Banking

Business organisations that allow one to borrow money, make investments, exchange their money used in their country for a currency used in another, are called financial institutions.

The money market is made up of all those people and organisations that want money and all the people and organisations willing and able to supply money(namely a banking system)

The main types of financial institutions are banks. A bank is a financial intermediary because it brings together customers who want to save money and customers who want to borrow money.

Banking

How do profit making banks earn money?

1. Increasing deposits - a bank accepts deposits of money and savings from customers and makes loans from this money. A bank attracts deposits and savings by paying customers interest on their money or a share of banking profits. It will lend this money to other customers. In turn, people and firms receiving payments, like loans will then deposit or save the money they receive with the bank.

2. By charging interest on loans - a customer who borrows money from a bank must repay the loan with interest over an agreed period of time. The interest is calculated as a percentage of the amount of a loan. The percentage of interest charged on a loan (interest rate) represents the cost of borrowing.

3. Banks invest in stocks

4. Charging fees for provision of other financial services - issuing debit or credit cards, storing valuables, providing insurances, exchanging and transferring foreign currencies, making investments.

2 groups of people that a bank addresses

1. People who have surplus money - who have plenty of savings and deposit excess money

2. People who need money - individuals who need to consume goods and services/businessmen investing or for production activities

People with surplus money deposit money in a bank. Bank keeps 20% of the deposits to themselves(in case the person who has deposited needs to withdraw) and loans the other 70% to people who need money(example)

• Bank uses up almost 40% for investments in the stock market

10% of total money goes to the central bank incase the bank goes bankrupt

Commercial banks

• High street banks: Located everywhere, at the doorstep of the customers

• Clearing banks: Used to transfer money, need to give a specific message to this bank for a transaction.

Functions of a commercial bank:

• Accepting deposits:

  • Current deposits: Usually in a current account, can transact everyday, limitless, no interest on deposits, for businessmen

  • Savings deposits: for common people, do not allow everyday transactions, limitations, minimum amount for deposits, for people who want to save extra money, for small investors, low interest rates: 3-4.5%

  • Fixed deposits aka term deposits: specific period of time for which they have to deposit money, only after the time period ends they can withdraw, interest rate increases with the years, used by banks to invest since people cannot withdraw, they can use it completely depending on the time period of the deposit, if the customer wants to withdraw money before the period, they get the money without or with very low simple interest, suitable for all individuals, high interest rates. 46 days - 5%, 1 year: 6.75 - 7.24%, compound interest

  • Cumulative deposit aka deferring deposit: every month, you have to deposit a constant amount, cannot reduce the amount, but you can top it up, cannot transact before a specific period of time ends. Interest rates 5-7%.

• Advancing credit facilities:

Providing loans:

Personal loan: For individuals, interest rates are high, no collateral required, the time period is 6 months to 10 years, EMI is used to pay

Commercial loan: Mainly for businesses and small traders, 1 year - 15 or 20 years. Interest rate between 10-15% collateral needed

Mortgage: Long term loan. Usually for 25 years, provided against some asset, usually a property, collateral present, high interest rate

Due draft aka bank overdraft: Provided to customers who have a good track record, they are allowed to repay with interest, within the time period of 6 months to 1 year. It's a short term loan facility and interest rates are high: 10- 15%

• Agency functions and utility functions:

The bank acts as an agent, it collects and pays cheques, bills of charge, dividends, interests, warrants

Bank provides certain facilities like

- Providing insurances

- Changing currencies

- Storing valuables

- Issuing debit and credit cards

• Credit creation

A bank creates credit for its customers

Two types of depositors:

1. Primary depositors: People who deposit money in the forms of deposits. Bank gives loans from money deposited by primary depositors.

2. Secondary depositors: People who take loans and then have to repay money. More accounts are created due to them

Payment Methods

Cash, cheque, bank deposit, credit and debit card, online transfer, third party payment

Central Bank

It is the apex bank of the country, it is government owned, provides banking services to the government and commercial banks. RBI is the central bank of India.

Functions

Issues notes and coins for the nation’s currency, only the central bank has the monopoly to issue currency and is in charge of the supply of money in the country. Circulates money in an economy. Can print and destroy notes, only central banks

1. Manages payments to and from the government, acts as a banker to the government. All sorts of transactions, taxes collected are deposited to the government’s account. Any kind of subsidy is provided by the central bank. Mediator between the public and government, carries out all actions. Government bonds are bought through the central bank. Advises government in case of financial and economic activities.

2. Manages national debt. All kinds of loans and payments are made through the central bank. All international debt is managed by the central bank.

3. Supervises the banking system, regulating the conduct of commercial banks, holding their deposits and transferring funds between them. Issues guidelines to all banks working in the country and makes sure they are following the guidelines. Does this to develop the public’s confidence in the banking system. Ensures that the banking structure moves smoothly.

4. It is the lender of last resort to the banking system. In case a bank goes to bankruptcy, the central bank comes to aid, tries to pump more money and fund the bank. Any monetary problems, the central bank comes as a rescuer.

5. It manages the nation’s gold and foreign currency reserve.

6. It operates the government’s monetary policy. In charge of interest rates, it may decrease or increase interest rates depending on economic conditions - inflation, deflation and unemployment. If inflation rises, then, the central bank increases the interest rates, thus persuades people to keep their money in the bank. If interest rates rise, then the cost of borrowing increases. Therefore borrowing decreases and investments decrease. People reduce taking loans, the public saves more and spends less. Less aggregate demand in the economy, thus prices fall.

Independence of Central Bank

Government appoints the governor of the central bank. Central bank can act independently.

If there is a dispute between the central bank and government, the government trumps the central bank.

Types of Banks

Investment banks:

Act as intermediaries between investors and small businesses

Designated to provide loans to business houses

Checks credits and buys stocks in companies

It helps individuals and organisations raise capital

Helps new firms go public

Does not directly deal with the public

Provides financial consultancy to them

JP Morgan Chase, Morgan Stanley, Goldman Sachs

Islamic bank:

aka non interest banking

Usually in islamic countries

Based on the principles of sharia law

Guided by islamic economics

Two fundamental principles:

1. Sharing of profit and loss

2. Prohibition of collection and payment of interest by lenders and investors

Interest is called “riba”

How does the bank operate?

Take a percentage of the profits of the businesses that have taken a loan

Individuals do not need to give a share of their profits. No interest on savings

Credit union

Similar to traditional banks: both offer financial products to customers.

Differ from banking chains:

Non profit institutions-offer higher interest rates on savings accounts and lower interest rates on loans and credit cards

Credit unions are member focused institutions

Working for betterment of members

Is a cooperative: means it is owned and operated by its members.

Each member has equal voting rights irrespective of what amount they invest

Initial membership deposit makes you a part owner of the credit union and gives you a say in the credit union’s decisions.

Member owned, not for profit financial cooperatives whose profits are shared by members

It is for people and communities

Members are owners

Service driven

Decisions made with members in mind

Mutual societies:

Cooperative bank

In line with credit union

Only difference is that credit unions provide short term loans and mutual societies provide Long term loans and are bigger in amount.

Gives loans to buy properties

Consumer spending and investor spending is part of aggregate demand.

Act as commercial banks