Chapter 3: Money Banking and Stock Market PDF

Chapter 3: Money Banking and Stock Market 11/20/23 1:19 PM Outline: Goal: 1. Background What is Money? 2. What is Money? 3. Money and Liquidity How banks create...

Chapter 3: Money Banking and Stock Market 11/20/23 1:19 PM Outline: Goal: 1. Background What is Money? 2. What is Money? 3. Money and Liquidity How banks create 4. Money and Banking System money? 5. The Stock Market 6. Summary How stock 7. Definitions markets reflect profitability of firms? Background There are two other financial institutions which are intricately linked to our financial lives—the banking system and the stock market. Banks are silent but salient partners in holding and channelling our private finances The stock market is an important partner in directing our finances to firms. What is Money? Income is measured per unit of time. Ex, a salary is earned per month and the profit made is reported for a given financial year. On the other hand, wealth is a stock concept, which is the result of accumulation of savings over time. Therefore, it is quoted at a given point in time and not for a given period of time. For example, Azim Premji is the richest man in India, what is really meant is that his savings accumulated over time were the highest at that particular point in time. Finally, money as understood in economics, or money supply as defined by the central bank, is yet another concept. Thus, money is a standard unit of measurement for economic magnitudes just as a kilometre and an hour are for distance and time, respectively. Money alo represents the cash balance that a household has on an average during a given period. That is to say, the optimal cash balance functions as a medium of exchange. Money is just that—a medium of exchange. Households keep cash balances for three purposes— 1. transactions, 2. Precautionary 3. speculative. Money and These cash balances facilitate the exchange of goods and services, including the buying (and philosophy! selling) of financial or real assets. Milton Friedman, recipient of the Nobel Memorial Prize in Economic Sciences, called these cash balances the ‘temporary abode of purchasing power’. Hence, apart from being a unit of measurement, money is also a medium of exchange and a temporary store of value (abode of purchasing power). M1: The world over, the currency with the public (that is, cash balances on hand) and the demand What is M1? deposits with banks are considered money. With some variation, the central banks of almost all countries accept this definition of money as the narrow definition of money, denoted as M1. Note: Demand deposit is not fixed deposit - it is what you can write a check against (Checking acct) Money and Liquidity What is liquidity? Liquidity is defined as the ease with which a financial or a real asset can be converted into cash without much loss of value. Money—the currency with the public and the chequable demand deposits—is the most liquid financial asset. Interest-bearing time deposits or fixed deposits with banks can be considered as being liquid to some degree, easily convertible and minimal penalty. Liquidity: Cash > FD/CD > Stocks > Real Estate What is M3/Broad ‘Broad Money’— M3 by central banks—also includes time deposits as money. Money? Table 3.1: Definition of Money* Money and Banking System Matching of mutual demands for a barter exchange, called ‘double coincidence of wants’, was a difficult proposition. Money eliminates the problem of a double coincidence of wants. It is due to our faith in the Indian government and its central bank that we accept the paper currency issued by RBI as money. When people deposit money in a bank, generally, they do not withdraw their money immediately. Double Even if people do withdraw cash from their bank accounts sooner or later, they do not coincidence of withdraw it in full. wants is Barter People do not withdraw money simultaneously with others. It keeps aside as reserve a certain portion of the initial cash deposit (primary deposit) of an account Three principles why holder and lends the remaining amount to a firm, on condition that the firm opens an account in Banks work. :) the bank, in which the money loaned is deposited. This creates an additional deposit—a secondary deposit—with the bank, for which no new cash was actually deposited in the bank. Keeping aside a certain portion of this secondary deposit as reserve, the bank lends the remaining amount to yet another firm. This process continues, and, thereby, the bank creates chequable deposits which are much larger Banks - lending than the initial cash deposited by a person. forward. Banks charge interest in this process and pay interest to the depositor. Needs to balance risk (cash reserve) with how much they earn If bank cannot meet surge of withdrawals it can result in bank run. RBI sets some minimum limits on the cash reserve to be maintained by banks against their deposit liabilities. This minimum limit, enforced by RBI, is called the Cash Reserve Ratio (CRR), and it What is CRR? varies from 20 percent to 3 percent of the deposit liabilities of banks. RBI is also concerned that a