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Central Banking and Monetary Management

This book is a part of the course by Jaipur National University, Jaipur.This book contains the course content for Central Banking and Monetary Management.

JNU, JaipurFirst Edition 2014

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Index

Content ........................................................................... II

List of Figures ............................................................. VII

List of Tables ..............................................................VIII

Abbreviations ...............................................................IX

Case Study .................................................................. 144

Bibliography ............................................................... 153

Self Assessment Answers ........................................... 156

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Contents

Chapter I ....................................................................................................................................................... 1Introduction to Banking .............................................................................................................................. 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction .............................................................................................................................................. 21.2 The Financial System ............................................................................................................................... 2 1.2.1 Lenders and Borrowers ............................................................................................................ 3 1.2.2 Financial Intermediaries .......................................................................................................... 3 1.2.3 Financial Instruments ............................................................................................................... 4 1.2.4 Financial Markets .................................................................................................................... 7 1.2.5 Money Creation ....................................................................................................................... 9 1.2.6 Price Discovery ........................................................................................................................ 9 1.2.7 Allied Participants on the Financial System ............................................................................ 91.3 Principles of Banking ............................................................................................................................. 10 1.3.1 Fundamental Issues in Banking ............................................................................................. 10 1.3.2 The Basic Reason for the Existence of Banks: Information Costs and Liquidity ................. 10 1.3.3 Broad Functions of Banks ...................................................................................................... 121.4 The Balance Sheet of a Bank ................................................................................................................. 15 1.4.1 Share Capital (Equity) ........................................................................................................... 15 1.4.2 Liabilities ............................................................................................................................... 16 1.4.3 Assets ..................................................................................................................................... 17 1.4.4 Liability and Asset Portfolio Management ............................................................................ 18 1.4.5 Money Creation ..................................................................................................................... 19 1.4.6 Off-Balance Sheet Activities.................................................................................................. 20Summary ..................................................................................................................................................... 21References ................................................................................................................................................... 21Recommended Reading ............................................................................................................................. 21Self Assessment ........................................................................................................................................... 22

Chapter II ................................................................................................................................................... 24Banker and Advisor to Government ....................................................................................................... 24Aim .............................................................................................................................................................. 24Objectives .................................................................................................................................................... 24Learning outcome ........................................................................................................................................ 242.1 Introduction ............................................................................................................................................ 252.2 The Interbank Markets (IBM) ................................................................................................................ 25 2.2.1 The Bank-To-Central Bank Interbank Market ....................................................................... 27 2.2.2 The Central Bank-To-Bank Interbank Market ....................................................................... 27 2.2.3 The Bank-To-Bank Interbank Market .................................................................................... 282.3 Bank Liquidity Management ................................................................................................................. 292.4 Banker to Government ........................................................................................................................... 302.5 Tax and Loan Accounts .......................................................................................................................... 31 2.5.1 Tax Payments ......................................................................................................................... 32 2.5.2 Receipts of Loan Issues ......................................................................................................... 33 2.5.3 Problem from the Perspective of Central Bank ..................................................................... 34 2.5.4 Problem from the Perspective of Government ...................................................................... 34 2.5.5 Problem from the Perspective of Banks ................................................................................ 34 2.5.6 The Solution ........................................................................................................................... 34 2.5.7 Monetary Policy Tool ............................................................................................................ 362.6 Public Debt Management ....................................................................................................................... 36 2.6.1 The Public Debt ..................................................................................................................... 36 2.6.2 The Central Bank and Public Debt Management .................................................................. 38

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2.7 Administration of Exchange Controls .................................................................................................... 38Summary ..................................................................................................................................................... 40References ................................................................................................................................................... 40Recommended Reading ............................................................................................................................. 40Self Assessment ........................................................................................................................................... 41

Chapter III .................................................................................................................................................. 43Management of Money and Banking System .......................................................................................... 43Aim .............................................................................................................................................................. 43Objectives .................................................................................................................................................... 43Learning outcome ........................................................................................................................................ 433.1 Introduction ............................................................................................................................................ 443.2 Banker to Private Sector Banks ............................................................................................................. 443.3 Settlement of Interbank Claims ............................................................................................................. 473.4 Supervision of Payments System ........................................................................................................... 503.5 Lender of Last Resort ............................................................................................................................. 50 3.5.1 Central Bank Transactions ..................................................................................................... 50 3.5.2 Large/Small Bank Problem .................................................................................................... 51 3.5.3 Confidence and the Bank Run ............................................................................................... 523.6 Currency (Notes and Coins) Management ............................................................................................. 533.7 Bank Supervision ................................................................................................................................... 54 3.7.1 Rationale for Regulation ........................................................................................................ 54 3.7.2 Objectives of Regulation ....................................................................................................... 553.8 Management of Foreign Assets .............................................................................................................. 55 3.8.1 Central Banks Hold Foreign Assets ....................................................................................... 56 3.8.2 The Desired Level of Reserves .............................................................................................. 56 3.8.3 Foreign Asset Reserve Management ...................................................................................... 56 3.8.4 The USD in Foreign Asset Reserve Management ................................................................. 573.9 Development of the Debt Market .......................................................................................................... 57Summary ..................................................................................................................................................... 60References ................................................................................................................................................... 60Recommended Reading ............................................................................................................................. 60Self Assessment ........................................................................................................................................... 61

Chapter IV .................................................................................................................................................. 63Money Creation and Framework of Monetary Policy ........................................................................... 63Aim .............................................................................................................................................................. 63Objectives .................................................................................................................................................... 63Learning outcome ........................................................................................................................................ 634.1 Introduction ............................................................................................................................................ 644.2 Measuring Money .................................................................................................................................. 644.3 Money Identity: Sources of Money Creation ......................................................................................... 66 4.3.1 Loan from Bank ..................................................................................................................... 67 4.3.2 Exports ................................................................................................................................... 68 4.3.3 Bonds Issued by the Government ......................................................................................... 69 4.3.4 Bank Notes ............................................................................................................................. 70 4.3.5 Money Destruction ................................................................................................................ 71 4.3.6 Bank Deposits and the Reserve Requirements ...................................................................... 724.4 Statutory Environment ........................................................................................................................... 724.5 Objectives of Monetary Policy .............................................................................................................. 734.6 Price Stability ......................................................................................................................................... 74 4.6.1 What Is Price Stability? ......................................................................................................... 74 4.6.2 The Benefits of Price Stability ............................................................................................... 744.7 Inflation Targeting Monetary Policy Framework .................................................................................. 754.8 Monetary Policy Accountability and Transparency ............................................................................... 76

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4.9 Limitations of Monetary Policy ............................................................................................................. 764.10 Instruments of Monetary Policy ........................................................................................................... 774.11 Independence of Central Banks ........................................................................................................... 79Summary ..................................................................................................................................................... 80References ................................................................................................................................................... 80Recommended Reading ............................................................................................................................. 80Self Assessment ........................................................................................................................................... 81

Chapter V .................................................................................................................................................... 83Monetary Policy: Models and Transmission ........................................................................................... 83Aim .............................................................................................................................................................. 83Objectives .................................................................................................................................................... 83Learning outcome ........................................................................................................................................ 835.1 Introduction ............................................................................................................................................ 845.2 Models of Monetary Policy ................................................................................................................... 84 5.2.1 Firm Required Reserves Model ............................................................................................. 84 5.2.2 Firm Borrowed Reserves Model ............................................................................................ 87 5.2.3 Interbank Rate Model ............................................................................................................ 895.3 Monetary Policy ..................................................................................................................................... 905.4 Path of Monetary Policy: From Interest to Inflation .............................................................................. 91Summary ..................................................................................................................................................... 94References ................................................................................................................................................... 94Recommended Reading ............................................................................................................................. 95Self Assessment ........................................................................................................................................... 96

Chapter VI .................................................................................................................................................. 98Financial Regulation and Supervision in Central Bank ......................................................................... 98Aim .............................................................................................................................................................. 98Objectives .................................................................................................................................................... 98Learning outcome ........................................................................................................................................ 986.1 Introduction ............................................................................................................................................ 996.2 Regulatory and Supervisory Functions .................................................................................................. 996.3 Commercial Banks ................................................................................................................................. 99 6.3.1 Licensing ................................................................................................................................ 99 6.3.2 Corporate Governance ......................................................................................................... 100 6.3.3 Statutory Pre-emptions ........................................................................................................ 100 6.3.4 Interest Rate ......................................................................................................................... 1006.4 Prudential Norms ................................................................................................................................. 100 6.4.1 Risk Management ................................................................................................................ 100 6.4.2 Disclosure Norms ................................................................................................................ 101 6.4.3 Know Your Customer Norms ............................................................................................... 101 6.4.4 Protection of Small Depositors ............................................................................................ 101 6.4.5 Para Banking Activities ....................................................................................................... 101 6.4.6 Supervisory Functions ......................................................................................................... 101 6.4.7 On-site Inspection ................................................................................................................ 101 6.4.8 Off-site Surveillance ............................................................................................................ 101 6.4.9 Periodic Meetings ................................................................................................................ 101 6.4.10 Monitoring of Frauds ......................................................................................................... 1016.5 Foreign Banks ...................................................................................................................................... 1026.6 Financial Institutions ............................................................................................................................ 1026.7 Rural Financing Institutions ................................................................................................................. 102 6.7.1 Rural Cooperative Banks ..................................................................................................... 102 6.7.2 Regional Rural Banks .......................................................................................................... 1036.8 Urban Cooperative Banks .................................................................................................................... 103 6.8.1 Regulatory Framework ........................................................................................................ 104

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6.8.2 Supervisory Framework ....................................................................................................... 1046.9 Non-Banking Financial Companies (NBFCs) ..................................................................................... 104 6.9.1 Regulatory Framework ........................................................................................................ 105 6.9.2 Supervisory Framework ....................................................................................................... 1056.10 Primary Dealers ................................................................................................................................. 1066.11 Credit Information Companies ........................................................................................................... 1066.12 Financial Markets ............................................................................................................................... 106Summary ................................................................................................................................................... 107References ................................................................................................................................................. 107Recommended Reading ........................................................................................................................... 107Self Assessment ......................................................................................................................................... 108

Chapter VII ...............................................................................................................................................110Settlement Systems, Policy Research and Credit Creation ...................................................................110Aim .............................................................................................................................................................110Objectives ...................................................................................................................................................110Learning outcome .......................................................................................................................................1107.1 Introduction ...........................................................................................................................................1117.2 Development, Consolidation and Integration .......................................................................................1117.3 Payment and Settlement System: Evolution and Initiatives .................................................................1117.4 Legal Framework ..................................................................................................................................1127.5 Institutional Framework ........................................................................................................................1127.6 Policy Research and Data Dissemination .............................................................................................1127.7 Internal Research ..................................................................................................................................1127.8 Data and Research Dissemination ........................................................................................................1137.9 Multiple Credit Creation by Commercial Banks ..................................................................................113 7.9.1 Cash Deposits by Customers ................................................................................................113 7.9.2 Bank Loans and Investments ................................................................................................1137.10 Limitations of Credit Creation ............................................................................................................1157.11 Balance Sheet of Commercial Banks .................................................................................................115 7.11.1 Liabilities of a Commercial Bank (Liabilities Portfolio) ....................................................116 7.11.2 Assets of a Commercial Bank (Assets Portfolio) ................................................................1167.12 Objectives of Portfolio Management (Trade-Off between Liquidity and Profitability) .....................117 7.12.1 Reconciling Twin Objectives ..............................................................................................1177.13 Factors Affecting Liquidity of Banks..................................................................................................118 7.13.1 Factors Affecting Profitability of Banks .............................................................................118Summary ................................................................................................................................................... 120References ................................................................................................................................................. 120Recommended Reading ........................................................................................................................... 121Self Assessment ......................................................................................................................................... 122

Chapter VIII ............................................................................................................................................. 124Evolution and Recent Trends in Banking Technology ......................................................................... 124Aim ............................................................................................................................................................ 124Objectives .................................................................................................................................................. 124Learning outcome ...................................................................................................................................... 1248.1 Introduction .......................................................................................................................................... 125 8.1.1 Phases of Banking Technology in India ............................................................................... 125 8.1.2 Technology Based Banking Services and their Characteristics in India .............................. 125 8.1.3 Various Committees on Banking Technology in India ........................................................ 126 8.1.4 Major Landmarks of Banking Technology and Transformation in India ............................ 1298.2 Recent Trends in Banking Technology ................................................................................................ 1308.3 Technology Application in Banks ........................................................................................................ 131 8.3.1 Data Warehouse ................................................................................................................... 131 8.3.2 Data Mining ......................................................................................................................... 132

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8.3.3 Electronic Data Interchange (EDI) ...................................................................................... 133 8.3.4 Corporate Website ................................................................................................................ 134 8.3.5 Management Information System (MIS) ............................................................................. 1358.4 Current Information Technology Tools ................................................................................................ 135 8.4.1 Electronic Clearing and Settlement System ......................................................................... 135 8.4.2 Plastic Money ...................................................................................................................... 137 8.4.3 Electronic Banking .............................................................................................................. 137Summary ................................................................................................................................................... 141References ................................................................................................................................................. 141Recommended Reading ........................................................................................................................... 141Self Assessment ......................................................................................................................................... 142

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List of Figures

Fig. 1.1 Simplified financial system .............................................................................................................. 2Fig. 1.2 Financial intermediaries ................................................................................................................... 4Fig. 1.3 Financial intermediaries and instruments/securities ......................................................................... 5Fig. 1.4 Primary and secondary markets ........................................................................................................ 8Fig. 1.5 Financial markets .............................................................................................................................. 8Fig. 1.6 Derivative markets ............................................................................................................................ 9Fig. 1.7 Risk and diversification .................................................................................................................. 13Fig. 1.8 Banks in the financial system ......................................................................................................... 15Fig. 1.9 The basic business of banking ........................................................................................................ 15Fig. 1.10 The business of banking: liabilities .............................................................................................. 17Fig. 1.11 The business of banking: full picture ............................................................................................ 18Fig. 2.1 Interbank rate and KIR ................................................................................................................... 27Fig. 2.2 Interbank markets ........................................................................................................................... 29Fig. 2.3 Change in government deposits with central bank (LLC millions) ................................................ 31Fig. 4.1 Money ............................................................................................................................................. 65Fig. 4.2 M3 and LNB ................................................................................................................................... 67Fig. 4.3 Objectives of monetary policy ........................................................................................................ 74Fig. 4.4 Monetary policy .............................................................................................................................. 78Fig. 5.1 Monetary policy .............................................................................................................................. 84Fig. 5.2 Monetary base fixed; banks fully lent ............................................................................................ 86Fig. 5.3 Supply of and demand for bank loans ............................................................................................ 87Fig. 5.4 KIR and PR (month-ends over 50 years) ........................................................................................ 88Fig. 5.5 Monetary Policy Transmission Mechanism (MPTM) .................................................................... 92Fig. 8.1 Components of banking technology ............................................................................................. 130Fig. 8.2 Data warehouse architecture ......................................................................................................... 132Fig. 8.3 Process of data warehouse architecture ........................................................................................ 132Fig. 8.4 EDI architecture ............................................................................................................................ 134Fig. 8.5 OCR creates ASCII text ................................................................................................................ 136

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List of Tables

Table 1.1 Financial intermediaries ................................................................................................................. 5Table 1.2 Financial instruments/securities ..................................................................................................... 7Table 2.1 Functions of central banks ........................................................................................................... 25Table 3.1 Out-clearing book: Bank A (pounds) ........................................................................................... 47Table 3.2 Out-clearing book: Bank B (pounds) ........................................................................................... 47Table 3.3 Out-clearing book: Bank C (pounds) ........................................................................................... 47Table 3.4 Total claims on and against (pounds) ........................................................................................... 47Table 3.5 Net claims and settlement (pounds) ............................................................................................. 49Table 7.1 Credit creation .............................................................................................................................114Table 7.2 Balance Sheet of a commercial bank ..........................................................................................116Table 8.1 Dimensions of IT innovation in Indian retail banking 1960-2009 ............................................. 125Table 8.2 Characteristics of banking services ............................................................................................ 126Table 8.3 Committees on computerisation ................................................................................................. 129

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Abbreviations

ACB - Automated Clearing BureauAFS - Available for SaleAIs - Alternative InvestmentsALCO - Active Asset and Liability CommitteeALPMs - Advanced Ledger Posting MachinesAML - Anti-Money LaunderingASCII - American Standard Code for Information InterchangeATMs - Automated Teller MachinesBas - Bankers’ AcceptancesBCBS - Basel Committee on Banking SupervisionBD - Bank DepositsBFS - The Board for Financial SupervisionBPSS - Board for Regulation and Supervision of Payment and Settlement SystemsBR - Borrowed ReservesBSSoC - Balance Sheet Sources of ChangeC - ConsumptionCA - CertificationAuthorityCAMELS - Capital, Asset Quality, Management, Earnings, Liquidity and SystemsCB - Central BankCBS - Central Bank SecuritiesCBS - Core Banking SolutionsCCIL - Clearing Corporation of India LimitedCDBMS - Central Database Management SystemCDBMSI - Centralised Data Based Management System-InternetCFMS - Centralised Funds Management SystemCFT - Combating Financing of TerrorismCH - Clearing HouseCI - Contractual IntermediariesCIC - Credit Information CompaniesCISs - Collective Investment schemesCLB - Company Law BoardCP - Commercial PaperCRAR - Capital to Risk-Weighted Assets RatioCRR - Cash Reserve RatioCTS - Cheque Truncation SystemDBOD - The Department of Banking Operations and DevelopmentDBS - The Department of Banking SupervisionDCCBs - District Central Cooperative BanksDFIs - Development Finance InstitutionsDICGC - Deposit Insurance and Credit Guarantee CorporationDNBS - The Department of Non-Banking SupervisionDPSS - Department of Payment and Settlement SystemsDvP - Delivery versus PaymentECB - European Central BankECS - Electronic Clearing ServiceEDI - Electronic Data InterchangeEFT - Electronic Funds TransferER - Excess ReservesETFs - Exchange Traded FundsFIMMDA - Fixed Income Money Market and Derivatives AssociationFSB - Financial Stability Board

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GDE - Gross Domestic ExpenditureGDP - Gross Domestic ProductHFs - Hedge FundsHFT - Held for TradingHICP - Harmonised Index of Consumer PricesHTM - Held to MaturityHVC - High-Value ClearingI - InvestmentIBMs - Interbank MarketsIDRBT - Institute for Development and Research in Banking TechnologyINFINET - Indian Financial NetworkIT - Information TechnologyKIR - Key Interest RateKYC - Know Your CustomerLNBPS - Loans to the NBPSLOLR - Lender of Last ResortLPMs - Ledger Posting MachinesLS - Liquidity ShortageLCC - Local Country (Thecurrency(‘corona’)codeofafictitiouscountry)LTCCIs - Long-Term Rural Cooperative Credit InstitutionsLTDM - Long-Term Debt MarketM3 - Broad measure of money and includes all bank deposits held by the domestic Non-Bank Private

Sector (NBPS).MBS - Monetary Banking SectorMD - Marketable DebtMICR - Magnetic Ink Character RecognitionMIS - Management Information SystemMPTM - Monetary Policy Transmission MechanismN&C - Notes and CoinsNABARD - National Bank for Agriculture and Rural DevelopmentNBFCs - Non-Banking Financial CompaniesNBFI - Non –Banking Financial InstitutionNBPS - Non-Bank Private SectorNCBs - National Central BanksNCDs - NegotiableCertificatesofDepositNDS - Negotiated Dealing SystemNDTL - Net Demand and Time LiabilitiesNECS - National Electronic Clearing ServiceNFA - Net Foreign AssetsNFS - National Financial SwitchNHB - National Housing BankNLG - Net Loans to GovernmentNMD - Non-marketable DebtNNCDs - Non-negotiableCertificatesofDepositNPA - Non-Performing AssetsNPCI - National Payments Corporation of IndiaNPS - National Payment SystemNRI - Non-Resident IndiansNSS - National Settlement SystemOCR - Optical Character RecognitionOD - OverdraftOLAP - On-Line Analytical ProcessingOMO - Open Market Operations

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OSMOS - Off Site Surveillance and Monitoring SystemOSS - Off-Site SurveillanceOTC - Over-the-CounterPACS - Primary Agricultural Credit SocietiesPCARDBs - Primary Cooperative Agriculture and Rural Development BanksPDAI - Primary Dealers Association of IndiaPDs - Primary DealersPEF’s - Private Equity FundsPI - Participation InterestsPKI - Public Key InfrastructurePMG - Paymaster General PR - Prime RatePUTs - Property Unit TrustsQFIS - Quasi-Financial IntermediariesRPCD - Rural Planning and Credit DepartmentRR - Required ReservesRRBs - Regional Rural BanksRTGS - Real Time Gross SettlementSA - Settlement AccountSCARDBs - State Cooperative Agriculture and Rural Development BanksSDDS - Special Data Dissemination StandardsSEBI - Securities and Exchange Board of IndiaSFMS - Structured Financial Messaging SystemSLR - Statutory Liquidity RatioSMS - Short Message ServiceSPVs - Special Purpose VehiclesStCBs - State Cooperative BanksSTCCIs - Short-term Rural Cooperative Credit InstitutionsSTDM - Short-Term Debt MarketSTP - Straight Through ProcessingSUTs - Securities Unit TrustsSWIFT - Society for Worldwide Interbank Financial TelecommunicationTBs - Treasury BillsTLAs - Tax and Loan AccountsTR - Total ReservesTTM - Term to MaturityUBD - Urban Banks DepartmentUCBs - Urban Cooperative Banks

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Chapter I

Introduction to Banking

Aim

The aim of this chapter is to:

introduce the concept of banking •

explainthefinancialsystem•

explicate the principles of banking•

Objectives

The objectives of this chapter are to:

explain the basic reason for the existence of banks: information costs and liquidity•

elucidate the balance sheet of a bank•

enlistfinancialmarkets•

Learning outcome

At the end of this chapter, you will be able to:

identify information costs•

understand broad functions of banks•

understandfinancial• intermediaries


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1.1 IntroductionPrivatesectorbanksplayaveryimportantroleinthefinancialsystemandtherealeconomy.Theyintermediatebetweenallsectorsoftheeconomyandotherfinancialintermediariesandinstitutions,andsomeofthemprovidethe payments system, which most of us use every day.

Banks are unique; in that their liabilities, Bank Notes and Coins (N&C–Central Bank) and Bank Deposits (BD–Private SectorBanks)areregardedasthemeansofpaymentsormediumofexchange,whichisthedefinitionofmoney.So,put simply, Money M3* = N&C + BD (held by the domestic Non-Bank Private Sector (NBPS). Due to this, banks are able to create additional money when required by individuals, businesses and government (with the assistance of the central bank). This unique feature, plus their balance sheet structure, places banks in a unique position. In another way, they are inherently unstable, and therefore require robust regulation and supervision.

*M3 is a broad measure of money and includes all bank deposits held by the domestic non-bank private sector (NBPS).

Banks are innovative, mainly a function of extreme competition, and they are then at the forefront of new developments,notjustinbanking,butalsointhewiderfinancialmarkets.Thismakesregulationandsupervisioncomplex. Banks are straightforward institutions. They take existing deposits (and loans to a small degree) and loan these funds, and, at the same time, make new loans and create new deposits (new money). On the other hand, while their basic function may be simple, the risks they take are not as simple, which makes them complex.

1.2 The Financial SystemThefollowingfigureillustratesthefinancialsystem:

ULTIMATE BORROWERS (deficiteconomic

units)

HOUSEHOLD SECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGN SECTOR

ULTIMATE LENDERS

(surplus economic units)

HOUSEHOLD SECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGN SECTOR

Direct investment / Financing

Indirect investment / Financing

Security

Surplus funds

FINANCIAL INTERMEDIARIESSecurity Security

Surplus funds Surplus funds

Fig. 1.1 Simplified financial system(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Itmaybeusefultointroducethesubjectofprivatesectorbankingbybrieflydescribingthefinancialsystem,thuscontextualising banking.. It is basically concerned with borrowing and lending. It has the following six parts or elements:

Lenders(surpluseconomicunits)andborrowers(deficiteconomicunits),i.e.,thenonfinancial-intermediary•economic units that undertake lending and borrowing. They can also be called the ultimate lenders and borrowers (todifferentiatethemfromthefinancialintermediarieswhodoboth).Lenderstryandearnthemaximumontheir surplus money and borrowers try and pay the minimum for money borrowed.Financial intermediaries, which intermediate the lending and borrowing process; they interpose themselves •betweentheultimatelendersandborrowersandendeavourtomaximiseprofitsfromthedifferentialbetween

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what they pay for liabilities (borrowings) and earn on assets (overwhelmingly loans). This is called the bank margin, in the case of the banks. Clearly, they endeavour to pay the least on deposits and earn the most on loans. (This is why you must be on your guard when they make you an offer for your money or when they want to lend to you.)Financial instruments,which are created to satisfy thefinancial requirements of the various participants.•These instruments may be marketable (e.g., treasury bills) or non-marketable (e.g., an utilised bank overdraft facility).The creation of money when demanded. As you know, banks (collectively) have the unique ability to create •their own deposits (money), because we the public generally accept their deposits as a means of payment.Financial markets, i.e., the institutional arrangements and conventions that exist for the issue and trading (dealing) •ofthefinancialinstruments.Price discovery, i.e., the price of shares and the price of debt (the rate of interest) are ‘discovered’, i.e., made •anddetermined,inthefinancialmarkets.Priceshaveanallocationoffundsfunction.

1.2.1 Lenders and BorrowersLendersandborrowersisthefirstelement.Theycanbecategorisedintothefourgroupsor‘sectors’oftheeconomy,as shown in Fig. 1.1:

Household sector (individuals)•Corporate sector (companies-private and government-owned)•Government sector (all levels of government-local, provincial and central)•Foreignsector(anyforeignentity-corporatesector,financialintermediaries,suchasretirementfunds)•

The members of these sectors can be either lenders or borrowers or both at the same time. For example, a member of the household sector may have a mortgage bond (borrower by the issue of a nonmarketable debt instrument) and at the same time hold a balance on your accounts at the bank (a lender; a holder of money).

1.2.2 Financial IntermediariesThesecondelement isfinancial intermediaries.Asshown inFig.1.1, lendingandborrowing takesplaceeitherdirectly between ultimate lenders and borrowers [for example, when an individual buys a share (also called equity orstock)issuedbyacompany],orindirectlyviafinancialintermediaries.Financialintermediariesessentiallysolvethedifferences(orconflicts)thatexistbetweenultimatelendersandborrowersintermsoftheirrequirements:risk,size, return, term of loan, etc.

For example, your friend Tom (a member of household sector) has *LCC2 10 000 he would like to lend out (invest) for 30 days at low risk. You (a member of household sector) would like to borrow LCC 20 000 for 365 days to buy a car. You don’t mind who you borrow from, because you represent the risk, not the lender. Your and Tom’s requirementsdon’tmatchatall;directfinancingwon’twork.HeplaceshisLCC10000ondepositwithaprimebank for 30 days and you borrow LCC 20 000 from the bank for 365 days. You and Tom are both in high spirits; thebanksatisfiedyourdifferentrequirements.

*LCCisthecurrency(‘corona’)codeofafictitiouscountry,LocalCountry.

Financial intermediaries exist not just because of the divergence of requirements of lenders and borrowers, but for the specialised services they provide, such as insurance policies (insurance companies), retirement fund products (retirement funds), investment products (securities unit trusts, exchange traded funds), overdraft and deposit facilities (banks), and so on. The banks also provide a payments system, the system we don’t see, but rely much on. The central bank provides an interbank settlement system.


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ULTIMATE BORROWERS(deficiteconomic

units)

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

ULTIMATE LENDERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

Debt

Debt & shares

Debt

Debt & shares

Debt &shares

Debt & shares

Debt & shares

CENTRAL BANK

BANKS

BANKS

QFIs:DFIs, SPVs, financialco’sInvestment co’s

INVESTMENT VEHICLES

CIs CISs AIs

Inter bankdebt

Inter bankdebt

Deposit

Deposit

Investmentvehiclessecurities(Pls)

Debt

Fig. 1.2 Financial intermediaries(Source: http://bookboon.com/en/banking-an-introduction-ebook)

ThemainfinancialintermediariesthatexistinmostcountriesandtheirrelationshipswithoneanotherarepresentedinFig.1.2.AusefulofclassificationofthemispresentedinBox1.Notethatthenon-depositintermediariesmayalso be seen as investment vehicles. Their products (their liabilities), which can be called Participation Interests (PIs),aredesignedasinvestmentsforthehouseholdsector(andinsomecasesotherfinancialintermediaries).

1.2.3 Financial InstrumentsThe thirdelement isfinancial instruments.Theyarealsoknownassecurities;borrowers issuesecurities.Theyare therefore evidences of debt or shares. They also represent claims on the issuers/borrowers. Ultimate lenders exchange money (deposits) for securities and ultimate borrowers exchange (issue new) securities for money. Financial intermediaries issue their own securities (e.g., deposits) and hold the securities of the ultimate borrowers (e.g., treasury bills). As you know, the banks have a special and unique role in this market for money in that they are able to create money (bank deposits) by making new loans (buying new securities).

Securitiesofferareturnthatisfixed(fixed-interestdebt)orvariable(variable-ratedebtandsharedividends).Thecapital amount of shares and debt is paid back after a period (bonds and preference shares) or not ever (perpetual bonds and shares). Securities are also either marketable of non-marketable.

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Box 1: Financial IntermediariesMainstream Financial Intermediaries

Deposit IntermediariesCentral bank (CB)Private sector banks

Non-Deposit Intermediaries (Investment vehicles) Contractual intermediaries (CIs) Insurers Retirement funds (pension funds, provident funds, retirement annuities) Collective investment schemes (CISs) Securities unit trusts (SUTs) Property unit trusts (PUTs) Exchange traded funds (ETFs) Alternative investments (AIs) Hedge funds (HFs) Private equity funds (PEF’s)

Quasi-Financial Intermediaries (QFIS)Developmentfinanceinstitutions(DFIs) Special purpose vehicles (SPVs) Finance companies Investment trusts/companies Micro lenders

Table 1.1 Financial intermediaries

TheinstrumentsofthefinancialsystemareshowninFig.1.3andoutlinedbelow.

ULTIMATE BORROWERS

(deficit economic units)

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

ULTIMATE LENDERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

Debt=NMD

Shares=MD & NMDDebt=MD (CP, Bas, bonds) & NMD

Debt=MD (bills, bonds)Shares Debt=MD (CP, bonds)

Debt &shares

sharesDebtsharesDebt

CENTRAL BANK

BANKS

BANKS

QFIs:DFIs, SPVs, finance,Co’s,etc

INVESTMENT

VEHICLES

CIs

CISs

AIs

Inter bankdebt

Inter bankdebt

CD’s= NCDs & NNCDs

CD’s= NCDs & NNCDs

Debt= MD (CP, bonds), & NMD


CDs

CDs

MD=marketabledebt,NMD=nonmarketabledebt,CP=commercialpaper,Bas=Bankersacceptances,CDs=certificatesofdeposit/s,NCDs=negotiablecertificatesofdeposit,NNCDs=non-negotiablecertificatesofdeposit,ForeignsectorissuesforeignsharesandforeignMD(foreignCP&foreign bonds) PI=participants interest (units)

Fig. 1.3 Financial intermediaries and instruments/securities(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Thetwocategoriesoffinancialinstrumentsareasfollows:Debt (and deposits)•Shares•


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The instruments of debt and shares and their issuers are discussed in the paragraphs below.

The household sector issuesThe household sector issues are as follows:

Non-marketable debt (NMD) securities•Examples: Overdraft loan from a bank and mortgage loan from a bank. �

The corporate sector issuesThe corporate sector issues are as follows:

Share securities (marketable = listed and non-marketable = non-listed)•Ordinary shares (common shares) �Preference shares (preferred shares) �

Debt securities•Non-marketable Debts (NMD) �Marketable Debts (MD) �

Examples: Corporate bonds, Commercial Paper (CP), Bankers’ Acceptances (BAs) and Promissory Notes (PNs)

The government sector issuesThe government sector issues are as follows:

Marketable Debt (MD) securities•Treasury Bills (TBs and T-bills) �Bonds (T-bonds) �

The foreign sector issuesThe foreign sector issues (into the local markets) are as follows:

Foreign share securities (inward listings)•Foreign debt securities (inward listings)•

The deposit financial intermediaries’ issuesThedepositfinancialintermediaries’(centralandprivatesectorbanks)issuesareasfollows:

Deposit securities•Central bank �-Non-NegotiableCertificatesofDeposits(NNCDs)- Notes and coins- Central bank securitiesPrivate sector banks �-Non-NegotiableCertificatesofDeposit(NNCDs)-NegotiableCertificatesofDeposit(NCDs)- Loans (mainly from the central bank)

The quasi-financial intermediaries’ issueThequasi-financialintermediaries’issuesareasfollows:

Debt securities•Non-Marketable Debt (NMD) �- Example: Utilised overdraft facilityMarketable Debt (MD) �- Examples: Bonds and Commercial Paper (CP)

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The above may be summarised as in Table 1.2.

Aswehaveindicated,itisrarethattheindividualinvestsinthesefinancialinstruments(theexceptionsarebankdeposits in the formofNNCDsandshares).Rather, they invest in theseultimatefinancial instrumentsvia theinvestment vehicles by buying their Participation Interests (PIs).

Debt and Deposits Shares

Non-marketable debt and deposits

Marketable debt and deposits

Nonmarketable Marketable

Non-listed ordinary shares*

Listed ordinary shares

Listed preference shares

Ultimate Borrowers

Household sectorOD & mortgage loans from banks

- - - -

Corporate sector(OD) & mortgage loans from banks

Corp bonds, CP, BAs, PNs YES YES YES

Government sector OD loans from banks

Foreign sector - Foreign bonds -YES (inward listing)

YES (inward listing)

Financial Intermediaries

Central bank NNCDs NCDs**, notes & coins - - -

Private sector banks NNCDs NNCDs - - -

Quasi-financialintermediaries

OD loans from banks Corp bonds, CP - - -

Investment vehicles Participation interests (PIs) - - - -

OD = Overdraft); CP = Commercial Paper; BAs = Bankers’ Acceptances; PNs = Promissory Notes; Corp = Corporate;NNCDs=Non-NegotiableCertificatesofDeposit;NCDs=NegotiableCertificatesofDeposit.* Non-listed preference shares do exist, but are rare. ** Central Bank (CB) securities, which are akin to NCDs.

Table 1.2 Financial instruments/securities

1.2.4 Financial MarketsThefourthelementofthefinancialsystemisfinancialmarkets.Financialmarketsarecategorisedaccordingtothesecuritiesissuedbyultimateborrowersandfinancialintermediaries.Itwasnotedabovethatfinancialsecuritiesareeithermarketableornon-marketable.ExamplesareNon-NegotiableCertificatesofDeposit(NNCDs)(anordinarydepositreceipt)andNegotiableCertificatesofDeposits(NCDs)issuedbytheprivatesectorbanks.

There are two market types or forms (see Fig. 1.4): primary market and secondary market. All securities are issued in their primary markets and the marketable ones are traded in the secondary markets. In the primary market, the issuer receives the money paid by the lender/buyer. In the secondary market, the seller receives the money paid by the buyer.


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LENDERS BORROWERS The difference

The difference

Secondary market

Funds

Securities

Primary market

Funds

Securities

BUYERS SELLERS

Fig. 1.4 Primary and secondary markets(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Debt market/interest bearing market/

fixed-interestmarket

FOREIGN FINANCIAL MARKETS

FOREIGN FINANCIAL MARKETS

Forex Market= Conduit

Forex Market

=Conduit

LOCAL FINANCIAL MARKETS

ST debt Market

LT debt Market

Share Market

Cpital Market

Marketable Part =

Marketable Part =

Money Market Bond

Market

Listed Share

Market

=

Fig. 1.5 Financial markets(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Thereareanumberofmarketsforfinancialinstruments,themarketforlifepolicies(aprimarymarketonly),themarket for PIs (also called units) of securities unit trusts (a primary market and a partial secondary market: the units are saleable to the issuer), the market for PIs in retirement funds (strictly a primary market), the deposit market (primary market for NNCDs and a secondary market for NCDs), the bond market (secondary market) and so on. ThefinancialmarketsaredepictedinFig.1.5.Aswewillshowlater,themoneymarketshouldbedefinedastheshort-term debt market (Short-Term Debt Market (STDM) = marketable and non-marketable debts), while the bond market is the marketable arm of the Long-Term Debt Market (LTDM).

The money market (STDM) and the LTDM together make up the debt market (also known as the interest-bearing marketandthefixed-interestmarket).Thetermsinterest-bearingandfixed-interestopposethedebtmarketfromthesharemarketbecausethereturnsonsharesaredividendsanddividendsarenotfixed.Theydependontheperformanceof companies. The LTDM and the share market together make up the capital market. The foreign exchange market isnotafinancialmarket,becauselendingandborrowingdonottakeplaceinthismarket.Rather,itisaconduitforforeigninvestorsintolocalfinancialmarketsandforlocalinvestorsintoforeignfinancialmarkets.

In addition to these cash or spot markets [where the settlement of deals takes place a few days after transaction date (T+0)], we have the so-called derivative markets. They are comprised of instruments (forwards, futures, swaps, optionsand‘others’,suchasweatherderivatives)thatarederivedfromandgettheirvaluefromthespotfinancialmarkets. Whereas, cash markets settle as soon as possible, derivative markets settle at some stage in the future.

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ULTIMATE BORROWERS (deficiteconomic

units)

ULTIMATELENDERS

(surplus economic units)

FINANCIAL MARKETS

FINANCIAL MARKETS

FINANCIAL MARKETS

Securities

Surplus Funds

Securities

Surplus Funds

Securities

Surplus Funds

Securities

Surplus Funds

FINANCIAL INTERMEDIARIES

BROKERSDEALERS

Fig. 1.6 Derivative markets(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Secondary markets are either Over-The-Counter (OTC), also called ‘informal markets’ (such as the foreign exchange and the money markets) because there is no exchange involved, or exchange-driven (or formal) markets, such as the share(orstock)exchange.TheplaceofthefinancialmarketsinthefinancialsystemmaybedepictedasinFig.1.6.Thefinancialmarketsdonotintermediatethefinanciallendingandborrowingprocessasdofinancialintermediaries,such as banks. They merely facilitate the primary and secondary markets.

1.2.5 Money CreationCreationofmoneyisthefifthelement.Asthisiscoveredindetaillater,wewillnotgiveitmuchattentionhere.Whenbanks make new loans/provide new credit (buy NMD, MD and shares), they create NBPS deposits (money).

The referee in this game is the central bank which controls the growth rate in money-creation (new bank deposits resulting from new bank loans) by means that differ from country-to-country (which are elucidated later). The principal method is the interest rate on banks’ loans (bank assets) via the central bank’s KIR interest rate, which influencesthecostofbankliabilities(i.e.,viathebankmargin).

1.2.6 Price DiscoveryThe sixth element is price discovery. Primary and secondary markets are important for a lot of reasons, the most important of which is price discovery, i.e., the establishment of interest rates for various terms and the prices of shares. Interest rates, as we will see, have an important role to play in the pricing of all assets. The central bank playsasignificantroleintheestablishmentofinterestrates.

1.2.7 Allied Participants on the Financial SystemThereareanumberofalliedparticipantson thefinancialsystem.Bythis,wemeanparticipantsother thantheprincipals(thosewhohavefinancialliabilitiesorassetsorboth).Theprincipalsareasfollows:

Lenders•Borrowers•Financial intermediaries•

The allied participants, who play a main role in terms of facilitating the lending and borrowing process (the primary market)andthesecondarymarketsarethefinancialexchangesandtheirmembers.Alsoweneedtomentionthefundmanagers,whoareactivelyinvolvedinsophisticatedfinancialmarketresearchandthereforeplayamajorrolepricediscovery,andtheregulatorsofthefinancialmarkets.Thusthealliednon-principalparticipantsinthefinancialmarketsareasfollows:

Financial exchanges•Broker-dealers•Fund managers•Regulators•


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1.3 Principles of BankingTheprevioussectionpresentedthebankingsectorinthecontextofthefinancialsystem.Thissectiongoesalittlefurther and covers the following aspects:

Fundamental issues in banking.•Basic reason for the existence of banks: Information costs and liquidity.•Broad functions of banks.•

1.3.1 Fundamental Issues in BankingBanksareuniquefinancialintermediaries.Theyaretheonlyintermediariesthatintermediatebetweenallultimatelendersandborrowersandallothernon-bankfinancialintermediaries.Inthismanner,theyperformcrucialfunctionsincludingthemeansofpayments.Infact,theyaresuchsignificantintermediariesthattheirverysurvival(particularlythe large banks) is in the interests of the country.

Due to this, banks are the most regulated intermediaries. In most countries, the central bank regulates and supervises the banks, and they are obliged to have large departments and skilled persons to carry out this function. The banks are innovative and create new products continually, because of the competitive nature of banking, making the task of the supervisor challenging. The hardware and software systems requirements of banks are sophisticated, not only because of the complex deals they undertake, but to cater for the strict and diverse reporting requirements of banks. This and the high capital resource requirements create substantial barriers to entry.

Banks exist because of the information costs they carry and because of the demand for liquidity by deposit clients. Banksearntheirkeepbythemanagementoffinancialrisks,andthisiswhatdifferentiatesthemfromothercompanies.Essentially, they are risk managers. According to Heffernan, “the organisation of risk management within a bank is as important as the development of risk management techniques and instruments to facilitate risk management.” There is no such thing as a generic banking strategy. However, banks need to be planning how, in the future, existing competitive advantage is going to be sustained and extended. The outlook for banks is optimistic, provided they can create, maintain, and sustain a competitive advantage in the products and services (old and new) they offer.”

The securities market is the main threat to banking. Many large, highly rated companies do not require the intermediation of banks to satisfy their borrowing requirements. Cognisant of this threat, many banks are involved in the creation of marketable debt instruments, and hold many of these in portfolio. The most unique function of banksistheirmoney-creatingability,undertheguidanceofthecentralbank,andthecentralbankusestheprofit-maximising behaviour of banks to execute monetary policy. This is where interest rates have their genesis.

1.3.2 The Basic Reason for the Existence of Banks: Information Costs and LiquidityBorrowersand lenderscome togetherwithout the intermediationofaprofit-maximisingcompanyoffering thisfunction, but this happens on a limited scale. Examples are as follows:

A father lending to his son, enabling his son to repay his bond. If we assume the bank home loan rate bond is •12% and the deposit rate is 8%, they will probably do the deal at 10%. Both score on the deal and they cut out the banking sector (called bank disintermediation).Amemberof thehousehold sectorholdingaportfolioof shares (herewe regard sharefinance as ‘infinite•borrowing’,wherethelendergetsashareoftheprofits).A corporate entity holding a treasury bill for LCC 5 million.•

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Itwillberecalledthattheseareexamplesofdirectfinancing.However,weneedtolookatthefollowinglikelyfacts:

The lenders are probably wealthy.•Inthefirstexample,themortgagebondisprobablyan‘accessbond’,i.e.,abondwheretheoutstandingamount•canbeflexible(uptoamaximum),i.e.,thesoncanaccessthebondwhenthefatherneedsthemoney.Thismeansthatthetermtomaturityofthebondisflexible.Ifthetermofthebondwas20yearsandtheoutstandingamountwasnotflexible,thefatherwouldprobablynothavedonethedeal.The father is fully aware of the creditworthiness of his son.•In the case of the corporate entity and the wealthy member of the household sector, the securities are marketable, •meaning that they lenders have access to their funds by selling the securities in the secondary markets.

There are two critical considerations that make banks useful intermediaries:Information costs: The dad lends money to his son because he has the knowledge that his son will repay the •loan. Banks lend funds to borrowers that are not known to the depositors, and they incur costs in gathering in information on the borrowers. Here we have one reason for the existence of banks, information costs.Asymmetry in liquidity preference: Only few dads lend to their sons, because most dads do not have the surplus •fundstodoso.Ingeneral,manydads,moms,companies,etc.,finditconvenienttogetinterestfromthebankwhile the money is available, which is probably for only a portion of the month. The banks lend to borrowers for long periods, for example, 25 years in the case of government bonds. Here, we have the second reason for the existence of banks: lenders and borrowers have different liquidity preferences. It is true that securities markets do provide liquidity for the lender; however, these markets are only accessible to high net worth individuals and companies.

The following is a discussion on these two main reasons for the existence of banks.

