Banking Chapter 1 an over view of banks and their functions

Chapter 1
1
Chapter One
An over view of banks and their
function

Con’d
Finance is the life blood of trade, commerce and
industry.
Now-a-days, banking sector acts as the backbone of
modern business.
Development of any country mainly depends upon the
banking system.
 Banking system evolved to meet the demands of the
citizens, vested interest and regulations governing their
establishment.
2

Con’d
Historical Background Of Banking
Historical Background Of Banking
1.
1. World Banking History
World Banking History
 There are different assumptions as to the origin of the word “bank”.
There are different assumptions as to the origin of the word “bank”.
o One assumption is that it is derived from the French word
One assumption is that it is derived from the French word
‘Banque’ or the Italian word “banco” which means in English a
‘Banque’ or the Italian word “banco” which means in English a
bench.
bench.
 This is derived from the experience of the merchants of Greece and
This is derived from the experience of the merchants of Greece and
Rome.
Rome.
 They used to sit
They used to sit on a bench in the center of the market and receive
on a bench in the center of the market and receive
deposits from the public and pay to the public from the deposit
deposits from the public and pay to the public from the deposit. They
. They
were referred as ‘benchers’.
were referred as ‘benchers’.
 Banking that time was mainly concerned with the services of currency
Banking that time was mainly concerned with the services of currency
exchange.
exchange.
o The merchants, goldsmiths and money lenders can be regarded as
The merchants, goldsmiths and money lenders can be regarded as
the ancestors of present day bankers.
the ancestors of present day bankers.

Con’d
 These people start the banking activity by accepting deposits
These people start the banking activity by accepting deposits
from the depositors and pay whenever demanded.
from the depositors and pay whenever demanded.
 For the deposit they accepted, they used to give written
For the deposit they accepted, they used to give written
evidences.
evidences.
 Through time, they see that the amount deposited is kept for a
Through time, they see that the amount deposited is kept for a
long period of time without being withdrawn.
long period of time without being withdrawn.
 At the same time there were others who were looking for money
At the same time there were others who were looking for money
to facilitate their trading activity. Hence these parties start to
to facilitate their trading activity. Hence these parties start to
lend with an interest.
lend with an interest.

Con’d
o As such, the origin of commercial banking can be traced back to around 2000
As such, the origin of commercial banking can be traced back to around 2000
B.C. by Babylonians who was performing the safe keeping and saving
B.C. by Babylonians who was performing the safe keeping and saving
functions in its oldest form.
functions in its oldest form.
• In ancient Greece and Rome, the practice of safe keeping of gold’s and coin at
In ancient Greece and Rome, the practice of safe keeping of gold’s and coin at
temples and granting loans for public and private purpose on interest was
temples and granting loans for public and private purpose on interest was
prevalent.
prevalent.
• Traces of credit by compensations and by transfer orders are found in Assyria,
Traces of credit by compensations and by transfer orders are found in Assyria,
Phoenicia and Egypt before the system attained full development in Greece and
Phoenicia and Egypt before the system attained full development in Greece and
Rome.
Rome.
o The bank of Venice, established in 1157, is supposed to be the first bank
The bank of Venice, established in 1157, is supposed to be the first bank
founded as a public enterprise. It was simply an office for the transfer of the
founded as a public enterprise. It was simply an office for the transfer of the
public debt and originally it was not a bank in the modern sense.
public debt and originally it was not a bank in the modern sense.
• There were other banks emerged in the Italian cites perhaps a little before
There were other banks emerged in the Italian cites perhaps a little before
1200AD.
1200AD.
Some of these bankers were carrying out business on their own
Some of these bankers were carrying out business on their own
account. The activity was almost similar to the modern bankers.
account. The activity was almost similar to the modern bankers.
People used to settle their accounts with their creditors by giving a
People used to settle their accounts with their creditors by giving a
check or draft on the bank or through transfer order, if the creditor has
check or draft on the bank or through transfer order, if the creditor has
an account in the same bank.
an account in the same bank.
5

Con’d
These bankers also received deposits and lent
These bankers also received deposits and lent
money.
money.
o As early as 1349 the drapers of Barcelona carried on the
As early as 1349 the drapers of Barcelona carried on the
business of banking.
business of banking.
 They were required to give sufficient security before their
They were required to give sufficient security before their
commence this business i.e. they were under regulation.
commence this business i.e. they were under regulation.
o During 1401 a public bank was established in Barcelona.
During 1401 a public bank was established in Barcelona.
 It was used to exchange money, receive deposits,
It was used to exchange money, receive deposits,
and discount bills of exchange for both the citizens
and discount bills of exchange for both the citizens
and for the foreigners.
and for the foreigners.
6

Con’d
o During 1407 the Bank of Genoa was established in Italy.
During 1407 the Bank of Genoa was established in Italy.
o In 1609 the Bank of Amsterdam was established to meet the needs
In 1609 the Bank of Amsterdam was established to meet the needs
of the merchants of the city.
of the merchants of the city.
– It accepts all kinds of specie on deposits.
It accepts all kinds of specie on deposits.
– Deposits could be withdrawn on demand or transferred from
Deposits could be withdrawn on demand or transferred from
the account of one person to another.
the account of one person to another.
– The bank also adopted a plan by which a depositor received a
The bank also adopted a plan by which a depositor received a
kind of certificate entitling him to withdraw his deposit within
kind of certificate entitling him to withdraw his deposit within
six months.
six months.
– These written orders, in course of time, came to be used in the
These written orders, in course of time, came to be used in the
same manner as the modern check
same manner as the modern check
Chapter 1 7

Con’d
o In England, banking had its origin with the London goldsmiths,
In England, banking had its origin with the London goldsmiths,
money lenders, merchants and money exchangers - during the reign
money lenders, merchants and money exchangers - during the reign
of queen Elizabeth-I.
of queen Elizabeth-I.
– They accepted a seizure of large gold hoards in the 17
They accepted a seizure of large gold hoards in the 17th
th
century
century
during the reign of King Charles-I.
during the reign of King Charles-I.
– They were scared to keep this sizable amount of gold with
They were scared to keep this sizable amount of gold with
themselves.
themselves.
– Hence they began to keep the gold at the “Exchequer” with the
Hence they began to keep the gold at the “Exchequer” with the
guarantee of the king.
guarantee of the king.
– However they were suffered during the reign of King Charles-II,
However they were suffered during the reign of King Charles-II,
who imposed several restrictions on the business of goldsmiths
who imposed several restrictions on the business of goldsmiths
was finally ruined when the King closed the “Exchequer” with
was finally ruined when the King closed the “Exchequer” with
out giving any compensation to the depositors.
out giving any compensation to the depositors.
– It is believed that many of these goldsmiths were converted into bankers and
It is believed that many of these goldsmiths were converted into bankers and
their activity is replaced with a large number of private bankers. Bank of
their activity is replaced with a large number of private bankers. Bank of
England was established in 1694.
England was established in 1694. 8

Con’d
2. Development of Banking in Ethiopia
2. Development of Banking in Ethiopia
• Banking is relatively a new concept in Ethiopia.
Banking is relatively a new concept in Ethiopia.
• The history of banking in Ethiopia can be traced back to the
The history of banking in Ethiopia can be traced back to the
establishment of
establishment of Bank of Abyssinia
Bank of Abyssinia in March 1905 in the premises
in March 1905 in the premises
of Ras Mekonen, the present main campus of Addis Ababa
of Ras Mekonen, the present main campus of Addis Ababa
University.
University.
– It was established and owned by the
It was established and owned by the National Bank of Egypt,
National Bank of Egypt,
an affiliate of the Bank of England
an affiliate of the Bank of England, which was given monopoly
, which was given monopoly
position in banking with regard to other foreign banking
position in banking with regard to other foreign banking
companies and other privileges set up a bank.
companies and other privileges set up a bank.
– The bank of Abyssinia’s headquarter in a new building was
The bank of Abyssinia’s headquarter in a new building was
inaugurated on 1
inaugurated on 1st
st
January, 1910.
January, 1910.
– Bank of Abyssinia has opened Branches at Dire Dawa, Gore
Bank of Abyssinia has opened Branches at Dire Dawa, Gore
and Dessie and agencies at Harrar and Gambella with the
and Dessie and agencies at Harrar and Gambella with the
construction of Franco-Ethiopia railway.
construction of Franco-Ethiopia railway.
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9

Con’d
– The bank was purchased by the order of the Emperor from the
The bank was purchased by the order of the Emperor from the
foreign company and was chartered on 29
foreign company and was chartered on 29th
th
August 1931 as
August 1931 as
Bank of Ethiopia.
Bank of Ethiopia.
o During the Italian occupation branches of Banco di’Italia, Banco
During the Italian occupation branches of Banco di’Italia, Banco
di’Roma, Banco di’Napali and Banco Nationale del Lavoro were
di’Roma, Banco di’Napali and Banco Nationale del Lavoro were
established.
established.
o In 1941 Barclays Bank and Dominion colonial & overseas came to
In 1941 Barclays Bank and Dominion colonial & overseas came to
Ethiopia with the British troops and organized Banking services in
Ethiopia with the British troops and organized Banking services in
Addis Ababa.
Addis Ababa.
They withdraw in 1943 with the British troop.
They withdraw in 1943 with the British troop.
The same year Banco di Indo China was established.
The same year Banco di Indo China was established.
Chapter 1 10

