Commercial Banks

Okay, let's break down the concepts of banking, its functions, and credit creation based on
the provided text

●​ Banking Regulation Act, 1949 (Section 5): This is a more comprehensive

definition.​

○​ A banking company is any company that does the "business of banking."

○​ Banking means:
■​ Accepting deposits of money from the public. This is a key activity
– taking money from people who want to save it.
■​ These deposits are accepted for the purpose of lending or
investment. Banks don't just hold the money; they use it to give out
loans or invest it to earn returns.
■​ The deposits are payable on demand or otherwise. This means you
can get your money back when you ask for it (like from a savings
account) or after a certain period (like a fixed deposit).
■​ Deposits are withdrawable by cheque, draft, or otherwise. This
points to the various ways customers can access their funds.

In simple terms, a bank is an institution that takes deposits from the public and uses
that money to make loans or investments.

The main jobs of a bank can be split into two types: primary functions and secondary
functions.

5.4.2 Primary Functions of a Bank

These are the core activities that a bank performs. Initially, it was mainly about taking
deposits and giving loans. But now, creating credit and dealing in foreign money are also
considered primary.

1. Collection of Deposits
This is the most important job of a commercial bank. Banks collect money from people
and businesses in various forms:
●​ Fixed Deposits (or Term Deposits):​

○​ What it is: You deposit a specific amount of money with the bank for a fixed
period (e.g., 1 year, 5 years).
 ○​ Interest: You earn interest on this deposit. The interest rate is generally the
highest compared to other deposit types because your money is locked in.
○​ Early Withdrawal: If you take your money out before the fixed period ends,
you might lose some or all of the interest you would have earned.
○​ Example: You deposit ₹1,00,000 for 5 years to save for a future goal.
●​ Savings Bank Deposits:​

○​ What it is: You can open this account with a very small amount of money. It's
for encouraging people to save.
○​ Withdrawals: You can withdraw money when you need it, but there might be
some limits on the number of withdrawals per week or month.
○​ Interest: The interest rate is usually higher than a current account but
lower than a fixed deposit.
○​ Benefit: Banks gather large amounts of funds by pooling small savings from
many individuals.
○​ Example: You deposit a portion of your monthly salary into a savings account
for everyday needs and short-term savings.
●​ Current Account Deposits (or Demand Deposits):​

○​ What it is: Often used by businesses and individuals who have a high
volume of transactions. The bank usually checks the customer's
creditworthiness before opening one.
○​ Withdrawals & Deposits: There are no limits on the amount you can
deposit or the number of withdrawals you can make.
○​ Interest: Normally, no interest is paid on current accounts. Sometimes,
banks might even charge a fee for maintaining these accounts.
○​ Example: A shop owner uses a current account to receive payments from
customers and pay suppliers daily.
●​ Recurring Deposits:​

○​ What it is: A newer type of deposit. You deposit a fixed amount every
month for a specified number of years.
○​ Payout: After the agreed period, you get back your total deposited amount
(principal) plus the accumulated interest.
○​ Interest: The interest rate is generally similar to that of fixed deposits.
○​ Example: You decide to save ₹5,000 every month for 3 years by opening a
recurring deposit to buy a new laptop.

2. Loans and Advances

After collecting deposits, banks use this money to give out short-term loans and advances
to various sectors:
●​ Loans to Business and Trade:​

○​ Banks provide short-term funds to businesses for their operational needs.

○​ Types:
■​ Overdraft: An arrangement where a customer (usually a business
with a current account) is allowed to withdraw more money than
they have in their account, up to a certain limit. This is usually
granted against some security (collateral). Interest is charged only
on the overdrawn amount.
■​ Example: A business has ₹50,000 in its account but needs to
make a payment of ₹70,000. If they have an overdraft facility of
₹30,000, they can make the payment, and they will be charged
interest on the ₹20,000 they overdrew.
■​ Cash Credit: A flexible loan given against the security of goods (like
raw materials or finished products) or personal security (a guarantee
from someone else). The bank sets a limit, and the borrower can
withdraw funds as needed up to that limit. Interest is charged only
on the amount actually used, not the total sanctioned limit.
■​ Example: A manufacturer gets a cash credit limit of ₹5 lakhs
against their stock. If they use only ₹2 lakhs, interest is charged
on ₹2 lakhs.
■​ Direct Loans: A specific amount of money is lent for a fixed period
against the security of movable properties. The borrower has to pay
interest on the entire loan amount from the day the loan is taken
until it's fully repaid.
■​ Example: Taking a loan to buy machinery, where the
machinery itself is the security.
■​ Bills Discounted: Businesses often receive bills of exchange (a
promise of future payment) from their customers. If a business needs
money immediately, it can take these bills to a bank. The bank will pay
the business the bill's amount after deducting a commission (the
"discount"). The bank then collects the full amount from the bill's
original payer on the due date. This is very popular in Western
countries.
■​ Example: Seller A has a bill for ₹10,000 due in 3 months from
Buyer B. Seller A needs cash now, so they go to the bank. The
bank might give them ₹9,800 (discounting ₹200) and collect
₹10,000 from Buyer B after 3 months.
●​ Loans to Industry:​
 ○​ Banks provide loans to industries mainly for their working capital
requirements (day-to-day operational expenses). These are usually in the
form of overdrafts, cash credits, and direct loans.
●​ Loans to Agriculture and Allied Activities:​

○​ Banks offer short-term credit for farming and related activities, such as:
■​ Crop loans (for seeds, fertilizers, etc.)
■​ Loans for irrigation, land development
■​ Loans for purchasing cattle, equipment, etc.
●​ Export and Import Trade:​

○​ Banks support international trade by providing loans and advances. This

includes direct loans, guaranteeing payments that are to be made later
(deferred payments), and discounting bills related to exports and imports.

