SEMESTER 2: MASTERS OF BUSINESS ADMINISTRATION (MBA)

[BATCH: 2023 – 25]

Course Title:
Indian Financial System and Financial Markets (IFSFM)
COURSE CODE: 23MBADSE215
MODULE 2: Banking and Money Markets

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Dr. Madhavi R
Professor & Programme Coordinator
CMS Business School

CMS Business School, JAIN (Deemed-to-be University)

 BANKING: Concepts of Commercial Banks

▪ A commercial bank carries all the operations related to the deposit and withdrawal of
money for the general public, providing loans for investment, and other such activities.
These banks are profit-making institutions and do business only to make a profit.

▪ The two primary characteristics of a commercial bank are lending and borrowing. The bank
receives the deposits and gives money to various projects to earn interest (profit). The rate
of interest that a bank offers to the depositors is known as the borrowing rate, while the rate
at which a bank lends money is known as the lending rate.

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 BANKING: Functions of Commercial Banks
Commercial Banks have both primary and secondary functions
Primary Functions:
▪ Accepting Deposits – Commercial banks accept deposits from their customers in the form of saving, fixed, and current
deposits.
▪ Providing Loans – One of the main functions of commercial banks is providing credit to organizations and individuals,
and profit from the earned interest. Usually, banks retain a small reserve for their expenses while offering the remaining
amount to customers as various types of short and long-term credits.
▪ Credit Creation – A unique function of commercial banks is credit creation. Instead of offering liquid cash, banks
create a line of credit and transfer the loan to a business or commercial body all at once.
Categories of Secured and Unsecured Loans provided by Commercial Banks
▪ Cash Credit – Commercial Banks and their Functions include extending advances to individuals and organizations
against bonds, inventories, and other types of securities. This facility, commonly known as cash credit, provides a more
substantial sum when compared to other forms of credit.
▪ Short-Term Credits – Short-term loans are usually pledged without any security, offering a smaller loan amount and
repayment tenor. These are also referred to as personal loans.

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 BANKING: Functions of Commercial Banks
Secondary Functions:
▪ Providing locker Facilities – Commercial banks provide locker facilities to customers who want to store valuables
safely. Locker facilities eliminate the impending risk of theft or loss, which prevail when kept at home.
▪ Dealing in Foreign Exchange – Commercial banks help provide foreign exchange to individuals and organizations that
export or import goods from overseas. However, only certain banks which have the license to deal in foreign exchange
are eligible for such transactions.
▪ Exchange of Securities – Another function of commercial banks is to trade in bonds and securities. Customers can
purchase or sell the units from the financial institution itself, which offers more convenience than alternate approaches.
▪ Discounting Bills of Exchange – The main function of a commercial bank in today’s date is to discount bills of
businesses. Bill discounting is considered a profitable investment for banks. Bills create a steady flow of funds, while
not becoming a risky venture during payment as it is considered as a negotiable instrument. These also do not involve
the financial institution in any litigation.
▪ Bank as an Agent –provide finance-related services to customers, fulfilling the role of an agent. These services usually
include acting as an administrator, trustee, or executor of a customer-owned estate. Assisting customers with tax returns,
tax refunds, and other similar tasks. Serving as a platform to pay premiums, repay loan installments, etc. Offering a
platform for electronic transactions of funds, processing of cheques, drafts, bills, etc.

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 BANKING STRUCTURE IN INDIA

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CMS Business School, JAIN (Deemed-to-be University)
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 Asset-Liability Management (ALM)
▪ Asset and liability management (ALM) is a practice used by financial
institutions to mitigate financial risks resulting from a mismatch of assets
and liabilities.

▪ ALM strategies employ a combination of risk management and financial

planning and are often used by organizations to manage long-term risks that
can arise due to changing circumstances.

▪ The practice of asset and liability management can include many factors,
including strategic allocation of assets, risk mitigation, and adjustment of
regulatory and capital frameworks. By successfully matching assets against
liabilities, financial institutions are left with a surplus that can be actively
managed to maximize their investment returns and increase profitability.