Con’d
o National and commercial Bank proclamation, August 1942, was
National and commercial Bank proclamation, August 1942, was
entrusted to the state Bank of Ethiopia for; controlling the issue
entrusted to the state Bank of Ethiopia for; controlling the issue
of currency, holding the foreign reserves of the country and
of currency, holding the foreign reserves of the country and
acting as a fiscal agent of the government.
acting as a fiscal agent of the government.
– Since the economy was highly under –developed the
Since the economy was highly under –developed the
monetary situation was quite confused and credit was
monetary situation was quite confused and credit was
practically non-existent.
practically non-existent.
o In 1945,
In 1945, Agricultural bank
Agricultural bank was established to help the rehabilitation of
was established to help the rehabilitation of
the agricultural sector.
the agricultural sector.
– Four years later(1949), the same was changed
Four years later(1949), the same was changed as agricultural and
as agricultural and
commercial bank.
commercial bank.
– On the recommendation and assistance of the World Bank (the
On the recommendation and assistance of the World Bank (the
IBRD), the bank was further converted in 1951 into the
IBRD), the bank was further converted in 1951 into the
development bank of Ethiopia.
development bank of Ethiopia.
11

Con’d
o Imperial Savings and Home Ownership Public Association
Imperial Savings and Home Ownership Public Association
(ISHOPA) was established in 1961 as a building society for
(ISHOPA) was established in 1961 as a building society for
encouraging thrift schemes in residential construction by the
encouraging thrift schemes in residential construction by the
effective mobilization of the sources in Ethiopia.
effective mobilization of the sources in Ethiopia.
o The Banking activity was reorganized in Ethiopia in December
The Banking activity was reorganized in Ethiopia in December
1963.
1963.
 It
It splits
splits the functions of Central Banking and Commercial
the functions of Central Banking and Commercial
Banking activities, which until this time was carried out by the
Banking activities, which until this time was carried out by the
State Bank of Ethiopia.
State Bank of Ethiopia.
 Commercial bank of Ethiopia was incorporated as Share
Commercial bank of Ethiopia was incorporated as Share
Company with the following activities and business purposes.
Company with the following activities and business purposes.
(1).The carrying out of all types of banking business and
(1).The carrying out of all types of banking business and
operations. (2). Attracting public deposits of all kinds
operations. (2). Attracting public deposits of all kinds
including savings and (3). Promoting the banking habit and
including savings and (3). Promoting the banking habit and
facilitating transactions.
facilitating transactions.
12

Con’d
o In 1963
In 1963 Development bank of Ethiopia
Development bank of Ethiopia was reorganized as
was reorganized as
Agricultural and Commercial Bank of Ethiopia
Agricultural and Commercial Bank of Ethiopia.
.
o On the same year, (1963),
On the same year, (1963), Ethiopian Investment Corporation
Ethiopian Investment Corporation was
was
established with the objectives of rendering services, which are
established with the objectives of rendering services, which are
beyond the scope of the exiting banking institutions, and
beyond the scope of the exiting banking institutions, and
conducting all operations incidental to a general investment
conducting all operations incidental to a general investment
banking business.
banking business.
o Addis Ababa Share Company
Addis Ababa Share Company, the first private domestic bank, was
, the first private domestic bank, was
established in October, 1964.
established in October, 1964.
o Mortgage Company of Ethiopia
Mortgage Company of Ethiopia was established in July 1965 to
was established in July 1965 to
make available financial means and credit facilities for the
make available financial means and credit facilities for the
construction of commercial, industrial and residential buildings
construction of commercial, industrial and residential buildings
against mortgage of immoveable properties.
against mortgage of immoveable properties.
13

Con’d
o In the year 1974, with the change in the government, all private
In the year 1974, with the change in the government, all private
banks were nationalized and there were only three banks:
banks were nationalized and there were only three banks:
Commercial Bank of Ethiopia
Commercial Bank of Ethiopia
 Agricultural and Industrial Bank
Agricultural and Industrial Bank
 Mortgage Bank of Ethiopia
Mortgage Bank of Ethiopia
o Again, after the fall of derg regime and with the free market
Again, after the fall of derg regime and with the free market
economy many private banks were established. These are:
economy many private banks were established. These are:
 Bank of Abyssinia S.C.
Bank of Abyssinia S.C.
Awash International Bank S.C.
Awash International Bank S.C.
Dashen Bank S.C.
Dashen Bank S.C.
 United Bank S.C.
United Bank S.C.
Wogagen Bank S.C.
Wogagen Bank S.C.
Nib International Bank S.C.
Nib International Bank S.C.
14

Con’d
THE NATURE & CLASSIFICATION OF BANKS
THE NATURE & CLASSIFICATION OF BANKS
Definition And Meaning of Banking
 The Banking Regulation Act of India, 1949 defines “Banking as
accepting the purpose of lending or investment, of deposits of
money from the public, repayable on demand or otherwise and
withdraw by cheque, draft, and order otherwise”.
 A banking system is a group or network of institutions that
provide financial services for us. These institutions are responsible
for operating a payment system, providing loans, taking deposits,
and helping with investments.
 A bank is a financial institution which deals with deposits and
advances and other related services.
 It receives money from those who want to save in the form of
deposits and it lends money to those who need it.
15

Con’d
• A Bank is a financial institution organized in a form of
A Bank is a financial institution organized in a form of
joint company basis so as to create value to the society
joint company basis so as to create value to the society
and profit to the share holders in a form of dividends.
and profit to the share holders in a form of dividends.
• It is an institution, which deals with money and credit.
It is an institution, which deals with money and credit.
• The term bank in the modern times refers to an institution
The term bank in the modern times refers to an institution
which:
which:
1.
1. deals with money:
deals with money: it accepts deposits and advance loans
it accepts deposits and advance loans
2.
2. deals with credit:
deals with credit: it has the ability to create credit,
it has the ability to create credit,
3.
3. is a commercial institution:
is a commercial institution: it aims at earning profits,
it aims at earning profits,
and
and
4.
4. creates a demand deposits
creates a demand deposits which serve as a medium of
which serve as a medium of
exchange, and as a result, the bank manages the payment
exchange, and as a result, the bank manages the payment
system of the country
system of the country
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16

Con’d
• A bank as a financial institution is the creator of money
A bank as a financial institution is the creator of money
in the form of credit money i.e. cheque.
in the form of credit money i.e. cheque.
• According to Westerfield, (1921) a bank is an institution
for the custody, loan, exchange, or issue of money and
credit, and for facilitating the transmission of funds by
bills of exchange.
• Banks deal in money and in credit, which is the deferred
payment of money.
17

Con’d
Characteristics / Features of a Bank
• Dealing in Money: Bank is a financial institution which deals with other
people's money i.e. money given by depositors.
• Individual / Firm / Company: A bank may be a person, firm or a
company. A banking company means a company which is in the business
of banking.
• Acceptance of Deposit: A bank accepts money from the people in the
form of deposits which are usually repayable on demand or after the
expiry of a fixed period. It gives safety to the deposits of its customers. It
also acts as a custodian of funds of its customers.
• Giving Advances: A bank lends out money in the form of loans to those
who require it for different purposes.
• Payment and Withdrawal: A bank provides easy payment and
withdrawal facility to its customers in the form of cheques and drafts, It
also brings bank money in circulation. This money is in the form of
cheques, drafts, etc.
Chapter 1
18

Con'd
• Agency and Utility Services: A bank provides various banking
facilities to its customers. They include general utility services and
agency services.
• Profit and Service Orientation: A bank is a profit seeking institution
having service oriented approach.
• Ever Increasing Functions: Banking is an evolutionary concept.
There is continuous expansion and diversification as regards the
functions, services and activities of a bank.
• Connecting Link: A bank acts as a connecting link between borrowers
and lenders of money. Banks collect money from those who have
surplus money and give the same to those who are in need of money.
• Banking Business: A bank's main activity should be to do business of
banking which should not be subsidiary to any other business.
• Name Identity: A bank should always add the word "bank" to its
name to enable people to know that it is a bank and that it is dealing in
money
Chapter 1
19

Con’d
Functions of Banks
Functions of Banks
• A modern bank performs a variety of functions : some basic
A modern bank performs a variety of functions : some basic
functions performed by the banks are discussed as follows:
functions performed by the banks are discussed as follows:
1.
1. Accepting deposits
Accepting deposits
• It is the primary functions of a bank.
It is the primary functions of a bank.
• The bank accepts deposits from those that can save.
The bank accepts deposits from those that can save.
• People consider it more rational to deposit their savings in a bank
People consider it more rational to deposit their savings in a bank
to earn interest and avoid the danger of theft.
to earn interest and avoid the danger of theft.
• To attract savings from all sorts of individuals, the banks maintain
To attract savings from all sorts of individuals, the banks maintain
different types of accounts:
different types of accounts:
a.
a. Fixed deposit account
Fixed deposit account
b.
b. Current deposit account
Current deposit account
c.
c. Saving deposit account
Saving deposit account
20

Con'd
i. Fixed deposit Accounts
i. Fixed deposit Accounts
• They are money deposited for a specific period of time.
They are money deposited for a specific period of time.
• They are also known as time liabilities.
They are also known as time liabilities.
• Interest is calculated for the whole amount for the same period.
Interest is calculated for the whole amount for the same period.
• If the depositor withdraws the deposit before the expiry date, the
If the depositor withdraws the deposit before the expiry date, the
depositor will pay penalty rate plus the banker should be willing to
depositor will pay penalty rate plus the banker should be willing to
pay before the expiry date.
pay before the expiry date.
ii. Current deposit accounts
ii. Current deposit accounts
• Current accounts are checkable accounts or demand deposit accounts.
Current accounts are checkable accounts or demand deposit accounts.
• Current accounts are operated through cheques.
Current accounts are operated through cheques.
• Here the bank undertakes the obligation of paying all cheques drawn
Here the bank undertakes the obligation of paying all cheques drawn
against it by the customer till it has adequate funds of the customer
against it by the customer till it has adequate funds of the customer
with it.
with it.
• The main purpose of current accounts is connivance of payments.
The main purpose of current accounts is connivance of payments.
21

Con’d
• Current account is owned by businesspersons and firms.
Current account is owned by businesspersons and firms.
• In Ethiopia individuals are not allowed to open current accounts.
In Ethiopia individuals are not allowed to open current accounts.
iii. Saving Deposit Accounts
iii. Saving Deposit Accounts
• are opened by individual savers and small business owners.
are opened by individual savers and small business owners.
• It is opened for saving purpose- to keep the money away from
It is opened for saving purpose- to keep the money away from
oneself and thieves.
oneself and thieves.
• Frequent withdrawals are not allowed from saving accounts.
Frequent withdrawals are not allowed from saving accounts.
• Interest is generally calculated on monthly basis on the minimum
Interest is generally calculated on monthly basis on the minimum
balances that remains in the account.
balances that remains in the account.

