Concept of Money

Money is any object that is generally accepted as payment of goods and services and the
repayment of debt. Money functions as medium of exchange, a unit of account and a store a
value.

Inflation is defined as a sustained increase in the general level of prices for goods and services.
It is measured as an annual percentage increase.

This module covers the basic concepts of Money such as interest rate calculation, inflation and
its impact on interest rates and cost of capital in a company.

At the end of this module, you will be able to:

1. Explain money and its time value

2. List the different types of interest

3. Explain cost of capital

4. Explain simple and compound interest.

5. Describe Internal Rate of Return and Net Present Value.

Introduction to money
Here are the basic characteristics of money:

1. It is a standardized unit of exchange.

2. It is measured in various currencies such as INR, USD and so on.

3. It is the exchange rate for various currencies.

4. Interest is the 'rent' paid for money.

5. Simple interest is calculated on the initial principal amount.

6. Compound Interest is calculated on both the initial principal amount and its accrued interest
of each period.

Simple and Compound Interest

Interest is primarily of two types- simple interest and compound interest.
Let's take a look at the following example to know how to calculate interest.

1. Principal amount invested: $100

2. Interest charged: 5% p.a.

3. Time period: 5 years

4. The simple interest is= $100*5%*5= $25

5. The compound interest is= 100*(1+5%)^5-100= $27.63

6. The continuous compound interest is= 100*e^(5%*5)-100 =$28.40

Nominal and Real Rate of Interest

Inflation occurs when there is a rise in cost of goods and services over a period of time. It is
calculated for the given year based on increase in wholesale price index i.e. increase in the
bucket of commodity and articles compared to base year index.

Calculation:

Real rate of interest = Nominal rate of interest - Inflation rate

example:

published home mortgage rate = 10.0%

Inflation rate = 3.5%

The real rate of interest for home loans = 10.0 -3.5 = 6.5%
 Retail Banking
Getting Started
Retail banking is a process in which a bank executes transactions directly with the consumers, rather
than corporations or other banks. Services offered include savings and checking accounts, mortgages,
personal loans, debit or credit cards and certificates of deposit (CDs). This module covers retail banking
operations, characteristics of retail banking sector, delivery channels and various payment instruments.

At the end of this module, you will be able to:

 Describe the operations of a retail bank

 Describe the characteristics of retail banking
 List the features of various deposit products
 List the features of different accounts
 Describe the types of delivery channels
 Identify the significance of branch banking and multi branch banking
 Describe the types of ATMs and identify the significance of ATM banking
 List the instruments for retail payments.

Assets & Liabilities

Assets are receivables, mortgages, loan amount lent out and interest payment that banks get.

Liabilities are interests to be paid on deposits made by individual customers and also the deposit
amount withhold by bank.

Operations of retail Banking system

The retail banking system operations are divided into three categories.

Front Office: The front office operations include:

 Sales and Marketing

 Customer Service
 Accounting Origination and Onboarding

Middle Office: The middle office operations include

 product Structuring
 product distribution
 Legal and compliance
 Audit, MIS, Central Bank Reporting and Risk Setup
Back Office: The back office operations include:

 A/C Maintenance
 Transaction Process
 Collections
 Reconciliation
 Accounting

Characteristics of retail banking

Let's look at the different segments, channels and products of retail banking.

Multiple products: The multiple products of retail banking include:

 Deposits
 Loans
 Mortgages
 Insurance
 Securities
 Payments-Cards

Multiple Channel Delivery: The multiple channel deliveries of retail banking include:

 Branch
 PC
 Call center
 ATM
 sales agent

Multiple Segments: The multiple segments of retail banking include:

 Mass
 Small Business
 Affluent
 Medium size business
 private
 Large business

Deposit Products
Deposits are classified into demand deposits and term deposits. Here are the features of deposit
products:
  A customer can deposit and withdraw money from his account. However, the frequency and
limit of withdrawal differs from account to account.
 A customer can issue checks to withdraw or transfer money from his account.
 There may be restrictions on the number of checks issued in a month.
 Interest is usually paid for all deposit products except for certain accounts like checking
accounts.
 A customer has to maintain a minimum balance in most of the accounts, except a No Frill or
Zero Balance account, failing which the bank will charge a penalty.

Demand Deposit: A demand deposit is a type of account which can be withdrawn at any time without
any advance notice to the depository institution.

Term Deposit: A Term deposit is a type of account which cannot be accessed for a pre-determined
period. Funds can be withdrawn after the fixed term.

Types of Accounts
The Features of different account types are shown in the comparison table.