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 Evolution of Asset-Liability Management (ALM)

• In the 1940s and the 1950s, funds were abundant in banks in the form of demand and savings
deposits. Hence, the focus then was mainly on asset management. But as the availability of low
cost funds started to decline, liability management became the focus of bank management efforts.

• In the 1980s, volatility of interest rates in USA and Europe caused the focus to broaden to include
the issue of interest rate risk.

• ALM began to extend beyond the bank treasury to cover the loan and deposit functions.

• Banks started to concentrate more on the management of both sides of the balance sheet

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 Asset-Liability Management (ALM) Process 3 Pillars

ALM Information Systems

▪ LM Information System is used for the collection of information accurately, adequately and expeditiously.
Information is the key to the ALM process. A good information system gives the bank management a complete
picture of the bank’s balance sheet.
ALM Organization
▪ The Asset-Liability Committee (ALCO) consisting of the bank’s senior management including CEO should be
responsible for adhering to the limits set by the board as well as for deciding the business strategy of the bank
in line with the bank’s budget and decided risk management objectives. ALCO is a decision-making unit
responsible for balance sheet planning from a risk return perspective including strategic management of
interest and liquidity risk. Consider the procedure for sanctioning a loan.
ALM Process (Risk parameters, Risk identification, Risk measurement, Risk management, Risk
polices and tolerance levels.
▪ Involves identification, measurement and management of risk parameters. The RBI in its guidelines has asked
Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk.
▪ https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=16&Mode=0

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 Basel- I (1988)

• It focused almost entirely on credit risk. (Credit risk is the possibility of a loss resulting from a
borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk
that a lender may not receive the owed principal and interest.)

• It defined capital and structure of risk weights for banks.

• The minimum capital requirement was fixed at 8% of Risk Weighted Assets (RWA).

• RWA means assets with different risk profiles.

• For example, an asset backed by collateral would carry lesser risks as compared to personal loans,
which have no collateral.

• India adopted Basel-I guidelines in 1999.

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 Basel- II

• Implemented in 2007; Consists of three pillars

• Minimum capital Requirements: the banks should measure the risk weighted assets
providing the due weightage to the three types of risks such as credit risk, market risk and
operational risk

• Supervisory Review Process: It is basically intended to ensure that the banks should have
enough capital bases to support all the risks associated with the banks business process.

• Market Discipline: Disclosures of a bank’s capital and risk-taking positions are

recommended to be released to the general public
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 Basel- III

• In 2010, Basel III guidelines were released.

• These guidelines were introduced in response to the financial crisis of 2008.

• A need was felt to further strengthen the system as banks in the developed

• economies were under-capitalized, over-leveraged and had a greater reliance on

• short-term funding.

• It was also felt that the quantity and quality of capital under Basel II were deemed insufficient to
contain any further risk.

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 Basel- III
The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital,
leverage, funding and liquidity.

• Capital: The capital adequacy ratio is to be maintained at 12.9%. The minimum Tier 1 capital ratio and the minimum
Tier 2 capital ratio have to be maintained at 10.5% and 2% of risk-weighted assets respectively. In addition, banks
have to maintain a capital conservation buffer of 2.5%.

• Counter-cyclical buffer is also to be maintained at 0-2.5%.

• Leverage: The leverage rate has to be at least 3 %. The leverage rate is the ratio of a bank’s tier-1 capital to average
total consolidated assets.

• Funding and Liquidity: Basel-III created two liquidity ratios: LCR and NSFR.

• The liquidity coverage ratio (LCR) will require banks to hold a buffer of high-quality liquid assets sufficient to deal
with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. This is to
prevent situations like “Bank Run”. The goal is to ensure that banks have enough liquidity for a 30-days stress
scenario if it were to happen.
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 Basel- III

• The Net Stable Funds Rate (NSFR) requires banks to maintain a stable funding profile in relation to their off-balance-
sheet assets and activities. NSFR requires banks to fund their activities with stable sources of finance (reliable over
the one-year horizon). The minimum NSFR requirement is 100%. Therefore, LCR measures short-term (30 days)
resilience, and NSFR measures medium-term (1 year) resilience.