Con’d
2. Advancing Loans
2. Advancing Loans
• After keeping certain cash reserves the bank lend their deposits to
After keeping certain cash reserves the bank lend their deposits to
the needy borrowers.
the needy borrowers.
• Before advancing loans, the banks satisfy themselves about the
Before advancing loans, the banks satisfy themselves about the
credit worthiness of the borrowers.
credit worthiness of the borrowers.
• The various types of loans granted by the bank are:
The various types of loans granted by the bank are:
A.
A. Money at call
Money at call
B.
B. Cash credit
Cash credit
C.
C. Overdraft facility
Overdraft facility
D.
D. Discounting of bills of exchange
Discounting of bills of exchange
E.
E. Term loan
Term loan
Chapter 1 23

Con’d
A. Call loan
A. Call loan
• This type of loan is granted for a period of an overnight to a
This type of loan is granted for a period of an overnight to a
maximum of fourteen days.
maximum of fourteen days.
• It is an interest-bearing loan.
It is an interest-bearing loan.
• Interest is calculated on daily basis.
Interest is calculated on daily basis.
• It usually granted without collateral.
It usually granted without collateral.
B. Cash Credit
B. Cash Credit
• A certain amount of money is granted for a customer.
A certain amount of money is granted for a customer.
• The customer can use any part of it and pay interest only for that
The customer can use any part of it and pay interest only for that
amount.
amount.
• The agreed interest rate is not applied on the unused amount of loan.
The agreed interest rate is not applied on the unused amount of loan.
• However, a penalty rate, usually very minimum and up to 1%, is
However, a penalty rate, usually very minimum and up to 1%, is
applied.
applied.
• This loan is granted against collateral.
This loan is granted against collateral.
24

Con’d
C. Overdraft Facility
C. Overdraft Facility
• This is also a type of loan granted to business owners
This is also a type of loan granted to business owners
whenever they face temporary financial shortage.
whenever they face temporary financial shortage.
• This loan is granted against collaterals.
This loan is granted against collaterals.
• Interest is calculated on daily basis on the debit balance of
Interest is calculated on daily basis on the debit balance of
the customers’ account.
the customers’ account.
• It is a permission granted to over draw his current account.
It is a permission granted to over draw his current account.
25

Con'd
D. Discounting Bills
D. Discounting Bills
• Bills are negotiable instruments issued to facilitate trade and
Bills are negotiable instruments issued to facilitate trade and
transaction.
transaction.
• Bills may be time or demand bill.
Bills may be time or demand bill.
• Demand bills are payable on demand whereas time bills are
Demand bills are payable on demand whereas time bills are
payable at the expiry of the period.
payable at the expiry of the period.
 Therefore, the holder of time bill has to wait until the time expires
Therefore, the holder of time bill has to wait until the time expires
in order to get the balance.
in order to get the balance.
 Here the banker to facilitate this transaction buys the bill before the
Here the banker to facilitate this transaction buys the bill before the
maturity date with a lesser value than its face value or maturity
maturity date with a lesser value than its face value or maturity
value, if the bill is non-interest bearing and interest bearing bill
value, if the bill is non-interest bearing and interest bearing bill
respectively.
respectively.
 An interest rate will be applied while discounting and such rate is known as
An interest rate will be applied while discounting and such rate is known as
discount rate.
discount rate.
 The amount given to the holder of the bill (the difference between the face value
The amount given to the holder of the bill (the difference between the face value
and the discount amount) will be known as proceed and the amount deducted
and the discount amount) will be known as proceed and the amount deducted
from the value of the bill is known as discount amount.
from the value of the bill is known as discount amount.
26

Con'd
E. Term loans
E. Term loans
• They are loans granted for a fixed period of time.
They are loans granted for a fixed period of time.
• The time period may be short-term, intermediate and long-term
The time period may be short-term, intermediate and long-term
loans.
loans.
• Short-term loan is usually a loan granted up to one year, and
Short-term loan is usually a loan granted up to one year, and
intermediate loans are from one to five years and long term loan is a
intermediate loans are from one to five years and long term loan is a
loan granted for above five years.
loan granted for above five years.
• The purpose of the loan may be for commercial, industrial,
The purpose of the loan may be for commercial, industrial,
merchandise, consumer, educational medical, etc.
merchandise, consumer, educational medical, etc.
Chapter 1

Con’d
3. Credit Creation
3. Credit Creation
• It is a unique function of the bank.
It is a unique function of the bank.
• is the natural outcome of the process of advancing loans as
is the natural outcome of the process of advancing loans as
adopted by the banks.
adopted by the banks.
• When a bank advances a loan to its customer, it does not lend cash
When a bank advances a loan to its customer, it does not lend cash
but opens an account in the borrower's name and credits the
but opens an account in the borrower's name and credits the
amount of loan to this account.
amount of loan to this account.
• Thus, whenever a bank grants a loan, it creates an equal amount of
Thus, whenever a bank grants a loan, it creates an equal amount of
bank deposit.
bank deposit.
• Creation of such deposits is called credit creation, which results
Creation of such deposits is called credit creation, which results
in a net increase in the money stock in the economy.
in a net increase in the money stock in the economy.
28

Con’d
4
4. Promoting Cheque System
. Promoting Cheque System
• In the modern business transaction, cheques have become
In the modern business transaction, cheques have become
much more convenient method of settling debts than the
much more convenient method of settling debts than the
use of cash.
use of cash.
• Through a cheque, the depositor directs the bankers to
Through a cheque, the depositor directs the bankers to
make payment to the payee.
make payment to the payee.
• Cheque is the most developed credit instrument in the
Cheque is the most developed credit instrument in the
money market.
money market.
29

Con’d
5. Agency Service
5. Agency Service
 Banks perform certain agency functions for and on behalf of their
Banks perform certain agency functions for and on behalf of their
customers besides their main functions such as:
customers besides their main functions such as:
A.
A. Collection and payment of credit instruments like cheques,
Collection and payment of credit instruments like cheques,
bills of exchange, promissory notes, etc
bills of exchange, promissory notes, etc
B.
B. Execution of standing orders.
Execution of standing orders.
• Banks execute the standing instructions of their customers for
Banks execute the standing instructions of their customers for
making various periodic payments against his account. They pay:
making various periodic payments against his account. They pay:
– Insurance premiums
Insurance premiums
– Subscriptions on clubs and societies, and
Subscriptions on clubs and societies, and
– Similar payments of a regularly recurring nature
Similar payments of a regularly recurring nature
C. Purchasing and sale of securities
C. Purchasing and sale of securities
• Banks undertake purchase and sale of various securities like
Banks undertake purchase and sale of various securities like
shares, stocks, bonds, debentures, etc. on behalf of their customers.
shares, stocks, bonds, debentures, etc. on behalf of their customers.
• They perform a broker function.
They perform a broker function.
30

Con’d
D. Collection of dividends on shares on behalf of his customer.
D. Collection of dividends on shares on behalf of his customer.
E. Income tax consultancy
E. Income tax consultancy
• Banks employ income tax experts to prepare income tax returns
Banks employ income tax experts to prepare income tax returns
for their customers and to help them to get refund of income tax.
for their customers and to help them to get refund of income tax.
F. Acting as trustee and executor.
F. Acting as trustee and executor.
• They administer properties of their customers, as they are
They administer properties of their customers, as they are
deceased.
deceased.
• Banks are assigned by either the deceased customer before his
Banks are assigned by either the deceased customer before his
death or may be nominated by the court.
death or may be nominated by the court.
G. Acting as representative and correspondent
G. Acting as representative and correspondent
• They get passports, traveler's tickets, book vehicles and plots for
They get passports, traveler's tickets, book vehicles and plots for
their customers and receive letters on their behalf.
their customers and receive letters on their behalf.
Chapter 1 31

Con’d
H. Remittance of funds
H. Remittance of funds
• Remittances of funds by banks are simple, convenient, safe and
Remittances of funds by banks are simple, convenient, safe and
inexpensive.
inexpensive.
• This service is available to both customers as well as non- -
This service is available to both customers as well as non- -
customers of the bank.
customers of the bank.
• The important methods of transferring funds from one place to
The important methods of transferring funds from one place to
another through banks are:
another through banks are:
– Bank draft
Bank draft
– Telegraphic transfers and
Telegraphic transfers and
– Mail transfer
Mail transfer
Chapter 1 32