3. Creation of Credit
This is a very important function and will be explained in detail in section 5.6 below. It's the
power of banks to expand loans and advances, essentially creating more "money" in the
economy than the initial cash deposits.

4. Foreign Exchange Dealings

Modern banks also play a crucial role in facilitating international trade and travel by dealing
in foreign currencies. They buy and sell foreign currencies, help with remittances (sending
money abroad), and provide other foreign exchange services.

5.4.3 Secondary Functions

Besides their main banking jobs, banks perform many other non-banking services for their
customers' convenience. These are generally divided into agency services and general
utility services.

1. Agency Services
Here, the bank acts as an agent for its customer.
●​ Collections:​

○​ Banks collect money on behalf of their customers for things like:

■​ Cheques and drafts
■​ Promissory notes and bills of exchange
■​ Dividends on shares, interest on investments
■​ Subscriptions, rents
 ○​ Banks usually charge a small service fee for this.
●​ Payments:​

○​ Banks make regular payments on behalf of customers, such as:

■​ Insurance premiums
■​ Rents, taxes
■​ Electricity bills, phone bills
○​ They charge a commission for these services.
●​ Sale and Purchase of Securities:​

○​ Banks buy and sell shares, bonds, and other securities for their customers,
charging a commission.
●​ Trustee, Executor, and Attorney:​

○​ Trustee: A bank can manage funds or property on behalf of a customer (e.g.,

for a trust set up for children).
○​ Executor: If a customer leaves a will, the bank can act as an executor to
carry out the wishes stated in the will after the customer's death.
○​ Attorney: A bank can be authorized to sign documents (like transfer forms)
on behalf of a customer.
●​ Correspondent:​

○​ Banks act as correspondents or representatives for their customers, helping

them with things like:
■​ Obtaining passports
■​ Booking traveler's tickets.

2. General Utility Services

These are various other useful services banks offer:
●​ Letters of Credit:​

○​ Banks issue letters of credit, especially for traders. This is a guarantee from
the bank that a buyer's payment to a seller will be received on time and for
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the correct amount. If the buyer is unable to make payment, the bank will
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cover the full or remaining amount. This is very useful for international trade,
giving confidence to sellers dealing with unknown buyers.
●​ Draft Facilities:​
 ○​ Banks issue drafts (like a cheque guaranteed by the bank) to help customers
transfer funds securely from one place to another.
●​ Underwriting:​

○​ When companies or the government want to raise money by issuing shares

or debentures (bonds), banks can "underwrite" the issue. This means the
bank guarantees to buy any shares/debentures that are not bought by the
public, ensuring the issuer raises the needed funds.
●​ Guarantee for Deferred Payments:​

○​ Sometimes importers need to buy goods but can't pay immediately. Exporters
might allow future payment if a bank guarantees it. The bank provides this
guarantee.
●​ Locker Facility:​

○​ Banks provide safe deposit lockers where customers can keep their valuables
like jewelry, important documents, and securities.
●​ Referee:​

○​ Banks can act as referees, providing information (with the customer's

consent) about a customer's financial standing, business reputation, and
reliability to other parties.
●​ Business and Statistical Information:​

○​ Banks often collect and analyze information about trade, commerce, and
industry. They may provide this information to their customers to help them
make business decisions.
●​ Foreign Exchange Dealings (also a primary function):​

○​ Facilitating currency exchange for travelers and businesses involved in

international trade.

5.5 Economic Significance of Banking

Banks are incredibly important for a country's economic development. They are not just
"dealers of money" anymore; they are vital players in the economy.
●​ Channeling Funds: Banks act like "rivers" and "oceans" for money. They collect
small savings ("tiny streamlets of capital") from the public (who might otherwise let it
sit idle or use it unproductively) and channel these funds ("ocean of national
finances") to businesses, industrialists, and entrepreneurs who need them to run and
grow their ventures.
 ●​ Driving Economic Activity: Banks "float the vessels of commerce and drive the
wheels of industry."
●​ Facilitating Trade and Industry: The growth of modern trade and industry relies
heavily on the availability of finance. Banks provide various types of loans and
financial help to encourage entrepreneurs and support industrial activity.
●​ Developing Agriculture: Agriculture is crucial, especially in developing countries.
Banks provide finance and technical advice to help modernize and improve this
sector (e.g., loans for fisheries, piggeries, etc.).
●​ Developing Service Sector: Banks provide finance for services like transport,
education, etc., which strengthens the economy's infrastructure.
●​ Contributing to Balanced Regional Growth: Banks help identify areas needing
development and provide finance to industries there. This supports backward areas
and promotes balanced growth across the country.
●​ Encouraging International Trade: By offering credit for exports and imports and
providing data, banks boost international trade.
●​ Social Service: Banks fulfill social needs by introducing schemes like
self-employment loans, village adoption programs, educational assistance, and slum
removal projects.
●​ Implementation of Monetary Policy: A well-developed banking system is essential
for the central bank to implement its monetary policy effectively, which is crucial for
sound economic development.

