity: Liquidity of an asset refers to the
degree of its encashability. Or, Liquidity refers
to the characteristic of an asset by virtue of which it can be encashed on
demand without loss of its value; more the loss of its value, less its
liquidity.
Solvency means the net worth of
the debtor. A debtor may have positive solvency without enough liquidity.
Near-money: Assets which are almost, but not quite,
money. The near-monies are those assets which can be relatively easily
converted into money, if desired, without much loss in their monetary worth
(because their monetary values are known). Examples: - bill of exchange, credit
cards, time or saving deposits, government bonds, debentures, post office savings,
cash values of insurance policies etc. It does not fulfill the primary
function of money i.e. medium of exchange but the people who hold
such assets may feel wealthier and hence will have a higher propensity to
consume.
Intrinsic/metallic value
of money: Intrinsic/metallic value of money
refers to the value of the matter/metal from which the money is made of.
Extrinsic/Face value of
money: Extrinsic/Face value of money refers
to the value of the money as denominated on it.
TYPES OF MONEY:
Standard money:
Standard money can be defined as the money which extrinsic value is
equal to its intrinsic value and is subject to free coinage. E.g. gold or
silver coins. At present, no country has such money.
Token money: Token money is that money which value
as money is significantly greater than the market value of the metals from
which they are made of. For example, coins.
Bank money: Bank money is cheque. In modern age,
bank money has superseded all other forms of money. Unlike money deposited in
the current account, money kept in the fixed deposit is not withdrawable by
cheque. Hence it is not treated as bank money. Money deposited in the current
account is bank money. Also, a part of saving deposits may be treated as bank
money because cheque facility is available in case of saving deposits as well.
But such facility is limited. Deposits in current accounts are bank money in
proper sense.
Paper money: When a printed paper is used as a
medium of exchange in economy by public, such paper is termed as paper money.
It has helped in economizing the precious metals. Paper money is of two types:
Convertible paper money and Inconvertible paper money.
Convertible paper money:
If the issuing authority of paper money promises to convert it into
standard money on demand, it is termed as convertible paper money.
Representative paper money means convertible paper money.
Inconvertible paper money:
If the issuing authority of paper money does not promise to convert it
into standard money on demand, it is termed as inconvertible paper money. It is
also known as fiat money (money by order) since it is accepted as money
because of the fiat or order of the currency authority.
Fiduciary/credit money: The money which is accepted as money
because of the credit/trust of its issuer is called credit money. The examples
are coins, paper notes, and demand deposits. The use of fiduciary money is
highly economical. It releases precious metal embodied in coins under
full-bodied metallic standards for non-monetary uses. But they are also a major
source of inflationary trends.
Legal tender money/or, fiat money: Coins and currency
notes are fiat money. They serve as money on the fiat/order of the government.
They are legal in the sense that they are guaranteed by the government or the
law of the land about their acceptability in settlement of payments of all
kinds.
The demand deposits are fiduciary
money but they can not be accepted in payment of all kinds. So, they are
not legal tender. They are fiduciary money proper. A person can legally
refuse to accept payment in demand deposits/cheques and insist on payment in
cash. This is because there is no guarantee that a cheque will be honored at
the issuer’s bank.
attributes of money:
The attributes of money help us in
making comparison among these different types of money. Some important
attributes or properties of money are as follows:
(1). General acceptability is the most important characteristic of money. Gold
and silver are commonly acceptable among different people across time and
space. Therefore, they are the best form of money. This is why in the
international trade; they occupy important position as money.
(2). Portability
is another important attribute of money. Paper money possesses this attribute
in best possible manner compared to others.
(3). Durability of
money refers to the attribute of money by virtue of which the money exchanged
again and again among individuals does not lead to deterioration of its
contents. Gold and silver possess such attribute. Paper money does not have
this quality.
(4). Homogeneity of
money implies the nature of uniformity among different units of money of same
denomination with respect to weight, shape, size, etc. By this virtue of money,
the different units of money of same denomination can be easily recognized by
the people.
(5). Divisibility is
the property of the matter from which the money is minted. Because of this
attribute, it is possible to divide money into units of different value. Gold
is highly divisible but diamond is not. So, gold is a better form of money than
diamond.
