Reforms in banking sector

Narasimham committee 1991 and 1998

Interest rate deregulation Reduction in pre-emptive reserves (SLR-CRR) Liberal Branch expansion policy Priority lending has been redefined Prudential norms for capital adequacy: asset classification, quality, provision on NPAs, NPA from 3% to 0% by 2002 Capital adequacy to be 8-10% (investment in Risk weighted asset) Entry norms for private banks Capital market access for banks Asset reconstruction fund Debt recovery tribunals (ARC, DRT) Dismantling BSRB Flexibility in remuneration for PSBs and permission for VRS Govt. holding to be reduced from 55 to 33% in SBI and 51 % in other public sector banks Rapid computerization Mandatory disclosure policies , greater transparency Centralized monitoring agency for fund transfers Mergers and acquisition Increased capital base for public sector banks and private sector for 300 crore
1

4/26/2012 11:18 PM

Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system within its country's borders. A central bank is distinguished from a normal commercial bank because it has a monopoly on creating the currency of that nation,

The primary function of a central bank is to provide the nation's money supply, but more active duties include controlling interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis. It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently. Most developed nations today have an "independent" central bank, that is one which operates under rules designed to prevent political interference. Examples include the European Central Bank (ECB) and the Federal Reserve System in the United State
4/26/2012 11:18 PM 2

Reserve Bank of India

The Reserve Bank of India is the central banking system of India and controls the monetary policy of the country Monetary authority: The Reserve Bank of India is the main monetary authority of the country and beside that the central bank acts as the bank of the national and state governments. It formulates, implements and monitors the monetary policy as well as it has to ensure an adequate flow of credit to productive sectors. Objectives are maintaining price stability and ensuring adequate flow of credit to productive sectors. Regulator: The institution is also the regulator and supervisor of the financial system and prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objectives are to maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public. The Banking Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI) for effective addressing of complaints by bank customers. Controller: The RBI controls the monetary supply, monitors economic indicators like the gross domestic product and has to decide the design of the rupee banknotes as well as coins

4/26/2012 11:18 PM

Manager of exchange control: The central bank manages to reach the goals of the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency: The bank issues and exchanges or destroys currency and coins not fit for circulation. The basic objectives of RBI are to issue bank notes, to maintain the currency and credit system of the country to utilize it in its best advantage, and to maintain the reserves. RBI maintains the economic structure of the country so that it can achieve the objective of price stability as well as economic development, because both objectives are diverse in themselves. Developmental role: The central bank has to perform a wide range of promotional functions to support national objectives and industries.[6] The RBI faces a lot of inter-sectoral and local inflation-related problems. Some of this problems are results of the dominant part of the public sector.
Related functions: The RBI is also a banker to the government and performs merchant banking function for the central and the state governments. It also acts as their banker. The National Housing Bank (NHB) was established in 1988 to promote private real estate acquisition. The institution maintains banking accounts of all scheduled banks, too. Stabilize Financial Mobility: The recent financial turmoil world-over, has however, vindicated the Reserve Bank's role in maintaining financial stability in India

4/26/2012 11:18 PM

Controlling Measures
.Bank Rate/ Interest Rate: RBI (Reserve Bank of India) lends to the commercial banks through its discount window to help the banks meet depositors demands and reserve requirements. The interest rate the RBI charges the banks for this purpose is called bank rate. If the RBI wants to increase the liquidity and money supply in the market, it will decrease the bank rate and if it wants to reduce the liquidity and money supply in the system, it will increase the bank rate. Cash Reserve Requirements (CRR): Every commercial bank has to keep certain minimum cash reserves with RBI. RBI can vary this rate between 3% and 15%. RBI uses this tool to increase or decrease the reserve requirement depending on whether it wants to affect a decrease or an increase in the money supply. An increase in CRR will make it mandatory on the part of the banks to hold a large proportion of their deposits in the form of deposits with the RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the money supply. Statutory Liquidity Requirements (SLR): Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities and balances with current accounts of RBI. RBI has stepped up liquidity requirements for two reasons: - Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances Open Market Operation Credit rationing Selective Credit Control REPO: rate offered for Purchase of securities /sanctions Reverse REPO rates offered for supply of securities /deposits Fixation of marginal requirement Minimum lending rate

4/26/2012 11:18 PM

Money market
The money market are market for financial assets that are close substitutes of money which consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to one year. Characteristics a) Not a single entity but collection of market for several instruments b) Wholesale market for short-term debt instruments c) Honor and creditworthiness of the participants are important d) Players are : a) RBI, b) DFHI c) NBFCs d) STCI e) PSUs and f) Mutual funds g) Banks h) Corporate investors i) State governments j) Non resident indians e) Need based market where demand and supply of money shapes the market Liquid and vibrant money market is necessary for the development of financial system and its capital market. Average turn over of indian money market is Rs. 40000 crores daily In india RBI ensures liquidity, short term interest rates Ensures flow of credits Bring order to Forex market through money market In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.

