UNIT 1 : BANKING THEORY AND PRACTICE-AN OVER VIEW

1.1 INTRODUCTION

This Unit is designed to introduce you with the history of banking both internationally and
Nationally. It also introduces the meaning of a bank. The chapter also identifies the types
banks as commercial banks development banks, agricultural banks investment banks,
foreign exchange banks, e.t.c. and banking systems like branch banking system, unit
banking system, investment banking system and mixed banking [Link] addition, the
role of the banking in the economic development.

1.2 HISTORICAL BACKGROUND

1.2.1 World Banking History

There are different assumptions as to the origin of the word “bank”. One assumption is that
it is derived from the French word ‘Banque’ or the Italian word “banco” which means in
English a bench. This is derived from the experience of the merchants of Greece and Rome.
They used to sit on a bench in the center of the market and receive deposits from the public
and pay to the public from the deposit. They were referred as ‘benchers’. Banking that time
was mainly concerned with the services of currency exchange.

The merchants, goldsmiths and money lenders can be regarded as the ancestors of present
day bankers. These people start the banking activity by accepting deposits from the
depositors and pay whenever demanded. For the deposit they accepted they used to give
written evidences.

Through time they see that the amount deposited is kept for a long period of time without
being withdrawn. At the same time there were others who were looking for money to
facilitate their trading activity. Hence these parties start to lend with an interest.
1.2.2 Development of Banking in Ethiopia
Banking is relatively a new concept in Ethiopia. The history of banking in Ethiopia can be
traced back to the establishment of Bank of Abyssinia in March 1905 in the premises of
RasMekonnen, the present main campus of Addis Ababa University. It was established and
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owned by The National Bank of Egypt, an affiliate of the Bank of England, which was given
monopoly position in banking with regard to other foreign banking companies and other
privileges set up a bank. The bank of Abyssinia’s headquarter in a new building was
inaugurated on 1st January, 1910.

1.3 THE NATURE AND CLASSIFICATION OF BANKS

MEANING OF BANK
A Bank is a financial institution organized in a form of joint company basis so as to create
value to the society and profit to the shareholders in a form of dividends. It is an institution,
which deals with money and credit. The term bank in the modern times refers to an
institution which: (1) deals with money; it accepts deposits and advance loans (2) deals
with credit; it has the ability to create credit, (3) is a commercial institution; it aims at
earning profits, and (4) creates a demand deposits which serve as a medium of exchange,
and as a result, the bank manages the payment system of the country. A bank as a financial
institution is the creator of money in the form of credit money i.e. cheque.

1.3.1 Based on the Structure

On the basis of organization structure and scale of operations, banking systems can be
divided into two categories. They are Branch Banking and Unit Banking systems.
The Branch Banking System
Under branch banking organization a big bank as a single institution and under single
ownership operates through a network of branches spread all over the country or outside
the country. The Ethiopian banks use this system. All of these banks have their head office
in Addis Ababa and a number of branches through out the country and outside
(Commercial Bank in Djibouti). The same thing is true with British banking system.

Advantage of Branch Banking System

Branch banking system possesses the following advantages.
1. Economies of large-scale operations:It possesses huge financial resources and enjoys
the benefits of large scale operations such as:
[Link] trained and experienced staff can be appointed.

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b. Division of labor is introduced in the banking operation
c. Funds are made available liberally and at chapter rates
d. Foreign exchange business is done economically
e. Large financial resources and wider geographical coverage increases public confidence
in the banking system.
2. Spreading of risk: The bank operates at different regions. As such the needs of
these regions may vary. At some regions the demand for loan may be high
whereas, in other areas the demand for credit may be low. In addition, business in
some regions may be developed and may be low in other regions. Therefore this
banking system will achieve the following benefits.
- Geographical spreading and diversification of risks
- Risks could be offseted by different branches
- It makes possible to raise large finance to face any crises

3. Economy in cash Reserves: As it is known, all banks are required by law to

maintain the minimum cash reserve. And here though the numbers of branches
are many only the head office is required to maintain the cash reserve. However, if
any branch faces scarcity of funds it can easily obtain from other branches through
the head office. Therefore, branches are not expected to maintain huge amount of
reserves with them.

4. Diversification on deposits and assets: Deposits are received from areas where
savings are in plenty. Loans are extended in those areas where funds are scarce
and interest rates are high. Therefore, it is possible to transfer fund from areas
where plenty of funds exist to areas where there is scarcity of funds.

5. Cheap Remittance Facilities: As the bank covers wider areas it is easy and cheap
to transfer funds from one place to another. It uses its own facilities and a number
of transfers can be mad with a single transaction with out additional charges.

6. Better Facilities to customers: Because there are many branches in a given bank
every branch will have small number of customers. Since there will be small

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 number of customers per branch and the increased efficiency achieved through
large-scale operations, customers get better and greater facilities.
7. Effective control by the central bank: Central bank is the controller of banks. If
the number of banks are many Central Bank is required to control all these banks.
But here there are few banks with many branches. Therefore, Central Bank is
expected only to control these few Head offices and hence through them the
branches.

Disadvantages of Branch Banking System

Branch banking system has the following disadvantages.
a. Management problem: There will be mismanagement of resources, unnecessary delay
of action and red-tapism in the banking business. Because branches are many and they
are far from the head office, in terms of both geography and hierarchy, there may be
difficulties to control their every day actions.
b. Lack of initiative: Managers cannot take independent decisions and have to wait for
the clearance signal from the head office. This will discourage them to take their own
decision.
c. Monopolistic tendencies: A few big banks dominate and control the whole banking
system of the country through their branches. This can lead to the concentration of
resources in to a few hands.
d. It creates regional imbalance: Funds flow from an area where investment is weak to an
area where business prospers.
e. There is an adverse linkage effect of inefficient branches: The over all performance of
the bank is evaluated and those branches which have low performance will hide behind
other successful branches.
f. Other defects:
a. Preferential treatment is given to the branches near the head office
b. There may be unhealthy competition among the branches of different banks in
big cities.

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The Unit Banking System
An individual bank operates through a single office or few branches within a strictly limited
area. The size and area of operation are much smaller as compared to those of the branch
banking system. They can be supported by correspondent banking system. The reason of
its development is the fear of emergency of monopoly in banking business. This is true with
the United States banking system.
1.3.2 Based on Activity Classification
Based on activity Banking systems can be classified as: Investing Banking and mixed
Banking
A. Investing Banking
They invest or help investment of funds in the shares or bonds of joint stock companies.
They act as an intermediary between Business Corporation and investors. They can be
classified;
1. Originators: -They bring out new issues of securities
2. Underwriters: - they act as agents on commission basis, they underwrite the issue of
securities
3. Retailers: - They purchase entire issue of new securities of companies or
government institutions and re- issue them for public subscription at a higher price.
They have to use their assets for longer investments and risky ventures.

B. Mixed Banking
This is that system of banking under which the commercial banks make both short-term as
well as long-term loans to commerce and industry. It is the combination or mix of
investment banking and commercial banking. Commercial banks mainly involve in short
term working capital with loans maturing in less then one year where as investments
banks engage in long-term loan running for several years.

1.3.3 Based on Their Functions

i. Commercial Banks:-They perform all kinds of banking business. They generally
finance trade and commerce. They usually accept short-term deposits and advance

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 short-term loans to the businesspersons and traders and avoid medium- term and
long term loans.
ii. Industrial Banks: - Also known as investment banks. They mainly meet the
medium-term and long-term financial needs of the industries. The main functions
are;
- Accept long-term deposits.
- Grant long-term loans to the industrialists to enable them to purchase land,
construct factory building, purchase heavy machinery, etc.
- Help selling or even underwrite the debenture and share of industrial firms.
- Provide information regarding the general economic position of the economy.

iii. Agricultural Banks: - They are banks that finance agriculture. Agricultural credit
needs are different from those of industry and trade. The agriculturists require:
iv. Exchange Banks: -They deal in foreign exchange and specialize in financing
foreign trade. They facilitate international payment through the sale and purchase
of bills of exchange.
- Short –term credit to buy seeds, fertilizers, and other inputs
- Long-term credit to purchase land, to make permanent improvements on
land, to purchase agricultural machinery and equipment, etc.
[Link] Banks: - The main purpose is to promote saving habits among the general
public and mobilize their small savings.
vi. Central Bank:-It is the apex institution, which controls, regulates and supervises
the monitory
vii. and credit system of the country. (Functions of the central bank will be discussed in
unit 2 of this course)
viii. World Bank: - It refers to an institution that provides financial assistance to
the member countries of the world. After the worldwide depression and World
War II, two international institutions were founded in 1944. International
Monitory Fund (IMF) to provide short term loans to overcome the balance of
payments difficulties.

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 a. International Bank of Reconstruction and Development (IBRD) or World
Bank organized to achieve the following two objectives.
- Reconstructing the war-damage economies, and
- Developing the less developed economies.
1.3.4 Based on Ownership
On the basis of ownership, banks can be classified into three
1. Public Sector Banks:-These are owned and controlled by the government.
2. Private sector Banks:-These are owned and controlled by the private individuals or
corporations and not by the government or co-operative societies.
3. Cooperative banks:- They are operated on the cooperative e lines.