(6). Cognizability
refers to the property of money by which a substance as money is easily
recognizable. Gold and silver are such metals that can be easily recognized
because of their unique metallic properties.
(7). Stability of value is
another property of money. Since money is the measuring rod of value of a
commodity, the value of money should be stable.
Deposits: Deposits are the entries in the ledgers of banks to the credits of
their holders. We can also say that deposits are the money accepted from public
by various monetary agencies to be held under stipulated terms and conditions.
Classification of Deposits: Deposits are analytically classified as demand and
term deposits. The savings account deposits include the features of these both
kinds of deposits. It is important to estimate the portion of the savings
account deposits that are as demand deposits or term deposits.
APPORTIONING
OF SAVINGS ACCOUNT DEPOSITS INTO DEMAND AND TIME DEPOSITS:
Earlier the RBI followed the convention that the
minimum amount required to keep in the savings account as time liability
portion of savings deposits and the amount above this in the account as demand
liability portion of savings deposits. This was termed as the portion of
savings frequently withdrawable (till 1978).
After 1978, the RBI amended the above rule of apportioning of savings account deposits into demand and time deposits.
Under the new rule, the average of the monthly minimum balances in a savings
account on which interest is being credited to the shall be treated as a time
liability and the excess over the said amount as a demand liability.
The rationale of the amendment does not lead to
simplification of the measurement of money supply. In fact, for simplicity, the
all deposits in savings account deposits should be treated as demand deposits.
Demand deposits are defined as deposits payable on
demand through cheque or otherwise. They
serve the medium of exchange function, so they are included as money. Demand
deposits are the deposits on which the customer of a bank can draw cheques. This
is why they are also termed as chequable
deposits.
Cheques:
The cheques are the instruments through which the demand deposits can be
transferred from the payer to the payee.
KINDS OF DEPOSITS :( 1) current account deposits, (2)
fixed deposits/term deposits (3) savings account deposits.
Current account deposits:
They are
payable on demand.
No
interest is paid on these deposits.
They can
be drawn upon by cheque without any restriction.
The
current account deposits are maintained by business units.
Fixed deposits/term
deposits:
They are
not payable on demand.
They can
not be drawn upon by cheque.
Interest
is paid on these deposits.
The rate
of interest on these deposits is fixed by the RBI.
A variety of term deposit is recurring
deposit. Compound interest is paid on this deposit. Recurring deposit helps
small savers to save on regular basis. Term deposits are characterized by two
factors: (1) cheques can not be drawn upon this deposit. (2) The amount
deposited in the term deposit can not be legally withdrawn without its
date of maturity. In practice, the commercial banks, however, give relaxations
to depositors under certain conditions.
Savings account deposits: Savings account deposits blend/combine
the features of both- current account deposits and fixed deposits/term
deposits. A savings account deposit can not be opened in the name of
business units. It is supposed that the holder of savings account deposit
will not use its cheque facility for business purposes. Interest is paid on
this deposit. The interest is payable on the minimum monthly balance held from
the eleventh day of a month till its end.
Post office deposits are of two types: Savings deposits and
term/time deposits. The savings deposits in post offices are withdrawable on
demand with the help of withdrawal slip but they are not chequable
deposits i.e. the deposits in the savings deposits of post offices are not
chequable deposits and so they do not directly fulfill the role of medium of
exchange.
Narrow definition of
money: Narrow definition of money is based on
the functional attribute of money as a medium of exchange. By this definition,
coins, paper money, and demand deposits or checking-account money are examples
of money.
Broader definition of
money: Broader definition of money is based on the liquidity approach which in turn is based
on the store-value attribute of money. By this definition, following are
included as money:
1. currency
2. demand deposits of commercial banks
3. savings deposits of commercial banks
4. time deposits of commercial banks
5. post office savings deposits
6. post office time deposits
The RBI measures of money supply based
on broader definition of money was called AMR (Aggregate
Monetary Resources).
SOME IMPORTANT POINTS OF INDIAN MONETARY
SYSTEM
The Reserve Bank of India India India India
Supply of money: Supply of money is a stock variable
because it is measured at a point of time. The change in money supply is,
however, a flow variable because it is measured in a time-interval.
