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a) Define what are money markets? (15 marks) b) Describe the two categories of bank lending...

a) Define what are money markets?

b) Describe the two categories of bank lending to corporations.

c) What are the benefits and costs for a bank when it decides to increase the amount of its capital?

d) “Bank managers should always seek the highest possible return on their assets”. Is this statement true, false, or uncertain? Explain your answer.

Solutions

Expert Solution

a,

Money market refers to all those activities and institutions which relate to sale and purchase of money. Sale and purchase of money refers to granting and receiving loans. Generally, loans are both short-term and long-term but there is only exchange of short-term loans in the money market.

In other words, like the market of commodities, money too has its market and there are sellers and purchasers in this market. The purchaser of market includes all those people, traders and industrialists who take loan from this market for the purpose of production. On the other hand, the seller of money includes those people and creditors who give their money as loan to those people who need it.

Just as in the market of goods and commodities, the prices are determined by the force of demand and supply, similarly in the money market, the value of money is determined by the demand and supply of money. This determined value is referred to as the rate of interest.

The important definitions of money market are as follows:

(1) According to Crowther, “Money market is the collective name given to the various firms and institutions that deal in the various grades of near money.”

(2) According to Prof. K.C. Chacko, “Money market may be defined as a place where short-term funds are bought and sold.”

(3) According to Sayers, ‘The money market properly speaking is the market for short term and day to day loans.

(4) According to a Publication of Reserve Bank of India, “Money market is the centre for dealing mainly of short-term character, in monetary assets. It meets the short-term requirements of borrower and provides liquidity or cash to tenders.”

On the basis of above definitions, it can be said that money market refers to that total area where the short-term seller and purchaser of money come in contact with one another and determine the value of money through its demand and supply to meet the requirements of one another. This determined value is called the rate of interest.

Essay # 2. Nature or Features of Money Market:

The main features of money market are described below:

(1) Dichotomy:

The most important feature of Indian Money Market is its dichotomy. It means that it is divided into two sectors—organised and unorganised. There is lack of proper contact and co-operation between these two. Reserve Bank of India, State Bank of India and other commercial banks, foreign banks etc. fall in the category of organised sector while the money lenders and native bankers are included in the unorganised sector.

(2) Transactions:

Transactions in the money market can be done with or without the help of brokers or mediators.

(3) Speedy Transactions:

The speed of practical activities in the money market is very fast. Most of the activities in it are done through telephone and the concerned paper work is done later. So, it is also called over the phone market.

(4) More Liquidity:

There is excess liquidity in the money market. It helps in providing ready market for money market instruments.

(5) Narrow Market:

It is a feature of Indian Money Market that it is the narrow market of government and semi-government securities. It limits the area of open market operations of credit control.

(6) Lack of Control of Unorganised Sector:

There is control of the Central Bank on the organised sector of Indian money market but there is no control of any institution on the unorganised sector. Consequently, the rate of interest in this sector is high.

(7) Appropriate Approach:

Money market provides an appropriate approach to the users of short-term funds to meet their requirements on proper conditions and interest rates. In other words, it establishes a balance between short-term financial demand and supply.

(8) Main Part of Financial Market:

Money market is the main part of financial market. It meets the short-term financial requirements of traders, industrialists and the government.

(9) Insufficient Development of Sub-Market:

There are many sub- markets of Indian money market but all these are not well developed. For example, despite many efforts the bill market in India is undeveloped.

(10) Consists of Many Sub-Markets:

Money market is a group of many sub-markets. In includes call money market, Treasury bill market, commercial paper market etc.

Essay # 3. Instruments of Money Market:

Money market is a group of many sub-markets. There is competition among these sub-markets.

The instruments through which the transaction of short- term loans takes place in these sub markets are as follows:

(1) Treasury Bill:

Treasury bill refers to that instrument of money market which is issued by Reserve Bank of India on behalf of the government of India to meet the short-term financial requirements of central government. These bills are generally purchased by commercial banks, non-banking financial institutions, Life Insurance Corporation, General Insurance Corporation, Unit Trust of India etc.

The maturity period of Treasury Bills are generally 14 days, 91 days, 182 days or 364 days. The nature of this bill is that of negotiable instrument and these can be transferred independently. These bills are considered extremely liquid and safe and no interest is paid on these. On the other hand, they are issued on discount. The minimum amount of this instrument is Rs. one lakh. However, it can be purchased by common people also but due to low rate of interest, they don’t invest in it.

Dealing Process:

Treasury bill is issued on a low price as compared to their market value while the maturity payment is on the face value. The difference between the face value and the issue value is the profit of the investors. The difference is called discount. No interest is paid on the Treasury bill, so it is also called Zero Coupon Bond.

The determination of discounting on the Treasury bill can be in two ways:

(i) On the Basis of Pre-Determined Discount Rate:

Pre-determined discount rate refers to the system of determining the amount of discount of the time of issuing of the bill itself. For example, if the treasury bill of Rs. 1 lakh is issued for a certain period at Rs. 95 thousand, the investor will get a profit of Rs. 5 thousand in that particular period.

