MONEY AND BANKINGMEANING OF MONEY:Money is any good that is widely used and accepted in transactions involving the transfer of goods and services from one person to another. Economists differentiate among three different types of money: commodity money, fiat money, and bank money.

FUNCTIONS OF MONEY:

Money is often defined in terms of the three functions or services that it provides. Money serves as a medium of exchange, as a store of value, and as a unit of account.

Medium of exchange: Money's most important function is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system, exchange can take place only if there is a double coincidence of wants between two transacting parties. The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others goods and services.

Store of value: In order to be a medium of exchange, money must hold its value over time; that is, it must be a store of value. If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps. Money may not even be the best store of value because it depreciates with inflation. However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of value that is available in a number of convenient denominations.

Unit of account:Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase.

Demand for money:The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives.

Transactions motive:The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises.

Precautionary motive:People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money.

Speculative motive:Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset.

Supply of money:

The total supply of money is the circulation in a given country's economy at a given time. Economics defines money supply as the total assets of stock that is accepted as an exchange media at a given time in an economy.

Money supply has a standardized representation with three monetary components which has been delineated as M0, M1 and M2.The following details their principal componentsM0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.

M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or "current" accounts).

M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).

M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of Eurodollars and repurchase agreements.

What do you mean by bank? Or define bank.

A bank is an institution which deals with money and credit. It refers to an individual or organization which acted as a money changer or exchanged one currency for another. It accepts deposits from the public, makes the funds available to those who need them and helps in the remittance of money from one place to another.

One that collects money from those who have it to spare or who are saving it out of their income and lends the money so collected to those who require it.

-Crowther

Banking means the accepting for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawal by cheque, draft, order or otherwise.

-Banking Regulation Act 1949,

What are the various classifications of banks?

The banks can be classified into various types on the basis of ownership, functions, domicile etc. The following are the various types of banks.

Central Bank (RBI):

Central bank is the bank of a country; its main function is to issue currency known as Bank notes. This bank acts as the lender of the banking system and money market of the country by regulating money and credit. These banks are the bankers to the government; they are bankers bank and the ultimate custodian of a nations foreign exchange reserves. The main aim of the central bank is not to earn profit, but to maintain price stability and to strive for economic development with all round growth of the country. The central bank of different countries is known by different names like RBI in India, Bank of England in U.K., Federal Reserve System in U.S.A.., etc.

Commercial banks:

It is a kind of bank which promotes commercial activities by lending for various commercial activities. They also perform certain agency services such as collection of cheques, dividends, interest on investment, issue of drafts, letter of credit, travelers cheque, investment advisory services etc.

Industrial banks:

When banks provide long term loans to industries, they are called industrial bank or investment banks. As investment banks, they take part in the share capital of companies. They may serve as catalytic agents in mobilization of capital in other forms of assistance such as underwriting, guarantee etc. Exchange banks:

Banks which are incorporated outside the country but doing banking business in India are called exchange banks. They provide foreign exchange, subject to the rules and regulations of the country in which they are located. Exchange banks deal in foreign exchange and specialize in financing foreign trade. They facilitate international payments through the sale and purchase of bills of exchange and this play an important role in promoting foreign trade.

Co-operative banks:

They are organized on co-operative principles of mutual help and assistance. In India, co-operative credit institutions are under the co-operative societys law. They grant short term loans to the agriculturists for purchase of seeds, harvesting and for other cultivation expenses. They accept money on deposit from and make loans to their members at a low rate of interest.

Agricultural Banks:

Agricultural banks help by providing loans to weaker sections. But they provide long term loans for agricultural activities which will enable the borrower to purchase new lands, to purchase heavy agricultural machinery, in repayment of old debts, in soil conservation and land reclamation.

