Principles of Banking: Reading 1

Banks and Banking Systems

Origin of Banking and Emergence of Modern Banking

In many ways, the origins of capitalism as we see it today lie in the operations of Italian
merchanting and banking groups in the 13th, 14th and 15th centuries. Italian states, like Lombardy
and Florence, were dominant economic powers. The merchants had trading links across borders
and used their cash resources for banking purposes.

The bankers sat at formal benches, often in the open air. The Italian for bench is 'banco', giving us
the modern word for bank. (If you happen to be in Prato, Italy, look in the Chapel of San
Francisco for a fresco showing the money-changers' banco. or counter.) If the bank went into
liquidation, the bench would be solemnly broken, giving us the bancorupto or bankrupt, as we say
today. The early associations were partnerships, as shareholding companies did not begin until
1550. As a result, people might write to the 'Medici e compagni', t,he 'Medici and their partners'. It
gives us the modern word - the company. 'It is the Italians who claim the oldest bank in the world,
Monte dei Paschi of Siena (1472).

For a long period, Florence was a major centre. As a result, many coins ended up with names
based on Florence. The UK had a 'florin' until the coinage was decimalised in 1971; Dutch
guilders have the abbreviation FL - florins; the Hungarian currency is the 'forint'. We also read
that, in 1826, Schubert sold his D major piano sonata for '120 florins'. As a result of all this, at the
EC Summit in Madrid in December 1996, John Major put forward the florin as the proposed name
for Europe's single currency. The meeting finally decided on the rather more boring name, the
euro.

Italian bankers had a long relationship with the British crown. The first bankers to lend money in
London came from Lombardy and London still has 'Lombard Street' at the heart of the financial
area. Bankers lent money to Edward I, Edward II and Edward III (naturally, to finance their
various wars). Edward III, however, defaulted on the loan in 1345 and the proud families, the
Bardi and the Peruzzi in Florence, crashed into liquidation as a consequence. Presumably this was
the world's first (but not last!) international banking crisis.

Those bankers were very advanced for their time. They used bills of exchange, letters of credit,
book entry for money instead of physically transporting it and double entry bookkeeping. The bill
was not 'discounted' in the modern sense, since this would imply charging interest on money and
this was forbidden by the Roman Catholic Church as 'usury'. The, bill represented a service to
facilitate trade and change foreign money- it could not appear to involve the lending of money. On
the deposit side, no formal interest could be paid for the same reason. Depositors received a share
of profits paid at discretion. Thus the liabilities side of the balance sheet was headed,
'Discrezione'. Islamic banking faces similar problems due to the Holy Quran’s rejection of the
concept' of interest as such.

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The one thing the Italians didn't invent was banknotes. For this, we look to goldsmiths in the UK.
There, merchants would keep money for safe keeping in the Royal Mint. It was good news for
goldsmiths who had secure vaults for gold and silver coins and began an era of goldsmiths as
bankers for some 150 years. Coutts Bank, still going today, began in 1692 as a goldsmith bank.
The goldsmiths found it convenient to give out receipts for a deposit of gold coins made out to 'the
bearer' and to issue ten receipts for a deposit of ten coins. In this way ,if the bearer owed someone
else three gold coins, they could pass on three bearer receipts. Even better, if someone wanted to
borrow five gold coins, the goldsmiths could lend them five of these nice pieces of paper and not
give gold coins. We are now very much into modern banking traditions, except that today the
notes aren't backed by gold or silver anyway! By the end of the 17th century, the goldsmiths'
receipts had become banknotes in a formal sense, the first being issued by the Bank of Sweden in
1661.

Internationally, the emphasis in banking, which had been in Florence, moved to Genoa, as gold
and silver were flooding in from the New World. Outside Italy, the Fugger family of Augsburg
created a financial dynasty comparable to the Italians. They were originally wool merchants, but
turned to precious metals and banking. They had gold, silver and copper mine' in Hungary and
Austria and became principal financiers to the Hapsburg empire in Germany, the Low Countries
and Spain.

The merchant bankers had two key activities - financing trade, using bills of exchange and raising
money for governments by selling bonds. Baring Brothers financed the huge reparations imposed
on France after the Napoleonic wars with a large international bond issue. (As a consequence, the
Duc de Richelieu dubbed them 'Europe's 6th super-power'!) In 1818, Rothschild's raised a large
loan for Prussia, to be redeemed after 36 years. They arranged to pay dividends to bondholders in
their local currency. The bonds were sold to merchants, private subscribers and the aristocracy.
Prussia paid 7.5% of which 5% was paid to bondholders and 2.5% was used to create a 'sinking
fund' to redeem the bond after 36 years. The Dutch Bank Mees, together with Baring Bros, helped
the American states finance the purchase of Louisiana from Napoleon in 1803. Later, corporate
finance emerged as another investment banking business. In 1886, Baring Bros floated Guinness -
police had to hold back the crowds!