The supply of money refers to the stock
of money held by the public.
So, the supply of money is just a part of total stock of money in an economy.
‘Public’ mean all economic units such as
households, firms, and institutions which demand for money. All non-bank
financial institutions, non-departmental public sector enterprises such as
Hindustan Steel , Indian Airlines, local
authorities, etc. are included as ‘public’. The
producers of money i.e. government and the banking system are excluded from ‘public’.
All state governments, central
government and the banking institutions are excluded from the ‘public’.
Whenever we talk about money supply, we are in fact dealing with the money held
by the public. So, net demand deposit of banks is part of M rather than total
demand deposits (which includes inter-bank deposits as well).
Summary of Money Supply Concepts of the
RBI:-
M: Narrow
measure of money supply (till 1967-68)
AMR
(Aggregate Monetary Resources) i.e. Broader measure of money supply: — (from
1967-68):— M + time deposits of banks held by the public.
Four Measures of Money Supply since
April 1977:
M1: C + DD + OD; C = Currency, DD= Demand
Deposits, OD= Other Deposits of RBI
M2: M1 +
saving deposits with post office savings banks
M3 (=AMR):
M1 + net time deposits of banks.
M4: M1 +
total deposits with the post office savings organizations excluding National
Savings Certificates
Net demand deposits of banks are included not their
total deposits; total deposits means deposits from public plus inter-bank
deposits.
A person
diversifies his wealth among different types of real and financial assets
considering the internal and external returns from them. In M1 definition money
is considered as non-interest bearing means of payment. In this form money has
no external or explicit rate of return, but it has implicit returns in form of
convenience, security and maneuverability that goes with having immediately
available purchasing power.
Portfolio management of an
individual is affected by these two types of returns from money apart from the
rate of returns from other types of assets.
Demand deposits mean current account
deposits plus demand deposit portion of savings deposits, all held by public.
Other deposits of the RBI are its deposits other than those held
by the government , banks, and a few others like the IDBI, the IMF , the World Bank etc. The OD is
nearly 1 per cent of total money supply.
The Liquidity Order: M1 <M2 < M3
< M4.
Bank: A bank is a financial institution that
accepts chequable deposits of money from the public and uses them for lending.
Thus, there are three essential elements required for a financial
institution to be a bank:
(1)The deposits must be money; it should
not be goods or non-money financial assets.
(2)Deposits must be from the public at
large and not merely from the share-holders of bank.
(3)Deposits must be demand deposits i.e.
chequable deposits.
Post office savings banks
are not banks: Post office savings
banks are not banks, by definition. In fact, such term is misnomer. Although post office accepts chequable
deposits, it does not lend to others. It lends to the government. Since post
office saving banks is run as departmental agencies of union government, they
lend money to their owner. Hence, post-office saving banks are not considered
as banks.
Depositing and lending are
not enough: Non-bank financial
institutions e.g. UTI, LIC, IDBI, etc are not banks since they do not provide cheque
facilities to their depositors, although they deposit and lend money.
Recently, these financial institutions have instituted banks e.g. UTI bank,
IDBI bank etc which are in deed banks.
TYPES OF BANKS:
1. Commercial banks:
Commercial banks are the banks which finance short- term credits to
businessmen and others for trade and commerce.
2. Exchange banks:
Exchange banks are the banks which are concerned with financing foreign
exchange for international trade.
3. Industrial banks:
Industrial banks are the banks which collect money for long term and lend it to
industries for long term. Industries require capital for a long period to buy
machinery and equipments. E.g. IDBI, IFCI.
4. Agricultural banks: Agricultural banks deal with long term credit to
agriculture sector. Land mortgage bank, also called land development bank,
provides long term loans. Long term loans are needed by farmers to purchase
land and or for permanent improvement of land.
5. Cooperative banks:
Cooperative banks provide short term credits to agricultural and industrial
sector. Short term loans are taken by farmers to purchase implements, seeds,
fertilizers, etc.