1.3.5 Based on Domicile

On the basis of domicile the banks are divided into two
1. Domestic Banks:-They are registered and incorporated within a country.
2. Foreign Banks:- These are foreign in origin and have their head offices in the country of
origin.
1.4 ROLE OF BANKING

Commercial banks play an important role in the economic growth of a country. They are
not only the warehouses of a country's wealth but are also the reservoirs of the country's
resources to speed up the process of growth. The economic history of the developed
industrial world bears ample testimony to the fact that commercial banking contributed
much to their industrial revolution.
i. Banks Promote Capital Formation
A well-organized banking system helps in pooling the small savings from the public. They
encourage the habit of thrift and saving among the public. When all the small and scattered
savings of the people, which would have remained idle, are combined together, they
become a sizable amount, which can be utilized for productive purposes. Thus the idle
resources are mobilized and funneled into productive channels. Savings is essential for
capital formation. a high rate of saving and investment constitutes capital formation.
Economic growth depends upon the diversion of resources from consumption to

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investment or production which facilitates higher rate of capital formation. They provide
safety and security to the savings of the people. Thus on one hand banks help the people to
get some income by way of interest on their savings and on the other hand banks help
country to mobilize more resources for raising the rate of investment in the country.
ii. Banks Promote Business, Trade and Industry
Banks help the development of business, trade and industry in the country. They provide
the liquid capital, which is the lifeblood of commercial and industrial activities. They grant
loans and advances to traders, industrialists and manufacturers to increase the real
national income of the country. By means of cheques, promissory notes, bills of exchange,
etc., banks provide adequate credit to encourage commercial and industrial expansion. In
Ethiopia they extend credit facilities only to the right type of traders, businessman and
industrialists in accordance with the objectives of our planned economic development. The
commercial banks route the surplus funds of the community into productive channels.
With the help of the banks, the financial resources of the community may be put to
optimum use. Bank credit helps entrepreneurs to increase their productive capacity. New
methods and techniques of production, with the help of more credit facilities, would help in
the optimum utilization of existing idle capacity in the country. With large-scale production
and specialization, the real national income of a country increases.

iii. Banks Provide Finance for Priority Sectors

Commercial banks divert their investment towards the priority sector. In Ethiopia,
agriculture, small scale industries, self employment schemes and export promotion
industries get more facilities from commercial banks as they are included in the list of
priority sector.

iv. Reduction of Regional and Economic Inequalities

Banks promote balanced regional development by minimizing regional disparities in
development. A country promotes balanced growth by proper distribution of investible
funds among the backward and less developed regions of the country. By establishing a
large number of branches in rural or semi-urban areas, uniform development of different
regions can be achieved. Not only the regional disparities but the economic inequalities

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among the people also can be bridged to some extent. For example, the National Bank of
Ethiopia provides credit at low rates of interest to the small traders, marginal farmers, self-
employed people, etc., under the differential rates of interest policy. The people are
encouraged to improve their economic position with the help of cheap credit provided by
the commercial banks.

v. Banks Influence interest Rates

The interest rate in the economy affects the level of economic activity. Higher interest rates
may discourage investment and economic activity and lower interest rates may encourage
higher investment and economic activities. The organized banking system under the
control of the central bank regulates fluctuations in economic activity by manipulating the
interest rates in the economy to maintain stable economic growth. Banks may raise the
interest rates when there is over-investment in the economy. To stimulate investment,
interest rates may be reduced. thus banks help to maintain equality between savings and
investment to avoid fluctuation in the economic activity and maintain stable growth.

vi. Banks Monetise Debt

By providing discount facilities and granting loans, commercial banks monetise debts.
Banks buy the debts of other persons. Demand deposits are created in exchange of debts.
When banks discount bills of exchange they create deposits on the debts of other persons.
The drawee's debt is monetized by the bank when the drawer gets the bill discounted.

vii. Banks create credit and help in business expansion

Expansion of bank credit provides funds to entrepreneurs for investment under condition
of unemployment it will push up production in the country. But under conditions of full
employment expansion of bank credit will have the effect of inflationary pressure. On the
other hand a decline in bank credit will result in decline in production, employment, sales
and prices. From the point of view of an underdeveloped economy the expansion of bank
credit offering more financial resources to industries is one of the contributory causes for
rapid economic development.
Thus commercial banks play a vital role in the process of economic growth of a country.
Banks help in accelerating the economic ectivity by increasing employment opportunities
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and the incomes of the people. the huge resources necessary for the planned economic
development of various countries are supplemented by the financial resources of the
banking sector to achieve the goals of economic development.

UNIT TWO

2.1 MEANING AND DEVELOPMENT OF CENTRAL BANKING

Central banking is the apex of banking system. It plays an active role in implementing
government’s economic policy in the country.

According to Will Rogers, Central Bank is one of the three great inventions in the human
development, with fire and wheel. It may not be accepted by others even if the importance
is known for certainty by all.

Today, central bank is the central arch of the monetary and fiscal framework in every
country of the world and its activities are essential for the proper functioning of the
economy and indispensable for the fiscal operations for the government.

Central banking is mostly a recent development being essentially a product of the

nineteenth century. The following cases can be considered here:
- Riksbank of Sweden – established in 1668

- Bank of England – established in 1694 – serve as a central bank in 1844

- Bank of France – established in 1800

- Reichs bank of Germany – established in 1876

- Bank of Netherlands – established in 1814 – on the ruins of old bank of Amsterdam

- National bank of Austria – established in 1817 – reorganized as the bank of Austria-

Hungary in 1877

- The bank of Norway – established in 1817

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 - The national bank of Denmark - established in 1818

- The national bank of Belgium - established in 1850

- The bank of Spain - established in 1856

- The bank of Russia - established in 1860

- The bank of Japan - established in 1882

- The bank of Italy - established in 1893

- The Swiss national bank - established in 1907

- National bank of Ethiopia - established in 1942 – National & Commercial Bank

proclamation, August 1942

- The Federal Reserve system in America - established in 1913

- The bank of Canada - established in 1934

In the nineteenth century Central Banks of many other countries were established. They
were empowered to issue notes with special principles and powers. They became bankers
and advisers of their respective governments

In 1920, The International Financial Conference held at Brussels resolved that “All those
countries which had not yet established a central bank should proceed to do so as soon as
possible, not only with a view to facilitating the restoration and maintenance of stability in
their monetary and banking systems but also in the interest of world cooperation.”

Hence, a number of Central Banks were added to the list of central banks in the world and
there is no independent country with out a central bank.

The central banks of these countries establish an effective relationship with IMF matters
relating to foreign exchange.

2.2 Nature and Function of Central Bank

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A Central Bank may be defined as that central monetary institution which is charged with
performing the duties of bankers’ bank, fiscal agent for the government and managing the
monetary system of the country.

Economists have defined central bank differently, emphasizing its one function or the
other.
 Vera Smith – The primary definition of central banking is a banking system
in which a single bank has either complete or a residuary monopoly of
note issue.

 Show – The Central Bank is a bank which controls credit.

 Haultrey – Central Bank is a bank which controls credit.

 Statutes of the bank for international settlements – A Central Bank is the

bank in any country to which has been entrusted the duty of regulating the
volume of currency and credit in the country.

 Kisch and Elkin – A Central Bank is a bank whose essential duty is to

maintain stability of the monetary standard.

2.3 Difference between Central Bank and Commercial Bank

A central bank is basically different from a commercial bank in the following ways:
1. The Central Bank is the apex institution of the monetary and banking structure of
the country. The commercial bank is one of the organs of the money market.

2. The Central Bank is a non-profit institution which implements the economic policies
of the government. But the commercial bank is a profit-making institution.

3. The Central Bank is owned by the government, whereas the commercial bank is
owned by shareholders.

4. The Central Bank is a banker to the government and does not engage itself in
ordinary banking activities. The commercial bank is a banker to the general public.

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 5. The Central Bank has the monopoly of note issue, while the commercial bank can
issue only cheques. The notes are legal tender. But the cheques have the nature of
near-money.

6. The Central Bank is the banker’s bank. As such, it grants accommodation to

commercial banks in the form of rediscount facilities, keeps their cash reserves, and
clears their balances

7. The Central Bank controls credit in accordance with the needs of business and
economy. The Commercial Bank creates credit to meet the requirements of
business.

8. Every country has only one Central Bank with its offices at important centers of the
country. On the other hand, there are many Commercial Banks with hundreds of
branches within and outside the country.

9. The Central Bank is the custodian of the foreign currency reserves of the country
while the Commercial Bank is the dealer of foreign currencies.

10. The chief executive of the central bank is designated as “Governor” whereas the
chief executive of a Commercial Bank is called “chairman” or “president” or
“managing director”.

11. The Central Bank helps the expansion of Commercial Banks whereas Commercial
Bank facilitates the expansion of industries by underwriting shares and debentures
and by meeting financial requirements.

2.4 Functions of a Central Bank

According to De Kock, and as accepted by the majority of economists the functions of a
Central Bank are:
A. Bank of Issue/Regulator of Currency

The central bank is the monopoly of bank note issue. Notes issued by it circulate as legal
tender money. The reasons for granting the exclusive monopoly of note issue to the
central bank are:

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 a) for credit control purpose

b) to impart the notes a distinctive prestige i.e., it brings stability in the monetary
system and creates confidence among the public.

c) to ensure uniformity in the notes issued which helps in facilitating exchange and
trade within the country.

d) to make it easy for the state to supervise and control the irregularities and
malpractices committed by the central bank in issuing notes.

e) to restrict or expand the supply of cash according to the requirements of the

economy.

f) to control the banking system by being the ultimate source of cash.

B. Government Banker, Fiscal Agent and Advisor

a) As banker to the government the Central Bank keeps deposits of the Federal and
regional governments makes payments on behalf of governments, but it does not
pay interest on government deposit’s. It buys and sells foreign currencies on behalf
of the government and keeps the stock of gold of the government. Thus it is the
custodian of government money and wealth.

b) As a fiscal agent, the central bank makes short-term loans to the government for a
period not exceeding 90 days, floats loans, pays interest on them, and finally repays
them on behalf of the government.

c) As advisor, the central bank advises the government on such economic and money
matters as controlling inflation or deflation, devaluation or revaluation of the
currency, deficit financing and balance of payments, etc

C. Custodian of commercial banks cash reserves

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 Commercial banks are required by law to keep a certain percentage of the time and
demand deposits as a reserve at the Central Bank. The purpose of keeping reserves at
the central banks are:
a) For transfer of funds between commercial banks through the clearinghouse.

b) As a source of great strength to the banking system of the country.

c) As the basis of a large and more elastic credit structure than if the same amount
were scattered among the individual banks.

d) Centralized cash reserves can be utilized fully and most effectively during periods of
seasonal strains and in financial crises or emergencies.

e) By varying these cash reserves the central bank can control the credit creation by
commercial banks.

f) The central bank can provide additional funds on a temporary and short term basis
to commercial banks to overcome their financial difficulties.

D. Custody and Management of Foreign Exchange Reserves

This function derived from its functions as the bank of issue and the custodian of
member banks’ cash reserves.
It is an official reservoir of gold and foreign currencies. It buys and sells foreign
currencies at international prices. It sells gold to the monetary authorities of other
countries. It fixes the exchange rates of the domestic currency in terms of foreign
currencies and tries to bring stability in foreign exchange rates. It manages exchange
control operations by supplying foreign currencies to importers and persons visiting
foreign countries on business, studies, etc. In keeping with the rules laid down by the
government.
E. Lender of the Last Resort

In its capacity of lender of the last resort, the central bank meets directly or indirectly
all reasonable demands for financial accommodation from the commercial banks,
discount houses, and other credit institutions subject to certain terms and conditions

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 which constitute its discount rate policy. Today this function is regarded as the sine qua
non of central banking
F. Bank of Central Clearance, Settlement and Transfer

As a bankers’ bank, the central bank acts as a clearing house for transfer and settlement
of mutual claims of commercial banks. Since commercial banks keep their surplus cash
reserves in deposits with the central bank it is far easier to clear and settle claims
between them by making transfer entries in their accounts maintained with the central
bank.
This function of the central bank is sometimes granted by law where as some other
times by customary functions of banks. It saves time and creates contingency plus test
at any time the degree of liquidity of banks.
G. Controller of Credit

The most important function of the central bank is to control the credit creation power
of commercial banks in order to control inflationary and deflationary pressures within
the economy.
For this purpose, it adopts quantitative and qualitative methods. Quantitative methods
aim at controlling the cost and quantity of credit by adopting bank rate policy, open
market operations and variations in reserve ratio of commercial bank.
Qualitative methods control the use and direction of credit. It involves selective credit
controls and direct action. By adopting such methods, the central bank tries to influence
and control credit creation by commercial banks in order to stabilize economic activity in
the country.
Besides to these, the central bank in a number of developing countries has been entrusted
with the responsibility of developing a strong banking system to meet the expanding
requirements of agriculture, industry, trade and commerce.

