1.3 Banking Definition The word Bank has been used differently in different geographies.

The regulator in the respective countries defines the scope of the functions and services the banks can offer. There are specific regulations related to the banking, which will be discussed later. As per English Common Law, a banker is defined as a person who carries on the business of Banking, which is specified as

Depository Institutions These institutions play an important role in the development of the financial markets. These institutions play an important role in channelizing the savings in the economy. Depository institutions mainly include: Commercial Banks Savings and Loan Associations Credit Unions Commercial Banks: These are depository institutions which are in the business of deposit taking and lending. They provide a range of products and services for individuals as well as businesses. Savings and Loan Associations: These institutions provide savings account facilities and are also into mortgage lending. Many of them provide a range of services similar to a commercial bank. Credit Unions: These are not-for-profit financial cooperatives that offer personal loans and other consumer banking services Commercial banks, savings and loan associations and credit unions together hold a large share of the nations money stock in the form of various types of deposits and help in their transfer to effect payments. They also lend these funds directly to individuals and businesses for a variety of purposes and also lend them indirectly through investment in financial instruments.

2 Introduction to Retail Banking

Retail Banking is one of the biggest shock absorbers in the banking system. If one were to closely study the Banking sector, one would observe that retail bank failures seldom happen. The reason for proliferation of retail banking is twofold. The principle of spreading the eggs in multiple baskets is the core philosophy of retail. The probability of all multiple loans failing together at the same time is less than a big loan failing occasionally. On the retail liability side, the retail portfolio generates low cost deposits which mean chasing current and savings accounts. The credit card business is also a lending business, in addition to fees generated by way of annual maintenance charges and other service charges. Private banking business is also similar to retail banking, except for the ticket size Deposit accounts are of classified into two broad types:

Demand Deposits by definition are deposits that can be withdrawn by customers on demand, while Term deposits are deposits that can be withdrawn after a specified period of time. Term deposits are also known as fixed deposit. The term fixed refers to the term of the deposit which is fixed in nature Traditional Clearing Process Scenario: Mr. John receives his salary check from Wal-Mart, his employer. Mr. John has his account with Wells Fargo while Wal-Marts banker is Citi Bank. The salary check will be drawn on Citibank and is referred to as the paying banker. Mr. Johns bank is referred to as the Collecting Bank. It is also assumed that the branches of the bank are situated in Washington DC. The diagram below depicts the typical inter-bank check clearing and settlement process through a Central Bank or Clearinghouse. The steps are as follows: Step 1: Mr. John will deposit his check with Wells Fargo Washington Branch Step2: Wells Fargo, after authenticating the check, accepts the check for payment. At the end of the day, the bank accumulates the checks received from its various customers sorts them into three categories viz. checks drawn on Wells Fargo Washington Branch, checks drawn on other branches of Wells Fargo and

checks drawn on other banks. Checks drawn on other banks will be sent to the service branch of financial institution for collection whereas checks drawn on Wells Fargo will be processed at the branch itself. Step 3: The Service branch of Wells Fargo will collect the checks form the various branches across Washington and send them to the clearinghouse. Step 4: At the clearinghouse, the checks are exchanged. Wells Fargo will hand over all the checks they have collected drawn upon the other members of the clearinghouse, and collect all the check drawn on the bank. Thus the check will go back to the Citibank. Step 5, 6 and 7: The Citibank will cross check the balances of Wal-Mart account and other particulars of the check. In case the check is found in order and there are sufficient balances then In case sufficient funds are not there in the Wal-Marts account in Citibank, the check is returned ,the check will physically traverse back all the way through the same route all the way back to the Johns bank i.e. Wells Fargo The physical check movement is called the clearing process. This is followed by the settlement process. The clearing house will then have to debit /credit the overall amount across banks for the checks processed.

Wealth management is a broader term than Investment management. Investment management is the science of choosing investments such as stocks, bonds and derivatives and combining them in a way that respects a clients specific risk-to-reward needs. It is also frequently called money management or asset management. On the other hand, the Wealth Management process is founded on the values of the client first. What is important to the clients? What goals do they have and how do they want to accomplish them? What is their timeline for implementing these values and accomplishing these goals? Answering these questions will establish the foundation upon which the wealth manager and client work together. Wealth management is an ongoing process. It involves keeping track of the needs of the clients and their changing definition of success. Constant attention should be paid to the portfolio and performance of investment should be monitored. Clearing Cycle 1. The batch is sent through the card network to request payment to the issuer 2. The card network distributes each transaction to the appropriate issuer 3. The issuer subtracts the interchange fees and transfers the amount 4. The card network routes the amount to the acquirer Illustration of a Credit Card Transaction8:

Funds settlement process:

Assuming a $100 transaction by a card-holding customer, following is the revenue each participant will make: Merchant revenue $98 (assuming a 2% discount rate agreement with the acquirer)

Processor revenue Acquirer revenue Association revenue Processor revenue Issuer revenue

$0.01 from the acquiring bank $0.08 $0.10 $0.01 from the issuing bank $1.80 of interchange fee.