In the second half of the 1700s and into the 1800s there was a large growth in Europe's population
(from 180 million in 1800 to 450 million by 1914).This period also saw the growth of
industrialization and urbanization. As a result, the spread of banking followed. While private
banks continued to flourish in many cases, the gradual change in legislation to allow joint stock
banks (that is, banks with shareholders) paved the way for the growth of larger commercial banks
with many branches and a strong deposit-taking function.

In the US, the Bank of New York and the Bank of Boston (later First National Bank of Boston)
opened in 1800. The water company, the Manhattan Company, became a bank around about the
same time (It became Chase Manhattan in 1955) The 'City Bank' opened in 1812, becoming the
National City Bank later and merging with First National Bank to form today's Citibank in 1955.

In Europe, we see the Societe Generale of Belgium formed in 1822; the Bayerische Hypotheken
und Wechsel Bank in 1822; Creditanstalt in Austria in 1856; Credit Suisse also in 1856; UBS in
1862; Credit Lyonnais in 1863 and the Societe Generale (France) in 1864 (by 1900 they had 200
and 350 branches respectively); Deutsche Bank in 1870 and Banca Commerciale Italiana in 1894.

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In the UK, the Bank of England's monopoly of joint stock banking ended in 1826. There were
1700 bank branches in 1850, 3300 by 1875 and nearly 7000 by 1900. The Midland Bank opened
in 1836 and the forerunners of National Westminster in 1833-36. Private banks, threatened by the
greater resources of the new joint stock banks, were either bought out or merged. One such
merger formed the Barclays we know today.

There is one interesting point about the UK. Although Rothschild's on the continent had a hand in
setting up some of the commercial banks (Creditanstalt and Societe Generale of France are
examples), in the UK, the merchant banks ignored the new developments and stuck to that which
they knew and did best (international bonds and trade finance). As a result, the British tradition
has been one of looking at two types of bank - the 'merchant' bank on the one hand and the
'commercial' bank on the other. It was only in the 1960s and later that the large commercial banks
thought it necessary to open merchant bank subsidiaries or buy one (for example, Midland Bank
buying Samuel Montagu).

On the continent of Europe, especially in Germany, Austria and Switzerland, The pattern became
that of hanks who did all types of banking - both 'merchant' and 'commercial'. This is the
'universal' bank tradition - banks like Deutsche Bank and the Union Bank of Switzerland. These
developments take us into this century and the age of computers, communications, automated
teller machines (ATMs), credit cards, bank mergers and electronic funds transfer at the point of
sale (EFT -POS).

The banking industry gradually spread outward from the classical civilizations of Greece and
Rome into northern and western Europe. Banking encountered religious opposition during the
Middle Ages, primarily because loans made to the poor often carried very high interest rates.
However, as the Middle Ages drew to a close and the Renaissance began in Europe, the bulk of
bank loans and deposits involved relatively wealthy customers, which helped to reduce religious
opposition to banking practices.

The development of new overland trade routes and improvements in navigation in the 15th, 16th,
and 17th centuries gradually shifted the center of world commerce from the Mediterranean region
toward Europe and the British Isles, where banking became a leading industry. During this period
were planted the seeds of the Industrial Revolution, which demanded a well-developed financial
system. In particular, the adoption of mass production methods required a corresponding
expansion in global trade to absorb industrial output, requiring new methods for making payments
and credit available. Banks that could deliver on these needs grew rapidly, led by such institutions
as the Medici Bank in Italy and the Hochstetter Bank in Germany.

When colonies were established in North and South America, Old World banking practices were
transferred to the New World. At first the colonists dealt primarily with established banks in the
countries from which they had come. As the 19th century began, however, state governments in
the United States began chartering banking companies. Many of these were simply extensions of
other commercial enterprises in which banking services were largely secondary to sale – for
example, the farm equipment business. The development of large, professionally managed
banking firms was centered in a few leading commercial centres, especially New York. The
federal government became a major force in U. S. banking during the Civil War. The Office of the
Comptroller of the Currency (OCC) was established in 1864, created by Congress to charter
national banks. This divided bank regulatory system, with both the federal government and the
states playing key roles in the control and supervision of banking activity, has persisted in the
United States to the present day.

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Finance and Financial System

A financial system should be distinguished from a payments system. The latter is the set of
institutional arrangements through which purchasing power is transferred from one transactor in
exchange to another. The payments system is, thus, concerned with payments in cash. The
financial system is much broader than a payments system in that it covers both cash and credit
transactions. The financial system is a set of institutional arrangements through which financial
surpluses (or commands over real resources) in the economy are mobilised from surplus units and
transferred to deficit spenders. The institutional arrangements include all conditions and
mechanisms governing the production, distribution, exchange, and holding of financial assets or
instruments of all kinds and the organization as well as the manner of operation of financial
markets and institutions of all descriptions. In concrete terms, financial instruments, financial
markets, and financial institutions are the three main constituents of any financial system.