Information costsFourmaintypesofinformationcostscanbeidentifiedasfollows:

Search costs•Verificationcosts•Monitoring costs•Enforcement costs•

Search costs are incurred whenever a transaction between two parties is done. The borrower is not concerned with the quality of the lender, but the lender is concerned with the quality of the borrower. Search costs include negotiation and the gathering of information, which take place during meetings that usually take some time.

Verificationcostsareincurredbecausethebankisobligedtoverifytheinformationgathered.Banksareconcernedwiththe well-known problem of asymmetric information (a gap in knowledge between lender and borrower), which can giverisetotheproblemsofadverseselection(poorselectionpriortotheloan)andmoralhazard(financiallyimmoralbehaviour by the borrower after the loan is made). It is interesting to note that a higher rate charged to compensate forariskyclientcanbenegativelyself-fulfilling,i.e.,itcanmaketheprojectforwhichthemoneyisborrowedunviable. A high rate is of course perfectly acceptable to the borrower who knows he is going to default.

Monitoring costs are incurred by the bank because once the money is lent, the bank has an incentive to monitor the client. Enforcement costs are incurred, when borrowers do not adhere to the terms of the contract, i.e., the terms of the loan. When conditions are breached, the bank (the injured party) has to take action, and ‘action’ could mean expensive ‘legal action’.


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The individual lender (surplus economic unit) does not have the time or the inclination or the skill to gather information, verify the information, monitor client-behaviour or enforce legal contracts, and delegates this function to the bank, which is skilled in this area. It may be said that banks have ‘informational economies of scope’; they focus on this function and consequently the cost per transaction is lower than in the case, where an individual lender assesses a few borrowers.

Asymmetry in liquidity preferenceLenders and borrowers have different requirements in terms of liquidity, which essentially means term to maturity of the loan or deposit. Borrowers usually borrow for projects that have long lives and consequently long-term repayment schedules, whereas lenders usually require deposits that are liquid, i.e., deposits that are available immediately or in the short-term. Banks satisfy both parties; they essentially transmute illiquid assets into liquid liabilities.

Depositors earn a rate of interest and have liquidity, and they accept a low rate of interest compared with the loan rate for this convenience. The large banks have little risk of losing funds (liquidity risk), because withdrawals of liquiddepositsdonotdepletethesystemoffunds;thesefundsremaininthesystemandflowbacktothedeficitbanks via the interbank market. The borrowers are prepared to pay a higher rate of interest than that available to the lenders because of the convenience, i.e., availability of the funds for the required period, which would most likely not be the case, if the ultimate lender loaned the funds.

OTC versus securities marketsItshouldbeclearthatbanksmainlyoperateintheinformal(over-the-counter)financialmarkettakingdepositsfromand making loans to individuals and smaller companies in the main. The alternative to the informal market is the formalisedmarket,i.e.,thefinancial(shareandbond)exchange/s,whereinformationalandliquidityproblemsareovercome by:

The borrowers (issuers of securities) being the large creditworthy borrowers (which are usually rated by credit •rating agencies)The existence of standardised contracts•The ability to dispose off investments when the need arises•

1.3.3 Broad Functions of BanksIn the earlier section, we discussed the basic underlying reason for the existence of banks: information costs and asymmetry in liquidity preference. These may also be seen as the main functions of banks. Allied to these functions are a number of other functions, for example payments services (which are closely related with the taking of deposits). The longer list of the functions of banks is as follows:

Facilitationofflowoffunds(thisistheobviousone)•Efficientallocationoffunds•Assistance in price discovery•Money-creation•Enhanced liquidity•Price risk lessened for the ultimate lender•Improveddiversification•Economies of scale•Payment system•Monetary policy function•

Facilitation of flow of fundsFinancialintermediariesfacilitatetheflowoffundsfromsurpluseconomicunitstodeficiteconomicunits.Withoutsoundfinancialintermediaries,muchofthesavingsoftheultimatelenderswillnotbeavailabletotheultimateborrowers. There are a number of examples in underdeveloped countries, where individuals keep their savings in the form of notes and coins as opposed to deposits with unsound banks.

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Efficient allocation of fundsBankshavetheexpertisetoensurethattheflowoffundsisallocatedinthemostefficientmanner.Asnoted,theyare aware of the existence of asymmetric information and its two by-products, the problems of adverse selection and moral hazard. Asymmetric information means that the potential borrower has more information than the bank does about his/her business.

As we have seen, the presence of asymmetric information leads to adverse selection and moral hazard problems. Adverse selection means that bad risk borrowers are more likely to want loans than good risk borrowers. Moral hazard purports that once a loan is granted; the borrower may be inclined to take risks with the money that are not disclosed to the bank in the application. These are two of the many real-life risks faced by banks. They are keenly aware of them, and this ensures that available funds are allocated to borrowers that will utilise the funds prudently, which in turn will lead to an increase in economic activity.

Assistance in price discoveryPricediscoveryiscloselyalliedwithefficientallocationoffunds.Thebanksaretheprofessionals/expertsinthefinancialsystemandarethereforekeenlyinvolvedinpricediscovery.Theyareactivelyinvolvedinthepricingoffinancialservicesandsecurities.Itisnotable,however,thatthecueforinterestrates,especiallyattheshort-endofthe yield curve, emanates from the central bank. This is elucidated in the separate section on money creation.

Money-creationMoneycreationisalsocloselyalliedwiththeefficientallocationoffunds.Thisfunctionmayalsobetermedthecreditofloanfunction.Notonlyareexistingfundsallocatedefficiently,butnewmoneyisalsoallocatedefficientlyby the banking sector. They have the unique ability to create money (their own deposits) by making new loans, i.e., literally by accounting entries. However, this takes place under the guidance of the central bank.

The banks may thus be seen as the intermediaries that ease the constraint of income on expenditure, thereby enabling theconsumertospendinanticipationofincomeandtheentrepreneurtoacquirephysicalcapital.Theseareofbenefitto the overall welfare of the country.

Enhanced liquidityEnhanced liquidity is created for the depositor with a bank. If an individual purchases the securities of the ultimate lenders (such as, making a loan to a company), liquidity is low or almost zero. Banks are in the business of purchasing less (or non-) marketable primary securities, and offering liquid investments to the ultimate lenders.

Price risk lessened for the ultimate lenderFlowing from the above is that banks take on price risk and offer products that have little or zero price risk. Banks have a diverse portfolio of non-marketable loans, bonds and share investments that carry price risk (also called marketrisk),andofferproductsthathavezeropricerisk,suchasfixeddeposits.

Improved diversification

Number of securities in portfolio

RiskPortfolio (total) risk

Specific/unsystematic

risk

Market / unsystematic

risk

Fig. 1.7 Risk and diversification(Source: http://bookboon.com/en/banking-an-introduction-ebook)


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Oneofthecentraldoctrinesofportfoliotheory(andpractice)isthatrisk(definedasvariabilityofreturnaroundthe mean return) is reduced as the number of securities in a portfolio is increased, provided that the returns are not perfectlypositivelycorrelated.Itmaybesaidthatpartoftheinvestmentriskis‘diversifiedaway’asoneincreasesthe number of securities (assets) in a portfolio. This concept is illustrated as in Fig. 1.7.

With investments, members of the household and (small and medium) corporate sectors can only achieve limited diversificationcomparedtoabankwhichaggregatessmallamountsofdepositsforinvestmentsinthesecurities(mainly NMD) of the ultimate borrowers. Thus, an investment with a bank is an indirect investment in a wide variety ofassets(mainlyNMD),achievingdiversificationandlesseningrisk.Earlier,weusedtheexampleofafatherlendingto his son. This is highly risky, because there is a fair probability of him receiving zero return and losing 100% of his investment. He lessens risk by lending to a number of individuals and companies via a bank deposit.

Economies of scaleA number of economies are achieved because of the sheer scale of banks. The two main economies that are realised are transactions costs and research (search) costs. The features of transaction costs and research costs are as follows:

Transactionscosts:Thelargestbenefitoffinancialintermediationisthereductionintransactionscosts;infact•someintermediarieshavebeenformedspecificallybecauseoftransactionscosts[e.g.,SecuritiesUnitTrusts(SUTs) and Exchange Traded Funds (ETFs). The obvious example is that the (transaction) cost involved in purchasing a small number of shares in a company via a broker-dealer is similar to the cost of purchasing many more shares. More important is payments system costs. The banking system, through the use of sophisticated technology,providesanefficientpaymentsservice(chequeclearingandelectronicpayments)thatisrelativelyinexpensive. Individual participants in thefinancial system cannot achieve this reduction in transactionscosts.Research (search) costs: An example is the purchase by an ultimate lender of shares and bonds as opposed to •holding bank deposits. He now has the task of monitoring the performance of each company, which involves economic analysis, industry analysis, ratio analysis, etc. Financial intermediaries have the resources to carry outresearch,whichessentiallybenefitstheholdersofitsproducts(deposits).

Payments systemThe banking sector provides the mechanism for the making of payments for anything that is purchased (goods, servicesandsecurities).Certainfinancialassetsserveasameansofpayments,andthereareinstrumentsoftransfer,andpurchases/payments,assuminganefficientpaymentssystem(clearingandsettlement).Thefinancialassets/instruments of transfer that are accepted as payment include the following:

Financial assets (money): Financial assets include the following:•Bank notes and coin (issued by the central bank in most cases) �Bank deposits �

Instruments of transfer: Instruments for transfer include the following:•Cheques �Credit, debit and smart cards �Electronic Funds Transfer (EFTs) facilities (such as, internet banking facilities) �

Monetary policy functionThe banks are both the instruments of money creation and the mechanism for the implementation of monetary policy.Themonetaryauthoritiesareabletoexertapowerfulinfluencethroughvariousmeansontheinterestratesofbanks,and,inturn,toinfluenceConsumption(C)andInvestment(I)spending.C+I=GDE(GrossDomesticExpenditure), and GDE contributes over 60% to GDP (Gross Domestic Product) (and as high as 80% in some countries). GDP growth is a major input in the other objectives of policy, such as stable employment, balance of paymentsequilibriumandlowinflation.

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1.4 The Balance Sheet of a BankThe balance sheet of a bank is comprised of, on the one side, equity and liabilities, and on the other, assets.

Equity and liabilities = Assets

Liabilities are made up of deposits and short-term loans (loans from the central bank, and repurchase agreements). Thus,theessenceofbankingisstraightforward.Thebanksfinancethemselveswithowncapitalandreserves(equity),deposits and short-term loans and they provide loans (NMD and MD). They also provide other services, such as indemnities, guarantees and broking services that are off-balance sheet.

The banks’ income derives from interest earnings on their loans (NMD and MD), the fees charged for services, as wellasopportunisticprofitsfromfinancialmarketdealing.Theircostsarecomprisedofinterestpaymentsondepositsand short-term loans, and the costs associated with running the bank. We repeat a previous illustration which shows theuniquepositionofbanksinthefinancialsystem.Itwillbeseenthatbanksalsobuyshares;however,thisisaminuscule part of the business and holdings are usually associated with opportunistic positions/dealing in shares.

BORROWERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

LENDERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

Debt

Debt & shares

Debt

Debt & shares

Debt &shares

Debt & shares

Debt & shares

CENTRAL BANK

BANKS

BANKS

QFIs:DFIs, SPVs, financialco’sInvestment co’s

INVESTMENT VEHICLES

CIs CISs AIs

Inter bankdebt

Inter bankdebt

Deposit

Deposit


Debt

Fig. 1.8 Banks in the financial system(Source: http://bookboon.com/en/banking-an-introduction-ebook)

The purpose of this section is to provide a brief introduction to the business of banking, with a sub-purpose of attempting to build a framework for this unique industry. The details are then presented in later texts. The broad outline of banking may be seen in basic terms as in Fig. 1.9.

MONEYCREATION

BUSINESS OF BANKING

SHARECAPITAL LIABILITIES ASSETS OFF-BALANCE SHEET

ACTIVITES

“SOURCES”OF FUNDS

“USES OFFUNDS”

+ =

Fig. 1.9 The basic business of banking(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Each of these areas of banking is presented in summary form below.

1.4.1 Share Capital (Equity)The share capital and unimpaired reserves (equity) required to be held by a bank is the principal prudential requirement of banking legislation, and it is ultimately applied to protect the bank’s deposit clients as well as the banking system from failure (systemic failure). The other prudential requirements are the cash reserves, liquid assets and large exposure requirements. The capital and reserves of the banks amount to around 8-10% of total capital and liabilities/assets.


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1.4.2 LiabilitiesApart from equity, the other sources of funds of banks are as follows:

Deposits•Loans•

Loans from the central bank �Interbank loans �Repurchase agreements (repos) �

DepositsDeposits are the primary source of the funding for a bank; there are two broad categories which are as follows:

Non-NegotiableCertificatesofDeposits(NNCDs)•NegotiableCertificatesofDeposits(NCDs)•

The proportions of the two categories vary from country-to-country, but the former is usually the higher one, because most deposits are small. The NNCD category includes many types, call money accounts, cash managed accounts, transmissionaccounts,chequeaccounts,savingsaccounts,fixeddepositaccounts,noticeofwithdrawalaccounts,and so on. The term of deposits ranges from a day to a number of years, although the overwhelming term is short. AsindicatedinFig.1.10,depositsaretakenfromalltheotherfinancialintermediaries,aswellasthefoursectorsof the economy, household, corporate, government and foreign. Deposits are denominated in LCC, and banks also offer foreign currency-denominated accounts to certain depositors.

LoansLoans are short-term in nature, there are three categories, loans from the central bank, interbank loans and repurchase agreements (repos). Loans from the central bank are related to monetary policy and are provided at the central bank’s Key Interest Rate (KIR called by many names such as, base rate, bank rate, repo rate and discount rate). Interbank loans are loans from banks-to-banks and are provided at the interbank rate. As we will see later, there are actually three interbank markets, but this one, the bank-to-bank Inter-Bank Market (b2b IBM), is the only one where a price is discovered (which is closely related to the KIR).

A repurchase agreement (repo) is a legal agreement in terms of which a security, or a parcel of securities, is sold for a portion of the life of the securities. For example, a bank may wish to take a short-term position (for 30 days) in 5-year government bonds (because it expects bond rates to fall in the 30-day period). At the same time, the bank may have a wholesale deposit client needing an investment for 30 days at a rate that is higher than the deposit rate for 30 days. The bank buys the bonds outright (with the purpose of selling them outright after 30 days) and would then sell them to the client under repurchase agreement (repo), i.e., under an agreement to repurchase the same securities 30 days after the deal is struck.

It will be evident that if a bank sells a security, it leaves the balance sheet of the bank. In reality it does (the security is in fact delivered to the client), but for purposes of the prudential requirements, banks are required to show the security as an asset and the funds advanced to the bank as a loan (received under repurchase agreement).

The repo is the preferred instrument for some central banks in the conduct of monetary policy (for legal reasons). Most central banks (except in exceptional circumstances) bring about a Liquidity Shortage (LS) and accommodate the banking system by means of outright overnight loans (see above) or by loans via purchasing repos from the banksforspecifiedshort-termperiods.Theratechargedbythecentralbankfor thisaccommodationisusuallycalled the repo rate (as noted, it is another name for the KIR). Fig. 1.10 is presented as a summary of the sources of funding of banks.

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MONEYCREATION

BUSINESS OF BANKING


ACTIVITES


REPOs

“USES OFFUNDS”

+ =

DEPOSITS LOANSNNCDs

NCDs

FROM CENTRAL BANK INTERBANK LOANS

Fig. 1.10 The business of banking: liabilities(Source: http://bookboon.com/en/banking-an-introduction-ebook)

1.4.3 AssetsThe assets of banks are categorised into two broad groups, with a few sub-groups as follows (we ignore ‘other assets’):

Central bank money•Notes and coins �Deposits (required and excess reserves) �

Loans•Non-Marketable Debt (NMD) �- Loans to non-banks- Interbank loansMarketable Debt (MD), i.e., investments �

Central bank moneyCentral bank money is the banks’ holding of bank notes and coin (which are the central bank’s liabilities), and deposits with the central bank. The latter is comprised of two accounts in some countries (current or settlement account and reserve account) and just one in others (called settlement or reserve account). The amounts held on this account/s are as follows:

The statutory Required Reserves (RR) of the banks, which are determined as a proportion of bank deposits (or •liabilities).Excess reserves (which may be held from time-to-time). Usually, interest is not paid on this account/s, meaning •that the banks keep the minimum required reserves in these accounts Ignoring the RR for a moment, the central bank account/s of the banks are also the clearing accounts, i.e., the interbank clearing takes place via these accounts.

Central bank money is only about 2–5% of total assets, and yet these accounts are at the very centre of the banking system and monetary policy. The central bank operates via these accounts to keep the banks short of reserves (usually), and accommodates them at the KIR. The latter is the ‘foundation’ rate in the interest rate structure.

LoansBank loans are also called advances and credit. This portion of the banks’ balance sheets makes up the vast majority of their assets. As we have seen, the following are the categories:


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Non-Marketable Debt (NMD)•Loans to non-banks �Interbank loans �

Marketable Debt (MD), i.e., investments•

The vast majority of bank loans are NMD, i.e., small loans, to non-banks, and there are many examples as follows:

Instalment sale credit (old name: hire-purchase credit)•Suspensive sales agreements•Leasingfinance•Credit card debtors•Foreign currency loans•Mortgage loans•Overdraft loans•

Of these NMD, the last two are in the majority. Interbank loans are the counterpart of the interbank loans that appear on the liability side of the balance sheet. Marketable Debt (MD) refers to the holdings of the banks of investments such as treasury bills, promissory notes, bonds, bankers’ acceptances and commercial paper. As noted, banks also hold shares (ordinary/common shares and redeemable preference shares), but this is unusual. In most cases, MD makes up a small proportion of assets.

Fig. 1.11 is presented as a summary of the assets (uses of funds) of banks (as well as the liabilities). This brings us to one of the unique features of banks: the ability to create new deposits (money) by making new loans.

MONEYCREATION

BUSINESS OF BANKING


ACTIVITES


REPOs

“USES OFFUNDS”

+ =

DEPOSITS LOANSNNCDs

NCDs

FROM CENTRALBANK

INTERBANKLOANS

INTERBANKLAONS

CENTRALBANK

MONEY

LOANS NON-

MARKETABLE

LOANS NON-

MARKETABLE

N&C DEPOSITE

NON-BANKS

Fig. 1.11 The business of banking: full picture(Source: http://bookboon.com/en/banking-an-introduction-ebook)

1.4.4 Liability and Asset Portfolio ManagementAsset and liability portfolio management is the essence of banking, and every bank has an active Asset and Liability Committee (ALCO) that meets frequently. In short, banks endeavour to balance liabilities and assets in such a way thatthemaximumprofitisgenerated,givenanacceptableriskprofile.

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Theultimatebalanceofliabilitiesandassetssoughtbybanksistohaveassetsthatgeneratethehighestfloatinginterestratepossible,andnocreditrisk,andliabilitiesthatcarrythelowestfloatingratepossible.Totheextentthatthereisatermandrate(fixedversusfloating)mismatch,theidealportfolioconstructdependsontheinterestrateview of the bank. If there is certainty in respect of interest rate movements, then in a falling rate environment (ideally with a positively sloped yield curve) assets should have the longest term possible and liabilities should be as short as possible. Conversely, in a rising rate environment, assets should have a short-term maturity and liabilities a long maturity. However, term mismatches are risky.

The reality is vastly different. Other banks are competing for business. Clients of the bank require deposits and investments and accommodation that differ from the bank’s ideal portfolio construct. Interest rate movements can be volatile and unpredictable (and subject to shocks), and there are many risks that banks face.

Banks are in the business of lending funds. Thus, they have a disposition to grow their asset ‘books’ to the extent dictatedbythecapitalrequirement,andtogenerateprofitsthatcanbeaddedtocapitalresources(retainedfunds)in order to grow the book even faster. In the past history of banking, locally and internationally, a number of banks have ‘gone for growth at all costs’, and in many cases, the cost has been failure. For this reason, the focus of the regulatory authorities is on risk management. It is easy for a bank to grow its asset book, but with this comes risk in many forms. Thus, banks have to balance the search for business with strict risk management. This is discussed at some length later.

1.4.5 Money CreationBank assets and liabilities are not static. They increase mainly as a result of money-creation. Keep in mind that broad money, M3, is made up of bank Notes and Coins (N&C) + Bank Deposits (BD) (held by the domestic Non-Bank Private Sector – NBPS):

M3 = N&C + BD

Of these, BD is the largest (+/- 95%). BD increase when banks make new loans = buy NMD and MD.

Balance Sheet 1: Company A (LCC Millions)

Assets Equity and liabilitiesGoods Bank deposits

-10+10

Total 0 Total 0

Balance Sheet 2: Company B (LCC Millions)Assets Equity and liabilities

Goods +10 Bank loan (overdraft) +10Total +10 Total +10

Balance Sheet 3: Bank A (LCC Millions)

Assets Equity and liabilitiesLoan to Company B +10 Deposit of Company A +10

Total +10 Total +10

CompanyAisaproducerofgoodsrequiredbyCompanyB.CompanyBrequiresfinanceofLCC10millioninorder to purchase the goods, and approaches Bank A for a loan. After a credit check, the bank grants Company B an overdraft facility.


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Company B draws a cheque for LCC 10 million on its overdraft facility and presents the cheque to Company A and takes delivery of the goods. Company A is thrilled with the sale, and deposits the cheque with bank A. The cheque is put through the interbank clearing system and the balance sheets of the respective parties end up as shown in Balance Sheets 1–3.

It will be evident that the deposit of Company A amounts to an increase in M3 (bank deposits held by the NBPS), and that its source was the increase in the overdraft granted to Company B and utilised by it (the real source of coursewasthedemandforloans(Δ=change):ΔM3=ΔBD=Δbankloans.Themechanismthatpreventstheincreaseinmoneycreationescalatingoutofhandis the monetary policy.

1.4.6 Off-Balance Sheet ActivitiesThe off-balance sheet activities of banks may be split into two categories as follows:

Off-balance-sheet activities that carry risk.•Off-balance-sheet activities and services that carry no or little risk.•

Off-balance-sheet activities that carry riskThe off-balance sheet activities of banks that carry risks are many and include the following:

Indemnities.•Guarantees.•Irrevocable letters of credit.•Underwriting.•Effective net open position in foreign currencies.•Portfolios managed by others on behalf of the bank.•Securities/commodities broking.•

Off-balance-sheet activities that carry no or little riskThe off-balance sheet activities of banks that carry little or no risk are multi-faceted and include the following:

Corporatefinance(mergers,acquisitionsandcompanylistings).•Debt origination (companies and government).•Projectfinance.•Bookkeeping services.•Economic advice to corporate and individual clients.•Advice on importing and exporting.•General investment advising.•Trust and estate services.•

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SummaryPrivatesectorbanksplayanimportantroleinthefinancialsystemandtherealeconomy.•Banks are unique in that their liabilities, bank Notes and Coins (N&C – central bank) and Bank Deposits (BD-•privatesectorbanks)areregardedasthemeansofpayments/mediumofexchange,whichisthedefinitionofmoney.Banks are innovative, mainly a function of extreme competition, and they are then at the forefront of new •developments,notjustinbankingbutalsointhewiderfinancialmarkets.Lendersandborrowersisthefirstelementofthefinancialsystem.•Ultimate lenders exchange money (deposits) for securities and ultimate borrowers exchange (issue new) •securities for money.The money markets, (STDM) and the LTDM together make up the debt market (also known as the interest-•bearingmarketandthefixed-interestmarket).Theforeignexchangemarketisnotafinancialmarket,becauselendingandborrowingdonottakeplaceinthis•market.When banks make new loans/provide new credit (NMD, MD and shares), they create NBPS deposits •(money).The securities market is the main threat to banking.•Financialintermediariesfacilitatetheflowoffundsfromsurpluseconomicunitstodeficiteconomicunits.•Asymmetric information means that the potential borrower has more information than the bank does about his/•her business.Money-creationisalsocloselyalliedwiththeefficientallocationoffunds.•Bank loans are also called advances and credit.•Marketable Debt (MD) refers to the holdings of the banks of investments, such as treasury bills, promissory •notes, bonds, bankers’ acceptances and commercial paper.Asset and liability portfolio management is the essence of banking, and every bank has an active Asset and •Liability Committee (ALCO) that meets frequently.

ReferencesAn Introduction to Banking. • [Pdf] Available at: <http://online.vmou.ac.in/oldweb/studymaterial/BBA%2010.pdf> [Accessed 06 June 2014].An Overview of the Banking Secto• r. [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/2031/10/10_chapter%201.pdf> [Accessed 06 June 2014].Choudhry, M., 2011. • An Introduction to Banking: Liquidity Risk and Asset-Liability Management. John Wiley & Sons.Iyengar, V., 2007. • Introduction to Banking. Excel Books India, New Delhi.Money and Banking: Lecture 1 - Money and the Economy. • [Video online] Available at: <https://www.youtube.com/watch?v=etsCGT542AI> [Accessed 06 June 2014].The Theory of Central Banking | Robert P. Murphy. • [Video online] Available at: <https://www.youtube.com/watch?v=6HAEPSt_12U> [Accessed 06 June 2014].

Recommended ReadingHamori, S. and Hamori, N., 2010. • Introduction of the Euro and the Monetary Policy of the European Central Bank.WorldScientific,Singapore.Glantz, M., 2003. • Managing Bank Risk: An Introduction to Broad-base Credit Engineering. Academic Press.Park, Y. S. and Essayyad, M., 1989. • International Banking and Financial Centers. Springer.


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Self Assessment__________sectorbanksplayanimportantroleinthefinancialsystemandtherealeconomy.1.

Privatea. Publicb. Governmentc. Nationald.

Thefinancialsystemhas__________partsorelements.2. Fivea. Threeb. Sixc. Twod.

Match the following3.

1. Financial intermediaries A. They are the third element. They are also known as securities; borrowers issue securities.

2. Financial instruments B. They are the second element.

3. Financial markets C.Itisthefifthelement.

4. Creation of money D.Theyarethefourthelementofthefinancialsystem.

1- C, 2- D, 3- B, 4- Aa. 1- A, 2- B, 3- C, 4- Db. 1- B, 2- A, 3- D, 4- Cc. 1- D, 2- C, 3- A, 4- Bd.

Whichofthefollowingisthesixthelementoffinancialsystem?4. Financial intermediariesa. Financial instrumentsb. Creation of moneyc. Price Discoveryd.

Which of the following are incurred, whenever a transaction between two parties is done?5. Verificationcostsa. Monitoring costsb. Enforcement costsc. Search costsd.

___________ costs are incurred, because the bank is obliged to verify the information gathered.6. Verificationcostsa. Monitoring costsb. Enforcement costsc. Search costsd.

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Which of the following statement is true?7. Searchcostiscloselyalliedwithefficientallocationoffunds.a. Pricediscoveryiscloselyalliedwithefficientallocationoffunds.b. Monitoringcostiscloselyalliedwithefficientallocationoffunds.c. Verificationplaniscloselyalliedwithefficientallocationoffunds.d.

What is the primary source of funding for a bank?8. Depositsa. Loansb. Share capitalc. Assetsd.

What refers to the holdings of the banks of investments, such as treasury bills, promissory notes, bonds, bankers’ 9. acceptances and commercial paper?

Bank loans a. Liquidity Shortage (LS)b. Marketable Debt (MD)c. NegotiableCertificatesofDeposit(NCDs)d.

Which of the following statement is false?10. Money-creationisalsocloselyalliedwiththeefficientallocationoffunds.a. Poor liquidity is created for the depositor with a bank.b. The securities market is the main threat to banking.c. Thecentralbankplaysasignificantroleintheestablishmentofinterestrates.d.


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Chapter II

Banker and Advisor to Government

Aim


introduce central bank’s roles as banker and advisor to government•

explain interbank markets•

explicate the bank-to-central bank interbank market•

Objectives


enlist tax payments•

elucidate the role of central bank as banker to government•

explain bank liquidity management•

Learning outcome


identify the public debt management•

understand the administration of exchange controls•

recognise the problem of changes in government’s balance at the central bank from the perspective of central •

bank, government and banks

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2.1 IntroductionFunctions of Central Banks (CB) are listed in Table 1.1. In its roles as banker and advisor to government, the CB has three responsibilities. In order to completely understand them and the sections which follow, we need to introduce the interbank markets in detail, as well as the role of the CB in bank liquidity management. The following are the subsections:

The interbank markets•Bank liquidity management•Banker to government•Tax and Loan Accounts•Public debt management•Administration of exchange controls•

Formulation and implementation of monetary policy (aimed at achieving and maintaining price stability)

Formulation of monetary policy frameworkInfluenceonthelevelofinterestrates(throughbankliquiditymanagement)Open market operations

Banker and advisor to governmentBanker to governmentPublic debt managementAdministration of exchange controls

Management of the money and banking systemLender of last resort (note: not a monetary policy function)Currency management (notes and coins)

Banker to private sector banksSettlement of interbank claimsBank supervisionSupervision of payments systemManagement of gold and foreign exchange reservesDevelopment of debt market

Provision of economic and statistical servicesProvision of internal corporate support services and systems

Table 2.1 Functions of central banks

2.2 The Interbank Markets (IBM)There are three interbank markets:

Bank-to-central bank interbank market.•Central bank-to-bank interbank market.•Bank-to-bank interbank market.•


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The balance sheets of the CB and the banks are the accounts through which the Interbank Markets (IBMs) function.

Balance Sheet 1: Central Bank (LCC Billions)Assets Liabilities

D. Foreign assetsE. Loans to governmentF. Loans to banks (Borrowed Re-serves – BR)@ Key Interest Rate (KIR)

1,0001,100

400

A. Notes and coinsB. Deposits

1. Government2. Banks’ reserve accounts (TR)

a. Required Reserves (RR = 500)b. Excess Reserves (ER = 0)

C. Foreign loans

1,000

900

500

100Total 2,500 Total 2,500


C. Notes and coinsD. Reserves with central bank (TR)1. Required reserves (RR = 500)2. Excess reserves (ER = 0)F. Loans to governmentG. Loans to private sector

100500

1,0003,800

A. Deposits of NBPS (BD)B. Loans from central bank (BR) @ KIR

5,000

400

Total 5,400 Total 5,400

The IBMs are where the settlement of interbank claims takes place and where monetary policy begins. In a few countries, banks have two accounts with the central bank, a reserve account in which Required Reserves (RR) are held and a Settlement Account (SA) over which the settlement of interbank claims takes place. In other countries, banks have one account with the central bank. It has many names, such as reserve account, settlement account, cash reserve account, etc. Here, we refer to it as reserve account. On these accounts, the banks hold their required RR and (if any) their Excess Reserves (ER). The total of the two amounts, we call Total Reserves (TR). Thus:TR = RR + ER.

Only one of the three IBMs is a true market, the bank-to-bank IBM. The IBM rate is shown with the KIR in Fig. 2.1. The KIR is determined administratively by the MPC. It exerts a powerful impact on the IBM rate; note that it is below the KIR.

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Interbank rate

KIR

5

7

9

11

13

15

17

19

21

23

25

Fig. 2.1 Interbank rate and KIR(Source: http://bookboon.com/en/banking-an-introduction-ebook)

2.2.1 The Bank-To-Central Bank Interbank MarketThebank-to-centralbankinterbank‘market’orb2cbIBMisthefirstIBMtobediscussed.Itisan‘administrative’marketinwhichtheflowisone-way,fromthebankstothecentralbankintheformofthecashreserverequirement.As mentioned before, cash reserve requirement amount is referred as Required Reserves (RR). The banks’ RR is held on their reserve accounts with the central bank. In the vast majority of countries, the RR balances earn no interest, which is an important element in monetary policy. Another important element of monetary policy in most countries is that banks are kept chronically short of reserves by the central bank, such that Excess Reseves (ER) for the banking system does not exist.

To explain the RR further, in most countries banks are required by statute to hold a certain ratio of their deposits in an account with the central bank. It has its origin in the gold coin reserves held by the goldsmith-bankers from the seventeenth century and later in voluntary note and deposit holdings with the Bank of England. In our accompanying balance sheets (1 and 2), the banks have deposits (BD) of LCC 5000 billion, an assumed statutory RR ratio (r) of 10% of deposits, and RR with the central bank of LCC 500 billion. Hence, they are holding the minimum required (TR = RR), and they do so because, the central bank does not pay interest on reserves. Also, in this example that the banks are borrowing LCC 400 billion from the central bank, so they will not have Excess Reserves (ER). To sum up, as regards the b2cb IBM:

BD × r = RR = TR.LCC 5 000 billion × 0.10 = LCC 500 billion = TR.ER = 0.

2.2.2 The Central Bank-To-Bank Interbank MarketThe second IBM we talk about is the central bank-to-bank interbank ‘market’, or cb2b IBM. It is also an ‘administrative’ market, and it is at the centre of the vast majority of countries’ monetary policy. It represents loans from the central bank to the banks (also called Borrowed Reserves-BR). The central bank provides these reserves at its KIR. This can be seen in the balance sheets above:

BR = LCC 400 billion.

In most countries, monetary policy is aimed at ensuring that the banks are indebted to the central bank at all times, so that the KIR is applied and therefore is ‘made effective’ on part of the liabilities of the banks (recall that bank liabilities=BD+BR).TheKIRhasamajorinfluenceonthebanks’depositratesand,viathemoreorlessstaticbank margin, on the banks’ prime rate. This is an extremely successful policy protocol.


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2.2.3 The Bank-To-Bank Interbank MarketThe third interbank market is a true market, the bank-to-bank interbank market, or b2b IBM. This market operates during the banking day, but particularly at the close of business each day (banks ‘close off their books’ every day). For example, a large corporate customer (Company A) withdraws LCC 100 billion of its call money deposits from Bank A and deposits it with Bank B, because Bank B offers a higher call money rate.

How does the settlement of these transactions take place between the two banks? It takes place over the banks’ reserve accounts: item B2 in Balance Sheet 1, and item D in the Balance Sheet 2. Balance Sheets 3–6 simplify the story.

Balance Sheet 3: Company A (LCC Billions)

Assets LiabilitiesDeposit at Bank ADeposit at Bank B

-100-100

Total 0 Total 0

Balance Sheet 4: Bank A (LCC Billions)Assets Liabilities

Reserve account at CB -100 Deposits (Company A) -100Total -100 Total -100

Balance Sheet 5: Bank B (LCC Billions)

Assets Liabilities

Reserve account at CB +100 Deposits (Company A) +100

Total +100 Total +100


Reserve accounts:Bank ABank B

-100+100

Total 0 Total 0

Assuming that at the close of business yesterday, the two banks were not borrowing from the central bank (BR = 0) and they did not have any surpluses with the central bank (TR = RR; ER = 0):

Bank A is now short of RR by LCC 100 billion, and therefore does not comply with the RR (TR < RR).•Bank B now has surplus reserves (TR > RR or TR – RR = ER = LCC 100 billion).•


Deposits (Company A)Loan (Bank B)

-100+100

Total 0 Total 0

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Balance Sheet 8: Bank B (LCC Billions)Assets Liabilities

Loan to Bank A +100 Deposits (Company A) +100Total +100 Total +100

We assume this is the only transaction that takes place during the day, and that bank B does not have outstanding borrowings from the central bank. We are now at the close of business. The electronic interbank settlement system presents the two banks with the above information that pertains to each of them. Bank A needs to borrow LCC 100 billion and Bank B would like to place its ER somewhere at a rate of interest.

Thefinalinterbankclearingprocessattheendofthebusinessdaytakesplaceoverthesesamereserveaccountswiththe central bank. In this b2b IBM the surplus bank, Bank B will place its ER of LCC 100 billion with Bank A, and this will take place at the IBM rate (after some haggling). Bank B will instruct the central bank to debit its reserve account and credit Bank A’s reserve account. The central bank’s balance sheet will be unchanged, and the banks’ balance sheets appear as in Balance Sheets 7 and 8.

Thus, in the b2b IBM, banks place funds with or receive funds from other banks depending on the outcome of the clearing. Surpluses are placed at the IBM rate. A critical issue here is that this rate is closely related to the KIR (as shown in Fig. 2.1) because banks endeavour to satisfy their liquidity needs in this market before last resort borrowing from the central bank at the KIR. In this example, it was possible. Later we will show that when the central bank does a deal in the open market Open Market Operations or OMO), it affects bank liquidity. As you now know, when one speaks of bank liquidity, one makes reference to the state of balances on the banks’ reserve accounts: the status of TR, RR, ER and BR. As we will demonstrate later, the central bank has total control over bank liquidity, and therefore over interest rates.

ULTIMATBORROWERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

ULTIMAT LENDERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

BANKS

BANKS

Securities

SecuritiesSecurities

Securities

IBM loans(b2b IBM)

Loans to= borrowed reserves (BR) (cb2b IBM)

Required reserves (RR) (b2sb IBM)

OTHERFINANCIAL

INTERMEDIARIES

CENTRAL BANK

Fig. 2.2 Interbank markets(Source: http://bookboon.com/en/banking-an-introduction-ebook)

In the b2b IBM, no new funds are created; existing funds are merely shifted around. New funds (reserves) are created in the cb2b IBM (in the long-term). The latter is a function of the ability of banks to create money in the form of deposit money. They are able to do this without restraint and the central bank supports this by the creation of the additional RR (a function of deposit growth). We portray the interbank markets in Fig. 2.2.

2.3 Bank Liquidity ManagementBalanceSheet9showsthebalancesheetofthecentralbankinsimplifiedform(wehaveleftoutunimportantitems,such as other assets, other liabilities and capital and reserves). From this balance sheet, we can create a money market identity as follows.


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On the left of the identity, we have the Net Excess Reserves (NER) of the banking sector, an indicator of bank liquidity. It is made up of the ER of the banks (item B2b) less the extent of CB loans to the banking sector (at the KIR), i.e., the LS (item G):

NER = B2b – G.

Balance Sheet 9: Central Bank (LCC Billions)

Assets LiabilitiesE. Foreign assetsF. Loans to government (government securities)G. Loans to banks (borrowed re-serves – BR)

+100 A. Notes and coinsB. Deposits1. Government2. Banks (TR)a. RRb. ERC. Foreign loansD. Central bank securities

+100


On the right hand side of the identity, we have all the remaining liability and asset items; thus:NER = B2b – G = (E + F) – (A + B1 + B2a + C + D).

If we group the related liability and asset items, we have:NER = B2b – G = (E – C) + (F – B1) – A – B2a – D.

Itwillalsobeevidentthat(Δ=change):ΔNER=Δ(E–C)+Δ(F–B1)–ΔA–ΔB2a–ΔD.

Thus, a change in the NER (and the LS which is its main component) of the banking system is caused by changes in the other appropriately grouped balance sheet items (which can be called Balance Sheet Sources of Change– BSSoC):

ΔNER=Δ(E–C)=NetForeignAssets(NFA)+Δ(F–B1)=NetLoanstoGovernment(NLG)–ΔA=notesandcoinsincirculation–ΔB2a=RR–ΔD=CentralBankSecurities(CBS).

The actual causes of change are the transactions that underlie the BSSoC. It will be apparent that the instruments of OMO are NFA (usually forex swaps), NLG (purchases/sales of government securities and changes in government deposits) and CBS (issues), and that RR can also be used (and is at infrequent times) to manipulate bank liquidity (NER). For example, the sale of forex to a bank (a forex swap) will decrease NER (increase the LS); the BSSoC is a decrease in NFA. Similarly, the sale of TBs to the banks will decrease NER (increase the LS). The BSSoC is a decreaseinNLG.Thus,theCBhastotalcontroloverbankliquidity(assumingefficientmarkets).

2.4 Banker to GovernmentWhen central banks emerged in the early 20th century, they all took on the role of sole banker to government. In most countries, the CB remains the sole banker to government. The two accounts maintained for government in most countries are the Exchequer Account and the Paymaster General Account. The former is the general account into which all receipts are placed, and the latter the account into which department allocations are placed prior to disbursement. Generally, the CB does not provide banking services to provincial governments or local authorities or state enterprises.

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In some countries, government maintains accounts, styled Tax and Loan Accounts (TLAs), with banks that qualify to hold these accounts (the large commercial banks). This structure is usually put in place to assist in the management of banking liquidity. The payment of taxes and loan receipts into the Exchequer Account amounts to a loss of funds (reserves) to the private banking sector, which necessitates the assistance (provision of BR) by the CB to the same extent.

With the TLAs in place, the movement of tax and loan funds from the private sector to the government sector does not disrupt the smooth functioning of the money market. It will be evident that this structure also represents a powerful monetary policy tool. The CB with the concurrence of the government is able to shift funds between the Exchequer accountandtheTLAsinordertoinfluencemoneymarketconditions,i.e.,theextentofBR.

2.5 Tax and Loan AccountsIt will be apparent that, when government banks with the CB only, funds received by the government represent funds lost to the private banking sector, and government disbursements represent funds gained by the private banking sector. There are many sources of government receipts and many destinations of government disbursements. Examples of the former are individual income tax, value-added tax, company tax, customs and excise duties and sales of government securities. The latter includes maturities of and interest on government securities, payment of salaries to employees and procurement of goods.

It will also be evident that there are timing differences between government receipts and disbursements and that the amountsinvolvedarelarge.Theeffectoftheseflowsonchangesingovernment’sbalanceattheCBoveraten-yearperiod (month-end data) is shown in Fig. 2.3 for a particular country before it introduced a TLA system (monetary unit changed to LCC).

6000

4000

2000

-2000

0

-4000

-6000

Fig. 2.3 Change in government deposits with central bank (LLC millions)(Source: http://bookboon.com/en/banking-an-introduction-ebook)

Theseflowshaveanequivalentbearingonbankliquidity.Herewegivefewexamplesanddiscusstheproblemfrom the point of view of the CB, government and the banks. Then present the solution (the TLA system), and give attention to the employment of the TLA system in monetary policy. The following are the sections:

Tax payments•Receipts of loan issues•Problem from perspective of central bank•Problem from perspective of government•Problem from perspective of banks•Monetary policy tool•


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2.5.1 Tax PaymentsThefirstexampleisflowoffundstogovernmentresultingfromtaxpaymentsofLCC100million.Thefollowingstepsmaybeidentified:Step 1: The step 1 includes the following:

Taxpayers (NBPS) draw cheques on their bankers and deliver them to the Revenue Authority (RA).•The RA deposits the cheques at the CB.•The cheques are cleared and the taxpayers’ accounts at their banks are debited; the banks’ accounts at the CB •are debited (see Balance Sheets 10–11).The CB credits the Exchequer account and debits the banks on which the cheques were drawn (see Balance •Sheet 12) (note: the CB is the only bank which does not maintain bank accounts elsewhere; the receipt of a cheque will thus result in that bank being debited in the books of the CB).Note: we ignore the effect of a change in deposits on the RR for the sake of simplicity.•

Balance Sheet 10: NBPS (LCC Billions)Assets Liabilities

Bank deposits -100 Tax liability -100Total -100 Total -100

Balance Sheet 11: Banks (LCC Billions)Assets Liabilities

Reserves at CB (TR)(RR = -100) -100 NBPS deposits -100

Total -100 Total -100

Balance Sheet 12: Central Banks (LCC Billions)Assets Liabilities

Reserves at CB (TR)(RR = -100) -100 NBPS deposits -100

Total -100 Total -100

Step 2:The bank concerned, which does not hold ER with the CB, is now in contravention of the reserve •requirementThe bank requests an overnight loan from the CB, which is granted automatically (see balance Sheets 13–•14).


Loan to banks (BR) @ KIR +100 Bank reserves (TR)(RR = +100) +100



Reserves at CB (TR)(RR = +100) +100 Loans from CB (BR) @ KIR +100


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Net effectThe net effect on various organisations is as follows:

NBPS: Decrease in tax liability and bank deposits (see Balance Sheet 15).•Banks: Decrease in NBPS deposits and increase in loans from CB (see Balance Sheet 16).•CB: Increase in government deposits and in loans to banks, i.e., decrease in bank liquidity = NER = increase •in BR; BSSoC = decrease in NLG (see Balance Sheet 17).








Loans to banks (BR) @ KIR +100 Government deposits +100Total +100 Total +100

2.5.2 Receipts of Loan IssuesThesecondexampleistheflowoffundstogovernmentresultingfromtheissueofLCC100millionbondswhichare bought by the banks. Here, we cut out the steps and fast-forward to the net effect. From Balance Sheets 18–20, we see the following:

Government: Increases deposits and bonds in issue.•Banks: Increase in bond holdings and loans from CB.•CB: Increase in government deposits and in loans to banks, i.e., decrease in bank liquidity = NER = increase •in BR; BSSoC = decrease in NLG.

