CHAPTER ONE: AN OVERVIEW OF BANKS AND THEIR FUNCTION

Introduction

You know people earn money to meet their day to day expenses on food, clothing, education of
children etc. They also need money to meet future expenses on marriage, higher education of
children, housing building and social functions. These are heavy expenses, which can be met if
some money is saved out of the present income. With this practice, savings were available for
use whenever needed, but it also involved the risk of loss by theft, robbery and other accidents.

Thus, people were in need of a place where money could be saved safely and would be available
when required. Banks are such places where people can deposit their savings with the assurance
that they will be able to withdraw money from the deposits whenever required. Bank is a lawful
organization which accepts deposits that can be withdrawn on demand. It also tends money to
individuals and business houses that need it.

Definitions of Bank
The term ‘Bank’ has been defined in different ways by different economists. A few definitions
are:
According to Walter Leaf “A bank is a person or corporation which holds itself out to receive
from the public, deposits payable on demand by check.” Horace White has defined a bank, “as a
manufacture of credit and a machine for facilitating exchange.”

According to Prof. Kinley, “A bank is an establishment which makes to individuals such

advances of money as may be required and safely made, and to which individuals entrust money
when not required by them for use.”

The Banking Companies Act of India defines Bank as “A Bank is a financial institution which
accepts money from the public for the purpose of lending or investment repayable on demand or
otherwise withdrawable by checks, drafts or order or otherwise.”
Thus, we can say that a bank is a financial institution which deals in debts and credits. It accepts
deposits, lends money and also creates money. It bridges the gap between the savers and
borrowers. Banks are not merely traders in money but also in an important sense manufacturers
of money.

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 Types of Banks
Banks can be classified into various types on the bases of their functions, ownership, domicile,
etc.
Classification on the basis of function: On the basis of their functions, the banking institution
may be divided into the following types:

A) Central Bank
A central bank functions as the apex controlling institution in the banking and financial system
of the country. It functions as the controller of credit, banker’s bank and also enjoys the
monopoly of issuing currency on behalf of the government. A central bank is usually control and
quite often owned, by the government of a country. The national bank of Ethiopia is such a bank
within our country.

Functions of the Central Bank

The functions of the central bank differ from country to country in accordance with the
prevailing economic situation. But there are certain functions which are commonly performed by
the central bank in all countries. According to De Kock, there are six functions which are
performed by the central bank in almost all countries.

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1. Monopoly of Note Issue: The issue of money was always the privilege of the government.
Keeping the minting of coins with it, the government delegated the right of printing currency
notes to the central bank. In fact the right and privilege of note issue was always associated with
the origin and development of central banks which were originally called as banks of issue.
Nowadays, central banks everywhere enjoy the exclusive monopoly of note issue and the
currency notes issued by the central banks are declared unlimited legal tender throughout the
country. The central bank keeps three considerations in view as regards issue of notes-
uniformity, elasticity (amount according to the need for money), and safety.

2. Custodian of Exchange Reserves: The central bank holds all foreign exchange reserves-key
currencies such as U.S. dollars, British pounds and other prominent currencies, gold stock, gold
bullion, and other such reserves-in its custody. This right of the central bank enables it to
exercise a reasonable control over foreign exchange, for example, to maintain the country’s
international liquidity position at a safe margin and to maintain the external value of the
country’s currency in terms of key foreign currencies.

3. Banker to the Government: Central banks everywhere perform the functions of banker,
agent and adviser to the government. As a banker to the government, the central bank of the
country keeps the banking accounts of the government both of the Centre and of the States
performs the same functions as a commercial bank ordinarily does for its customers. As a banker
and agent to the government, the central bank makes and receives payments on behalf of the
government. It helps the government with short-term loans and advances (known as ways and
means advances) to tide over temporary difficulties and also floats public loans for the
government. It also manages the public debt (i.e., floats services and redeems government loans).
It advises the government on monetary and economic matters.

4. Banker to Commercial Banks: Broadly speaking, the central bank acts as the banker’s bank
in three different capacities: (a) It acts as the custodian of the cash reserves of the commercial
banks (b) It acts as the lender of the last resort (c) It is the bank of central clearance, settlement
and transfer. We shall now discuss these three functions one by one.

(a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks
keep part of their cash balances as deposits with the central bank of a country known as

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centralization of cash reserves. Part of these balances are meant for clearing purposes, that is,
payment by one bank to another will be simple book entry adjustment in the books of the central
bank. There are many advantages when all banks keep part of their cash reserves with the central
bank of the country. In the first place, with the same amount of cash reserves, a large amount of
credit creation is possible. Secondly, centralized cash reserves will enable commercial banks to
meet crises and emergencies. Thirdly, it enables the central bank to provide additional funds to
those banking institutions which are in temporary difficulties. Lastly, it enables the central bank
to influence and control the credit creation of commercial banks by making the cash reserves of
the latter more or less.

(b) Lender of the last resort: As the banker’s bank, the central bank can never refuse to
accommodate commercial banks. Any commercial bank wanting accommodation from the
central bank can do so by rediscounting (selling) eligible securities with the central bank or can
borrow from the central bank against eligible securities. By lender of the last resort, it is implied
that the latter assumes the responsibility of meeting directly or indirectly all reasonable demands
for accommodation by commercial banks in times of difficulties and crisis.

(c) Clearing agent: As the central bank becomes the custodian of cash reserves of commercial
banks, it is but logical for it to act as a settlement bank or a clearing house for other banks. As all
banks have their accounts with the central bank, the claims of banks against each other are
settled by simple transfers from and to their accounts. This method of settling accounts through
the central bank, apart from being convenient, is economical as regards the use of cash. Since
claims are adjusted through accounts, there is usually no need for cash. It also strengthens the
banking system by reducing withdrawals of cash in times of crisis.

Furthermore, it keeps the central bank of informed about the state of liquidity of commercial
banks in regard to their assets.