5.6 Creation of Credit

This is one of the most unique and important functions of commercial banks. It's their ability
to expand loans and advances, which in turn creates more deposits. Essentially, banks
can "create" money beyond the initial cash they have.

5.6.1 Principles of Portfolio Management (How Banks Manage Their Money)

Before understanding credit creation, it's useful to know how banks manage their funds
(their "portfolio" of assets and liabilities). They try to balance three main, often conflicting,
goals:
1.​ Liquidity:​

○​ What it is: The bank's ability to pay back depositors their money in cash
whenever they demand it. This is crucial for maintaining public confidence.
If people think a bank can't give them their money back, they'll rush to
withdraw it (a "bank run").
○​ Factors influencing liquidity needs:
■​ Nature of the economy (developed vs. developing)
■​ Development of the money market
■​ Banking habits of people (do they use banks a lot?)
 ■​ Banking structure (unit banking vs. branch banking)
■​ Business conditions (inflation, depression)
■​ Seasonal needs for money (busy vs. slack season)
■​ Minimum cash reserve ratio set by the central bank
■​ How depositors behave (do they withdraw large sums unexpectedly?)
2.​ Profitability:​

○​ What it is: Banks are businesses, so they need to earn profits to cover their
operating expenses (salaries, rent), pay interest to depositors, and give
dividends to their owners (shareholders).
○​ How they earn profits: By investing the funds they collect in ways that
generate the maximum possible income (e.g., by giving loans at a higher
interest rate than they pay on deposits).
○​ Factors influencing profitability: Investment patterns, interest rates earned,
cost of operations.
3.​ Safety (or Solvency):​

○​ What it is: Ensuring the bank remains solvent, meaning its assets (what it
owns, like loans given out) are worth more than its liabilities (what it owes,
like deposits). This ensures the safety of the depositors' funds.
○​ If a bank's assets are equal to or greater than its liabilities, it's considered
solvent.

The Challenge: These three principles often conflict.

●​ Assets that are very liquid (like cash) earn little or no profit.
●​ Assets that are very profitable (like long-term loans to risky ventures) might be less
liquid and less safe.
●​ So, banks must constantly balance liquidity, profitability, and safety for sound
financial health.

5.6.2 Credit Creation Explained

●​ Primary Deposit: When a customer deposits cash into a bank, this initial deposit is
called a primary deposit.
●​ The Logic:
○​ Banks know from experience that not all depositors will withdraw all their
money at the same time.
○​ They are required by the central bank to keep a certain percentage of their
deposits as a reserve to meet day-to-day withdrawals. This is called the
Cash Reserve Ratio (CRR).
●​ The Process:
 ○​ A bank receives a primary deposit.
○​ It keeps a portion aside as CRR.
○​ The remaining amount (called excess reserves) can be lent out.
○​ Crucially, when a bank grants a loan, it usually doesn't hand over cash
to the borrower. Instead, it credits the loan amount to the borrower's
account in the same bank or another bank. This act of crediting the
borrower's account creates a new deposit.
○​ This newly created deposit is called a secondary or derivative deposit.
○​ The bank (or the banking system) can then keep a reserve against this new
derivative deposit and lend out the rest, creating yet another deposit, and so
on.
●​ Definition of Credit Creation: The power of banks to multiply loans and
advances by creating these derivative deposits. Newlyn defines it as "the power
of commercial banks to expand secondary deposits either through the process of
making loans or through investment in securities."
●​ Credit Multiplier: This shows how many times banks can expand the initial primary
deposit into total deposits (primary + derivative). It is the ratio of total derivative
deposits to the total primary deposits.
○​ Formula (Simplified): Credit Multiplier = 1 / CRR
■​ If CRR is 10% (or 0.10), the credit multiplier is 1 / 0.10 = 10. This
means an initial primary deposit can theoretically lead to a tenfold
increase in total deposits.

