1. Money and Banking Chapter 5 1

2. Money and Banking If money were to grow on trees, everybody would be dealing in bananas. 2 3. Definition and functions money Money is something which is generally accepted as a medium of exchange. Before money came into existence, exchange took place through barter system. Barter occurs when people directly exchange their goods for someone else's goods. The barter system has certain advantages: 1. Simple and reduces the complexity of the modern monetary system 2. There is no question of over/under production 3 4. Definition and functions money 3. The problem of international trade such as foreign exchange crisis, adverse BoP do not occur in barter system 4. There is no problem of concentration of economic power in the hands of few since things can not be stored for long. 4 5. Definition and functions money Difficulties of barter system: 1. Lack of double coincidence of wants 2. Absence of common measure of value 3. Lack of divisibility 4. The problem of storing wealth 5. Difficulty of deferred payments 6. Problem of transportation 5 6. Definition and functions money Evolution and development of money Animal money: In ancient India, according to Veda, Go Dhan (cow wealth) was accepted as a form of money. In Roman state up to 4th century BC, cow and sheep were officially recognized as money used for collecting taxes and fines. Commodity money: In many countries, a number of commodities like bows, arrows, animal skins, shells, precious stones, rice, tea were used as money. The selection of commodity was dependent on factors like the location of the community, climate of the region, cultural economic development of the society. For example, community living close to sea shore chose shells, fish hooks as money. 6 7. Definition and functions money Evolution and development of money 3. Metallic money (uncoined metals and coins): Along with the growth of society from pastoral to commercial stage, the composition of money also changed from animal and commodity money to metallic money. Gold and silver were mainly used a money. 4. Paper money: Initially paper receipts against metallic money carried by merchants for safety. Later, scarcity of metals led to the introduction of convertible paper currency i.e. paper money convertible into metals. But in the later stage, paper money developed into fiat money i.e. paper money not convertible into metals. 7 8. Definition and functions money Evolution and development of money 5. Credit money: Mainly cheques issued against the demand deposits. 6. Near Money: In recent days near money are also accepted as money since they provide almost all the major functions of money. Such money are bills of exchange, treasury bills, bonds, debentures, savings certificates etc. 8 9. Definition and functions money Classification of money: 1. Metallic: Standard Money - Under this, face value of money is equal to intrinsic value. Such money are also called as full bodied coins. Token Coins - Under this, face value is always greater than intrinsic value. Such money are also called as representative coins. Subsidiary Money - Coins minted to assist for transaction are token coins e.g. coins of less than one rupee. 9 10. Definition and functions money Classification of money: 2. Paper Money: Representative Paper Money - Paper money issued with 100 % backing of gold and silver are called representative money. Convertible - Though the backing of the currency is less than 100 % but still the currency are convertible into gold on demand. Inconvertible - also called fiduciary money. Present bank notes come under this category. They don't have 100 % backing neither convertible into gold on demand. Backed by the law of the government. Also called fiat money. 10 11. Definition and functions money Classification of money: 3. Credit Money: Cheque or draft come under this category. Such money are not legal tender but highly used in present day economic transactions. 11 12. Definition and functions money Definition: In simple term, anything that is generally acceptable as a means of exchange and at the same time acts as a measure and store of value is called money. Approaches to the definition: 1. Traditional approach: Money is regarded only as a medium of exchange. According to this approach, money includes currency (C) and demand deposits (D). This approach is analytically superior because it provides the most liquid and exact measure of money. 12 13. Definition and functions money Definition: 2. Monetarist approach: The Chicago school led by Milton Friedman defined money anything that serves the function as a temporary abode of purchasing power. According to this approach, money = currency+demand deposits+ time deposits. This approach emphasizes on the store of value function of money and provides a broader measure of money. 3. Gurley and Shaw approach: John Gurley and Edward Shaw further widened the approach of money . According to this approach, money includes currency +demand deposits +time deposits+ the liabilities of non-banking intermediaries. The liabilities of non-banking intermediaries cover saving bank deposits, shares, bonds etc and are close substitutes of money. 