5. Controller of Credit: Probably the most important of all the functions performed by a
central bank is that of controlling the credit operations of commercial banks in order to control
inflationary and deflationary pressures within the economy. In modern times, bank credit has
become the most important source of money in the country, relegating coins and currency notes

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to a minor position. As controller of credit, the central bank attempts to influence and control the
volume of bank credit and also to stabilize business conditions in the country.

Objectives of Credit Control

• To Stabilize the Internal Price Level: - Abnormal amount of credit affects in both ways. In
case of excess; inflation grabs the economy and in case of shortage deflation plays the role.
Thus, the aim of the policy of the credit control should be to check the prices.

• Checking Booms and Depressions: - The operation of trade cycles causes instability in the
country. So the objective of the credit control should be to reduce the uncertainties caused by
these cycles. The central bank adjusts the operation of the trade cycles by increasing and
decreasing the volume of credit.

• Promotion of Economic Development: - The objective of credit control should be to

promote economic development and employment in the country. When there is lack of
money, its supply should be increased so that there are more and more economic activities
and more and more people may get employment.

• Stability of the Money Market: - The central bank should operate its weapons of credit
control so as to neutralize the seasonal variations in the demand for funds in the country. It
should liberalize credit in terms of financial stringencies to bring about stability in the money
market.

• Stability in Exchange Rates: - This is also an important objective of credit control. Credit
control measures certainly influence the price level in the country. The internal price level
affects the volume of exports and imports of the country which may bring fluctuations in the
foreign exchange rates. While using any measure of credit control, it should be ensured that
there will be no violent fluctuation in the exchange rates.

Methods Used by the Central Bank for Credit Control

Some of the methods that can be used by the central bank for credit control are discussed as
follows:
• Bank Rate or Discount Rate Policy: - It is the rate fixed by the central bank at which it
rediscounts first class bills of exchange and government securities held by commercial banks.

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 It is the interest rate charged by the central bank at which it provides rediscount to banks
through the discount window. The central bank controls credit by making variations in the
bank rate. If the need of the economy is to expand credit, the central bank lowers the bank
rate and vice versa.

 Open Market Operations: - This method refers to the sale and purchase of securities, bills
and bonds of government as well as private financial institutions by the central bank. But in
its narrow sense, it simply means dealing only in government securities and bonds. This
causes the monetary base (the quantity of notes and coins in circulation plus the quantity held
by the banking system) to be affected.

• Variable Reserve Ratio: - In some countries, banks are required to hold a certain fraction of
deposits as cash reserves, and the central bank can influence the money supply. If the reserve
ratio is raised, it means banks have to reduce their lending, so the money supply is reduced.

• Direct Action: - It is in the form of “directives’’ issued from time to time to the commercial
banks to follow a particular policy which the central bank wants to enforce immediately. This
policy may not be used against all banks but against erring banks. For example, the central
bank refuses rediscounting facilities to certain banks which may be granting too much credit
for speculative purposes.

6. Promoter of Economic Development: In developing economies the central bank has to play
a very important part in the economic development of the country. Its monetary policy is carried
out with the object of serving as an instrument of planned economic development with stability.
The central bank performs the function of developing long-term financial institutions, also
known as development banks, to make available adequate investible funds for the development
of agriculture, industry, foreign trade, and other sectors of the economy. The central bank has
also to develop money and capital markets.

A central bank functions as the apex controlling institution in the banking and financial system
of the country. It functions as the controller of credit, banker’s bank and also enjoys the
monopoly of issuing currency on behalf of the government. A central bank is usually control and
quite often owned, by the government of a country. The national bank of Ethiopia is such a bank
within our country.`

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 B) Commercial Banks
A commercial bank is a profit seeking business firm, dealing in money and credit. It is a financial
institution dealing in money in the sense that it accepts deposits of money from the public to
keep them in its custody for safety. So also, it deals in credit, i.e., it creates credit by making
advances out of the funds received as deposits to needy people. It thus, functions as a mobiliser
of saving in the economy. A bank is, therefore like a reservoir into which flow the savings, the
idle surplus money of households and from which loans are given on interest to businessmen and
others who need them for investment or productive uses.

Types of Commercial Banks

Broadly speaking, banks can be classified into commercial banks and central bank. Commercial
banks are those which provide banking services for profit. The central bank has the function of
controlling commercial banks and various other economic activities. There are many types of
commercial banks such as deposit banks, industrial banks, savings banks, agricultural banks,
exchange banks, and miscellaneous banks.

1. Deposit Banks: The most important type of deposit banks is the commercial banks. They
have connection with the commercial class of people. These banks accept deposits from the
public and lend them to needy parties. Since their deposits are for short period only, these

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 banks extend loans only for a short period. Ordinarily these banks lend money for a period
between 3 to 6 months. They do not like to lend money for long periods or to invest their
funds in any way in long term securities.
2. Industrial Banks: Industries require a huge capital for a long period to buy machinery and
equipment. Industrial banks help such industrialists. They provide long term loans to
industries. Besides, they buy shares and debentures of companies, and enable them to have
fixed capital. Sometimes, they even underwrite the debentures and shares of big industrial
concerns. The industrial banks play a vital role in accelerating industrial development. The
important functions of industrial banks are:
i. They accept long term deposits.
ii. They meet the credit requirements of industries by extending long term loans.
iii. These banks advise the industrial firms regarding the sale and purchase of shares
and debentures.
3. Savings Banks: These banks were specially established to encourage thrift among small
savers and therefore, they were willing to accept small sums as deposits. They encourage
savings of the poor and middle class people.
4. Agricultural Banks: Agriculture has its own problems and hence there are separate banks to
finance it. These banks are organized on co-operative lines and therefore do not work on the
principle of maximum profit for the shareholders. These banks meet the credit requirements
of the farmers through term loans, viz., short, medium and long term loans.
5. Exchange Banks: These banks finance mostly for the foreign trade of a country. Their main
function is to discount, accept and collect foreign bills of exchange. They buy and sell
foreign currency and thus help businessmen in their transactions. They also carry on the
ordinary banking business.
6. Miscellaneous Banks: There are certain kinds of banks which have arisen in due course to
meet the specialized needs of the people. In England and America, there are investment
banks whose object is to control the distribution of capital into several uses. American Trade
Unions have got labour banks, where the savings of the labourers are pooled together. In
London, there are the London Discount House whose business is “to go about the city
seeking for bills to discount.” There are numerous types of different banks in the world,
carrying on one or the other banking business.