The issuers get the maximum revenue because: 1. They are the ones that loan the money to the consumer during the grace period when the transaction occurs and when the consumer is obligated to pay the issuer. 2. They are the ones that assume payment risks in case the card-holding consumer defaults on his/her obligation.

1.1 What are Financial Markets? In any economy, entities such as individuals, organizations and governments may have surplus funds or may need funds for a variety of purposes. Thus, funds are exchanged between those who have them in surplus (savers/investors/lenders) and those who need them (issuers/borrowers). Broadly speaking, individuals are the principal savers and organizations and governments are the principal borrowers or fund raisers.1 This transfer of funds takes place through the mechanism of financial markets. What are financial assets or securities? When investors lend their surplus funds to organizations or governments, they receive an acknowledgement for the same from these organizations or governments in the form of financial securities. Thus, financial securities are instruments issued by those who need capital2 and represent the fact that such issuers have raised funds from investors. For investors who have invested in such securities, these securities become financial assets. These financial assets represent a claim on the issuers earnings or resources. The issuers have certain obligations towards investors, the most important among them being providing return on investments. Financial securities are primarily of two types i.e. equity shares or stocks and fixed income securities. Equity share represents ownership capital i.e. an investor buying equity shares issued by a company becomes a fractional owner of the company. Fixed income securities, on the other hand, are like a loan taken by the company from the holder of those securities. Financial markets are divided into primary and secondary markets. Primary market The relationship is between the issuer and investor The issuer (a company) issues shares and convertible bonds to the investor. Shares can be issued through initial public offering (IPO), rights offer and bonus offer. In fixed income markets, treasury auctions are conducted by central banks, bonds are issued by government and quasi government bodies as well as private sector companies Secondary market

The relationship is between two investors Investor A holds 100 Infosys shares which he wishes to sell. He puts in a trade for selling 100 Infosys shares through his broker. These shares are automatically matched with any buy order for Infosys shares. Thus, exit/investment opportunities are readily available to all investors

Based on the settlement cycle Financial markets are divided into spot and forward/futures/options (Derivatives).The distinction is based on the period of settlement. The spot market or cash market has immediate delivery (T+3 in the US markets) In the forward/futures/options market, the investor enters into a buy/sell transaction on date T with a final delivery and settlement at a future date T+1month, T+2months, T+3months up to T+3 years (in the US markets). Some of the contracts are extended beyond three years as well. Most Futures/options contracts have final settlement on third Friday or last Thursday of the month. Nature of market Financial markets can be divided into Over-The-Counter (OTC) markets and Exchange Traded markets based on the nature of markets. Other terms used to describe exchange traded markets are organized markets and regulated markets. In an OTC market, a trade takes place between two investors directly without routing it through an exchange or intermediary. In an exchange traded market, a trade is routed through the exchange. Retail Banks: As the name suggests, these banks basically satisfy the needs of retailers i.e. individuals. They offer services such as:

urchase and sale of mutual funds and securities through specific subsidiaries

Commercial Banks: Commercial Banks do not restrict their operations to individuals; in fact their main clients are business enterprises. These banks offer different kinds of services such as: ecured

Underwriting services 8 with the help of banks corporate finance departments

Whenever investors buy securities issued by US government, they need to be transferred from the seller of securities to the buyer. Similarly funds have to be transferred from buyer of securities to seller of securities. This means that these trades need to be cleared and settled. Clearing of US government securities is done by banks. Clearing and settlement of various securities is explained in detail in subsequent modules. Custodian Banks: We have already seen earlier that institutional investors have vast resources at their disposal and hence their investments are large. The securities in which they invest need to be kept safely and administered such that the record of buying /selling and the stock of securities is updated continuously. This service is called custody service, which is provided by Custodian

banks. Custodian banks manage securities as well as cash. A custodian may perform services for institutions and for wealthy individuals (HNIs). Banks generally form separate legal entities or departments to offer these services. Mutual Funds