disproportionate amount of loan should not be given to less creditworthy and risky borrowers. RBI mandates that banks maintain a certain proportion of their What is SLR? deposit liabilities in the form of secure investments—government securities, gold and/or cash. This RBI requirement is called the Statutory Liquidity Ratio (SLR), which was as high as 39 percent a few decades ago and currently is at 23 percent. I promise to pay the bearer the sum of one hundred rupees! History: Kings and Queens issuing their gold/silver/copper coins Started depositing these precious metals with goldsmiths in exchange for "deposit receipts" Governments followed similar approach. Then Govts, broke the gold reserve need and promise to pay is backed by govt. RBI is not required to have more than Rs 115 crores in gold to back rupee currency. Runs on the banks arise due to deposit holders’ loss of faith and confidence in the banks. To counter such panic situations, governments generally support a deposit insurance mechanism for the banks. (aftermath of the great depression of the 1930s. ) India, deposit holders’ bank accounts are insured up to a maximum of Rs 1 lakh each, per insured bank by the Deposit Insurance and Credit Guarantee Corporation (DICGC). Bank runs are less likely to occur when deposit holders are assured of the value of their money in the banks. Fourteen major commercial banks were nationalized by the government in 1967 and a few more in 1980. The government, felt that banks were not serving the priority sectors of society and that India could reach commanding heights through the nationalization of banks. Economic depression spiral Housing, realty prices started going down Realtors and the consumers could not repay bank loans loan defaults banks were reluctant to give new loans bank customers felt money not safe in banks Panic run on the banks people started to withdraw cash Banks started holding more cash money supply to fall people started selling bonds fall in the prices of bonds interest rates started going up reduced private investment, employment and output fueling the economic depression. The Stock Market The income which remains after deducting taxes is called disposable income, that is, income that is available for spending on goods and services. What remains out of the disposable income, after a household spends on goods and services, is the savings of the household. Govt Securities: Relatively risk free Debentures: Loan by public to private firms. Relatively higher risk for higher interest. Gold Bonds: To avoid physical handling of the metal. The owners of the shares of a firm are also the owners of the firm. Bond owners have 1st claim for interest or repayment. The shareholders are the residual claimants of the profits made by the firms. This residual amount received by the shareholders is called dividend. Riskier - dividend can be high or low depending on profits. Interest is constant. East India Company - Those who were interested in trading with India formed a company called the British East India Company. History of stock market Others, who wanted to make a fortune in this venture, could join the company as owners if they contributed to the financial stock of the company. The risks were high but so were the returns. Eventually, many companies were formed in this manner, either for trade or for producing goods. These companies or firms had to be registered with the government so that they could officially raise financial stock or capital for their firm. Getting into this company or getting out required a marketplace where they could buy and sell the shares of the financial stock. This need for raising initial stock or capital for firms and the need to trade in the shares of existing stock led to the formation of stock exchanges. Bombay Stock Exchange (BSE) is the oldest stock market in Asia and was established in Mumbai during the British rule. Its origin can be traced to the 1850s, when share brokers used to gather under a banyan tree for trading, and they formed an official organization in 1875 known as The Native Share and Stock Brokers’ Association. After Independence, BSE was the first in the country to be granted permanent recognition under the Securities Contracts (Regulation) Act of 1956. In 1990s the National Stock Exchange (NSE) which is also based in Mumbai was formed. Buying stocks in multiple companies to diversify is not easy for the common investor. What are mutual Therefore, specialized firms evolved into what are called mutual fund managers, which invest in funds? shares on behalf of small individual customers. Individuals invest in the mutual funds of these specialized financial firms which, in turn, invest in shares of different companies on behalf of the individual customers. Small investors who can take advantage of the expertise of mutual fund managers in getting a sound return on their financial investments. SENSEX is a share price index of thirty sensitive and actively traded shares on the Bombay Stock Exchange. NIFTY is an acronym for National Fifty, an index based on fifty shares traded on the National Stock Exchange of India which covers twenty-one