6. Saving banks:
Saving banks collects/mobiles the small savings of the people. Post office
savings bank and savings departments of commercial banks are engaged in
mobilizing such savings.
Scheduled Vs Non-Scheduled
commercial banks:
A scheduled bank is one which is included in the second schedule of the RBI
Act, 1934.
Eligibility criteria for a bank to be
scheduled one are as follows:
(1) It must have paid-up capital and
reserves of an aggregate value not less than five lakhs,
(2) It must be a corporation and not a
partnership or a single-owner firm,
(3) It must work following the
guide-lines of the RBI and without harming the interest of its customers.
Non-scheduled banks are also subject to
the rules and regulations of the RBI but they enjoy certain relaxations. For
example, although a non-scheduled bank has to follow the cash reserve ratio
requirement of the RBI but it is not necessary that they will keep this ratio
of cash with the RBI. They can also approach the RBI in need. But scheduled
banks enjoy certain privileges like concessional remittance facilities through
the offices of the RBI and its agents which non-scheduled banks do not.
Functions of Commercial Banks: Commercial banks carry out a number of important functions which are as follows:
(1).Depositing and lending: They deposits the surplus of economic
units such as households, firms and government through varieties of deposits
like current account deposits, savings account deposits, fixed deposits etc.
The banks lend these deposits to the businessmen and traders.
(2).Overdraft facility:
Commercial banks provide overdraft facilities to the current account holders.
An over draft is a system of bank lending by which the borrower is allowed to
draw cheques beyond the credit balance in his account , up to an agreed limit,
and to pay interest on daily amounts by which his account is overdrawn.
Depending on the borrower, a bank may or may not require a collateral
security for this facility. [Definition: Overdraft is a short term
arrangement between a bank and his customer allowing him to ‘advance’ (i.e.
take excess money) up to an agreed limit from his current account than is in it
on behalf of the credit of his financial assets.]
(3).Finance of foreign trade: The commercial banks also finance the
foreign trade by accepting the bill of exchange drawn by the customers. For
this facility to the customers, they charge some amounts which are termed as
discounting of bill. A bill of exchange
is a financial paper drawn to finance foreign trade transactions. The bank
discounts its commission on the bill.
(4).Agency functions: The commercial banks act as agents of
their customers in collecting and paying cheques, bills, dividends, insurance
premium, etc. They also buy and sell securities on behalf of their customers.
(5).Other facilities: The banks provide many other services
like locker facility, travelers cheques etc.
Central bank:
Central bank is the apex bank in the banking and monetary institutions
of a country and is set up by the government of the country with view to
regulate and control the financial activities in the economy usually by the
help of regulating and controlling the supply of money. In India
FUNCTIONS OF A CENTRAL BANK
Issue and circulation of
currencies of different denominations: The central bank issues and circulates coins and
currency notes in the country. It has monopoly in this regard. In India
Banker & advisor of
the government: The treasuries of government are kept with
the central bank free of interest. The central bank lends money to central and
state governments in case of requirement. Taxes flow to government only in
certain parts of year, while funds are needed through out the year. The
government borrows temporarily from the central bank in such times. These loans
are known as ways and means advances. Apart from these, all other
government loans - temporary and permanent- are floated through the central
bank. Also, it purchases foreign currencies, remits government funds and
manages public debt. It also acts as financial advisor of the government.
Banker’s banker:
All banks in the country are legally bound to obey the rules and
regulations of the central bank. The commercial bank is required to keep a
certain proportion of their total deposits as reserve to the central bank. This
helps the central bank to keep control over the credit creation capacity of
the commercial banks. The commercial
banks can keep their spare cash with the central bank which they can withdraw
when needed.
Lender of last resort: The commercial banks borrows from each
other. Such loans are known as inter-bank loan. In case of emergency, when a
bank fails to obtain loan from other banks, it may resort to central bank. The
central bank provides loans on the security of approved securities or through
rediscounting of bill of exchange. Scheduled banks enjoy the privilege of
rediscounting their papers with the RBI as well as securing loans against
approved securities when in need. These banks have to keep at least 3% of their
total deposit liabilities as reserve with the RBI.
Control of credit: The commercial bank is required to keep
a certain proportion of their total deposits as reserve to the central bank.
