banking & credit structure

8/8/2019 Banking & Credit Structure

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Banking & Credit StructureBanking & Credit Structure


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MoneyMoney

Money is a thing offunctions fourMoney is a thing offunctions four

Medium, Measure, Standard, StoreMedium, Measure, Standard, Store


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Demand for Money

Transactions Motive

Precautionary Motive

Speculative Motive Price of securitiesand their rate of yield real rate of

interest are related inversely. If the

market trading price of a GOI bond is

high, then its yield rate is low.


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Supply of Money

The quantity of money in existence at a

particular time or the supply of money

in a spendable form consists of :a. Currency component : Currency notes and

coins issued by the Central Bank

b. Deposit component : Deposit money

consisting of bank deposits of the generalpublic which can be withdrawn by means

of cheques


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Supply of Money

The currency component of money

supply is called ordinary money or

common money. This includes currencyheld by the general public and excludes

currency held by the Banks.

The currency money with the people in

India stood at Rs. 2,41,440 crores in

2002.


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Currency with the Public in India(in crores)

1970-71 1990-91 2001-02

1. Notes in

circulation

4,170 53,660 2,44,610

2. Circulation ofrupee coins 250 940 4,810

3. Circulation of

small coins

140 680 1,410

4. Cash in hand withbanks

190 2,230 9,390

Total (1+2+3-4) 4,370 53,050 2,41,440


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Supply of Money

The deposit component of the money supply

comprises of demand deposits of the people in

Banks and other deposits with RBI. RBI has

two types of deposits one is the deposits ofCommercial Banks with RBI and the other is

the individual accounts like that of ex-

governors and others. In deposit money, we

include demand deposits of people withcommercial banks and with RBI. The growth of

deposit money is shown in the following table.


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Deposit Money with the Public in India(Rs. In crores)

1970-71 1990-91 2001-02

1. Demanddeposits of

Banks

2,910 39,170 1,76,920

2. Other depositswith RBI

60 670 2,840

Total (1+2) 2,970 39,840 1,79,760


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Supply of Money

Indian banks consider only the following two

components to be deposit money :

a. That portion of savings deposits subject to

the cheque system

b. That portion of savings deposits not subject

to the cheque system ie. time deposits.

The following table shows the total moneysupply with the public in India


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Money Supply with the Public in India

(M1) (Rs. In crores)

1970-71 1990-91 2001-02

1. Currency withthe public

4,370 53,050 2,41,440

2. Deposit moneywith the Public

2,970 39,840 1,79,760

Money Supply

(M1) with the

Public

7,340 92,890 4,21,200


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Narrow and Broad money

The previous table bears testimony to

the growing spread and reach of the

banking system in India as also the

growth of the banking habit among the

general public in India.

This concept of money supply in a

country is known as narrow money whichRBI denotes as M1.


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M1 and M3

If the fixed deposits of the banking

system are added to the narrow money

or M1, we arrive at what RBI calls Broad

Money or M3. The basic distinction

between narrow and broad money is the

treatment of time deposits with banks.

RBI shows the calculation of broadmoney in India as in the next table:


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Broad Money Supply (M3) in India(Rs. Crores)

1970-71 1990-91 2001-02

1. Narrow Money(M1)

7,340 92,890 4,21,200

2. Time Depositswith banks

3,640 1,72,940 10,75,930

Broad Money

(M3)

10,980 2,65,830 14,97,130


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Monetary Aggregates in India

RBI presently calculates four concepts ofmoney supply in India known as monetaryaggregates or money stock measures. Theyare:

M1 = Currency with the public ie coins andcurrency notes + demand deposits of thepublic (narrow money)

M2 = M1 + Post Office savings deposits

M3 = M1 + Time deposits of the public withbanks (broad money)

M4 = M3 + Total post office deposits


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Money Stock Measures(Rs. Crores)

1970-71 1990-91 2001-02

1. Money supply with

the people (M1)

7,340 92,890 4,21,200

2. PO savings deposits 990 4,210 5,040

3. M2 (M1 + item no. 2) 8,330 97,090 4,26,240

4. Time deposits with

Banks

3,640 1,72,940 10,75,930

5. M3 (M1 + item no.4) 10,980 2,65,830 14,97,130

6. Total PO deposits 1,180 14,680 25,970

7. M4 (M3 + item no. 6) 12,160 2,80,510 15,23,100


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Monetary Aggregates in India

As the RBI does not have direct control

on the post offices and since these

deposits are anyway small, these

deposits ie M2 are assumed constant

over an year. M2 and M4 are mere

statistical measures and are insignificant

compared to M1 and M3.