Financial Instruments: Financial assets or instruments are evidences of financial claims of one
party against another party. More specifically, these are the financial claims of holders against
issuers. Financial assets or claims are generally subdivided under the two heads of primary (or
direct) securities and secondary (or indirect) securities. The former are financial claims against
real-sector units. The examples are bills, bonds, equities, book debts, etc. They are created by real-
sector units as ultimate borrowers for raising funds to finance their deficit spending. The
secondary securities are financial claims issued by financial institutions or intermediaries against
themselves to raise funds from the public. The examples are such diverse financial assets as the
currency, bank deposits, life insurance policies, ICB units, and mutual funds, etc.

In the present-day, important financial assets are currency, bank deposits (current, savings, and
fixed), post office savings deposits, life insurance policies, provident fund contributions, bonds
(government and corporate), bills, corporate shares (ordinary and preference), units of the ICB,
compulsory deposits, deposits with - investment companies/trusts, etc. The list is not meant to be
exhaustive. Nor is any asset listed above homogeneous.

Financial Intermediaries/Institutions: In a modern economy a wide variety of financial

institutions, more popularly called financial intermediaries (FIs) have grown. FIs are generally
classified under two main heads: (a) banks and (b) non-banks financial intermediaries (NBFIs).
Financial Intermediaries (FIs) are institutions or firms that mediate or stand between ultimate
lenders and ultimate borrowers or between those with budget surpluses and those who wish to run
budget deficits. The examples are banks, insurance companies, unit trusts (or mutual funds),
investment companies, provident funds, etc. the central function of all FIs is to collect surpluses
(savings) of other economic units and to lend them on to deficit spenders. Both the surplus units
and the deficit spenders belong to the real sector of the economy. Their principal economic
activity is to buy and sell productive factors and current output, whereas the principal economic
activity of financial institutions is the purchase and sale of financial assets.

The FIs are dealers in securities. What they buy are primary securities, what they sell are
secondary securities. By absorbing primary securities in their asset portfolios and producing
secondary securities to finance them, they virtually transmute primary securities into secondary
securities. The essence and the success of financial intermediation lie in this asset transformation.

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This is the alchemy which only the FIs possess. They alone are able to produce securities that are.
in general, far more acceptable to surplus units than the primary securities produced by deficit
spenders. The latter themselves cannot produce financial claims that meet as well the asset
preferences (in terms of risk, liquidity, convenience, etc.) of the wealth-holding public as the
secondary securities manufactured by the FIs. The latter embody innovations in financial
technology whereby disparate asset-debt preferences of lenders and borrowers are reconciled and
satisfied to the satisfaction of both the parties.

One simple example of the asset-transmutation role of the FIs will throw further light on it.
Consider a farmer who wants a crop loan against his promissory note supported by the crop sown
in his field. An urban household will not be willing to lend to the farmer because of high risk and
inconvenience involved. The urban household may be operating a savings account with this bank
and thereby entrusting a part of its surpluses to the bank. The bank will be lending a part of the
savings of the urban household to the farmer. Yet the urban household does not care so long as it
has confidence in the bank's ability to pay cash on demand. Thus, the secondary security in the
form of savings deposits has enabled the bank to mobilise savings of households which can be
used to lend even to a distant farmer, who could not otherwise borrow directly from an urban
household on the strength of his own promise to pay.
Financial Markets: Financial Markets are the markets where the financial instruments are
traded, bought and sold. The financial markets may be viewed as channels through which moves a vast
flow of funds that is continually being drawn upon by demanders of funds and continually being
replenished by suppliers of funds.

Money and Capital market: One of the most important divisions in the financial system is
between the money market and the capital market. The money market is designed for the making
of short-term loans. It is the institution through which individuals and institutions with temporary
surpluses of funds meet the needs of borrowers who have temporary funds shortages. Thus, the
money market enables economic units to manage their liquidity positions. By convention, a
security or loan maturing within one year or less is considered to be a money market instrument.In
contrast, the capital market is designed to finance long-term investments by businesses,
governments, and households. Financial instruments in the capital market have original maturities
of more than one year and range in size from small loans to multimillion dollar credits.

