BCC 303-Money and Banking

1. Explain the different types of demand for money. Ans. This concept amounts to the use of money as a medium of exchange. In the Keynesian theory money becomes much more than a medium of exchange. People also demand money for speculative purposes & as a security. The demand of money has thus been broken down into three types. Transaction demand- Daily transactions require some money. However, the timing of receipt & payments may vary from person to person. If all purchases were made at the same instant income was received, there would be no transactions demand for money. Everyone must hold some amount of money to cover unevenness between the timing of what comes in & what goes out.

There are two determinants of transaction of demand for money: Income Rate of interest

The amount of money balances that the public as a whole wishes to hold for transaction purposes depends directly on the level of the income. It is possible to except the amount of money demanded for transactions purposes to vary directly with the level of income. Similarly, it is possible to except it to vary inversely with the rate of interest.

Precautionary demand This demand arises due to uncertainty of future receipts & expenditures. The precautionary demand enables persons to meet unanticipated increases in expenditure or unanticipated delays in receipts.

This type of demand for money may be expected to vary with the level of income. People need more money & are better able to set aside more money for this purpose at higher income levels. Precautionary demand may also be expected to vary inversely with interest rate. In practice there is some rate of interest at which both transaction demand & precautionary demand becomes interest inelastic. There is no longer a simple linear relation between the demand for money (both transaction & precautionary) & rate of interest. For example, at a high rate of interest, one may be tempted to assume the greater risk of a similar precautionary balance in exchange for the high interest rate that can be earned by converting part of this balance into interest bearing assets. Although precautionary demand may be formally distinguished from transactions demand, the total amount of money held to meet both demands is viewed primarily as a function of the level of income. Speculative demand 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.

For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money.

2. Discuss about the main propositions of Post-Keynesian theory. Ans. Freidman understood the point made by Keynesian theory, revisited his own theory once again, & developed a model for money demand based on the general theory of asset demand. Money demand, like the

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demand for any other asset, should be a function of wealth & the returns of other assets relative to money. His money demand function is as follows: =f(

Money demand is positively related to permanent income. However, permanent income, since it is a long-run average, is more stable than current income, so this will not be the source of a lot of fluctuation in money demand. The other terms in Freidmans money demand function are the expected returns on bonds, stocks & goods relative the expected return on money. These items are negatively related to money demand: the higher the returns of bonds, equity & goods relative the return on money, the lower the quantity of money demanded. Freidman did not assume the return on money to be zero. The return on money depended on the services provided on bank deposits (check cashing, bill paying, etc) & the interest on some checkable deposits. Apart from Freidman, there were many other economists who developed the theory. Wicksell, Schumpeter, Keynes, Kalecki, Robinson & Kaldor are the most prominent post Keynesian economists. The post-Keynesian theory is an alternative view on money. The assumptions of this theory are uncertainty, historical time & importance of money. The source of money is demanded of businessmen & households for credits. Money is endogenous & is determined by its demand a pulled by credits. Endogenous money refers to the theory that money comes into existence as it is needed by the real economy & that banking system reserves are enlarged or drained as needed to accommodate the demand for lending at the prevailing interest rates. Basically, so long as the banks can find profitable lending while borrowing at the discount rate set by the Federal Reserves then the creation of banking system reserves necessary to support the lending will be automatically supplied by the central bank through Open market operations. Post Keynesian economists believe that supply of money is credit-driven & determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities. Monetary policy operates primarily through interest rates at a fixed rate by monetary authorities, who are being forced to accommodate any increases in demand for reserves caused by bank lending. Even if the monetary authority refuses to accommodate any increases in demand for reserves, banks will still be able to increase in; oan demand through their own initiatives. According to Minsky, money supply is strictly defined as the sum of high-powered money & demand deposits.

