Tag: introduction

A brief history of Banking

Today we’ll talk a little about the history of banking…how modern banks as we know them came about. We shall also cover the important types of banks and the role of a central banking authority. As with last week, the source of a lot of this information is the book ‘An Introduction to Global Financial Markets’ by Stephen Valdez.


European Central BankIn a lot of ways, modern banking owes its origins to the Italian merchants of the 13th, 14th and 15th centuries. The merchants would sit in open air benches, called ‘banco’ in Italian, to do their money lending business, hence giving us the word ‘bank’. If the business went into liquidation, the bench would be officially broken, giving us the word ‘bancorupto’ or bankrupt! These  bankers were very advanced for their times, they used to do business with traders as far away as London, experimented with marine insurance, had book entry for money instead of physically transporting it and even double entry book keeping systems. Banknotes were invented in the UK by goldsmiths. Goldsmiths has secure vaults of gold and silver coins and would give out receipts for deposits and borrowings backed by gold coins. In fact, for a period of about 150 years goldsmiths were synonymous with bankers in the UK!

Types of banks

Commercial banks

These banks are involved in classic banking activities – taking deposits from investors in return for interest payments and lending money to individuals/businesses. Some commercial banks are into retail banking i.e. catering to the general public and small businesses. Some are into wholesale banking catering to large businesses and institutional investors. Wholesale banking usually involves lesser volumes of transactions than retail banking but the transactions are generally of much higher value.

Merchant and Investment banks

Merchant or Investment banking is the business of ‘helping people raise money’. These banks advice their clients on issues related to merging with or acquiring other companies, issuing new bonds or equity and deciding on the best way to raise capital. If the clients want to raise capital by issuing bonds or equity, these banks help them zero in on the right price, assist in selling the issue to investors and sometimes also underwrite the issue – i.e. buy the securities issued if investors do not.

In the UK, the terms Merchant banking and Investment banking are used interchangeably and mean the same. However, in the US, Merchant banking is used to the practice of applying the banks own capital in takeover/merger activities.

We will talk in more detail about Investment banking activities like Merger and Acquisitions (M&A), Initial Public Offerings (IPO) and underwriting in the coming weeks.

A bank’s balance sheet

English: Detail from Government. Mural by Elih...

A bank’s liabilities would include the shareholders equity plus any retained profits, customer deposits (the largest figure) and other borrowings (for e.g. bonds issued). The liabilities are money borrowed from others that the bank needs to repay at some point. Assets represent how this borrowed money has been utilized. The money may be held as cash reserves, invested in short term securities like money market funds (available at short notice), invested in other securities like Treasury bills, or may be in the form of property or equipment that cannot be easily liquidated. The balance sheet shows what the bank is worth at a particular point in time as the difference between the assets and liabilities will give the profit or loss for that period.

The role of the Central bank

In many countries, though not all, there is a central bank which oversees all the other banks and also serves as the market maker for the country’s economy and manages the government’s money. In some countries there is a separate authority other than the central bank for regulation. In general, the central bank plays the following roles –

  1. Serves as a supervisor of the banking system
  2. Maintains the economic health of the country
  3. Issues bank notes
  4. Serves as a banker to the government
  5. Acts as a ‘lender of last resort’

The Central bank often mandates that all banks report their profit/losses, liquidity and any large exposures to it at regular intervals. It also has rules pertaining to the minimum amount of cash reserves that banks should maintain, called the liquidity ratio. Often, the Central bank requires banks to deposit a ‘balance of reserves’ with it. The idea behind this is that the banks should be able to repay investors even if a certain percentage of borrowers default on their loans. Thus, the banks should maintain a healthy capital ratio i.e. the ratio between its borrowing (capital) and lending.

Central banks maintain the economic health of the country by regulating interest rates. The concept is – as interest rates are raised, loan payments go up and so does the cost of borrowing money. Therefore, people have less money to spend and the price of goods has to be lowered to attract buyers. This leads to a recession like scenario.  Conversely, when interest rates are lowered, loan payments come down and the cost of borrowing is reduced. So, people go out and spend more. This boosts the economy and stimulates growth.

Central banks help governments raise money by handling government issues like bonds. The cumulative sum of money owed by governments by borrowing is called the national debt. Economists compare the national debt to the national income as a ratio to measure the country’s economic situation. For this purpose, the figure for Gross Domestic Product (GDP) is used as equivalent to the national income.

Finally, Central banks also help other banks temporarily when they meet problems with their liquidity. Though, given the current global economic problems, the term ‘lender of last resort’ has come to mean simply, the rescuer of banks in big trouble who are too big to fail!



Conglomerates: Heartbreak hotel?

Conglomerates are companies that either partially or fully own a number of other companies. Sprawling conglomerates litter the Indian landscape: from the Birlas to the Welspun Group, they have a finger in just about every pie.

The case for conglomerates can be summed up in one word: diversification. Because the business cycle affects industries in different ways, diversification results in a reduction of investment risk. A downturn suffered by one subsidiary can be counterbalanced by stability, or even expansion, in another venture.

