Class 1

Banking Practices & Regulations

Class 1 - Role played by the commercial banks

1. It can create further money be lending to people

a. Money Multiplier effect – The expansion of country’s money supply that results from banks being able to lend. The higher the reserve requirement, the tighter the money supply which results in a lower multiplier effect for every dollar deposited.

2. Banks are short term financial institutions (Short term deposit acceptance). Larger short term exposure to avoid asset-liability mismatch

3. Bank Nationalization – Policies of banks are in line with government fiscal policies. Fiscal deficit of Indian government is funded by nationalized banks like SBI.

a. Banks can create money by printing currency, which leads to further inflation. Money creation is done to curb government fiscal deficit. Printing of currency also leads to currency depreciation (Mirage of high export market)

b. Hence, Central Bank should not subscribe to government securities (Direct fiscal deficit funding of government). Instead they can use measures like CRR & SLR reduction to adjust / pump liquidity in the market (which in-turn increases cash in the system, thereby improving business opportunities)

4. Offering Services to the public – Like selling of insurance, mutual funds, ATMs management, vendor management, Cash management

a. Services do not involve funds of the bank. Role of bank is like an agent for obtaining a commission – Fee based facility. (Fund based facility – Earning of bank due to difference in interest rate of loans & deposits). To cater to competition, interest margin (spread) has reduced. Hence, bank is now focusing on fee based income. Bank has now become mall of banking.

b. Deposits used to walk in earlier. Now, banks need to sell deposits

c. Bringing in psychological advantage like ULIP Plans, Minor Savings account for children

5. Intermediaries – Spread, Difference between rates of lending of loans & savings deposit rate. A credit worthy borrower can go to other institutions by sidelining e banks. For example – ADR, GDR, FCCB (equity based borrowing from foreign; ADR / GDR is normally for long term fund requirements). Hence, role of banks as intermediaries is getting challenged.

a. (100-Age of Customer) = Risk taking capacity

b. Effective Interest Rate = Nominal Interest Rate – Inflation (EIR should not be less than 3%)

c. In India, rate of inflation > Rate of savings in bank. Hence, investors (in bank’s shares) are subsidized at the cost of savers.

6. Payment System – Method by which person who pays accesses the person who receives the payment. Here, buyers and sellers are separated by different legal & financial system or may be separated by distance.

a. Banking channel is a legal channel, an organized system of exchange.

b. Layering in Money Laundering – Original source of money can’t be traced

7. Other services –

a. Insurance Sales, Portfolio management, factoring services, investment banking, mutual funds

b. Merchant banking – Loan syndication, under-writing, floating of issues

c. Management of Estate – (Beyond certain wealth, it is called estate) Banks act as lawyer & distribute the property after the death of the applicant to the necessary beneficiaries.