UNIT 1: MONEY AND INTERNATIONAL FINANCE

Stages in the evolution of Money

Commodity Money (Barter system of trade

Standard goods were widely understood as usually valuable by practically
everyone. For example, wheat, salt, rice, and other food products were
always needed to create meals.
In fact, salt was used as a form of currency long after the development of
metallic currencies.
For example, Roman soldiers were sometimes paid in salt rations. That’s
where the phrase “worth your salt” comes from!
Metallic Money (coins of precious, semi precious and non Metallic
money originally began as physical coins minted out of the valuable
metals of the time and place, like gold, silver, bronze, copper, and more.
But over time, coins were minted with cheaper metals that weren’t as
valuable and stood in place of those precious metals to keep them
safe. precious metals)

Paper Money

The first transition to paper money occurred in 700 BC in China. This

happened when the Chinese elected to switch from metal currency or
coins to paper because paper currencies were easier for the government
to issue and easier to transport as paper is much lighter than coins
Plastic money arose as a direct consequence of electronic banking
systems; after all, modern credit and debit cards wouldn’t work if they
couldn’t access funds records electronically at a moment’s notice. Similar
to the transition from metal currency to paper currency, plastic money
became the go-to choice for payments because of its convenience.
For example, keeping your funds in a bank and electronically accessing
them is much safer than carrying a bunch of cash around in your wallet,
which can much more easily be stolen.lastic Money

Electronic / Digital Money

The electronic money is the latest version of the evolution of money. A
computerized device’s digital storage of a medium of trade is known as
electronic money (or e-money). A cashless payment system that
facilitates fast and simple money transfers of any amount is a major
benefit. The global shift to digital currencies is greatly influenced by
electronic money.
 Cryptocurrencies are another type of electronic money used in modern-
day economies. This form of money is digital and is neither controlled or
issued by one particular organization.
Due to the decentralized nature of blockchain technology, it’s almost
impossible for someone to fabricate a cryptocurrency transaction, add a
transaction, or fabricate coins out of the ether.

Characteristics of Money
Durability. A cow is fairly durable, but a long trip to market runs the risk
of sickness or death for the cow and can severely reduce its value.
Twenty-dollar bills are fairly durable and can be easily replaced if they
become worn. Even better, a long trip to market does not threaten the
health or value of the bill.
Portability. While the cow is difficult to transport to the store, the
currency can be easily put in my pocket
Divisibility. A 20-dollar bill can be exchanged for other denominations,
say a 10, a 5, four 1s, and 4 quarters. A cow, on the other hand, is not
very divisible.
Uniformity. Cows come in many sizes and shapes and each has a
different value; cows are not a very uniform form of money. Twenty-
dollar bills are all the same size and shape and value; they are very
uniform.
Limited supply. In order to maintain its value, money must have a limited
supply. While the supply of cows is fairly limited, if they were used as
money, you can bet ranchers would do their best to increase the supply
of cows, which would decrease their value. The supply, and therefore the
value, of 20-dollar bills—and money in general—are regulated by the
Federal Reserve so that the money retains its value over time.
Acceptability. Even though cows have intrinsic value, some people may
not accept cattle as money. In contrast, people are more than willing to
accept 20-dollar bills. In fact, the U.S. government protects your right to
use U.S. currency to pay your bills.
General Acceptability
Durability
Portability
Cognizability
Homogeneity
Divisibility
Stability
Non-counterfeit ability
Functions of Money
Money performs numerous primary, secondary, contingent and other
functions which happen to smoothen the functioning of trade and
industry and eliminate the difficulties of barter system as well.
Primary Functions
1. Money as Medium of Exchange
Removes the need for double coincidence of wants.
Becomes acceptable and maintains the affordability of freedom of
choice.
Acts as an intermediary, helps production through specialization and
division of labor.
A/c to Prof. Walters, ‘money serves as a factor of production,
enabling output to increase and diversify
Primary Functions
2. Money as Unit of Value
Money becomes standard
for measurement of value just as meters or kilometers is for distance.
Eliminates the necessity of quoting the price of one good in terms of the
other. Simply, facilitates the comparison in terms of value of exchange.
Facilitates accounting of all kinds of incomes, expenses, assets and
liabilities.
Helps in calculation of economic variables including estimations
of national product, profitability, costs and revenues etc.
Secondary Functions
1. Money as Standard for Deferred Payments
Process of debt taking and repayments is simplified.
Facilitates borrowing by firms and businessmen from banks and NBFIs
Helps developing financial and capital markets as it facilitates the capital
formation process .
Although change in value of money in terms of another
currency over time may har’m or benefit the creditors and debtors.
Secondary Functions
2. Money as Store of Value
Can be kept for long periods without deterioration.
Bridge from present to future.
2. Money as Transfer of Value
a person holding money can transfer that to any other person implying
the facilitation of transfer of value between persons and places
Contingent Functions (as proposed by Prof. David Kinley)

Money as the Most Liquid of all Liquid Assets

Basis of the Credit System
Equalizer of Marginal Utilities and Productivities
Measurement of National Income
Distribution of National Income
Other Functions

Helpful in Making Decisions.

Money as basis of Adjustment.

Theories of Demand
for Money
Demand for money arises from two important functions of money, first
being the money acting as medium of exchange
Fisher’s Equation of ExchangeDemand for Money

Helpful in Making Decisions.

Money as basis of Adjustment.

It is on the basis of these functions that money guarantees the solvency

of the payer and provides options to the holder of money to use it
any way, they like.
It is on the basis of these functions that money guarantees the solvency
of the payer and provides options to the holder of money
to use it any way, they like.
18.0 QUANTITY THEORY OF MONEY— CLASSICAL APPROACH OR THEORY
OF PRICE LEVEL

Several versions of classical Quantity Theory of Money are popular. One

version, also known as transactions version is due to Fisher. It is also
called Fisher equation of exchange:

M.V = P.T

Where
T is number of transaction of average size
M is defined as quantity
money,
V is velocity of circulation of money, and
P is the average price level.
where T is a proxy for level of income.
The classical macroeconomic theory relies on the QTM as the theory of
demand for money. This theory says that it
is the quantity of money in the hands of the public that determines how
high or low the price level will be. Such a conclusion has been reached
since level of output in the classical model is always at the full capacity
(or full employment) level.

It is assumed that output in classical system is ‘given’ or constant for the

duration of the analysis. There T is fixed and it is a proxy for national
income. Velocity of circulation of money (V) is dependent on the
payment behaviour
of people and is, therefore, a long term constant. It is defined as a
number of times a rupee changes hands during a given accounting
period.

Given as above definitions, product PT will represent product of number

of average sized transaction and average price, which is equal to the total
amount of money needed to help facilitate sale/purchase of total output.
On the other hand, components of the product MV shows how many
rupees are in circulation and how many times each is used for
payments. Thus, MV equals the amount of money available for
transaction. When money available equals money needed, then will be
equilibrium in the system.

Re-arranging the terms of the equation of exchange, MV = PT we get:

P   V  M
T
Quantity Theory of Money

Since V and T are both constants, this form of equation gives us a direct
relationship between money supply and price level. If M doubles, P will
also double. If M is reduced by half, Price level will also be halved. In this
sense, classical quantity theory of money can be called a theory of price
level.

According to another approach the classical QTM the demand for money
can be described as the following relationships with ‘nominal output’

M.v=P.y

where

M = Demand for money

Money and Prices v = Velocity of money circulation

P = Price level
y = Real output level
The above identity is converted into the QTM under the assumption that
v and y are constant or stable in the short run. With v and y being
constant, the assumption that price level is passive means that P
depends on changes in M rather than changes in M depend on changes
in P. These assumptions give us the nice and straightforward result that
any short run increase (or decrease) in M must lead to proportional rise
(or fall) in P. With any one or more of these assumptions not valid would
imply that the proportionality is unlikely to hold between M and P.

Quantity Theory of Money

The quantity theory of money is a framework to understand

price changes in relation to the supply of money in an economy.
The theory reflects to the idea that the quantity of
money available (money supply) grows at the same
rate as price levels do in the long run.

The quantity theory of money states that the general price level of
goods and services is directly proportional to the amount of money in
circulation, or money supply. For example, if the amount of money in
an economy doubles, the theory predicts that price levels will also be
double.

One implication of the theory is that the value of money is

determined by the amount of money available in an economy. An
increase in the money supply results in a decrease in the value of
money because an increase in the money supply also causes the rate
of inflation to increase. As inflation rises, purchasing power decreases.
When the purchasing power of a unit of currency decreases, it requires
more units of currency to buy the same quantity of goods or services.
The whole are argument can be shown with the help of the following
figure.
 The above figure depicts the money market in a sample economy.
The money supply curve is vertical because the monetary authority
(Example, RBI) sets the amount of money available without
consideration for the value of money. The money demand curve slopes
downward because as the value of money decreases, consumers are
forced to carry more money to make purchases because goods and
services cost more money. Similarly, when the value of money is high,
consumers demand little money because goods and services can be
purchased for low prices. The intersection of the money supply curve
and the money demand curve shows both the equilibrium value of
money as well as the equilibrium price level.
 Versions of Quantity Theory of Money

1. Quantity Theory of Money— Fisher’s Version:

The most common version, sometimes called the "neo-quantity
theory" or Fisherian theory given by an American Economists -

Irving Fisher suggests that there is a mechanical and fixed proportional

relationship between changes in the money supply and the general

price level. According to Irving Fisher, like the price of a

commodity, value of money is determined by the supply

of money and demand for money. In his theory of

demand for money, Fisher attached emphasis on the

use of money as a medium of exchange. In other words,

money is demanded for transaction purposes.

The Fisher equation is calculated as:

M×V=P×T (1)

where:

M=money
supply
V=velocity
of money
P=average
price level
T=volume of transactions in the economy
Generally speaking, the quantity theory of money explains how
increases in the quantity of money tends to create inflation, and vice
versa. In the original theory, V was assumed to be constant and T is
assumed to be stable with respect to M, so that a change in M directly
impacts P. In other words, if the money supply increases then the
average price level will tend to rise in proportion (and vice versa), with
little effect on real economic activity. The same argument can be shown
with the following numerical example.

Fisher’s cash transaction version can be extended by

including bank deposits in the definition of money

supply. Now money supply comprises not only legal

tender money, M but also bank money, M’. This bank

money has also a stable velocity of circulation, V’.

Thus the above equation 1 can be written as:
 Assuming V, V’, T and the ratio of M and M’ constant, an

increase in M and M’, say by 5 p.c., will cause P to rise also by

the same percentage.

It is, however, not easier to measure the number of

transactions T. Let us replace T by Y. Thus P. Y is the nominal

income or output where Y is the total income. Now the

quantity theory equation becomes: PY = MV. This is known as

the ‘income version’ of quantity theory of money.

2. Quantity Theory of Money: Cambridge Version:

An alternative version, known as cash balance version,

was developed by a group of Cambridge economists like

Pigou, Marshall, Robertson and Keynes in the early 1900s.

These economists argue that money acts both as a store of

wealth and a medium of exchange. Here, by cash balance and

money balance we mean the amount of money that people

want to hold rather than savings.

According to Cambridge economists, people wish to hold

cash to finance transactions and for security against

unforeseen needs. They also suggested that an individual’s

demand for cash or money balances is proportional to his

income. Obviously, larger the incomes of the individual,

greater is the demand for cash or money balances.

Thus, the demand for cash balances is specified by:

Md = kPY

-----------(1)

where

Y is the physical level of aggregate or national output,

P is the average price
k is the proportion of national output or income that people
want to hold.
Let us assume that the supply of money, MS’ is

determined by the monetary authority, i.e., MS = M

---------(2)

Equilibrium requires that the supply of money must equal the

demand for money, or

k and Y are determined independently of the money

supply. With k constant given by the transaction demand for

money and Y constant because of full employment, increase

or decrease in money supply leads to a proportional increase

and decrease in price level. This conclusion holds for

Fisherian version also. Note that Cambridge ‘k’ and Fisherian

V are reciprocals of one another, that is, 1/k is the same as V

in Fisher’s equation

18.0 KEYNESIAN THEORY OF

DEMAND FOR MONEY
This theory was formulated by Keynes in his famous
book “The General Theory of Employment, Interest and
Money”, Published in 1936.

To understand Keynes’ theory two questions

need to be separated: first, why is money
demanded? and second, what
are the determinants of demand for money? Both these questions are inter-
linked. Keynesian demand for
money has 3 components, they are
transaction demand, precautionary demand
and the speculative demand.

Keynes made the demand for money a

function of 2 variables; namely,

i) money income, or Y; and

ii) rate of interest, or r.

In functional form:

Md = Md (Y, r)

Keynes retained the transactions approach

(explained above ) to the demand for money
under which demand for money is
hypothesized to be a function of nominal
income. But, according to him, this only
explained the transaction demand for money
and not the entire demand for money. The
revolutionary insight of Keynes has been the
speculative demand for money component.
Through it Keynes made this part of the
demand for money a declining function of
rate of interest, which is purely a monetary
phenomenon and solely influenced by the
monetary influences in the economy. The
speculative demand for money arises from
the speculative motives for holding money
due to changes in the rate of interest in the
market and uncertainty about them.
18.5.1 Transaction
t
Demand for Money i.e., Md =
k.Y = k . P . y
Money is needed to carry out day-to-day
transactions. There are discrepancies
0<k<1
between receipts of income (say, once in a
week or a month) and the expenditures of a This equation
person. A person may be assumed to incur says that if
expenditure almost daily throughout the the level of
week till her income is exhausted. Thus, income
while receipts of income are discrete, (nominal) is
expenditure is almost continuous. Because of say, Rs. 800
this discrepancy, it is necessary that crore and k
individuals have cash at their disposal for = 2/5, then,
meeting their current (or daily) expenditures. the
This demand for money is called the transaction
transaction demand for money. The level demand for
of income determines the control over goods money in the
and services in the market. Given the economy
payments habit of the community, an would
individual has to have cash at her disposal to amount to Rs.
meet these expenditure requirements. An 320 crore
individual with higher level of income has a [800x(2/5) =
greater demand for goods and services (in 320]. This
general) than an individual with a lower means that
level of income. It means that transactions the economy
are directly related to the level of income. would
In other words, more cash is needed by an requires Rs.
individual with a higher level of income 320 crore of
compared to one with lower level of money in
income. Thus, order to
Mdt = M
t
d (Y) finance
smoothly
The classical economists, the Quantity production
Theorists, also considered the transaction and sale
demand for money, which emphasizes the worth of
role of money as medium of exchange. goods and
However, the precautionary and the services of
‘speculative’ demand for money are Keynes’ Rs. 800
additional sources of ‘liquidity preference’ crore. If the
(or, demand for money). level of
For simplicity, we can say that transaction national
demand for money, is a constant proportion, income
k, of the level of national income, Y
(nominal)
goes up to Rs. 1000 crore and k remains at Quantity Theory
the same level of 2/5 then the transaction
of Money
demand for money will be Rs. 400 crore.
We know thatt Md = k .Y
it follows then,

Fig. 18.1
DMd = k t

. DY
Mt = k . Y

Y2
Level of Income

Y1

M1 M2
Transactionary Demand of Money

Fig. 18.1: Depicts transactionary Demand for money as a proportion k of money income. As
income rises by Y2-Y1. The demand for money goes up by M2-M1. Note that M2-M1=k(Y2-Y1)
11
Money and Prices

12
where be M1M2
= OM2-OM1.
DMd = change int the Fig.
transaction demand for 18.2
money
DY = change in the level
of national
Rate of Interest
Y
income(nominal) 1

Y Y Y
In case of a decline of Rs. 1 2 3

200 crore in the level of

national income(nominal)
there will be a decline in
the transaction demand
for money by Rs. 80
crore.
Tra
The functional relationship nsa t

between transaction ctio

demand for money(Md ) nar
and the level of nominal y
national income (Y) is De
depicted in Figure 18.1. ma
In this figure, the nd
transaction demand for for
money is shown on X-axis Mo
and level of nominal
ney
national income (Y) is
shown on the Y-axis, At Fig. 18.2 : This figures emphasizes the idea that rate of int
OY1 level of national transactionary demand for money. Y1, Y2 and Y3 represent differen
money needed by people at these levels is constant, for each level,
income, OM1 money will of the rate of interest.

be demanded to meet Not

transactions demand and e: Y
at the OY2 level, OM2 indic
amount will be demanded. ates
This means that as the
level
level of national income
(nominal) increases from of
OY1 to OY2, the Inco
additional transaction me
demand for money would According to transaction
demand theory, the uncertain nature like
determinant of demand accidents, prolonged
for money is the level of illness, sudden change in
national income technology forcing firms to
(nominal). The replace machinery to stay
transaction demand for competitive. These are
money is not affected by referred to as
the rate of interest. precautionary demand
Figure 18.2 shows three for money. Like the
different level of National transaction demand for
income(nominal) where money, precautionary
Y1<Y2<Y3. This figure demand for money is also
illustrates the relation, or closely related to the level
rather lack of relation, of income. At the higher
between rate of interest level of income, individuals
& transaction demand for and firms may keep more
money. Here vertical axis cash balances for meeting
depicts the rate of
interest and horizontal
axis depicts transaction
demand for money. The
fact that each curve is a
vertical straight line
means that the rate of
interest does not affect
the transaction demand
for money.

18.5.2 Precautionary p

Demand for Money

(Md )

The Precautionary
demand for money arises
out of the need for any
contingent
payments/expenditures.
Individuals and firms
desire to hold cash
balances for covering
events of a more
unforeseen situations. Thus, the Quantity Theory
precautionary demand for money is also a of Money
function of level of Y:

Mdp = g(Y)

Keynes aggregated transaction and

precautionary demands for money and
pointed out that these two demands are a
stable function of the level of national
income(nominal). The rate of interest as an
important determinant of demand for money
enters through the third motive, the
speculative demand for money.

d
18.5.3 Speculative Demand for
sp Money, M

In addition to working as a medium of

exchange, money also serves a role of store
of value. The speculative demand for money
is the demand for money as an asset or as a
store of value. This is considered by Keynes,
as ‘Liquidity Preference Proper’. This was
truly novel and revolutionary
element of Keynes’ theory of demand for money.
Through it Keynes made (a part of) the demand for
money a declining function of rate of interest. The
speculative demand for money constitutes
the main pillar of Keynes’ revolution in
monetary theory and Keynes’ attack on
Quantity Theory of Money.
 Fig. 18.3

r
1
Interest

M sp = L(r)
Rate of

r P Q
2

r*

O M1 M2 Speculative Demand for Money

Fig. 18.3: Sepculative Demand for money is a function of rate of interest. At very low rate of
interest, r*, the demand for money function becomes parallel to horizontal axis-the stretch
PQ. This is known as liguidity trap.

The speculative demand for money arises from the speculative

motive for holding money.
This arises from the variability of interest rates in the market and
uncertainty about them. For simplicity, Keynes’ assumed all
securities (bonds, shares etc.) to be of only one type, i.e., perpetual
bonds. These perpetual bonds are the only non- money financial
assets, which compete with money in the asset portfolio of the
public. Money doesn’t earn its
holders any interest income but its capital value. Bonds on the other
hand, yield interest income to their holders. But this income can be
more than wiped out if bond prices fall in future. We can show
algebraically that the price of a (perpetual) bond is given by the
reciprocal of the market rate of interest times the coupon rate of
interest (payable on the bond).
 Criticisms of Keynes Theory of Money and

Prices:

Keynes’ views on money and prices have been

criticised by the monetarists on the following

grounds.