13 14. Definition and functions money Definition: 4. The Radcliffe Approach: This is also known as liquidity approach based on the recommendations made by the committee of Radcliffe in 1959 in the UK. According to this approach, money covers the whole liquidity position that is relevant to spending decisions. The spending is not limited to the amount of money in existence. It is related to the amount of money that people think they can get hold of whether by receipts of income, by disposal of assets or by borrowing. Thus money supply includes: cash + all kinds of bank deposits + deposits with other institutions +near money assets + borrowing facilities available to the people. 14 15. Definition and functions money What is the best definition? There is no clear answer on this. There are many official definitions such as M1, M2, M3 etc. The definition of money depends on the purpose. For example, if one asks which definition of money supply is the most controllable by monetary authority, the answer is the narrow medium of exchange. But if one wants to know which correlates best with the economic activity, the broader liquidity definition. There are strong arguments against the view of Gurley, Shaw and Radcliffe committee. Critics say that liabilities of nonbank institutions do not work as the medium of exchange and are not under the control of monetary authority. 15 16. Definition and functions money Functions of Money The definition of money is anything that serves as a medium of exchange, unit of account, and a store of value. That is why throughout history, money has taken the form of precious metals, furs, and even cigarettes. Functions of money also relate to the definition of money. 16 17. Definition and functions money Functions of Money 1. Money as a Medium of Exchange. If one of society's goals is to expand the number of transactions, then the function of medium of exchange is vitally important. Medium of exchange means that money is widely accepted in exchange for goods and services. It stimulates and increases trade by providing an easy method of exchange. Since coins and currency are small and portable, money is an effective medium of exchange. This useful feature makes bartering unnecessary. 17 18. Definition and functions money Functions of Money 2. Money as a Unit of Account. This function of money provides a common measurement of the relative value of goods and services. Without money, there is no common denominator. How would a farmer know how many bushels of corn it would take to buy tools from a hardware store? How would governments collect taxes? Or for that matter, spend money on programs? 18 19. Definition and functions money Functions of Money 3. Money as a Store of Value. A third function of money is its use as a store of value. This means money has the ability to hold value over time. This makes money a useful mechanism for transforming income in the present into future purchases. This function is valuable if we look at the barter system. Imagine you are a farmer. You have a crop to sell, let's say apples. How would you make future purchases? Your apples might spoil and lose their value. Not so with money. 19 20. Definition and functions money Functions of Money 4. Money acts as a standard of deferred payments: During the barter system there was a problem of future payments. Money has helped for the future payments of present borrowings. 5. Money as a transfer of value: There was also difficulty to transfer the value from one place to another during the barter system since the value or the property were in terms of kind and was difficult to transfer from one place to another. Now money has helped to transfer the value easily from one place to another. 20 21. Definition and functions money Functions of Money In short, the functions of money can be summed up as below: Money is a matter of functions four, A medium, a measure, a standard, and a store; As this does not complete the picture, We may add transferability more. 21 22. Banking system and the economy Bank-A financial institution whose main activities are borrowing and lending money. Banks borrow by accepting deposits from the general public or other financial institutions. Bank loans are an important source of finance for firms, consumers, and government. According to Miller and Vanhoose, banking development is attributed to: (1) Goldsmith Bankers, and (2) The merchant (from Money, Banking and Financial Markets by Roger Leroy Miller and David Vanhoose) 22 23. The goldsmith bankers The first goldsmith bankers can not be traced with certainty to any specific time or place. There is evidence that such activities took place in Mesopotamia sometimes during the first millennium B.C. In ancient Greece goldsmith operations existed in Delphi, Didyma, and Olympia at least as early as the seventh century BC. By sixth century B.C., banking was a well developed feature of the economy of Athens. 