Demystifying Monetary Systems

CA. Sunny Sabharwal

Some basics

• Financial MarketA market where funds (finance) are taken from those who have surplus (investors) and provided to those who need it (business)

• Who are financial intermediaries?Banks, insurance companies, NBFCs, etc.

• What is relevance of financial market?An efficient financial market encourages & channelizes investments and hence fuels business growth

• Shares and bonds markets most crucial; major funding sources for corporates

Monetary System

Investors

SEBIRBI Regulators

Financial Intermedi

ary

Financial Intermedi

aryBusiness

NBFCsInsurance

Cos.Banks

Investment Loan

Control

InterestReturn

Responsibilities of a Bank Head

• Liquidity Management : Ensuring enough liquidity to honoring liabilities

• Liability Management : Acquire funds at low cost

• Asset Management : The risk-profile, tenure and class of assets in which to invest funds

• Capital Management : Match requirement of capital (of RBI and Reserves)

Principle in Banking: Borrow Long, lend

short

Principle in Banking: Borrow Long, lend

short

Source : RBI

Typical Balance Sheet of a Bank

LIABILITY(OUTFLOWS)

ASSET (INFLOWS)

1 Capital 1 Cash & Balances with RBI

2 Reserves & Surplus 2 Balances with Banks & Money at call/Short-notice

3 Deposits 3 Investments

4 Borrowings 4 Advances

5 Other Liabilities & Provisions 5 Fixed Assets

6 Contingent Liabilities 6 Other Assets

Major factors that affect money

→ Interest Rate→ Inflation→ Monetary Policies→ Business Growth→ Investor Sentiment

Interest Rate

• Consists of –– TVM (Cost of money)– Inflation– Risk Premium

• Determined by:– Monetary Policy– Inflation– Risk– Demand & Supply of Money (bonds and money market)

• Fall/increase in interest rate -> increases/decreases bonds prices– Repercussions

Expected return on bonds falls Investors switch from bonds to other assets Overall borrowing increases

Bond Price (P) = CP1 + FV

(1+r)1 (1+r)2

Factor Relation Effect1 Monetary Policy Both Easing Policy: Low Interest Rate

Tight Policy: High2 Inflation Direct3 Risk Direct4 Demand of Money Direct5 Supply of Money Indirect

Inflation

• Abnormal inflation results in higher interest rates• Why:

– Mathematically : (1+Real Rate) x (1+ Inflation Rate) = (1+ Nominal Rate)

– For people : Reduces incomes & investments Investors now require more return (impetus to invest)

– For businesses : increases cost of capital; affects ongoing operations reduces expansion plans

• In-turn is affected by –– Demand & Supply: Actual & speculation– Expectations

• Tools for taming –– Monetary Policies : tight or easing– Government Policies

E.g. BPLR

Monetary Policies

• Purpose : to govern economic variables

• Mainly used –– Policy Rates

Repo & Reverse Repo Bank rate CRR, SLR

– Open market transactions

Source : RBI

Liquidity Adjustment Facility (LAF) a short-term discretionary instrument for smooth equilibrating of liquidity in the system. The repo and reverse repo interest rates are key signaling rates in the system

Policy Tool Meaning

Repo Rate at which banks borrow from RBI : Short-term

Reverse Repo Rate at which RBI borrows from Banks

Bank rate Rate at which banks borrow from RBI : Long-term

CRR Amount of cash as a % of deposits to be kept with RBI

SLR % of money (after reducing CRR) to be invested in govt. securities

Investor Expectations

• How different investors’ expectations cause change in prices– Using Dividend Discount Model – Two investors : A & B

Past Dividend : Rs. 10 Ke : 15%

– Different growth rates expected : A (retail investor) = 5% B (industry expert) = 10%

– Result : Price (A) = Rs.105 Price (B) = Rs. 220

• Why different expectations –– Asymmetric Information (lack of correct and complete information

to some)– Personal bias : e.g. a previous loss may prevent from making riskier

investments

Price (P) = Price (P) = D * (1+g)D * (1+g) (K(Kee – g) – g)Price (P) = Price (P) = D * (1+g)D * (1+g) (K(Kee – g) – g)

THE CRISIS

The Sub-prime Crisis

Worst hit sectors

• Information Technology– Clients in US/elsewhere going bust

• Realty– Hit from supply side – non-availability of funds– Slack sales – high interest rates and job losses

• Auto• SME

– due to reduced demand from parent industries

13

The Crisis

• Begun with sub-prime crisis in developed countries

• Marking to market reduced B/S

• Led to worldwide liquidity crunch

• Since capital is required by all businesses; affected all

• Observed to start affecting India in Sept ’08

2008 2009 GDP 8.9 5.3 Industrial 8.8 2.8 Infra 5.8 3.0

“Lemon Problem”

Buyer does not know whether what he is buying is a peach or lemon. In recessionary times, when buyers are more risk-averse, one might forgo a

peach fearing of a lemon.

This leads to a contagious fear in the market of holding on cash or invest in short-term assets.

Experts say : “2008 was a recessionary

year; 2009 to be consolidating”

Source : RBI

Investor Sentiment

• The one thing that AFFECTS the MARKET the MOST

• Main reason behind extreme losses after any crisis

• Functions both ways – – Buyer (Businesses) :

Aggressive or Defensive– Seller (Lenders) : Risk-takers

or Risk-averse

• Bad thing for the depressed markets –– Falls geometrically– Recovers arithmetically

Till Mid 2008

Till Mid 2008

MarketsMarkets

Since thenSince then

Buyer (Defensive

)

Buyer (Defensive

)

Buyer (Aggressiv

e)

Buyer (Aggressiv

e)

Seller (Risk-taker)

Seller (Risk-taker)

Seller (Risk-

averse)

Seller (Risk-

averse)

What RBI is doing

• Policy rates lowered –– Repo, CRR, SLR– BPLR

• Housing loan –– Lowering of interest rates– Increasing the tenure

• Relief package for NBFCs thru SPV– More loans– at lower rates

• Other measures– Permitted banks to issue

guarantees for > 10 years

SPV : Industrial Development Bank of India Stressed Asset Stabilization Fund (IDBI SASF)

One of the main problems faced by banks in India is issue of long-term liabilities at high interest rates

What to expect

→ 2009 to be a consolidating year→ Increased Government expenditure→ Banking & Infra to be see favorable future→ Sectors like Realty and Manufacturing to take

time→ More focus on agriculture and MSME sector→ Balancing of portfolio of banks rather than

expansion→ Things to be more clearer after General

Elections

Thank You !

Please feel free to contact me at

Cell : +91 99586 77766 Email:

sabharwal.sunny@yahoo.com