Con’d
I. Bank draft
I. Bank draft
• It is an order to pay money drawn by one branch/ office of the
It is an order to pay money drawn by one branch/ office of the
bank upon another branch of the same bank to pay a specific sum
bank upon another branch of the same bank to pay a specific sum
of money to a person named therein or to his order.
of money to a person named therein or to his order.
Essential features of a bank draft
Essential features of a bank draft
 A bank draft possesses the following important features.
A bank draft possesses the following important features.
i.
i. It is drawn by one branch of a bank upon some other branch of
It is drawn by one branch of a bank upon some other branch of
the same bank
the same bank
ii.
ii. It is payable on demand, not payable to the banker
It is payable on demand, not payable to the banker
iii.
iii.It is equivalent to a bill of exchange
It is equivalent to a bill of exchange
Chapter 1 33

Con’d
• The person who intends to remit the money through a bank draft has
The person who intends to remit the money through a bank draft has
to deposit the money to be remitted together with the commission,
to deposit the money to be remitted together with the commission,
which the banker charges for its services.
which the banker charges for its services.
• A bank draft has three parties. They are;
A bank draft has three parties. They are;
a.
a. The drawer branch (the branch that receives money to be
The drawer branch (the branch that receives money to be
remitted).
remitted).
b.
b. The drawee branch( the branch that is ordered to pay the
The drawee branch( the branch that is ordered to pay the
remitted money to a person named in the draft); and
remitted money to a person named in the draft); and
c.
c. The Payee (the party in whose favor money is transferred)
The Payee (the party in whose favor money is transferred)
• The remitter does not remain a party to the instrument.
The remitter does not remain a party to the instrument.
34

Con’d
Difference between a cheque and a bank draft
Difference between a cheque and a bank draft
 The Negotiable Instruments Act has taken that they are similar.
The Negotiable Instruments Act has taken that they are similar.
However a bank draft is different from a cheque in several respects.
However a bank draft is different from a cheque in several respects.
The points of differences are:
The points of differences are:
1.
1. A draft cannot be made payable to the bearer while a cheque
A draft cannot be made payable to the bearer while a cheque
can be so drawn.
can be so drawn.
2.
2. A banker is under a legal obligation to pay the money of a
A banker is under a legal obligation to pay the money of a
draft. Its payment cannot be stopped except in cases where
draft. Its payment cannot be stopped except in cases where
loss or theft of the draft has been reported.
loss or theft of the draft has been reported.
3.
3. In case of a draft, the banker has a direct liability to pay.
In case of a draft, the banker has a direct liability to pay.
The remitter after he purchases the draft is not part of the
The remitter after he purchases the draft is not part of the
instrument and the drawer is under obligation to transfer the
instrument and the drawer is under obligation to transfer the
fund to be paid by the drawee branch to the payee - whose
fund to be paid by the drawee branch to the payee - whose
name is in the draft.
name is in the draft.
Chapter 1 35

Con’d
o In case of a cheque, the banker has indirect liability.
In case of a cheque, the banker has indirect liability.
– The primary liability is that of the drawer of the cheque.
The primary liability is that of the drawer of the cheque.
– The banker will make payment of the cheque only when it has
The banker will make payment of the cheque only when it has
sufficient funds of the drawer with it for payment and the cheque
sufficient funds of the drawer with it for payment and the cheque
in order.
in order.
Stopping payment of the draft
Stopping payment of the draft
• The banker even on receiving instructions from purchaser of the
The banker even on receiving instructions from purchaser of the
draft cannot stop the payment of the draft.
draft cannot stop the payment of the draft.
• This is for the simple reason that by issuing a bank draft, the banker
This is for the simple reason that by issuing a bank draft, the banker
takes upon himself a commitment in favor of a third party (i.e. the
takes upon himself a commitment in favor of a third party (i.e. the
payee) to pay a certain amount of money.
payee) to pay a certain amount of money.
36

Con’d
Loss of the draft
Loss of the draft
• A banker can stop payment of a draft in those cases where either the
A banker can stop payment of a draft in those cases where either the
purchaser of the draft or the payee of the draft has reported about the
purchaser of the draft or the payee of the draft has reported about the
draft being lost or stolen.
draft being lost or stolen.
• The bank should take extreme caution and should immediately
The bank should take extreme caution and should immediately
inform the drawee branch about the loss.
inform the drawee branch about the loss.
• There can be two different situations
There can be two different situations
– When the draft is lost before it is endorsed
When the draft is lost before it is endorsed
– When the draft is lost after it has been endorsed
When the draft is lost after it has been endorsed
Loss of the draft before endorsement
Loss of the draft before endorsement
• If the drawer branch is satisfied about the lose of the draft, the
If the drawer branch is satisfied about the lose of the draft, the
drawee branch should not pay such a draft, if it is presented for
drawee branch should not pay such a draft, if it is presented for
payment with any endorsement, it should be returned with the
payment with any endorsement, it should be returned with the
remark
remark
• Draft reported to be lost Payee's endorsement requires verification
37

Con’d
II. Loss of draft after endorsement
II. Loss of draft after endorsement
• In this case there can be two situations
In this case there can be two situations
A.
A. The payment of the draft may be requested at the counter of
The payment of the draft may be requested at the counter of
the bank (drawee) in such a case, the banker should satisfy it
the bank (drawee) in such a case, the banker should satisfy it
self about the identity of the claimant and the endorsement in
self about the identity of the claimant and the endorsement in
his favors. If it is not satisfied, it should return the draft with
his favors. If it is not satisfied, it should return the draft with
the remark.
the remark.
 Draft reported to be lost Payee's endorsement requires
verification
A.
A. The payment of the draft may be required through a collecting
The payment of the draft may be required through a collecting
banker.
banker.
 In such a case, also the drawee banker should follow all the
In such a case, also the drawee banker should follow all the
above precautions.
above precautions.
38

Con’d
Issue of a duplicate draft
Issue of a duplicate draft
• In case a draft is reported lost and a duplicate draft is required to be
In case a draft is reported lost and a duplicate draft is required to be
issued, the banker should attend the following steps:
issued, the banker should attend the following steps:
i.
i. It should satisfy itself regarding genuineness of the party
It should satisfy itself regarding genuineness of the party
requesting issue of a duplicate draft.
requesting issue of a duplicate draft.
ii.
ii. It should obtain the necessary confirmation of the drawee
It should obtain the necessary confirmation of the drawee
branch that the relevant draft is still outstanding with that
branch that the relevant draft is still outstanding with that
branch.
branch.
iii.
iii. An indemnity bond should be obtained from the purchaser of
An indemnity bond should be obtained from the purchaser of
the draft.
the draft.
iv.
iv. While issuing a duplicate draft, the number of the draft
While issuing a duplicate draft, the number of the draft
originally issued should be incorporated boldly on the draft
originally issued should be incorporated boldly on the draft
form.
form.
Chapter 1 39

Cancellation Of Draft
Cancellation Of Draft
• In case the purchaser of the draft makes a request to cancel the draft
In case the purchaser of the draft makes a request to cancel the draft
and refund him the amount of draft, the bank should do so after
and refund him the amount of draft, the bank should do so after
taking the following precautions.
taking the following precautions.
A.
A. It should satisfy itself that the draft has not been delivered to the
It should satisfy itself that the draft has not been delivered to the
payee.
payee.
• Making, accepting and endorsement of a negotiable instrument is
Making, accepting and endorsement of a negotiable instrument is
completed only when it is delivered to the person concerned (section
completed only when it is delivered to the person concerned (section
46 of the negotiable Instrument Act)
46 of the negotiable Instrument Act)
• Delivery could be actual or constructive. It can be through delivery
Delivery could be actual or constructive. It can be through delivery
and endorsement & delivery. Or it can be transferred through post
and endorsement & delivery. Or it can be transferred through post
office.
office.
B. In case the purchaser wants to get the draft cancelled after it has
B. In case the purchaser wants to get the draft cancelled after it has
been delivered to the payee, he can do so only with the consent of
been delivered to the payee, he can do so only with the consent of
the payee.
the payee.
 The advice regarding cancellation of the draft should be sent to the
The advice regarding cancellation of the draft should be sent to the
drawee branch
drawee branch
40

Con’d
• The drawee branch should also make a suitable note regarding
The drawee branch should also make a suitable note regarding
cancellation of the draft in its records.
cancellation of the draft in its records.
ii.
ii. Mail/Telex Transfers
Mail/Telex Transfers
• A mail transfer is an internal message sent through ordinary postal
A mail transfer is an internal message sent through ordinary postal
channel advising the payee branch or bank to pay a specifically stated
channel advising the payee branch or bank to pay a specifically stated
amount of money to a specified payee or to his order.
amount of money to a specified payee or to his order.
• As the banker accepts money to transfer, it has to consider certain
As the banker accepts money to transfer, it has to consider certain
requirements. This method is commonly used between two branches of
requirements. This method is commonly used between two branches of
same bank.
same bank.
• The following are the necessary requirements.
The following are the necessary requirements.
 The name of the beneficiary
The name of the beneficiary
 His/her account number, if any
His/her account number, if any
 The amount to be transferred, and
The amount to be transferred, and
 The name of the branch where the account is maintained or the
The name of the branch where the account is maintained or the
beneficiary can receive.
beneficiary can receive. 41