• The deadline for the implementation of Basel-III was March 2019 in India. It was postponed to March 2020. In light
of the coronavirus pandemic, the RBI decided to defer the implementation of Basel norms by further 6 months.
Extending more time under Basel III means lower capital burden on the banks

• In terms of provisioning requirements, including the NPAs. This extension would impact the perception of Indian
Banks and central banks in the eyes of the global players.

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 Money Markets

• The money market is a crucial financial market segment where short-term borrowing
and lending of funds occur.

• It facilitates the smooth functioning of the economy by providing a platform for

participants to meet their immediate cash needs and manage liquidity.

• The participants in the money market include governments, corporations, financial

institutions, and individual investors.

• Transactions in the money market typically involve highly liquid and low-risk
instruments with maturities of one year or less.

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 Money Markets
Features Of Money Market Instruments
▪ High Liquidity- One of the key features of these financial assets is high liquidity offered by them. They
generate fixed-income for the investor and short term maturity makes them highly liquid. Owing to this
characteristic money market instruments are considered as close substitutes of money.

▪ Secure Investment- These financial instruments are one of the most secure investment avenues
available in the market. Since issuers of money market instruments have a high credit rating and the
returns are fixed beforehand, the risk of losing your invested capital is minuscule.

▪ Fixed returns- Since money market instruments are offered at a discount to the face value, the amount
that the investor gets on maturity is decided in advance. This effectively helps individuals in choosing
the instrument which would suit their needs and investment horizon.

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 Interest rate

Nominal Interest Rate VS Real Interest Rate

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 Interest rate
Nominal Interest Rate
▪ Nominal interest rate refers to the interest rate before taking inflation into account. The interest
rate is the rate at which interest is charged on borrowings. Growing inflation reduces the value of
borrowed money since higher interest becomes payable on loans. Nominal interest rate is
adjusted to consider the effect of inflation.
▪ Nominal Interest Rate = Real Interest Rate + Inflation Rate
Real Interest Rate
▪ Real interest rate is the nominal rate minus inflation. In other words, this is the rate expected by
lenders after allowing for inflation. Real interest rate amounts to the true return generated by
borrowed or lent funds.
▪ Real Interest Rate = Nominal Interest Rate − Inflation Rate

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 Interest rate
▪ (1+r) (1+i) = (1+R)
▪ r = Real Interest Rate
▪ i = Inflation rate
▪ R = Nominal Interest Rate
▪ E.g. If the real interest = 5% and Inflation rate = 2% then the nominal rate will be,
▪ (1+5%) (1+2%) = (1+R)
▪ (1+0.05%) (1+0.02%) = (1+0.071)
▪ = 7.1%
▪ Inflation affects a country’s economy in many ways and its impact on interest rates is a
predominant one. The governments control the rate of inflation through monetary policy
to reduce its negative impact on interest rates.

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 Solve problems
▪ The nominal rate of interest that has been prevailing for a long time has been around 9%, and the
rate of inflation has come out as 3%. You are required to calculate the real rate of interest.
▪ The World Bank has been tasked with completing statistics of some of the countries. They are now
left with two countries for which the deadline to complete the statistics is by next week. William
has recently joined the team, which calculates interest rates. William is an economist and has done
the master’s in it. He was given a task to calculate the real rate of interest for the remaining two
countries, X and Y. Below are the details collected by the ex-employee for these countries.

▪ Based on the above available information, you are required to calculate the real rate of interest. If
someone wants to invest their funds, where should one invest whether in Country X or Country Y?

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 Money Markets

Money Market- instruments

▪ short-term financing instruments aiming to increase the financial liquidity of
businesses.
▪ they can be easily converted to cash, thereby preserving an investor's cash
requirements.
▪ usually traded over the counter and, therefore, cannot be done by standalone
individual investors themselves. It has to be done through certified brokers or a
money market mutual fund.