4/26/2012 11:18 PM

Instruments
Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months Call money market or money at short notice: Certificate of deposit - Time deposits, commonly offered to consumers by banks, thrift institutions, and credit unions. Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value. Commercial Bills Collateral borrowings Other instruments: Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States. Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues. Repurchase agreements - Short-term loansnormally for less than two weeks and frequently for one dayarranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. Short-lived mortgage- and asset-backed securities
4/26/2012 11:18 PM 7

Treasury bill
Treasury bills (or T-Bills) are issued by the central bank or government to tide over short term liquidity falls mature in one year or less(91/182/364) like zerocoupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.
Negotiable instruments Highly liquid Assured yield/discount and maturity at par Included in SLR requirement s for banks by RBI Available in multiples of Rs. 25000 Auctions by RBI every week
4/26/2012 11:18 PM 8

Commercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. In india the CPs were introduced by RBI in 1990 which was femilier in US since 19th century FIIs are eligible to invest in CPs as per the guidelines and restrictions of SEBI issued from time to time Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rate Means It is an unsecured P-Note in which the interest rates are determined by the market force in a dematerialized format at a discount Issuance of CPs

Pass resolution by the company Execute reserve bank norms Rate by credit rating agencies IPA (issuing and paying agent) may be a scheduled commercial bank as an agent for the company to deal Each CP has be reported by IPA to RBI and the company has to identify the brokers to place the CP in market may be financial institutions, merchant banks and other dealers Banks use to deposit in CPs rather sanctioning loans to corporate which enhance their liquidity requirements and reduce the risks

4/26/2012 11:18 PM

Commercial bills
The working capital of a firm is through cash-credits, overdrafts, purchase of discounting of commercial bills which is a short term negotiable instrument with low risk enhances the liability of payment on a fixed date when goods are bought/sold. It is the order signed by the maker directing to pay the certain amount only to the concerned person/bearer of the instrument on a particular date The banks or financial institutions may be willing to discount the bills keeping a margin with them on behalf of interest which they can even further rediscounted from DFHI, LIC, GIC, UTI etc. in which the maturity shall not normally exceed 30-90 days It is mostly foreign trade that is financed through bill market in india also the bill market is now not very attractive to the banks since the misuse of the bills in early 90s Inland Bills less attractive Foreign Bills attractive
4/26/2012 11:18 PM 10

Certificate of deposit
CDs unsecured negotiable short term instrument in the bearer form issued by banks and development financial institutions introduced in 1989 by government and are similar to FDs but different in term guidelines and its bearer format. They are different from savings accounts in that the CD has a specific, fixed term. usually, a fixed interest rate. It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest. CDs are issued by banks during the tight liquidity period CDs are also subject to SLR requirements by RBI.
4/26/2012 11:18 PM 11

Call money or short notice

Call money market is a market for very short term funds repayable on demand or short notice The maturity period varies from 1 to 14 days without any collateral security Banks are the important participants in call money market either to employ the surplus funds or to meet the cash reserve requirements
4/26/2012 11:18 PM 12

Repurchase agreement
A Repurchase agreement, also known as a Repo or Sale and Repurchase Agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price will be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party who originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest. A repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is effectively the interest on the loan while the settlement date of the forward contract is the maturity date of the loan.
4/26/2012 11:18 PM 13

Eurodollar
Eurodollars are deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term was originally coined for U.S. dollars in European banks, but it expanded over the years to its present definition: a U.S. dollardenominated deposit in Tokyo or Beijing would be likewise deemed a Eurodollar deposit. There is no connection with the euro currency.
4/26/2012 11:18 PM 14

Municipal bond
A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. In the United States, interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
4/26/2012 11:18 PM 15

Liquidity crisis
The term liquidity crisis may refer to : a "general feeling of mistrust in the banking system conducting to a temporary disappearance of credit; a lack of cash experienced by one particular business or a credit crunch. A credit crunch is a sharp increase in the interest rates and a strong decrease in allocated credit A liquidity crisis occurs when a business experiences a lack of cash required to grow the business, pay for day-to-day operations, or meet its debt obligations when they are due, causing it to default. When "liquidity crisis" is used to refer to an economy as a whole it means that liquidity crises affecting principal players in the economy are resulting in diminished availability of credit. Housing Finance Bubble in US. Lehman Brothers AIG Morgan Stanly/Meryl Lynch
4/26/2012 11:18 PM 16

INFLATION
Inflation is nothing more than a sharp upward rise in price level. Too much money chasing, too few goods. Inflation is a state in which the value of money is falling i.e. price are rising.

4/26/2012 11:18 PM

17

HOW TO CONTROL INFLATION

Monetary Measures Fiscal Measures Other Measures

4/26/2012 11:18 PM

18

Monetary Measures
Credit Control Demonetization of Currency Issue of New Currency

4/26/2012 11:18 PM

19

Fiscal Measures
Reduction in Unnecessary Expenditure Increase in Taxes Increase in Savings Surplus Budgets Public Debt

4/26/2012 11:18 PM

20

OTHER MEASURES
To Increase Production Rational Wage Policy Price Control

4/26/2012 11:18 PM

21

How is it Measured?
Consumer Price Index Wholesale Price Index

4/26/2012 11:18 PM

22

Consumer Price Index

CPI is a measure estimating the average price of consumer goods and services purchased by households. CPI measures a price change for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It is a price index determined by measuring the price of a standard group of goods meant to represent the typical market basket of a typical urban consumer. The percent change in the CPI is a measure estimating inflation.