23 24. The goldsmith bankers Bullion and asymmetric information: In the earliest times, people used uncoined gold and silver, known as bullion, to make transactions. But by using bullion people exposed themselves to asymmetric information problems: adverse selection and moral hazard. Adverse selection was that mostly those people whose bullion contained less pure gold or silver were ready to make transaction. And moral hazard was that the trader offering bullion in exchange for goods and services has an incentive to reduce the purity of gold. Goldsmith specialized in reducing the extent of these asymmetric information problems. 24 25. The goldsmith bankers Bullion and asymmetric information: Parties to a transaction would pay a goldsmith to weigh bullion and to assess its purity. Many goldsmiths would issue the holder of bullion a certificate attesting to the bullions weight and gold or silver content. Other goldsmiths went a step further. To provide the holder of bullion with ready proof of the bullions weight and purity, they produced standardized weights of gold or silver that they imprinted with a seal of authenticity. These standardized units were the earliest coins. 25 26. The goldsmith bankers Bullion deposits and fractional reserve banking: Eventually, some goldsmiths simplified the process further by issuing paper notes indicating that the bearers held gold or silver of given weights and purities on deposit with the goldsmith. Then the bearers of notes could transfer the notes to others in exchange for goods and services. These were the first paper money. The gold and silver held on deposit with goldsmiths were the first bank deposits. Once goldsmiths became depository institutions, they took the final step toward modern banking by becoming lenders. 26 27. The goldsmith bankers Bullion deposits and fractional reserve banking: Goldsmiths noticed that withdrawals of bullion relative to new bullion deposits were fairly predictable. As long as the goldsmiths held reserves of gold and silver to cover expected bullion withdrawals, they could lend paper notes in excess of the amounts of bullion that they actually kept on hand. By lending funds in excess of the reserves money (gold and silver bullion) that they actually possessed, these goldsmith bankers developed the earliest form of fractional-reserve banking. A system in which banks hold reserves equal to less than the amount of total deposits. 27 28. The merchant The merchant: The modern term bank derives from the merchants bench, or banco, on which money changed hands in the marketplaces of medieval Italy. During the medieval period of the twelfth and thirteenth centuries A.D., merchant bankers flourished throughout Italy. 28 29. The merchant Because of the possibility of theft of metallic money, the early traders having high reputation and credit began to issue documents which were taken as titles of money. This gave rise to the institution of hundi or the letter of transfer whereby the banker directs another banker to pay the bearer of hundi the specified amount of money and debit this amount against the drawer of hundi. 29 30. The advent of modern banking While most of the Italian merchant bankers quarreled, those originally from the Lombardy region of Italy worked to maintain their merchant banking operations in other European locales, such as London and Berlin. In London, the Italian merchant bankers became such an important fixture that the citys financial dealings were centered around Lombard street, which remains the financial heart of city today. The German central bank, the Deutche Bundesbank, called one interest rate at which it lent funds to private banks the Lombard rate. 30 31. Banking system and the economy Now, after knowing the brief history of banking, think why there is the need of financial intermediaries. In an ideal world one can think that there is perfect competition, with public information and costless contract negotiation and enforcement. But, in the real world, there are market frictions arising from information costs (asymmetric information which result in adverse selection and moral hazard), transactions costs, monitoring costs, and enforcement costs. Because of the market friction, the need of the financial intermediaries arises. 31 32. What do financial intermediaries do? Mobilizing savings immense works. In their absence, saving behavior would be different. Remember the role of financial intermediaries in Japan and other East Asian economies during 1960s in mobilizing savings. Allocating capital/ Efficient allocation of resources the banker authorizes the entrepreneur in the name of society to innovate Implications for small firms and poverty Monitoring firms/Exerting corporate control 32 33. What do financial intermediaries do? Ease trading of goods, services and contracts (Payment system). The story of a French singer is mentioned by economist Stanley. For her melodious voice, the singer was offered fruits, pigs, poultry and lots of other things but finally she couldnt carry any things except a few. But today, the role of the payment system is much more. Augmenting liquidity and managing risk the financial revolution was a necessary precondition for the industrial revolution Sir John Hicks 33 34. Banking system and the economy Getting the financial system to work well is critical to the success of an economy. To understand why, we need to recognize that the financial system is like the brain of the economy: it is a coordinating mechanism that allocates capital to building factories, houses and roads. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently and economic growth will be low. 34 35. Banking system and the economy No work ethic can compensate for a misallocation of capital. Working hard will not make a country rich because hard-working workers will not be productive unless they work with the right amount and kinds of capital. 35 36. Banking system and the economy Brain is more important than brawn, and similarly an efficient financial system is more important than hard work to an economys success. Indeed, workers in poor countries often work longer hours than their counterparts in rich countries, and yet they remain poor. When they emigrate to countries with a superior financial system, they often become very rich. Look how successful immigrants from India have been in the United States: their average income now makes them one of the richest groups in the U.S. (Fredric Mishkin, the Next Great Globalization). 36 37. Banking system and the economy Empirical evidences drawn by King and LevineEmpirical evidences drawn by King and Levine and by many others also show that impact ofand by many others also show that impact of finance on development runs primarily throughfinance on development runs primarily through productivity!productivity! the banker authorizes the entrepreneur in the name of society to innovate How about microeconomic evidence? 37 38. Banking system and the economy Rajan/Zingales: Industries that are naturally heavy users of external finance benefit disproportionately from financial development. Demirguc-Kunt/Maksimovic: Countries with better financial systems ease financing constraints and allow firms to grow faster. Beck, Demirguc-Kunt, Laeven, & Levine: Small firms benefit disproportionately from financial development. 38 39. Banking system and the economy Finance Poverty Alleviation ... Big! If Peru had the level of financial development as Chile 13% vs. 54%), then ... 2% living on less than $1/day Actual level: 15% 39 40. Banking system and the economy Number of people living in poverty Year Indonesia Republic of Korea Thailand 1990 1996 1998 1999 2000 80.9 50.6 NA 76.3 70.3 14.7 4.7 9.1 NA 6.0 18.4 (1988) 7.5 7.6 9.7 8.7 40 41. Banking system and the economy Banks are one form of financial intermediaries. Banks, on the basis of their nature of work, can be categorized into: central bank, commercial banks, development banks, industrial banks, exchange banks, savings banks and so on. Banks, on the basis of ownership, can be classified into public bank, private bank, foreign bank, joint venture bank. 41 42. Functions of commercial banks According to R. R. Paul, Commercial Banks perform following functions: Accepting Deposits in various types of accounts such as fixed (time), saving and checking account. Advancing loans in the form of commercial and industrial loans, consumer loans, real estate loans, inter bank loans, overdraft etc. 42 43. Functions of commercial banks 3. Credit Creation: a natural outcome of the loan advancing process. When a bank advances a loan to its customer, it does not lend cash but opens an account in the borrower's name and credits the amount of loan to this account. Thus, whenever a bank grants a loan, it creates an equal amount of bank deposit. Creation of such deposits is called credit creation which results in a net increase in the money stock of the economy. Banks have the ability to create credit many times more than their deposits and this ability of multiple credit creation depends upon the cash-reserve ratio of the banks. 43 44. Functions of commercial banks 4. Agency Functions: Remittance of Funds Collection and Payment of Credit Instruments like cheques, bills of exchange, promissory note, etc. Execution of Standing Orders Purchasing and Sale of Securities Collection of Dividend's on Shares Acting as Trustee and Executor Acting as Representative and Correspondent 44 45. Functions of commercial banks 5. General Utility Function Locker Facility Traveler's Cheques Letter of Credit. Collection of Statistics Underwriting Securities Foreign Exchange Business. 