Type of Checking Interest Money Market Savings Certificate of

Account Account Checking A/C (MMDA) Account Deposit(CD)
Account
(NOW)
Will I earn No Yes Yes,usually Yes Yes, usually
interest? higher than higher than
now MMDA
May I write Yes Yes Yes, only three No NO
checks? per month
Are there any No No Yes, six YEs, six No, generally
withdrawal transfers per transfers per no withdrawals
limitations? month month until the date
of maturity
Do I have to Yes Yes Yes Yes Yes,
pay fees withdrawals of
principal will
attract penalty
in interest
rates
Do I need to YEs Yes Yes, higher Yes N/A
maintain than other
minimum accounts
balance
Retail banking also comprises of few specialized accounts such as:

 Basic or No Frill Banking accounts

 Credit Union Accounts
 Individual Retirement Accounts(IRAs)
1. Roth IRA
2. Traditional IRA
3. SEP IRA
4. Simple IRA
5. Self-Directed IRA

Delivery Channels
Delivery channel is the mode through which products and services reach customers. Efficient delivery
channels provide easy access to the customers throughout the world. Until recently, branch banking was
the single delivery channel for banking products and services but now it is supplemented with multiple
channels.

The delivery channels operationalized by the retail banks are:

 Branch Banking
 Atm Banking
 Mobile Banking
 Online Banking
 Telephone Banking

Branch Banking
Branch banking is a banking system consisting of a head office and interconnected branches providing
financial services in different parts of the country.

Branch networks have re-emerged as combined centers that:

 Deliver wide range services from banking products to brokerage services

 Transform transaction processing centers into customer-centric financial sales and service
centers

A Typical retail branch at a bank has two primary activities:

Teller Operations : Accept and process customer transactions at the teller window

Relationship Manager: Performs tasks, such as new account opening, account maintenance and product
sales
Teller Operations: The following functionalities form a part of teller operations:

 Cash advances
 consumer mortgage/loan payments
 Currency and coin orders
 Deposits, including commercial deposits
 Fee collection
 Foreign currency exchange
 Payments
 Stop payments
 Transfers
 Wire Transfers
 Withdrawals

Multi Branch Banking

Banks are now looking to provide "Multi Branch Banking" service to customers through a network of the
bank's branches. Under this service, a customer of one branch is able to transact on his or her account
from any other networked branch of the bank.

The typical services provided by multi branch banking include:

 Cash Deposits
 Cash Payments
 Transfer of funds
 Balance Inquiry
 Marking stop payment of a check

ATM Banking
The number of ATMs has increased from 9.3% in 1982 to 15.5% in 2002. Access to ATM is done by
means of a card, typically a dual ATM or debit card. Transaction is directly linked to the consumer's bank
account. The amount is debited against the funds in that account.

The Services provided by an ATM include:

 cash withdrawal where the limit per day is restricted by respective bank guidelines
 Money transfer between accounts
 Cash or check deposits
 Utility bill Payments
 Balance enquiry or account statements
Types of Risks
Here is a comprehensive view of the various types of risks

1. Credit Risk
2. Liquidity Risk
3. Market Risk
 currency risk
 commodity risk
 equity risk
 Interest rate risk
4. Operational Risk
5. Legal Risk

Risk Measurement
Value at Risk (VaR) is an estimate of the worst expected loss of a portfolio under normal market
conditions over a specific time interval at a given confidence level.

The three pillars of risk management are define, measure, and manage.

Factors Affecting Risk Measurement: The following factors are considered during risk measurement:

 probability of occurrence of any unfavorable event

 Estimated monetary impact on an organization

Calculation Methodologies: The methodologies used for VaR calculation are:

 Historic Simulation
 Variance Covariance
 Monte Carlo Simulation

Risk Management Methods: Let's take a look at the methods by which risks are managed:

 Diversifying
 Hedging or Insurance
 Setting Risk Limits
 Ignoring Risk

Basel I, II, and III

Basel I, II, and III accords help banking institutions to manage risks. Here is an overview of Basel I, II, and
III.
Basel I: Basel I capital accord was instituted in 1988 to establish minimum capital requirements. Here are
some pieces of information related to Basel I:

 Single, standard measure of risk is used to determine minimal capital requirements

 Tier 1 is the sum of equity and reserves deducted from core capital
 Tier 2 is the supplementary capital
 Tier 1 capital is at least 50% of Total Capital
 Risk weights are for various asset classes
 Target standard ratio is set at 8% (of which the core capital element will be at least 4%)

