CHAPTER TWO

2. Banking System

Banking Company is one which transacts the business of banking which means
accepting deposit for the purpose of lending or investment of deposits money from the public
repayable on demand or can be withdrawn through cheque, draft, and order. And also
bank imply that bank is a business institution which deals in money and use of money.
Thus a proper and scientific definition of the bank should include various functions
performed by a bank in a proper manner. Any institution, company or enterprise can be
a bank after fulfilling all the requirements of registration as a bank. The business of a
bank consists of acceptance of deposits, withdrawals of deposits, making loans and
advances, investments on account of which credit is exacted by banks.

2.1. Central Banking

2.1.1. Introduction

A central bank can generally be defined as a financial institution responsible for

overseeing the monetary system for a nation, or a group of nations, with the goal of
fostering economic growth without inflation. In the monetary and banking setup of a
country, central bank occupies central position and perhaps, it is because of this fact that this
called as the central bank. In this way, this bank works as an institution whose main objective is
to control and regulate money supply keeping in view the welfare of the people. Central bank is
an institution that fulfills the credit needs of banks and other credit institution, which woks as
banker to the banks and the government and which work for the economic interest of the
country.

2.1.2. Functions of Central Bank

A central bank functions as the apex controlling institution in the banking and financial system
of the country. The core functions of central banks in any countries are: to manage monetary
policy with the aim of achieving price stability; to prevent liquidity crises, situations of money
market disorders and financial crises; and to ensure the smooth functioning of the payments
system.
The main functions of a central bank are discussed in the following section.

A. Monopoly of note issue

The central bank has the sole monopoly of note issue in almost every country. The currency
notes printed and issued by the central bank become unlimited legal tender throughout the
country.

B. Banker, Agent and Adviser to the Government

The central bank functions as a banker, agent and financial adviser to the government:
(a) As a banker to government, the central bank performs the same functions for the government
as a commercial bank performs for its customers. It maintains the accounts of the central as well
as state government; it receives deposits from government; it makes short-term advances to the
government; it collects cheques and drafts deposited in the government account; it provides
foreign exchange resources to the government for repaying external debt or purchasing foreign
goods or making other payments,

(b) As an Agent to the government, the central bank collects taxes and other payments on behalf
of the government. It raises loans from the public and thus manages public debt. It also
represents the government in the international financial institutions and conferences,
(c) As a financial adviser to the lent, the central bank gives advice to the government on
economic, monetary, financial and fiscal ^natters such as deficit financing, devaluation, trade
policy, foreign exchange policy, etc.

C. Bankers’ bank

As a custodian of the cash reserves of the commercial banks the central bank maintains the cash
reserves of the commercial banks. Every commercial bank has to keep a certain percentage of its
cash balances as deposits with the central banks. These cash reserves can be utilised by the
commercial banks in times of emergency. Such cash reserves with the Central Bank have the
following advantages:

i. Centralized cash reserves inspire confidence of the public in the banking system of the
country.
ii. Centralized reserves can be used to the fullest possible extent and in the most

effective manner during the periods of seasonal strains and financial emergencies.

iii. Centralized reserves enable the central bank to provide financial accommodation to the
commercial banks which are in temporary difficulties.

D. Lender of Last Resort

As the supreme bank of the country and the bankers' bank, the central bank acts as the lender of
the last resort. In other words, in case the commercial banks are not able to meet their financial
requirements from other sources, they can, as a last resort, approach the central bank for financial
accommodation. The central bank provides financial accommodation to the commercial banks by
rediscounting their eligible securities and exchange bills.

E. custodian of National reserves

Central Bank is the custodian of nation's gold and foreign exchange reserves. The value of a
currency depends upon the gold reserves or foreign exchange reserves held as the backing for the
currency. As such, it is the responsibility of the Central Bank to maintain sufficient reserves and
to prevent their depletion.