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Reserve Money

Reserve Money (RM) is the money of

the government printed / minted by the

RBI and held by the people and the

Banks. It comprises:

1. Currency held by the people (C)

2. Cash reserves of the banks (CR)

3. Other deposits with RBI (OD)

Hence, RM = C + CR + OD


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Reserve Money

C is the currency with the public consisting ofcurrency notes and coins

Banks hold their cash reserves (CR) in theform of cash in hand and as cash balanceswith RBI to meet their cash reserve ratios(CRR)

Other deposits with RBI (OD) representdemand deposits of the general public with

RBI Narrow money (M1) = C + DD + OD

C + OD is common to M1 and RM.


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Reserve Money

While C and OD are common to M1 and RM,DD and CR are the only two differentvariables. This difference is quite significant.For, cash reserves of banks (CR) in the

reserve money is the actual base for the totaldemand deposit (DD) structure of the bankingsystem. By manipulating CR, RBI caninfluence the total volume of bank credit andthe total volume of bank deposits in the

country. Hence, CR is regarded as highpowered money though RM is at the base ofthe money multiplier of the banks.


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Reserve Money and its components(Rs. Crores)

Year Currency

in

circulation

(C)

Bankers

deposits

with RBI

(CR)

Other

deposits

with RBI

(OD)

Reserve

Money

(2+3+4)

(1) (2) (3) (4) (5)

1970-71 4,560 200 60 4,820

1990-91 55,280 31,820 680 87,780

2001-02 2,50,830 84,150 2,850 3,37,830


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Money Multiplier

Most of the change in money supply is due tothe change in RM. Mathematically, therelationship can be shown as:

M = mRM where m is the money multiplier or

m = M / RM

The above formula can be rewritten in terms ofnarrow money and broad money:

m = M1 / RM or M3 / RM.

The money multiplier depicts the nature of theeffect on M1 or M3 as a result of a change inRM. The following table illustrates the same.


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Money Multiplier

Year M1(Rs. Crores)

M3(Rs. Crores)

RM(Rs. Crores)

M1 /

RM

M3 /

RM

1970-71 7,370 11,020 4,820 1.53 2.29

1990-91 92,890 2,65,830 87,780 1.06 3.03

2001-02 4,21,200 14,97,130 3,37,830 1.24 4.43


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Composition of money supply and

monetary management

The monetary policy / management is greatly

dependent on the composition of money

supply. While the currency component is

directly controlled by Central Bank, the depositcomponent is created by commercial banks. In

the short run, it is not possible to alter currency

component and hence its supply is inelastic.

Supply of bank money is elastic and is a vitaltool in monetary management


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Contemporary issues

a. India is predominantly an agriculturaleconomy where the currency component faroutweighs the deposit component of money

supply. Hence, monetary policy /management is not very effective. Seasonalvariations in demand for money supplyposes another problem to the Central Bank.

b. In the last four years, the net foreignexchange assets of the banking sector havegrown significantly and have influenced themoney supply in the economy


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Contemporary issues

c. Increasing money supply on account of

government securities being pledged to

RBI. This has an adverse effect on the

price level and inflation rates of the

economy.


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INFLATION - definitions

Too much currency in relation to the

physical volume of business being done

Too much money chasing too few goods Prices rise due to an increase in the

volume of money as compared to the

supply of goods

Abnormal increase in the quantity of

money


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Inflation

Keynes relates inflation to a rise in price levelwhich comes into existence after the stage offull employment. Keynes states that the rise inprices up to the stage of full employment is a

good thing for the country since there is anincrease in output and also in employment. Hedifferentiates two types of rises in price:

A. rise in prices accompanied by increase inproduction

B. rise in prices not accompanied by increasein production


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Kinds of Inflation

DEMAND PULL INFLATION

This is caused by increased demand for goods

that is not accompanied by relative increase in

supply of goods. Bottlenecks may preventsupply to increase commensurate with

increase in demand. Increase in demand is

essentially rapid economic development, rising

private investment or high governmentexpenditure.


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Kinds of Inflation

COST PUSH INFLATION

Costs of production are essentially onaccount of increase in wage rates

(through trade union activities) orincreased profit margins for themanufacturers. Higher taxation,profiteering, hoarding and speculatingare the other causes for this type ofinflation.


