Types of Money Market Instruments in India

Types of Money Market Instruments in India
The money market is a monetary system of lending and borrowing of short-term funds. After the globalization initiative in 1992, India has witnessed a growth in its money markets. Financial institutions have been employing money market instruments to finance the short-term monetary requirements of industries such as agriculture, finance and manufacturing. The money markets have performed well in the past 20 years. The Reserve Bank of India (RBI) has been playing the key role of regulator and controller of such money markets. The RBI intervenes regularly to curb crisis situations, such as liquidity crunching in the markets, by reducing the cash reserve ratio (CRR) or by pumping in more money.
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1. Types of Money Market Instruments in India

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Money market instruments provide for borrowers' short-term needs and gives needed liquidity to lenders. The types of money market instruments are treasury bills, repurchase agreements, commercial papers, certificate of deposit, and banker's acceptance.
Treasury Bills (T-Bills)

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Treasury bills began being issued by the Indian government in 1917. They are short-term instruments issued by the Reserve Bank of India. They are one of the safest money market instruments because they are risk free, but the returns from this instrument are not very large. The primary as well as the secondary markets circulate this instrument. They have 3month, 6-month and 1-year maturity periods. T-bills are issued with a separate price from their face value. The face value is achieved upon maturity, as is the interest earned on the buy value. The buy value is set by a bidding process in auctions.
Repurchase Agreements
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Repurchase agreements are also known as repos. They are short-term loans that buyers and sellers agree to sell and repurchase. As of 1992, repo transactions are allowed only between RBI-approved securities such as state and central government securities, T-bills, PSU bonds, FI bonds and corporate bonds. Repurchase agreements are sold by sellers with
a promise of purchasing them back at a given price and on a given date in the future. The buyer will also purchase the securities and other instruments in the repurchase agreement with a promise of selling them back to the seller.
Commercial Papers
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Commercial papers are promissory notes that are unsecured and issued by companies and financial institutions. They are issued at a discounted rate of their face value. They have a fixed maturity of 1 to 270 days. They are issued for financing of inventories, accounts receivables, and settling short-term liabilities or loans. Commercial papers yield higher returns than T-bills. They are usually issued by companies with strong credit ratings, as these instruments are not backed by collateral. They are usually issued by corporations to raise working capital and are actively traded in the secondary market. Commercial papers were first issued in the Indian money market in 1990.
Certificate of Deposit
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A certificate or deposit is a short-term borrowing note, like a promissory note, in the form of a certificate. It enables the bearer to receive interest. It has a maturity date, a fixed rate of interest and a fixed value. It usually has a term between 3 months and 5 years. The funds cannot be withdrawn on demand, but it can be liquidated on payment of a penalty. The returns are higher than T-bills as the risk is higher. Returns are based on an annual percentage yield (APY) or annual percentage rate (APR). In APY, interest is gained by compounded interest calculation, whereas in APR simple interest calculation is done to calculate the return.The certificate of deposit was first introduced to the money market of India in 1989.
Banker's Acceptance
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A banker's acceptance is a short-term investment plan created by a company or firm with a guarantee from a bank. It is a guarantee from the bank that a buyer will pay the seller at a future date. A good credit rating is required by the company or firm drawing the bill. The terms for these instruments are usually 90 days, but this period can vary between 30 and 180 days. Companies use the acceptance as a time draft for financing imports, exports and other trade
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INDIAN FINANCIAL MARKET

You are fully aware that business units have to raise short-term as well as long-term funds to meet their working and fixed capital requirements from time to time. This necessitates not only the ready availability of such funds but also a transmission mechanism with the help of which the providers of funds (investors/ lenders) can interact with the borrowers/
users (business units) and transfer the funds to them as and when required. This aspect is taken care of by the financial markets which provide a place where or a system through which, the transfer of funds by investors/lenders to the business units is adequately facilitated.
OBJECTIVES
After studying this lesson, you will be able to: explain the concept and functions of financial markets; state the nature and importance of money market; state the nature and types of capital market; distinguish between capital market and money market; explain the nature and functions of a stock exchange; state the advantages of stock exchanges from the points of view of companies, investors and society as a whole; state the limitations of stock exchanges; explain the concept of speculation and distinguish it from investment; outline the stock exchanges in India; and describe the nature of regulation of stock exchanges in India and the role of SEBI.
18.1 FINANCIAL MARKET

We know that, money always flows from surplus sector to deficit sector. That means persons having excess of money lend it to those who need money to fulfill their requirement.
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MODULE -4 Business Finance
Similarly, in business sectors the surplus money flows from the investors or lenders to the businessmen for the purpose of production or sale of goods and services. So, we find two different groups, one who invest money or lend money and the others, who borrow or use the money. Now you think, how these two groups meet and transact with each other. The financial markets act as a link between these two different groups. It facilitates this function by acting as an intermediary between the borrowers and lenders of money. So, financial market may be defined as a transmission mechanism between investors (or lenders) and the borrowers (or users) through which transfer of funds is facilitated. It consists of individual investors, financial institutions and other intermediaries who are linked by a formal trading rules and communication network for trading the various financial assets and credit instruments.
Before reading further let us have an idea about some of the credit instruments. A bill of exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to or to the order of a certain person, or to the bearer of the instrument. To clarify the meaning let us take an example. Suppose Gopal has given a loan of Rs. 50,000 to Madan, which Madan has to return. Now, Gopal also has to give some money to Madhu. In this case, Gopal can make a document directing Madan to make payment up to Rs. 50,000 to Madhu on demand or after expiry of a specified period. This document is called a bill of exchange, which can be transferred to some other persons name by Madhu. A promissory note is an instrument in writing (not being a bank note or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to or to the order of a certain person or to the bearer of the instrument. Suppose you take a loan of Rs. 20,000 from your friend Jagan. You can make a document stating that you will pay the money to Jagan or the bearer on demand. Or you can mention in the document that you will pay the amount after three months. This document, once signed by you, duly stamped and handed over to Jagan, becomes a negotiable instrument. Now Jagan can personally present it before you for payment or give this document to some other person to collect money on his behalf. He can endorse it in somebody elses name who in turn can endorse it further till the final payment is made by you to whosoever presents it before you. This type of a document is called a Promissory Note. Let us now see the main functions of financial market. (a) It provides facilities for interaction between the investors and the borrowers. (b) It provides pricing information resulting from the interaction between buyers and sellers in the market when they trade the financial assets. (c) It provides security to dealings in financial assets.
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(d) It ensures liquidity by providing a mechanism for an investor to sell the financial assets. (e) It ensures low cost of transactions and information.
18.2 TYPES OF FINANCIAL MARKETS

A financial market consists of two major segments: (a) Money Market; and (b) Capital Market. While the money market deals in short-term credit, the capital market handles the medium term and long-term credit. Let us discuss these two types of markets in detail.
18.3 MONEY MARKET

The money market is a market for short-term funds, which deals in financial assets whose period of maturity is upto one year. It should be noted that money market does not deal in cash or money as such but simply provides a market for credit instruments such as bills of
exchange, promissory notes, commercial paper, treasury bills, etc. These financial instruments are close substitute of money. These instruments help the business units, other organisations and the Government to borrow the funds to meet their short-term requirement. Money market does not imply to any specific market place. Rather it refers to the whole networks of financial institutions dealing in short-term funds, which provides an outlet to lenders and a source of supply for such funds to borrowers. Most of the money market transactions are taken place on telephone, fax or Internet. The Indian money market consists of Reserve Bank of India, Commercial banks, Co-operative banks, and other specialised financial institutions. The Reserve Bank of India is the leader of the money market in India. Some Non-Banking Financial Companies (NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.
18.3.1 MONEY MARKET INSTRUMENTS

Following are some of the important money market instruments or securities. (a) Call Money: Call money is mainly used by the banks to meet their temporary requirement of cash. They borrow and lend money from each other normally on a daily basis. It is repayable on demand and its maturity period varies in between one day to a fortnight. The rate of interest paid on call money loan is known as call rate. (b) Treasury Bill: A treasury bill is a promissory note issued by the RBI to meet the short-term requirement of funds. Treasury bills are highly liquid instruments, that means, at any time the holder of treasury bills can transfer of or get it discounted from RBI. These bills are normally issued at a price less than their face value; and redeemed at face value. So the difference between the issue price and the face value of the treasury bill represents the interest on the investment. These bills are secured instruments and are issued for a period of not exceeding 364 days. Banks, Financial institutions and corporations normally play major role in the Treasury bill market.
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(c) Commercial Paper: Commercial paper (CP) is a popular instrument for financing working capital requirements of companies. The CP is an unsecured instrument issued in the form of promissory note. This instrument was introduced in 1990 to enable the corporate borrowers to raise short-term funds. It can be issued for period ranging from 15 days to one year. Commercial papers are transferable by endorsement and delivery. The highly reputed companies (Blue Chip companies) are the major player of commercial paper market. (d) Certificate of Deposit: Certificate of Deposit (CDs) are short-term instruments issued by Commercial Banks and Special Financial Institutions (SFIs), which are freely transferable from one party to another. The maturity period of CDs ranges
from 91 days to one year. These can be issued to individuals, co-operatives and companies. (e) Trade Bill: Normally the traders buy goods from the wholesalers or manufactures on credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or in immediate need of money he/she can draw a bill of exchange in favour of the buyer. When buyer accepts the bill it becomes a negotiable instrument and is termed as bill of exchange or trade bill. This trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.
18.4 CAPITAL MARKET

Capital Market may be defined as a market dealing in medium and long-term funds. It is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares debentures, bonds, etc. In the present chapter let us discuss about the market for trading of securities. The market where securities are traded known as Securities market. It consists of two different segments namely primary and secondary market. The primary market deals with new or fresh issue of securities and is, therefore, also known as new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as stock market or stock exchange.
18.4.1 PRIMARY MARKET

The Primary Market consists of arrangements, which facilitate the procurement of longterm funds by companies by making fresh issue of shares and debentures. You know that companies make fresh issue of shares and/or debentures at their formation stage and, if necessary, subsequently for the expansion of business. It is usually done through private placement to friends, relatives and financial institutions or by making public issue. In any
case, the companies have to follow a well-established legal procedure and involve a number of intermediaries such as underwriters, brokers, etc. who form an integral part of the primary market. You must have learnt about many initial public offers (IPOs) made recently by a number of public sector undertakings such as ONGC, GAIL, NTPC and the private
sector companies like Tata Consultancy Services (TCS), Biocon, Jet-Airways and so on.
18.4.2 SECONDARY MARKET

The secondary market known as stock market or stock exchange plays an equally important role in mobilising long-term funds by providing the necessary liquidity to holdings in shares and debentures. It provides a place where these securities can be encashed without any difficulty and delay. It is an organised market where shares, and debentures are traded regularly with high degree of transparency and security. In fact, an active secondary market facilitates the growth of primary market as the investors in the primary market are assured of a continuous market for liquidity of their holdings. The major players in the primary market are merchant bankers, mutual funds, financial institutions, and the individual investors; and in the secondary market you have all these and the stockbrokers who are members of the stock exchange who facilitate the trading. After having a brief idea about the primary market and secondary market let see the difference between them.
18.5 DISTINCTION BETWEEN PRIMARY MARKET AND SECONDARY MARKET

The main points of distinction between the primary market and secondary market are as follows: 1. Function : While the main function of primary market is to raise long-term funds through fresh issue of securities, the main function of secondary market is to provide continuous and ready market for the existing long-term securities. 2. Participants: While the major players in the primary market are financial institutions, mutual funds, underwriters and individual investors, the major players in secondary market are all of these and the stockbrokers who are members of the stock exchange. 3. Listing Requirement: While only those securities can be dealt within the secondary market, which have been approved for the purpose (listed), there is no such requirement in case of primary market. 4. Determination of prices: In case of primary market, the prices are determined by the management with due compliance with SEBI requirement for new issue of securities. But in case of secondary market, the price of the securities is determined by forces of demand and supply of the market and keeps on fluctuating.
18.6 DISTINCTION BETWEEN CAPITAL MARKET AND MONEY MARKET

Capital Market differs from money market in many ways. Firstly, while money market is related to short-term funds, the capital market related to long term funds. Secondly, while money market deals in securities like treasury bills, commercial paper, trade bills, deposit
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certificates, etc., the capital market deals in shares, debentures, bonds and government securities. Thirdly, while the participants in money market are Reserve Bank of India, commercial banks, non-banking financial companies, etc., the participants in capital market are stockbrokers, underwriters, mutual funds, financial institutions, and individual investors. Fourthly, while the money market is regulated by Reserve Bank of India, the capital market is regulated by Securities Exchange Board of India (SEBI).
INTEXT QUESTIONS 18A

1. Define financial market. ______________________________________________________________ ______________________________________________________________ ______________________________________________________________ 2. Complete the table given below. (a) Distinction between Primary Market and Secondary Market. Points of Difference Primary Market Secondary Market 1. Function (i) To provide continuous and ready market for existing long-term securities. 2. Participants Financial Institutions, (ii) mutual funds, underwriters and individual investors. 3. Listing Listing is not required for (iii) Requirement dealing in the primary market. 4. Determination (iv) Prices are determined by of Prices forces of demand and supply and keep on fluctuating. (b) Differentiate between Money Market and Capital Market. Point of Distinction Money Market Capital Market 1. Time period / Term 2. Instrument dealt in 3. Participants 4. Regulatory body
18.7 STOCK EXCHANGE

As indicated above, stock exchange is the term commonly used for a secondary market,
which provide a place where different types of existing securities such as shares, debentures and bonds, government securities can be bought and sold on a regular basis. A stock exchange is generally organised as an association, a society or a company with a limited number of members. It is open only to these members who act as brokers for the buyers and sellers. The Securities Contract (Regulation) Act has defined stock exchange as an association, organisation or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business of buying, selling and dealing in securities. The main characteristics of a stock exchange are: 1. It is an organised market. 2. It provides a place where existing and approved securities can be bought and sold easily. 3. In a stock exchange, transactions take place between its members or their authorised agents. 4. All transactions are regulated by rules and by laws of the concerned stock exchange. 5. It makes complete information available to public in regard to prices and volume of transactions taking place every day. It may be noted that all securities are not permitted to be traded on a recognised stock exchange. It is allowed only in those securities (called listed securities) that have been duly approved for the purpose by the stock exchange authorities. The method of trading nowadays, however, is quite simple on account of the availability of on-line trading facility with the help of computers. It is also quite fast as it takes just a few minutes to strike a deal through the brokers who may be available close by. Similarly, on account of the system of scrip-less trading and rolling settlement, the delivery of securities and the payment of amount involved also take very little time, say, 2 days.
18.7.1 FUNCTIONS OF A STOCK EXCHANGE

The functions of stock exchange can be enumerated as follows: 1. Provides ready and continuous market: By providing a place where listed securities can be bought and sold regularly and conveniently, a stock exchange ensures a ready and continuous market for various shares, debentures, bonds and government securities. This lends a high degree of liquidity to holdings in these securities as the investor can encash their holdings as and when they want. 2. Provides information about prices and sales: A stock exchange maintains
complete record of all transactions taking place in different securities every day and supplies regular information on their prices and sales volumes to press and other media. In fact, now-a-days, you can get information about minute to minute movement in prices of selected shares on TV channels like CNBC, Zee News, NDTV and
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Headlines Today. This enables the investors in taking quick decisions on purchase and sale of securities in which they are interested. Not only that, such information helps them in ascertaining the trend in prices and the worth of their holdings. This enables them to seek bank loans, if required. 3. Provides safety to dealings and investment: Transactions on the stock exchange are conducted only amongst its members with adequate transparency and in strict conformity to its rules and regulations which include the procedure and timings of delivery and payment to be followed. This provides a high degree of safety to dealings at the stock exchange. There is little risk of loss on account of non-payment or nondelivery. Securities and Exchange Board of India (SEBI) also regulates the business in stock exchanges in India and the working of the stock brokers. Not only that, a stock exchange allows trading only in securities that have been listed with it; and for listing any security, it satisfies itself about the genuineness and soundness of the company and provides for disclosure of certain information on regular basis. Though this may not guarantee the soundness and profitability of the company, it does provide some assurance on their genuineness and enables them to keep track of their progress. 4. Helps in mobilisation of savings and capital formation: Efficient functioning of stock market creates a conducive climate for an active and growing primary market. Good performance and outlook for shares in the stock exchanges imparts buoyancy to the new issue market, which helps in mobilising savings for investment in industrial and commercial establishments. Not only that, the stock exchanges provide liquidity and profitability to dealings and investments in shares and debentures. It also educates people on where and how to invest their savings to get a fair return. This encourages the habit of saving, investment and risk-taking among the common people. Thus it helps mobilising surplus savings for investment in corporate and government securities and contributes to capital formation. 5. Barometer of economic and business conditions: Stock exchanges reflect the changing conditions of economic health of a country, as the shares prices are highly sensitive to changing economic, social and political conditions. It is observed that during the periods of economic prosperity, the share prices tend to rise. Conversely, prices tend to fall when there is economic stagnation and the business activities slow down as a result of depressions. Thus, the intensity of trading at stock exchanges and the corresponding rise on fall in the prices of securities reflects the investors assessment of the economic and business conditions in a country, and acts as the barometer
which indicates the general conditions of the atmosphere of business. 6. Better Allocation of funds: As a result of stock market transactions, funds flow from the less profitable to more profitable enterprises and they avail of the greater potential for growth. Financial resources of the economy are thus better allocated.
18.7.2 ADVANTAGES OF STOCK EXCHANGES

Having discussed the functions of stock exchanges, let us look at the advantages which
can be outlined from the point of view of (a) Companies, (b) Investors, and (c) the Society as a whole. (a) To the Companies (i) The companies whose securities have been listed on a stock exchange enjoy a better goodwill and credit-standing than other companies because they are supposed to be financially sound. (ii) The market for their securities is enlarged as the investors all over the world become aware of such securities and have an opportunity to invest (iii) As a result of enhanced goodwill and higher demand, the value of their securities increases and their bargaining power in collective ventures, mergers, etc. is enhanced. (iv) The companies have the convenience to decide upon the size, price and timing of the issue. (b) To the Investors: (i) The investors enjoy the ready availability of facility and convenience of buying and selling the securities at will and at an opportune time. (ii) Because of the assured safety in dealings at the stock exchange the investors are free from any anxiety about the delivery and payment problems. (iii) Availability of regular information on prices of securities traded at the stock exchanges helps them in deciding on the timing of their purchase and sale. (iv) It becomes easier for them to raise loans from banks against their holdings in securities traded at the stock exchange because banks prefer them as collateral on account of their liquidity and convenient valuation. (c) To the Society (i) The availability of lucrative avenues of investment and the liquidity thereof induces people to save and invest in long-term securities. This leads to increased capital formation in the country. (ii) The facility for convenient purchase and sale of securities at the stock exchange provides support to new issue market. This helps in promotion and expansion of industrial activity, which in turn contributes, to increase in the rate of industrial growth. (iii) The Stock exchanges facilitate realisation of financial resources to more profitable and growing industrial units where investors can easily increase their investment substantially. (iv) The volume of activity at the stock exchanges and the movement of share prices reflect the changing economic health.
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(v) Since government securities are also traded at the stock exchanges, the government borrowing is highly facilitated. The bonds issued by governments, electricity boards, municipal corporations and public sector undertakings (PSUs) are found to be on offer quite frequently and are generally successful.
18.7.3 LIMITATIONS OF STOCK EXCHANGES

Like any other institutions, the stock exchanges too have their limitations. One of the common evils associated with stock exchange operations is the excessive speculation. You know that speculation implies buying or selling securities to take advantage of price differential at different times. The speculators generally do not take or give delivery and pay or receive full payment. They settle their transactions just by paying the difference in prices. Normally, speculation is considered a healthy practice and is necessary for successful operation of stock exchange activity. But, when it becomes excessive, it leads to wide fluctuations in prices and various malpractices by the vested interests. In the process, genuine investors suffer and are driven out of the market. Another shortcoming of stock exchange operations is that security prices may fluctuate due to unpredictable political, social and economic factors as well as on account of rumours spread by interested parties. This makes it difficult to assess the movement of prices in future and build appropriate strategies for investment in securities. However, these days good amount of vigilance is exercised by stock exchange authorities and SEBI to control activities at the stock exchange and ensure their healthy functioning, about which you will study later.
18.8 SPECULATION IN STOCK EXCHANGES