Accordingly, the central bank possess some additional powers listed as follows.
- supervision and control over the commercial banks

- issuing licenses to newly established financial institutions

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 - the regulation of branch expansion by commercial banks

- see that every bank maintains the minimum paid up capital and reserves as
provided by law

- inspecting or auditing the accounts of banks

- approve the appointment of chairmen and directors of such banks in accordance

with the rules and qualifications

- to control and recommend merger of weak banks in order to avoid their failure and
protect the interest of depositors

- to recommend nationalization of certain banks to the government in public interest

- to publish periodical reports relating to different aspects of monetary and economic

policies for the benefit of banks and the public, and

- to engage in research and train banking personnel, etc

i. Objective of Credit Control

The central bank controls credit to achieve the following objectives

a) To stabilize the internal price level

Inflationary or deflationary trends need to be prevented. This can be achieved by

adopting a judicious policy of credit control. As price rise the central bank decreases
money in circulation and as price decline it increases the money supply.
b) To stabilize the rate of foreign exchange

With the change in the internal prices level, exports and imports of the country are
affected. When price decline exports increase and imports decline which leads to
increase in the demand for domestic currency in the foreign markets and exchange
rate also increased. When price rise in the domestic market export decline and
imports increase. This leads to an increase in the demand for foreign currency and

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 decline in demand for domestic currency which in turn leads to a decline in
exchange rate.
c) To protect the outflow of gold

The central bank holds the gold reserves of the country in its vaults. Increase in
bank credit leads to increase in prices and decline in exports and rise in imports.
This create an unfavorable balance of payments. This necessitates the export of gold
to other countries in order to have an equilibrium balance of payments.
d) To control business cycles

Business cycles are characterized by alternating periods of prosperity and

depression.
During prosperity – Large expansion in the volume of credit; production,
employment and prices rise
During depression – Credit contracts: production, employment and price fall. The
central bank can counteract such cyclical fluctuations through contraction of bank
credit during boom periods, and expansion of bank credit during depression.
e) To meet business needs

Credit is needed to meet the requirements of trade and industry. As business

expands, larger quantity of credit is needed and when business contracts, less credit
is needed. Therefore, it is the central bank which can meet the requirements of
business by controlling credit.
f) To have growth with stability

The principal objective of credit control is to have growth with stability; price
stability foreign exchange rate stability, to help in achieving full employment, and
accelerate growth with stability in the economy without inflationary pressures and
balance of payments defects.

ii. Methods of Credit Control

The central bank adopts two methods of credit control. They are:
1. The quantitative methods

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 Which aims at controlling the cost and quantity of credit by adopting such
techniques as variations in the bank rate, open market operations and variations in
the reserve ratios of commercial banks.
a. Bank rate or discount rate policy
These rates are determined by the central bank. The central bank rediscounts
first class bills of exchange and government securities held by the commercial
banks.
The central bank controls credit by making variations in the bank rate.
 If the need of the economy is to expand credit; central bank lowers the bank
rate thus borrowing from the central bank will be cheaper and easy, commercial
banks will borrow more. They will intern advance loans to customers at a lower
rate. The market ate of interest will be reduced which encourages the business
activity and the expansion of credit. This results in a rise in prices of goods and
services.
 If the need of the economy is to contract credit: Central bank raises the bank
rate, making borrowing costly for commercial banks. The banks borrow less and
raise their lending rates to customers. The market rate of interest also raise
which discourages fresh loans and puts pressure on borrowers to pay their past
debts and discourage business activity.
Lowering the bank rate offsets deflationary tendencies and raising the bank rate
controls inflation

 The significance of central bank’s bank rate policy

1. The bank rate indicates the rate at which the public should be able to obtain
financial accommodation against the approved securities from the commercial
banks.

2. The bank rate indicates the rate of interest at which the commercial banks can
borrow funds from the central bank against the security of government and other
approved securities.

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 3. The bank rate acts as a barometer of the economic situation in the country. A rise
bank rate is a danger signal while a fall shows clear path.

 The bank rate policy proves more ineffective during depression than during the boom

Limitations of bank rate policy

Its credit controlling efficiency is limited by the following factors
1. Market rates do not change with bank rate: The theory of bank rate policy pre-
supposes that other rates of interest prevailing in the money market change in the
direction of the change in the bank rate.

1. Wages, costs and prices are not elastic: The success of the bank rate policy requires
elasticity not only in interest rates but also in wages, costs and prices i.e., when bank
rate rise wages, costs and prices should automatically be lower.

2. Banks do not approach central bank: It is only if the commercial banks approach the
central bank for rediscounting facilities that this policy can be a success. But the
banks keep with them large amounts of liquid assets and do not find it necessary to
approach the central bank for financial help.

3. Bills of exchange is not used: The bills of exchange as an instrument of financing

commercial and trade has fallen into disuse. Business men and banks prefer cash
credit and overdrafts.

4. Pessimism or optimism of business men: If they are pessimism, even if bank rate
fall, they do not need the bank loan. Whereas if they are optimism, even if bank rate
rises they will take /need the bank loan.

5. Power to control deflation is limited: Its power to force a reduction in the market
rates of interest is limited whereas, it may control inflationary tendencies by forcing
an increase in the market rates of interest

6. Level of bank rate in relation to market rate: If in a boom the bank rate is not raised
to such an extent as to make borrowing costly from the central bank, and it is not

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 lowered during a recession so as to make borrowing cheaper form it, it would have a
destabilizing effect on economic activity.

7. Non-discriminating: It does not distinguish between productive and unproductive

activities in the country. It affects all sectors uniformly.

8. Not successful in controlling BOP (Balance of Payment) disequilibrium: Because it

requires the removal of restrictions on foreign exchange and movements of
international capital.

B. Open Market Operations

This method refers to the sale and purchase of securities, bills and bonds of government
and private financial institutions by the central bank in the financial market.
There are two principal motives of open market operations
1. To influence the reserves of commercial banks in order to control their power of
credit creation, and

2. To affect the market rates of interest so as to control the commercial bank credit.

The method of operation is used as follows

To control inflationary pressures: Central bank sells securities, bills and bonds in the open
market. The buyer (the commercial bank or the public) pay the value of these documents
with cheques drawn on the commercial bank. This reduces the reserve of commercial
banks at the central bank and curtails their lending abilities as the reserve determines the
credit creation capacity of commercial banks.
To control depression of the economy (recessionary period) expansionary policy is used:
central bank purchases securities from commercial banks and other government and
private institutions. The central bank pays the sellers its cheques drawn against itself
which are deposited into their accounts with the commercial banks. This increases the
reserve of the commercial bank which rises its ability to create credit.
 When the supply of money changes as a result of open market operations, the market
rates of interest also changes. A decrease in the money supply leads to rise in rates of
interest and increase in the money supply leads to a decline in the rate of interest.

21
Limitations of open market operations
The success of the system depends upon the existence of a number of conditions
a) Availability of securities market. This is a very essential condition to buy and sell
securities by the central bank. In addition the central bank must have enough
saleable securities with it.

b) Stability of cash reserve ratio by the commercial banks. Commercial banks should
have stable cash reserve ratio and should be able to sensitive to the central bank
policy. However, in actuality, commercial banks usually have excess reserves and
become non-responsive to the central bank policies.

c) Penal bank rate. Penal bank rate should be available to control the credit creation of
commercial banks whenever there is higher credit interest from the public.

This rate is a higher rate by the central bank over the market rates of interest i.e., if
the central bank applies a higher rate of interest, whenever commercial banks
borrow from it, it is going to be expensive for commercial banks which makes in
turn, borrowing from commercial banks dearer to the borrowers.
d) The act of others should be similar with the central bank. The people should act the
way the central bank expects them. But in actuality this may not be possible. When
the central bank sells securities people start to demand more credit and when the
central bank buys securities, people start to hoard money.

e) Pessimistic or optimistic attitude of borrowers

During depression, even if the central bank purchases securities and increase the
supply of bank money, businessmen may not be willing to take loans – pessimistic
situation. During boom, even if the central bank sells securities and decrease the
supply of bank money, and rise the market rate of interest, businessmen may not be
discouraged to take loans – optimistic situation.
f) Non constant velocity of credit money. The success of the method needs/depends
upon a constant velocity of circulation of bank money. But the velocity of credit

22
 money is not constant. It increases during periods of risk business activity and
decreases in periods of falling prices.

C. Variable reserve ratio

Alternatively, known as required reserve ratio, or legal minimum requirements
It was first suggested by Keynes in 1930 and was adopted by the federal reserve system of
the USA in 1935. Every commercial bank is required by law to maintain a minimum
percentage of its deposits with the central bank. This amount may be a percentage of its
time and demand deposits together or separately.
The excess amount of money over the required reserve that remain in the commercial bank
is known as the excess reserves. The excess reserve is the basis of credit creation. The
larger the excess reserves, the greater is the power of a bank to create credit, and vice
versa. The larger the required reserve ratio the lower the excess reserve the lower the
power of a bank to create credit, and vice versa.
If the commercial bank has birr 100.00
The required reserve ratio = 10%
10
x 100 = 10 birr should be deposited with the central bank
100
The excess reserves will be Birr 90.00
Therefore, the maximum amount of credit the bank can create is Br. 900.00
ER 90 90
i.e., =   x 100 = 900.00
RRr 0.10 10
or
1 100
C.M = 1 RRR   = 10
10 10
Credit creation = credit multiplier  initial excess reserve
= 10  90
= 900.00
* Limitations of variable reserve ratio
a) Excess reserves by commercial bank. Commercial banks possess higher/large excess
reserves and they are not responsive to the reserve ratio requirements of the
central bank.
23
 b) Clumsy method. The method does not clearly define the area, place and time when it
is applied.

c) Discriminatory. It affects only banks with lower excess reserve but not banks with
large excess reserves. In addition, non-banking financial intermediaries are not
affected by this policy like

- co-operative societies - building societies

- insurance companies - development banks, etc.

d) Inflexibility. This policy is applicable at a time to all banks in a country.