3. Explain the role and functions of central banks. Ans. Functions of central banks1. Bank of Note Issue: The central bank has the sole monopoly of note issue in almost every country. The currency notes printed and issued by the central bank become unlimited legal tender throughout the country. In the words of De Koch, "The privilege of note-issue was almost everywhere associated with the origin and development of central banks." However, the monopoly of central bank to issue the currency notes may be partial in certain countries. For example, in India, one rupee notes are issued by the Ministry of Finance and all other notes are issued by the Reserve Bank of India. The main advantages of giving the monopoly right of note issue to the central bank are given below: (i) It brings uniformity in the monetary system of note issue and note circulation. (ii) The central bank can exercise better control over the money supply in the country. It increases public confidence in the monetary system of the country. (iii) Monetary management of the paper currency becomes easier. Being the supreme bank of the country, the central bank has full information about the monetary requirements of the economy and, therefore, can change the quantity of currency accordingly. (iv) It enables the central bank to exercise control over the creation of credit by the commercial banks.

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(v) The central bank also earns profit from the issue of paper currency. (vi) Granting of monopoly right of note issue to the central bank avoids the political interference in the matter of note issue. 2. Banker, Agent and Adviser to the Government: The central bank functions as a banker, agent and financial adviser to the government, (a) As a banker to government, the central bank performs the same functions for the government as a commercial bank performs for its customers. It maintains the accounts of the central as well as state government; it receives deposits from government; it makes short-term advances to the government; it collects cheques and drafts deposited in the government account; it provides foreign exchange resources to the government for repaying external debt or purchasing foreign goods or making other payments, (b) As an Agent to the government, the central bank collects taxes and other payments on behalf of the government. It raises loans from the public and thus manages public debt. It also represents the government in the international financial institutions and conferences, (c) As a financial adviser to the lent, the central bank gives advice to the government on economic, monetary, financial and fiscal ^natters such as deficit financing, devaluation, trade policy, foreign exchange policy, etc. 3. Bankers' Bank: The central bank acts as the bankers' bank in three capacities: (a) Custodian of the cash preserves of the commercial banks; (b) As the lender of the last resort; and (c) as clearing agent. In this way, the central bank acts as a friend, philosopher and guide to the commercial banks As a custodian of the cash reserves 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 banks. These cash reserves can be utilised by the commercial banks in times of emergency. 4. Lender of Last Resort: As the supreme bank of the country and the bankers' bank, the central bank acts as the lender of the last resort. In other words, in case the commercial banks are not able to meet their financial requirements from other sources, they can, as a last resort, approach the central bank for financial accommodation. The central bank provides financial accommodation to the commercial banks by rediscounting their eligible securities and exchange bills. 5. Clearing Agent: As the custodian of the cash reserves of the commercial banks, the central bank acts as the clearing house for these banks. Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks against each other with least use of cash. The clearing house function of the central bank has the following advantages: (i) It economies the use of cash by banks while settling their claims and counter-claims. (ii) It reduces the withdrawals of cash and these enable the commercial banks to create credit on a large scale. (iii) It keeps the central bank fully informed about the liquidity position of the commercial banks. Roles of central bank: A Central Bank (referred to as the Federal Reserve System in the United States), also known as the Reserve Bank of the government is separate from the country's ministry of finance. It's still referred to as the government's bank because it manages buying and selling of government bonds and other instruments. Most developed nations today have an "independent" central bank that is one which operates under rules designed to prevent political interference.

4. Describe the progress of commercial banking after Nationalization. Ans. Over the years, the banking sector in India has seen a number of changes. Most of the banks have begun to take an innovative approach towards banking with the objectives of creating more value for customers, & consequently, the banks. Some of the significant changes in the Indian banking sector are discussed below: 1. Technology for value creation: With firms increasingly relying on ubiquitous computing to implement major business initiatives, it is becoming ever more necessary to understand the technological aspects of business developments. Moreover, the design of the value-creation process should not be limited to the single supplier or customer organization, as ubiquitous computing applications take no notice of organizational boundaries.