1. Direct Relation:

Keynes mistakenly took prices as fixed so that

the effect of money appears in his analysis in terms

of quantity of goods traded rather than their average

prices. That is why Keynes adopted an indirect

mechanism through bond prices, interest rates and

investment of the effects of monetary changes on

economic activity. But the actual effects of monetary

changes are direct rather than indirect.

2. Stable Demand for Money:

Keynes assumed that monetary changes were

largely absorbed by changes in the demand for

money. But Friedman has shown on the basis of his

empirical studies that the demand for money is

highly stable.

3. Nature of Money:

Keynes failed to understand the true nature of

money. He believed that money could be exchanged

for bonds only. In fact, money can be exchanged for

many different types of assets like bonds, securities,

physical assets, human wealth, etc.

4. Effect of Money:
 Since Keynes wrote for a depression period, this

led him to conclude that money had little effect on

income. According to Friedman, it was the

contraction of money that precipitated the

depression. It was, therefore, wrong on the part of

Keynes to argue that money had little effect on

income. Money does affect national income.

Source: https://www.yourarticlelibrary.com/

Friedman’s Theory of the Demand for Money

(Theory and Criticisms)

Friedman’s Theory:

In his reformulation of the quantity theory,

Friedman asserts that “the quantity theory is in the

first instance a theory of the demand for money. It is

not a theory of output, or of money income, or of the

price level.” The demand for money on the part of

ultimate wealth holders is formally identical with

that of the demand for a consumption service. He

regards the amount of real cash balances (M/P) as a

commodity which is demanded because it yields

services to the person who holds it. Thus money is an

asset or capital good. Hence the demand for money

forms part of capital or wealth theory.

For ultimate wealth holders, the demand for

money, in real terms, may be expected to be a

function primarily of the following variables:

1. Total Wealth:

The total wealth is the analogue of the budget

constraint. It is the total that must be divided among

various forms of assets. In practice, estimates of total

wealth are seldom available. Instead, income may

serve as an index of wealth. Thus, according to

Friedman, income is a surrogate of wealth.

2. The Division of Wealth between Human and

Non-Human Forms:

The major source of wealth is the productive

capacity of human beings which is human wealth.

But the conversion of human wealth into non-human

wealth or the reverse is subject to institutional

constraints. This can be done by using current

earnings to purchase non-human wealth or by using

non-human wealth to finance the acquisition of skills.

Thus the fraction of total wealth in the form of non-

human wealth is an additional important variable.

Friedman calls the ratio of non-human to human

wealth or the ratio of wealth to income as w.

3. The Expected Rates of Return on Money and

Other Assets:

These rates of return are the counterparts of the

prices of a commodity and its substitutes and

complements in the theory of consumer demand. The

nominal rate of return may be zero as it generally is

on currency, or negative as it sometimes is on

demand deposits, subject to net service charges, or

positive as it is on demand deposits on which interest

is paid, and generally on time deposits. The nominal

rate of return on other assets consists of two parts:

first, any currently paid yield or cost, such as interest

on bonds, dividends on equities, and costs of storage

on physical assets, and second, changes in the prices

of these assets which become especially important

under conditions of inflation or deflation.

4. Other Variables:

Variables other than income may affect the

utility attached to the services of money which

determine liquidity proper. Besides liquidity,

variables are the tastes and preferences of wealth

holders. Another variable is trading in existing

capital goods by ultimate wealth holders. These

variables also determine the demand function for

money along-with other forms of wealth. Such

variables are noted as u by Friedman.

Broadly, total wealth includes all sources of

income or consumable services. It is capitalised

income. By income, Friedman means “permanent

income” which is the average expected yield on

wealth during its life time.

Wealth can be held in five different forms:

money, bonds, equities, physical goods, and human

capital. Each form of wealth has a unique

characteristic of its own and a different yield.

1. Money is taken in the broadest sense to

include currency, demand deposits and time deposits

which yield interest on deposits. Thus money is

luxury good. It also yields real return in the form of

convenience, security, etc. to the holder which is

measured in terms of the general price level (P).

2. Bonds are defined as claim to a time stream

of payments that are fixed in nominal units.

3. Equities are defined as a claim to a time

stream of payments that are fixed in real units.

4. Physical goods or non-human goods are

inventories of producer and consumer durable.

5. Human capital is the productive capacity of

human beings. Thus each form of wealth has a

unique characteristic of its own and a different yield

either explicitly in the form of interest,

dividends, labour income, etc., or implicitly in

the form of services of money measured in terms of

P, and inventories. The present discounted value of

these expected income flows from these five forms of

wealth constitutes the current value of wealth which

can be expressed as:

W = y/r

Where W is the current value of total wealth, Y is

the total flow of expected income from the five forms

of wealth, and r is the interest rate. This equation

shows that wealth is capitalised income. Friedman in

his latest empirical study Monetary Trends in the

United States and the United Kingdom (1982) gives

the following demand function for money for an

individual wealth holder with slightly different

notations from his original study of 1956 as:

M/P = f (y, w; Rm, Rb, Re, gp, u)

Where M is the total stock of money demanded;

P is the price level; у is the real income; w is the

fraction of wealth in non-human form: Rm is the

expected nominal rate of return on money; Rb is the

expected rate of return on bonds, including expected

changes in their prices; Re is the expected nominal

rate of return on equities, including expected

changes in their prices; gp=(1/P) (dP/dt) is the

expected rate of change of prices of goods and hence

the expected nominal rate of return on physical

assets; and и stands for variables other than income

that may affect the utility attached to the services of

money.

The demand function for business is roughly

similar, although the division of total wealth and

human wealth is not very useful since a firm can buy

and sell in the market place and hire its human

wealth at will. But the other factors are important.

The aggregate demand function for money is the

summation of individual demand functions with M

and у referring to per capita money holdings and per

capita real income respectively, and w to the fraction

of aggregate wealth in nonhuman form.

The demand function for money leads to the

conclusion that a rise in expected yields on different

assets (Rb, Re and gp) reduces the amount of money

demanded by a wealth holder, and that an increase

in wealth raises the demand for money. The income

to which cash balances (M/P) are adjusted is the

expected long term level of income rather than

current income being received.

Empirical evidence suggests that the income

elasticity of demand for money is greater than unity

which means that income velocity is falling over the

long run. This means that the long run demand for

money function is stable and is relatively interest

inelastic, as shown in fig. 68.1. where MD is the

demand for money curve. If there is change in the

interest rate, the long-run demand for money is

negligible.

In Friedman’s restatement of the quantity theory

of money, the supply of money is independent of the

demand for money. The supply of money is unstable

due to the actions of monetary authorities. On the

other hand, the demand for money is stable. It means

that money which people want to hold in cash or

bank deposits is related in a fixed way to their

permanent income.
 If the central bank increases the supply of

money by purchasing securities, people who sell

securities will find their holdings of money have

increased in relation to their permanent income.

They will, therefore, spend their excess holdings of

money partly on assets and partly on consumer

goods and services.

This spending will reduce their money balances

and at the same time raise the nominal income. On

the contrary, a reduction in the money supply by

selling securities on the part of the central bank will

reduce the holdings of money of the buyers of

securities in relation to their permanent income.

They will, therefore, raise their money holdings

partly by selling their assets and partly by reducing

their consumption expenditure on goods and

services. This will tend to reduce nominal income.

Thus, on both counts, the demand for money remains

stable. According to Friedman, a change in the

supply of money causes a proportionate change in

the price level or income or in both. Given the

demand for money, it is possible to predict the

effects of changes in the supply of money on total

expenditure and income.

If the economy is operating at less than full

employment level, an increase in the supply of money

will raise output and employment with a rise in total

expenditure. But this is only possible in the short

run. Friedman’s quantity theory of money is

explained in terms of Figure 68.2. Where income (Y)

is measured on the vertical axis and the demand for

the supply of money are measured on the horizontal

axis. MD is the demand for money curve which varies

with income. MS is the money supply curve which is

perfectly inelastic to changes in income. The two

curves
 intersect at E and determine the equilibrium

income OY. If the money supply rises, the MS curve

shifts to the right to M1S1. As a result, the money

supply is greater than the demand for money which

raises total expenditure until new equilibrium is

established at E1 between MD and M1S1, curves.

The income rises to OY1.

Thus Friedman presents the quantity theory as

the theory of the demand for money and the demand

for money is assumed to depend on asset prices or

relative returns and wealth or income. He shows how

a theory of the stable demand for money becomes a

theory of prices and output. A discrepancy between

the nominal quantity of money demanded and the

nominal quantity of money supplied will be evident

primarily in attempted spending. As the demand for

money changes in response to changes in its

determinants, it follows that substantial changes in

prices or nominal income are almost invariably the

result of changes in the nominal supply of money.

Its Criticisms:

Friedman’s reformulation of the quantity theory

of money has evoked much controversy and has led

to empirical verification on the part of the

Keynesians and the Monetarists. Some of the

criticisms levelled against the theory are discussed

as under.
 1. Very Broad Definition of Money:

Friedman has been criticised for using the broad

definition of money which not only includes currency

and demand deposits (М1) but also time deposits

with commercial banks (M2). This broad definition

leads to the obvious conclusion that the interest

elasticity of the demand for money is negligible. If

the rate of interest increases on time deposits, the

demand for them (M2) rises. But the demand for

currency and demand deposits (M1) falls.

So the overall effect of the rate of interest will

be negligible on the demand for money. But

Friedman’s analysis is weak in that he does not make

a choice between long-term and short-term interest

rates. In fact, if demand deposits (M1) are used a

short-term rate is preferable, while a

long-term rate is better with time deposits (M2).

Such an interest rate structure is bound to influence

the demand for money.

2. Money not a Luxury Good:

 Friedman regards money as a luxury good

because of the inclusion of time deposits in money.

This is based on his finding that there is higher trend

rate of the money supply than income in the United

States. But no such ‘luxury effect’ has been found in

the case of England.

3. More Importance to Wealth Variables:

In Friedman’s demand for money function,

wealth variables are preferable to income and the

operation of wealth and income variables

simultaneously does not seem to be justified. As

pointed out by Johnson, income is the return on

wealth, and wealth is the present value of income.

The presence of the rate of interest and one of these

variables in the demand for money function would

appear to make the other superfluous.

4. Money Supply not Exogenous:

Friedman takes the supply of money to be

unstable. The supply of money is varied by the

monetary authorities in an exogenous manner in

Friedman’s system. But the fact is that in the United

States the money supply consists of bank deposits

created by changes in bank lending. Bank lending, in

turn, is based upon bank reserves which expand and

contract with (a) deposits and withdrawals of

currency by non-bank financial intermediaries; (b)

borrowings by commercial banks from the Federal

Reserve System; (c) inflows and outflows of money

from and to abroad: and (d) purchase and sale of

securities by the Federal Reserve System. The first

three items definitely impart an endogenous element

to the money supply. Thus the money supply is not

exclusively exogenous, as assumed by Friedman. It is

mostly endogenous.

5. Ignores the Effect of Other Variables on

Money Supply:

Friedman also ignores the effect of prices,

output or interest rates on the money supply. But

there is considerable empirical evidence that the

money supply can be expressed as a function of the

above variables.

6. Does not consider Time Factor:

Friedman does not tell about the timing and

speed of adjustment or the length of time to which

his theory applies.

7. No Positive Correlation between Money

Supply and Money GNP:

Money supply and money GNP have been found

to be positively correlated in Friedman’s findings.

But, according to Kaldor, in Britain the best

correlation is to be found between the

quarterly variations in the amount of cash held

in the form of notes and coins by the public and

corresponding variations in personal consumption at

market prices, and not between money supply and

the GNP.

8. Conclusion:

Despite these criticisms, “Friedman’s application

to monetary theory of the basic principle of capital

theory—that is the yield on capital, and capital the

present value of income—is probably the most

important development in monetary theory since

Keynes’s General Theory. Its theoretical significance

lies in the conceptual integration of wealth and

income as influences on behaviour.”

Friedman Vs Keynes:

Friedman’s demand for money function differs

from that of Keynes’s in many ways which are

discussed as under.

First, Friedman uses a broader definition of

money than that of Keynes in order to explain his

demand for money function. He treats money as an

asset or capital good capable of serving as a

temporary abode of purchasing power. It is held for

the stream of income or consumable services which

it renders. On the other hand, the Keynesian

definition of money consists of demand deposits and

non-interest bearing debt of the government.

Second, Friedman postulates a demand for

money function quite different from that of Keynes.

The demand for money on the part of wealth holders

is a function of many variables. These are Rm, the

yield on money; Rb, the yield on bonds; Re, the yield

on securities; gp, the yield on physical assets; and u

referring to other variables. In the Keynesian theory,

the demand for money as an asset is confined to just

bonds where interest rates are the relevant cost of

holding money.

Third, there is also the difference between the

monetary mechanisms of Keynes and Friedman as to

how changes in the quantity of money affect

economic activity. According to Keynes, monetary

changes affect economic activity indirectly through

bond prices and interest rates.

The monetary authorities increase the money

supply by purchasing bonds which raises their prices

and reduces the yield on them. Lower yield on bonds

induces people to put their money elsewhere, such as

investment in new productive capital that will

increase output and income. On the other hand, in

Friedman’s theory monetary disturbances will

directly affect prices and production of all types of

goods since people will buy or sell any asset held by

them. Friedman

emphasises that the market interest rates play

only a small part of the total spectrum of rates that

are relevant.

Fourth, there is the difference between the two

approaches with regard to the motives for holding

money balances. Keynes divides money balances into

“active” and “idle” categories. The former consist of

transactions and precautionary motives, and the

latter consist of the speculative motive for holding

money. On the other hand, Friedman makes no such

division of money balances.

According to him, money is held for a variety of

different purposes which determine the total volume

of assets held such as money, physical assets, total

wealth, human wealth, and general preferences,

tastes and anticipations.

Fifth, in his analysis, Friedman introduces

permanent income and nominal income to explain his

theory. Permanent income is the amount a wealth

holder can consume while maintaining his wealth

intact. Nominal income is measured in the prevailing

units of currency. It depends on both prices and

quantities of goods traded. Keynes, on the other

hand, does not make such a distinction.

 UNIT 1: MONEY AND INTERNATIONAL

FINANCE

Money and Inflation

Value of Money = Purchasing power of money

over goods and services.

It is a relative concept expressing the

relationship between a unit of money and goods &

services that can be bought with it.

If V is the value of

money and P is the price level, then simply

V=1/P.

Value of money can be internal as well as

external. Internal value being the domestic

purchasing power and external

value being the global or international

purchasing power of the money.

Fisher’s Variant of Quantity Theory of Money:

The Cash Transactions Approach

Quantity of Money is the prominent determinant

of price level or the value of money.

According to Irving Fisher, “Other things

remaining unchanged, as the quantity of money in

circulation increases, the price level also increases in

direct proportion and the value of money decreases

and vice versa”.

Fisher has explained his theory in terms of his

equation of exchange:

PT = MV + M’ V’

where P = price level, or 1/P = the value of

money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M’ = the total quantity of credit money;

V’ = the velocity of circulation of M’;

T = the total amount of goods

and services exchanged for money or

transactions perfoPanel A of the figure shows the

effect of changes in the quantity of money on the

price level. To begin with, when the quantity of

money is M, the price level is P.

When the quantity of money is doubled to M2,

the price level is also doubled to P2. Further, when

the quantity of money is increased four-fold to M4,

the price level also increases by four times to P4.

This relationship is expressed by the curve P=f (M)

from the origin at 45°.

Panel B, however, shows the inverse relation

between the quantity of money and the value of

money. When the quantity

of money is M1 the value of money is 1/P. But

with the doubling of the quantity of money to M2, the

value of money becomes one-half of what it was

before, 1 /P2. And with the quantity of money

increasing by four-fold to M4, the value of money is

reduced by 1 /P4. This inverse relationship between

the quantity of money and the value of money is

shown by downward sloping curve 1 /P=f (M).

Fisher’s
Fisher’s theory is based on the following assumptions
. P is passive factor in the equation of exchange which is affected by
the other factors.
2. The proportion of M’ to M remains constant.
3. V and V are assumed to be constant
and are independent of changes in M and M’.
4. T also remains constant and is independent of other factors such
as M, M’, V and V.
5. It is assumed that the demand for money is proportional to the
value of transactions.
6. The supply of money is assumed as an exogenously determined
constant.
7. It is based on the assumption of the existence of full employment
in
The economy.

Criticisms of the Theory

Other things not equal:
The direct and proportionate relation between quantity of money
and price level in Fisher’s equation is based on the assumption that
“other things remain unchanged”. But in real life, V, V and T are not
constant. Moreover, they are not independent of M, M’ and P.
Rather, all elements in Fisher’s equation are interrelated and
interdependent. For instance, a change in M may
cause a change in V.
Constants Relate to Different Time:
Prof. Halm criticizes Fisher for multiplying M and V because M relates
to a point of time and V to a period of time. The former is a static
concept and the latter a dynamic. It is therefore, technically
inconsistent to multiply two non-comparable factors.

Weak Theory:
According to Crowther, the quantity theory is weak in following
aspects.
First, it cannot explain ‘why’ there are fluctuations in the price level
in the short run.
Second, it gives undue
importance to the price level as if changes in prices were the most
critical and important phenomenon of the economic system.
Neglects Interest Rate:
One of the main weaknesses of Fisher’s
quantity theory of money is that it neglects the role of the rate of
interest as one of the causative factors between money and prices.
Fisher’s equation of exchange is related to an equilibrium situation in
which rate of interest is independent of the quantity of money.
Neglects Store of Value Function:
Another weakness of the quantity theory of money is that it
concentrates on the supply of money and assumes the demand
for money to be constant. In order words, it neglects the store-of-
value function of money and considers only the medium-of-exchange
function of money. Thus the theory is one-sided.
Static:
Fisher’s theory is static in nature because of its such unrealistic
assumptions as long run, full employment, etc. It is, therefore, not
applicable to a modern dynamic economy.
A brief about Inflation
Inflation is the persistent and general increase in the price level of
goods and services in an economy over time. It leads to a decrease in
the purchasing power of money.
Causes of Inflation
Demand Pull Inflation: Occurs when aggregate demand exceeds
aggregate supply, leading to an increase in prices.
Cost Push Inflation : Arises when the production costs of goods and
services increase, leading to higher prices
Built-In Inflation : Occurs due to expectations of future price
increases, leading to higher wages and production costs.
Measuring Inflation
Consumer Price Index (CPI): Measures changes in the cost of a
basket of goods and services consumed by a typical urban
household.
Producer Price Index (PPI): Tracks changes in the prices received by
producers for their goods and services.