Variable reserve ratio Vs open market operations

The Variable reserve ratio

- Affects the power of the commercial banks more directly, immediately and
simultaneously than open market

- It is not time consuming – simply declaring the change of RRr

- It is meant for making major and long run adjustments in the liquidity position of
the commercial banks. Therefore, they are not suitable for short-term adjustments.

- It is used in underdeveloped or developed countries.

The open market operations

- It affects non-banking financial intermediaries. They are outside the legal control of
the central bank. Therefore, they are not required to deposit a reserve with the
central bank. But they buy and sell government or private organizational securities.

- Its success depends upon the existence of broad and well-organized market for
securities. Therefore, it is successful only in developed countries

- It has a loss in buying and selling securities on a day-to-day and week-to-week basis.

2. Selective/Qualitative Credit Controls

24
The aim of selective credit controls is to channelize the flow of bank credit from speculative
and other undesirable purposes to socially desirable and economically useful activities.
They also restrict the demand for money by laying down certain conditions for borrowers.
The main types of selective credit controls used by the central banks in different countries
are discussed as follows.
a) Regulation of Margin Requirements
Its purpose is to prevent excessive use of credit to purchase or carry securities by
speculators. The central bank fixes minimum margin requirements on loans for
purchasing or carrying securities.
Advantages
1. It is non-discriminatory – applied equally to borrowers and lenders to commercial
banks and non-banking financial intermediaries. It affects all financial institutions
uniformly.

2. It increases the supply of credit for more productive uses.

3. It controls the expansion of credit in those sectors of the economy which breed
inflation

4. It is simple and easy to administer.

Disadvantages
1. A borrower may not show his intention clearly

2. A borrower may purchase stocks with his own source and borrow to finance other
activities.

3. Non-banking financial intermediaries may increase their security loans when others
are being controlled by high margin requirements.

b) Regulation of Consumer Credit

It aims at the regulation of consumer installment credit or hire purchase finance. Its
main objective is to regulate the demand for durable consumer goods in the interest of

25
 economic stability. It employees two devices: Minimum down payment and Maximum
periods of repayment
It is technically defective and difficult to administer because it has a narrow base. It
affects only a particular class of borrowers whose demand for credit forms an
insignificant part of the total credit requirements.
c) Rationing of Credit
There are two types of credit rationing methods
1. Variable portfolio ceiling. The central bank fixes a ceiling on the aggregate portfolios
of the commercial banks and they cannot advance loans beyond this ceiling.
2. Variable capital assets ratio. This is the ratio which the central bank fixes in relation
to the capital of a commercial bank to its total assets.
d) Direct Action
The central bank resort to direct the action of commercial banks by issuing “directives”
from time to time so that all or some of the commercial banks to follow. For example,
The central bank may refuse rediscounting facilities to certain banks which may be
granting too much credit for speculative purposes, or in excess of their capital and
reserves, or restrains them from granting advances against the collateral of certain
commodities, etc.
 The central bank may also charge a penal rate of interest form those banks which
want to borrow from it beyond the prescribed limit.

 The central bank may even threaten commercial bank to be taken over by it in case
it fails to follow its policies and instruction.

e) Moral Suasion (Strong recommendation not an order)

It is the method of persuasion, of request, of informal suggestion and advice to the
commercial bank usually adopted by the central bank.
Limitations
It is a method “without any teeth” and hence its effectiveness is limited to
1. The extent to which commercial banks accept central bank as a leader and need
accommodation from it

26
 2. The excess reserve maintained by the commercial banks. If the commercial banks
possess excessive reserves, they may not follow its advice.

3. The economic condition. It may not be successful during booms and depression
when there is a wave of pessimistic and optimistic situations

4. It is not a controlling device at all, as it involves cooperatives by the commercial

banks.

f) Publicity
It publishes weekly or monthly statements of the assets and liabilities of the
commercial bank for the information to the public.
It also publishes statistical data relating to money supply, prices, production and
employment, capital and money market, etc at making the public aware to the policies
being adopted by the commercial bank vis-à-vis the central bank in the light of the
prevailing economic condition in the country. It needs well educated public that can
understand and act according to the requirement.
Limitations of selective credit controls
1. Limited coverage. They are only applicable to the commercial banks but not to non-
banking financial institutions.

2. No guarantee for use of specific purpose. There is no guarantee that the bank loans would
be used for the specific purpose for which they are sanctioned.

3. Difficult to distinguish between essential and non-essential factors.

4. Require large staff by the central bank to check the credits given by the commercial banks

5. Discriminatory. It unnecessarily restrict the freedom of borrowers and lenders. Small

borrowers and small banks are hit harder by this method than big borrowers and large
banks.

6. Malallocation of resources. When they are applied to selected sectors, areas and
industries while leaving others to operate freely, leads to malallocaiton of resources.

27
Conclusion
Indeed the coordination of selective and general controls appears to have been more
effective than the use of any one of them singly and by itself. Selective credit controls are
adjoin to the general controls and are only “second-line instruments”

2.5 Role of Central Bank in a Developing Economy

The central bank in a developing economy performs both traditional and non-
traditional functions. The traditional functions are the monopoly of note issue, banker
to the government, banker’s bank, lender of the last resort, controller of credit and
maintaining stable exchange rate.

It aims at the promotion and maintenance of a rising level of production, employment, and
real income in the country. It is given a wider power to promote the growth of economies
in underdeveloped countries. They, therefore, perform the following functions towards this
end.
1. Creation and expansion of financial institutions

2. Proper adjustment between demand for and supply of money

3. Creating a suitable interest rate policy

4. Debt management

5. Credit control

6. Open market operations

7. Solving the balance of payments problem

UNIT THREE
COMMERCIAL BANKS

Commercial banks are one form of banks that any country can have. They perform all kinds of
banking business. They generally finance trade and commerce. They usually accept short-term

28
deposits and advance short-term loans to the businessperson and traders and avoid medium term
and long term loans.

3.1 Functions of Commercial Banks

A modern bank performs a variety of functions. Hence it is difficult to discuss all functions here.
However, some basic functions performed by the banks are discussed as follows:
A. Accepting deposits
The bank accepts deposits from those who can save but cannot profitably utilize this saving
themselves. People consider it more rational to deposit their savings in a bank because by doing
so they, on the one hand, earn interest and on the other, avoid the danger of theft. Banks provide
alternative deposit accounts that permits depositors to chose based on their respective objectives.
Some of these accounts are: Time deposits, savings deposit accounts, and chaking accounts.
B. Advancing loans
The purpose of accepting deposit is to mobilize funds to be used for advancement of loans. The
bank, after keeping certain cash reserves, lend their deposits to the needy borrowers. Before
advancing loans, the bank must satisfy themselves about the credit worthiness of the borrowers.
The bank can grant different types of loans such as: call loans, cash credit, term loans, overdraft
facilities and discounting loans.

C. Agency services
In addition to the main functions of the bank stated above, banks perform many agency and
general utility functions. The bank offers the following agency services.
i) Collection and payment of credit instruments
ii) Execution of standing customer orders
i) Purchasing and sale of securities on behalf of customers
ii) Collection of dividends on shares on behalf of his customer
iii) Income tax consultancy
iv) Acting as trustee and executor
v) Acting as representative and correspondent
vi) Remittance of funds
The bank can also provides the following general service functions to customers
i) Traveler’s cheques

29
 ii) Safe custody of valuables and securities
iii) Letters of credit facilities

D. Creation of Credit
A bank multiply its deposits (primary) into secondary or derivative deposits. As customers
initially deposit their money in the bank, an account is opened in their names. This is referred as
a primary deposit. However, the bank accepts this deposit to make loans to customers and as loan
is granted to customers, money/cash is not given to the customer rather an account is opened in
the borrower’s name to be withdrawable with cheques. Hence the account opened in the name of
the customer is referred as secondary or derivative deposits. Thus, the multiple expansion of
deposits is called credit creation.

Credit means getting the purchasing power (i.e., money) now by a promise to pay at some time
in future. In a sense; the words credit, debt and loan are synonymous; credit or loan is the
liability of the debtor and the asset of the bank.

Creation refers to the ability of the bank to expand deposits as a multiple of its reserves.
Therefore, “credit creation refers to the process of making loans through investment in
securities”, Newlyn. “The creation of derivative deposits is identical with what is commonly
called the creation of credit”. Hence commercial banks have been aptly called the factories of
credit or manufacturers of money.
3.2 Mechanism of Credit Creation
There was a time when it was thought that a bank could not create credit. They believed as a
banker is just like a cloakroom attendant and cannot lend more than what it has received as
deposits. Suppose, the bank receives a deposit of Br. 10.00, it can lend only up to Br. 10.00, if no
cash reserve ratio is applied and no more-these people argue.

However, these days it is believed that commercial banks are credit creators. In order to create
credit, it must be accepted that the amount lent may come back to the same bank or some other
bank as fresh deposits. The bank whose deposits have increased will lend the same. This will
create more deposits with the same bank or some other bank. Thus, there will be creation of
credit by the banks. The mechanism of credit creation has been discussed in the following
manner.

30
Suppose, Ato Abebaw deposits Br. 10, 000.00 with Dashen Bank S.C and there are a number of
banks in the country which follow the cash reserve ratio of 10%. In this case Cash balance of
Dashen Bank will increase by Br. 10.000.00 because it is a case of primary deposit. The effect of
this deposit can be shown in the following balance sheet.
Balance sheet Dashen Bank
Liabilities Assets
Deposits 10,000.00 Cash 10,000.00
Credit creation takes place only when a bank grants a loan. If the cash reserve ratio is 10% the
bank can lend up to Br. 9,000.00 out of the primary deposits of Br.10,000.00, as the bank has to
keep only Br. 1,000.00 in cash. Suppose, Ato Hagos approaches Dashen Bank for a loan of Br. 9,
000.00 and the bank grants him the loan, then this transaction will appear in the balance sheet of
Dashen bank as follows.

