ECONOMICS BY PRATHAM SINGH

MONEY & BANKING (GE) (CBCS)

Unit -2:Financial Institutions,
Markets, Instruments And Financial
Innovations
PART- B
Financial Innovation

(Go to My YouTube Channel for the playlist videos of this Unit)

Concept – 2
Future Contract / Financial Futures (Important For Exam)
A future contract is a tradable agreement to buy or sell a particular asset on a particular date in
future at a particular price. They are used to hedge against price risk and to avoid adverse
movements. Future contract or futures are exchange traded instruments in electronic format.

Functioning of Financial Futures

• A buyer (Long Position) of Future agrees to take possession or charge of an asset (underlying
asset) at fixed price. On contrary, A seller (Short Position) promises to sell or deliver the
asset to buyer at agreed price.
• The Future contract is a binding agreement and the price at which parties to the contract
transact is called the Future’s Price.
• For Example, As on 8 May 2022, the Price of 31 st December Gold Future is quoted at
₹50,000 per 10 Grams. Then the Price of Gold Future is ₹50,000 at which the buyers and
sellers can agree to trade for Delivery of Gold contract expiring in 31st December 2022.
 ECONOMICS BY PRATHAM SINGH
Some Basic Concepts Under Financial Futures
1) Position & Profits
• When an investor is a buyer of future contracts, he is said to have taken a Long
Position.
• When an investor is a seller of Future Contracts, he is said to have taken a Short
Position.
• When the contract price changes in the Future, the difference between the agreed
price and the actual price results in Profit or Loss.
• When Price of the Contract rises in Future
- It gives profit to the Buyer (Long Position) & Loss to the Seller (Short Position)
• When Price of the Contract Falls in Future
- It gives Loss to the Buyer (Long Position) & Profit to the Seller (Short Position)

2) Settlement Date
• A contract is considered to be ‘Completely settled’ if the Party to contract enters an
opposite transaction against his initial position. The Contract is complete only if :
▪ Buyer settles a position by selling the contract and
▪ Seller settles a position by buying the contract
• The contracts where the investors does not engage in opposite position for settlement
are called Open Position or Open Contracts.
• Example: As investor who bought a 31st December Delivery contract of Gold on 8
May 2022 can settle the contract or close the position by selling the contract prior to
the delivery or expiry data. If he closes the position on 11 October, then the settlement
date will be October and the profit or loss will be calculated for the price prevailing
in September.
 ECONOMICS BY PRATHAM SINGH
3) Clearing House
There is an intermediary in the derivatives market which is called Clearing House. During
the Transaction, each party to the contract requires someone to take an opposite position to
help complete the transaction. When a buyer tries to purchase an asset, the clearing house
become the counter party to the transaction and sells the assets. Similarly, for a seller, the
clearing house negotiates by buying the asset.
Such provision help in reducing the risk of solvency of the counter party. Clearing House
builds the confidence among the investors by not worrying about the defaults by other
investors. It is the very reason that settlements are made easy and investors can liquidate
their position prior to the date of expiry.

4) Initial Margin
An Exchange always suffers from the risk of default whereby a contract holder might default
on fulfilling the contract. In order to protect itself, the exchange charges a fee for the
contract, which is called the Margin. When an investor initially enters a transaction, he is
charged an ‘initial Margin’ which he must deposit with the broker. The amount of margin is
a fraction of the total value of an asset. It provides a sense of security against the contract.
The price of a contract fluctuates on daily basis, leading to changes in the returns on every
contract. Such revision might result in the profit/losses which are adjusted through the
margin money kept in the investors account which he deposits.

5) Maintenance Margin
In case of a loss, the margin cannot fall below a level called the ‘maintenance margin’.
When there is reduction in the margin below the maintenance margin, the exchange will
direct the broker to alert the investor about this position. An investor must upgrade his
account with the money immediately to make his contract survive. And He need to deposit
all the amount which is equal to Initial Margin.
 ECONOMICS BY PRATHAM SINGH
6) Price Limits
when large number of buyers or sellers acquire a position in the market, these investors can
drive the market behaviour in their favour resulting in Uni-directional price movements. To
avoid such speculative activities, the exchange introduces daily price limits. Daily price
limits are set on every contract on daily basis. If the upper or lower price limits are reached,
the exchange stops the trading for few minutes until the new revised contract prices are
decided.

7) Leverage
Leverage is the ability to control a large contract value with a relatively small amount of
capital. For example, if you want to enter in a contract of 10gm Gold valued Rs. 50,000. So
you don’t need to deposit all Rs. 50,000. If the Margin Requirement is 10%, then you need
to deposit only Rs. 5,000 to enter in the contract of Rs. 50, 000. This is Called the Leverage
Effect.
Example of Future Contract
Price of Share = ₹100 Settlement Date = 11 October
No. of Contract / Shares = 1000
Margin Requirement (Leverage Effect) = 10%
Maintenance Margin = ₹6000
 ECONOMICS BY PRATHAM SINGH

Concept – 2
Forward Contract (Important For Exam)
• A forward contract is a non-standardized or customized contract where the parties to the
trade agree to exchange an asset at pre-determined price and date in the future time period.
• Forward contract are over the counter (OTC) contract.
• Forward contract are signed between the two parties, there is no involvement of Clearing
House to complete the transaction.
• It is Settled on the Maturity Date, it means there is no requirement of MTM (Mark to
Market).
• It is less liquid.
• Risk is High in Forward Contract.
• There is No Regulated Authority for Forward Contract.
 ECONOMICS BY PRATHAM SINGH

Concept – 3
Option Contract : Call Option & Put Option
(Important For Exam)
• An option contract is a right and not an obligation. It enables the buyer of an option to
purchase or sell an asset without a boundation or obligation as per his will.
• There are two parties to an option; a buyer of the option and a writer/seller of the an option.
• Seller of an option contract provide power to the buyer to take decision about the asset at
his free will. The buyer is not obliged or forced upon to exercise his right. In exchange of
this right, the buyers pays the writer of an option, a price which is referred to as the ‘Option
Price’.
• The option deals with the right to buy or sell an underlying asset at a price called ‘exercise
price’ or ‘strike price’.
• The Option which grant right to buy an asset is called a ‘Call option’.
• The Option which grant the right to sell the asset is called a ‘Put Option’.
• Option can be classified into four types :
- Buying a call Option (or Long Call)
- Selling a call Option (or Short Call)
- Buying a Put Option (or Long Put)
- Selling a Put Option (or Short Put)
 ECONOMICS BY PRATHAM SINGH
Case – 1 : Buying a Call Option
Buying a call option or long call means the investor has purchased the right to buy the
asset on a specified date at a specified strike or exercise price.
Assume that a call option is purchased by an investor named Pratham from another investor
named Champa for an asset with strike price ₹1000. Champa is the seller of the option and
Pratham is the buyer of the call option. The Price paid to acquire such option is set at ₹30.

Risk & Return Characteristic of Buying a Call Option

Since the Option is about buying the assets from Champa, the investor Pratham will buy this
assest only if the assets is available at a lesser price than the market price on the date of
expiry. Here, he buys the assets from champa at cheaper price and sells it in the market at
higher price. But strategies will change with the change in the market price of the assets.
Let’s consider some of the strategies at different market price and look at the risk and
return for Pratham, the buyer of the call Option.
(a) If the Market Price of the assets is 1140, Pratham will exercise the option. It will result
in profit after adjusting the option price. In this case, pratham will get the profit of
1140 – 1000 – 30 = 110.
 ECONOMICS BY PRATHAM SINGH
(b) If the Market Price of the assets is 1100, Pratham will exercise the option. It will result
in profit after adjusting the option price. In this case, pratham will get the profit of
1100 – 1000 – 30 = 70.
(c) If the Market Price of the assets is 1015, Pratham will exercise the option. It will
minimize the loss. In this case, pratham will bear the loss of 1015 – 1000 – 30 = -
15. On the other Hand, if Pratham will choose to not exercise the contract, then his
loss would have been 30.
(d) If the Market Price of the Assets is 1000, Pratham will be indifferent between
choosing to buy the asset from the market or buying the asset from Champa. Because
if he comes to the contract, the loss will be 1000 – 1000 – 30 = - 30. And if he don’t
come to the contract, the loss also will be of Rs. 30.
(e) If the Market price of the assets is 950, then it is not profitable for pratham to come
to the contract. Because the assets is cheaper in the market at Rs. 950 than the buying
from Champa at Rs. 1000. He will not exercise the option but bears the cost of option
of Rs. 30.
(f) If the Market Price of the assets is Rs. 900, then it is not profitable for pratham to
come to the contract. Because the assets is cheaper in the market at Rs. 900 than the
buying from Champa at Rs. 1000. He will not exercise the option but bears the cost
of option of Rs. 30.
Any price below the 1000 will attract a constant maximum loss of Rs. 30 of Option
price.
 ECONOMICS BY PRATHAM SINGH
Case – 2 : Writing / Selling a Call Option
The situation of seller or writer is completely opposite to that of the buyer of a call
option. The Profit of Buyer is Unlimited and Loss is Limited. Whereas, the profits of
the seller is Limited and Loss is Unlimited.
Here is the same example.
Assume that a call option is purchased by an investor named Pratham from another investor
named Champa for an asset with strike price ₹1000. Champa is the seller of the option and
Pratham is the buyer of the call option. The Price paid to acquire such option is set at ₹30.