Balance Sheet 18: Government (LCC Billions)Assets Liabilities

Deposits at CB +100 Bonds +100Total +100 Total +100


Bonds +100 Loans from CB (BR) @ KIR +100Total +100 Total +100


Loans to banks (BR) @ KIR +100 Government deposits +100Total +100 Total +100

Clearly, when government spends the funds, the money market situation will return to normal, except that there is aninfluenceonRR.


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2.5.3 Problem from the Perspective of Central BankIdeally, central banks would like to use bank liquidity (NER and the Liquidity Shortage – LS) as a strong signal to the market in respect of monetary policy. Some central banks use the LS as the cutting edge of monetary/interest rate policy. It will be evident that, given the large and frequent changes in government deposits at central banks, this is not possible. It is notable that the solution to the problem, as outlined below, not only makes the central bank’s task in terms of using the LS as a signal easier, but it also represents an additional tool of monetary policy.

2.5.4 Problem from the Perspective of GovernmentThedisruptive effect on themoneymarket and short-term interest rates of theflowof funds to and from thegovernment sector are also of concern to Treasury. Firstly, volatile interest rates have a bearing on the timing and success of government securities issues and the rates, it is able to negotiate.

Secondly, Treasury is closely involved in monetary policy and would like to see such policy implemented smoothly. Thirdly,abankingsystemwithoutTLAsmakesefficientcashflowmanagementdifficult,forexample,thePaymasterGeneral account is funded in advance of payments. This often requires treasury to make securities issues earlier, with cost consequences.

2.5.5 Problem from the Perspective of BanksWeknowthattheflowsoffundstoandfromthegovernmentsectorleadtocommensurate,butoppositeeffectsonthe private banking system. This produces a number of disorders:

Banks are obligated to hold larger amounts of eligible (for accommodation) government paper, which could be •said to ‘crowd out’ the private sector.Interestratesareinfluencedwhichreflectseasonalflows;suchchangescouldgivethewrongsignaltolenders•and borrowers.There are unnecessary administrative problems created (associated with acquiring frequent accommodation •and the repayment thereof).Theflowsgenerallydisrupttheintermediationprocess.•

2.5.6 The SolutionTheproblemoftheflowsoffundstoandfromthegovernmentsectorarisesfromthefactthattheCBhasthefunctionof ‘banker to the government’. The solution is therefore straightforward, the implementation of a system, whereby government also ‘banks’ with the private banking system. A broad outline of the system follows:

ThegovernmentopensTLAsattheheadofficesoftheparticipatingbanks(therearecriteria).•Revenue authorities deposit receipts of funds on a same-day-basis in the TLAs.•The proceeds of securities issues are also deposited in the TLAs.•The Paymaster General Account (PMG) remains at the CB and all government disbursements are made from •this account. As payments are made, the PMG account is funded from the TLAs.

In order to ensure that no balance remains on the PMG account, this account is operated on an ‘imprest’ or debit basis. This means that the PMG account is not funded in advance, and that when government warrant vouchers/cheques are presented, they are debited to the PMG account.

Thus, after the interbank clearing, the PMG account is in debit, and the exact amount of the debit is known. At this time (under the same date), funds are transferred from the TLAs at the banks to the Exchequer account and from the Exchequer account to the PMG account. It will be clear that the balance on the PMG account is thus always zero. The process described above means that the government’s balances effectively never leave the private banking system. Thus, there is no money market effect, i.e., no effect on the reserves of the banks and therefore on BR. Relevant examples follow.

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Tax payments by individualsThe NBPS pays LCC 100 million in taxes (see Balance Sheets 21–22).


Bank deposits -100 Tax liability -100Total -100 Total -100


NBPS depositsTLAs

-100+100

Total 0 Total 0

Issues of government securitiesWe assume LCC 100 million bonds are purchased by the NBPS (see Balance Sheets 23–25).


NBPS depositsTLAs

-100+100

Total 0 Total 0


Bank depositsBonds

-100+100

Total 0 Total 0


NBPS depositsTLAs -100

+100Total 0 Total 0

Disbursement of funds (for procurement of goods from NBPS)Government purchases LCC 100 million goods from the NBPS (see Balance Sheets 26–28).


GoodsBank deposits (TLAs)

+100-100

Total 0 Total 0


GoodsBank deposits (TLAs)

+100-100

Total 0 Total 0


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NBPS depositsTLAs

+100-100

Total 0 Total 0

2.5.7 Monetary Policy ToolIt should be clear that the TLAs represent a powerful tool of monetary policy. An example: the CB decides to increase the LS by LCC 100 million (decrease NER by same). It simply shifts LCC 100 million from the TLAs to the Exchequer account. This is shown in Balance Sheets 29–31. Note that this time we have not ignored the effect on RR of the change in bank deposits; assumption: r = 10% of deposits.


Deposits at CB (Exchequer ac-count)TLAs

+100-100

+100-100

Total 0 Total 0


Reserves at CB (TR)(RR = -10) -10 TLAs

Loans from CB (BR) @ KIR-100+90

Total -10 Total -10


Loans to banks (BR) @ KIR +90 Government depositsBank reserves (TR)

(RR = -10)

+100-10

Total -10 Total +90

2.6 Public Debt ManagementSome central banks manage the public debt on behalf of government, and some participate in a small, but meaningful way. Before discussing the central bank’s involvement in public debt management, it may be useful to be reminded of the issues surrounding the public debt. The following are the sections to be covered:

The public debt.•The central bank public debt management.•

2.6.1 The Public DebtMostcentralgovernmentsrunanannualbudgetdeficit,whichmeanstheyneedtoborrowinthedomesticandforeigndebt markets. They do this in terms of a statute, usually called Public Finance Act or Public Finance Management Act. The statute spells out the details and the constraints (deference to Parliament), but it generally permits central government to do as follows:

Financethebudgetdeficit(i.e.,thedifferencewhenrevenue<expenditure)byincurringdebt.•Borrow by issuing debt instruments: bonds and treasury bills, locally and internationally.•Refinancematuringdebtoradebtredeemedbeforematuritydate(forexample,itcanbuyupexistingdebtand•cancel it).Issue debt instruments in order to assist the CB in controlling the domestic monetary situation (this is rarely •implemented).

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Clearly,thetotalpublicdebtoutstandingreflectsaccumulationofthebudgetdeficitsofthepast.Issuesinvolvedinpublic debt management include the following:

Domestic versus foreign debt.•Term structure of debt.•Relationship with monetary policy.•In-progress debt management.•Debt to GDP ratio.•

Domestic versus foreign debtAssuming government debt has an investment-grade credit rating; it is able to issue debt domestically and in internationalmarkets.Localdebtistreasurybillsandbondsofvarioustypes[plainvanilla(fixed-couponandfixed-term),inflation-linked,zero-coupon,floatingrateandsoon].TheyaredenominatedinLCC.

Foreign debt issues are made only in bonds, and they are usually of the plain vanilla type. These bonds are one of the following:

Foreign bonds (issued in the currency of the investors, e.g., USD).•Eurobonds (issued in countries other than the country of the currency in which they are denominated). For •example, the Kenyan government could issue a USD-denominated bond in the UK. Another example is a Euro-LCC bond, i.e., a bond that is denominated in LCC and is issued in another country.Global bonds (issued in two or more markets, but are denominated in the currency of one of the markets. An •example: Local Country issues a global bond denominated in USD in both the US bond market (in which case it is a foreign bond and called a Yankee bond), as well as in the Eurobond market (in which case it is called a Eurodollar bond).

The constraint on domestic issues lies in ‘crowding out’ the private sector, resulting in higher interest rates. The constraint on foreign issues is a balance of payments-related one. Foreign exchange reserves must be available to repay the debt on maturity. Failure to do so will result in a default-status credit rating, and the non-availability of foreign investors and foreign exchange from this source.

Term structure of debtAs seen, locally-registered government debt is made up of bonds (maturity > one year) and treasury bills (maturity < one year). In this discussion, we assume the plain vanilla bond is the bond of choice (which it is in real life).

The choice of term of an issue is largely a function of the interest rate view of government. If rates are expected toriseandremainhighforanextendedperiod,theappropriatedtermoffinancingislong-term.Theconversealsoapplies.Theobjectiveistominimisetheinterestburden.Anotherconsiderationisthematurityprofileofdebt.Itisessential to avoid the bunching of debt redemptions for certain periods, i.e., to create ‘smooth’ maturity structure. Thisensurestheeaseofrefinancingwithpositiveimplicationsfortheinterestburden.

Relationship with monetary policyAt the core of monetary policy is the creation by the CB of a LS and its accommodation at the KIR. The method of CB accommodation is usually either overnight loans or repos. In both cases, treasury bills and short-term government bonds (usually < three years) are utilised by the banks. This means that central government is required to ensure thatsufficiencyofsupplyoftreasurybillsandshort-termgovernmentbondsistakenintoaccountindecisionsonthe term to maturity of new issues.


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In-progress debt managementOnce a debt is issued, it does not mean that it cannot be repurchased by government. The considerations in this respect are:

Cashflowmanagement(e.g.,repurchasedebt).•Term structure management (e.g., if government would like to smooth the debt maturity structure and repurchase •relevantdebtandfinancethiswithrelevantnewdebt).Minimise interest burden (e.g., repurchase long-term debt, if rates are expected to fall for an extended •period).

Theratiogovernmentdebt(GD)/GDPisusedinternationallyasameasureoffiscaldiscipline.Inmostcountries,aratio in excess of 60 per cent is deemed to be excessive. The ratio has a bearing on the credit-rating of the country and therefore on the availability of foreign funds and the level of interest rate.

2.6.2 The Central Bank and Public Debt ManagementPublicdebtmanagementispartoffiscalpolicy.Fiscalpolicyandmonetarypolicyco-ordinationisanessentialpart of economic policy. Apart from this obvious macro relationship, the CB plays a role in micro public debt management.

The CB acts as an agent for treasury in the placing of treasury bills and government bonds in the debt market. It conducts regular (usually weekly) treasury bill tenders as well as other special tenders of bills when required. It conducts tenders for government bonds, when required. Where a primary dealership system is in place, the CB organises it, appoints the dealers and conducts the tenders as well. Usually, the primary dealers are obliged to tender for a certain minimum amount. The bonds on offer are allocated in ascending order of yields bid. The CB participates in treasury’s debt management meetings, and acts an advisor in decisions on the timing, size, type of security, and the maturity structure of bond issues. It also advises treasury in respect of foreign issues of bonds.

2.7 Administration of Exchange ControlsExchange controls, detailed in the exchange control regulations, are instituted under the relevant statute, and are theresponsibilityoftheministryoffinance/treasury.TheMinisterofFinance/Treasurydelegatestheadministrationand execution of exchange controls to the governor of the CB in terms of the Exchange Control Regulations. The governor creates an Exchange Control Department, which is responsible for the day-to-day administration of exchange controls.

The Minister of Finance/Treasury, also under the Exchange Control Regulations, appoints certain banks as Authorised Dealers in foreign exchange (forex). The appointment affords the banks the right to buy and sell forex, subject to certain conditions and within limits prescribed by the Exchange Control Regulations. Authorised Dealers are not agents for the Exchange Control Department, but act on behalf of their customers within the Regulations.

The Exchange Control Regulations are designed to restrict the free movement of forex in order to protect the domestic economyfromlargeanddisruptivefluctuationsincapitalmovementsandothereconomicshocks,suchasspikesincommodity prices. It is also designed to preserve scarce forex reserves for crucial purposes.

There are few advantages to exchange control; some would say there are none, only disadvantages, such as:They negatively affect the image of the country.•Theyimpedepricediscovery.The‘official’forexmarketpriceisfixedundersomeregimes.•This creates a ‘black market’ in forex (which discovers the true price = exchange rate).•They ‘make’ criminals of certain members of the public (usually the wealthy and the businessmen/women). It •is normal to endeavour to hedge wealth.They encourage businesses to move to a country, which does not have exchange controls.•They encourage the best human capital to make a home elsewhere.•

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They enable incompetent governments to remain in power for longer than otherwise.•By restricting their expansion to other countries, they hinder the development of local companies.•They discourage inward foreign investment.•They are expensive and time-consuming to the CB, the authorised dealers in forex, business and the public.•They cause major frustrations for the authorised dealers, business and the public, which contributes too many of •the above mentioned disadvantages, such as encouraging the best human capital to make a home elsewhere.


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SummaryThere are three interbank markets, Bank-to-central bank interbank market, Central bank-to-bank interbank •market and Bank-to-bank interbank market.The IBMs are where the settlement of interbank claims takes place and where monetary policy begins.•Only one of the three IBMs is a true market, the bank-to-bank IBM.•The banks’ RR is held on their reserve accounts with the central bank.•In the b2b IBM, no new funds are created; existing funds are merely shifted around.•When central banks emerged in the early 20th century, they all took on the role of sole banker to government.•There are many sources of government receipts and many destinations of government disbursements.•Taxpayers (NBPS) draw cheques on their bankers and deliver them to the Revenue Authority (RA).•Thedisruptiveeffectonthemoneymarketandshort-terminterestratesoftheflowoffundstoandfromthe•government sector are also of concern to treasury.Banks are obligated to hold larger amounts of eligible (for accommodation) government paper, which could be •said to ‘crowd out’ the private sector.Some central banks manage the public debt on behalf of government, and some participate in a small, but •meaningful way.Assuming government debt has an investment-grade credit-rating, it is able to issue debt domestically and in •international markets.The constraint on domestic issues lies in ‘crowding out’ the private sector, resulting in higher interest rates.•The choice of term of an issue is largely a function of the interest rate view of government.•Theratiogovernmentdebt(GD)/GDPisusedinternationallyasameasureoffiscaldiscipline.•Publicdebtmanagementispartoffiscalpolicy.•Exchange controls, detailed in the Exchange Control Regulations, are instituted under the relevant statute, and •are the responsibility of the Ministry of Finance/Treasury.

ReferencesReserve Bank of India: Functions and Working. • [Pdf] Available at: <http://rbidocs.rbi.org.in/rdocs/Content/PDFs/FUNCWWE080910.pdf> [Accessed 06 June 2014].The Role of Interbank Markets in Monetary Policy. • [Pdf] Available at: <http://www.econ.upf.edu/~freixas/more/FreixasJorgeTheRole.pdf> [Accessed 06 June 2014].Jain, T. R. and Ohri, V. K., 2013. • Introductory Microeconomics and Macroeconomics. VK Publications.Jain, T. R. and Ohri, V. K., • Introductory Macroeconomics. FK Publications, New Delhi.Interbank Market Analysis: Understanding Inter-market analysis. • [Video online] Available at: <https://www.youtube.com/watch?v=s6pKY-pvxYU> [Accessed 06 June 2014].Money and Banking: Lecture 7 - Interest Rates and Present Value 2. • [Video online] Available at: <https://www.youtube.com/watch?v=R3CH09n2DRg> [Accessed 06 June 2014].

Recommended ReadingKhanna, O. P. and Jain, T. R., • Economic Concepts and Methods. FK Publications, New Delhi.Khanna, O. P. and Jain, T. R., • Macro Economic Analysis and Policy. VK Publications.Collyns, C., 1983. • Alternatives to the Central Bank in the Developing World. International Monetary Fund.

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Self AssessmentHow many interbank markets are there?1.

Foura. Threeb. Sixc. Fived.

When central banks emerged in the _______ 20th century, they all took on the role of sole banker to 2. government.

earlya. lateb. beforec. afterd.

Match the following3. 1. Foreign debt A. Issued in the currency of the investors, e.g., USD

2. Foreign bonds B. Issued in two or more markets, but are denominated in the currency of one of the markets.

3. Eurobonds C. These issues are made only in bonds and they are usually of the plain vanilla type.

4. Global bonds D. Issued in countries other than the country of the currency in which they are denominated

1- B, 2- C, 3- A, 4- Da. 1- A, 2- D, 3- B, 4- Cb. 1- D, 2- B, 3- C, 4- Ac. 1- C, 2- A, 3- D, 4- Bd.

The constraint on _________ issues is a balance of payments-related one; foreign exchange reserves must be 4. available to repay the debt on maturity.

domestica. foreignb. privatec. publicd.

What is largely a function of the interest rate view of government?5. The choice of term of an issuea. The choice of maturityb. The choice of term debtc. The choice of interestd.

Which of the following statement is true?6. Authorised dealers negatively affect the image of the country.a. Exchange control negatively affects the image of the country.b. Fiscal policy negatively affects the image of the country.c. Private debt management negatively affects the image of the country.d.


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Whatisthepartoffiscalpolicy?7. Private debt managementa. Public debt managementb. Global debt managementc. Interest debt managementd.

Which of the following is false?8. Exchange control impede price discovery.a. Exchange control discourages inward foreign investment.b. Exchange control discourages the best human capital to make a home elsewhere.c. Exchange control encourages businesses to move to a country which does not have exchange controls.d.

Which of the following is an essential part of the economic policy?9. Public debt management and monetary policy co-ordination.a. Fiscal policy and Public debt management co-ordination.b. Exchange controls and monetary policy co-ordination.c. Fiscal policy and monetary policy co-ordination.d.

The ratio government debt (GD)/GDP is used internationally as a measure of _________ discipline.10. fiscala. debtb. interestc. exchanged.

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Chapter III

Management of Money and Banking System

Aim


introduce the concept of management of money and banking system•

explain central bank’s role as a banker to private sector banks•

explicate the settlement of interbank claims•

Objectives


enlist the reasons why central banks hold foreign assets•

elucidate the supervision of payments system•

explain the central bank's function as a lender of last resort•

Learning outcome


identify the currency (notes and coins) management•

understand the management of foreign assets•

recognise bank supervision•


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3.1 IntroductionProficientmanagementof themoneyandbankingsystem isa significantcomponentoffinancial stability.Thecentral bank’s function management of the money and banking system carries a number of responsibilities. These are critical responsibilities and, many of them overlap with the monetary policy function.

Inordertocompletelyappreciate(someof)them,weneedtofirstdiscussthefunction‘settlementofinterbankclaims’. The following is the order of the sections:

Banker to private sector banks•Settlement of interbank claims•Supervision of payments system•Lender of last resort•Currency (notes and coins) management•Bank supervision•Management of foreign assets•Development of debt market•

3.2 Banker to Private Sector BanksA CB acts as the custodian of the reserves that banks are legally required to hold with the CB (the RR). It is called the reserverequirement,anditisaratio(r)ofbankdeposits(orbankliabilitiesinsomecases).Inordertoinfluencebankliquidity, the CB also has the authority to change the reserve requirement ratio, although this is rarely used as a tool, becauseitisabletoundertakeOMO.Ittendstobeutilised,onlyincountrieswithfledglingfinancialmarkets.

A CB explains in this regard, “The bank acts as custodian of the cash reserves banks are legally required to hold or prefer to hold voluntarily with the bank. The bank has the authority to change the minimum cash reserves that banksarerequiredtoholdandcanusesuchadjustmentstoinfluencebankliquidityandtheamountofmoneyincirculation.”

In some countries, the banks are required to maintain two accounts with the Reserve Bank, reserve accounts and current accounts (the latter are also known as free balance accounts or settlement accounts). The former are the accounts in which the legally required amount of reserves must be held at all times, and the latter the accounts in which the clearing/settlement of interbank claims takes place. In some countries, the banks are required to have just one account for the RR and settlement of interbank claims. We assume one account called the reserve account.

The banks’ balances on their reserve accounts are usually kept to the minimum required (the RR), for a simple reason. The CB does not pay interest on the RR or the ER of the banks (in most cases). Thus, banks place free balances theymayhavewithdeficitbanksduringtheinterbankclearingprocess.

A caveat is required, this is the norm; in exceptional circumstances, central banks have been known to bring about a situation in which the banks hold ER for extended periods in order to ensure that interest rates are at a minimum, the motivation being stimulation of the economy. In essence, this means that the banks are encouraged to make loans and create new money (deposits). As we know, banks only make loans, if there is a demand for loans, and underlying the demand for loans is economic activity.

CB function began in the days of the London silver and goldsmiths in the 17th century. For many reasons (such as plundering by the king when coins were kept at the Mint in the Tower of London), the London wealthy began making use of the secure facilities of the goldsmiths for their wealth, which was then comprised of precious metal coins. They deposited their coins with the goldsmiths and the latter issued a receipt for the gold.

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It was later found that these receipts were a convenient means of payments for goods and services, and it came to pass that the goldsmiths were requested to split receipts into smaller denominations and to issue them without being payable to a person (i.e., to bearer). For example, if Mr A deposited 100 one pound gold coins, the goldsmith-banker would be asked for 100 receipts, each with a face value of one pound. These receipts became the principal means of payment, i.e., money. Thus, at this stage, the amount of money in circulation was the sum total of gold coins in circulation plus goldsmith-banker receipts in the possession of the public.

The receipts became money because they were convertible into gold, i.e., any holder of a receipt could present it to the relevant goldsmith and demand gold. At that time, loans were made by the goldsmiths in the form of the gold in their possession. The goldsmiths over time became more involved in banking business which led to the name: goldsmith-bankers, and later just bankers.

It did not take long for a goldsmith-banker to realise that if their receipts were being used as the means of payment, thenloandemandcouldbesatisfiednotbygoldcoins,butbytheissueofnewgoldsmith-bankerreceipts.Thiswasanhistoricaleventofmomentousproportionsandchangedtheeconomicsoftheworldforever.Themostsignificantevent in banking, money creation by the new banks was born, which endures to this day. It liberated economies fromtheoftenstiflingshortageofpreciousmetalsfromwhichmoneywasstruck.Itisappropriatefromhereontorefer to goldsmith-banker receipts as bank notes and to the goldsmith-banker as bank.

Balance Sheet 1: Bank (Pounds)Assets Liabilities

Gold coins (1 000 000 of one pound each) (1) 1 000 000 Bank notes/receipts (1) 1 000 000

Total 1 000 000 Total 1 000 000

An example is appropriate. Balance Sheet 1 indicates a bank’s stock balance sheet before the making of loans by the issue of new notes. We assume that gold coins had a face value of one pound (which was not the case then). All bank notes were covered in full by gold. Balance Sheet 2 (step 2) shows the balance sheet after loans are made with the issue of new bank notes to the value of 500 000 pounds. Now, bank notes are covered by gold to the extent of 0.67% (1 000 000/1 500 000).


Gold coins (1 000 000 of one pound each) (1)Loans (2)

1 000 000 500 000

Bank notes/receipts (1)Bank notes/receipts (2) 1 000 000

500 000Total 1 500 000 Total 1 500 000

The next step, bank deposit money was a logical inevitability. The opening of current accounts (then called ‘running caches’) from which payments are made to other accounts by means of an instrument of transfer, the cheque. Thus, money (the means of payments) became bank notes and gold coins (N&C), and bank deposits (BD):

M = N&C + BD (in the possession of the NBPS).

It did not take long for the banks to realise that loans could be made by simple bookkeeping entry, credit the current account. See Balance Sheet 3 (Step 3: the initial credit to, and after spending by, the borrower).


Gold coins (1 000 000 of one pound each) (1)Loans (2)Loans (3)

1 000 000 500 000 500 000

Bank notes/receipts (1)Bank notes/receipts (2)Current account deposits (3)

1 000 000 500 000 500 000

Total 2 000 000 Total 2 000 000


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It will be evident that current account balances are convertible into bank notes and that the gold coverage ratio now becomes 0.5 or 50% (1 000 000/2 000 000). This ratio became important, because the banks realised that there is alimittotheirextensionofloans/deposits,theymustholdsufficientgoldreservestomeetdemandforgoldcoins.This is the origin of the Reserve Requirement (RR), a self-imposed limit to new bank loans/creation of new deposits (note: they are counterparts).

Thus, it came to pass that new loans could only be made when new deposits of gold coins were made. If the acceptable gold reserve ratio requirement (the r) is 10%, and a deposit of gold coins of 100 000 pounds were made, then the banks could extend new loans to the extent of:New loans = New reserves × (1 / r) – New reserves = 100 000 pounds × 0.10 – 100 000 = 1 000 000 – 100 000 = 900 000 pounds.


Gold coins (1)Loans (2)

+100 000+900 000

Deposits (1)Deposits (2)

100 000900 000

Total 1 000 000 Total 1 000 000

Thus, a fresh 100 000 pounds of gold was ‘backing’ 1 000 000 in new deposits (liabilities) = 0.10 or 10%.

In 1875, a scholar on money matters wrote (based on studies that indicated that an r of 5% is the norm).

“Thus, the whole fabric of our vast commerce is found to depend upon the improbability that the merchants and other customers of the banks will ever want, simultaneously and suddenly, so much as one-twentieth part of the gold money which they have a right to receive on demand at any moment during banking hours.”

If he was exasperated in 1875, he would have been more so, when the gold standard was abolished in the 20th century.Thiseventhasalongandintricatehistory;sufficeittosaythattherewereperiodsofuncertainlywhenconvertibility of bank liabilities into gold was suspended. Once abolished in the 20th century, there was nothing ‘backing’ bank liabilities. The acceptable reserves (RR) then became bank notes of and deposits at the CB, and now some countries have abolished CB notes as ranking as reserves (for many reasons).

This paved the way for ‘fractional reserve banking’, where central banks are able to control bank-lending/deposit-creation by restricting the amount of reserves created (which is CB money, CBM over which central banks have a monopoly, i.e., no bank except the CB can create CBM. This paved the way for excessive money creation andhyperinflation,whencentralbankswerepressuredbygovernmentstocreatereservesondemand.Thetermhyperinflationwascoinedduringthefirsthalfofthe20thcentury.

Today, most central banks do not rely on bank reserves to curb bank lending/deposit creation, but on interest rates. TheRRisbutoneofmanyfactorsthatinfluencebankliquidity,aswehaveseen.Innormaltimes,centralbankscreateapermanentliquidityshortageandchargethebankstheKIRinordertoinfluencebanklendingrates.Intheend,wepresentabriefhistoryofthefirstdepositbyabankatacentralbank.TheBankofEngland,whichonlylater morphed into a CB, was formed in 1694, in competition with the goldsmith-bankers/banks. It was afforded the sole right to issue banks notes (there were a few exceptions for a while), much to the chagrin of the banks. It came to pass that the banks made deposits with the Bank of England, and they regarded deposits as reserves, in addition to gold coins.

Thefirstgoldsmith-bankers/bankstoopenaccountswiththeBankofEnglandwerethefirmsofRichardHoare(later C Hoare & Co, which still exists as a London private banker today) and Freame & Gould (the forerunner of Barclays Bank). They opened their accounts with the Bank of England in March 1695, and in the course of time the other banks followed suit. This was a presaging of the Bank of England, in its later role of central bank, performing the function of custodian of the reserves of banks.

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3.3 Settlement of Interbank ClaimsAn important function of central bank is the provision of facilities for the central clearance and settlement of claims among banks, originating from cheque and other payments made. Settlement of claims among banks in the UK started with the goldsmith-bankers in the 17th century (i.e., in the absence of a CB).

Example: There are three banks, all of which have a so-called ‘out-clearing book’ indicating new deposits they have received in the form of cheques drawn on the other banks (see Tables 3.1– 3.3). For example, Bank A has a new deposit of 2 000 pounds from Client A; the cheque is drawn on Bank B; thus, Bank B owes Bank A 2 000 pounds. Similarly, Bank C has a new deposit of 5 000 pounds from Client G; the cheque is drawn on Bank A; thus, Bank A owes Bank C 5 000 pounds.

Bank B Bank C TotalClient A 2000 2000Client B 5000 5000Client C 1000Total 2000 6000 8000

Table 3.1 Out-clearing book: Bank A (pounds)

Bank B Bank C TotalClient D 3000 3000Client E 3000 3000Client F 4000 4000Total 6000 4000 10 000

Table 3.2 Out-clearing book: Bank B (pounds)

Bank B Bank C TotalClient G 5000 5000Client H 1000 1000Client I 2000 2000Total 7000 1000 8000

Table 3.3 Out-clearing book: Bank C (pounds)

The banks get together in a physical location, present their claims against the other banks, and receive the claims against themselves of the other banks (into in-clearing books). The outcome is presented in Table 3.4. Bank B has gained 7 000 pounds in deposits, while Bank A lost deposits of 5 000 pounds and Bank C lost deposits of 2 000 pounds. Initially, the individual banks settled the amounts between themselves:

Bank A paid Bank B 4 000 pounds (6 000 – 2 000).•Bank A paid Bank C 1 000 pounds (7 000 – 6 000).•Bank C paid Bank B 3 000 pounds (4 000 – 1 000).•

Claims On

ClaimsAgainst

Bank A Bank B Bank C TotalBank A X 6 000 7 000 13 000Bank B 2 000 X 1 000 3 000Bank C 6 000 4 000 X 10 000Total 8 000 10 000 8 000 26 000

Table 3.4: Total claims on and against (pounds)


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The amounts were settled in bank notes initially, and the balance sheets of the banks will have changed as indicated in Balance Sheets 5–7.


DepositsBank notes issued (Bank B)Bank notes issued (Bank C)

-5 000+4 000+1 000

Total 0 Total 1 000 000


Bank notes (Bank A)Bank notes (Bank C)

+4 000+3 000 Deposits +7 000

Total +7 000 Total +7 000


Bank notes (Bank A) +1 000 DepositsBank notes issued (Bank B)

-2 000+3 000


Later when current accounts evolved that banks made loans to one another (called interbank loans). Their balance sheets would have indicated the changes shown in Balance Sheets 8–10.


DepositsInterbank loan (Bank B)Interbank loan (Bank C)

-5 000+4 000+1 000

Total 0 Total 0


Interbank loan (Bank A)Interbank loan (Bank C)

+4 000+3 000 Deposits +7 000



Interbank loan (Bank A) +1 000 DepositsInterbank loan (Bank B)

-2 000+3 000


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AformalClearingHouse(CH)firstemergedinLondoninabout1775,accordingtoJevons.AClearingHouse’smain function is to net-off reciprocal claims and to ensure secure settlement. Table 3.5 presents an example of the net outcome of the CH numbers. Instead of the banks settling debts as indicated above, under a CH system the numberofdealsissignificantlyreduced.Inourexample,settlementtakesplaceinthatBankAandBankCsettlenot with one another, but only with Bank B (see Balance Sheets 11–13).

Bank A Bank B Bank C TotalClaims On 8 000 10 000 8 000 26 000Claims Against -13 000 -3 000 -10 000 -26 000Total -5 000 7 000 -2 000 0

Table 3.5 Net claims and settlement (pounds)


DepositsInterbank loan (Bank B)

-5 000+5 000

Total 0 Total 0



+5 000+2 000 Deposits +7 000




+5 000+2 000 Deposits +7 000


Jevons informs that (as the book was published in 1875 the ‘more recently’ referred to could be between 1860 and 1870), “More recently a suggestion was carried into effect, and the balances were paid by drafts upon the bank of England, in which bank each city banker deposits a large part of his spare cash.”

This heralded to CB function of central clearing and settlement, the central point being the banks’ accounts at the Bank of England. Using the above example, the changes in the banks’ balance sheets would be as indicated in Balance Sheets 14–17.


Banks’ reserve accountsBank ABank BBank C

-5 000+7 000-2 000

Total 0 Total 0


Reserve account at CB -5 000 Deposits -5 000Total -5 000 Total -5 000


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Reserve account at CB +7 000 Deposits +7 000Total +7 000 Total +7 000


Reserve account at CB -2 000 Deposits -2 000Total -2 000 Total -2 000

All countries have an interbank clearing and settlement system, and most have an automated system, generally called an Automated Clearing Bureau (ACB). The netted amounts payable/receivable are delivered on the banks’ CB accounts. Most countries also have a system for large payments, and these are not netted and settled in real time over banks’ CB accounts. It is called the Real Time Gross Settlement (RTGS) system (note the absence the word clearing, which refers to netting). Where RTGS systems exist, the ACB systems remain, but for small payments.

3.4 Supervision of Payments SystemIn most countries, there are three payments systems:

RTGS system, for large payments.•ACB system, for retail payments (cheques and Electronic Transfer of Funds [ETFs]).•The payments system for the exchange of Automatic Teller Machine (ATM) transactions between banks.•

The three systems, and others that may exist, collectively, can be called the National Payment System (NPS). The systems make use of the settlement facility at the CB, and because of this, the system is secure. When payments are made by banks they are made from their existing reserves. If these payments leave individual banks short of RR at theendofthebusinessday,theyarerequiredtofindthefundsintheinterbankmarket,orfromtheCBintheformof loans against collateral.

TheCBisultimatelyresponsiblefortheNPS,andregardsitaspartofthefoundationsoffinancialstability.

3.5 Lender of Last ResortIt was seen above that with interbank settlements the amounts, colloquially-speaking, equal out; it is a zero-sum game. No new funds are created in, and no funds are lost to, the banking system, what one bank loses in deposits, others gain. However, there are circumstances when this does not happen:

When the CB does a local deal.•When larger banks do not lend to smaller banks.•Whenconfidenceinaparticularbankwanesasaresultofrumoursorabankrun.•

3.5.1 Central Bank TransactionsThefirstbulletpointisamonetarypolicyissue.Intheprevioussection,thebankliquiditychroniclewasoutlinedwhich,inessence,meansthatwheneverthecentralbankdoesadealinthefinancialmarkets,thedealhasconsequencesfor the liquidity of banks. A reminder is required (see Balance Sheet 18).

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Balance Sheet 18: Central Bank (LCC Millions)Assets Liabilities

E. Foreign assetsF. Government securities (claims on govt)G. Loans to banks (borrowed reserves – BR)

A. Notes and coinsB. Deposits1. Government2. Banks (TR)a. RRb. ERC. Foreign loansD. Central bank securities

We presented the change identity:ΔNER=Δ(E–C)+Δ(F–B1)–ΔA–ΔB2a–ΔD.

A change in the NER (B2b – G) of the banking system is caused by changes in the other appropriately grouped balance sheet items (which can be called balance sheet sources of change – BSSoC):

ΔNER=Δ(E–C)=NetForeignAssets(NFA)+Δ(F–B1)=NetLoanstoGovernment(NLG)–ΔA=notesandcoinsincirculation–ΔB2a=RR–ΔD=CentralBankSecurities(CBS).

The actual causes of change are the transactions that underlie the BSSoC. As said before, if deposits move from banks-to-banks, the liquidity of the banking sector (NER) does not change. As soon as the CB does a deal or when bank deposits or the demand for N&C changes, NER changes. Thus, we have the following two sets of BSSoC:

Passive BSSoC.•Operational BSSoC.•

The passive BSSoC are as follows:Bank deposit (money) volume changes have a RR consequence. While this factor is not operational, the CB •doeshaveanindirectinfluenceonit.Notesandcoins(N&C)incirculation.ThisitemisinfluencedbythedemandforN&Cfromthepublicandthe•banks.

The operational BSSoC are as follows:NFA (usually forex swaps). For example, the sale of forex to a bank (a forex swap) will decrease NER (increase •the LS).NLG (purchases/sales of government securities and changes in government deposits). For example, the sale of •TBs to the banks will decrease NER (increase the LS).CBS issues. A new issue will decrease NER (increase the LS).•Reserve requirement ratio (r) can be changed by the CB. An increase in r will decrease NER (increase the •LS).

3.5.2 Large/Small Bank ProblemIn certain countries, where the banking sector is dominated by large banks, there may be reluctance by the large banks to deal in the interbank market with the small banks. This means that as deposits move from small banks to large banks, the latter may not recycle the funds, and the interbank market will not clear. This in turn will mean that the CB will have to accommodate the small banks at KIR. An example: LCC 100 million deposits shift from small banks to large banks (see Balance Sheets 19–21).


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Balance Sheet 19: Central Bank A (LCC Millions)Assets Liabilities

Banks’ reserve accountsSmall banksLarge banks

-100+100

Total 0 Total 0

Balance Sheet 20: Small Banks (LCC Millions)Assets Liabilities

Reserve account at CB -100 Deposits -100Total -100 Total -100

Balance Sheet 21: Large Banks (LCC Millions)Assets Liabilities

Reserve account at CB +100 Deposits +100Total +100 Total +100

The obvious solution is an interbank transaction. However, if the large banks refuse to lend to the small banks there is little the CB can do, except perhaps encourage a collateral deal, or a repo deal. The transaction takes place, with collateral changing hands in the background.

3.5.3 Confidence and the Bank RunConfusion exists in respect of the expression lender of last resort. Lending to the banks for monetary policy purposes isdeliberateandalmosttotallyunderthecontroloftheCB.Thisisnotlastresortlending;itisfirstresortlending,in that it is engineered by the CB, because they desire to make the KIR effective.

Thelenderof last resort functionof theCBisafinancialstability issue.Whenabankis ‘in trouble’,aswhenconfidenceinthebankislostleadingtoabankrun,thatbankcannotmeetalldepositdemands(nobankisableto). The bank will fail if the lost deposits are not recycled back to it in the interbank market. The other banks will not entertain this (as in the above, large bank/small bank example). Thus, it is left to the CB to decide to whether to rescue the bank. This is an imperative issue, and it has systemic failure implications. It leads to the question: are certain banks too big to fail?

InthisregardtheBankofEnglandasserts,“Whereathreattothestabilityofthefinancialsystemisperceivedtobe present, the Bank may intervene to stand between an intermediary and the market place in order to facilitate paymentsandsettlements,whichmightotherwisenotbecompleted.Inextremecases,emergencyfinancialsupportby the Bank might be provided, the so-called ‘Lender Of Last Resort’ (LOLR) function, but this is only done where the failure of one institution could bring down other, otherwise viable, institutions. This function may involve the Bank lending money to the failing institution to prevent its failure and hence to stop repercussions of its collapse fromspreadingthroughthefinancialsystem.Thissafetynetexiststoprotectthestabilityofthefinancialsystemasa whole and not to protect individual institutions or their managers and shareholders.”

“TheuseoftheBank’sLOLRfunctionmustbecarefullyjustifiedintermsofthedamagethatwouldresulttothefinancialsystemandthewidereconomyifinterventiondidnottakeplace.ThisisbecausetheLOLRrolerequirestheuseofpublicmoneyandcanalsoencourageexcessiverisk-taking(andhencefinancialfragility)ifinstitutionsbelievethattheywillbebailedoutwhenevertheyexperiencedifficulties.TheserisksmeantheBankandtheFSAneed to co-operate closely when a problem emerges, and inform the Treasury. The Bank also needs to satisfy its Court of Directors that any risks it accepts are manageable in relation to the Bank’s own capital, when they are to be carried on the Bank’s balance sheet.”

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The opinion of the South African Reserve Bank is, “The Reserve Bank provides liquidity to banks during periods of temporary shortages of cash. This function is referred to as the Bank’s ‘lender-of-last-resort lending activities’.”

“This function implies giving assistance to a bank facing liquidity problems. Such assistance is only given after a fullanalysisoftheproblemsafflictingsuchabankandthereasonstheyarose.Theassistancewillonlybegivenonspecificconditions,anditspurposeistopreventthebankruptcyofthebankreceivingassistance,and/oravoidthedanger of problems spreading to other banks through a ‘run on such a bank’.”

“A bankrupt bank will often not be able to repay its depositors, and the main purpose of special assistance is, therefore, to protect depositors. However, such assistance is never guaranteed or given automatically, and banks may accordingly go bankrupt, leading to severe hardships for depositors who lose their deposits at such a bank. The maintenance of stability in the banking system is, therefore, of the utmost importance to any country.”

3.6 Currency (Notes and Coins) ManagementAs the CB (in most cases) has the sole right to manufacture, issue and destroy banknotes and coin in the country, ithastheobligationtoensurethattherearesufficientquantitiesofnotesandcoinsofanacceptablequalityinthepublic domain. This is to ensure that small transactions may continue unhindered.

In this section, we highlight the following:Legal tender•Sole right to issue•Denominations•Design•Issue of banknotes and coin•Managing quality of banknotes and coin in circulation•Managing public awareness for fraud prevention•Branch functions in respect of banknotes and coin•

All notes and coins issued by the CB are legal tender. This means they have to be accepted in payment (up to a certain amount). If not, the debt is extinguished. As noted, the CB has the sole right to manufacture issue and destroy banknotes and coins in local country. This right is bestowed on the CB by government and is contained in the statute regulating the CB.

Thedenominationsofbanknotesandcoinsdependonmanyfactors,butespecially inflationandtheexchangerate.Forexample,iflocalcountryexperiencedhighinflationinthepastanditsexchangerateagainstthevehiclecurrency, the USD, is USD/LCC 205, it would most likely have had bank note denominations of LCC 1 000, LCC 500, LCC 100, LCC 50, LCC 20 and LCC 10.

However, as Local Country’s exchange rate against the USD is USD/1.50, its bank note denominations are LCC 100, LCC 50, LCC 20, LCC 10, LCC 5 and LCC 1. One LCC made up of 100 cents and the denominations are: 50c,20c,10c,5c,2cand1c.Inpasthighinflationcountries,thelowerdenominationswillnotexist.Asregardsthedesign of bank notes and coins, all new designs must have the prior approval of government before they are placed into circulation. The same applies to denominations, although the CB makes recommendations.

As regards the issue of banknotes and coins, the CB takes the following actions:Calculates the country’s new bank notes and coins requirements on an annual basis.•Places new bank notes and coins into circulation on an ongoing basis, according to demand.•Ensuresthatsufficientnewbanknotesandcoinsareavailabletoreplacethosethatareremovedfromcirculation•due to ‘soil’ and mutilation levels.


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The quality of bank notes and coins in circulation is important for many reasons, including the following:To avoid fraudulent copying/printing (counterfeiting). Central banks follow the advances in technology and •introduce security and technical features to keep ahead of the counterfeiter.To ensure that mechanical sorting and counting of notes and coins is possible.•To ensure they are acceptable to members of the public and foreign visitors.•To enhance the image of the country internationally.•

The CB undertakes to reimburse soiled and mutilated bank notes and coins which are not wilfully damaged. Soiled and mutilated bank notes and coins are deposited at commercial banks who will in turn forward them to the CB for payment. The bank note covenant I promises to pay the bearer on demand for the Reserve Bank (signed by the governor; see Fig. 3.1). Its genesis is of course the convertibility of bank notes into gold. Managing public awareness for fraud prevention is another function of the CB in this respect. It engages the public to be aware of the security features in bank notes and so prevent the spread of counterfeit bank notes.

As regards branch functions in respect of bank notes and coins, most central banks have branches, and their main functions are as follows:

Accept bulk deposits and withdrawals of bank notes and coins (but this mainly applies to bank notes). Bank •notes and coins are non-interest-earning assets for banks. They therefore endeavour to keep their holdings to a minimum (in teller drawers and ATMs). Excess bank notes and coins are deposited at the CB (and their reserve accounts are credited), and withdrawals are made in anticipation of public demands (just before and during salary payment periods). These are paid for by debits to the banks’ reserve accounts.Ensure that adequate bank notes and coins of acceptable quality are available.•Inspect bank notes and coins and those not meeting the required quality standards are destroyed.•

Although this is rarely used, members of the public have access to teller facilities at the branches for the replacement of soiled and mutilated bank notes and coins.

3.7 Bank SupervisionThemissionofcentralbanksistheachievementandmaintenanceoffinancialstability.Oneofthefoundationsoffinancialstabilityistheregulationandsupervisionofthebankingsystemwithaviewtoattaininganefficientandsound banking system in the interest of depositors and the economy as a whole.

The four elements to regulation/supervision are as follows:Institution of rules of conduct (regulation).•Monitoring (observance of whether the regulations instituted are obeyed).•Supervision (observance of the behaviour of participants).•Enforcement (ensuring that the rules are adhered to).•

Thistopicissosignificantthatitrequiresmuchattention,whichwedonothavespaceforhere.Instead,wewillcover in broad strokes as follows:

Rationale for regulation•Objectives of regulation•

3.7.1 Rationale for RegulationThefinancialsectorplaysapivotalroleintheeconomyinthatinitsabsenceorpartialfailuretheeconomicmachinewill be severely damaged. Imagine if the payments system failed or the banks are closed for extended periods (such as,occurredinArgentinain2001/2,wheresegmentsoftheeconomywerereducedtobartertrade).Thefinancialsector is also a major employer and is a major attractor of foreign exchange, if soundly managed. This sector also carries the responsibility of allocating capital to the most productive uses.