Principal money market instruments:

Treasury bills
Certificates of deposit
Small time and savings deposits at banks and thrifts
Securities issued by federal and federally sponsored agencies
Federal funds sold and repurchase agreements
Eurodollar deposits
Commercial paper
Bankers' acceptances
Principal capital market instruments:
Mortgages
Common stocks
Corporate and foreign bonds
Treasury notes and bonds
State and local government bonds and notes
Consumer loans

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Security versus Non-Security Markets: The Security markets are financial markets where
financial instruments (both short and longterm) which are to be traded are security papers,
whereas in the non-security markets, the financial instruments are not security papers, these
might be cash or non-cash (leasing).
Open versus Negotiated Markets: Another distinction between markets in the financial system
that is often useful focuses on open markets versus negotiated markets. For example, some
corporate bonds are sold in the open market to the highest bidder and bought and sold any number
of times before they mature and are paid off. In contrast, in the negotiated market for corporate
bonds, securities generally are sold to one or a few buyers under private contract.
An individual who goes to his or her local banker to secure a loan for a new car enters the
negotiated market for auto loans. In the market for corporate stocks there are the major stock
exchanges, which represent the open market. Operating at the same time, however, is the
negotiated market for stock, in which a corporation may sell its entire stock issue to one or a
handful of buyers.
Primary versus Secondary Markets: The financial markets (specially security markets) may also
be divided into primary markets and secondary markets. The primary market is for the trading
of new securities never before issued. Its principal function is raising financial capital to support
new investment in buildings, equipment, and inventories.
In contrast, the secondary market deals in securities previously issued. Its chief function is to
provide liquidity to security investors — that is, provide an avenue for converting financial
instruments into ready cash. If you sell shares of stock or bonds you have been holding for some
time to a friend or call a broker to place an order for shares currently being traded on the Stock
Exchange, you are participating in a secondary-market transaction.

The volume of trading in the secondary market is far larger than trading in the primary market.
However, the secondary market does not support new investment. Nevertheless, the primary and
secondary markets are closely intertwined. For example, a rise in security prices in the secondary
market usually leads to a similar rise in prices on primary-market securities and vice versa. This
happens because some investors will switch from one market to another in response to differences
in price and yield.

Spot versus Derivatives: We may also distinguish between spot markets, futures or forward
markets, and option markets. A spot market is one in which securities or financial services are
traded for immediate delivery (usually within one or two business days). If you pick up the
telephone and instruct your broker to purchase Telecom Corporation shares at today's price, this is
a spot market transaction.

A futures or forward market, on the other hand, is designed to trade contracts calling for the
future delivery of financial instruments. For example, you may call your broker and ask to
purchase a contract from another investor calling for delivery to you of $1 million in Treasury
bonds six months from today. The purpose of such a contract would be to reduce risk by agreeing
on a price today rather than waiting six months, when Treasury bond prices might have risen.

Finally, options markets also offer investors in the money and capital markets an opportunity to
reduce risk. These markets make possible the trading of options on selected stocks and bonds,
which are agreements (contracts) that give an investor the right to either buy from or sell
designated securities to the writer of the option at a guaranteed price at any time during the life of
the contract.

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Perfect and Efficient Markets: All financial markets are closely tied to one another due to their
perfection and efficiency. What is a perfect market? It is one in which the cost of carrying out
transactions is zero or nearly so and all market participants are price takers (rather than being able
to dictate prices to the market). In such a market, there are no significant government restrictions
on trading and the movement of funds; rather, competition among buyers and sellers sets the
terms of trade.

Some financial markets may also have another very desirable characteristic: The prices of
financial instruments may accurately reflect their inherent value and fully reflect all available
information. Moreover, any new information supplied to the market may quickly be impounded in
a new set of prices. A market in which prices fully reflect the latest available information is an
efficient market. In an efficient market, no information that might affect security prices or
interest rates is wasted. Thus, no buyer or seller can expect to reap excess profits from collecting
information and then trading on the basis of that information.

Functions performed by the Financial System and The Financial Markets

Saving Function: The system of financial markets and institutions provides a conduit for the
public’s savings. Bonds, stocks, and other financial claims sold in the money and capital markets
provide a profitable, relatively low-risk outlet for the public’s savings, which flow through the
financial markets into investment so that more goods and services can be produced, increasing
society’s standard of living. When savings flows decline, investment and living standards begin to
fall.

Wealth Function: Wealth is defined as the sum of the values of all assets. For those business and
individuals choosing to save, the financial instruments sold in the money and capital markets
provide an excellent way to store wealth ( i. e., preserve the value of assets) until funds are needed
for spending. Although we might choose to store our wealth in “things” (e.g., automobiles), such
items are subject to depreciation and often carry great risk of loss. However, bonds, stocks, and
other financial instruments do not wear out over time and usually generate income: moreover,
their risk of loss often is much less than for other forms of stored wealth.