4/26/2012 11:18 PM

23

Wholesale Price Index

WPI was published in 1902,and was one of the economic indicators available to policy makers until it was replaced by most developed countries by the CPI market. index in the 1970. WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. Some countries (like India and The Philippines) use WPI changes as a central measure of inflation. However, India and the United States now report a producer price index instead.
4/26/2012 11:18 PM 24

Problems with WPI

In present day service sector plays a key role in Indian economy. Consumers are spending loads of money on services like education and health. And these services are not incorpated in calculation of WPI. WPI measures general level of price changes either at level of wholesaler or at the producer and does not take into account the retail margins. Therefore we see here that WPI does give the true picture of inflation.

4/26/2012 11:18 PM

25

Problems with WPI

WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index.

4/26/2012 11:18 PM

26

Weight edge to CPI & WPI

4/26/2012 11:18 PM

27

Inflation rate
PI for a certain year - PI for a comparative year PI for a comparative year X 100

4/26/2012 11:18 PM

28

INFLATION RATES
2006-2007 Inflation Food inflation Non-food inflation 2011-12
4/26/2012 11:18 PM

2007-2008 12.0 17.6 6.8

7.8 10.3 6.2

?
29

EFFECTS OF INFLATION
They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Uncertainty about the future purchasing power of money discourages investment and saving.

4/26/2012 11:18 PM

30

EFFECTS OF INFLATION
There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation. Higher income tax rates. Inflation rate in the economy is higher than rates in other countries; this will increase imports and reduce exports, leading to a deficit in the balance of trade.
4/26/2012 11:18 PM 31

EXAMPLE
Increase in the price of wheat Increase in the price of world oil Increase in the price of rice Increase in the price of CNG

4/26/2012 11:18 PM

32

Cost of Inflation Index

COST INFLATION INDEX 1981-82 100 1982-83 1983-84 109 116

1984-85
1985-86 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99

125
133 140 150 161 172 182 199 223 244 259 281 305 331 351

1999-2000 389 2000-2001 406

2001-2002 426
2002-2003 447 2003-2004 463 2004-2005 480

2009-2010 632
2010-2011 - 711

4/26/2012 11:18 PM

33

Monetary Policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being expansionary, or a contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and a contractionary policy expands

What is Monetary Policy?

Monetary Authoritys policy to manage supply of money to achieve predetermined macroeconomic goals primarily Price Stability Policy affecting quantity of money which determines cost and availability of credit.

Types of Monetary Policy

Expansionary
Contractionary

Goals/Objectives
Theoretically.. Monetary Policy aims to achieve

Higher Economic Growth

Top priority in the economic agenda Level of economic growth determines fulfillment of social and economic need of people Only way to create job and eradicate poverty

Higher Rate of Employment

Congruent with economic growth objective Go Hand-in-Hand High employment is desired: Unemployment leads to lost output Full employment: All resources available in country are mobilized, National Income is maximum

Price Stability
Inflation increases price deflation decreases Inflation: Fixed income group face economic problem. Problem in every sector of economy Deflation: Flexible income earners face problem. May paralyze the economy Remain free from inflation and deflation! Control money supply. Does not mean stable price. Reasonable limit.

Neutrality of Money
Quantity of money increase: Inflation Quantity of money decrease: Deflation Inflation/Deflation: Disequilibrium Control quantity of money: So that no change in
Aggregate production Aggregate buying and selling General price level

Stability
Exchange Rate Financial Market Interest Rate

Instruments of Monetary Policy

Quantitative Instruments Qualitative Instruments

Quantitative Instruments
Bank Rate/ Discount Rate Open Market Operations(OMOs)
Cash reserve Ratio

Qualitative Instruments
Credit Ceiling Change in Margin Lending Directed Credit Control Moral Suasion
Non-official' tool of monetary policy which governments employ to persuade (instead of coerce through law making power) financial institutions in following suggested guidelines on the availability and cost of credit. Moral suasion is used typically by making policy announcements to induce the desired response, before resorting to mandatory compliance through statutory regulations.

Importance in Developing Countries

Development of Financial Institutions

Underdeveloped country: Lack of Financial Institutions People do not use Bank : All income goes to consumption No encouragement in Saving No Saving: No Investment Obstruction in economic growth

Monetization of Rural Sector

Underdeveloped countries: More people live to rural areas Transaction in barter system Monetary policy helps to remove barter system

Development of Organized Money Market

Lack of organized money market: Money market controlled by big and rich money lenders Exploit general class Central Bank: Unorganized money market into organized. Appropriate interest rate.

Increase in Investment
Low income: No Saving No Saving : No Investment Monetary Policy: Proper environment for saving, Capital formation
Increasing interest rate (encourage saving) Loan at appropriate interest rate (encourage investment)

Appropriate BOP
Export <Import Export raw material, Import finished goods Monetary Policy: Encourages production of export goods providing subsidies

ThanQ
4/26/2012 11:18 PM 52