Types of Inflation
Mild Inflation: Low and stable inflation, typically seen as beneficial
for economic growth.
Hyperinflation: Extremely high and uncontrollable inflation, leading
to the collapse of a country's currency and economy.
 Deflation: A sustained decrease in the general price level, which can
result in economic stagnation.
Controlling Inflation
1. Monetary Policy
Central banks use monetary policy tools, such as interest rates and
reserve requirements, to control inflation.
Raising interest rates reduces borrowing and spending, slowing
down inflation.
Lowering interest rates encourages borrowing and spending to
stimulate economic activity.
2. Fiscal Policy
Governments can use fiscal policy, such as taxation and public
spending, to influence inflation.
Reducing government spending can help control inflation by
reducing demand in the economy

UNIT 1: MONEY AND INTERNATIONAL

Topic: International Transactions and Balance of Payments
A country has to deal with other countries in respect of the
following:
Visible items which include all types of physical goods exported and
imported.
Invisible items which include all those services whose export and
import are not visible. e.g. transport services, medical services etc.
Capital transfers
Which are concerned with capital receipts and capital payment.
Balance Of Payment : Definition
The balance of payments of a country is a systematic record of all
economic transactions between the residents of a country and the
rest of the world. It presents a classified record of all receipts on
account of goods exported, services rendered and capital received
by residents and payments made by them on account of goods
imported and services received from the capital transferred
to non-residents or foreigners.
- Reserve Bank of India
Features of BoP
It is a systematic record of all economic transactions between
one country and the rest of the world.
It includes all, visible as well as invisible, transactions.
It relates to a period of time. Generally
it is an annual statement.
It adopts a double-entry book-keeping system and has two sides:
credit side and debit side. Receipts are recorded on the credit side
and payments on the debit side.
Balance of Trade
Balance of trade (BOT) is the difference between the value of a
country's imports and exports for a given period and is the largest
component of a country's balance of payments (BOP).
A country that imports more goods and services than it exports in
terms of value has a trade deficit making it unfavorable while a
country that exports more goods and services than it imports has a
trade surplus making it favorable.
Viewed alone, a favorable balance of trade is not sufficient to gauge
the health of an economy. It is important
to consider the balance of trade with respect to other economic
indicators, business cycles, and other indicators
Debit items include imports, foreign aid, domestic spending
abroad and domestic investments abroad.
Credit items include exports, foreign spending in the
domestic economy and foreign investments in the domestic
economy.
Example of How to Calculate the BOT
Here's an example of how to calculate the balance of trade:
Let's say that a country's exports of goods in a given year are worth
$100 million, and its imports of goods are worth $80 million. To
calculate the balance of trade, you would subtract the value of the
imports from the value of the exports:
Balance of trade = Exports - Imports
= $100 million - $80 million
= $20 million
In this example, the balance of trade is $20 million, which means that
the country has a trade surplus of +$20 million.
It's important to note that the balance of trade is typically measured
in the currency of the country whose trade balance is being
calculated. For example, if the country in the above example is the
United States, the balance of trade would be measured in US dollars.
If the country is Japan, it would be measured in Japanese yen, and so
on.
Balance of Trade V/s Balance of Payment

Importance of Balance Of Payments

Balance of Payment is an essential document or transaction in the
finance department as it gives the status of a country and its
economy.
It examines the transaction of all the exports and imports of goods
and services for a given period.
It helps the government to analyze the potential of a particular
industry export growth and formulate policy to support that growth.
It gives the government a broad perspective on a different range of
import and export tariffs. The government then takes measures to
increase and decrease the tax to discourage import and encourage
export, respectively, and be self-sufficient.
If the economy urges support in the mode of import, the
government plans according to the BOP, and divert the cash flow and
technology to the unfavorable sector of the economy, and seek
future growth.
The balance of payment also indicates the government to detect the
state of the economy, and plan expansion. Monetary and fiscal policy
are established on the basis of balance of payment status of the
country.
The General Rule in BOP Accounting
If a transaction earns foreign currency for the nation, it is a credit
and is recorded as a plus item.
If a transaction involves spending of foreign currency it is a debit and
is recorded as a negative item.
The various components of a BOP statement
Current Account
Capital Account
Reserve Account
Errors & Omissions
Current Account Balance
The current account of the balance of payments includes a country's
key activity, such as capital markets and services.
A surplus is indicative of an economy that is a net creditor to the rest
of the world. A deficit reflects a government and an economy that is
a net debtor to the rest of the world.
The four major components of a current account are goods, services,
income, and current transfers.
Components of Current Account of BoP

Goods
These are movable and physical in nature, and for a transaction to be
recorded under "goods," a change of ownership from or to a resident
(of the local country) to or from a non-resident (in a foreign country)
has to take place. Movable goods include general merchandise,
goods used for processing other goods, and non-monetary gold. An
export is marked as a credit (money coming in), and an import is
noted as a debit (money going out).

Services
These transactions result from an intangible action, such as
transportation, business services, tourism, royalties, or licensing. If
money is being paid for a service, it is recorded as an import (a
debit). If money is received, it is recorded as an export (credit).
Income
Income is the money going in (credit) or out (debit) of a country from
salaries, portfolio investments (in the form of dividends, for
example), direct investments, or any other type of investment.
Together, goods, services, and income provide an economy with fuel
to function. This means that items under these categories are actual
resources that are transferred to and from a country for economic
production.
Current Transfers
Current transfers are unilateral transfers with nothing received in
return. These include workers' remittances, donations, aids and
grants, official assistance, scholarships and pensions. Due to their
nature, current transfers are not considered real resources that
affect economic production.
Capital Account Balance
The capital account records all international transactions that involve
a resident of the country concerned changing either his assets with
or his liabilities to a resident of another country. Transactions in the
capital account reflect a change in a stock – either assets or
liabilities.
It is difference between the receipts and payments on account of
capital account. It refers to all financial transactions.
The capital account involves inflows and outflows relating to
investments, short term borrowings/lending, and medium term to
long term borrowing/lending.
The capital account, on a national level, represents the balance of
payments for a country.
The capital account keeps track of the net change in a nation's assets
and liabilities during a year.
The capital account's balance will inform economists whether the
country is a net importer or net exporter of capital.
The Reserve Account
The Three accounts: IMF, SDR, & Reserve and Monetary Gold are
collectively called as The Reserve Account.
The IMF account contains purchases (credits) and re- purchase
(debits) from International Monetary Fund.
Special Drawing Rights (SDRs) are a reserve asset created by IMF and
allocated from time to time to member countries. It can be used to
settle international payments between monetary authorities of two
different countries.
Errors & Omissions
The entries under this head relate mainly to leads and lags in
reporting of transactions

It is of a balancing entry and is needed to offset the overstated or

understated components.
Disequilibrium In The Balance Of Payments
A disequilibrium in the balance of payment means its condition of
either Surplus Or deficit which accrues to the current account
because and disequilibrium in BoP is settled/offset by the capital
account.
A Surplus in the BOP occurs when Total Receipts exceeds Total
Payments. When CREDIT>DEBIT BoP account shows a surplus.
A Deficit in the BOP occurs when Total Payments exceeds Total
Receipts. When CREDIT<DEBIT, BoP account shows a deficit.
Causes of Disequilibrium In The BoP
Cyclical fluctuations
Short fall in the exports
Economic Development
Rapid increase in population
Structural Changes
Natural Calamites
International Capital Movements

Measures To Correct Disequilibrium in the BoP

Monetary Measures :-
Monetary Policy
The monetary policy is concerned with money supply and credit in
the economy. The Central Bank may expand or contract the money
supply in the economy through appropriate measures which will
affect the prices.

Fiscal Policy
Fiscal policy is government's policy on income and expenditure.
Government incurs development and non - development
expenditure,. It gets income through taxation and non - tax sources.
Depending upon the situation governments expenditure may be
increased or decreased.
Exchange Rate Depreciation
By reducing the value of the domestic currency, government can
correct the disequilibrium in the BoP in the economy. Exchange rate
depreciation reduces the value of home currency in relation to
foreign currency. As a result, import becomes costlier and export
become cheaper. It also leads to inflationary trends in the country,
Devaluation
devaluation is lowering the exchange value of the official currency.
When a country devalues its currency, exports becomes cheaper
and imports become expensive which causes a reduction in the BOP
deficit.
Deflation
Deflation is the reduction in the quantity of money to reduce prices
and incomes. In the domestic market, when the currency is deflated,
there is a decrease in the income of the people. This puts curb on
consumption and government can increase exports and earn more
foreign exchange.
Exchange Control
All exporters are directed by the monetary authority to surrender
their foreign exchange earnings, and the total available foreign
exchange is rationed among the licensed importers. The license-
holder can import any good but amount if fixed by monetary
authority.
Non- Monetary measures :-
Export Promotion
For export promotions the country may adopt measures to stimulate
exports like:
export duties may be reduced to boost exports
cash assistance, subsidies can be given to exporters to increase
exports
goods meant for exports can be exempted from all types of taxes.
Import Substitutes
Steps may be taken to encourage the domestic production of import
substitutes. This will save foreign exchange in the short run by
replacing the use of imports by these import substitutes.
Import Control
Import may be kept in check through the adoption of a wide variety
of measures like quotas and tariffs. Under the quota system, the
government fixes the maximum quantity of goods and services that
can be imported during a particular time period.
Quotas – Under the quota system, the government may fix and
permit the maximum quantity or value of a commodity to be
imported during a given period. By restricting imports through the
quota system, the deficit is reduced and the balance of payments
position is improved.
Tariffs – Tariffs are duties (taxes) imposed on imports. When tariffs
are imposed, the prices of imports would increase to the extent of
tariff. The increased prices will reduced the demand for imported
goods and at the same time induce domestic producers to produce
more

UNIT 2: MONEY AND MONETARY POLICY e of import substitutes

History

The Reserve Bank of India was established on April 1, 1935 in

accordance with the provisions of the Reserve Bank of India Act
1934.
The Central Office of the Reserve Bank was initially established in
Kolkata but was permanently moved to Mumbai in 1937.
The Central Office is where the Governor sits and where policies are
formulated.
Though originally privately owned, since nationalization in 1949, the
Reserve Bank is fully owned by the Government of India.
Preamble
The Preamble of the Reserve Bank of India describes the basic
functions of the Reserve Bank as:
"to regulate the issue of Bank notes and keeping of reserves with a
view to securing monetary stability in India and generally to operate
the currency and credit system of the country to its advantage; to
have a modern monetary policy framework to meet the challenge of
an increasingly complex economy, to maintain price stability while
keeping in mind the objective of growth.“

Function prescribed in Preamble

Issue of Bank notes
Securing monetary stability
Operate the currency and credit system
Meet the challenge of an increasingly complex economy
The Preamble in the RBI Act, as amended by the Finance Act, 2016,
provides that the primary objective of the monetary policy is to
maintain price stability, while keeping in mind the objective of
growth, and to meet the challenge of an increasingly complex
economy.

However, the functions which the RBI is undertaking is not restricted

only within the provisions of the RBI Act.
It also extends to various areas, such as, regulation and supervision
of banks, consumer protection, management of foreign exchange,
management of government securities, regulation and supervision of
payment systems, etc.
For these functions, powers are drawn from various laws, namely,
the Banking Regulation Act, 1949, Foreign Exchange Management
Act, 1999, Government Securities Act, 2006, Payment and
Settlement Systems Act, 2007, etc.
Functions of RBI
Banking Function

Section 17 of the RBI Act enables RBI to do banking business, such as

accepting deposits, without interest, from any person.
The other business, which the RBI may transact are also
mentioned in the said provision.
It states that the RBI may transact various businesses such as
acceptance of deposits without interest from Central Government
and State Governments,
Purchase, sale and rediscount of Bills of Exchange, making of
short term loans and advances to banks and other institutions,
Providing of annual Contributions to National Rural Credit
Funds,
Purchase and sale of Government Securities, Purchase and sale
of shares of State Bank of India, National Housing Bank, Deposit
Insurance and Credit Guarantee Corporation, etc.,
Keeping of Deposits with SBI for specific purposes, and making
and issue of Banknotes, etc.
Section 18 facilitates the RBI to act as a ‘Lender of Last Resort’
 Issue Functions

Issuance of bank notes is one of the key central banking

functions the RBI is authorized and mandated to do.

Section 22 of the RBI Act confers on RBI the sole right to issue
bank notes in India. The issue of bank notes shall be conducted by a
department called the Issue Department.

The design, form and material of bank notes shall be approved

by the Central Government on the recommendations of Central
Board of the RBI.

Every bank note shall be a legal tender at any place in India,

however, on recommendation of the Central Board, the Central
Government may declare any series of bank notes of any
denomination to be not a legal tender.

Another important function is exchange of mutilated or torn

notes, which under the RBI Act is not a matter of right, but of grace.
Banking Regulation & Supervision
India has a variety of banks viz.,
Banking companies (banks which are companies and regulated
by the Banking Regulation Act, 1949),
State Bank of India (constituted by the State Bank of India Act,
1955),
 Nationalized Banks (constituted by the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1970/ 1980),
Regional Rural Banks (constituted under the Regional Rural
Banks Act, 1976) and
Co-operative banks (constituted either under the Multi-State
Co-operative Societies Act, 2002 or State Co-operative Societies
Acts).

Although RBI is entrusted with the task of regulating and

supervising all types of banks in the country, the powers exercisable
by it towards different banks are not uniform.
The power to regulate and supervise banking companies has
been provided by the provisions of the Banking Regulation Act, 1949
(BR Act, 1949) to the RBI.
Although, preamble to the BR Act, 1949, states that it is an Act
to consolidate and amend the law relating to banking. The powers of
RBI to formulate banking policy, regulate and supervise banking
business etc., are scattered across the BR Act, 1949.
Section 5(ca) of the BR Act, 1949, states that banking policy
means any policy, which is specified from time to time by the RBI, in
the interest of the banking system or in the interest of monetary
stability or sound economic growth, having due regard to the
interests of the depositors, the volume of deposits and other
resources of the bank and the need for equitable allocation and the
efficient use of these deposits and resources.
The appointment of chairman and whole-time directors of a
banking company shall not have effect, unless done with the
previous approval of the Reserve Bank.
 Similarly, as a part of control over management, Section 36-AB
of BR Act, 1949, empowers RBI to appoint additional directors on the
boards of banking companies.
Section 36-AA of the BR Act, 1949 enables RBI to remove
executives, officers and employees of a banking company under
certain conditions.

Moreover, the RBI has been empowered under BR Act, 1949, to

supersede the boards of banking companies.
Though it is not the role of the Reserve Bank to micro-manage
the affairs of banks, it has powers tor to control advances by banking
companies.
Section 22 of the BR Act, 1949 confers on RBI the power to
issue licenses and also to cancel licenses of banking companies.
Another important regulatory power that has been vested in the RBI
is the power to issue directions to banking companies.
Under Section 35-A of the BR Act, 1949, RBI has the power to
issue directions to banking companies in public interest or in the
interest of banking policy or to prevent the affairs of any banking
company being conducted in a manner detrimental to the interests
of the depositors or in a manner prejudicial to the interests of the
banking company or to secure the proper management of any
banking company.
Regulation and Supervision of NBFCs
The regulation and supervision of non-banks is one of the
critical functions that the RBI has been entrusted with.
Section 45-IA of the RBI Act mandates every non-banking
financial company to obtain a certificate of registration from the RBI
and to have a net owned fund as may be specified by the RBI in the
Official Gazette, before commencing such non-banking financial
business.
Further, as a part of regulation and supervision of non-banks,
the RBI has been conferred with the statutory powers to regulate or
prohibit issue of prospectus or advertisements soliciting deposits of
money by non-banking financial companies, power to determine
policy and issue directions to non-banking financial companies, etc.

Foreign Exchange Management

The powers and responsibilities with respect to external trades
and payments, development and maintenance of foreign exchange
market in India are conferred on the RBI under the provisions of the
Foreign Exchange Management Act, 1999 (‘FEMA").
Section 10 of the FEMA empowers the RBI to authorize any
person to be known as authorized person to deal in foreign exchange
or in foreign securities, as an authorized dealer, money changer or
off-shore banking unit or in any other manner as it deems fit.
Similarly, it empowers the RBI to revoke an authorization
issued to an authorized dealer in public interest, or the authorized
person has failed to comply with the conditions subject to which the
authorization was granted or has contravened any of the provisions
of the FEMA or any rule, regulation, notification, direction or order
issued by the RBI.

Monetary Policy Functions

The RBI Act provides for a statutory basis for the Monetary
Policy Framework and the Monetary Policy Committee.
 The Central Government, in consultation with the RBI shall
determine the inflation target in terms of the Consumer Price Index,
once in every five years, which needs to be notified in the Official
Gazette.

Similarly, it is the Central Government that should constitute a

Monetary Policy Committee by notification in the Official Gazette.

The Monetary Policy Committee shall consist of

(a) The Governor of the RBI;
(b) Deputy Governor of the RBI in charge of Monetary Policy;
(c) One officer of the RBI to be nominated by the Central Board;
and
(d) Three persons to be appointed by the Central Government.

The Monetary Policy Committee has been entrusted with the

statutory duty to determine the Policy Rate required to achieve the
inflation target.

The decision of the Monetary Policy Committee is binding on

the RBI and the RBI shall publish a document explaining the steps to
be taken by it to implement the decisions of the Monetary Policy
Committee.
Consumer Protection and promotion Functions

Protection of the interests of the depositors is one of the vital

mandates of the RBI.
 The various provisions in the RBI Act, 1934, BR Act, 1949, etc.,
are replete with the phrases like “in the interests of depositors”
wherever it entrusts powers to the RBI.

Apart from depositors, the resolution of grievances of

customers who deal with its regulated entities is also important for
the Reserve Bank of India.

Reserve Bank of India has formulated three Ombudsman

Schemes for covering operations of banks, NBFCs and payment
systems.

UNIT 2: MONEY AND MONETARY POLICY

Background
In May 2016, the RBI Act, 1934 was amended to provide a
statutory basis for the implementation of the flexible inflation
targeting framework.

Inflation Target: Under Section 45ZA, the Central Government,

in consultation with the RBI, determines the inflation target in terms
of the Consumer Price Index (CPI), once in five years and notifies it in
the Official Gazette.

Accordingly, on August 5, 2016, the Central Government

notified in the Official Gazette 4 per cent Consumer Price Index (CPI)
inflation as the target for the period from August 5, 2016 to March
31, 2021 with the upper tolerance limit of 6 per cent and the lower
tolerance limit of 2 per cent.

On March 31, 2021, the Central Government retained the

inflation target and the tolerance band for the next 5-year period –
April 1, 2021 to March 31, 2026.

Section 45ZB of the RBI Act provides for the constitution of a

six-member Monetary Policy Committee (MPC) to determine the
policy rate required to achieve the inflation target.

Failure to Maintain Inflation Target

The Central Government has notified the following as the

factors that constitute failure to achieve the inflation target:

The average inflation is more than the upper tolerance level of

the inflation target for any three consecutive quarters; or
The average inflation is less than the lower tolerance level for
any three consecutive quarters.

Where the Central Bank fails to meet the inflation target, it

shall set out in a report to the Central Government:
The reasons for failure to achieve the inflation target;
Remedial actions proposed to be taken by the Bank; and
An estimate of the time-period within which the inflation target shall
be achieved pursuant to timely implementation of proposed
remedial actions.

The Monetary Policy Committee

Section 45ZB of the amended RBI Act, 1934 provides for an
empowered six-member monetary policy committee (MPC) to be
constituted by the Central Government by notification in the Official
Gazette.

The first such MPC was constituted on September 29, 2016.

The present MPC members, as notified by the Central

Government in the Official Gazette of October 5, 2020, are as under:

1. Governor of the Reserve Bank of India—Chairperson, ex

officio;

2. Deputy Governor of the Reserve Bank of India, in charge of

Monetary Policy—Member, ex officio;

3. One officer of the Reserve Bank of India to be nominated by

the Central Board—Member, ex officio;

4. Prof. Ashima Goyal, Professor, Indira Gandhi Institute of

Development Research —Member;
 5. Prof. Jayanth R. Varma, Professor, Indian Institute of
Management, Ahmedabad—Member; and
6. Dr. Shashanka Bhide, Senior Advisor, National Council of Applied
Economic Research, Delhi—Member

Members referred to at 4 to 6 above, will hold office for a period of

four years or until further orders, whichever is earlier

The MPC determines the policy repo rate required to achieve

the inflation target.

The MPC is required to meet at least four times in a year.

The quorum (minimum number of members) for the meeting of

the MPC is four members.

Each member of the MPC has one vote, and in the event of an
equality of votes, the Governor has a second or casting vote.