Liquidity Function: For wealth stored in financial instruments, the financial marketplace provides
a means of converting those instruments into cash with little risk of loss. Thus, the financial
markets provide liquidity for savers who hold financial instruments but are in need of money. In
modern societies, money consists mainly of deposits held in banks and is the only financial
instrument possessing perfect liquidity. However, money generally earns the lowest rate of return
of all assets traded in the financial system, and its purchasing power is seriously eroded by
inflation. That is why, savers generally minimize their holdings of money and hold other financial
instruments until they really need spendable funds.

Credit Function: In addition to providing liquidity and facilitating the flow of savings into
investment to build wealth, the financial markets furnish credit to finance consumption and
investment spending. Credit consists of a loan of funds in return for a promise of future payment.
Consumers need credit to purchase a home, buy groceries, repair the family automobile, and retire
outstanding debts. Businesses as draw on their lines of credit to stock their shelves, construct new
buildings, meet payrolls, and grant dividends to their stockholders. State, local, and federal
governments borrow to construct buildings and other public facilities and to cover daily cash
expenses until tax revenues flow in.

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Payments Function: The financial system also provides a mechanism for making payments for
goods and services. Certain financial assets, mainly checking accounts and negotiable order of
withdrawal (NOW) accounts, serve as a medium of exchange in making payments. Plastic credit
cards issued by banks and credit unions give the customers instant access to short-term credit but
are also widely accepted as a convenient means of payment. Plastic cards and electronic means of
payment, including computer terminals in homes, offices, and stores will eventually displace
checks and other pieces of paper as the principal means of payment in the future.

Risk Function: The financial markets offer business, consumers, and governments, protection
against life, health, property and income risks. This is accomplished, first of all, by the sale of
insurance policies. In addition to making possible the sale of insurance policies, the money and
capital markets have been used by businesses and consumers to “self-insure” against risk; that is,
holdings of wealth which are built up as a precaution against future loss.
Policy Function: Finally, in recent decades, the financial markets have been the principal channel
through which government has carried out its policy of attempting to stabilize the economy and
avoid inflation. By manipulating interest rates and the availability of credit, government can affect
the borrowing and spending plans of the public, which, in turn influence the growth of jobs,
production and prices.

Different Forms of Finance

How do the financial markets perform the function of efficient allocation of funds from the
saving-surplus to the saving-deficit units? These can be illustrated with reference to the following
three situations: (a) Rudimentary finance (b) Direct finance, and (c) Indirect finance.

Rudimentary finance: Rudimentary finance refers to the financial system in a rudimentary or

traditional economy that is an economy in which the per capita output is low and declining over a
period of time. In the rudimentary financial milieu the basic feature is the absence of an array of
financial assets that would stimulate savings and the array of financial markets that would allocate
savings competitively to investments. In such a system there are no financial assets other than
money. The implication of this feature is that an economy without financial assets would require
each spending unit to invest in new tangible assets whatever part of its current income was not
consumed. No unit could invest more than its savings because there would be no financial asset in
which to put the excess savings. Each spending unit would, therefore, be forced into a balanced
budget position with savings equalling investments. This sort of arrangement would very likely
lead to a relatively low level of investments and savings and, hence, to a relatively low growth
rate of output.

The primitive financial structure outlined above puts the private economic development in a
straight jacket and severely hampers economic development. A new financial structure has to
emerge to break the shackles of the rudimentary milieu. If the limitations to the saving-investment
process are to be removed to speed up economic growth the establishment of new forms of
financial organization is obviously called for.

For an improvement in the situation arising out of the Rudimentary finance the financial system
must bring the two groups, namely, savers and investors, together and reconcile their conflicting
objectives. Two types of basic financial techniques / marketing have been gradually developed.
The first of the two basic techniques developed for bringing borrowers and lenders together is
direct in the sense that there are no intermediary financial institutions such as banks, unit trusts
and investment companies etc. to link them. The second type of financial marketing, as a
technique to link the savers and entrepreneurs, involves various financial intermediaries. The

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former type of arrangement is referred to as Direct finance while the second type is designated as
Indirect finance. The main elements of these two types of financial organizations and how they
contribute to more efficient capital information in the sense of mobilization of savings from as
wider a section of the investing public as possible are outlined in the subsequent discussions.

Direct Finance: Direct finance represents an improvement over rudimentary finance in that the
obstacles to efficient capital formation in the latter are eliminated in the former. The terms ‘direct’
as applied to the financial organization signifies that collection of savings effected directly from
the saving-surplus units without the intermediation of financial institutions like banks, investment
companies, insurance companies, units trusts and so on. The ability of the financial markets to
mobilize more savings is improved, under direct finance, through the introduction of three
innovations.
The first element in the growth of financial technology under direct finance is the introduction of
financial assets/instruments, other than money. Many of the problems cited in rudimentary finance
are eliminated consequent upon the introduction of this financial innovation. Investment in real
assets would not be conditioned by the amount of savings of an economic unit. To meet the
investment requirements it can issue financial assets in the form of ‘primary’ security or ‘direct
loan’, defined as a financial asset/security issued by non-financial economic units. These financial
assets will be found of equal value by the savings-surplus units in that they represent an outlet for
their surplus funds which would otherwise remain idle and provide no return to them. In brief, the
financial assets, as the first innovation in direct finance, to the extent they ensure that savings do
not remain idle with the savers on the one hand and profitable investment opportunities are not
unexploited on the other, would stimulate capital formation and, thus, contribute to speedy
economic development.