The Central Bank manipulates the bank rates and takes other steps to conserve the reserves of
gold and foreign exchange. Some Central Banks have absolute powers to control the foreign
exchange reserves and to license the various uses to which the foreign exchange is put to use. In
modern times, the foreign exchange control has become the essential function of the Central
Bank.

F. Clearing House

Central bank acts as a Clearing house and facilitates banking transactions and their internal
exchanges. All commercial bank have their accounts with the central bank. They have to send
their reports. The internal adjustment of dealing of banks is made without transfer of
money by the central bank. This system saves time and expenditure of the bank. Therefore,
central bank settles the mutual transactions of banks and thus saves all banks controlling each
other individually for setting their individual transaction. Clearing house keeps the central bank
fully informed about the liquidity position of the commercial banks.

G. Collection of Data

Central banks in almost all the countries collects statistical data regularly relating to economic
aspects of money, credit, foreign exchange, banking etc. from time to time, committees and
commission are appointed for studying various aspects relating to the aforesaid problem.

H. Monetary policy

Monetary policy is the process of controlling the supply of money, often targeting a rate of
interest, by the central bank in order to promote economic growth and stability.
The most important function of any central bank is to undertake monetary control
operations. Typically, these operations aim to administer the amount of money
(money supply) in the economy and differ according to the monetary policy objectives
they intend to achieve. These latter are determined by the government’s overall
macroeconomic policies.

Monetary policy is one of the main policy tools used to influence interest rates,
inflation and credit availability through changes in the supply of money (or
liquidity) available in the economy. It is important to recognize that monetary
policy constitutes only one element of an economic policy package and can be
combined with a variety of other types of policy (e.g., fiscal policy) to achieve
stated economic objectives.

2.1.3. Monetary policy objectives

Historically, monetary policy has, to a certain extent, been subservient to fiscal

and other policies involved in managing the macro economy, but now a days it can
be regarded as the main policy tool used to achieve various stated economic policy
objectives (or goals).

The main objectives of monetary policy include:

A. Economic growth: Economic growth can be enhanced by investment in capital, such as

more or better machinery. A low interest rate implies that firms can loan money to invest in
their capital stock and pay less interest for it. Lowering the interest is therefore considered to
encourage economic growth and is often used to alleviate times of low economic growth.
B. High employment – Monetary policy affects the national money supply and the
availability of credit for business and consumers. This leads to the demand for the
employees who produce those goods and services hence leads to a decrease in
unemployment rate

C. Price stability- Price stability means that one year from now a birr/dollar will buy roughly the
same as it buys today. Strong rising (inflation) or falling (deflation) prices leads to insecurity and
will harm the economy. Hence price stability is a necessary precondition for a healthy economy.
Rapidly rising prices erode purchasing power. People will start demanding higher wages.
Companies will, in turn, factor the higher wages into the prices of their products. In such an
environment, where all goods and services keep growing more and more expensive, consumers
and business are left without solid ground to base sound economic decisions on. Price stability
offers them security and confidence, which contribute to sustainable economic growth. This is
why the central bank is directed at maintaining price stability.

2.2. Commercial Banking

2.2.1. Definition of commercial banking

Commercial Bank act as Intermediaries because they accept deposits from savers and
lend these funds to borrowers. Commercial Bank is financial institution that accepts
deposits for the purpose of lending. In other words, commercial banks provide services
such as accepting deposits, giving business loans and allow for variety of deposit
accounts. They collect money from those who have it to spare and lend to those who
require it. Commercial Bank is a banker to the general public.

Commercial banks are privately owned, profit-seeking institutions; yet their actions
strongly affect the nation's economic health. They hold deposits and make payments,
smoothing the process of exchange and promoting the advantages of specialization.
They create new purchasing power which permits and encourages economic growth.
Without a well-developed system of commercial banks, our living standards would not
have improved so dramatically over the years.