COMMERCIAL BANKS:

Commercial banks in India are controlled or owned by three different groups of organizations. They are the public sector, private sector and foreign banks. We can also display the commercial banking system in India as given below;

COMMERCIAL BANKS

PUBLIC SECTOR BANKS

PRIVATE SECTOR BANKS

FOREIGN BANKS

SBI AND SUBSIDIARIES

NATIONALISED

1969 (14 BANKS)

1980 (6 BANKS)

Public sector banks:

After independence, in 1949 the banking companies Act was passed to regulate the working of commercial banks in India. Mr. Gorwalla who headed the All India Rural Credit Survey Committee recommended nationalization of leading commercial banks for providing more finance to agriculture. Accordingly, the Imperial Bank of India was nationalized and state bank of India came into existence in May, 1955. In 1969, 14 major scheduled banks were nationalized. Again in 1980, 6 more banks were nationalized. Thus, we find 28 banks are there in the public sector. The break up is as follows, state bank of India and its subsidiaries, totaling to 8 and 20 commercial banks.

Private sector banks:

The private sector banks are providing more assistance to the priority sector owing to the statutory compulsions especially under the provisions of the Banking companies Act. This Act was renamed in 1966 as Banking Regulation Act.

Foreign banks:

The Foreign banks though not allowed liberally earlier, are nor being welcomed, with the adoption of economic liberalization policy in our country. Prior to 1990, we had only limited foreign banks operating in our country, but now we have more number of foreign banks operating in our country.

What are the various functions of commercial banks?

The following are the various modern functions of commercial banks to promote commerce and industrial activity in the country.

FUNCTIONS OF MODERN COMMERCIAL BANKS

PRIMARY FUNCTIONS

SECONDARY FUNCTIONS

AGENCY SERVICE

GENERAL

ACCEPTING DEPOSITS GRANTING LOANS

UTILITY SERVICE

DISCOUNTING OF BILLS

SB A/CCURRENT A/CFIXED DEPOSITS A/C

RD A/C

LOANS

CASH CREDIT

OVER DRAFT

CLEAR LOANS SECURED LOANS

PLEDGE MORTGAGE HYPOTHICATION ASSIGNMENT

Accepting of deposits:

Savings a/c:

Saving a/c can be opened by any person above the age of 18 and he / she has to be introduced by another customer of the same branch. In saving a/c, the credit balance of the customers must be sufficient enough so that cheque issued by the customers could be honored. A saving a/c can also be opened without a cheque book facility. The bank will be providing to the saving a/c holder interest on the minimum credit balance. The interest is payable half yearly and is credited to the account of the customer.

Current a/c:

Unlike saving a/c, current a/c cannot be opened by every individual. For opening a current a/c, a letter of introduction is required which testify the character and conduct of a person who intend to open the current a/c. Normally, this type of account is held by business people who may require money for various activities. The advantage of current a/c is that the customer can draw more than his credit balance, provided he is given overdraft facility. Banker will not pay interest for current balance of the customer. But any debit balance in the current a/c will be charged interest rate on day to day basis.

Fixed deposit:

When a customer deposits certain sum of money to be kept with the banker for a fixed period, it is called a fixed deposit a/c. The fixed deposit amount is payable on maturity only to that deposit holder in whose name the deposit receipt stands. The deposit amount is payable along with the interest at the rate as agreed upon. But a customer has the option to foreclose the deposit even before the date of maturity. In such a case, the customer will not be entitled to the agreed rate of interest.

Recurring deposit:

A stipulated amount of money is deposited every month for a fixed period, say one or two years, which is payable at the expiry of the fixed period along with interest is called recurring deposit. The interest rate on recurring deposits will be higher as they are calculated on a cumulative basis.

Granting of loans:

Clear loans:

Clear loan is a loan granted by the banker without any security but the banker safeguards himself by granting clear loan to salaried people on the basis of their future income. The employer of the salaried person will deduct from the salary and pay to the banker the installment amount due on the loan. The only condition is that the employment of the borrower should be permanent in nature.

Secured loan:

Pledge:

When loans are granted against the security of the borrower, it is a secured loan. The borrower will hand over the security to the banker under pledge e.g., Jewel loan.

Mortgage:

In mortgage, the loan is granted against fixed immovable property. If the borrower fails to repay the loan, the mortgage property will be sold and the loan amount realized.