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Kinds of Inflation

Sectoral Demand Shift Theory

Inflation is confined to one sector of theeconomy but because of the importance of this

sector, the inflationary impulses percolate toother sectors also. Increase in agriculturalprices, petroleum prices or tertiary sectorprices will have a overbearing and overarchingeffect on all the other sectors of the economy.This concept also explains the simultaneousexistence of inflation in one sector anddeflation in another sector called Stagflation.


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Control of inflation

Anti-inflationary measures are of four

kinds:

1. Monetary policy2. Fiscal policy

3. Price control and rationing

4. Other methods


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Control of inflation

1. Monetary policy during inflationary times,money supply is reduced, interest rates arehiked, reserve ratios of banking system are

increased and foreign exchange restrictionsare placed on importers

2. Fiscal policy inflation is sought to becurbed by lessening governmentexpenditure, increasing tax rates, public debtmanagement and mopping up operations ofexcess liquidity.


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Monetary Policy

The management of the expansion and

contraction of the volume of the money

in circulation for the explicit purpose of

attaining a specific objective such as full

employment Raymond P Kent


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Monetary Policy

The objectives of monetary policy are

a. Stability of price

b. Stability of exchange ratec. Full employment

d.Economic growth


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Monetary Policy - Objectives

a. Stability of price

Fluctuations in price level are alwaysaccompanied by fluctuations in the level of

business activity. However, price instabilitycreates difficult problems of production anddistribution affecting different sections of thepeople in the country differently. Duringperiods of falling prices, there is widespreadcollapse of businesses resulting intremendous increase in unemployment anddecrease in production and income.


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Periods of rising prices, on the other hand,witness shifts in the distribution of wealth andincome from the poor to the rich.

Only periods of relatively stable prices havebeen able to combine an active and stableprosperity with a largely neutral effect onwealth distribution. Moreover, periods of priceand business fluctuations have also witnessedeconomic and political turmoil. Therefore,stabilisation of internal prices is a majorobjective of the monetary policy.


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b. Stability of exchange rate

Stable exchange rate is an essential condition forpromotion of healthy foreign trade. Fluctuations inexchange rates result in flight of capital and lack of

investor confidence. It also results in speculativeactivity in the foreign exchange market. Hence,monetary policy lays great emphasis on exchangerate stability which is deemed to be the bestguarantee for maximum economic and socialwelfare. In recent times, however, the formation of

economic unions like European Union and ASEANas also the emergence of international bodies likeIMF and IBRD have taken this objective out of thesole ambit of monetary policy.


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c. Full employment

In cases of economies suffering from unemploymentbecause of deficiency of investment, monetarypolicy could try to: (a) create additional bank

deposits, (b) create additional money, and (c)increase velocity of circulation of money throughactivating of idle cash balances. All thesenecessitate reduction in rate of interest to stimulateborrowings from banks for investment. Hence,

monetary policy designed to promote investmentand ultimately achieve full employment is commonlyknown as cheap money policy.


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d. Economic growth

The monetary authorities strive to establish anefficient currency and banking system to facilitateand foster economic growth. Horizontal penetration

of the banking system into rural and semi-urbanareas and vertical penetration into sophisticated andspecialised money markets in the urban areas is avital task of the monetary authorities.

The Central Bank must ensure money supply that is

adequate to the growth process and is sufficientlyelastic. Paper money must replace coins andbanking instruments must gradually takeover papermoney.


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As economic growth reaches maturity, monetarysystem becomes less important. In the later stages ofdevelopment, the monetary system becomes part ofthe entire financial mechanism which controls the flowof funds as well as securities. But in the meantime, themonetary authorities must help the continuousexpansion of the banking and financial systems.

Monetary authorities have another importantresponsibility as regards growth viz. creation of newfinancial institutions for mobilising savings for

productive use. Presently, the credit system is moreprone to providing credit to large estates, plantations,export industries and so on. Credit facilities are notreadily available to peasants, small industries andsmall traders.


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Finally, the monetary authorities must solve the BOPproblem that every developing country faces. Tocounter adverse BOP, Central Bank must resort todirect control over foreign exchange and bank rates.

Central banking in a planned economy can hardly beconfined to the regulation of the overall supply of creditor to a somewhat negative regulation of the flow ofbank credit. It would have to take a direct and activerole. Firstly, in creating or helping to create themachinery needed for financing development activities

all over the country, and secondly, in ensuring that thefinance available flows in the direction intended. Planning Commission.


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Methods of Credit Control

Quantitative controls consist of bank rate

or discount rate policy, open market

operations and reserve requirements.

