Category Archives: Finance

rupee

The Art of Money Creation

Reserve Bank of India
Reserve Bank of India – India’s Central Bank

Banks create money out of thin air. It is a by-product of their quest for profit. The entire economy thrives (and occasionally, falls too) on this ability of ‘credit creation‘ by ‘money factories‘. How do banks create more money than actually exists? How does this enable an increase in total volume of money in the economy? What are the risks?

First, let’s get on the same page with some basics:

  • Banks get money from what we deposit in them.
  • Deposits are banks’ liabilities, since banks must return it to us when we ask for the money.
  • Banks lend loans by using this deposit money of ours.
  • Loans are bank’s assets.

The CRR:

Reserve Bank of India (RBI) is the central note issuing authority in India. Commercial Banks in India are required to hold a certain proportion of their deposits in the form of  cash. This minimum ratio (that is the part of the total deposits  to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. It is a tool used by RBI to control liquidity in the banking system.

The Process:

Let’s assume there are various Banks in the Banking System. Bank_1, Bank_2, Bank_3, etc. Let’s assume the CRR to be 10%.

  1. Anand deposits Rs. 100 in Bank_1. Keeping Rs. 10 in reserve (CRR is 10%), Bank_1 lends Rs. 90 to Bala.
  2. Bala deposits his Rs. 90 in Bank_2. Keeping Rs. 9 in reserve, Bank_2 lends Rs. 81 to Clara.
  3. Clara deposits her Rs. 81 in Bank_3.

This process continues.

The Math Behind This:

Time for some calculations. In the first cycle, the bank could loan out 90% of Rs. 100. In the second cycle, the bank could loan out 90% of 90% of Rs. 100. Thus the amount of money the bank can loan out in some period n of the cycle is given by:

Rs. 100 * (90%)n

  • Let A be the amount of money infused into the system (in our case, Rs. 100)
  • Let R be the required reserve ratio (in our case 10%).
  • Let T be the total amount the bank loans out
  • Let n represent the period we are in.

From the equation above, the amount of money the bank can loan out in any period is:

A * (1 – R)n

Thus, the total loan amount is:

T  =  A*(1 – R)1 + A*(1 – R)2 + A*(1 – R)3 + …

T  = A * [ (1 – R)1 + (1 – R )2 + (1 – R)3 + … ]

Mathematics says,

x1 + x2 + x3 + x4 + … = x / (1-x)

Thus,

T  = A * (1 – R) / R

How much money have our banks loaned out using the Rs. 100 deposited initially? Using the above equation, this would total up to 100 * (1 – 0.1)/0.1 = Rs. 900.

In this entire process, to find the total amount deposited (D), we need to take into account the initial Rs. 100 too.

D  = A + T

D  = A +  [ A * (1 - R) / R ]

D  = A * (1/R)

which, for our example, will total to Rs. 1000.

The cash in reserve for any period is:

R * A * (1 – R)n-1

Total reserve is:

( R * A ) [1 + (1 – R)1 + (1 – R)2 + (1 – R)3 … ]

which simplifies to A = Rs. 100

The Balance Sheet:

This is how the combined balance sheet of the Banks will look like:

Bank Liabilities  Deposits Assets Credits Reserve Total Assets
Bank_1 100 90 10 100
Bank_2 90 81 9 90
Bank_3 81 72.9 8.1 81
- - - - -
- - - - -
Bank_n 00 00 00 00
Total 1,000 900 100 1000

Such is the power of this simple process that banks have created an asset of Rs. 1000 using an initial money of Rs. 100. In other words, Banks have created money. This type of banking is called “Fractional Reserve Banking”

Why does this process succeed?

This process succeeds because most money transfers today do not involve cash or currency. It involves just cheques, DD, etc. or electronic transfer – mere numbers on a computer screen.

When would it fail?

This system fails in two main cases:

  1. Cascade of withdrawals
    When all depositors come asking for their money back at the same time. The banking system will not have enough currency to meet the demands. In fact, one main purpose of the CRR is that the banks must be able to repay deposits when there are significantly large number of withdrawals.
  2. Loan defaults
    What would happen when the debtors default or fail to repay the loans? This would also result in banks having insufficient money to pay back depositors.

The financial system is much more complicated than what we have discussed. But the above two are one of the basic reasons for the recent recession – just that it involved a cascade of selling stocks on the market, and defaults of subprime mortgage loans.

The key thought here is:

Cash or Currency refers to the physical notes in our purses. Money, on the other hand, is a symbol of promise or trust (I promise to pay the bearer the sum of …). While cash is limited in an economy, money is unlimited.