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Themainrationaleforgovernmentinterventionis‘marketmalfunction’whichmeansthatthefinancialsystemwillproduceasub-optimaloutcomeintheabsenceofregulation.Thus,governmentinterventionhaswelfarebenefits.The consumer and the participants want regulation and are even prepared to pay for it. The ‘rationale’ for regulation amounts to ‘why regulation is necessary’. There are a number of reasons as follows:

Systemic malfunction.•Market imperfections.•The moral hazard problem.•Economies of scale.•Consumerconfidenceandconsumerdemandforregulation.•Supplier demand for regulation.•

Thefinancialsystemplaysavitalroleintheeconomy,andfailureormalfunctionofthesystemcandisrupteconomicactivityseverely.Banksaretheonlyfinancialintermediariesthatintermediatebetweenallsectorsoftheeconomy(household,corporate,governmentandforeign)andalltheotherfinancialintermediaries.Inaddition,thebankingsystem provides the payments and clearing systems for all transactions that take place in the economy. The failure of a major bank not only causes losses for depositors and shareholders, but also disrupts payments and the settlement of previously effected transactions immediately and possibly for some time.

3.7.2 Objectives of RegulationTheultimateobjectivesofregulationcanbenarrowlydefinedasfollows:

Promotionoffinancialstability.•Promotion of fair and healthy competition.•Promotion of consumer protection.•

Thefirsttwoobjectivesmayberolledtogetherundertheheading‘highdegreeofeconomicefficiency’.

3.8 Management of Foreign AssetsForeign assets are holdings of bank deposits in foreign banks and foreign securities such as USD treasury bills and GBP government bonds. The prudent management of the foreign asset reserves is an important function of the CB, and is covered under the following:

Why do central banks hold foreign assets?•The desired level of reserves.•Foreign asset reserve management.•The USD in foreign asset reserve management.•


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3.8.1 Central Banks Hold Foreign AssetsCentral banks hold foreign assets/exchange for the following four main reasons:

Central banks are the custodians of the foreign asset reserves of the country. Essentially, they hold a stock •of reserves on behalf of government and the public. In other words, they are required by government to hold sufficientreserves.Tointervene,i.e.,tosellorbuyforeignexchange,intheforeignexchangemarketinordertoinfluencethevalue•of the currency. A stock of foreign exchange (forex) is required for this purpose.For transactions purposes: An example is to supply government with forex to enable it to repay a maturing •foreign loan. Another is to be able to supply forex to the market, if there is an unusually large demand for forex (for example, if the airline needs to pay for the purchase of aircraft), in order to prevent a sudden fall in the exchange rate.Foreign (inward) investments tend to take place in countries that have large and stable forex reserves.•

Foreign assets held by the CB are like a fund of assets, and all the portfolio management principles apply, including diversification.Forthisreason,countriesusuallydiversifytheirforeignassetportfoliosintoUSD,EUR,GBP,JPY,CAD,andsoon.Goldisusuallyalsofordiversificationreasons.

3.8.2 The Desired Level of ReservesThereisnofixedrulefortheideallevelofforexreserves.Theconsiderationsinthisregardaremanyandincludethe following:

The extent of exchange rate volatility.•A higher level of reserves enhances the credibility of the central bank’s exchange rate policy.•Thelevelofreservesinfluencestheimageofthecountryingeneral.•The ‘openness’ of the economy, as measured by: foreign trade/GDP.•Theelasticityoftheeconomy,itsabilitytoadjusttochangesinforeigncapitalflowsandforeigntrade.•The cost of holding reserves: If local interest rates are higher than foreign rates, it is expensive to hold forex •reserves.

Whilethereisnofixedrule,thereisaruleofthumbguideline.Alevelofforexreservesequaltothevalueofthreemonths’ imports.

3.8.3 Foreign Asset Reserve ManagementAs indicated earlier, the management of forex reserves of a country embraces all the principles expounded in portfoliomanagement,exceptthatherethemainriskiscurrencyrisk.However,currencyriskislargely‘diversifiedaway’(asinthecaseofasset-specificrisk)bybeinginvestedinthemajorcountries.Themajorcurrenciesexhibitreciprocalfluctuations, so that theoutcome isminimal risk, if theCB invests in themajorcurrencies inequalproportions. As the number of securities held increases, risk (volatility) is reduced. In the case of foreign reserves, the number of currencies held does not have to be vast. Assets denominated in USD, GBP, EUR, CAD, JPY and CNYaresufficient.

Other considerations relating to foreign currency assets include the following:The type of instrument.•Thematurityprofile(3-monthGBPtreasurybillsorGBP10-yeartreasurybonds).•Theestablishmentoflimitsforspecificassets.•The use of a management information system for:•

Measuring exposures to risks �Ensuring that these risks are managed �The measurement of performance. �

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The use or not of external fund managers. Generally, central banks manage their own portfolios, for reasons of •security,confidentiality,costsandimage(centralbanksdonotwantitknownthattheydonothavetheexpertiseto manage their own portfolio).

3.8.4 The USD in Foreign Asset Reserve ManagementDespite the benefits of diversification, theUSD remains the primary investmentmedium (deposits, treasurybills, bonds, etc.). The relative importance of the USD in foreign asset holdings can be attributed to a number of factors:

The continuing role of the USD as the primary international reserve currency.•TheUSDfinancialmarketsofferawiderangeofinstrumentsandliquidmarketsinwhichlargetransactions•can be readily accomplished.A large proportion of countries’ exports and imports are denominated in USD.•USD-denominated debt forms a major proportion of most countries’ external debt.•The USD is used almost exclusively in spot and in forward transactions between the CB and the banks authorised •to deal in foreign exchange.

3.9 Development of the Debt MarketExcludingderivatives(whichdonotrepresentborrowingandlending,buthedging),therearetwofinancialmarkets:share market and debt market. The debt market is comprised of the following:

Short-Term Debt Market (STDM), made up of ST Marketable Debt (ST-MD) and ST Non-Marketable Debt •(ST-NMD).Thisentiremarketisreferredtoasthemoneymarket(definitionsdodifferinthisrespect;wepreferthisdefinitionbecausepricediscoverytakesplaceintheentireSTDM.Long-Term Debt Market (LTDM), made up LT Marketable Debt (LT-MD) and LT Non-Marketable Debt (LT-•NMD). The bond market is the LT-MD market, and it is isolated because price discovery primarily takes place in this market.

Centralbankshaveaninterestinallfinancialmarketsbecausethisiswhereborrowingandlendingtakesplace(weregard shares as evidences of LT and perpetual borrowing) and where money is created. However, the CB has a special interest in the debt market, because this is the market in which it operates, and the stability of which is an integralpartoffinancialstability(inwhichcentralbankshaveamajorinput).

In developing countries, borrowing and lending startswith the banks. Initially the entirefinancialmarket is aST-NMDmarketvia thebanks.ThefirstST-MDinstrument toappear is the treasurybill,adebtobligationofgovernment, usually followed by the central bank security (which we call CB bills). The latter are issued for the purpose of monetary policy and the backdrop to it is usually surplus liquidity created by the sale of donor funds (forex) by government to the central bank. Balance Sheets 22–25 show the steps to the creation of excess liquidity (ER) (r = 10%).


Deposit at foreign bank (1)Deposit at foreign bank (2)Deposit at central bank (3)Deposit at central bank (4)Goods (5)

+100-100+100-100+100

Donation (1) +100



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Deposit at foreign bank (3) +100

Government deposit (3)Government deposit (4)Reserve accounts (TR) (5)(RR = +10)(ER = +90)

+100-100+100



Reserve accounts (TR) (5)(RR = +10)(ER = +90)

+100 Deposits (NBPS) (5) +100


Balance Sheet 25: NPBS (LCC Billions)Assets Liabilities

Goods (5)Deposits at bank (5)

-100+100


Assuming the banks were ‘balanced’ at the outset (had no ER and no BR), they now have ER of LCC 90 billion (LCC10 billion was absorbed into RR). Interest rates will fall sharply and the CB can only prevent this by issuing CB bills. This is shown in Balance Sheets 26–27.


CB billsReserve accounts (TR)(RR = +10)(ER = 0)

+90+10



CB billsReserve accounts (TR)(RR = 0)(ER = -90)

+90-90

Total 0 Total 0

To make this exercise more apparent, Balance Sheets 29–29 are presented to illustrate the net effect.

The expansionary effect of the donation has been neutralised.Balance Sheet 28: Bank A (LCC Billions)

Assets Liabilities

Deposit at foreign bank +100


+90+10


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+90+10

Deposits (NBPS) +100


In many developing countries, an unusual intermediary that has a history that goes back to the UK in the 17th century was encouraged to enter the market, the discount house. They started off life as trade bill brokers and morphed into specialised banks, which took short-term deposits only from the banks (and other depositors in some cases), invested in STMD and made markets in these assets. The motivation is that it is not in banks’ interest to make markets, because theythriveininefficientmarketsintermsofwidemargins.Discounthousesarethebaneofbanks’livesbecausetheysuccessfullyreducebankmarginsthroughmarketmakingandeducationofthefinancialservicessector.Theyalso are instrumental in creating new assets in the form of CP, NCDs and bonds.

Countries that do not encourage discount houses endeavour to introduce a primary dealership method of issuing and market making, not always with success, because of the banks’ reluctance to make markets.

After the development of the money market, there is usually impetus to develop the share market as a provider of long-term (preference shares) and perpetual (ordinary/common shares) capital. This follows, because there is reluctance to invest in long-term bonds. The bond market is sometimes correctly initiated by the CB, in the form of creating and publishing a ‘pattern of rates’ on government bonds. This is designed to stimulate interest from the banks and stock-broking community, and is often followed by the CB acting as a market maker in bonds, i.e., quoting buying (bid) and selling (offer) rates simultaneously on all existing bonds.

This initiative stimulates activity in the market and leads to a secondary market made by the banks/stockbrokers. The corporate bond market follows because a risk-free yield curve is required as a benchmark. One of the principles of investments is that the return on government securities is the lowest rate acceptable because it delivers a risk-free rate (rfr), and that all other investments must deliver a return (called a required rate of return (rrr) equal to (rp = risk premium):

rrr = rfr + rp.

ThereasonwhyaCBwantsactivefinancialmarketsisasfollows:ItneedstoconductOpenMarketOperations(OMO)withthepurposeinfluencingbankliquidityanditcanonly•do so in liquid markets.Efficient price discovery,which is a product of liquidmarkets, is required, so that interest rates can react•immediately to changes in monetary policy stimuli.


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SummaryProficientmanagementofthemoneyandbankingsystemisasignificantcomponentoffinancialstability.•A CB acts as the custodian of the reserves that banks are legally required to hold with the CB (the RR).•Banks only make loans, if there is a demand for loans, and underlying the demand for loans is economic •activity.The Bank of England, which only later morphed into a CB, was formed in 1694, in competition with the •goldsmith-bankers/banks.An important function of central banks is the provision of facilities for the central clearance and settlement of •claims among banks, originating from cheque and other payments made.AformalClearingHouse(CH)firstemergedinLondoninabout1775,accordingtoJevons.•A Clearing House’s main function is to net-off reciprocal claims and to ensure secure settlement.•All countries have an interbank clearing and settlement system, and most have an automated system, generally •called an Automated Clearing Bureau (ACB).In certain countries, where the banking sector is dominated by large banks, there may be reluctance by the large •banks to deal in the interbank market with the small banks.The Reserve Bank provides liquidity to banks during periods of temporary shortages of cash.•Thedenominationsofbanknotesandcoinsdependonmanyfactors,butespeciallyinflationandtheexchange•rate.Themissionofcentralbanksistheachievementandmaintenanceoffinancialstability.•Foreign assets are holdings of bank deposits in foreign banks and foreign securities such as USD treasury bills •and GBP government bonds.The corporate bond market follows because a risk-free yield curve is required as a benchmark.•

ReferencesBanking Structure in India. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:7CZSDvUIfMUJ:rbidocs.rbi.org.in/rdocs/Speeches/PDFs/FIBACS130813.pdf+&cd=1&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Risk Management for electronic Banking and electronic Money Activities. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:IaMbBD2EcZoJ:www.bis.org/publ/bcbs35.pdf+&cd=2&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Padmalatha, S ., 2011. • Management of Banking And Financial Services. Pearson Education India, New Delhi.Singh, K. and Dutta, V., 2 0 1 3 . • Commercial Bank Management. Tata McGraw-Hill Education, New Delhi.Financial Management - Lecture 01. • [Video online] Available at: <https://www.youtube.com/watch?v=mX9nd0eQ-6g> [Accessed 06 June 2014].Money and Banking: Lecture 1 - Money and the Economy. • [Video online] Available at: <https://www.youtube.com/watch?v=etsCGT542AI> [Accessed 06 June 2014].

Recommended ReadingHossain, A. A., 2009. • CentralBankingandMonetaryPolicyintheAsia-Pacific. Edward Elgar Publishing.Sundararajan, V., Marston, D. and J Ghiath, S ., 1998. • Monetary Operations and Government Debt Management under Islamic Banking. International Monetary Fund.Mayo, H., 2011. • Basic Finance: An Introduction to Financial Institutions, Investments and Management. Cengage Learning.

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Self Assessment___________ managementofthemoneyandbankingsystemisasignificantcomponentoffinancialstability.1.

Capablea. Moneyb. Proficientc. Bankingd.

Banks only make ________, if there is a demand for it, and underlying the demand for loans is economic activity 2. (C + I = GDE).

loansa. moneyb. profitc. systemd.

Which of the following began in the days of the London silver and goldsmiths in the 17th century?3. Money functiona. CB functionb. Market functionc. Deposit functiond.

Which of the following term wascoinedduringthefirsthalfofthe20thcentury?4. Macro-inflationa. Micro-inflationb. Hypo-inflationc. Hyperinflationd.

Which of the following statement is true?5. AformalClearingHouse(CH)firstemergedinLondoninabout1775,accordingtoJevons.a. AformalClearingHouse(CH)first emerged in London in about 1715, according to Jevons.b. AformalClearingHouse(CH)first emerged in London in about 1767, according to Jevons.c. AformalClearingHouse(CH)first emerged in London in about 1721, according to Jevons.d.

Which of the following started with the goldsmith-bankers in the 17th century (i.e., in the absence of a CB)?6. Settlement of claims among banks in the USAa. Loans among banks in the UKb. Settlement of claims among banks in the UKc. Loans among banks in the USAd.

The_____________ofbanknotesandcoinsdependonmanyfactors,butespeciallyinflationandtheexchange7. rate.

profita. lendersb. denominationsc. policyd.


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Which of the following statement is false?8. Bank notes and coins are non-interest-earning assets for banks.a. Themissionofcentralbanksistheachievementandmaintenanceoffinancialstability.b. There are four elements to regulation/supervision.c. Thefinancial sector is also aminor employer and is aminor attractor of foreign exchange if soundlyd. managed.

The __________ bond market follows because a risk-free yield curve is required as a benchmark.9. corporatea. bankb. riskc. safetyd.

Which of the following is a product of liquid markets, so that interest rates can react immediately to changes 10. in monetary policy stimuli?

Open market operations a. Long-term debt market b. Efficientpricediscoveryc. Short-term debt marketd.

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Chapter IV

Money Creation and Framework of Monetary Policy

Aim


introduce money-creation and framework of monetary policy•

discuss measuring money•

explicate money identity: sources of money creation•

Objectives


enlistthebenefitsofpricestability•

elucidate the statutory environment•

explain the• objectives of monetary policy

Learning outcome


identify instruments of monetary policy•

understand the concept of price stability•

recogniseinflationtargetingmonetarypolicyframework•


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4.1 IntroductionItisundisputedthatexcessivegrowthinthemoneystockisthecauseofinflation.Ashighinflationhasamajornegativeimpact on the economy, we need a policy in respect of money stock growth, a monetary policy. All countries have central banks and a monetary policy in place. However, the policies are not always well-formulated, implemented and executed. Monetary policy is afforded three subsections; they are at the heart of monetary policy, but there is much more to discuss, such as money-creation, measuring money, the framework of monetary policy and so on.

4.2 Measuring MoneyThe stock of money is made up of bank notes and coins and bank deposits in possession of the NBPS. We have two questionsinthisregard,howdocentralbankscalculatethemoneystockandwhattermofbankdepositqualifiesas money?

Asregardsthelatter,centralbanksacrosstheworldhavevariousdefinitionsofmoney,andtheyrangefromM1toM5. They all include bank notes and coins held by the NBPS; where they differ is in the cut-off point of the term to maturity (ttm) of NBPS deposits, and the higher numbers add in other near-money assets. For the sake of simplicity, we will use one of the measures, M3. It includes Notes and Coins (N&C) in the hands of the NBPS and all NBPS deposits with banks, and we justify this on the basis that the vast majority of deposits with banks are short-term in nature.

To know how one calculates the NBPS’s holdings of N&C, take a look at the balance sheets of the central bank (called CB from now on) and the banks shown in Balance Sheets 1–2. You will see that the bank notes and coins held by the NBPS can be derived from the two balance sheets:

Total in issue (in the CB’s balance sheet = item A)Less: N&C held by the banks (item C in the banks’ collective balance sheet)

Therefore, the stock of N&C held by the NBPS:N&C of NBPS = LCC 1 000 billion – LCC 100 billion= LCC 900 billion


D. Foreign assetsE. Loans to governmentF. Loans to banks(Borrowed reserves – BR) @ KIR

1 0001 100

400

A. Notes and coinsB. Deposits1. Government2. Banks’ Total Reserve accounts (TR)C. Foreign loans

1 000900500100

Total 2 500 Total 2 500


C. Notes and coinsD. Reserves with CB (TR)F. Loans to governmentG. Loans to NBPS

1005001 0003 800

A. Deposits of NBPSB. Loans from CB (BR)

5 000400


It should be noted that the banks have two types of liabilities (see Balance Sheet 2). Item A (BD of the NBPS) is money.

M3 = N&C + BD of the domestic NBPS = LCC 1 000 billion – LCC 100 billion + LCC 5 000 billion = LCC 5 900 billion

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ULTIMATBORROWERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

ULTIMAT LENDERS

HOUSEHOLDSECTOR

CORPORATESECTOR

GOVERNMENTSECTOR

FOREIGNSECTOR

BANKSNotes & Coins

Notes & CoinsDepositCertificates

M3

CENTRAL BANK

Fig. 4.1 Money(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

Central banks calculate M3, as well as its counterparts (elucidated later), from the consolidated balance sheet of the banks and the CB. In most countries, there are also other ‘monetary institutions’ (such as, rural banks, building societies, mutual banks, land banks and so on); they are also consolidated with the central bank’s and the banks’ balance sheets. The consolidated balance sheet appears as in Balance Sheet 3 called the consolidated balance sheet of the Monetary Banking Sector (MBS).


D. Foreign assetsE. Loans to governmentF. Loans to NBPS

1 0002 1003 800

A. Notes and coins of NBPSB. Deposits1. Government2. NBPSC. Foreign loans

Assets/Liabilities9009005 000100


How does consolidated balance sheet arrive? It nets out all the interbank claims. For ease of understanding, the relevant items have been highlighted in Balance Sheets 4–5. Note that:

CB loans to banks (LCC 400 billion) in Balance Sheet 4 are netted off against CB loans (LCC 400 billion) in •Balance Sheet 5.Bank reserves (LCC 500 billion, found in both balance sheets) are netted off.•N&C: LCC 1 000 billion less LCC 100 billion = LCC 900 billion (see item A in the consolidated balance •sheet.


D. Foreign assetsE. Loans to governmentF. Loans to banks (borrowed reserves – BR)@ KIR

1 0001 100

400

A. Notes and coinsB. Deposits1. Government2. Banks’ reserve accounts (TR)C. Foreign loans

1 000

900500100



C. Notes and coinsD. Reserves with CB (TR)F. Loans to governmentG. Loans to NBPS

1005001 0003 800

A. Deposits of NBPSB. Loans from CB (BR)

5 000400



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FromtheconsolidatedbalancesheetoftheMBS(BalanceSheet3),themoneystockiseasilyidentified(theitemshave been highlighted): item A and item B2:

M3 = A + B2 = LCC 900 billion + LCC 5 000 billion = LCC 5 900 billion.

Of the two components of money, we know that N&C is the minor party. In most countries, the proportion of N&C in M3 is as low as 2%. We also know that central banks (as the sole issuers of notes and coins (in most cases) do not use N&C to create new money; they merely react to the demand for N&C, for which deposits are used as payment).

New money is created by bank lending (domestic and foreign). These sources of money creation are also found in the consolidated balance sheet (balance Sheet 3). Thus, we have the tools for an analysis of money-creation. Note that what we are about to show is done by all central banks the world over on a monthly basis.

4.3 Money Identity: Sources of Money CreationWe replicate the consolidated balance sheet here for ease of reference (see Balance Sheet 6).

Balance Sheet 6: MBS (LCC Billions)Assets Liabilities


1 0002 1003 800


900

9005 000100


It is evident that, because the balance sheet balances, items A + B2 must be equal to all the asset items minus the remaining liability items. Therefore:

M3 = A + B2 = (D + E + F) – (B1 + C).

It will also be evident that we should combine the related asset and liability items, and they are as follows:Foreign assets and foreign loans (D – C).•Loans to government and government deposits (E – B1).•

Therefore,M3 = A + B2 = (D – C) + (E – B1) + F.

In terms of the numbers in Balance Sheet 6 we have:M3 = A + B2 = (D – C) + (E – B1) + FM3 = 900 + 5 000 = (1 000 – 100) + (2 100 – 900) + 3 800= 5 900 = 900 + 1 200 + 3 800= 5 900.

In words:Money stock (M3) = its ‘counterparts’ = Net foreign assets

+ Net loans to government + Loans to NBPS.

This is the money identity: the ‘counterparts’ of the money stock (the amount of money in circulation) are Net Foreign Assets (NFA), Net Loans to Government (NLG) and Loans to the NBPS (LNBPS).

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It will be evident that any change in the money stock must be equal to and therefore is ‘explained’ by changes in NFA, NLG and LNBPS (the sources):

ΔM3=ΔNFA+ΔNLG+ΔLNBPS

This is the money identity. It provides an analysis of the balance sheet sources of changes (BSSoC) in M3. The actual sources are the transactions that underlie the BSSoC, and they are as follows:

Net Foreign Assets (NFA): Bank and CB dealings in the foreign exchange market. If these institutions do nothing •in the forex market, the market clears at a particular exchange rate. If they do, they alter the demand/supply equation of the forex market and create/destroy money, and the market will clear at a different exchange rate.Net Loans to Government (NLG):•

Bank and CB purchases or sales of government securities. �The movement of NBPS deposits at banks to government (which we assume banks at the CB only), for �example when taxes are paid; and the movement of government deposits to the NBPS, when government spends locally.

Loans to the NBPS (LNBPS):•ThedemandforloansbytheNBPSwhichissatisfiedbythebanks. �

Inmostcountriesthelatteristheoverridingsourceofmoneycreation,whereasindevelopingcountriesthefirsttwo mentioned play the overriding role. The accompanying chart shows the year-on-year growth rates for M3 and LNBPS over a 40-year period for a particular country. It is quite evident that the overriding BSSoC in M3 was changes in LNBPS.

LNBPS

M3

-5

0

5

5

15

20

25

30

35

40

Fig. 4.2 M3 and LNB(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

4.3.1 Loan from BankExample: It will be helpful to give a few examples of the sources of changes in M3. It is to be noted that, here we do not indicate the effect of changes in bank deposits on the banks’ reserve requirements. This is because we do not wish to divert attention from the principles of money-creation. The effect of deposit changes on the reserve requirement is introduced at a later stage.

You will recall that when Company A sells goods to Company B and Company B acquires a loan facility from Bank A and utilises it for the purchase, the relevant balance sheets changes are as indicated in Balance Sheets 7–9 (amount = LCC 100 million).


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Balance Sheet 7: Company A (LCC Millions)Assets Liabilities

GoodsDeposits at Bank A

-100+100

Total 0 Total 0

Balance Sheet 8: Company B (LCC Millions)Assets Liabilities

Goods +100 Loan from Bank A +100Total +100 Total +100

Balance Sheet 9: Bank A (LCC Millions)Assets Liabilities

Loan to Company A +100 Deposits of Company A +100Total +100 Total +100

Seen in the balance sheet of the MBS (see Balance Sheet 10), these transactions should be clearer. On this day (of the balance sheet construction), M3 increased by LCC 100 million and there was one BSSoC in M3: LNBPS increased byLCC100million.Therealsourcewasthedemandforloanswhichwassatisfiedbythebank.


D. Foreign assetsE. Loans to governmentF. Loans to NBPS +100 +100


+100


4.3.2 ExportsExample: Another example: a Local Country exporter, LC Exporter (member of NBPS), exports goods to the value of LCC 100 million to a US Importer; the exchange rate is USD/LCC 10.0 (see Balance Sheets 11–13).


GoodsDeposits at US Bank

-100+100

Total 0 Total 0

Balance Sheet 12: US Importer (LCC Millions)Assets Liabilities

GoodsUS Bank deposits

+10-10

Total 0 Total 0


Deposits of US ImporterDeposits of LC Exporter

-10+10

Total 0 Total 0

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There was no change in the money stock (i.e., there was no change to the local bank’s (LC Bank) balance sheet. LC Exporter now sells the LCC 100 million foreign exchange earnings (USD) to LC Bank (see Balance Sheets 14–16).


Deposits at US BankDeposits at LC Bank

-100+100

Total 0 Total 0

Balance Sheet 15: LC Bank (LCC Millions)Assets Liabilities

Deposits at US Bank +100 Deposits of LC Exporter +100Total +100 Total +100

Balance Sheet 16: US Bank (LCC Millions)Assets Liabilities

Deposits of LC ExporterDeposits of LC Bank

-10+10

Total 0 Total 0

It will be clear that the balance sheet of LC Bank (i.e., the local bank) changed. LC Bank bought a foreign deposit of USD 10 million (= forex) and paid LC Exporter by crediting his account; this leads to an increase in the local deposits of the NBPS = an increase in M3. In terms of the balance sheet of the MBS, we have changes as indicated in Balance Sheet 17. M3 increased by LCC 100 million and the BSSoC is an increase in NFA (the increased foreign deposit). The real cause is the transaction, a portfolio decision, the purchase of forex by LC Bank.

Balance Sheet 17: MBS (LCC Millions)Assets Liabilities


+100

A. Notes and coins of NBPSB. Deposits1. Government2. NBPSC. Foreign loans +100


Had LC Exporter sold the forex into the forex market, the market would have cleared at a better exchange rate, say USD/LCC 9.99, than when the forex was withheld by LC Bank from the commercial supply/demand forces in the forex market.

4.3.3 Bonds Issued by the Government Example: Another example will be useful. The government issues LCC 1 000 million bonds and they are purchased by a number of the retirement funds (members of the NBPS) (see Balance Sheets 18–21).

Balance Sheet 18: Government (LCC Millions)Assets Liabilities

Deposits at CB +1000 Bonds +1000Total +1000 Total +1000


Loans to banks @ KIR +1000 Government deposits +1000Total +1000 Total +1000


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Balance Sheet 20: Retirement Funds (NBPS) (LCC Millions)Assets Liabilities

BondsDeposits at banks

+1 000-1 000

Total 0 Total 0

Balance Sheet 21: Retirement Funds (NBPS) (LCC Millions)Assets Liabilities

0 Deposits of NBPSLoans from CB @ KIR

-1 000+1 000

Total 0 Total 0

This action of government drains liquidity from the banks and they have no option, but to borrow from the CB (discussed later). When the balance sheets of the banks and the CB are consolidated (see Balance Sheet 22) it will be seen that M3 has fallen by LCC 100 million and the BSSoC is a decline in NLG (a result of the increase in government deposits). The real cause is the issue of bonds. When government spends the money, which is the purpose of the debt issue, the situation will be restored (M3 will increase again). It is important to understand that if the banks had purchased the bonds, M3 would have increased, as indicated in Balance Sheets 23–24.




+100-100

Total 0 Total 0

Balance Sheet 23: Banks (LCC Millions)Assets Liabilities

Bonds +1 000 Deposits of NBPS +1 000Total +1 000 Total +1 000


D. Foreign assetsE. Loans to government (bonds)F. Loans to NBPS

+1 000


+1 000

Total 0 Total 0

4.3.4 Bank NotesExample:Afinalexample:Thepublic(membersoftheNBPS)popsofftothebanks’ATMsandwithdrawLCC100million in bank notes with their debit cards (a direct debit to their current accounts) (see Balance Sheets 25–26).

Balance Sheet 27 shows for the position of the MBS, which is the same as for the banks. You will recall that M3 = N&C + BD. The N&C holdings of the NBPS increased by LCC 100 million and their deposits decreased by the same amount. Thus, the money stock did not change, only the composition did. Recall that Item A in the MBS balance sheet = the CB’s N&C liability less the N&C held by banks. The former was unchanged and the latter decreased by LCC 100 million.

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N&C -100 Deposits of NBPS -100Total -100 Total -100

Balance Sheet 26: NBPS (LCC Millions)Assets Liabilities

N&CDeposits at banks

+100-100

Total 0 Total 0




+100

-100

Total 0 Total 0

4.3.5 Money DestructionMoney is created, when banks provide new loans (to the government sector or the NBPS), or buy forex. The overridingsourceofmoneycreationisbankloansinabalancesheetsense,andthedemandforloansthatissatisfiedby the banks, in a real life sense. Obviously, the money stock can also fall, but this is rare, as seen in Fig. 4.2. In this particular country, and it applies to most countries, not in any month did the growth rate in M3 decrease.

However, it would be amiss if a fall in the money stock was not discussed. Take the example of Mrs A. She took a loan of LCC 50 000 from Bank A in the past. In order to repay the loan, she would accumulate a balance of LCC 50 000 on her bank account over time, and repay the bank on the due date of the loan. Balance Sheets 28–29 show this transaction.

Balance Sheet 28: Mrs A (NBPS) (LCC)Assets Liabilities

Deposit at bank -50 000 Bank loan -50 000Total -50 000 Total -50 000

Balance Sheet 29: Bank A (NBPS) (LCC)Assets Liabilities

Bank loans (NBPS) -50 000 Deposits of NBPS (M3) -50 000Total -50 000 Total -50 000

The position of the MBS will be the same as that of Bank A (see Balance Sheet 30).

Balance Sheet 30: MBS (LCC)Assets Liabilities

D. Foreign assetsE. Loans to governmentF. Loans to NBPS -50 000 -50 000

A. Notes and coins of NBPSB. Deposits1. Government2. NBPSC. Foreign loans -50 000

Total -50 000 Total -50 000


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4.3.6 Bank Deposits and the Reserve RequirementsAs we have seen, by consolidating the balance sheets of the banks and the CB, all the cb2b IBM and the b2cb IBM claims were netted out. This obscures an aspect of the money market and monetary policy: the effect of changes in bank deposits on the banks’ required reserves (RR). We introduce it here.

YouwillrecallfromthefirstexampleabovethatwhenCompanyAsellsgoodstoCompanyBandCompanyBacquires a loan facility from Bank A and utilises it for the purchase, a new bank deposit (new money) is created. It did not show the effect on the RR. We now need to add the balance sheet of the CB (see Balance Sheets 31–34) (the amount of the bank loan = LCC 100 million; the RR ratio = 10% of deposits).

Balance Sheet 31: Company A (LCC)Assets Liabilities

GoodsDeposits at Bank A

-100+100

Total 0 Total 0

Balance Sheet 32: Company B (LCC)Assets Liabilities

Goods +100 Loan from Bank A +100Total +100 Total +100

Balance Sheet 33: Bank A (LCC)Assets Liabilities

Loan to Company BReserves with CB (TR)(RR +10)

+100+10

Deposits of Company ALoan from CB @ KIR

+100+10


In this example, the required reserves increase by LCC 10 million (increased deposit of LCC 100 million × 0.10). As Bank A cannot create CB money, the CB will make to loan to the bank (BR). The TR of the banks increases by LCC 10 million (as a result of RR = +LCC 10 million).


Loans to banks (BR) @ KIR +10 Bank reserves (TR)(RR +10) +10

Total +10 Total +10

The change in RR is just one of many factors that impact on bank liquidity, and that bank liquidity management is an essential ingredient in monetary policy.

4.4 Statutory EnvironmentMonetarypolicyinmanycountriesisunderpinnedbylaw,whichisconfirmationofthesignificantroleofmonetarypolicy.

ExamplesSome of the examples are as follows:

In the US, the responsibility for setting monetary policy is contained in the Federal Reserve Act of 1913.•In the UK, the Bank of England Act of 1998 formally gives the operational responsibility for setting monetary •policy to the Bank of England. The mandate for the European Central Bank to conduct monetary policy is laid down in Article 105 (1) of the Treaty establishing the European Community.In South African law, the responsibility for setting monetary policy is contained in the Constitution of the Republic •of South Africa Third Amendment Act 26 of 1996 and the South African Reserve Bank Act 90 of 1989.

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4.5 Objectives of Monetary PolicyMonetary policy embodies the formulation and execution of policies by the central bank, in the form of open market operations to render its key interest rate effective, aimed at guiding bank lending rates to a level where loan demand and its counterpart, deposits (money) growth, are at a level consistent with the economy’s supply elasticity, all of whicharepremeditatedontheattainmentoflowinflationandhighandsustainableeconomicoutput.

TheFederalReserveBoarddefinesmonetarypolicyasfollows,“Theterm‘monetarypolicy’referstotheactionsundertakenbyacentralbank,suchastheFederalReserve,toinfluencetheavailabilityandcostofmoneyandcredittohelppromotenationaleconomicgoals.”Mostcentralbanksdefinemonetarypolicyintermsofitsobjectives.Some examples are discussed in the paragraphs given below.

Bank of England“The objective of monetary policy is price stability to maintain the value of money or, to put it another way, to restraininflationorthegeneralincreaseinthepricesofgoodsandservices.Uncertaintyaboutinflationandthusabout future price levels is damaging to the proper functioning of the economy. With a stable general price level, individual price signals can be read more clearly, and more rational decisions taken about whether to save or to borrow, how much to invest and to consume, and what and when to produce. In this way, price stability can help to foster sustainable long-term economic growth.”

Bank of Canada“The goal of Canadian monetary policy is to contribute to rising living standards for all Canadians through low and stableinflation.Specifically,theBankaimstokeeptherateofinflationinsideatargetrangeestablishedjointlywiththe government. Since 1995, the target range has been 1 to 3 per cent.”

These views may be synthesised as follows:Centralbankshavetwoobjectives,onethatcouldbetermedtheprimaryobjective(whichisbestdefinedaslow•andstableinflation)andonethatcouldbetermedtheultimateobjective(whichisbestdefinedassustainablehigh economic growth).Theultimateobjectiveisthedependentvariable.However,lowandstableinflationisnotasufficientcondition•forattainmentofthisloftyideal;itisoneofmany,butitistheoneofthemostsignificant.Uncertaintyaboutinflationisharmfultotheproperfunctioningoftheeconomy.Highinflationisassociated•with low real interest rates and highly volatile nominal rates of interest. High volatility means risk, and business does not like risk. Businesses do not do well in high risk environments because their efforts are redirected to hedging risk.A stable general price level and stable rates of interest means that the most important economic signals are •transparent, leading to lower risk and easier decision-making. In this way, price stability contributes to high and sustainable long-term economic growth.

In order to achieve the primary and ultimate objectives, central banks have intermediate objectives, and these are many, including sustainable growth in bank loans/money and stability in other indicators such as the exchange rate and asset prices. The discussion on monetary policy thus far may be summarised as in Fig. 4.3. The large gap is noticeable;itis‘filled’withtheoperationalsideofmonetarypolicy.


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Operation of Monetary Policy

Sustainable high

economic growth

Sustainable growth rate in bank loans/money,

stability in other indicators (exchange

rate/ asset prices, etc.)

Low and stable inflation

Monetary Policy is:

Decisions Aimed at Achieving Objectives

Intermediate Objectives

Ultimate Objective

PrimaryObjectives

Fig. 4.3 Objectives of monetary policy(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

4.6 Price StabilityTheprimaryobjectiveofcentralbankshasbeendescribedastheachievementoflowandstableinflation,andtheultimate objective as sustainable high economic growth, to which achievement of the primary objective contributes handsomely.Itisopportunetoexpressaviewhereonwhatpricestabilityisandwhatthebenefitsofpricestabilityare.

4.6.1 What Is Price Stability?PricestabilitydefinedbytheECBas,“ayear-on-yearincreaseintheHarmonisedIndexofConsumerPrices(HICP)for the euro area of below 2%”, and it adds that “Price stability is to be maintained over the medium term.” Other centralbankshavesimilardefinitions,forexample,aninflationtargetrangeof3–6%.

Fortheeconomy,itmeansthatcentralbankswanttoachievelowinflationonasustainablebasis,becausethisstateof affairs brings about low volatility in prices in general and in interest rates which is an important input in business decisions. Put another way, the private sector is able to plan ahead in terms of expenditure and investment (C + I = GDE; GDE + TAB = GDP) decisions without being constrained by uncertainty.

4.6.2 The Benefits of Price StabilityThebenefitsofpricestabilityarevast.TheECBarticulatesthebenefitsasfollows:

In general, it contributes to the achievement of a higher and sustainable level of economic output and •employment.It improves the transparency of the price mechanism.•It contributes to bringing about stability in interest rates, the most important price in the economy in terms of •savings and investment decisions.Itcontributestotheavoidanceofunproductivebusinessactivities,hedgingagainstinflationordeflation.•It assists in restoring the equal redistribution of income and wealth.•It contributes towards reducing the distortionary effects on economic behaviour that results from the impact of •inflationonthetaxandsocialsecuritysystems.

Benefits of price stability: ECB“The objective of price stability refers to the general level of prices in the economy. It implies avoiding both prolonged inflationanddeflation.”Pricestabilitycontributestoachievinghighlevelsofeconomicactivityandemploymentby resorting to the following means:

Improving the transparency of the price mechanism. Under price stability, people can recognise changes in •relative prices (i.e., prices between different goods), without being confused by changes in the overall price-level. This allows them to make well-informed consumption and investment decisions and to allocate resources moreefficiently.

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Reducinginflationriskpremiaininterestrates(i.e.,compensationcreditorsaskfortherisksassociatedwith•holding nominal assets). This reduces real interest rates and increases incentives to invest.Avoidingunproductiveactivitiestohedgeagainstthenegativeimpactofinflationordeflation.•Reducingdistortions of inflationor deflation,which can exacerbate the distortionary impact on economic•behaviour of tax and social security systems.Preventinganarbitraryredistributionofwealthandincomeasaresultofunexpectedinflationordeflation.•

“While the treaty clearly establishes the maintenance of price stability as the primary objective of the ECB, it does notgiveaprecisedefinitionofwhatismeantbypricestability.TheECB’sGoverningCouncilhasdefinedpricestability as ‘a year-on-year increase in the Harmonised Index of Consumer Prices (HICP)’ for the euro area of below 2%. Price stability is to be maintained over the medium-term.” It will be recalled that the other central banks quoted earlier expressed the same sentiment, generally that price stability contributes to achieving high levels of economic activity, i.e., the achievement of the ultimate objective.

4.7 Inflation Targeting Monetary Policy FrameworkInorder toachieve theprimaryobjectiveofpricestability,manycountrieshave inplacean inflation targetingmonetarypolicyframework.Underthisframework,anumericaltargetortargetrangefortheinflationratethatisintendedtobeachievedoveraspecifiedtimeperiodispubliclyannouncedbygovernment.Thus,itisagovernmenttarget, and it is to be executed by the CB, because the CB has the operational tools to best achieve it.

Aninflation-targetingmonetarypolicyframeworkisnotonlyaboutthetarget.Theotherelements/advantagesofthe framework are as follows:

It makes the objective of monetary policy crystal clear and thereby improves planning in the private and public •sectors.Itmakesitclearthatgovernmentispartofaformalisedandco-ordinatedefforttocontaininflationinpursuit•of the broader economic objective of sustainable high economic growth and employment creation.It focuses monetary policy and enhances the accountability of government and the central bank to the public.•Itprovidesananchorforexpectationsoffutureinflation,whichhasaninfluenceonpriceandwagesetting.•Itoftencontainsthecaveatofthetargetbeingflexible,asmanifestedinatargetrange(insomecases),anditis•to be attained over a period (usually the medium-term).

As regards the last point, some discretion is allowed because circumstances can arise which dictate that exclusive emphasisoninflationgoalsisnotappropriate.Examplesarenaturaldisasters,largeanddisruptiveinternationalcapitalflows,supplyshockssuchasaspikeintheoilprice,demandshockssuchasasharpfallinthedemandforcocoa (Ghana) or copper (Zambia). In these circumstances, a rigorously applied rule deprives the central bank of its ability to deal effectively with them. Some discretion must be applied in order to avoid costly losses in terms of output and jobs.

Although discretion is claimed as a right by most central banks, they are mindful of the importance of the credibility of the CB and of the target. One CB articulates in this regard, “It is also important that the inherent discipline of inflationtargetingisnotforegonebyapplyingdiscretion.Theobjectiveoftheexerciseis,afterall,toachievethetargetrange.Aninflation-targetingmonetarypolicyframeworkcanonlybesuccessful,ifthepublicisconvincedthatthecentralbankisseriousaboutcontaininginflation.Thebenefitsofinflationtargetingdependonwhetherwageandpricesettingareresponsivetotheinflationtargetoftheauthorities.Publicbuy-inisessentialtoobtainlowinflationanditsconsequentbenefitsforall.Thisrequiresanationaleffort,anchoringexpectationsaroundtheinflationrange.”

Inflationtargetsreplacemoneystockgrowthratetargets.Theinflation-targetingmonetarypolicyframeworkstillregards money stock and bank loan extension as critically important, and they are monitored closely, but together with other economic indicators as follows:

The level of international interest rates.•The shape and position of the yield curve.•


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Changes in nominal and real salaries and wages.•Changes in employment.•Nominal unit labour costs.•The gap between potential and actual national output.•General money market conditions.•Changes in asset prices.•The overall balance of payments position.•The terms of trade.•Exchange rate developments.•Public sector borrowing requirement.•

4.8 Monetary Policy Accountability and TransparencyThevirtuesoftheinflation-targetingmonetarypolicyframeworkintermsofmonetarypolicyaccountabilityandtransparency are discussed in detail here. The following steps are taken by most central banks to enhance monetary policy accountability and transparency:

Theinflationtargetisannouncedopenlytothepublic;inthiswayitindicatesvisiblythatthecentralbankis•accountable for the targetandmakes theapplicationof the inflation targeting frameworkas transparentaspossible.Announcement of the target makes the intent of monetary policy explicit; the corporate sector is therefore well-•informed and better able to plan in terms of production and expansion of production.If the target is not met, the central bank has to explain the situation to the public (in Parliament).•The governor of the central bank is obliged to report to the Minister of Finance (Parliament) twice per annum •and report on the stance of monetary policy.The monetary policy stance of the central bank is communicated regularly to the public in various formats:•A monetary policy statement issued after each meeting of the Monetary Policy Committee (MPC).•In some cases, central banks invite the public to Monetary Policy Forums held in the major centres of the country, •where presentations are made and discussions are held in which the public participates.In some cases, central banks publish a Monetary Policy Review. It describes in detail the decisions taken by the •centralbankandanalysesthefactorsthatcouldhaveaninfluenceonfutureinflation.

These components of accountability and transparency are mostly common to the central banks that have adopted an inflationtargetedmonetarypolicy.WithregardtothesituationintheUK,theBankofEnglandreports,“Increasedaccountability to Parliament and the public is achieved through the publication of the minutes, and the continued publicationoftheBank’sInflationReport,aswellasthroughappearancesbyMPCmembersbeforetheTreasurySelect Committee of Parliament and through the Bank’s Annual Report. The Governor is also obliged to write an openlettertothechancellor,ifinflationdeviatesmorethan1%oneithersideofthe2.5%target.Undercertaincircumstances,theBankofEnglandActallowstheTreasurytogiveinstructionstotheBankinthefieldofmonetarypolicyforalimitedperiodoftime.Thesepowerscanonlybeused,iftheTreasuryissatisfiedthattheyarerequiredin the public interest and only by ‘extreme economic circumstances’.”

4.9 Limitations of Monetary PolicyIt should be evident from the discussion above that there is a limit to what monetary policy can achieve. The ultimate objective of all governments is to improve the welfare of the nation. There are many factors that contribute to the welfare of people, education, work ethic, culture, mineral resources, technology, population growth, political stability, price stability, etc.

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Price stability is just one of these factors, meaning that the central bank cannot achieve the lofty ideal of improving the welfare of the nation; it can merely make a contribution to this ideal. Price stability is the only factor that is firmlywithinthecontrolofthecentralbank.TheviewoftheECBisrelevant,“Inthelong-run,acentralbankcanonly contribute to raising the growth potential of the economy by maintaining an environment of stable prices. It cannot enhance economic growth by expanding the money supply or keeping short-term interest rates at a level inconsistentwithpricestability.Itcanonlyinfluencethegenerallevelofprices.”