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 Money Market
Objectives of Money Market
▪ Providing short-term financing to borrowers such as private investors, governments, and
others at a reasonable cost. Lenders will also benefit from liquidity because money
market securities are short-term.
▪ Since most businesses lack the necessary working capital, the money market assists such
businesses in obtaining the monies required to meet their working capital requirements.
▪ It is a major source of government funding for both domestic and foreign trade. As a
result, it provides an opportunity for banks to lodge their excess funds.
▪ It also enables lenders to convert idle capital into productive investments. Both the lender
and the borrower benefit from this arrangement.
▪ The RBI oversees the money market. As a result, it contributes to the regulation of the
economy's liquidity level.

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 Types of Money Market
CALL /NOTICE / TERM MONEY
The call/notice/term money market facilitates lending and borrowing of funds between banks and
entities like Primary Dealers. An institution which has surplus funds may lend them on an
uncollateralized basis to an institution which is short of funds. Money market transactions are
categorized as follows:
▪ Borrowing/Lending for 1 day is known as Call Money
▪ Borrowing/Lending for 2-14 days is known as Notice Money
▪ Borrowing/Lending for more than 14 days is known as Term Money

The interest rates on such funds depend on the surplus funds available with lenders and the demand
for the same which remains volatile.
▪ RBI issues guidelines for the various participants in the call/notice money market. The entities are
permitted to participate both as lenders and borrowers in the call/notice money market are
Scheduled Commercial Banks (excluding RRBs), Co-operative Banks (other than Land
Development Banks) and Primary Dealers (PDs).

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 Types of Money Market
1. CALL /NOTICE / TERM MONEY
▪ The call/notice/term money market facilitates lending and borrowing of funds between banks and entities
like Primary Dealers. An institution which has surplus funds may lend them on an uncollateralized basis
to an institution which is short of funds. Money market transactions are categorized as follows:
▪ Borrowing/Lending for 1 day is known as Call Money
▪ Borrowing/Lending for 2-14 days is known as Notice Money
▪ Borrowing/Lending for more than 14 days is known as Term Money

▪ The interest rates on such funds depend on the surplus funds available with lenders and the demand for
the same which remains volatile.
▪ This market is governed by the Reserve Bank of India which issues guidelines for the various participants
in the call/notice money market.
▪ The entities permitted to participate both as lender and borrower in the call/notice money market are
Scheduled Commercial Banks (excluding RRBs), Co-operative Banks (other than Land Development
Banks) and Primary Dealers (PDs).
https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9023

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 Types of Money Market
2. COMMERCIAL BILLS
▪ It is used for financing a transaction in goods that takes some time to complete.
▪ It shows the liability to make the payment on a fixed date when goods are bought on credit.
▪ It is an asset which is "shiftable", and which carries a low degree of risk of loss
▪ Bills of exchange are known as Bankers' Acceptances in the US
▪ There is no single fixed maturity period for bills in general
Classification of Bills
▪ Demand bill - A bill in which no time for payment is specified
▪ Usance or time bill - It is payable at a specified later date
▪ Inland bill -Must (a) be drawn or made in India, and must be payable in India, or (b) be drawn upon
any person resident in India
▪ Foreign bill • Drawn outside India and may be payable in and by a party outside India, or may be
payable in India or drawn on a party resident in India, or (b) drawn in India and made payable
outside India

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 Types of Money Market
3. COMMERCIAL PAPERS (CP)

▪ Commercial paper, or CP, is a short-term debt instrument issued by companies to raise funds
generally for a time period up to one year.

▪ It is an unsecured money market instrument issued in the form of a promissory note and was
introduced in India in 1990.

▪ Corporates which enjoy a high rating can diversify their sources of short-term borrowings using
CPs.

▪ Investors get an additional instrument.