Balance Sheet-Dashen Bank

Liabilities Assets
Deposits 10, 000.00 Cash 1,000.00
________ Loans to Ato Hagos 9,000.00
Br. 10,000.00 Br. 10,000.00

Suppose the borrower purchases goods from Ato Gemechu and makes him the payment of Br.
9,000.00, who deposits the amount with Abyssinia bank. The deposits of Abyssinia Bank
increases by Br. 9,000.00 and cash serves also by Br. 900.00. Abyssinia bank can lend the
amount retaining 10% of it. If the bank advances loans to Ato Bedru, then the position of the
bank will be follows.

Balance Sheet-Abyssinia Bank

Liabilities Assets
Deposits 9, 000.00 Cash 900.00
________ Loans to Ato Bedru8,100.00
Br. 9,000.00 Br. 9,000.00

31
Ato Bedru can make payment to some other person, Ato Goitom in some settlement, who may
deposit the amount with United Bank. United Bank will also keep 10% of the deposits and lend
the balance to another customer, Ato Mustofa amounting to Br. 7, 290. If this happens, the effect
of this transaction will appear in the balance sheet of United Bank as follows:
Balance Sheet-United Bank
Liabilities Assets
Deposits 8, 100.00 Cash 810.00
________ Loans to Ato Mustofa 7,290.00
Br. 8,100.00 Br. 8,100.00

This process will continue till the credit is created by 10 times (the credit multiplier) the original
deposits of cash. But if banks have different cash reserve ratio, the outcome will be different.
The above discussion was made on the assumption that there are many banks in the country
following similar bank lending policy. Now let us see if there is only one bank in the country.
The discussion will be presented as follows:
Assets Liabilities
Reserves Required Reserve Excess Reserve Loans & invt /derivative Total demand
Total (RR) 10% (ER) 90% demand deposits (DD) deposits (TD)
10,000.00 1000.00 9,000.00 - 10,000.00
1 10,000.00 900.00 8,100.00 9,000.00 19,000.00
2 10,000.00 810.00 7,290.00 17,100.00 27,100.00
3 10,000.00 729.00 6561.00 24,390.00 34,390.00
4 10,000.00 656.10 5904.90 30,951.00 40,951.00
5 10,000.00 590.49 5314.41 36,855.90 46,855.90
6 10,000.00 531.44 4782.97 42,170.31 52,170.31
7 10,000.00 478.30 4304.67 46,953.28 56,953.28
. . . . .
. . . . .
. . . . .
Final stage 10,000.00 0 90,000.00 100,000.00

Assumption
1. The cash reserve ratio remains constant through all the stages of credit creation process
2. The banks adjust their assets in such a manner as to maintain a fixed relationship between
their deposit liabilities and cash reserves.

32
3. There is no leakage in the credit creation process
b) The excess reserves are turned in to derivatives through granting loans.
c) The derivative deposits, in turn, become primary deposits with the banks.
4. There is a well-developed banking system in the country and the people have banking
habits.
5. The central bank does not adopt any credit control policy
6. There exist normal business conditions in the country.

If all the assumptions mentioned above are fulfilled, the amount of credit created will depend
upon the percentage of cash reserved to be maintained by the banks. This percentage will
determine the credit multiplier. The credit multiplier can be calculated by the following formula;
1
, where C is the percentage of cash reserve. Hence, in our example above the cash reserve
C
100
ratio is only 10% then the multiplier will be 110%  110  = 10 times. If the cash reserve
100 10
1
ratio is 25 percent, the credit multiplier will be  1 25  100 = 4 times. Thus, the higher
25% 100 25

the rate of cash reserves, the lower is the credit creation and vice versa.
Credit creation depends upon the ratio of cash reserves to deposits. The credit or the deposit
multiplier is k = 1/r = when k = the credit multiplier
r = the cash reserve ratio
Thus, credit multiplier is the reciprocal of cash reserve ratio. In order to determine the additional
aggregate deposits (AD), we can use the following formula.
R
D = kR =
r
whenD = Derivative deposits
R = Initial excess reserves (which are measured as initial primary deposits minus reserve
requirements)
r = cash reserve ratio
k = credit multiplier
In our example above, the initial excess reserve is Br. 9,000.00 and the cash reserve ratio is 10%.
Thus the additional aggregate deposit will be:

33
 R
D = kR or =
r
9,000
= 10 x 9,000.00 =
1
10

= 90,000.00 = 9,000.00 x 10
= 90,000.00
Therefore, the total deposit will be: the initial deposit (i.e., 10,000.00) plus the derivative deposit
(i.e., 90,000.00) = Br. 100,000.00. See the preceding table.

3.3 Limitations of Credit Creation

Banks may not be able to create credit to the extent of maximum potential as dictated by the
deposit multiplier because of the following limitations.
a. Amount of Deposits: The power to create credit depends on the cash deposits received by the
bank. If the depositors have no faith in the banking system or are reluctant to deposit money
with the banks, the banks will have loss cash with them and thus their power to create will be
curtailed.
b. Cash Reserve Ratio: All the banks are required by law to keep a certain percentage of
deposits in cash as reserves. The higher the ratio of cash reserve, the lower will be the
amount of credit creation and vice versa. Some banks try to work safely by keeping larger
cash reserves than required by law. In such cases, they will be able to create less credit.
c. Leakages: There are at least two leakages in the credit creation process.
b) Excess reserves – The banks may not be willing to utilize their
surplus funds for granting loans and may decide to maintain excess
reserves.
c) Currency drains – The system assumes that the amounts of loans
granted by the banks return to them by way of new deposits. But
the people may use the currency without making a deposit.
d. Security for Loans: The bank grants loans on the basis of certain security. If a customer is
not able to provide the bank with sufficient security, the bank will not lend money and hence,
there will be no credit expansion.
e. Liquidity Preference: The amount of credit creation is also limited if the people give
preference to the liquidity. Suppose, a bank gives loans to a customer who in turn makes

34
 payment to his creditor. If the creditor keeps the amount in pocket, there will he no further
expansion of credit.
f. Business Condition: The nature of economic condition in the country also restricts the
ability of the banks to create credit. If there is depression in the country, traders will be
incurring losses. They will not willing to take loans and invest, and hence there will be no
credit creation. But during boom periods, the traders will approach the banks for loans and
the volume of credit will increase.
g. Monetary Policy: The monetary policy of the central bank also influences the extent of
creation of credit. The central bank is the controller of credit in the country. If it is of the
opinion that credit creation should be discouraged, it may increase the cash reserve ratio.
This will check the ability of the commercial banks to create credit. The Central/National
bank can also use other weapons of credit control either to expand or contract bank money in
the country.
h. Availability of Borrowers: Banks create credit by means of loans and advances. Loans and
advances will be given only when there are people who demand a loan. Demand for loan, is
not enough to create loans, the borrower must fulfill at least the minimum requirements
expected of him like security, credit worthiness, character, etc.
i. Credit Policy of Other Banks: If the said total deposits to be attained in the credit creation
process, all banks should apply and follow similar credit policy.
j. Banking Habits: Development of banking system and the banking habits of the people
influences the extent of credit creation. If the depositors have no faith in the banking system
or are reluctant to deposit money with the banks, the banks will have less cash with them and
thus their power to create will be curtailed. Moreover, if the society prefers cheques than
cash for transaction, credit creation will be increased.

Basic concepts for discussion

The following points/concepts shall be discussed in order to understand the credit creation
process of banks.

35
a) Bank as a Business Institution: It aims at maximizing profits through loans and advances
from the deposits. A bank is organized on a joint stock company bases so as to maximize
rewards to the stockholders in a form of dividend.
b) Bank deposits: They form the basis for credit creation. According to professor Halm they
can be classified into two types.
i) Primary deposits: When a bank accepts cash from the customer and opens a deposit
account in his name, these deposits simply convert currency money into deposit money.
However, they form the basis for the creation of credit or money. The bank remains
passive as regards this account. It is created only by the willingness of depositors.
ii) Secondary or Derivative Deposits: When a bank grants loans and advances, it, instead of
giving cash to the borrower; opens a deposit account in his name. This is secondary or
derivative deposit. Every loans are converted into deposits. The bank plays active role in
creating derivative deposits, they are also called active deposits as creation of derivative
deposits means creation of credit or money.
c) Cash-Reserve Ratio: The percentage of total deposits which the banks are required to hold in
cash reserves for meeting the depositors demand for cash is called cash-reserve ratio.
d) Excess Reserves: The reserve that the bank holds above the required cash reserves are called
excess reserves. They are equal to total reserves (total deposits) minus required reserves.
e) Credit Multiplier: The ratio between the total amount of derivative deposits and the initial
excess reserves is known as the credit multiplier. It is the reciprocal of cash reserve ratio.
Total Derivative Deposits
K = 1 /r or K=
Initial Excess Reserve
where k = credit multiplier
r = cash reserve ratio

3.4 The Role of Commercial Banks in Economic Development

Commercial banks play important roles in bringing economic development in a give country.
Some of the roles of commercial banks shall be discussed as follows:
a) Mobilizing savings for capital formation
Commercial banks provide facilities to customers to save their surplus income (Income-
consumption expenditure). Those who save their money in a bank gets interest income, or

36
 can easily effect payment with convinency. This situation helps capital formation in the
country. Capital formation also helps to encourage investment, employment, production, etc
b) Financing Industry
Commercial banks finance industries by providing loans to buy raw materials machineries,
etc., through different loan mechanisms.
c) Financing Trade
d) Financing Agriculture
e) Financing consumers to acquire durable goods
f) Financing service rendering enterprises
g) Co-operate with the central bank to implement monetary policy.

CHAPTER FOUR
SECURED LOAN ADVANCES
4.1. Modes of creating charge
The main principle of sound lending is to ensure safety of funds lent by the banker to his
customer. In this regard the banker relies on the character, Capacity, capital, collateral, etc of the
borrower in ensuring the safety of funds. The viability of the project and the honesty and
capability of the borrower ensure to a large extent the safety of funds lent by the banker. But the
bank can hardly afford to take any risk in this regard and hence reliance is placed on the tangible
assets owned by the borrower. In case of default by the borrower in repaying the loan, the
banker’s interests are safeguarded if he possesses a charge or right over a tangible asset of the
borrower. Loan with such rights conferred upon the banker are called “Secured loans” Thus
secured advances are those, which provided absolute safety to the banker by means of a charge
created on the tangible assets of the borrower in favour of the banker. In such cases, the banker
gets certain rights in the tangible assets over which a charge is created. There are several modes
of creating a charge. They are as follows;

1. Lien
2. Pledge
3. Hypothecation
4. Mortgage

37
 1) Lien
Lien is the right to retain property belonging to another person until a debt due from the debtor is
paid. A lien is of two kinds: particular and general. In the case of general lien. The bank has a
general right to the securities of the goods, which come into the possession of the bank in the
ordinary course of banking business. The banker has no lien on safe custody deposits or on the
bills of exchange and other documents entrusted to the bank for special purposes. A particular
lien is the right to retain goods in respect of which the debt was incurred.

