CH # 7 BANKING

Terms to know Definition of BANK 1 Kinds of BANK 2 Functions of central and commercial BANKS 3 Credit creation 4

Definition:  “Bank is a financial institution. It deals in other people’s money”. OR  “A financial institutions that accept deposits and make loans”.  Banks get surplus money from the people as deposits.  They advance the same amount as loans.

Central bank and Commercial banks: Commercial banks: Commercial banks are the financial institutions, which perform general banking functions; i.e.  Receiving deposits  Advance loans  Create credit Central bank: The central bank is the head, the leader and the supervisor of the banking and monetary system of a country.  it controls total amount of currency.  It acts as advisor to the govt. Bank

Kinds of banks: kinds of banks Commercial bankCentral bank Industrial banks Agricultural banks Mortgage banks Exchange banks

Functions of central bank: A central bank performs the following functions; 1)Regulator of currency:  The central bank has the monopoly of note issue. Under this system the central bank keeps proportional reserves in the form of gold or foreign currencies. 2)Banker, fiscal agent and advisor to the govt.:  As banker to the govt. it keeps the deposits and make payments on behalf of the govt.  As a fiscal agent it makes short-term loans to the govt.  The central bank also advises the govt. on such economic and money matters as inflation and deflation, deficit financing, balance of payments etc.

Functions of central bank (continued): 3)Banker’s bank: The central bank acts as banker’s bank. It  keeps cash reserves of banks.  On the bases of cash reserves the central bank can control the credit creation by commercial banks. 4) Lender of last resort:  when the commercial banks are short of funds and are unable to get help from anywhere, the central bank provides them loans. 5) Control of foreign exchange:  The whole business of foreign exchange control and financing of international trade is done by the central bank.

Functions of commercial banks: Commercial banks perform the following functions: 1)Receiving deposits : This is the primary function of commercial bank. Deposits are of three kinds; Demand deposits or current account: On demand deposits, the banks pay no interest. The deposits can be withdrawn at any time in full or in part. Saving deposits: Some people put their money in saving deposit. On such deposits they earn some interest and also having the facility to withdraw the amount, subject to certain restrictions. Time deposits or Fixed deposits: The amount under this deposit cannot be withdrawn before the expiry of the fixed period without due notice. The rate of interest on such deposits is high.

Functions of commercial banks (continued): 2)Advance loans: Bank receive money and lend it. Banks advance loans in three ways; Running finance (RF) or Over draft facility (OD):  In case of running finance (over draft facility), the customer is allowed to draw certain amount of money over and above his own deposited money.  Interest is charged on the amount actually utilized. Cash credit or cash finance:  In case of cash credit, a definite amount is credited to the customer’s account.  Interest is charged on the whole amount whether it is utilized in part or full.  Against such loans, the borrower has to offer some assets as security…..either a property or stock of goods.

Functions of commercial banks (continued) : Discounting bills ( short –term business loans):  The businessmen can also get short-term loans through discounting bills. When a seller sells goods on credit, he writes a bill of exchange and gets it signed by the buyer. This bill (receipt) is kept by the seller till the promised date of payments. 3) Transfer of money:  The banks help in the transfer of funds from one place to another and from one person to another through cheques, drafts, pay order etc. 4)Safe custody of valuables:  Banks provides the safe custody for valuables of customers such as jewellery (gold), documents etc.

CERDIT CREATION  Creation of credit means that banks increase the supply of money through creation of new deposits in the name of borrowers. It become possible as follows;  Some people deposit cash with banks. Banks earn interest to lend it. The banks keep only a small percentage of cash as reserves to meet the demand of the depositors and advance the remaining part as loans.  While lending money, the banks do not hand over cash to the borrowers. Simply an account is opened in the name of the borrower and the money is credited to this account. The customer can draw the money through cheques.  Thus every loan makes a deposit.

CH # 7 Prepared by M. Ihsan