Risk & Return Characteristic of Buying a Call Option

Since the Option is about buying the assets from Champa, the investor Pratham will buy this
assest only if the assets is available at a lesser price than the market price on the date of
expiry. Here, he buys the assets from champa at cheaper price and sells it in the market at
higher price. But strategies will change with the change in the market price of the assets.
Let’s consider some of the strategies at different market price and look at the risk and
return for champa, the seller of the call Option.
(a) If the Market Price of the assets is 1140, Pratham will exercise the option. It will result
in profit after adjusting the option price. In this case, pratham will get the profit of
1140 – 1000 – 30 = 110. But here champa will get the loss of 110.
 ECONOMICS BY PRATHAM SINGH
(b) If the Market Price of the assets is 1100, Pratham will exercise the option. It will result
in profit after adjusting the option price. In this case, pratham will get the profit of
1100 – 1000 – 30 = 70. But here champa will get the loss of 70.
(c) If the Market Price of the assets is 1015, Pratham will exercise the option. It will
minimize the loss. In this case, pratham will bear the loss of 1015 – 1000 – 30 = -
15. On the other Hand, if Pratham will choose to not exercise the contract, then his
loss would have been 30. But here champa will get the profit of 15.
(d) If the Market Price of the Assets is 1000, Pratham will be indifferent between
choosing to buy the asset from the market or buying the asset from Champa. Because
if he comes to the contract, the loss will be 1000 – 1000 – 30 = - 30. And if he don’t
come to the contract, the loss also will be of Rs. 30. Here champa will get the profit
of 30.
(e) If the Market price of the assets is 950, then it is not profitable for pratham to come
to the contract. Because the assets is cheaper in the market at Rs. 950 than the buying
from Champa at Rs. 1000. He will not exercise the option but bears the cost of option
of Rs. 30. Here champa will get the profit of 30.
(f) If the Market Price of the assets is Rs. 900, then it is not profitable for pratham to
come to the contract. Because the assets is cheaper in the market at Rs. 900 than the
buying from Champa at Rs. 1000. He will not exercise the option but bears the cost
of option of Rs. 30. Here champa will get the profit of 30.
Any price below the 1000 will give a constant maximum profit of Rs. 30 of Option
price.
 ECONOMICS BY PRATHAM SINGH
Case – 3 : Buying a Put Option
Buying a Put option or long Put means the investor has purchased the right to sell the
asset on a specified date at a specified strike or exercise price.
Assume that, Jethalal and Bhide come to an agreement of an Asset. Jethalal is the Seller of
the Asset and Bhide is the Buyer of the Asset. A Put option is purchased by an Jethalal from
Bhide for an asset with strike price ₹500. Jethalal is the buyer of the option and Bhide is the
seller of the Put option. The Price paid to acquire such option is set at ₹20.

Risk & Return Characteristic of Buying a Put Option

Since the Option is about selling the assets to Bhide. The investor jethalal will sell this
assest to Bhide only if when selling price of assets is higher than the market price on the
date of expiry. Here, he sells the assets to bhide at higher price and buys that assets from the
market at lower price. But strategies will change with the change in the market price of the
assets. Let’s consider some of the strategies at different market price and look at the risk
and return for Jethalal, the buyer of the put Option.
(a) If the Market Price of the assets is 440, Jethalal will exercise the option. It will result
in profit after adjusting the option price. In this case, Jethalal will get the profit of 500
– 440 – 20 = 40.
 ECONOMICS BY PRATHAM SINGH
(b) If the Market Price of the assets is 460, Jethalal will exercise the option. It will result
in profit after adjusting the option price. In this case, Jethalal will get the profit of 500
– 460 – 20 = 20.
(c) If the Market Price of the assets is 480, Jethalal will exercise the option. In this case,
Jethalal will bear No loss (500 – 480 – 20 = 0, Called Break Even Point). On the other
Hand, if Jethalal will choose to not exercise the contract, then his loss would have
been 20.
(d) If the Market Price of the assets is 490, Jethalal will exercise the option. It will
minimize the loss. In this case, Jethalal will bear the loss of 500 – 490 – 20 = -10. On
the other Hand, if Jethalal will choose to not exercise the contract, then his loss would
have been 20.
(e) If the Market Price of the Assets is 500, Jethalal will be indifferent between choosing
to sell the asset to the market or to Bhide. Because if he comes to the contract, the
loss will be 500 – 500 – 20 = - 20. And if he don’t come to the contract, the loss also
will be of Rs. 20.
(f) If the Market price of the assets is 540, then it is not profitable for Jethalal to come to
the contract. Because the assets price is higher in the market at Rs. 540 than the strike
price at Rs. 500. He will not exercise the option but bears the cost of option of Rs.
20.
Any price above the 500 will give a constant maximum loss of Rs. 20 of Option price.
 ECONOMICS BY PRATHAM SINGH
Case – 4 : Writing/Selling a Put Option
The situation of seller or writer is completely opposite to that of the buyer of a Put
option. The Profit of Buyer is Unlimited and Loss is Limited. Whereas, the profits of
the seller is Limited and Loss is Unlimited.
Assume that, Jethalal and Bhide come to an agreement of an Asset. Jethalal is the Seller of
the Asset and Bhide is the Buyer of the Asset. A Put option is purchased by an Jethalal from
Bhide for an asset with strike price ₹500. Jethalal is the buyer of the option and Bhide is the
seller of the Put option. The Price paid to acquire such option is set at ₹20.

Risk & Return Characteristic of Selling a Put Option

Since the Option is about selling the assets to Bhide. The investor jethalal will sell this
assest to Bhide only if when selling (Strike) price of assets is higher than the market price
on the date of expiry. Here, he sells the assets to bhide at higher price and buys that assets
from the market at lower price. But strategies will change with the change in the market
price of the assets. Let’s consider some of the strategies at different market price and look
at the risk and return for Bhide, the Seller of the put Option.
 ECONOMICS BY PRATHAM SINGH
(a) If the Market Price of the assets is 440, Jethalal will exercise the option. It will result
in profit after adjusting the option price. In this case, Jethalal will get the profit of 500
– 440 – 20 = 40. But, Here Bhide will get the loss of 40.
(b) If the Market Price of the assets is 460, Jethalal will exercise the option. It will result
in profit after adjusting the option price. In this case, Jethalal will get the profit of 500
– 460 – 20 = 20. But, Here Bhide will get the loss of 20.
(c) If the Market Price of the assets is 480, Jethalal will exercise the option. In this case,
Jethalal will bear No loss (500 – 480 – 20 = 0, Called Break Even Point). Here Bhide
will also bear No Profit. On the other Hand, if Jethalal will choose to not exercise the
contract, then his loss would have been 20. And here the profit of bhide would have
been 20.
(d) If the Market Price of the assets is 490, Jethalal will exercise the option. It will
minimize the loss. In this case, Jethalal will bear the loss of 500 – 490 – 20 = -10.
Here Bhide will get the profit of 10.On the other Hand, if Jethalal will choose to not
exercise the contract, then his loss would have been 20. And here the profit of bhide
would have been 20.
(e) If the Market Price of the Assets is 500, Jethalal will be indifferent between choosing
to sell the asset to the market or to Bhide. Because if he comes to the contract, the
loss will be 500 – 500 – 20 = - 20. And if he don’t come to the contract, the loss also
will be of Rs. 20. Here Bhide will get the profit of 20.
(f) If the Market price of the assets is 540, then it is not profitable for Jethalal to come to
the contract. Because the assets price is higher in the market at Rs. 540 than the strike
price at Rs. 500. He will not exercise the option but bears the cost of option of Rs.
20. Here Bhide will get the profit of 20.
 ECONOMICS BY PRATHAM SINGH
Difference between Future Contract & Option Contract

Concept – 4
Interest Rate Swap
• An interest rate swap is contractual agreement between two parties to exchange interest
payments. In which one stream of future interest payments is exchanged for another stream
based on a specified principal amount. In other words, Interest rate swaps usually involve
the exchange of a fixed interest rate for a floating rate or vice versa.
• For example, Party A agrees to make payments to Party B based on the fixed interest rate,
and Party B agrees to pay party A based on the floating interest rate.
• The floating exchange rate is based upon a reference rate (plus some differentials). The
floating exchange rate is decided using benchmark like LIBOR or MIBOR.
(LIBOR – London Interbank Offered Rate) & (MIBOR - Mumbai Interbank Offered Rate )
• In Interest Rate Swap Agreement, the Principal amount is Notional. Only Interest rate is
transferred between the counter parties.
• The notional principal amount refers to the predetermined amount in an interest rate swap
on which interest payments are based. It is the face value that is used to calculate interest
payments on financial instruments
 ECONOMICS BY PRATHAM SINGH
Pre-requisites of the Swap Agreement :
a) There should be Contrary objective of the Parties. Floating exchange rate buyers wants to
shift to the fixed exchange rate and Vice-Versa.
b) There is should be Commercial Need of the Counter Parties.
c) Currency Should be Same.
d) Amount of Loan Should be Equal to the Both Parties.