45 46. Functions of CBs R.R. Paul says CBs help development in developing economies through following functions: Capital formation Encouraging entrepreneurial innovation Monetization of economy Influencing economic activity through altering interest rates and exte4dnign credit Implementation of monetary policy Promotion of trade and industry Encouragement to right type of industries Regional development Development of agriculture and other neglected sectors 46 47. Balance sheet of CBs in Nepal: NRB Directives Form no 9.1 Liabilities Rs. Assets Rs. 1. Capital and Reserve fund 1. Cash Balance 2. Borrowings 2. Bank Balance 3. Deposits 3. Money at call 4. Bills Payable 4. Investment on bonds 5. Other Liabilities 5. Shares and other investment 6. Reconciliation 6. Loan and advances 7. Profit and loss account 7. Bills Purchase 8. Loan against bills collection 9. Fixed assets 10. Others assets 11. Deferred expenditure 12. Non Banking assets 13. Reconciliation 14. Profit and loss account Total Total 47 48. Credit creation Loans are the children of deposits, and deposits are the children of loans. 48 49. Credit creation Bank credit means bank loans and advances. A bank keeps a certain portion of its deposits as minimum reserve for meeting the demand of the depositors and lends out the remaining excess reserve to earn income. The bank loan is not paid directly to the borrower but is only credited in his account. Every bank loan creates an equivalent deposit in the bank. Thus, credit creation means multiple expansion of deposits. The word creation refers to the ability of bank to expand deposits as multiple of its reserves. 49 50. Credit creation Basic concepts 1. Bank as a business institution 2. Bank deposits Primary deposits: When a bank accepts cash from the customer and opens a a deposit account in his name, it is called primary deposit. Primary deposits simply convert currency money into deposit money. Secondary or derivative deposits: When a bank advances loan to its customers, it opens a deposit account in his name instead of giving him cash. This is called secondary or derivative deposit. Every loan creates a derivative deposit. Creation of derivative deposit means creation of credit. 50 51. Credit creation Basic concepts 3. Cash reserve ratio: Banks do not hold their deposits in reserve. From their general experience, they know that all depositors will not withdraw all deposits at the same time. They keep a fraction of the total deposits for meeting the cash demand of the depositors and lend out the remaining excess reserves. 4. Excess reserves: The reserve that a bank hold above the required reserve is called excess reserve. Excess reserves are equal to total deposits- required reserves. It is the excess reserve out of which loans are granted and credit is created. 51 52. Credit creation Basic concepts 5. Credit multiplier: Credit multiplier is the ratio between the total amount of derivative deposits and the initial amount of ecess reserve. If the initial excess reserves of Rs. 1000 creates total derivative deposits of Rs. 6000, then the credit multiplier is 6. Credit multiplier= Total derivative deposits/ initial excess reserves Credit multiplier is the reciprocal of cash reserve ratio. 52 53. Credit creation The process of credit creation can be analyzed in two ways: Credit creation by a single bank, and credit creation by the banking system as a whole. Credit creation by a single bank: Suppose that CRR is 20% and a person deposits in a bank Rs. 1000. Expanding this case, we are developing an example in the next slide. 53 54. Credit creation by a single bank Rounds Primary deposits Cash reserves R=20% Credit creation or derivative deposits (D) 1. Person (A) 2. Person (B) 3. Person (C) 4. Person (D) --- --- Rs. 1000 IPD Rs. 800 Rs. 640 Rs. 512 --- --- Rs. 200 Rs. 160 Rs. 128 Rs. 102 --- --- Rs. 800 IER Rs. 640 Rs. 512 Rs. 410 ---- --- Total 5000 1000 4000 54 55. Credit creation The table shows the following points: 1. On the basis of the CRR of 20% and with the initial primary deposit of Rs. 1000, the bank creates derivative deposits (i.e., credit) of Rs. 4000 and the total demand deposits will be Rs. 5000 (i.e. primary plus derivative deposits). 2. The credit expansion (i,.e. Rs. 4000) is five times the initial excess reserves (i.e. Rs. 800). 3. The credit multiplier (k) will be 5. 55 56. Credit creation The table shows the following points: 4. K=5000/1000=5, k=4000/800=5, k=1/0.2=5 5. The additional aggregate deposits (D) or the creation of derivative demand deposits or the potential credit creation will be the initial excess reserve (R) multiplied by k or the inverse of CRR (r). 6. D=k R= R/r 56 57. Credit creation by banking system In the real world there are many banks. While a single bank can not lend beyond the amount of excess reserves, the banking as a whole can do what a single bank can not do. When a bank creates derivative deposits, it loses cash to other banks. The loss of deposit of one bank is the gain of deposit by some other bank. This transfer of cash within the banking system increases credit many more times than the initial excess reserves, which is called multiple credit creation. 