Hypothecation:

Hypothecation is a kind of loan wherein the borrower is enabled to purchase a vehicle or machinery with the help of bank loan. The document of title will have the mention of hypothecation. For e.g., R.C. book of vehicle containing hypothecation. If the borrower fails to repay the loan, the bank will take over the possession of security and dispose the same towards the recovery of the loan.

Assignment:

This is transfer of an actionable claim. If the borrower of a bank has an insurance policy, he can transfer the policy in favors of the bank before its maturity and obtain a loan. The bank will adjust the loan amount from the policy amount when it is matures.

Overdraft:

This is a facility given to the current a/c holders wherein depending upon their credit worthiness, the banker grants OD facilities by which the customer can draw over and above his credit balance up to a fixed amount. For e.g., if a customer has Rs.10,000 in his a/c as credit balance, he may be granted an overdraft of Rs.5,000 by which he can draw up to Rs.15,000. As and when the customer deposits money, the loan amount will be adjusted. The interest rate is calculated on day-to day basis and hence this interest will be cheaper for the customers.

Cash credit:

For the benefit of businessmen who are in need of working capital, cash credit system is arranged under this system, the customer may be given for example, Rs.1 lakh as credit from 1st January to 31st December. If the customer draws Rs.30, 000 in March and another Rs.30,000 in August and the remaining Rs.40,000 in December, the bank will charge interest according to the period of the loan. The first Rs.30,000 will carry interest rate for a period of 10 months, the next Rs.30,000 will carry interest rate for a period of 5 months and the last loan of Rs.40,000 will carry interest rate for a period of 1 month.

Discounting of bills of exchange:Under this method, a holder of bills of exchange can get it discounted by the banks. In bills of exchange, the debtor accepts the bill drawn upon him by the creditor (i.e., holder of the bill) and agrees to pay the amount mentioned on maturity. After making some managerial deductions in the form of commission the bank pays the value of the bills to the holder. When the bills of, exchange mature the bank gets its payment from the party which had accepted the bills. Thus such a loan is self-liquidating.Agency services:

The banker undertakes to collect cheque, bills and pro notes for customers. The standard instruction of customer such as payment of telephone bills, insurance premium etc., are done.

Collecting dividends, interest on various securities.

Purchasing and selling securities as per customers instruction.

Undertaken to transfer funds from one branch to another.

Dispenses salary to employees on instruction from employer.

Issue of credit cards, both in rural and urban areas.

General Utility Services:

Purchase and sells foreign exchange on permission from RBI.

On behalf of importer, the banker issues letter of credit to the exporter.

It provides safe deposit vault in which customer can keep their valuables.

It accepts income tax on behalf of RBI.

The bank also supplies data and trade information required by businessmen.

What are the Roles or Importance of commercial banks in economic development?

Commercial banks in our country play an important role in the economic development of our country. They are as follows;

Development of trade and industry:

All economic progress in the last 200 years are so has been made on extensive trade and industrialization, which could not have taken place without the use of money among countries trade is financed through bills of exchange, which are discounted by banks. Without the use of the bank cheque, the bank draft and the bill of exchange, international and internal trade could not have developed and without such trade specialization and industrial development could not have taken place.

Regional development:

Another way by which commercial banks encourage production and enhance national income is by the transference of surplus capital from region where it is not wanted so much to those regions where it can be more useful and efficiently employed.

Expansion of business:

Banks provide funds to entrepreneurs for investment under conditions of unemployment. It will push up production in the country. From the view of an under developed economy, the expansion of bank credit, offering more financial resources to industries, is one of the contributory causes for rapid economic development.

Capital formation:

Commercial banks provide facilities for saving and thus encourage habits of thrift among people. A higher rate of saving and investment i.e., therefore, what constitutes real capital formation.

In a developing country like India, banking facilities are highly inadequate. These banks have come to occupy an important place in the industrial and commercial life of a nation. A developed banking organization is a necessary condition for the industrial development of a country.

Development of agriculture and small scale industries:

The development of a country not only depends upon the industrial development but also on the development of agriculture and small scale industries and cottage industries. Agriculture contributes a sizeable portion (about 25%) to the GDP of our country. Similarly, small scale industries provide large employment opportunities and goods manufactured by this sector are also exported out of India. The banker caters to the financial requirements of these sectors which lead to the economic progress of the country.

