ABC of Banking & the Banking Business

Financial System Framework

The world of Finance can be categorized into:

• Instruments: Shares, bonds etc – Financial instruments that get transacted in the financial markets by the institutions.

• Markets: Stock, Debt, Currency, Derivative markets – where financial institutions transact in the instruments mentioned above.

• Institutions: Banks, Financial Institutions

• Regulators: Central Banks – the Federal Reserve, Banque de France, Bundesbank, SEBI (India),SEC (USA) , FSA (UK)

What is a Bank?

The term ‘Bank’ is used to refer to any Financial Institution that is licensed to accept deposits, which are repayable on demand and issue credit money through loans. A bank channelises funds from Savers to Borrowers.

Why do we need a bank?

As Individuals:

• They provide a return (pay interest) on our savings.

• Safety of principal and interest

• Provide payment mechanisms: convenience of being able to write checks and use cards

• Raising funds when required (Home loans, Vehicle loans, Personal Loans)

As Institutions:

• Borrowing: They are the primary source of finance for businesses.

• Investing Surplus Funds: When businesses have temporary surplus cash, banks provide an Investing option.

• Transactions – FX: Banks act as the intermediaries for purchase and sale of foreign exchange.

• Advisory Services: Such as valuation of firms, guiding a firm through the IPO process etc.

• Trade and Commerce: Facilitation of business for Importers and Exporters. 

 The Central Bank and its functions.

 The Central bank of any country can be called the banker’s bank.

It acts as a regulator for other banks, while providing various facilities to facilitate their functioning. It also acts as the Government’s bank. The Federal Reserve is the Central Bank of the United States, while Reserve Bank of India is the Central Bank in India.

The main objective of a Central Bank is to provide the nation with a safer, more flexible, and more stable Monetary and Financial system. It has the following responsibilities:

• Conducting the nation’s Monetary Policy: Central banks define the monetary policy and then take necessary actions to create an environment to make those policies feasible. The Federal Open Market Committee (FOMC) releases interest rate guidances every 2 months, giving indications as to market interest rates.

• Ensuring Sufficient pool of funds: The CB can increase or decrease money supply through various means to control interest rates and inflation.

• Providing Financial Services to the Government: The CB acts as the Central Government’s bank and provides various services.

• Monitoring the Foreign Currency Assets and Liabilities: The Country will have foreign currency reserves and also need to make payments in forex. It is the CB’s responsibility to manage forex receipts and payments.

• Maintaining the Stability of the Financial System: The Central Bank supervises and regulates banks and financial institutions. Some key regulations affecting banks are the Capital Adequacy Ratio (CAR) and Reserve Requirements

 How do banks make Money?

Banks are like any other regulated business; the product they deal with is “Money”.

So they borrow money from Individuals or businesses who have money, and lend it to those who need money, by adding a mark up, to pay for expenses and profit. The difference between the rates, which banks offer to depositors and lenders is generally referred to as “Spread”.

(The term “Spread” is generic and refers to the difference in the purchase and sale prices of any financial instrument quoted by any financial “Intermediary” such as a bank, a broker, etc.) .

Banks also make money on fees, advisory services, trading profit, etc.

Structure of a Bank

The Service offerings of banks are organized along the following divisions:

• Retail Banking: Lending, deposit and branch banking services to individuals and small businesses

• Private Banking: Investment and relationship management for HNIs

• Corporate Banking: Lending, deposit and corporate finance services to businesses only

• Investment Banking: Trading and advisory Services

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