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Functions of commercial banks

Commercial banks have to perform a variety of functions which are common to both developed
and developing countries. These are known as ‘General Banking’ functions of the commercial
banks. The modern banks perform a variety of functions. These can be broadly divided into two
categories: (a) Primary functions and (b) Secondary functions.
A. Primary Functions
1. Acceptance of Deposits: Accepting deposits is the primary function of a commercial bank
mobilizes savings of the household sector. Banks generally accept three types of deposits
viz., (a) Current Deposits (b) Savings Deposits, and (c) Fixed Deposits.
a) Current Deposits: These deposits are also known as demand deposits. These deposits
can be withdrawn at any time. Generally, no interest is allowed on current deposits, and in
case, the customer is required to leave a minimum balance undrawn with the bank. Checks
are used to withdraw the amount. These deposits are kept by businessmen and
industrialists who receive and make large payments through banks. Current deposits are
very useful to business houses.

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 b) Savings Deposits: This is meant mainly for professional men and middle class people to
help them deposit their small savings. It can be opened without any introduction. Money
can be deposited at any time. Banks often impose certain restrictions on the operation of
saving accounts, though these restrictions vary from bank to bank. For instance, there
might be a restriction on the amount that can be withdrawn at a particular time or during a
week. In such a case if the customer wishes to withdraw more than the specified amount at
any one time, he has to give prior notice. Interest is allowed on the credit balance of this
account. The rate of interest is less than that on fixed deposit. This system greatly
encourages the habit of thrift or savings.
c) Fixed Deposits: These deposits are also known as time deposits. These deposits cannot be
withdrawn before the expiry of the period for which they are deposited or without giving a
prior notice for withdrawal. If the depositor is in need of money, he has to borrow on the
security of this account and pay a slightly higher rate of interest to the bank. They are
attracted by the payment of interest which is usually higher for longer period. Fixed
deposits are liked by depositors both for their safety and as well as for their interest. The
scheme of fixed deposits is also advantageous to the banker because these deposits offer
facilities to the banker to earn profit out of these deposits by lending them for productive
purposes without the fear of unexpected demand from the depositors.
2. Advancing Loans: The second primary function of a commercial bank is to make loans and
advances to all types of persons, particularly to businessmen and entrepreneurs. Loans are
made against personal security, gold and silver, stocks of goods and other assets. The most
common way of lending is by:
a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw
over and above his account up to a previously agreed limit. Suppose a businessman has
only Br. 30,000/- in his current account in a bank but requires Br. 60,000/- to meet his
expenses. He may approach his bank and borrow the additional amount of Br. 30,000/-.
The bank allows the customer to overdraw his account through checks. The bank,
however, charges interest only on the amount overdrawn from the account. An interest
slightly higher than that of the deposit is charged.
b) Cash Credit: Under this account, the bank gives loans to the borrowers against certain
security. But the entire loan is not given at one particular time, instead the amount is

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 credited into his account in the bank; but under emergency cash will be given. The
borrower is required to pay interest only on the amount of credit availed to him. He will
be allowed to withdraw small sums of money according to his requirements through
checks, but he cannot exceed the credit limit allowed to him.
c) Discounting Bills of Exchange: This is another type of lending which is very popular
with the modern banks. The holder of a bill can get it discounted by the bank, when he is
in need of money. After deducting its commission, the bank pays the present price of the
bill to the holder. Such bills form good investment for a bank. They provide a very liquid
asset which can be quickly turned into cash. The commercial banks can rediscount the
discounted bills with the central banks when they are in need of money. These bills are
safe and secured bills. When the bill matures the bank can secure its payment from the
party which had accepted the bill.
d) Money at Call: Money at call is a type of very short notice loan given by a bank to
another bank or financial institution. The amount of loan is repayable after a day or at the
most after 14 days. Such advances are repayable immediately at short notice hence; they
are described as money at call or call money.
e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists also
against some collateral securities. Term loans are so-called because their maturity period
varies between 1 to 10 years. Term loans, as such provide intermediate or working capital
funds to the borrowers. Sometimes, two or more banks may jointly provide large term
loans to the borrower against a common security. Such loans are called participation
loans.
f) Consumer Credit: Banks also grant credit to households in a limited amount to buy some
durable consumer goods such as television sets, refrigerators, etc., or to meet some
personal needs like payment of hospital bills etc. Such consumer credit is made in a lump
sum and is repayable in installments in a short time. In addition banks of course offer an
extensive array of mortgage products for the purchase of property. The main types of
mortgages are typically extended for 20–25 years.
g) Miscellaneous Advances: Among other forms of bank advances there are packing credits
given to exporters for a short duration, export bills purchased/discounted, import finance-
advances against import bills, finance to the self-employed, credit to the public sector,