Provide infrastructural facilities:

Banks can develop comprehensive infrastructural facilities in the country. It includes social, educational, fiscal and other aspects, whose development is essential for the economic progress of a nation.

Implementation of monetary policy:

Economic development needs an appropriate monetary policy. But a well-developed banking system is a necessary pre condition for the effective implementation of monetary policy. Control and regulation of credit by the monetary authority is not possible without the active co-operation of the banking system in the country.

Balancing balance of trade:

Through properly devised banking system, the country can promote exports through easy and timely credit facilities to exporters, quickly obtaining money from foreign buyers of goods etc. This may help maintain the balance of trade at favorable position.

RESERVE BANK OF INDIA (RBI):

Reserve bank of India is the central bank of India. It was started in 1934 as a share holders bank. After independence the government passed the transfer of public ownership Act by which RBI was nationalized on 1st January 1949. In March 1949 the banking company Act was passed which gave more powers to RBI to control and regulate the working of commercial banks.

What are the various Functions performed by RBI?

The functions of RBI can be classified under three parts. They are traditional functions, promotional functions and supervisory functions.

TRADITIONAL FUNCTIONS:Issue of currency notes: RBI undertakes issue of currency and the system adopted in India is the minimum reserve system.

All the currency notes from Rs.2 to Rs.1000 are issued by RBI and carry the signature of Governor of RBI. They are called unlimited legal tender money.

The one rupee notes and small coins are issued by the Government and they are called limited legal tender. The one rupee note carries the signature of secretary to the ministry of finance.

Banker to the Government: The RBI functions as a banker, agent and financial adviser to the government.

RBI acts as a banker to the government by maintaining the account of central government and also that of state government. It receives deposits and makes short term advances to the government.

It collects cheque and drafts deposited in the government account.

It also provided overdraft facility to both state and central government.

It provides foreign exchange resources to the government for repaying external debt or purchasing foreign goods or making other payments.

The public borrowing of government are done through RBI.

Payments to the government such as income tax are also accepted by RBI.

It gives advices on monetary, economic, financial and fiscal matters etc.

Bankers to the bank: RBI acts as a bankers bank in the following manner.

Custodian of the cash reserve of the commercial banks. As a custodial of cash reserve of the commercial banks, the central bank maintains the cash reserves of the commercial banks.

Every commercial bank has to keep a certain percentage of its cash balances as deposits with the central bank. These cash reserves can be utilized by the commercial banks in times of emergency.

It acts as the lender of the last resort.

It also acts as a clearing agency for the claims of the commercial banks.

In this way, the central bank acts as a friend, philosopher and guide to the commercial banks.

Lender of the last resort:The commercial banks have to maintain certain percentage of their deposits with RBI which is called Cash Reserve Ratio (CRR). By increasing or decreasing this percentage of CRR, RBI allows adequate funds for lending purpose by commercial banks. This fund will be extended by RBI to any commercial bank which is facing crisis.

Custodial of foreign exchange reserves:The RBI also functions as the custodian of countrys foreign exchange reserves. This function helps the RBI to overcome the balance of payment difficulties and to maintain stability in the exchange rate. In order to minimize the fluctuations in the foreign exchange rate the central bank (buys or sells) foreign currencies in the market as the value of foreign currency falls or rise. Control of credit:

Controlling credit is the most important function of the central bank. Uncontrolled credit causes economic fluctuation in the economy. By controlling the credit effectively the central bank establishes stability not only it the internal price level, but also in the foreign exchange rates. Such stability is necessary for economic growth and smooth functioning of the economy.

Other functions:The RBI also performs certain other miscellaneous functions. To maintain relation with international institutions, such as the IMF, World Bank (IBRD) etc.

It collects various types of statistics providing information about current state of the economy.

It conducts survey; seminars etc, and publish reports on other matters.

It helps in developing the banking system and banking habit in the country.