“Ultimately,inflationisamonetaryphenomenon.Prolongedperiodsofhighinflationaretypicallyassociatedwithhigh monetary growth. While other factors (such as variations in aggregate demand, technological changes or commoditypriceshocks)caninfluencepricedevelopmentsovershorterhorizons,overtimetheireffectscanbeoffset by a change in monetary policy.”

The South African Reserve Bank articulates in this regard:“The Bank believe[s] that the best contribution that monetarypolicycanmake togrowth is toprovidea lowandstable inflationenvironment that isconducive tosustainable long-term growth.”

4.10 Instruments of Monetary PolicyMonetary policy had a chequered career in most countries, and a look over the shoulder to the past reveals some instruments of policy that would make a young central banker cringe. In general, today there is little debate on the instruments of monetary policy; it is almost a case of the existence of a standard set of instruments, and the only differences that exist are nuance-like.

Thefirstreasonfordigginguptheoldinstrumentsofmonetarypolicyiscompletenessandthesecondishistory.Oneneeds to be reminded of the ‘dreadful’ past in terms of instruments of monetary policy, in order to avoid them. We hasten to add that the present-day instruments, while effective, can also be harmful in the hands of a non-independent central bank coupled with a delinquent President/Prime Minister. Meijer provides the following comprehensive list of monetary policy instruments used in the past and presently:

Management of the public debt.•Open market operations.•Central bank discount policy.•Variations in the reserve requirements for banks or (more generally) in the prescriptions governing the portfolio •compositionsofbanksandotherfinancialinstitutions.Imposition and variation of quantitative restrictions on bank lending (credit ‘ceilings’).•Selective credit controls.•Deposit and/or lending interest rate controls.•Moral suasion.•Variations in the terms and conditions of hire-purchase and instalment credit (consumer credit).•Capital issues control.•Import deposit schemes.•Officialforeignborrowing(undercertainconditions).•Changes in exchange control regulations (under certain conditions).•Central bank intervention in the spot and forward foreign exchange markets (under certain conditions).•

Theinstrumentsofmonetarypolicycanbeclassifiedintothenew/indirect/marketoriented,andold/direct/non-marketoriented instruments. The old/direct/non-market oriented instruments of monetary policy are those that are used to accomplish the aims of monetary policy by prescription of the conduct of banks. They do not rely on market forces toinfluencethebehaviourofbanks,andusuallyengageinflexiblebehaviourrulesorthespecificationofcertainquantitative rules. Usually, if the banks do not comply with the rules penalties or prosecution is possible. Examples include the following:


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Quantitative ceilings on bank lending.•Specifiedinterestrateceilingsand/orfloorsonloansanddeposits.•Exchange controls.•Simultaneous quantitative control of bank reserves and interest rate control.•

The new/indirect/market oriented (new in the sense of a few decades) instruments of monetary policy are those that areusedtoaccomplishtheaimsofmonetarypolicybyinfluencingthebanks’andthepublic’sconductinrespectoftheirlendingandborrowingactivities.TheinfluencingarisesfrominterestratechangesbroughtaboutbythecentralbankinitsKIRwhichinturninfluenceratesinthefinancialmarkets(buttheyremainlinkedtotheKIR).

An administered rate (KIR) change does not imply ‘market-oriented’. This is so, but it rests on the fact that the vast majority of the money stock is bank deposits of the NBPS. Due to this, banks are able to create money (deposits) by mere lending, provided a demand for loans exists. Thus, normal supply and demand forces are absent, and some entity isrequiredtogeneratethegenesisinterestrate.TheCBprovidesthisintheformoftheKIRandthisrateinfluencesthe b2b IBM rate and banks’ deposit rates (bank liabilities) and, via the bank margin, bank lending rates, which in turninfluencesthepublic’sdemandforbankloans.Thus,theCBexercisesalargemeasureofdiscretion.

The KIR is only effective, if the banks are actually indebted to the CB, i.e., making use of BR. This means that the CB has to create and maintain a condition of a Liquidity Shortage (LS). This is where Open Market Operations (OMO) entersthefray.TheCBmakesuseoftheopenmarketforfinancialinstrumentstobringaboutpermanentLS:

Buying and selling government securities (treasury bills and government bonds.•Forex swaps with the banks.•Issues and repurchases of CB securities.•Shifting government funds between the Exchequer Account at the CB and the TLAs at the banks.•

In abnormal times, a liquidity surplus can prevail, also brought about by the CB through OMO. The motivation is to coerce banks to drop interest rates to the lowest level possible.

In summary, in normal times the instruments of monetary policy are as follows:Creation of a LS condition to make KIR effective.•Changing KIR when appropriate.•Executing OMO in its various forms in order to ensure a LS condition.•

Fig. 4.4 completes Fig. 4.3 by including these instruments of monetary policy; when combined they represent the operation of monetary policy.


Sustainable high

economic growth





Monetary Policy is:


KIR

Bank Indebtedness

to CB

Open Market Operations


Ultimate Objective

PrimaryObjectives

Fig. 4.4 Monetary policy(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

Theeffectiveapplicationoftheseinstrumentsisdependentonadevelopedfinancialsysteminwhichpricediscoveryisefficient.

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4.11 Independence of Central BanksThere is not much debate on the independence of central banks. It is generally accepted that total operational independence is the norm, and that consultation with the Treasury is required, and is acknowledged as not compromising monetary policy. The independence of central banks is embedded in statute in most countries. For example, in the case of the South African Reserve Bank its independence is imbedded in the Constitution. Subsection (2) of section 224 (Primary object) states in this regard, “The South African Reserve Bank, in pursuit of its primary object, must perform its functions independently and without fear, favour or prejudice, but there must be regular consultationbetweentheBankandtheCabinetmemberresponsiblefornationalfinancialmatters.”


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SummaryItisundisputedthatexcessivegrowthinthemoneystockisthecauseofinflation.•All countries have central banks and a monetary policy in place.•The stock of money is made up of bank notes and coins and bank deposits in possession of the NBPS.•New money is created by bank lending (domestic and foreign).•Bank and CB dealings in the foreign exchange market.•When banks provide new loans (to the government sector or the NBPS), or buy forex, money is created.•Money is created when banks provide new loans (to the government sector or the NBPS), or buy forex.•The overriding source of money creation is bank loans in a balance sheet sense, and the demand for loans that •issatisfiedbythebanks,inareallifesense.The change in RR is just one of many factors that impact on bank liquidity, and that bank liquidity management •is an essential ingredient in monetary policy.Monetarypolicy inmanycountries isunderpinnedby law,which isconfirmationof thesignificant roleof•monetary policy.In the US, the responsibility for setting monetary policy is contained in the Federal Reserve Act of 1913.•‘The term ‘monetary policy’ refers to the actions undertaken by a central bank, such as the Federal Reserve, to •influencetheavailabilityandcostofmoneyandcredittohelppromotenationaleconomicgoals.”Thebenefitsofpricestabilityarevast.•Inflationtargetsreplacemoneystockgrowthratetargets.•Pricestabilityistheonlyfactorthatisfirmlywithinthecontrolofthecentralbank.•The instrumentsofmonetarypolicycanbeclassified into thenew/indirect/marketoriented,andold/direct/•non-market oriented instruments.The KIR is only effective, if the banks are actually indebted to the CB, i.e., making use of BR.•

ReferencesA Monetary and Fiscal Framework for Economic Stability: a Friedmanian Approach to Restoring Growth. • [Pdf] Available at: <http://www.cfeps.org/pubs/wp-pdf/WP22-Wray.pdf> [Accessed 06 June 2014].The Rote of Money and Monetary Policy. • [Pdf] Available at: <http://research.stlouisfed.org/publications/review/68/07/Money_July1968.pdf> [Accessed 06 June 2014].Page, S ., 2013. • Monetary Policy in Developing Countries. Routledge.Mahadeva, L. and Sterne, G., 2 0 1 2 . • Monetary Policy Frameworks in a Global Context. Routledge.18. Monetary Policy. • [Video online] Available at: <https://www.youtube.com/watch?v=_SpIaGTq0u8> [Accessed 06 June 2014].Money and Banking: Lecture 39 - Monetary Policy 1. • [Video online] Available at: <https://www.youtube.com/watch?v=uHP0BO2x8cw> [Accessed 06 June 2014].

Recommended ReadingCardoso, E. and Galal, A., 2006. • Monetary Policy and Exchange Rate Regimes. American Univ in Cairo Press.Goodfriend, M. and Prasad, E ., 2006. • A Framework for Independent Monetary Policy in China (EPub). International Monetary Fund.Hammond, G., Kanbur, S. M. R. and Prasad, E ., 2009. • Monetary Policy Frameworks for Emerging Markets. Edward Elgar Publishing.

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Self AssessmentIt is undisputed that excessive growth in the money stock is the cause of __________.1.

profita. lossb. inflationc. price stabilityd.

What is created by bank lending (domestic and foreign)?2. Old moneya. Moneyb. Policyc. New moneyd.

Match the following3. 1. The new/indirect/market oriented

instruments of monetary policyA. It is a year-on-year increase in the Harmonised Index of

Consumer Prices (HICP) for the euro area of below 2%.

2. The old/direct/non-market oriented instruments of monetary policy

B. They are those that are used to accomplish the aims of monetary policybyinfluencingthebanks’andthepublic’sconductinrespect of their lending and borrowing activities.

3. Price stability C. It refers to the actions undertaken by a central bank.

4. Monetary policy D. They are those that are used to accomplish the aims of monetary policy by prescription of the conduct of banks.

1- C, 2- A, 3- B, 4- Da. 1- B, 2- D, 3- A, 4- Cb. 1- A, 2- C, 3- D, 4- Bc. 1- D, 2- B, 3- C, 4- Ad.

What is created when banks provide new loans (to the government sector or the NBPS), or buy forex?4. Pricea. New marketb. Moneyc. Old marketd.

In the US, the responsibility for setting monetary policy is contained in the Federal Reserve Act of ________.5. 1913a. 1949b. 1924c. 1903d.

Which of the following statement is true?6. Certaintyaboutinflationisharmfultotheproperfunctioningoftheeconomy.a. Securityaboutinflationisharmfultotheproperfunctioningoftheeconomy.b. Uncertaintyaboutinflationisharmfultotheproperfunctioningoftheeconomy.c. Safetyaboutinflationisharmfultotheproperfunctioningoftheeconomy.d.


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_________ targets replace money stock growth rate targets.7. Moneya. Inflationb. Central Bankc. Price stabilityd.

Which of the following statement is false?8. Thebenefitsofpricestabilityarelimited.a. Price stability improves the transparency of the price mechanism.b. Price stability assists in restoring the equal redistribution of income and wealth.c. Pricestabilitycontributestotheavoidanceofunproductivebusinessactivities–hedgingagainstinflationd. ordeflation.

Whichofthefollowingistheonlyfactorthatisfirmlywithinthecontrolofthecentralbank?9. Moneya. Inflationb. Central Bankc. Price stabilityd.

The independence of _________ is embedded in statute in most countries.10. moneya. inflationb. central banksc. price stabilityd.

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Chapter V

Monetary Policy: Models and Transmission

Aim


introduce the concept of monetary policy•

explain models of monetary policy•

explicatethefirm-RRmodel•

Objectives


explainthefirm-BRmodel•

elucidate interbank rate model•

explicate monetary policy•

Learning outcome


identifypathofmonetarypolicy:frominteresttoinflation•

understand monetary policy•

recognise the three models of monetary policy•


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5.1 IntroductionWehavepresentedmonetarypolicyintwoparts.Thefirstcoveredthemeasurementofmoney,money-creation,the framework of monetary policy and related issues. With these as background, this section discusses the three models of monetary policy, followed by a brief discourse on the transmission of monetary policy from changes in theKIRtoinflation.

5.2 Models of Monetary PolicyThe primary instruments of monetary policy are as follows:

Creation of a Liquidity Shortage (LS) condition to make the KIR effective.•Changing KIR when appropriate.•Executing OMO in its various forms in order to ensure a LS condition.•

Fig. 5.1 illustrates these primary instruments within the context of the objectives of monetary policy. The effective application of these instruments is dependent on a developed financial system inwhich price discovery isefficient.


Sustainable high

economic growth





Monetary Policy is:


KIR

Bank Indebtedness

to CB

Open Market Operations


Ultimate Objective

PrimaryObjectives

Fig. 5.1 Monetary policy(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

There are three models of monetary policy. We discuss these and the related issues under the following sections:Firm required reserves model•Firm borrowed reserves model•Interbank rate model•Quoins of monetary policy•

5.2.1 Firm Required Reserves ModelLet’sbeginwiththefirstmodel,thefirm-RRmodel.NoteherethatweassumethatN&Cdonotrankasreserves.Where N&C do rank as reserves (also called the ‘monetary base model’), it is a minor part of the story, and its inclusion would only serve to mask the principles.

In real life, the causation path of money creation runs from bank loans (bank asset) to money (bank liability). The RR comes into play in that as deposits (money) increase, as a result of new bank loans extended or the purchase of newly issued securities (bank loans), the amount of RR to be held with the CB increases. However, the banks can get the additional reserves required only by borrowing from the CB. The previous example of government borrowing and spending is a true life example. Here, we provide another (see Balance Sheets 1–4); it is the same as the one presented earlier, but with the RR and the CB included.

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Balance Sheet 1: Company A (NBPS) (LCC Millions)Assets Liabilities

GoodsDeposit at bank

-100+100

Total 0 Total 0

Balance Sheet 2: Company B (NBPS) (LCC Millions)Assets Liabilities

Goods +100 +100Total +100 Total +100

Balance Sheet 3: Bank (LCC Millions)Assets Liabilities

Loans to Company BReserves at CB (TR)(RR = +10)

+100+10

Deposits of Company ALoan from CB @ KIR

+100+10



Loans to banks (BR) @ KIR +10 Bank reserves (TR)(RR = +10) +10

Total +10 Total +10

We emphasise here again that no bank can create CBM (reserves); only the CB can. Therefore, what happens in the above case? The simple answer is that it cannot, unless the CB allows it to come about by providing the reserves (note that +BR = +RR). You will recall that where a reserve requirement exists, which applies to bank deposits, thereisafixedrelationshipbetweenRRandBankDeposits(BD):

RR = BD × r

Thus if BD = LCC 100 million and r = 10%, we have:RR = LCC 100 million × 0.1 = LCC 10 million.

This means that the banks cannot supply any further loans unless the CB supplies BR. So, without the CB supplying BR, the banking system comes to a halt in terms of new loans, and therefore money-creation. It will be evident that in such a system, assuming the existence of a demand for loans, interest rates (Prime Rate-PR) will rise up to a point, where new projects are rendered non-viable. Recall that companies need to have an expected return on the project for which borrowing is required, which is higher the cost of borrowing (PR).

This model can be illustrated as in Fig. 5.2. Once the banks have no excess reserves, they cannot make new loans. Therefore, in the case of an upward shift in the demand for loans (from D1 to D2), interest rates will rise.


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InterestRate (ir)

Quantity of loans

Banks’prime

lendingrate

ir2

D2D1

Q

S

ir1

Fig. 5.2 Monetary base fixed; banks fully lent(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

This is an extreme case, which we are presenting here to make a point. The central banks that operate this model (few do) provide reserves to the extent that is consistent with their money growth target. The calculation is simple. If the banking system is in balance (no BR and no ER) and the money stock in the form of BD is LCC 100 billion, and the CB would like the money stock in this form to grow by 12% over the next twelve months (to LCC 112 billion), it will supply additional reserves to the extent of LCC 1.2 billion, which will be used by the banking sector as the ‘backing’ for money stock growth of LCC 12 billion.

How does the CB achieve this? The answer is OMO purchases of government securities (bonds) to the extent of LCC 1.2 billion. We assume these are forthcoming from the banks (they will offer them at a tender). The CB will do this in stages, to avoid a sharp drop in interest rates that accompanies the creation of ER. For the sake of clear illustration, we assume it is done in one go (see Balance Sheets 5–6).


Government bonds +1 200Bank reserves (TR)(RR = +0)(ER = +1 200)

+1 200

Total +10 Total +1 200


Government bondsReserves at CB (TR)(RR = +0)(ER = +1 200)

-1 200+1 200

Total 0 Total 0

Asnoted,thebankswillovertimebeabletomeetnewdemandorloans;thefinaloutcomeispresentedinBalanceSheets 7–8.


Bank reserves (TR)(RR = +1 200)(ER = -1 200)

0

Total 0 Total 0

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Reserves at CB (TR)(RR = +1 200)(ER = -1 200)Loans to NBPS

0

+12 000

Deposits of NBPS +12 000

Total +12 000 Total +12 000

The money stock has increased by LCC 12 billion and ER has shifted to RR. It will be quite evident by now that once the banking system has expanded to the point where all its ER shifted into RR, it cannot expand any further. Interestratesinthissystemarefreetofindtheirownlevels,andwillnowreflectthequantitativeconstraintonmoneygrowth. The lending rate of the banks, Prime Rate (PR) will increase sharply.

As the scholars of money and banking will know, essentially this is theoretical money ‘supply’ model. Some of theworld’slargecentralbanksflirtedwiththismodelinthepast,butrejecteditbecausetheprofoundconsequenceof the quantitative control of bank reserves was extremely volatile interest rates. As noted in some parts of the developing world, this model is imposed on the central banks as part of developmental programmes that includes donor funds.

You will understand that the RR has replaced the gold coin/bullion holdings of the banks/central banks of old, which were held against deposits and bank notes issued. As the deposits/bank notes were convertible to gold, the bankers could not afford to allow the gold reserves to drop too low in relation to deposits/notes. This represented the brake on the system.

5.2.2 Firm Borrowed Reserves Model

InterestRate (ir)

Quantity of loans

Supply

Q1 Q2

Banks’prime

lendingrate

ir2

D2D1

ir1

Fig. 5.3 Supply of and demand for bank loans(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

Attheotherextremeisthefirm-BRmodel(seeFig.5.3).Inthismodel,theCBensuresthatthebanksareindebtedto it (the CB) at all times, and whether the banks have a reserve requirement or not (which is the case in a few countries) is immaterial. The CB relies entirely on interest rates to allocate funds (new money in fact), and the CB has absolute control over interest rates. Therefore, in this system monetary policy is virtually all about the item in the central bank’s books, ‘loans to banks’ (BR) and the KIR that is applied to these loans. The existence of loans to banks, the outstanding amount of which is also called the Liquidity Shortage (LS), is what makes the KIR effective andinfluencesthebanks’interestratesonbothsidesoftheirbalancesheets,andthroughtheirlendingrate,thedemand for loans.


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TheCBmakesdailyandlongerforecastsoftheitemsthatinfluencebankliquidity,whichimpactonthenetreservebalanceofthebankingsystemthatwillreflectonthereserveaccountsattheendofthebusinessdays,andthenundertake OMO to ensure that the banks are borrowing from the CB (or do nothing, if the net amount remains negative). The KIR is applied to the CB loans to the banks. There are a number of central banks that engage this model. The South African Reserve Bank follows this model; the banks are permanently indebted to the CB and it has been able to ‘control’ the banks’ lending rates in an almost exacting fashion, as indicated in Fig. 5.4.

0

5

10

15

20

25

30

KIR

Prime Rate

Fig. 5.4 KIR and PR (month-ends over 50 years)(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

The Bank of England also follows this model, as indicated in the following, “In practice the pattern of Government and bank operations usually results in a shortage of cash in the market each day. The Bank supplies the cash which thebankingsystemasawholeneedstoachievebalancebytheendofeachsettlementday.AstheBankisthefinalprovider of cash to the system, it can choose the interest rate at which it will provide these funds each day. The interestrateatwhichtheBanksuppliesthesefundsisquicklypassedthroughoutthefinancialsystem,influencinginterest rates for the whole economy. When the Bank changes its rate, the commercial banks change their own base rates from which deposit and lending rates are calculated.” There are extraordinary times when drastic measures are taken, away from CB lending to the banks and towards creating a money market surplus (a +ER condition).

“In March 2009, the Monetary Policy Committee announced that, in addition to setting Bank Rate at 0.5%, it would starttoinjectmoneydirectlyintotheeconomyinordertomeettheinflationtarget.Theinstrumentofmonetarypolicy shifted towards the quantity of money provided, rather than its price (Bank Rate). However, the objective of policyisunchangedtomeettheinflationtargetof2percentontheCPImeasureofconsumerprices.Influencingthe quantity of money directly is essentially a different means of reaching the same end.”

“Significantreductionsinbankratehaveprovidedalargestimulustotheeconomy,butasBankRateapproacheszero, further reductions are likely to be less effective in terms of the impact on market interest rates, demand and inflation.Interestratescannotbelessthanzero.TheMPCthereforeneedstoprovidefurtherstimulustosupportdemandinthewidereconomy.Ifspendingongoodsandservicesistoolow,inflationwillfallbelowitstarget.”

“The MPC boosts the supply of money by purchasing assets like Government and corporate bonds, a policy often known as ‘Quantitative Easing’. Instead of lowering bank rate to increase the amount of money in the economy, the bank supplies extra money directly. This does not involve printing more banknotes. Instead the bank pays for these assets by creating money electronically and loaning the accounts of the companies, it bought the assets from. This extramoneysupportsmorespendingintheeconomytobringfutureinflationbacktothetarget.”

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Let us analyse this statement, the Bank of England buys securities (assume government bonds) from retirement funds to the extent of GBP 200 billion. The banking system was indebted to the Bank by GBP 100 million. [Note that we have ignored the reserve requirement here for the sake of simplicity]. The transaction has increased the money stock by GBP 200 billion and created GBP 100 in ER (the other GBP 100 was used to repay the banks’ BR to the Bank of England). The banks’ ER reinforces the lower Bank rate (i.e., KIR) and puts pressure on them to make loans to the NBPS at lower rates.

Thereferencetobringinginflationbanktothetarget(of2%)isanallusiontothedangersofdeflation(whenpricesdecline),whichmakesassets(likehomes)worthless,whilekeepingdebts(likemortgagedebt)unchanged.Deflationhas a major negative impact on GDE, because investors in assets are worse off.

Balance Sheet 9: Retirement funds (NBPS) (GBP Billions)Assets Liabilities

Government bondsDeposits at banks

-200+200

Total 0 Total 0

Balance Sheet 10: Banks (GBP Billions)Assets Liabilities

Bank reserves (TR)(ER = +100) +100 Deposits of NBPS

Loans from CB (BR)+200-100

Total 0 Total +100

Balance Sheet 11: Banks (GBP Billions)Assets Liabilities

Government bondsLoans to banks (BR)

+200-100

Bank reserves (TR)(ER = +100) +100


The Reserve Bank of Australia has a similar monetary policy execution style (note that ‘overnight loans’ are loans from the CB to the banks, and the interbank rate is termed ‘cash rate’).

“Monetary policy decisions involve setting the interest rate on overnight loans in the money market. Other interest ratesintheeconomyareinfluencedbythisinterestratetovaryingdegrees,sothatthebehaviourofborrowersandlendersinthefinancialmarketsisaffectedbymonetarypolicy(thoughnotonlybymonetarypolicy).Throughthesechannels, monetary policy affects the economy in pursuit of the goals.”

“From day-to-day, the Bank has the task of maintaining conditions in the money market, so as to keep the cash rate at or near an operating target decided by the Board. The cash rate is the rate charged on overnight loans between financialintermediaries.Ithasapowerfulinfluenceonotherinterestratesandformsthebaseonwhichthestructureof interest rates in the economy is built. Changes in monetary policy mean a change in the operating target for the cashrate,andhenceashiftintheinterestratestructureprevailinginthefinancialsystem.”

5.2.3 Interbank Rate ModelTheIBRmodelisavariationofthefirm-BRmodel.Itisamodel,whereanumberofcentralbankspositionthemselvesin terms of monetary policy. They set a target range for the second stage of the Monetary Policy Transmission Mechanism (MPTM), the interbank rate. You will recall that this is the b2b IBM, which takes its cue from the KIR, provided that the banks are indebted to the CB (have a +BR number in their balance sheets). The argument is that when the ‘short’ banks in the interbank clearing are attempting to avoid borrowing from the CB, they are willing to pay interbank rates that are a fraction below the KIR.


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There is a proviso to this, and that is when the banking system is in balance (no surplus with the CB (no ER) and no borrowing from the CB (no BR) (an unusual state because CB forecasts cannot be precise), just the mere threat ofborrowingfromtheCBissufficienttomaketheKIReffective.Furthermore,therearecentralbanksthatallowERs to exist and make their interest rate policy effective by paying an interest rate on these amounts. The effective rate then becomes this rate [let’s call this the KIR-D – for KIR for bank deposits (ER); while the CB lending rate becomes the KIR-L (i.e., for BR)]. Thus, through this mechanism, the CB can create a ‘tunnel of KIRs’ and this becomes the cue or the target for the b2b IBM rate. Clearly, the KIR-L forms the upper level of the tunnel and the KIR-D the bottom level.

A good example of this method on monetary policy is Canada. The Bank of Canada states, “The Bank carries out monetarypolicyby influencingshort-term interest rates. Itdoes thisby raisingand lowering the target for theovernightrate.Theovernightrateistheinterestrateatwhichmajorfinancialinstitutionsborrowandlendone-day(or ‘overnight’) funds among themselves; the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank’s key interest rate or key policy rate.”

“Changesinthetargetfortheovernightrateinfluenceotherinterestrates,suchasthoseforconsumerloansandmortgages. They can also affect the exchange rate of the Canadian dollar.” “The instrument that the Bank uses to ensurethatinflationremainswithinthistargetrangeistheBankRate,therateofinterestthattheBankchargesonshort-termloanstofinancialinstitutions.”

“Morespecifically,theBanksetsatargetbandforthemarketrateforovernighttransactions.TheupperendofthebandistheBankRate,theratechargedonloanstofinancialinstitutionsparticipatingdirectlyinthepaymentssystem.ThebottomendofthebandistheratetheBankpaysonsettlementbalancesheldbyparticipatingfinancialinstitutions.”

The essence of the European Central Bank’s (ECB’s) monetary policy style is to create a ‘corridor’ of interest rates within which the ‘overnight market interest rate’ (that is, the b2b IBM rate) is determined (i.e., same as explained earlier). It announces its ‘key interest rates’ (it actually terms its rates as such) from time-to-time, thus broadcasting its monetary policy stance.

As in the case of Canada, it has two KIRs, the interest rate on the marginal lending facility (i.e., for overnight loans), which constitutes the ceiling rate for the overnight b2b IBM rate (as KIR-L above), and the interest rate on thedepositfacility(forovernightdepositswhenthebankingsystemhasasurplus=ER),whichconstitutesafloorrate for the overnight b2b IBM rate (as KIR-D above). These transactions (lending and taking of deposits) are not undertaken by the ECB itself, but by the individual National Central Banks (NCBs).

The US monetary policy system operates in a similar fashion. The Federal Reserve targets the ‘Federal funds-Fedfunds-rate’, which is a b2b IBM rate, and they steer the liquidity of the banking system, such that they at most times utilise the lending facility (there are 3), called the discount window, at the ‘discount rate’. Given a liquidity shortage,thisratehasapowerfulinfluenceontheb2bIBMrate,andsoinfluencesthebankingsector’sdepositandlending rates (and the exchange rate).

5.3 Monetary PolicyThemonetarypolicyessencewillnowbecleartoyou.Itisapolicyonmoneycreationandspecificallyonthegrowthrateinmoneycreation.NoCBwouldliketoengineernegativemoneygrowth,becausethiscouldleadtodeflation,anddeflationmeansadeclineinassetvalues,whichmeansadeclineinwealth.

A decline in wealth means a fall in consumption and investment expenditure, Gross Domestic Expenditure (GDE), the principal driver of economic growth and Gross Domestic Product (GDP). Hence, the policy is aimed at sustainable economicgrowthwhichrequiresastableandlowinflationenvironment.Monetarypolicyimplementationmustinclude a position on the economy’s elasticity of supply.

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Money is created by bank loans to the government and the NBPS and that bank purchases of forex also create money. Hence, the drivers of money growth are the demand for loans by government and the NBPS and decisions by banks to purchase forex (a minor factor usually). Central banks have tools at their disposal to control the creation of money and these are the reserve requirement (the ‘r’ can also be changed, but is rarely used), the KIR and OMO.

Underthefirm-RRmodel,thereserverequirementisusedtocurbM3growthinaquantitativemannerviacreating,throughOMOpurchases,adesiredvolumeofreserves(ER).Interestratesarefreetofindtheirownlevels(orshouldbe because a CB cannot control both without creating unsustainable distortions).

Underthefirm-BRmodel,themainoperationaltoolisthecentralbank’slendingrate(KIR-L)tothebankswhichis made effective by ensuring through OMO a liquidity shortage (BR) at all times (i.e., the CB keeps the loans-to-bankswindowopenatalltimes).The‘effective-making’oftheKIRfiltersthroughtothebanks’primerate(andtoallotherratesandtheexchangerate),thusinfluencingthedemandforloans(themaindriverofmoneycreation).

The IBRmodel is similar to thefirm-BRmodel, but focuseson thebanks’ interbank rate and influences it inconditions of both bank liquidity surpluses and bank liquidity shortages. As in the former case, this model also aims to ultimately bring to bear a major impact on the banks’ lending rates (and the exchange rate and other rates), and soinfluencedemand.Itwillbeevidentthatunderthelattertwomodels,thereserverequirement(ifitexists;aswehave seen, it does not in all cases) is an unimportant element in money creation; it is merely one of many factors thatinfluencebankliquidity,asdetailedearlier.

Banks are supposed to provide loans to creditworthy customers and for projects that are viable. Central banks have all the tools to curb excessive money growth. The system is an elegant one, because money is always available, liberating economiesfromthestiflinglackofmoney(goldcoinsandbullion)inearliertimes,butthereismuchevidencethatthe authorities are not being responsible enough. The consequences are painful. Is a new implementation model required, one that takes due account of the elasticity of the economy? A model in terms of which bank borrowing by the governments of poor countries for developmental projects can take place to the extent that the borrowings create revenue to cover the borrowing interest rate, assuming that the domestic economy can produce the goods (for development) demanded?

5.4 Path of Monetary Policy: From Interest to InflationVisits to central banks’ websites will reveal that all of them have an objective of monetary policy and it is that inflationshouldbesubdued.Therationaleunderlyingthisobjectiveisthatalowinflationenvironmentisconducivetosustainableeconomicgrowth.Highinflationcanbedestructiveforeconomicgrowthbecausetheattentionoftheconsumerandbusinessisdirectedatsafeguarding/hedgingwealthasopposedtoefficiencyinproduction.Inflationfeedsuponitselfanditisdifficultindeedtogetridof.

Togivesubstancetotheobjective,mostofthedevelopedcountriesoftheworldhaveinflationtargetsinplace,andtheyareeithersetat2%paorhavearangeof2–3%pa(orhaveaflexibletargetasinthecaseoftheUS).Thetarget is generally set by government and executed by the CB, which is in most cases operationally independent of government. This separation from government is generally accepted as crucial because the CB may need to take monetarypolicyactionsthatarecounter-veilingtogovernmentfinancial(andother)activities.AcountrywhoseCBis not operationally independent of government is not taken to be part of the big league.

Inflationof2–3%isconsideredacceptablebecauseatthisleveleconomicgrowthandwealthcreationprospectsareoptimal. At higher and lower levels, the destructive effects of safeguarding/hedging wealth enter the equation. The principalcauseofunacceptablyhighinflationistotaldemandoutstrippingthecapacityoftheeconomytodeliver(total supply). Underlying the growth in demand and supply is the capacity of the banking system to create money. Themaincauseofdeflationisstagnantornegativemoneycreation.

Giving rise to money creation is the demand for loans by government, businesses and individuals, and underlying growth in the demand for loans is the banks’ lending rate (PR and related). The corporate and household sectors are particularly interest rate sensitive. The lending rate of the banks is determined almost exactly by the CB through


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the operational tools it has at its disposal, the reserve requirement (in most cases), open market operations to influencebankliquidity,andtherate/ssetbytheCBfortheirloanstobanks(BR)(KIR-L)orforexcessreserves(ER) (KIR-D).

Essentially the above is the path of monetary policy in reverse. We now present a brief description of the so-called Monetary Policy Transmission Mechanism (MPTM) which starts with the central bank’s rates and ends with the inflationrate.Anothervisittocentralbanks’websiteswillrevealthatmanyofthemhaveillustrationsoftheirviewoftheMPTM,i.e.,thepathfromCBratestopricedevelopments(inflationorthedreadeddeflation).Fig.5.5isanamalgamation of some of them.

BeforewebeginwithanelucidationoftheMPTM,weneedtounderscorethesignificantrealitythatthetransmissionofachangeinmonetarypolicycantakebetweenoneandtwoyearstoinfluencepricedevelopments.Therefore,monetary policy needs to be anticipatory in nature; for this reason central banks make use of extremely sophisticated econometric modelling, which is constantly under revision.

Bank money creation

Domesticinflationary

pressure

Domesticdemand

C + I

Net externaldemandX - M

Pricedevelopments=Inflation/deflation

Importprices

Totaldemand

Totalsupply

Private bankrates

Other assetprices

OMO / bankliquidity

Expectations / politicalmilieu,

etc

Centralbankrates

Exchangerates

Fig. 5.5 Monetary Policy Transmission Mechanism (MPTM)(Source: http://bookboon.com/en/central-banking-monetary-policy-an-introduction-ebook)

ThegenesisofinterestratesistheadministrativelydeterminedratesoftheCB.Somecentralbankshaveone‘official’rate,aKIR-L,whichisappliedtoaliquidityshortageandsomehavetwo‘official’rates,theaforementionedanda deposit rate for bank surpluses, KIR-D. Both models impact directly on the b2b IBM rate, which in turn impact significantlyonthecallmoneyratesofthebanks(especiallytherateonwholesaleone-daydeposits).Allotherdeposit rates of the banks are affected by this rate.

Thebanks,intheirendeavourstomaximiseprofitsforshareholders,attempttomaintainafixedmarginbetweenthecostofdeposits/loansandearningsonassets.Therefore,achangeintheofficialratesimpactssignificantlyonbanklendingrates.ThehighprofileloansextensionrateofthebanksisPrimeRate(PR);alllendingratesofthebanksfor NMD are benchmarked on PR. The rates on Marketable Debt [(MD), such as treasury bills and commercial paper]arealsosignificantlyinfluenced.Ingeneral,changesinthecentralbanks’KIRsarematchedbyachangeinbank lending rates.

Bank lending rates are a major input in decisions to borrow. Individuals borrow from the banks and consume in anticipation of future income. Companies borrow for the purpose of expansion (on inventories and expansion to business infrastructure). The banking sector accommodates the demand for loans and creates money (deposits), provided individuals are creditworthy (employed and able to service the debt) and companies are borrowing for newprojectsonwhichthefuturecashflows/returns(FVs)exceedthecostofborrowing.Ariseinrateswillrendermore individuals un-creditworthy and more projects unviable, reducing the growth rate in bank loans, while a fall in rates will do the opposite. Borrowing/money creation is a major factor in changes in domestic demand.

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Not every individual and company borrows from the banking sector. A large number of the public are lenders/savers, and interest rates to them are just as important as for borrowers. A lower interest rate makes saving less attractive and spending more attractive. The converse also applies.

Achangeintheofficialrateshasanimmediateimpactalsoonotherassetprices.Whatarethese?Thesearetheprices of assets other than bank asset prices, and they are bonds, equities (shares), property, and commodities. With theexceptionofcommodities,theassetsmentioned(bonds,sharesandproperty)allhavecashflowsinthefuture.You will recall that to value them, their Future Cash Flows are discounted by certain relevant interest rates. Thus whenratesriseassetvaluesfall,andviceversa.Commoditiesdon’thavecashflowsinthefuture,buthigherratesmakethemlessattractiveandviceversa.Asindividualsandcompaniesaretheownersoftheassetsofthefinancialsystem (directly or indirectly via the banks and investment vehicles) asset values have a major impact on domestic demand.

Changesinthecentralbank’sofficialratesalsoimpactontheexpectationsandtheconfidencelevelsofcompaniesand individuals, which have an impact on domestic demand. They also impact the foreign sector and therefore the exchangerate.Theexchangerateimpactssignificantlynetexternaldemandandimportprices.Changesindomesticdemand have an impact on employment. If there is pressure on the supply of skills, there is pressure on wages, which in turn impacts consumer prices.

As seen, all of the above are significant factors in domestic demand, and the banking systemassists demandthrough the provision of loans [loans satisfaction is the counterpart of new bank deposits (money)]. The ability of the economy to supply new goods and services to satisfy increased demand is a critical factor. The wider the gap between aggregate (total) demand and aggregate supply is the foremost factor in price developments. The change in the prices of imported goods, to a large degree a function of the exchange rate, is the other important factor, but this depends on the size of net external demand relative to domestic demand.

The circle is completed when one considers that price developments in turn impact on monetary policy decisions. In 2007–08, we saw the ugly side of the monetary system. Money creation was excessive (prior to this period) and wesawinflationrisingworldwide,asreflectedinrisinginternationalcommodityprices,suchasoil,food,steelandso on.

As you know, it was to a large extent (in the US) based on bank lending to un-creditworthy (non-prime) borrowers. This was a failure not only of the position of trust that banks occupy, given their ability to create money, because we the public generally accept bank deposits as our main means of payments, but also of the failure of some of the allied participants in the monetary system, the central banks in their ineffectual conduct of monetary policy, the bank regulators who did not supervise the banks effectively, and some of the large loan rating agencies which were blinded by the revenues emanating from rating the debt of Special Purpose Vehicles/Entities (SPVs/SPEs) and forgot aboutthesignificantconflictofintereststheyhad.Obviously,thisdidnotapplytoallcountries.


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SummaryThere are three models of monetary policy.•In real life, the causation path of money creation runs from bank loans (bank asset) to money (bank liability).•Without the CB supplying BR, the banking system comes to a halt in terms of new loans, and therefore money •creation.Once the banks have no excess reserves, they cannot make new loans.•In practice, the pattern of Government and Bank operations usually results in a shortage of cash in the market •each day.In March 2009, the Monetary Policy Committee announced that, in addition to setting Bank Rate at 0.5%, it •wouldstarttoinjectmoneydirectlyintotheeconomyinordertomeettheinflationtarget.DeflationhasamajornegativeimpactonGDE,becauseinvestorsinassetsareworseoff.•Monetary policy decisions involve setting the interest rate on overnight loans in the money market.•TheIBRmodelisavariationofthefirm-BRmodel.•The IBR model is, where a number of central banks position themselves in terms of monetary policy.•Money is created by bank loans to the government and the NBPS and that bank purchases of forex also create •money.TheIBRmodelissimilartothefirm-BRmodel,butfocusesonthebanks’interbankrateandinfluencesitin•conditions of both bank liquidity surpluses and bank liquidity shortages.Therationaleunderlyingthisobjectiveisthatalowinflationenvironmentisconducivetosustainableeconomic•growth.Highinflationcanbedestructiveforeconomicgrowth,becausetheattentionoftheconsumerandbusinessis•directedatsafeguarding/hedgingwealthasopposedtoefficiencyinproduction.At higher and lower levels, the destructive effects of safeguarding/hedging wealth enter the equation.•Themaincauseofdeflationisstagnantornegativemoneycreation.•Thebanks,intheirendeavourstomaximiseprofitsforshareholders,attempttomaintainafixedmarginbetween•the cost of deposits/loans and earnings on assets.Bank lending rates are a major input in decisions to borrow.•

ReferencesModelling monetary policy in developing countries. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:nyXs5sOwpZsJ:www.pftac.org/filemanager/files/Macro2/workshop/2.pdf+&cd=8&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].TheEffectivenessofMonetaryPolicyTransmissionunderCapitalInflows:EvidencefromAsia.[• Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:xJ8W6U1O28cJ:https://www.imf.org/external/pubs/ft/wp/2012/wp12265.pdf+&cd=5&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Angeloni, I ., Kashyap, A.K. and Mojon, B., 2003. • Monetary Policy Transmission in the Euro Area: A Study by the Eurosystem Monetary Transmission Network. Cambridge University Press.Tsangarides, C. G., 2 0 1 0 . • Monetary Policy Transmission in Mauritius Using a Var Analysis. International Monetary Fund.Ch25: Transmission Mechanisms of Monetary Policy. • [Video online] Available at: <https://www.youtube.com/watch?v=MlMab_uM_d8> [Accessed 06 June 2014].Monetary Policy Tools and Techniques (Unit 5, Lecture 4). • [Video online] Available at: <https://www.youtube.com/watch?v=cgLkRnmoyOQ> [Accessed 06 June 2014].

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Recommended ReadingKuijs, L., 2002. • MonetaryPolicyTransmissionMechanismsandInflationinSlovakia. International Monetary Fund.Ciccarelli, M. and Rebucci, A., 2002. • The Transmission Mechanism of European Monetary Policy: Is There Heterogeneity? Is it Changing over Time? (EPub). International Monetary Fund.Dunn, J. C., Yiqun, W., Davies, M., Yang, Y. and Shengzu, W., 2011. • Monetary Policy Transmission Mechanisms inPacificIslandCountries. International Monetary Fund.


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Self AssessmentThere are _______ models of monetary policy.1.

threea. fiveb. twoc. sixd.

In which model, does the CB ensure that the banks are indebted to it (the CB) at all times, but whether the banks 2. have a reserve requirement or not as immaterial?

Thefirm-RRmodela. Thefirm-BRmodelb. The IBR modelc. Thefirm-PRmodeld.


1.Thefirm-RRmodel A. They have all the tools to curb excessive money growth.

2.Thefirm-BRmodel B. In this model, the CB ensures that the banks are indebted to it (the CB) at all times.

3. The IBR model C. Here, we assume that N&C do not rank as reserves.

4. Central banks D. It is a model, where a number of central banks position themselves in terms of monetary policy.

1-B, 2-C, 3-A, 4-Da. 1-A, 2-D, 3-C, 4-Bb. 1-C, 2-B, 3-D, 4-Ac. 1-D, 2-A, 3-B, 4-Cd.

Whichofthefollowingisavariationofthefirm-BRmodel?4. The IBR modela. Thefirm-BRmodelb. Thefirm-RRmodelc. Thefirm-PRmodeld.

Which of the following statement is true?5. Monetary policy has all the tools to curb excessive money growth.a. Central banks have all the tools to curb excessive money growth.b. Central banks have no tools to curb excessive money growth.c. Monetary policy has no tools to curb excessive money growth.d.

Changes in domestic demand have an impact on____________.6. banksa. external demandb. employmentc. exchange rated.

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Whichisapolicyonmoneycreationandspecificallyonthegrowthrateinmoneycreation?7. The BR policya. The RR policyb. The bank policyc. The monetary policyd.

Which of the following statement is false?8. Inflationfeedsuponitselfanditisdifficultindeedtogetridof.a. Highinflationcanbedestructiveforeconomicgrowth.b. A country whose CB is operationally independent of government is not taken to be part of the big league.c. Themaincauseofdeflationisstagnantornegativemoneycreation.d.

The corporate and household sectors are particularly interest rate___________.9. pronea. negativeb. positivec. sensitived.

Bank lending rates are a _______input in decisions to borrow.10. majora. minorb. unimportantc. triviald.


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Chapter VI

Financial Regulation and Supervision in Central Bank

Aim


introducefinancialregulationandsupervision•

explain regulatory and supervisory functions•

explicate commercial banks•

Objectives


explain prudential norms•

elucidate foreign banks•

explicatefinancialinstitutions•

Learning outcome


identifyruralfinancinginstitutions•

understand urban cooperative banks•

recognisenon-bankingfinancialcompanies•

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6.1 IntroductionThe Reserve Bank’s regulatory and supervisory domain extends not only to the Indian banking system, but also to thedevelopmentfinancialinstitutions(DFIs),primarydealers,Non-BankingFinancialCompanies(NBFCs),creditinformationcompaniesandselectsegmentsofthefinancialmarkets.Inrespectofbanks,theReserveBankderivesitspowers from the provisions of the Banking Regulation Act, 1949, while the other entities and markets are regulated and supervised under the provisions of the Reserve Bank of India Act, 1934. The credit information companies are regulated under the provisions of Credit Information Companies (Regulation) Act, 2005.