▪ It is typically issued by large banks or corporations to cover short-term receivables and meet
short-term financial obligations, such as funding for a new project

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 Who can issue the CP?
3. COMMERCIAL PAPERS (CP)

▪ Companies
▪ Non-Banking Finance Companies (NBFCs)
▪ All India Financial Institutions (AIFIs)
▪ Other entities with a net worth of Rs. 100 Crore or higher viz.
▪ Co-operative societies / Unions
▪ Government entities
▪ Trusts
▪ Limited Liability Partnerships
▪ Any other body corporate having presence in India
▪ Any other entity specifically permitted by the Reserve Bank of India (RBI)

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 Commercial Paper cost

▪ Net Amount Realized: The net amount realized by the borrowing company is the amount which is received after deducting all the
related discount and charges. These charges include stand by facility charges, stamp duty, dealing bank fee, agent charges, credit
rating charges, etc.

▪ The formula to determine the net amount realized is:

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 Commercial Paper cost
▪ Face Value-Rs 5,00,000/-
▪ Maturity period= 180 days
▪ Net amount Realised = Rs 4,80,000/-
▪ Pre-tax effective cost of commercial paper ?

• Source: Prasanna Chandra – Financial Management

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 T-Bills
▪ Treasury bills are money market instruments issued by the Government of India as a promissory note
with guaranteed repayment at a later date.
▪ Minimum Investment: ₹10,000 and multiples of ₹10,000

▪ Trading: The RBI, on behalf of the central government, auctions such securities every week (on
Wednesday) in the market, depending upon the total bids placed on major stock exchanges
▪ Funds collected through such tools are typically used to meet short term requirements of the
government, hence, to reduce the overall fiscal deficit of a country

▪ The Reserve Bank of India (RBI) also issues such treasury bills under its Open Market Operations
(OMO) strategy to regulate its inflation level and influence spending/borrowing habits of individuals.
▪ Types of Treasury Bills:- 91 Days T-Bills, 182 Days-T Bills and 364 Days T-Bills

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 Who should invest in T-Bills

▪ Individuals can park surplus funds in a secure investment tool to enjoy substantial
yields.
▪ The RBI facilitates a non-competitive bidding process for such bonds, allowing
individual investors to partake in the same by placing their bid with the respective
primary dealer of a scheduled commercial bank.
▪ Also, as details regarding the discount rate and par value are published beforehand,
individuals enjoy full transparency in the investment process.
▪ It also aids in the process of financial planning for robust wealth accumulation.

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Yield Rate of T-Bills

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 Problems

• 91 days’ T-bill at issue is Rs. 98.20/-.

• A) compute the yield
• B) compute the yield if it is trading at Rs. 99 after 41 days.
• A) (100-98.2/98.2)*(365/91)*100 = 7.35%
• B) (100-99/99)*(365/50)*100 = 7.37%

• HOME WORK:
• 181 days T-bill issued at 96.20
• 364 days T-bill issued at 92
• Calculate the yield of a 364 –day T-bill issued at a price of 97 after 90 days having
the par value of 100.

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 T-Bills Auction

• Auction is a process of calling of bids with an objective of arriving at the market price

• A yield based auction is generally conducted when a new Government security is

issued.
• Investors bid in yield terms up to two decimal places (for example, 7.49 per cent, 8.21
per cent, etc.)

• Bids are arranged in ascending order and the cut-off yield is arrived at the yield
corresponding to the notified amount of the auction.

• The cut-off yield is taken as the coupon rate for the security. •

• Successful bidders are those who have bid at or below the cut-off yield. Bids which are
higher than the cut-off yield are rejected

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 T-Bills Auction
• A price based auction is conducted when Government of India re-issues securities
issued earlier.
• Bidders quote in terms of price per Rs.100 of face value of the security (e.g.,
Rs.102.00, Rs.101.00, Rs.100.00, Rs.99.00, etc., per Rs.100/-).