Example of Credit Creation (Single Bank, then Multiple Banks):

Let's use the example from the text:
●​ Assumptions:
○​ Initial (Primary) Deposit = ₹2,000
○​ Cash Reserve Ratio (CRR) = 10% (meaning banks must keep 10% of
deposits as cash and can lend out 90%)

Scenario 1: Credit Creation by a Single Bank (Simplified View)

1.​ Step 1: A depositor puts ₹2,000 into Canara Bank. This is a primary deposit.
○​ Canara Bank keeps 10% of ₹2,000 as reserve: ₹200.
○​ Canara Bank can lend out the rest: ₹2,000 - ₹200 = ₹1,800 (this is the initial
excess reserve).
2.​ Step 2: Canara Bank grants a loan of ₹1,800 to Person A by crediting it to Person
A's account. This ₹1,800 is a derivative deposit.
○​ Against this new deposit of ₹1,800, the bank keeps 10% as reserve: ₹180.
 ○​ It can now lend out: ₹1,800 - ₹180 = ₹1,620.
3.​ Step 3: Canara Bank grants a loan of ₹1,620 to Person B, creating another
derivative deposit.
○​ Reserve (10% of ₹1,620) = ₹162.
○​ Can lend out: ₹1,620 - ₹162 = ₹1,458.
4.​ And so on... This process continues. Each loan creates a new deposit, and a
portion of that new deposit can be lent out again.
●​ Total Derivative Deposits Created: ₹1,800 + ₹1,620 + ₹1,458 + ... = ₹18,000
●​ Total Deposits (Primary + Derivative): ₹2,000 (initial) + ₹18,000 (created) =
₹20,000
●​ Credit Multiplier Calculation:
○​ Using the formula: 1 / CRR = 1 / 0.10 = 10.
○​ Total Deposits = Initial Primary Deposit * Credit Multiplier = ₹2,000 * 10 =
₹20,000.
○​ Total Credit Created (Derivative Deposits) = Initial Excess Reserve * Credit
Multiplier = ₹1,800 * 10 = ₹18,000. (Note: The text says "credit creation (total
derivative deposits of Rs. 18,000) is ten times of the initial excess reserve."
and "credit creating ability of a bank is the product of credit multiplier and
excess reserve of primary deposit (i.e., 10 x Rs. 1,800 = Rs. 18,000).")

Scenario 2: Multiple Credit Creation by the Banking System (More Realistic)

It's more likely that when a loan is given, the borrower uses that money, and it ends up in
another bank, which then continues the process.
1.​ Step 1: Depositor puts ₹2,000 in Canara Bank (Primary Deposit).
○​ Canara Bank keeps ₹200 (10% CRR).
○​ Lends ₹1,800 to Person X by crediting their account.
2.​ Step 2: Person X pays ₹1,800 (say, by cheque) to a supplier. The supplier deposits
this ₹1,800 cheque into their account at State Bank of India (SBI).
○​ For SBI, this ₹1,800 is now a primary deposit (as fresh cash has come into
SBI).
○​ SBI keeps ₹180 (10% of ₹1,800) as reserve.
○​ SBI can lend out ₹1,620. SBI lends this to Person Y.
3.​ Step 3: Person Y uses this ₹1,620 to pay a creditor, who deposits it into Syndicate
Bank.
○​ For Syndicate Bank, this ₹1,620 is a primary deposit.
○​ Syndicate Bank keeps ₹162 (10% of ₹1,620).
○​ Syndicate Bank can lend out ₹1,458.
4.​ And so on... The money moves from bank to bank, and each bank in the system
can create new loans and derivative deposits based on the reserves it receives.
 ●​ Outcome: The total amount of derivative deposits created by the entire banking
system will still be ₹1,800 + ₹1,620 + ₹1,458 + ... = ₹18,000.
●​ The initial ₹2,000 cash deposit has supported the creation of ₹18,000 in new
loans/derivative deposits, leading to a total of ₹20,000 in the banking system.

Key Idea: The banking system as a whole can create credit that is a multiple of the initial
cash reserves. This is because the money lent by one bank generally comes back as a
deposit in another bank (or the same bank), allowing for further lending.

Assumptions of the Credit Multiplier:

For this multiplier effect to work perfectly as described, certain conditions are assumed:
1.​ Constant CRR: The cash reserve ratio remains the same throughout the process.
2.​ No Leakage: All money lent out comes back into the banking system as deposits.
There are no "leakages" like:
○​ People holding onto cash instead of depositing it.
○​ Banks choosing to hold more reserves than the required CRR (excess
reserves).
3.​ Well-Developed Banking System: There's an efficient network of banks.
4.​ Banking Habits: People use banking services extensively and prefer to make
payments through cheques/digital means rather than holding cash.
5.​ No Central Bank Intervention: The central bank is not actively trying to control
credit (e.g., by changing CRR or other policies during this specific process).
6.​ Normal Business Conditions: The economy is stable, not in a deep recession
(where no one wants to borrow) or hyperinflation.

