UGC NET FINANCIAL ECONOMICS MATERIAL
Financial economics
MONEY SUPPLY
By the term money supply we mean the total currency in circulation in the economy.
Definition of Money Supply is as under:
M1 = Currency with the public + Demand deposits with the banks + Other Deposits (with the RBI)
M2 = M1 + Savings deposits with the Post office savings bank
M3 = M1 + Time deposits with the banks
M4 = M3 + All deposits with the post office savings bank (excluding National Savings Certificates)
MONEY MARKET
Features of Money Market:
1. Money market deals with short term funds.
2. Money market comprises of a well organised banking system.
3. There is perfect mobility of funds.
Functions of Money Market:
1. Maintains a balance between the demand and supply of money for short term monetary
transactions.
2. Promotes economic growth by making the funds available easily for various sectors like
agriculture, industry, etc.
3. Helps in implementing the monetary policy by way of changing CRR and SLR, etc.
4. Helps in capital formation due to increased investment possible with the help of money
market.
Instruments of Money Market
1. Treasury Bills: It is a short term instrument, issued by the RBI on behalf of the government to
meet the short term liquidity shortfalls. Assured return on such securities is low due to low risk
involved. Treasury bills are of following types:
Adhoc T-bills (1955): The government maintains the cash balance with the RBI and this was the
method of automatic monetization of government's budget deficit. Such securities no longer exist in India
Ordinary T-bills: These are sold to the public or banks and are freely marketable. Types of
ordinary T-bills are 91-day, 182-days, 364-days.
2. Repurchase Agreements: It is a transaction in which two parties agree to sell and repurchase
the securities under a contract and mutually decide a future date and price when the transaction
would take place.
Two important terms:
Repo: From seller’s point of view. It is the sale of securities by a seller, promising to buy the same
at some future date. In this case, the buyer of the securities acts as a lender.
Reverse Repo: From buyer’s point of view.
An agreement is termed as Repo or Reverse Repo, depending on which party initiated the
agreement.
Repurchase agreements are used to change the liquidity in the economy.
3. Commercial Papers: Commercial Papers are the short term, unsecured promissory notes
issued by the corporations and the financial institutions at some discounted value.
These are the instruments used by a company to enhance its liquidity with a period of
maturity ranging between one and 270 days.
These securities yield higher returns as compared to the T-bills. Overall, commercial papers
act as a low cost alternative to the bank loans.
A point to note here is that corporations with high quality credit rating can issue the
commercial papers.
4. Bills of Exchange: These securities are also known as “Bankers’ acceptance”.
It contains an unconditional order signed by the maker directing a certain person to pay a
certain sum of money only to or to the order of a certain person or to the bearer of instrument.
These securities are also guaranteed by the banks. Mostly, the bankers’ acceptance have a
maturity period of 90 days, but it can range from 30 to 180 days as well.
5. Certificate of Deposits: Certificate of Deposits are the short term instruments entitling the
bearer to receive interest at some future date.
The maturity period ranges from three months to five years and it restricts the bearer to
withdraw funds before the maturity date. This instruments yields higher interest rate because
it assumes greater level of risk involved.
6. Call money market: This is an inter-bank transactory market.
It is a very volatile and liquid market. Call money market is the most sensitive part of the
organised money market.
It is the market for short term funds with a maturity period ranging from one day to 14 days.
Types of Money Market : 1) Unorganized Money Market
2) Organized market
Unorganized market is old Indigenous market mainly made of indigenous
bankers, money lenders etc. Organized market is that part which comes under the
regulatory purview of RBI and SEBI. The nature of the money market transactions is such that
they are large in amount and high in volume.
Organized Money Market includes:
1. Reserve Bank of India 2. Scheduled Commercial Banks
3. Lenders 4. Development Banks
5. Investment institutions 6. Regional Rural Banks
7. Foreign banks 8. State Finance Corporations
9. Discount and Finance House of India
Unorganized Money Market includes:
1. Indigenous Bankers 2. Chit funds and Nidhis
3. Money Lenders
CAPITAL MARKET
Capital market is a market for long term funds,
It is regulated in India by SEBI.
Instruments of Capital Market
1. Equity/Ordinary shares and Preference Shares: These are the ownership securities which
have certain advantages in favour of the issuing companies and investors; depending on their
attitude towards risk.
2. Bonds and Debentures: These are the long term credit instruments of the country. A bond is a
secured instrument with a fixed income security.