2.2.2. The Functions and services of Commercial Banks

In addition to the acceptance of deposits of various types for the purpose of lending or
for investment, banks are permitted to engage in some other forms of business, such as
collection of checks, bills and other instruments, remittance of funds, opening Letter of
Credit (L/C), issuing traveler checks, accepting articles for safe custody, executors and
trustees, underwriting the issue of shares, debentures, and so forth.

The following business may be undertaken by a commercial bank. These Businesses can
be broadly categorized into four:

1) Main Functions of Commercial Bank

 Receiving deposits: the primary function of commercial Banks is accepting
deposits from the public. Banks maintain deposits account for their customers
and convert deposit money into cash and vice versa, at the discretion of the latter.
 Making loans and advances: lending money is one of the important functions
of the bank. This lending or advancing of money can be either upon or without
security. Banks accept deposits from those who have surplus money and grant
loans and advance to those who need them. Banks charge comparatively higher
rate of interest on the amount advanced as a loan. Loans are advanced by the
bank in such a ways as: overdrafts, discount of bills, short notice loans, and
various forms of direct loans to traders and producers.
2) Subsidiary or Ancillary Functions
 Safe deposits vaults
 Personal tax assistance, preparing income tax /sales tax/wealth tax returns
 Investment facilities such as under writing of new issues, guidance to invest,
stock exchange assistance.
 Credit transfers
 Credit cards
3) Agency Services
Bankers perform certain function for and on behalf of their customers, such as:
  Customers can arrange for dividends to be sent to their bank and paid directly
into bank accounts, or for the basic to detach coupons from bearer bonds and
present them for payment and to act upon announcements in the press of
drawn bonds, coupon payable, etc.
 To collect and make payment for bills, checks, promissory notes, interest,
rent, subscription, insurance premiums, etc. for their services, some charges
are usually levied by the banks.
4) Credit Creation

Multiple expansions of deposits is called credit creation and the ability of the banks to
expand the deposits makes them unique and distinguish them from other non-bank
financial institutions. Demand deposits are an important constituent of money supply
and the expansion of demand deposits means expansion of money supply.

The whole structure of banking is based on credit. Credit means getting the purchasing
power (i.e., money) now by a promise to pay at some time in future. In the words of
Kent, "Credit may be defined as the right to receive payment or the obligation to make
payment on demand or at some future tune on account of an immediate transfer of
goods." In a sense, the words credit, debt and loan are synonymous.

In nutshell, credit creation refers to the unique power of the banks to multiply loans and
advances, and hence deposits. With a little cash in hand, the banks can create additional
purchasing power to a considerable degree. It is because of the multiple credits creating
power that the commercial banks have been aptly called the 'factories of credit' or
'manufactures of money'.

In the words of Newlyn. "Credit creation refers to the power of commercial banks to
expand secondary deposits either through the process of making loans or through
investment in securities." The banks expand loans by much more than the amount of
cash possessed by them. This tendency on the part of the banks to lend more than the
amount of cash possessed by them is called Creation of credit in Economics.
2.2.3. Limitation of Credit
Banks have not unlimited credit creation powers, but there are limiting factors:
1. Restriction By The Central Bank:- If the banks have large deposits they can create
more credit and if they have small deposits then their power of credit creation will be
limited. While we know the commercial bank has the monopoly of note issue, if the
central bank increase the quantity of money the deposits of commercial banks will
increase and they will expand the volume of credit in the enquiry. On the other hand if
supply of money decreases, the volume of credit also of decreases. The credit creation
power of the commercial bank is directly affected by the policy of the central bank.

2. Habits Of The Customers:- The power to create credit by the commercial banks is
very much influenced by the habits of the people living in that country. If the people are
habitual in using the cheques then the volume of credit will expand on the other it will be
contracted.

3. The Cash Ratio:- Every bank keeps an adequate cash reserves for meeting the cash
requirements of its customers. The bank will not allow its cash ratio to fall below a
certain minimum level. When this level is reached then bank will not advance money.

4. The Collateral Security Available:- The bank advances loan to the borrowers
against some kind of Collateral Security. If these are not available then the power of
credit creation will be restricted.