2) Pledge
A delivery of goods or the documents of title to goods, by a debtor to is creditors as security for a
debt, or for any other obligation. Here, the person who is pledging his goods or document of title
to goods is the debtor and the person whose favour they are pledged is the creditor. Thus, the

Debtor is known as pledgor and the creditor is known as pledge. It is understood that, the subject
of the pledge will be retuned to the pledgor when the debt has been paid or the obligation is
fulfilled. The legal ownership remains with the pledgor (the debtor).

3) Hypothecation and letter of hypothecation

In the case of hypothecation movable property is offered as a security for a debt. The
borrower continues to be the owner of the property and the property is not delivered to
the lender. An equitable charge is created in favour of the lender. In other words, the
ownership of the property rests with the borrower. Besides, the property will be in the
possession of the borrower. Of course, the borrower agrees to deliver the goods to the
lender, whenever the lender is asking for it, thus, hypothecation can be converted into a
pledge by the lender at any time. In such a case the lender enjoys the powers and rights of
a pledge.

Letter of hypothecation is an instrument of document of charge, which conveys to the

bank the full right to the property in the goods concerned. A letter of hypothecation is
sometimes used to describe a trust letter. Bankers lend money against hypothecation of
raw materials to the manufacture of goods. This, in turn enables the borrower to earn
money. When, he fails to pay the debt or instalments, the banker may ask the borrower to

38
deliver the raw materials to him. An advance against stock in trade in possession of the
borrower is risky. The borrower may sell the goods hypothecated and may not deliver the
hypothecated goods when he is required to do so by the banker. Thus the banker has to
grant such loans to honest, reliable and sound parties only. The banker must also make
periodical inspection of goods hypothecated.

4) Mortgage:
When a customer offers immovable property like land and building as security for a loan
Charge thereon is created by means of mortgage.
Mortgage is defined as “the transfer of an interest in specific immovable property for the
purpose of securing the payment of money advanced or to be advanced by way of loan,
and an existing or future debt, or the performance of an engagement which may give rise
to a pecuniary liability”

The transferor (borrower) is called “mortgagor” the transferee (creditor) is called

“mortgagee” the instrument by which the transfer is effected is called a “mortgage deed”
 Characteristics of mortgage:
1) A mortgage is the transfer of an interest in the specific immovable property and
differs from sale where in the ownership of the property is transferred. Transfer of
interest in the property means that the owner transfers some of the ownership rights to
the mortgagee and retains the retaining rights with himself.
2) If there are more than one co-owners of an immovable property every co-owner is
entitled to mortgage his share in the property,
3) The property intended to be mortgaged must be specific (that is, it can be described
and identified by its location, size boundaries, etc) A mortgagor must mention which
of his properties is intended to be mortgaged.
4) The objective of transfer of interest in the property must be to secure a lean or to
ensure the performance of an engagement, which results in monetary obligation.

39
 Thus, the property may be mortgaged to ensure the performance of an engagement,
which results in monetary obligation. Thus, the property may be mortgaged to provide
security to the creditor in respect of the loan, which he intends to take in future. An
existing overdraft can also be secured by the mortgage of the property. But if the
person transfers his property for a purpose other than the above, it will not be called a
mortgage for example, transfer of property in discharge of a debt is not a mortgage.
5) The actual possession of the property need not always be transferred to the mortgagee.
6) The mortgagee gets, subject to the conditions of the mortgage need, the right to
recover the amount of the loan out of the sales proceeds of the mortgaged property.
7) The interest in the mortgage property is returned to the mortgager on the repayment of
the loan amount along with the interest.
4.2. General principles of secured advances
The following are the principles to be observed by the banker while granting advances
on the basis of securities.
1. Adequacy of margin
The word “margin” has special meaning and significance in the banking business. In
banking terminology, margin means the b/c b/n the market value of the security and
the amount of the advance granted against it for example if a banker sanctions a loan
of Br 70,000 against the security of goods worth Br 100,000 Br 70,000 is called a
margin.
A banker always keeps an adequate margin because of the following reasons;
(i) The market value of the securities is liable to fluctuations in future with the
result that the banker’s fully secured loans may turn into partly secured loans.
(ii) The liability of the borrower towards the banker increases gradually as
interest and other charges becomes payable by him. For example, if a loan of
Br 1,000 is sanctioned by a banker today, the liability of the borrower at a
future date, say, a year after, would be increased by him. Hence the banker
keeps adequate margin to cover not only the present debt but also the
additions to the debt.
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  Factors determining margin

(i) The amount of margin depends upon the likely fluctuations is the prices of various
commodities. For example, if a commodity enjoys steady demand and an essential
item of consumption, lower margin is fixed. But if the prices of articles fluctuate
widely, then the banker should be careful in accepting such goods as securities and
thus margin will nr high.
(ii) In case of stocks of industrial concerns, the financial position and the reputation of
the issuing companies is also taken into account. The stocks issued by sound and
well-known industries are treated as good as government securities and a lower
margin is required.
(iii) Margin are fixed keeping in view the credit and reputation of the borrower
concerned, that is, a lower margin may be fixed for the borrower having good
reputation against the security of the same commodity.
(iv) The margin, determined at the time of sanctioning of loan, may be raised or
reduced subsequently according to the variations in the prices of the securities.
(v) In case of commodities, which are subject to selective credit control of the central
bank, margins are usually prescribed by the central bank from time to time. It is
essential for the banks to keep such margin.
2. Marketability of securities:
Advances are usually granted for short periods by the commercial banks because their
deposits resources (except term deposits) are either repayable on demand or at short
notice. If the customer defaults in make payment, the banker has to liquidate the
property. Therefore, it is essential that the security offered by borrower may be
disposed of with out loss of time are not easily marketable.
3. Documentation:
Documentation means that necessary document Such as agreement of pledge or
mortgage, etc, are prepared and signed by the borrower at the time of securing a loan
from the bank. Though it is not necessary under to law to have such agreements in

41
 writing and mere deposit of goods and securities will be sufficient to constitute a
charge over them. But it is highly desirable to get the documents contain al the terms
and conditions on which a loan is sanctioned by the banker and hence any
misunderstanding or dispute later on may easily be avoided.
4.3. Advance against goods;
Commercial banks make advances against goods of different varieties. The following are
the main items against which the loans are given;
- Agricultural products
- Food articles
- Industrial raw materials
- Industrial products
The main purpose of such advances is to meet the working capital needs of the business
and industrial concerns. In fact such advances are essential for all trading and commercial
activities in the country that is, storing the agricultural output, the industrial raw materials
and the finished products from the time of their harvest or production till their final
consumption.
 Precautions to be taken by the banker while accepting goods as a security

Goods and commodities are safe, sound and dependable securities for a banker but they
are not always free from certain risks. A banker should. Therefore, be very careful in
accepting them as security and take the following precautions;
1) Though goods and commodities are the best securities to a banker for granting
loans, the customer is also equally important. The customer must be honest and
trustworthy otherwise the risks of fraud or dishonest practice always remain. The
banker depends upon his past experience about the customer and also on the good
will enjoyed by the customer in the market, the customer must posses business
talent and experience, otherwise oven a honest and reliable customer without
competence and practical experience is out free from risk

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2) Before accepting any commodity as sec only the banker must be will acquainted
with the nature of its demand. He must enquire whether the commodity is an item
of necessity. or hosiery and whether its demand is elastic or otherwise, is constant
throughout the year or a seasonal in nature. He should readily accept the
commodities, which are necessaries of life and are regularly consumes, which are
necessaries of life and are regularly by large number of people because of their
easy marketability in case of need.
3) The banker should also confirm whether the commodity can be stored for a
reasonable period of time without deterioration in its quality, or value.
4) The banker must be well acquainted with the commodity market. He should know
well the commodities offered as security, the conditions and customs of their trade
also the trend of their prices in the market. Such knowledge is essential for him to
regulate the margins to be maintained.
5) The banker should take delivery of goods before he grants a loan against it to a
customer. Delivery may be either actual or constructive delivery. In case of
constructive delivery, the customer must hand over the keys of the storehouse
where the goods are being stored or transfers the services of the watchman. In
some cases the banker provides facilities usually called “factor type” meaning
thereby that the stocks pledged with the banker are permitted to be processed or
utilized by the debtor. The banker retains his charge over the same and a
nameplate of the banker is displayed at an important pace in the business premises
of the debtor to indicate that the goods are pledged to the banker.
6) The banker should estimate the value of the goods very carefully. He should
ensure the exact quantity of goods pledged and find out their prices in the market
through a broker, if necessary. The in voice price given by the borrower should be
checked because it may be inflated one
7) The banker should also take necessary care regarding the storage of goods
pledged. The storehouses should be safe from water, fire, etc. And should be
situated in good locality. Proper record should be kept in the storehouse register.

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 8) The goods should duly and adequately insured against fire, theft, etc. As the fire
insurance policies contain as “average clause” the banker must get the goods
insured for their full value irrespective of the amount of the loan advanced because
if the full value is not insured
The insurance company will pay the damages in the same proportion in which the
total stands to the amount insured
9) As the borrower is all owed by the banker to repay the loan in parts and to get the
commodities released it is very impotent for the banker to insure that the goods
released should be in proportion to the amount of the loan repaid by the customer.
Hence the banker should strictly regulate the delivery of goods. All deliveries
must be signed by the manager
4.4. Advance against documents of title to good

A document which gives right to a person to take delivery or possession of goods is

called documents of title to goods that is the documents is entitled to the possession of
the goods stated in it the following are the main documents of little to goods,

A) Bill of lading
A bill of lading is a receipt for goods. Upon shipment signed by some authorized
by the ship owner, the documents states that the goods have been shipped in good
order, and quotes the rate at which the freight is to be paid by the consignees.
Here. The consignor is the person who is sending the goods (exporter) and the
consignee is the person to whom the goods are being sent (importer) a note is
usually made upon the bill of lading that the weight. Quantity and the quality of
the cargo is unknown. The ship owner undertakes to deliver the good at their port
of destination in the same condition as they also contain various terms and
conditions under which the shipping company agrees to transport the goods,
Bill of lading is usually drawn in three copes and in addition there are two copies
of these two copies. One is given to the master of the ship and the loading brokers
retain the other. These two copies have no value and they are sometimes marked

44
 “copy not negotiable” one of the three bills of lading is sent by the shipping
company to the consignee by one mail. And another is sent to him by another
route it possible or by the following support of a claim for insurance in the event
of ship being lost. The goods were in the ship on the arrival of the ship in the port
of destination. The paying all claims for freight and other charges obtain the goods
if the consignee simply wants to transfer the goods to some other person. He can
by simply endorsing the bill it landing and delivers it to that person thus the person
getting the bill of lading endorsed in his favour will become the absolute owner of
the consignment.
B. Warehouse-keeper’s certificate or receipt.
A document issued by a warehouse keeper stating the certain goods is held in his
warehouse at the disposal of the person named, such a certificate of receipt is not
transferable and the goods are not deliverable upon its production, it is simply an
acknowledgement of having received certain goods. The receipt can be transferred
by endorsement and delivery. The lawful holder is entitled to receive the goods
stated in it from the warehouse keeper.
C. Delivery order:
An order by the owner or holder of title to goods, addressed to ware house keeper,
to the superintendent of a dock or to a railway company, holding the goods,
authorizing and requesting him to deliver the goods, whether in whole or part to
the bearer or the holder or to the party thereon named by endorsement. When
delivery orders are taken as security, the banker’s letter of lien should be signed by
the customer and the bank should instruct the warehouse keeper to store the goods
in the bank’s name.
D. Railway receipt
It issued by a railway company. The railway company acknowledges the receipt of
goods described therein and undertakes to deliver the goods to the specific person
at the place mentioned in the documents.