Numerical Example of Interest Rate Swap

Here, Aman & Bindu enter into an interest rate swap agreement on Notional Principal of
₹10 lakh, where Aman agrees to pay 6.75% fixed rate (since he wants to be a fixed rate
payer) and receives a floating rate from Bindu on the same notional principal at the rate of
MIBOR + 1.75%. Hence aman is also a floating rate receiver.
On the other hand, Bindu pay Aman the floating rate (since she wants to be a floating rate
payer) and receives the fixed rate from aman. Bindu is hence a fixed rate receiver and a
floating rate payer in this swap agreement.
By entering into the swap agreement, both Aman & Bindu are able to adjust their obligation
with respect to their interest rate expectations and are able to reduce their risk.
We can calculate the total cost or returns to both the parties to the contract.
For Aman
Inflows : MIBOR + 1.75%
Outflows : 6.75% + (MIBOR + 2%)
 ECONOMICS BY PRATHAM SINGH
Net Cost = Outflow – Inflow
= 6.75% + (MIBOR + 2%) - MIBOR + 1.75%
= 7%.

For Bindu :
Inflows : 6.75%
Outflows : 7% + (MIBOR + 1.75%)

Net Cost = Outflow – Inflow

= 7% + (MIBOR + 1.75%) - 6.75%
= MIBOR + 2%
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MONEY & BANKING (GE) (CBCS)

Unit -4 : Banking System
(Go to My YouTube Channel for the playlist videos of this Unit)
Concept – 1
NPA (Non – Performing Assets) (Important for Exam)
Concept of NPA
When a bank offers a loan, it charges interest on the amount, which is why it is regarded as an asset
to the bank. When the borrower stops paying the interest, or the principal, or both, the lender loses
money. Such a loan then becomes a non-performing asset (NPA) for the bank. The banking industry
in India is seriously affected by the NPA crisis with the rising number of defaulters.
As per the Reserve Bank of India (RBI), a loan is considered a “bad loan” or an NPA when the
interest payment is overdue for a period of 90 days. However, this time period may vary based on
the terms and conditions agreed upon by the bank and the borrower.

Types of NPA
Performing Assets (Standard Assets)
It is a kind of performing asset which creates continuous income and repayments as and when they
become due. These assets carry a normal risk and are not NPA in the real sense of the word. Hence,
no special provisions are required for standard assets.
Non Performing Assets
1) Sub-Standard Assets: Loans and advances which are non-performing assets for a period
of 12 months, fall under the category of Sub-Standard Assets.
2) Doubtful Assets: The Assets considered as non-performing for a period of more than 12
months are known as Doubtful Assets.
3) Loss Assets: All those assets which cannot be recovered by the lending institutions are
known as Loss Assets.
 ECONOMICS BY PRATHAM SINGH
Causes of NPA
1) Misutilisation : when borrower use the borrowed fund for some other purpose instead of
using it for the purpose he take loan. It causes NPA.
2) Willful Defaults : This is the common factor behind NPA. There are borrowers who are
capable of paying back loans but they intentionally do not repay. E.g., Nirav Modi (PNB
Bank)
3) No Proper Follow up : once the loan amount disbursed by the Bank to borrowers, banks
need to follow up or need to be in contact of borrower.
• Borrower can shift to new Address
• Borrower can shift to another country
4) Industrial Sickness : Industrial sickness is caused by many factors like lack of advance
technology, ineffective management, frequent change in govt. policy et. The banks that
finance such industries eventually end up with low recovery of their loans.
5) Ineffective lending : This is the another major reason for increasing NPA for bank. When
Loan is granted to a person without proper analysis of creditworthiness. May be Borrower
already having other loan too ; his earning are not good to repay loan; Purpose of Loan.
6) Natural Calamities : In countries like India, Natural calamities are a common occurrence.
These natural calamities lead to destruction of property and assets, thereby reducing the
payback capacities of the borrowers.
7) Economic Condition : In economy many stages come like Recession, Boom, Depression
etc. This Stages also affects the NPA. If the situation is tough in the economy like
Recession/Depression then it will increase the risk of NPA for Banks.
8) Pressure from Seniors : When the employee have pressure from their seniors to achieve
the target regarding the disbursement of Loan. Then, employee tried to achieve their target
by granting loan to the wrong Person whose creditworthiness is not good, or who is having
other loan, without proper background analysis also without incomplete documents.
9) Ineffective recovery Tribunal : Number of recovery tribunal have been setup by the govt.
for the purpose of recovery of loans and advances, Like The Debt recovery Tribunals (1993),
Lok Adalats (2001) etc. But these tribunals have not been very effective.
10) Lack of Demand : No one can accurately predict future demand for goods and services.
When businessman fail to accurately predict demand they end up having a large pile of
 ECONOMICS BY PRATHAM SINGH
unsold stocks. It leads to reduced profits thereby making entrepreneurs unable to repay their
loans and advances.
Impacts of NPA
1) Reduction in Profitability : Interest on Loan is the main income of the bank. High level of
NPA looses the Principal and Interest on Loan. As a result, it reduces profit.
2) Effects on Funding : Rise in NPA results in less funding to other borrowers due to fear of
further NPA. It will have negative impact on the whole economy.
3) Loss of Goodwill : Higher amount of NPAs reduces the profitability of the banks in reality
as well as in Balance sheet. It results poor image & poor goodwill of bank.
4) A twin balance sheet problem : Higher NPA put stress on the balance sheet of both, banks
and corporate houses.
5) Recapitalisation by Govt. : Govt Budget comes under pressure to bailouts (giving financial
assistance) have to be given.
6) Reduction in Share Price :Higher NPA reduces the goodwill of the Bank, which ultimately
lead to fall in the price of shares of that bank. Shares of Punjab National Bank (PNB) have
fallen in the BSE about 55 percent in a span of five months since the Rs. 13,600 crore Nirav
Modi fraud came to light.
7) Disclosure of the Bank : When NPA is very much high. It is impossible to recover the
amount of NPA. In such a case, bank may disclose.
8) Social & Political cost : Higher NPA reduces the Tax amount for government, it reduces
the dividend amount for the government etc. It ultimately affects the Development of the
economy.
Net NPA & GROSS NPA
1) Gross NPA : Gross NPA refer to the sum of all the loans that have been defaulted
(unpaid) by the borrowers. The gross non-performing asset does not amount to the actual
loss of the organization because the provision for unpaid debts has not been deducted.
2) Net NPA : Net NPA refers to the amount left after deducting all the provisions made for
NPA from Gross NPA.
Net NPA = Gross NPA – (Provision + Insurance claim + Collected Amount)
 ECONOMICS BY PRATHAM SINGH

Concept – 2
Two Episodes of NPA (Important For Exam)
▪ The problem of NPAs is not new for India's banking sector.
▪ Since the reforms of 1991, India has had two episodes of NPA problems, one during 1997-
2002 and the current one after the global financial crisis of 2008.
▪ The problem of NPAs in the current episode started around 2010 and aggravated (became
worse) after 2013.
▪ To compare and contrast the two high bank-NPA episodes, we describe the
macroeconomic and institutional differences and similarities across both the periods.
▪ Let’s Discuss these two episodes one by one.