A mutual fund is a fund collected by Managed Investment Companies that is invested in a diversified portfolio of securities. The individuals who buy shares or units of a mutual fund are known as its shareholders or owners. The amounts received from the shareholders are used to buy securities such as stocks, bonds, commodities and derivatives. Mutual funds help create
savings; they are simple and accessible. Major benefits of mutual funds are- Diversification: Professional Management: Convenience: Low Costs Liquidity: Protecting the Investors: Types of Funds There are three types of mutual funds based on asset class: US. hese mutual funds invest mostly in bonds. -term securities issued by the US government and its agencies, US corporations, and state and local governments. Stock Funds These funds invest primarily in stocks. A share of stock fund signifies a unit of ownership in a company. If a company is successful, shareholders earn profit in two ways:

The company passes profit to shareholders in the form of dividend.

Bond Funds

These funds invest basically in securities known as bonds. A bond is referred to as a type of security that resembles a loan. Whenever a bond is purchased, money is lent to the company, municipality or government agency that issues the bond. In exchange for use of this money, the issuer promises to repay the amount loaned. In other words, it promises to repay the principal, also known as the face value of the bond, on a specific maturity date. Apart from this, the issuer characteristically assures periodic interest payments over the entire period of the loan.
Money Market Funds

This fund invests in a pool of short-term, interest-bearing securities. Money market instruments are short-term debt instruments issued by the US government, US corporations, and state and local governments. These instruments have a maturity period of less than a year. The short-term character of money market investments makes money market funds less volatile than any other type of funds.
Investment Banks Investment banks offer a number of services including broking services and underwriting of new securities. Their different businesses may be considered as buy-side or sell-side businesses in the securities industry. The role of investment banks and the functions they perform are extremely vital for the securities industry. The services provided by investment banks are as follows: In this case, investment banks provide research on industries and companies to their clients so that the clients can make investment decisions.

Portfolio management The investment portfolios of the clients need to be monitored or altered regularly in response to developments in financial markets. This service is provided by investment banks. for the clients Investment banks act as brokers and trade on behalf of their clients. Already explained in the section on Banks. This is a service provided to HNIs where their wealth is managed as per their objectives by the investment banks.

In the corporate world, developments such as merger of two companies and acquisition of a company take place continuously. Investment banks play a vital role in identifying opportunities for M & A, valuing companies in case of M & A, meeting the necessary regulatory requirements etc. for clients. Stock Exchanges Stock exchanges are institutions that provide trading facilities to individuals or firms via trading members of stock exchanges. Once the issuers issue securities, these securities are listed on the stock exchanges. The most important objective of getting securities listed is that participants can trade in the securities. Let us see how this process works. Suppose Investor A purchases a few securities issued by Issuer ABC. The stock exchange provides the platform to sell these securities to another investor; if investor A opts to sell without involvement of stock exchanges, trading would have been difficult. Over-the-Counter (OTC) Market Unlike stock exchanges, an OTC market for stocks consists of dealers who buy or sell stocks by negotiating through telephones and computer systems. OTC market trading in the US is done through network of computer systems called National Association of Securities Dealers Automated Quotations (NASDAQ) System. It was put into operation by the National Association of Securities Dealers (NASD). This nationwide communication system allows brokers to know instantly the terms currently offered by all major dealers in securities covered by the system. The dealers buy stocks for their own account and sell them to investors at prices higher than the buying prices. A number of companies are listed on the NASDAQ. 3.1 Main Asset Class In the earlier sections, we have seen that issuers issue different types of securities. These securities represent various alternatives available to the investors for making investments. Types of securities that have similar characteristics can be classified into a category called an asset class. Thus, an asset class is nothing but a specific category of assets or investments. The assets within classes have similar features, are traded in similar market places, and are subject to the same laws and regulations. Following are the main asset classes. Equity Equity is a share in the ownership of a company. It represents a claim on the company's assets and earnings. As one acquires more stock, the persons ownership stake in the company becomes greater. As an owner, the shareholder is entitled to the company's earnings (popularly known as dividend) as well as any voting rights attached to the stock. There are two major types of stocks known as common stock or equity and preferred stock. Common Stock - Common stock represents ownership in a company and a claim (dividend) on a portion of profits. Whenever we refer to equity shares, we are referring to common stock. Common stock is also known as ordinary stock or shares. Equity shares are listed on stock exchanges or they trade over the counter. Trading in equity shares is active in well-developed financial markets across the globe. Equity represents ownership capital and being ownership capital, common stocks carry risks and rewards of ownership. As far as rewards are concerned, the price appreciation is the most promising reward. A large number of shareholders hold equity shares because they expect prices to go up. Other rewards include dividend paid out of profit of a company. Apart from this, shareholders have a right to vote and right

