Money and Banking

Learning Outcomes

1. Grasp the concept and importance of Fiat Money as a government-declared legal tender.
2. Understand India’s Money Supply measures, including M0, M1, M2, and M3.
3. Identify key Financial Institutions and Markets in India’s Financial Sector.
4. Distinguish between Organized and Unorganized Money Markets.
5. Comprehend the Functions and Instruments of the Money Market.

Money

Fiat Money is declared as legal tender by a government, mandating its acceptance for payment of debts, public and private, within a country. The money supply in a country comprises currency (banknotes and coins) and bank money (balances in checking and savings accounts). Developed nations primarily rely on bank money, often stored electronically.

Measures of Money Supply in India

Money Supply refers to the stock of liquid assets that the public can freely exchange for goods and services. The Reserve Bank of India (RBI) calculates four monetary aggregates: M0, M1, M2, and M3. A working group led by Dr. YB Reddy introduced these measures:

1. M0: Currency in circulation + Bankers’ deposits with RBI + Other deposits with RBI.
2. M1: Currency with the public + Demand deposits with the Banking System + Other deposits with RBI.
3. M2: M1 + Savings deposits of Post Office Savings Banks.
4. M3: M1 + Time deposits with the Banking System.

• M4 = M3 + Office Savings of Banks.

Liquidity decreases in the order M0 > M1 > M2 > M3, reflecting a shift from the medium of exchange to a store of value. Demand deposits are payable by banks on demand, such as savings accounts.

Indian Currency Symbol (₹)

The Indian Rupee symbol (₹) was adopted on 15th July 2010. India became the fifth economy to adopt a unique currency symbol. The design, an integration of Devanagari ‘Ra’ and the Roman ‘R’, was created by D. Udaya Kumar, a postgraduate from IIT Mumbai.

Liquidity Aggregates

1. L1: M3 + Deposits with Post Office Savings Banks (excluding National Savings Certificates).
2. L2: L1 + Term deposits with lending institutions + Borrowing by Financial Institutions (FIs) + Certificates of Deposit issued by FIs.
3. L3: L2 + Public deposits of Non-Banking Financial Companies.

Important Note

Liquidity Aggregates help assess a nation’s overall financial stability and are crucial for monetary policy decisions.

Financial Sector in India

A country’s Financial Sector reflects its economic development level. A robust financial system fosters savings and investment, promoting economic growth. India’s financial sector includes:

1. Financial Institutions: Primarily collect and mobilize savings, converting them into investments. These include all banks and Non-Banking Financial Institutions (NBFIs).
2. Financial Markets: Collect savings from surplus units and lend to deficit units for investment, comprising the money market (short-term) and the capital market (long-term).
3. Financial Assets: Instruments like shares, debentures, and certificates traded in financial markets through intermediaries.

Financial Markets

A Financial Market is where financial transactions occur, primarily categorized into money markets and capital markets.

Money Market

The money market deals with short-term securities, loans, gold, and foreign exchange. It’s vital for monetary operations conducted by the Central Bank. It operates through instruments with maturities ranging from overnight to one year.

Functions of the Money Market:

1. Provides a balancing mechanism for the demand and supply of short-term funds.
2. Enables short-term borrowing and investment at market-clearing prices.
3. Allows Central Bank intervention to manage liquidity, transmitting monetary policy to the real economy.

Regulation of Indian Money Market

The RBI oversees the Indian Money Market, which has two segments: organized and unorganized. The RBI regulates the market using instruments such as call, notice, and term money, repo market, certificates of deposit, and commercial paper.

Organized Money Market

1. Call Money Market: An interbank market where funds are borrowed or lent on demand. Notice Money involves periods between 1 and 14 days; Call Money is for less than 1 day.
2. Banker’s Acceptance Market: A short-term credit investment guaranteed by a bank.
3. Collateral Loan Market: Loans secured against collateral such as pledges or mortgages.
4. Treasury Bill Market: T-bills finance the government’s short-term needs, offered in 14-day, 91-day, 182-day, and 364-day formats.

Important Note

The RBI regularly issues Treasury Bills to manage market liquidity and guide interest rates.

Liquidity and Its Instruments

1. Certificates of Deposits (CDs): Low-risk investments issued by banks for up to one year.
2. Repo Market: Facilitates collateralized short-term borrowing through the sale or purchase of debt instruments.
3. Commercial Papers (CPs): Short-term, unsecured promissory notes issued by reputable organizations.
4. Money Market Mutual Funds (MMMFs): Introduced in 1992 to provide short-term avenues for individual investors.