57 58. Multiple credit creation by banking system Banks Primary deposits Cash reserves R=20% Credit creation or derivative deposits (D) 1. Bank (A) 2. Bank (B) 3. Bank (C) 4. Bank (D) --- --- Rs. 1000 IPD Rs. 800 Rs. 640 Rs. 512 --- --- Rs. 200 Rs. 160 Rs. 128 Rs. 102 --- --- Rs. 800 IER Rs. 640 Rs. 512 Rs. 410 ---- --- Total 5000 1000 4000 58 59. Limitations of credit creation 1. Amount of cash: Higher the amount of cash, higher is the credit creation. Thus, the power to create credit is limited by the banks cash. 2. CRR: the size of the CRR determines credit creation. Higher CRR leads to lower credit creation and vice versa. 3. Leakages: The actual credit creation by the banking system may be less than the potential because of certain leakages: excess reserves and cash drains. 59 60. Limitations of credit creation 3. Leakages: If banks instead of granting loans maintain excess reserves because of the fear of recession or expectation of interest rate hike, credit creation may be constrained. Similarly, if people instead of depositing money with bank hold currency with themselves, the power of the bank to create credit is reduced. 4. Availability of borrowers and securities/collateral 5. Banking habit 6. Business condition 7. Monetary policy 60 61. Financial intermediaries (FIs) Financial intermediaries play an important role in the economy. Remember the five roles of FIs that we discussed earlier. FIs are categorized into (a) depository institutions, which accept deposits (b) non depository institutions, which do not have deposit liabilities. Depository institutions, which include commercial banks, savings banks and savings and loan associations, and credit unions. In context of Nepal, Commercial banks, development banks, finance companies are main depository institutions. 61 62. Financial intermediaries (FIs) Non-depository institutions, which include securities market institutions, insurance companies, pension funds, mutual funds. Investment banks, and Securities brokers and dealers are the securities market institutions. Investment banks specialize in securities underwriting. Underwriting can be firm commitment underwriting in which investment bank purchases and distributes to dealers and other purchasers all securities offered by a business and standby commitment underwriting in which the investment bank earns commissions for helping the issuing firm sell its securities under the guarantee that the investment bank will purchase for resale any initially unsold securities. 62 63. Financial intermediaries (FIs) Securities brokers specialize in matching buyers and sellers in secondary financial markets. Dealers, in contrast, sell securities from their own portfolio and seek to profit by buying low and selling high. Insurance companies offer policies that are financial guarantees to cover losses of life and property. Pension funds manage the retirement benefit of the employees. These can be contributory or non contributory. Contributory is one in which both employers and employees contribute for the retirement benefit of the latter. In noncontributory, only employers contribute. 63 64. Financial intermediaries (FIs) Mutual funds are portfolios of financial instruments managed by investment companies on behalf of the shareholders. These are subject to regulation. However, hedge funds are private companies that typically are operated as limited partnerships subject to little or no government regulation. 64 65. Nepalese financial structure Nepalese Financial Structure (Rs. in million) mi d-July 2006 Total assets/liabilities Percentage share in total Ratio of total assets to nomina l GDP (in percentage) Financi al institutions 615761.4 88.4 105.6 Nepal Rastra Bank 167606.8 24.1 28.8 Co mme rcia l banks 387678.3 55.7 66.5 Finance companies 38841.0 5.6 6.7 Develop ment Banks* 10611.0 1.5 1.8 Cooperatives 2834.0 0.4 0.5 Microcredit financia l institutions 8190.4 1.2 1.4 Contr actual Savings institutions 80533.0 11.6 13.8 Emp loyees Provident Fund 51060.0 7.3 8.8 Citizen Investment Trust 6750.0 1.0 1.2 Insurance companies 22688.0 3.3 3.9 Total 696294.4 100.0 119.4 No mina l GDP 582948 Ratio of stock Market capitalizitation 16.6 65 66. No. of NRB licensed FIs Number of Institutions in mid-July Type of Financial Institutions 1980 1985 1990 1995 2000 2005 2006 Jan-07 Commercial Banks 2 3 5 10 13 17 18 19 Development Banks 2 2 2 3 7 26 29 35 FinanceCompanies - - - 21 45 60 70 72 Micro Credit Development Banks - - - 4 7 11 11 11 Saving and Credit Cooperatives - - - 6 19 20 19 19 NGOs (Performing limited Banking activities) - - - - 7 47 47 47 Source:NRB 66 67. Financial Institutions In addition to NRB licensed financial institutions, there are 21 insurance companies, one provident fund, one citizens investment fund, Securities Board of Nepal, Nepal Stock Exchange, Deposit Insurance and Credit Guarantee Corporation, Postal Saving Bank, and saving and credit cooperatives licensed by Cooperatives Department in Nepal. 67 68. Conclusion Review: 1. What is money and what are its functions. 2. What is the role of banking system in an economy? 3. What is credit creation? 4. What do FIs do? 68