Limitations of Credit Creation (Why it might not work perfectly in practice):

In reality, the full theoretical credit creation might not occur due to several limitations:
1.​ Amount of Cash: The most basic limit. If banks don't have much initial cash
(primary deposits), their ability to create credit is limited. More cash allows for more
credit.
2.​ Cash Reserve Ratio (CRR):
○​ A lower CRR means banks can lend out a larger portion of their deposits,
leading to greater credit creation.
○​ A higher CRR means banks must keep more in reserve, reducing their
ability to create credit.
3.​ Leakages:
○​ Excess Reserves: Banks might choose to keep more reserves than legally
required, especially if they are cautious or don't find enough creditworthy
borrowers.
 ○​ Currency Drains: If borrowers or the public withdraw cash and hold it,
instead of redepositing it into the banking system, the chain of deposit
creation is broken.
4.​ Availability of Reliable Borrowers: Banks can only create credit if there are
enough trustworthy people and businesses willing to take loans. If demand for loans
is low, credit creation will be less.
5.​ Availability of Securities: Banks often require collateral (security) for loans. If
borrowers don't have adequate securities to offer, they may not get loans.
6.​ Credit Policy of the Central Bank: The central bank can directly influence credit
creation by:
○​ Changing the CRR.
○​ Using other monetary policy tools (like interest rates) to encourage or
discourage lending.
7.​ Banking Habits of the People: If people don't use banks much or prefer cash
transactions, the money lent out may not return to the banking system as deposits,
limiting further credit creation.
8.​ Business Conditions:
○​ Inflation: During high inflation, banks might be more willing to lend, and
people might want to borrow more.
○​ Depression/Recession: During economic downturns, businesses are less
likely to invest and borrow, and banks might be more cautious about lending,
reducing credit creation.
9.​ Uniformity among Banks: The assumption is that all banks follow the same lending
behavior. In reality, some banks might be more aggressive in lending, while others
are more conservative.

This detailed explanation should cover the nature and significance of banks, their functions,
and the crucial concept of credit creation.

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ROLE OF FINANCIAL MKT

3. Economic (Macro) Functions

1.​ Resource Allocation​

○​ Channel savings into productive investments (factories, infrastructure).​

2.​ Price Discovery​

○​ Market forces set fair interest rates and security prices through supply & demand.​

3.​ Liquidity Provision​

○​ Allow quick buying/selling of assets with minimal price impact.​

4.​ Risk Sharing & Diversification​

○​ Enable investors to spread and trade risk (e.g., by holding a mix of stocks,
bonds).​

5.​ Information Aggregation​

○​ Prices reflect all known information (company outlook, economic data), guiding
decisions.​

4. Financial (Micro) Functions

1.​ Financing for Borrowers​

○​ Businesses and governments raise funds by issuing shares or bonds.​

2.​ Investment Returns for Savers​

○​ Savers earn dividends, interest or capital gains.​

3.​ Matching Maturities​

 ○​ Short-term needs met in the money market; long-term needs in the capital
market.​

4.​ Transaction Cost Reduction​

○​ Standardised contracts and centralised trading lower search and negotiation

costs.​

5.​ Facilitating Payments​

○​ Instruments like commercial paper and certificates of deposit serve as near-cash.​

​
​
Okay, let's break down the role of financial markets in the economy in a way that's easy
to understand and remember for your exam.
Think of the economy as a giant system where people and businesses make, sell, and buy
things. For this system to work smoothly and grow, it needs a way to handle money
effectively. That's where the financial system comes in.

What is the Financial System All About?

At its heart, the financial system is concerned with money, credit, and finance.
1
●​ Money is what we use to buy things (like cash or money in your bank account).
2
●​ Credit is borrowing money that you promise to pay back later, often with interest.
●​ Finance is a broader term that covers how money is managed, invested, and raised
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for various purposes.

These three are closely related but slightly different. The financial system is like the
plumbing of the economy; it's a complex network of institutions (like banks), agents
(like brokers), rules, markets, and transactions that help money flow from those who
have it to those who need it.

Economists have long debated how important the financial system is for economic growth.
●​ Early economists like Bagehot (1873) and Schumpeter (1911) strongly believed
that an efficient financial system is crucial for a nation's economy to grow.
●​ Schumpeter, as highlighted by Ross Levine, specifically argued that
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well-functioning banks help drive technological innovation. They do this by
 funding entrepreneurs who have promising ideas for new products or better ways
of doing things.

1.2 Nature of the Financial System

The financial system is a complex, well-integrated set of sub-systems that work

5
together to transfer and allocate funds (money) efficiently and effectively.

It has four main building blocks:

1.​ Financial Institutions
2.​ Financial Markets
3.​ Financial Instruments
4.​ Financial Services

Let's look at each one:

1.2.1 Financial Institutions

These are like the organizations or businesses within the financial plumbing system.

Their main jobs are:

●​ Mobilisers and depositors of savings: They collect savings from people and
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businesses. Think of you depositing your pocket money in a bank.
●​ Purveyors of credit or finance: They provide loans and other forms of finance to
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those who need to borrow. Think of a business taking a loan from a bank to buy
new machinery.
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●​ They also offer various financial services to the community.