Each Member of the Monetary Policy Committee writes a

statement specifying the reasons for voting in favour of, or against
the proposed resolution.
The Monetary Policy Process
 The Reserve Bank has notified Reserve Bank of India Monetary
Policy Committee and Monetary Policy Process Regulations, 2016
which came into effect from August 01, 2016.
In terms of Regulation, the Monetary Policy Process consists of
the following:

Meeting schedule
The schedule of monetary policy voting/decision meetings for
the entire fiscal year is announced in advance.
Meeting notice
Ordinarily, not less than fifteen days’ notice is given to
members for meetings of the Committee.
Should it be found necessary to convene an emergency
meeting, 24 hours’ notice is given to every member to enable
him/her to attend, with technology enabled arrangements for even
shorter notice period for meetings.
Meeting duration
The duration of monetary policy meetings is as decided by the
Committee.
The policy resolution is publicly released after the conclusion of
the MPC meeting keeping in view the functioning and timing of
financial markets.

The Reserve Bank’s Monetary Policy Department (MPD) assists

the MPC in formulating the monetary policy.

The MPC in its meetings reviews

 The surveys conducted by the Reserve Bank to gauge consumer
confidence,
Households’ inflation expectations,
Corporate sector performance,
Credit conditions,
The outlook for the industrial sector,
Services and infrastructure sectors, and
The projections of professional forecasters.

The MPC also reviews in detail the staff’s macroeconomic

projections, and alternative scenarios around various risks to the
outlook.

Drawing on the above and after extensive discussions on the

stance of monetary policy, the MPC adopts a resolution.
The MPC Resolution
The Bank publishes, after the conclusion of every meeting of
the MPC, the resolution adopted by the said Committee.
The resolution includes the MPC’s decision on the policy repo
rate.

Minutes of the MPC meeting

On the 14th day after every meeting of the MPC, the minutes
of the proceedings of the MPC are published which include:

(a) The resolution adopted by the MPC;

 (b) The voting of each member on the resolution; and
(c) Short written statements of individual members justifying
the vote, consistent with the provisions of Section 45ZL of the RBI
Act.
Minutes shall be released at 5 pm on the 14th day from the
date of the policy day (or next earliest working day, if a holiday in
Mumbai).

The Monetary Policy Report

Once in every six months, the Reserve Bank publishes the
Monetary Policy Report containing the following elements:

a) Explanation of inflation dynamics in the last six months and

the near term inflation outlook;
b) Projections of inflation and growth and the balance of risks;
c) An assessment of the state of the economy, covering the real
economy, financial markets and stability, fiscal situation, and the
external sector, which may entail a bearing on monetary policy
decisions;
d) An updated review of the operating procedure of monetary
policy; and
e) An assessment of projection performance.
Types of Monetary Policy
As we understood, monetary policy directs the activities carried
out by the RBI in order to control the money supply in the economy.
 This control of money supply helps in managing the inflation or
deflation (negative inflation) situations.
Thus, a monetary policy can be of two types – expansionary or
contractionary

UNIT 2: MONEY AND MONETARY POLICY

Instruments of Monetary Policy
Liquidity Adjustment Facility (LAF): The LAF refers to the
Reserve Bank’s operations through which it injects/absorbs liquidity
into/from the banking system.

It consists of overnight as well as term repo/reverse repos

(fixed as well as variable rates), SDF and MSF.

Apart from LAF, instruments of liquidity management include

outright open market operations (OMOs), and market stabilization
scheme (MSS).
 LAF Corridor: The LAF corridor has the marginal standing facility
(MSF) rate as its upper bound (ceiling) and the standing deposit
facility (SDF) rate as the lower bound (floor), with the policy repo
rate in the middle of the corridor.
Quantitative measures

1. CRR (Cash Reserve Ratio)

CRR is the average daily balance that a bank is needed to
maintain with the RBI, one of the prime regulators of banks and
financial institutions.
The CRR is a share of such a percentage of its NDTL (Net
Demand and Time Liabilities) that the RBI may alter on a regular
basis in the Gazette of India.

2. SLR (Statutory Liquidity Ratio)

The SLR is the share of NDTL that banks are mandated to
maintain in the form of safe and liquid assets. These include
government securities, cash, and gold.
If there is any change in the SLR, it influences the availability of
resources in the banking industry for extending loans to the private
sector.

Net Demand and Time Liabilities (NDTL)= Demand Liabilities

+Time Liabilities + Other Demand and Time Liabilities – Assets with
the Banking System
 Demand Liabilities (DL): The demand liabilities for a bank
include all those liabilities which are payable on demand.
Time Liabilities (TL): Time liabilities of a bank are those liabilities
which are payable after an agreed period.

Examples
Demand liabilities of a bank include:
Current deposits,
Demand liabilities portion of savings bank deposits,
Margins held against letters of credit/guarantees,
Balances in overdue fixed deposits, cash certificates and
cumulative/recurring deposits payable on demand

Time Liabilities of a bank include:

Fixed deposits, cash certificates, cumulative and recurring
deposits,
Portion of savings bank deposits, staff security deposits, margin
held against letters of credit, if not payable on demand,
Gold deposits.
Assets with the banking system of a bank include:
Balances with banks in current account,
Balances with banks and notified financial institutions in other
accounts,
Funds made available to banking system by way of loans or
deposits repayable at call or short notice of a fortnight or less
 3. Repo Rate
The rate of interest the RBI charges from its customer base on
their short-term borrowings is the Repo Rate. Hence, it is basically an
abbreviated form of “rate of purchase”.
In practical form, it is not called an interest rate. Instead, it is
considered as a discount on the dated government securities that are
deposited by the institution to borrow for a short term.
Repo Rate is fixed to be in the range of 5% to 9%
4. Reverse Repo Rate
It is the rate of interest that the RBI pays to its customer base
that offers short-term loans to it.
As the name suggests, it is the reverse of the repo rate and it
was started in November 1966 as a part of the LAF (Liquidity
Adjustment Facility) by the RBI.
The Reverse Repo Rate is utilized by the RBI in the wake of over
money supply with the banks and lower loan disbursal to serve both
the purposes of cutting down losses in the prevailing interest rates.
The reverse repo rate ranges from 5% to 9%
5. Marginal Standing Facility (MSF)

The MSF enables the banks to borrow overnight up to 1% of

their NDTL from the RBI at the interest rate 1% higher than the
current repo rate.

The penal rate at which banks can borrow, on an overnight

basis, from the Reserve Bank by dipping into their Statutory Liquidity
Ratio (SLR) portfolio up to a predefined limit (2 per cent).
 This provides a safety valve against unanticipated liquidity
shocks to the banking system. The MSF rate is placed at 25 basis
points above the policy repo rate.

The minimum amount of MSF of INR 1 crore is accepted by the

RBI.
The MSF is fixed to be in the range of 6% to 10%
The Marginal Standing Facility (MSF) is an overnight liquidity
support scheme by the RBI to provide funds (liquidity injection) to
commercial banks with a higher interest rate over the repo rate.
Basically, the MSF is an emergency liquidity facility and is available
on all working days and on most of the holidays except Saturdays.

The scheme has been introduced by RBI with the aim of

reducing volatility in the overnight lending rates in the inter-bank
market and to enable smooth monetary transmission in the financial
system.

The significance of Marginal Standing Facility (MSF) is that it is

one of the most frequently used liquidity seeking (injection) facility
for banks. The other frequently used instrument is the Standing
Deposit Facility -but for an opposite purpose of liquidity absorption
(parking funds with the RBI). The phasing out of Repo and Reverse
Repo operations by the RBI have increased the significance of MSF
and SDF for the purposes of liquidity injection and absorption
respectively.
6. Bank Rate
Bank Rate is the rate of interest which the RBI charges on its
long-term lendings.
 Borrowers who borrow through this route are the government
of India, state government, other banks, Non Banking Financial
Companies (NBFCs), financial institutions, cooperative banks, etc.
The bank rate is fixed in the range of 5% to 7%

7. Open Market Operations (OMOs)

The OMOs are organized by the RBI via the sale and/ or
purchase of securities of the government to/ from the market with
the main intention of regulating rupee liquidation in the market.
OMOs are effective quantitative tools in the RBI’s inventory,
however, they are constrained by the stock of government securities
available with it at a point of time.
8. Standard Deposit Facility Scheme (SDFS)
Standing Deposit Facility (SDF) Rate: The rate at which the
Reserve Bank accepts uncollateralized deposits, on an overnight
basis
The SDF is also a financial stability tool in addition to its role in
liquidity management.
The SDF rate is placed at 25 basis points below the policy repo rate.
The SDFS scheme has been proposed by the Union Budget of
2018-19. However, such a tool was proposed by the RBI back in
November 2015.The Standing Deposit Facility (SDF) is a collateral-
free liquidity absorption mechanism introduced by the RBI to absorb
excess liquidity from the banks by providing an interest payment.
There are several mechanisms already used by the RBI to withdraw
excess liquidity in the banking system and the popular one was the
reverse repo. The unique feature of SDF is that it is a collateral free
liquidity absorption mechanism to absorb liquidity from the
commercial banking system into the RBI. Collateral free means the
RBI will not give any collateral like G-Secs while bank gives funds to
the RBI. Government in the Budget’s (2018) Finance Act included a
provision for the introduction of the Standing Deposit Facility
(SDF).The SDF was introduced on April 8, 2022.

The main purpose of SDF is to reduce the excess liquidity of Rs

8.5 lakh crore in the system, and control inflation.

Qualitative Measures
Qualitative measures are the ones that are related to the
financial system and are managed like flow according to rates.

In these, the volume of money is not controlled. Below are

some of the qualitative measures used in the monetary policy:
1. Margin Requirement
The bank gives loan on the basis of tangible security or
collateral security. The RBI fixes the minimum marginal requirements
on loan for purchasing or carrying securities. Market value of the
security and the amount lent by the bank against security is called
Margin requirement. If the Central bank fixes a margin of 20% then,
on a security of 10,000, the bank will lend Rs 8,000 only. If the
central bank is to restrict credit to socially undesirable sector, it may
raise the margin to 25%. In that case bank will be able to lend Rs
7,500 only. In case the central bank desires to expand credit to
socially desirable sectors it may lower margin to 10%.
(Security value – Loan amount = Margin Requirement)
2. Moral Suasion
 Sometimes it is not possible or required to control the flow of
money directly. At such times, the RBI releases informal advisories to
the customers and the banks.
Here, the banks and customers are not compelled.

3. Direct Action
Direct action refers more or less, a corrective measure against
those commercial banks who fails to toe the line of the central bank
monetary policy. It may refuse to rediscount their bills of exchange
or grant them other financial accommodation, or come to their
rescue in their crisis hour. However commercial banks can ill-afford
to earn the wealth of the central bank and be its defaulter.

4. Control through Directives

Banks are directed by the central bank to be liberal in granting
credit to the priority sectors, like agriculture, power, infrastructure,
housing education, etc rather than less priority sectors.

Limitation of Monetary Policy

The importance of monetary policy is realized in the fact it tries
to promote economic development by supervising inflationary and
deflationary gaps, disequilibrium in balance of Payments, stability in
exchange rate, infusion of capital formation yet monetary policy
faces certain barriers which are highlighted as under:
1. Money market is not organized: There is a huge size of
money market in our country which is unorganized such as
indigenous bankers like money lenders etc. they do not come under
the control of the RBI. Thus any tool of the Monetary Policy does not
affect the unorganized money market making Monetary Policy less
effective.
2. Large Non-monetized Sector: Large non-monetized sector
which hinders the success of monetary policy since all the
transactions conducted therein are mere barter exchanges. People
do not deposit money with banks rather than use them for
conspicuous consumption, etc. Such activities encourage inflationary
pressures because they lie outside the control of the monetary
authority.
3. Large Number of NBFIs: Coverage area of Monetary Policy is
limited since Monetary Policy covers only commercial banking
sector. Other non-banking institutions remain untouched. NBFI
which do not come under the purview of monetary policy greatly
hampers to achieve the objectives of monetary policy in the less
developed country.
4. Existence of Parallel Economy: The existence of parallel
economy limits the working of the monetary policy. The black money
is not recorded since the borrowers and lenders keep their
transactions secret and hidden. Consequently the supply and
demand of money gap arises and also doesn’t remain as desired by
the monetary policy.
5. Deficit Financing: A monitory authority wants to check the
supply of money while deficit financing helps to increase the supply.
In today’s scenario deficit financing is the main source of financing
development activities and thereof with deficit financing objectives
of monetary policy becomes ineffective.
6. Only a Persuasive Policy: In underdeveloped economies
monetary policy is soft, persuasive and lenient which sometimes
leave a scope of tax evasion, antisocial elements, black money etc. in
the economy which limits the effectiveness of monetary policy
7. Time lag: Monetary Policy works judiciously only after series
of time lags. The time gap between the formulation of the plan and
implementation of it is known as time lag.

Indian Banking Industry: Challenges and Opportunities

Competition
With the ever increasing pace and extent of globalization of
the Indian economy and the systematic opening up of the
Indian Banking System to global competition, banks need to
equip themselves to operate in the increasingly competitive
Environment. This will make it imperative for Banks to
enhance their systems and procedures to international
standards and also simultaneously fortify their financial
positions.
4.8. Transparency and Disclosures
In order to bring about meaningful disclosure of the true
financial positionof banks to enable the users of financial
statements to study and have a meaningful comparison of their
positions, a series of measures were initiated by RBI.
a. Low Profitability and Productivity
b. Lack of Integrity
c. Increase of Administrative Expenses
d. Survival of loss making branches
 e. Scandals
f. Lack of Professional Behavior
g. Lack of professional and friendly approaches with
customer
h. Non-performing Assets
i. Customer oriented market
j. Problem of customer satisfaction
k. Depression period running over the country
l. Managing work force
m. Management of technological advancement
CHALLENGES IN BANKING SECTOR :-
There has been considerable widening and deepening of the
Indian financial system in the recent years. The enhanced role
of the Banking sector in the Indian Economy, the increasing
levels of deregulation and the increasing levels of competition
have placed numerous demands on our Banks. The adverse
consequences of malfunction of the Banking system could be
more severe than in the past. Hence, focus of RBI, the
regulator & supervisor of Indian Banking system is at ensuring
greater financial stability. While operating in this highly
demanding environment, the banking system is exposed to
various risks & challenges few of them are discussed as under:

4.1. Improving Risk Management System

RBI had issued guidelines on asset liability management and
Risk Management Systems in Banks in 1999 and Guidance
Notes on Credit Risk Management and Market Risk
Management in October 2002 and the Guidance note on
Operational Risk Management in 2005. Though Basel II
focuses significantly on risks it implementation cannot be seen
as an end in itself. The current business environment demands
an integrated approach to risk management. It is no longer
sufficient to manage each Risk Independently. Banks in India
are moving from the individual segment system to an
enterprise wide Risk Management System. This is placing
greater demands on the Risk Management skills in Banks and
has brought to the forefront, the need for capacity building,
while the first priority would be risk integrating across the
entire Bank, the desirability of Risk aggregation across the
Group will also need attention. Banks would be required to
allocate significant resources towards this objective over the
next few years.

4.2. Rural Coverage

Indian local banks specially state bank groups having a good
coverage and many branches in rural areas. But that is quite
lacking technical enhancement. The services available at cities
are specifically not available to rural branches, which are
necessary if banks want to compete now a day.

4.3. Technological Problems

That is true that Indian banks were already started
computerized workings and so many other technological up
gradation done but is this sufficient? In metro cities Indian
local banks are having good comparable technology but that
cannot be supported and comparable by the whole network of
other cities and village branches.
 4.4. Corporate Governance
Banks not only accept and deploy large amount of
uncollateralized public funds in fiduciary capacity, but they
also leverage such funds through credit creation. Banks are
also important for smooth functioning of the payment system.
Profit motive cannot be the sole criterion for business
decisions. It is a significant challenge to banks where the
priorities and incentives might not be well balanced by the
operation of sound principles of Corporate Governance. If the
internal imbalances are not re-balanced immediately, the
correction may evolve through external forces and may be
painful and costly to all stakeholders. The focus, therefore,
should be on enhancing and fortifying operation of the
principles of sound Corporate Governance.

4.5. Customer Services

There are concerns in regard to the Banking practices that tend
to exclude vast sections of population, in particular
pensioners, self employed and those employed in unorganized
sector. Banks are expected to oblige to provide Banking
services to all segments of the population, on equitable basis.
Further, the consumers interests are at times not accorded full
protection and their grievances are not properly attended to by
Banks. Banks are expected to encourage greater degree of
financial inclusion in the country setting up of a mechanism
for ensuring fair treatment of consumers; and effective
redressed of customer grievances.

4.6. Branch Banking

Traditionally Banks have been looking to expansion of their
Branch Network to increase their Business. The new private
sector banks as well as the foreign banks have been able to
achieve business expansion through other means. Banks are
examining the potential benefits that may accrue by tapping
the agency arrangement route and the outsourcing route.
While proceeding in this direction banks ought not to lose
sight of the new risks that they might be assuming in
outsourcing. Hence they have to put in place appropriate
strategies and systems for managing these new risks.
trategies and systems for managing these new risks.

4.7. Competition
With the ever increasing pace and extent of globalization of
the Indian economy and the systematic opening up of the
Indian Banking System to global competition, banks need to
equip themselves to operate in the increasingly competitive
Environment. This will make it imperative for Banks to
enhance their systems and procedures to international
standards and also simultaneously fortify their financial
positions.

4.8. Transparency and Disclosures

In order to bring about meaningful disclosure of the true
financial position of banks to enable the users of financial
statements to study and have a meaningful comparison of their
positions, a series of measures were initiated by RBI. It
covered a No. of aspects such as capital adequacy, asset
quality, profitability, country risk exposure, risk exposures in
derivatives, segment reporting and related party disclosures
etc. With a view to moving closer towards international best
practices and International Accounting Standards and the
disclosure need under pillar 3 of Basel II, RBI has proposed
enhanced disclosures of certain qualitative aspects. Banks
are20
 required to formulate a formal disclosure policy that addresses
the banks’ approach for determining what disclosures it will
make and the internal controls over the disclosure process.

4.9. Known Your Customer Guidelines

The guidelines were revisited in the context of the
recommendations made by the financial action task force on
Anti Money Laundering Standards and on Combating
Financing of Terrorism. Compliance with these standards both
by the banks/financial institutions and the country has become
necessary for international financial relationships. Compliance
with this requirement is a significant challenge to the entire
banking industry to fortify itself against misuse by anti social
persons / entities and thus project a picture of solidarity and
financial integrity of the Indian Banking system to the international
community.

UNIT 3: BANKING
Topic: Designing and Pricing of Deposit Services
Interest Rate framework: Deposits
Scheduled commercial banks shall pay interest on deposits of
money (other than current account deposits) accepted by them or
renewed by them in their
Domestic,
Ordinary Non-Resident (NRO),
Non-Resident (External) Accounts (NRE) and
Foreign Currency (Non-resident) Accounts (Banks) Scheme
{FCNR(B)} deposit account
 on the terms and conditions specified in these directions:
(a) There shall be a comprehensive policy on interest rates on
deposits duly approved by the Board of Directors or any committee
of the Board to which powers have been delegated.

(b) The rates shall be uniform across all branches and for all
customers and there shall be no discrimination in the matter of
interest paid on the deposits, between one deposit and another of
similar amount, accepted on the same date, at any of its offices.
(c) Interest rates payable on deposits shall be strictly as per the
schedule of interest rates disclosed in advance. The banks shall
maintain the bulk deposit interest rate card in their Core banking
system to facilitate supervisory review.
(d) The rates shall not be subject to negotiation between the
depositors and the bank.
(e) The interest rates offered shall be reasonable, consistent,
transparent and available for supervisory review/scrutiny as and
when required.
(f) All transactions, involving payment of interest on deposits
shall be rounded off to the nearest rupee for rupee deposits and to
two decimal places for FCNR(B) deposits.