Episode - 1
▪ The banking crisis that started around 1997 was preceded by a banking reforms initiated in
1991. As a result of these reforms, new private banks started operating roughly from 1995
onward.
▪ The reforms of the early 1990s also triggered a big investment boom in the economy. It also
give the way for foreign firms to enter. This created competition for the existing domestic
firms. Also when the licensing restrictions were removed, domestic firms rushed to expand
capacity. But several of them were not able to adapt to the changing environment or
competition from other domestic firms and foreign entrants and became economically
unviable (not capable to work). This resulted in stress in the advances (Loan) portfolio of
the commercial banks.
▪ Apart from private and PSU banks, there also existed financial intermediaries called
Development Finance Institutions (DFIs). DFIs such as IDBI, ICICI, and IFCI were critical
players in the financial sector in the 1990s. They were term-lending institutions that
extended long term finance to the industrial sector. Although the DFIs were not deposit
taking entities. Almost all the lending for new industrial projects (referred to as project
finance) was done by the DFIs while commercial banks focused mostly on working capital
finance.
▪ The DFIs had access to low cost capital from RBI. With the initiation of macroeconomic
and financial sector reforms in the 1990s, the operating environment for the DFIs underwent
 ECONOMICS BY PRATHAM SINGH
a significant change. Their access to low-cost capital was withdrawn which meant that DFIs
had to raise capital in the market. They also faced stiff competition from the banks that
started doing project financing but at lower rates. This caused severe stress in the financial
position of the DFIs and their NPAs accumulated to very high levels. By the late 1990s they
were no longer economically viable.
▪ In the late 1990s the Indian economy experienced a series of external shocks. The Asian
financial crisis happened in 1997. This was followed by India conducting nuclear blasts in
1998. Then there was the collapse of the Internet bubble in the US in 2000-2001. These
events led to a general slowing down of the economy. The average real GDP growth rate
between 1997 and 2002 slowed down to around 5% from an average of 7% during 1994-97.
In some sense, the banking crisis of 1997-2002 was an outcome of post-liberalisation
structural changes in the economy.
▪ From 1997 to 2002, Gross NPA amounted to 11% and Net NPA amounted to 6%. The NPA
of PSUs banks were higher than that of Private Sector Bank.

Episode - 2
▪ The Growth rate of NPA is significantly higher in present crisis than the Previous Crisis.
▪ GNPAs have ranged from 9.5% in 2017 to 7.5% in 2020.
▪ The period from 2003 to 2008 witnessed unprecedented economic growth, remarkable
growth in exports and favourable macroeconomic conditions in the form of low inflation
and low interest rates. India witnessed the period of economic boom.
▪ The banking sector also witnessed structural changes in the 2000s. There was a remarkable
increase in the volume of bank credit. Bank credit grew at a rate of 25% during 2003-2007.
The credit boom in general was larger during the mid 2000s than the one in the 1990s and
the NPA problem was also much bigger.
▪ With the death of the DFIs under the burden of ever growing NPAs, project financing
became a part of commercial bank lending. Providing credit for infrastructure became a part
of banking business. They also lent excessively.
▪ The roots of the present crisis can be traced to the excessive lending done by the banks
during the boom of 2003-2008. In 2008, the world witnessed the Global Financial Crisis.
As a result of the crisis India experienced a dramatic slowdown in growth, a massive
depreciation of the exchange rate, high inflation and a sustained period of monetary
 ECONOMICS BY PRATHAM SINGH
contraction during which RBI raised interest rates to deal with rising inflation. All of these
events caused havoc for the corporate sector and the banking sector. This led to a fresh wave
of NPAs especially in sectors such as infrastructure, steel, metals, textiles etc.

Concept – 3
Basel – 3 Introduction, Objectives & Norms
(Important For Exam)
▪ The Basel Committee (BCBS) was established by the Governor of central-banks of the Ten
countries at the end of 1974. The purpose of the committee to ensure that financial
institutions have enough capital to absorb unexpected losses. The first meeting took place
in February 1975 in Basel, Switzerland.
▪ The Basel Committee has established a series of international standards for bank regulations
which are commonly known as Basel I (1988), Basel II (2004) and most recently Basel III
(2010).
▪ Basel III is an internationally agreed set of measures/rules to strengthen the regulation,
supervision and risk management of banks.
▪ Basel III is developed by the Basel Committee on Banking Supervision in 2010 in response
to the financial crisis of 2008.
▪ Main Aim of Basel III are :
a) Improve banks stability to absorb losses/shocks
b) Improve risk Management & Governance
c) Strengthen Bank’s transparency & disclosure
d) Greater emphasis on Capital Adequacy Ratio

Norms Under Basel - III

▪ Micro-Prudential Norms (elements)
1) Capital Adequacy Ratio (CAR/CRAR)
2) Levarage Ratio
3) Liquidity Coverage Ratio
4) Net Stable Funding Ratio
 ECONOMICS BY PRATHAM SINGH
1. Capital Adequacy Ratio
Definition of Capital : Bank’s consist two types of Capital i.e., Tier – 1 Capital & Tier – 2 Capital.
Tier – 1 Capital is also called Going Concern Capital or Core Capital. And Tier – 2 Capital is also
called Gone Concern Capital (Supplementary Capital).
• Tier – 1 Capital is the capital which can absorb losses without triggering bankruptcy of the
bank. It includes Equity Share Capital, Reserves, Capital Reserve arising due to sale of
assets.
• Tier – 2 Capital is the capital which will absorb losses only in a situation of liquidation of
Banks. It includes Preference share capital, undisclosed reserve etc.
• Capital adequacy ratio (CAR) is an important measure of “safety and soundness” for banks
because it serves as a buffer or cushion for absorbing losses. It is also called Capital to risk
weighted assets ratio (CRAR).
• According to Basel III the CRAR of Banks should be minimum of 8%. (As per RBI,
Commercial Banks operating in India shall maintain a minimum of total capital of 9%).
2. Capital Conservation Buffer
• The capital conservation buffer was introduced to ensure that banks have an additional layer
of usable capital that can be drawn down when losses are incurred.
• The buffer is set at 2.5% of total risk-weighted assets.
• It must be met with Common Equity Tier 1 (CET1) capital only, and it is established above
the regulatory minimum capital requirement.
3. Countercycle Capital Buffer
• The CCCB is implemented as an extension of the capital conservation buffer.
• The CCCB is intended to protect the banking sector against losses that could be caused by
cyclical systemic risks increasing in the economy.
• The CCCB varies between 0 and 2.5% of total risk-weighted assets and must be met with
CET1 capital.
• The rule was first introduced in Basel III as an extension of another buffer (called the capital
conservation buffer).
• The RBI advised that the CCCB would be activated as and when the circumstances
warranted.
 ECONOMICS BY PRATHAM SINGH
4. Leverage Ratio
• Leverage ratio shows the amount to capital as compared to assets (majorly Loan) of the
Bank. The leverage ratio is a measure of the bank’s core capital to its total assets.
• Formula : Leverage Ratio = Tier – 1 Capital / Total Assets
• Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by
dividing Tier 1 capital by the bank's total assets; the banks were expected to maintain a
leverage ratio of minimum 3% under Basel III.
• As per RBI, minimum leverage ratio shall be 4% for Domestically Systemically Important
Banks (DSIBs) and 3.5% for other banks.

5. Liquidity Coverage ratio

• The LCR ensures that a bank should has an adequate stock of unencumbered high-quality
liquid assets (HQLA) that can be converted into cash easily and immediately to meet its
liquidity needs for a 30 calendar day to survive in liquidity stress scenario.
• LCR enhances banks' short-term resilience (Ability to absorb losses/shocks)
• Unencumbered means “not having any burden” or “Free from liabilities”
• HQLA means assets which can be easily and immediately converted into cash at little or no
loss of value.
6. Net Stable Funding ratio
• The Net Stable Funding Ratio (NSFR) - aims to promote resilience over a longer time
horizon.
• Stable funding is defined as types and amounts of equity and liability financing expected to
be reliable sources of funds over a one-year time horizon.
 ECONOMICS BY PRATHAM SINGH

Basel 2, Basel 3 & RBI

Concept – 4
10 Questions on Basel – 3 : Dr. D Subbarao
(Important For Exam)
Q1. There is a view that it was actually the risk sensitive framework of Basel II that caused
the crisis. Is that view valid?
Ans: According to Dr. D Subbarao. The view is valid, but only partly. Let’s understand this.
There are many charges against basel II :
a) Charge – 1 : In good times (Boom), banks are doing well and the market is willing to invest
capital in Banks. But Basel II does not impose significant additional capital requirement on
banks. (This provision started in Basel III in the form of CCB and CCCB). On the other
hand, in stressed times (Recession), Banks require additional capital. But markets are wary
(afraid) of supplying that capital. As we saw during the crisis (2008), it was the failure for
banks to bring in capital.
b) Charge – 2 : The second charge against Basel II was that even as it was supposedly risk
sensitive, but it did not bring in any corresponding changes in the definition and composition
of regulatory capital in response to actual change in the market dynamics. Basel II failed to
measure The risk from the complex derivative products that were coming on to the market
 ECONOMICS BY PRATHAM SINGH
in a big way. And banks don’t have sufficient capital to mitigate that risk or to absorb the
losses.
c) Charge – 3 : The third charge against Basel II about leverage. Note that Basel II did not
have any provision of leverage. At that time, Banks had excessive leverage. Excessive
leverage of banks was one of the prime causes of the crisis. Because, Basel II did not cover
liquidity risk. Since liquidity risk, if left unaddressed, could convert into a solvency risk,
this proved to be cause of the crisis.
d) Another Problem in Basel – II was it focusing exclusively on individual financial
institutions, it was ignoring the interconnectedness across institutions (GSIB and DSIB)

Q2. How is Basel III an improvement over Basel II?