However, the system of direct loan suffers from a serious limitation as reflected in the
inconvenience/difficulty encountered by the saving deficit units in identifying saving-surplus
units. In case the requirements of finance are large so that a large number of pockets of available
savings are to be located, negotiation of multiple loans would accentuate/magnify these
difficulties. Probably the main reason responsible for this difficulty is the limited communication
network. Consequently, if the ultimate savers and investors are to be brought together in a more
efficient manner than through direct loans between the two parties, there is need for some
institutional arrangement to establish a channel of communication between them. The second
element of direct finance, namely, brokers aim at servicing exactly this need. Through brokerage
function their main job is to find savers and bring them together with economic unit needing
funds. The communication channel thus set up and the resulting increased attractiveness of
primary securities/direct loans would have the effect of improving the flow of savings from savers
to users of funds. In addition to brokerage function, the brokers contribute to the efficient flow of
funds in another way also. This refers to the service provided by them in the form of underwriting
of issues of primary securities. Underwriting implies that they bear the risk of selling the issue to
the public.

In the task of mobilization of resources the requirements of savings surplus units deserve as much
attention as those of the saving-deficit units. The second financial innovation as explained in the
preceding para, is intended to cater to the needs of the latter. An innovation, as the third element
in direct finance, has the objective of serving the needs of the surplus units and, to that extent,
enhance the efficiency of the flow of savings. This has a reference to the development of the
secondary markets/stock exchanges where existing securities can be regularly and continuously
purchased and sold.

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To sum up, direct finance represents a definite improvement over rudimentary finance. The three
innovations, namely, financial assets in the form of primary security, brokers/investment bankers
and secondary markets, as the main elements, would be found of considerable value both by the
savers and investors. All the innovations contribute to the efficiency of flow of savings from
ultimate savers to ultimate users through direct loan/primary security. As a result capital
formation would be greatly stimulated, leading to an increase in the rate of growth.

There is, however, a serious constraint on the efficiency of capital formation inasmuch as direct
transfer of funds alone are inconvenient, expensive, risky and ineffective as means of promoting
the flow of savings into investment. This is mainly because collection of savings in direct finance
is largely confined to the relatively richer/wealthier sections of the savings populace of the
country. Investment of funds by an investor in fulfillment of his investment objectives requires
careful selection of securities, a diversification of risk and continuous supervision of the portfolio
to keep abreast of changing economic and financial conditions. That knowledge, experience,
training and so on are needed to construct and successfully administer investment portfolio needs
no reiteration. The relatively smaller investors would find it almost impossible to cope with these
requirements of investment management. The relatively large investors could well be expected to
make up the deficiency through engaging the services of experts like investment counsel/advisers
etc. The implication of the preceding discussion is that in the absence of intermediary institutions
only the investors with relatively larger savings can participate in industrial investment while the
relatively small investors would be debarred. If more efficient capital formation is to take place in
the sense of the mobilization of savings from as large a section of the investing public as possible,
there is a need for intermediary financial institutions which will take care of the problems of
investment management of the small investors and thereby contribute to the evolution of a vibrant
financial organization on the one hand and speed up economic growth on the other. The
institutional arrangement to do the needful is covered under indirect finance, as discussed below.

Indirect Finance: The second type of financial marketing / technique in the mobilisation of
saving is ‘Indirect finance’. The term indirect finance refers to the flow of saving from savers to
the entrepreneurs through intermediary financial institutions like banks, investment companies,
unit trusts and insurance companies and so on. With indirect finance, as already observed, it is
possible to collect saving from a wider section of the investing public. Why is it so? The most
notable feature of this type of financial arrangement is the existence of an array of financial
intermediaries defined as those various institutions which collect savings from others, issuing in
return claims against themselves and use the funds thus raised to purchase ownership or debt
claims. Their outstanding feature is that they issue to savers claims whose characteristics may be
quite different from those that these institutions buy and hold. In other words, financial
intermediaries come, in the saving investment process, between the ultimate borrowers and
ultimate lenders. They represent a very significant change in the whole process of a transfer of
choice of investment from individual saver to institutional agent.