Qualitative controls consist of regulation

of margin requirements, regulation of

consumer credit, rationing of credit,

control through directives, moral suasionand direct action.


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Bank Rate Policy

Bank rate is the rate of interest that the Central

Bank levies while discounting or rediscounting

eligible bills and securities of Commercial

Banks to meet their funds requirement. Sincethe Central Bank is the lender of last resort,

the Bank rate is related closely to all other

rates of interest in the money market. The

eligible bills or first class bills or gilt-edgedsecurities are treasury bills/bonds and

commercial bills.


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Open market operations

Deliberate and direct buying of securities and bills by theCentral Bank in the money market, on its own initiative, iscalled open market operations.

In periods of inflation, the Central Bank will sell in themarket first class bills in its possession to buyers like

Commercial Banks and others. This reduces the cashreserves of the Commercial Banks which in turn will reduceits capability to give loans and advances. Thereby,business activity in the country will be cut short.

During recession, Central Bank buys bills from CommercialBanks and thereby increases their cash reserves. Business

activity receives a fillip. The Central Bank thus influences the lending operations of

Commercial Banks and ultimately influences businessactivity and economic conditions in the country.


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OMO - Advantages

Strategically, OMO as a method ofinfluencing money supply is effectivebecause the initiative to control the

volume of money supply in the country iskept by the Central Bank itself. But thebank rate policy is passive in the sensethat its success depends upon the willing

response of the Commercial Banks andtheir customers.


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OMO - Limitations

Commercial Banks may prefer to operate withhigh cash reserves rather than expand creditin the economy though this might negativelyimpact their profitability.

Commercial Banks will also have an optimaltrade off between excess cash reserves andbuying low yielding securities.

Credit expansion must be followed by the

willingness of businessmen to come forward toborrow. However, their willingness might beguided by real and not monetary factors in theeconomy.


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Cash Reserve Ratio

According to the RBI Act 1934, every scheduled bankhas an obligation to maintain a certain portion of theirdemand and time deposits as a reserve with theCentral Bank. This provision was fixed for threeimportant reasons

1. To ensure the liquidity and solvency of individualCommercial Banks and of the banking system as awhole

2. To provide the Central Bank with supply of deposits forlocal operations

3. To influence and ultimately restrict Commercial Banksexpansion of credit.

Hence CRR is an additional instrument of creditcontrol of the Central Bank


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Selective Credit Controls

The quantitative controls like bank rate, OMO andCRR affect indiscriminately all sections of theeconomy which depend on bank credit. Besides, thereare some groups of borrowers who are engaged inimportant spheres of economic activity and whom the

Central Bank would like to insulate from thesequantitative effects. Hence, Central Banks have beenadopting the tool of selective credit controls orqualitative controls whose special features are:-

a. They distinguish between essential and non-essential

uses of bank creditb. Only non-essential uses are brought under the scope

of Central Bank controls

c. They affect not only the lenders but also the borrowers


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Methods of Selective Credit Controls

A. Margin Requirements

B. Regulation of consumer credit

C. Moral SuasionD. Control through directives

E. Rationing of credit


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The Indian Banking System

Reserve Bank of India (Central bank & Monetary Authority)

Commercial Banks Regional Rural Banks Co-operative Banks

Public SectorPrivate

Sector

Indian

Foreign

State Bank GroupOther Nationalized

banks

Stage Bank

Of India

Associate

Banks

State Co-operative

Banks

Urban Co-operative Banks

Central

C-operative banks

Primary Credit Societies


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SBI and its Associate Banks

The main consideration for opening State Bank ofIndia was to have a big commercial bank having anation-wide reach. Thus, SBI was required as adevelopment agency besides performing the

traditional functions of a commercial bank. It usheredin a new era of a mixed banking system in the country.It financed agriculture, priority sectors and viablecommercial activity. It was this structure of SBI thatinfluenced the nationalisation of 14 banks in 1969. The

SBI and its associate banks account for 20% of totalbank branched and 30% of the total banking businessin the country. RBI has diluted its share holding in SBIfrom 99% earlier to 59% presently.


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Other Nationalised banks

The second category of the public sectorbanks are the 19 commercial banks whichwere nationalised each having a deposit baseof above Rs. 50 crore. Their policies should beinspired by the larger social purpose and be inaccordance with the national priorities andobjectives. Banks were to be instruments ofeconomic development. After nationalisation,

the share of private sector banks declined to9%. The total number of branches of the 19nationalised banks was 33,211 in 2004.