Ans : Following Key points explains the improvement of Basel III over Basel II.
1) Better Capital Quality : Much stricter definition of capital, High loss absorbing capacity.
2) Introduction of Capital Conservation Buffer : 2.5% of RWA
3) Introduction of Countercycle Capital Buffer : 0% to 2.5% of RWA
4) Minimum Common Equity Tier – 1 Capital : 4.5 % in lieu of 2%
5) Minimum Total Capital requirement : 10.5 % in lieu of 8%
6) Introduction of Leverage Ratio : 3%
7) Introduction of Liquidity Ratio (LCR and NSFR) : 30 Days and 1 year
8) Provisioning norms : For expected Loss
9) Disclosure Norms : Disclose all relevant details
(Explain all the above points yourself)
 ECONOMICS BY PRATHAM SINGH
Q3. What is the additional capital that Indian banks have to mobilize to conform to Basel III?
What are the options for, and challenges in, raising this size of capital?
Ans: Indian banks already meet the minimum capital requirements of Basel III, even though some
individual banks may have to top up. Currently, the bank credit – GDP ratio in India is around 55
per cent. (A higher credit-to-GDP ratio indicates aggressive and active participation of the banking
sector in the real economy).
But, Our economy goes through a structural transformation, the share of the industry sector will
increase and the credit-GDP ratio will rise even further. It means is that Indian banks would have
been required to raise additional capital even in the absence of Basel III in near future.
The reserve bank estimated an additional capital requirement of 5 Trillion, of which 3.25 will be
the non – equity capital and 1.75 will be the equity capital at the end of March 2018.
The additional equity capital requirement of the order of 1.75 trillion raises two questions.

1. Can Market provide capital of this size?

The amount the market will have to provide will depend on how much of the recapitalization burden
of PSBs the Government will meet. Market will have to provide will be in the range of 700 billion–
1 trillion. Over the last five years, banks have revised equity capital to the tune of 520 billion
through the primary markets. Raising an additional 700 billion– 1 trillion over the next five years
from the market should therefore not be an insurmountable problem.

2. Second, what will be the burden on the Government in capitalizing public sector banks (PSBs)
and what are its options?
Government which owns 70 per cent of the banking system. If the Government opts to maintain its
shareholding at the current level, the burden of recapitalization will be of the order of 900 billion;
on the other hand, if it decides to reduce its shareholding in every bank to a minimum of 51 per
cent, the burden reduces to under 700 billion.

Q4. Will Basel III hurt growth?

Ans: In India credit demand will expand rapidly than the GDP because :
• India will shift increasingly from services to manufactures, and the credit intensity of
manufacturing is higher than that for services.
 ECONOMICS BY PRATHAM SINGH
• Second, we need to double our investment in infrastructure which will place enormous
demands on credit.
• Finally, financial inclusion, which both the Government and the Reserve Bank are driving,
will bring millions of low income households into the formal financial system with almost
all of them needing credit.
All this means is that we are going to have to impose higher capital requirements on banks as per
Basel III at a time when credit demand is going to expand rapidly.
Empirical research by economists shows that even if Basel III may impose some costs in the short-
term, it will secure medium to long term growth prospects.

Q5. How will Basel III affect the profitability of banks? Will it alter their incentive structure?
Ans: Basel III requires higher and better quality capital. For Sure, the cost of equity capital is high.
The average Return on Equity (ROE) of the Indian banking system for the last three years has been
approximately 15%. Implementation of Basel III is expected to a decline in Indian banks’ ROE in
the short-term. However, the expected benefits arising out of a more stable and stronger banking
system will provide the more ROE in the medium to long term.

Q6. Does India really need Basel III? Don’t the costs outweigh the benefits?
Ans: Adoption of Basel III was not compulsory for India. It is voluntary. But, According to RBI,
India should transit to Basel III because of the following reasons :
The most important reason is that as India integrates with the rest of the world, as many Indian
banks go abroad and many foreign banks come on to our country. we cannot afford to have a
regulatory deviation from global standards. Any deviation will hurt us both.
The lower standard regulatory regime will put Indian banks at a disadvantage in global competition.
We have to recognize that Basel III provides for improved risk management systems in banks. It is
important that Indian banks should adopt Basel III. It provides us cushion to absorb losses and
system to tackle with shocks. Some of the prescriptions of Basel III have already been in existence
in India, and the net additional burden will be lower than we tend to imagine.
 ECONOMICS BY PRATHAM SINGH
Q7. The Reserve Bank has already rolled out (started) the implementation of Basel III even
as many countries are yet to do so. Why did you have to front run and why are some of your
regulations more onerous (difficult) than required under Basel III?
Ans: The Reserve Bank issued final guidelines on Basel III capital regulation in May 2012 These
guidelines were to be implemented as on January 1, 2013 in a phased manner and were to be fully
implemented as on March 31, 2018. We have not advanced the start date. It is the same as the
internationally agreed date of January 1, 2013. However, we have advanced the end date from the
internationally agreed date of December 31, 2018 by nine months to March 31, 2018. We did this
to align our date with the close of the Indian fiscal year, which is March 31. We could have gone
up to March 31, 2019, but that would have overshot the Basel III prescription by three months and
would have attracted adverse notice. Our assessment is that the cost of that adverse notice will far
exceed the marginal burden of a slightly earlier close date. So, we settled for March 31, 2018.
The Reserve Bank has prescribed higher capital and leverage norms for Indian banks than the Basel
III minimum. The minimum total capital in Basel – 3 is to be 8% but India will maintain this
minimum capital requirement at 9%. Similarly, Reserve Bank prescribed a higher leverage ratio,
4.5 per cent, against the Basel III norm of 3 per cent. The higher prescription is intended to address
any judgmental error in capital adequacy viz. wrong application of standardized risk weights,
misclassification of asset quality etc.
The Reserve Bank’s prescriptions were a percentage point higher than the international norms.
Experience shows that this prescriptions on our part had been helpful and was positive on the cost-
benefit calculus.
Please note that India has not been an outlier in prescribing higher capital standards. Several other
jurisdictions, particularly Asian countries, have proposed higher capital adequacy ratios under
Basel III.
 ECONOMICS BY PRATHAM SINGH
Q8. What are the potential challenges in implementing the countercyclical capital buffer?
Ans: Countercyclical capital buffer mandates banks to build up a higher level of capital in good
times that could be used in times of economic contraction. This is conceptually neat, but is
challenging in operational terms. The foremost challenge is identifying the inflexion point in an
economic cycle which should trigger the release of the buffer. Too early or too late can be costly
in macroeconomic terms. The identification of the inflexion point therefore needs both a better
database (long series data on economic cycles) more refined statistical skills in analyzing economic
cycles.

Q9. What are D-SIBs? Will any Indian bank be classified as a D-SIB?
Ans: D-SIB (Domestic Systemically Important Banks ) means that the bank is too big to fail.
According to the RBI, some banks become systemically important for the whole economy. If such
a bank fails, there would be significant disruption in the overall economy.
Banks whose assets exceed 2% of GDP are considered part of this group. In India, SBI, HDFC and
ICICI falls the category of DSIB.
Similarly GSIB means Globally Systemically Important Banks. The list of G-SIBs is to be reviewed
annually. Currently, no Indian bank appears in the list of G-SIBs.

Q10. What sort of capacity building is required in the implementation of Basel III, especially
in the area of risk management? What should banks do and what should the Reserve Bank
do in this regard?
Ans: To efficiently implement Basel III, There is a need for building capacity within the banks and
also in the Reserve Bank which is the regulator.
There should be a radical change in banks’ approach to risk management. Banks in India are
currently operating on the Standardized Approaches of Basel II. The banks need to migrate to the
Advanced Approaches Which will enable banks to manage their capital more efficiently and
improve their profitability.
Advanced Approaches requires three things. (1) change in perception from looking the capital
framework as a compliance function to seeing it as a necessary pre-requisite for keeping the bank
sound, stable, and therefore profitable (2) Deeper and more broad based capacity in risk
management (3) Adequate and good quality data.
 ECONOMICS BY PRATHAM SINGH

MONEY & BANKING (GE) (CBCS)

Unit -5 : Central Banking
& Monetary Policy
(Go to My YouTube Channel for the playlist videos of this Unit)
Concept – 1
Monetary Policy & its Targets
Monetary policy is the macroeconomic policy laid down by the monetary authority of the country,
usually the central bank.
It involves management of money supply, availability of credit and interest rate.
Money Supply is applied in order to maintain price stability and to increase economic growth.
In the words of Harry G. Jhonson, the monetary policy means regulatory policy, whereby the
central bank maintains its control over the supply of money to achieve general economic objective.
In India, RBI construct the Monetary Policy.
Under the RBI Act,1934 (as amended in 2016), RBI is entrusted with the responsibility of
conducting monetary policy in India with the primary objective of maintaining price stability while
keeping in mind the objective of growth.