(ii) On the Basis of Auction:

To issue Treasury bill on the basis of auction, Reserve Bank of India invites tenders through advertisement in newspapers. Among the different tenders received, the one with the minimum rate of discount is accepted.

These days, Treasury Bills are issued mostly on the basis of auction:

(2) Commercial Paper Market:

Commercial paper is an unsecured and unsafe Promissory Note. So, it is issued only by the reputed companies. Its purchasers include banks, Insurance Companies, Unit Trust of India and firms etc. It is issued generally to obtain working capital. Its period is generally up to 12 months. The minimum face price of a commercial paper is at least Rs. 5 lakhs. It can be sold directly or indirectly, it means the company can sell these commercial papers directly to the purchasers or it can do so with the help of certain agency.

Dealing Process:

This instrument is very popular in USA, England, Japan, Australia etc. It was started in India in 1990. It is issued for a maximum period of 12 months. Generally, it is issued on discount but sometimes it is issued on certain interest rates. There is no active secondary market for it but the issuing company repurchases it on request.

(3) Call Money or Call Loans:

It refers to such loan instrument which is paid on the basis of short notice. The period of loan in it is from 1 to 15 days with the view of liquidity, its place is just after cash. The loan receiver are those banks which face temporary shortage of cash and the loan provider are those banks which have temporary surplus of cash.

It is used by banks to control SLR (Statutory Liquid Ratio). These days, insurance companies, financial institutions and mutual funds also supply short term funds. The transactions of call money are done generally through telephone and documentary formality.

Dealing Process:

The number of those who deal with the help of this instrument is very limited but the amount of every dealing is very high. The minimum amount of this instrument is Rs. 10 crore but most of the dealing are of Rs. 100 crore. Its initial dealing is through telephone and paper work is completed later.

The creditor grants credit to the debtor by issuing a cheque of Reserve Bank of India. The debtor pays the loan through a cheque of Reserve Bank of India and gets back receipt. This loan is for a very short term but can be renewed as per need.

(4) Certificate of Deposit (CD):

Certificate of Deposit is a negotiable document. It can be transferred through endorsement after a certain period. It is issued by scheduled commercial banks and other financial institutions like IFCI, SIDBI, EXIM Banks etc. to people, federations, companies, corporations etc. The minimum marked price of certificate of deposit is Rs. 5 lakhs and it is essential for an investor to take certificate of deposit for the minimum amount of Rs. 25 lakhs. Its period is from 91 days to 1 year.

Dealing Process:

The duration of certificate of deposit is from 91 days to 3 year. It is issued on discount; it can be endorsed to any person after 45 days of purchasing. The stamp duty on it has to be paid on the basis of market price.

(5) Commercial Bill Market:

Bill Market refers to that sector in which short-term bills are purchased and sold. An organised bill market is very essential for the proper development of money market of any country, but unfortunately there has not been proper development of bill market in India so far now.

In the modern time, the transactions of goods are done both on cash and credit. In the situation of selling on credit, the seller wants to get an assurance of payment on a certain time from his purchaser or debtor. The purchaser can give the assurance of payment with the help of various kinds of credit instruments. These include bill of exchange, promissory note, hundi etc. b)

A secured loan is a loan backed by collateral—financial assets you own, like a home or a car—that can be used as payment to the lender if you don't pay back the loan.

The idea behind a secured loan is a basic one. Lenders accept collateral against a secured loan to incentivize borrowers to repay the loan on time. After all, the prospect of losing your home or car is a powerful motivator to pay back the loan, and avoid repossession or foreclosure.

When you apply for a secured loan, the lender will ask which type of collateral you'll put up to "back" the loan. If you have trouble paying the loan, the lender can put a lien on the collateral (a lien is the legal term for the lender's claim to the borrower's collateral.)

The lender can keep the lien active until the loan is fully paid. At that point, the lien is lifted, and the collateral ownership reverts back to the borrower. In the event the borrower defaults on a secured loan, the lender can retrieve the secured loan collateral and sell it to cover any losses incurred on the loan.

That's why it's imperative for secured loan borrowers to understand what asset they're using as loan collateral, and to weigh the value of that asset against a possible lien or collateral loss if the secured loan falls into default.

Types of Secured Loans

Secured loans come in multiple forms, but the three most common types of secured loans include three financial consumer loan mainstays, all requiring appropriate collateral before the loan is approved.

  • Mortgage Loans: Mortgage loans are at the top of the list of secured loans. Such loans are deemed "securable" by lenders because the borrower puts his or her house up as collateral. If the borrower doesn't pay back the secured loan, the home can go into foreclosure and the borrower can lose the home.
  • Vehicle Loans: Loans for autos, boats, motorcycles and even private airplanes are considered secured loans, as the vehicles are used as collateral in securing the loan. Just like with a mortgage, failure to repay the secured loan can result in the vehicle being repossessed by the lender.
  • Secured Credit Cards: For consumers with no credit history, secured credit cards are a good way to get credit and build up your credit scores. Yet unlike a mortgage or vehicle secured loan, secured credit cards require a cash deposit as collateral. If the card user doesn't pay the monthly bill, the cash deposit can be withdrawn from the card user's account, and applied toward the bill.