It formulates appropriate monetary policy to deal with economic crisis in the country.

It extends training facilities to the staff working in various banking institutions.

CREDIT CONTROL METHODS:

What are the credit control methods adopted by RBI to control credit created by commercial banks?

When the central bank exercises control on commercial banks with the view to increase or decrease the money supply, it is called credit control. An excess bank credit leads to more money supply in the hands of customer who in turn demands more consumer goods, with the result, the price level increases.

The credit control is of two types.

Quantitative control and

Qualitative control

Quantitative credit control:

It consists of three weapons, which are Bank Rate, Open Market Operation and Variable Cash Reserve Ratio.

Bank Rate:

It is the rate at which the RBI rediscounts the bills presented by the commercial banks for giving loans. Whenever the commercial banks are in need of funds they approach the central bank by presenting eligible securities, mainly government securities. By discounting these securities, the central bank grants loans to the commercial banks. It is based on this rate that the commercial banks in turn grant loans to its customers. Thus, if the bank rate is increased, the commercial banks will have to pay a higher rate of interest for their borrowings from central bank. In turn, commercial banks will charge higher interest rate when they grant loans to their customers. Thus, the amount of credit is controlled.

Open Market Operation:

When the central bank resorts to direct buying and selling of securities in the money market, it is called open market operation. By selling in the money market, the central bank tries to absorb the excess money supply with the commercial banks, insurance companies and other financial institutions. Thus, during a period of inflation, the sale of security by central bank will encourage commercial banks to buy. In this process, the surplus cash with the commercial banks disappears. When the commercial banks are left with fewer amounts of funds, they cannot lend more and thereby credit is contracted.

Variable Cash Reserve Ratio (VCRR):

Under this weapon of credit control, the CBI prescribes the minimum percentage of cash the commercial banks are to maintain against their funds time and demand deposits. If there is inflation, then the central bank will hike the percentage of cash reserve ratio. This will leave a lesser amount of cash at the disposal of commercial banks for lending. If the cash reserve ratio (CRR) is reduced, the banks will be maintaining low cash in hand and this will enable them to give more loans. Increased lending by commercial banks will lead to more economic activities.

Selective (Qualitative) credit control:

The selective credit control mechanism has following measures.

Margin requirements:

Under this method, the central bank will prescribe the percentage of margin a bank should maintain while granting loans. For e.g., if a borrower comes to the bank with the security consisting of a gold coin and the market value of which is Rs.10,000. The central bank will inform the commercial bank that a margin of 50% should be maintained. In such a case, for the gold coin with the market value of Rs. 10,000, only Rs. 5,000 is granted as loan as 50% of its value is taken as a margin. During inflation, the central bank will increase the margin leaving a less amount of cash at the disposal of the borrower. This will affect their borrowing capacity and thereby the demand for other goods. The same margin will be lowered during depression so that more money is given as loan enabling the borrower to demand more goods.

Rationing of credit:

The central bank may instruct the commercial banks not to lend for undesirable and unproductive purposes and direct credit only for productive purposes. For this purpose, the central bank will specifically inform the commercial banks that they will discount only certain specific bills and will refuse to discount other bills. In this manner, control on bank advances is brought about.

Moral suasion:It is nothing but a request made by a central bank to cooperate with the policies of central bank. The appeal of the central bank will be accepted by the commercial bank only when a cardinal relationship exists among them. The effectiveness of this control depends on the strength of the central bank and its influence on the commercial banks.

Direct action:

Under this method, the central bank will inform commercial banks that they must strictly adhere to the regulations imposed by it on commercial banks. Failing which;

A penal interest will be levied

Rediscounting facility to the commercial banks will be refused

Additional credit will not be granted to such commercial backs which are found violating the regulations.

Publicity:

The central bank also uses publicity as a method of credit control. The central bank regularly publishes the statement of their assets and liabilities; review of credit and business conditions; reports on their own activities; money market and banking conditions; etc. From the published materials, the banks and the general public can anticipate the further changes in policies of the central bank. But this method is not very useful in the less developed countries where majority of the people are illiterates and do not understand the significance of banking statistics.