The buyers and sellers at the stock exchange undertake two types of operations, one for speculation and the other for investment. Those who buy securities primarily to earn a regular income from such investment and possibly make some long-term gain on account of price rise in future are called investors. They take delivery of the securities and make full payment of the price. Such transactions are called investment transactions. But, when the securities are bought with the sole object of selling them in future at higher prices or these are sold now with the intention of buying at a lower price in future, are called speculation transactions. The main objective of such transactions is to take advantage of price differential at different times. The stock exchange also provides for settlement of such transactions even by receiving or paying, as the case may be, just the difference in
prices. For example, Rashmi bought 200 shares of Moser Baer Ltd. at Rs. 210 per share and sold them at Rs. 235 per share. He does not take and give delivery of the shares but settles the transactions by receiving the difference in prices amounting to Rs. 5,000 minus brokerage. In another case, Mohit bought 200 shares of Seshasayee Papers Ltd. at Rs. 87 per share and sold them at Rs. 69 per share. He settles these transactions by simply paying the difference amounting to Rs. 3600 plus brokerage. However, now-a-days stock exchanges have a system of rolling settlement. Such facility is limited only to transactions of purchase and sale made on the same day, as no carry forward is allowed. 25x200 = 5000 18x200 = 3600
Rolling Settlement: Earlier trading in the stock exchange was held face-to-face (called pit-trading) without the use of computers and the advanced computer software as it is today. In those times, transactions were settled (i.e., actual delivery of shares, through share certificates, by the seller and payment of money by the buyer) in the stock exchange, only on a fixed day of the week, say on a Saturday, or a Wednesday irrespective of which day of the week the shares were bought and sold. This was called Fixed Settlement. Today, with the electronic / computer based system of recording and carrying out of share transactions, stock exchanges go in for rolling settlement. That means, transaction are settled after a fixed number of days of the transaction rather than on a particular day of the week. For example, if a stock exchange goes in for T+2 days of rolling settlement, the transaction is settled within two working days of occurring of the transaction, T being the day of the transaction. In T+7 days of rolling settlement, the transaction is settled on the 7th day after the transaction. This is facilitated through electronic transfer of shares, through Dematerialised Account or Demat Account i.e., the share does not have a physical form of a paper document, but is a computerised record of a person holding a share, and through transfer of money electronically or through cheques payment is settled. Though speculation and investment are different in some respects, in practice it is difficult to say who is a genuine investor and who is a pure speculator. Sometimes even a person who has purchased the shares as a long-term investment may suddenly decide to sell to reap the benefit if the price of the share goes up too high or do it to avoid heavy loss if the prices starts declining steeply. But he cannot be called a speculator because his basic
intention has been to invest. It is only when a persons basic intention is to take advantage of a change in prices, and not to invest, then the transaction may be termed as speculation. In strict technical terms, however, the transaction is regarded as speculative only if it is settled by receiving or paying the difference in prices without involving the delivery of securities. It is so because, in practice, it is quite difficult to ascertain the intention. Some people regard speculation as nothing but gambling and consider it as an evil. But it is not true because while speculation is based on foresight and hard calculation, gambling is a kind of blind and reckless activity involving high degree of chance element. No only that, speculation is a legal activity duly recognised as a prerequisite for the success of stock exchange operations while gambling is regarded as an evil and a punishable activity. However, reckless speculation may take the form of gambling and should be avoided.
INTEXT QUESTIONS 18B

1. Enumerate the main characteristics of a stock exchange. ______________________________________________________________ ______________________________________________________________ ______________________________________________________________
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2. Identify if the following statement about stock exchanges are True or False. If the statement is False, rewrite it in the correct form. (a) Stock Exchange provides a ready market for sale and purchase of gold and silver. __________________________________________________________ (b) In the stock exchange, transactions take place between companies and their shareholders directly. __________________________________________________________ (c) Stock exchange transactions facilitate flow of funds from less profitable to more profitable enterprises. __________________________________________________________ (d) It becomes difficult for investors to raise loans from banks against collateral of their holdings in securities traded at the stock exchange. __________________________________________________________ (e) Speculation is the same thing as gambling. __________________________________________________________ 3. State two limitations of stock exchanges. (a) __________________________________________________________ (b) __________________________________________________________
18.9 STOCK EXCHANGES IN INDIA

The first organised stock exchange in India was started in Mumbai known as Bombay
Stock Exchange (BSE). It was followed by Ahmedabad Stock Exchange in 1894 and Kolkata Stock Exchange in 1908. The number of stock exchanges in India went upto 7 by 1939 and it increased to 21 by 1945 on account of heavy speculation activity during Second World War. A number of unorganised stock exchanges also functioned in the country without any formal set-up and were known as kerb market. The Security Contracts (Regulation) Act was passed in 1956 for recognition and regulation of Stock Exchanges in India. At present we have 23 stock exchanges in the country. Of these, the most prominent stock exchange that came up is National Stock Exchange (NSE). It is also based in Mumbai and was promoted by the leading financial institutions in India. It was incorporated in 1992 and commenced operations in 1994. This stock exchange has a corporate structure, fully automated screen-based trading and nation-wide coverage. Another stock exchange that needs special mention is Over The Counter Exchange of India (OTCEI). It was also promoted by the financial institutions like UTI, ICICI, IDBI,
IFCI, LIC etc. in September 1992 specially to cater to small and medium sized companies with equity capital of more than Rs.30 lakh and less than Rs.25 crore. It helps entrepreneurs in raising finances for their new projects in a cost effective manner. It provides for nationwide online ringless trading with 20 plus representative offices in all major cities of the country. On this stock exchange, securities of those companies can be traded which are exclusively listed on OTCEI only. In addition, certain shares and debentures listed with other stock exchanges in India and the units of UTI and other mutual funds are also allowed to be traded on OTCEI as permitted securities. It has been noticed that, of late, the turnover at this stock exchange has considerably reduced and steps have been afoot to revitalise it. In fact, as of now, BSE and NSE are the two Stock Exchanges, which enjoy nation-wide coverage and handle most of the business in securities in the country.
18.10 REGULATIONS OF STOCK EXCHANGES

As indicated earlier, the stock exchanges suffer from certain limitations and require strict control over their activities in order to ensure safety in dealings thereon. Hence, as early as 1956, the Securities Contracts (Regulation) Act was passed which provided for recognition of stock exchanges by the central Government. It has also the provision of framing of proper bylaws by every stock exchange for regulation and control of their functioning subject to the approval by the Government. All stock exchanges are required submit information relating to its affairs as required by the Government from time to time. The
Government was given wide powers relating to listing of securities, make or amend bylaws, withdraw recognition to, or supersede the governing bodies of stock exchange in extraordinary/abnormal situations. Under the Act, the Government promulgated the Securities Regulations (Rules) 1957, which provided inter alia for the procedures to be followed for recognition of the stock exchanges, submission of periodical returns and annual returns by recognised stock exchanges, inquiry into the affairs of recognised stock exchanges and their members, and requirements for listing of securities.
18.11 ROLE OF SEBI

As part of economic reforms programme started in June 1991, the Government of India initiated several capital market reforms, which included the abolition of the office of the Controller of Capital Issues (CCI) and granting statutory recognition to Securities Exchange Board of India (SEBI) in 1992 for: (a) protecting the interest of investors in securities; (b) promoting the development of securities market; (c) regulating the securities market; and (d) matters connected there with or incidental thereto. SEBI has been vested with necessary powers concerning various aspects of capital market such as: (i) regulating the business in stock exchanges and any other securities market;
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(ii) registering and regulating the working of various intermediaries and mutual funds; (iii) promoting and regulating self regulatory organisations; (iv) promoting investors education and training of intermediaries; (v) prohibiting insider trading and unfair trade practices; (vi) regulating substantial acquisition of shares and take over of companies; (vii) calling for information, undertaking inspection, conducting inquiries and audit of stock exchanges, and intermediaries and self regulation organisations in the stock market; and (viii) performing such functions and exercising such powers under the provisions of the Capital Issues (Control) Act, 1947 and the Securities Contracts (Regulation) Act, 1956 as may be delegated to it by the Central Government. As part of its efforts to protect investors interests, SEBI has initiated many primary market reforms, which include improved disclosure standards in public issue documents, introduction of prudential norms and simplification of issue procedures. Companies are now required to disclose all material facts and risk factors associated with their projects while making public issue. All issue documents are to be vetted by SEBI to ensure that the
disclosures are not only adequate but also authentic and accurate. SEBI has also introduced a code of advertisement for public issues for ensuring fair and truthful disclosures. Merchant bankers and all mutual funds including UTI have been brought under the regulatory framework of SEBI. A code of conduct has been issued specifying a high degree of responsibility towards investors in respect of pricing and premium fixation of issues. To reduce cost of issue, underwriting of issues has been made optional subject to the condition that the issue is not under-subscribed. In case the issue is under-subscribed i.e., it was not able to collect 90% of the amount offered to the public, the entire amount would be refunded to the investors. The practice of preferential allotment of shares to promoters at prices unrelated to the prevailing market prices has been stopped and private placements have been made more restrictive. All primary issues have now to be made through depository mode. The initial public offers (IPOs) can go for book building for which the price band and issue size have to be disclosed. Companies with dematerialised shares can alter the par value as and when they so desire. As for measures in the secondary market, it should be noted that all statutory powers to regulate stock exchanges under the Securities Contracts (Regulation) Act have now been vested with SEBI through the passage of securities law (Amendment) Act in 1995. SEBI has duly notified rules and a code of conduct to regulate the activities of intermediaries in the securities market and then registration in the securities market and then registration with SEBI is made compulsory. It has issued guidelines for composition of the governing bodies of stock exchanges so as to include more public representatives. Corporate membership has also been introduced at the stock exchanges. It has notified the regulations on insider trading to protect and preserve the integrity of stock markets and issued guidelines for mergers and acquisitions. SEBI has constantly reviewed the traditional trading systems of Indian stock exchanges and tried to simplify the procedure, achieve transparency in
Book Building: It is a process of determining price of shares based on market feedback. In this process the issue price of the share is not fixed in advance. It is determined by offer of potential investors about the price they may be willing to pay for the
issue. Business Studies 81 Notes MODULE -4 Business Finance
transactions and reduce their costs. To prevent excessive speculations and volatility in the market, it has done away with badla system, and introduced rolling settlement and trading in derivatives. All stock exchanges have been advised to set-up clearing corporation / settlement guarantee fund to ensure timely settlements. SEBI organises training programmes for intermediaries in the securities market and conferences for investor education all over the country from time to time.
INTEXT QUESTIONS 18C

1. State the three main objectives for which SEBI was granted statutory recognition in 1992. (i) __________________________________________________________ (ii) __________________________________________________________ (iii) __________________________________________________________ 2. Give a specific term/name for the following: (a) The prominent stock exchange enjoying nation wide coverage that commenced operations in 1994. (b) The stock exchange that specially caters to small and medium-sized companies. (c) The first organised stock exchange in India. (d) The Act passed in the year 1956 for providing recognition of stock exchanges by the central government. (e) The regulatory body of stock exchanges in our country granted statutory recognition in the year 1992. 3. List any three primary market reforms initiated by SEBI. (i) __________________________________________________________ (ii) __________________________________________________________ (iii) __________________________________________________________
18.12 WHAT YOU HAVE LEARNT

Financial market is the market that facilitates transfer of funds between investors/ lenders and borrowers/ users. It deals in financial instruments like bills of exchange, shares, debentures, bonds, etc. It provides security to dealings in financial assets, liquidity to financial assets for investors and ensures low cost of transitions and information. Financial Markets can be classified as (1) Money market and (2) Capital market.
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Money market refer to the network of financial institutions dealing in short term funds
through instruments like bills of exchanges, promissory notes, commercial paper, treasury bills etc. Capital Market is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares debentures, bonds, etc. The securities market has two different segments namely primary and secondary market. The primary market consists of arrangements for procurement of long-term funds by companies by fresh issue of shares and debentures. The secondary market or stock exchange provides a ready market for existing longterm securities. Stock exchange is the secondary market, which provides a place for regular sale and purchase of different types of securities like shares, debentures, bonds & government securities. It is an organised market where all transactions are regulated by the rules and laws of the concerned stock exchanges. The functions of a stock exchanges are to provide ready and continuous market for securities, information about prices and sales, safety to dealings and investment, helps mobilisation of savings and capital formation. It acts as a barometer of economic and business conditions and helps in better allocation of funds. Stock exchanges provide many benefits to companies, investors and the society as a whole. But they also suffer from limitations like exclusive speculation and fluctuation in prices due to rumours and unpredictable events. Along with genuine investment, at times, stock exchange transactions may be undertaken by persons as a speculation. There are 23 stock exchanges in India presently, including BSE, NSE and OTCEI. Stock Exchanges are regulated by the Securities Contracts (Regulation) Act and by SEBI. SEBI has initiated a number of reforms in the primary and secondary market to regulate the stock market. Documentary and procedural requirements for listing and trading have been made stricter and foolproof to protect investors interest.
18.13 KEY TERMS

Call money Capital market Certificate of deposit Commercial paper Financial Market
Money market New issue market NSE OTCEI
Primary market Rolling settlement SEBI Secondary market Speculation Stock exchange Trade bill Treasury bill
18.14 TERMINAL QUESTIONS

Very Short Answer Type Questions 1. What do you mean by Financial Market? 2. Give four examples of credit instruments of the money market. 3. State the meaning of capital market. 4. List two advantages of stock exchanges to companies. 5. Mention the organisations that are part of the organised money market in India. Short Answer Type Questions 6. Define money market and explain its importance in a modern economy. 7. What is capital market? How does it differ from money market? 8. Distinguish between primary market and secondary market. 9. How does the stock exchange helps in mobilizing savings and capital formation? 10. Describe the measures taken by SEBI to regulate the secondary market. Long Answer Type Questions 11. Define stock exchange and explain its functions. 12. Explain the importance of stock exchanges from the points of view of companies and investors. 13. Explain the role played by SEBI in protecting investors interests and controlling the business at stock exchange.
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14. Give explanatory notes on (a) stock exchange in India; and (b) Regulations of stock exchanges. 15. Describe the two components of the securities market, in detail.
18.15 ANSWERS TO INTEXT QUESTIONS

18A 1. It is market that facilitates transfer of funds between investors/lenders and borrowers/users. It deals in financial instrument like bills of exchange, shares, debentures, bonds etc. 2. (a) (i) To raise long-term funds through fresh issue of securities (ii) Stock brokers who are members of the stock exchange and mutual funds, financial institutions, and individual investors, (iii) Listing in stock exchange is required to deal in a security in the stock exchange. (iv) Prices are determined by the company/institutions management, with due confirmation with SEBI.
(b) Point of Distinction Capital Market Money Market 1. Time period / Term Long term funds dealt Deals in short-term funds. with 2. Instrument Dealt In Deals in shares, Deals in securities like debenture, bonds and treasury bills, commercial government securities. paper, bills of exchange, certificate of deposits etc. 3. Participants Stock brokers, Participants are commercial underwriters, mutual banks, non-banking finance funds, financial institutions companies, chit funds etc. and individual investors. 4. Regulatory body SEBI (Securities and RBI (Reserve Bank of India) Exchange Board of India.) 18B 2. (a) False: Stock Exchange provides a ready market for sale and purchase of various shares, debentures, bonds and government securities. (b) False: In the stock exchange, transactions take place between its members or their authorised agents. (c) True (d) False: It becomes easy for investors to raise loans from banks against collateral of their holdings in securities traded at the stock exchange. (e) False: Speculation is different from gambling.
3. (a) Excessive speculation (b) fluctuation in security prices due to unpredictable political, social and economic factors as well as on account of rumours spread. 18C 1. (a) protecting interest of investors (b) promoting development of securities market (c) regulating the securities market. 2. (a) National Stock Exchange (NSE) (b) Over The Counter Exchange of India (OTCEI) (c) Bombay Stock Exchange (BSE) (d) Securities Contracts (Regulation) Act. (e) Securities and Exchange Board of India (SEBI) 3. (i) Improved disclosure standards in public issue documents. (ii) Introduction of prudential norms. (iii) Simplification of the issue procedures.
DO AND LEARN
1. Identify any two persons in your vicinity who are associated with the financial market/ stock exchanges, either as an investor or as a stockbroker. Talk to them and find out (i) how sale and purchase of securities takes place; (ii) what are the popular instruments traded in the market; and (iii) about recent SEBI/ government guidelines that may have affected their transactions.
2. Read the Business Section of a daily newspaper or a specialised Business Newspaper. Locate the segment where share prices of important stock exchanges are given. Select any five companies and record their share prices everyday for a period of there weeks. Observe their price movement and see how major events in the economic, political or social environment affect the prices of these shares. You may even get information about these share prices from the television.
ROLE PLAY
Sunita and Kavita are good friends. Kavita is very god-fearing kind, while Sunita was an enterprising person, having practical in approach. Read the following conversation. Kavita : Hi, Sunita! What are you doing? Sunita : Hi, I am reading the newspaper - financial market page that gives us information about the shares price.
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Kavita : Shares, that is an area of big gambles. Sunita : No, not really! You must understand how it works. Kavita : Frankly speaking, I think this Capital market is all a gambling game and I dont see any use of them. Sunita : No, you are seriously mistaken; you do not know the importance of capital market. I will tell how it is needed for an individual and an economy. You are required to play the role of Sunita and continue the conversation.
Chapter at a Glance
18.1 Financial market 18.2 Types of financial markets 18.3 Money market 18.3.1 Money market instruments 18.4 Capital market 18.4.1 Primary market 18.4.2 Secondary market 18.5 Distinction between primary market and secondary market. 18.6 Distinction between capital market and money market 18.7 Stock exchanges 18.7.1 Functions of a stock exchange 18.7.2 Advantages of stock exchanges 18.7.3 Limitations of stock exchanges 18.8 Speculation in stock exchanges 18.9 Stock exchanges in India 18.10 Regulations of stock exchanges 1
FAQs on the Debt Markets