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2. Rural India catching up: With a majority of the Indian population living in rural areas, rural banking forms a vital component of the Indian banking system. Besides, rural banking operations in India are rather different from urban operations, due to the strong disparity that exists between urban and rural life, and the needs of these two sections of people are also different. 3. Banking beyond banking: While traditionally, banking meant borrowing & lending, in the latter part of the th 20 century, the word took on a different meaning altogether. Banks no longer restricted themselves to traditional banking activities, but explored newer avenues to increase business & capture new markets. Indian banks could not be left behind. They innovated their operations into fields unexplored as yet & venturing into varied activities already discussed in the above new markets. 4. Credit/Debit cards: In the late 1990s, the plastic cards market in India, comprising credit cards, smart cards, debit cards, charge cards, stored value cards and others picked up momentum like never before, growing at an annual rate of 25%. Analysts attributed this growth largely to the rapidly increasing user base of debit cards. The growth of debit cards was all the more impressive considering the fact that credit cards, introduced in the country in the early 1980s, had managed to reach the 10 million-user base level only in 2000. Thus, the debit card user base had reached one-third of the credit card user base in just around one-tenth of the time. Also, smart cards introduced in the late 1990s, had become very popular, especially in the financial services, banking, healthcare, transport and telecommunication businesses. The demand for co-branded cards during 2001 was a further indication of the fact that the Indian market had finally realized the potential of plastic money. 5. Money market mutual funds: Money market mutual funds were an interesting innovation arising or rather necessitated by the ceilings which governments placed on bank deposit interest rates. These funds offered (savers) investors the benefits of both liquidity & a rate of return higher than they could earn on bank deposits. Commercial banks, very early on, saw money market mutual funds as a key competitor. Over the course of many years they have developed many deposit products which seek to provide depositors the same flexibility which money market fund provide. This therefore was an innovation which triggered greater efficiency in the intermediation of savings & investments in the financial system, though its initial impact was to modify the characteristics of the deposit base of the banking system. 6. Expansion of branches: The number of branches has increased from 88262 in 1969 to 68500 in 2005.

5. Discuss the role of IT (Information Technology) development in the banking sector. Ans. For a long time, the banking sector has been the monopolistic provider of economy-wide payment & settlement systems. Technology is a boon to several industries in the post modern world, and the banking industry is another one to benefit from the multi dimensional efficiency levels of technology. Technology banks helps in the process of clarity, simplicity and efficiency in complex banking processes, also reaches out for something superior and a wider range of customers. Services provided through the means of computers, mobiles and other telecommunication mediums have also added upon the benefits and multitude of tasking for the banks. The importance of technology in the banking sector has made banking a very easy affair. The introductions of ATMs, internet banking and phone banking are all the outcomes of the technological modifications. Banking has definitely improved from just being somewhere one had to rush every now and then to keep a tally of their accounts and to deposit and withdraw cash, to something which is so easy and efficient that it does not at all seek for added attention. Electronic banking has also emerged as one of the most efficient delivery channel for the banking industry. Information technology of IT revolution has essentially changed the face of the world and the economic, financial and social status has taken a giant leap from what it used to be previously. The financial operations are very fast and reliable and that has eventually resulted into strengthening the banking sector. The cost of global funds transfer has gone down drastically due to the progressive nature of the technology. An unprecedented economical and financial expansion is witnessed across the globe and the IT revolution forms the