As the regulator and the supervisor of the banking system, the Reserve Bank has an important role to play in ensuring the system’s safety and soundness on an ongoing basis. The aim of this function is to protect the interest of depositors through an effective prudential regulatory framework for orderly development and conduct of banking operations, andtomaintainoverallfinancialstabilitythroughvariouspolicymeasures.

India’sfinancialsystemincludescommercialbanks,localareabanks,regionalruralbanks,cooperativebanks,financialinstitutionsandnon-bankingfinancialcompanies.ThebankingsectorreformsmadestabilityinthefinancialsectoranimportantplankoftheReserveBank’sfunctions.Besides,theglobalfinancialmarketshave,inthelast75years,grown phenomenally in terms of volumes, number of players and instruments. The Reserve Bank’s regulatory and supervisory role has, therefore, acquired added importance. The Board for Financial Supervision (BFS), constituted in November 1994, is the principal guiding force behind the Reserve Bank’s regulatory and supervisory initiatives.

There are various departments in the Reserve Bank that perform these regulatory and supervisory functions. The Department of Banking Operations and Development (DBOD) frames regulations for commercial banks. The Department of Banking Supervision (DBS) undertakes supervision of commercial banks, including the local area banks and all-Indiafinancial institutions.TheDepartment ofNon-BankingSupervision (DNBS) regulates andsupervises the Non-Banking Financial Companies (NBFCs), while the Urban Banks Department (UBD) regulates and supervises the Urban Cooperative Banks (UCBs). Rural Planning and Credit Department (RPCD) regulates the Regional Rural Banks (RRBs) and the Rural Cooperative Banks, whereas their supervision has been entrusted to NABARD.

6.2 Regulatory and Supervisory FunctionsTraditionally, the Reserve Bank’s regulatory and supervisory policy initiatives are aimed at the protection of the depositors’ interests, orderly development and conduct of banking operations, and liquidity and solvency of banks. With the onset of banking sector reforms during the 1990s, various prudential measures were initiated that have, ineffect,strengthenedtheIndianbankingsystemoveraperiodoftime.Improvedfinancialsoundnessofbankshashelpedthemtoshowstabilityandresilienceinthefaceoftherecentsevereglobalfinancialcrisis,whichhadseriouslyimpactedseveralbanksandfinancialinstitutionsinadvancedcountries.However,thereisstillaneedtostrengthen the regulatory and supervisory architecture. The Reserve Bank represents India in various international forums, such as, the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB). Its presence on such bodies has enabled the Reserve Bank’s active participation in the process of evolving global standards for enhanced regulation and supervision of banks.

6.3 Commercial BanksThe regulatory functions of the Reserve Bank with respect to commercial banks are discussed below.

6.3.1 LicensingA licence from the Reserve Bank is required for commencing banking operations in India, whether by an Indian or a foreign bank. The opening of new branches by banks and change in the location of existing branches are also regulatedaspertheBranchAuthorisationPolicy.ThispolicyhasrecentlybeenliberalisedsignificantlyandIndianbanks no longer require a licence from the Reserve Bank for opening a branch at a place with population of below 50,000. The Reserve Bank continues to emphasise opening of branches by banks in unbanked and under-banked areas of the country. The Reserve Bank also regulates merger, amalgamation and winding up of banks.


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6.3.2 Corporate GovernanceEnsuring high-quality corporate governance in banks is an objective of the Reserve Bank’s policy. It has issued guidelinesstipulating‘fitandproper’criteriafordirectorsofbanks.Intermsoftheguidelines,amajorityofthedirectors of banks are required to have special knowledge or practical experience in various relevant areas. The Reserve Bank also has powers to appoint additional directors on the board of a banking company.

6.3.3 Statutory Pre-emptionsCommercial banks are required to maintain a certain portion of their Net Demand and Time Liabilities (NDTL) in the form of cash with the Reserve Bank, called Cash Reserve Ratio (CRR) and in the form of investment in unencumbered approved securities, called Statutory Liquidity Ratio (SLR). The Reserve Bank also monitors compliance with these requirements by banks in their day-to-day operations.

6.3.4 Interest RateThe interest rates on most of the categories of deposits and lending transactions have been deregulated and are largely determined by banks. However, the Reserve Bank regulates the interest rates on savings bank accounts and deposits of Non-Resident Indians (NRI), small loans up to rupees two lakh, export credits and a few other categories of advances.

6.4 Prudential NormsThe Reserve Bank has prescribed prudential norms to be followed by banks in several areas of their operations. It keepsaclosewatchondevelopingtrendsinthefinancialmarkets,andfine-tunestheprudentialpolicies.Inorderto strengthen the balance sheets of banks, the Reserve Bank has been prescribing appropriate prudential norms for theminregardtoincomerecognition,assetclassificationandprovisioning,capitaladequacy,investmentsportfolioand capital market exposures, to name a few. A brief description of these norms is furnished below.

Capital adequacyThe Reserve Bank has instructed banks to maintain adequate capital on a continuous basis. The adequacy of capital is measured in terms of Capital to Risk-Weighted Assets Ratio (CRAR). Under the recently revised framework, banks are required to maintain adequate capital for credit risk, market risk, operational risk and other risks. Basel II standardised approach is applicable with road map drawn up for advanced approaches.

Loans and advancesIn order to maintain the quality of their loans and advances, the Reserve Bank requires banks to classify their loan assets as performing and Non-Performing Assets (NPA), primarily based on the record of recovery from the borrowers. NPAs are further categorised into Sub-standard, Doubtful and Loss Assets depending upon age of the NPAs and value of available securities. Banks are also required to make appropriate provisions against each category of NPAs. Banks are also required to have exposure limits in place to prevent credit concentration risk and limit exposures to sensitive sectors, such as, capital markets and real estate.

For investmentsThe Reserve Bank requires banks to classify their investment portfolios into three categories for the purpose of valuation, Held to Maturity (HTM), Available for Sale (AFS) and Held for Trading (HFT). The securities held under HFT and AFS categories have to be marked-to-market periodically and depreciation, if any, needs appropriate provisions by banks. Securities under HTM category must be carried at acquisition/amortised cost, subject to certain conditions.

6.4.1 Risk ManagementBanks in their daily business face various kinds of risks. The Reserve Bank requires banks to have effective risk management systems to cover credit risk, market risk, operational risk and other risks. It has issued guidelines, based on the Basel II capital adequacy framework, on how to measure these risks as well as how to manage them.

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6.4.2 Disclosure NormsPublic disclosure of relevant information is an important tool for enforcing market discipline. Hence, over the years, the Reserve Bank has strengthened the disclosure norms for banks. Banks are now required to make disclosures in their annual report, among others, about capital adequacy, asset quality, liquidity, earnings aspects and penalties, if any, imposed on them by the regulator.

6.4.3 Know Your Customer NormsTo prevent money laundering through the banking system, the Reserve Bank has issued ‘Know Your Customer’ (KYC), Anti-Money Laundering (AML) and Combating Financing of Terrorism (CFT) guidelines. Banks are required to carry out KYC exercise for all their customers to establish their identity and report suspicious transactions to authorities.

6.4.4 Protection of Small DepositorsThe Reserve Bank has set up Deposit Insurance and Credit Guarantee Corporation (DICGC) to protect the interest of small depositors, in case of bank failure. The DICGC provides insurance cover to all eligible bank depositors up to Rs.1 lakh per depositor per bank.

6.4.5 Para Banking ActivitiesThe banking sector reforms and the gradual deregulation of the sector inspired many banks to undertake non-traditional banking activities, also known as para banking. The Reserve Bank has permitted banks to undertake diversifiedactivities, suchas assetmanagement,mutual fundsbusiness, insurancebusiness,merchantbankingactivities, factoring services, venture capital, card business, equity participation in venture funds, and leasing.

6.4.6 Supervisory FunctionsThe Reserve Bank undertakes supervision of banks to monitor and ensure compliance by them with its regulatory policy framework. This is achieved through on-site inspection, off-site surveillance and periodic meetings with top management of banks.

6.4.7 On-site InspectionTheReserveBankundertakesannualon-siteinspectionofbankstoassesstheirfinancialhealthandtoevaluatetheir performance in terms of quality of management, capital adequacy, asset quality, earnings, liquidity position aswellasinternalcontrolsystems.Basedonthefindingsoftheinspection,banksareassignedsupervisoryratingsbased on the CAMELS (CALCS for foreign banks in India) supervisory model and are required to address the weaknessesidentified.

6.4.8 Off-site SurveillanceThe Reserve Bank requires banks to submit detailed and structured information periodically under its Off Site Surveillance and Monitoring System (OSMOS). This information is thoroughly analysed by the RBI to assess the health of individual banks and that of the banking system, and also glean early warning signals which could serve as a trigger for necessary supervisory intervention.

6.4.9 Periodic MeetingsTheReserveBankperiodicallymeetsthetopmanagementofbankstodiscussthefindingsofitsinspections.Inaddition, it also has quarterly/monthly discussions with them on important aspects based on OSMOS returns and other inputs.

6.4.10 Monitoring of FraudsThe Reserve Bank regularly sensitises banks about common fraud-prone areas, the modus operandi and the measures necessary to prevent frauds. It also cautions banks about unscrupulous borrowers, who have perpetrated frauds with other banks.


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6.5 Foreign BanksIn February 2005, the Government of India and the Reserve Bank released the ‘Roadmap for presence of Foreign BanksinIndia’layingoutatwo-trackandgradualistapproachaimedatincreasingtheefficiencyandstabilityofthe banking sector in India. One track was the consolidation of the domestic banking system, both in private and public sectors, and the second track was the gradual enhancement of the presence of foreign banks in a synchronised manner.Theroadmapwasdividedintotwophases,thefirstphasespanningtheperiodMarch2005-March2009,andthesecondphasebeginningApril2009afterareviewoftheexperiencegainedinthefirstphase.

Inviewoftherecentglobalfinancialmarketturmoil,thereareuncertaintiessurroundingthefinancialstrengthofbanks around the world. Further, the regulatory and supervisory policies at national and international levels are under review. In view of this, the current policy and procedures governing the presence of foreign banks in India will continue. The proposed review will be taken up after consultation with the stakeholders once there is greater clarityregardingstability,recoveryoftheglobalfinancialsystemandasharedunderstandingontheregulatoryandsupervisory architecture around the world.

6.6 Financial InstitutionsFinancialinstitutionsareanimportantpartoftheIndianfinancialsystemastheyprovidemediumtolong-termfinanceto different sectors of the economy. These institutions have been set up to meet the growing demands of particular segments, such as export, rural, housing and small industries. These institutions have been playing a crucial role in channelising credit to the above sectors and addressing the challenges/issues faced by them.

Therearefourfinancialinstitutions,suchasEximBank,NationalBankforAgricultureandRuralDevelopment(NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI) which are underfull-fledgedregulationandsupervisionoftheReserveBank.Asinthecaseofcommercialbanks,prudentialnormsrelatingtoincomerecognition,assetclassificationandprovisioning,andcapitaladequacyratioareapplicabletothesefinancialinstitutionsaswell.Theseinstitutionsalsoaresubjecttoon-siteinspectionaswellasoff-sitesurveillance.

6.7 Rural Financing InstitutionsRuralfinancinginstitutionsarediscussedintheparagraphsgivenbelow.

6.7.1 Rural Cooperative BanksRuralcooperativesoccupyanimportantpositionintheIndianfinancialsystem.ThesewerethefirstformalinstitutionsestablishedtopurveycredittoruralIndia.Cooperativeshavebeenakeyinstrumentoffinancialinclusioninreachingout to the last mile in rural areas. Cooperative banks are registered under the respective State Co-operative Societies Act or Multi State Cooperative Societies Act, 2002 and governed by the provisions of the respective acts. The legal character, ownership, management, clientele and the role of state governments in the functioning of the cooperative banks make these institutions distinctively different from commercial banks. The distinctive feature of the cooperative credit structure in India is its heterogeneity.

Structure of rural cooperative credit institutionsRural cooperatives structure is bifurcated into short-term and long-term structure. The short-term cooperative structure is a three-tier structure with State Cooperative Banks (StCBs) at the apex (State) level, District Central Cooperative Banks (DCCBs) at the intermediate (district) level and Primary Agricultural Credit Societies (PACS) at the ground (village) level. The short-term structure caters primarily to the various short/medium-term production and marketing credit needs for agriculture.

The long-term cooperative structure has the State Cooperative Agriculture and Rural Development Banks (SCARDBs) at the apex-level and the Primary Cooperative Agriculture and Rural Development Banks (PCARDBs) at the district or block level. These institutions were conceived with the objective of meeting long-term credit needs in agriculture. As on end-March 2008, there were 95,352 Short-term Rural Cooperative Credit Institutions (STCCIs). This included 31 StCBs, 371 DCCBs and 94,950 PACS. There were 717 Long Term Rural Cooperative Credit Institutions (LTCCIs) comprising 20 SCARDBs and 697 PCARDBs.

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Regulatory and supervisory frameworkWhile regulation of State Cooperative Banks and District Central Cooperative Banks vests with Reserve Bank, their supervision is carried out by National Bank for Agriculture and Rural Development (NABARD). The Board of Supervision, a Committee of the Board of Directors of NABARD, gives directions and guidance in respect of policies and matters relating to supervision and inspection of StCBs and DCCBs. A large number of StCBs as well as DCCBs are unlicensed and are allowed to function as banks till they are either granted licence or their applications for licence are rejected. The Committee on Financial Sector Assessment (Chairman: Dr. Rakesh Mohan and Co-Chairman: Shri Ashok Chawla) had observed that there is a need for a roadmap to ensure that only licensed banks operate in the cooperative space and that banks which fail to obtain a licence by 2012 should not be allowed to operate to expedite the process of consolidation and weeding out of non-viable entities from the cooperative space. A roadmap has been put in place to achieve this position.

Capital adequacy normsThe CRAR norms are not applicable to StCBs and DCCBs at present. However, since March 31, 2008, they are required to disclose the level of CRAR in the ‘notes on accounts’ to their balance sheets every year. The income recognition,assetclassificationandprovisioningnormsareapplicableasinthecaseofcommercialbanks.

6.7.2 Regional Rural BanksRegional Rural Banks were set up under the Regional Rural Banks Act, 1976 with a view to developing the rural economy by providing credit and other facilities, particularly to the small and marginal farmers, agricultural labourers, artisans and small entrepreneurs. Being local-level institutions, RRBs together with commercial and co-operative banks were assigned a critical role to play in the delivery of agriculture and rural credit.

The equity of the RRBs was contributed by the Central Government, concerned State Government and the sponsor bank in the proportion of 50:15:35. As of March 31, 2009, there were 86 RRBs having a total of 15,107 branches. ThefunctionoffinancialregulationoverRRBsisexercisedbyReserveBankandthesupervisorypowershavebeen vested with NABARD. CRAR norms are not applicable to RRBs. However, the income recognition, asset-classificationandprovisioningnormsasapplicabletocommercialbanksareapplicabletoRRBs.

6.8 Urban Cooperative BanksUrban co-operative banks play an important role in providing banking services to the middle and lower income groups of society in urban and semi-urban areas. The primary (urban) co-operative banks (UCBs), like other co-operative societies, are registered under the respective State Co-operative Societies Act or Multi State Cooperative Societies Act, 2002 and governed by the provisions of the respective acts.

With a view to bringing primary (urban) co-operative banks under the purview of the Banking Regulation Act, 1949, certain provisions of the Banking Regulation Act, 1949 were made applicable to co-operative banks effective March 1, 1966. With this, these banks came under the dual control of respective State Governments/Central Government and the Reserve Bank. While the non-banking aspects like registration, management, administration and recruitment, amalgamation and liquidation are regulated by the State/Central Governments, matters related to banking are regulated and supervised by the Reserve Bank under the Banking Regulation Act, 1949 (as applicable to co-operative societies).

As of March 31, 2009, there were 1721 primary (urban) co-operative banks including 53 scheduled banks. The UCBs are largely concentrated in a few States, such as, Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu. Apart from a few large banks, most of the UCBs are often functioning as a unit bank.


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6.8.1 Regulatory FrameworkRegulatory frameworks are discussed in the paragraphs given below.

LicensingUCBs have to obtain a licence from the Reserve Bank for doing banking business. The unlicensed primary (urban) co-operative banks can continue to carry on banking business till they are refused a licence. Further, UCBs also have to obtain prior authorisation of the Reserve Bank to open a new place of business.

Prudential normsPrudentialnormsrelatingtoincomerecognition,assetclassification,provisioning,andcapitaladequacyratioareapplicable to urban co-operative banks as well.

6.8.2 Supervisory FrameworkTo ensure that primary (urban) co-operative banks function on sound lines and their methods of operation are consistent with statutory provisions and are not detrimental to the interests of depositors, they are subject to the following:

On-site inspection •Off-site surveillance•

On-site inspectionThe principal objective of inspection of primary (urban) co-operative banks is to safeguard the interests of depositors and to build and maintain a sound banking system in conformity with the banking laws and regulations. While all scheduled urban co-operative banks and select non-scheduled urban co-operative banks are inspected on an annual basis, other non-scheduled UCBs are inspected once in two years. The banks are graded into four categories based onfourparameters,viz.,CRAR,netNPA,profitabilityandcompliancewithCRR/SLRstipulations.

Off-site surveillanceIn order to have continuous supervision over the UCBs, the Reserve Bank has supplemented the system of periodic on-site inspection with off-site surveillance (OSS) through a set of periodical prudential returns to be submitted by UCBs.

6.9 Non-Banking Financial Companies (NBFCs)Non-bankingFinancialCompaniesplayanimportantroleinthefinancialsystem.AnNBFCisdefinedasacompanyengaged in the business of lending, investment in shares and securities, hire purchase, chit fund, insurance or collection of monies. Depending upon the line of activity, NBFCs are categorised into different types. Recognising the growth in the sector, initially the regulatory set-up primarily focused on the deposit taking activity in terms of limits and interest rate.

The recommendations of the Joint Parliamentary Committee which looked into the stock market scam of early 90s and the Shah Committee (1992) suggested that there was a need to expand the regulatory and supervisory focus also to the asset side of NBFCs’ balance sheet. Legislative amendments were adopted to empower the Reserve Bank to regulate Non-Banking Financial Companies to ensure that they integrate their functioning within the Indian financialsystem.

The amended Act provides that for commencing/carrying on the business of Non-Banking Financial Institution (NBFI), a company has to have a minimum level of Net Owned Funds (NoF). At end- June 2009, there were 12,740 NBFCs.Outofthese,336havebeenpermittedtoacceptdepositsandareclassifiedasNBFC-D.Thenon-deposittakingcompaniesareclassifiedasNBFC-ND.

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6.9.1 Regulatory FrameworkRegulatory framework is listed in the paragraphs given below.

NBFCs accepting Public depositsThe Reserve Bank issues directions about the quantum of public deposits that can be accepted, the period of deposits, which should not be less than 12 months and should not exceed 60 months, the maximum rate of interest payable on such deposits (presently 12.5 per cent), brokerage fees and other expenses amounting to a maximum of 2 per cent and 0.5 per cent of the deposits, respectively, and the contents of the application forms, as well as the advertisement for soliciting deposits.

Companies which accept public deposits are required to comply with all the prudential norms on income recognition, assetclassification,accountingstandards,provisioningforbadanddoubtfuldebts,capitaladequacy,credit,andinvestment concentration. Additional disclosures in balance sheets have also been prescribed. In order to restrict indiscriminate investment by Non-Banking Financial Companies in real estate and in unquoted shares, they have been directed to limit their investment in real estate, except for their own use, up to 10 per cent of their owned funds. Further, a ceiling of 20 per cent has also been prescribed for investment in unquoted shares of other than group/subsidiary companies.

In case an NBFC defaults in the payment of matured deposits, the depositors can lodge their claims against the Company with the Company Law Board (CLB). NBFCs also have to maintain SLR (15 per cent) as a percentage of deposits. However, there is no CRR prescription for NBFCs, as they do not accept demand deposits.

NBFCs not accepting public depositsNon-Banking Financial Companies not accepting public deposits are regulated in a limited manner. However, with the opening up of foreign direct investment in NBFCs and the opportunities for credit growth in the economy, the sector has witnessed the entry of some large companies in the category of NBFC-ND. As these companies, unlike the NBFC-D, were earlier not subject to prudential norms for capital adequacy and exposures, their borrowings increased considerably. Unlike banks, the NBFC sector does not have any cap on exposure to the capital market, theseentitieshaveasapartoftheirbusinessbeentakingsignificantexposureonthecapitalmarket.

Inviewof theabove,non-deposit takingNBFCswithasset sizeofRs100croreandabovewereclassifiedassystemically important and were required to comply with exposure and capital adequacy norms . To facilitate off-site supervision, they are also required to provide additional information to the Reserve Bank through monthly and annual returns. Further, to contain the risks of the NBFC sector spilling over to the banking sector, exposure of banks to the NBFC sector, either in the form of credit facilities or in the form of equity contribution has been prudentially capped.

6.9.2 Supervisory FrameworkSupervisory framework is given in the paragraphs given below.

On-site inspectionAllNBFC-DandalllargeNBFC-NDsaresubjectedtoregularannualinspectiontoassesstheirfinancialperformanceand the general compliance with the directions issued by the Reserve Bank. The inspection focuses on Capital, Asset Quality,Management,Earnings,LiquidityandSystems(CAMELSpattern)andidentifiesthesupervisoryconcerns.These are taken up with the respective institutions for remedial action.

Off-site surveillance systemIn order to supplement information between on-site inspections, several returns have been prescribed for NBFCs as part of the off-site surveillance system. The information provided is analysed to identify potential supervisory concerns and in certain cases serves as a trigger for on-site inspection.


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External auditingThe responsibility of ensuring compliance with the directions issued by the Reserve Bank, as well as adherence to the provisions of the RBI Act has also been entrusted to the statutory auditors of the Non-Banking Financial Companies. The statutory auditors are required to report to the Reserve Bank about any irregularity or violation of regulations concerning acceptance of public deposits, credit rating, prudential norms and exposure limits, capital adequacy, maintenance of liquid assets and regularisation of excess deposits held by the companies.

6.10 Primary DealersIn 1995, the Reserve Bank introduced the system of Primary Dealers (PDs) in the Government Securities Market, which comprised independent entities undertaking Primary Dealer activity. PDs play an active role in the Government securities market by underwriting and bidding for fresh issuances and acting as market makers for these securities. In order to broaden the Primary Dealership system, banks were permitted to undertake Primary Dealership business departmentally in 2006-07. Further, the standalone PDs were permitted to diversify into business activities, other than the core PD business, in 2006-07, subject to certain conditions. As on June 30, 2009, there were six standalone PDs and eleven banks authorised to undertake PD business departmentally.

RegulationPDs are required to meet registration and such other requirements as stipulated by the Securities and Exchange Board of India (SEBI) including operations on the Stock Exchanges, if they undertake any activity regulated by SEBI. PDs are expected to join the Primary Dealers Association of India (PDAI) and the Fixed Income Money Market and Derivatives Association (FIMMDA) and abide by the code of conduct and such other actions as initiated by these Associations in the interest of the securities markets. Any change in the shareholding pattern/capital structure of a PD needs prior approval of the Reserve Bank. The Reserve Bank reserves the right to cancel the Primary Dealership if, in its view, the concerned institution has failed to adhere to the terms of authorisation or any other applicable guideline. A Primary Dealer should bring to the Reserve Bank’s attention any major complaint against it or action initiated/taken against it by the Stock Exchanges, SEBI, CBI, Enforcement Directorate, Income Tax, or any other authority.

SupervisionSupervisionisclassifiedintothefollowingtwotypes:

Off-site supervision: PDs are required to submit to the Reserve Bank, periodic returns which are analysed to •identify any concerns.On-site inspection: The Reserve Bank has the right to inspect the books, records, documents and accounts of •thePD.PDsarerequiredtomakeavailableallsuchdocumentsandrecordstotheReserveBankofficersandrender all necessary assistance as and when required.

6.11 Credit Information CompaniesCredit Information Companies (CIC) play an important role in facilitating credit to various borrowers on the basis of their track record. Credit Information Companies (Regulation) Act 2005 empowers the Reserve Bank to regulate CICs. The Reserve Bank announced in November 2008 that Foreign Direct Investment up to 49 per cent in CICs would be considered in the following cases:

Where the investor was a company with an established track record of running a credit information bureau in •a well-regulated environment. No shareholder in the investor company held more than 10 per cent voting rights in that company.•Preferably, the company was a listed company on a recognised stock exchange. The Reserve Bank, in April •2009, issued ‘in-principle approval’ to four companies to set up CICs.

6.12 Financial MarketsDeepandefficientfinancialmarketsareessentialforrealisingthegrowthpotentialofaneconomy;however,disorderlyfinancialmarketscouldbeasourceofrisktobothfinancialinstitutionsandtheeconomy.TheReserveBankregulatesonlycertainsegmentsoffinancialmarkets,namelythemoneymarket,thegovernmentsecuritiesmarketandtheforeign exchange market. Various measures have been taken to deepen these markets over a period of time.

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SummaryThe Reserve Bank’s regulatory and supervisory domain extends not only to the Indian banking system, but also •to the Development Financial Institutions (DFIs), primary dealers, Non-Banking Financial Companies (NBFCs), creditinformationcompaniesandselectsegmentsofthefinancialmarkets.The credit information companies are regulated under the provisions of Credit Information Companies •(Regulation) Act, 2005.As the regulator and the supervisor of the banking system, the Reserve Bank has an important role to play in •ensuring the system’s safety and soundness on an ongoing basis.India’sfinancialsystemincludescommercialbanks,localareabanks,regionalruralbanks,cooperativebanks,•financialinstitutionsandnon-bankingfinancialcompanies.The Reserve Bank represents India in various international forums, such as the Basel Committee on Banking •Supervision (BCBS) and the Financial Stability Board (FSB).A licence from the Reserve Bank is required for commencing banking operations in India, whether by an Indian •or a foreign bank.To ensure high-quality corporate governance in banks is the objective of the Reserve Bank’s policy.•The banking sector reforms and the gradual deregulation of the sector inspired many banks to undertake non-•traditional banking activities, also known as para-banking.The Reserve Bank requires banks to submit detailed and structured information periodically under its Off Site •Surveillance and Monitoring System (OSMOS).RuralcooperativesoccupyanimportantpositionintheIndianfinancialsystem.•Urban co-operative banks play an important role in providing banking services to the middle and lower income •groups of society in urban and semi-urban areas.Credit Information Companies (Regulation) Act 2005 empowers the Reserve Bank to regulate CICs.•TheReserveBankregulatesonlycertainsegmentsoffinancialmarkets,namelythemoneymarket,thegovernment•securities market and the foreign exchange market.

ReferencesFinancial Regulation and Supervision. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:nyXs5sOwpZsJ:www.pftac.org/filemanager/files/Macro2/workshop/2.pdf+&cd=8&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Regulatory and Supervisory Independence and Financial Stability. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:1akAwKSZAiEJ:www.imf.org/external/pubs/ft/wp/2002/wp0246.pdf+&cd=4&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Eijffinger,S .andMasciandaro,B.,2012.• Handbook of Central Banking, Financial Regulation and Supervision: After the Financial Crisis. Edward Elgar Publishing.Mwenda, K . K., 2 0 0 2 . • BankingandMicro-financeRegulationandSupervision. Universal-Publishers.Financial Institutions, Lecture 01. • [Video online] Available at: <https://www.youtube.com/watch?v=btdTkebcwSs > [Accessed 06 June 2014].19. Investment Banks. • [Video online] Available at: <https://www.youtube.com/watch?v=2yycGEFCNYE > [Accessed 06 June 2014].

Recommended ReadingDownes, P. and Vaez-Zadeh, R., 1991. • Monetary The Evolving Role of Central Banks (EPub). International Monetary Fund.Pellerin, S., 2010. • Consolidation of Financial Regulation. DIANE Publishing.Santomero, A. M., Viotti, S. and Vredin, A ., 2001. • Challenges for Central Banking. Springer.


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Self AssessmentThe credit information companies are regulated under the provisions of _____________.1.

Credit Information Companies (Regulation) Act, 1974a. Credit Information Companies (Regulation) Act, 1989b. Credit Information Companies (Regulation) Act, 2005c. Credit Information Companies (Regulation) Act, 2000d.

Which of the following undertakes supervision of commercial banks, including the local area banks and all-2. Indiafinancialinstitutions?

The Department of Banking Supervision (DBS)a. The Department of Banking Operations and Development (DBOD)b. The Department of Non-Banking Supervision (DNBS)c. The Urban Banks Department (UBD)d.


1. The Department of Banking Operations and Development (DBOD)

A. It regulates and supervises the Non-Banking Financial Companies (NBFCs).

2. The Department of Non-Banking Supervision (DNBS)

B. It regulates the Regional Rural Banks (RRBs) and the Rural Cooperative Banks, whereas their supervision has been entrusted to NABARD.

3. The Urban Banks Department (UBD) C. It frames regulations for commercial banks.

4. Rural Planning and Credit Department (RPCD)

D. It regulates and supervises the Urban Cooperative Banks (UCBs).

1-C, 2-A, 3-D, 4-Ba. 1-D, 2-B, 3-C, 4-Ab. 1-A, 2-C, 3-B, 4-Dc. 1-B, 2-D, 3-A, 4-Cd.

A ___________ from the Reserve Bank is required for commencing banking operations in India, whether by 4. an Indian or a foreign bank.

forma. policyb. approvalc. licenced.

What is the portion of Net Demand and Time Liabilities (NDTL) that is maintained in the form of cash with 5. the Reserve Bank called?

Cash Reserve Ratio (CRR)a. Basel Committee on Banking Supervision (BCBS)b. Financial Stability Board (FSB)c. Capital to Risk-Weighted Assets Ratio (CRAR)d.

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Which of the following statement is true?6. The adequacy of capital is measured in terms of Capital to Risk-Weighted Assets Ratio (CRAR).a. The adequacy of capital is measured in terms of Financial Stability Board (FSB).b. The adequacy of capital is measured in terms of Basel Committee on Banking Supervision (BCBS).c. The adequacy of capital is measured in terms of Cash Reserve Ratio (CRR).d.

___________ disclosure of relevant information is an important tool for enforcing market discipline.7. Privatea. Bankb. Publicc. Nationald.

What are the non-traditional banking activities known as?8. Meta-bankinga. Para-bankingb. On-site-bankingc. Off-site -bankingd.

Which of the following statement is false?9. Therearefourfinancialinstitutions.a. RuralcooperativesoccupyanimportantpositionintheIndianfinancialsystem.b. Rural cooperatives structure is bifurcated into short-term and long-term structure.c. The CRAR norms are applicable to StCBs and DCCBs at present.d.

An/A_____________isdefinedasacompanyengagedinthebusinessoflending,investmentinsharesand10. securities, hire purchase, chit fund, insurance or collection of monies.

NBFCa. CRARb. FSBc. CRRd.


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Chapter VII

Settlement Systems, Policy Research and Credit Creation

Aim


introduce the payment and settlement system•

explain RBI’s three-pronged strategy of development, consolidation and integration•

explicate the legal framework of RBI•

Objectives


enlist the evolution and initiatives of payment and settlement system initiatives•

elucidate the institutional framework of RBI•

explain policy research and data dissemination of RBI•

Learning outcome


identify multiple credit creation by commercial banks•

understand data and research dissemination of RBI•

recognise limitations of credit-creation•

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7.1 IntroductionThe regulation and supervision of payment systems is being increasingly recognised as a core responsibility of central banks.Safeandefficientfunctioningofthesesystemsisanimportantpre-requisitefortheproperfunctioningofthefinancialsystemandtheefficienttransmissionofmonetarypolicy.TheReserveBank,astheregulatoroffinancialsystemshasbeeninitiatingreformsinthepaymentandsettlementsystemstoensureefficientandfasterflowoffundsamongvariousconstituentsofthefinancialsector.Theincreasingmonetisationintheeconomy,thecountry’slargegeographic expanse, people’s preference for paper-based instruments and rapid changes in technology are among factors that make this task a formidable one.

7.2 Development, Consolidation and IntegrationThe Reserve Bank has adopted a three-pronged strategy of consolidation, development and integration to establish amodernandrobustpaymentandsettlementsystemwhichisalsoefficientandsecure.Theconsolidationrevolvesaround expanding the reach of the existing products by introducing clearing process in new locations. The reach is also facilitated by the use of latest technology, such as mechanised cheque processing, image-based cheque processing systems, and interconnection of the clearing houses.

The Reserve Bank has also taken steps towards integrating the payment system with the settlement systems for government securities and foreign exchange. To facilitate settlement of Government securities transactions, it created the Negotiated Dealing System, a screen-based trading platform. The NDS facilitates the dealing process and provides for electronic reporting of trades, online information dissemination and settlement in a centralised system. For settlement of trade in foreign exchange, Government securities and other debt instrument, it has set up the Clearing Corporation of India Limited (CCIL). This plays the role of a central counter party to transactions and guarantees settlement of trade, thus managing the counter party risk.

7.3 Payment and Settlement System: Evolution and InitiativesEvolution and initiatives of payment and settlement system are as follows:

Computerisationofclearingoperationswasthefirstmajorsteptowardsmodernisationofthepaymentssystem,•its aim being to reduce the time taken in clearing, balancing and settlement, apart from providing accuracy in thefinalsettlement.Mechanisation of the clearing operations was another milestone with the introduction of Magnetic Ink Character •Recognition (MICR)-based cheque-processing technology using High Speed Reader Sorter systems driven by mainframe computers. The Reserve Bank introduced mechanised clearing in the four metro cities of Mumbai, New Delhi, Kolkata and Chennai during 1986.To facilitate faster clearing of large-value cheques (of value of rupees one lakh and above), the Reserve Bank •introduced ‘High-Value’ Clearing (HVC), covering select branches of banks for same day settlement. However, with the development of other electronic modes of transfer and to encourage customers to move from paper-based modes to electronic products, the Reserve Bank has advised the clearing houses to gradually discontinue its use.The Reserve Bank has also introduced a ‘Cheque Truncation System’ (CTS) in the National Capital Territory of •NewDelhi.Thissystemeliminatesthephysicalmovementofchequesandprovidesamoresecureandefficientmethod for clearing cheques.The Reserve Bank has introduced Electronic Clearing Service (ECS). This uses a series of electronic payment •instructions for transfer of funds instead of paper instruments. The ‘ECS–Credit’ enables companies to pay interestordividendtoalargenumberofbeneficiariesbydirectcreditoftheamounttotheirbankaccounts.‘ECS-Debit’ facilitates payment of charges to utility services, such as electricity, telephone companies, payment of insurance premia and loan instalments, directly by debit to the customer’s account with a bank.The National Electronic Clearing Service (NECS) facilitates credits to bank accounts of multiple customers •against a single debit of remitter’s account. NECS (Debit) when launched would facilitate multiple debits to destination account holders against a single credit to the sponsor bank. The system has a pan-India characteristic leveraging on Core Banking Solutions (CBS) of member banks, facilitating all CBS bank branches to participate in the system, irrespective of their location. As at the end of September 2009, as many as 114 banks with 30,780 branches were participating in NECS.


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The Reserve Bank has introduced an Electronic Funds Transfer scheme to enable an account holder of a bank •to electronically transfer funds to another account holder with any other participating bank.The Real Time Gross Settlement system settles all inter-bank payments and customer transactions above rupees •onelakh.Participantsinthissystemincludebanks,financialinstitutions,primarydealersandclearingentities.Allsystemically important payments including securities settlement, forex settlement and money market settlements are processed through the RTGS system.Pre-paid payment instruments facilitate purchase of goods and services against the value stored on these •instruments. To encourage the use of this safe payment mechanism, the Reserve Bank has issued guidelines that lay down the basic eligibility criteria and the conditions for operating such payment systems in the country.The Reserve Bank has also issued guidelines for the use of mobile phones as a medium for providing banking •services. Only banks which are licensed and supervised in India and have a physical presence in India are permitted to offer mobile banking services in the country. The guidelines focus on systems for security and inter-bank transfer arrangements through authorised systems.The Reserve Bank encouraged the setting up of the National Payments Corporation of India (NPCI) to act as •an umbrella organisation for operating the various retail payment systems in India. NPCI is expected to bring greaterefficiencyinretailpaymentbywayofuniformityandstandardisationasalsoexpansionofreachandinnovative payment products to augment customer convenience.

7.4 Legal FrameworkThe Payment and Settlement Systems Act, 2007 provides for regulation and supervision of payment systems in India and designates the Reserve Bank as the authority for the purpose. As per the Act, only payment systems authorised by the Reserve Bank can be operated in the country. The Act also provides for the settlement effected under the rulesandproceduresofthesystemprovidertobetreatedasfinalandirrevocable.

7.5 Institutional FrameworkThe Reserve Bank has put in place an institutional framework and structure for oversight of the payment systems. In 2005, it created a Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) as a Committee of the Central Board. A new department called the Department of Payment and Settlement Systems (DPSS) was constituted to assist the BPSS in performing its functions.

7.6 Policy Research and Data DisseminationThe Reserve Bank has over time established a sound and rich tradition of policy-oriented research and an effective mechanism for disseminating data and information. Like other major central banks, the Reserve Bank has also developeditsownresearchcapabilitiesinthefieldofeconomics,financeandstatistics,whichcontributetoabetterunderstanding of the functioning of the economy and the ongoing changes in the policy transmission mechanism.

7.7 Internal ResearchThe research undertaken at the Reserve Bank revolves around issues and problems arising in the current environment at national and international levels, which have critical implications for the Indian economy. The primary data compiled by the Reserve Bank becomes an important source of information for further research by the outside world. The Reserve Bank also disseminates data and information regularly in the form of several publications and through its website.

The Reserve Bank has made focused efforts to provide quality data to the public at large, which has emanated from its internal economic research and robust statistical system, established and strengthened over the years. It endeavours to provide credible statistics and information to users across the spectrum of market participants, businesses, the media, professionals and the academics. This is done through various tools, such as website, press releases, and weekly,monthly,quarterlyandannualpublications.IndiaisamongthefirstfewsignatoriesoftheSpecialDataDisseminationStandards(SDDS)asdefinedbytheInternationalMonetaryFundforthepurposeofreleasingdataandtheReserveBankcontributestoSDDSinasignificantmanner.

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7.8 Data and Research DisseminationThe Reserve Bank releases several periodical publications that contain a comprehensive account of its operations as well as information of the trends and developments pertaining to various areas of the Indian economy. Besides, thereareperiodicalstatementsonmonetarypolicy,officialpressreleases,andspeechesandinterviewsgivenbythetop management which articulate the Reserve Bank’s assessment of the economy and its policies.

The Reserve Bank is under legal obligation under The RBI Act to publish two reports every year, the Annual Report and the Report on Trend and Progress of Banking in India. Besides these and the regular periodical publications, it alsopublishesreportsofvariouscommitteesappointedtolookintospecificsubjects,anddiscussionpaperspreparedby its internal experts. The Reserve Bank has also set up an enterprise-wide data warehouse through which data is made available in downloadable and reusable formats. Users now have access to a much larger database on the Indian economy through the Reserve Bank’s website. This site has a user-friendly interface and enables easy retrieval of data through pre-formatted reports. It also has the facility for simple and advanced queries.

Under the aegis of the Development Research Group in the Department of Economic Analysis and Policy, the Reserve Bank encourages and promotes policy-oriented research backed by strong analytical and empirical basis on subjects of current interest. The DRG studies are the outcome of collaborative efforts between experts from outside the Reserve Bank and the pool of research talent within. The annual Report on Currency and Finance has now been made into a theme-based publication, providing in-depth information and analysis on a topical subject. It has become a valuable reference point for research and policy formulation.

The Handbook of Statistics on the Indian Economy constitutes a major initiative at improving data dissemination byprovidingstatisticalinformationonawiderangeofeconomicindicators.TheHandbookwasfirstpublishedin1996andovertheyears,itscoveragehasimprovedsignificantly.TheReserveBank’stworesearchdepartments,Department of Economic Analysis and Policy and Department of Statistics and Information Management provide analytical research on various aspects of the Indian economy.

7.9 Multiple Credit Creation by Commercial BanksCreation of credit is an important function of a commercial bank. Prof. Sayers said “Banks are not merely purveyors of money but, also in an important sense manufacturer of money.” In a modern economy, Bank’s deposits form a major proportion of total money supply. A bank’s demand deposits arise mainly from cash deposits by customers and bank loans and investments.

7.9.1 Cash Deposits by CustomersThese are termed as primary deposits as they arise from the actual deposits of cash in a bank made by its customers. In receiving such deposits, the bank plays a passive role. The creation of primary deposits however is nothing, but transforming the currency money in to deposit money.

7.9.2 Bank Loans and InvestmentsThese are termed as derivative or active deposits. The derivative deposits are lent in the form of loans or advances, discounting of bills or used for purchasing securities or other assets. Deposit account in the name of the customer or seller, credits him with the amount of loan granted or value of security purchased, subject to withdrawal by cheque, as required. Hence loans advanced or purchases of securities create deposits.

Thus every loan creates a deposit. They increase the quantity of bank money. The size of derivative demand deposits isdeterminedbythebank’slendingandinvestmentactivities.Therewillbeaconstantinflowandoutflowofcashwith the banks. For the sake of liquidity and safety, some proportion of total deposit must be maintained in cash, for e.g., 10% to 20% to meet the demand for cash at the counter. This is known as Cash Reserve Ratio.

Primary deposits serve as a basis for creating derivative deposits, that is credit creation, and for increasing money supply.Commercialbanksareprofit-seekinginstitutionsandwhentheyfindthatlargevolumeofcashreceivedis idle, they use these resources for advancing loans or for making investment in securities, shares, etc., thereby earning high rate of interest. The creation of credit also depends on excess cash reserves or cash reserve ratio. The derivative deposits are used as working capital.


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When the borrower withdraws money from his loan account by cheque, it is deposited by the payee in some other bank. Those banks again create deposit on the basis of fresh deposits received after keeping required reserves. Ultimately, the total volume of credit or derivative deposits or bank money created by all banks would be a multiple of the original amount of new cash reserves in the system. Thus, multiple expansion of credit takes place.

ExampleSuppose the Cash Reserve Ratio is 20% and a person deposits Rs. 10,000/- with Bank of India. This is primary deposit. The bank keeps Rs. 2000/- as CRR and balance of Rs. 8000/- is used for granting credit.

Now suppose Bank of India lends Rs. 8000/- to Mr. A and Mr. A pays a cheque of Rs. 8000/- to Mr. B, who has an account in Bank of Baroda. Then Bank of Baroda receives Rs. 8000/- as primary deposit. It keeps Rs. 1,600/- (20%) as CRR and excess amount of Rs. 6,400/- is used for giving credit. Now if, Mr. C is granted this loan and Mr. C gives a cheque of Rs. 6,400/- to another person who may deposit it in Bank of Maharashtra. Bank of Maharashtra will keep Rs. 1,280/- as CRR and issue a loan of Rs. 5,120/-. This process continues until the original excess reserves ofRs.8000/-withthefirstBankofIndia,havebeenparcelledoutamongvariousbanksandhavebeenrequiredresources. As a result, the aggregate of derivative deposits in the entire banking system, approximates 5 times the initial derivative deposit over a period of time.

Let us explain with the help of table:

Banks Primary deposit

CRR20%

Credit creation or creation of derivative deposits

Bank of India 10,000 2000 8000Bank of Baroda 8,000 1,600 6,400Bank of Maharashtra 6,400 1,280 5,120Total of all Banks 50,000 10,000 40,000

Table 7.1 Credit creation

Intheabove,e.g.,thecreditexpansionisfivetimestheinitialexcessreserveofRs.8,000/-whenCRRis20%.

Where TC = Total CreditPD = Primary Deposit.PCR = Primary Cash Reserve.CCR = Cash Reserve Ratio.

Cash Creation = = = 40,000

The Credit Multiplier depends on CRR. r = CRR If CRR is 20 % then, credit multiplier will be

The multiple expansion of credit is the inverse of CRR maintained by banks. Higher the CRR, lower the expansion of credit and vice versa.

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AssumptionsThe bank deposit multiplier discussed above is based on the following assumptions:

There is no leakage from the banking system. All the money should remain with banking system.•The banks must receive new deposits.•They must be willing to make loans or buy securities.•The CRR remains constant through all the stages.•People must be willing to borrow.•The business conditions are normal.•There is no credit control policy of central bank.•There should be popular banking habit in the country and a well developed banking system.•

7.10 Limitations of Credit CreationCommercial banks do not have unlimited powers of deposit or credit creation, because their activities in this direction are subject to a number of restrictions which are explained in the paragraphs given below.