Con’d
• In case of telex transfer the message for transfer of funds is
In case of telex transfer the message for transfer of funds is
communicated through telex machine instead of postal channel.
communicated through telex machine instead of postal channel.
• The remitting bank generally recovers from the transferor the telex
The remitting bank generally recovers from the transferor the telex
charges in addition to the usual service expenses
charges in addition to the usual service expenses
6. General Utility Function
6. General Utility Function
A.
A. Traveler's cheques
Traveler's cheques
• Banks to avoid the risk of loss or inconvenience in carrying large
Banks to avoid the risk of loss or inconvenience in carrying large
amount of cash while traveling issue Traveler’s cheques.
amount of cash while traveling issue Traveler’s cheques.
• These cheques are issued in variable denominations and are
These cheques are issued in variable denominations and are
encashable on any office of the issuing bank or corresponding
encashable on any office of the issuing bank or corresponding
bank.
bank.
• They are usually used foreign purposes.
They are usually used foreign purposes.
Chapter 1 42

Con’d
The following are their essential features of traveler’s cheques:
The following are their essential features of traveler’s cheques:
a.
a. Traveler's cheques can be purchased by any one. He need not be a
Traveler's cheques can be purchased by any one. He need not be a
customer of the bank
customer of the bank
b.
b. A person may buy any number of traveler’s cheques. The
A person may buy any number of traveler’s cheques. The
equivalent amount of money must be deposited.
equivalent amount of money must be deposited.
c.
c. Each traveler’s cheque should be signed by the purchaser at place
Each traveler’s cheque should be signed by the purchaser at place
marked. "When counter signed below with this signature." Before
marked. "When counter signed below with this signature." Before
the official who issues the cheques.
the official who issues the cheques.
d.
d. The purchaser in English script should sign the cheque
The purchaser in English script should sign the cheque
e.
e. The travelers' cheques are issued in single name i.e. not in joint
The travelers' cheques are issued in single name i.e. not in joint
names or names or clubs, societies and companies etc.
names or names or clubs, societies and companies etc.
f.
f. The travelers' cheques are generally encashable only at the
The travelers' cheques are generally encashable only at the
branches of the issuing bank or the branches of the other banks with
branches of the issuing bank or the branches of the other banks with
which the issuing bank may have arrangement.
which the issuing bank may have arrangement.
43

Con’d
g.
g. The purchaser of the traveler’s cheques has to sign the
The purchaser of the traveler’s cheques has to sign the
traveler’s cheques again at the time of encashing the
traveler’s cheques again at the time of encashing the
traveler’s cheques at the place marked "counter-sign here
traveler’s cheques at the place marked "counter-sign here
in presence of person cashing"
in presence of person cashing"
h. There is no expiry period for the travelers' cheque.
h. There is no expiry period for the travelers' cheque.
Unused cheques can be returned back to the issuing bank
Unused cheques can be returned back to the issuing bank
and the payment can be returned back to the issuing bank
and the payment can be returned back to the issuing bank
and the payment can be obtained for them.
and the payment can be obtained for them.
Chapter 1 44

Con’d
Loss of the travelers' cheques
Loss of the travelers' cheques
• In case the travelers' cheques are reported lost the following
In case the travelers' cheques are reported lost the following
precautions should be taken by the issuing branch of the bank
precautions should be taken by the issuing branch of the bank
entertaining any claim regarding lost travelers' cheques:
entertaining any claim regarding lost travelers' cheques:
– The bank should satisfy itself that the purchaser did not endorse
The bank should satisfy itself that the purchaser did not endorse
the cheques before they were lost
the cheques before they were lost
– A letter of indemnity together with sureties should be obtained
A letter of indemnity together with sureties should be obtained
for the amount involved.
for the amount involved.
B. Safe custody of valuable and securities
B. Safe custody of valuable and securities
• Banks accept valuables for safe custody purpose.
Banks accept valuables for safe custody purpose.
• Valuables such as: negotiable securities, jewelers and documents of
Valuables such as: negotiable securities, jewelers and documents of
the title to property, etc.
the title to property, etc.
• The modern bank being equipped with safe and strong rooms is
The modern bank being equipped with safe and strong rooms is
naturally a very safe and convenient depository of valuables.
naturally a very safe and convenient depository of valuables.
Chapter 1 45

Con’d
• There are two ways through which a modern banker ensures safe
There are two ways through which a modern banker ensures safe
custody of its customer’s valuables.
custody of its customer’s valuables.
a.
a. By accepting the valuable from the customers for safe
By accepting the valuable from the customers for safe
custody.
custody.
b.
b. By hiring out safe deposit vaults or lockers to the
By hiring out safe deposit vaults or lockers to the
customers.
customers.
Chapter 1 46

Con’d
I. Accepting of valuables for safe custody
I. Accepting of valuables for safe custody
• A banker may accept delivery of valuables from its customers for safe
A banker may accept delivery of valuables from its customers for safe
custody.
custody.
• The rules regarding accepting of the valuables for safe custody and
The rules regarding accepting of the valuables for safe custody and
their redelivery can be summarized as follows.
their redelivery can be summarized as follows.
A.
A. The safe custody facility should be extended only to the bank’s
The safe custody facility should be extended only to the bank’s
customers
customers
B.
B. The safe custody facility should be confined only to:
The safe custody facility should be confined only to:
• Securities such as government promissory notes, stock/share
Securities such as government promissory notes, stock/share
certificates, bonds, debentures, certificates, title deeds, wills
certificates, bonds, debentures, certificates, title deeds, wills
and post office national savings certificate, etc…
and post office national savings certificate, etc…
• Envelopes and packets, which are properly sealed with
Envelopes and packets, which are properly sealed with
customers’ distinctive seals, markings, etc. with instructions
customers’ distinctive seals, markings, etc. with instructions
regarding delivery.
regarding delivery.
• Locked boxes with customers’ names painted on the top
Locked boxes with customers’ names painted on the top
thereof or otherwise adequately identifiable.
thereof or otherwise adequately identifiable.
Chapter 1 47

Con’d
• The banker is not supposed to have any precise
The banker is not supposed to have any precise
information about the contents of the box or envelope.
information about the contents of the box or envelope.
c. The banker should maintain a register of the articles
c. The banker should maintain a register of the articles
accepted for safe custody and the customer should be
accepted for safe custody and the customer should be
given a receipt for the articles accepted under safe
given a receipt for the articles accepted under safe
custody from the safe custody receipt book.
custody from the safe custody receipt book.
d. On delivery of the valuables to the customer, the fact
d. On delivery of the valuables to the customer, the fact
should be duly recorded in the safe custody register
should be duly recorded in the safe custody register
maintained by the bank.
maintained by the bank.
e. It should be noted that the articles received for safe
e. It should be noted that the articles received for safe
custody are not subject to general lien of the banker.
custody are not subject to general lien of the banker.
Chapter 1 48

Con’d
Liability of a Banker
Liability of a Banker
• A banker is bound to take reasonable care of the valuables
A banker is bound to take reasonable care of the valuables
entrusted to him.
entrusted to him.
• In case the banker has taken such care, he will not be liable for any
In case the banker has taken such care, he will not be liable for any
loss or damage to the valuables in the absence of any contract to the
loss or damage to the valuables in the absence of any contract to the
contrary.
contrary.
• The customer may hold the banker liable for loss suffered by him in
The customer may hold the banker liable for loss suffered by him in
each of the following cases.
each of the following cases.
a.
a. Negligence by the banker
Negligence by the banker
• The banker can be held liable for negligence.
The banker can be held liable for negligence.
For example, if the safe deposit vaults are not as strong as they
For example, if the safe deposit vaults are not as strong as they
should have been and if the baker leaves the safe deposit vaults
should have been and if the baker leaves the safe deposit vaults
unlocked and the valuables are removed by some one, etc.
unlocked and the valuables are removed by some one, etc.
b. For conversion
b. For conversion
• In case the banker delivers the valuables accepted by it for safe custody to
In case the banker delivers the valuables accepted by it for safe custody to
a wrong person, it shall be liable for the loss suffered by the customer.
a wrong person, it shall be liable for the loss suffered by the customer.
49

Con’d
c. Fraud by its own employees
c. Fraud by its own employees
• In case any of the bankers’ employees concerned with safe custody
In case any of the bankers’ employees concerned with safe custody
found guilty of fraud resulting in loss to the customer, the banker
found guilty of fraud resulting in loss to the customer, the banker
shall be held responsible.
shall be held responsible.
II. Hiring of safe Deposit Vaults
II. Hiring of safe Deposit Vaults
• The banks facilitate strong rooms, which are equipped with safe
The banks facilitate strong rooms, which are equipped with safe
deposit locker for hiring purpose.
deposit locker for hiring purpose.
• The lockers are of different size and they are hired out to the public.
The lockers are of different size and they are hired out to the public.
• The rent for the lockers may vary depending on the size of the locker.
The rent for the lockers may vary depending on the size of the locker.
• The following rules are applied.
The following rules are applied.
a.
a. Any person can take or hire a safe deposit locker from the bank.
Any person can take or hire a safe deposit locker from the bank.
b.
b. The person taking a locker on rent has to fill in a proper lease
The person taking a locker on rent has to fill in a proper lease
document which contains the terms and conditions of hiring the
document which contains the terms and conditions of hiring the
locker.
locker.
50