• Bids are arranged in descending order and the successful bidders are those who have
bid at or above the cut-off price. Bids which are below the cut-off price are rejected

• In a Uniform Price auction, all the successful bidders are required to pay for the
allotted quantity of securities at the same rate, i.e., at the auction cut-off rate,
irrespective of the rate quoted by them

• Multiple Price auction, the successful bidders are required to pay for the allotted
quantity of securities at the respective price / yield at which they have bid

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 T-Bills Auction

Competitive bids
• Made by well informed investors such as banks, financial institutions, primary dealers,
mutual funds, and insurance companies.
• The minimum bid amount is Rs.10,000 and in multiples of Rs.10, 000 thereafter.
Multiple bidding is also allowed, i.e., an investor may put in several bids at various
price/ yield levels.

Non-competitive bidding
• Open to individuals, HUFs, RRBs, co-operative banks, firms, companies, corporate
bodies, institutions, provident funds, and trusts.
• Under the scheme, eligible investors apply for a certain amount of securities in an
auction without mentioning a specific price /yield. Such bidders are allotted securities
at the weighted average price /yield of the auction

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 Repo Rate (Repurchasing Agreement)

• Repo rate refers to the rate at which commercial banks borrow money by selling their securities to
the Central bank of our country i.e Reserve Bank of India (RBI) to maintain liquidity, in case of
shortage of funds or due to some statutory measures.
• It is one of the main tools of RBI to keep inflation under control.
• Banks also borrow money from RBI during a cash crunch on which they are required to pay interest
to the Central Bank. This interest rate is called the repo rate.
• Technically, repo stands for ‘Repurchasing Option’ or ‘Repurchase Agreement’.
• It is an agreement in which banks provide eligible securities such as Treasury Bills to the RBI while
availing overnight loans.
• An agreement to repurchase them at a predetermined price will also be in place.

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Discount Market

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 Gilt-Edged Securities
• Gilt-edged securities, or simply "gilts," refer to high-quality debt instruments issued by
governments or reputable corporations.

• Safest and most reliable investments in the financial markets, offering a lower risk profile and
predictable returns

• Low on default risk, as they are issued by financially stable entities.

• This low risk is often accompanied by a lower yield when compared to other investments. These
securities typically have a fixed interest rate, which is paid periodically to bondholders.

• Gilt-edged securities play a crucial role in global financial markets, as they provide a benchmark
for risk-free investments.

• They also offer a stable source of income for investors, facilitate long-term financial planning,
and serve as a significant source of capital for governments and corporations.

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 Types of Gilt-Edged Securities
• Government Bonds: are debt securities issued by national governments. They are generally backed
by the full faith and credit of the issuing country, making them low-risk investments.

• Treasury Bonds: are long-term debt securities issued by the government's treasury department. They
generally have a maturity period of more than ten years and pay a fixed interest rate to bondholders.
Investors consider them among the safest fixed-income investments.

• Sovereign Bonds: are debt securities issued by a country's government in foreign currencies. They
carry slightly higher risk than domestic treasury bonds, as they are subject to currency fluctuations and
the creditworthiness of the issuing country.

• Corporate Bonds: are debt securities issued by companies to raise capital for business expansion or
other purposes. They typically offer higher yields than government bonds, as they carry a higher risk of
default.

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 Types of Gilt-Edged Securities

• Investment-grade corporate Bonds: are issued by companies with strong credit ratings,
indicating a lower risk of default. These bonds are considered gilt-edged securities because of
their high credit quality and lower default risk, making them attractive to conservative investors.

• Convertible Bonds: are corporate bonds that can be converted into a predetermined number of
the issuer's shares at specific times during the bond's life.

• These bonds offer the potential for capital appreciation if the company's stock price rises, while
still providing the safety of a fixed-income investment.

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 REFERENCES

▪ Basic text by L M Bhole & Jitendra Mahakud

▪ Images courtesy: Google Images
▪ Websites of Financial organisations like Post office, NBFCs, etc.

Some useful references for basics:’

- https://www.tatamutualfund.com/professor-simply-simple

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