By BSE Debt Segment Bombay Stock Exchange Limited (BSE) BASICS OF DEBT MARKETS 1. What is the Debt Market? 2. What is the Money Market? 3. Why should one invest in fixed income securities? 4. What are the advantages of investing in Government Securities (G-Secs)? 5. Who can issue fixed income securities? 6. What are the different types of instruments, which are normally traded in this market? 7. What is the importance of the Debt Market to the economy? 8. What are the benefits of an efficient Debt Market to the financial system and the economy? 9. What are the different types of risks with regard to debt securities? MARKET STRUCTURE 10. What is the trading structure in the Wholesale Debt Market? 11. Who are the main investors of Govt. Securities in India? 12. Who regulates the fixed income markets? 13. What are the main features of G-Secs and T-Bills in India? 14. What are the segments in the secondary debt market? 15. What is the structure of the Wholesale Debt Market? 16. Who are the most prominent investors in the Wholesale Debt Market in India? 17. What is the issuance process of G-secs? 18. What are the types of trades in the Wholesale Debt Market? 19. What is a Repo trade and how is it different from a normal buy or sell transaction? 20. What is Yield? 21. How is the Yield to Maturity computed? 22. How is the price determined in the debt markets? 23. How is Yield related to the price? MARKET STRUCTURE AND TRADING METHODOLOGY IN WDS 24. What is the concept of the broken period interest as regards the Debt Market?
25. What are the conventions followed for the calculation of Accrued Interest? 26. What is the Clean Price and the Dirty Price in reference to trading in G-Secs? 27. How are the Face Value, Trade Value and the settlement value different from each other? 28. How can investors in India hold G-Secs? 29. What are the type of transactions which take place in the market? 30. What is the role of the Exchanges in the WDS? BSE WHOLESALE DEBT SEGMENT (WDS) 31. When was the BSE accorded regulatory permission for the WDS? 32. How is the settlement carried out in the Wholesale Debt Market? 33. What are the trading and reporting facilities offered by the BSE Wholesale Debt Segment? 34. What are the three modules in the GILT system? 35. What is the membership criteria and charges for the membership of the BSE Wholesale Debt Segment? 36. What is the settlement mode allowed in GILT? 37. What are the aspects for settlement of trades in G-secs in GILT? CORPORATE DEBT MARKET 38. What is the structure of the Corporate Debt Market in India? 39. What are the various kinds of debt instruments available in the Corporate Debt Market? 40. How is the trading, clearing and settlement in Corporate Debt carried out at BSE? BSE RETAIL DEBT SEGMENT (REDS) 41. What are the securities/instruments traded in the Retail Debt Segment (REDS) at the Exchange? 42. Who are the participants in the Retail Debt Market? 43. What is the membership criteria and procedure for the membership of the BSE Retail Debt Segment (REDS)? 44. How are the Retail Transactions in G-Secs. executed at the Exchange? 45. What is the listing procedure for G-Secs. in respect of the Retail Debt Market? 46. What is the trading methodology in case of the Retail trading in G-Secs.? 47. How does the Clearing & Settlement of the Retail G-Sec. transactions take place in REDS? 48. How are the security delivery shortages treated in the Retail Debt Segment? 49. How is the margining structure at the Exchange for the Retail Debt Market? INVESTOR SAFEGUARDS
50. What are the main points to be kept in mind by the investor while investing in the Debt Markets? 51. What is the future scenario for the Retail Debt Market in India?
BASICS OF DEBT MARKETS 1. Q. A. What is the Debt Market? The Debt Market is the market where fixed income securities of various types and features are issued and traded. Debt Markets are therefore, markets for fixed income securities issued by Central and State Governments, Municipal Corporations, Govt. bodies and commercial entities like Financial Institutions, Banks, Public Sector Units, Public Ltd. companies and also structured finance instruments. TOP
2.
Q. A.
What is the Money Market? The Money Market is basically concerned with the issue and trading of securities with short term maturities or quasi-money instruments. The Instruments traded in the money-market are Treasury Bills, Certificates of Deposits (CDs), Commercial Paper (CPs), Bills of Exchange and other such instruments of short-term maturities (i.e. not exceeding 1 year with regard to the original maturity) TOP
3.
Q. A.
Why should one invest in fixed income securities? Fixed Income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments. Therefore, most debt securities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. y y y y The investors benefit by investing in fixed income securities as they preserve and increase their invested capital and also ensure the receipt of regular interest income. The investors can even neutralize the default risk on their investments by investing in Govt. securities, which are normally referred to as risk-free investments due to the sovereign guarantee on these instruments. The prices of Debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments. Debt securities enable wide-based and efficient portfolio diversification and thus assist in portfolio risk-mitigation.
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4.
Q. A.
What are the advantages of investing in Government Securities (G-Secs)? The Zero Default Risk of the G-Secs. offer one of the best reasons for investments in G-secs so that it enjoys the greatest amount of security possible. The other advantages of investing in G- Secs are: y y y y y y y Greater safety and lower volatility as compared to other financial instruments. Variations possible in the structure of instruments like Index linked Bonds, STRIPS Higher leverage available in case of borrowings against G-Secs. No TDS on interest payments Tax exemption for interest earned on G-Secs. up to Rs.3000/- over and above the limit of Rs.12000/- under Section 80L (as amended in the latest Budget). Greater diversification opportunities Adequate trading opportunities with continuing volatility expected in interest rates the world over TOP
5.
Q. A.
Who can issue fixed income securities? Fixed income securities can be issued by almost any legal entity like Central and State Govts., Public Bodies, Banks and Institutions, statutory corporations and other corporate bodies. There may be legal and regulatory restrictions on each of these bodies on the type of securities that can be issued by each of them TOP
6.
Q. A.
What are the different types of instruments, which are normally traded in this market? The instruments traded can be classified into the following segments based on the characteristics of the identity of the issuer of these securities: Market Segment Government Securities Issuer Central Government Instruments Zero Coupon Bonds, Coupon Bearing Bonds, Treasury Bills, STRIPS Coupon Bearing Bonds. Govt. Guaranteed Bonds, Debentures
State Governments Public Sector Bonds Government Agencies / Statutory Bodies Public Sector Units
PSU Bonds, Debentures, Commercial Paper
Private Sector Bonds
Corporates
Debentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-Corporate Deposits Certificates of Deposits, Debentures, Bonds Certificates of Deposits, Bonds
Banks Financial Institutions
The G-secs are referred to as SLR securities in the Indian markets as they are eligible securities for the maintenance of the SLR ratio by the Banks. The other non-Govt securities are called Non-SLR securities.ss TOP
7.
Q. A.
What is the importance of the Debt Market to the economy? The key role of the debt markets in the Indian Economy stems from the following reasons: y y y y Efficient mobilization and allocation of resources in the economy Financing the development activities of the Government Transmitting signals for implementation of the monetary policy Facilitating liquidity management in tune with overall short term and long term objectives.
Since the Government Securities are issued to meet the short term and long term financial needs of the government, they are not only used as instruments for raising debt, but have emerged as key instruments for internal debt management, monetary management and short term liquidity management. The returns earned on the government securities are normally taken as the benchmark rates of returns and are referred to as the risk free return in financial theory. The Risk Free rate obtained from the G-sec rates are often used to price the other non-govt. securities in the financial markets. TOP
8.
Q. A.
What are the benefits of an efficient Debt Market to the financial system and the economy? y y y y y Reduction in the borrowing cost of the Government and enable mobilization of resources at a reasonable cost. Provide greater funding avenues to public-sector and private sector projects and reduce the pressure on institutional financing. Enhanced mobilization of resources by unlocking illiquid retail investments like gold. Development of heterogeneity of market participants Assist in development of a reliable yield curve and the term structure of interest rates.
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9.
Q. A.
What are the different types of risks with regard to debt securities? The following are the risks associated with debt securities: y y Default Risk: This can be defined as the risk that an issuer of a bond may be unable to make timely payment of interest or principal on a debt security or to otherwise comply with the provisions of a bond indenture and is also referred to as credit risk. Interest Rate Risk: can be defined as the risk emerging from an adverse change in the interest rate prevalent in the market so as to affect the yield on the existing instruments. A good case would be an upswing in the prevailing interest rate scenario leading to a situation where the investors' money is locked at lower rates whereas if he had waited and invested in the changed interest rate scenario, he would have earned more. Reinvestment Rate Risk: can be defined as the probability of a fall in the interest rate resulting in a lack of options to invest the interest received at regular intervals at higher rates at comparable rates in the market. The following are the risks associated with trading in debt securities: y y Counter Party Risk: is the normal risk associated with any transaction and refers to the failure or inability of the opposite party to the contract to deliver either the promised security or the salevalue at the time of settlement. Price Risk: refers to the possibility of not being able to receive the expected price on any order due to a adverse movement in the prices.
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MARKET STRUCTURE 10. Q. A. What is the trading structure in the Wholesale Debt Market? The Debt Markets in India and all around the world are dominated by Government securities, which account for between 50 - 75% of the trading volumes and the market capitalization in all markets. Government securities (G-Secs) account for 70 - 75% of the outstanding value of issued securities and 90-95% of the trading volumes in the Indian Debt Markets. State Government securities & Treasury Bills account for around 3-4 % of the daily trading volumes. The trading activity in the G-Sec. Market is also very concentrated currently (in terms of liquidity of the outstanding G-Secs.) with the top 10 liquid securities accounting for around 70% of the daily volumes.
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11.
Q. A.
Who are the main investors of Govt. Securities in India? Traditionally, the Banks have been the largest category of investors in G-secs accounting for more than 60% of the transactions in the Wholesale Debt Market. The Banks are a prime and captive investor base for G-secs as they are normally required to maintain
25% of their net time and demand liabilities as SLR but it has been observed that the banks normally invest 10% to 15% more than the normal requirement in Government Securities because of the following requirements:y y Risk Free nature of the Government Securities Greater returns in G-Secs as compared to other investments of comparable nature
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12.
Q. A.
Who regulates the fixed income markets? The issue and trading of fixed income securities by each of these entities are regulated by different bodies in India. For eg: Government securities and issues by Banks, Institutions are regulated by the RBI. The issue of non-government securities comprising basically issues of Corporate Debt is regulated by SEBI.
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13.
Q. A.
What are the main features of G-Secs and T-Bills in India? All G-Secs in India currently have a face value of Rs.100/- and are issued by the RBI on behalf of the Government of India. All G-Secs are normally coupon (Interest rate) bearing and have semi-annual coupon or interest payments with a tenor of between 5 to 30 years. This may change according to the structure of the Instrument. Eg: a 11.50% GOI 2005 security will carry a coupon rate(Interest Rate) of 11.50% p.a. on a face value per unit of Rs.100/- payable semi-annually and maturing in the year 2005. Treasury Bills are for short-term instruments issued by the RBI for the Govt. for financing the temporary funding requirements and are issued for maturities of 91 Days and 364 Days. T-Bills have a face value of Rs.100 but have no coupon (no interest payment). T-Bills are instead issued at a discount to the face value (say @ Rs.95) and redeemed at par (Rs.100). The difference of Rs. 5 (100 - 95) represents the return to the investor obtained at the end of the maturity period. State Government securities are also issued by RBI on behalf of each of the state governments and are coupon-bearing bonds with a face value of Rs.100 and a fixed tenor. They account for 3-4 % of the daily trading volumes. TOP
14.
Q. A.
What are the segments in the secondary debt market? The segments in the secondary debt market based on the characteristics of the investors and the structure of the market are: y y Wholesale Debt Market - where the investors are mostly Banks, Financial Institutions, the RBI, Primary Dealers, Insurance companies, MFs, Corporates and FIIs. Retail Debt Market involving participation by individual investors, provident funds, pension funds,
private trusts, NBFCs and other legal entities in addition to the wholesale investor classes. TOP
15.
Q. A.
What is the structure of the Wholesale Debt Market? The Debt Market is today in the nature of a negotiated deal market where most of the deals take place through telephones and are reported to the Exchange for confirmation. It is therefore in the nature of a wholesale market. TOP
16.
Q. A.
Who are the most prominent investors in the Wholesale Debt Market in India? The Commercial Banks and the Financial Institutions are the most prominent participants in the Wholesale Debt Market in India. During the past few years, the investor base has been widened to include Co-operative Banks, Investment Institutions, cash rich corporates, Non-Banking Finance companies, Mutual Funds and high net-worth individuals. FIIs have also been permitted to invest 100% of their funds in the debt market, which is a significant increase from the earlier limit of 30%. The government also allowed in 1998-99 the FIIs to invest in T-bills with a view towards broadbasing the investor base of the same. TOP
17.
Q. A.
What is the issuance process of G-secs? G-secs are issued by RBI in either a yield-based (participants bid for the coupon payable) or price-based (participants bid a price for a bond with a fixed coupon) auction basis. The Auction can be either a Multiple price (participants get allotments at their quoted prices/yields) Auction or a Uniform price (all participants get allotments at the same price). RBI has recently announced a non-competitive bidding facility for retail investors in G-Secs through which non-competitive bids will be allowed up to 5 percent of the notified amount in the specified auctions of dated securities. TOP
18.
Q. A.
What are the types of trades in the Wholesale Debt Market? There are normally two types of transactions, which are executed in the Wholesale Debt Market : y y An outright sale or purchase and A Repo trade
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19.
Q. A.
What is a Repo trade and how is it different from a normal buy or sell transaction? An outright Buy or sell transaction is a one where there is no intended reversal of the trade at the point of execution of the trade. The Buy or sell transaction is an independent trade and is in no way connected with any other trade at the same or a later point of time. A Ready Forward Trade (which is normally referred to as a Repo trade or a Repurchase Agreement ) is a transaction where the said trade is intended to be reversed at a later point of time at a rate which will include the interest component for the period between the two opposite legs of the transactions. So in such a transaction, one participant sells securities to other with an agreement to purchase them back at a later date. The trade is called a Repo transaction from the point of view of the seller and it is called a Reverse Repo transaction from point of view of the buyer. Repos therefore facilitate creation of liquidity by permitting the seller to avail of a specific sum of money (the value of the repo trade) for a certain period in lieu of payment of interest by way of the difference between the two prices of the two trades. Repos and reverse repos are commonly used in the money markets as instruments of short-term liquidity management and can also be termed as a collateralised lending and borrowing mechanism. Banks and Financial Institutions usually enter into reverse repo transactions to manage their reserve requirements or to manage liquidity. TOP
BOND ANALYTICS 20. Q. A. What is Yield? Yield refers to the percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note. There are many different kinds of yields depending on the investment scenario and the characteristics of the investment. Yield To Maturity (YTM) is the most popular measure of yield in the Debt Markets and is the percentage rate of return paid on a bond, note or other fixed income security if you buy and hold the security till its maturity date. Current Yield is the coupon divided by the Market Price and gives a fair approximation of the present yield. Therefore, Current Yield = Coupon of the Security(in %) x Face Value of the Security (viz. 100 in case of G-Secs.)/Market Price of the Security Eg: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on the security will be (0.1018 x 100)/120 = 8.48%
The yield on the government securities is influenced by various factors such as level of money supply in the economy, inflation, future interest rate expectations, borrowing program of the government & the monetary policy followed by the government.
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21.
Q. A.
How is the Yield to Maturity computed? The calculation for YTM is based on the coupon rate, length of time to maturity and market price. It is the Internal Rate of Return on the bond and can be determined by equating the sum of the cash-flows throughout the life of the bond to zero. A critical assumption underlying the YTM is that the coupon interest paid over the life of the bond is assumed to be reinvested at the same rate. The YTM is basically obtained through a trial and error method by determining the value of the entire range of cash-flows for the possible range of YTMs so as to find the one rate at which the cash-flows sum up to zero. So, say, a G-Sec - 8.00% GOI Loan 2004 with only 2 cash flows remaining to maturity as under: Maturity Date: 30th January 2004 Interest Payment Dates: 30th January, 30th July and trading currently at Rs. 115 for 1 Unit, will have a YTM as follows: Settlement Date: 17th March 2003 (Date at which ownership is transferred to the Buyer) Frequency of Interest Payments: 2 Day Count Convention: 30/360 (which in MS-EXCEL is taken as Basis 4) Yield To Maturity: 4.8626% The same can be computed from MS-EXCEL through the YIELD Formula by input of the parameters given above. It can be checked by discounting the said cash-flows, i.e., the two coupons of Rs. 8.00 each and the principal repayment of Rs.100/- from the interest payment dates and maturity dates to the date of settlement.
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22.
Q. A.
How is the price determined in the debt markets? The price of a bond in the markets is determined by the forces of demand and supply, as is the case in any market. The price of a bond in the marketplace also depends on a number of other factors and will
fluctuate according to changes in y y y y y Economic conditions General money market conditions including the state of money supply in the economy Interest rates prevalent in the market and the rates of new issues Future Interest Rate Expectations Credit quality of the issuer
There is however, a theoretical underpinning to the determination of the price of the bond in the market based on the measure of the yield of the security. TOP
23.
Q. A.
How is Yield related to the price? Yields and Bond Prices are inversely related. So a rise in price will decrease the yield and a fall in the bond price will increase the yield. There will be an immediate and mostly predictable effect on the prices of bonds with every change in the level of interest rates.(The predictability here however refers to the direction of the price change rather than the quantum of the change) When the prevailing interest rates in the market rise, the prices of outstanding bonds will fall to equate the yield of older bonds into line with higher-interest new issues. This will happen as there will be very few takers for the lower coupon bonds resulting in a fall in their prices. The prices would fall to an extent where the same yield is obtained on the older bonds as is available for the newer bonds. When the prevailing interest rates in the market fall, there is an opposite effect. The prices of outstanding bonds will rise, until the yield of older bonds is low enough to match the lower interest rate on the new bond issues. These fluctuations ensure that the value of a bond will never be the same throughout the life of the bond and is likely to be higher or lower than its original face value depending on the market interest rate, the time to maturity (or call as the case may be) and the coupon rate on the bond.
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MARKET STRUCTURE AND TRADING METHODOLOGY IN WDS 24. Q. A. What is the concept of the broken period interest as regards the Debt Market? The concept of the Broken period interest or the accrued interest arises as interest on bonds are received after certain fixed intervals of time to the holder who enjoys the ownership of the security at that point of time. Therefore an investor who has sold a bond which makes half-yearly interest payments three months after the previous interest payment date would not receive the interest due to him for these three months from the issuer. The interest on these previous three months would be received by the buyer who has held it for only the next three months but receive interest for the entire six month periods
as he happens to be holding the security at the interest payment date. Therefore, in case of a transaction in bonds occurring between two interest payment dates, the buyer would pay interest to the seller for the period from the last interest payment date up to the date of the transaction. The interest thus calculated would include the previous date of interest payment but would not include the trade date.
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25.
Q. A.
What are the conventions followed for the calculation of Accrued Interest? The Day Count Convention to be followed for the calculation of Accrued Intetest in case of transactions in G-Secs is 30/360. I.e. each month is to be taken as having 30 days and each year is to be taken as having 360 days, irrespective of the actual number of days in the month. So, months like February, March, January, May, July, August, October and December are to be taken as having 30 days.
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26.
Q. A.
What is the Clean Price and the Dirty Price in reference to trading in G-Secs? G-Secs are traded on a clean price (Trade price) but settled on the dirty price (Trade price + Accrued Interest). This happens, as the coupon payments are not discounted in the price, as is the case in the other non-govt. debt instruments.
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27.
Q. A.
How are the Face Value, Trade Value and the settlement value different from each other? The Cumulative face Value of the securities in a transaction is the face Value of the Transaction and is normally the identifiable feature of each transaction. Say, a transaction of Rs.5,00,000 worth of G-Secs will comprise a trade of 5000 G-Secs of Rs.100 each. The Trade value is the cumulative price of the traded G-Secs (i.e. no. of securities multiplied by the price) Say, the G-Secs referred to above may be traded at Rs.102 each so that the Trade Value is Rs.5,10,000 (102 x 5000). The Settlement value will be the trade value plus the Accrued Interest. The Accrued Interest per unit of the Bond is calculated as = Coupon of Bond x Face Value of the G-Sec. (100) x (No. of Days from Interest Payment Date to
Settlement Date)/360 In computing the no. of days between the Interest Payment Date and the Settlement Date of the trade, only one of the two days is to be included.
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28.
Q. A.
How can investors in India hold G-Secs? G-Secs can be held in either of the following forms: y y y y Physical Security (which is mostly outdated & not used much) SGL (Subsidiary General Ledger) A/c with the Public Debt Office of the RBI. The SGL A/cs are however restricted only to few entities like the Banks & Institutions. Constituent SGL A/c with Banks or PDs who hold the G-secs on behalf of the investors in their SGL-II A/cs of RBI, meant only for client holdings. Same Demat A/c as is used for equities at the Depositories. NSDL & CDSL will hold them in their SGL-II A/cs of RBI, meant only for client holdings.
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29.
Q. A.
What are the type of transactions which take place in the market? The following two types of transactions take place in the Indian markets: y y Direct transactions between banks and other wholesale market participants which account for around 25% of the Wholesale Market volumes: Here the Banks and the Institutions trade directly between themselves either through the telephone or the NDS system of the RBI. Broker intermediated transactions, which account for around 70-75% of the trades in the market. These brokers need to be members of a Recognized Stock Exchange for RBI to allow the Banks, Primary Dealers and Institutions to undertake dealings through them.
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30.
Q. A.
What is the role of the Exchanges in the WDS? BSE and other Exchanges offer order-driven screen based trading facilities for Govt. securities. The trading activity on the systems is however restricted with most trades today being put through in the broker offices and reported to the Exchange through their electronic systems which provide for reporting of "Negotiated Deals" and "Cross Deals". TOP
BSE WHOLESALE DEBT SEGMENT (WDS) 31. Q. A. When was the BSE accorded regulatory permission for the WDS? The Reserve Bank of India, vide it's circular DBOD.FSC.BC.No. 39 /24.76.002/2000 dated October 25, 2000 permitted the Banks and the Financial Institutions in India to undertake transactions in debt instruments among themselves or with non-bank clients through the members of Bombay Stock Exchange Limited (BSE). This notification paved the way for the Exchange to commence trading in Government Securities and other fixed income instruments. TOP
32.
Q. A.
How is the settlement carried out in the Wholesale Debt Market? The settlement for the various trades is finally carried out through the SGL of the RBI except for transfers between the holders of Constituent SGL A/cs in a particular Bank or Institution like intra-a/c transfers of securities held at the Banks and CCIL. As far as the Broker Intermediated transactions are concerned, the settlement responsibility for the trades in the Wholesale market is primarily on the clients i.e. the market participants and the broker has no role to play in the same. The member only has to report the settlement details to the Exchange for monitoring purposes. The Exchange reports the trades to RBI regularly and monitors the settlement of these trades.
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33.
Q. A.
What are the trading and reporting facilities offered by the BSE Wholesale Debt Segment? The BSE Wholesale Debt Segment offers trading and reporting facilities through the GILT System, an automatic on-line trading system, which will over a period of time provide an efficient and reliable trading system for all the debt instruments of different types and maturities including Central and State Govt. securities, T-Bills, Institutional bonds, PSU bonds, Commercial Paper, Certificates of Deposit, Corporate debt instruments and the new innovative instruments like municipal securities, securitized debt, mortgage loans and STRIPs. TOP
34.
Q. A.
What are the three modules in the GILT system? GILT permits trading in the Wholesale Debt Market through the three following avenues: y y y Order Grabbing System - which provides for active interaction between the market participants in keeping with the negotiated deal structure of the market. Negotiated Deal Module - which permits the reporting of trades undertaken by the market participants through the members of the Exchange. Cross Deal Module - permitting reporting of trades undertaken by two different market
participants through a single member of the Exchange. TOP
35.
Q.
What is the membership criteria and charges for the membership of the BSE Wholesale Debt Segment? The membership of the debt market segment is being granted only to the Existing Members of the Exchange. The members need to have a minimum net worth of Rs.1.5 crores for admission to undertaking dealings on the debt segment. No security deposit is applicable for the membership of the Debt Segment as in other Exchanges. The annual approval/renewal charges at present is Rs.25,000/-.
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TOP 36. Q. A. What is the settlement mode allowed in GILT? The settlements for all the trades executed on the GILT system are on a rolling basis. Each order has a unique settlement date specified upfront at the time of order entry and used as a matching parameter. The Exchange will allow settlement periods ranging from T+0 to T+5. TOP
37.
Q. A.
What are the aspects for settlement of trades in G-secs in GILT? The Settlement for the securities traded in the Debt Segment would be on a Trade by Trade DVP basis. The primary responsibility of settling trades concluded in the wholesale segment rests directly with the participants who would settle the trades executed in the GILT system on their behalf through the Subsidiary Ledger Account of the RBI. Each transaction is settled individually and netting of transaction is not allowed. The Exchange would monitor the Clearing and Settlement process for all the trades executed or reported through the 'GILT' system. The Members need to report the settlement details to the Exchange for all the trades undertaken by them on the GILT system. TOP
CORPORATE DEBT MARKET 38. Q. A. What is the structure of the Corporate Debt Market in India? The Indian Primary market in Corporate Debt is basically a private placement market with most of the corporate bond issues being privately placed among the wholesale investors i.e. the Banks, Financial Institutions, Mutual Funds, Large Corporates & other large investors. The proportion of public issues in the total quantum of debt capital issued annually has decreased in the last few years. Around 92% of the total funds mobilized through corporate debt securities in the Financial Year 2002 was through the private placement route. The Secondary Market for Corporate Debt can be accessed through the electronic order-matching
platform offered by the Exchanges. BSE offers trading in Corporate Debt Securities through the automatic BOLT system of the Exchange. The Debt Instruments issued by Development Financial Institutions, Public Sector Units and the debentures and other debt securities issued by public limited companies are listed in the 'F Group' at BSE. TOP
39.
Q. A.
What are the various kinds of debt instruments available in the Corporate Debt Market? The following are some of the different types of corporate debt securities issued: y y y y y y Non-Convertible Debentures Partly-Convertible Debentures/Fully-Convertible Debentures (convertible in to Equity Shares) Secured Premium Notes Debentures with Warrants Deep Discount Bonds PSU Bonds/Tax-Free Bonds
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40.
Q. A.
How is the trading, clearing and settlement in Corporate Debt carried out at BSE? The trading in corporate debt securities in the F Group are traded on the BOLT order-matching system based on price-time priority. The trades in the 'F Group' at BSE are to be settled on a rolling settlement basis with a T+2 Cycle with effect from 1st April 2003. Trading continues from Monday to Friday during the week. The Trade Guarantee Fund (TGF) of the Exchange covers all the trades in the 'F' Group undertaken on the electronic BOLT system of the Exchange.
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BSE RETAIL DEBT SEGMENT (REDS) 41. Q. A. What are the securities/instruments traded in the Retail Debt Segment (REDS) at the Exchange? The Retail trading in Central Government Securities commenced on January 16, 2003 through the BOLT System of the Exchange. Central Government Securities (G-Secs.) are currently listed at the Exchange under the G Group. The Exchange may introduce, in due course of time, retail trading in other debt securities like the following, subject to the receipt of regulatory approval for the same: y y y State Government Securities Treasury Bills STRIPS
Interest Rate Derivative products
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42.
Q. A.
Who are the participants in the Retail Debt Market? The following are the main investor segments who could participate in the Retail Debt Market: y y y y y y y y y y y Mutual Funds Provident Funds Pension Funds Private Trusts. Religious Trusts and charitable organizations having large investible corpus State Level and District Level Co-operative Banks Housing Finance Companies NBFCs and RNBCs Corporate Treasuries Hindu-Undivided Families (HUFs) Individual Investors
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43.
Q. A.
What is the membership criteria and procedure for the membership of the BSE Retail Debt Segment (REDS)? Eligibility Criteria for Members: The Members of the Segment possessing a net-worth of Rs. 1 crore and above are eligible to trade in the Retail Debt segment. The members are required to submit additional contribution of Rs. 5 lakhs as refundable contribution towards the separate Trade Guarantee Fund for this Segment. This contribution of Rs.5 lakhs towards the Trade Guarantee Fund could be submitted in terms of cash or FDR or Bank Guarantee. However, the Exchange has permitted the Members to earmark Rs.5 lakhs from their additional capital for a period of one month or till such time separate contribution for TGF is provided by them, whichever is earlier TOP
44.
Q. A.
How are the Retail Transactions in G-Secs. executed at the Exchange? Retail Trading in Government Securities takes place by electronic order matching based on price-time priority through the BOLT (BSE OnLine Trading) System of the Exchange with the continuous trading sessions from 9.55 a.m. to 3.30 p.m as is operational in the Equities Segment. The Retail Trading in Gsecs is to be settled on a rolling settlement basis with a T+2 Delivery Cycle with effect from 1st April 2003. TOP
45.
Q. A.
What is the listing procedure for G-Secs. in respect of the Retail Debt Market? y Eligible Securities: All outstanding and newly issued central government securities are eligible to be traded on the automated, anonymous , order driven system of the eligible stock exchange. The Rules, Bye-Laws and Regulations of the Exchange provide for trading in Government securities as all G-secs are deemed to be admitted to dealings on the Exchange from the date on which they are issued as per Bye-Law 22(a) and 22(b) of the Exchange. Group: The Government securities have been introduced as a new group of securities - "G" Group in the BOLT system. The G-secs are allotted a 6-digit scrip code (in the 800000 series) and a 11 characters alpha-numeric scrip ID. The interpretation for the Scrip IDs of G-Secs. in BOLT is as under: y y y y First 2 characters signify Central Government Security - CG Next 4 Digits signify the coupon or interest rate of the G-Sec Next 1 character is a differentiator which would be 'S' in case of a normal security and 'A' incase there exists another security with the same coupon and maturity year Next 2 Digits signify the Issue Year and the last 2 digits signify the Maturity Year
The
date
in
the
Scrip
Name
stands
for
the
Maturity
Date
of
the
Security.
The Exchange will implement and monitor the suspension of trading during the shut down period so that no settlements fall due in the no-delivery period which is on the T-3, T-2 and T-1 days for Government Securities (where T is the interest payment date for the security).
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46.
Q. A.
What is the trading methodology in case of the Retail trading in G-Secs.? y Trading Methodology: The G-Secs shall be traded on the system and settled at the same price, which will be inclusive of the accrued interest i.e. the Dirty Price as per the market parlance in the Wholesale Debt Market. This is similar to the trading on the cum-interest price as is witnessed in the case of corporate debentures. The minimum order size shall be 10 units of G-Secs with a face value Rs.100/- each equivalent to an order value of Rs. 1000/- and the subsequent orders will be in lots of 10 securities each. Trading & Exposure Limits: The members of the Retail Debt Segment are permitted gross exposure in government securities along their gross exposure in equity segment upto 15 times of their additional capital deposited by them with the Exchange. However, no gross exposure is permitted to the members against their Base Minimum Capital + contribution of Rs.10 lakhs towards TGF in the cash segment. Transactions done by the members in this segment along with their transactions in the equity segment would form part of their Intra-day Trading Limits and are subject to a limit of 33.33 times of the capital deposited with the Exchange. However, institutional business would not form part of these Intra-Day & Gross Exposure limits.
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47.
Q. A.
How does the Clearing & Settlement of the Retail G-Sec. transactions take place in REDS? The Clearing and Settlement mechanism for the Retail trading in G-Secs is based on the existing institutional mechanism available at the Stock Exchanges for the Equity Markets. The trades executed throughout the continuous trading sessions will be netted out at the end of the trading hours through a process of multilateral netting. The transactions will be netted out member-wise and then scrip-wise so as to determine the net settlement and payment obligations of the members. The Delivery obligations and the payment orders in respect of these members are generated by the Clearing and Settlement system of the Exchange. These statements indicate the pay-in and pay-out positions of the members for securities and funds who would then give the necessary instructions to their Clearing Banks and depositories. Custodial confirmation of the retail trades in G-Secs. by using 6A-7A mechanism as available in the Equity segment is also available. The schedule of various settlement related activities like obligation download, custodial confirmation, pay-in/pay-out of funds and securities is similar to what is at present applicable in the equities segment. As per an RBI Circular, the RBI regulated entities are to settle their transactions in the Retail Debt Segment at the Exchange through a Custodian.
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48.
Q. A.
How are the security delivery shortages treated in the Retail Debt Segment? In the event of failure/shortage in delivery of securities, the Exchange would close-out such shortages at the ZCYC valuation for prices plus a 5% penalty factor which would be debited to the account of the member who has failed to deliver the securities against his sale obligation. The buyer in the event of nondelivery of securities by the seller would be eligible to receive the compensation/consideration which would be computed at the higher of either the highest trade price from the trade date to the date of close out or closing price of the security in the normal market on the close-out date plus interest calculated at the rate of overnight FIMMDA-NSE MIBOR for the close-out date. The difference between the amount debited to the seller and amount payable to the buyer on the basis discussed above would be credited to the Investor Protection Fund of the Exchange. The Exchange has also set up a separate Trade Guarantee Fund (Settlement Guarantee Fund ) for the Retail Trading in G-Secs. as was mandated by SEBI through its circular.
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49.
Q.
How is the margining structure at the Exchange for the Retail Debt Market?
A.
Margining - Mark to Market : The positions in the Retail Debt segment are marked to market until settlement and mark to market margin on net outstanding position of the members is collected on all open net positions. The mark to market margin is calculated based on the prices derived from the Zero Coupon Yield Curve (ZCYC). This margin is to be collected on the T+1 day along with the margin on the outstanding positions in cash segment. Margin exemption to Institutional business: Institutional business (i.e., business done by members on behalf of Indian Financial Institutions, Foreign Institutional Investors, Scheduled Commercial Banks, Mutual Funds registered with SEBI) would be exempted from margin, as is applicable in the case of transactions in the equity segment, as the institutions are required under the relevant regulations to transact only on the basis of giving and taking delivery. The members would, however, be required to mark client type 'FI' at the time of order entry for availing of exemption from payment of margins and also exclusion of such trades from Intra-day Trading and Gross Exposure Limits. Custodial trades on behalf of Provident Funds transacting through a SGL-II account (Constituent SGL a/c) would also be eligible for margin exemption. Margin Exemption against delivery: Margin exemption for early pay-in of securities in case of sale transactions as applicable for the equities segment would also be available for this segment.
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INVESTOR SAFEGUARDS 50. Q. A. What are the main points to be kept in mind by the investor while investing in the Debt Markets? The main features which you need to check for any debt security is: y Coupon (or the discount implied by the price as in the case of zero coupon bonds) and the frequency of interest payments. The securities can also be chosen in such a manner so that the interest payments coincide with any requirements of funds at that point of time. Timing of Cash Flows - In case the interest and redemption proceeds, at one single point or at different points of time, are planned to be used for meeting certain planned expenses in the future. Information about the Issuer and the Credit Rating - It is essential to obtain enough information about the background, the business operations, the financial position, the use of the funds being collected and the future projections to satisfy oneself of the suitability of the investment. As per the regulations in force in the capital markets, it is essential for any corporate debt security to obtain a credit rating from any of the major credit rating agencies. A proper analysis of the background and the financials of the issuer of any non-govt. debt instrument and especially the credit rating would lend greater safety to your investments. Other Terms of particular Issue - It is also advisable to check on certain terms of the issue like the use of the issue proceeds, the monitoring agency, the formation of trustees, the secured or unsecured nature of the bonds, the assets underlying the security and the credit-worthiness of the organization.
Most of the said information can be available from the prospectus of the said issue (In case of and any
required and relevant details can also be obtained on demand from the lead manager of the issue y Obtain all the relevant knowledge on the debt security like the coupon, maturity, interest payments, put and call options (if any), Yield To Maturity (at the particular price at which the trade is intended to be carried out) and the Duration of the Instrument. Check the Yield To Maturity (YTM) of the debt security with the YTMs of other comparable debt securities of the same class and features. Remember that the Yield and the Price are inversely related. So, you will be able to obtain a higher yield at a lower price. It is desirable to check on the liquidity of any corporate debt instrument before investing in it so as to ensure the availability of satisfactory exit options. The Debt Markets are suited for investors who seek decent returns over a longer time horizon with periodic cash flows. There is also a tax exemption for interest earned on G-Secs. up to Rs.3000/- under Section 80L of the Income Tax Act.
The investor should be well aware of the set of risks associated with the Debt Markets like the default risk (non-receipt or delay in receipt of interest or principal), price risk, interest rate risk (risk of rates moving adversely after investment), settlement risk (or risk of non-delivery of securities and funds in the secondary market) and the re-investment risk (interest payments fetching a lower return when reinvested) . Investors in the Debt Markets should follow a process of judicious investing after a careful study of the economic and money market condition, various instruments available for investment, the desired returns and its compatibility with existing investment opportunities, alternative modes available for investments and the relevant transaction costs.
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51.
Q. A.
What is the future scenario for the Retail Debt Market in India? The Retail Debt Market is set to grow tremendously in India with the broadening of the market participation and the availability of a wide range of debt securities for retail trading through the Exchanges. The following are the trends, which will impact the Retail Debt Market in India in the near future: y y y y y Expansion of the Retail Trading platform to enable trading in a wide range of government and non-government debt securities. Introduction of new instruments like STRIPS, G-Secs. with call and put options, securitised paper etc. Development of the secondary market in Corporate Debt Introduction of Interest Rate Derivatives based on a wide range of underlying in the Indian Debt and Money Markets. Development of the Secondary Repo Markets.
The BSE vision for the Indian Debt Market foresees the markets growing in leaps and bounds in the near future, soon attaining global standards of safety, efficiency and transparency. This will truly help the Indian capital markets to attain a place of pride among the leading capital markets of the world.
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8. Fractional reserve banking