(g) Deposits maturing on non-business working day

If a term deposit is maturing for payment on a non-business
working day, Scheduled Commercial Banks shall pay interest at the
originally contracted rate on the original principal deposit amount
for the non-business working day, intervening between the date of
the maturity of the specified term of the deposit and the date of
payment of the proceeds of the deposit on the succeeding working
day.
(ii) In case of reinvestment deposits and recurring deposits,
Scheduled Commercial Banks shall pay interest for the intervening
non-business working day on the maturity value.

(h) Consequence of transfer of branch of one bank to another

bank: Deposits accounts transferred from one bank branch to
another bank branch on account of takeover of bank branches in
rural and semi-urban centers shall adhere to the following
conditions:
(i) deposit accounts shall deemed to be transferred to the new
bank and will continue to be governed by the terms of contract
agreed to between the customer and the bank branch that is being
taken over.
(ii) the same rate of interest shall be payable till maturity on
such transferred deposits, as was payable at the time of takeover of
the branch.

Interest rate on different Account

Interest rate on domestic Current Account
No interest shall be paid on deposits held in current accounts.
Provided that balances lying in current account standing in the
name of a deceased individual depositor or sole proprietorship
concern shall attract interest from the date of death of the depositor
till the date of repayment to the claimant/s at the rate of interest
applicable to savings deposit as on the date of payment.
 Interest Rate on domestic Saving Deposits
In addition to the conditions laid down in of the Directions
(given in the interest framework), interest on domestic rupee savings
deposits shall be subject to the following:
(a) Interest on domestic rupee savings deposits shall be
calculated on a daily product basis as under:
A uniform interest rate shall be set on balance up to Rupees
one lakh, irrespective of the amount in the account within this limit.
Differential rates of interest may be provided for any end-of-
day savings bank balance exceeding Rupees one lakh.
Interest Rates on domestic Term Deposits
In addition to the conditions laid down in the Directions (given
in the interest framework), interest rates on term deposits shall vary
only on account of one or more of the following reasons:

(i) Tenure of Deposits: Banks shall have the freedom to

determine the maturity/tenure of the deposit subject to the
condition that minimum tenure of the deposit offered shall be seven
days.
(ii) Size of Deposits: Differential interest rate shall be offered
only on bulk deposits.
Provided that differential interest shall not be applicable on
deposit schemes framed on the basis of the Bank Term Deposit
Scheme, 2006 or the deposits received under the Capital Gains
Accounts Scheme, 1988.

(iii) Non- availability of Premature withdrawal option

 Banks shall have the freedom to offer term deposits without
premature withdrawal option.
Provided that all term deposits accepted from individuals (held
singly or jointly) for amount of Rupees fifteen lakh and below shall
have premature-withdrawal-facility.

(b) Payment of Interest on pre-mature withdrawal:

The interest rates applicable on term deposits withdrawn

before the maturity date shall be as under:

Interest shall be paid at the rate applicable to the amount and

period for which the deposit remained with the bank and not at the
contracted rate.

No interest shall be paid, where premature withdrawal of

deposits takes place before completion of the minimum period
specified in section (a)(i) of the previous slide.

UNIT 3: BANKING

Interest Rate framework Direction

These Directions shall be called the Reserve Bank of India
(Interest Rate on Advances) Directions, 2016.

These directions shall come into effect on the day it is placed

on the official website of the Reserve Bank of India.
 The provisions of these Directions shall apply to every
Scheduled commercial bank (excluding RRBs), Small Finance Bank
and Local Area Bank. These directions shall not be applicable to
operations of foreign branches of Indian banks.
Advance against own deposit means advance granted against
Rupee/FCNR(B) term deposit and the deposits that stand in the
name of:

 the borrower, either singly or jointly

 one of the partners of a partnership firm and advance is made to
the said firm.
 the proprietor of a proprietary concern and advance is made to
such concern.
o a ward whose guardian is competent to borrow on behalf
of the ward and where the advance is made to the guardian
of the ward in such capacity. (Wards are either minor
children or incapacitated persons.)
o
Definition of the important terms
Benchmark Prime Lending Rate (BPLR) means internal
benchmark rate used to determine the interest rates on
advances/loans sanctioned upto June 30, 2010.

Benchmark rate means the reference rate used to determine

the interest rates on loans.

External benchmark rate means the reference rate which

includes:
 Reserve Bank of India policy Repo Rate
 Government of India 3-Months and 6-Months Treasury Bill
yields published by Financial Benchmarks India Private Ltd
(FBIL)
 Any other benchmark market interest rate published by FBIL.

Fixed rate loan means a loan on which the interest rate is fixed for
the entire tenure of the loan.
Floating rate loan means a loan on which interest rate does not
remain fixed during the tenure of the loan. The total rate paid by
the customer varies, or "floats", in relation to some base rate, to
which a spread or margin is added (or more rarely, subtracted).
There is uneven nature of monthly installments which makes
financial planning difficult.
Internal benchmark rate means a reference rate determined
internally by the bank.

Interest Rate framework: Lending

Scheduled commercial banks shall charge interest on advances on

the terms and conditions specified in these directions.
There shall be a comprehensive policy on interest rates on
advances duly approved by the Board of Directors or any
committee of the Board to which powers have been delegated.

All floating rate loans, except those mentioned in section 13, shall
be priced with reference to the benchmark rate (explained in the
previous slide)

Banks shall have the freedom to offer all categories of advances

on fixed or floating interest rates.

When the floating rate advances are linked to an internal

benchmark rate, banks shall determine their actual lending rates
by adding the components of spread to the internal benchmark
rate.
Note: Interest rate spread is the interest rate charged by banks on
loans to private sector customers minus the interest rate paid by
commercial or similar banks on demand or time deposits.

The reference benchmark rate used for pricing the loans shall form
part of the terms of the loan contract.

Interest shall be charged on all advances at monthly rates.

Provided that interest on agricultural advances and advance to
farmers shall be charged as per the instructions contained in
circulars RPCD.No.CPFS.BC. 60/PS.165-85 dated June 06,
1985 and RPCD.No.PLFS.BC.129 /05.02.27/97-98 dated June
29, 1998.

Interest chargeable on rupee advances shall be rounded off to the

nearest rupee.

Interest charged on small value loans, particularly, personal loans

and such other loans of similar nature shall be justifiable having
regard to the total cost incurred by the bank in extending the
loan and the extent of return that could be reasonably expected
from the transaction.
In case of takeover of bank branches in rural and semi urban
centres from one commercial bank to another commercial bank,
transfer of borrower accounts of the existing branch to the
branch of acquiring bank shall be on mutually agreed terms of
contract.
Provided that the existing borrowers shall not be put into any
disadvantage and shall have the option of continuing with the
existing bank or the acquiring bank.

There shall be no lending below the benchmark rate for a

particular maturity for all loans linked to that benchmark.

These directions shall also be applicable to Rupee advances

 granted against FCNR(B) deposits to a third party or out of
resources mobilized under the FCNR(B) scheme.

UNIT3:BANKING
Credit Creation Process
Introduction

The central bank of a country is responsible for ensuring the supply

of money in the economy by circulating the currency.
It also ensures that for fulfilling all the transactions, there should be
appropriate currency in the system.
This process cannot be implemented by the central bank alone.
For this, they require the help of commercial banks and their
reserves.
Commercial banks perform the function of credit creation in an
economy.
The process of credit creation is considered one of the most
important functions performed by a commercial bank.
Credit creation refers to expanding the availability of money through
the advancement of loans and credit by banks and financial
institutions.

These institutions use their demand deposits to provide loans to

their customers, giving borrowers higher purchasing power and
competitive interest rates.

In the process of credit creation, banks keep some share of their

deposits as minimum reserves to meet the demand of their
depositors.
Thus, banks lend out the excess reserves for loans and investment
purposes, and the interest earned becomes income for the banks.

Therefore, the factors that drive the credit creation process are
liquidity and profitability of the banks.

Conditions Essential for Credit Creation

The following conditions are essential for credit creation in an
economy:
Willingness of public depositing money into the commercial banks

Willingness of commercial banks to lend money to individuals or

businesses in the form of credit

Willingness of individuals or businesses in seeking money from the

commercial banks in the form of credit

Formula for determining the Credit creation

Total credit creation = Original deposit ✕ Credit multiplier coefficient

Where, Credit multiplier coefficient = 1/r where r = Cash reserve

requirement also known as cash reserve ratio (CRR)

If the money deposited in a bank is ₹10,000 and the bank has a CRR
of 10%, then what will be the credit multiplier coefficient?

Credit multiplier coefficient = 1/10% = 1/0.1 = 10

Total credit creation = 10,000 ✕ 10 = 1,00,000

Similarly, if CRR = 20%

Then, Credit multiplier coefficient = 1/20% = 1/0.2 = 5
Therefore, total credit creation = 10,000 ✕ 5 = 50,000
A low CRR value results in high credit creation and a high CRR results
in low credit creation. Therefore, with the help of credit creation,
the money gets multiplied in the economy.
Limitations of Credit Creation

The following are some of the limitations that are experienced by the
commercial banks during the credit creation process.

Cash amount present in the bank

The higher the amount of deposits made by the public, the higher
credit creation from the commercial banks can be seen. However,
there is a certain limit on the amount of cash that can be held by the
banks at a time.

This limit is determined by the central bank, as the central bank may
contract or expand this limit by selling or purchasing the securities.

Cash reserve ratio or CRR

It refers to the amount of money in the form of reserve that needs to

be kept with the central banks by the commercial banks. This
amount is used for meeting the cash requirements of the users. Any
fall in the CRR will lead to more credit creation.

Borrower availability
Credit creation will flourish if there are borrowers. The credit
creation will not be done if there are no borrowers of the money in
an economy or they prefer to borrow from sources other than banks.

Prevalent business conditions

If an economy is witnessing a depression, then the businesses will
not be seeking credit that leads to contraction of credit creation.

Whereas, if a nation is prospering, then the businesses will seek new

funds in the form of credit from the banks that would lead to credit
creation.

UNIT 3: BANKING
Background
India's financial system is backed with number of issues in which the
gigantic quantity of non-performing assets on the bank's balance
sheet is one of the major issue.

The banks must keep the level of non-performing assets (NPAs) low
in order for the banking sector to function properly in the economy.

The most negative impact on the bank's financial health is because of

Non-performing loans (NPLs).

The bank's main business is granting loans to people in need.

One of the main activities of banks and financial institutions is
lending of capital (Creation of Credit).

Credit makes up the majority of a bank's or financial institution's

asset portfolio. Granting loans and the paying back of funds with
interest, back from borrowers is the major component of bank's
funding and credit-dispensing activity, in addition to obtaining
resources through new deposits.

What do non-performing assets (NPAs) mean?

The loan advanced by the banks are all can be termed as 'assets of
the bank’.

A loan whose specified interest is not paid or else there is no

repayment of the principal debt to the designated lender such loan
can be termed as Non-Performing Asset. An NPA is a loan that does
not generate revenue for a bank.

The 'Non-Performing Asset' is borrower's asset or account that has

been termed as substandard and dubious by the bank or financial
institution.

Here, the borrower has failed to make any previously agreed-upon

instalments or to pay the principal amount, rendering the loan
account non-performing.
If a borrower fails to pay dues in the form of principle and interest
for 180 days, the asset is categorize as a non-performing asset (NPA).

However, beginning in March 2004, if a borrower's dues are not paid

for 90 days, the borrower would be placed in default.

If a bank's advance or credit facilitated become non-performing asset

then the bank classifies all credit facilities/advances given to that
borrower as non-performing, regardless of whether some credit
facilities/advances remain in good standing.

The loan is declared bad, or an NPA, if the borrower fails to make his
equivalent monthly instalment (EMI) for 90 days. High
nonperforming assets (NPAs) indicate poor financial health.

Categories of Non-performing asset (NPA)

Standard:
It is when the borrower repays the principal and interest in a timely
manner to the bank. Here, the crucial factor is that the arrear in the
repayment of the principal and interest should not exceed 90 days at
the end of the financial year.

Sub-Standard:
These are non-performing assets for less than or equal to 12 months.

Loss:
Assets, which the bank's internal or external auditors, or the RBI
have identified as a loss, but the lost amount is completely not
written off the books. In other words these are those assets that is
deemed uncollectible or have been identified of such low value that
their continued status as a bankable asset is questionable even if
there is some recovery potential.

Doubtful:
An asset would be classified as doubtful if it has remained non
performing or in the sub-standard category for a period of 12
months. Such assets have flaws to render full collection or
liquidation.
Reasons leading to rising of NPAs
The economy's overall performance
The amount of non-performing assets held by banks has a significant
impact on the economy of the country.
When the economy is in dark and recessionary phase, borrowers,
especially the commercial ones finds it difficult to repay loans.

Firms' cyclicality
A Firm's cyclicality refers to a business cycle where the revenues are
higher during the intervals of economic expansion and lower during
the spans of economic contraction.
The cyclicality of the firm has a direct impact on the banks' capacity
to repay their loans. As a result, it affects the amount of non-
performing assets held by banks.

Intentional defaults and financial indiscipline

The most common reason for non-payment of loans is intentional
default.
The majority of defaulters are uninterested in repaying their loans.

Debt recovery: Background

Given the overall tough climate, recovery is critical to the banking
sector's stability.

The cost and recovery management, backed by an enabling

legislative environment, is the key to Indian banks' long-term health
and competitiveness.

Banks are currently having significant issues collecting loans and

enforcing securities attached to them.

The current approach for recovering bank loans has resulted in a

considerable amount of their capital tied up in non-productive assets
whose value depreciates over time.
Legal Framework for debt recovery
The Banks and Financial Institutions Debt Recovery Act of 1993

This Act was what led to the creation of the Debts Recovery Tribunals
(DRT) and Debts Recovery Appellate Tribunals (DRAT).

39 DRTs and 5 DRATs were established in India to recover debts

which were due, to the financial institutions like banks, etc.

These helped with speedy settlement and debt recovery due to

banks and other financial institutions and for issues connected with it
or incidental to it.
Debts Recovery Tribunals are presided over by a Presiding Officer
(PO), who is appointed by the Central Government and is an
individual qualified to be a District Judge.

In the case of a DRAT, it is presided by a chairperson, who is qualified

to be appointed or has been appointed as a Judge of a High Court or
has been a member of the Indian Legal Services, who was a Grade I
holder for at least three years in such services.

As per the DRT Act, an Original Application (OA) can only be filed
before the DRT by banks and financial institutions.

DRTs adopted the summary procedure to settle the disputes.

Besides, the defendants can file a counterclaim against the claimed

amount.

Furthermore, the final orders shall be passed by the tribunal, who

shall determine the amount payable by borrowers.

In case the borrower does not or is not able to pay the necessary
amount, a recovery certificate shall be issued against the borrower,
which shall be executed by the DRT’s Recovery Officer.

Anyone dissatisfied by an order passed by DRT may choose to file an

appeal before DRA
Securitization & Reconstruction of Financial Assets & Enforcement
of Security Interest (SARFAESI) Act, 2002

This legislation claims to create a central source of assets on which

the security interests were created on.

Certain creditors were appointed by the SARFAESI to manage

collateral properties with assistance from the relevant authorities of
the district where the collateral is found.

The guidelines under the SARFAESI Act shall be applicable to Security

Interest created in favor of Secured Creditor.

Applications filed under Section 17 of the SARFAESI Act shall be

made before the DRT within 45 days from the date the Section 13(4)
Notice is issued.

Such applications filed under Section 17 shall be disposed by the DRT

as per the procedure defined under the DRT Act.

Anyone dissatisfied with the order passed by the DRT may appeal to
the DRAT.

The Enforcement of Security Interest and Recovery of Debts Laws

and Miscellaneous Provisions (Amendment) Act, 2016
Over the years, it has been noticed that the DRTs are not able to
resolve cases within the allotted period of six months, which has
resulted in late resolution of cases and an increase in the cases
pending overall.

The Enforcement of Security Interest and Recovery of Debts Laws

and Miscellaneous Provisions (Amendment) Act, 2016 was created
with the purpose of boosting the efficiency of disposing such cases.

This Act ultimately amends the Securitization and Reconstruction of

Financial Assets and Enforcement of Security Interest Act, 2002, the
Indian Stamp Act, 1899, the Depositories Act, 1996, and the
Recovery of Debts due to Banks and Financial Institutions Act, 1993,
and for issues related thereto or incidental therewith.

The Insolvency and Bankruptcy Code (IBC), 2016

The Insolvency and Bankruptcy Code, 2016 is a combination of the
existing Insolvency laws and act like a united set of laws that aim to
eliminate multiple forums to reduce the delay in getting justice.

It repealed the Presidency Towns Insolvency Act, 1909 and the

Provincial Insolvency Act, 1920. It also brought amendments to 11
other laws such as the SARFAESI Act, Companies Act, and the DRT
Act.

The aim of this Code is not to recover money but revive

enterprise/corporate debtors.
 Although, in the worst-case scenario, if the debtor cannot be
revived, it goes through liquidation in an waterfall method as stated
in the Code.

Note: The waterfall method deals with the power of a secured

financial creditor who has been admitted under security. It provides
the priority for distribution of sale proceeds in the liquidation
process.

Therefore, in one way or the other, it can be said that this Act helps
with recoveries to a certain extent.
The legal framework includes:
Insolvency professionals.
The regulator (Insolvency and Bankruptcy Board of India).
Information utilities.
Adjudicatory mechanisms (NCLT & National Company Law Appellate
Tribunal – NCLAT).

Such frameworks and bodies aim to promote corporate governance

and bring about time-bound and formal resolutions for insolvent
cases.

The key features of the Code include insolvency resolution for

corporate debtors through a two-step process, where the default
amount is INR 1 crore.

Two processes are proposed by this Code:

Insolvency Resolution Process: The creditors play a vital role in
assessing and determining if the debtor’s business can be carried on
and, if so, what are the options available for the same.

Liquidation: If revival fails or is not possible, creditors can choose to

liquidate the company. Once winding up/liquidation is complete,
assets of the debtor are to be distributed.

Secured creditors of the corporate individual in liquidation cases are

protected under Section 52.

Section 52(1) states that a secured creditor in liquidation

proceedings may either:

Relinquish their security interest to the liquidation estate and receive

the funds generated by the liquidator through asset sales as per the
ways stated under Section 53, or

Realize their security interest as per the ways specified under Section
53.

Section 52(9) states that in cases where proceeds of realization are

not ample to repay the debts owed to the secured creditor, the
unpaid debts shall be paid by the liquidator in the ways specified
in clause (e) of Section 53(1).

UNIT 3: BANKING
MICROFINANCE
Microfinance is a banking service provided to low-income individuals
or groups who otherwise would have no other access to financial
services.
Microfinance allows people to take on reasonable small business
loans safely, in a manner that is consistent with ethical lending
practices.
The majority of micro-financing operations occur in developing
nations, such as Bangladesh, Cambodia, India, Afghanistan,
Democratic Republic of Congo, Indonesia, and Ecuador, among
others.
Like conventional lenders, micro-financiers charge interest on loans
and institute specific repayment plans.
The global microfinance market was valued at an estimated $187
billion in 2022, and is expected to exceed $488 billion by 2030.
Microfinancing organizations support a large number of activities,
ranging from bank checking and savings accounts—to startup capital
for small business entrepreneurs and educational programs that
teach the principles of investing.
These programs necessarily focus on such skills as bookkeeping,
cash-flow management, and technical or professional skills, like
accounting.