Financial institutions can be classified in a couple of key ways:

a) Banking Institutions vs. Non-Banking Institutions

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●​ Banking Institutions (Banks): These are special.
○​ They are part of the economy's payments mechanism (e.g., you can write
cheques or use debit cards linked to your bank account to pay for things –
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this is called providing transaction services).
 ○​ The money people deposit in banks (deposit liabilities) forms a big chunk of
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the country's money supply.
○​ Crucially, banks can create deposits or credit, which is essentially
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creating money. This is a unique ability.
○​ Think of it like this: If you deposit ₹1000 in a bank, the bank might keep ₹100
(as reserve) and lend out ₹900. This ₹900 might get deposited in another
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bank, which can then lend out a portion of it, and so on. This process
effectively increases the amount of money circulating.
○​ Sayers called banks "creators" of credit.
●​ Non-Banking Institutions: These also deal with money and loans but don't have all
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the special features of banks. They don't participate in the payment mechanism in
the same way, their liabilities aren't a core part of the money supply, and they can't
create money like banks.
○​ Sayers called these "purveyors" (suppliers) of credit – they lend out
money they have, but don't create new money in the process. Examples
could include insurance companies or mutual funds (though some non-banks
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can be financial intermediaries).

b) Intermediaries vs. Non-Intermediaries

●​ Financial Intermediaries: These act as middlemen between savers and
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borrowers/investors.
○​ They mobilise savings from people who have extra money (savers).
○​ They lend this money to people or businesses who need it (investors or
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borrowers).
○​ So, their liabilities (what they owe) are to the savers (e.g., your bank
deposit).
○​ Their assets (what they own or are owed) are the loans they've given to
borrowers (e.g., a home loan they provided).
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○​ All banking institutions are intermediaries. Many non-banking
institutions also act as intermediaries, and these are called non-banking
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financial intermediaries (NBFIs).
●​ Non-Intermediary Institutions: These institutions also make loans, but they don't
get their resources directly from savers. They might get their funds from other
sources, like borrowing from other institutions or issuing their own bonds.
1.2.2 Financial Markets

These are not necessarily physical places, but mechanisms or setups where people and
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institutions can buy and sell financial claims (like shares or bonds).

●​ Think of a bustling marketplace, but instead of fruits and vegetables, people are
21
trading financial products.
●​ The market helps determine the price of these claims based on supply and
demand.
●​ Participants include financial institutions, brokers, dealers, borrowers, lenders,
22
savers, all connected by rules and communication networks.

Financial markets are also classified in important ways:

a) Primary Market vs. Secondary Market

●​ Primary Market (New Issue Market): This is where brand new financial claims or
23
securities are sold for the first time.
○​ Example: When a company offers its shares to the public for the very first
24
time (an Initial Public Offering or IPO), it happens in the primary market.
○​ The primary market mobilises savings and directly provides fresh capital
25
to businesses. This is how companies raise money to build new factories
or launch new products.
●​ Secondary Market: This is where already existing or previously issued
26
securities are traded among investors.
○​ Example: If you buy shares of an established company from another investor
27
through the stock exchange, you're dealing in the secondary market. The
company itself doesn't get new money from this transaction.
○​ The secondary market doesn't directly provide new capital to
28
companies. However, it plays a vital role indirectly by making securities
liquid. Liquidity means how easily you can sell an asset (like a share) for
29
cash. If investors know they can easily sell securities later in the secondary
30
market, they are more willing to buy them in the primary market.
○​ Imagine a flow: Primary market is where the company gets the water (money)
directly from the source (investors). The secondary market is like a system of
pipes allowing people to trade that water among themselves easily.
b) Money Market vs. Capital Market

This classification is based on the maturity period (the length of time until the financial claim
is due to be repaid) of the securities traded.31

●​ Money Market: This is the market for short-term securities, typically with a
32
maturity of one year or less.
○​ It deals with temporary cash needs and surpluses.
○​ Examples of money market instruments include Treasury Bills (government
borrowing for short periods) or Commercial Paper (short-term borrowing by
33
companies).
●​ Capital Market: This is the market for long-term securities, with a maturity period
34
of more than one year.
○​ It deals with long-term funding for investments in assets like buildings,
machinery, or infrastructure.
○​ Examples of capital market instruments include shares (which have no fixed
35
maturity) and bonds (long-term loans to companies or governments).

Financial markets can also be categorized as:

●​ (i) Organised and Unorganised: Organised markets have formal rules and
36
regulations (e.g., stock exchanges). Unorganised markets are less formal (e.g.,
37
local moneylenders).
●​ (ii) Formal and Informal: Similar to organised/unorganised. Formal markets operate
under established legal frameworks.
●​ (iii) Official and Parallel: Official markets are legally recognized. Parallel markets
38
might operate outside these official channels.
39
●​ (iv) Domestic and Foreign: Domestic markets operate within a country. Foreign
markets are international.

1.2.3 Financial Instruments

40
These are the actual products that are traded in financial markets.

●​ A financial instrument is essentially a claim against a person or institution for a

41
future payment. This payment could be:
 ○​ A sum of money at a future date (e.g., repaying a loan).
○​ AND/OR a periodic payment like interest (on a bond or loan) or dividend (on
a share). The "and/or" means either or both can be promised.
42
●​ Example: A company bond is a financial instrument. The company (issuer)
promises to pay the bondholder (investor) regular interest payments and the
43
principal amount at a future date.

Primary Securities vs. Secondary Securities

●​ Primary Securities (Direct Securities): These are issued directly by the ultimate
borrowers of funds (e.g., a company issuing shares or bonds) to the ultimate
44
savers/investors.
●​ Secondary Securities: These are issued by financial intermediaries. For instance,
when you deposit money in a bank, the bank's deposit receipt is a secondary
security for you (the bank owes you money), while the loan the bank gives out using
your money is a primary security (the borrower owes the bank money).