This provision is termed as Cash Reserve Ratio (CRR). This helps the central bank to keep control
over the credit creation capacity of the commercial banks. Apart from the CRR,
some other quantitative and selective monetary measures such as Bank rate, Statutory
Liquidity Ratio (SLR), open market operation, margin requirement, moral
suasion, direct action etc are used by the RBI to control the volume and
direction of credit in the economy.
Maintenance of exchange
rate: It is very important that the exchange
rate is stable in the economy. The stability of the external value of the home
currency is necessary to maintain and promote the foreign trade of country and
to encourage the inflow of foreign investments. The central bank fixes the
exchange rate in desired manner to achieve these goals.
Custodian of national
reserve: The central bank of the country is the
custodian of nation’s reserve of gold and foreign currencies.
Collection of data: The central bank of a country collects,
compiles and publishes statistical information pertaining to financial
institutions and their functions periodically.
Developmental functions: The central bank formulates and
implements various kinds of monetary and banking facilities so as to achieve a
number of socio-economic objectives such as promotion of exports, reduction of
unemployment, rapid growth of GNP, reduction of inflation, etc.
DIFFERENCE BETWEEN CENTRAL BANK AND COMMERCIAL BANK
The difference between commercial banks
and central banks are described below:
(1.Number: There is one and only one central bank
in a country while there are large numbers of commercial banks.
(2)Institutor: The central bank is set up by the
government of a country while commercial banks are set up by business units.
(3)Profitability: The central bank operates with view to
social profitability while commercial banks operate for monetary profits.
(4)Genesis: Commercial bank is comparatively older in its
origin than a central bank.
(5)Guide-Lines: The commercial banks have to follow
certain guide-lines of the central bank but the reverse is not true. Commercial
banks can never order central bank.
(6)Involvement In Monetary
Policy: Central bank is
directly involved in the monetary policies of the economy but commercial banks
are seldom directly involved in such policies.
(7) Custodian: Central bank is the custodian of
nation’s gold and foreign exchange reserve.
(8)Dealing: Commercial banks deal with the public
i.e. business units and households; but the central bank does not deal with
these economic units.
(9)Bulletins: The central bank of a country collects,
compiles and publishes statistical information of the country pertaining to
financial institutions and their functions periodically but commercial banks
does not publish any such financial data excluding their balance sheets and profit-and-loss
accounts.
(10)Uni-directional loans: Central bank may lend money to commercial banks but
not vice versa.
Difference
between Cash Credit and Overdraft Credit:
In case of cash credit, real assets such as
inventories of raw materials, goods in process or finished goods, and
receivables are the forms of security. In case of overdraft credit, financial
assets such as shares, debentures, LIC policies or fixed deposits are
considered as forms of security. Cash credit is comparatively for longer period
than overdraft credit.
Pros & cons of cash credit system
From the
borrower’s point of view:
The borrower can withdraw cash any number of times
within the agreed limit and subject to withdrawing rights. He can also repay
any number of times in to the account. So the borrower has huge flexibility.
Interest is payable only on the net amount of credit
actually utilized and not on the limit granted.
Securities furnished by the borrower are flexible
and changeable.
From the
lender’s i.e. bank’s and economy’s point of view:
ü Banks have no control over actual level of cash
credit; only over the credit limit.
ü Cash management is headache of the banks; borrowers
put their cash surplus to save interest.
ü Banks provide a large credit limit for they know by
experience that borrowers use only a part of the credit limit. But during
sudden spurts borrowers withdraw a large sum making banks to scurry for funds
in the money market.
ü It militates against the RBI restrictive credit
policies.
ü There is no effective control over the end-use of
credit.
ü Borrower can swindle (cheat) a bank as no bank can
devise a fully fool-proof system of credit evaluation.
ü It favors big and established borrowers to the
disadvantage of small and new borrowers.
ü It leaves enough room for multiple-finance. The
borrowers can borrow from several banks at the same time. Consortium banking can reduce such abuses.
Short term credit is usually of less than one year; but it may be of
more than that period. Medium
term credit is of less than ten years. Long term credits are for more than ten years.
