Principles of Banking

Learning Objective

Understand Meaning and Purpose of Money Learn about the Financial System How Financial Markets work Overview of Financial System in India Banking Structure in India Know Functions of Commercial Banks

Money

What is Money ?

Money

• Barter entails the exchange of one good for another.• Barter is inefficient because it requires satisfaction

of the double coincidence of wants (party one must have what party two desires, and vice versa) and

• pricing problems (the number of prices of goods equals the number of possible pairs).

• Money is anything that reduces the transaction costs of barter, anything that is commonly accepted as payment or in exchange.

Money - Functions

• Money serves as a medium of exchange (physical means of payment)

• Unit of account (measure of economic value)• Store of value (method of storing said value

over time)• Standard of deferred payment (basis upon

which debts are repaid).

Properties of Money

• The best medium of exchange combines – Ease of authentication– Uniformity– Divisibility– Durability– Portability– Elasticity of supply

The Financial System

• A financial system is a densely interconnected network of financial intermediaries, facilitators, and markets that serves three major purposes: – Allocating capital– Sharing risks– Facilitating inter-temporal trade

Financial System : Inter-linkageAs Borrower As Saver

Car Loan

Education Loan

Mortgage

Depositor

Shareholder

Insured

Student

Financial System - Purpose

• A financial system is necessary because few businesses can rely on internal finance alone.

• Specialized financial firms that have achieved minimum efficient scale are better at connecting investors to entrepreneurs than nonfinancial individuals and companies.

Information asymmetry• Asymmetric information occurs when one party knows

more about an economic transaction or asset than the other party does.

• Financial systems help to reduce the problems associated with both adverse selection and moral hazard.

• Adverse selection occurs before a transaction takes place. If unmitigated, lenders and insurers will attract the worst risks.

• Moral hazard occurs after a transaction takes place. If unmitigated, borrowers and the insured will take advantage of lenders and insurers.

What do Savers / Investors want ?

Investment Pyramid

What do Borrowers Want ?

• Cheapest funds; preferably zero interest• Repayment Terms as flexible as possible• Option to pre-pay without any penalty• No collateral !

Financial Markets

• Financial markets can be categorized or grouped by issuance – Primary vs. secondary markets

• Type of instrument – Stock, bond, derivative

• Market organization – Exchange or OTC

Financial Instruments

• Financial instruments can be grouped by • Time to maturity – Money Market – short term funds (1 year)– Capital Market – long term funds

• Type of obligation – Stock / Shares– Bond / Debenture– Derivative (options and futures)

Financial System - India

Banking Structure in India

Banking Structure in India

Indian Banking structure – contd.

Commercial Bank

• Definition of Commercial Bank• Banking Regulation Act, (BR Act), 1949.According to

Section 5(c) of the BR Act, a banking company is a company which transacts the business of banking in India.

• Further, Section 5(b) of the BR Act defines banking as, accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable, by cheque, draft, order or otherwise.

Commercial Banks - Functions

• Commercial banks have to perform a variety of functions which are common to both developed and developing countries.

• These are known as ‘General Banking’ functions of the commercial banks.

• The modern banks perform a variety of functions divided into two broad categories: (a) Primary functions (b) Secondary functions

Commercial Banks - Functions

Commercial Banks – Agency Functions

• Agency Functions for and on behalf of their customers. – Collection and Payment of Credit Instruments– Purchase and Sale of Securities– Collection of Dividends on Shares– Acts as Correspondent– Income-tax Consultancy

Commercial Banks - Functions

• Execution of Standing Orders• Acts as Trustee and Executor • General Utility Services• Locker Facility• Traveller’s Cheques and Credit Cards• Letter of Credit• Collection of Statistics• Underwriting Securities and Merchant Banking