Objectives/Targets/Goals of Monetary Policy

1) Economic Growth : The monetary policy can influence economic growth by controlling
interest rate and its impact on investment. Decline in interest rate can boost up the level of
investment in the economy and vice versa. Fast economic growth is possible if the monetary
policy is succeeds in maintaining price stability.
2) Price Stability : Another Goal of the Monetary policy is attain economic stability or price
stability. Both inflation and deflation can harmful to an economy. Monetary policy tries to
keep the value of money stable. During Recession (Deflation), central bank adopts easy
 ECONOMICS BY PRATHAM SINGH
(expansionary) monetary policy and during Boom (Inflation), central bank adopts dear
(tight) monetary policy.
3) Trade Cycle Stability : Economy always faces trade cycle or Business cycle. Monetary
policy always tries to save the economy from the harmful effects of trade cycle. Like In
Recession, Central Bank adopts easy (expansionary) monetary policy and in Boom, Central
Bank adopts tight (dear) Monetary policy.
4) Full Employment : Monetary Policy aims at achieving full employment. In order to achieve
full employment, central bank adopts expansionary monetary policy which encourage credit
supply in the economy. It increases the investment as well as employment in the economy.
5) Exchange rate Stability : Exchange rate refers to the price of a domestic currency
expressed in terms of any foreign currency. The monetary policy aims at maintain the
stability in the exchange rate. The central bank by altering the foreign exchange reserve tries
to maintain the exchange rate stability.
6) Interest-rate stability : Interest-rate stability is important in an economy. Fluctuations in
interest rates can create uncertainty in the economy. Fluctuations in interest rates also affect
consumers’ willingness to buy durable goods, such as houses, motor cars, refrigerators,
washing machines or even personal computers. Monetary policy helps in maintain the
interest rate stability.

Concept – 2
Monetary Policy Tools/Instruments
There are two types of tools/instruments in Monetary Policy :
a) Quantitative Tools : The quantitative instruments are also known as general tools used by
the RBI (Reserve Bank of India). These instruments are related to the quantity and volume
of the money. These instruments are designed to control the total volume/money in the
economy. It affects all the sectors of the economy.
It includes Bank Rate, Repo Rate, CRR, SLR, Open Market Operation, Reverse Repo
Rate, Liquidity Adjustment Facility, Margin Standing Facility etc.
b) Qualitative Tools : Qualitative instruments are also known as selective instruments of the
RBI's monetary policy. These tools affects the selected sectors of the economy.
It includes Credit Rationing, Margin Requirement, Moral Suasion etc.
 ECONOMICS BY PRATHAM SINGH

Quantitative Tools
Bank Rate
a) It is also known as the discount rate. Bank rates are interest charged by the Central Bank
for providing funds and loans to the Commercial bank. It is for Long – Term.
b) An increase in bank rate increases the cost of borrowing by commercial banks which
results in the reduction in credit volume to the banks and hence the supply of money
declines. An increase in the bank rate is the symbol of the tightening of the RBI monetary
policy.
c) Similarly, an decrease in Bank rate, decreases the money supply in the economy. It is the
symbol of expansionary Monetary Policy.

Repo Rate
a) Repo rates also called Repurchase Rate. Repo rates are interest charged by the Central Bank
for providing funds and loans to the Commercial bank. It is for Short Term.
b) An increase in Repo rate increases the cost of borrowing by commercial banks which results
in the reduction in credit volume to the banks and hence the supply of money declines. An
increase in the Repo rate is the symbol of the tightening of the RBI monetary policy.
c) Similarly, an decrease in Repo rate, decreases the money supply in the economy. It is the
symbol of expansionary Monetary Policy.

Reverse repo rate

a) Reverse repo rate is the rate at which the central bank of a country borrows money from
commercial banks within the country. OR it is the rate at which commercial bank of a
country park their surplus money with the Central Bank.
b) An increase in Reverse Repo rate decreases the cash reserve of commercial banks. It reduces
the in credit volume in the economy and hence the supply of money declines.
c) Similarly, an decrease in Reverse Repo rate, increases the money supply in the economy.
 ECONOMICS BY PRATHAM SINGH
Cash Reserve Ratio
a) Cash Reserve Ratio is the minimum proportion of Total Deposit (Net Time & Demand
Liabilities) which the commercial banks are required to keep with the Central Bank in the
form of reserves or balances.
b) The higher the CRR with the Central Bank, the lower will be the liquidity in the system and
lower will be the Loan in the economy, which results fall in the Money Supply.
c) Similarly, The lower the CRR, higher will be the money Supply in the economy.

Statutory Liquidity Ratio

a) Statutory Liquidity Ratio is the minimum proportion of Total Deposit (Net Time & Demand
Liabilities) which the commercial banks are required to keep with themselves in the form of
reserves or balances.
b) The higher the SLR, lower will be the Loan in the economy, which results fall in the Money
Supply.
c) Similarly, The lower the SLR, higher will be the money Supply in the economy.

Open market operation

a) An open market operation refers to the buying/selling of securities like government bond
with public and banks.
b) The RBI sells government securities to control the flow of credit and buys government
securities to increase credit flow.

Qualitative Tools
Margin Requirements
a) Margin is the difference between the amount of Loan and the market value of the security
offered by the borrower against the loan.
b) An increase in margin requirement reduces the borrowers capacity. Thus, there would be
less credit creation in the market.
c) On the other hand. A fall in margin requirements encourages the people to borrow more.
Thus, there would be more credit creation in the market.
 ECONOMICS BY PRATHAM SINGH
Credit rationing or Selective Credit Control
a) Credit rationing refers to a method in which the central bank give directions to commercial
banks to give or not to give credit for certain purpose to particular sectors.
b) This method restricts the flow of credit in undesirable sector & diverts it into the most
desirable sector.
c) For example: The central bank has raise the maximum ceiling on agriculture sector to
promote the flow of credit in Rural sector.

Moral suasion
a) Moral suasion is a request by the RBI to the commercial banks to take specific measures as
per the economy's trends.
b) For instance, RBI may direct banks not to give out certain loans.
c) If the commercial banks do not follow the advice extended by the Central Bank, no penal
action is taken against them.
d) The success of this method depends upon the co-operation between the Central Bank and
Commercial Banks.

Concept – 3
LAF & MSF
Liquidity adjustment facility (LAF)
A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily by the Reserve
Bank of India (RBI) that allows banks to borrow money through repurchase agreements (repos) or
to make loans to the RBI through reverse repo agreements.
This arrangement is effective in managing liquidity pressures and assuring basic stability in
the financial markets.
The RBI can use the liquidity adjustment facility to manage high levels of inflation. It does so by
increasing the repo rate, which raises the cost of servicing debt. This, in turn, reduces investment
and money supply in India’s economy
The RBI introduced the LAF as part of the outcome of the Narasimham Committee on Banking
Sector Reforms of 1998.
 ECONOMICS BY PRATHAM SINGH
Let’s assume a bank has a short-term cash shortage due to a recession in the economy. The bank
would use the RBI's liquidity adjustment facility by executing a Repo agreement by
selling government securities to the RBI in return for a loan with an agreement to repurchase those
securities back. For example, say the bank needs a one-day loan for 5 Crore Indian rupees and
executes a repo agreement at 6.25%. The bank's payable interest on the loan is ₹8,561.64 (₹ 5Crore
x 6.25% / 365).
Now let’s suppose the economy is expanding and a bank has excess cash on hand. In this case, the
bank would execute a Reverse repo agreement by making a loan to the RBI in exchange for
government securities, in which it agrees to repurchase those securities. For example, the bank may
have ₹2.5 Crore available to loan the RBI and decides to execute a one-day reverse repo agreement
at 6%. The bank would receive ₹4109.59 in interest from the RBI (₹2.5 Crore x 6% / 365).

Marginal standing facility (MSF)

Marginal standing facility (MSF) is a penal rate at which banks can borrow money from RBI when
they are completely exhausted of all borrowing assistance. It is used in an emergency when inter-
bank liquidity dries up completely.
The Marginal standing facility is a scheme launched by RBI while reforming the monetary policy
in 2011-12.
The Marginal Standing facility allows banks to borrow money with an interest rate above the repo
rate and can be termed as the Marginal standing facility rate.