Gains of Indirect Mode of Financing and Economic Basis

Talking generally, why do surplus units prefer to lend to FIs rather than directly to deficit
spenders? In other words, why do they prefer secondary securities to primary securities? The main
advantages to ultimate lenders are summed up below.
Low risk. Lenders are interested in minimising all kinds of risk of capital and interest loss on
loans or financial investments they make. These risks may arise in the form of risk of default or
risk of capital loss on stock-market assets. Such risks on secondary securities are far less than on
primary securities for individual lenders. How FIs are able to reduce such risks even though they
themselves hold primary securities will be explained later. Besides, government regulation of the

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organization and working of major FIs helps in reducing risks of their creditors. Any
strengthening of the financial system that goes to inspire public confidence in it reduces further
any psychological risk suffered by lenders.
Greater Liquidity. FIs offer much greater liquidity on their secondary securities to their lenders.
Demand deposits of banks are perfectly liquid. Even time deposits to be drawn upon subject to
certain conditions. Primary securities do not carry any of these features, because primary
borrowers need funds for agreed periods to finance their expenditures.
Convenience. Secondary securities sold by FIs are easy to buy, hold, and sell. The information
cost and transaction cost involved are very low.
Other Services. In addition, they transfer funds, collect cheques for their clients, offer safe-deposit
vaults, and most important of all, are the dominant lenders. These other services can be had only
when particular kinds of secondary securities carrying them are bought.
Borrowers also have a preference for FIs due to the following reasons:
-FIs have big pools of funds; big individual demands for funds can be satisfied only by the FIs:
-There is much greater certainty of the availability of funds with the FIs at all times'.
-The rate of interest charged by the FIs is generally lower than that charged by other lenders: and
-Regulated FIs do not fleece small borrowers in the manner moneylenders do.
The question arises how are the FIs able to offer better financial facilities both to the lenders and
borrowers? What is the economic basis of their success or of the financial alchemy whereby they
purchase and hold primary securities, which are much riskier and far less liquid than the
secondary securities they sell as their liabilities to the general public and yet earn handsome
profits on their activities? The answer will help us understand better the source of social gain
accruing from improvements in financial technology.

The true economic basis of financial intermediation lies in the economies of scale in portfolio
management and in the law of large numbers.
Law of large number. Banks, insurance companies, unit trusts, and all other FIs operate on the
assumption, supported by statistical law of large numbers, that not all the creditors will put
forward their claims for cash at the same time. Add to this the fact that if some creditors are
withdrawing cash, some others (whether old or new) are paying in cash. Besides, FIs receive
regularly interest payments on loans and investments made and repayments of loans due. Fortified
by this knowledge, banks keep in cash only a small fraction of even their demand liabilities and
invest or lend the rest. For the same reason, unit trusts can also afford to keep most of their funds
(liabilities) invested in securities and yet offer to buy back all the units the unitholders like to sell
at any time. Life insurance companies also operate on the actuarial fact that a determinable
fraction of lives insured will actually expire in a normal year, so that they need to keep only an
estimated fraction of their total life funds in cash and near-cash and the rest of them can be
invested on long-term basis. Thus FIs can afford to manufacture liabilities (secondary securities)
that are far more liquid than the primary securities they buy as earning assets.
Economies of Scale in Portfolio Management. The average size of the asset portfolios of
banks, insurance companies and other organized-sector FIs is quite large in value. So, these FIs
can reap several economies of scale in portfolio management, which improve significantly their
net rates of return from their asset holdings. These economies accrue in the following main forms:
Reduction of Risk through Portfolio Diversification. Lending/investing is always risky. It
carries risk of default and of capital loss on marketable assets. One common way of reducing risk
is through pooling of independent risks by placing funds in' a diversified portfolio. Thereby what
the investor may lose in a few- directions may more than make up in other directions. An average

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wealthowner cannot afford the degree of portfolio diversification and the resulting reduction of
risk that an average Fl can. Moreover, a large FI can schedule maturities of its loans to match
anticipated outflows and thereby safeguard its liquidity.
Professional Management. The large size of the asset portfolios to be managed allows FIs to
employ professional managers, who are well-versed in the complexities of modern finance, in
appraising loan proposals, in evaluating investment opportunities, in monitoring their loans and
investments. Individual wealth owners cannot afford the cost of professional management and
other support staff.
Indivisibilities and market imperfections. Some loans and investments are of very large size
individually. Even FIs have to come together in consortia, pool their resources, and spread their
risks to finance them. The average administration cost of large loans borne by Fls is quite low.
Thus, FIs with large asset portfolios can earn interest even on very short-term funds and construct
the maturity structure of their assets as desired. Small assetholders cannot do so.
Other cost economies. Because of the large volume of business, the fixed cost of establishment,
cost of information and various transactions costs are lower per unit of transaction to a FI than to
an average household wealth owner.