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Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction (called the reserve ratio) of the quantity of deposits as reserves. Some of the funds lent out are subsequently deposited with another bank, increasing deposits at that second bank and allowing further lending. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank. That multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators, and by the excess reserves kept by commercial banks.[1][2] Central banks generally mandate reserve requirements that require banks to keep a minimum fraction of their demand deposits as cash reserves. This both limits the amount of money creation that occurs in the commercial banking system,[2] and ensures that banks have enough ready cash to meet normal demand for withdrawals. Problems can arise, however, when depositors seek withdrawal of a large proportion of deposits at the same time; this can cause a bank run or, when problems are extreme and widespread, a systemic crisis. To mitigate this risk, the governments of most countries (usually acting through the central bank) regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks. Fractional-reserve banking is the most common form of banking and is practiced in almost all countries. Although Islamic banking prohibits the making of profit from interest on debt, a form of fractional-reserve banking is still evident in most Islamic countries.
Contents
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y y y
y y
y y y y y
1 History o 1.1 Reason for existence 2 How it works 3 Money creation o 3.1 Example of deposit multiplication o 3.2 Money multiplier 3.2.1 Formula o 3.3 Reserve requirements o 3.4 Alternative views 4 Money supplies around the world 5 Regulation o 5.1 Central banks o 5.2 Liquidity and capital management for a bank o 5.3 Risk and prudential regulation o 5.4 Example of a bank balance sheet and financial ratios 5.4.1 Other financial ratios 5.4.2 How the example bank manages its liquidity 6 Criticisms 7 See also 8 References 9 Further reading 10 External links
[edit] History
Savers looking to keep their valuables in safekeeping depositories deposited gold coins and silver coins at goldsmiths, receiving in turn a note for their deposit (see Bank of Amsterdam). Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths' notes.[3] As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born. However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to redeem (pay) their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.[3] Repeated bank failures and financial crises led to the creation of central banks public institutions that have the authority to regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if a bank runs low on liquidity. The emergence of central banks mitigated the dangers associated with fractional reserve banking.[2][4] From about 1991 a consensus had emerged within developed economies about the optimum design of monetary policy. In essence central bankers gave up attempts to directly control the amount of money in the economy and instead moved to indirect means by targeting interest rates. This consensus is criticized by some economists.[5]
[edit] Reason for existence

Fractional reserve banking allows people to invest their money, without losing the ability to use it on demand. Since most people do not need to use all their money all the time, banks lend out that money, to generate profit for themselves. Thus, banks can act as financial intermediaries facilitating the investment of savers' funds.[2][6] Full reserve banking, on the other hand, does not allow any money in such demand deposits to be invested (since all of the money would be locked up in reserves) and less liquid investments (such as stocks, bonds and time deposits) lock up a lender's money for a time, making it unavailable for the lender to use. According to mainstream economic theory, regulated fractional-reserve banking also benefits the economy by providing regulators with powerful tools for manipulating the money supply and interest rates, which many see as essential to a healthy economy.[7]
[edit] How it works

The nature of modern banking is such that the cash reserves at the bank available to repay demand deposits need only be a fraction of the demand deposits owed to depositors. In most legal systems, a demand deposit at a bank (e.g., a checking or savings account) is considered a loan to the bank (instead of a bailment) repayable on demand, that the bank can use to finance its investments in loans and interest bearing securities. Banks make a profit based on the difference between the interest they charge on the loans they make, and the interest they pay to their depositors (aggregately called the net interest margin (NIM)). Since a bank lends out most of the money deposited, keeping only a fraction of the total as reserves, it necessarily has less money than the account balances of its depositors. The main reason customers deposit funds at a bank is to store savings in the form of a demand claim on the bank. Depositors still have a claim to full repayment of their funds on demand even though most of the funds have already been invested by the bank in interest bearing loans and securities.[8] Holders of demand deposits can withdraw all of their deposits at any time. If all the depositors of a bank did so at the same time a bank run would occur, and the bank would likely collapse. Due to the practice of central banking, this is a rare event today, as central banks usually guarantee the deposits at commercial banks, and act as lender of last resort when there is a run on a bank. However, there have been some recent bank runs: the Northern Rock crisis of 2007 in the United Kingdom is an example. The collapse of Washington Mutual bank in September 2008, the largest bank failure in history, was preceded by a "silent run" on the bank, where depositors removed vast sums of money from the bank through electronic transfer.[citation needed] However, in these cases, the banks proved to have been insolvent at the time of the run.[citation needed] Thus, these bank runs merely precipitated failures that were inevitable in any case. In the absence of crises that trigger bank runs, fractional-reserve banking usually functions smoothly because at any one time relatively few depositors will make cash withdrawals simultaneously compared to the total amount on deposit, and a cash reserve can be maintained as a buffer to deal with the normal cash demands from depositors seeking withdrawals. In addition, in a normal economic environment, cash is steadily being introduced into the economy by the central bank, and new funds are steadily being deposited into the commercial banks. However, if a bank is experiencing a financial crisis, and net redemption demands are unusually large over a period of time, the bank will run low on cash reserves and will be forced to raise additional funds to avoid running out of reserves and defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing from the money market or using lines of credit held with other banks), or by selling assets, or by calling in shortterm loans. If creditors are afraid that the bank is running out of cash or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining cash reserves before they do, triggering a cascading crisis that can result in a full-scale bank run.
[edit] Money creation

Main article: Money creation
Modern central banking allows banks to practice fractional reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals.[9][10] Though not a mainstream economic belief, a number of central bankers, monetary economists, and text books, have said that banks create money by 'extending credit', where banks obligate themselves to borrowers, and then later manage whatever liabilities this creates for them, where if the central bank targets interest rates, it must supply base money on demand to meet the banks reserve requirements, after the banks have begun the lending process[11][12][13][14][15][16][17][18] and that rather than deposits leading to loans, causality is reversed, and loans lead to deposits.[19][20][21][22] There are two types of money in a fractional-reserve banking system operating with a central bank:[23][24][25]
1. Central bank money: money created or adopted by the central bank regardless of its form precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money 2. Commercial bank money: demand deposits in the commercial banking system; sometimes referred to as chequebook money
When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of M1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the m1 money supply expands by the size of the loan.[2] This process is called deposit multiplication.
[edit] Example of deposit multiplication

The table below displays the mainstream economics relending model of how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractionalreserve rate of 20% to ultimately create $500 of commercial bank money. Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands. The relending model begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point, the money supply actually totals $180, not $100, because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial bank money is equivalent to central bank money it is impossible to tell the two forms of money apart unless a bank run occurs (at which time everyone wants central bank money).[2] At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.
Table Sources: Individual Bank A B C D E F G H I J K Amount Deposited 100 80 64 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 Total Reserves: 89.26 Total Amount of Deposits: 457.05 Total Amount Lent Out: 357.05 Total Reserves + Last Amount Deposited: 100 Lent Out 80 64 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 Reserves 20 16 12.80 10.24 8.19 6.55 5.24 4.19 3.36 2.68
The expansion of $100 of central bank money through fractional-reserve lending with a 20% reserve rate. $400 of commercial bank money is created virtually through loans.
Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400. For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. Deposits will always be equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's balance sheet. Fractional reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to some degree by actions of the central bank. This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money.[23] The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.[23][24] The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.[26] Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.[27]
[edit] Money multiplier

Main article: Money multiplier
The expansion of $100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the money multiplier calculates.
The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.
[edit] Formula
The money multiplier, m, is the inverse of the reserve requirement, R:[28] Example For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction: So then the money multiplier, m, will be calculated as: This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to. The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily holdusually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.[29] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.[30] Confusingly there are many different "money multipliers", some referring to ratios of rates of change of different money measures and others referring to ratios of absolute values of money measures.
[edit] Reserve requirements

The modern mainstream view of reserve requirements is that they are intended to prevent banks from:
1. generating too much money by making too many loans against the narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although the reserve is thought to be a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).
In practice, some central banks do not require reserves to be held, and in some countries that do, such as the USA and the EU they are not required to be held during the day when the banks are lending, and banks can borrow from other banks at near the central bank policy rate to ensure they have the necessary amount of required reserves by the close of business. Required reserves are therefore considered by some central bankers, monetary economists and textbooks to only play a very small role in limiting money creation in these countries. Most commentators agree however, that they help the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence. The UK for example, which does not have required reserves, does have requirements that the banks keep a certain amount of cash, and in Australia while there are no reserve requirements, there are a variety of requirements to ensure the banks have a stabilising ratio of liquid assets, such as deposits held with local banks. Individual countries adhere to varying required reserve ratios which have changed over time. In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some mainstream economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.
[edit] Alternative views

See also: Endogenous money
Theories of endogenous money date to the 19th century, and were described by Joseph Schumpeter, and later the post-Keynesians.[31] Endogenous money theory states that the supply of money is creditdriven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities. Charles Goodhart worked for many years to encourage a different approach to money supply analysis and said the base money multiplier model was "such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction"[32] Ten years later he said: "Almost all those who have worked in a [central bank] believe that this view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system...".[33] Goodhart has characterized the money stock as a dependent endogenous variable.[34] In 1994, Mervyn King said that the causation between money and demand is a contentious issue, because although textbooks assume that money is exogenous, in the United Kingdom money is endogenous, as the Bank of England provides base money on demand and broad money is created by the banking system.[35][36][37] Seth B. Carpenter and Selva Demiralp concluded the simple textbook base money multiplier is implausible in the United States.[38]
[edit] Money supplies around the world

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of central bank money was $750.5 billion while the amount of commercial bank money (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is
M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because the federal reserve ceased reporting it.[clarification needed]
Components of the euro money supply 1998-2007 Main articles: Money supply and Inflation
Fractional-reserve banking determines the relationship between the amount of central bank money (currency) in the official money supply statistics and the total money supply. Most of the money in these systems is commercial bank money. Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply through the deposit creation multiplier. The issue of money through the banking system is a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).
[edit] Regulation
Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.[4][39]
[edit] Central banks

Main article: Central bank
Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:
1. Minimum required reserve ratios (RRRs) 2. Minimum capital ratios 3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK) 5. Sanction on bank defaults and protection from creditors for many months or even years, and 6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.
[edit] Liquidity and capital management for a bank

Main articles: Capital requirement and Market liquidity
To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:
1. 2. 3. 4. 5.
Selling or redeeming other assets, or securitization of illiquid assets, Restricting investment in new loans, Borrowing funds (whether repayable on demand or at a fixed maturity), Issuing additional capital instruments, or Reducing dividends.[citation needed]
Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:
1. Demand deposits with other banks 2. High quality marketable debt securities 3. Committed lines of credit with other banks[citation needed]
As with reserves, other sources of liquidity are managed with targets. The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank.[citation needed] Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '23 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.[citation needed]
[edit] Risk and prudential regulation