3. Gilt-Edged Securities: These are the government securities, be it central or state issue. These
securities are backed by the RBI. The features of gilt-edged securities are:
1. Contains a promise by the President of India.
2. Maturity period 3-20 years.
3. Held by banks, foreign investors, etc.
Most active financial institutions in capital market are:
1. Industrial Finance Corporation in India (1948)
2. Industrial Credit and Investment Corporation of India - ICICI (1956)
3. State Financial Corporations 4. Industrial Development Bank of India (1964)
5. National Industrial Development Corporations 6. Unit Trust of India (1963)
7. Life Insurance Corporation of India (1956) 8. Nationalised Commercial Banks (1969 & 1980)
9. Mechant Banking institutions 10. Credit Guarantee Corporation of India
Industrial Development Bank of India (1964)
Objective: To Provide credit and other facilities to protect the industrial state of our economy.
It is the 10th largest development bank in the world in terms of number of ATMs, branches, etc.
Small Industries Development Bank of India (SIDBI): April 2, 1990
Objective: Main objective was to help micro, small and medium enterprises in India to grow with
easy availability of finance.
Functions
1. Provides financial support to the National Small Industries Corporation for the purpose of
their purchase, leasing activities.
2. Refinances existing loans and advances of the small-scale units.
Unit Trust of India:1963
Objective : The main and primary objective of UTI was to encourage the poor and middle income
groups to pool their savings. Also UTI aimed to enable these families to share the benefits from
industrial development of our economy.
Functions Deals in securities like promissory notes, bills of exchange, etc.
Grants loans and advances.
Deal in foreign exchange in terms of buying and selling.
Invest in schemes introduced by Central Government or RBI.
Industrial Investment Bank of India: March, 1997
Objective: To Provide term loan assistance for project finance, equity subscription, asset credit, etc.
Financial Intermediaries In Capital Market
1. Mechant Banks: It facilitates and finances production and trade of commodities. Mechant banks
do not perform regular banking activities.
2. Mutual Funds: Mutual funds pool in the resources from many investors and invest in stocks,
bonds or any other instrument.
3. Venture Capital: Provides capital to the enterprise or new ventures with huge growth potentials,
exposing themselves to high risks. Point to note here is that venture capital is a subset of private
equity.
Derivative Market
Derivatives are a kind of financial instruments, the values of which is based on the index of
other securities. In other words, value of a derivative is derived from certain underlined indices.
Parts of Derivative Market
1. Forward Contract: Buy or sell an asset at a certain future time for a certain price. One of the
parties assumes a long position who agrees to buy the underlying asset and the other party
assumes a short position and agrees to sell the asset at the same time and agreed price.
2. Future Contract: It is different from forward contract in the way that an exact delivery data is
not usually specified and the holder of the short position has the right to choose the time during
the delivery period when it will make the delivery.
3. Options Market:
Call option: It gives the holder the right to buy the underlying asset at a particular time and for a
particular price.
Put option: It gives the holder the right to sell the underlying asset at a certain date for a certain
price.
Depository/Depositors: They hold the certificates in the material form. There are specialist
financial organization holding securities in either certified or uncertified form so that ownership
can be transferred through a book entry rather than transfer of physical certificates
Clearing Houses: Clearing house is an agency or corporation of a future exchange responsible for
settling trading accounts. They act as a third party to all futures and options contract. It is a part of
capital market and functions in derivative market.
Primary dealers: They buy securities directly from the Central bank and resell them to others,
thus acting as market makers of government securities.
Underwriters: They will accept some of the risk on a given venture and will distribute the
securities, but if they do not find enough investors, they will then have to purchase the remaining
securities.
CREDIT RATING AGENCIES
Credit Rating Agencies are also known as Ratings Service. It is a company that assigns credit
ratings, that is, rating of a debtor’s ability to pay back the debt by making timely interest
payments and of the likelihood of default.
Credit Rating Agency provides ratings of:
1. Credit worthiness
2. Debt instruments
In some cases the services of underlying debt can also be rated but not of individual
consumers.
Indian Credit Rating Agencies:
1. Credit Rating Information Services of India Limited (CRISIL): 1988
2. Investment information and Credit Rating Agency (ICRA): 1991.
3. Credit Analysis and Research Limited (CARE): 1993
QUESTIONS FOR CLARIFICATION
1. Agricultural income tax is levied by
A) Central government B) Local bodies
C) State government D) All the above
2. In India the fiscal year is
A) From January 1 to December 31
B) From March 1 to February 28
C) From June 1 to May 31
D) From April 1 to March 31
3. The type of note issue system followed in India is
A) Maximum fiduciary system B) Minimum reserve system
C) Proportional Fiduciary system D) Fixed fiduciary system
4. R.N. Malhotra committee gave recommendations in the field of
A) Agricultural sector B) Sick industries
C) Insurance sector D) Banking sector
5. NABARD was established on the recommendations of
A) Public Accounts Committee B) Shivaraman Committee
C) Narasimhan Committee D) None of these
6. Which of the following has made recommendations in respect of centre-state financial relation
in India?
