Money, Banking & Financial Systems Guide
Money, banking, and financial systems form the backbone of modern economies, facilitating transactions, capital formation, and wealth management. They encompass the mechanisms for creating, distributing, and managing money, alongside institutions like banks and regulatory frameworks. Understanding these systems is crucial for economic stability and individual financial well-being.
Key Takeaways
Liquidity defines asset convertibility to cash without market impact.
Money serves as exchange medium, unit of account, and store of value.
Monetary aggregates measure money supply, impacting economic policy.
Financial markets facilitate short-term (money) and long-term (capital) funding.
Regulations like SARFAESI and IBC address financial distress and recovery.
What is Liquidity in Financial Systems?
Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its market price. It is a crucial concept in finance, determining how quickly and efficiently individuals or institutions can access funds for transactions or investments. High liquidity ensures financial flexibility, while low liquidity can pose challenges during economic downturns or urgent needs.
- Definition: Ease of converting an asset to cash without affecting market price.
- Examples: Cash, Gold, Cheque, Bond.
- Liquidity Trap: People hold money despite interest rate changes, rendering monetary policy ineffective.
What are the Primary Functions of Money?
Money serves several fundamental roles in an economy, enabling efficient commerce and economic activity. Its primary functions facilitate transactions, provide a common measure of value, and allow for wealth preservation over time. These roles are essential for moving beyond a barter system and fostering complex economic interactions.
- Medium of Exchange
- Unit of Account
- Store of Value
- Professor Walker's definition: Modern paper money has value due to government backing, durability, divisibility, and high portability.
What are the Different Types of Money in an Economy?
The money supply in an economy comprises various forms, ranging from physical currency to different types of deposits held in financial institutions. Understanding these categories helps in analyzing monetary policy and economic health. These types collectively represent the total liquid assets available for transactions and investments within a financial system.
- Currency in Circulation
- Deposits with RBI (Reserve Bank of India): Bank Deposits with RBI (includes CRR), Other Deposits with RBI (from government, international organizations, etc.)
- Deposits with Banks: Demand Deposits (Saving, Current Accounts), Term Deposits (Fixed, Recurring Deposits)
- Postal Deposits: Demand Deposits, Term Deposits
Why Do Individuals and Businesses Hold Money?
People hold money for various reasons, driven by both immediate needs and future uncertainties. These motives explain the demand for money within an economy, influencing interest rates and monetary policy effectiveness. Understanding these motivations helps central banks manage the money supply and maintain economic stability.
- Transaction Motive: For smooth spending on goods and services.
- Speculative Motive: To take advantage of investment opportunities or avoid potential losses (Keynes' theory).
How are Monetary Aggregates Measured?
Monetary aggregates are key measures of the money supply within an economy, categorized by their liquidity. Central banks use these aggregates to formulate and implement monetary policy, influencing inflation, economic growth, and employment. Different aggregates provide varying insights into the economy's financial health and liquidity levels.
- M3: Monetary Base/High Powered Money/Reserve Money (Currency in circulation, Bankers' deposits with RBI, Other deposits with RBI)
- Narrow Money (M1: Priority)
- Broad Money (M3: Priority)
- M2: M1 + Saving deposits with Post Office
- M3: M2 + Time deposits with Bank
- M4: M3 + All deposits with Post Office
- Liquidity Order: M3 > M2 > M1 > M4
- Money Multiplier: Illustrates how initial deposits can expand money supply through lending.
What is the Difference Between Money and Capital Markets?
Financial markets are broadly categorized into money markets and capital markets, distinguished by the maturity period of the financial instruments traded. Money markets deal with short-term borrowing and lending, while capital markets facilitate long-term investments. Both are crucial for channeling funds from savers to borrowers, supporting economic growth and development.
- Money Market (Short-term loans: Call Money, Notice Money): LIBOR/MIBOR/SOFR (Interbank money transfer rates)
- Capital Market (Long-term loans: Treasury Bills): Treasury Bills (Issued by RBI; Maturity less than 1 year)
What are Assets in a Financial Context?
Assets represent resources owned by an individual or entity that have economic value and are expected to provide future benefits. In banking, assets primarily include loans extended to customers and reserves held with the central bank. Proper classification and management of assets are vital for a financial institution's stability and profitability, especially concerning loan quality.
- Definition: Resources owned by an individual or entity.
- Types (Reserve + Loan): Regular Assets (Long term, stressed, performing), Stressed Assets (Overdue loans, NPA classification), Non-Performing Assets (NPA) (Overdue > 90 days, classified into Sub-standard, Doubtful, and Write-off)
What is the Role of Bad Banks?
Bad banks are specialized financial entities established to acquire and manage non-performing assets (NPAs) from commercial banks. Their primary role is to clean up bank balance sheets, allowing traditional banks to focus on core lending activities. This mechanism helps in resolving distressed assets, improving financial sector health, and facilitating economic recovery.
- Financial entity to buy NPA (Recovery of NPAs)
- Examples: India Debt Resolution Company Ltd (IDRCL), National Asset Reconstruction Company Ltd (NARCL)
What is the SARFAESI Act and Its Purpose?
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act) of 2002 empowers banks and financial institutions to recover their non-performing assets without court intervention. This legislation streamlines the recovery process for secured creditors, enabling them to seize and sell collateralized properties of defaulting borrowers. It aims to reduce NPAs and strengthen the financial system.
- Full form: Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act.
- Provides power to banks to seize property of defaulting borrowers.
- Wilful Defaulter: Person who doesn't pay even if able to.
What is the Insolvency and Bankruptcy Code (IBC)?
The Insolvency and Bankruptcy Code (IBC) of 2016 is a comprehensive law in India that consolidates and amends existing laws relating to insolvency and bankruptcy resolution for individuals, companies, and partnership firms. It establishes a time-bound process for resolving insolvency, aiming to maximize the value of assets, promote entrepreneurship, and ensure a fair distribution to creditors. The IBC provides a structured framework for debt recovery and business revival.
- Consolidates and amends existing laws on bankruptcy and insolvency resolution. Establishes a time-bound process.
Frequently Asked Questions
What is a liquidity trap?
A liquidity trap occurs when people hoard money despite low interest rates, making traditional monetary policy ineffective. This happens during economic downturns when consumers and investors prefer cash over investments.
What are the three main functions of money?
Money primarily functions as a medium of exchange, a unit of account, and a store of value. These roles enable efficient transactions, standardized pricing, and wealth preservation within an economy.
How do monetary aggregates like M1 and M3 differ?
M1 represents narrow money, including currency and demand deposits, highly liquid. M3 is broad money, encompassing M1 plus time deposits with banks, indicating a wider measure of money supply.
What is a Non-Performing Asset (NPA)?
An NPA is a loan or advance where the principal or interest payment remains overdue for more than 90 days. Banks classify NPAs into sub-standard, doubtful, and loss assets based on the period of non-payment.
What is the purpose of a bad bank?
A bad bank is created to take over and manage the non-performing assets (NPAs) of commercial banks. Its purpose is to clean up bank balance sheets, allowing them to focus on lending and improving financial stability.