In a fractional-reserve banking system, in the event of a bank run, the demand depositors and note holders would attempt to withdraw more money than the bank has in reserves, causing the bank to suffer a liquidity crisis and, ultimately, to perhaps default. In the event of a default, the bank would
need to liquidate assets and the creditors of the bank would suffer a loss if the proceeds were insufficient to pay its liabilities. Since public deposits are payable on demand, liquidation may require selling assets quickly and potentially in large enough quantities to affect the price of those assets. An otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand). Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default[citation needed]. For this reason, fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders)[citation needed]. Many governments have enforced or established deposit insurance systems in order to protect depositors from the event of bank defaults and to help maintain public confidence in the fractionalreserve system. Responses to the problem of financial risk described above include:
1. Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below); 2. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and, 3. Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used; 4. Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved.
[edit] Example of a bank balance sheet and financial ratios

An example of fractional reserve banking, and the calculation of the reserve ratio is shown in the balance sheet below:
Example 2: ANZ National Bank Limited Balance Sheet as at 30 September 2007[citation needed] ASSETS Cash Balance with Central Bank Other Liquid Assets NZ$m LIABILITIES 201 2809 1797 Demand Deposits NZ$m 25482
Term Deposits and other borrowings 35231 Due to Other Financial Institutions 3170
Due from other Financial Institutions 3563 Trading Securities Derivative financial instruments Available for sale assets Net loans and advances Shares in controlled entities Current Tax Assets Other assets Deferred Tax Assets Premises and Equipment Goodwill and other intangibles Total Assets 1887 4771 48
Derivative financial instruments Payables and other liabilities Provisions Bonds and Notes
4924 1351 165 14607 2775 2062 99084 5943 83 2667 8703 107787
87878 Related Party Funding 206 112 1045 11 232 3297 [subordinated] Loan Capital Total Liabilities Share Capital [revaluation] Reserves Retained profits Total Equity
107787 Total Liabilities plus Net Worth
In this example the cash reserves held by the bank is $3010m ($201m currency + $2809m held at central bank) and the demand liabilities of the bank are $25482m, for a cash reserve ratio of 11.81%.
[edit] Other financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc. For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:
1. 2. 3. 4. 5.
The cash reserve ratio is $3010m/$25482m, i.e. 11.81%. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%. The equity capital ratio is $8703m/107787m, i.e. 8.07%. The tangible equity ratio is ($8703m-$3297m)/107787m, i.e. 5.02% The total capital ratio is ($8703m+$2062m)/$107787m, i.e. 9.99%.
It is very important how the term 'reserves' is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.
[edit] How the example bank manages its liquidity

See also: Duration gap
The ANZ National Bank Limited explains its methods as:[citation needed]
Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements. The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour. Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007[citation needed] Total carrying value Assets Liquid Assets 4807 4807 Less than 3 3 12 months months 1 5 years Beyond 5 No Specified years Maturity
Due from other 3563 financial institutions Derivative Financial Instruments Assets available for sale Net loans and advances 4711
2650
440
187
286
4711
48
33
13
87878
9276
9906
24142 44905
Other Assets Total Assets Liabilities
4903 107787
970 18394
179 10922 25013 45343
3754 8115
Due to other 3170 financial institutions Deposits and other borrowings Derivative financial instruments Other liabilities Bonds and notes Related party funding Loan capital Total liabilities Net liquidity gap Net liquidi 70030
2356
405
32
377
53059
14726
2245
4932
4932
1516 14607
1315 672
96 4341
32 9594
60
13
2275
2275
2062 99084 8703 60177 (41783)
100 19668 (8746)
1653
309 4937 3178
13556 746 11457 44597
11 RCommercial bank
From Wikipedia, the free encyclopedia Jump to: navigation, search
Banking
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A commercial bank (or business bank) is a type of financial institution and intermediary. It is a bank that provides transactional, savings, and money market accounts and that accepts time deposits.[1]
Contents
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1 Origin of the word 2 The role of commercial banks 3 Types of loans granted by commercial banks o 3.1 Secured loan 3.1.1 Mortgage loan o 3.2 Unsecured loan 4 References 5 Further reading
[edit] Origin of the word

The name bank derives from the Italian word banco "desk/bench", used during the Renaissance by Florentine bankers, who used to make their transactions above a desk covered by a green tablecloth.[2] However, traces of banking activity can be found even in ancient times. In fact, the word traces its origins back to the Ancient Roman Empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called macella on a long bench called a bancu, from which the words banco and bank are derived. As a moneychanger, the merchant at the bancu did not so much invest money as merely convert the foreign currency into the only legal tender in Rome- that of the Imperial Mint.[3]
[edit] The role of commercial banks

Commercial banks engage in the following activities: y y y y y y y y y y
processing of payments by way of telegraphic transfer, EFTPOS, internet banking, or other means issuing bank drafts and bank cheques accepting money on term deposit lending money by overdraft, installment loan, or other means providing documentary and standby letter of credit, guarantees, performance bonds, securities underwriting commitments and other forms of off balance sheet exposures safekeeping of documents and other items in safe deposit boxes distribution or brokerage, with or without advice, of insurance, unit trusts and similar financial products as a financial supermarket cash management and treasury merchant banking and private equity financing traditionally, large commercial banks also underwrite bonds, and make markets in currency, interest rates, and credit-related securities, but today large commercial banks usually have an investment bank arm that is involved in the mentioned activities.
[edit] Types of loans granted by commercial banks
[edit] Secured loan

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral in the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally lent to the borrower, for example, foreclosure of a home. From the creditor's perspective this is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount. The opposite of secured debt/loan is unsecured debt, which is not connected to any specific piece of property and instead the creditor may only satisfy the debt against the borrower rather than the borrower's collateral and the borrower.
[edit] Mortgage loan

A mortgage loan is a very common type of debt instrument, used to purchase real estate. Under this arrangement, the money is used to purchase the property. Commercial banks, however, are given security - a lien on the title to the house - until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it. In the past, commercial banks have not been greatly interested in real estate loans and have placed only a relatively small percentage of assets in mortgages. As their name implies, such financial institutions secured their earning primarily from commercial and consumer loans and left the major task of home financing to others. However, due to changes in banking laws and policies, commercial banks are increasingly active in home financing. Changes in banking laws now allow commercial banks to make home mortgage loans on a more liberal basis than ever before. In acquiring mortgages on real estate, these institutions follow two main practices. First, some of the banks maintain active and well-organized departments whose primary function is to compete actively for real estate loans. In areas lacking specialized real estate financial institutions, these banks become the source for residential and farm mortgage loans. Second, the banks acquire mortgages by simply purchasing them from mortgage bankers or dealers. In addition, dealer service companies, which were originally used to obtain car loans for permanent lenders such as commercial banks, wanted to broaden their activity beyond their local area. In recent years, however, such companies have concentrated on acquiring mobile home loans in volume for both commercial banks and savings and loan associations. Service companies obtain these loans from retail dealers, usually on a nonrecourse basis. Almost all bank/service company agreements contain a credit insurance policy that protects the lender if the consumer defaults.
[edit] Unsecured loan

[Unsecured Loans] are monetary loans that are not secured against the borrower's assets (i.e., no collateral is involved). These may be available from financial institutions under many different guises or marketing packages: y
bank overdrafts
An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be "overdrawn". If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the POSITIVE balance exceeds the agreed terms, then additional fees may be charged and higher interest rates may apply. y y y
corporate bonds credit card debt credit facilities or lines of credit
personal loans
What makes a bank limited liability company A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business.[1] The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.) Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category.[clarification needed] Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs like Bonds.com and MarketAxess, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets. Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity. Corporate Credit spreads may alternatively be earned in exchange for default risk through the mechanism of Credit Default Swaps which give an unfunded synthetic exposure to similar risks on the same 'Reference Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS and the credit spreads on corporate bonds can be significantly different. y y y
Assets and Liabilities of Commercial Banks in the United States Glass-Steagall Act Mortgage constant
ole oFederal Reserve System

From Wikipedia, the free encyclopedia (Redirected from Federal Reserve) Jump to: navigation, search "FRB" and "FED" redirect here. For other uses, see FRB (disambiguation) and FED (disambiguation).
Federal Reserve System
Seal Federal Reserve System headquarters (Eccles Building)
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Washington, D.C.
Established
December 23, 1913 (98 years ago)
Chairman
Ben Bernanke
Central bank of
United States
Currency
United States dollar
ISO 4217 Code
USD 0% 0.25%[1]
Base borrowing rate
Website
federalreserve.gov
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The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907.[2][3][4] Over time, the roles and responsibilities of the Federal Reserve System have expanded and its structure has evolved.[3][5] Events such as the Great Depression were major factors leading to changes in the system.[6] The Congress established three key objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act.[7] The first two objectives are sometimes referred to as the Federal Reserve's dual mandate.[8] Its duties have expanded over the years and today, according to official Federal Reserve documentation, include conducting the nation's monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions.[9]The Fed also conducts research into the economy and releases numerous publications, such as the Beige Book. The Federal Reserve System's structure is composed of the presidentially appointed Board of Governors (or Federal Reserve Board), the Federal Open Market Committee (FOMC), twelve regional Federal Reserve Banks located in major cities throughout the nation, numerous privately owned U.S. member banks and various advisory
councils.[10][11][12] The FOMC is the committee responsible for setting monetary policy and consists of all seven members of the Board of Governors and the twelve regional bank presidents, though only five bank presidents vote at any given time. The Federal Reserve System has both private and public components, and was designed to serve the interests of both the general public and private bankers. The result is a structure that is considered unique among central banks. It is also unusual in that an entity outside of the central bank, namely the United States Department of the Treasury, creates the currency used.[13] According to the Board of Governors, the Federal Reserve is independent within government in that "its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government." Its authority is derived from statutes enacted by the U.S. Congress and the System is subject to congressional oversight. The members of the Board of Governors, including its chairman and vice-chairman, are chosen by the President and confirmed by the Senate. The government also exercises some control over the Federal Reserve by appointing and setting the salaries of the system's highest-level employees. Thus the Federal Reserve has both private and public aspects.[14][15][16][17] The U.S. Government receives all of the system's annual profits, after a statutory dividend of 6% on member banks' capital investment is paid, and an account surplus is maintained. In 2010, the Federal Reserve made a profit of $82 billion and transferred $79 billion to the U.S. Treasury.[18] This was followed at the end of 2011 with a transfer of $77 billion in profits to the U.S. Treasury Department.[19]
Contents
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1 History o 1.1 Central banking in the United States 1.1.1 Timeline of central banking in the United States 1.1.2 Creation of First and Second Central Bank 1.1.3 Creation of Third Central Bank 1.1.3.1 Federal Reserve Act o 1.2 Key laws 2 Purpose o 2.1 Addressing the problem of bank panics 2.1.1 Elastic currency 2.1.2 Check Clearing System 2.1.3 Lender of last resort 2.1.3.1 Emergencies 2.1.3.2 Fluctuations o 2.2 Central bank 2.2.1 Federal funds o 2.3 Balance between private banks and responsibility of governments 2.3.1 Government regulation and supervision 2.3.1.1 Preventing asset bubbles o 2.4 National payments system 3 Structure o 3.1 Board of Governors 3.1.1 List of members of the Board of Governors 3.1.2 Nominations o 3.2 Federal Open Market Committee o 3.3 Federal Reserve Banks 3.3.1 Legal status of regional Federal Reserve Banks o 3.4 Member banks
y y y y y
o 3.5 Accountability 4 Monetary policy o 4.1 Interbank lending is the basis of policy o 4.2 Tools 4.2.1 Federal funds rate and open market operations 4.2.1.1 Repurchase agreements 4.2.2 Discount rate 4.2.3 Reserve requirements 4.2.4 New facilities 4.2.4.1 Term auction facility 4.2.4.2 Term securities lending facility 4.2.4.3 Primary dealer credit facility 4.2.4.4 Interest on reserves 4.2.4.5 Term deposit facility 4.2.4.6 Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility 4.2.4.7 Commercial Paper Funding Facility 4.2.5 Quantitative policy 5 Measurement of economic variables o 5.1 Net worth of households and nonprofit organizations o 5.2 Money supply o 5.3 Personal consumption expenditures price index 5.3.1 Inflation and the economy o 5.4 Unemployment rate 6 Budget 7 Net worth o 7.1 Balance sheet 8 See also 9 References 10 Bibliography o 10.1 Recent o 10.2 Historical 11 External links o 11.1 Official Federal Reserve websites and information 11.1.1 Open Market operations 11.1.2 Repurchase agreements 11.1.3 Discount window 11.1.4 Economic indicators 11.1.5 Federal Reserve publications o 11.2 Other websites describing the Federal Reserve o 11.3 Sites critical of the Federal Reserve
[edit] History
[edit] Central banking in the United States
Main article: History of central banking in the United States
In 1690, the Massachusetts Bay Colony became the first to issue paper money in what would become the United States, but soon others began printing their own money as well. The demand for currency in the colonies was due to the scarcity of coins, which had been the primary means of trade.[20] Colonies' paper currencies were used to pay for their expenses, as well as a means to lend money to the colonies' citizens. Paper money quickly became the primary means of exchange within each colony, and it even began to be used in financial transactions with other colonies.[21] However, some of the currencies were not redeemable in gold or silver, which caused them to depreciate.[20] The Currency Act of 1751 set limits on the issuance of Bills of Credit by the New England states and set requirements for the redemption of any bills issued. This Act was in response to the overissuance of bills by Rhode Island, eventually reducing their value to 1/27 of the issuing value.[22] The Currency Act of 1764 completely banned the issuance of Bills of Credit (paper money) in the colonies and the making of such bills legal tender because their depreciation allowed the discharge of debts with depreciated paper at a rate less then contracted for, to the great discouragement and prejudice of the trade and commerce of his Majesty's subjects. The ban proved extremely harmful to the economy of the colonies and inhibited trade, both within the colonies and abroad.[23] The first attempt at a national currency was during the American Revolutionary War. In 1775 the Continental Congress, as well as the states, began issuing paper currency, calling the bills "Continentals". The Continentals were backed only by future tax revenue, and were used to help finance the Revolutionary War. Overprinting, as well as British counterfeiting caused the value of the Continental to diminish quickly. This experience with paper money led the United States to strip the power to issue Bills of Credit (paper money) from a draft of the new Constitution on August 16, 1787. [24] as well as banning such issuance by the various states, and limiting the states ability to make anything but gold or silver coin legal tender. [25] In 1791 the government granted the First Bank of the United States a charter to operate as the U.S. central bank until 1811.[20] The First Bank of the United States came to an end under President Madison because Congress refused to renew its charter. The Second Bank of the United States was established in 1816, and lost its authority to be the central bank of the U.S. twenty years later under President Jackson when its charter expired. Both banks were based upon the Bank of England.[26] Ultimately, a third national bank, known as the Federal Reserve, was established in 1913 and still exists to this day.
[edit] Timeline of central banking in the United States

y y y y y y y
1791 1811 1816 1837 1846 1863 1913
1811: First Bank of the United States 1816: No central bank 1836: Second Bank of the United States 1862: Free Bank Era 1921: Independent Treasury System 1913: National Banks Present: Federal Reserve System
Sources: "Remarks by Chairman Alan Greenspan "Our banking history"". May 2, 1998. http://www.federalreserve.gov/BoardDocs/Speeches/1998/19980502.htm., "History of the Federal Reserve". http://www.federalreserveeducation.org/about%2Dthe%2Dfed/history., "Historical Beginnings...The Federal Reserve" (PDF). 1999. http://www.bos.frb.org/about/pubs/begin.pdf., Chapter 1
[edit] Creation of First and Second Central Bank

The first U.S. institution with central banking responsibilities was the First Bank of the United States, chartered by Congress and signed into law by President George Washington on February 25, 1791 at the urging of Alexander Hamilton. This was done despite strong opposition from Thomas Jefferson and James Madison, among numerous others. The charter was for twenty years and expired in 1811 under President Madison, because Congress refused to renew it.[27]
In 1816, however, Madison revived it in the form of the Second Bank of the United States. Years later, early renewal of the bank's charter became the primary issue in the reelection of President Andrew Jackson. After Jackson, who was opposed to the central bank, was reelected, he pulled the government's funds out of the bank. Nicholas Biddle, President of the Second Bank of the United States, responded by contracting the money supply to pressure Jackson to renew the bank's charter forcing the country into a recession, which the bank blamed on Jackson's policies[citation needed]. Interestingly, Jackson is the only President to completely pay off the national debt. The bank's charter was not renewed in 1836. From 1837 to 1862, in the Free Banking Era there was no formal central bank. From 1862 to 1913, a system of national banks was instituted by the 1863 National Banking Act. A series of bank panics, in 1873, 1893, and 1907, provided strong demand for the creation of a centralized banking system.
[edit] Creation of Third Central Bank

Main article: History of the Federal Reserve System
The main motivation for the third central banking system came from the Panic of 1907, which caused renewed demands for banking and currency reform.[28] During the last quarter of the 19th century and the beginning of the 20th century the United States economy went through a series of financial panics.[29] According to many economists, the previous national banking system had two main weaknesses: an inelastic currency and a lack of liquidity.[29] In 1908, Congress enacted the Aldrich-Vreeland Act, which provided for an emergency currency and established the National Monetary Commission to study banking and currency reform.[30] The National Monetary Commission returned with recommendations which were repeatedly rejected by Congress. A revision crafted during a secret meeting on Jekyll Island by Senator Aldrich and representatives of the nations top finance and industrial groups later became the basis of the Federal Reserve Act.[31][32] Many believe this act was passed on December 23, 1913, in a special session, when many opponents of the Act had left Washington for Christmas.[33] However, this is not the case as the House voted on December 22, 1913 with 298 yeas to 60 nays and 76 not voting and the Senate voting on December 23, 1913 with 43 yeas to 25 nays and 27 not voting. [34] President Woodrow Wilson signed the bill later that day at 6:02pm.[35] [edit] Federal Reserve Act
Main article: Federal Reserve Act
Newspaper clipping, December 24, 1913

The head of the bipartisan National Monetary Commission was financial expert and Senate Republican leader Nelson Aldrich. Aldrich set up two commissionsone to study the American monetary system in depth and the other, headed by Aldrich himself, to study the European central banking systems and report on them.[30] Aldrich went to Europe opposed to centralized banking, but after viewing Germany's monetary system he came away believing that a centralized bank was better than the government-issued bond system that he had previously supported. In early November 1910, Aldrich met with five well known members of the New York banking community to devise a central banking bill. Paul Warburg, an attendee of the meeting and long time advocate of central banking in the U.S., later wrote that Aldrich was "bewildered at all that he had absorbed abroad and he was faced with the difficult task of writing a highly technical bill while being harassed by the daily grind of his parliamentary duties".[36] After ten days of deliberation, the bill, which would later be referred to as the "Aldrich Plan", was agreed upon. It had several key components, including a central bank with a Washingtonbased headquarters and fifteen branches located throughout the U.S. in geographically strategic locations, and a uniform elastic currency based on gold and commercial paper. Aldrich believed a central banking system with no political involvement was best, but was convinced by Warburg that a plan with no public control was not politically feasible.[36] The compromise involved representation of the public sector on the Board of Directors.[37] Aldrich's bill met much opposition from politicians. Critics charged Aldrich of being biased due to his close ties to wealthy bankers such as J. P. Morgan and John D. Rockefeller, Jr., Aldrich's son-in-law. Most Republicans favored the Aldrich Plan,[37] but it lacked enough support in Congress to pass because rural and western states viewed it as favoring the "eastern establishment".[2] In contrast, progressive Democrats favored a reserve
system owned and operated by the government; they believed that public ownership of the central bank would end Wall Street's control of the American currency supply.[37] Conservative Democrats fought for a privately owned, yet decentralized, reserve system, which would still be free of Wall Street's control.[37] The original Aldrich Plan was dealt a fatal blow in 1912, when Democrats won the White House and Congress.[36] Nonetheless, President Woodrow Wilson believed that the Aldrich plan would suffice with a few modifications. The plan became the basis for the Federal Reserve Act, which was proposed by Senator Robert Owen in May 1913. The primary difference between the two bills was the transfer of control of the Board of Directors (called the Federal Open Market Committee in the Federal Reserve Act) to the government.[2][27] The bill passed Congress on December 23, 1913,[38][39] on a mostly partisan basis, with most Democrats voting "yea" and most Republicans voting "nay".[27]
[edit] Key laws

Key laws affecting the Federal Reserve have been:[40] y y y y y y y y y y y y y y y y
Federal Reserve Act Glass Steagall Act Banking Act of 1935 Employment Act of 1946 Federal Reserve-Treasury Department Accord of 1951 Bank Holding Company Act of 1956 and the amendments of 1970 Federal Reserve Reform Act of 1977 International Banking Act of 1978 Full Employment and Balanced Growth Act (1978) Depository Institutions Deregulation and Monetary Control Act (1980) Financial Institutions Reform, Recovery and Enforcement Act of 1989 Federal Deposit Insurance Corporation Improvement Act of 1991 Gramm-Leach-Bliley Act (1999) Financial Services Regulatory Relief Act (2006) Emergency Economic Stabilization Act (2008) Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)
[edit] Purpose
The primary motivation for creating the Federal Reserve System was to address banking panics.[3] Other purposes are stated in the Federal Reserve Act, such as "to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes".[41] Before the founding of the Federal Reserve, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. Today the Federal Reserve System has broader responsibilities than only ensuring the stability of the financial system.[42] Current functions of the Federal Reserve System include:[9][42] y y y
To address the problem of banking panics To serve as the central bank for the United States To strike a balance between private interests of banks and the centralized responsibility of government o To supervise and regulate banking institutions
o To protect the credit rights of consumers To manage the nation's money supply through monetary policy to achieve the sometimesconflicting goals of o maximum employment [43] o stable prices, including prevention of either inflation or deflation o moderate long-term interest rates y To maintain the stability of the financial system and contain systemic risk in financial markets y To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system o To facilitate the exchange of payments among regions o To respond to local liquidity needs y To strengthen U.S. standing in the world economy y
[edit] Addressing the problem of bank panics