Amount of cashThe larger the amount of cash with banking system, the greater will be the excess funds and that larger will be the credit-creation power of the bank. The bank’s power of creating money or credit is thus limited by cash it can get in its hands on, primarily through primary deposits.

Cash reserve ratioHigher the cash reserve ratio, smaller the volume of credit creation and vice versa. If CRR falls to a certain minimum, then power of the banks to create credit is limited.

External drainExternal drain refers to the withdrawal of cash from the banking system by public. Every rupee in cash that is withdrawn from the banking system lowers the reserves of the banks and thus checks further deposit expansion.

Willingness to borrowCredit-creation will be larger during a period of business prosperity and smaller during a depression. Bankers cannot create credit at will. The amount of credit is conditioned by the needs and will of the borrowers.

Supply of collateral securities The availability of good securities places one more limitation on the power of banks to create money. If approved securities are not available, the bank cannot create credit without inviting trouble. “The bank does not create money out of thin air; it transmutes other forms of wealth in to money.”

Banking habits and banking systemIn the absence of banking habits and banking system, credit-creation will be impossible. The banking habit will become popular only if there is a sound, developed banking system.

Monetary policy of control bankTheCentralbankhasthepowertoinfluencethevolumeofmoneyinthecountryandfromtime-to-time,usevariousmethodsofcreditcontrolandthusitsinfluencesthebankstoexpandorcontractcredit.

7.11 Balance Sheet of Commercial Banks Banksarethemostimportantfinancialintermediaryinaneconomy.Bank’sperformancecanbeanalysedbyitsbalancesheetandprofitandlossaccount.Bankspublishbalancesheetintheirannualaccounts.Thebalancesheetof a commercial bank is a statement of its liabilities and Assets at a particular time. Liabilities show the sources of funds through which bank raises funds for its business. Assets represent uses of funds to generate income for bank. Thus, the balance sheet indicates the manner in which bank has raised funds and invested them in various types of assets. It is customary to state liabilities on left and assets on right side.


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A model of balance sheet of a bank is given below:

Balance Sheet of a Commercial BankLiabilities Assets

Share Capital (paid up)1. Cash Balances1.

With central banka. With other banksb.

Reserves and surplus2. Money at call and short notice2.

Deposits:3. Time depositsa. Demand depositsb. Saving depositsc.

Bills discounted, including treasury bills3.

Borrowings4. Investments 4.

Other liabilities5. Loans and advances 5.

Other assets6.

Table 7.2 Balance Sheet of a commercial bank

7.11.1 Liabilities of a Commercial Bank (Liabilities Portfolio)The following liabilities of a commercial bank show how the bank raises funds for its business.

Share capital (Paid-up): It is the contribution made by the shareholders of the bank. This indicates the bank’s •liabilities to its shareholders.Reserves and surplus: It is the amount accumulated over the years out of undistributed profits tomeet•contingencies. Reserves and surplus are liabilities of the bank, as they belong to its shareholders.Deposits: Deposits from the public constitute the biggest proportion of banks working funds. The deposits •acceptedbybank incurrent,fixedandsavingsaccountare liabilitiesofbank to their customers.Theyarecategorised as demand, time and saving deposits. These funds are liabilities of bank to their customers, which have to be returned to them. However at the same time, these funds are also assets to bank, since the banker can make use of them to get certain interest yielding assets.Borrowings:Whenabankborrowsfromotherbanks,liabilityiscreated.Itconsistsofborrowing/refinance•obtainedfromRBI,commercialbanksandotherfinancialinstitutions.Italsoincludesoverseasborrowings.Other liabilities: In course of its business, miscellaneous liabilities are incurred by bank. They include bills •payable like drafts, travellers cheques, pay slips, etc. It also includes income tax provision.

7.11.2 Assets of a Commercial Bank (Assets Portfolio)The assets portfolio described below shows how the bank uses the funds entrusted to it.

Cash balancesA bank holds cash to meet the day-to-day withdrawals of deposits by its customer. This is known as cash reserve. Bank hold cash balances with itself, with other banks and with RBI. In India, Commercial Banks are obliged to keep a certain proportion of total deposits in the form of cash reserve requirement with RBI. Cash has perfect liquidity, butyieldsnoprofit.

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Money at call and short noticeIt refers to short-term loans made in money market. Such loans are borrowed by speculators in stock exchange market. Their maturity varies from one day to 15 days. These loans are repayable on demand and at the option of either lender or borrower. Thus, these forms of assets are highly liquid and are interest earning too, though at a comparatively low rate.

Bills discountedBanks’ funds are invested in commercial bills, which are short-dated, usually three months. Banks also invest in treasury bills. These assets are self-liquidating in nature.

InvestmentsInvestment in various kinds of securities is a major part of assets of a bank. Mainly commercial banks invest in government securities, shares, etc. Securities and bonds are known as banks secondary reserves because they are shiftable and interest yielding. Usually banks prefer medium and short-term securities. This secondary reserve fails to convert securities in to cash at the same time.

Loans and advances Themostimportantassetiteminthebalancesheetofabankisloansadvances.Theprofitabilityofabankdependsupon the extent to which it grants loans advances to customers. The various types of loans advances provided by banks are cash credit, overdraft, loans, instalments, purchase and discounting of bills. Banks mostly grant short-term workingcapitalloansonly,sothattheycanhavefairliquiditywithhighprofitability.

Other assetsItincludesfixedassets,furnitureandfixtures,etc.Itwillalsoincludethenetpositionofinter-officeaccount.Fromabove assets and liabilities, banks will have to balance their revenues against expenses in such a way to generate incometosustainprofitabilityfrombusiness.

7.12 Objectives of Portfolio Management (Trade-Off between Liquidity and Profitability)Acommercialbankhastomanageitsassetsandliabilitieswiththreeobjectivesinmind,thatis,liquidity,profitabilityand solvency. Liquidity means the capacity of the bank to give cash on demand in exchange for deposits. However, acommercialbankisaprofit-seekinginstitution.Ithastoarrangeitsassetsinsuchawaythatitmakesmaximumprofits.Thebankshouldalsomaintaintheconfidenceofpublicbymakingcashavailableondemand.Liquidityandprofitabilityare,therefore,conflictingconsiderationsforbankers.

Cashhasperfectliquidity,butyieldsnoreturnatall,whileotherincome-yieldingassetssuchasloansareprofitable,buthavenoliquidity.Thebankshouldstrikeabalancebetweenliquidityandprofitability.Anotherconsiderationof the bank is its own solvency and security. This refers to liquidity and shiftability. Liquidity is the capacity to produce cash on demand. Shiftability means the assets acquired by bank should be easily shiftable to other banks or central bank. Those securities would be preferred by a bank which can be shifted easily without any loss to the bank,thantheriskyandmoreprofitableones.

A bank which is solvent may not be liquid. Its assets may exceed its liabilities, but the assets may not be in such a formthattheyarereadilyconvertibleintocash.Thus,thetwomotivesofabank’sliquidityandprofitabilityarecontradictory, but have to be reconciled. A good banker is one who follows a wise investment policy and distributes theassetsinsuchawaythatboththerequirementsofliquidityandprofitabilityaresatisfied.Theassetsshouldbringinmaximumprofitsandshouldprovidemaximumsecuritytothedepositors.Thesecretofsuccessofabankliesinstrikingasoundbalancebetweenliquidityandprofitability.

7.12.1 Reconciling Twin ObjectivesA good banker is one who follows a wise investment policy and distributes the assets in such a way that both the requirementsofliquidityandprofitabilityaresatisfied.Thesecretofsuccessofabankliesinstrikingabalancebetweenliquidityandprofitability.Thecommercialbankarrangesitsassetsinanascendingorderofprofitabilityand descending order of liquidity. As we move down the balance sheet the assets become less and less liquid and moreandmoreprofitable.Themoreliquidtheassets,thelessprofitableitis.Itcanbedescribedasfollows:


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Cash:Cashbalancehasperfect liquidity,butnoprofitability.Cashisheldtomeetthewithdrawalneedsof•depositors.Money at call: Surplus cash of commercial banks is lent to each other. This earns some interest and is also very •liquid.Investment in securities: Statutorily, banks have to invest a part of their assets in government securities. These •securities have low rate of interest but banks can borrow from RBI against these securities. Thus, investment in securities provides returns as well as liquidity to bank.Loansandadvances:Hereliquidityislow,butprofitabilityishigh.•

Thusbanksholdvariousassetsinsuchawaythattherequirementsofliquidityandprofitabilityarebalanced.

7.13 Factors Affecting Liquidity of BanksThe amount of liquid assets held by bank depends upon the following factors:

Statutory requirements: Every commercial bank has to keep minimum cash balance by law. The extent of reserves •heldbybankdependsuponthestatutoryrequirementslikeCRRandSLR.Theselimitsarefixedbycentralbank.Commercial banks also have to maintain liquid assets in the form of gold and approved securities.Nature of money market: It will be easy for banks to buy and sell securities, if the money market is fully •developed. In such case, need for cash will be less.Banking habits: Banking habits of customers have a direct bearing on banks cash balance and liquidity position. •In developed countries for making payments, cheques are used and hence the use of cash is less. On other hand, in developing countries banking habits are not fully developed, so banks have to maintain large cash reserves.Structure of banks: Under unit banking, every bank is an independent unit and they have to keep a high degree •ofliquidity.Underbranchbanking,thecashreservescanbecentralisedinheadofficeandbranchescanhavesmaller liquid reserves.Business conditions: In industrialised countries, business in brisk and speculative activities is undertaken and •hence the demand for money is large. In agricultural countries, during off season, demand is less so, the banks can manage with small cash balances.Monetary transactions: During busy season such as festival times, harvest season, beginning of month, etc., •banks will have to keep large percentage of cash. Thus, the size of liquid reserves also depends on the number and magnitude of monetary transactions.Number and size of deposits: When the number and size of deposits rise, banks have to keep more liquidity •and vice versa.Nature of deposits: The nature of deposits also determines the liquidity requirements of a bank. Deposits are •various types such as time deposits, demand deposits, etc. Larger the demand and short-term deposits, larger will be liquidity.Clearing house facility: When clearing house facilities are available, then large transactions can be made through •book adjustments. This will reduce cash requirements of commercial banks.Liquidity policy of other banks: A bank which decides to hold large cash balances will have more customers •due to goodwill. Hence, other bank will also try to improve their liquidity position to attract customers. Thus, the liquidity position of one bank depends on the liquidity policy of other banks. On the whole, we can say by looking into past experience, each bank has to take its own decisions on liquidity requirement.

7.13.1 Factors Affecting Profitability of BanksThefactorsaffectingprofitabilityofbanksaregivenbelow.

Cost of fundsShare capital, reserves, deposits, borrowing and other liabilities are the sources of funds for bank. The cost of funds refers to interest expenses.

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Yield on fundsBanks’ funds are used for different sources like CRR, SLR requirement, loans and advances, etc. Many of these give rise to yields mainly in terms of interest income. This depends on the portfolio management of banks.

SpreadThedifferencebetweeninterestincomeandinterestexpensesisdefinedasspread.Highinterestspreadsshowsthelevelofefficiencyandarelativelylesscompetitivemarket.

Non-interest incomeNon-interestincomeisincomederivedfromnon-financialassetsandservicesandincludescommissionandbrokerageon remittance facilities, guarantees underwriting, contracts, etc., locker rentals and other service charges.

Amount of working capitalProfitabilityisdirectlyrelatedtotheamountofworkingfundsdeployedbybanks.Workingfundsarefundsdeployedby a bank in its business.

Non-performing assetsProfitabilityalsodependsonNPAs.LargertheNPAs,lowerwillbetheprofitabilityandviceversa.

CompetitionWhenthelevelofcompetitionincreases,thereisfallinmarginsandhenceitresultsinlowerprofitability.

Operating costIfoperatingcostishigher,profitabilityofbankswillbelowerandviceversa.Operatingcostincludessalaries,bonus,gratuity, expenses on stationery, printing, rent, depreciation, etc.

Risk costRisk cost is the cost which is likely to be incurred on annual loss on assets. Provisions for bad and doubtful debts areincludedunderthishead.Thus,riskcostalsoaffectstheprofitabilityofbanks.

BurdenThe total non-interest expenses representing the transaction cost will generally be more than miscellaneous income. Thedifferencebetweenthetwoisknownasburden.Highertheburden,lesserwillbetheprofitabilityofbanks.

Thusfromabove,wecansaythattheobjectivesofliquidityandprofitabilityhavetobereconciled.Asuccessfulbankerwilladoptaprudentinvestmentpolicy,keepingtherequirementsofliquidityandprofitability.


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SummaryThe regulation and supervision of payment systems is being increasingly recognised as a core responsibility •of central banks.The consolidation revolves around expanding the reach of the existing products by introducing clearing process •in new locations.The Reserve Bank has also taken steps towards integrating the payment system with the settlement systems for •government securities and foreign exchange.The National Electronic Clearing Service (NECS) facilitates credits to bank accounts of multiple customers •against a single debit of remitter’s account.Pre-paid payment instruments facilitate purchase of goods and services against the value stored on these •instruments.The Payment and Settlement Systems Act, 2007 provides for regulation and supervision of payment systems •in India and designates the Reserve Bank as the authority for the purpose.The primary data compiled by the Reserve Bank becomes an important source of information for further research •by the outside world.Creation of credit is an important function of a commercial bank.•In a modern economy, bank’s deposits form a major proportion of total money supply.•The size of derivative demand deposits is determined by the bank’s lending and investment activities.•Primary deposits serve as a basis for creating derivative deposits, that is credit-creation, and for increasing •money supply.Commercial banks do not have unlimited powers of deposit or credit-creation, because their activities in this •direction are subject to a number of restrictions.Banksarethemostimportantfinancialintermediaryinaneconomy.•A bank holds cash to meet the day-to-day withdrawals of deposits by its customer.•A commercial bank has to manage its assets and liabilities with three objectives in mind, that is, liquidity, •profitabilityandsolvency.A good banker is one who follows a wise investment policy and distributes the assets in such a way, that both •therequirementsofliquidityandprofitabilityaresatisfied.

ReferencesRole of Payment and Settlement Systems in Monetary Policy and Financial Stability: Integrative Report. • [Pdf] Availableat:<http://www.seacen.org/file/file/2014/RP90/RPSS%20-%20chapter%201.pdf>[Accessed06June2014].Money Creation. • [Pdf] Available at: <http://staffweb.hkbu.edu.hk/awong/CMs/econ1220/Lectures/lecture%207/L7C32.pdf> [Accessed 06 June 2014].Leiderman, L . and Razin, A., 1994. • Capital Mobility: The Impact on Consumption, Investment and Growth. Cambridge University Press.Hoang, V. Q., Dung, T. T. and Houtte, D. V. • An Analysis on Mono- and Multi- Depository Systems. Dr. Vuong Quan Hoang.Can central banks really control money creation? • [Video online] Available at: <https://www.youtube.com/watch?v=zjCsD6njp10> [Accessed 06 June 2014].Steven Horwitz at FFF: “Do We Really Need a Central Bank?” • [Video online] Available at: <https://www.youtube.com/watch?v=S2M0RF6faC0> [Accessed 06 June 2014].

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Recommended ReadingCaprio, G., 2012. • The Evidence and Impact of Financial Globalization. Academic Press.Ugolini, P., 1996. • National Bank of Poland: The Road to Indirect Instruments (EPub). International Monetary Fund.Rochon, L. P. and Rossi, S., 2006. • Monetary and Exchange Rate Systems: A Global View of Financial Crises. Edward Elgar Publishing.


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Self AssessmentThe Reserve Bank has adopted a three-pronged strategy of consolidation, development and ____________ to 1. establishamodernandrobustpaymentandsettlementsystemwhichisalsoefficientandsecure.

managementa. integrationb. modernisationc. prioritisationd.

What revolves around expanding the reach of the existing products by introducing clearing process in new 2. locations?

Consolidationa. Developmentb. Integrationc. The Reserve Bankd.


1. Electronic Clearing Service (ECS) A. This facilitates credits to bank accounts of multiple customers against a single debit of remitter’s account.

2. The National Electronic Clearing Service (NECS)

B. This facilitates purchase of goods and services against the value stored on these instruments.

3. The Real Time Gross Settlement system

C. This uses a series of electronic payment instructions for transfer of funds instead of paper instruments.

4. Pre-paid payment instruments D. This settles all inter-bank payments and customer transactions above rupees one lakh.

1-C, 2-A, 3-D, 4-Ba. 1-A, 2-D, 3-B, 4-Cb. 1-B, 2-C, 3-A, 4-Dc. 1-D, 2-B, 3-C, 4-Ad.

Whichofthefollowingenablescompaniestopayinterestordividendtoalargenumberofbeneficiariesby4. direct credit of the amount to their bank accounts?

The ‘ECS-Debit’a. The NECSb. The ‘ECS-Credit’c. The CBSd.

The Payment and Settlement Systems Act, _______ provides for regulation and supervision of payment systems 5. in India and designates the Reserve Bank as the authority for the purpose.

2001a. 2007b. 2003c. 2006d.

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Which of the following statement is true?6. In a modern economy, Bank’s deposits form a minor proportion of total money supply.a. In a modern economy, Bank’s withdrawal forms a minor proportion of total money supply.b. In a modern economy, Bank’s deposits form a major proportion of total money demand.c. In a modern economy, Bank’s deposits form a major proportion of total money supply.d.

What are termed as primary deposits as they arise from the actual deposits of cash in a bank made by its 7. customers?

Cash deposits by customersa. Bank loans and investmentsb. Cash back by customersc. Bank deposits and investmentsd.

Which of the following statement is false?8. Every loan creates a deposit.a. The creation of credit also depends on excess cash reserves or cash reserve ratio.b. Cash deposits by customers are termed as derivative or active deposits.c. The derivative deposits are used as working capital.d.

What are termed as derivative or active deposits?9. Cash deposits by customersa. Bank loans and investmentsb. Cash back by customersc. Bank deposits and investmentsd.

_____________ are liabilities of the bank, as they belong to its shareholders.10. Share capital (Paid-up)a. Depositsb. Borrowingsc. Reserves and surplusd.


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Chapter VIII

Evolution and Recent Trends in Banking Technology

Aim


introduce recent trends in banking technology•

explain phases of banking technology in India•

explicate various committees on banking technology in India•

Objectives


enlist major landmarks of banking technology and transformation in India•

elucidate recent trends in banking technology•

explain technology application in banks•

Learning outcome


identify current information technology tools•

understand management information system•

recognise technology-based banking services and their characteristics in India•

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8.1 IntroductionThe usage of Information Technology (IT), broadly referring to computers and peripheral equipment, has seen remarkable growth in service industries in the recent past. The most obvious example is perhaps the banking industry, where through the introduction of IT-related products in internet banking, security investments, electronic payments, information exchanges (Berger, 2003), and banks now can provide more diverse services to customers with less manpower.

8.1.1 Phases of Banking Technology in IndiaTechnological innovation in general and Information Technology (IT) applications in particular, have had a major effectinbankingandfinance.OutstandingIT-basedinnovationsareconsideredandgroupedintofourdistinctperiods,suchasspecificapplication,earlyadoption,emergenceanddiffusion.TheirperiodsbasedonIndianscenariosareas follows:

Early adoption (1960-1980)•Specificapplication(1980-1990)•Emergence (1990-2000)•Diffusion (2000-till date)•

Impact on the Provision of

Retail Finance

Use of Technology in the Organisation

Early adoption (1960-1980)

Specific application (1980-1990)

Emergence (1990-2000)

Diffusion (2000-2009)

Innovation in service offering

Reduce inter-market price differentials

Conversion from branch •to bank relationshipsAutomated bank •statementsCheque guarantee cards•

Growth of •cross border paymentsATM •introduced

Supply of non-payment products like insurance, mortgages and pensions

Operational function

innovation

Increased coordination between head officeandbranches

Reduce cost of labour-intensive activities (i.e., clearing system)

Automation •of branch accounting.Real time •control begins

Growth of alternative distribution channels, such as phone banking and EFTPOS.

Table 8.1 Dimensions of IT innovation in Indian retail banking 1960-2009

8.1.2 Technology Based Banking Services and their Characteristics in IndiaTable 8.2 gives the characteristics of banking services.

Banking Services Key characteristics

Online servicesProvide online real-time transaction processing between banks and branches Customers are not restricted to transactions at account-opening branches.

Automated teller machine (ATM)Replace the functions of tellers in cash receiving and dispensing, fund transfer between accounts, balance enquiries etc. Provide convenient services unrestricted by banking hours.


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Point of sale system (POS)

Provide convenient services by directly debiting accounts at the point of sale, avoiding the need to carry cash The complexities of using the machine (terminal) are transferred to the service providers.A trend towards a cashless society

Phone banking

Provide easy and convenient to account balance and other information i.e. interest rates and foreign exchange rates. Provide the transfer of funds within and between account holders or payment of public utilities by telephone Credit card retailers can check the status of the card by telephone

Internet banking

Provide customers with access to making an inquiry about their accounts as well as allowing customers to perform internet-based transactions (such as fun transfer, e-cash card payment) from the customer’s workplace or home.

Table 8.2 Characteristics of banking services

8.1.3 Various Committees on Banking Technology in IndiaIn 1984 and 1989, the foundation for large-scale induction of IT in the banking sector was provided by the recommendations of the committees headed by Dr. C. Rangarajan. Subsequently, in 1994, the Reserve Bank constituted a committee on ‘Technology Up-gradation in the Banking Sector’. The committee made a number of recommendations covering payment systems including setting up of an autonomous centre for development and research in banking technology.

The IDRBT was created as a sequel. The Institute has established and operates the Indian Financial Network (INFINET), performs research in banking technology and provides consultancy services apart from providing educational and training facilities for the banking sector.

Name of the Committee with Year Head of the Committee Recommendations

Working group to consider feasibility of introducing MICR/OCR Technology for Cheque Processing (1982)

Dr.Y.B.Damle, Adviser, Management Services Department, Reserve Bank of India.

Introduction of ‘item processing’ (sorting and •listing of cheques with the help of computers) in three phases.Inthefirstphaseatthefourmetropolitancities,•viz., Mumbai, New Delhi, Chennai and Calcutta, with the help of MICR technology.In the second phase, all state capitals and important •commercial centres.Inthefinalphase,nationalclearingtobeintroduced•by dividing the country into four regional grids with headquarters at Mumbai, New Delhi, Chennai and Calcutta.Each regional centre was to perform two •functions:To act as a clearing house for intra-grid •instruments.Participate in national clearing on behalf of the •grid for extra-grid outstation cheques.

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Committee on Mechanisation in the Banking Industry (1984)

Dr.C. Rangarajan, Deputy Governor, Reserve Bank of India

Banks should set up service branches at centres •where they have more than 10 branches. The service branch so set up would exclusively be devoted to clearing operations of the bank at that particular centre.Banks to be in readiness for the introduction of •MICR Clearing at the four metropolitan cities by assessing their requirements for encoders, adopting standardised cheque forms and reorganising work procedures where necessary, and training staff down to the branch-level.

Committees on Communication Network for Banks and SWIFT implementation (1987)

Shri T. N. A. Iyer, Executive Director, Reserve Bank of India.

Setting up of X.25 based packet switching network •called ‘BANKNET’ to be jointly owned by the Reserve Bank and the public sector banks.Inter-bank fund transfers on banks’ own account •and on customers’ account.Inter-branch funds transfers on banks’ own account •and on customers’ account.Currency chest transactions.•Government transactions.•Improvements in payment systems by facilitating •automated clearing services.India should join the SWIFT (Society for Worldwide •Interbank Financial Telecommunication) Network for the transmission and reception of international financialmessages.


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Committee on Computerisation in Banks (1988)

Dr. C. Rangarajan, Deputy Governor, Reserve Bank of India

Computerisation of the settlement operations in the clearing houses managed by Reserve Bank of India at Bhubaneshwar, Guwahati, Jaipur, Patna and Thiruvananthapuram.

Operationalisation of MICR technology and the •National Clearing of inter-city cheques at the four metropolitan cities.Introduction of one-way collection of cheques •drawn on the 4 metros received from Ahmedabad, Bangalore, Nagpur and Hyderabad.Framing of uniform regulations and rules of •clearing houses.Branch-level computerisation and the establishment •of connectivity between branches.Improvements in customer service and introduction •of online banking.Standardisation and rigorous security features to •ensureanefficientandriskfreetransferoffundselectronically.Setting up a network of Automated Teller •Machines (ATMs)Introduction of a single ‘All Bank’ credit card•

Committee on Technology Issues relating to Payments System, Cheque Clearing and Securities Settlement in the Banking Industry (1994)

Shri W.S.Saraf, Executive Director, Reserve Bank of India

Establ ishment of an Elect ronic Funds •Transfer (EFT) system, with the BANKNET communications network as its carrier. Enactment of suitable legislation on the lines of the Electronic Funds Transfer Act 1978, USA and Data Protection Act 1984, UK.MICR clearing introduced at all centres with more •than 100 bank branches.Introduction of a Delivery versus Payment (DvP) •system for SGL transactions, with settlement on gross basis both for securities transactions in PDO and funds transactions in current.Introduction of Electronic Clearing Service •Credit for low value repetitive transactions such as interest, dividend, salary, pension payments and an Electronic Debit Clearing for payments to utility companies.Switch over to on-line inter-bank clearing on a •gross basis.Large-scale induction of computers and •communication technology in service branchesOptimal usage of SWIFT.•

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Committee on Technology Issues relating to Payments System, Cheque Clearing and Securities Settlement in the Banking Industry (1994)

Smt.K.S.Shere, Principal Legal Adviser, Reserve Bank of India.

EFT system could be introduced immediately by framing regulations under Section 58 of the RBI Act. A Model Customer Contract agreement to govern the banker-customer relationship with regard to EFT should be adopted by all banks participating in the system.

Report of the Committee on Technology Up-gradation in the banking sector

Dr A.Vasudevan Report of the Working Group on Technology Up-•gradation of Banks

Report of Working Group on Screen Based Trading In Government Securities(2004)

Dr.R.H.PatilSeparate trading platform•Ensure authenticity•

Report of the Expert Group on Internet Deployment of Central Database Management System (CDBMS) (2004)

Prof.A.Vaidyanathan Internet Deployment of Central Database •Management System (CDBMS)

Report of The Working Group on Preparing Guidelines for Access to Payment Systems( 2007)

Shri. R. Gandhi Payment system•

Table 8.3 Committees on computerisation

8.1.4 Major Landmarks of Banking Technology and Transformation in IndiaMajor landmarks of banking technology and transformation in India are as follows:

TheintroductionofMICR-basedchequeprocessing,afirstfortheregion,duringtheyears1986-88.•Computerisation of branches of banks: An activity which commenced from the late eighties with the introduction •of Ledger Posting Machines (LPMs), Advanced Ledger Posting Machines (ALPMs), followed by stand alone computer systems which metamorphosed into network-based systems and the latest development pertaining to the installation of Core Banking solutions..Facilitating computerisation of Government business from the late nineties, which has now resulted in all •branches handling Government business using technology.The setting up of the Institute for Development and Research in Banking Technology (IDRBT), Hyderabad in •the mid nineties, as a research and technology centre for the Banking sector.The commissioning in 1999, of the Indian Financial Network as a Closed User Group based network for the •exclusive use of the Banking sector with state-of-the-art safety and security. The network supports applications having features such as Public Key Infrastructure (PKI) which international networks such as S.W.I.F.T. are now planning to implement.CommencementofCertificationAuthority(CA)functionsoftheIDRBTforensuringthatelectronicbanking•transactions get the requisite legal protection under the Information Technology Act, 2000.Ensuring Information Systems Audit (IS Audit) in the banks for which detailed guidelines relating to IS Audit •were formulated and circulated.Enabling IT based delivery channels which enhance customer service at banks, in areas, such as cash delivery •through shared Automated Teller Machines (ATMs), card based transaction settlements, etc.Providing Guidelines for Internet Banking, which facilitated the banks to ensure that common minimum •requirements relating to Internet Banking offerings were provided for.


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Providingdetailedspecificationstobanksontheconfigurationofsystemsrelatingtocriticalinter-bankpayment•system applications such as Real Time Gross Settlement (RTGS) System, Negotiated Dealing System (NDS), Centralised Funds Management System (CFMS), etc.Implementation of the National Financial Switch (NFS) to ensure interconnectivity of shared ATMs and to •provide for funds settlement across various banks.Establishmentofe-paymentgatewaysforthebenefitofcustomers(suchasthegatewaysforfundstransfersand•other account-related transactions) and for facilitating e-commerce.Sharing of information through the secured internet website for the Centralised Data Based Management •System-Internet (CDBMSI) project.Providing a platform for transmission of electronic messages across banks using common standards, for •facilitating ‘Straight Through Processing’ (STP) in the form of the Structured Financial Messaging System (SFMS), which will be similar to the SWIFT messaging pattern.Setting up connectivity of all clearing houses of the country, so as to enable the introduction of the National •Settlement System (NSS).Introducing a secured website for internet-based data transfer to Central and State Government. Government •Departments may populate the data from the secured website to their own systems based on their requirements.

8.2 Recent Trends in Banking TechnologyBankingtechnologyisaconfluenceofseveraldisparatedisciplines,suchasfinance(includingriskmanagement),computer science, information technology, communication technology, and marketing science. The tremendous influenceofinformationandcommunicationtechnologiesonbankinganditsproducts,thequintessentialroleplayedbycomputersciencehelpedinfulfillingbanks’marketingobjectiveofservicingcustomersbetteratlesscostandtherebyreapingmoreprofits.Advancedstatisticsandcomputerscienceareusedtomeasure,mitigate,andmanagevariousrisksassociatedwithbanks’businesswithitscustomersandotherbanks.Thegrowinginfluenceofcustomer-relationship management and data mining in tackling various marketing-related problems and fraud detection problems in the banking industry is well documented. Fig. 8.1 explains the components of banking technology.

Finance &Risk

Management

BankingTechnology

MarketingScience

InformationTechnology

CommunicationTechnology

ComputerScience

Fig. 8.1 Components of banking technology(Source:http://shodhganga.inflibnet.ac.in/bitstream/10603/5600/11/11_chapter%203.pdf)

Technology is no longer being used simply as a means for automating processes. Instead, it is being used as a revolutionary means of delivering services to customers. The adoption of technology has led to the following benefits,greaterproductivity,profitability,andefficiency,fasterserviceandcustomersatisfaction,convenienceandflexibility,24x7operationsandspaceandcostsavings.

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8.3 Technology Application in BanksIndianbankingindustryadoptedvarioustechnologyapplicationsinbanking.Theyareclassifiedasfollows:

Data warehousing•Data mining•Electronic data interchange•Corporate websites•Management information system•

8.3.1 Data WarehouseData warehouse is a storehouse of an organisation’s electronically stored data. Data warehouses are designed to facilitate reporting and analysis. A data warehouse houses a consistent, standardised, clean and integrated form of datasourcedfromvariousoperationalsystemsinuseintheorganisation,structuredinawaytospecificallyaddressthe reporting and analytic requirements.

Thisdefinitionofthedatawarehousefocusesondatastorage.However,themeanstoretrieveandanalysedata,to extract, transform and load data, and to manage the data dictionary are also considered essential components of a data warehousing system. Many references to data warehousing use this broader context. Thus, an expanded definitionfordatawarehousingincludesbusinessintelligencetools,toolstoextract,transform,andloaddataintothe repository, and tools to manage and retrieve metadata.

Data warehouse architectureArchitecture, in the context of an organisation’s data warehousing efforts, is a conceptualisation of how the data warehouse is built. There is no right or wrong architecture; rather multiple architectures exist to support various environments and situations. The worthiness of the architecture can be judged by how the conceptualisation aids in the building, maintenance, and usage of the data warehouse. Fig. 8.2 and Fig. 8.3 explain data warehouse architecture and its process respectively. One possible simple conceptualisation of data warehouse architecture consists of the following interconnected layers.

Operational database layerThe source data for the data warehouse, an organisation’s Enterprise Resource Planning system falls into this layer.

Data access layerThe interface between the operational and informational access layer, tools to extract, transform and load data into the warehouse fall into this layer.

Metadata layerThe data directory is usually more detailed than an operational system data directory. There are dictionaries for the entire warehouse and sometimes dictionaries for the data that can be accessed by a particular reporting and analysis tool.

Informational access layerThe data accessed for reporting and analysing and the tools for reporting and analysing data, business intelligence tools fall into this layer. The Inmon-Kimball differences about design methodology, discussed later, have to do with this layer.


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Pre-DataWarehouse

DataCleansing

DataRepositories

Front-EndAnalytics

OLTP Server

OLAP

Data Mining

Reporting

Data Visualization

Meta-Data Repository

ETLData

Warehouse

DataMart

DataMart

ODS

Data Flow

Fig. 8.2 Data warehouse architecture(Source:http://shodhganga.inflibnet.ac.in/bitstream/10603/5600/11/11_chapter%203.pdf)

ProductusDatabase

SalesDatabase

CustomerDatabase

DataWarehouse

ETL

ETL ETL ETL

ETL

OperationalApplications

Data Marts

DWStaging

Area

Fig. 8.3 Process of data warehouse architecture(Source:http://shodhganga.inflibnet.ac.in/bitstream/10603/5600/11/11_chapter%203.pdf)

8.3.2 Data MiningData mining is the process of removing patterns from data. More data is gathered, with the amount of data doubling every three years. Data mining is becoming an increasingly important tool to transform these data into information. Itiscommonlyusedinawiderangeofprofilingpractices,suchasmarketing,frauddetection,surveillanceandscientificdiscovery.

While data mining can be used to uncover patterns in data samples, it is important to be aware that the use of non-representative samples of data may produce results that are not indicative of the domain. Similarly, data mining will notfindpatternsthatmaybepresentinthedomain,ifthosepatternsarenotpresentinthesamplebeing‘mined’.Thereisatendencyforinsufficientlyknowledgeable‘consumers’oftheresultstoattribute‘magicalabilities’todatamining, treating the technique as a sort of all-seeing crystal ball. Like any other tool, it only functions in conjunction withtheappropriaterawmaterial:inthiscase,indicativeandrepresentativedatathattheusermustfirstcollect.Further, the discovery of a particular pattern in a particular set of data does not necessarily mean that pattern is representative of the whole population from which that data was drawn. Hence, an important part of the process is theverificationandvalidationofpatternsonothersamplesofdata.

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The term data mining has also been used in a related, but negative sense, to mean the deliberate searching for apparent, but not necessarily representative patterns in large numbers of data. To avoid confusion with the other sense, the terms data dredging and data snooping are often used. Note when developing and clarifying hypotheses that dredging and snooping can be (and sometimes are) used as exploratory tools.

Architecture for data miningTobestapplytheseadvancedtechniques,theymustbefullyintegratedwithadatawarehouseaswellasflexibleinteractive business analysis tools. Many data mining tools currently operate outside of the warehouse, importing, requiring extra steps for extracting, and analysing the data. Furthermore, when new insights require operational implementation,integrationwiththewarehousesimplifiestheapplicationofresultsfromdatamining.Theresultinganalytic data warehouse can be applied to improve business processes throughout the organisation in areas, such as promotional campaign management, fraud detection, new product rollout, and so on.

The ideal starting point is a data warehouse containing a combination of internal data tracking all customer contacts coupled with external market data about competitor activity. Background information on potential customers also provides an excellent basis for prospecting. This warehouse can be implemented in a variety of relational database systems,Sybase,Oracle,Redbrick,andsoon,andshouldbeoptimisedforflexibleandfastdataaccess.

An OLAP (On-Line Analytical Processing) server enables a more sophisticated end-user business model to be applied when navigating the data warehouse. The multi-dimensional structures allow the user to analyse the data as they want to view their business, summarising by product line, region, and other key perspectives of their business. The Data Mining Server must be integrated with the data warehouse and the OLAP server to embed ROI-focused businessanalysisdirectlyintothisinfrastructure.Anadvanced,process-centricmetadatatemplatedefinesthedataminingobjectivesforspecificbusinessissueslikecampaignmanagement,prospecting,andpromotionoptimisation.Integration with the data warehouse enables operational decisions to be directly implemented and tracked.

As the warehouse grows with new decisions and results, the organisation can continually mine the best practices and apply them to future decisions. This design represents a fundamental shift from conventional decision support systems. Rather than simply delivering data to the end user through query and reporting software, the Advanced Analysis Server applies users’ business models directly to the warehouse and returns a proactive analysis of the most relevant information. These results enhance the metadata in the OLAP Server by providing a dynamic metadata layer that represents a distilled view of the data. Reporting, visualisation, and other analysis tools can then be applied to planfutureactionsandconfirmtheimpactofthoseplans.

8.3.3 Electronic Data Interchange (EDI)Electronic Data Interchange (EDI) refers to the structured transmission of data between organisations by electronic means. It is used to transfer electronic documents from one computer system to another, i.e., from one trading partner to another trading partner. It is more than mere e-mail; for instance, organisations might replace bills of lading andevenchequewithappropriateEDImessages.Italsorefersspecificallytoafamilyofstandards,includingtheX12 series. However, EDI also exhibits its pre-internet roots, and the standards tend to focus on ASCII (American Standard Code for Information Interchange)-formatted single messages rather than the whole sequence of conditions and exchanges that make up an inter-organisation business process. Fig. 8.6 explains the EDI architecture.


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Cus

tom

er

Phoe

nix

Con

tact

Ordering

Payment Instruction

Confirmation

Delivery Note

Invoice

ApplicationData

EDITranslator Gateway

Trading Partners

Trading Partners

Trading Partners

VANS

Fig. 8.4 EDI architecture(Source:http://shodhganga.inflibnet.ac.in/bitstream/10603/5600/11/11_chapter%203.pdf)

8.3.4 Corporate WebsiteA corporate website or corporate site is an informational website operated by a business or other private enterprise, suchasacharityornon-profit foundation.Corporatesitesdiffers fromelectroniccommerce,portal,orsites inthat they provide information to the public about the company, rather than transacting business or providing other services.Thephraseisatermofartreferringtothepurposeofthesiteratherthanitsdesignorspecificfeatures,orthe nature, market sector, or business structure of the site operator. Nearly every company that interacts with the public has a corporate site or else integrates the same features into its other websites. Large companies typically maintain a single umbrella corporate site for all of their various brands and subsidiaries.

Corporate website common featuresCorporate websites usually include the following:

A homepage.•A navigation bar or other means for accessing various site sections.•Aunifiedlookandfeelincorporatingthecompanylogos,stylesheets,andgraphicimages.•A summary of company operations, history, and mission statement.•A list of the company’s products and services.•A ‘people’ section with biographical information on founders, board members, and/or key executives. Sometimes, •provides an overview of the company’s overall workforce.A ‘news’ section containing press releases, press kits, and/or links to news articles about the company.•An ‘investor’ section describing key owners/investors of the company.•A list of key clients, suppliers, achievements, projects, partners or others.•Pagesofspecialinteresttospecificgroups.•An employment section where the company lists open positions and/or tells job seekers how to apply.•Investorpageswiththeannualreport,businessplan,currentstockprice,financialstatements,overviewofthe•companystructure,SECfilingorotherregulatoryfilings.Pagesforemployees,suppliers,customers,strategicpartners,affiliates,etc.•

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Contact information: Sometimes includes a feedback form by which visitors may submit messages•Terms of use-document and statement of intellectual property ownership and policies as they apply to site •content.A privacy policy.•A splash page as an entry point that directs users to the site’s home page.•Embedded search engines allowing users to search pages from within the website, or external searches of the •Web.A site map.•A blog with news and commentary about the company, its products and services.•‘Community’ pages describing the company’s environmental/sustainability, charity, corporate citizenship, and •other policies as they affect the public.A‘storelocator’orsimilarfeatureusedtofindnearbyretaillocationsofthecompanyorwherethecompany’s•products or services can be found.A ‘downloads’ or ‘media’ section for users to obtain web tools, free or trial software, software patches, company •demos, promotional material, and the like.A calendar or events section.•A‘links’pagewithhyperlinkstoconsumer-orientedorotherwebsites,orinformationaboutspecificbrandsor•subsidiaries of the company.Links •

8.3.5 Management Information System (MIS)A Management Information System (MIS) is a subset of the overall internal controls of a business covering the application of people, technologies, documents, and procedures by management accountants to solve business problems, such as costing a product, service or a business-wide strategy. Management information systems are distinct from regular information systems in that they are used to analyse other information systems applied in operational activities in the organisation. Academically, the term is commonly used to refer to the group of information management methods tied to the automation or support of human decision making, e.g., Decision Support Systems, Expert systems, and Executive information systems. It has been described as, “MIS ‘lives’ in the space that intersects technology and business. MIS combines tech with business to get people the information they need to do their jobs better/faster/smarter. Information is the lifeblood of all organisations, now more than ever. MIS professionals work as systems analysts, project managers, systems administrators, etc., communicating directly with staff and management across the organisation.

8.4 Current Information Technology ToolsBanks adopt various Information Technology Tools, apart from already mentioned technology. These tools are as follows:

Electronic clearing and settlement system•Plastic money•Electronic banking•

8.4.1 Electronic Clearing and Settlement SystemSome of the electronic and settlement systems are OCR clearing, Debit Clearing, MICR clearing, RTGS, SFMS, and SWIFT.

Optical Character Recognition (OCR)Optical Character Recognition is the machine recognition of printed characters. OCR systems can recognise many different OCR fonts, as well as typewriter and computer-printed characters. Advanced OCR systems can recognise hand printing. When a text document is scanned into the computer, it is turned into a bitmap, which is a picture of the text. OCR software analyses the light and dark areas of the bitmap in order to identify each alphabetic letter and


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numericdigit.Whenitrecognisesacharacter,itconvertsitintoASCIItext(seeASCIIfile).Handprintingismuchmoredifficulttoanalysethanmachine-printedcharacters.Old,wornandsmudgeddocumentsarealsodifficult.Scanning documents and processing them with OCR is sometimes as much an art as it is a science. Fig. 8.7 explains the operation of OCR clearing system.

Page of text Scanner

ASCII text2-3KBPer page

Bitmap50-150KB+Per page

OCR

Fig. 8.5 OCR creates ASCII text(Source:http://shodhganga.inflibnet.ac.in/bitstream/10603/5600/11/11_chapter%203.pdf)

When text documents are scanned, they are ‘photographed’ and stored as pictures in the computer. OCR software analyses the symbols in the image and converts each letter and digit into an ASCII character.

Magnetic ink character recognitionMagnetic ink character recognition is the machine recognition of numeric data printed with magnetically charged ink. It is used on bank cheques and deposit slips. MICR readers detect the characters and convert them into digital data. Although optical methods (OCR) became as sophisticated as the early MICR technology, magnetic ink is still used. It serves as a deterrent to fraud, because a photocopied cheque will not be printed with magnetic ink.

MICR technologyMICR characters are printed using an ink laden with iron oxide particles. Iron oxide has magnetic properties and canretainmagneticfieldswhenitisappliedonit.TheworkingofaMICRreaderisessentiallybasedontheconceptof moving characters printed with this magnetic ink over two magnetic heads, one that charges the characters and thesecondonethatimmediatelyfollowsthefirstandreadsthemagneticcharge.Thepatternoftheelectricalfieldis what determines the character being read. The characteristic shape of the MICR font is designed to give a unique electrical signature pattern to each character which can be easily recognised by the machine with minimum ambiguity and maximum tolerance. Another related topic of interest is the very common bar code, we so often see on items on the shelves of a supermarket. Bar coding utilises a technique is similar to Morse code, a series of narrow and wide bars make up for one character. The reader contains a photo diode and a light/laser source. The photo diode measurestheintensityoflightasthelightsourceismovedacrossthebarcode.Thewaveformofreflectedlightthusproduced is decoded to read the contents.

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8.4.2 Plastic MoneyPlasticmoneycanbeclassifiedasfollows:

Credit card•Debit card•Smart card•

Debit cardA debit card (also known as a bank card or cheque card) is a plastic card that provides an alternative payment method to cash when making purchases. Functionally, it can be called an electronic cheque, as the funds are withdrawn directly from either the bank account or from the remaining balance on the card. In some cases, the cards are designed exclusively for use on the internet, and so there is no physical card.