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  Precautions to be taken by the banker while advancing against documents of
title to goods:
A banker should take the following precautions while lending against the
documents to title to goods;
i. The banker should deal with honest reliable and experienced customer there is a
greater scope for committing fraud in the case of documents of tile to goods than
in the case of goods. A dishonest person may forge the document. So, a banker
should grant loans only when the customer is strictly honest.
ii. The banker must receive certificate of packing. The documents contain the
description of goods only. Thus it is necessary for the banker to know whether the
packages contain the goods described or not. So, he should ask for certificate of
packing issued by a reliable packer. Alternatively, he may depute a responsible
person to be present at the time of packing the goods.
iii. The bill of lading is issued in set of three. A banker should ask his customer to
submit both copies of the bill of lading before granting loan. Otherwise, the
customer may present one copy of the bill of lading and obtain the delivery of
goods with out the knowledge of the banker.
iv. A banker must see that the goods are fully insured. He must ask the customer to
submit the insurance policy to him.
v. A banker should ask his customer to endorse the bill of lading in blank. In such
case, the customer will be liable to pay freight if not it will be calculated as part of
loan.
vi. When a banker wants to deliver the bill of lading or goods without receiving
payment he must take a trust receipt from the customer. The implication of this
trust receipt is that the customer agrees to hold goods or sales proceeds in trust of
the baker until entire amount of loan is repaid. If the customer fails to pay the sale
proceeds, he will be liable for criminal breach of trust.
vii. The unpaid seller of goods has the right to stop the goods on their way to the buyer
if the buyer becomes insolvent before the goods are delivered to him. Therefore,

46
 the banker should ask whether such an agreement exists between the buyer and the
seller.
4.5. Advances against stock exchange securities

We have different securities that are traded in money market and capital market
such as shares, debentured, bill of exchange, bonds, treasury bills, etc. Some of
them are for short-term securities traded in money market and others for long-term
securities traded in the capital market. These stock exchange securities are bought
and sold in the stock exchange market. Based on the past performance and on the
future forecast Prices of these securities fluctuate. Borrowers sometimes offer
these securities as pledge to secure loans from banks.

 Precautions to be taken by the banker while advancing against stock exchange

securities:

1) A banker must study the working and progress of various companies whose
shares are purchased and sold on the stock exchange. For this, he must
examine carefully the profit and loss account and balance sheet of the
companies for a number of years. He must also enquire about the character and
ability of directors or persons authorized to manage the company
2) A banker should prefer preference shares and debentures to ordinary shares.
The reason is fluctuations in the prices of debentures and preference shares will
be small. If he decides to lend on ordinary share, he should lend against shares
of first class companies. He should avoid lending money against shares of new
companies.
3) He should examine whether the shares are partly paid or fully paid. In the case
of partly paid share, calls may be made by the company. A banker should take
an undertaking from the customer that he would pay the call, if made, so he
should make advances against fully paid shares, and no advance as far as
possible should be made against partly paid shares.

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 4) Most of the stock exchange securities are not negotiable. So a banker must
verity whether the party offering securities for an advance has a good title to
them or not.
5) The banker must also study carefully the prices of securities. He must obtain
official list of prices of securities from the stock exchange authorities. When
the prices of securities fall. He must ask the customers to keep sufficient
margin. This can be done by repaying part of the loan or depositing additional
security by the customers.
6) The banker must not accept securities in the name of a third party. The reason
is he may be holding them as a trustee. A banker should lend only when the
securities are in the name of the borrower.
7) It is better that the securities are transferred to the banker and tat the transfer is
registered. When the loan is repaid, the banker may transfer them to the
customer. Alternatively the banker may secure equitable charge on the
securities. He may ask the customer to deposit securities with in and take a
blank transfer deed duly signed by the customer. In case of default of the loan,
the banker may fill in the transfer deed and get the securities registered in his
name.
8) The banker should also immediately give a notice to the company stating that
the securities have been deposited with him and he has a charge on them. The
notice will prevent the issue of duplicate certificate.
9) The banker should release securities on payment of the loan. He may release
proportionate value of securities when part payment is made. But he should
never hand over security to the customer unless full payment is made.
10) The banker must receive the securities in good faith. If he has any doubt about
the ownership of the customer, he should not lend.
4.6. Advances against land and building

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Housing or building societies advance loans against houses. Land mortgage banks
advance loans against the mortgage of lands. But commercial banks do no generally grant
advances against real estates like land and buildings. They generally try to avoid them as
security for their advances on account of many risks and disadvantages. Advance against
property of this nature are not of a liquid nature, because it is difficult to effect the sale of
the property when the banker wants to sell. Therefore, investment of banks in advances
against property is usually very small.

CHAPTER FIVE

5.1 CUSTOMERS ACCOUNT WITH THE BANKER: OPENING AND OPERATION

PROCEDURES

The relationship between a bank and a customer begins when the customer opens an account
with the bank. The customer opens all the accounts with a deposit of cash money and that is why,
they are also known as deposit account. As we know that it is the most important function of a
modern bank to borrow money or to receive deposits from the public. The bulk of the resources
of a bank are mobilized by accepting deposits from the public.
5.1.1 Current Account
It is also known as demand deposit account. A businessperson or an organization can open
current account with a bank by making an initial deposit, which may vary from bank to bank.
There is no upper limit to the amount, which can be deposited in this account. The amount can be
withdrawn by drawing cheques on this account. There is no restriction regarding the number of
withdrawals and the amount of withdrawal so long as there is sufficient balance in the account.
That is why, it is also knows as a running and active account.
The other features of the current account are as follows: -
i) Current accounts generally do not carry any interest, as the amount deposited in these accounts
is repayable on demand without any restriction.
ii) Most of the banks charge incidental charges on such account, which depend upon the amount
of balance, kept by the customer. Where a customer keeps a sufficient balance to compensate
the bank, the bank may waive such charges.

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 i) Temporary loans and advances against fixed deposit receipt, life insurance policies and
securities are granted through current accounts.
ii) Third party cheques and cheques with endorsements may be deposited in the current
account for collection and credit facility.
Advantages of Current Deposit Accounts
The customer derives the following advantages from current accounts:-
i) It enhances business transaction: - Demand deposits are treated at par with cash. They
constitute cheque currency. Cheques are readily accepted in business for making and
receiving payments.
ii) It decreases circulation of legal tender money. This decreases the printing cost of
currencies.
iii) It minimizes the risk and inconveniencies of carrying of huge money. Businesspersons
have to receive and make a large number of payments every day. It is difficult to handle cash.
The cheque facility removes this difficulty i.e. you can issue a cheque with single leaf having
huge value
iv) It facilitates Payment. There is no restriction on the number of cheques or on the amount to
be drawn at a time by on cheque.
v) It strengthens the credit system: - Cheques save the use of legal tender money, which in turn
save the reserve of the bank. As the reserve at the bank increases, its credit creation power
also increases. It also helps to multiply derivative deposits without affecting each bank’s
reserves.
vi) It Facilitates Overdraft Loans. The banks allow overdraft facilities to the current account
holders.
vii) It facilitates documentation of flow of funds and related activities
viii) The check stubs are used to know the daily balances of the customer’s account.
Disadvantage of Demand Deposit Accounts
Although demand deposit accounts have the above stated advantages, it also initials the
following disadvantages:-
i). It is non-interest bearing account to the public
ii). It is very open for fraud, if it is not handled properly
iii). The occurrence of insufficient fund and using the cheque as a promissory notes

50
5.1.2 Savings Deposit Account
Savings deposit account is meant for small businesspersons and individuals who wish to save a
little money out of their current incomes to safe guard their future and also to earn some interest
on their savings. A savings account can be opened with a small sum and small amounts can be
withdrawn. There are restrictions on the maximum amount that can be deposited in this account
and also on the withdrawal 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. This is always described on the inside part of the outer part of the passbook.
Savings account holders are allowed to deposit cheques, drafts, dividend warrants, etc, which
stand in their name only. However, the bank does not accept cheques or instruments payable to
third party for deposit in the saving deposit account. Banks allow interest on deposits maintained
in savings account according to the rates prescribed by the National Bank of Ethiopia. Savings
deposit account is very popular among the general public because of the following advantages.
- A savings deposit account can be opened with little sum of money. It helps the people
of small means to save for their future
- The balance lying in the savings account earns some interest. The customer is
benefited as his money grows with the bank.
- The money lying with the bank is quite safe. There is no fear of theft.
- The money can be withdrawn concurrently from the saving account.
- The customer may get the cheque book facility in order to facilitate payment to third
parties by issuing cheques.
Opening procedure of Savings Bank Accounts
The banker should be very careful in entertaining a new customer as he opens a saving account.
The necessary precautions should be taken here like that of the opening of current deposit
accounts. The bank may follow the following procedures, in this regard, as given below,

i). The opening application format

This is a standard format designed by the bank, which replaces personal application. The
prospective customers should complete this form. He/she should present at least one proper ID
card, photocopy of renewed trade license for traders

51
 ii) Specimen Signature Card
This form is designed to obtain customers signatures at the time of opening account. This will be
used by the banker to compare the signature on transaction, especially withdrawals, and to
ascertain the, genuinety of the customer /presenter/.
iii) Deposit of cash
Before opening the account the customer must deposit the minimum initial deposit required by
the respective banks.
iv) Issue of pass Book
The bank issues a passbook to the customer after the account has been owned and an account
number has been allocated. The passbooks contain the record of transactions between the bank
and the customer. It is a copy of the account 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.
The pass book helps the customer to know the position of his account and know certain items
like interest, incidental charges, dividends collected, bills paid, etc. This will also enable the
customer to reconcile his records with that of the banker-used as 'Bank Reconciliation
statetment'.
5.1.3 Fixed Deposit Accounts
The term ' Fixed deposit' means the deposit repayable only after the expiry of a specified period,
which ordinarily varies from fifteen days to five years. Since it is to be repayable only after a
fixed period of time, which is to be determined at the time of opening the account, it is also
known as time deposit.
Deposit: -People, who can afford to keep their money with banks for a certain period without
withdrawing it, meanwhile go in for fixed deposits. Fixed deposits are the most suitable form of
raising resources for a commercial bank. Since they are repayable only after a fixed period of
time, the bank need not keep cash reserves more than the statutory requirement against these
liabilities. It may employ these funds more profitably by lending at higher rates of interest and
for relatively longer periods. It is because of this reason that banks offer higher rates of interest
on such deposits.
The rate of interest on fixed deposits depends upon the length of the time of the deposit and the
amount of deposit. The longer the period, the higher is the rate of interest offered and vise versa.