Financial instruments vary greatly in terms of:

45
●​ Marketability: How easily it can be bought and sold.
●​ Liquidity: How quickly it can be converted to cash without significant loss of
46
value.
●​ Reversibility: How easily a transaction can be undone.
●​ Type of options: Some instruments might have embedded options (e.g., a bond that
47
can be converted into shares).
●​ Return: The profit or income it generates.
48
●​ Risk: The uncertainty of the return or the possibility of loss.
49
●​ Transaction costs: The expenses involved in buying or selling the instrument.

1.2.4 Financial Services

These are the services provided by financial institutions and professionals that help
50
the financial system work smoothly.

●​ Financial intermediaries provide key services like:

 ○​ Merchant banking: Services for companies like managing their IPOs,
51
helping with mergers and acquisitions.
○​ Leasing: Allowing a company to use an asset (like machinery) for a period by
52
paying rent, instead of buying it.
○​ Hire purchase: Similar to leasing, but often with an option to buy the asset at
53
the end of the term.
○​ Credit rating: Assessing the creditworthiness of borrowers (individuals or
54
companies) and assigning them a score.
●​ These services bridge the gap between the lack of knowledge on the part of
investors and the increasing sophistication of financial instruments and
markets. They make it easier for people to participate in the financial system.

1.3 Equilibrium in Financial Markets

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Like any market, financial markets also tend towards an equilibrium.

●​ This is usually understood by assuming perfect competition (many buyers and

sellers, so no single one can influence the price much) and using the economic tools
of demand and supply.
●​ Equilibrium in financial markets is reached when the total desired borrowing
(demand for funds/credit) matches the total desired lending (supply of funds
56
from savings and credit creation).
57
○​ At this point, an equilibrium rate of interest is established. Think of the
58
interest rate as the "price" of borrowing money.
○​ Imagine a graph with two crossing lines: one sloping upwards showing that as
interest rates rise, people are willing to supply more funds (save more), and
another sloping downwards showing that as interest rates rise, people and
59
businesses demand fewer funds (borrow less). The point where these lines
60
intersect is the equilibrium – where supply meets demand.
●​ If either the demand for funds or the supply of funds changes, the equilibrium
61
will be disturbed, and a new equilibrium interest rate will be established.

Supply of Funds: Where does the money for lending come from?
●​ Mainly from aggregate savings of the:
 62
○​ Household sector (individuals and families)
○​ Business sector (retained profits of companies)
○​ Government sector (if the government has a surplus)
●​ Saving (S) = Disposable Income (Yd) – Consumption (C). It's the income left after
63
spending on consumption.
●​ Factors influencing the volume of savings:
○​ Level of current and expected income.
○​ Cyclical changes in income (people might save more during economic
booms).
○​ Age-wise variations in income (younger people might save less,
64
middle-aged more).
65
○​ Distribution of income in the economy.
○​ Degree of certainty of income.
○​ Wealth (wealthier people might save more).
66
○​ Inflation (high inflation can discourage saving if returns don't keep up).
○​ Desire to provide for old age, emergencies (contingencies).
○​ Habit of thrift.
67
○​ Rate of interest (higher rates can encourage more saving).
○​ Availability of saving media with preferred features (e.g., safe and
easy-to-access bank accounts).
●​ Another major determinant of the supply of funds is the development of banks and
other financial institutions, which determines the credit multiplier (the ability of
banks to create more money from initial deposits).

Demand for Funds: Who needs to borrow money and why?

●​ Investment in fixed capital (like machinery, buildings) and working capital (for
68
day-to-day operations).
69
●​ Demand for consumer durables (like cars, appliances, often bought on credit).
●​ Investment in housing.
●​ Determinants of total investment demand:
○​ Current level of capital stock (existing machinery, etc.).
○​ Capacity utilisation (how much of the existing capacity is being used).
○​ Desired capital stock, influenced by:
■​ Business expectations about future demand, prices, profits.
■​ Government policies.
 70
○​ Availability of internal funds (company's own profits).
71
○​ Cost of funds (interest rates – lower rates make borrowing cheaper).
72
○​ Technological changes (new tech might require new investments).
●​ Determinants of demand for consumer durables:
○​ Changes in tastes and preferences.
○​ Fashion.
○​ Demonstration effect (seeing others own something makes you want it).
○​ Cost of funds (interest rates on loans for these goods).

Important Note: In reality, financial markets are not perfectly competitive. They have
imperfections, restrictive practices, and externalities (side effects on others not directly
involved in a transaction). Because of these, markets often experience either excess
demand or excess supply of funds, and the actual interest rates can differ
significantly from the theoretical equilibrium rate.

1.4 Functions of the Financial System in the Process of Economic Development

A healthy financial system is like fertile soil for economic growth.