The use of debit cards has become widespread in many countries and has overtaken the cheque and in some instances cash transactions by volume. Like credit cards, debit cards are used widely for telephone and Internet purchases, and unlike credit cards the funds are transferred from the bearer’s bank account instead of having the bearer to pay back on a later date. Debit cards can also allow for instant withdrawal of cash, acting as the ATM card for withdrawing cash and as a cheque guarantee card. Merchants can also offer ‘cashback’/‘cashout’ facilities to customers, where a customer can withdraw cash along with their purchase

Difference between credit card and debit cardFor consumers, the difference between a ‘debit card’ and a ‘credit card’ is that the debit card deducts the balance from a deposit account, like a checking account, whereas the credit card allows the consumer to spend money on credit to the issuing bank. In other words, a debit card uses the money you have and a credit card uses the money you don’t have. ‘Debit cards’ which are linked directly to a checking account are sometimes dual-purpose, so that they can be used as a credit card, and can be charged by merchants using the traditional credit networks. A merchant will ask for ‘credit or debit?’, if the card is a combined credit +debit card. If the payee chooses ‘credit’, the credit balance will be debited the amount of the purchase; if the payee chooses ‘debit’, the bank account balance will bedebitedtheamountofthepurchase.The‘debit’networksusuallyrequirethatapersonalidentificationnumberbe supplied. The ‘credit’ networks typically require that purchases be made in person and often allow cards to be charged with only a signature, and/or picture ID. However, most merchant agreements in the United States forbid picture ID as a requirement to use a credit card.

Types of debit cardA typical debit card contains Issuing bank logo, EMV chip, card number, hologram, card brand logo, expiration date, cardholder’s name. The reverse side of a typical debit card contains magnetic strip, signature strip, card security code. There are currently three ways that debit card transactions are processed, online debit (also known as PIN debit),offlinedebit(alsoknownassignaturedebit)andelectronicpursecard.

8.4.3 Electronic BankingElectronic banking includes ATM, internet banking, phone banking, SMS banking, EFT, and IVRS.

SMS bankingShort Message Service (SMS) is a communication service standardised in the GSM mobile communication system using standardised communications protocols allowing the interchange of short text messages between mobile telephone devices. SMS text messaging is the most widely used data application on the planet, with 2.4 billion active users, or 74% of all mobile phone subscribers sending and receiving text messages on their phones. SMS banking is a technology-enabled service offering from banks to its customers, permitting them to operate selected banking services over their mobile phones using SMS messaging. SMS banking services are operated using both push and pull messages. Depending on the selected extent of SMS banking transactions offered by the bank, a customer can beauthorisedtocarryouteithernon-financialtransactions,orbothandfinancialandnon-financialtransactions.SMSbankingsolutionsoffercustomersarangeoffunctionality,classifiedbypushandpullservicesasoutlinedbelow.


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Typical push servicesTypical push services would include:

Periodic account balance reporting (say at the end of month).•Reporting of salary and other credits to the bank account.•Successful or un-successful execution of a standing order.•Successful payment of a cheque issued on the account.•Insufficientfunds.•Large value withdrawals on an account.•Large value withdrawals on the ATM or EFTPOS on a debit card.•Large value payment on a credit card or out of country activity on a credit card.•One-time password and authentication.•

Typical pull servicesTypical pull services would include the following:

Account balance enquiry.•Mini statement request.•Electronic bill payment.•Transfers between customers’ own accounts, like moving money from a savings account to a current account •to fund a cheque.Stop payment instruction on a cheque.•Requesting for an ATM card or credit card to be suspended.•De-activating a credit or debit card when it is lost or the PIN is known to be compromised.•Foreign currency exchange rates enquiry.•Fixed deposit interest rates enquiry.•

Mobile bankingMobile banking (also known as M-Banking, SMS Banking, etc.) is a term used for performing balance cheques, payments, account transactions, etc., via a mobile device, such as a mobile phone. Mobile banking today is most often performed via SMS or the Mobile Internet, but can also use special programs called clients downloaded on the mobile devices. Mobile banking can offer the following services.

Account informationAccount information services are as follows:

Mini-statements and checking of account history•Alerts on account activity or passing of set thresholds•Monitoring of term deposits•Access to loan statements•Access to card statements•Mutual funds/equity statements•Insurance policy management•Pension plan management•Status on cheque and stop payment on cheque•Ordering cheque books•Balance checking in the account•Recent transactions•Due date of payment (functionality for stop, change and deleting of payments)•PIN provision, Change of PIN and reminder over the internet•Blocking of (lost and stolen) cards•

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Payments, deposits, withdrawals and transfersPayments, deposits, withdrawals and transfers are listed below:

Domestic and international fund transfers•Micro-payment handling•Mobile recharging•Commercial payment processing•Bill payment processing•Peer-to-Peer payments•Withdrawal at banking agent•Deposit at banking agent•

InvestmentsInvestments are as follows:

Portfolio management services•Real-time stock quotes•Personalisedalertsandnotificationsonsecurityprices•

SupportSupport services involve the following:

Status of requests for credit, including mortgage approval and insurance coverage•Cheque book and card requests•Exchange of data messages and email, including complaint submission and tracking•ATM location•

Content servicesContent services are as follows:

General information, such as weather updates, news•Loyalty-related offers•Location-based services•

Based on a survey conducted by Forrester, mobile banking will be attractive mainly to the younger, more ‘tech-savvy’ customersegment.Athirdofmobilephoneuserssaythattheymayconsiderperformingsomekindoffinancialtransaction through their mobile phone. However, most of the users are interested in performing basic transactions, such as querying for account balance and making bill payment.

Telephone banking and/or IVRSTelephonebankingisaserviceprovidedbyafinancialinstitutionwhichallowsitscustomerstoperformtransactionsover the telephone. Telephone banking usually uses an automated phone answering system with phone keypad responseor voice recognition capability.Toguarantee security, the customermustfirst authenticate through anumeric or verbal password or through security questions asked by a live representative With the obvious exception of cash withdrawals and deposits, it offers virtually all the features of an automated teller machine: account balance information and list of latest transactions, electronic bill payments, funds transfers between a customer’s accounts, etc.

Usually, customers can also speak to a live representative located in a call centre or a branch, although this feature is not guaranteed to be offered 24/7. In addition to the self-service transactions listed earlier, telephone banking representatives are usually trained to do what was traditionally available only at the branch, loan applications, investment purchases and redemptions, chequebook orders, debit card replacements, change of address, etc. Banks which operate mostly or exclusively by telephone are known as phone banks.


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Electronic Funds Transfer (EFT)ElectronicFundsTransferorEFT refers to the computer-based systemsused toperformfinancial transactionselectronically. The term is used for a number of different concepts:

Cardholder-initiated transactions, where a cardholder makes use of a payment card.•Direct deposit payroll payments for a business to its employees, possibly via a payroll services company.•Direct debit payments from customer to business, where the transaction is initiated by the business with customer •permission.Electronic bill payment in online banking, which may be delivered by EFT or paper cheque.•Transactions involving stored value of electronic money, possibly in a private currency.•Wire transfer via an international banking network (generally carries a higher fee).•ElectronicBenefitTransfer.•

Electronic Funds Transfer at Point of Sale (EFTPOS)EFTPOS (Electronic Funds Transfer at Point of Sale) is an Australian and New Zealand electronic processing system for debit cards, credit cards and charge cards. European banks and card companies also sometimes reference ‘EFTPOS’ as the system used for processing card transactions through terminals on points of sale, though the system is not the trademarked Australian/New Zealand variant.

Credit cards EFT may be initiated by a cardholder when a payment card such as a credit card or debit card is used. This may take place at an Automated Teller Machine (ATM) or Point of Sale (POS), or when the card is not present, which covers cards used for mail order, telephone order and internet purchases.

A number of transaction types may be performed, including the following:Sale: Where the cardholder pays for goods or service.•Refund: Where a merchant refunds an earlier payment made by a cardholder.•Withdrawal: The cardholder withdraws funds from their account, e.g., from an ATM. The term Cash advance •may also be used, typically when the funds are advanced by a merchant rather than at an ATM.Deposit: Where a cardholder deposits funds to their own account (typically at an ATM).•Cashback: Where a cardholder withdraws funds from their own account at the same time as making a •purchase.Inter-account transfer: Transferring funds between linked accounts belonging to the same cardholder.•Payment: Transferring funds to a third party account.•Enquiry:Atransactionwithoutfinancialimpact.Forinstance,balanceenquiry,availablefundsenquiry,linked•accounts enquiry, or request for a statement of recent transactions on the account.E top-up: Where a cardholder can use a device (typically POS or ATM) to add funds (top-up) their pre-pay •mobile phone.Mini-statement: Where a cardholder uses a device (typically an ATM) to obtain details of recent transactions •on their account.Administrative:Thiscoversavarietyofnon-financialtransactionsincludingPINchange.•The transaction types offered depend on the terminal. An ATM would offer different transactions from a POS •terminal, for instance.

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SummaryThe usage of Information Technology (IT), broadly referring to computers and peripheral equipment, has seen •remarkable growth in service industries in the recent past.Technological innovation in general and Information Technology (IT) applications in particular, have had a •majoreffectinbankingandfinance.In 1984 and 1989, the foundation for large-scale induction of IT in the banking sector was provided by the •recommendations of the committees headed by Dr. C. Rangarajan.Advanced statistics and computer science are used to measure, mitigate, and manage various risks associated •with banks’ business with its customers and other banks.Data warehouse is a storehouse of an organisation’s electronically stored data.•Data mining is the process of removing patterns from data.•Many data mining tools currently operate outside of the warehouse, importing, requiring extra steps for extracting •and analysing the data.Electronic Data Interchange (EDI) refers to the structured transmission of data between organisations by •electronic means.A corporate website or corporate site is an informational website operated by a business or other private enterprise, •suchasacharityornon-profitfoundationMICR characters are printed using an ink laden with iron oxide particles.•A typical debit card contains Issuing bank logo, EMV chip, card number, hologram, card brand logo, expiration •date, cardholder’s name.Mobile banking (also known as M-Banking, mbanking, SMS Banking, etc.) is a term used for performing balance •cheques, payments, account transactions, etc., via a mobile device, such as a mobile phone.Most telephone banking uses an automated phone answering system with phone keypad response or voice •recognition capability.ElectronicfundstransferorEFTreferstothecomputer-basedsystemsusedtoperformfinancialtransactions•electronically.EFTPOS (Electronic Funds Transfer at Point of Sale) is an Australian and New Zealand electronic processing •system for debit cards, credit cards and charge cards.

ReferencesEvolution and Recent Trends in Banking Technology. • [Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/5600/11/11_chapter%203.pdf> [Accessed 06 June 2014].Creating Value in Financial Services. • [Pdf] Available at: <http://www.stern.nyu.edu/om/cvfs/chapter1.pdf> [Accessed 06 June 2014].Baker, R . H ., 2000. • Technology and Banking: Congressional Hearing. DIANE Publishing.Chiline, V. V., 2002. • Modern Trends in Global Banking Development. Universal-Publishers.Tech Trends - the future of technology and payments. • [Video online] Available at: <https://www.youtube.com/watch?v=hrz1pnbmh8E> [Accessed 06 June 2014].Technology in Banking: Facing the Challenges of Scale and Complexity. • [Video online] Available at: <https://www.youtube.com/watch?v=9JzLQKKGhjo> [Accessed 06 June 2014].

Recommended ReadingAltig, D. E. and Smith, B.D., 2003. • Evolution and Procedures in Central Banking. Cambridge University Press.Shrivastava, M. P., Pandey, P. K and Vidyarthi, V. P., 2007. • Banking Reforms and Globalisation. APH Publishing.Gup, B. E., 2003. • The Future of Banking. Greenwood Publishing Group.


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Self AssessmentOutstanding IT-based innovations are considered and grouped into ________ distinct periods.1.

Threea. Fourb. Fivec. Twod.

Which of the following is a storehouse of an organisation’s electronically stored data?2. Data warehousea. Data miningb. Electronic Data Interchangec. Data managementd.


1. Data warehousingA. It is used to transfer electronic documents from one computer

system to another, i.e., from one trading partner to another trading partner.

2. Data mining B. Itiscommonlyusedinawiderangeofprofilingpractices,suchasmarketing,frauddetection,surveillanceandscientificdiscovery.

3. Electronic Data Interchange (EDI) C. It is a storehouse of an organisation’s electronically stored data.

4. Management Information System (MIS)

D. They are distinct from regular information systems in that they are used to analyse other information systems applied in operational activities in the organisation.

1-D, 2-A, 3-C, 4-Ba. 1-A, 2-D, 3-B, 4-Cb. 1-B, 2-C, 3-D, 4-Ac. 1-C, 2-B, 3-A, 4-Dd.

____________ includes ATM, internet banking, phone banking, SMS banking, EFT, and IVRS.4. SMS bankinga. Telephone banking b. Mobile bankingc. Electronic bankingd.

Which of the following statement is true?5. Data mining is designed to facilitate reporting and analysis.a. Data warehouses are designed to facilitate reporting and analysis.b. Electronic data interchange is designed to facilitate reporting and analysis.c. A management information system (MIS) is designed to facilitate reporting and analysis.d.

What is the process of removing patterns from data?6. Data mininga. Data warehouseb. Electronic data interchangec. Data managementd.

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__________ characters are printed using an ink laden with iron oxide particles.7. OCRa. AICb. MIRc. MICRd.

Which of the following statement is false?8. Optical Character Recognition is the machine recognition of printed characters.a. MICR readers detect the characters and convert them into digital data.b. Advanced OCR systems cannot recognise hand printing.c. MICR is used on bank cheques and deposit slips.d.

What is a term used for performing balance cheques, payments, account transactions, etc.?9. SMS bankinga. Telephone bankingb. Mobile bankingc. Electronic bankingd.

Which of the following refers to the computer-based systems used to perform financial transactions 10. electronically?

Electronic Funds Transfer (EFT)a. Electronic Funds Transfer at Point of Sale (EFTPOS)b. Mobile bankingc. Electronic bankingd.


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Case Study I

The Turnaround of Indian Bank

AbstractThe case discusses the turnaround of the Indian Bank, a prominent public sector bank based in Chennai, a south Indian city. The Indian Bank was established in 1907 and was nationalised by the Indian Government in 1969. The bank functioned reasonably well with the aid of the government, till prudential norms were introduced for public sector banks in 1992. While the new norms caused most of the public sector banks in India to falter, the Indian BankpostedanindustryrecordlossofRs1336croreinthefiscalyear1995-1996.In2000,thebankundertookacomprehensive restructuring programme under the guidance of Ranjana Kumar, known in Indian banking circles for her ability to turnaround hopeless banking situations.

After a restructuring programme that involved considerable changes in structure, operations and human resources, theIndianBankmanagedtoturnaroundbypostingitsfirstnetprofitinsixyearsforthefiscalyear2001-2002.Planswere also on the anvil for a public issue in 2005. The issues were as follows:

The nature and working of public sector banks in India•The reasons for the decline of a prominent public sector bank in India•The possible options in effecting the turnaround of the bank•

“The case of Indian Bank is a case of political blunder. The solution is not closing down the bank, but stern action against the defaulters so that repayments are made. This is the way to serve the interests of the depositors.” - Gurudas Dasgupta, CPI Rajya Sabha member in 2000.

“During the three years of the restructuring plan, the bank could achieve consistent growth in business and also sustain its turnaround due to initiation of various structural, operational and cost-control measures. The bank has also worked on marketing and motivational strategies and strengthened its planning and monitoring systems.” - Mrs. Ranjana Kumar, chairperson and managing director, Indian Bank in 2003.

Indian bank achieves a turnaroundInmid-2002,IndianBank,aprominentpublicsectorbank(PSB)inIndia,postedanetprofitofRs33.22croresforthefiscalyear2001-2002.ThismarkedIndianBank’sreturntotheblackafterbeingintheredforsixconsecutiveyears,followinganindustryrecordlossofRs.1336.4croreinthefiscal1995-1996.

In 1999, Indian Bank was formally recognised as a weak bank by the Verma Committee, set up by the Government of India (GoI) earlier that year. Following this, the bank embarked on a comprehensive restructuring programme, under the leadership of Ranjana Kumar (Kumar), who was known in the Indian banking circles as the ‘Turnaround Queen’ for her unique ability to create something worthwhile out of the most hopeless banking failures. The restructuring process, eventually led to the turnaround of Indian Bank in 2002. By 2003, the bank was looking forward to a promising future. Analysts said that the turnaround of the Indian Bank was one of the most successful turnaround cases in the history of Indian Banking.

Background noteIndian Bank was set up as part of the Swadeshi Movement in 1907. Incorporated on March 5, 1907, with an authorisedcapitalofRs20lakh,theBankcommencedoperationsonAugust15,thesameyear.Duringthefirstyearofoperations,theBankreceiveddepositsofRs2,01,157andmadeaprofitofRs.5,505.HeadquarteredinChennai(formerly known as Madras) in the south Indian State of Tamil Nadu, Indian Bank enjoyed a good customer-base inthesouth.Asabankbackedbythegovernment,IndianBankcontinuedtoflourishandboastedofthetrustithadbeen enjoying since the early 1900s.

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The ‘nine decades of trust’, suddenly came under threat in the 1990s, when the GoI and the Reserve Bank of India (RBI) introduced a new set of norms for the banking sector. The once respected bank found itself with the ignominiousdistinctionofbeingclassifiedasoneofthethreeweakbanksinIndia,alongsideUCOBankandUnitedBank of India.

The Indian banking sectorThe GoI realised the importance of a strong banking sector for the development of the country and gave due importance to banking. Before India’s independence in 1947, banking was essentially an informal, local process, with moneylenders playing a prominent role. Banking institutions were usually private bodies and operated at the local-level.

After 1947, the RBI and the State Bank of India (SBI) played a prominent role in the Indian banking sector along with other private banks. In keeping with the country’s principle of socialism, the GoI undertook nationalisation ofseveralprivatebanksin1969.Inthefirstphaseofthenationalisationprogramme,14banksweretakenoverbythe government. The second phase of nationalisation was initiated in 1980, when six other banks were made PSBs. This brought the number of PSBs to 28 - 20 nationalised banks and the eight associate banks of SBI. In 1993, the New Bank of India merged with the Punjab National Bank to form a single entity, bringing down the number of PSBs to 27.

Besides PSBs, private banks, foreign banks, Regional Rural Banks (RRBs) and cooperative banks also formed a partofthebankingsector.TherewerealsospecialisedfinancialinstitutionsliketheIndustrialDevelopmentBankof India (IDBI), Industrial Finance Corporation of India (IFCI) and the National Bank for Agriculture and Rural Development(NABARD),whichprovidedloansandfinancetocertainsectors.

With branches numbering well over 60,000 and deposits of Rs 1, 10,000 crore, PSBs held a combined market share of 90 percent by the early 1990s. One important reason behind the continued success of PSBs was the assistance and backing of the government. According to analysts, most PSBs depended on the government for their additional capital requirements and received regular infusion of funds to maintain capital adequacy. Apart from a few cases, where additional capital was needed to support a growing volume of business, most of the banks depended on additional funds to sustain their regular business, which was on the decline because of chronic weaknesses in the banks.

ExcerptsThe trouble with Indian BankAnalysts felt that the decline of Indian Bank was not a sudden phenomenon, but rather a result of weaknesses buildingupovertheyears.Theoperationsofthebankhadbeenfaultyforsometime,butbecauseoffinancialandother forms of aid provided by the GoI, this did not come to light earlier.

The loopholes were exposed by the introduction of the new banking norms in 1992. The reasons behind the weaknesses are described below. First, though the bank had a loyal customer-base, analysts felt that people stayed with the Indian Bank only because of a lack of competitive alternatives. Customers, who felt that one PSB was as good as another, did not feel the need to move to other banks. However, with the opening up of the banking sector inthe1990s,privatebanksbeganofferingmorevarietyandflexibilityinservices.Theratherobsoletesystemsofoperation at the Indian Bank caused customers to drift way. The report of the committee also suggested that some of the credit decisions taken by the bank in the early 1990s were faulty.

The optionsThe Verma committee pondered over the various options available to the Indian Bank. It decided that closure was not advisable, because of the extremity of such an action.

The committee felt that the cost of closure would be too high for the depositors, clients and employees of the bank and it would have adverse consequences on too many people. Merger with a healthier institution was also ruled out because of the possible undesirable consequences of merging a sick unit with a healthier one. The Indian banking sector had witnessed only one merger between PSBs, PNB and New Bank of India in 1993. This merger, however,


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wasnotsuccessful.PNB,astrongbankwithanuninterruptedrecordofprofits,sufferedanetlossofRs.95.90crorein 1996. The bank also had to face litigation and other problems, especially with regard to service conditions of the staff taken over from the New Bank of India.

Efforts at restructuringEfforts at reviving the Indian Bank began in July 2000 when the management, led by Kumar, submitted a plan to the GOI with details of the steps it proposed to take during the three-year restructuring period. Kumar requested thefinanceministrytoproviderecapitalisationfunds,butthegovernmentdecidedtodeferittillthebankshoweda distinct improvement. Kumar began the restructuring by entering into a written agreement with the trade unions, seekingtheircooperationonthethreeyearlonginitiative.Soonafter,thebank’sstructurewasmodifiedtomakeoperationssimplerandensurequickdecisions.Theoriginalfour-tieredstructurewasmodifiedintoathree-tieredone,bydoingawaywiththezonalofficelevel.

The revivalTheofficialturnaroundperiodoftheIndianBankwasthreeyears-2000to2003.However,effortsstartedyieldingfruitwithinthefirstyearitself.Thefirstrayofsunshinecamein2000-2001,whenthebankposteditsfirstoperatingprofitofRs61.59croreaftersufferinglossesforyears.

Theturnaroundfinallyhappened,whentheIndianBankposteditsfirstnetprofitofRs33croreinsixyearsin2001-2002.Inthefiscalyear2002-2003,netprofitsincreasedby468percenttoRs.188crore(ReferExhibit-III).

In the Business Standard Annual ‘Banker of the Year Survey’ 2003, the Indian Bank was ranked second on the growth parameter. Analysts felt that this was no mean achievement for a bank, which was in the throes of losses half a decade ago. The honour was not surprising, as over 25 percent of Indian Bank’s business since its inception had been done in the three-year period between 2000 and 2003 (Out of the total business of Rs.40,000 crore, Rs.11,000 crore was gained during the three-year period).

Looking aheadEncouraged by the progress achieved during the three years of restructuring leading to the turnaround, the Indian Bank developed a new long-term vision document called Vision 2010. The document, which embodied the vision of the bank, looked ahead to the year 2010 and included plans for a public issue which was likely to open in early 2005 (According to norms laid down by the Securities Exchange Board of India, an entity can come out with an IPO only,ifitpostsprofitsforthreeconsequentyearsandtheIndianBankwasexpectingtopostitsthirdconsequentprofitinthefiscalyear2004).

(Source: The Turnaround of Indian Bank. [Pdf] Available at: <http://www.icmrindia.org/casestudies/catalogue/Business%20Strategy2/The%20Turnaround%20of%20Indian%20Bank%20Business%20Strategy.htm> [Accessed 02 June 2014]).

QuestionsWhat is the issue discussed in this case?1. AnswerThe case discusses the turnaround of the Indian Bank, a prominent public sector bank based in Chennai, a south Indian city. The Indian Bank was established in 1907 and was nationalised by the Indian Government in 1969. The bank functioned reasonably well with the aid of the government, till prudential norms were introduced for public sector banks in 1992. While the new norms caused most of the public sector banks in India to falter, the IndianBankpostedanindustryrecordlossofRs1336croreinthefiscalyear1995-1996.

When was the bank a part of Swadeshi Movement?2. AnswerIndian Bank was set up as part of the Swadeshi Movement in 1907.

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Whendidtheturnaroundfinallyhappen?3. AnswersTheturnaroundfinallyhappened,whentheIndianBankposteditsfirstnetprofitofRs33croreinsixyearsin2001-2002.Inthefiscalyear2002-2003,netprofitsincreasedby468percenttoRs.188crore.


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Case Study II

Improving Operational Efficiency of a Bank

AbstractThecasediscussestheneedforimprovingtheoperationalefficiencyofabanktodeliverbettercustomerservice.It examines the advantages and disadvantages of automating a bank’s services. It also studies the ways of reducing waiting time for customers through change in production and operations standards. It also throws light on the various work methods and behavioural dimensions of job-design. The case also discusses the role of technology in improvingtheoperationalefficiencyofabank.

IssuesThe importance of the automation of processes in a bank•The role of technology in providing faster and better customer service•

Bharat Vikas Bank is a public sector bank in India. It has been in operation for over two decades and has more than 200 branches spread across the country. It has been focusing only on retail banking since its inception. Till 1991, the banking sector was not opened to private and foreign players and, there was not much competition among the banks. The level of service was not an issue for customers as all public sector banks provided the same level of service.Therefore,peopledidnothaveanyspecificcriteriaforchoosingabank.Theironlyconcernwastofindoneclose to their locality. Since then, the market dynamics has changed considerably in addition to private local banks; many foreign banks have now opened branches in the country.

As customers now have a range of options, they select a bank on the basis of its performance. Therefore, in the last one decade, other public sector banks have also changed their processes and adopted technology to provide better service to customers. However, Bharat Vikas Bank, however, did not gear itself up for the competition and continued toprovidesamelevelofservice.Asaresult,itscustomer-basehasbeenerodingforthelastfiveyears.Itsmarketshare has also reduced considerably during this period.

Almost all transactions were manually recorded into registers. Sorting and searching those registers was a time-consumingtask.Itwasalsodifficulttoavoidthemistakesassociatedwithmanualentry.Sucherrorscouldonlybeidentifiedduringthemonthlyreconciliationandcheckingofaccountsandcorrectingtheminvolvedconsiderableworkandtime.Thetimetakentoexecuteeachtaskwasthreetofivetimesmorethanthatofbetter-managedbanks.

(Source: ImprovingOperationalEfficiencyofaBank.[Pdf] Available at: <http://www.icmrindia.org/casestudies/catalogue/Operations/OPER038.htm> [Accessed 02 June 2014]).

QuestionsWhyshouldabankimproveitsoperationalefficiency?1. What are the advantages and disadvantages of automating a bank’s services?2. Whatistheroleoftechnologyinimprovingtheoperationalefficiencyofabank?3.

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Case Study III

State Bank of India: Competitive Strategies of a Market Leader

AbstractState Bank of India (SBI) is the largest nationalised commercial bank in India in terms of assets, number of branches, deposits,profitsandworkforce.WiththeliberalisationoftheIndianbankingindustryinthemid-1990s,SBIfacedstiffcompetitionfromtheprivatesectorandforeignbankswhichresultedinsignificantlossofitsmarketshare.The case describes the efforts of SBI to regain its lost market share by undergoing a major restructuring exercise which involved redesigning its branch network, providing alternate banking channels, emphasis on lean structure and technology up gradation.

The case also discusses how SBI is building its image as a customer-friendly bank by launching innovative products and services and promoting its brand. Finally, it discusses the challenges faced by SBI in 2004 and its plans in the future. The case includes a note on the recent trends in the Indian banking industry.

IssuesUnderstand the strategies adopted by a market leader in the banking industry to retain its market share.•Explorethereasonshowamarketleadercanloseitsmarketsharesignificantly.•Examine and analyse the key elements of the restructuring exercise undertaken by SBI.•Study the marketing initiatives adopted by SBI to reposition itself as a customer-oriented bank.•Examine the challenges that can be faced by a market leader due to the changes in the industry structure•Study and analyse the structure of the Indian banking industry •

“The nationalised banking industry would be subject to tremendous pressures to perform as otherwise their very survival would be at stake. The nationalised banking industry in India will have to get its act together, if it has to survive in the new millennium since it would be subject to intense competition not only from the new domestic players,butalsofromestablishedglobaloutfits.”-SKGupta,ChiefGeneralManager,(BengalCircle),StateBankof India.

“We are second to none in banking technology, though we were initially far behind the private sector banks in launching core banking solutions to facilitate anywhere banking facility. We are now in a position to take the lead in the banking technologies as we have become front runners in the sector.”–A. Ramesh Kumar, Chief General Manager, SBI’s Mumbai Circle.

IntroductionIn March 2003, State Bank of India (SBI) and its associate banks had 13,579 branches, one of the largest branch networksforanybankintheworld.ItplayedakeyroleinprovidingworkingcapitalfinanceandtermloanstoIndian industry.

In 2003, SBI had eight business units, such as corporate banking, international banking and domestic banking for concentrating on core business areas; associate banks unit for looking after these banks, credit division unit to monitoroverallcreditandthreeotherbusinessunitsincludingfinance,corporatedevelopmentandinspectionforin-house work. (Refer Exhibit I for the Organisation Structure of SBI). SBI was the largest commercial bank in India in terms of revenues, assets, deposits, branches and workforce. Since the late 1990s, SBI had been losing market share in the Indian banking industry due to the tough competition from private sector banks (Refer Exhibit II for market share of public, private and foreign banks in 2001).

Byadoptingmoderntechnologyandofferingsuperiorcustomerservice,theprivatesectorbanksgainedasignificantshare in urban banking. Expressing concern over this trend in an interview to the Asian Banking Journal, AK Purwar, SBI’s Chairman and Managing Director, said, “The top most priority for the bank has been retention of market share.


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AsaPSUbank,SBIwaslosingitsmarketshare.Althoughitwasataveryslowpace,itwasdefinitelylosingitsmarket share.” To regain lost ground, SBI initiated a major internal restructuring exercise. The bank responded to competition by taking several measures including offering an array of new products and services, forging alliances with other business entities, entering new areas of business and adopting novel ways of reaching out to customers and providing them value-added services.

Background noteThe origin of SBI dates back to the early 19th century, when the Bank of Calcutta was established in Calcutta (present day Kolkata in the state of West Bengal) in June 1806 under the aegis of the Government of Bengal.

Three years after its inception, the bank was renamed Bank of Bengal on receiving its charter. It was a unique bankinginstitutionasitwasthefirstjoint-stockbankinBritishIndia.NextwastheBankofBombayinApril1840,followed by the Bank of Madras on July 1843. By 1876, the three presidency banks, together with their branches, agencies and sub-agencies, covered major inland trade centres in India. Bank of Bengal had 18 branches, while the other two had 15 branches each. Initially, the business of these banks was restricted to discounting bills of exchange or other negotiable private securities, keeping cash accounts and receiving deposits and issuing and circulating cash notes. The last quarter of the 19th century witnessed rapid commercialisation in India owing to the expansion of the railway network, to cover all major geographic regions of the country.

Thethreepresidencybankswerebothbeneficiariesandpromotersofthiscommercialisationprocessastheybecameinvolvedinthefinancingofpracticallyeverytrading,manufacturingandminingactivityintheIndiansub-continent.The three presidency banks were amalgamated in January 1921 to form the Imperial Bank of India. The new bank performed the triple role of a commercial bank, a banker’s bank and a banker to the government.

However, the quasi-central bank role performed by the Imperial Bank ended with the formation of the Reserve Bank of India (RBI) as the central bank of India in 1935. RBI’s establishment was a catalyst in the conversion of the Imperial Bank into a purely commercial bank. At the time of Independence in 1947, the Imperial Bank had acquired a paramount position in the country’s banking industry.

It had a capital base of Rs.118.5 mn, deposits of Rs. 2.7514 bn and advances of Rs. 729.4 mn. It had a network of 172branchesandover200sub-officesspreadalloverIndia.WhenthefirstFiveYearPlanwaslaunchedin1951,the rural sector was given top priority. The Imperial Bank and other commercial banks too operated mainly in urban areas and had not yet penetrated the rural sector. To overcome this lacuna, it was recommended that a state-partnered and state-sponsored bank be created to take over the Imperial Bank and integrate the former state-owned or state-associated banks with it.

ExcerptsLiberalisation of the Indian banking industryPrivatesectorbanksmadetheirfirstappearanceinJanuary1993.Duringthatperiod,PublicSectorBanks(PSBs)accounted for over three-fourths of total banking industry assets. They were weighed down with huge NPAs (Non-Performing Assets), falling revenues, lack of modern technology and a massive and highly unionised workforce. New entrants began to erode the market share of the nationalised banks, especially in metro cities and urban areas. ThePSBsfounditincreasinglydifficulttocompetewiththenewprivatesectorbanksandtheforeignbanks.Thesebanks also employed state-of-the-art technology, which helped them to save on manpower costs and concentrate on providing better service.

The restructuringTo overcome the intense competition from private and foreign banks, SBI planned a major organisational restructuring exercise. The key aspects involved redesigning of branches, providing alternate channels; focus on a lean structure and technological up-gradation. A Business Process Reengineering (BPR) team was constituted in June 2003 with McKinsey & Company as consultants. The BPR’s basic goal was to create an operating architecture that would facilitateservicedeliveryofinternationalstandards.Theprojectobjectivesweredefinedas“increasingcustomersatisfaction and convenience, freeing up time for branch manager and branch staff to focus on sales and marketing,

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simplifyingprocess for employees, enhancingSBI’scompetitiveness in themarket, increasing theprofitabilitythroughhighermarketshareandimprovedprocessefficiency.”

New products and servicesApart from restructuring, SBI launched several innovative, value-added products and services to project a customer friendly image. It launched a special service for corporate customers called ‘telebanking and remote login to support transactional requests.

Thisfacilitywouldbeavailableat593branches,andremoteloginat269branches.Thebank’stradefinancesolution,calledEXIMBILLS,wasintendedtohandletradefinancetransactionsefficientlyandenhancetherangeofservicesprovided to corporates and network branches. In March 2004, SBI announced that it would introduce ‘anywhere banking’ facility for its customers from over 9000 branches across India in the next two years. All branches in Mumbai would provide this facility by December 2004. SBI also launched different customised loan programmes to cater to various sections of society depending on income levels and repayment capabilities. Interest rates and repayment periods were tailor-made to suit the customer groups.

Alliances and tie-upsTo boost its business, SBI entered into several alliances and tie-ups with automobile, insurance, mutual fund, project financeandmedicalequipmentcompanies.

Auto financeUnlike other competitors that relied on reduced interest rates to get business, SBI extended the tenure of car loans fromfivetosevenyears,therebyloweringthemonthlydebtrepaymentburdenoftheloanseeker.SBIenteredintoa tie-up with Maruti, the largest automobile manufacturer in India, to provide loans for purchase of Maruti cars at the rate of 10.05 per cent and 11.25 per cent for three years and above three years respectively. After the scheme wasintroduced,SBIemergedasthelargestfinancierforMaruticarsinIndiaandthenumberofMarutivehiclesfinancedgrewby17percentinthefiscal2003-04overfiscal2002-03.

The marketing initiativesSBI carried out various marketing initiatives to enhance its reach. They included segregating and targeting existing high value customers, cross sales of other products, setting up call centres and outbound sales force to secure new customers. Plans were also made to utilise database marketing to pursue large and medium-sized corporates, governmentandtradefinancecustomers.Databasemarketingwasexpectedtodrawincreasedrevenuefromcrossselling, lower costs and increased customer loyalty. SBI also introduced various other ways of reaching out to customers like extension of hours of work and aggressive marketing through print and television media. SBI increased daily working hours by two hours and Sunday banking was introduced.

Looking aheadSBI’srestructuringexerciseandgrowthstrategiesresultedinanincreaseinprofitsforthefiscal2003-04.NetprofitsstoodatRs36.81bnforthefiscalended2003-04asagainstRs31.05bnthepreviousfiscal,anincreaseof18.55percent.OperatingprofitsstoodatRs95.535bncomparedtoRs77.754bninthefiscal2002-03.InspiteofSBI’sefforts to reduce workforce, staff costs rose by 13.3 per cent, mainly due to additional contribution to pension fund andprovisionforleaveencashment.ThenetNPAlevelcamedownfrom4.5percentinthefiscal2002-03to3.5percentin2003-04.SBIaimedat2percentNPAby2004-05(ReferExhibitIV&Vforthefinancialhighlightsof SBI group).

ExhibitsExhibit I: Organisation Structure of SBIExhibit II: Market Share of Banks (December 2001)Exhibit III: Code of Fair Banking PracticeExhibit IV: Financial Performance of SBI (1998-2001)Exhibit V: SBI Group - Key Operational Highlights (As on March 31, 2004)Exhibit VI: Indian Banking Industry (March 2003)


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Exhibit VII: Performance of SBI Compared to Other Banks (2003-04)Exhibit VIII: Deposits Market Share Trends

(Source: State Bank of India: Competitive Strategies of a Market Leader. [Pdf] Available at: <http://www.icmrindia.org/casestudies/catalogue/Business%20Strategy2/BSTR132.htm> [Accessed 02 June 2014]).

QuestionsWhat were the efforts taken by SBI to regain its lost market share?1. How did SBI build its image as a customer-friendly bank by launching innovative products and services and 2. promoting its brand?What were the challenges faced by SBI in 2004 and its plans for the future?3.

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Leiderman, L . and Razin, A., 1994. • Capital Mobility: The Impact on Consumption, Investment and Growth. Cambridge University Press.Mahadeva, L. and Sterne, G., 2 0 1 2 . • Monetary Policy Frameworks in a Global Context. Routledge.Modelling monetary policy in developing countries. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:nyXs5sOwpZsJ:www.pftac.org/filemanager/files/Macro2/workshop/2.pdf+&cd=8&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Monetary Policy Tools and Techniques (Unit 5, Lecture 4). • [Video online] Available at: <https://www.youtube.com/watch?v=cgLkRnmoyOQ> [Accessed 06 June 2014].Money and Banking: Lecture 1 - Money and the Economy. • [Video online] Available at: <https://www.youtube.com/watch?v=etsCGT542AI> [Accessed 06 June 2014].Money and Banking: Lecture 1 - Money and the Economy. • [Video online] Available at: <https://www.youtube.com/watch?v=etsCGT542AI> [Accessed 06 June 2014].Money and Banking: Lecture 39 - Monetary Policy 1. • [Video online] Available at: <https://www.youtube.com/watch?v=uHP0BO2x8cw> [Accessed 06 June 2014].Money and Banking: Lecture 7 - Interest Rates and Present Value 2. • [Video online] Available at: <https://www.youtube.com/watch?v=R3CH09n2DRg> [Accessed 06 June 2014].Money Creation. • [Pdf] Available at: <http://staffweb.hkbu.edu.hk/awong/CMs/econ1220/Lectures/lecture%207/L7C32.pdf> [Accessed 06 June 2014].Mwenda, K . K., 2 0 0 2 . • BankingandMicro-financeRegulationandSupervision. Universal-Publishers.Padmalatha, S ., 2011. • Management of Banking And Financial Services. Pearson Education India, New Delhi.Page, S ., 2013. • Monetary Policy in Developing Countries. Routledge.Regulatory and Supervisory Independence and Financial Stability. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:1akAwKSZAiEJ:www.imf.org/external/pubs/ft/wp/2002/wp0246.pdf+&cd=4&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Reserve Bank of India: Functions and Working. • [Pdf] Available at: <http://rbidocs.rbi.org.in/rdocs/Content/PDFs/FUNCWWE080910.pdf> [Accessed 06 June 2014].Risk Management for electronic Banking and electronic Money Activities. • [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:IaMbBD2EcZoJ:www.bis.org/publ/bcbs35.pdf+&cd=2&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].Role of Payment and Settlement Systems in Monetary Policy and Financial Stability: Integrative Report. • [Pdf] Availableat:<http://www.seacen.org/file/file/2014/RP90/RPSS%20-%20chapter%201.pdf>[Accessed06June2014].Singh, K. and Dutta, V., 2 0 1 3 . • Commercial Bank Management. Tata McGraw-Hill Education, New Delhi.Steven Horwitz at FFF: “Do We Really Need a Central Bank?” • [Video online] Available at: <https://www.youtube.com/watch?v=S2M0RF6faC0> [Accessed 06 June 2014].Tech Trends - the future of technology and payments. • [Video online] Available at: <https://www.youtube.com/watch?v=hrz1pnbmh8E> [Accessed 06 June 2014].Technology in Banking: Facing the Challenges of Scale and Complexity. • [Video online] Available at: <https://www.youtube.com/watch?v=9JzLQKKGhjo> [Accessed 06 June 2014].TheEffectivenessofMonetaryPolicyTransmissionunderCapitalInflows:EvidencefromAsia.• [Pdf] Available at: <http://webcache.googleusercontent.com/search?q=cache:xJ8W6U1O28cJ:https://www.imf.org/external/pubs/ft/wp/2012/wp12265.pdf+&cd=5&hl=en&ct=clnk&gl=in> [Accessed 06 June 2014].The Role of Interbank Markets in Monetary Policy. • [Pdf] Available at: <http://www.econ.upf.edu/~freixas/more/FreixasJorgeTheRole.pdf> [Accessed 06 June 2014].The Rote of Money and Monetary Policy. • [Pdf] Available at: <http://research.stlouisfed.org/publications/review/68/07/Money_July1968.pdf> [Accessed 06 June 2014].

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The Theory of Central Banking | Robert P. Murphy. • [Video online] Available at: <https://www.youtube.com/watch?v=6HAEPSt_12U> [Accessed 06 June 2014].Tsangarides, C.G., 2 0 1 0 . • Monetary Policy Transmission in Mauritius Using a Var Analysis. International Monetary Fund.

Recommended ReadingAltig, D. E. and Smith, B. D., 2003. • Evolution and Procedures in Central Banking. Cambridge University Press.Caprio, G., 2012. • The Evidence and Impact of Financial Globalization. Academic Press.Cardoso, E. and Galal, A., 2006. • Monetary Policy and Exchange Rate Regimes. American Univ in Cairo Press.Ciccarelli, M. and Rebucci, A ., 2002. • The Transmission Mechanism of European Monetary Policy: Is There Heterogeneity? Is it Changing over Time? (EPub). International Monetary Fund.Collyns, C., 1983. • Alternatives to the Central Bank in the Developing World. International Monetary Fund.Downes, P. and Vaez-Zadeh, R., 1991. • Monetary The Evolving Role of Central Banks (EPub). International Monetary Fund.Dunn, J. C., Yiqun, W., Davies, M., Yang, Y. and Shengzu, W., 2011. • Monetary Policy Transmission Mechanisms inPacificIslandCountries. International Monetary Fund.Glantz, M., 2003. • Managing Bank Risk: An Introduction to Broad-base Credit Engineering. Academic Press.Goodfriend, M. and Prasad, E ., 2006. • A Framework for Independent Monetary Policy in China (EPub). International Monetary Fund.Gup, B.E., 2003. • The Future of Banking. Greenwood Publishing Group.Hammond, G., Kanbur, S.M.R. and Prasad, E ., 2009. • Monetary Policy Frameworks for Emerging Markets. Edward Elgar Publishing.Hamori, S. and Hamori, N., 2010. • Introduction of the Euro and the Monetary Policy of the European Central Bank.WorldScientific,Singapore.Hossain, A. A., 2009. • CentralBankingandMonetaryPolicyintheAsia-Pacific. Edward Elgar Publishing.Khanna, O. P. and Jain, T. R. • Economic Concepts and Methods. FK Publications, New Delhi.Khanna, O. P. and Jain, T. R. • Macro Economic Analysis and Policy. VK Publications.Kuijs, L., 2002. • MonetaryPolicyTransmissionMechanismsandInflationinSlovakia. International Monetary Fund.Mayo, H., 2011. • Basic Finance: An Introduction to Financial Institutions, Investments and Management. Cengage Learning.Park, Y. S. and Essayyad, M., 1989. • International Banking and Financial Centers. Springer.Pellerin, S., 2010. • Consolidation of Financial Regulation. DIANE Publishing.Rochon, L. P. and Rossi, S., 2006. • Monetary and Exchange Rate Systems: A Global View of Financial Crises. Edward Elgar Publishing.Santomero, A. M., Viotti, S.and Vredin, A ., 2001. • Challenges for Central Banking. Springer.Shrivastava, M. P., Pandey, P. K and Vidyarthi, V. P., 2007. • Banking Reforms and Globalisation. APH Publishing.Sundararajan, V., Marston, D. and Ghiath, S ., 1998. • Monetary Operations and Government Debt Management under Islamic Banking. International Monetary Fund.Ugolini, P., 1996. • National Bank of Poland: The Road to Indirect Instruments (EPub). International Monetary Fund.


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Self Assessment Answers

Chapter Ia1. c2. c3. d4. d5. a6. b7. a8. c9. b10.

Chapter IIb1. a2. d3. b4. a5. b6. b7. c8. d9. a10.

Chapter IIIc1. a2. b3. d4. a5. c6. c7. d8. a9. c10.

Chapter IVc1. d2. b3. c4. a5. c6. b7. a8. d9. c10.

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Chapter Va1. b2. c3. a4. b5. c6. d7. c8. d9. a10.

Chapter VIc1. a2. a3. d4. a5. a6. c7. b8. d9. a10.

Chapter VIIb1. a2. a3. c4. b5. d6. a7. c8. b9. d10.

Chapter VIIIb1. a2. d3. d4. b5. a6. d7. c8. c9. a10.

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