Instrument	Maturity	Risk	Issuer
T-Bills	14, 91, 182, 364 days	Lowest	Government of India
CDs	Up to 1 year	Low	Banks and FIs
Commercial Papers	Up to 1 year	Moderate	Reputable Organizations
Repo	Up to 1 year	Low	Central Bank, Securities

Capital Market

The Capital Market addresses long-term funding needs through the buying and selling of equity and debt instruments. It encompasses two primary segments:

1. Industrial Securities Market: Deals in equities and debentures, split into the primary market (new securities) and the secondary market (existing securities traded on stock exchanges).
2. Gilt-Edged Market: Trades government and semi-government securities backed by the RBI. These securities are risk-free and highly liquid.

Other Financial Instruments

Derivatives: Their value is derived from an underlying asset like securities or commodities. They include futures, options, and forwards contracts.

Regulatory Framework in India

The Capital Market is regulated by the Capital Markets Division of the Ministry of Finance and the Securities and Exchange Board of India (SEBI). SEBI regulates stock exchanges, brokers, and intermediaries while protecting investor interests.

Important Note

SEBI has the authority to prohibit insider trading, ensure market discipline, and promote investor education.

Banking in India

The banking sector in India originated in the 19th century, evolving through nationalization, liberalization, and regulation by the RBI.

Reserve Bank of India (RBI)

The RBI is India’s central bank, established in 1935, and nationalized in 1949. It serves as the monetary authority, issuer of currency, and regulator of banks.

Functions of RBI:

1. Issuing Authority: RBI issues currency, managing reserves against coins, gold, and government securities.
2. Banker to the Government: Manages government transactions and remittances.
3. Banker to Banks: Holds reserves of commercial banks, acting as the lender of last resort.
4. Regulator and Supervisor: Issues licenses, sets minimum capital requirements, inspects bank operations, and oversees amalgamations or liquidation.
5. Custodian of Foreign Reserves: Manages foreign reserves, ensuring market stability.

Methods of Credit Control

RBI employs both quantitative and qualitative credit control methods:

1. Quantitative Control:

• Bank Rate: Interest rate charged by RBI on loans to commercial banks.
• Cash Reserve Requirement (CRR): Mandates banks to maintain a portion of deposits with the RBI.
• Statutory Liquidity Ratio (SLR): Requires banks to keep a percentage of deposits in liquid assets.
• Open Market Operations (OMOs): Buying or selling government securities to regulate money supply.
• Repo Rate: Short-term lending rate to banks.
• Reverse Repo Rate: Rate at which banks park funds with RBI.

1. Qualitative Control:

• Margin Requirements: Difference between loan amounts and security value.
• **Rationing of Credit**: Regulates credit allocation.
• Moral Suasion: RBI advises banks to follow policies.

Types of Banks in India

Scheduled Commercial Banks in India include:

1. Public Sector Banks: Owned by the government, including State Bank of India (SBI) and its associates.
2. Nationalized Banks: Banks nationalized in 1969 and 1980, such as Punjab National Bank, Canara Bank, etc.
3. Private Banks: Owned by private entities, including old and new private sector banks.
4. Foreign Banks: Operate through branches and representative offices.
5. Regional Rural Banks: Established to cater to rural needs.
6. Co-operative Banks: Include State Co-operative Banks (SCBs) and Urban Co-operative Banks (UCBs).

Important Note

The RBI supervises the functioning of banks, ensuring compliance with regulatory frameworks.

Non-Banking Financial Companies (NBFCs)

NBFCs operate similarly to banks but do not require a banking license. Governed by the RBI (Amendment) Act, 1997, they include:

1. Deposit-taking NBFCs (NBFC-D).
2. Non-deposit-taking NBFCs (NBFC-ND).

Category	Principle Business
Equipment Leasing Company	Leasing and financing
Hire Purchase Finance	Hire purchase transactions
Investment Company	Securities trading
Loan Company	Making loans/advances

Important Concept

NBFCs constitute 11.2% of the total financial system, providing medium to long-term finance.

Multiple-Choice Question

Which of the following is a primary function of the Reserve Bank of India (RBI)?

1. Issuing government bonds
2. Managing personal savings accounts
3. Regulating and supervising the banking sector
4. Providing insurance to depositors

Correct Answer: 3. Regulating and supervising the banking sector