A) Kelkar Commission B) Sarkaria Commission
C) Rekhi Committee D) Chelliah Committee
7. The issue authority of one rupee currency note is
A) RBI B) State Bank of India
C) Ministry of Finance D) Finance Commission
8. In cost benefit analysis, the method which solves for the rate of interest which will make the
present value of the net benefit of the project zero is
A) Working capital method B) Internal rate of return method
C) Capital turnover criterion D) None of these
Answers:-
1) C 2) D 3) B 4) C 5) B 6) A 7) C 8) B
STOCK EXCHANGES IN INDIA
1. Over The Counter Exchange of India (OTCEI): This was incorporated in 1990 and became
fully operational in 1992
No physical location
Promoted jointly by a number of financial institutions like ICICI, IDBI, etc.
There are restrictions on listing of securities.
Price fixation is regulated.
It is a market for only spot deals.
It has a decentralized style of working.
2. National Stock Exchange (NSE): Established in 1992.
Number of listed companies are 1665
Index for this stock is NIFTY.
Headquarters: Delhi
All operations are carried out from Mumbai.
Fully automated screen based trading system.
There are two segments in NSE: Firstly, Capital market segment, Secondly, Wholesale Debt
Market Segment.
There are no trading flows.
3. Bombay Stock Exchange (BSE): Established in 1875.
Number of listed companies are 5191.
Index: SENSEX
Largest Stock Exchange in India.
4. MCX-SX (Multi-Commodity Exchange): Established on February 3, 2013.
Number of listed companies are 1116.
Index: SX-40
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
SEBI was formed on April 12, 1988 and was given statutory status in January 30, 1992. It
performs regulatory and development functions in the capital market.
Functions of SEBI
1. To protect the interest of the investors.
2. To promote the development of and to regulate the securities market.
3. To prevent insider trading and any kind of unfair practices.
4. Investor’s education and training of intermediaries.
5. Conducts research and publish information.
6. Registration of brokers and sub-brokers, etc.
7. Given the power to levy, cease or other charges, in case of any legal activities.
REGIONAL RURAL BANKS (RRBS): October 2, 1975
Objective: To Provide credit to the weaker sections staying in rural areas, especially the small and
marginal farmer, agricultural labourers, artisans and small entrepreneurs.
Capital Structure: Jointly owned by the Government of India, Government of the concerned state
and public sector bank in the ratio 50:15:35.
CO-OPERATIVE BANKS
Co-operative banks are defined as the institution which is established on the co-operative
principles of co- operation, self-help and mutual help and is engaged in the normal banking
activities.
Structure of Co-operative Banks
State Co- operative Banks District Co- operative Banks Primary Agricultural Credit Societies
Main objective: Provide credit facilities to the rural sector.
Concentrates mainly on the credit requirements of the trade and industry.
Interest rate are high on savings/ deposits and low on credit; exact opposite in case of commercial banks.
NON-BANKING FINANCIAL INSTITUTIONS (NBFIS): Concept of Non-Banking Financial Institution was given by Gurley and Shaw. These are the institutions which provide banking services without meeting the legal definition of a bank, that is, one that does not hold a banking license.
Regulations relating to acceptance of deposits by the NBFIs are:
1. Allowed to accept/renew public deposits for a minimum period of 12 months and maximum
period of 60 months.
2. Cannot accept deposits repayable on demand.
3. Cannot offer interest rates higher than the ceiling rate as prescribed by the RBI.
4. Cannot offer gifts/incentives to the depositors.
5. Should have minimum investment grade credit rating.
6. Deposits are not insured.
7. Repayment of deposits by NBFIs are not guaranteed by RBI.
BANKING SECTOR REFORMS
Banking Sector Reforms were brought in our economy by Narsimham Committee. It came in two phases: 1991 and 1998. The main aim of the reforms was to improve the banking sector and change the bank rates.
Main provisions in Banking Sector Reforms are:
1. Main aim of the reforms was to reduce SLR and CRR. SLR was reduced from 35% to 25%. On
the other hand, CRR was reduced from 15% to 3 to 5%.
2. Phasing out direct credit programme. The programme compelled the banks to earmark the
financial resources for the poor sections of the society at a concessional rate of interest.
3. Dual control of the banking system by Ministry of Finance and RBI to be abolished.
4. De-regulations of interest rates. Interest rates should be rather determined by the markets.
5. Liberal view for allowing foreign banks to the country.
6. Should have a 4-tier banking system. 7. Banks to be given more autonomy.
8. Primary targets for credit to be redefined. 9. Computerization of the banking system.
10. Banks should be authorized to appoint banking official at their own discretion.
11. Granting resources to Development Financial Institutions at concessional rates to be abolished
in the next three years.
12. Structural reorganization of banks. 13. Asset reconstruction fund was formed to
take care of Non-Performing Assets.