Con’d
c. The bank maintains safe deposit vaults register in which all
c. The bank maintains safe deposit vaults register in which all
transactions relating to each of the rented out lockers are
transactions relating to each of the rented out lockers are
recorded on a separated page. A pass word or code word is
recorded on a separated page. A pass word or code word is
chosen by the hirer.
chosen by the hirer.
d. In case of a locker being hired in joint names, specific
d. In case of a locker being hired in joint names, specific
instructions should be obtained as to the mode of operation
instructions should be obtained as to the mode of operation
and access to the lockers from joint lessees.
and access to the lockers from joint lessees.
e. Two keys are used for opening the lockers, one of which is kept
e. Two keys are used for opening the lockers, one of which is kept
by the hirer in his possession, while the other remain with the
by the hirer in his possession, while the other remain with the
banker i.e. the master key will remain with the banker.
banker i.e. the master key will remain with the banker.
f. The bank does not know the contents of the locker.
f. The bank does not know the contents of the locker.
g. In the event of death of the hirer the contents of the locker
g. In the event of death of the hirer the contents of the locker
should be redelivered to the legal representative of the
should be redelivered to the legal representative of the
deceased only after his producing a valid succession
deceased only after his producing a valid succession
certificate from the court.
certificate from the court. 51

Con’d
h. No locker should be leased out to minors, blind and illiterate
h. No locker should be leased out to minors, blind and illiterate
persons
persons
i. The manager or any other authorized person should examine the
i. The manager or any other authorized person should examine the
locker soon after its operation, in order to ensure that it has been
locker soon after its operation, in order to ensure that it has been
properly locked by the visitors and that no articles are left
properly locked by the visitors and that no articles are left
behind him inadvertently.
behind him inadvertently.
j. The master key should remain in the custody of he manager or
j. The master key should remain in the custody of he manager or
any other authorized officer during the day. It should be kept in
any other authorized officer during the day. It should be kept in
the safe under dual control of the manager/head cashier
the safe under dual control of the manager/head cashier
overnight.
overnight.
k. The duplicate key of the safe deposit vaults should be kept for
k. The duplicate key of the safe deposit vaults should be kept for
safe custody with another branch of the bank and where there is
safe custody with another branch of the bank and where there is
no other branch of the bank with other bank
no other branch of the bank with other bank.
.
52

Con’d
C. Letters of credit
C. Letters of credit
• A letter of credit is a document issued by a banker, authorizing
A letter of credit is a document issued by a banker, authorizing
some other banker to whom it is addressed, to honor the cheques of
some other banker to whom it is addressed, to honor the cheques of
a person named in the document, to the extent of a sated amount in
a person named in the document, to the extent of a sated amount in
the letter and to charge the same to the account of the guarantor of
the letter and to charge the same to the account of the guarantor of
the letter of credit.
the letter of credit.
• Letters of credit may be either personal or commercial.
Letters of credit may be either personal or commercial.
• Personal Letters of credit is usually a clean one i.e. no trade
Personal Letters of credit is usually a clean one i.e. no trade
document is attached, whereas, commercial letters of credit is a
document is attached, whereas, commercial letters of credit is a
documentary letter of credit.
documentary letter of credit.
• Letter of credit has Four parties: the customer, the issuing bank,
Letter of credit has Four parties: the customer, the issuing bank,
the advisory bank and the seller.
the advisory bank and the seller.
• The customer may be the debtor or the one who buy on credit.
The customer may be the debtor or the one who buy on credit.
• The issuing bank is the one that guarantees the credit sale through
The issuing bank is the one that guarantees the credit sale through
the letter.
the letter.
53

Con’d
• The advising bank is the bank that accomplishes payment to the
The advising bank is the bank that accomplishes payment to the
seller on behalf of the issuing bank.
seller on behalf of the issuing bank.
• The last party is the beneficiary, who sells goods on credit.
The last party is the beneficiary, who sells goods on credit.
54

Con’d
• There are different types of letters of credit, which can be discussed
There are different types of letters of credit, which can be discussed
as follows;
as follows;
1.
1. Clean letter of credit:-Under this form acceptance of bills is
Clean letter of credit:-Under this form acceptance of bills is
unconditional
unconditional
2.
2. Documentary L.C:- Bills acceptance is conditional on the receipt of
Documentary L.C:- Bills acceptance is conditional on the receipt of
the documents of title to goods.
the documents of title to goods.
3.
3. Revocable L.C:- The bill (l.c.) can be canceled at any time by the
Revocable L.C:- The bill (l.c.) can be canceled at any time by the
issuing banker
issuing banker
4.
4. Irrevocable L.C: - The bill (l.c.) Can’t be canceled before expiry of
Irrevocable L.C: - The bill (l.c.) Can’t be canceled before expiry of
the period.
the period.
5.
5. Confirmed irrevocable L.C: - The bill (l.c.) cannot be canceled
Confirmed irrevocable L.C: - The bill (l.c.) cannot be canceled
before expiry of the period. In addition, a correspondent bank with
before expiry of the period. In addition, a correspondent bank with
in which the issuing bank has an account to the advisory bank
in which the issuing bank has an account to the advisory bank
confirms the position of the issuing bank. Therefore, payment is
confirms the position of the issuing bank. Therefore, payment is
100% guaranteed.
100% guaranteed.
55

Con’d
D. Foreign exchange
D. Foreign exchange
• In assisting foreign trade by discounting foreign bills of exchange
In assisting foreign trade by discounting foreign bills of exchange
and facilitating foreign currency, a bank has sometimes arrange for
and facilitating foreign currency, a bank has sometimes arrange for
the payment of costs to the transport, insurance and warehousing of
the payment of costs to the transport, insurance and warehousing of
goods.
goods.
E. Collection of statistics
E. Collection of statistics
• Banks collect statistics relating to industry, trade and commerce,
Banks collect statistics relating to industry, trade and commerce,
money and banking and publish journals and bulletins containing
money and banking and publish journals and bulletins containing
research articles on economic and financial matters.
research articles on economic and financial matters.
F. Underwriting securities
F. Underwriting securities
• They underwrite securities issued by the government, public or
They underwrite securities issued by the government, public or
private bodies.
private bodies.
56

Con’d
SYSTEMS OF BANKING ORGANIZATION
SYSTEMS OF BANKING ORGANIZATION
• Banks may be organized on different systems.
Banks may be organized on different systems.
• The various types of banking organizations are the following:
The various types of banking organizations are the following:
Branch banking, Unit banking, Group banking, Chain banking, and
Branch banking, Unit banking, Group banking, Chain banking, and
Mixed banking.
Mixed banking.
1. Based on the Structure
1. Based on the Structure
• On the basis of
On the basis of organization structure
organization structure and
and scale of operations
scale of operations,
,
banking systems can be divided into two categories. They are:
banking systems can be divided into two categories. They are:
A.
A. Branch Banking
Branch Banking
B.
B. Unit Banking systems.
Unit Banking systems.
57

Con’d
A.
A. The Branch Banking System
The Branch Banking System
 Under branch banking organization a big bank as a single
Under branch banking organization a big bank as a single
institution and under single ownership operates through a
institution and under single ownership operates through a
network of branches spread all over the country or
network of branches spread all over the country or
outside the country.
outside the country.
 The Ethiopian banks use this system.
The Ethiopian banks use this system.
• All of these banks have their head office in Addis Ababa
All of these banks have their head office in Addis Ababa
and a number of branches through out the country and
and a number of branches through out the country and
outside (Commercial Bank in Djibouti, South Sudan).
outside (Commercial Bank in Djibouti, South Sudan).
 The same thing is true with British banking system.
The same thing is true with British banking system.
58

Con’d
Advantage of Branch Banking System
Advantage of Branch Banking System
• Branch banking system possesses the following advantages.
Branch banking system possesses the following advantages.
1.
1. Economies of large-scale operations:
Economies of large-scale operations: It possesses huge financial
It possesses huge financial
resources and enjoys the benefits of large scale operations such as:
resources and enjoys the benefits of large scale operations such as:
• Highly trained and experienced staff can be appointed.
Highly trained and experienced staff can be appointed.
• Division of labor is introduced in the banking operation
Division of labor is introduced in the banking operation
• Funds are made available liberally and at cheaper rates
Funds are made available liberally and at cheaper rates
• Foreign exchange business is done economically
Foreign exchange business is done economically
• Large financial resources and wider geographical coverage
Large financial resources and wider geographical coverage
increases public confidence in the banking system.
increases public confidence in the banking system.
59

Con’d
2. Spreading of risk:
2. Spreading of risk: The bank operates at different regions. As such
The bank operates at different regions. As such
the needs of these regions may vary.
the needs of these regions may vary.
• At some regions the demand for loan may be high whereas, in
At some regions the demand for loan may be high whereas, in
other areas the demand for credit may be low.
other areas the demand for credit may be low.
• In addition, business in some regions may be developed and may
In addition, business in some regions may be developed and may
be low in other regions.
be low in other regions.
• Therefore this banking system will achieve the following benefits.
Therefore this banking system will achieve the following benefits.
a.
a. Geographical spreading and diversification of risks
Geographical spreading and diversification of risks
b.
b. Risks could be offset by different branches
Risks could be offset by different branches
c.
c. It makes possible to raise large finance to face any crises
It makes possible to raise large finance to face any crises
60