Further information: bank run and fractional-reserve banking
Bank runs occur because banking institutions in the United States are only required to hold a fraction of their depositors' money in reserve. This practice is called fractional-reserve banking. As a result, most banks invest the majority of their depositors' money. On rare occasion, too many of the bank's customers will withdraw their savings and the bank will need help from another institution to continue operating. Bank runs can lead to a multitude of social and economic problems. The Federal Reserve was designed as an attempt to prevent or minimize the occurrence of bank runs, and possibly act as a lender of last resort if a bank run does occur. Many economists, following Milton Friedman, believe that the Federal Reserve inappropriately refused to lend money to small banks during the bank runs of 1929.[44]
[edit] Elastic currency
The monthly changes in the currency component of the U.S. money supply show currency being added into (% change greater than zero) and removed from circulation (% change less than zero). The most noticeable changes occur around the Christmas holiday shopping season as new currency is created so people can make withdrawals at banks, and then removed from circulation afterwards, when less cash is demanded.
One way to prevent bank runs is to have a money supply that can expand when money is needed. The term "elastic currency" in the Federal Reserve Act does not just mean the ability to expand the money supply, but
also to contract it. Some economic theories have been developed that support the idea of expanding or shrinking a money supply as economic conditions warrant. Elastic currency is defined by the Federal Reserve as:[45]
Currency that can, by the actions of the central monetary authority, expand or contract in amount warranted by economic conditions.
Monetary policy of the Federal Reserve System is based partially on the theory that it is best overall to expand or contract the money supply as economic conditions change.
[edit] Check Clearing System

Because some banks refused to clear checks from certain others during times of economic uncertainty, a checkclearing system was created in the Federal Reserve system. It is briefly described in The Federal Reserve SystemPurposes and Functions as follows:[46]
By creating the Federal Reserve System, Congress intended to eliminate the severe financial crises that had periodically swept the nation, especially the sort of financial panic that occurred in 1907. During that episode, payments were disrupted throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks, a practice that contributed to the failure of otherwise solvent banks. To address these problems, Congress gave the Federal Reserve System the authority to establish a nationwide check-clearing system. The System, then, was to provide not only an elastic currency that is, a currency that would expand or shrink in amount as economic conditions warranted but also an efficient and equitable check-collection system.
[edit] Lender of last resort

In the United States, the Federal Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications for the economy. It took over this role from the private sector "clearing houses" which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent bank runs. [edit] Emergencies According to the Federal Reserve Bank of Minneapolis, "the Federal Reserve has the authority and financial resources to act as 'lender of last resort' by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy."[47] The Federal Reserve System's role as lender of last resort has been criticized because it shifts the risk and responsibility away from lenders and borrowers and places it on others in the form of inflation.[48] [edit] Fluctuations Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these loans is the discount rate (officially the primary credit rate). By making these loans, the Fed serves as a buffer against unexpected day-to-day fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates.[49] For example, on
September 16, 2008, the Federal Reserve Board authorized an $85 billion loan to stave off the bankruptcy of international insurance giant American International Group (AIG).[50][51]
[edit] Central bank

Further information: Central bank
In its role as the central bank of the United States, the Fed serves as a banker's bank and as the government's bank. As the banker's bank, it helps to assure the safety and efficiency of the payments system. As the government's bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve, through which incoming federal tax deposits and outgoing government payments are handled. As part of this service relationship, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation's coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation's cash supply and, in effect, sells the paper currency to the Federal Reserve Banks at manufacturing cost, and the coins at face value. The Federal Reserve Banks then distribute it to other financial institutions in various ways.[52] During the Fiscal Year 2008, the Bureau of Engraving and Printing delivered 7.7 billion notes at an average cost of 6.4 cents per note.[53]
[edit] Federal funds

Main article: Federal funds
Federal funds are the reserve balances (also called federal reserve accounts) that private banks keep at their local Federal Reserve Bank.[54][55] These balances are the namesake reserves of the Federal Reserve System. The purpose of keeping funds at a Federal Reserve Bank is to have a mechanism for private banks to lend funds to one another. This market for funds plays an important role in the Federal Reserve System as it is what inspired the name of the system and it is what is used as the basis for monetary policy. Monetary policy works partly by influencing how much interest the private banks charge each other for the lending of these funds. Federal reserve accounts contain federal reserve credit, which can be converted into federal reserve notes. Private banks maintain their bank reserves in federal reserve accounts.
[edit] Balance between private banks and responsibility of governments

The system was designed out of a compromise between the competing philosophies of privatization and government regulation. In 2006 Donald L. Kohn, vice chairman of the Board of Governors, summarized the history of this compromise:[56]
Agrarian and progressive interests, led by William Jennings Bryan, favored a central bank under public, rather than banker, control. But the vast majority of the nation's bankers, concerned about government intervention in the banking business, opposed a central bank structure directed by political appointees. The legislation that Congress ultimately adopted in 1913 reflected a hardfought battle to balance these two competing views and created the hybrid public-private, centralized-decentralized structure that we have today.
In the current system, private banks are for-profit businesses but government regulation places restrictions on what they can do. The Federal Reserve System is a part of government that regulates the private banks. The balance between privatization and government involvement is also seen in the structure of the system. Private banks elect members of the board of directors at their regional Federal Reserve Bank while the members of the Board of Governors are selected by the President of the United States and confirmed by the Senate. The private
banks give input to the government officials about their economic situation and these government officials use this input in Federal Reserve policy decisions. In the end, private banking businesses are able to run a profitable business while the U.S. government, through the Federal Reserve System, oversees and regulates the activities of the private banks.
[edit] Government regulation and supervision
Ben Bernanke (lower-right), Chairman of the Federal Reserve Board of Governors, at a House Financial Services Committee hearing on February 10, 2009. Members of the Board frequently testify before congressional committees such as this one. The Senate equivalent of the House Financial Services Committee is the Senate Committee on Banking, Housing, and Urban Affairs.
Federal Banking Agency Audit Act enacted in 1978 as Public Law 95-320 and Section 31 USC 714 of U.S. Code establish that the Federal Reserve may be audited by the Government Accountability Office (GAO).[57] The GAO has authority to audit check-processing, currency storage and shipments, and some regulatory and bank examination functions, however there are restrictions to what the GAO may in fact audit. Audits of the Reserve Board and Federal Reserve banks may not include:
1. transactions for or with a foreign central bank or government, or nonprivate international financing organization; 2. deliberations, decisions, or actions on monetary policy matters; 3. transactions made under the direction of the Federal Open Market Committee; or 4. a part of a discussion or communication among or between members of the Board of Governors and officers and employees of the Federal Reserve System related to items (1), (2), or (3).[58][59]
The financial crisis which began in 2007, corporate bailouts, and concerns over the Fed's secrecy have brought renewed concern regarding ability of the Fed to effectively manage the national monetary system.[60] A July 2009 Gallup Poll found only 30% Americans thought the Fed was doing a good or excellent job, a rating even lower than that for the Internal Revenue Service, which drew praise from 40%.[61] The Federal Reserve Transparency Act was introduced by congressman Ron Paul in order to obtain a more detailed audit of the Fed. The Fed has since hired Linda Robertson who headed the Washington lobbying office of Enron Corp. and was adviser to all three of the Clinton administration's Treasury secretaries.[62][63][64][65] The Board of Governors in the Federal Reserve System has a number of supervisory and regulatory responsibilities in the U.S. banking system, but not complete responsibility. A general description of the types of regulation and supervision involved in the U.S. banking system is given by the Federal Reserve:[66]
The Board also plays a major role in the supervision and regulation of the U.S. banking system. It has supervisory responsibilities for state-chartered banks[67] that are members of the Federal Reserve
System, bank holding companies (companies that control banks), the foreign activities of member banks, the U.S. activities of foreign banks, and Edge Act and "agreement corporations" (limitedpurpose institutions that engage in a foreign banking business). The Board and, under delegated authority, the Federal Reserve Banks, supervise approximately 900 state member banks and 5,000 bank holding companies. Other federal agencies also serve as the primary federal supervisors of commercial banks; the Office of the Comptroller of the Currency supervises national banks, and the Federal Deposit Insurance Corporation supervises state banks that are not members of the Federal Reserve System.
Some regulations issued by the Board apply to the entire banking industry, whereas others apply only to member banks, that is, state banks that have chosen to join the Federal Reserve System and national banks, which by law must be members of the System. The Board also issues regulations to carry out major federal laws governing consumer credit protection, such as the Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure Acts. Many of these consumer protection regulations apply to various lenders outside the banking industry as well as to banks. Members of the Board of Governors are in continual contact with other policy makers in government. They frequently testify before congressional committees on the economy, monetary policy, banking supervision and regulation, consumer credit protection, financial markets, and other matters.
The Board has regular contact with members of the President's Council of Economic Advisers and other key economic officials. The Chairman also meets from time to time with the President of the United States and has regular meetings with the Secretary of the Treasury. The Chairman has formal responsibilities in the international arena as well.
[edit] Preventing asset bubbles The board of directors of each Federal Reserve Bank District also has regulatory and supervisory responsibilities. For example, a member bank (private bank) is not permitted to give out too many loans to people who cannot pay them back. This is because too many defaults on loans will lead to a bank run. If the board of directors has judged that a member bank is performing or behaving poorly, it will report this to the Board of Governors. This policy is described in United States Code:[68]
Each Federal reserve bank shall keep itself informed of the general character and amount of the loans and investments of its member banks with a view to ascertaining whether undue use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purpose inconsistent with the maintenance of sound credit conditions; and, in determining whether to grant or refuse advances, rediscounts, or other credit accommodations, the Federal reserve bank shall give consideration to such information. The chairman of the Federal reserve bank shall report to the Board of Governors of the Federal Reserve System any such undue use of bank credit by any member bank, together with his recommendation. Whenever, in the judgment of the Board of Governors of the Federal Reserve System, any member bank is making such undue use of bank credit, the Board may, in its discretion, after reasonable notice and an opportunity for a hearing, suspend such bank from the use of the credit facilities of the Federal Reserve System and may terminate such suspension or may renew it from time to time.
The punishment for making false statements or reports that overvalue an asset is also stated in the U.S. Code:[69]
Whoever knowingly makes any false statement or report, or willfully overvalues any land, property or security, for the purpose of influencing in any way...shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.
These aspects of the Federal Reserve System are the parts intended to prevent or minimize speculative asset bubbles, which ultimately lead to severe market corrections. The recent bubbles and corrections in energies, grains, equity and debt products and real estate cast doubt on the efficacy of these controls.
[edit] National payments system

The Federal Reserve plays an important role in the U.S. payments system. The twelve Federal Reserve Banks provide banking services to depository institutions and to the federal government. For depository institutions, they maintain accounts and provide various payment services, including collecting checks, electronically transferring funds, and distributing and receiving currency and coin. For the federal government, the Reserve Banks act as fiscal agents, paying Treasury checks; processing electronic payments; and issuing, transferring, and redeeming U.S. government securities.[70] In passing the Depository Institutions Deregulation and Monetary Control Act of 1980, Congress reaffirmed its intention that the Federal Reserve should promote an efficient nationwide payments system. The act subjects all depository institutions, not just member commercial banks, to reserve requirements and grants them equal access to Reserve Bank payment services. It also encourages competition between the Reserve Banks and private-sector providers of payment services by requiring the Reserve Banks to charge fees for certain payments services listed in the act and to recover the costs of providing these services over the long run. The Federal Reserve plays a vital role in both the nation's retail and wholesale payments systems, providing a variety of financial services to depository institutions. Retail payments are generally for relatively small-dollar amounts and often involve a depository institution's retail clientsindividuals and smaller businesses. The Reserve Banks' retail services include distributing currency and coin, collecting checks, and electronically transferring funds through the automated clearinghouse system. By contrast, wholesale payments are generally for large-dollar amounts and often involve a depository institution's large corporate customers or counterparties, including other financial institutions. The Reserve Banks' wholesale services include electronically transferring funds through the Fedwire Funds Service and transferring securities issued by the U.S. government, its agencies, and certain other entities through the Fedwire Securities Service. Because of the large amounts of funds that move through the Reserve Banks every day, the System has policies and procedures to limit the risk to the Reserve Banks from a depository institution's failure to make or settle its payments. The Federal Reserve Banks began a multi-year restructuring of their check operations in 2003 as part of a longterm strategy to respond to the declining use of checks by consumers and businesses and the greater use of electronics in check processing. The Reserve Banks will have reduced the number of full-service check processing locations from 45 in 2003 to 4 by early 2011.[71]
[edit] Structure
Main article: Structure of the Federal Reserve System
Organization of the Federal Reserve System

The Federal Reserve System has both private and public components, and can make decisions without the permission of Congress or the President of the U.S.[14] The System does not require public funding, and derives its authority and purpose from the Federal Reserve Act passed by Congress in 1913. The four main components of the Federal Reserve System are (1) the Board of Governors, (2) the Federal Open Market Committee, (3) the twelve regional Federal Reserve Banks, and (4) the member banks throughout the country.
[edit] Board of Governors

Main article: Federal Reserve Board of Governors
The seven-member Board of Governors is a federal agency. It is charged with the overseeing of the 12 District Reserve Banks and setting national monetary policy. It also supervises and regulates the U.S. banking system in general.[72] Governors are appointed by the President of the United States and confirmed by the Senate for staggered 14-year terms.[49] One term begins every two years, on February 1 of even-numbered years, and members serving a full term cannot be renominated for a second term.[73] The Board is required to make an annual report of operations to the Speaker of the U.S. House of Representatives. The Chairman and Vice Chairman of the Board of Governors are appointed by the President from among the sitting Governors. They both serve a four year term and they can be renominated as many times as the President chooses, until their terms on the Board of Governors expire.[74]
[edit] List of members of the Board of Governors

The current members of the Board of Governors are as follows:[73]
Commissioner Ben Bernanke (Chairman) Janet Yellen (Vice Chairman)
Entered office[75] February 1, 2006
Term expires January 31, 2020 January 31, 2014 (as Chairman) January 31, 2024 October 4, 2014 (as Vice Chairman)
October 4, 2010
Elizabeth A. Duke Daniel Tarullo
August 5, 2008
January 31, 2012
January 28, 2009 January 31, 2022
Sarah Bloom Raskin October 4, 2010 January 31, 2016 Vacant Vacant January 31, 2014 January 31, 2018
[edit] Nominations
In late December, 2011, President Barack Obama nominated two individuals to fill the vacant seats on the board, Jeremy Stein, a Harvard University finance professor and a Democrat, and Jerome Powell, formerly of Dillon Read, Bankers Trust[76] and The Carlyle Group[77] and a Republican. Both candidates also have Treasury Department experience in the Obama and George H.W. Bush administrations respectively.[76] "Obama administration officials regrouped to identify Fed candidates after Peter Diamond, a Nobel Prizewinning economist, withdrew his nomination to the board in June [2011] in the face of Republican opposition. Richard Clarida, a potential nominee who was a Treasury official under George W. Bush, pulled out of consideration in August [2011]", one account of the December nominations noted.[78] The two other Obama nominees in 2011, Yellen and Raskin,[79] were confirmed in September.[80] One of the vacancies was created in 2011 with the resignation of Kevin Warsh, who took office in 2006 to fill the unexpired term ending January 31, 2018 and resigned his position effective March 31, 2011.[81][82]
[edit] Federal Open Market Committee

Main article: Federal Open Market Committee
The Federal Open Market Committee (FOMC) consists of 12 members, seven from the Board of Governors and 5 of the regional Federal Reserve Bank presidents. The FOMC oversees open market operations, the principal tool of national monetary policy. These operations affect the amount of Federal Reserve balances available to depository institutions, thereby influencing overall monetary and credit conditions. The FOMC also directs operations undertaken by the Federal Reserve in foreign exchange markets. The president of the Federal Reserve Bank of New York is a permanent member of the FOMC, while the rest of the bank presidents rotate at two- and three-year intervals. All Regional Reserve Bank presidents contribute to the committee's assessment of the economy and of policy options, but only the five presidents who are then members of the FOMC vote on policy decisions. The FOMC determines its own internal organization and, by tradition, elects the Chairman of the Board of Governors as its chairman and the president of the Federal Reserve Bank of New York as its vice chairman. It is informal policy within the FOMC for the Board of Governors and the New York Federal Reserve Bank president to vote with the Chairman of the FOMC; anyone who is not an expert on monetary policy traditionally votes with the chairman as well; and in any vote no more than two FOMC members can dissent.[83] Formal meetings typically are held eight times each year in Washington, D.C. Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion. The FOMC generally meets eight times a year in telephone consultations and other meetings are held when needed.[84]
[edit] Federal Reserve Banks

Main article: Federal Reserve Bank
Federal Reserve Districts

There are 12 Federal Reserve Banks located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Each reserve Bank is responsible for member banks located in its district. The size of each district was set based upon the population distribution of the United States when the Federal Reserve Act was passed. Each regional Bank has a president, who is the chief executive officer of their Bank. Each regional Reserve Bank's president is nominated by their Bank's board of directors, but the nomination is contingent upon approval by the Board of Governors. Presidents serve five year terms and may be reappointed.[85] Each regional Bank's board consists of nine members. Members are broken down into three classes: A, B, and C. There are three board members in each class. Class A members are chosen by the regional Bank's shareholders, and are intended to represent member banks' interests. Member banks are divided into three categories large, medium, and small. Each category elects one of the three class A board members. Class B board members are also nominated by the region's member banks, but class B board members are supposed to represent the interests of the public. Lastly, class C board members are nominated by the Board of Governors, and are also intended to represent the interests of the public.[86] A member bank is a private institution and owns stock in its regional Federal Reserve Bank. All nationally chartered banks hold stock in one of the Federal Reserve Banks. State chartered banks may choose to be members (and hold stock in their regional Federal Reserve bank), upon meeting certain standards. About 38% of U.S. banks are members of their regional Federal Reserve Bank.[87] The amount of stock a member bank must own is equal to 3% of its combined capital and surplus.[88][89] However, holding stock in a Federal Reserve bank is not like owning stock in a publicly traded company. These stocks cannot be sold or traded, and member banks do not control the Federal Reserve Bank as a result of owning this stock. The charter and organization of each Federal Reserve Bank is established by law and cannot be altered by the member banks. Member banks, do however, elect six of the nine members of the Federal Reserve Banks' boards of directors.[49][90] From the profits of the Regional Bank of which it is a member, a member bank receives a dividend equal to 6% of their purchased stock.[14] The remainder of the regional Federal Reserve Banks' profits is given over to the United States Treasury Department. In 2009, the Federal Reserve Banks distributed $1.4 billion in dividends to member banks and returned $47 billion to the U.S. Treasury.[91]
[edit] Legal status of regional Federal Reserve Banks

The Federal Reserve Banks have an intermediate legal status, with some features of private corporations and some features of public federal agencies. The United States has an interest in the Federal Reserve Banks as taxexempt federally-created instrumentalities whose profits belong to the federal government, but this interest is not proprietary.[92] In Lewis v. United States,[93] the United States Court of Appeals for the Ninth Circuit stated that: "The Reserve Banks are not federal instrumentalities for purposes of the FTCA [the Federal Tort Claims Act], but are independent, privately owned and locally controlled corporations." The opinion went on to say, however, that: "The Reserve Banks have properly been held to be federal instrumentalities for some purposes." Another relevant decision is Scott v. Federal Reserve Bank of Kansas City,[92] in which the distinction is made between Federal Reserve Banks, which are federally-created instrumentalities, and the Board of Governors, which is a federal agency. Regarding the structural relationship between the twelve Federal Reserve banks and the various commercial (member) banks:
[ . . . ] the "ownership" of the Reserve Banks by the commercial banks is symbolic; they do not exercise the proprietary control associated with the concept of ownership nor share, beyond the statutory dividend, in Reserve Bank "profits." [ . . .] Bank ownership and election at the base are therefore devoid of substantive significance, despite the superficial appearance of private bank control that the formal arrangement creates.[94]
[edit] Member banks

According to the web site for the Federal Reserve Bank of Richmond, "[m]ore than one-third of U.S. commercial banks are members of the Federal Reserve System. National banks must be members; state chartered banks may join by meeting certain requirements."[95]
[edit] Accountability
The Board of Governors of the Federal Reserve System, the Federal Reserve banks, and the individual member banks undergo regular audits by the GAO and an outside auditor. GAO audits are limited and do not cover "most of the Feds monetary policy actions or decisions, including discount window lending (direct loans to financial institutions), open-market operations and any other transactions made under the direction of the Federal Open Market Committee" ...[nor may the GAO audit] "dealings with foreign governments and other central banks." [96] Various statutory changes, including the Federal Reserve Transparency Act, have been proposed to broaden the scope of the audits. Bloomberg L.P. News brought a lawsuit against the Board of Governors of the Federal Reserve System to force the Board to reveal the identities of firms for which it has provided guarantees.[97] Bloomberg, L.P. won at the trial court level,[98] and as of early September 2010 the case is on appeal at the United States Court of Appeals for the Second Circuit.[99]
[edit] Monetary policy

Further information: Monetary policy of the United States
The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. What happens to money and credit affects interest rates (the cost of credit) and the performance of an economy. The Federal Reserve Act of 1913 gave the Federal Reserve authority to set monetary policy in the United States.[100][101]
[edit] Interbank lending is the basis of policy