The core of the idea came from a Harvard Business School proposition that management is management. If you could manage an oil business; you could also manage a movie studio, because the basic fundamental principles were the same. But anybody who has actually managed a business knows that success depends on understanding deeply the industry in which one operates. However, the megalomaniac allure of being everywhere and owning everything is hard to resist. After all, managers are also human, aren’t they?

The case against conglomerates can be summed up in two words: size and complexity. Bigger size slows down decision-making while complexity creates confusion. Diversified companies often allocate capital to keep poorly performing divisions alive. The market would have cut them off, but in a diversified firm, good money is thrown after bad. For investors, conglomerates can be difficult to understand – accounting can leave a lot to be desired and can obscure the performance of separate divisions. Behind every Tata company there is the unlisted and opaque Tata Sons lurking in the background.

So should we break up these behemoths and force them to be independent entities? It depends. Research shows that companies with one division operating in a high-growth industry and another in a low-growth industry will generally do a worse job of allocating capital than one with two divisions operating in industries with comparable growth prospects. It means that the Reliance of yore, the vertically integrated petrochemicals major, is an example of a “good” conglomerate. Whereas the new Reliance, the one that wants to be in every vertical possible, is an example of a “bad” conglomerate.

Forewarned is forearmed!



Introduction to Financial Markets

Ever wonder why we have banks? Where does money come from? Why do we need the Reserve Bank? And yet, these concepts and institutions touch every facet of our lives. Let’s begin a journey to understand the basics of this financial system we are in. Over a period of the next few weeks, we’ll go over the different spokes of the financial wheel from a beginner’s point of view.

Reference material for the following posts comes from the book ‘An Introduction to Global Financial Markets’ by Stephen Valdez.

Why do we need any financial markets? Who are the players?

First there are parties who need to borrow money – these parties could be individuals, like you, private companies or governments. People may need to borrow money to pay off home loans and so on, private companies may need to borrow money to further their growth and expansion, and we all know governments need to spend a lot of money on public projects for which taxes collected from citizens is probably not going to be sufficient!

Then, believe it or not there are parties with surplus funds that they are willing to lend to the borrowers. We all know that idle cash doesn’t make money on its own! They may be people depositing savings in a bank, insurance or pension funds, or companies with profits to invest. In an ideal world where every borrower could meet a lender and vice versa without any intermediary, there would be no need for financial institutions or markets. But as it happens, we need intermediaries to facilitate the transactions between borrowers and lenders – the intermediaries are banks, other financial institutions and markets.

To give you a perspective – a private investor might deposit money in a bank at a 10% rate of interest p.a. for her savings account. Meaning that for a deposit of Rs. 1,00,000, she will get Rs. 1,10,000 back from the bank at the end of the year. How will the bank get the additional Rs. 10,000 to pay the investor at the end of the year? Obviously the bank will need to invest that money elsewhere, where the rate of interest is greater than 10% p.a. leaving enough profit for the bank to pay back the investor plus a surplus amount which is income for itself. We’ll see what options the bank has in a bit, but before that let’s take a look at the different types of securities in play in the financial markets.

Securities at play


Bonds, also called debt instruments, are securities that pay out fixed amounts at regular intervals. That’s why bonds are also known as fixed income products or securities. Governments or private companies issue bonds when they want to raise capital. The purchaser of a bond is basically granting a loan to the issuer, which will be paid back over at the end of the borrowing duration. In the meantime, fixed interest payments are made by the borrower (the bond issuer) to the lender (purchaser). The fixed interest payments are also called coupons because in the days of yore, bonds were actually pieces of paper with the principal amount borrowed, interest rate and maturity printed on them. Interest payments could be redeemed by tearing off the coupons attached to the bond!

In our banking example above, the bank could purchase a fixed interest bond with a 12% rate of interest p.a. That means the bank earns Rs. 1,12,000 at the end of the year, leaving enough money to pay back the private investor in addition to a Rs. 2,000 profit for itself.

Of course, the ability of the borrower/issuer of the bond to pay back the principal depends on their creditworthiness which is what makes the bond desirable to purchasers. A government for instance, is considered safe as it’s unlikely to go bankrupt and will be able to repay its borrowings. The creditworthiness of private companies is a range determined by several credit ratings agencies such as Moody’s or Standard and Poor’s who assign ratings based on their analysis of the company’s liquidity.


The terms equity, common stock and shares are used interchangeably to mean the same thing. Shares are another means for companies to raise money from investors, but unlike bonds where fixed interest payments are made in return for the investment, shareholders don’t get fixed payments but actually own part of the company, corresponding to their share in the company’s profits. The percentage of the company owned by a shareholder would be proportional to the number of shares they own as a percentage of the total number of shares of that company in circulation. If this is the first time the company has issued shares to the public to raise capital, it’s called a new issue or the Initial Public Offering (IPO). Unlike in the case of bonds, there is no expectation for the company to return the original investment; the returns are realized in the form or capital gains when the company is profitable. Since the investor is part owner of the company, profitability increases the share prices, so the shareholder can sell the shares to other interested investors at a higher price in the secondary market.

We shall cover both these types of securities in much more detail in the coming weeks in addition to the several more complicated securities like options, swaps, forwards, futures and derivatives.

Next week, we talk about the history of banking and the different types of banking – commercial banking and investment banking. Stay tuned!