Note- Unlike typical financing situations, in which the lender is

primarily concerned with the borrower having enough collateral to
cover the loan, many microfinance organizations focus on helping
entrepreneurs succeed.
Microfinance in India
Lately, the RBI had released its 26th Financial Stability Report
(December 2022). In the report, it remarked that the credit to the
Microfinance sector has grown at a steady pace. However, the report
highlighted the building stress levels in the loans portfolio (i.e., bad
loans are increasing). The share of loans overdue by more than 90
days has risen to 14% in September 2022, from 12% in March 2022.
Microfinance is considered a potent tool to ensure balanced and
inclusive growth, especially by providing access to credit to the rural
citizens and small entrepreneurs. The rising delinquency in
Microfinance is indicative of the challenges faced by the sector. The
Government has been supporting the sector through various
initiatives.
(Being delinquent refers to a situation wherein the borrower is
overdue on a loan payment by a certain number of days)

Features of Microfinance

Collateral requirement: The major feature of the lines of credit and

loans under microfinance is that collateral is rarely required. Many
microfinancing institutions offer collateral-free financial services to
businesses and individuals.
Economic status of borrowers: Generally, the borrowers in
microfinance are small businesses or individuals with low income.
The purpose is to provide financial assistance to people who do not
have access to easy banking solutions and small businessmen or
entrepreneurs.
Amount of loans: Microfinancing institutions usually provide lines of
credit and loans in smaller amounts. The amount may vary
depending on factors like the type of business and the location.
Loan tenure: The tenure of the loans under microfinance is usually
short as an individual can repay the amount in smaller instalments.
The borrowers repay the amount of the loan within the time period
that micro-financing institutions decide.
Purpose: Microfinance loans are for small businesses and low income
group individuals. So the main objective of microfinancing
institutions is to generate income for the businesses in undeveloped
parts of the country.
Benefits of Microfinance
Provides accessibility
Individuals with little or zero assets often fail to get loans from major
banks. Microfinance loans are easily available for small businesses
that have less income. Many entrepreneurs find it difficult to provide
identification or certification to the traditional banks for loans.
Microfinance makes it easier for them to get financial assistance.

Offers better loan repayment

Microfinance helps businesses and individuals become financially
empowered so that they can repay their loans. Many microfinancing
institutions offer better loan repayment to women entrepreneurs.
Providing more women with the benefits of microfinancing can
directly help in women empowerment.

Provide education opportunities

Many small families in rural areas depend on farming for their
income. This can make it difficult for them to invest a lot of money in
the education of their children. Further, such families may require
men at the farm, so their children usually work with them. In such
cases, microfinance can help families to focus on providing better
education to their children.
Opens possibilities for future investments
Sometimes in rural areas, due to lack of source of income, small
businesses compromise with their basic requirements. This can
directly affect the profits and revenue. Microfinancing helps such
businesses to meet their basic requirements, minimising the financial
hindrances and helping them progress. When all the basic
requirements of a small business meeting, the possibilities of future
investments may also increase.

Creates job opportunities

Microfinancing often provides businesses with an opportunity to
create employment. Businesses can hire employees for different job
roles. A business properly funded through microfinance can create
local job opportunities and help in local economic growth.

Reduces financial burden

Microfinancing can help individuals and businesses in reducing
monetary issues by providing them with financial services that allow
them to pay their monthly bills. Businesses funded through
microfinance gain motivation to focus more on offering better
products and services to the target audience. Microfinance can make
entrepreneurial activities less stressful and allow other community
members to engage in such businesses.
Types of Microfinance

MICROCREDIT
Microcredit is a part of the larger microfinance industry which
focuses on providing individuals having low income with credit,
savings, insurance and other possible financial services. The
institutions offering microcredit may ask for different interest rates
than the traditional loan providing institutions.
The reason being the difference between the cost of providing small
loans in rural areas and the cost of providing large loans in developed
urban areas. Individuals with low income in rural areas may require a
small amount of money through microcredits. For example, a farmer
may require small funds to buy seeds for the season. Here, the
microcredit institutions can offer the farmer small lines of credit and
small loans.
MICROLOANS
Many entrepreneurs or individuals may require a small amount of
loan to start their business. Microloans are short-term loans in small
amounts that microfinancing institutions offer to individuals.
Individuals who avail microloans can be self-employed,
manufacturers, traders or small retailers, women entrepreneurs and
individuals with minimum wages or less.
Microloans can be helpful in activities related to business including
launching a new small business; paying salaries to the newly
appointed employees and maintaining cash flow. The main objective
of financing a microloan is to promote socio-economic development
and to support new start ups.
MICROINSURANCE

Micro-insurance targets individuals in the informal sector and is

available for people with low income. It is the practice in which the
institutions providing insurance can divide the traditional insurance
into much smaller terms.
Micro-insurance can be helpful in onetime events, such as a one-day
trip or emergency health requirements. Individuals and businesses
with a few assets can benefit from micro-insurance as it offers
coverage to them. Many micro-insurance providers also cover
business risks, such as the loss of crops for an agricultural operation.
MICRO SAVINGS

Micro savings are the savings accounts that allow individuals and
businesses to save money in smaller amounts or increments. Many
individuals with low income may find it difficult to save money. Micro
savings allow them to remove the difficulties they face in making
savings. Interest in these types of savings accounts may vary
depending on different factors.
Micro savings can offer many benefits like zero service fees, absence
of criteria for minimum deposit and also allows flexible withdrawals.
Many institutions offer micro savings through mobile saving
applications. Individuals and businesses trying to develop a regular
saving habit can benefit from the method of micro savings.

Types of Microfinance Institutions in India

Joint Liability Groups: JLGs are informal group of 4-10 people that
seek mutually assured loans. Agriculture-related loans are typical.
Farmers, rural labourers, and renters are among the debtors in this
category. JLG members are equally responsible for loan repayment.

Self-Help Groups: An SHG is a group of people in similar

socioeconomic situations who come together to help each other.
They are self-governed. Members come together (often for a limited
time) to form a shared fund for their mutual business requirements.
This type of cooperative financing does not necessitate the use of
collateral. In addition, borrowing rates are often cheap. Several
banks have formed partnerships with SHGs in order to increase
financial inclusion in the country’s rural areas e.g., the NABARD-SHG
linkage program, allows numerous self-help groups to borrow money
from banks if they can show that their borrowers have made regular
payments.

Regional Rural Bank Model: The main purpose of this strategy is to

boost the rural economy. They have been created to serve rural
areas with basic banking and financial services.

Cooperatives: Rural cooperatives were established at the time of

India’s Independence. Through the cooperatives, resources of the
poor are pooled and financial services are made available. MFIs,
based on their set-up, are regulated as NBFCs by the RBI, or through
Companies Act, 2013.

Challenges associated with Microfinance

Financial Illiteracy: Financial illiteracy leads to lack of awareness
about various MFIs, and the services the offer. This makes the poor
people reluctant to approach the MFIs.

Inability to Generate Funds: MFIs face difficulty to raise sufficient

funds as they are generally not ‘for-profit’. This restricts their access
to funds from private equity investors or other market-based
avenues of funding.
Heavy Dependence on Banks: MFIs are dependent on borrowing
from banks. For most MFI’s funding sources are restricted to private
banks. Funds available from these banks are typically for short term,
generally 2 years. Moreover, Banks tend to disburse loans at the end
of financial year to meet the targets. This can create issues for MFIs if
there is delay in repayment of loans by borrowers.
Weak Governance: Many MFI’s are not willing to convert to a
corporate structure; hence there is lack of transparency. This also
limits their ability to attract capital. MFI’s face challenge to strike a
balance between social and business goals.

Interest Rate: Some MFIs charge high interest rates, which the poor
find difficult to pay. MFIs are private institutions and do not get any
subsidized credit for their lending activities. Thus they tend to charge
higher interest rate.

Regional Imbalances: There is unequal geographical growth of MFIs

and SHGs in India. About 60% of the total SHG credit linkages in the
country are concentrated in the Southern States. In poorer regions
like in Jharkhand, Bihar etc. where the proportion of the poor is
higher, the coverage is comparatively lower. This could be attributed
to lack of State government support, NGO concentration and public
awareness.

UNIT 3: BANKING

FinTech
FinTech refers to emerging technological start-ups that challenge
traditional banking and financial players, offering services like crowd
funding platforms, mobile payment solutions, online portfolio
management tools, and international money transfers. Major
FinTech products include Peer to Peer lending platforms, crowd
funding, blockchain technology, distributed ledgers, Big Data, smart
contracts, and robo advisors.
FinTechs are attracting interest both from users of banking services
and investment funds. In continuity the retail groups, and telecom
operators also tend to explore the potential in the same segment
about the future financial landscape.

What is FinTech?
FinTech is an umbrella term coined in the recent past to denote
technological innovation having a bearing on financial services.
According to Financial Stability Board (FSB), of the BIS, “FinTech is
technologically enabled financial innovation that could result in new
business models, applications, processes, or products with an
associated material effect on financial markets and institutions and
the provision of financial services”.
FinTech innovations have the potential to deliver a range of benefits,
in particular efficiency improvements and cost reductions.
FinTech and its impact on global Financial Services
FinTech innovations, products and technology
This categorization does not represent a comprehensive review of all
FinTech innovations, it highlights those regarded as potentially
having the greatest effects on financial markets
 1. Payments, Clearing and Settlement
Innovations are targeted at improving the speed and
efficiency of payments, clearing, and settlement, reducing
cost and changing the ways people access financial services
and conduct financial transactions.

a. Mobile and web-based payment applications

The majority of developments in the areas of payments are based on
mobile technology by providing wrappers over existing payments
infrastructure.
Examples include Apple Pay, Samsung Pay, and Android Pay, which
sit on top of existing card payment infrastructure enabling the user’s
mobile devices to act as their credit/debit cards. There are also
mobile payments built on new payment infrastructure, for example
mobile phone money services, such as M-Pesa in Kenya and IMPS in
India.

Major web based payment services in India are:

NEFT
(National Electronic Fund Transfer)
2.RTGS
(Real Time Gross Settlement)
3. IMPS
(Immediate Payment Services)
 b. Digital currencies (DCs)
Digital currencies (DCs) are digital representations of value,
currently issued by private developers and denominated in their own
unit of account. They are obtained, stored, accessed, and transacted
electronically and neither denominated in any sovereign currency
nor issued or backed by any government or central bank.
DCs are not necessarily attached to any fiat currency, however,
are accepted by natural or legal persons as a means of exchange and
can be transferred, stored or traded electronically. DC schemes
comprise two key elements:
the digital representation of value or ‘currency’ that can be
transferred between parties; and
the way in which value is transferred from a payer to a payee.
Facilitate peer-to-peer exchange, possibly at lower cost for end-
users and with faster transaction times, especially across borders. DC
schemes are also known as ‘crypto currencies’ due to their use of
cryptographic techniques.

c. Distributed ledgers Technology

Distributed Ledger Technology (DLT) is a digital system for

recording the transactions of assets in which the transactions and
their details are recorded in multiple places at the same time. Unlike
traditional databases, distributed ledgers have no central data store
or administration functionality.

DLTs provide complete and secure transaction records,

updated and verified by users, removing the need for a central
authority. These technologies allow for direct peer-to-peer
transactions, which might offer benefits, in terms of efficiency and
security, over existing technological solutions.

The major benefits are reduced cost; faster settlement time;

reduction in counterparty risk; reduced need for third party
intermediation; reduced collateral demand and latency; better fraud
prevention; greater resiliency; simplification of reporting, data
collection, and systemic risk monitoring; increased
interconnectedness; and privacy.

d. Block chain Technology

Block chain is a distributed ledger in which transactions (e.g.
involving digital currencies or securities) are stored as blocks (groups
of transactions that are performed around the same point in time)
on computers that are connected to the network.

The ledger grows as the chain of blocks increases in size. Each

new block of transactions has to be verified by the network before it
can be added to the chain. This means that each computer
connected to the network has full information about the transactions
in the network.
 Block chain potentially has far-reaching implications for the
financial sector, and this is prompting more and more banks, insurers
and other financial institutions to invest in research into potential
applications of this technology.

Frequently cited benefits of Block chain are its transparency,

security and the fact that transactions are logged in the network.

While the disadvantages currently include the lack of

coordination and the scalability of this technology. One of the best-
known applications of Block chain technology at the present time is
Bitcoin. Transactions in this virtual currency are largely anonymous.
This creates ethical risks for financial institutions dealing with users
of this currency, because they are unable to (fully) verify their
identity.
2. Deposits, lending and capital raising services
Alternative models of lending and capital raising are gaining
prominence, potentially changing the market dynamics of traditional
lenders and affecting the role of traditional intermediaries.
A few examples of the products offered by FinTechs are as under:
a. Peer-to-peer (P2P) lending
Peer-to-peer (P2P) lenders connect lenders and borrowers,
using advanced technologies to speed up loan acceptance. These
technologies are designed to increase the efficiency and reduce the
time involved in access to credit.
While P2P lending originally involved direct matching of
individual lenders and borrowers on a one-to-one basis, it has
evolved into a form of marketplace lending where institutional and
high net worth individual investors lend into a pool that borrowers
can access.
 The principal benefit of P2P lending for borrowers is the fast
and convenient access to funding, while for investors it is the
potential for high returns.
Some of P2P platforms in India are LenDenClub, Mobikwik Xtra,
Cred Mint etc
b. Crowd funding
Crowd funding is a way of raising debt or equity from multiple
investors via an internet-based platform.
Securities and Exchange Board of India (SEBI) has released a
paper and defined crowd funding as “solicitation of funds (small
amount) from multiple investors through a web-based platform or
social networking site for a specific project, business venture or
social cause.”
Some jurisdictions have chosen to enact special legislative
regimes to determine the conditions under which this service can be
made available to retail investors. The platform matches borrowers /
issuers with savers/investors
Providers of the platform offer a range of information about
the potential borrowers/issuers, ranging from credit ratings (for most
peer-to-peer loan arrangements) to business model to verification of
information and AML(Anti Money Laundering) checks of firms that
want to raise equity capital.

3. Market provisioning services

Advances in computing power are facilitating faster and cheaper
provision of information and services to the market. A few of these
innovations are:
, a. Smart contracts
 Smart contracts are computer protocols that can self-execute,
self-enforce, self-verify, and self-constrain the performance of a
contract. Development of smart contracts in relation to financial
services could have a large impact on the structure of trade, finance
or derivatives trading, especially more bespoke contracts, and could
also be integrated into Robo-advice wealth management services.
The widespread adoption of smart contracts in financial services
could be facilitated by the establishment of distributed ledger
technology
b. E-Aggregators
E-Aggregators provide internet-based venues for retail
customers to compare the prices and features of a range of financial
(and non-financial) products such as standardized insurance,
mortgages, and deposit account products.
They can also be firms that provide services that allow users to
aggregate and analyze their data on their payment patterns, across
separate accounts and products (example-paisabazaar).
E-Aggregators also provide an easy way to switch between
providers and may become a major distributor for a variety of
financial products.
Reserve Bank of India has issued directions regarding Account
Aggregators which requires that no entity other than a company can
undertake the business of an Account Aggregator, no company shall
commence or carry on the business as an Account Aggregator
without obtaining a certificate of registration from the RBI and every
company seeking registration with the RBI as Non-Banking Financial
Company - Account Aggregator shall have a net owned fund of not
less than ₹ 2crore or such higher amount, as the RBI may specify.
Provided that, entities being regulated by other financial sector
regulators and aggregating only those accounts relating to the
financial assets of that particular sector will be excluded from the
registration requirement.

c. Cloud computing

Cloud-based IT services can deliver internet-based access to a

shared pool of computing resources that can be quickly and easily
deployed. Infrastructure, Platform, Service and Mobile backend as a
service are offered under cloud based services.

The use of these services is an important enabler for new

entrants to the financial services arena to set up quickly and with low
start-up cost, with easy options to expand their capability as the firm
grows. This enables the financial institutions to reduce their data
storage costs with a pay-as-you-go pricing model.

Depending on the type of services of the cloud service availed,

it can potentially pose several challenges including the ability of
jurisdictional enforcement authorities to effectively ensure security
of data.
d. Big data
As more business activity is digitized, new sources of
information are becoming available.
Combining these data sources with the availability of increased
computing power is delivering faster, cheaper, and more
comprehensive analysis for better informed decision-making.
 Big Data allows FinTech companies to keep an eye on a user’s
payment behavior and their communication with other financial
firms.
For example, wider use of increasingly large datasets could
deliver material improvements in credit risk assessments. Financial
institutions may desire to monetize aggregated data by selling them
or bundling them with other products and services offered.

e. Artificial Intelligence (AI) & Robotics

AI provides a competitive edge to the companies where in the
companies need to work through the implications of machines that
can learn, conduct human interactions, and engage in other high-
level functions at an unmatched scale and speed.
AI often requires, for example, a new structure, of both
centralized and decentralized activities, that can be challenging to
implement.
All companies might benefit from this approach, but it is
mandatory for AI-enabled processes, to undergo constant learning
and adaptation for both man and machine.
4. Investment management services
Automated systems have the potential to transform the
business of investment management. Few commonly used
applications in investment management services are :
a. Robo advice
“Robo-advice” is the provision of financial advice by
automated, money management providers, thereby
disintermediating human financial advisors and reducing costs. It can
offer more investor choice, especially for low and middle income
investors who do not have access to the wealth management
divisions of the banks.
They use client information and algorithms to develop
automated portfolio allocation and investment recommendations
that are meant to be tailored (to a greater or lesser degree) to the
individual client.
b. E-Trading
Electronic trading has become an increasingly important part of
the market landscape, notably in fixed income markets.
Innovative trading venues and protocols, reinforced by changes
in the nature of intermediation, have proliferated, and new market
participants have emerged.
This, in turn, has had implications for the process of price
discovery and for market liquidity.
It could also lead market structures to evolve from over-the-
counter to a structure where all-to-all transactions can take place.
The development of e-trading platforms contributes to
improving the efficiency of market orders and to reducing average
trading costs.

UNIT 4: NON-BANKING FINANCIAL INSTITUTIONS

Introduction to Mutual Funds
Mutual funds are a popular and accessible way for individuals
to invest their money and build wealth. They are a crucial topic for
anyone looking to understand personal finance and investment.

What is a Mutual Fund? A mutual fund is an investment vehicle

that pools money from a group of investors to buy a diversified
portfolio of stocks, bonds, or other securities. It is managed by a
professional investment team or fund manager. When you invest in a
mutual fund, you effectively own a portion of the entire fund's
holdings.
Diversification: One of the primary advantages of mutual funds
is diversification. Diversification means spreading your investments
across a variety of assets to reduce risk. With a mutual fund, your
money is invested in many different securities, which helps to spread
risk. If one investment performs poorly, others may perform well,
helping to balance out your overall returns.
Professional Management: Mutual funds are managed by
experienced professionals who make investment decisions on behalf
of the investors. These fund managers conduct research, select the
securities, and make buy/sell decisions. Their expertise can be
valuable in achieving strong returns.
Types of Mutual Funds:
There are various types of mutual funds, each with its unique
characteristics. The main categories include:
Equity Funds: Invest in stocks, aiming for capital appreciation.
Fixed-Income Funds: Invest in bonds, providing regular interest
income.
Money Market Funds: Invest in short-term, low-risk securities
like government bonds and commercial paper.
Balanced Funds: Diversify investments across both stocks and
bonds.
Specialty Funds: Focus on specific sectors, industries, or
regions.
Index Funds: Mirror the performance of a specific market
index.
 How to Invest: To invest in a mutual fund, you can open an
account with a mutual fund company or through a brokerage
account. You typically need to complete an application form and
invest a specific amount of money (the minimum investment varies
by fund). You can also set up regular contributions through a
systematic investment plan (SIP).