NATIONALIZATION OF BANKS
On July 19, 1969, 14 banks were nationalized which had a deposit base of over Rupees 50
crores. Second set of nationalization took place in April 1980, where 6 more banks were
nationalized. In 1993, New Bank of India merged with Punjab National Bank, reducing the
number of nationalized banks from 20 to 19.
The Union Cabinet had approved the merger of five associate banks along with Bharatiya
Mahila Bank with SBI in 2017.
Ten Public Sector Undertaking (PSU) banks will be amalgamated into four banks from from 1
April, 2020. In the biggest consolidation exercise in the banking space, the government in
August 2019 had announced the merger of 10 public sector lenders into four bigger and
stronger banks. With this, the number of public sector banks in India will come down to 12.
1) Oriental Bank of Commerce (OBC) and United Bank of India will be merged
into Punjab National Bank (PNB).
2) Syndicate Bank will be merged into Canara Bank
3) Indian Bank will be merged with Allahabad Bank.
4) Union Bank of India will be merged with Andhra Bank and Corporation Bank
Objectives behind nationalization of banks
1. Social welfare: The needy were deprived of the funds from the financial institutions. As a result,
there was a need to direct the funds to the required sectors of the economy.
2. Controlling private monopolies who benefitted before nationalization due to easy availability of
finance to them.
3. Expansion of banking sector of the economy.
4. Reducing the regional imbalances in the economy.
5. Lending finance to the priority sectors of the economy like agriculture and allied activities, etc.
6. Developing banking habits among the population.
RESERVE BANK OF INDIA
RBI is the Central banking institution of India and controls the monetary policy of India. RBI was
established on April 1, 1935 on the recommendations of the Hilton-Young
Commission. It was nationalized in 1949.
Functions of RBI
1. It is the Issuer of the currency
2. RBI acts as a banker to the central and the state government.
3. It manages the government securities.
4. RBI also acts as a banker to the other banks.
5. It is the controller of Money supply and Credit.
6. Publisher of Monetary data and other related data as well.
BANK’S PORTFOLIO MANAGEMENT
Portfolio Management → Managing bank’s asset & liabilities, which is the optimum
combination of income or profit, liquidity & safety
Theories of portfolio Management
1. Commercial Loan (Real Bill) Theory
Bank should advance only short-term loans which are self-liquidating. As a result, they are more productive in nature.
2. Moulton’s shift ability Theory
Applicable to short-term market instruments like T-bills. Asset should be perfectly shift
able/immediately transferable without any capital loss.
3. Prochnow’s Anticipated Income Theory
Loan given = f (Liquidation, Expected/Anticipated income of the borrower)
This is because bank gets paid in installments.
4. Liabilities Management theory
No need for granting self-liquidity loans/keeping liquid assets. Because at times of need; banks
can borrow the reserve money or Issue shares, etc…
LAGS OF MONETARY POLICY
Lags of Monetary Policy: Change in monetary policy does not have immediate effect on change
in aggregate Spending & action taken by commercial banks)
Inside lag: Recognition of a problem by policy makers, basis of measurement of the problem.
Outside Lag: Change in money income due to changes in policy
There are two Inside Lags;
Recognition lag:- Time taken to recognize that the economy has changed due to existing policy.
Action lag :- Caused by 1. Time taken to work out details for change.
2. Disagreement among policy makers
3. Political pressure
4. Delayed due to desirable change in monetary policy
QUESTIONS FOR CLARIFICATION
1. Which movement encouraged the formation of commercial banks?
A. Swadeshi movement
B. Quit India Movement
C. Non Cooperation Movement
D. Civil Disobedience Movement
2. In which year was the Banking Regulation Act passed?
A. 1949 B. 1955
C. 1959 D. 1969
3. The features of the commercial paper are
A. It is an unsecured instrument issued in the form of promissory note.
B. The highly rated corporate borrowers can raise short term funds through this instrument.
C. It is an additional instrument to the investing community.
D. All of the above
4. Which of the following is used for International Monetary Transfer?
A. RTGS B. NEFT C. SWIFT D. None of these
5. Banking ombudsman may reject the complaint
A. immediately after receipt B. after hearing both parties
C. at any stage D. None of the above
6. India has been witnessing high rate of inflation because
A. Public expenditure and money supply both are continuously increasing.
B. The agricultural and industrial sectors have not performed adequately.
C. Both agricultural and administered prices have been hiked.
D. All of the above
7. Which one of the statement is not true?
A. Institutional infrastructure facilities makes intelligence.
B. STC is the chief canalizing agent for export and import of agriculture products.
C. IPO organizes trade fairs and exhibitions.
D. Letter of credit does not indicate that the bank will pay the value of imports to the exporter.
Answers:-
1) A 2) A 3) D 4) C 5) C 6) D 7) D