52
The principal types of bank time deposits are: savings certificates, money market certificates and
certificates of deposits.
i. Savings certificates
They are bank liabilities issued in a designated amount, specifying a fixed rate of interest and
maturity date. The interest rate is generally higher than on savings accounts. The main purpose
of these accounts is to generate income to the depositor. They are important sources of funds for
small, consumer-oriented banks. They are held primarily by consumers or other small depositors.
ii. Money Market Certificates
They are designed primarily to service consumers and small businesses. They help commercial
banks to compete effectively with money market funds. The minimum amounts, maturity date
and interest rates are determined by bank regulators.
iii. Certificates of Deposit, (CD)
Certificates of deposit commonly referred to as CDs, are very large unsecured liabilities of
commercial banks issued in verity of denominations to business firms and individuals. They have
a fixed maturity date, pay an explicit rate of interest, and are negotiable if they meet certain legal
specifications-Negotiable CDs are issued by large, well -known commercial banks of the highest
credit standing and are traded actively in a well-organized secondary market;
CDs are attractive both to holders of large funds and commercial banks. They can be redeemed
at any time in the secondary market without loss of deposit funds to the bank.

5.2 GENERAL RELATIONSHIP BETWEEN BANKER AND CUSTOMER

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5.2.1 Debtor and Creditor Relationship
This is the primary relationship between a banker and its customer. When the customer deposit
money in the bank, the customer is a creditor and the banker is a debtor. When the customer
over drawn his account he become debtor and the bank a creditor. The money deposited with the
banker becomes his property and is absolutely at his disposal whether he pays or does not pay
interest on it. This is because the banker undertakes to repay on demand a sum equivalent to the
amount deposited with it. The customer has no right whatsoever to claim identical coins or notes
deposited by him with the banker. The banker can pay in any kind of legal tender money. The
banker only under takes to repay a sum equivalent to the amount deposited with him.
5.2.2 Trustee and Beneficiary Relationship
Where a banker, pursuant to instructions, express or implied has credited the proceed of a bill or
other document entrusted to him for collection, the relationships of debtor and creditor arises
from the time of his doing so. Where, however, the banker has suspended his business before
receipt of such amount, he holds the money as a trustee for the customer, irrespective of whether
or not the latter had an account with him on the date of the receipt of money and whether or not
the money has been credited in the account.
The banker acts as a trustee for his customers in those cases where
1. He accepts securities and other valuables for safe custody.
2. If money is deposited to the bank with a special instruction to retain it till the
customer gives further instruction.
3. When a cheque or bill is deposited with the bank for collection until it is collected
and credited to the customer’s account
In such cases the customer continues to be the owner of the valuables or securities or cheque or
bills deposited with the bank and they are not available for distribution among the bank’s
creditors in the event of bank going into liquidation.
5.2.3 Agent and Principal Relationship
Banker acts as the agent of the customer in those cases where it performs agency functions:-
Such as; collection of cheque and bills of exchange on behalf his customer, government,
purchasing and selling of securities on behalf of his customer, payment of insurance premium,
executing standing instructions, etc.
5.2.4 Bailer and Bailee

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When a customer deposits with the bank valuables, documents, shares, debentures, etc. for safe
custody, he becomes a bailer and the bank bailee. The bank as a bailee is liable to keep those in
safe custody as a custodian on specified charges. It is also liable to compensate any loss to the
property under its custody.
5.3 OBLIGATION OF A BANKER

The obligations of the banker are the rights of the customer and the rights of the banker are the
obligation of the customers. Two important obligations of the banker towards his customer are as
follows.
1. To honor cheques: The banker is bound to honor his customer’s cheques if there is
sufficient balance in his account and the cheque has been drawn as per provisions of the
law.
2. To Maintain Secrecy of Account:-. In an ordinary debtor-creditor relationship, there is no
obligation of secrecy. But in the case of banker, one of the implied terms of the contract is
that he is obliged to keep the affairs of his customer secret except under special
circumstances such as:-
a) Where disclosure is under compulsion by law
b) Where there is a duty to the public to disclose
c) Where the interest of the banker requires disclosure
d) Were disclosure is made with the consent of the customer
5.4 RIGHTS OF BANKERS

The banks have been conferred by low two special rights which are not available to an ordinary
creditor, These are:-
5.4.1 Right of Lien
Lien means the right of a creditor to retain in his possession the goods and securities owned by
the debtor until the debit has been discharged, but not the right to sell. However, the right of a
banker amounts to an implied pledge, which gives him a right to sell the goods in due course to
realize his dues.
The banker has the right to general lien in respect of the amount due to him by the customer. It is
not restricted to specific or particular goods. The banker has the right to retain possession of
goods belonging to the borrower of the general balance of account.

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Lien can be either (i) a general lien, or (ii) a particular lien. General lien entitles the creditor in
possession to retain the goods and securities till all his claims against the power of goods have
been satisfied. Thus, it is applicable in respect of all amounts due from the debtor to the creditor.
But a particular lien is a specific lien, which confers a right to retain those goods for which the
amount is to be paid.
5.4.2 Right of Set Off
A customer may maintain two or more accounts at one branch or at several branches of the same
bank. This right enables the banker to combine the two accounts in the name of the same
customer and to set to the debt, if there is no agreement to the contrary. The right of set off gives
a special protection of the banker in case of a default by a customer whose one account is
overdrawn and the other account has a credit balance. Thus, where a customer maintains two
accounts in his name, and one of them shows a debit balance, the bank can set off the debit
balance against the credit in the second account. However, depending on the custom or
agreement between the banker and the customer at the time the two accounts are opened, notice
to the customer of the banker's intention to combine accounts may or may not be necessary.
5.4.3 Right of Appropriation
A customer may owe several debts to a banker and make some payment to the banker, which is
not sufficient to discharge all his debt. Then, the problem of appropriating this payment arises.
As to which debt should be discharged first?
Right of appropriation is the right of a banker to appropriate the money paid by the customer to
any of the loans including the time-barred debts. The banker can do so when the debtor has not
asked the banker at the time of making the payment to cancel or reduce any one of the debts,
irrespective of the order of the time when the debt is incurred.
5.4.4 Right to Close Account
A customer may close the account with the banker at any time he feels without assigning any
reason. Similarly, a banker may close the account of his customer by sending a written
intimation to the customer. The banker must give the customer a sufficient notice before closing
the account. If he closes the account without giving proper notice, he will dishonor cheques
drawn before the closure of the account. This will injure the credit of the customer for which he
may claim damages. The length of the notice will depend on the circumstances of the case and
nature of the business of the customer. When a customer does not comply with the request of the

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banker to close his account even after the expiry of a reasonable notice given to him, the banker
can close the account by returning the entire balance due to him. He must ask his customer to
return the unused cheques. In the following cases, a banker can close the account of a customer
without giving notice: -
 When a customer dies, the banker must close the account of his customer on receiving a
notice of death.
 When a banker comes to the knowledge that a customer has become insane, he should
close his account.
 When a banker comes to the knowledge that a customer has become insane, he should
close his account.
 A banker should not honor cheques after receiving the garnishee order from the court
attaching his customer's account in execution of a decree.
 When a banker receives a notice of assignment of his customer's account to a third
party, he should not honor cheques issued after the assignment.
5.5 CLOSURE OF ACCOUNTS OF A CUSTOMER

The relationship between the banker and the customer arises out of a contract between the two
and it continues as long as both of them agree to it. This relationship may also be discontinued
by the operation of law in certain cases. The following are circumstances under which a banker
can close or stop the operation of the account of a customer.
A. A customer can close his account with the banker at any time he like without assigning
any reason. The banker must close the account with immediate effect on receipt of notice
and pay him the balance in his account. After the notice is received, the banker should not
make payment of the cheques presented. It is the normal practice to require the customer
to return the unused cheque leaves.
B. The banker may ask the customer to close his account if the account is not operated for a
long time-became dormant account. In case the customer is not traceable, the banker may
close his account and transfer the amount to unclaimed deposits account. Similarly the
banker may close the account of a customer if the latter is fond "Undesirable " for valid
reasons
A customer is deemed to be undesirable under the following circumstances:-

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  When a customer is convicted of an offence of forging the cheques or bills.
 When a customer issues a cheque when sufficient credit balance is not there in his
account; and
 When a customer does not return the loan taken from the banker or does not repay
overdrafts.

5.6 SPECIAL TYPE OF CUSTOMERS AND PRECAUTION IN DEALING WITH

THEM

General precaution are taken at the time of opening an account whenever a bank deal with
majors/persons who are above the age of 18/and for all those who need to be customers of a
bank. But a bank has to open and operate account for different types of customers such as
individuals, partnership, join stock companies, building societies, local authorities etc. In case of
individuals, the account may be opened for two or more persons in which case the account is
called a joint account. Again all individuals are not alike. Although every persons is legally
capable of opening an account with a banker provided the latter is willing to take him as a
customer and transact banking business with him however the capacity of certain person is
restricted by law. So many restrictions are placed in their capacity to contract or their power to
exercise certain rights. Therefore, the banker must take the necessary precaution in dealing with
such customers in order to safeguard his position. The position of the banker wish regard to these
special types of customer and the precautions, which he should take in dealing with them.

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