Commercial
bills are used by firms engaged in business. Generally,
they are of three-month maturity. They are lie post-dated cheques drawn by the
sellers of goods on the buyers of the goods for the value received.
Treasury bills are short term 91 days bills which are the
liabilities of the government of India
Ad hoc treasury bills are not sold to the general public or banks and are
not marketable. Their holders, when in need can sell them back to the RBI.
Ordinary or regular treasury bills are sold to the general public or banks. They are
freely marketable and their buyers are almost entirely commercial banks. All
treasury bills are sold by the RBI. The interest on the treasury bills are
very low which has kept the public debt to be very low but at the same time it
has caused the treasury bill market to be undeveloped.
Money market deals with short term credits. Money market is of
two types: 1. national money market and 2. Short-term credit market Short term
credit market may be organized or unorganized. The examples of organized short
term credit market are: - call money market, bill market, (Treasury bill and
commercial bill), bank loan market etc. The RBI and various commercial and
cooperative banks participate in this market.
Capital
market deals with long term securities. Stock market is a
component of capital market. The stock market deals with open market securities
while capital market deals with negotiated loans as well. Industrialists bring
‘securities’ in the stock market to acquire capital. Industrialists also take
long term loans from banks (i.e. negotiated loans); such activity is part of
capital market.
Open market securities are securities or market papers which are bought and
sold openly in the market like marketable goods and services.
Negotiable loans: The
negotiable loans are negotiated directly or through a broker between the
brokers and lender. They appear only in the account books of the lenders and
borrowers s’ promissory notes which are not salable in the market.
Financial reserve banking: Banks do not keep all the liquid assets against the
deposit liabilities but only a fraction of them. Such process helps the bank to
expand their credit facilities. Banks expand credit on the basis of their
excess reserves.
Primary or Direct
securities are bill, bond, equity, etc. Primary securities are
purchased by surplus sector to direct finance the deficit spenders. Secondary
or indirect securities are raised
by financial institutions. Their examples are Reserve Bank currency, bank
deposits, LIC policies, UTI units, IDBI bonds etc.
Credit is finance made available by one party to another;
the former party is called lender and the later one is called debtor. Credit is
the claim made by the lending party to borrowing party. In narrow sense, credit
is ‘debt finance’. Financial system is concerned with cash and credit
transactions. Payment system is concerned with only cash transactions.
Primary
securities are those which are purchased by
the surplus real sector units to direct finance the deficit spenders (i.e.
ultimate borrowers). There is no role of financial intermediaries in direct
finance. Examples are bill, bond, equity etc.
Secondary
securities are raised by various financial intermediaries.
Examples are bank deposits, LIC policies, RBI currency notes, UTI units, IDBI
bonds etc.
Financial
intermediaries are intermediaries or mediators
between ultimate lenders and ultimate borrowers. The chief function of FIs is
to collect surplus of different economic units and lend them to deficit
spenders. Thus financial intermediaries
help in indirect finance. They purchase and sell secondary securities.
Financial
intermediation: The process of transfer of fund
from the ultimate lenders to the ultimate borrowers is called financial
intermediation.
Why
do surplus economic units prefer to lend FIs rather than lend directly to
deficit spenders?
1. Low risk,
2. Greater liquidity,
3. Convenience,
4. Other services.
Reserves: Reserves mean the liquid assets – the currency in
banks’ vaults and their deposits with the central bank – against their deposit
liabilities.
Legal
reserves: Legal reserves are the liquid assets that a bank may
lawfully use as reserves against its deposit liabilities.
Required
reserves denote the minimum legal reserves that a bank is
required by law to keep behind its deposit liabilities.
Excess
reserves: Excess reserves denote excess of legal reserves
over the required reserves. A bank is in equilibrium or ‘fully used up’ when it
has no ‘unused lending power’.
Reserve
ratio denotes the ratio of reserve to total liability.
Cash
reserve ratio (CRR) is the ratio of cash to deposit
liability.
Liquidity
ratio is ratio of liquid assets to total deposit
liability.
Bank’s
portfolio: Income earning assets of a bank plus its cash
constitute the bank’s portfolio.