Credit and the Financial System

The term credit may be defined broadly or narrowly. Speaking broadly, credit is finance made
available by one party (lender, seller, or shareholder/owner) to another (borrower, buyer,
corporate or non-corporate firm). The term credit is also used narrowly for debt finance. Credit is
simply the opposite of debt. Debt is the obligation to make future payments. Credit is the claim to
receive these payments. Both are created in the same act of borrowing and lending.

Credit is a stock-flow variable. At any point of time, there is a certain amount of credit (of any one
kind or all kinds) outstanding. It is a revolving stock. Once a loan is repaid, the amount received
can be advanced to the same party or some other party or parties. Any increment (decrement) in
the stock of credit per period represents a positive (negative) flow of credit per period.

Credit should be carefully distinguished from money. Even bank credit is not the same thing as
money. Their nature and functions are not the same. Money is an asset of the holding public. It is
a liability of the banking system (including the BB). However, it is not all the liabilities of the
banking system that are money, but only those that serve as media of exchange, namely currency
and the demand deposits. Bank credit, on the other hand, is a liability of the borrowing public to
banks and an asset of banks.

The bank credit is only one form of credit. In a modern economy, there exist several other sources
of credit as well. Collectively they constitute the financial system.

In a credit economy, that is economy with borrowing and lending, each spending unit (whether a
household, a firm, or the government) can be placed in any one of the three categories: deficit
spenders, surplus spenders, and balanced spenders, as its total expenditure is greater than, less
than, or equal to its total (owned or internal) receipts respectively. The chief function of credit is
to relax the constraint of balanced budgets. It is through this chief function that the financial
system is able to promote savings, investment, better allocation of resources, and growth in the
economy. It is also worth remembering that if credit is not well managed, it can cause inflation or

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deflation and unemployment. It can also lead to malutilisation of resources, excessive
concentration of income and wealth in a few hands, and exploitation of the weak and the poor.
Kinds of Credit: Credit is not one homogeneous good or asset. It is of various kinds. We may
classify credit from four different angles: (a) source (Institutional & Non-institutional) (b) end-use
(Production and Consumption (c) term (Short, Medium and Long-term), and (d) cost
(Cheap/subsidized and market rate).

Financial Sector and Economic Development

The basic role of the financial sector is to provide payment services to the economy. The financial
sector provides the economy with medium of exchange by issuing notes, holding demand deposits
and honoring checks drawn upon the latter. Without the financial sector, an economy would be
confined to barter and specialization in production would be limited. Economies of scale could not
be fully exploited and hence economic growth would be constrained. It is therefore widely
recognized that the financial sector helps economic development by providing payment services,
thereby improving overall efficiency of the economy.

In addition to the role of the financial sector in facilitating payments, the financial sector also
induces and mobilizes financial saving and allocates credit (Figure). A financial system promotes
savings by providing a wide array of financial assets with attractive combinations of income and
safety. This will induce larger savings out of the same level of real income. The financial sector
systemizes the relationship between savers and investors in the economy by providing its own
securities to savers and purchasing primary securities from borrowers. Through this intermediary
function, the saving activity of savers is facilitated as is the financing of investment activities of
entrepreneurs and enterprises. Without the financial sector, investment will have to be self-
financed by individual investors from their own resources. The funds required for undertaking
viable investments are, however, often beyond the means of an individual investor. The financial
sector creates economies of scale by pooling the relatively small savings of a large number of
individuals and making them available for relative large investment.

In regard to resource mobilization, a distinction between financial saving and real saving is to be
made. The former is defined as an increase in financial assets held by the public, while the latter
refers to an increase in physical assets that are not consumed.

Increased incentives to saver through diversification of financial assets and/or higher interest rates
on financial assets will increase financial savings. This, however, does not necessarily mean that
total real savings will increase. According to E. S. Shaw and R. McKinnon, interest rate ceilings
on deposits and lendings is the most important instrument of “financial repression.” Raising or
liberalizing the interest rate ceiling (from the repressed level) will increase both savings and
investments. Savings rises along the positively sloping savings function as the interest ceiling is
raised. Investment also rises reflecting the expansion of investible resources by the rise in savings.
Raising the interest rate ceilings deters entrepreneurs from undertaking low yielding projects.
Hence the average return to aggregate investment increases and rate of economic growth rises.

References:
Baldez, Stephen. An Introduction to Global Financial Market. Macmillan Press Ltd. London.
2000
Gupta, S. B. Monetary Economics: Institutions, Theory and Policy. S. Chand & Company. New
Delhi. 1999.
Khan, M. Y. Indian Financial System. Vikas, New Delhi, 2000.
Rose. P. S. Commercial Bank Management. McGraw-Hill Irwin. N. Y. 2002.

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