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 credit to the cooperative sector and above all, credit to the weaker sections of the
community at concessional rates.
3. Creation of Credit: A unique function of the bank is to create credit. Banks supply money
to traders and manufacturers. They also create or manufacture money. Bank deposits are
regarded as money. They are as good as cash. The reason is they can be used for the purchase
of goods and services and also in payment of debts. When a bank grants a loan to its
customer, it does not pay cash. It simply credits the account of the borrower. He can
withdraw the amount whenever he wants by a check. In this case, bank has created a deposit
without receiving cash. That is, banks are said to have created credit. Sayers says “banks are
not merely purveyors of money, but also in an important sense, manufacturers of money.”
4. Promote the Use of Checks: The commercial banks render an important service by
providing to their customers a cheap medium of exchange like checks. It is found much more
convenient to settle debts through checks rather than through the use of cash. The check is
the most developed type of credit instrument in the money market.
5. Financing Internal and Foreign Trade: The bank finances internal and foreign trade
through discounting of exchange bills. Sometimes, the bank gives short-term loans to traders
on the security of commercial papers. This discounting business greatly facilitates the
movement of internal and external trade.
6. Remittance of Funds: Commercial banks, on account of their network of branches
throughout the country, also provide facilities to remit funds from one place to another for
their customers by issuing bank drafts, mail transfers or telegraphic transfers on nominal
commission charges. As compared to the postal money orders or other instruments, bank
drafts have proved to be a much cheaper mode of transferring money and have helped the
business community considerably.

B. Secondary Functions
Secondary banking functions of the commercial banks include:
1. Agency Services
2. General Utility Services
These are discussed below.

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1. Agency Services: Banks also perform certain agency functions for and on behalf of their
customers. The agency services are of immense value to the people at large. The various
agency services rendered by banks are as follows:
a) Collection and Payment of Credit Instruments: Banks collect and pay various credit
instruments like checks, bills of exchange, promissory notes etc., on behalf of their
customers.
b) Purchase and Sale of Securities: Banks purchase and sell various securities like shares,
stocks, bonds, debentures on behalf of their customers.
c) Collection of Dividends on Shares: Banks collect dividends and interest on shares and
debentures of their customers and credit them to their accounts.
d) Acts as Correspondent: Sometimes banks act as representative and correspondents of
their customers. They get passports, traveler’s tickets and even secure air and sea
passages for their customers.
e) Income-tax Consultancy: Banks may also employ income tax experts to prepare income
tax returns for their customers and to help them to get refund of income tax.
f) Execution of Standing Orders: Banks execute the standing instructions of their
customers for making various periodic payments. They pay subscriptions, rents,
insurance premium etc., on behalf of their customers.
g) Acts as Trustee and Executor: Banks preserve the ‘Wills’ of their customers and execute
them after their death.
2. General Utility Services: In addition to agency services, the modern banks provide many
general utility services for the community as given.
a) Locker Facility: Bank provides locker facility to their customers. The customers can keep
their valuables, such as gold and silver ornaments, important documents; shares and
debentures in these lockers for safe custody.
b) Traveler’sChecks and Credit Cards: Banks issue traveler’schecks to help their customers
to travel without the fear of theft or loss of money. With this facility, the customers need
not take the risk of carrying cash with them during their travels.
c) Letter of Credit: Letters of credit are issued by the banks to their customers certifying
their credit worthiness. Letters of credit are very useful in foreign trade.

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 d) Collection of Statistics: Banks collect statistics giving important information relating to
trade, commerce, industries, money and banking. They also publish valuable journals and
bulletins containing articles on economic and financial matters.
e) Acting Referee: Banks may act as referees with respect to the financial standing, business
reputation and respectability of customers.
f) Underwriting Securities: Banks underwrite the shares and debentures issued by the
Government, public or private companies.
g) Gift Checks: Some banks issue checks of various denominations to be used on auspicious
occasions.
h) Accepting Bills of Exchange on Behalf of Customers: Sometimes, banks accept bills of
exchange, internal as well as foreign, on behalf of their customers. It enables customers to
import goods.
i) Merchant Banking: Some commercial banks have opened merchant banking divisions to
provide merchant banking services.

Sources of bank’s income

A bank is a business organization engaged in the business of borrowing and lending money. A
bank can earn income only if it borrows at a lower rate and lends at a higher rate. The difference
between the two rates will represent the costs incurred by the bank and the profit. Bank also
provides a number of services to its customers for which it charges commission. This is also an
important source of income. The followings are the various sources of a bank’s profit:
1. Interest on Loans: The main function of a commercial bank is to borrow money for the
purpose of lending at a higher rate of interest. Bank grants various types of loans to the
industrialists and traders. The yields from loans constitute the major portion of the income of
a bank. The banks grant loans generally for short periods. But now the banks also advance
call loans which can be called at a very short notice. Such loans are granted to share brokers
and other banks. These assets are highly liquid because they can be called at any time.
Moreover, they are source of income to the bank.
2. Interest on Investments: Banks also invest an important portion of their resources in
government and other first class industrial securities. The interest and dividend received from

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 time to time on these investments is a source of income for the banks. Bank also earns some
income when the market prices of these securities rise.
3. Discounts: Commercial banks invest a part of their funds in bills of exchange by discounting
them. Banks discount both foreign and inland bills of exchange, or in other words, they
purchase the bills at discount and receive the full amount at the date of maturity. For
instance, if a bill of Br. 1,000 is discounted for Br. 975, the bank earns a discount of Br. 25
because bank pays Br. 975 today, but will get Br. 1,000 on the due date. Discount, as a matter
of fact, is the interest on the amount paid for the remaining period of the bill. The rate of
discount on bills of exchange is slightly lower than the interest rate charged on loans and
advances because bills are considered to be highly liquid assets.
4. Commission, Brokerage, etc.: Banks perform numerous services to their customers and
charge commission, etc., for such services. Banks collect checks, rents, dividends, etc.,
accept bills of exchange, issue drafts and letters of credit and collect pensions and salaries on
behalf of their customers. They pay insurance premiums, rents, taxes etc., on behalf of their
customers. For all these services banks charge their commission. They also earn locker rents
for providing safety vaults to their customers. Recently the banks have also started
underwriting the shares and debentures issued by the joint stock companies for which they
receive underwriting commission.