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Regional Rural Banks (RRBs)

Nationalisation of banks did not solve theproblem of rural indebtedness and thestranglehold of money lenders. This saw theemergence of RRBs which were sponsored by

a public sector bank and had a multi-agencyapproach to rural credit. The RRBs meet thecredit requirements of weaker sections, smalland marginal farmers, artisans and smallentrepreneurs. In 2004, the branch network of

RRBs was 14,507 of which 90% were in ruralareas. However, over the years RRBs haveaccumulated massive losses and NPAs.


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Private sector commercial banks

Presently, relatively small scheduledcommercial banks and 10 newly establishedprivate banks with a network of 5794 branchedare operating in the private sector. In terms ofbranches and also the business done by themthey are much smaller than both thenationalised banks and also the foreign banksand their share in the financial system is just

marginal. These private sector banks accountfor less than 15% of both bank deposits andadvances and 12.4% of banking assets.


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Foreign Banks

In 2004, there were 218 branches of foreign bankslocated mainly in big cities. Majority of these bankshave operated in India for a very long time and havebuilt up considerable expertise in finance of foreign

trade, accepting deposits and lending funds for tradeand commerce. These banks initially had a virtualmonopoly on finance of foreign trade. Foreign banksaccount for 6.9% of total banking assets. Their unfaircompetition with the Indian banks and the practice of

financing Indias foreign trade through short term fundsfrom London money market were irritants in the past.However, the growing strength of the nationalisedbanks has nullified these bad practices.


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Banking Sector Reforms

Prudential Regulation and Supervision

1. RBI has moved away from micro interventionto prudential regulation as the first step inbanking reforms. They have issued

guidelines for income recognition, assetclassification and provisioning, and adoptedthe Basle capital adequacy standards.

2. Banks are expected to reach a 9% capital torisk weighted asset ratio (CRAR). The SBIand its associates and 19 other nationalizedbanks reached this norm in 2002. This figureeven improved to 13.4% in 2005.


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3. Accrued income from non-performing loanscan no longer be treated as income of thebanks. Non-performing loans have beendefined as credit facility in respect of which

interest has not been received for 180 days.Provisioning has to be made to cover theseloans.

4. The Board of Financial Supervision has beenconstituted as a supervisory authority.

Earlier, off-site back-up was very muchlacking on account of out of date informationsystems.


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Rehabilitation ofPublic Sector banks

1. In 1994, the overall non-performing assets as aproportion to assets was as high as 24.8% forseveral banks. The government decided torecapitalize the banks which included direct infusionof capital through budgetary provisions. Accordingly,more than Rs. 14,000 crores were infused into thebanking system.

2. The banks have been provided legal support in theirrecovery effort and special tribunals were set up.

The enactment of Securitization, Reconstruction ofFinancial Assets and Enforcement of SecurityInterest Act 2002 (SARAFESI Act) enables thesetting up of asset management companies foraddressing the problems of NPAs.


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Reduction in the SLR and CRR rates

1. From a high of 38.5% in 1991, SLR was reduced to25% since 1997.

2. CRR which was around 13% earlier was brought

down to 5% in 2004.3. These steps had augmented the loanable funds of

the banks and financial institutions.

Deregulation of Interest Rates

1. The system of concessional interest rates whichexisted prior to reforms led to political populism anddistorted the credit system and bank profitability.


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2. Dismantling this structure, RBI had given

freedom to banks to vary their interest rates

subject to minimum rate fixed by RBI and not

the maximum. This was considerednecessary for better allocation of credit.

Interest rates should increasingly be allowed

to perform their main function of allocating

scarce loanable funds among alternativeusers. Interest rates to be allowed to be

determined by the market forces.


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Phasing out ofDirected Credit

1. To ensure equity in the society, credit was directedtowards certain sections of the society and industries.However, directed credit had only a mildly positive

effect on output and a zero effect on employment inthe agricultural sector.

2. The Narasimhan Committee had recommended thephasing out of the directed credit in the form ofpriority sector lending from 40% to 10%. However,

political will seems to be lacking in implementing thisrecommendation.


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Competition

Until 1991, there was little competition in theBanking sector with the public sector banks

dominating the industry. The governmenthas now recognized the need to makebanking industry more competitive. It hasthus made certain policy changes such asderegulation of interest rates and dilution of

consortium of lending requirements. Bankinghas been opened up to the private sector.Branch expansion has also been liberalized.

banking & credit structure

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