Features of MSF
▪ Banks borrow from the RBI by pledging government securities at a rate greater than the
repo rate under LAF (liquidity adjustment facility).
▪ The MSF rate is pegged 100 basis points or a percentage point above the repo rate.
MSF = Repo Rate + 1%
▪ Under MSF, banks can borrow funds up to one per cent of their net demand and time
liabilities (NDTL).
▪ MSF is always equals to Bank Rate.
Bank Rate = MSF > Repo Rate > Reverse Repo Rate
▪ Banks can borrow through MSF on all working days except Saturdays.
 ECONOMICS BY PRATHAM SINGH
▪ The minimum amount for which RBI receives application is Rs.1 Crore, and afterwards in
multiples of Rs.1 Crore.
▪ MSF works as last resort for banks to borrow short term funds.
▪ MSF is eligible only for scheduled Commercial Banks. (Paid up Capital must be atleast 5
Lakh)

Difference between MSF & Repo Rate

a) Repo rate is charged on short-term loans, whereas MSF is charged on overnight or
emergency funds.
b) Repo rate is applicable for commercial banks, and MSF is applicable for eligible scheduled
banks.
c) In the case of repo rate, banks sell government securities against a repurchase agreement,
but for MSF, banks sell the extra government securities to avail funds.
d) When borrowing against the MSF rate, banks can use the SLR securities, which is not
allowed when borrowing against the repo rate.
e) MSF rate is always 0.25% higher than that of the repo rate. For Example, Current MSF Rate
is _________ and Current Repo Rate is ________.

Difference between MSF & LAF

 ECONOMICS BY PRATHAM SINGH

Concept – 4
Number of Independent Instruments & targets
In 1952, economist Jan Tinbergen pointed out that to achieve a certain number of targets requires
at least the same number of instruments. Thus, one target can be achieved with one instruments,
two targets with two instruments and so on. A Single Monetary Instrument cannot achieve all the
targets set by RBI.
It is shown in the Diagram.
The economy is initially at point E where AD
and SRAS intersects with price level Po and
Real GDP Yo. We assume that the policy maker
has two targets : one for the price level and one
for the real GDP.
The Target for the Price level is Pt and the target
for the real GDP is Yt as indicated by point T.
It requires shifting aggregate supply to right,
from SRAS to SRAS1 and Shifting Aggregate
Demand to the right from AD to AD1.

Thus, in this example two instruments : One that changes aggregate demand and one that changes
aggregate supply are sufficient to achieve two targets.
However, it is assume that the central bank has available two instrument, one that can shift
aggregate demand and one that can shift aggregate supply. But in reality, Central bank has more
than two instruments and they all affect only aggregate demand. The bank does not have control of
an instruments that can alter aggregate supply.

Now, Suppose central banks can only change the aggregate demand but cannot change the
aggregate supply. How will the central bank reaches the target level.
As you can see no shift in Aggregate Demand alone, with aggregate supply fixed, will move the
economy from point to E to point T. It is simply impossible which as Tinbergen’s point more than
70 years ago.
 ECONOMICS BY PRATHAM SINGH
The RBI can achieve target level Pt by Shifting AD to
AD3 but the equilibrium point H achieves the price
level target with output level Yh, which is below the
target level of Yt.
The RBI can achieve Yt by shifting AD3 to AD2 but
the equilibrium at point G achieves the output target Yt
with a price level Pg that is above the target level.
Finally RBI may choose equilibrium at point F where
price level is Pf and output level is Yf. Here both price and output targets are missed but the output
miss is less than at point H, and the price level miss is less than at point G.
It is important to note that all points lie on the original aggregate supply curve SRAS. It is the
inability to shift SRAS that forces the central bank to choose between hitting one target and missing
the other by relatively large margin, such as point G or H AND missing both targets by a relatively
smaller margin such as at point F.

Q. Policy may have both a final real GDP target and a final price level target. If so, the
monetary policymaker faces an instruments shortage. Can Fiscal Policy help solve this
problem?
OR How Monetary policy and Fiscal Policy both working together achieve the Dual targets
of Price & Output?
Ans : The instrument shortage problem here is due to the inability of monetary policy to shift
aggregate supply. If fiscal policy affects only aggregate demand, it cannot help achieve both the
price level and real GDP Targets.
However, we have seen that the Marginal Tax rates imposed by the fiscal authority might have
affect aggregate supply. If so, this enables fiscal policy to manipulate aggregate supply, with lower
marginal tax rates shifting it to the right and higher rates shifting it to the left. In such a situation,
fiscal policy might work with monetary policy to better achieve the dual final targets.
 ECONOMICS BY PRATHAM SINGH

Concept – 5
Link Between Money & Policy Targets
The RBI should change the money supply to deal with economic upheavals, it is important to keep
the underlying economic model in Mind.
We have two model : A long Run model and A Short Run Model.
The effect of change in Money supply differ in these models.
LONG RUN
Diagram Shows the achievement of Price level target in the Long Run.
The price level target is Pt and the economy starts in
equilibrium at either point E1 with AD1 or Point E2 with
AD2.
At E1, aggregate demand must be decreased to AD to
achieve the target level Pt. whereas, if the initial
equilibrium is at point E2, aggregate demand must be
increased to AD to achieve this target.
In either situation, appropriate changes in the money
supply can be used to shift aggregate demand and achieve
the price target.

The RBI has no control over long run Aggregate Supply Curve so
it cannot change the output or cannot achieve higher output level.
Hence, the AS curve is Vertical.
In the diagram, Economy starts at point E with a price level OP
and Output level OY. The Target level OYt is above the OY.
In an effort to increase the output towards the target level, the
Bank might increase the money supply and hence aggregate
demand, shifting AD to the right. But with a vertical aggregate
supply curve, this merely drives up the price level to OP1. Long Run output stays at OY. Thus, the
output target cannot be achieved in the long run. The RBI would waste its time and drive up the
price level, if it attempted to use monetary policy to increase output in the long run.
 ECONOMICS BY PRATHAM SINGH
SHORT RUN
In this case, short run aggregate supply is not vertical.
Here we begin with equilibrium at point E, with price level
P and Output Y. The Target level of output is Yt.
Now the RBI can increase the money supply, thereby
shifting the aggregate demand to the right and moving the
equilibrium to point T, where output equals to the target
Yt.
It is not possible to achieve two targets. If there are two
targets, Yt and OP the target of policy is point labelled as
T’. The RBI cannot achieve both OYt and OP by changing
the Money Supply and Aggregate Demand. In this case, bank faces a choice between point E (where
the price level target is achieved, but the output target is missed), Point T (Where the output target
is achieved, but the price level target is missed) or Some point on the line segment ET on the
aggregate supply curve, where both targets are missed by some amount smaller than the largest
miss at point E or T.

Concept – 6
Intermediate Targets
Intermediate targets are the targets that the central bank attempts so as to attain the final targets. In
other words, these are the targets that the RBI want to achieve because doing so would help to
achieve final targets.
They are aimed at ensuring better hitting of Final Targets.
Reason why RBI adopts Intermediate Targets :
a) These targets changes debate (direction) of monetary policy from difficult goal like full
employment, GDP growth, price stability to the debate (direction) over the goal for
intermediate target.
b) Intermediate targets provides the timely information which helps to judge the Success or
Failure of RBI in achieving Final Targets.
 ECONOMICS BY PRATHAM SINGH
Properties of a Good Intermediate Targets :
a) It should be consistent with the final goal or target of the monetary policy
b) It should be Accurately measurable on timely basis
c) It should be Controllable so that RBI can actually hope to achieve it

(1) Money Aggregate as an Intermediate Target

To target something like inflation rate or GDP growth rate, RBI can use money stock as an
intermediate target (via the quantity theory of money). RBI manipulates its instruments (Bank Rate,
CRR, SLR, RRR etc.) to keep the money supply at target level.
If money demand rises, it leads to an increase in the equilibrium Money stock level then RBI
reduces the money supply such that the new equilibrium level is achieved at the Money stock target
level. Although it achieves the Money stock level target but by doing so leads to an increase in the
interest rates.
Similarly, if money demand falls, it leads to an decrease in the equilibrium Money stock level then
RBI increases the money supply such that the new equilibrium level is achieved at the money stock
target. Although it achieves the Money stock level target but by doing so leads to an decrease in
the interest rates.
In the diagram, interest is shown on X-axis and
Nominal Money Stock is shown on Y-axis. Money
demand curve is downward sloping and Money
Supply curve is upward sloping (Endogenous Money
Supply Curve, it is the curve which is affected by the
rate of interest). Increase in the price level shift the
money demand curve to the Right from Md to Md1,
which shifts the equilibrium from A to B, At B
money stock rises from its target. RBI manipulates its
instruments, and reduces the money supply from Ms to Ms1 to achieve at the target level of money
stock at equilibrium C. Similarly, Decrease in the price level shift the money demand curve to the
left from Md to Md2, which shifts the equilibrium from A to D, At D money stock falls from its
target. RBI manipulates its instruments, and increases the money supply from Ms to Ms2 to achieve
at the target level of money stock at equilibrium E.
 ECONOMICS BY PRATHAM SINGH
(2) Interest Rate as an Intermediate Target
Now, consider the same situation for the case of an intermediate interest rate targets. RBI
manipulates its instruments (Bank Rate, CRR, SLR, RRR etc.) to keep the interest rates at target
level.
If money demand rises, it leads to an increase in the equilibrium interest rate level then RBI increase
the money supply such that the new equilibrium level is achieved at the interest rate target level.
Although it achieves the interest rate level target but by doing so leads to an increase in the money
stock.
Similarly, if money demand falls, it leads to an decrease in the equilibrium interest rate level then
RBI decreases the money supply such that the new equilibrium level is achieved at the interest rate
target. Although it achieves the interest rate level target but by doing so leads to an decrease in the
Money stock.
In the diagram, interest is shown on Y-axis and
Nominal Money Stock is shown on X-axis.
Money demand curve is downward sloping and
Money Supply curve is upward sloping
(Endogenous Money Supply Curve, it is the
curve which is affected by the rate of interest).
Increase in the price level shift the money
demand curve to the Right from Md to Md1,
which shifts the equilibrium from A to B, At B
interest rate rises from its target. RBI manipulates its instruments, and increase the money supply
from Ms to Ms1 to achieve at the target l evel of interest rate at equilibrium C.
Similarly, Decrease in the price level shift the money demand curve to the left from Md to Md2,
which shifts the equilibrium from A to D, At D interest rate falls from its target. RBI manipulates
its instruments, and decrease the money supply from Ms to Ms2 to achieve at the target level of
money stock at equilibrium E.
 ECONOMICS BY PRATHAM SINGH

Concept – 6
Problems in Monetary Policy Making
1) Time Lags
The time lag is the period between the time a monetary policy is implemented and the time an
economic impact is felt. These lags are of two types implementation lags and Effectiveness lags.
A) Implementation Lags
There is a time lag for the monetary policy implementation, which is called implementation lags.
It takes some months for the implementation of monetary policy.
Implementation lags have three category :
i) Information Lags : There is a lag in the availability of information about the state of the
economy. For example, it takes months for the information about Inflation, GDP,
unemployment etc.
ii) Recognition lags : After the getting information, Now policymakers have to decide about
the action needed to correct the state of the economy. The time taken for deciding this, called
Recognition lags. For example, they have to decide what should be the bank rate, repo rate,
CRR, SLR etc.
iii) Legislative Lags : After deciding the action Which is needed, there is a lag in the enactment
of the appropriate legislation needed for a policy to occur, which is called legislative lags.
For example, Monetary Policy have to pass through many committees for its
implementation.
B) Effectiveness Lags
The effectiveness lag is the time between a monetary policy action is taken and effects of
that policy are realized. Monetary policy involves longer delays; the time between a change
in monetary policy and its ultimate effect on economy may be between 12 or 13 Months or
more.
For example, if there is fall in Consumer Price index, then RBI will try to increase the price
level by increasing the money supply. This action immediately increases aggregate demand
and price level. But this is done quickly in theoretical model. In practical application of
monetary policy things do not occur quickly.
 ECONOMICS BY PRATHAM SINGH
The average length of recession in US since world war II has been less than one year. And
effectiveness lag for monetary policy can last take a year or even more. If a recession starts today,
we would expect it to be over before any monetary policy instrument could begin to finish it.
For this, Milton Friedman states that there should be increase in money supply at a constant rate of
3 percent regardless of business condition.
Another solution for this would be, central bank to forecast where the economy will be a year from
now so that it can take the appropriate action today. An action taken today would show its effect
after a year from now when the recession/depression starts. If the forecast was accurate, the policy
action taken today could help in achieving final targets. But unfortunately, economic forecasts over
a year or more are not very accurate.

2) Instrument Instability
Instrument instability can arise when a change in the instrument affect the targeted variable over a
number of future periods. Suppose, the central bank wants to keep the price level constant from
quarter to quarter. Then, if the price level is below target today, the bank will conduct an open
market purchase to raise the price level to the target within three months. In the following three
months , the increase in money supply due to the open market purchase in the first three months
continues to exert its influence on prices, causing the price level to rise. The central bank counteract
this only through open market sale to decrease the money supply. Furthermore, in the third three
months, the initial increase in the Money supply continues to cause prices to rise, while the
reduction in the money supply during the second three months causes price to fall. This dynamic
continues and the required open market operation necessary to only counteract the previous
changes in the money supply to keep the price level constant. This is called the instrument
instability, where the central bank must tolerate changes in the instrument to hold the targeted
variable at target.

3) Inaccurate Macroeconomic Models

Policy Makers works with a model of the economy, on the other hand macroeconomic models are
not very much accurate. Macroeconomic models have a poor reputation for empirical accuracy.
Macroeconomics has been criticised widely as subjective and untestable on the poor data available.
 ECONOMICS BY PRATHAM SINGH
Hence, Policy decision that appear correct based on a particular macroeconomics model may turn
out badly because the model used to formulate the policy is only an approximation of reality.

4) Conflicting Goals
We have seen how price level goals and output goals cause conflict when there is a change in the
aggregate supply. When policy action achieves the price level target, it lead to failure of output
target. And when policy action achieves the output target, it lead to failure of price target. Tin-
Bergen rightly said, when there are more goals than the independent instruments, the conflict
will rise.

5) Conflict Among Policy Makers

Policymakers have the conflict between them. Specifically the monetary policymakers and the
fiscal policymakers can choose conflicting goals. Monetary policy makers controls the money
supply. Fiscal policy makers controls governments spending and tax collection. In many countries,
these two policymakers are under the control of ruling government, but in the US (as well as
Germany & Switzerland), the monetary authority is largely independent of the fiscal policy makers.
The problem is that, monetary policy makers and fiscal policy makers may disagree over their
Goals. For example, the fiscal authority might have an output target and the monetary authority a
price level target.
 ECONOMICS BY PRATHAM SINGH

Past Paper Question (Delhi University)

November 2016
Q1. What are the intermediaries targets? Critically examine rate of interest and money
aggregates as intermediate targets. 7 Marks

Ans: Concept - 6

Q2. 'It is not merely the number of instruments that is important but the number of
instruments exerting independent effects on the target variables'. Explain this statement in
the context of monetary policy instruments targets. 8 Marks

Ans: Concept - 4

Q3. Explain the Lags in the operation of Monetary Policy. 7.5 Marks

Ans: Concept – 7 (Implementation Lags & Effectiveness Lags )

December 2017
Q1. There is a conflict between interest rate and money supply as an intermediate target of
achieving objectives of monetary policy. Which of the two, do you think is better & why?

Ans : Not in Notes (Follow DU Readings pg 684 to 687 or DD Chaturvedi Book pg 220 to 222)

Case for an Intermediate interest rate Targets

Case against an Intermediate interest rate Targets

Case for an Intermediate Money Targets

Case against an Intermediate Money Targets

Q2. What are the policy targets and instruments of monetary policy? What are the problems
associated with the operation of monetary policy?

Ans : Concept 1, Concept 2 , Concept 7

December 2018
Q1. Suppose monetary authority aims to target output & price level as final targets in its
monetary policy. Do you think that the monetary authority can successfully achieve both the
targets simultaneously in short run as well as in the long run?

Ans : Concept 5
 ECONOMICS BY PRATHAM SINGH
Q2. Critically examine rate of interest as intermediate targets.

Ans : Concept 6

Q3. Explain the lags in monetary policy.

Ans : Concept 7 (Implementation & Effectiveness Lags)

Q4. What is Liquidity adjustment facility (LAF) and how does it facilitate RBI to manage.

Ans : Concept 3

December 2019
No Exam in December 2019 Due to COVID-19

December 2020 (OBE)

Q1. Several variables can be placed in one or more of the following categories: policy
instruments, operating targets, intermediate targets, or final targets. Which of the following
variables can be placed in which of these categories and why?

(i) Non borrowed reserves

(ii) The interest rate
(iii) The money stock.

Ans : Non Borrowed Reserve = Operating Target

The Interest Rate = Intermediate Target

The Money Stock = Intermediate Target

Q2. What are the problems in monetary policy making faced by monetary authorities?

Ans : Concept 7
 ECONOMICS BY PRATHAM SINGH
Q3. Difference between Repos and Reverse Repos

Ans : Concept 2

December 2021 (OBE)

Q1. Can the central bank choose money aggregate as an intermediate target? Explain the
points in favour of and against the money aggregate as an intermediate target.

Ans : Topic 6 (Money Aggregate as an intermediate Target)

Favour of and against the money aggregate as an intermediate target (Not in Notes, follow
DU Readings pg 686, 687 OR DD Chaturvedi pg 221, 222)

Q2. Discuss the implementation lags & effectiveness lags.

Ans : Topic 7

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