Commercial banks also deal in foreign exchange. They sell demand drafts, issue letters of credit
and help remittance of funds in foreign countries. They also act as brokers in foreign exchange.
Banks earn income out of these operations.

Credit creation
An important function performed by the commercial banks is the creation of credit. The process
of banking must be considered in terms of monetary flows, that is, continuous depositing and
withdrawal of cash from the bank. It is only this activity which has enabled the bank to
manufacture money. Therefore the banks are not only the purveyors of money but manufacturers
of money.

Basis of Credit Creation: The basis of credit money is the bank deposits. The bank deposits are
of two kinds viz., (1) Primary deposits, and (2) Derivative deposits.

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1. Primary Deposits: Primary deposits arise or formed when cash or check is deposited by
customers. When a person deposits money or check, the bank will credit his account. The
customer is free to withdraw the amount whenever he wants by checks. These deposits are
called “primary deposits” or “cash deposits.” It is out of these primary deposits that the bank
makes loans and advances to its customers. The initiative is taken by the customers
themselves. In this case, the role of the bank is passive. So these deposits are also called
“passive deposits.” These deposits merely convert currency money into deposit money. They
do not create money. They do not make any net addition to the stock of money. In other
words, there is no increase in the supply of money.
2. Derivative Deposits: Bank deposits also arise when a loan is granted or when a bank
discounts a bill or purchase government securities. Deposits which arise on account of
granting loan or purchase of assets by a bank are called “derivative deposits.” Since the bank
play an active role in the creation of such deposits, they are also known as “active deposits.”
When the banker sanctions a loan to a customer, a deposit account is opened in the name of
the customer and the sum is credited to his account. The bank does not pay him cash. The
customer is free to withdraw the amount whenever he wants by checks. Thus the banker
lends money in the formof deposit credit. The creation of a derivative deposit does result in a
net increase in the total supply of money in the economy;Hartly Withers says “every loan
creates a deposit.” It may also be said “loans make deposits” or “loans create deposits.” It is
rightly said that “deposits are the children of loans, and credit is the creation of bank clerk’s
pen.”

Granting a loan is not the only method of creating deposit or credit. Deposits also arise when a
bank discounts a bill or purchase government securities. When the bank buys government
securities, it does not pay the purchase price at once in cash. It simply credits the account of the
government with the purchase price. The government is free to withdraw the amount whenever it
wants by check. Similarly, when a bank purchase a bill of exchange or discounts a bill of
exchange, the proceeds of the bill of exchange is credited to the account of the seller and
promises to pay the amount whenever he wants. Thus asset acquired by a bank creates an
equivalent bank deposit. It is perfectly correct to state that “bank loans create deposits.” The
derivate deposits are regarded as bank money or credit. Thus, the power of commercial banks to
expand deposits through loans, advances and investments is known as “credit

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creation.”Therefore, credit creation implies multiplication of bank deposits. Credit creation may
be defined as “the expansion of bank deposits through the process of more loans and advances
and investments.”

Limitation on Credit Creation

The commercial banks do not have unlimited power of credit creation. Their power to create
credit is limited by the following factors:

1. Amount of Cash: The power to create credit depends on the cash received by banks. If
banks receive more cash, they can create more credit. If they receive less cash they can create
less credit. Cash supply is controlled by the central bank of the country.
2. Cash Reserve Ratio: All deposits cannot be used for credit creation. Banks must keep
certain percentage of deposits in cash as reserve. The volume of bank credit depends also on
the cash reserve ratio the banks have to keep. If the cash reserve ratio is increased, the
volume of credit that the banks can create will fall. If the cash reserve ratio is lowered, the
bank credit will increase. The Central Bank has the power to prescribe and change the cash
reserve ratio to be kept by the commercial banks. Thus the central bank can change the
volume of credit by changing the cash reserve ratio.
3. Banking Habits of the People: The loan advanced to a customer should again come back
into banks as primary deposit. Then only there can be multiple expansion. This will happen
only when the banking habit among the people is well developed. They should keep their
money in the banks as deposits and use checks for the settlement of transactions.
4. Nature of Business Conditions in the Economy: Credit creation will depend upon the
nature of business conditions. Credit creation will be large during a period of prosperity,
while it will be smaller during a depression. During periods of prosperity, there will be more
demand for loans and advances for investment purposes. Many people approach banks for
loans and advances. Hence, the volume of bank credit will be high. During periods of
business depression, the amount of loans and advances will be small because businessmen
and industrialists may not come to borrow. Hence the volume of bank credit will be low.
5. Leakages in Credit-Creation: There may be some leakages in the process of credit creation.
The funds may not flow smoothly from one bank to another. Some people may keep a
portion of their amount as idle cash.

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6. Sound Securities: A bank creates credit in the process of acquiring sound and profitable
assets, like bills, and government securities. If people cannot offer sound securities, a bank
cannot create credit. Crowther says “a bank cannot create money out of thin air. It transforms
other forms of wealth into money.”
7. Liquidity Preference: If people desire to hold more cash, the power of banks to create credit
is reduced.
8. Monetary Policy of the Central Bank: The extent of credit creation will largely depend
upon the monetary policy of the Central Bank of the country. The Central Bank has the
power to influence the volume of money in circulation and through this it can influence the
volume of credit created by the banks. The Central Bank has also certain powerful weapons,
like the bank rate, open market operations with the help of which it can exercise control on
the expansion and contraction of credit by the commercial bank.

Thus, the ability of the bank to create credit is subject to various limitations. Still, one should not
undermine the importance of the function of credit creation of the banks. This function has far-
reaching effect on the working of the economy, especially on the business activity. Bank credit is
the oil which lubricates the wheels of the business machine.
C) DEVELOPMENT BANKING
It is considered as a hybrid institution which combines in itself the functions of a finance
corporation and a development corporation. They also act as a catalytic agent in promoting
balanced and viable development by assuming promotional role of discovering project ideas,
undertaking feasibility studies and also provide technical, financial and managerial assistance for
the implementation of project.