Basel II: Here are some pieces of information relevant to Basel II. It involves:

 Enhancement of capital adequacy framework by capital regulation. This covers:

1. Minimum capital requirements, supervisory review and market discipline
2. Substantial increase in the risk sensitivity of the minimum capital requirements
 Extensive dialogue with industry participants and supervisors from outside member countries
 Promotion of safety and soundness in the financial system, which includes:
1. Allocation of capital to reflect risk
2. Three interdependent dimensions called pillars
 Fundamental change in handling and measuring credit risk
 Capital charge for operational risk. It is mandatory to establish a framework for industries like
securities processing

Basel III : Basel III helps to strengthen bank capital requirements by increasing bank liquidity and
decreasing bank leverage.

The Key principles of Basel III are:

 Capital requirements: Basel III rule from 2010 requires bank to hold 4.5% of common equity and
6% to tier I capital.
 Leverage ratio: The banks maintain a leverage ratio in excess of 3% under Basel III.
 Liquidity requirements: Basel III introduces two required liquidity ratios. They include Liquidity
coverage ratio and net stable funding ration.

Basel III Framework

The Basel III framework consists of three mutually reinforcing pillars:

 Pillar 1 - Minimum capital requirements

 Pillar 2 - Supervisory Review Process
 Pillar 3 - Market Discipline

Quantitative: Quantitative pillar involves minimum capital requirements. The calculation of capital
requirements is done considering:
  The credit risk
 The operational risk
 The trading book changes (market risk)

Qualitative: Qualitative pillar involves the supervisory review process, which includes the following:

 Overview of supervisory review

 Key principles
 Capital management processes
 Interest rate risk in the banking book

Market Forces: Market Forces pillar involves market discipline.

The disclosure requirements are:

 Capital structure
 Risk exposures
 Capital adequacy

Minimum Capital Requirements

Let's take a look at how to calculate minimum capital requirements:

Bank's Minimum Capital Ratio = Total Capital/(Market Risk + Credit Risk + Operational Risk)

The table below illustrates the minimum capital requirements in detail.

Credit Risk Operational

Risk
Simple Standardized Basic (Single)
Indicator
Approach
Intermediate Foundation Internal Ratings Standardized
Based (IRB) Method Approach
Advanced Advanced IRB Method Advanced
Measurement
Approach

complexity and IT investment capital charge

Approaches for credit Risk Measurement

Standardized and IRB approach are the two methods for credit risk measurement.

Standardized: Here are the features of standardized approach:

  It is similar to Basel I. Banks need to slot their credit exposures into the supervisory categories
with fixed risk weights.
 This approach uses external credit assessments to enhance risk sensitivity compared to Basel I
and corporate exposures are differentiated based on it.
 For sovereign exposures, these credit assessments may include those developed by organization
for economic cooperation and development (OECD) export credit agencies, as well as those
published by private rating agencies.

IRB Approach: The bank's internal assessment of key risk drivers serve as the primary input. Risk weights
and capital charges are determined by the quantitative inputs from banks and formulas specified by
Bank for International settlements (BIS). IRB approach depends on four quantitative inputs. These are:

 Probability of Default (PD) - It is the likelihood with which a borrower defaults over a given time
horizon.
 Loss Given Default (LGD) - It is the percentage of exposure that is lost if a default occurs.
 Exposure at Default (EAD) - It is the amount of the facility that is likely to be drawn if a default
occurs.
 Maturity (M) - It is the remaining economic maturity of the exposure.

Historical Method of VaR Calculation

The QQQ started trading in march 1999. If each daily return is calculated, a rich data set of almost 1400
points is produced. Here's a histogram that compared the frequency of return buckets.

Let's Recap
In this module, you have learnt the following:

 Risk is defined as the deviation from deviation from expectation and is an extremely important
concept for financial services industry.
 Hedging and insurance are good techniques to reduce risks.
 BASEL I,II and III implications help banking institutions to manage risks.
 VaR is an efficient way to measure risk as a factor of time, confidence level and percentage of
loss on investment.
 Historical, Variance Co-variance and Monte Carlo based methods are used to measure VaR.
There is a rumor that the public issue of Gamma Ltd. will be a hot issue in the market. Based on that
rumor, Mr. James invests all his savings in this public issue. What type of investor is Mr.James?

ans:speculator

Which of the following terms are needed to calculate value of a bond?

ans: npv of expected cash flow, interest rate

what are the functions of sec?

protects investors

Maintains fair, orderly, and efficient markets

facilitates capital formation