What Types of Collateral Can be Used to Back a Secured Loan?

Any asset allowed by law can be used to obtain a secured loan, although lenders will seek collateral that is liquid (i.e., easily sold for cash) and has a value roughly equal to the secured loan amount being borrowed.

Typically, secured loan collateral comes in the following forms:

  • Real estate, including any financial equity earned since purchasing the residence
  • Bank accounts, including checking accounts, savings accounts, certificates of deposit accounts, and money market accounts
  • Cars, trucks, SUVs, motorcycles, boats, or other vehicles
  • Stocks, mutual funds, or bond investments
  • Insurance policies, including life insurance
  • Precious metals, high-end collectibles, and other valuables.   

    An unsecured loan is more straightforward – you borrow money from a bank or another lender and agree to make regular payments until it’s paid in full.

    Because the loan isn’t secured on your home, the interest rates tend to be higher.

    If you don’t make the payments, you might incur additional charges. This could damage your credit rating.

    Also, the lender can go to court to try and get their money back.

    This could include applying for a charging order on your home - although they should make clear upfront, whether or not this is part of their business strategy.

    Some loans might be secured on something other than your home - for example, it could be secured against your car, or on jewellery or other assets that you pawn, or you could get a loan with a guarantor (such as a family member or friend) who guarantees to make repayments if you can’t.

    How to get the best deal

  • If you have decided that a secured loan is the best choice for you, then your first step should be to approach your mortgage lender to see what they offer. Some will offer special deals to those borrowers who have a good record repaying their mortgage.
  • Next, check some comparison websites to see if you can get a better deal with another lender. However, bear in mind that comparison websites do not always offer a comprehensive selection of deals. As well as researching the cost of borrowing, be sure to compare the terms and conditions of each loan and what could happen if you’re unable to repay.
  • If you’re comparing lots of deals, for example on a comparison site, check whether this will show up on your credit file. Some lenders will carry out a full credit check on you before providing a quote, so it can look like you’ve actually applied for the loan. If this happens lots of times, it could harm your credit rating. Ask if they offer a ‘quotation search’ or ‘soft search credit check’ instead, which doesn’t show up on your credit reference file - this can be useful when you are shopping around and not yet ready to apply.
  • How to complain if things go wrong

    If you are unhappy, your first step should be to complain to the loan company.If you don’t get a satisfactory response within eight weeks you can complain to the Financial Ombudsman Service. C)

    A bank incurs some costs and also gains some benefits once it chooses to increase its bank capital. The main benefit of increasing bank capital lies in the fact that chances of insolvency are greatly minimized. This is because bank capital ensures that the bank has enough cash reserves, therefore, reducing the chances of bank runs occurring.

    The bank, however, incurs costs since its ROE (return on investment) is reduced. ROE reduces when banks decide to increase their capital.

    Importantly, capital is a source of funds that the bank uses to acquire assets. This means that, if a bank were to issue an extra dollar worth of equity or retain an additional dollar of earnings, it can use this to increase its holding of cash, securities, loans, or any other asset. When the bank finances additional assets with capital, its leverage ratio rises.

    Banks (and many other financial intermediaries) issue a far larger proportion of debt (relative to equity) than nonfinancial firms.

    Bank capital acts as self-insurance, providing a buffer against insolvency and, so long as it is sufficiently positive, giving bank management an incentive to manage risk prudently. Automobile insurance is designed to create a similar incentive: auto owners bear part of the risk of accidents through deductibles and co-pays, which also motivate them to keep their vehicles road-ready and to drive safely.

    When capital is too low relative to assets, however, bank managers have an incentive to take risk. The reason is straightforward. Shareholders’ downside risk is limited to their initial investment, while their upside opportunity is unlimited. As capital deteriorates, potential further losses shrink, but possible gains do not. Because shareholders face a one-way bet, they will encourage bank managers to gamble for redemption. This problem goes away as the level of capital rises. That is, when shareholders have more skin in the game, they will be exposed to greater losses and will encourage the bank managers to act more prudently

d,Bank managers should always seek the highest possible return on their assets”.

Management's most important job is to make good choices when allocating its resources and the best managers are great capital allocators.

These allocators can create more assets from the assets they already have and create more income for the company from those assets.

The major assets of a bank are its loans to individuals, businesses, and other organizations and the securities that it holds. It's liabilities are its deposits and the money that it borrows, either from other banks or by selling commercial paper in the money market.

Banks can increase their profitability by using leverage and profits can be measured by return on equity or return on assets.

Because of leverage, banks earn a much higher return on equity than they do on assets.

However, to purchase more assets, a bank needs to pay for it either with more liabilities or with bank capital. Therefore, if the owners want to earn a greater return, they would rather use liabilities rather than their capital because this greatly increases their return.

When a bank increases its liabilities to pay for assets, it is using leverage- otherwise, a limit to bank's profit would be the fees that it can charge and its interest rate spread.


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