In Ethiopia development bank of Ethiopia is the unique example of development bank. It has
been designated as the principal institution of the country for coordinating the working of the
institutions engaged in financing, promoting or development of industry.

• It renders several services like

– discovery of investment projects,

– preparation of project reports, management services etc.

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 • Thus, development banks provide capital, technology and entrepreneurship.

Function of Development Bank

• Promote the development of Small Scale Industries

• Promote the development of Housing Sector

• Promote the development of large-scale industries

• Helps agricultural & rural development processes

• Enhance Foreign Trade

• Facilitate entrepreneurship development

• Facilitate rural and regional development

• Contribute to the growth of capital markets.

D) Investment banks
• Investment banking is a type of financial service that focuses on helping companies,
acquire funds and grow their portfolios.
• Much of this comes in the form of stock and bonds transfer, but investment capital and
wholesale corporate acquisitions are also part of the equation.
• Bankers within this sector are usually highly trained, and are widely recognized as
some of the most elite participants in the financial market place.
• They are often required as much for their consulting and advising services as they are
for actually executing transactions.
• Investment banking firms perform two general functions:
i. They assist client companies in obtaining funds by selling securities, i.e., raise
funds for clients.
ii. They act as brokers or dealers in the buying and selling securities in secondary
markets, i.e., assisting clients in the sale or purchase of securities.
Classification on the Basis of Ownership: On the basis of ownership, banks can be classified
into three categories:

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a) Public Sector Banks: These are banks that are owned and controlled by the government of a
country.
b) Private Sector Banks: These banks are owned by the private individuals or corporations and
not by the government or co- operative societies.
c) Co-operative Banks: Cooperative banks are operated on the co-operative lines. They give
special emphasis to agricultural and agro-based business financing.

Classification on the basis of Domicile: On the basis of domicile, banks are divided into two
categories:
a) Domestic banks: These are registered and incorporated within the country.
b) Foreign banks: These are foreign in origin and have their head offices in the country of
origin.

Types of Banking

Banking is described as the business carried on by an individual at a bank. Today, several forms
of banking exist, giving consumers a choice in the way they manage their money most people do
a combination of at least two banking types. However, the type of banking a consumer uses
normally based on convenience.

These are different types of banking through which consumer can attach to it-

(A)Walk-in-Banking

It is still a popular type of banking. As, in the past, it still involves bank tellers and specialized
bank officers. Consumers must walk into a bank to use this service normally, in order to
withdraw money or deposit it; a person must fill out a slip of paper with the account and specific
monetary amount and show a form of identification to a bank letter. The advantage of walk in
banking is the face to face connection between the banker and a letter. Also unlike drive thru and
ATM banking, a person can apply for a loan and invest money during a walk in.

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(B) ATM Banking

It is very popular because it gives a person 24 hour access to his bank account. Walk in and drive
thru banking does not offer this perk. In order to use an ATM, a person must have an ATM card
with personal identification number (PIN) and access to an ATM machine. Any ATM machine
can be used, but charges apply if the ATM machine is not affiliated with the bank listed on the
ATM card. By sliding an ATM card into an ATM machine, it is activated and then through
touching buttons on the machine, a consumer is able to withdraw or deposit money.

(C) Online Banking

It allows a person to get on the internet and sign into their bank. This process is achieved with
the use of a PIN, different from the one used for the ATM card. By going website of a bank and
entering it, a consumer can get into his account, withdraw money, deposit money, pay bills,
request loans and invest money. Online banking is growing in popularity because of its
convenience.

These different types of banking give a consumer the power of choice and also give them a
comfortable banking system that gives them a convenient choice.

BANKING SERVICE

1. OPENING AND OPERATING BANK ACCOUNTS

The most important function of a bank is to accept deposits from the public. Customers deposit
their savings for safety and earning interest. A bank provides facilities to open various types of
accounts keeping in mind the needs of its customers. Generally, the bank accounts are classified
into three categories: (a) the current accounts, (b) the fixed deposit accounts, and (c) the saving
deposit accounts. In recent years, a few new types of accounts have also been introduced by
banks. It is important to point out that the rates of interest offered by different banks under
different schemes do not vary much because these are governed by the directives from the
National Bank of the respective country.

Types of Accounts

The bank accounts are classified into three categories. These are as follows:

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1. Current Account: A Current Account or Demand Deposit Account is a running and active
account which may be opened with a bank by a businessman or an organization by making
an initial deposit. This account may also be operated upon any number of times during a
working day. This account never becomes time barred, because no interest is paid for credit
balance in this account.

Benefits of Current Accounts

(a) Demand deposits are treated at par with cash. They constitute check currency. Checks are
readily accepted in business for making and receiving payments.
(b) Businessmen have to receive and make a large number of payments every day. It is difficult
to handle cash. The check facility removes the difficulty.
(c) There are no restrictions on the number of checks or on the amount to be drawn at a time by
one check.
(d) Overdraft facilities are allowed by the banks to the current account holders.

2. Savings Bank Account: Savings deposit account is meant for small businessmen and
individuals who wish to save a little out of their current incomes to safeguard their future and
also to earn some interest on their savings. In most of the Ethiopian Commercial Banks a
savings account can be opened with as a small sum of Br. 25.

There are restrictions on the maximum amount that can be deposited in this account and also on the
withdrawals from this account. The bank may not permit more than one or two withdrawals during
a week and may lay down a limit on the amount that can be withdrawn at one time.
Savings account holders are allowed to deposit cheques, drafts, dividend warrants, etc., which stand
in their name only. For this facility, it is necessary that account holder must be introduced by a
person having a current or savings account in the same bank. However, the banks do not accept
cheques or instruments payable to third party for deposit in the savings bank account. Banks allow
interest on deposits maintained in savings accounts according to the rates prescribed by the National
Bank of Ethiopia.

