MANAGEMENT OF BANKING AND FINANCIAL SERVICES

CHAPTER 2MONETARY POLICY IMPLICATIONS FOR BANK MANAGEMENT PADMALATHA SURESH

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MACROECONOMIC POLICIES
The Governments primary objective is to achieve economic stability and growth Three indicators are targeted and monitored to achieve this objective: Prices, Employment and Balance of payments The two pillars of macroeconomic policy are Fiscal and Monetary policies

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MONEY, MONEY SUPPLY AND MONETARY POLICY

Money is something that people are universally willing to accept in payment for goods and services or to pay off debts Money supply is the total quantity of money in the economy Monetary Policy marks the management of money supply and its links to prices, interest rates and other economic variables
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TYPICAL MONEY SUPPLY MEASURES

NARROW MONEY [M1] =narrow measure of money as a medium of exchange BROAD MONEY [M2] = M1 + broader measure to reflect moneys function as store of value BROAD MONEY [M3] = M2 +still broader measure to cover items regarded as close substitutes of money
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COMPONENTS OF THE FINANCIAL SYSTEM

FINANCIAL MARKETS, which act as brokers, and FINANCIAL INTERMEDIARIES, which act as asset transformers The objectives of both financial markets and intermediaries are to:
Bring together savings-surplus units and savingsdeficit units Transfer resources from surplus units to deficit units Facilitate flow of savings into investment
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How banks create creditTHE MONEY MULTIPLIER

Banks, as financial intermediaries, cannot create currency. But they can create deposits, which in turn can be lent The operation of the Money multiplier makes Money creation by banks an iterative process The key variables determining money supply are the monetary base and level of leakage The monetary base is represented by the financial liabilities of the central bank Central bank can control monetary base and strongly influences leakage Central bank sets reserve requirements [=leakage], which places a limit on banks ability to create credit
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CENTRAL BANKS TOOLS FOR MONETARY MANAGEMENT

Variations in reserve requirements Variations in the bank rate [the rate at which banks borrow from the central bank] Open Market Operations [OMO]

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MEASURES OF MONEY SUPPLY IN INDIA

New monetary aggregates conforming to the residency principle and progressive liquidity M0 the Monetary Base M1 Narrow money M2 M3 Broad Money
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LIQUDITY AGGREGATES IN INDIA

Apart from monetary aggregates, in conformity with the progressive norms, liquidity aggregates are also computed L1 = M3 + all deposits with Post office savings banks, excluding NSCs L2 = L1 + term deposits with term lending institutions + term borrowings by institutions + CDs issued by institutions L3 = L2 + public deposits of non banking financial companies
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MONETARY POLICIES IN INDIA

Emphasize co-ordination between monetary and fiscal policies Have, as their main objectives, price stability and ensuring availability of adequate credit to productive sectors of the economy They also increasingly emphasize Financial Stability
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RBIs reserve requirements

All banks in India are required to maintain a specified amount of reserves as cash / bank balances with the RBI and as investment in approved securities. All such reserves that are to be maintained as a legal requirement are termed Primary Reserves. These reserve requirements are categorized as [a] Cash Reserve Ratio [CRR] and [b] Statutory Liquidity Ratio [SLR]
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The CRR and SLR

CRR is the FRACTIONAL RESERVE and is maintained as cash balances with RBI The SLR is maintained to
facilitate government borrowings through bank investment in approved securities Provide additional profitability/ liquidity to banking system

Developmental financial institutions not required to maintain reserves

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Maintenance of reserve requirements

CRR and SLR are prescribed as a minimum percentage of Net Demand and time Liabilities [NDTL] of each bank operating in India Conceptually, NDTL is the aggregate of liabilities to others and net inter bank liabilities [NIBL], where Net Inter bank liabilities = liabilities of the banking system LESS assets with the banking system. NDTL is measured on every alternate Friday by banks these Fridays are termed Reporting Fridays. Maintenance of CRR and SLR are computed based on the NDTL as on the Reporting Friday. There are penal provisions for non compliance with the reserve requirements
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Reserve requirements vs OMO

RBI is increasingly resorting to OMO to regulate money supply in the economy The reserve requirements are being used as a short term tool When OMOs are used as the primary policy instrument, the use of other tools such as reserves and bank rate become selective and restricted.
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OMO and the Repo

Use of OMO has given rise to active repo markets in many countries
REPURCHASE AGREEMENT [REPO] IS
An agreement Between 2 parties Where one party SELLS securities [for raising short term funds] At a specified price With commitment to BUY BACK At another date At another predetermined price

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REVERSE REPOS
For the buyer of these securities, it is a reverse repo transaction- a contract to buy and resell the securities at a predetermined date and price. Used to adjust short term surpluses. The economic effect of repos and reverse repos amounts to a secured loan This is also called a collateralized lending obligation
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WHY ARE REPOS IMPORTANT?

Repos used as the policy rate to signify the central banks monetary policy stance They can influence interest rates by controlling liquidity and signifying desired interest rate levels They can be used to offset short term fluctuations in bank reserves

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