Risks: While mutual funds offer diversification and professional

management, they are not risk-free. The value of your investment
can go up and down, and there is no guarantee that you will make a
profit. It's essential to assess your risk tolerance and choose funds
that align with your financial goals.

Costs and Fees: Mutual funds come with expenses, such as

management fees, sales charges (loads), and operating costs.
Understanding these costs is important when evaluating a fund's
performance and potential returns.
Liquidity: Mutual funds offer liquidity, meaning you can usually
buy or sell your shares on any business day. This makes them
relatively easy to access when compared to other investments like
real estate or certificates of deposit.

Monitoring and Review: It's essential to monitor your mutual

fund investments regularly and review their performance against
your financial goals. You can find information about your fund's
performance in regular reports and online statements.

In conclusion, mutual funds are a versatile investment option

that allows you to participate in the financial markets without
needing expert knowledge or substantial capital. Understanding how
mutual funds work and conducting proper research before investing
is crucial to making informed financial decisions in your adult life.
Introduction to Insurance
Insurance is a vital financial concept that plays a crucial role in
our lives. It serves as a safety net, protecting individuals and
businesses from unexpected financial losses.

What is Insurance? Insurance is a financial arrangement that

provides protection against unforeseen events or risks. It operates
on the principle of risk management, where a large group of people
or entities pool their resources to create a fund from which
compensation can be provided to those who experience a covered
loss. In essence, insurance is a means of transferring risk from an
individual to a larger group.

How Does Insurance Work?

Premium: When you purchase insurance, you pay a regular

amount known as a premium. This premium is usually paid monthly
or annually and varies based on the type of insurance, your risk
profile, and the coverage you choose.
Policy: In return for your premium, the insurance company
provides you with a policy. This document outlines the terms and
conditions of the coverage, including what is covered, what is not,
and how claims are processed.
Coverage: Insurance policies offer protection for specific risks.
Common types of insurance include health insurance, auto
insurance, home insurance, life insurance, and more. Each type of
insurance provides financial support in the event of a related loss,
like a car accident or a medical emergency.
Claim: If you experience a loss that falls within the scope of
your policy, you can file a claim with the insurance company. They
will then assess the situation and provide compensation, either in
the form of repairs, replacements, or a cash payout, depending on
the terms of the policy.
Types of Insurance: There are various types of insurance,
including:
Health Insurance:
What it covers: Health insurance provides coverage for medical
expenses, including doctor visits, hospital stays, prescription
medications, and various treatments.
Why it matters:
Financial Protection: It prevents individuals and families from
incurring exorbitant medical bills that can lead to financial ruin.
Access to Healthcare: Health insurance ensures that people can
access necessary medical care, promoting overall well-being.
Preventive Care: Many health insurance plans offer coverage
for preventive services, encouraging regular check-ups and early
detection of health issues.
Auto Insurance:
What it covers: Auto insurance protects against losses related
to accidents, theft, vandalism, and damage to your vehicle.
Why it matters:
Legal Requirement: In many places, it's mandatory to have auto
insurance to drive legally.
 Financial Security: Auto accidents can lead to substantial repair
costs or medical expenses, which can be covered by insurance.
Peace of Mind: Knowing you're covered in case of an accident
allows you to drive with confidence.
Home Insurance:
What it covers: Home insurance provides protection for your
home, its contents, and liability for accidents on your property.
Why it matters:
Asset Protection: It safeguards your home and belongings from
damage due to natural disasters, theft, or accidents.
Mortgage Requirement: If you have a mortgage, your lender
typically requires home insurance to protect their investment.
Liability Coverage: Home insurance can cover legal expenses if
someone is injured on your property.
Life Insurance:
What it covers: Life insurance offers financial support to your
beneficiaries in the event of your death.
Why it matters:
Family Protection: It provides financial security to your loved
ones, ensuring they are taken care of when you're no longer there.
Debt Repayment: Life insurance can be used to pay off debts
like mortgages and loans.
Estate Planning: It can play a role in estate planning, ensuring
assets are distributed as you wish.
Travel Insurance:
 What it covers: Travel insurance typically includes coverage for
trip cancellations, medical emergencies while traveling, lost luggage,
and more.
Why it matters:
Trip Protection: It safeguards your investment in a trip, offering
reimbursement in case your plans are disrupted.
Healthcare Abroad: It covers medical expenses when traveling
abroad, where your regular health insurance may not apply.
Peace of Mind: Travel insurance provides peace of mind when
facing uncertainties during your journeys.
Why Insurance Matters:
 Financial Security: Insurance is a financial safety net,
preventing you from suffering devastating financial losses
due to unforeseen events.
 Risk Management: It helps individuals and businesses
manage risk effectively by spreading it across a larger
group. This prevents the burden of significant losses from
falling solely on one party.
 Peace of Mind: Knowing you have insurance in place
gives you peace of mind, allowing you to focus on your
daily life without the constant worry of potential financial
setbacks.
 Legal Requirements: In many cases, insurance is legally
required, such as auto insurance for drivers. Failing to
have the necessary insurance can lead to legal
consequences.
 Economic Stability: Insurance contributes to the stability
of the economy by reducing the financial shockwaves
caused by large, unexpected losses. It ensures that
individuals and businesses can recover from setbacks and
continue contributing to the economy.
 Understanding the different types of insurance and why
insurance matters is a crucial step toward managing your
 finances responsibly and ensuring your well-being in an
uncertain world.

Introduction to Investment Banking

Investment banking is a complex and exciting field in the world
of finance that plays a crucial role in the global economy. It involves a
wide range of financial services and activities.

Definition of Investment Banking: Investment banking is a

specialized sector within the financial industry that primarily deals
with providing financial advisory and raising capital for corporations,
governments, and other entities. It plays a key role in the financial
markets, helping organizations access funding, manage financial
transactions, and make strategic financial decisions.
Key Functions of Investment Banking:

 Capital Raising: Investment banks help companies raise

capital by issuing stocks and bonds. This process is known
as "underwriting." They assist in determining the optimal
pricing and structuring of these financial instruments to
attract investors.

 Mergers and Acquisitions (M&A): Investment bankers

facilitate mergers, acquisitions, and divestitures of
companies. They provide advice on the valuation of
businesses, negotiate deals, and ensure that transactions
are executed efficiently.

 Advisory Services: Investment banks offer financial and

strategic advice to clients. This includes helping
companies with their financial strategies, risk
 management, and overall financial health. They might also
provide guidance on how to enhance shareholder value.

 Asset Management: Some investment banks manage assets

for institutional clients, such as pension funds and mutual
funds. They create and manage investment portfolios on
behalf of these clients.

 Trading and Market Making: Investment banks engage in

trading various financial instruments, including stocks,
bonds, derivatives, and currencies. They often act as
market makers, facilitating the buying and selling of these
assets.

 Research: Investment banks employ analysts who provide

research reports and analysis on various industries and
companies. These reports are valuable for investors and
traders to make informed decisions.

 Skills and Qualifications:

 To work in investment banking, one often needs a strong
educational background in finance, economics, or related
fields. Many investment bankers have undergraduate
degrees in these areas and may pursue further education
such as an MBA. Skills in financial analysis, quantitative
reasoning, communication, and attention to detail are
crucial for success in this field.

Structure of an Investment Bank:

 Investment banks are typically divided into several
divisions or departments, including:
 Front Office: This division includes roles involved in
 revenue generation, such as investment banking, sales and
trading, and asset management.
 Middle Office: Compliance, risk management, and internal
control functions are part of this division, ensuring that the
bank operates within regulatory guidelines.
 Back Office: Operations, settlement, and accounting
functions are handled in the back office, which supports
the front office activities.
 In conclusion, investment banking is a dynamic and
critical sector within the financial industry, involved in
capital raising, M&A, and providing valuable financial
advice.
 It's a field that offers opportunities for those interested in
finance, economics, and making a substantial impact on
the world of business and finance.

INSURANCE SERVICE
Introduction to Insurance
Insurance is a vital financial concept that plays a crucial role in
our lives. It serves as a safety net, protecting individuals and
businesses from unexpected financial losses.

What is Insurance? Insurance is a financial arrangement that

provides protection against unforeseen events or risks. It operates
on the principle of risk management, where a large group of people
or entities pool their resources to create a fund from which
compensation can be provided to those who experience a covered
loss. In essence, insurance is a means of transferring risk from an
individual to a larger group.
 Insurance cannot prevent occurrence of risk but it provides for
the losses of risk. It is a scheme which covers large risk by paying
small amount of capital. Insurance is also means of saving and
investment. The insurance involves four aspects which are:
An asset
The risk insured against
The principle of pooling
The contract
Insurance and mutual funds are fundamentally different in their
objectives. The objective of insurance is to cover the eventuality of
death while mutual funds are purely investment gain vehicles.
Represented in a form of policy, Insurance is a contract in
which the individual or an entity gets the financial protection, in
other words, reimbursement from the insurance company for the
damage (big or small) caused to their property.
The insurer and the insured enter a legal contract for the
insurance called the insurance policy that provides financial security
from the future uncertainties.
In simple words, insurance is a contract, a legal agreement
between two parties, i.e., the individual named insured and the
insurance company called insurer. In this agreement, the insurer
promises to help with the losses of the insured on the happening
contingency. The insured, on the other hand, pays a premium in
return for the promise made by the insurer.
How Does Insurance Work?
Premium: When you purchase insurance, you pay a regular
amount known as a premium. This premium is usually paid monthly
or annually and varies based on the type of insurance, your risk
profile, and the coverage you choose.
 Policy: In return for your premium, the insurance company
provides you with a policy. This document outlines the terms and
conditions of the coverage, including what is covered, what is not,
and how claims are processed.
Coverage: Insurance policies offer protection for specific risks.
Common types of insurance include health insurance, auto
insurance, home insurance, life insurance, and more. Each type of
insurance provides financial support in the event of a related loss,
like a car accident or a medical emergency.
Claim: If you experience a loss that falls within the scope of
your policy, you can file a claim with the insurance company. They
will then assess the situation and provide compensation, either in
the form of repairs, replacements, or a cash payout, depending on
the terms of the policy.

Functions of an Insurance Company

1] Provides Reliability
The main function of insurance is that eliminates the
uncertainty of an unexpected and sudden financial loss. This is one of
the biggest worries of a business. Instead of this uncertainty, it
provides the certainty of regular payment i.e. the premium to be
paid.

2] Protection
Insurance does not reduce the risk of loss or damage that a
company may suffer. But it provides a protection against such loss
that a company may suffer. So at least the organisation does not
suffer financial losses that debilitate their daily functioning.
 3] Pooling of Risk
In insurance, all the policyholders pool their risks together.
They all pay their premiums and if one of them suffers financial
losses, then the payout comes from this fund. So the risk is shared
between all of them.
4] Legal Requirements
In a lot of cases getting some form of insurance is actually
required by the law of the land. Like for example when goods are in
freight, or when you open a public space getting fire insurance may
be a mandatory requirement. So an insurance company will help us
fulfil these requirements.
5] Capital Formation
The pooled premiums of the policyholders help create a capital
for the insurance company. This capital can then be invested in
productive purposes that generate income for the company.
Principles of Insurance
The concept of insurance is risk distribution among a group of
people. Hence, cooperation becomes the basic principle of
insurance.
To ensure the proper functioning of an insurance contract, the
insurer and the insured have to uphold the 7 principles of Insurances
mentioned below:
Utmost Good Faith
Proximate Cause
Insurable Interest
Indemnity
Subrogation
 Contribution
Loss Minimization
1. Principle of Utmost Good Faith

The fundamental principle is that both the parties in an

insurance contract should act in good faith towards each other, i.e.
they must provide clear and concise information related to the terms
and conditions of the contract.

The Insured should provide all the information related to the

subject matter, and the insurer must give precise details regarding
the contract.

Example – Jacob took a health insurance policy. At the time of

taking insurance, he was a smoker and failed to disclose this fact.
Later, he got cancer. In such a situation, the Insurance company will
not be liable to bear the financial burden as Jacob concealed
important facts.
2. Principle of Proximate Cause
This is also called the principle of ‘Causa Proxima’ or the
nearest cause. This principle applies when the loss is the result of
two or more causes. The insurance company will find the nearest
cause of loss to the property. If the proximate cause is the one in
which the property is insured, then the company must pay
compensation. If it is not a cause the property is insured against,
then no payment will be made by the insured.

Example –
 Due to fire, a wall of a building was damaged, and the
municipal authority ordered it to be demolished. While demolition
the adjoining building was damaged. The owner of the adjoining
building claimed the loss under the fire policy. The court held that
fire is the nearest cause of loss to the adjoining building, and the
claim is payable as the falling of the wall is an inevitable result of the
fire.

In the same example, the wall of the building damaged due to

fire, fell down due to storm before it could be repaired and damaged
an adjoining building. The owner of the adjoining building claimed
the loss under the fire policy. In this case, the fire was a remote
cause, and the storm was the proximate cause; hence the claim is
not payable under the fire policy.
3. Principle of Insurable interest
This principle says that the individual (insured) must have an
insurable interest in the subject matter. Insurable interest means
that the subject matter for which the individual enters the insurance
contract must provide some financial gain to the insured and also
lead to a financial loss if there is any damage, destruction or loss.
Example – the owner of a vegetable cart has an insurable
interest in the cart because he is earning money from it. However, if
he sells the cart, he will no longer have an insurable interest in it.
To claim the amount of insurance, the insured must be the
owner of the subject matter both at the time of entering the contract
and at the time of the accident.
4. Principle of Indemnity
This principle says that insurance is done only for the coverage
of the loss; hence insured should not make any profit from the
insurance contract. In other words, the insured should be
compensated the amount equal to the actual loss and not the
amount exceeding the loss.
The purpose of the indemnity principle is to set back the
insured at the same financial position as he was before the loss
occurred. Principle of indemnity is observed strictly for property
insurance and not applicable for the life insurance contract.
Example – The owner of a commercial building enters an
insurance contract to recover the costs for any loss or damage in
future. If the building sustains structural damages from fire, then the
insurer will indemnify the owner for the costs to repair the building
by way of reimbursing the owner for the exact amount spent on
repair or by reconstructing the damaged areas using its own
authorized contractors.
5. Principle of Subrogation
Subrogation means one party stands in for another. As per this
principle, after the insured, i.e. the individual has been compensated
for the incurred loss to him on the subject matter that was insured,
the rights of the ownership of that property goes to the insurer, i.e.
the company.
Subrogation gives the right to the insurance company to claim
the amount of loss from the third-party responsible for the same.
Example – If Mr A gets injured in a road accident, due to
reckless driving of a third party, the company with which Mr A took
the accidental insurance will compensate the loss occurred to Mr A
and will also sue the third party to recover the money paid as claim.
6. Principle of Contribution
Contribution principle applies when the insured takes more
than one insurance policy for the same subject matter. It states the
same thing as in the principle of indemnity, i.e. the insured cannot
make a profit by claiming the loss of one subject matter from
different policies or companies.

Example – A property worth Rs. 5 Lakhs is insured with

Company A for Rs. 3 lakhs and with company B for Rs.1 lakhs. The
owner in case of damage to the property for 3 lakhs can claim the full
amount from Company A but then he cannot claim any amount from
Company B. Now, Company A can claim the proportional amount
reimbursed value from Company B.
7. Principle of Loss Minimisation
This principle says that as an owner, it is obligatory on the part
of the insurer to take necessary steps to minimise the loss to the
insured property. The principle does not allow the owner to be
irresponsible or negligent just because the subject matter is insured.

Example – If a fire breaks out in your factory, you should take

reasonable steps to put out the fire. You cannot just stand back and
allow the fire to burn down the factory because you know that the
insurance company will compensate for it.
INSURANCE REGULATORY AND DEVELOPMENT AUTHORITY
What is the IRDAI Act?

The IRDAI Act provides a complete regulation of the insurance

sector in India (all the insurance business in India is regulated by
IRDAI). The IRDAI plays a key role in the development of regulatory
mechanisms of insurance in the insurance sector.
A committee was established by the Government of India to
examine the structure of the insurance sector and to advocate
revisions to the rules and regulations to make it more effective and
efficient.
IRDAI was presented in the parliament in 1999. The bill was
discussed and debated before it finally became the Insurance
Regulatory and Development Authority of India (IRDAI) Act of 1999.
The Roles Of The IRDAI In The Insurance Sector:
1. IRDAI issues a certificate of registration to the life insurance
company and also renews, modifies, withdraws, suspends, and
cancels the registration.
2. The regulatory body secures the policyholder’s interests in
areas like assigning of policy, nomination by policyholders, insurable
interest, settlement of insurance claim, surrender value of the policy,
and other terms and conditions applicable to an insurance contract.
3. It specifies the requisite qualifications, code of conduct, and
practical training required for insurance intermediaries and agents.
4. IRDAI ensures that the code of conduct is followed by
surveyors and loss assessors.
5. The autonomous body promotes efficiency in the conduct of
the insurance business.
6. It also promotes and regulates professional organizations
connected with the insurance and reinsurance business.
7. It levies fees and other charges for carrying out the purposes
of the IRDAI Act.
8. IRDAI carries out functions like inspection, conducting
inquiries and investigations, including an audit of the insurers,
insurance intermediaries, and other organizations involved with the
insurance business.
 9. The rates, advantages, terms, and conditions that may be
offered by insurers with respect to the general insurance business
are also controlled and regulated by the regulatory body.
10. It also specifies the form and manner in which books of
account should be maintained, and the statement of accounts should
be rendered by insurers and insurance intermediaries.
11. IRDAI monitors the investment of funds by insurance
companies and governs the maintenance of the margin of solvency.
12. It also judges the disputes between insurers and
intermediaries or insurance intermediaries.
13. It supervises the functioning of the Tariff Advisory
Committee.
14. IRDAI specifies the percentage of premium income of the
insurer to finance schemes for promoting and regulating professional
organizations referred to in clause (f).
15. It specifies the percentage of life insurance and general
insurance business to be undertaken by the insurer in the rural or
social sector.
16. With so many roles, the IRDAI maintains the standard of the
industry and takes measures to eliminate insurance fraud.
ROLE OF INSURANCE IN ECONOMIC GROWTH OF INDIA
Many economic risks are covered by insurance. It safeguards
businesses against the risk of losing or damaging goods and other
assets used in manufacturing, marketing, transportation, and other
related activities.
This safety gives businesses a sense of security. Businessmen
and industrialists will take risky decisions in expanding their area of
operation and taking financial risks that they couldn't possibly take
as their assets are insured. As a result, insurance promotes nation-
building while also raising the number of jobs for the people.
Millions of households in the country have access to affordable
life insurance. In certain ways, this also benefits the government
because it relieves the cost of providing social assistance to impacted
families
4. Premiums are collected from policyholders and invested in
government bonds, corporate securities, and other permitted
financial instruments. In this way, insurance firms may assist in the
funding of new ventures or indeed the expansion of existing ones.
5. Furthermore, these funds are used to finance development
projects that have a long gestation period. Moreover, this lending of
funds for infrastructure and other development has a positive impact
on the government's decision-making process.
MISSION STATEMENT OF THE AUTHORITY
To protect the interest of and secure fair treatment to
policyholders .
To bring about speedy and orderly growth of the insurance
industry (including annuity and superannuation payments), for the
benefit of the common man, and to provide long term funds for
accelerating growth of the economy;
To set, promote, monitor and enforce high standards of
integrity, financial soundness, fair dealing and competence of those
it regulates;
To ensure speedy settlement of genuine claims, to prevent
insurance frauds and other malpractices and put in place effective
grievance redressal machinery;
To promote fairness, transparency and orderly conduct in
financial markets dealing with insurance and build a reliable
management information system to enforce high standards of
financial soundness amongst market players;
To take action where such standards are inadequate or
ineffectively enforced;
To bring about optimum amount of self-regulation in day-to-
day working of the industry consistent with the requirements of
prudential regulation.
protection of the interests of the policy holders in matters
concerning assigning of policy, nomination by policy holders,
insurable interest, settlement of insurance claim, surrender value of
policy and other terms and conditions of contracts of insurance;
specifying requisite qualifications, code of conduct and
practical training for intermediary or insurance intermediaries and
agents
specifying the code of conduct for surveyors and loss assessors;