3. Fixed Deposit Account: Money in this account is accepted for a fixed period, say one, two
or five years. The money so deposited cannot be withdrawn before the expiry of the fixed
period. The rate of interest on this account is higher than that on other accounts. The longer

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 the period, the higher is the rate of interest. Fixed deposits are also called “time deposits” or
“time liabilities.” The following are the special characteristics of fixed deposits:
(a) Suitability: Fixed deposits are usually chosen by people who have surplus money and do not
require it for some time. These deposit accounts are also favored by the bankers because fixed
deposit funds can be utilized by them freely till the due date of the repayment.
(b) Rate of Interest: Banks can use fixed deposits for the purpose of lending or investments. So
they pay higher rate of interest on fixed deposits.
(c) Restrictions on Withdrawals: Withdrawal of interest or the principal amount through
checks is not permitted. The depositor is not given a check book. At the request of the customer,
the banker may credit the amount of interest or the principal to his saving or current account
from which he may withdraw the same through check.
(d) Payment before Due Date: Banks also permit encashment of a fixed deposit even before the
due date, if the depositor so desires. But the interest agreed upon on such deposit shall be reduced.
(e) Advances against Fixed Deposits: The banker may also grant a loan to the depositor on the
security of the fixed deposit receipt.

Opening of Fixed Deposit Account

Fixed deposit account can be opened either with placement of cash or check. The depositor has
to fill in an “Application Form” requiring the bank to accept deposit of a specified sum of money
on deposit account. The application form contains the particulars of the customer, the amount
proposed to be deposited, the terms of deposit etc. The specimen signatures of the customer are
also to be obtained along with the application. If it is being opened by joint-parties, there should
be mandate as to its discharge. A fixed deposit receipt is then issued to the depositor by the bank.
The fixed deposit receipt is an acknowledgement of the receipt of the particular amount of
money from the person or party named therein.

Contents of Fixed Deposit Receipt

The fixed deposit receipt issued under the seal of the bank has the following contents:

(a) Name and address of the depositor.

(b) Amount deposited, described in words and figures.
(c) The period for which the deposit is made.

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(d) The rate of interest allowed on the deposit.
(e) The date of opening the deposit account.
(f) The date on which the deposit will become due for repayment.
(g) The name of the bank, place of its office accepting the deposit.
(h) The words “not transferable” appear prominently across the face of the receipt to indicate its
“non-negotiable” character.
(i) Signature of the Manager or other authorized Officer of the bank.
(j) On the back of the receipt, particulars of interest accruals, and payment and repayment of
deposit on maturity are recorded to be filled in from time to time.

Procedure of Opening Current and Savings Accounts

A bank should be very careful in entertaining a new customer. It will be taking a great risk if it
opens an account of a customer without knowing the where-abouts of the latter. As said earlier,
the opening of an account involves the honouring of checks on the part of the bank so long as
customer’s account has credit balance. The bank will also provide a number of other services to
the customer like collection of checks, dividends, etc., and acting as agent of the customer. When
the customer is not adequately known to the bank, it may result in wrong payment or encashment
of forged checks. Hence, it is essential that the bank should make through enquiry regarding the
customer before opening an account with him. For this purpose, the bank may follow the
procedure given below.

1. Presenting of Application: The applicant should fill in the prescribed form for opening of an
account available in the concerned bank. Banks may keep different forms for individuals,
partnership firm, companies, etc. The applicant should fill in the relevant form and mentions
his name, occupation, full address, specimen signature and other particulars required by the
bank. The applicant has also to declare that he will be bound by the bank’s rules for the time
being in force for the conduct of the concerned account.
2. Specimen Signature: The applicant is required to give his specimen signature on a card
meant for this purpose. This will help to protect the bank against forgery because whenever
the check is presented at the counter of the bank for payment the signature will be tallied
with those on the card computer.

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3. Deposit Cash: When the above formalities are completed, the bank will agree to open an
account in the name of the applicant. Before opening the account, the customer must deposit
the minimum initial deposit in cash as per the rules of the respective bank.
4. Issue of Pass Book: A pass book is issued by the bank to the customer after the account has
been opened and an account number has been allocated. The pass book contains the record of
transactions between the bank and the customer. It is a copy of the account of the customer in
the bank’s ledger as on a particular date. It is written by the bank from its records and is
meant for the use of the customer. It is called a pass book because it frequently passes
between the bank and the customer.A pass book is very important for a customer because he
can know the position of his account and know certain items like interest, incidental charges,
dividends collected, bills paid, etc. This will also enable him to prepare a ‘Bank
Reconciliation Statement’

Forms Used in Operation of Bank Account

Operating a bank account means that the customer deposits a sum of money in near future and
withdraws money from the account according to the needs. The following forms can be used for
the operation of the bank account:

(1Deposit slip

(2) Check Book

(3) Pass Book.

1. Deposit slip: The bank supplies Deposit slip either in book form or loose to the customer
while depositing cash, checks, drafts etc., to the credit of his account. The depositor is expected
to fill in the amount, nature of account, account number, date, details of currency notes, and
coins, signature etc., in the Deposit slip. After recovery the cash, check or draft, the bank puts the
date-stamp and is signed by the Teller and the counterfoil is returned to the depositor, which is
used for the record of the customer.

2. Check Book: A check book contains bank check forms with counterfoils which can be used
by the customer to withdraw money from his account. The check book and the counterfoils are

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 serially numbered and these numbers are entered into the check book register of the bank and
also recorded in the bank ledger.

3. Pass Book: A pass book is a book in which the banker keeps a full record of the customer’s
account. It is written by the bank, and hence it is essential for a customer to send it (pass book)
periodically to the bank, so that up-to-date entries may be entered by the bank. Some banks, like
American Express, Grindlays Bank send a Statement of Account periodically, i.e., fortnightly or
monthly to the customer in place of pass book. (It should be noted that a Statement of Account is
very popular among Current Account holders.)