to information. However, these rewards do bring along with them risks in terms of decrease in dividend or price of shares not being paid since they are not mandatory. Moreover, if a company goes bankrupt21 and gets liquidated, the common shareholders will not receive money until the creditors, bondholders, and preferred shareholders are all paid. That is why equity capital is called residual capital. That means, claims of equity holders are residual claims.

Preferred Stock - Preferred stock represents some degree of ownership in a company but usually it does not come with the same voting rights. Preferred stock or preference shares have a combination of features of equity and debt. Normally, holders of preference shares are entitled to a fixed dividend. This is different from common stock, which has variable dividend that is not guaranteed. Preferred shareholders are paid off before the common shareholders in case of liquidation of the company. As for the risk-return profile of preference shares is concerned, it lies between the fixed income securities and equity. Fixed Income Securities Fixed income securities are securities that promise to pay a fixed amount as a return to the investors. Unlike equities, where dividend or capital appreciation can hardly be determined when an investment is made, in case of fixed income securities, interest payments (called coupon payments) and principal payments are determined at the time of investments. From the issuers perspective, these instruments represent a kind of loan or borrowing that the issuer has made. Hence, these securities are also called debt securities. Issuers of fixed income securities involve governments and corporations. For example, the US government and US corporations issue these fixed income products which have varying maturities. These securities are marketable and provide liquidity to the users. Treasury securities (fixed income securities issued by governments) form a major chunk of fixed income securities which are in the form of treasury bills, treasury notes, and treasury bonds. Currencies Currency market refers to market for foreign currencies. All entities may require foreign exchange for a variety of purposes. For example, individuals need them for funding their education, travel plans, and investments etc. Corporations require foreign currency for meeting their payment obligations in foreign currency, making investments in foreign country, or for trading purposes. Commodities Commodities have been the oldest asset class. As a simple investment strategy, traders would hold stocks of a commodity if they felt that the price of that commodity would go up. Organized trading in commodities emerged since the evolution of Chicago Board of Trade, an exchange for trading in commodities set up 1848. A number of exchanges all over the world provide trading in commodities. As an example, following commodities are traded on the Chicago Board of Trade, which is one of the oldest commodity exchanges: Agricultural Products: Soybeans, Wheat, Rice, Corn, Soybean Oil, Soybean meals, Oats, Precious Metals: Gold, Silver. Other commodities that are usually traded include livestock and meat, base metals such as aluminum, copper, steel, nickel and zinc. Energy products such as natural gas, oil, and gasoline are traded actively. Derivatives Derivatives are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be equity, fixed income instruments, interest rates, foreign exchange or commodities. The price movements of derivative products relate to that of the underlying securities. Types of Derivatives A forward contract is a contract between two parties that allows them to exchange the underlying asset at some future date at a price decided today. For example, a buyer may enter into a contract with a seller to buy shares of company ABC at $ 50 after one month. Thus, the actual exchange takes place after a month but the price is decided today. This removes uncertainty for both the buyers and the sellers. Futures Contracts A futures contract is similar to a forward contract except that futures contracts are traded on a futures exchange. Thus, in case of futures contracts, buyers and sellers execute the same through the futures exchange and not among themselves as it happens in case of forward contracts. Because transactions are done through a futures exchange, the terms of futures contract are standardized.