Types of Insurance: There are various types of insurance,

including:
Health Insurance:
What it covers: Health insurance provides coverage for medical
expenses, including doctor visits, hospital stays, prescription
medications, and various treatments.
Why it matters:
Financial Protection: It prevents individuals and families from
incurring exorbitant medical bills that can lead to financial ruin.
Access to Healthcare: Health insurance ensures that people can
access necessary medical care, promoting overall well-being.
 Preventive Care: Many health insurance plans offer coverage
for preventive services, encouraging regular check-ups and early
detection of health issues.
Auto Insurance:
What it covers: Auto insurance protects against losses related
to accidents, theft, vandalism, and damage to your vehicle.
Why it matters:
Legal Requirement: In many places, it's mandatory to have auto
insurance to drive legally.
Financial Security: Auto accidents can lead to substantial repair
costs or medical expenses, which can be covered by insurance.
Peace of Mind: Knowing you're covered in case of an accident
allows you to drive with confidence.
Home Insurance:
What it covers: Home insurance provides protection for your
home, its contents, and liability for accidents on your property.
Why it matters:
Asset Protection: It safeguards your home and belongings from
damage due to natural disasters, theft, or accidents.
Mortgage Requirement: If you have a mortgage, your lender
typically requires home insurance to protect their investment.
Liability Coverage: Home insurance can cover legal expenses if
someone is injured on your property.
Life Insurance:
What it covers: Life insurance offers financial support to your
beneficiaries in the event of your death.
Why it matters:
 Family Protection: It provides financial security to your loved
ones, ensuring they are taken care of when you're no longer there.
Debt Repayment: Life insurance can be used to pay off debts
like mortgages and loans.
Estate Planning: It can play a role in estate planning, ensuring
assets are distributed as you wish.
Travel Insurance:
What it covers: Travel insurance typically includes coverage for
trip cancellations, medical emergencies while traveling, lost luggage,
and more.
Why it matters:
Trip Protection: It safeguards your investment in a trip, offering
reimbursement in case your plans are disrupted.
Healthcare Abroad: It covers medical expenses when traveling
abroad, where your regular health insurance may not apply.
Peace of Mind: Travel insurance provides peace of mind when
facing uncertainties during your journeys.
Why Insurance Matters:
Financial Security: Insurance is a financial safety net, preventing
you from suffering devastating financial losses due to unforeseen
events.
Risk Management: It helps individuals and businesses manage
risk effectively by spreading it across a larger group. This prevents
the burden of significant losses from falling solely on one party.
Peace of Mind: Knowing you have insurance in place gives you
peace of mind, allowing you to focus on your daily life without the
constant worry of potential financial setbacks.
 Legal Requirements: In many cases, insurance is legally
required, such as auto insurance for drivers. Failing to have the
necessary insurance can lead to legal consequences.
Economic Stability: Insurance contributes to the stability of the
economy by reducing the financial shockwaves caused by large,
unexpected losses. It ensures that individuals and businesses can
recover from setbacks and continue contributing to the economy.
Understanding the different types of insurance and why
insurance matters is a crucial step toward managing your finances
responsibly and ensuring your well-being in an uncertain world.
UNIT 4: NON-BANKING FINANCIAL INSTITUTIONS
Investment banking is a complex and exciting field in the world
of finance that plays a crucial role in the global economy. It involves a
wide range of financial services and activities.

Definition of Investment Banking: Investment banking is a

specialized sector within the financial industry that primarily deals
with providing financial advisory and raising capital for corporations,
governments, and other entities. It plays a key role in the financial
markets, helping organizations access funding, manage financial
transactions, and make strategic financial decisions.
Key Functions of Investment Banking:

Capital Raising: Investment banks help companies raise capital

by issuing stocks and bonds. This process is known as "underwriting."
They assist in determining the optimal pricing and structuring of
these financial instruments to attract investors.
 Mergers and Acquisitions (M&A): Investment bankers facilitate
mergers, acquisitions, and divestitures of companies. They provide
advice on the valuation of businesses, negotiate deals, and ensure
that transactions are executed efficiently.

Advisory Services: Investment banks offer financial and

strategic advice to clients. This includes helping companies with their
financial strategies, risk management, and overall financial health.
They might also provide guidance on how to enhance shareholder
value.

Asset Management: Some investment banks manage assets for

institutional clients, such as pension funds and mutual funds. They
create and manage investment portfolios on behalf of these clients.
Trading and Market Making: Investment banks engage in
trading various financial instruments, including stocks, bonds,
derivatives, and currencies. They often act as market makers,
facilitating the buying and selling of these assets.

Research: Investment banks employ analysts who provide

research reports and analysis on various industries and companies.
These reports are valuable for investors and traders to make
informed decisions.

Skills and Qualifications:

To work in investment banking, one often needs a strong
educational background in finance, economics, or related fields.
Many investment bankers have undergraduate degrees in these
areas and may pursue further education such as an MBA. Skills in
financial analysis, quantitative reasoning, communication, and
attention to detail are crucial for success in this field.
Structure of an Investment Bank:
Investment banks are typically divided into several divisions or
departments, including:
Front Office: This division includes roles involved in revenue
generation, such as investment banking, sales and trading, and asset
management.
Middle Office: Compliance, risk management, and internal
control functions are part of this division, ensuring that the bank
operates within regulatory guidelines.
Back Office: Operations, settlement, and accounting functions
are handled in the back office, which supports the front office
activities.
In conclusion, investment banking is a dynamic and critical
sector within the financial industry, involved in capital raising, M&A,
and providing valuable financial advice.
It's a field that offers opportunities for those interested in
finance, economics, and making a substantial impact on the world of
business and finance.
Types Of Investment Banks
Full-service global-investment banks which operate on a global
basis and provide a complete set of services to their clients. These
are large investment firms that serve large corporates, usually
multinational corporations. Jefferies, Goldman Sachs, JP Morgan
Chase & Co. and Kotak Investment Banking are some of the full-
service investment banks.
Regional-investment banks concentrated in a particular region
with specialized geographic knowledge and a variety of product
offerings and are also known as ‘speciality investment banks.’ For
example, Piper Jaffray Companies is a leading, international middle-
market investment bank and institutional securities firm serving the
needs of middle market. Simmons & Company is the only
independent investment bank specializing in the entire spectrum of
the energy industry in Europe.
Boutique firms are small investment banks organized at a local
level and specialize in a particular industry or product. They are
independent firms whose focus is on advisory services such as M&A.
Because of their expertise, they are better advisors in particular
deals. They provide personalized services to their clients and try to
be more of partners rather than merely being advisors.
Investment-Banking Services
Advisory Services
(a) Export and Project Finance
Export-credit Finance: They provide both single- as well as
multi-sourced export-credit facilities by developing relationships with
many of the principal export-credit agencies in different countries.
Project Advisory They provide advisory services to
governments, project sponsors, contractors and special-purpose
project companies in a range of industrial sectors.
Project-debt Arranging They also deliver a range of debt
products, including commercial bank debt, capital-market bonds,
export credit, local-currency bank debt and multi-lateral agency
debt.
Forfaiting They can structure and execute the non-recourse off-
balance-sheet facilities worldwide using bills of exchange, letters of
credit, guarantees and formal loan agreements.
 (b) Mergers and Acquisitions (M & A)
Investment banks give M&A guidance regarding strategic
alternatives, financial restructurings and ownership transitions.
The package of services includes strategic advice, sell-side and
buy-side advisory, divestitures, recapitalizations, management and
leveraged buyouts, and capital raising. Their scope of services include
undertaking of legal documentation in vertical and horizontal
mergers, notice to shareholders, resolutions, and preparation of
documents to be filed with high court.
They also perform valuation of the amalgamated and
amalgamating companies with a view to arrive at the ratios of equity
swaps. Investment banks provide both buy-side as well as sell-side
advisory services as part of their M&A advisory offering.
Buy-side Advisory They work with clients who have identified
particular acquisition targets and assist them in negotiation,
structuring, due diligence, financing and documentation of the
transaction.
Sell-side Advisory The investment bank helps corporates in the
sale of a minority interest, a majority interest, or 100% of the stock
or assets of the company, by identifying the specific qualified buyers
unique to each engagement, which may include private companies,
public companies, private-equity funds, hedge funds and
international buyers.
iii) Promoter and Acquisition-financing Advisory
Investment banks structure the appropriate financing solutions
for client-specific needs. They arrange for Promoter Financing and
Acquisition Financing.
Promoter Financing: It is mostly done to enable promoters to
raise their stake in the company. The financing is usually against
collateral of shares or other securities held by the promoter in any of
the group company. It can also be structured to refinance a loan
raised against the same shares by the promoter earlier.
Acquisition Financing: Indian companies are now on a spree of
acquisitions, both domestic as well as overseas. Acquisition financing
plays a critical role in the success of inorganic growth planned by the
acquirer.
(iv) Private-equity Advisory
They also provide advice on private-equity funding to both the
corporates as well as private-equity funds.
They help the private-equity fund identify the emerging
industries and firms with a good potential to invest therein. They
help these investors explore transactions with target firms, help
investors meet the target companies and help the investor prioritise
among the targets short-listed. They also advise promoters and
companies on the key considerations in a Private Equity (PE) fund-
raising exercise.
(v) Infrastructure Advisory
Infrastructure development on a commercial viable basis is the
need of the hour. Infrastructure advisory encompasses power
generation, airport construction and transportation including air-
cargo transportation and development of roads, airports, and
associated infrastructures. This sector has unique financing
requirements.
Their advisory services include providing specialized project
services from concept to commissioning—from pre-investment
feasibility studies and appraisals to development of joint ventures
and company formation, assisting international companies in
identifying and implementing projects in India, and providing
specialized information for profitable and economic implementation
of projects.
 (vi) Strategic Advisory Services
Investment banks help corporates frame and implement key
strategies relating to their business. These key strategies relate to
entry into new geographies/services, exit from certain
businesses/corporate restructuring and off-shoring for end-
customers/on-shore vendors. They also help companies form
strategic business alliances and assess capital-structure alternatives
that create flexibility for executing on-growth opportunities.

(vii) Financial Restructuring and Turnaround Financing

Investment banks assist sick corporates with financial
turnaround objectives to structure their capital. They design
innovative structures and revival plans for implementing turnaround
strategies and financial restructuring of liabilities. They also assist
these corporates to raise funds. Investment banks play a significant
role in leveraged buyouts of companies in distress. They also work
with domestic and foreign banks in India in selling as well as buying
NPA portfolios.
(viii) Sales and Trading
Investment banks provide trade execution and liquidity services
to institutional investors. Sales and trading include trading in bonds,
equity, currency, futures and options, and commodities.

(ix) Equities Research and Broking

An investment bank through its research team offers research
and analysis of specific industries and offers advice for equities to its
clients.
UNIT 4: NON-BANKING FINANCIAL INSTITUTIONS
 A Non-Banking Financial Company (NBFC) is a critical
component of the Non-Bank Financial Institutions (NBFIs) sector.
Non-Bank Financial Institutions (NBFIs)
- NBFIs are financial institutions that provide banking services
without holding a full banking license. They are part of the broader
financial system and complement traditional banks by offering
specialized financial products and services.
- NBFIs include entities such as NBFCs, insurance companies,
mutual funds, housing finance companies, and more.

Non-Banking Financial Company (NBFC)

- An NBFC is a specific type of NBFI that primarily engages in
financial activities related to lending, investing, and other financial
services.
- NBFCs do not have the full suite of banking functions like
accepting demand deposits, but they do provide credit, offer leasing
and hire-purchase services, and engage in investment activities.

Characteristics of NBFCs

Financial Intermediation: NBFCs act as intermediaries between

borrowers and savers by providing credit, loans, and investment
options. They mobilize funds from the public and channel them into
various financial activities.
Lending and Investment: NBFCs extend credit to individuals,
businesses, and other entities. They may provide personal loans,
auto loans, housing loans, and business loans. They also invest in
assets like stocks, bonds, and real estate.
 Regulation: In many countries, including India, NBFCs are
regulated by the central bank (e.g., Reserve Bank of India) or other
relevant financial authorities. Regulation ensures that NBFCs
maintain financial stability, adhere to prudential norms, and protect
the interests of depositors and investors.
Asset-Liability Mismatch: Unlike traditional banks, NBFCs may
have a more significant asset-liability mismatch, meaning that they
might borrow funds for shorter durations and lend for longer
periods. Managing this mismatch is a crucial challenge for NBFCs.
Credit Risk: NBFCs are exposed to credit risk as they lend to
various borrowers. Effective risk management practices are essential
to mitigate this risk.
Functions of NBFCs
Lending: NBFCs provide credit and loans to individuals and
businesses, often focusing on segments that may be underserved by
traditional banks.

Investment: They invest in various financial assets such as

stocks, bonds, mutual funds, and real estate.

Leasing and Hire-Purchase: Some NBFCs offer leasing and hire-

purchase services, allowing customers to acquire assets on a rental
basis with the option to purchase later.

Microfinance: Many NBFCs engage in microfinance activities,

offering small loans to low-income individuals and micro-
entrepreneurs.
 Infrastructure Financing: Some NBFCs specialize in
infrastructure financing, supporting the development of essential
infrastructure projects.

TYPES OF MUTUAL FUND SCHEMESMUTUAL FUND SCHEME

CLASSIFICATION
Mutual funds come in many varieties, designed to meet
different investor goals. Mutual funds can be broadly classified based
on –

Organisation Structure – Open ended, Close ended, Interval

Management of Portfolio – Actively or Passively
Investment Objective – Growth, Income, Liquidity
Underlying Portfolio – Equity, Debt, Hybrid, Money market
instruments, Multi Asset
Thematic / solution oriented – Tax saving, Retirement benefit,
Child welfare, Arbitrage
Exchange Traded Funds
Overseas funds
Fund of funds

INTRODUCTION TO MUTUAL FUNDS WHAT ARE MUTUAL

FUNDS?
A mutual fund is a collective investment vehicle that collects &
pools money from a number of investors and invests the same in
equities, bonds, government securities, money market instruments.
 The money collected in mutual fund scheme is invested by
professional fund managers in stocks and bonds etc. in line with a
scheme’s investment objective. The income / gains generated from
this collective investment scheme are distributed proportionately
amongst the investors, after deducting applicable expenses and
levies, by calculating a scheme’s “Net Asset Value” or NAV. In return,
mutual fund charges a small fee.

In short, mutual fund is a collective pool of money contributed

by several investors and managed by a professional Fund Manager.

Mutual Funds in India are established in the form of a Trust

under Indian Trust Act, 1882, in accordance with SEBI (Mutual Funds)
Regulations, 1996.

The fees and expenses charged by the mutual funds to manage

a scheme are regulated and are subject to the limits specified by
SEBI.

HOW A MUTUAL FUND WORKS?

One should avoid the temptation to review the fund's
performance each time the market falls or jumps up significantly. For
an actively-managed equity scheme, one must have patience and
allow reasonable time - between 18 and 24 months - for the fund to
generate returns in the portfolio.

When you invest in a mutual fund, you are pooling your money
with many other investors. Mutual fund issues “Units” against the
amount invested at the prevailing NAV. Returns from a mutual fund
may include income distributions to investors out of dividends,
interest, capital gains or other income earned by the mutual fund.
You can also have capital gains (or losses) if you sell the mutual fund
units for more (or less) than the amount you invested.

Mutual funds are ideal for investors who –

lack the knowledge or skill / experience of investing in stock
markets directly.
want to grow their wealth, but do not have the inclination or
time to research the stock market.
wish to invest only small amounts.

WHY INVEST IN MUTUAL FUNDS?

As investment goals vary from person to person – post-
retirement expenses, money for children’s education or marriage,
house purchase, etc. – the investment products required to achieve
these goals too vary. Mutual funds provide certain distinct
advantages over investing in individual securities. Mutual funds offer
multiple choice investment across equity shares, corporate bonds,
government securities, and money market instruments, providing an
excellent avenue for retail investors to participate and benefit from
the uptrends in capital markets. The main advantages are that you
can invest in a variety of securities for a relatively low cost and leave
the investment decisions to a professional manager.
ADVANTAGES OF INVESTING IN MUTUAL FUNDS
 1. Professional Management — Investors may not have the
time or the required knowledge and resources to conduct their
research and purchase individual stocks or bonds. A mutual fund is
managed by full-time, professional money managers who have the
expertise, experience and resources to actively buy, sell, and monitor
investments. A fund manager continuously monitors investments
and rebalances the portfolio accordingly to meet the scheme’s
objectives. Portfolio management by professional fund managers is
one of the most important advantages of a mutual fund.

2. Risk Diversification — Buying shares in a mutual fund is an

easy way to diversify your investments across many securities and
asset categories such as equity, debt and gold, which helps in
spreading the risk - so you won't have all your eggs in one basket.
This proves to be beneficial when an underlying security of a given
mutual fund scheme experiences market headwinds. With
diversification, the risk associated with one asset class is countered
by the others. Even if one investment in the portfolio decreases in
value, other investments may not be impacted and may even
increase in value. In other words, you don’t lose out on the entire
value of your investment if a particular component of your portfolio
goes through a turbulent period. Thus, risk diversification is one of
the most prominent advantages of investing in mutual funds.

3. Affordability & Convenience (Invest Small Amounts) — For

many investors, it could be more costly to directly purchase all of the
individual securities held by a single mutual fund. By contrast, the
minimum initial investments for most mutual funds are more
affordable.

4. Liquidity — You can easily redeem (liquidate) units of open

ended mutual fund schemes to meet your financial needs on any
business day (when the stock markets and/or banks are open), so
you have easy access to your money. Upon redemption, the
redemption amount is credited in your bank account within one day
to 3-4 days, depending upon the type of scheme e.g., in respect of
Liquid Funds and Overnight Funds, the redemption amount is paid
out the next business day.

However, please note that units of close-ended mutual fund

schemes can be redeemed only on maturity. Likewise, units of ELSS
have a 3-year lock-in period and can be liquidated only thereafter.

5. Low Cost — An important advantage of mutual funds is their

low cost. Due to huge economies of scale, mutual funds schemes
have a low expense ratio. Expense ratio represents the annual fund
operating expenses of a scheme, expressed as a percentage of the
fund’s daily net assets. Operating expenses of a scheme are
administration, management, advertising related expenses, etc. The
limits of expense ratio for various types of schemes has been
specified under Regulation 52 of SEBI Mutual Fund Regulations,
1996.

6. Well-Regulated — Mutual Funds are regulated by the capital

markets regulator, Securities and Exchange Board of India (SEBI)
under SEBI (Mutual Funds) Regulations, 1996. SEBI has laid down
stringent rules and regulations keeping investor protection,
transparency with appropriate risk mitigation framework and fair
valuation principles.

7. Tax Benefits —Investment in ELSS upto ₹1,50,000 qualifies

for tax benefit under section 80C of the Income Tax Act, 1961.
Mutual Fund investments when held for a longer term are tax
efficient.