Featured image: Saad Akhtar (Flickr)

sensex

SENSEX – My understanding

SENSEX - What is it ???
SENSEX – What is it ???

What is the buzzword now in India? The SENSEX. All that I knew a few weeks back was that the Sensex was at 21000 points, and now it is at 9000 points. What exactly are these points? How are they calculated? What is Sensex? What is happening in the financial world? A quest for answers to these questions helped me in understanding the market scenario. Now when I watch NDTV Profit, I am able to understand what they are speaking about!!!

A small story…

Suppose I buy a hotel, say for 50 lakh Rupees Then I manage the hotel successfully for one year with high profit, say 10 lakh. The profit continues for the next year also. So the establishment can be considered as an investment which gives profit in interest. Now how much is my hotel worth? If I plan to sell, there might be a buyer who might offer 100 lakh, considering the fact that the hotel is already running successfully yielding a profit of 10 lakh, and the profits might increase. So I plan to sell it at 100 lakhs.

There might be 10 buyers willing to buy. But none has 100 lakh. So, I plan to sell ’shares’ in the hotel. I can sell one share at 10 lakh to each of the ten buyers. Or I can divide the ownership into 1000 shares, at 10000 each. Or I can have 500 shares for myself and sell the others. This will help me retain a majority of shares, and remain in control of the hotel establishment. This is the basics of what shares are.

A different scenario. I need to start a hotel. I don’t have money to invest. So I request the public for money. This is called initial public offering. I can sell 1 lakh shares at 50 Rupees each, to get 50 lakh “Rupees immediately. This money I use to build and establish a hotel. The first year I get a profit of 10 lakh. I can do two things with this. I can share the profit with all shareholders, giving a ‘dividend’ of 10 rupees. Or I can save profits for further development of the company, which in turn will increase the company’s value and the share value. A shareholder can then sell his share and get profit (or loss, if the company’s value goes down)

Shares of public companies are bought and sold in stock exchanges. The BSE is the oldest and the largest stock exchange in India. The index that BSE uses is called the Sensex.

Free float market capitalization

An understanding of the Sensex requires the knowledge about ‘free flow market capitalization’. The word ‘capitalization’ or ‘market capitalization’ of a company refers to the ‘net worth’ of the company. This includes the total assets of a company. This is actually equal to the share price times the number of shares outstanding of a public company.

All shares of a public company will not be available for the public to buy or sell. Some shares might be held by the founders or directors, the government might own some shares, associate companies might own some, and so on. The free float shares refer to the shares that are available for trade in the open market. The free flow market capitalization is the total value of all shares that are available for trade by public.

Specifically, the following categories of holding are generally excluded from the definition of free-float:

  • Shares held by founders/directors/ acquirers which has control element
  • Shares held by persons/ bodies with “Controlling Interest”
  • Shares held by Government as promoter/acquirer
  • Holdings through the FDI Route
  • Strategic stakes by private corporate bodies/ individuals
  • Equity held by associate/group companies (cross-holdings)
  • Equity held by Employee Welfare Trusts
  • Locked-in shares and shares which would not be sold in the open market in normal course.

The remaining shares come under the free-float category.

Free float factor

The percentage of free float shares among the total number of shares is calculated for every indexed company, based on the information specified by them regarding their shares. This percentage is rounded off to the higher multiple of 5. The corresponding fraction is the free float factor.

Let 43% of all shares come under the free float category.
43% when rounded off to the nearest multiple of 5 gives 45%
The corresponding factor is 0.45.
The free float factor is 0.45
This free float factor means that only 45% of the total market capitalization of the company will be taken for index calculation.

SENSEX Calculation

Sensex is calculated taking into consideration stock prices of 30 different BSE listed companies. This means that the level of index at any point of time reflects the market value of its 30 component stocks relative to a base period. The year 1978-79 is considered as the base period and the base value has been set to 100 index points.

Sensex value = Current free-float market value of constituents stocks / Index Divisor

The Index Divisor adjusts the original base period of the Sensex to its present level. The Divisor is the only link to the original base period value of the Sensex. This keeps the Sensex comparable over time.

The calculation is ‘claimed’ to be simple, involving basic mathematical concepts of ratios and proportions. If the free-float market capitalisation is Rs 9,00,000 crore and if the Sensex value is 14,500 — then, for a free-float market capitalisation of Rs 9,50,000 crore, the Sensex value will be 15,306.
9,50,000 x 14,500 / 9,00,000 = 15,306 (approx.)

[ Not much is known about the Index Divisor value. The value has not been released publicly, and there are doubts whether the divisor is a true constant or not. As far as I know, the value lies somewhere close to 64. ]