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basement of it. The new age customer faces has also undergone a radical change from its yester years counterparts and they are much more tech savvy themselves and demanding and would essentially want to avail the most improved version of services for themselves. The back office requirements and financial accounting is also managed by the banks through the development of advanced software. Other services include everything from medical, electrical, telephone and shopping bill payments to payment of excise duty and service tax, railway and air ticket booking, prepaid mobile recharges, instant alerts, sports updates, movie tickets bookings, mobile banking, international money transfer and so on and so forth. Express delivery, funds transfer, card to card transfer, instant software download to stop payment, payment blockings every little detail and service is provided by internet banking and other technological services. The importance of technology has eventually contributed a lot in the way of cost reduction for the customers and has offered a varied number of products and services. Thus costs cuttings have a direct effect influencing the profit margins therefore resulting into a thriving business sector. Technology henceforth, is the main reason of development and growth of the banking sector. Apart from all this, technology aids the adept security measure for the banking houses in order to secure the customer confidentialities and monetary details. Giant business houses have their important papers, documents and passwords stored up in the banks which are taken care of by the highly sensitive and skilful technological security devices. For the bank, during the last decade, banks applied IT to a wide range of back and front office tasks in addition to a great number of new products. The major advantages for the bank to implement IT are:

Availability of a wide range of inquiry facilities, assisting the bank in business development and followup. Immediate replies to customer queries without reference to ledger-keeper as terminals are provided to Managers and Chief Managers. Automatic and prompt carrying out of standing instructions on due date and generation of reports. Generation of various MIS reports and periodical returns on due dates. Fast and up-to-date information transfer enabling speedier decisions, by interconnecting computerized branches and controlling offices. For the employees, IT has increased their productivity through the followings:

Accurate computing of cumbersome and time-consuming jobs such as balancing and interest calculations on due dates. Automatic printing of covering schedules, deposit receipts, pass book / pass sheet, freeing the staff from performing these time-consuming jobs, and enabling them to give more attention to the needs of the customer. Signature retrieval facility, assisting in verification of transactions, sitting at their own terminal. Avoidance of duplication of entries due to existence of single-point data entry.

Banks face a serious challenge. The basic structure of the bank is increasingly in conflict with the changing product, delivery, and service needs of the customers the future belongs to financial service providers not traditional banks. The vast majority of large banks will create value networks. Doing so presents tremendous challenges. Banks will have to first develop a comprehensive distribution system that will enable customers to touch them at multiple points. Banks must also create performance measurement systems to assure the mix products and services they offer are beneficial to both the customer and the bank. They must determine whether to deploy new technologies themselves or with other service providers. Nevertheless, technology alone will not solve issues or create advantages. This technology needs to be integrated in an organization, with the change management issues linked to people resisting new concepts and ideas. It also needs to support a clearly defined and well communicated business strategy.

6. Identify the source of funds used by Indian banks to raise funds from foreign markets. Ans. It is worthwhile to appreciate that there are multiple Ways to overcome the financing barriers in the infrastructure sector. One of the major sources of financing is external financing, which is provided by multiple agencies and has different favours. An important example of external financing is the international bond market. The major advantage of international bonds is long maturities, maturities of 10~3O years being typical. Although financing through the international bond market may low more expensive than syndicated ions, the matching of bond tenure with projects protects them against interest rate fluctuations. Another key source of external financing is funding from multilateral institutions soon as the World Bank and the Asian Development Bank.

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Traditionally, funding from these bodies has been limited to public sector infrastructure projects. A notable shift is observed in the approach of these multilateral institutions in terms of their willingness to support projects with private sector participation, especially public-private partnership (PPP) projects. The International Finance Corporation (IFC), an arm of the World Bank, which focuses on the private sector, also provides an entire range of financing services with the objective of profit making and risk sharing. Debt financing from banks could be another source of financing infrastructure projects, which is evident from the syndication for various infrastructure projects in India, especially in the PPP domain. However, there are limitations to borrowing from banks, given the peculiar nature of the duration on their assets and liability side. Since the banks have to look in the loans granted to the infrastructure sector for a long gestation period (typically upwards of five years), funding these loans through snort-term deposits poses risks and limits the lending ability of the bank. The searing pace of Indias economic growth has prompted businesses to go in for revamps or new operations. For this, they need money, which they are seeking in financial markets at home and, increasingly, abroad. Indian companies have traditionally been conservative, relying on their profits and bank loans for funding. But in recent years, they have begun to look outwards, lured by the international financial markets that are cheaper, quicker and nimbler than the old, high cost domestic ones.