different sectors of the Indian economy. Since these indices show the general trend of the stock market, they are also called derivatives, where investors can trade in these indices. (They are not derivatives :)) - Bulls and Bears in Dalal Street and Share Prices In 1928, a plot of land in Mumbai—where it still stands today—was acquired for it, and the adjoining street was named Dalal Street. Public limited joint stock companies are registered and listed with stock exchanges and they can raise their ownership capital through what is called Initial Public Offer (IPO), where the public can contribute to the stock of a company by subscribing to and purchasing newly issued shares. Bulls - upbeat, Bears - wait/sell Practical Implications That is, we park a part of our savings in the form of cash or a bank account, only to the extent that we demand money for transactions purpose, precautionary purpose, and some for making speculative investments. The rest of the savings may be held in the form of real assets and various financial instruments we discussed above. How and where to invest depends on The interest rates offered Tax exemptions Risk Own perception about dividends, expected prices of instruments Rule of thumb: Diversify your financial investments in various forms of instruments. PPF - safe and saves tax If you have time - research and invest in stocks Think of investing in mutual funds if in the middle. Summary Banks may not have all the cash you have deposited into your account, for they do not keep your cash idle. Multiple-deposit creation occurs as banks start lending your bank balance to firms and other borrowers. However, the banking system does work, since all of us do not withdraw cash at the same time, and, all of us do not withdraw all the cash at one time. Moreover, we have faith in our banking system, and we do not expect a run on the banks. This faith in the banking system is strengthened by the stipulations of RBI regarding CRR, SLR, and the deposit insurance scheme. Therefore, when choosing a bank, one can depend, ceteris paribus, upon the convenience, the consumer-friendly services and features, and past performance of the bank. Lastly, we also know now that RBI can change the money supply in the economy by altering the CRR or SLR requirements for commercial banks. For example, a lowering of CRR would imply that more cash from a fresh deposit is available to banks to be further lent out to firms. More loans to firms implies more bank deposits from firms, and, therefore, a bigger money supply (remember, chequable deposits are a part of the money supply, M1). RBI has changed the CRR and SLR rates over time. This results in a change in the money supply. In fact, there are a few other important ways in which RBI changes the money supply in the economy. Why would RBI like to change the money supply? Discussion of this issue is related to RBI’s monetary policy, to which we will return in later chapters. Definitions Bank run: A panic situation where deposit holders queue up en masse at banks to withdraw cash from their accounts due to a fear that the banks may not have sufficient funds. Bearish stock market: Description of a stock market, where the collective sentiment about the current and future performance of firms and the economy is negative, and results in falling share prices. Bullish stock market: Description of a stock market, where the collective sentiment about the current and future performance of firms and the economy is positive, and results in rising share prices. CRR: Cash Reserve Ratio. A minimum percentage of net demand and time liabilities that banks are mandated by RBI to maintain in the form of cash. Demand for money: People’s desire to hold money for transaction, precautionary, and speculative purposes. Double coincidence of wants: The matching of mutual demands for two goods for a successful barter exchange. Money: A unit of measuring value, a medium of exchange, and a store of value. Money Supply (M1): Currency with the public plus chequable demand deposits with banks, plus other deposits with RBI. Money Supply (M3): M1 plus time deposits with banks. Mutual Fund: A financial instrument whereby specialist managers diversify risk by parking investors’ funds into different stocks, hoping to offer reasonable returns to the investors. NIFTY: Acronym for National Fifty, an index based on fifty shares traded on the National Stock Exchange of India which covers twenty-one different sectors of the Indian economy. SENSEX: A share price index of thirty sensitive and actively traded shares on the Bombay Stock Exchange. Shares: The stock of a firm divided into smaller denominations, such as, Rs 100, and traded on the stock market for a price that reflects the firm’s current and future prospects and profitability. SLR: Statutory Liquidity Ratio. A minimum percentage of net demand and time liabilities that banks are mandated by RBI to maintain in the form of government securities, cash on hand, and gold. Stock: The capital invested in a firm by its owners. Stock market: A market where shares, debentures, mutual funds, and other financial instruments are traded.