The Federal Reserve sets monetary policy by influencing the Federal funds rate, which is the rate of interbank lending of excess reserves. The rate that banks charge each other for these loans is determined in the interbank market but the Federal Reserve influences this rate through the three "tools" of monetary policy described in the Tools section below. The Federal Funds rate is a short-term interest rate the FOMC focuses on directly. This rate ultimately affects the longer-term interest rates throughout the economy. A summary of the basis and implementation of monetary policy is stated by the Federal Reserve:
The Federal Reserve implements U.S. monetary policy by affecting conditions in the market for balances that depository institutions hold at the Federal Reserve Banks...By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives.[102]
This influences the economy through its effect on the quantity of reserves that banks use to make loans. Policy actions that add reserves to the banking system encourage lending at lower interest rates thus stimulating growth in money, credit, and the economy. Policy actions that absorb reserves work in the opposite direction. The Fed's task is to supply enough reserves to support an adequate amount of money and credit, avoiding the excesses that result in inflation and the shortages that stifle economic growth.[103]
[edit] Tools
There are three main tools of monetary policy that the Federal Reserve uses to influence the amount of reserves in private banks:[100]
Tool
Description Purchases and sales of U.S. Treasury and federal agency securities the Federal Reserve's principal tool for implementing monetary policy. The Federal Reserve's objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate (the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed), a process that was largely complete by the end of the decade.[104] The interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility the discount window.[105] The amount of funds that a depository institution must hold in reserve against specified deposit liabilities.[106]
Open market operations
Discount rate
Reserve requirements
[edit] Federal funds rate and open market operations

Further information: open market operations, money creation, and federal funds rate The effective federal funds rate charted over more than fifty years.
The Federal Reserve System implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. This rate is actually determined by the market and is not explicitly mandated by the Fed. The Fed therefore tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations. The Federal Reserve System usually adjusts the federal funds rate target by 0.25% or 0.50% at a time. Open market operations allow the Federal Reserve to increase or decrease the amount of money in the banking system as necessary to balance the Federal Reserve's dual mandates. Open market operations are done through the sale and purchase of United States Treasury security, sometimes called "Treasury bills" or more informally "T-bills" or "Treasuries". The Federal Reserve buys Treasury bills from its primary dealers. The purchase of these securities affects the federal funds rate, because primary dealers have accounts at depository institutions.[107] The Federal Reserve education website describes open market operations as follows:[101]
Open market operations involve the buying and selling of U.S. government securities (federal agency and mortgage-backed). The term 'open market' means that the Fed doesn't decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an 'open market' in which the various securities dealers that the Fed does business with the primary dealers compete on the basis of price. Open market operations are flexible and thus, the most frequently used tool of monetary policy.
Open market operations are the primary tool used to regulate the supply of bank reserves. This tool consists of Federal Reserve purchases and sales of financial instruments, usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises. Open market operations are carried out by the Domestic Trading Desk of the Federal Reserve Bank of New York under direction from the FOMC. The transactions are undertaken with primary dealers.
The Fed's goal in trading the securities is to affect the federal funds rate, the rate at which banks borrow reserves from each other. When the Fed wants to increase reserves, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer's bank. When the Fed wants to reduce reserves, it sells securities and collects from those accounts. Most days, the Fed does not want to increase or decrease reserves permanently so it usually engages in transactions reversed within a day or two. That means that a reserve injection today could be withdrawn tomorrow morning, only to be renewed at some level several hours later. These short-term transactions are called repurchase agreements (repos) the dealer sells the Fed a security and agrees to buy it back at a later date.
[edit] Repurchase agreements
Further information: repurchase agreement

To smooth temporary or cyclical changes in the money supply, the desk engages in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. On the day of the transaction, the Fed deposits money in a primary dealer's reserve account, and receives the promised securities as collateral. When the transaction matures, the process unwinds: the Fed returns the collateral and charges the primary dealer's reserve account for the principal and accrued interest. The term of the repo (the time between settlement and maturity) can vary from 1 day (called an overnight repo) to 65 days.[108]
[edit] Discount rate

Further information: discount window
The Federal Reserve System also directly sets the "discount rate", which is the interest rate for "discount window lending", overnight loans that member banks borrow directly from the Fed. This rate is generally set at a rate close to 100 basis points above the target federal funds rate. The idea is to encourage banks to seek alternative funding before using the "discount rate" option.[109] The equivalent operation by the European Central Bank is referred to as the "marginal lending facility".[110] Both the discount rate and the federal funds rate influence the prime rate, which is usually about 3 percent higher than the federal funds rate.
[edit] Reserve requirements
Another instrument of monetary policy adjustment employed by the Federal Reserve System is the fractional reserve requirement, also known as the required reserve ratio.[111] The required reserve ratio sets the balance that the Federal Reserve System requires a depository institution to hold in the Federal Reserve Banks,[102] which depository institutions trade in the federal funds market discussed above.[112] The required reserve ratio is set by the Board of Governors of the Federal Reserve System.[113] The reserve requirements have changed over time and some of the history of these changes is published by the Federal Reserve.[114]
Reserve Requirements in the U.S. Federal Reserve System[106] Requirement Liability Type Percentage of liabilities Effective date Net transaction accounts $0 to $10.7 million More than $10.7 million to $58.8 million More than $58.8 million Nonpersonal time deposits Eurocurrency liabilities 0 3 10 0 0 12/30/10 12/30/10 12/30/10 12/27/90 12/27/90
As a response to the financial crisis of 2008, the Federal Reserve now makes interest payments on depository institutions' required and excess reserve balances. The payment of interest on excess reserves gives the central bank greater opportunity to address credit market conditions while maintaining the federal funds rate close to the target rate set by the FOMC.[115]
[edit] New facilities

In order to address problems related to the subprime mortgage crisis and United States housing bubble, several new tools have been created. The first new tool, called the Term Auction Facility, was added on December 12, 2007. It was first announced as a temporary tool[116] but there have been suggestions that this new tool may remain in place for a prolonged period of time.[117] Creation of the second new tool, called the Term Securities Lending Facility, was announced on March 11, 2008.[118] The main difference between these two facilities is that the Term Auction Facility is used to inject cash into the banking system whereas the Term Securities Lending Facility is used to inject treasury securities into the banking system.[119] Creation of the third tool, called the Primary Dealer Credit Facility (PDCF), was announced on March 16, 2008.[120] The PDCF was a fundamental change in Federal Reserve policy because now the Fed is able to lend directly to primary dealers, which was previously against Fed policy.[121] The differences between these 3 new facilities is described by the Federal Reserve:[122]
The Term Auction Facility program offers term funding to depository institutions via a bi-weekly auction, for fixed amounts of credit. The Term Securities Lending Facility will be an auction for a fixed amount of lending of Treasury general collateral in exchange for OMO-eligible and AAA/Aaa rated private-label residential mortgage-backed securities. The Primary Dealer Credit
Facility now allows eligible primary dealers to borrow at the existing Discount Rate for up to 120 days.
Some of the measures taken by the Federal Reserve to address this mortgage crisis have not been used since The Great Depression.[123] The Federal Reserve gives a brief summary of these new facilities:[124]
As the economy has slowed in the last nine months and credit markets have become unstable, the Federal Reserve has taken a number of steps to help address the situation. These steps have included the use of traditional monetary policy tools at the macroeconomic level as well as measures at the level of specific markets to provide additional liquidity. The Federal Reserve's response has continued to evolve since pressure on credit markets began to surface last summer, but all these measures derive from the Fed's traditional open market operations and discount window tools by extending the term of transactions, the type of collateral, or eligible borrowers.
A fourth facility, the Term Deposit Facility, was announced December 9, 2009, and approved April 30, 2010, with an effective date of Jun 4, 2010.[125] The Term Deposit Facility allows Reserve Banks to offer term deposits to institutions that are eligible to receive earnings on their balances at Reserve Banks. Term deposits are intended to facilitate the implementation of monetary policy by providing a tool by which the Federal Reserve can manage the aggregate quantity of reserve balances held by depository institutions. Funds placed in term deposits are removed from the accounts of participating institutions for the life of the term deposit and thus drain reserve balances from the banking system. [edit] Term auction facility
Further information: Term auction facility

The Term Auction Facility is a program in which the Federal Reserve auctions term funds to depository institutions.[116] The creation of this facility was announced by the Federal Reserve on December 12, 2007 and was done in conjunction with the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank to address elevated pressures in short-term funding markets.[126] The reason it was created is because banks were not lending funds to one another and banks in need of funds were refusing to go to the discount window. Banks were not lending money to each other because there was a fear that the loans would not be paid back. Banks refused to go to the discount window because it is usually associated with the stigma of bank failure.[127][128][129] [130] Under the Term Auction Facility, the identity of the banks in need of funds is protected in order to avoid the stigma of bank failure.[131] Foreign exchange swap lines with the European Central Bank and Swiss National Bank were opened so the banks in Europe could have access to U.S. dollars.[131] Federal Reserve Chairman Ben Bernanke briefly described this facility to the U.S. House of Representatives on January 17, 2008:
the Federal Reserve recently unveiled a term auction facility, or TAF, through which prespecified amounts of discount window credit can be auctioned to eligible borrowers. The goal of the TAF is to reduce the incentive for banks to hoard cash and increase their willingness to provide credit to households and firms...TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.[132]
It is also described in the Term Auction Facility FAQ[116]
The TAF is a credit facility that allows a depository institution to place a bid for an advance from its local Federal Reserve Bank at an interest rate that is determined as the result of an auction. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress. In short, the TAF will auction term funds of approximately one-month maturity. All depository institutions that are judged to be in sound financial condition by their local Reserve Bank and that are eligible to borrow at the discount window are also eligible to participate in TAF auctions. All TAF credit must be fully collateralized. Depositories may pledge the broad range of collateral that is accepted for other Federal Reserve lending programs to secure TAF credit. The same collateral values and margins applicable for other Federal Reserve lending programs will also apply for the TAF.
[edit] Term securities lending facility The Term Securities Lending Facility is a 28-day facility that will offer Treasury general collateral to the Federal Reserve Bank of New York's primary dealers in exchange for other program-eligible collateral. It is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally.[133] Like the Term Auction Facility, the TSLF was done in conjunction with the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank. The resource allows dealers to switch debt that is less liquid for U.S. government securities that are easily tradable. It is anticipated by Federal Reserve officials that the primary dealers, which include Goldman Sachs Group. Inc., J.P. Morgan Chase, and Morgan Stanley, will lend the Treasuries on to other firms in return for cash. That will help the dealers finance their balance sheets.[citation needed] The currency swap lines with the European Central Bank and Swiss National Bank were increased. [edit] Primary dealer credit facility The Primary Dealer Credit Facility (PDCF) is an overnight loan facility that will provide funding to primary dealers in exchange for a specified range of eligible collateral and is intended to foster the functioning of financial markets more generally.[122] This new facility marks a fundamental change in Federal Reserve policy because now primary dealers can borrow directly from the Fed when this previously was not permitted. [edit] Interest on reserves As of October 2008, the Federal Reserve banks will pay interest on reserve balances (required & excess) held by depository institutions. The rate is set at the lowest federal funds rate during the reserve maintenance period of an institution, less 75bp.[134] As of October 23, 2008, the Fed has lowered the spread to a mere 35 bp.[135] [edit] Term deposit facility The Term Deposit Facility is a program through which the Federal Reserve Banks will offer interestbearing term deposits to eligible institutions. By removing "excess deposits" from participating banks, the overall level of reserves available for lending is reduced, which should result in increased market interest rates, acting as a brake on economic activity and inflation. The Federal Reserve has stated that:
Term deposits will be one of several tools that the Federal Reserve could employ to drain reserves when policymakers judge that it is appropriate to begin moving to a less
accommodative stance of monetary policy. The development of the TDF is a matter of prudent planning and has no implication for the near-term conduct of monetary policy.[136]
The Federal Reserve initially authorized up to five "small-value offerings are designed to ensure the effectiveness of TDF operations and to provide eligible institutions with an opportunity to gain familiarity with term deposit procedures."[137] After three of the offering auctions were successfully completed, it was announced that small-value auctions would continue on an on-going basis.[138] The Term Deposit Facility is essentially a tool available to reverse the efforts that have been employed to provide liquidity to the financial markets and to reduce the amount of capital available to the economy. As stated in Bloomberg News:
Policy makers led by Chairman Ben S. Bernanke are preparing for the day when they will have to start siphoning off more than $1 trillion in excess reserves from the banking system to contain inflation. The Fed is charting an eventual return to normal monetary policy, even as a weakening near-term outlook has raised the possibility it may expand its balance sheet.[139]
Chairman Ben S. Bernanke, testifying before House Committee on Financial Services, described the Term Deposit Facility and other facilities to Congress in the following terms:
Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on balances that banks hold at the Federal Reserve Banks. By increasing the interest rate on banks' reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in higher longer-term interest rates and in tighter financial conditions more generally....
As an additional means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. A proposal describing a term deposit facility was recently published in the Federal Register, and the Federal Reserve is finalizing a revised proposal in light of the public comments that have been received. After a revised proposal is reviewed by the Board, we expect to be able to conduct test transactions this spring and to have the facility available if necessary thereafter. The use of reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so. When these tools are used to drain reserves from the banking system, they do so by replacing bank reserves with other liabilities; the asset side and the overall size of the Federal Reserve's balance sheet remain unchanged. If necessary, as a means of applying monetary restraint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have the effect of reducing the size of the Federal Reserve's balance sheet as well as further reducing the quantity of reserves in the banking system. Restoring the size and composition of the balance sheet to a more normal configuration is a longer-term objective of our policies. In any case, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve's dual mandate of maximum employment and price stability.
In sum, in response to severe threats to our economy, the Federal Reserve created a series of special lending facilities to stabilize the financial system and encourage the resumption of private credit flows to American families and businesses. As market conditions and the
economic outlook have improved, these programs have been terminated or are being phased out. The Federal Reserve also promoted economic recovery through sharp reductions in its target for the federal funds rate and through large-scale purchases of securities. The economy continues to require the support of accommodative monetary policies. However, we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus. We have full confidence that, when the time comes, we will be ready to do so.[140]
[edit] Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility The Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCPMMMFLF) was also called the AMLF. The Facility began operations on September 22, 2008, and was closed on February 1, 2010.[141] All U.S. depository institutions, bank holding companies (parent companies or U.S. broker-dealer affiliates), or U.S. branches and agencies of foreign banks were eligible to borrow under this facility pursuant to the discretion of the FRBB. Collateral eligible for pledge under the Facility was required to meet the following criteria: y y
y y
was purchased by Borrower on or after September 19, 2008 from a registered investment company that held itself out as a money market mutual fund; was purchased by Borrower at the Fund's acquisition cost as adjusted for amortization of premium or accretion of discount on the ABCP through the date of its purchase by Borrower; was rated at the time pledged to FRBB, not lower than A1, F1, or P1 by at least two major rating agencies or, if rated by only one major rating agency, the ABCP must have been rated within the top rating category by that agency; was issued by an entity organized under the laws of the United States or a political subdivision thereof under a program that was in existence on September 18, 2008; and had a stated maturity that did not exceed 120 days if the Borrower was a bank or 270 days for non-bank Borrowers.
[edit] Commercial Paper Funding Facility The Commercial Paper Funding Facility (CPFF): on October 7, 2008 the Federal Reserve further expanded the collateral it will loan against, to include commercial paper. The action made the Fed a crucial source of credit for non-financial businesses in addition to commercial banks and investment firms. Fed officials said they'll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify. There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of October 1, 2008, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion.[142] This program lent out a total $738 billion before it was closed. Forty-five out of 81 of the companies participating in this program were foreign firms. Research shows that Troubled Asset Relief Program (TARP) recipients were twice as likely to participate in the program than other commercial paper issuers who did not take advantage of the TARP bailout. The Fed incurred no losses from the CPFF.[143]
[edit] Quantitative policy
A little-used tool of the Federal Reserve is the quantitative policy. With that the Federal Reserve actually buys back corporate bonds and mortgage backed securities held by banks or other financial institutions. This in effect puts money back into the financial institutions and allows them to make loans and conduct normal business. The Federal Reserve Board used this policy in the early 1990s when the U.S. economy experienced the savings and loan crisis.[citation needed] The bursting of the United States housing bubble prompted the Fed to buy mortgage-backed securities for the first time in November 2008. Over six weeks, a total of $1.25 trillion were purchased in order stabilize the housing market, about one-fifth of all U.S. government-backed mortgages.[144]
[edit] Measurement of economic variables

The Federal Reserve records and publishes large amounts of data. A few websites where data is published are at the Board of Governors Economic Data and Research page,[145] the Board of Governors statistical releases and historical data page,[146] and at the St. Louis Fed's FRED (Federal Reserve Economic Data) page.[147] The Federal Open Market Committee (FOMC) examines many economic indicators prior to determining monetary policy.[148] Some criticism involves economic data compiled by the Fed. The Fed sponsors much of the monetary economics research in the U.S., and Lawrence H. White objects that this makes it less likely for researchers to publish findings challenging the status quo.[149]
[edit] Net worth of households and nonprofit organizations
The net worth of households and nonprofit organizations in the United States is published by the Federal Reserve in a report titled, Flow of Funds.[150] At the end of fiscal year 2008, this value was $51.5 trillion.
[edit] Money supply

Further information: Money supply Components the U.S. money supply (currency, M1 and M2), 1960 2010
The most common measures are named M0 (narrowest), M1, M2, and M3. In the United States they are defined by the Federal Reserve as follows:
Measure M0
Definition The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency. M0 + those portions of M0 held as reserves or vault cash + the amount in demand accounts ("checking" or "current" accounts). M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000). M2 + all other CDs, deposits of eurodollars and repurchase agreements.
M1
M2 M3
The Federal Reserve stopped publishing M3 statistics in March 2006, saying that the data cost a lot to collect but did not provide significantly useful information.[151] The other three money supply measures continue to be provided in detail.
[edit] Personal consumption expenditures price index

Further information: Personal consumption expenditures price index
The Personal consumption expenditures price index, also referred to as simply the PCE price index, is used as one measure of the value of money. It is a United States-wide indicator of the average increase in prices for all domestic personal consumption. Using a variety of data including U.S. Consumer Price Index and Producer Price Index prices, it is derived from the largest component of the Gross Domestic Product in the BEA's National Income and Product Accounts, personal consumption expenditures. One of the Fed's main roles is to maintain price stability, which means that the Fed's ability to keep a low inflation rate is a long-term measure of the their success.[152] Although the Fed is not required to maintain inflation within a specific range, their long run target for the growth of the PCE price index is between 1.5 and 2 percent.[153] There has been debate among policy makers as to whether or not the Federal Reserve should have a specific inflation targeting policy.[154][155][156]
[edit] Inflation and the economy

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There are two types of inflation that are closely tied to each other. Monetary inflation is an increase in the money supply. Price inflation is a sustained increase in the general level of prices, which is equivalent to a decline in the value or purchasing power of money. If the supply of money and credit increases too rapidly over many months (monetary inflation), the result will usually be price inflation. Price inflation does not always increase in direct proportion to monetary inflation; it is also affected by the velocity of money and other factors. With price inflation, a dollar buys less and less over time.[101] The effects of monetary and price inflation include:[101]
y y y y y y y y y
Price inflation makes workers worse off if their incomes don't rise as rapidly as prices. Pensioners living on a fixed income are worse off if their savings do not increase more rapidly than prices. Lenders lose because they will be repaid with dollars that aren't worth as much. Savers lose because the dollar they save today will not buy as much when they are ready to spend it. Debtors win because the dollar they borrow today will be repaid with dollars that aren't worth as much. Businesses and people will find it harder to plan and therefore may decrease investment in future projects. Owners of financial assets suffer. Interest rate-sensitive industries, like mortgage companies, suffer as monetary inflation drives up long-term interest rates and Federal Reserve tightening raises short-term rates. Developed-market currencies become weaker against emerging markets.[157]
In his 1995 book The Case Against the Fed, economist Murray N. Rothbard argues that price inflation is caused only by an increase in the money supply, and only banks increase the money supply, then banks, including the Federal Reserve, are the only source of inflation. Adherents of the Austrian School of economic theory blame the economic crisis in the late 2000s[158][not in citation given] on the Federal Reserve's policy, particularly under the leadership of Alan Greenspan, of credit expansion through historically low interest rates starting in 2001, which they claim enabled the United States housing bubble. Most mainstream economists favor a low, steady rate of inflation.[159] Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy.[160] The task of keeping the rate of inflation low and stable is usually given to monetary authorities.
[edit] Unemployment rate

United States unemployment rates 1975 2010 showing variance between the fifty states Further information: Unemployment_rate#United_States_Bureau_of_Labor_Statistics and List of U.S. states by unemployment rate
One of the stated goals of monetary policy is maximum employment. The unemployment rate statistics are collected by the Bureau of Labor Statistics, and like the PCE price index are used as a barometer of the nation's economic health, and thus as a measure of the success of an administration's economic policies. Since 1980, both parties have made progressive changes in the basis for calculating unemployment, so that the numbers now quoted cannot be compared directly to the corresponding rates from earlier administrations, or to the rest of the world.[161]
[edit] Budget
Further information: seignorage
The Federal Reserve is self-funded. The vast majority (90%+) of Fed revenues come from open market operations, specifically the interest on the portfolio of Treasury securities as well as "capital gains/losses" that may arise from the buying/selling of the securities and their derivatives as part of Open Market
Operations. The balance of revenues come from sales of financial services (check and electronic payment processing) and discount window loans.[162] The Board of Governors (Federal Reserve Board) creates a budget report once per year for Congress. There are two reports with budget information. The one that lists the complete balance statements with income and expenses as well as the net profit or loss is the large report simply titled, "Annual Report". It also includes data about employment throughout the system. The other report, which explains in more detail the expenses of the different aspects of the whole system, is called "Annual Report: Budget Review". These are comprehensive reports with many details and can be found at the Board of Governors' website under the section "Reports to Congress"[163]
[edit] Net worth

[edit] Balance sheet
One of the keys to understanding the Federal Reserve is the Federal Reserve balance sheet (or balance statement). In accordance with Section 11 of the Federal Reserve Act, the Board of Governors of the Federal Reserve System publishes once each week the "Consolidated Statement of Condition of All Federal Reserve Banks" showing the condition of each Federal Reserve bank and a consolidated statement for all Federal Reserve banks. The Board of Governors requires that excess earnings of the Reserve Banks be transferred to the Treasury as interest on Federal Reserve notes.[164][165] Below is the balance sheet as of July 6, 2011 (in billions of dollars): NOTE: The Fed balance sheet shown in this article has assets, liabilities and net equity that do not add up correctly. The Fed balance sheet is missing the item "Reserve Balances with Federal Reserve Banks" which would make the balance sheet balance.
ASSETS: Gold Stock Special Drawing Rights Certificate Acct. Treasury Currency Outstanding (Coin) Securities Held Outright U.S. Treasury Securities Bills Notes and Bonds, nominal Notes and Bonds, inflation11.04
LIABILITIES: Currency in Circulation 5.20 Reverse repurchase agreements Deposits Term Deposits U.S. Treasury, general account U.S. Treasury, supplementary financing
CAPITAL (AKA Net Equity) Capital Paid In Surplus 68.09 Other Capital 91.12 0 Total Capital 4.16 56.78
1031.30
26.71
25.91
43.98
2647.94
1623.78 18.42 1530.79
MEMO (off-balance-sheet
items)
76.56 Marketable securities held in custody for foreign
3445.42
65.52
indexed Inflation Compensation Federal Agency Debt Securities Mortgage-Backed Securities Repurchase Agreements Loans Primary Credit Secondary Credit Seasonal Credit Credit Extended to AIG Inc. Term AssetBacked Securities Loan Facility Other Credit Extended Commercial Paper Funding Facility LLC Net portfolio holdings of Maiden Lane LLC, Maiden Lane II LLC, and Maiden Lane III LLC Preferred Interest in AIG LifeInsurance Subsidiaries Net Holdings of 9.04
account Foreign official Service Related Other Deposits Funds from AIG, held as agent Other Liabilities Total liabilities 0.17 2.53 6.85
official and international accounts U.S. Treasury Securities Federal Agency Securities Securities lent to dealers Overnight
115.30
2708
908.85
0 12.74 12 0 53
737.31
73.06 1263.73 30.46
30.46 0
0 Term 12.67
60.32
0.75
TALF LLC Float Central Bank Liquidity Swaps Other Assets Total Assets -1.05 0 133.56 2914.51
Total combined assets for all 12 Federal Reserve Banks.
Total combined liabilities for all 12 Federal Reserve Banks.