Precautions for Payment of Checks

Honouring of checks drawn by his customer is a very important obligation of a banker. He
should not dishonour his customer’s checks without adequate ground. The customer can claim
damages for the injury caused to his credit owing to wrongful dishonour of checks. Further, if he
honours a check which is not properly drawn or contrary of the instructions of his customer or
against the intention of his customer or when the customer has no adequate balance, he gets into
trouble. So, the banker has to take care when honouring or dishonouring a check drawn by his
customer.”The banker has to take the following precautions while honouring the checks of his
customers:

i. Proper Form: A banker should see whether the check is in the proper form.
ii. Date of the Check: The paying banker has to see the date of the check. It must be properly
dated. The undated checks are usually not honoured.
iii. Mutilated Check: The banker should be careful when mutilated checks are presented for
payment. A check is said to be mutilated when it has been cut or torn, or when a part of it is
missing. Mutilation may be either accidental or intentional. If it is accidental, the banker
should get the drawer’s confirmation before honouring it. If it is intentional, he should refuse
payment. The check is to be returned with a remark ‘Mutilated check’.
iv. Words and Figures: The amount of the check should be expressed in words, or in words and
figures, which should agree with each other. When the amount in words and figures differ,
the banker should refuse payment.
v. Alterations and Over-writings: The banker should see whether there is any alteration or
over-writing on the check. If there is any alteration, it should be confirmed by the drawer by

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 putting his full signature. The banker should not pay a check containing material alteration
without confirmation by the drawer. The banker is expected to exercise reasonable care for
the detection of such alterations. Otherwise, he has to take risk. Material alterations make a
check void.
vi. Proper Endorsements: Checks must be properly endorsed.
vii. Sufficiency of Funds: The banker should see whether the credit balance in the customer’s
account is sufficient to pay the check or not. If there is an overdraft agreement, he should see
that the limit is not exceeded. The banker should not make part-payment of the check. He
should pay either full amount or refuse payment. In case of insufficiency of funds, the banker
should return the check with the remark ‘No Funds’ or ‘Not Sufficient Funds’.
viii. Verification of Drawer’s Signature: The banker takes specimen signatures of his
customers’ at the time of opening the account. He should compare the drawer’s signature on
the check with the specimen signature of the customer. He should carefully examine the
signature to find out whether the drawer’s signature is forged or not. If there is any difference
or doubt, he should not honour the check. He should get the confirmation of the drawer. If
there is forgery and there is negligence on the part of the banker to detect the same, there is
no protection to the banker.

Banking Services and Issues in 21stCentury

At the beginning of the 21st century, the biggest banks in the industrial world have become
complex financial organizations that offer a wide variety of services to international markets and
control billions of dollars in cash and assets.

Supported by the latest technology, banks are working to identify new business niches, to
develop customized services, to implement innovative strategies and to capture new market
opportunities. With further globalization, consolidation, deregulation and diversification of the
financial industry, the banking sector will become even more complex. Furthermore, the modern
banking industry has brought greater business diversification.

Competitive Divisions of Banking Today

Commercial banking - banking that covers services such as cash management (money transfers,
payroll services, bank reconcilement), credit services (asset-based financing, lines of credits,

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commercial loans or commercial real estate loans), deposit services (checking or savings account
services) and foreign exchange;

Investment banking - banking that covers an array of services from asset securitization,
coverage of mergers, acquisitions and corporate restructuring to securities underwriting, equity
private placements and placements of debt securities with institutional investors.

Development of Internet Banking

Internet banking involves consumers using the Internet to access their bank account and to
undertake banking transactions. At the basic level, Internet banking can mean the setting up of a
Web page by a bank to give information about its product and services.

At an advance level, it involves provision of facilities such as accessing accounts, funds transfer,
and buying financial products or services online. This is called ``transactional'' online banking.

There are two ways to offer Internet banking.

 First, an existing bank with physical offices can establish a web site and offer Internet
banking in addition to its traditional delivery channels.

 Second, a bank may be established as a "branch less, Internet only, or virtual bank"
without any physical branch.

A). Levels of Banking services

(i) The Basic Level Services use the banks' websites which disseminate information on different
products and services offered to customers and members of public in general. It may receive and
reply to customers' queries through e-mail.

(ii) In the next level are Simple Transactional Websites which allow customers to submit their
instructions, applications for different services, queries on their account balances, etc, but do not
permit any fund-based transactions on their accounts.

(iii) The third level of Internet banking services are offered by Fully Transactional Websites
which allow the customers to operate on their accounts for transfer of funds, payment of different

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bills, subscribing to other products of the bank and to transact purchase and sale of securities,
etc.

(B). Structure of Banking services

A basic tier of Internet banking products includes customer account inquiry, funds transfer and
electronic bill payment. A second or premium tier includes basic services plus one or more
additional services such as

1) Brokerage. 2) Cash management. 3) Credit applications. 4) Credit and debit cards. 5)

Customer correspondence. 6) Demat holdings. 7) Financial advice Foreign exchange trading. 9)
Insurance. 10) Online trading. 11) Opening accounts 12) Requests and intimations. 13) Tax
services. 14) E-shopping. 15) Standing instructions. 16) Investments. 17) Asset management
services etc.

Traditional Vs. Internet Banking

 In traditional banking, the customer has to visit the branch of the bank in person to
perform the basic banking operations viz., account enquiry, funds transfer, cash
withdrawing etc.,

 On the other hand, E-banking enables the customers to perform the basic banking
transactions by sitting at their homes or at offices through a desktop or laptop round the
clock globally through electronic media. This is called anytime, anywhere banking.

 The customers can access the banks' website for viewing their account details and
perform the transactions as per their requirements. Customers can make use of these
services with no restricted banking hours, no queues, no tellers and no waiting.

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