 Suppose, as stated in an example given earlier, a buyer and a seller decide to exchange shares of ABC at $ 50 after a month, a buyer reserves the right to sell the shares to B, then this contract is called an options contract. This means the buyer has the right but not the obligation to sell (in this case) or buy the underlying asset. He/she gets this privilege if he/she pays some amount when the contract is entered into. This amount is known as option premium. Options can be traded on exchange or traded over the counter between two parties. 3.2 Types of Risks Market participants deal in various asset classes. This exposes them to different types of risks. Broadly the risks are as follows. Credit /Counterparty Risk - This refers to the risk that the counterparty fails to meet its obligations. For example, if an investor has invested in a fixed income security, the issuer may fail to repay interest and / or principal of the security. Another example is that of a bank loan where the borrower is unable to repay the loan. Suppose buyer A buys 100 units of a particular security from seller B. Both of them face credit risk. Buyer A faces the risk that seller B does not deliver the securities, while Seller B faces the risk that Buyer A does not pay the due amount. All these risks can be classified as credit / counterparty risk. Market Risk - Market risk is the risk of losses due to movements in financial market variables. These may be interest rates, foreign exchange rates, and security prices. So market risk is the risk of fluctuations in portfolio values because of movements in these variables. The market risks mainly relate to risks of price, interest rate, forex, and liquidity which are explained below: o Price risk Prices of securities keep changing continuously. Thus all the market participants are worried about adverse changes in market prices. Interest rate risk Interest rate is an important variable that affects prices of securities. Fluctuations in interest rates cause prices of securities to change and this leads to generation of interest rate risk. Returns for those who have invested in fixed income securities also fluctuate with changes in interest rates. o Forex risk Foreign Exchange refers to currency of a foreign country. Since value of foreign currency in terms of domestic currency keeps changing, this leads to foreign exchange risk. o Liquidity risk Liquidity refers to the ability to liquidate (sell) investments whenever required at the right price. Sometimes, one may not be able to sell securities because enough number of buyers or sellers is not available to trade in that security. Hence, an investor may not be able to sell securities whenever he wants. This is liquidity risk. 4.1 Primary Market and Secondary markets Primary market Primary market is a market in which securities are sold at the time of their issuance. In other words, sale of new securities takes place in primary markets. For instance, when the General Electric needs money to expand its plant and construction activities, it issues new common stocks in the primary markets. Or, when the US Federal government wants to issue treasury bills or bonds for the first time, it does so through the primary market. A number of market participants are involved in placing securities for the first time. For corporate issues, investment banks play an important role. They help the issuer sell the shares to investors. In fact, they underwrite the issue, which means they subscribe to any unsubscribed portion of the issue, ensuring that the company gets the full amount of the issue. As far as issue of government securities is concerned, central banks of the respective countries for example, Federal Reserve in case of the US, plays an important role.

Role of primary markets Primary market enables issuers to raise capital from investors. Thus, it has a major role in bringing investors and issuers together. A vibrant primary market ensures that a number of corporations issue securities, which in turn provides a range of investment opportunities for investors. This leads to increase in market size, attracting more investors. Secondary Markets If primary markets provide investment opportunities, secondary markets provide exit option to investors. Secondary market for financial securities is a market where outstanding securities i.e. securities that have already been issued by the issuer are traded. Thus, when a corporation issues new shares, it does so

through the primary market. Once these shares are issued to the investors, a mechanism is established so that shares can be exchanged between interested parties. This is called the secondary market. Role of secondary market The main function of the secondary market is to create liquidity in financial instruments. In simple words, it provides an entry point to investors who want to buy securities and an exit point to those who want to sell them. Thus, a vibrant secondary market increases market size, attracts more participation from investors, and leads to development of sound financial markets. In fact, a healthy secondary market also supports the primary market. Money and Capital Markets This classification of financial markets is based on the period for which securities are issued or maturity of securities23. The market where securities with shorter maturities are traded and issued is referred to as money markets. The money market is a market for short-term instruments. The short term is generally defined as less than a year. Issuers can be governments or corporations. The following table depicts money market instruments, their maturities, principal borrowers and the nature of secondary market in US: Equity-related instruments Refer to section on equity in asset classes. - Refer to section on equity in asset classes. These instruments, when issued, are fixed income securities to be converted into equity shares after some time. The conversion into equity shares can be optional or mandatory. The conversion terms are generally pre-specified so that the investor knows how many shares he gets after conversion. Warrants entitle warrant holders to subscribe to equity shares at a particular price sometime in future. It is similar to options explained earlier. However, equity options traded on the exchanges are of short-term maturity while warrants generally have a long-term maturity. Warrants are generally issued along with another security. For example, a company, at the time of issuing fixed income securities, may issue equity warrants. These warrants may be listed and traded separately on stock exchanges. By equity index, we mean a weighted average price for a group of securities that make that index. For example, Standard & Poors 500 Index consists of weighted average price for shares of 500 companies that make this index. An equity index may be traded just like a single stock. Moreover, derivatives based on equity indices as underlying assets are also available.

Futures and Options are already explained. In this case, the underlying assets are equity shares. Fixed Income or debt markets In these markets, fixed income instruments are traded. Fixed Income Instruments Fixed income instruments can be classified broadly into three categories: