1. Monetary Policy
Monetary policy is the process by which the monetary authority of a country
control the supply of money, often targeting a rate ofinterest for the purpose of
promoting economic growth and stability. The official goals usually include relatively
stable prices and low unemployment.
Monetary theory provides insight into how to craft optimal monetary policy. It is
referred to as either being expansionary or contractionary, where an expansionary
policy increases the total supply of money in the economy more rapidly than usual, and
contractionary policy expands the money supply more slowly than usual or even shrinks
Expansionary policy is traditionally used to try to
combat unemployment in a recession by lowering interest rates in the
hope that easy credit will entice businesses into expanding.
Contractionary policy is intended to slow inflation in order to avoid the
resulting distortions and deterioration of asset values.
Monetary policy rests on the relationship between the rates of interest in an
economy, that is, the price at which money can be borrowed, and the total supply of
money. Monetary policy uses a variety of tools to control one or both of these, to
influence outcomes like economic growth, inflation, exchange rates with other
currencies and unemployment.
A policy is referred to as contractionary if it reduces the size of the money supply
or increases it only slowly, or if it raises the interest rate. An expansionary policy
increases the size of the money supply more rapidly, or decreases the interest rate.
Furthermore, monetary policies are described as follows: accommodative, if the interest
rate set by the central monetary authority is intended to create economic growth;
2. neutral, if it is intended neither to create growth nor combat inflation; or tight if
intended to reduce inflation.
Monetary policy is the process by which the government, central bank, or
monetary authority of a country controls (i) the supply of money, (ii) availability of
money, and (iii) cost of money or rate of interest to attain a set of objectives oriented
towards the growth and stability of the economy.
Trends in Central Banking
The central bank influences interest rates by expanding or contracting the
monetary base, which consists of currency in circulation and banks' reserves on deposit
at the central bank. The primary way that the central bank can affect the monetary base
is by open market operations or sales and purchases of second hand government debt,
or by changing the reserve requirements. If the central bank wishes to lower interest
rates, it purchases government debt, thereby increasing the amount of cash in
circulation or crediting banks' reserve accounts.
Alternatively, it can lower the interest rate on discounts or overdrafts (loans to
banks secured by suitable collateral, specified by the central bank). If the interest rate on
such transactions is sufficiently low, commercial banks can borrow from the central
bank to meet reserve requirements and use the additional liquidity to expand their
balance sheets, increasing the credit available to the economy. Lowering reserve
requirements has a similar effect, freeing up funds for banks to increase loans or buy
other profitable assets.
A central bank can only operate a truly independent monetary policy when
the exchange rate is floating. If the exchange rate is pegged or managed in any way, the
central bank will have to purchase or sell foreign exchange. These transactions in
foreign exchange will have an effect on the monetary base analogous to open market
purchases and sales of government debt; if the central bank buys foreign exchange, the
monetary base expands, and vice versa. But even in the case of a pure floating exchange
rate, central banks and monetary authorities can at best "lean against the wind" in a
world where capital is mobile.
3. Accordingly, the management of the exchange rate will influence domestic
monetary conditions. To maintain its monetary policy target, the central bank will have
to sterilize or offset its foreign exchange operations. For example, if a central bank buys
foreign exchange (to counteract appreciation of the exchange rate), base money will
increase. Therefore, to sterilize that increase, the central bank must also sell government
debt to contract the monetary base by an equal amount. It follows that turbulent activity
in foreign exchange markets can cause a central bank to lose control of domestic
monetary policy when it is also managing the exchange rate.
o The value of a country's total exports minus the value of its total imports.
It is used to calculate a country's aggregate expenditures, or GDP, in an
o In other words, net exports is the amount by which foreign spending on a
home country's goods and services exceeds the home country's spending
on foreign goods and services. For example, if foreigners buy $200 billion
worth of U.S. exports and Americans buy $150 billion worth of foreign
imports in a given year, net exports would be positive $50 billion. Factors
affecting net exports include prosperity abroad, tariffs and exchange rates.
o An economic measure of a negative balance of trade in which a country's
imports exceeds its exports. A trade deficit represents an outflow of
domestic currency to foreign markets.
o Economic theory dictates that a trade deficit is not necessarily a bad
situation because it often corrects itself over time. However, a deficit has
been reported and growing in the United States for the past few
decades, which has some economists worried. This means that large
amounts of the U.S. dollar are being held by foreign nations, which may
decide to sell at any time. A large increase in dollar sales can drive the
value of the currency down, making it more costly to purchase imports.
4. Trade Surplus
o An economic measure of a positive balance of trade, where a country's
exports exceeds its imports. A trade surplus represents a net inflow of
domestic currency from foreign markets, and is the opposite of a trade
deficit, which would represent a net outflow.
o When a nation has a trade surplus, it has control over the majority of its
own currency. This causes a reduction of risk for another nation selling
this currency, which causes a drop in its value. When the currency loses
value, it makes it more expensive to purchase imports, causing an even a
o Because a trade surplus usually creates a situation where the surplus only
grows (due to the rise in the value of the nations currency making imports
cheaper), there are many arguments against Milton Friedman's belief that
trade imbalances will correct themselves naturally.
o A financial situation that occurs when an entity has more money going out
than coming in. The term "budget deficit" is most commonly used to refer
to government spending rather than business or individual spending.
When it refers to federal government spending, a budget deficit is also
known as the "national debt." The opposite of a budget deficit is a budget
surplus, and when inflows are equal to outflows, the budget is said to be
o Government budget deficits can be cured by cutting spending, raising
taxes or a combination of the two. Deficits must be financed by borrowing
money. Interest must be paid on borrowed funds, which worsens the
5. Budget Surplus
o A situation in which income exceeds expenditures. The term "budget
surplus" is most commonly used to refer to the financial situations of
governments; individuals speak of "savings" rather than a "budget
surplus." A surplus is considered a sign that government is being run
efficiently. A budget surplus might be used to pay off debt, save for the
future, or to make a desired purchase that has been delayed. A city
government that had a surplus might use the money to make
improvements to a run-down park, for example.
o When spending exceeds income, the result is a budget deficit, which must
be financed by borrowing money and paying interest on the borrowed
funds, much like an individual spending more than he can afford and
carrying a balance on a credit card. A balanced budget occurs when
spending equals income. The U.S. government has only had a budget
surplus in a few years since 1950. The Clinton administration (1993-2001)
famously cured a large budget deficit and created a surplus in the late
Required Reserve Ratio
o The portion (expressed as a percent) of depositors' balances banks must
have on hand as cash. This is a requirement determined by the country's
central bank, which in the U.S. is the Federal Reserve. The reserve
ratio affects the money supply in a country.
o For example, if the reserve ratio in the U.S. is determined by the Fed to be
11%, this means all banks must have 11% of their depositers' money on
reserve in the bank. So, if a bank has deposits of $1 billion, it is required to
have $110 million on reserve.
o The interest rate that an eligible depository institution is charged to
borrow short-term funds directly from a Federal Reserve
6. Bank. Different types of loans are available from Federal Reserve Banks
and each corresponding type of credit has its own discount rate.
o The interest rate used in discounted cash flow analysis to determine the
present value of future cash flows. The discount rate takes into account the
time value of money (the idea that money available now is worth more
than the same amount of money available in the future because it could be
earning interest) and the risk or uncertainty of the anticipated future cash
flows (which might be less than expected).
o This type of borrowing from the Fed is fairly limited. Institutions will often
seek other means of meeting short-term liquidity needs. The Federal
Funds Discount Rate is determined by the average rate which banks are
willing to charge each other for overnight funds.
o A debt investment in which an investor loans money to an entity
(corporate or governmental) that borrows the funds for a defined period of
time at a fixed interest rate. Bonds are used by companies, municipalities,
states and U.S. and foreign governments to finance a variety of projects
o Bonds are commonly referred to as fixed-income securities and are one of
the three main asset classes, along with stocks and cash equivalents.
o The indebted entity (issuer) issues a bond that states the interest rate
(coupon) that will be paid and when the loaned funds (bond principal) are
to be returned (maturity date). Interest on bonds is usually paid every six
months (semi-annually). The main categories of bonds are corporate
bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which
are collectively referred to as simply "Treasuries."
o Two features of a bond - credit quality and duration - are the principal
determinants of a bond's interest rate. Bond maturities range from a 90-
day Treasury bill to a 30-year government bond. Corporate and
municipals are typically in the three to 10-year range.
The rate at which the general level of prices for goods and services is rising, and,
subsequently, purchasing power is falling. Central banks attempt to stop severe
inflation, along with severe deflation, in an attempt to keep the excessive growth of
prices to a minimum.An increase in the money supply may be called monetary inflation,
to distinguish it from rising prices, which may also for clarity be called 'price inflation'.
The inflation rate is a measure of inflation, or the rate of increase of a price
index such as the consumer price index. It is the percentage rate of change in price level
over time, usually one year. The rate of decrease in thepurchasing power of money is
Causes of Inflation
Historically, a great deal of economic literature was concerned with the question
of what causes inflation and what effect it has. There were different schools of thought
as to the causes of inflation. Most can be divided into two broad areas: the Demand Pull
Inflation and the Cost Push Inflation. The Demand Pull Inflation is an inflation cause by
the increase in the demand that occurs when the level of the spending exceeds the
amond firms are capable of producing. The Cost Push Inflation is an inflation cause by
the decrease in the cost of production that occurs when the vital resource become scarce
causing its price to rise and raising the cost of production of the firms.
Demand Pull Inflation
o A term used in Keynesian economics to describe the scenario that
occurs when price levels rise because of an imbalance in the
aggregate supply and demand. When the aggregate demand in
an economy strongly outweighs the aggregate supply, prices
increase. Economists will often say that demand-pull inflation is a
result of too many dollars chasing too few goods.
o This type of inflation is a result of strong consumer demand. When
many individuals are trying to purchase the same good, the price
8. will inevitably increase. When this happens across the entire
economy for all goods, it is known as demand-pull inflation.
Cost Push Inflation
o A phenomenon in which the general price levels rise (inflation) due
to increases in the cost of wages and raw materials.
o Cost-push inflation develops because the higher costs of production
factors decreases in aggregate supply (the amount of total
production) in the economy. Because there are fewer goods being
produced (supply weakens) and demand for these goods remains
consistent, the prices of finished goods increase (inflation).
Types of Inflation
Other economic concepts related to inflation include: deflation – a fall in the general
price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-
control inflationary spiral; stagflation – a combination of inflation, slow economic
growth and high unemployment; and reflation – an attempt to raise the general level of
prices to counteract deflationary pressures.
is a decrease in the general price level of goods and services. Deflation occurs
when the inflation rate falls below 0% (a negative inflation rate). This should not
be confused with disinflation, a slow-down in the inflation rate (i.e. when
inflation declines to lower levels). Inflation reduces the real value of money over
time; conversely, deflation increases the real value of money – the currency of a
national or regional economy. This allows one to buy more goods with the same
amount of money over time.
Deflation is caused by a shift in the supply-and-demand curve for goods and
services, particularly a fall in the aggregate level of demand. That is, there is a fall in
how much the whole economy is willing to buy, and the going price for goods.
Because the price of goods is falling, consumers have an incentive to delay purchases
9. and consumption until prices fall further, which in turn reduces overall economic
activity. Since this idles the productive capacity, investment also falls, leading to
further reductions in aggregate demand. This is the deflationary spiral. An answer to
falling aggregate demand is stimulus, either from the central bank, by expanding
the money supply, or by the fiscal authority to increase demand, and to borrow at
interest rates which are below those available to private entities.
occurs when a country experiences very high, accelerating, and perceptibly
"unstoppable" rates of inflation. In such a condition, the general price level
within an economy rapidly increases as the currency quickly loses real
value. Meanwhile, the real values of specific economic items generally stay
the same with respect to each other, and in terms of other relatively stable
foreign currencies. This includes the economic items that generally
constitute the government's expenses.
Hyperinflation occurs when there is a continuing (and often accelerating)
rapid increase in the amount of money that is not supported by a
corresponding growth in the output of goods and services.
The price increases that result from the rapid money creation creates a
vicious circle, requiring ever growing amounts of new money creation to
fund government activities. Hence both monetary inflation and price
inflation proceed at a rapid pace. Such rapidly increasing prices cause
widespread unwillingness of the local population to hold the local currency
as it rapidly loses its buying power. Instead they quickly spend any money
they receive, which increases the velocity of money flow; this in turn
causes further acceleration in prices.
a portmanteau of stagnation and inflation, is a term used in economics to
describe a situation where an inflation rate is high, the economic growth
rate slows down, and unemployment remains steadily high. It raises a
10. dilemma for economic policy since actions designed to lower inflation may
exacerbate unemployment, and vice versa.
Economists offer two principal explanations for why stagflation occurs.
First, stagflation can result when the productive capacity of an economy is
reduced by an unfavorable supply shock, such as an increase in the price of
oil for an oil importing country. Such an unfavorable supply shock tends to
raise prices at the same time that it slows the economy by making
production more costly and less profitable. Milton Friedman famously
described this situation as "too much money chasing too few goods".
Second, both stagflation and inflation can result from inappropriate
macroeconomic policies. For example, central banks can cause inflation by
permitting excessive growth of themoney supply and the government can
cause stagnation by excessive regulation of goods markets and labour
markets. Either of these factors can cause stagflation.
Money is any object or record that is generally accepted as payment for goods
and services and repayment of debts in a given socio-economic context or country.
Money is historically an emergent market phenomenon establishing a commodity
money, but nearly all contemporary money systems are based on fiat money. Fiat
money, like any check or note of debt, is without intrinsic use value as a physical
commodity. It derives its value by being declared by a government to be legal tender;
that is, it must be accepted as a form of payment within the boundaries of the country,
for "all debts, public and private". Such laws in practice cause fiat money to acquire the
value of any of the goods and services that it may be traded for within the nation that
The money supply of a country consists of currency (banknotes and coins)
and bank money (the balance held in checking accounts andsavings accounts). Bank
11. money, which consists only of records (mostly computerized in modern banking), forms
by far the largest part of the money supply in developed nations.
Functions of Money
The main functions of money are distinguished as:
a medium of exchange
a unit of account
a store of value
There have been many historical disputes regarding the combination of money's
functions, some arguing that they need more separation and that a single unit is
insufficient to deal with them all. One of these arguments is that the role of money as
a medium of exchange is in conflict with its role as a store of value: its role as a store
of value requires holding it without spending, whereas its role as a medium of
exchange requires it to circulate. Others argue that storing of value is just deferral of
the exchange, but does not diminish the fact that money is a medium of exchange
that can be transported both across space and time. The term 'financial capital' is a
more general and inclusive term for all liquid instruments, whether or not they are a
uniformly recognized tender.
Medium of Exchange
When money is used to intermediate the exchange of goods and
services, it is performing a function as a medium of exchange. It
thereby avoids the inefficiencies of a barter system, such as the 'double
coincidence of wants' problem.
Unit of Account
A unit of account is a standard numerical unit of measurement of the
market value of goods, services, and other transactions. Also known as
a "measure" or "standard" of relative worth and deferred payment, a
12. unit of account is a necessary prerequisite for the formulation of
commercial agreements that involve debt.
To function as a 'unit of account', whatever is being used as money must be:
Divisible into smaller units without loss of value; precious metals
can be coined from bars, or melted down into bars again.
Fungible: that is, one unit or piece must be perceived as equivalent
to any other, which is why diamonds, works of art or real estate are
not suitable as money.
A specific weight, or measure, or size to be verifiably countable. For
instance, coins are often milled with a reeded edge, so that any
removal of material from the coin (lowering its commodity value)
will be easy to detect.
Store of Value
To act as a store of value, a money must be able to be reliably saved,
stored, and retrieved – and be predictably usable as a medium of
exchange when it is retrieved. The value of the money must also remain
stable over time. Some have argued that inflation, by reducing the
value of money, diminishes the ability of the money to function as a
store of value.
In economics, money is a broad term that refers to any financial instrument that
can fulfill the functions of money. These financial instruments together are collectively
referred to as the money supply of an economy. In other words, the money supply is the
amount of financial instruments within a specific economy available for purchasing
goods or services. Since the money supply consists of various financial instruments
(usually currency, demand deposits and various other types of deposits), the amount of
13. money in an economy is measured by adding together these financial instruments
creating a monetary aggregate.
Types of Money
Currently, most modern monetary systems are based on fiat money. However, for
most of history, almost all money was commodity money, such as gold and silver coins.
As economies developed, commodity money was eventually replaced by representative
money, such as the gold standard, as traders found the physical transportation of gold
and silver burdensome.
Many items have been used as commodity money such as naturally
scarce precious metals, conch shells, barley, beads etc., as well as many
other things that are thought of as having value.
Commodity money value comes from the commodity out of which it is
The commodity itself constitutes the money, and the money is the
Examples of commodities that have been used as mediums of exchange
These items were sometimes used in a metric of
perceived value in conjunction to one another, in various
commodity valuation or Price System economies.
Use of commodity money is similar to barter, but a commodity money
provides a simple and automatic unit of accountfor the commodity which
is being used as money.
In 1875, the British economist William Stanley Jevons described the
money used at the time as "representative money".
Representative money is money that consists of token coins, paper
money or other physical tokens such as certificates, that can be reliably
exchanged for a fixed quantity of a commodity such as gold or silver.
The value of representative money stands in direct and fixed relation to
the commodity that backs it, while not itself being composed of that
Fiat money or fiat currency is money whose value is not derived from
any intrinsic value or guarantee that it can be converted into a valuable
commodity (such as gold).
Instead, it has value only by government order (fiat).
Fiat money, if physically represented in the form of currency (paper or
coins) can be accidentally damaged or destroyed.
However, fiat money has an advantage over representative or
commodity money, in that the same laws that created the money can
also define rules for its replacement in case of damage or destruction.
For example, the U.S. government will replace mutilated Federal
Reserve notes (U.S. fiat money) if at least half of the physical
15. note can be reconstructed, or if it can be otherwise proven to
have been destroyed.By contrast, commodity money which has
been lost or destroyed cannot be recovered.
These factors led to the shift of the store of value being the metal itself:
at first silver, then both silver and gold, at one point there was bronze
as well. Now we have copper coins and other non-precious metals as
coins. Metals were mined, weighed, and stamped into coins. This was
to assure the individual taking the coin that he was getting a certain
known weight of precious metal.
Coins could be counterfeited, but they also created a new unit of
account, which helped lead to banking. Archimedes' principle: coins
could now be easily tested for their fine weight of metal, and thus the
value of a coin could be determined, even if it had been shaved,
debased or otherwise tampered with.
In most major economies using coinage, copper, silver and gold formed
three tiers of coins.
Gold coins were used for large purchases, payment of the
military and backing of state activities.
Silver coins were used for midsized transactions, and as a unit of
account for taxes, dues, contracts and fealty.
Copper coins represented the coinage of common transaction.
The advantages of paper currency were numerous:
it reduced transport of gold and silver, and thus lowered
it made loaning gold or silver at interest easier, since the
specie (gold or silver) never left the possession of the
lender until someone else redeemed the note;
16. and it allowed for a division of currency into credit and
specie backed forms.
It enabled the sale of stock in joint stock companies, and the
redemption of those shares in paper.
Commercial Bank Money
Commercial bank money or demand deposits are claims against financial
institutions that can be used for the purchase of goods and services. A
demand deposit account is an account from which funds can be withdrawn
at any time by check or cash withdrawal without giving the bank or
financial institution any prior notice.
Banks have the legal obligation to return funds held in demand deposits
immediately upon demand (or 'at call'). Demand deposit withdrawals can
be performed in person, via checks or bank drafts, using automatic teller
machines (ATMs), or through online banking.
Commercial bank money is created through fractional-reserve banking,
the banking practice where banks keep only a fraction of
their deposits in reserve (as cash and other highly liquid assets) and lend
out the remainder, while maintaining the simultaneous obligation to
redeem all these deposits upon demand.
Commercial bank money differs from commodity and fiat money in two
firstly it is non-physical, as its existence is only reflected in the
account ledgers of banks and other financial institutions, and
secondly, there is some element of risk that the claim will not be
fulfilled if the financial institution becomes insolvent.
The process of fractional-reserve banking has a cumulative effect of money
creation by commercial banks, as it expands money supply (cash and
demand deposits) beyond what it would otherwise be. Because of the
prevalence of fractional reserve banking, the broad money supply of most
countries is a multiple larger than the amount of base money created by
17. the country's central bank. That multiple (called the money multiplier) is
determined by thereserve requirement or other financial
ratio requirements imposed by financial regulators.
Digital currencies gained momentum in before the 2000 tech
bubble. Flooz and Beenz were particularly advertised as an alternative
form of money. While the tech bubble caused them to be short lived, many
new digital currencies have reached some, albeit generally small
Most digital currencies are simply fiat currencies parleyed across a digital
medium. However, protocols like Bitcoin allow money to only exist in
cyberspace which allows for some classic limitations to be lifted.
Never before has the sending of money across a geographical divide not
required the trust of a third party which of course then is susceptible to
New forms of currency coming to fruition this very day allow for the free
exchange of wealth across distances.
A bank is a financial institution and a financial intermediary that accepts deposits
and channels those deposits into lending activities, either directly by loaning or
indirectly through capital markets. A bank is the connection between customers that
have capital deficits and customers with capital surpluses.
Due to their influence within a financial system and an economy, banks are
generally highly regulated in most countries. Most banks operate under a system known
as fractional reserve banking where they hold only a small reserve of the funds deposited
and lend out the rest for profit. They are generally subject to minimum capital
requirements which are based on an international set of capital standards, known as the
Banks act as payment agents by conducting checking or current accounts
for customers, paying cheques drawn by customers on the bank, and
collecting cheques deposited to customers' current accounts.
Banks also enable customer payments via other payment methods such as
Automated Clearing House (ACH), Wire transfers or telegraphic transfer,
EFTPOS, and automated teller machine (ATM). Banks borrow money by
accepting funds deposited on current accounts, by accepting term
deposits, and by issuing debt securities such as banknotes and bonds.
Banks lend money by making advances to customers on current accounts,
by making installment loans, and by investing in marketable debt
securities and other forms of money lending.
Banks provide different payment services, and a bank account is
considered indispensable by most businesses and individuals.
Non-banks that provide payment services such as remittance companies
are normally not considered as an adequate substitute for a bank account.
Banks offer many different channels to access their banking and other
Automated Teller Machines
A branch is a retail location
Call center: A call centre or call center is a centralised office used for
the purpose of receiving or transmitting a large volume of requests
bytelephone. An inbound call centre is operated by a company to
administer incoming product support or information inquiries from
consumers. Outbound call centers are operated for telemarketing,
solicitation of charitable or political donations and debt collection.
In addition to a call centre, collective handling of letter, fax, live
chat, and e-mail at one location is known as a contact centre.
19. Mail: most banks accept cheque deposits via mail and use mail to
communicate to their customers, e.g. by sending out statements
Mobile banking is a method of using one's mobile phone to conduct
Online banking is a term used for performing multiple transactions,
payments etc. over the Internet
Relationship Managers, mostly for private banking or business
banking, often visiting customers at their homes or businesses
Telephone banking is a service which allows its customers to
perform transactions over the telephone with automated attendant
or when requested with telephone operator
Video banking is a term used for performing banking transactions
or professional banking consultations via a remote video and audio
connection. Video banking can be performed via purpose built
banking transaction machines (similar to an Automated teller
machine), or via a video conference enabled bank branch
A transactional account is a deposit account held at a bank or
other financial institution, for the purpose of securely and
quickly providing frequent access to funds on demand,
through a variety of different channels.
Transactional accounts are meant neither for the purpose of
earning interest nor for the purpose of savings, but for
convenience of the business or personal client; hence they
tend not to bear interest. Instead, a customer can deposit or
withdraw any amount of money any number of times,
subject to availability of funds.
20. Savings account
Saving account are accounts maintained by retail financial
institutions that pay interest but cannot be used directly as
money in the narrow sense of a medium of exchange (for
example, by writing a cheque).
These accounts let customers set aside a portion of their
liquid assets while earning a monetary return.
For the bank, money in a savings account may not be callable
immediately and in some jurisdictions, does not incur a
reserve requirement, freeing up cash from the bank's vault to
be lent out with interest.
Money market account
A money market account (MMA) or money market deposit
account (MMDA) is a financial account that pays interest
based on current interest rates in the money markets.
Money market accounts typically have a relatively high rate
of interest and require a higher minimum balance (anywhere
from $1,000 to $10,000 to $25,000) to earn interest or
avoid monthly fees. The resulting investment strategy is
therefore similar to, and meant to compete with, a money
market fund offered by a brokerage. The two account types
are otherwise unrelated.
Certificate of deposit (CD)
A certificate of deposit (CD) is a time deposit, a financial
product commonly offered to consumers in the United States
by banks, thrift institutions, and credit unions.
CDs are similar to savings accounts in that they are insured
and thus virtually riskfree; they are "money in the bank".
21. CDs are insured by the Federal Deposit Insurance
Corporation (FDIC) for banks and by the National Credit
Union Administration (NCUA) for credit unions. They are
different from savings accounts in that the CD has a specific,
fixed term (often monthly, three months, six months, or one
to five years), and, usually, a fixed interest rate.
It is intended that the CD be held until maturity, at which
time the money may be withdrawn together with the accrued
Individual retirement account (IRA)
An Individual Retirement Account is a form of retirement
plan, provided by many financial institutions, that provides
tax advantages for retirement savings in the United States as
described in IRS Publication 590, Individual Retirement
The term IRA encompasses an individual retirement
account; a trust or custodial account set up for the exclusive
benefit of taxpayers or their beneficiaries; and an individual
retirement annuity, by which the taxpayers purchase an
annuity contract or an endowment contract from a life
A credit card is a payment card issued to users as a system of
payment. It allows the cardholder to pay for goods and
services based on the holder's promise to pay for them.
The issuer of the card creates a revolving account and grants
a line of credit to the consumer (or the user) from which the
user can borrow money for payment to a merchant or as a
cash advance to the user.
22. Debit card
A debit card (also known as a bank card or check card) is a
plastic card that provides the cardholder electronic access to
his or her bank account(s) at a financial institution.
Some cards have a stored value with which a payment is
made, while most relay a message to the cardholder's bank to
withdraw funds from a payee's designated bank account.
The card, where accepted, can be used instead of cash when
making purchases. In some cases, the primary account
number is assigned exclusively for use on the Internet and
there is no physical card.
A mortgage loan is a loan secured by real property through
the use of a mortgage note which evidences the existence of
the loan and the encumbrance of that realty through the
granting of a mortgage which secures the loan. However, the
word mortgage alone, in everyday usage, is most often used
to mean mortgage loan.
The word mortgage is a French Law term meaning "death
contract", meaning that the pledge ends (dies) when either
the obligation is fulfilled or the property is taken through
Home equity loan
A home equity loan is a type of loan in which the borrower
uses the equity in their home as collateral. Home equity
loans are often used to finance major expenses such as home
repairs, medical bills or college education. A home equity
loan creates a lien against the borrower's house, and reduces
actual home equity.
23. Mutual fund
A mutual fund is a type of professionally managed collective
investment vehicle that pools money from many investors to
While there is no legal definition of the term "mutual fund",
it is most commonly applied only to those collective
investment vehicles that are regulated and sold to the
They are sometimes referred to as "investment companies"
or "registered investment companies." Most mutual funds
are "open-ended," meaning investors can buy or sell shares
of the fund at any time. Hedge funds are not considered a
type of mutual fund.
In finance, unsecured debt refers to any type of debt or
general obligation that is not collateralized by a lien on
specific assets of the borrower in the case of a bankruptcy or
liquidation or failure to meet the terms for repayment.
In the event of the bankruptcy of the borrower, the
unsecured creditors will have a general claim on the assets of
the borrower after the specific pledged assets have been
assigned to the secured creditors, although the unsecured
creditors will usually realize a smaller proportion of their
claims than the secured creditors.
A time deposit is a money deposit at a banking institution
that cannot be withdrawn for a certain "term" or period of
time (unless a penalty is paid).
When the term is over it can be withdrawn or it can be held
for another term. Generally speaking, the longer the term the
24. better the yield on the money. In its strict sense, certificate
deposit is different from that of time deposit in terms of its
negotiability. CDs are negotiable and can be rediscounted
when the holder needs some liquidity, while time deposits
must be kept until maturity.
The opposite, sometimes known as a sight deposit or "on
call" deposit, can be withdrawn at any time, without any
notice or penalty: e.g., money deposited in a checking
account or savings account in a bank.
An ATM card (also known as a bank card, client card, key
card, or cash card) is a card issued by a financial institution,
such as a bank, credit union, or building society, that can be
used in an automated teller machine (ATM) for transactions
such as: deposits, withdrawals, obtaining account
information, and other types of transactions, often through
It can also be used on improvised ATMs, such as merchants'
card terminals that deliver ATM features without any cash
drawer (commonly referred to as mini ATMs). These
terminals can also be used as Cashless scrip ATMs by
cashing the fund transfer receipt at the merchant's Cashier.
A current account is the form of transactional account found
in the United Kingdom and other countries with a UK
banking heritage; a current account offers various flexible
payment methods to allow customers to distribute money
directly to others.
Most current accounts come with a cheque book and offer
the facility to arrange standing orders, direct debits and
25. payment via a debit card. Current accounts may also allow
borrowing via an overdraft facility.
Business (or commercial/investment) banking
In finance, a loan is a debt evidenced by a note which
specifies, among other things, the principal amount, interest
rate, and date of repayment. A loan entails the reallocation of
the subject asset(s) for a period of time, between the lender
and the borrower.
In a loan, the borrower initially receives or borrows an
amount of money, called the principal, from the lender, and
is obligated to pay back or repay an equal amount of money
to the lender at a later time. Typically, the money is paid
back in regular installments, or partial repayments; in an
annuity, each installment is the same amount.
The loan is generally provided at a cost, referred to as
interest on the debt, which provides an incentive for the
lender to engage in the loan. In a legal loan, each of these
obligations and restrictions is enforced by contract, which
can also place the borrower under additional restrictions
known as loan covenants.
Acting as a provider of loans is one of the principal tasks for
financial institutions. For other institutions, issuing of debt
contracts such as bonds is a typical source of funding.
Capital raising (Equity / Debt / Hybrids)
The Stock Exchange provide companies with the facility to
raise capital for expansion through selling shares to the
26. Mezzanine finance
Mezzanine capital, in finance, refers to a subordinated debt
or preferred equity instrument that represents a claim on a
company's assets which is senior only to that of the common
shares. Mezzanine financings can be structured either as
debt (typically an unsecured and subordinated note) or
Mezzanine capital is often a more expensive financing source
for a company than secured debt or senior debt. The higher
cost of capital associated with mezzanine financings is the
result of it being an unsecured, subordinated (or junior)
obligation in a company's capital structure (i.e., in the event
of default, the mezzanine financing is only repaid after all
senior obligations have been satisfied).
Additionally, mezzanine financings, which are usually
private placements, are often used by smaller companies and
may involve greater overall leverage levels than issuers in the
high-yield market; as such, they involve additional risk. In
compensation for the increased risk, mezzanine debt holders
require a higher return for their investment than secured or
more senior lenders.
Project finance is the long-term financing of infrastructure
and industrial projects based upon the projected cash flows
of the project rather than the balance sheets of its sponsors.
Usually, a project financing structure involves a number of
equity investors, known as 'sponsors', as well as a 'syndicate'
of banks or other lending institutions that provide loans to
27. They are most commonly non-recourse loans, which are
secured by the project assets and paid entirely from project
cash flow, rather than from the general assets or
creditworthiness of the project sponsors, a decision in part
supported by financial modeling.
The financing is typically secured by all of the project assets,
including the revenue-producing contracts. Project lenders
are given a lien on all of these assets and are able to assume
of a project if the project company has difficulties complying
with the loan terms.
Revolving credit is a type of credit that does not have a fixed
number of payments, in contrast to installment credit.
Credit cards are an example of revolving credit used by
Corporate revolving credit facilities are typically used to
provide liquidity for a company's day-to-day operations.
They were first introduced by the Strawbridge and Clothier
o Typical characteristic
Case study is required
The borrower may use or withdraw funds up to
a pre-approved credit limit.
The amount of available credit decreases and
increases as funds are borrowed and then
The credit may be used repeatedly.
The borrower makes payments based only on
the amount they've actually used or withdrawn,
28. The borrower may repay over time (subject to
any minimum payment requirement), or in full
at any time.
In some cases, the borrower is required to pay
a fee to the lender for any money that is
undrawn on the revolver; this is especially true
of corporate bank loan revolving credit
Risk management (FX, interest rates, commodities,
Risk management is the identification, assessment, and
prioritization of risks (defined in ISO 31000 as the effect of
uncertainty on objectives, whether positive or negative)
followed by coordinated and economical application of
resources to minimize, monitor, and control the probability
and/or impact of unfortunate events or to maximize the
realization of opportunities.
Risks can come from uncertainty in financial markets,
project failures (at any phase in design, development,
production, or sustainment life-cycles), legal liabilities,
credit risk, accidents, natural causes and disasters as well as
deliberate attack from an adversary, or events of uncertain or
Several risk management standards have been developed
including the Project Management Institute, the National
Institute of Standards and Technology, actuarial societies,
and ISO standards.
Methods, definitions and goals vary widely according to
whether the risk management method is in the context of
project management, security, engineering, industrial
29. processes, financial portfolios, actuarial assessments, or
public health and safety.
The strategies to manage risk typically include transferring
the risk to another party, avoiding the risk, reducing the
negative effect or probability of the risk, or even accepting
some or all of the potential or actual consequences of a
Certain aspects of many of the risk management standards
have come under criticism for having no measurable
improvement on risk, whether the confidence in estimates
and decisions seem to increase.
A term loan is a monetary loan that is repaid in regular
payments over a set period of time. Term loans usually last
between one and ten years, but may last as long as 30 years
in some cases. A term loan usually involves an unfixed
interest rate that will add additional balance to be repaid.
Term loans can be given on an individual basis but are often
used for small business loans. The ability to repay over a long
period of time is attractive for new or expanding enterprises,
as the assumption is that they will increase their profit over
Term loans are a good way of quickly increasing capital in
order to raise a business’ supply capabilities or range. For
instance, some new companies may use a term loan to buy
company vehicles or rent more space for their operations.
Cash Management Services (Lock box, Remote Deposit
Capture, Merchant Processing)
30. Risk and capital
Banks face a number of risks in order to conduct their business, and how well
these risks are managed and understood is a key driver behind profitability, and how
much capital a bank is required to hold. Some of the main risks faced by banks include:
Credit risk: risk of lossarising from a borrower who does not make
payments as promised.
Liquidity risk: risk that a given security or asset cannot be traded
quickly enough in the market to prevent a loss (or make the required
Market risk: risk that the value of a portfolio, either an investment
portfolio or a trading portfolio, will decrease due to the change in value of
the market risk factors.
Operational risk: risk arising from execution of a company's business
Macroeconomic risk: risks related to the aggregate economy the bank
is operating in.
The capital requirement is a bank regulation, which sets a framework
on how banks and depository institutions must handle their capital. The
categorization of assets and capital is highly standardized so that it can be
risk weighted (see risk-weighted asset).
Types of Banks
Banks' activities can be divided into retail banking, dealing directly with
individuals and small businesses; business banking, providing services to mid-market
business; corporate banking, directed at large business entities; private banking,
providing wealth management services to high net worth individuals and families; and
investment banking, relating to activities on the financial markets. Most banks are
profit-making, private enterprises. However, some are owned by government, or are
31. Types of retail banks
Commercial bank: the term used for a normal bank to distinguish it
from an investment bank. After the Great Depression, the U.S. Congress
required that banks only engage in banking activities, whereas investment
banks were limited to capital market activities. Since the two no longer
have to be under separate ownership, some use the term "commercial
bank" to refer to a bank or a division of a bank that mostly deals with
deposits and loans from corporations or large businesses.
Community banks: locally operated financial institutions that empower
employees to make local decisions to serve their customers and the
Community development banks: regulated banks that provide
financial services and credit to under-served markets or populations.
Credit unions: not-for-profit cooperatives owned by the depositors and
often offering rates more favorable than for-profit banks. Typically,
membership is restricted to employees of a particular company, residents
of a defined neighborhood, members of a certain labor union or religious
organizations, and their immediate families.
Postal savings banks: savings banks associated with national postal
Private banks: banks that manage the assets of high net worth
individuals. Historically a minimum of USD 1 million was required to open
an account, however, over the last years many private banks have lowered
their entry hurdles to USD 250,000 for private investors.
Offshore banks: banks located in jurisdictions with low taxation and
regulation. Many offshore banks are essentially private banks.
32. Savings bank: in Europe, savings banks took their roots in the 19th or
sometimes even in the 18th century. Their original objective was to
provide easily accessible savings products to all strata of the population. In
some countries, savings banks were created on public initiative; in others,
socially committed individuals created foundations to put in place the
necessary infrastructure. Nowadays, European savings banks have kept
their focus on retail banking: payments, savings products, credits and
insurances for individuals or small and medium-sized enterprises. Apart
from this retail focus, they also differ from commercial banks by their
broadly decentralized distribution network, providing local and regional
outreach—and by their socially responsible approach to business and
Building societies and Landesbanks: institutions that conduct retail
Ethical banks: banks that prioritize the transparency of all operations
and make only what they consider to be socially-responsible investments.
A Direct or Internet-Only bank is a banking operation without any
physical bank branches, conceived and implemented wholly with
Types of investment banks
Investment banks "underwrite" (guarantee the sale of) stock and bond
issues, trade for their own accounts, make markets, provide investment
management, and advise corporations on capital market activities such as
mergers and acquisitions.
Merchant banks were traditionally banks which engaged in trade
finance. The modern definition, however, refers to banks which
33. provide capital to firms in the form of shares rather than loans.
Unlike venture capital firms, they tend not to invest in new
Universal banks, more commonly known as financial services companies,
engage in several of these activities. These big banks are very diversified groups that,
among other services, also distribute insurance— hence the term bancassurance, a
portmanteau word combining "banque or bank" and "assurance", signifying that both
banking and insurance are provided by the same corporate entity.
Other types of banks
Central banks are normally government-owned and charged with quasi-
regulatory responsibilities, such as supervising commercial banks, or
controlling the cash interest rate. They generally provide liquidity to the
banking system and act as the lender of last resort in event of a crisis.
Islamic banks adhere to the concepts of Islamic law. This form of banking
revolves around several well-established principles based on Islamic canons.
All banking activities must avoid interest, a concept that is forbidden in Islam.
Instead, the bank earns profit (markup) and fees on the financing facilities
that it extends to customers.
Banks in the Economy
The economic functions of banks include:
1. Issue of money, in the form of banknotes and current accounts subject
to check or payment at the customer's order. These claims on banks can act as
34. money because they are negotiable or repayable on demand, and hence valued at
par. They are effectively transferable by mere delivery, in the case of banknotes,
or by drawing a check that the payee may bank or cash.
2. Netting and settlement of payments – banks act as both collection and
paying agents for customers, participating in interbank clearing and settlement
systems to collect, present, be presented with, and pay payment instruments.
This enables banks to economize on reserves held for settlement of payments,
since inward and outward payments offset each other. It also enables the
offsetting of payment flows between geographical areas, reducing the cost of
settlement between them.
3. Credit intermediation – banks borrow and lend back-to-back on their own
account as middle men.
4. Credit quality improvement – banks lend money to ordinary commercial and
personal borrowers (ordinary credit quality), but are high quality borrowers. The
improvement comes from diversification of the bank's assets and capital which
provides a buffer to absorb losses without defaulting on its obligations. However,
banknotes and deposits are generally unsecured; if the bank gets into difficulty
and pledges assets as security, to raise the funding it needs to continue to
operate, this puts the note holders and depositors in an economically
5. Asset liability mismatch/Maturity transformation – banks borrow more
on demand debt and short term debt, but provide more long term loans. In other
35. words, they borrow short and lend long. With a stronger credit quality than most
other borrowers, banks can do this by aggregating issues (e.g. accepting deposits
and issuing banknotes) and redemptions (e.g. withdrawals and redemption of
banknotes), maintaining reserves of cash, investing in marketable securities that
can be readily converted to cash if needed, and raising replacement funding as
needed from various sources (e.g. wholesale cash markets and securities
6. Money creation – whenever a bank gives out a loan in a fractional-reserve
banking system, a new sum of virtual money is created.