Analyzing the Federal Reserve's balance sheet reveals a number of facts: y
The Fed has over $11 billion in gold stock (certificates), which represents the Fed's financial interest in the statutory-determined value of gold turned over to the U.S. Treasury in accordance with the Gold Reserve Act on January 30, 1934.[166] The value reported here is based on a statutory valuation of $42 2/9 per fine troy ounce. As of March 2009, the market value of that gold is around $247.8 billion. The Fed holds more than $1.8 billion in coinage, not as a liability but as an asset. The Treasury Department is actually in charge of creating coins and U.S. Notes. The Fed then buys coinage from the Treasury by increasing the liability assigned to the Treasury's account. The Fed holds at least $534 billion of the national debt. The "securities held outright" value used to directly represent the Fed's share of the national debt, but after the creation of new facilities in the winter of 2007 2008, this number has been reduced and the difference is shown with values from some of the new facilities.
y y
The Fed has no assets from overnight repurchase agreements. Repurchase agreements are the primary asset of choice for the Fed in dealing in the open market. Repo assets are bought by creating depository institution liabilities and directed to the bank the primary dealer uses when they sell into the open market. The more than $1 trillion in Federal Reserve Note liabilities represents nearly the total value of all dollar bills in existence; over $176 billion is held by the Fed (not in circulation); and the "net" figure of $863 billion represents the total face value of Federal Reserve Notes in circulation. The $916 billion in deposit liabilities of depository institutions shows that dollar bills are not the only source of government money. Banks can swap deposit liabilities of the Fed for Federal Reserve Notes back and forth as needed to match demand from customers, and the Fed can have the Bureau of Engraving and Printing create the paper bills as needed to match demand from banks for paper money. The amount of money printed has no relation to the growth of the monetary base (M0). The $93.5 billion in Treasury liabilities shows that the Treasury Department does not use private banks but rather uses the Fed directly (the lone exception to this rule is Treasury Tax and Loan because the government worries that pulling too much money out of the private banking system during tax time could be disruptive).[citation needed] The $1.6 billion foreign liability represents the amount of foreign central bank deposits with the Federal Reserve. The $9.7 billion in 'other liabilities and accrued dividends' represents partly the amount of money owed so far in the year to member banks for the 6% dividend on the 3% of their net capital they are required to contribute in exchange for nonvoting stock their regional Reserve Bank in order to become a member. Member banks are also subscribed for an additional 3% of their net capital, which can be called at the Federal Reserve's discretion. All nationally chartered banks must be members of a Federal Reserve Bank, and statechartered banks have the choice to become members or not. Total capital represents the profit the Fed has earned, which comes mostly from assets they purchase with the deposit and note liabilities they create. Excess capital is then turned over to the Treasury Department and Congress to be included into the Federal Budget as "Miscellaneous Revenue".
In addition, the balance sheet also indicates which assets are held as collateral against Federal Reserve Notes.
Federal Reserve Notes and Collateral Federal Reserve Notes Outstanding Less: Notes held by F.R. Banks Federal Reserve notes to be collateralized Collateral held against Federal Reserve notes 1128.63 200.90 927.73 927.73
Gold certificate account Special drawing rights certificate account U.S. Treasury, agency debt, and mortgage-backed securities pledged Other assets pledged
11.04 5.20 911.50 0
[edit]
f SFlow of funds
From Wikipedia, the free encyclopedia (Redirected from Flow of Funds) Jump to: navigation, search
Flow of funds accounts are a system of interrelated balance sheets for a nation, calculated periodically. There are two types of balance sheets, those showing y y
The aggregate assets and liabilities for financial and nonfinancial sectors, and What sectors issue and hold financial assets (instruments) of a given type.
The sectors and instruments are listed below. These balance sheets measure levels of assets and liabilities. From each balance sheet a corresponding flows statement can be derived by subtracting the levels data for the preceding period from the data for the current period. (In the statistical analysis of time series, this operation is known as "first differencing.") The change in a level item between two adjacent periods is known as a "fund flow"; hence the name for these accounts.
Financial assets of broad sectors of USA economy, 1945 2009. Source: Federal Reserve System, flow of funds data. Liabilites of broad sectors of USA economy, 1945 2009. Source: Federal Reserve System, flow of funds data. Financial net worth of broad sectors of USA economy, 1945 2009. Source: Federal Reserve System, flow of funds data.
Contents
[hide]
y
1 Main topics covered in the FF accounts
y y
2 Organization of the flow of funds accounts of the US o 2.1 Broad structure of the economy o 2.2 Firms o 2.3 Instruments (asset types) 3 See also 4 External links
[edit] Main topics covered in the FF accounts

y y y y
Total debt broken down by issuer and holder Connection to national accounts, and derivation of measures of aggregate saving Fund flows originating in each sector Levels: o Assets and liabilities for broad sectors and for specific financial sectors o Sectors issuing and holding instruments of a given class Miscellaneous aggregate financial data
[edit] Organization of the flow of funds accounts of the US

The flow of funds (FF) accounts of the United States are prepared by the Flow of Funds section of the Board of Governors of the Federal Reserve System, and published quarterly in a publication called Release Z.1. The historical FF data, starting in 1952:I (quarterly) or yearend 1945 (annual), are available on the Fed's website. The flow of funds accounts follow naturally from double-entry bookkeeping; every financial asset is also a liability of some domestic or foreign human entity. A fundamental fact about any economic sector is its balance sheet, a breakdown of its physical and financial assets, and of its liabilities. The only physical assets noted in the FF accounts are those of private nonfinancial sectors.
[edit] Broad structure of the economy

Nonfinancial sectors: y y
Households and nonprofit organizations Nonfinancial firms o Corporations, farms excepted o Unincorporated firms, farms excepted o Farms Government o Federal o State & local Rest of the world (foreign sector)
Financial sector: y y
Firms Instruments
[edit] Firms
y y
y y y
y y y y y y y y y y
Federal Reserve System Depository institutions: o US chartered commercial banks o Branch offices of foreign banks o Bank holding companies o Banks in US possessions o Thrifts o Credit unions Property-casualty insurance Life insurance Pension funds: o Federal government o State & local government o Private employers Money market mutual funds Other open-ended mutual funds Closed end & exchange traded funds Government-sponsored enterprises (GSEs) Federal mortgage pools Issuers of asset-backed securities Finance companies Real estate investment trusts Security brokers & dealers Funding corporations
[edit] Instruments (asset types)

y y y y y y y y y y y y y y y y
Official reserve assets Treasury currency and SDRs American-owned deposits in other countries Net interbank transactions Checkable deposits & Fed currency Time & savings deposits Money market mutual fund shares Federal funds & Repos Privately issued short-term paper Treasury securities Agency & GSE-backed securities Municipal bonds & related debt Corporate & foreign bonds Corporate equities Mutual fund shares Mortgages: o Home (single family residence) o Multifamily residence
y y y y y y y y y
Commercial Farm Consumer credit Other bank loans Trade credit Security credit Other loans & advances Reserves of life insurance companies & pension funds Taxes payable Proprietors' equity in unincorporated firms Miscellaneous financial assets
o o
[edit] See also

EBImortgage loan is a loan secured by real property through the use of a mortgage note which evidences the
existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan. However, the word mortgage alone, in everyday usage, is most often used to mean mortgage loan. The word mortgage is a Law French term meaning "death contract," meaning that the pledge ends (dies) when either the obligation is fulfilled or the property is taken through foreclosure.[1] A home buyer or builder can obtain financing (a loan) either to purchase or secure against the property from a financial institution, such as a bank, either directly or indirectly through intermediaries. Features of mortgage loans such as the size of the loan, maturity of the loan, interest rate, method of paying off the loan, and other characteristics can vary considerably. In many jurisdictions, though not all (Bali, Indonesia being one exception[2]), it is normal for home purchases to be funded by a mortgage loan. Few individuals have enough savings or liquid funds to enable them to purchase property outright. In countries where the demand for home ownership is highest, strong domestic markets have developed. A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.[1]
dvantages
Mutual funds have advantages compared to direct investing in individual securities.[3] These include: y y y y y y y
Increased diversification Daily liquidity Professional investment management Ability to participate in investments that may be available only to larger investors Service and convenience Government oversight Ease of comparison
[edit] Disadvantages
Mutual funds have disadvantages as well, which include[4]: y
Fees
y y y
Less control over timing of recognition of gains Less predictable income No opportunity to customize
[edit] History [edit] Trade credit

The word credit is used in commercial trade in the term "trade credit" to refer to the approval for delayed payments for purchased goods. Credit is sometimes not granted to a person who has financial instability or difficulty. Companies frequently offer credit to their customers as part of the terms of a purchase agreement. Organizations that offer credit to their customers frequently employ a credit manager.
[edit] Consumer credit

Consumer debt can be defined as money, goods or services provided to an individual in lieu of payment. Common forms of consumer credit include credit cards, store cards, motor (auto) finance, personal loans (installment loans), consumer lines of credit, retail loans (retail installment loans) and mortgages. This is a broad definition of consumer credit and corresponds with the Bank of England's definition of "Lending to individuals". Given the size and nature of the mortgage market, many observers classify mortgage lending as a separate category of personal borrowing, and consequently residential mortgages are excluded from some definitions of consumer credit - such as the one adopted by the Federal Reserve in the US. The cost of credit is the additional amount, over and above the amount borrowed, that the borrower has to pay. It includes interest, arrangement fees and any other charges. Some costs are mandatory, required by the lender as an integral part of the credit agreement. Other costs, such as those for credit insurance, may be optional. The borrower chooses whether or not they are included as part of the agreement. Interest and other charges are presented in a variety of different ways, but under many legislative regimes lenders are required to quote all mandatory charges in the form of an annual percentage rate (APR). The goal of the APR calculation is to promote truth in lending, to give potential borrowers a clear measure of the true cost of borrowing and to allow a comparison to be made between competing products. The APR is derived from the pattern of advances and repayments made during the agreement. Optional charges are not included in the APR calculation. So if there is a tick box on an application form asking if the consumer ife insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money (the "benefits") upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger payment. The policy holder typically pays a premium, either regularly or as a lump sum. Other expenses (such as funeral expenses) are also sometimes included in the premium; however, in Australia the predominant form simply specifies a lump sum to be paid on the policy holder's death. The advantage for the policy owner is "peace of mind", in knowing that the death of the insured person will not result in financial hardship for loved ones. Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; common examples are claims relating to suicide, fraud, war, riot and civil commotion. Life-based contracts tend to fall into two major categories: y
Protection policies designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form of this design is term insurance.
Investment policies where the main objective is to facilitate the growth of capital by regular or single premiums. Common forms (in the US) are whole life, universal life and variable life policies.
Contents
[hide] Table 1: Total Assets of the Major Financial Institutions 2009(a)
Rs. bn Central Bank of Sri Lanka Banking Sector 821.9 3835.2 2506.6 506.7 315.7 185.3 124.5 5.9 257.4 11.8 99.8 6.4 10.6 1.5 0.2 27.1 1205.5 181.0 772.0 107.3 121.9 23.3 5613.8 2010(b) Rs. bn % share of Total 985.4 14.7 3549.4 2969.3 578.5 400.9 53.0 44.4 8.6 6.0 2010(b) Sept. 2011 (b) % share Rs. % share Rs. bn % Share of of Total bn of Total Total 14.6 985.4 14.7 1,158.4 15.6 53.7 3549.4 53.0 4014.8 54.0 44.7 2969.3 44.4 3387.6 45.6 9.0 578.5 8.6 627.2 8.4 5.6 400.9 6.0 360.7 4.9 3.3 2.2 0.1 4.6 2.0 1.8 0.1 0.2 0.0 0.0 0.5 21.5 3.2 13.8 1.9 2.2 0.4 100.0 233.6 3.5 160.6 2.4 6.7 0.1 354.8 5.3 154.1 2.3 125.8 1.9 13.2 0.2 23.0 0.3 1.6 0.0 0.1 0.0 37.0 0.6 1401.5 21.0 221.7 3.3 902.0 13.5 125.9 1.9 126.2 1.9 25.7 0.4 6690.4 100.0 Sept. 2011 (b) Rs. bn 1,158.4 4014.8 3387.6 627.2 360.7 301.0 52.7 7.0 372.6 154.7 149.6 14.6 27.8 1.9 0.2 23.8 1516.4 249.8 987.0 137.3 115.1 27.2 7422.6 4.1 0.7 0.1 5.0 2.1 2.0 0.2 0.4 0.0 0.0 0.3 20.5 3.4 13.3 1.8 1.6 0.4 100.0
Licensed Commercial Banks Licensed Specialised Banks

Other Deposit Taking Financial Institutions
Registered Finance Companies Co-operative Rural Banks

Thrift and Credit Co-op. Societies Other Specialised Financial Institutions
Specialised Leasing Companies Primary Dealers Stock Brokers Unit Trusts Venture Capital Companies Credit Rating Agencies Market Intermediaries
Contractual Savings Institutions
Insurance Companies Employees Provident Fund Employees Trust Fund Private Provident Funds Public Service Provident Fund
Total
Table 1: Total Assets of the Major Financial Institutions 2009(a)

Rs. bn Central Bank of Sri Lanka Banking Sector 821.9 3835.2 2506.6 506.7 315.7 % share of Total 14.6 53.7 44.7 9.0 5.6
% Share of Total 15.6 54.0 45.6 8.4 4.9
Licensed Commercial Banks Licensed Specialised Banks

Other Deposit Taking Financial Institutions
Registered Finance Companies Co-operative Rural Banks

Thrift and Credit Coop. Societies Other Specialised Financial Institutions
185.3 124.5 5.9 257.4 11.8 99.8 6.4 10.6 1.5 0.2 27.1 1205.5 181.0 772.0 107.3 121.9 23.3
3.3 2.2 0.1 4.6 2.0 1.8 0.1 0.2 0.0 0.0 0.5 21.5 3.2 13.8 1.9 2.2 0.4
233.6 160.6 6.7 354.8 154.1 125.8 13.2 23.0 1.6 0.1 37.0 1401.5 221.7 902.0 125.9 126.2 25.7
3.5 2.4 0.1 5.3 2.3 1.9 0.2 0.3 0.0 0.0 0.6 21.0 3.3 13.5 1.9 1.9 0.4
301.0 52.7 7.0 372.6 154.7 149.6 14.6 27.8 1.9 0.2 23.8 1516.4 249.8 987.0 137.3 115.1 27.2
4.1 0.7 0.1 5.0 2.1 2.0 0.2 0.4 0.0 0.0 0.3 20.5 3.4 13.3 1.8 1.6 0.4
Specialised Leasing Companies Primary Dealers Stock Brokers Unit Trusts Venture Capital Companies Credit Rating Agencies Market Intermediaries
Contractual Savings Institutions
Insurance Companies Employees Provident Fund Employees Trust Fund Private Provident Funds Public Service Provident Fund
Total y
5613.8 100.0 6690.4 100.0 7422.6 100.0 Commercial Banks: At present there are 26 commercial banks in operation in the country. 10 of these are locally incorporated and the balance are branches of foreign banks. Two of the local commercial banks are state owned. Rapid technological advancement including an automated check clearing house that clears checks from most part of the country within three days, ATMs, credit cards, electronic funds transfer facilities and several financial derivatives are available. Several banks have introduced tele-banking and electronic business banking and many have extended banking hours with some services being made available 24 hours a day through automation. The banking system is now linked closely to the worldwide networks via SWIFT and credit card gateways. Almost all commercial banks have established Foreign Currency Banking Units
Demand deposits
(Current /Checking Accounts)
Current/Checking Accounts facilitate cashless Business transactions.
For whom y y y y y y
Partnership Businesses Limited Liability Companies Clubs/Associations/Societies Government/Semi Government Institutions Incorporated Bodies Statutory Boards/Corporation
Deposits and withdrawals by cheque are not limited by amount/period. Accounts can be operated exceeding the available balance by using pre-arranged overdraft limits.
Among the other facilities are y
Fund transfers and Standing Orders to meet utility billings/Insurance premia etc.
Current accounts are linked on-line and Deposits/Withdrawals can be made at any BOC Branch. BOC ensures total secrecy in your business transactions
2010 Bank of Ceylon - Technology Division
y
> Corporate banking > Deposits > Fixed Deposits
Fixed deposits
This is the ideal investment instrument for Short to Medium Term (1-24 months). y
Individuals/Companies and legally accepted entities can hold Fixed Deposits.
y y y
Period of Deposit is pre-arranged (minimum 01 month, maximum 24 months.) No upper limit for investment. You would get competitive Interest rates based on market rates. Special rates for high volume deposits can be negotiated. You have two options to receive interest, either monthly or at the end of the agreed period.
Want ?
to draw your deposit before the agreed period
No problem, but a reduced interest payment would apply, depending on the completed period. In the alternative, you can get a loan/overdraft facility against the deposit.
2010 Bank of Ceylon - Technology Division

Types of Money Market Instruments in India

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Types of Money Market Instruments in India

1. Types of Money Market Instruments in India

Treasury Bills (T-Bills)

Read more: Types of Money Market Instruments in India | eHow.com http://www.ehow.com/about_5489094_types-money-market-instrumentsindia.html#ixzz1lXYLHCYd

INDIAN FINANCIAL MARKET

18.1 FINANCIAL MARKET

18.2 TYPES OF FINANCIAL MARKETS

18.3 MONEY MARKET

18.3.1 MONEY MARKET INSTRUMENTS

18.4 CAPITAL MARKET

18.4.1 PRIMARY MARKET

18.4.2 SECONDARY MARKET

18.5 DISTINCTION BETWEEN PRIMARY MARKET AND SECONDARY MARKET

18.6 DISTINCTION BETWEEN CAPITAL MARKET AND MONEY MARKET

Senior Secondary Notes

INTEXT QUESTIONS 18A

18.7 STOCK EXCHANGE

18.7.1 FUNCTIONS OF A STOCK EXCHANGE

18.7.2 ADVANTAGES OF STOCK EXCHANGES

Senior Secondary Notes

18.7.3 LIMITATIONS OF STOCK EXCHANGES

18.8 SPECULATION IN STOCK EXCHANGES

INTEXT QUESTIONS 18B

18.9 STOCK EXCHANGES IN INDIA

18.10 REGULATIONS OF STOCK EXCHANGES

18.11 ROLE OF SEBI

issue. Business Studies 81 Notes MODULE -4 Business Finance

INTEXT QUESTIONS 18C

18.12 WHAT YOU HAVE LEARNT

18.13 KEY TERMS

Money market New issue market NSE OTCEI

18.14 TERMINAL QUESTIONS

18.15 ANSWERS TO INTEXT QUESTIONS

FAQs on the Debt Markets

PSU Bonds, Debentures, Commercial Paper

Private Sector Bonds

Banks Financial Institutions

participants through a single member of the Exchange. TOP

Interest Rate Derivative products

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8. Fractional reserve banking

Electronic funds transfer[show]

Banks and banking[show]

[edit] Reason for existence

[edit] How it works

[edit] Money creation

[edit] Example of deposit multiplication

[edit] Money multiplier

[edit] Reserve requirements

[edit] Alternative views

[edit] Money supplies around the world

[edit] Central banks

[edit] Liquidity and capital management for a bank

[edit] Risk and prudential regulation

[edit] Example of a bank balance sheet and financial ratios

107787 Total Liabilities plus Net Worth

[edit] Other financial ratios

[edit] How the example bank manages its liquidity

Other Assets Total Assets Liabilities

179 10922 25013 45343

2062 99084 8703 60177 (41783)

100 19668 (8746)

309 4937 3178