Con’d
3. Economy in cash Reserves:
3. Economy in cash Reserves: As it is known, all banks are required
As it is known, all banks are required
by law to maintain the minimum cash reserve.
by law to maintain the minimum cash reserve.
 And here though the numbers of branches are many only the head
And here though the numbers of branches are many only the head
office is required to maintain the cash reserve.
office is required to maintain the cash reserve.
 However, if any branch faces scarcity of funds it can easily obtain
However, if any branch faces scarcity of funds it can easily obtain
from other branches through the head office.
from other branches through the head office.
 Therefore, branches are not expected to maintain huge amount of
Therefore, branches are not expected to maintain huge amount of
reserves with them.
reserves with them.
4. Diversification on deposits and assets:
4. Diversification on deposits and assets: Deposits are received from
Deposits are received from
areas where savings are in plenty.
areas where savings are in plenty.
• Loans are extended in those areas where funds are scarce and
Loans are extended in those areas where funds are scarce and
interest rates are high.
interest rates are high.
• Therefore, it is possible to transfer fund from areas where plenty of
Therefore, it is possible to transfer fund from areas where plenty of
funds exist to areas where there is scarcity of funds.
funds exist to areas where there is scarcity of funds. 61

Con’d
5. Cheap Remittance Facilities
5. Cheap Remittance Facilities: As the bank covers wider areas, it is
: As the bank covers wider areas, it is
easy and cheap to transfer funds from one place to another.
easy and cheap to transfer funds from one place to another.
• It uses its own facilities and a number of transfers can be made with
It uses its own facilities and a number of transfers can be made with
a single transaction with out additional charges.
a single transaction with out additional charges.
6. Better Facilities to customers
6. Better Facilities to customers: Because there are many branches in
: Because there are many branches in
a given bank, every branch will have small number of customers.
a given bank, every branch will have small number of customers.
• Since there will be small number of customers per branch and the
Since there will be small number of customers per branch and the
increased efficiency achieved through large-scale operations,
increased efficiency achieved through large-scale operations,
customers get better and greater facilities.
customers get better and greater facilities.
7.
7. Effective control by the central bank
Effective control by the central bank: Central bank is the
: Central bank is the
controller of banks.
controller of banks.
• If the number of banks are many Central Bank is required to control all
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.
these banks. But here there are few banks with many branches.
• Therefore, Central Bank is expected only to control these few Head
Therefore, Central Bank is expected only to control these few Head
offices and hence through them the branches.
offices and hence through them the branches. 62

Con’d
Disadvantages of Branch Banking System
Disadvantages of Branch Banking System
• Branch banking system has the following disadvantages.
Branch banking system has the following disadvantages.
– Management problem:
Management problem: There will be mismanagement of
There will be mismanagement of
resources, unnecessary delay of action in the banking business.
resources, unnecessary delay of action in the banking business.
 Because branches are many and they are far from the head
Because branches are many and they are far from the head
office, in terms of both geography and hierarchy, there may be
office, in terms of both geography and hierarchy, there may be
difficulties to control their every day actions.
difficulties to control their every day actions.
– Lack of initiative:
Lack of initiative: Managers cannot take independent decisions
Managers cannot take independent decisions
and have to wait for the clearance signal from the head office.
and have to wait for the clearance signal from the head office.
 This will discourage them to take their own decision.
This will discourage them to take their own decision.
– Monopolistic tendencies:
Monopolistic tendencies: A few big banks dominate and control
A few big banks dominate and control
the whole banking system of the country through their branches.
the whole banking system of the country through their branches.
This can lead to the concentration of resources in to a few hands.
This can lead to the concentration of resources in to a few hands.
– It creates regional imbalance
It creates regional imbalance: Funds flow from an area where
: Funds flow from an area where
investment is weak to an area where business prospers.
investment is weak to an area where business prospers.
63

Con’d
– There is an adverse linkage effect of inefficient
There is an adverse linkage effect of inefficient
branches:
branches: The over all performance of the bank is
The over all performance of the bank is
evaluated and those branches which have low
evaluated and those branches which have low
performance will hide behind other successful
performance will hide behind other successful
branches.
branches.
– Other defects
Other defects:
:
a.
a. Preferential treatment is given to the branches near
Preferential treatment is given to the branches near
the head office
the head office
b.
b. There may be unhealthy competition among the
There may be unhealthy competition among the
branches of different banks in big cities.
branches of different banks in big cities.
64

Con’d
The Unit Banking System
The Unit Banking System
• An individual bank operates through a single office or
An individual bank operates through a single office or
few branches within a strictly limited area.
few branches within a strictly limited area.
• The size and area of operation are much smaller as
The size and area of operation are much smaller as
compared to those of the branch banking system.
compared to those of the branch banking system.
• They can be supported by correspondent banking system.
They can be supported by correspondent banking system.
• The reason of its development is the fear of emergency of
The reason of its development is the fear of emergency of
monopoly in banking business.
monopoly in banking business.
• This is true with the United States banking system.
This is true with the United States banking system.
65

Con’d
Advantages of Unit banking system
Advantages of Unit banking system
• Local development:
Local development: It is localized banking.
It is localized banking.
 It will have a specialized knowledge on the local problems and serves
It will have a specialized knowledge on the local problems and serves
the requirements.
the requirements.
 It also uses funds that it receives in form of deposit accounts to the
It also uses funds that it receives in form of deposit accounts to the
development of the region.
development of the region.
• Promotes Regional Balances:
Promotes Regional Balances: There is no transfer of resources from
There is no transfer of resources from
rural and backward areas to the big industrial commercial centers.
rural and backward areas to the big industrial commercial centers.
• Easy of management:
Easy of management: There are fewer chances of fraud and
There are fewer chances of fraud and
irregularities in the financial management.
irregularities in the financial management.
• No Monopolistic Tendencies
No Monopolistic Tendencies
• No inefficient branch, otherwise due to branch banking
No inefficient branch, otherwise due to branch banking
operations.
operations.
• Initiative in banking business because decisions are made at the
Initiative in banking business because decisions are made at the
branch level.
branch level.
•
66

Con’d
Disadvantage of Unit banking
Disadvantage of Unit banking
• No distribution of risks – inability to face crisis
No distribution of risks – inability to face crisis
• No banking development in backward areas because all unit
No banking development in backward areas because all unit
banks would p
banks would prefer already developed areas or regions.
refer already developed areas or regions.
• Lack of specialization:
Lack of specialization: Because of their small size they are not
Because of their small size they are not
able to introduce, and get advantages of dividing of labor and
able to introduce, and get advantages of dividing of labor and
specialization. They cannot employ highly trained and specialized
specialization. They cannot employ highly trained and specialized
staff.
staff.
• Costly Remittance of Funds:
Costly Remittance of Funds: It has to depend upon the
It has to depend upon the
correspondent banks for transfer of funds, which is very expensive.
correspondent banks for transfer of funds, which is very expensive.
• Local pressures:
Local pressures: Local pressures and interferences generally
Local pressures and interferences generally
disrupt their normal functioning.
disrupt their normal functioning.
• Undesirable competition:
Undesirable competition: Different management independently
Different management independently
run smaller banks. This results in undesirable competition among
run smaller banks. This results in undesirable competition among
different unit banks.
different unit banks.
67

Con’d
2 Based on Ownership
2 Based on Ownership
• On the basis of ownership banks can be classified as: Group banking and chain
On the basis of ownership banks can be classified as: Group banking and chain
banking.
banking.
A.
A. Group banking
Group banking
 is the system in which two or more independently incorporated banks are
brought under the control of a holding company.
• It is a system whereby the affairs of two or more banks are directly controlled by
It is a system whereby the affairs of two or more banks are directly controlled by
a holding company. The holding company may or may not be a banking
a holding company. The holding company may or may not be a banking
company.
company.
Advantages of Group banking
Advantages of Group banking
• Each member bank retains its separate entity and maintains its board of directors.
Each member bank retains its separate entity and maintains its board of directors.
• It enjoys the benefits of centralized administration. There is grater liquidity and
It enjoys the benefits of centralized administration. There is grater liquidity and
mobility of resources.
mobility of resources.
• There is economy of advertisement expenditure.
There is economy of advertisement expenditure.
• There is a common purchasing agency, which leads to economy in purchases.
There is a common purchasing agency, which leads to economy in purchases.
68

Con’d
• Services of experts can be made available to the member banks to
Services of experts can be made available to the member banks to
manage their business efficiently.
manage their business efficiently.
• Common standardized accounting system improves the working of
Common standardized accounting system improves the working of
the member banks.
the member banks.
• Large-scale banking operations allow superior credit facility.
Large-scale banking operations allow superior credit facility.
Disadvantage of Group banking
Disadvantage of Group banking
• Group banking system possesses the following disadvantages.
Group banking system possesses the following disadvantages.
– Effective supervision is not possible
Effective supervision is not possible
– Control is less direct
Control is less direct
– The management of the holding company adversely affects
The management of the holding company adversely affects
efficiency of the member banks.
efficiency of the member banks.
– The failure of the bank has its adverse effect on other member
The failure of the bank has its adverse effect on other member
banks.
banks.
69

Con’d
B. Chain Banking
B. Chain Banking
Chain banking system involved when a group of persons
came together to own and control 3 or more
independently chartered banks.
The common management of two or more banks may be
The common management of two or more banks may be
by single or a group of persons through stock ownership
by single or a group of persons through stock ownership
or otherwise.
or otherwise.
• The advantage and disadvantages of chain banking
The advantage and disadvantages of chain banking
system are more or less similar to those of group banking
system are more or less similar to those of group banking
system.
system.
70