1.4.1 Lack of Financial System and Vicious Circles

What happens if a country has a poor or non-existent financial system? It can get stuck in
vicious circles or poverty traps.
●​ Low Investment Cycle:
○​ Lack of a financial system -> less incentive for people to save and invest ->
low level of investment -> slower or no economic growth -> this further
73
hinders the development of the financial system.
○​ Imagine a circular diagram: No good banks/markets -> People don't
save/invest much -> Businesses can't get funds to grow -> Economy
stagnates -> No resources to improve banks/markets.
●​ Low Savings Cycle:
○​ Lack of a financial system -> low saving rate (people might hoard cash or
not have safe places to save) -> low level of investment -> slow or no
economic growth -> which again retards the financial system.
●​ High Information Costs Cycle:
○​ Lack of a financial system -> information costs for savers and
borrowers are extremely high. It's hard for savers to find good borrowers,
and for borrowers to find willing lenders.
 ○​ These high information costs -> reduce business investment -> slow
economic growth.
●​ Compounded Impact: The low savings and high information costs both reduce
investment, slowing economic growth, which in turn further slows the development of
the financial system. It's a downward spiral.
○​ This creates a poverty trap: Lack of financial system -> low official savings ->
low investment -> slow economy -> underdeveloped financial system, and the
cycle repeats, often made worse by high information costs.

1.4.2 Functions of the Financial System

A well-developed financial system is a prerequisite for rapid economic

74
development. It helps accelerate development in three main ways:

1.​ Supports Technical Progress: Modern economic growth often relies on technical
progress (new technologies, better methods). This progress needs human capital
75
(skilled people) and physical capital (machines, infrastructure). Building these up
requires higher saving and investment, which the financial system helps to
achieve.
2.​ Drives Capital Formation: The financial system contributes to economic
76
development directly. Development heavily depends on the rate of capital
77
formation (creating more capital goods). There's a strong, direct link between
capital and output. A good financial system ensures that finance is available in
time, in adequate quantity, and on favourable terms for capital formation.
3.​ Enlarges Markets and Efficiency: It helps expand markets over space
(geographically) and time (e.g., by allowing borrowing against future income). It
enhances the efficiency of exchange (buying and selling goods and services),
which aids economic development.

To play this crucial role, a financial system performs several key functions:

i. Linking Savers and Investors: This is a core function. It mobilises savings from those who
have surplus funds and allocates these savings efficiently and effectively to those who need
funds for productive investments.78

* By efficiently channeling resources, it allows for continuous upgrading of technologies,

promoting sustained growth.

ii. Project Selection, Monitoring, and Payment Mechanism:

* It helps in selecting viable projects to be funded.79

* It inspires operators to monitor the performance of investments to ensure funds are used
well.

* It provides a payment mechanism (like banking services) for the exchange of goods and
services.

* It transfers economic resources through time (e.g., savings for retirement) and across
geographic regions and industries.80

iii. Optimum Allocation of Risk:

* Investing always involves risk.81 The financial system helps to limit, pool, and trade
risks.82

* For example, insurance companies pool risks from many individuals.83 Stock markets
allow investors to diversify their risks.84

* An efficient system aims to contain risk within acceptable limits and reduce the cost of
gathering and analyzing information so that people can make careful decisions.

iv. Providing Price-Related Information:

* Financial markets (like stock markets) generate a lot of price information (e.g., share
prices, interest rates, exchange rates).85 This information is valuable for those making
economic and financial decisions.

* Think of stock prices reflecting the perceived value and future prospects of companies.86

v. Minimizing Information Asymmetry:

* Information asymmetry occurs when one party in a transaction has more or better
information than the87 other.88 This can lead to bad decisions or unfair outcomes.

* The financial system, through regulations, disclosures, and financial analysis, tries to
reduce these information imbalances.89

vi. Providing Financial Services and Portfolio Adjustment:

* It offers important financial services like insurance (protecting against risk) and pension
funds (saving for retirement).

* It provides portfolio adjustment facilities, meaning it allows investors to easily change their
mix of investments (their "portfolio") to suit their changing needs or market conditions.

vii. Lowering Transaction Costs:

* A good financial system aims to reduce the costs of making financial transactions (e.g.,
brokerage fees, search costs).

* This benefits both savers (who can get higher returns) and borrowers (who face lower
borrowing costs).

* When saving is more rewarding and borrowing is cheaper, it encourages people to save
more.

viii. Promoting Financial Deepening and Broadening:

* Financial Deepening: This refers to an increase in financial assets as a percentage of the

Gross Domestic Product (GDP). It means the financial sector is becoming larger and more
significant relative to the overall economy.

* Imagine the total value of all stocks, bonds, bank deposits, etc., in a country growing faster
than the country's total income.90

* Financial Broadening: This refers to an increasing number and variety of financial

participants (more people and institutions using financial services) and instruments (more
types of financial products available).91

* Think of more bank branches opening in rural areas, more people having bank accounts,
or new types of investment products being introduced.

In Short: The fundamental jobs of the financial system are to establish a bridge between
savers and investors, thereby enlarging markets over space and time, and to allocate
financial resources efficiently for socially desirable and productive purposes.

The ultimate goal of all this? To accelerate the rate of economic development and
improve the overall well-being of the society.