Con’d
3. Based on Activity Classification
3. Based on Activity Classification
• Based on activity Banking systems can be classified as: Investing
Based on activity Banking systems can be classified as: Investing
Banking and mixed Banking
Banking and mixed Banking
A. Investing Banking
A. Investing Banking
• They invest or help investment of funds in the shares or bonds of
They invest or help investment of funds in the shares or bonds of
joint stock companies.
joint stock companies.
• They act as an intermediary between Business Corporation and
They act as an intermediary between Business Corporation and
investors. They can be classified;
investors. They can be classified;
– Originators: -They bring out new issues of securities
Originators: -They bring out new issues of securities
– Underwriters: - they act as agents on commission basis, they
Underwriters: - they act as agents on commission basis, they
underwrite the issue of securities
underwrite the issue of securities
– Retailers: - They purchase entire issue of new securities of
Retailers: - They purchase entire issue of new securities of
companies or government institutions and re- issue them for
companies or government institutions and re- issue them for
public subscription at a higher price. They have to use their
public subscription at a higher price. They have to use their
assets for longer investments and risky ventures.
assets for longer investments and risky ventures. 71

Con’d
B. Mixed Banking
B. Mixed Banking
• This is that system of banking under which the commercial banks
This is that system of banking under which the commercial banks
make both short-term as well as long-term loans to commerce and
make both short-term as well as long-term loans to commerce and
industry.
industry.
• It is the combination or mix of investment banking and
It is the combination or mix of investment banking and
commercial banking.
commercial banking.
• Commercial banks mainly involve in short term working capital
Commercial banks mainly involve in short term working capital
with loans maturing in less then one year where as investments
with loans maturing in less then one year where as investments
banks engage in long-term loan running for several years.
banks engage in long-term loan running for several years.
Advantages of mixed Banking
Advantages of mixed Banking
• Mixed banking system possesses the following advantages.
Mixed banking system possesses the following advantages.
– The industrial units will have the advantage of receiving an expert
The industrial units will have the advantage of receiving an expert
guidance on various financial issues from their banker.
guidance on various financial issues from their banker.
– It helps banks to invest in the industrial development of the country.
It helps banks to invest in the industrial development of the country.
– Banks can acquire a thorough knowledge of the working of the
Banks can acquire a thorough knowledge of the working of the
industrial system of the country.
industrial system of the country. 72

Con’d
Disadvantage of mixed Banking
Disadvantage of mixed Banking
 Mixed banking system has the following disadvantages
Mixed banking system has the following disadvantages.
.
1.
1. It constitutes serious threat to the stability of the banks.
It constitutes serious threat to the stability of the banks.
 Because the bank’s liability is short term, usually in a form of
Because the bank’s liability is short term, usually in a form of
demand deposits withdrawable on demand, but the loans are
demand deposits withdrawable on demand, but the loans are
granted for long-term purposes.
granted for long-term purposes.
 This leads to scarcity of liquid cash, as customers demand to
This leads to scarcity of liquid cash, as customers demand to
withdraw from their deposit accounts.
withdraw from their deposit accounts.
2. It is not a safe practice to lock up the bank’s resources in long-term
2. It is not a safe practice to lock up the bank’s resources in long-term
investment.
investment.
 The types of loans granted by such banks are long term and in the
The types of loans granted by such banks are long term and in the
long term the possibility of loss is high due to many factors such as;
long term the possibility of loss is high due to many factors such as;
credit risk, interest rate risk and liquidity risk.
credit risk, interest rate risk and liquidity risk.
 These types of risks are discussed thoroughly in chapter four.
These types of risks are discussed thoroughly in chapter four.
73

Con’d
CLASSIFICATIONS OF BANKS
CLASSIFICATIONS OF BANKS
• Banks can be classified into various types on the basis of their
Banks can be classified into various types on the basis of their
functions, ownership, domicile, etc.
functions, ownership, domicile, etc.
1. Based on Their Functions
1. Based on Their Functions
– Commercial Banks
Commercial Banks:-
:-
They perform all kinds of banking business.
They perform all kinds of banking business.
They generally finance trade and commerce.
They generally finance trade and commerce.
They usually accept short-term deposits and advance short-
They usually accept short-term deposits and advance short-
term loans to the businesspersons and traders and avoid
term loans to the businesspersons and traders and avoid
medium- term and long term loans.
medium- term and long term loans.
– Industrial Banks
Industrial Banks: -
: -
Also known as investment banks.
Also known as investment banks.
They mainly meet the medium-term and long-term financial
They mainly meet the medium-term and long-term financial
needs of the industries.
needs of the industries.
74

Con’d
The main functions are;
The main functions are;
I.
I. Accept long-term deposits.
Accept long-term deposits.
II.
II. Grant long-term loans to the industrialists to enable them to
Grant long-term loans to the industrialists to enable them to
purchase land, construct factory building, purchase heavy
purchase land, construct factory building, purchase heavy
machinery, etc.
machinery, etc.
III.
III. Help selling or even underwrite the debenture and share of
Help selling or even underwrite the debenture and share of
industrial firms.
industrial firms.
IV.
IV. Provide information regarding the general economic position
Provide information regarding the general economic position
of the economy
of the economy.
.
75

Con’d
– Agricultural Banks: -
Agricultural Banks: - They are banks that finance agriculture.
They are banks that finance agriculture.
o Agricultural credit needs are different from those of industry
Agricultural credit needs are different from those of industry
and trade.
and trade.
– Exchange Banks:
Exchange Banks: -They deal in foreign exchange and
-They deal in foreign exchange and
specialize in financing foreign trade.
specialize in financing foreign trade.
• They facilitate international payment through the sale and
They facilitate international payment through the sale and
purchase of bills of exchange.
purchase of bills of exchange.
– Savings Banks
Savings Banks: - The main purpose is to promote saving habits
: - The main purpose is to promote saving habits
among the general public and mobilize their small savings.
among the general public and mobilize their small savings.
76

Con’d
– Central Bank
Central Bank:-It is the apex institution, which controls, regulates
:-It is the apex institution, which controls, regulates
and supervises the monitory and credit system of the country.
and supervises the monitory and credit system of the country.
• A central bank may be defined as “the central monetary institution
charged with performing the duties of bankers’ bank, physical agent
for the government and managing the monetary system of the
country”.
• is a special institution, which regulates the entire banking structure and
operation to maintain monetary stability in a country.
• It works in the best interest of the nation and not merely for profit.
• The central bank is the only independent bank within the
government
 77

Con’d
Purpose of Central/ National/ Reserve Bank.
I. A central bank is established for public service rather than for
private profit.
II. Central bank has special relationship with the government of the
country.
III.Central bank generally does not deal directly with the public; it
deals with the public indirectly through the commercial banks and
money market.
Functions
• The main functions of the central bank are:
1. Issue of currency Note.
2. To take monetary policy in the country.
3. To act as an agent for the Government (inflation, IR increase…).
4. To control foreign exchange.
78

Con’d
 Functions of the central bank are:
Functions of the central bank are:
– It has the monopoly of note issue.
It has the monopoly of note issue.
– It acts as the banker, agent and financial advisor to the
It acts as the banker, agent and financial advisor to the
state.
state.
– It is the custodian of member bank’s reserves.
It is the custodian of member bank’s reserves.
– It is the custodian of nation’s reserves of international
It is the custodian of nation’s reserves of international
currency.
currency.
– It serves as the lender of the last resort.
It serves as the lender of the last resort.
– It functions as the bank of central clearance, settlement,
It functions as the bank of central clearance, settlement,
and transfer.
and transfer.
– It acts as the controller of credit.
It acts as the controller of credit.
79

Con’d
– World Bank
World Bank: - It refers to an institution that provides financial
: - It refers to an institution that provides financial
assistance to the member countries of the world.
assistance to the member countries of the world.
 After the worldwide depression and World War II, two
After the worldwide depression and World War II, two
international institutions were founded in 1944.
international institutions were founded in 1944.
1.
1.International Monitory Fund (IMF) to provide short term
International Monitory Fund (IMF) to provide short term
loans to overcome the balance of payments difficulties.
loans to overcome the balance of payments difficulties.
2.
2.International Bank of Reconstruction and Development
International Bank of Reconstruction and Development
(IBRD) or World Bank organized to achieve the following
(IBRD) or World Bank organized to achieve the following
two objectives.
two objectives.
» Reconstructing the war-damage economies, and
Reconstructing the war-damage economies, and
» Developing the less developed economies.
Developing the less developed economies.
80

Con’d
Based on Ownership
Based on Ownership
• On the basis of ownership, banks can be classified into three
On the basis of ownership, banks can be classified into three
» Public Sector Banks
Public Sector Banks:-These are owned and
:-These are owned and
controlled by the government.
controlled by the government.
» Private sector Banks
Private sector Banks:-These are owned and
:-These are owned and
controlled by the private individuals or corporations
controlled by the private individuals or corporations
and not by the government or co-operative societies.
and not by the government or co-operative societies.
» Cooperative banks
Cooperative banks:- They are operated on the
:- They are operated on the
cooperative lines.
cooperative lines.
81

Con’d
3. Based on Domicile
3. Based on Domicile
• On the basis of domicile the banks are divided into two
On the basis of domicile the banks are divided into two
A.
A. Domestic Bank
Domestic Banks:-They are registered and incorporated
s:-They are registered and incorporated
within a country.
within a country.
B.
B. Foreign Banks
Foreign Banks:- These are foreign in origin and have
:- These are foreign in origin and have
their head offices in the country of origin.
their head offices in the country of origin.
82

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