Chapter Two: Banking System

Chapter contents:
– Central Banking System
• Evolution of Central Banking
• Definition of a Central Bank
• Central Banking Functions
• Credit Control Methods
• Monetary Policy & its Objectives
• Regulation of the financial system
• Central banking system in Ethiopia
– Commercial Banking system
• Definition of commercial banking
• Commercial banking services
• Domestic and international banking operation

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 2.1. Central Banking System
The entity responsible for overseeing the monetary
system for a nation,
Central banks have a wide range of responsibilities,
from overseeing monetary policy to implementing
specific goals such as currency stability, low inflation
and full employment.
 Central banks also generally issue currency, function
as the bank of the government, regulate the credit
system, oversee commercial banks, manage
exchange reserves and act as a lender of last resort.
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2.1. Central Banking System (cont)
 Origins of the Central Banking System
 With the increase in the size of global trade and
the corresponding increase of the volume of
international payments in the seventeenth
century, the need arose for the creation of more
central banks throughout Europe.
 The founding of the Bank of England (BoE) in
1694 marks the de facto origin of central banking
since the BoE was the archetype for central
banks that were created in Europe during the
eighteenth and nineteenth centuries.
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 Cont
 The roles of central banks have grown in
importance over time and their activities
continue to evolve.
 While most central banks of the world share
many common features and goals, there are
a number of differences in the structure and
policy tools that each central bank adopts.
 The European Central Bank (ECB) came
into existence on June 1, 1998, in order to
handle the transitional issues of the nations
that comprise the Eurozone. 4
 Cont
 The Federal Reserve System, also known as the
Federal Reserve bank or the Fed for short, is one of the
largest and most influential central banks in the
world.
 Canada was late in founding a central bank because its
need for a central bank to supervise the Canadian
financial sector was not apparent till after the Great
Depression. The Bank of Canada (BoC) started its
operations in 1935 in Ottawa as a privately owned
financial institution but was turned into public
ownership since 1938.
 In practice, however, the Bank of Canada does
essentially control monetary policy. 5
 Cont
 The Chinese central bank is known as
the People’s Bank of China (PBoC).
 The main mandate of the People’s Bank
of China is to maintain the stability of
the value of the currency, reduce overall
risk and promote stability of the financial
system to enhance economic growth.

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Objectives of Central Banks:
 The main objectives of central banks as following:

1- To provide their countries' currencies with price

stability by controlling inflation.

2- Acts as the regulatory authority of a country's
monetary policy

7
 Cont…

3- Administering policies of Balance of Payments

which includes:

a. Encouragements of Exports.

b. Monitoring public debt.

c. Minimum import for consumption

8
Central Banking Functions
The important functions of Central Banks are as
follows:-

1-Sole right of note issue

2-Banker to the state

3-Banker's bank.

4-Banker's clearing house

9
Cont…
5-Lender to the last resort

6-Financial agent

7-Effective monetary policy

8-External functions

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Credit control methods
There are four most common credit control
methods used by central banks. These are:

1. Bank Rate or Discount Rate Policy

2. Open Market Operations

3. Variable Reserve Ratio

4. Selective Credit Controls:

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1. Bank Rate or Discount Rate Policy
 Bank rate is a term describing the interest rate a
country’s central bank charges its domestic banks on
loans it makes to them.
 The loans are usually short-term loans lasting for just a
day, or even just overnight.
 The bank rate is important because commercial banks use
it as a basis for what they eventually charge their
customers for loans.
 Such loans are given out either by direct lending or by
rediscounting (buying back) the bills of commercial
banks and treasury bills. Thus, bank rate is also known as
discount rate
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 Cont…
The central bank controls credit by making variations in the bank rate.
If the need of the economy is to expand credit, the central bank
lowers the bank rate.
Borrowing from the central bank becomes cheap and easy.
 So the commercial banks will borrow more.
They will, in turn, advance loans to customers at a lower rate.
The market rate of interest will be reduced. This encourages business
activity, and expansion of credit follows which encourages the rise in
prices.
The opposite happens when credit is to be contracted in the economy.
The central bank raises the bank rate which makes borrowing costly
from it. So the banks borrow less. They, in turn, raise their lending rates
to customers.

13
 Cont…
The market rate of interest also rises because of
the tight money market.
This discourages fresh loans and puts pressure on
borrowers to pay their past debts.
This discourages business activity.
There is contraction of credit which depresses
the rise in price.
Thus lowering the bank rate offsets deflationary
tendencies and raising the bank rate controls
inflation.
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2. Open Market Operations:
are another method of quantitative credit control
used by a central bank.
refers to the sale and purchase of securities, bills
and bonds of government.
But in its narrow sense, it simply means dealing
only in government securities and bonds.

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3. Variable Reserve Ratio:
Variable reserve ratio (or required reserve ratio or legal
minimum requirements), as a method of credit control
was first suggested
Every commercial bank is required by law to maintain a
minimum percentage of its deposits with the central
bank.
The minimum amount of reserve with the central bank
may be either a percentage of its time and demand
deposits separately or of total deposits.
Whatever the amount of money remains with the
commercial bank over and above these minimum
reserves is known as the excess reserves.
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 Cont…
It is on the basis of these excess reserves that the
commercial bank is able to create credit.
 The larger the size of the excess reserves, the greater is
the power of a bank to create credit, and vice versa.
 It can also be said that the larger the required reserve
ratio, the lower the power of a bank to create credit, and
vice versa.
When the central bank raises the reserve ratio of the
commercial banks, it means that the latter are required to
keep more money with the former.
 Consequently, the excess reserves with the commercial
banks are reduced and they can lend less than before.
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4. Selective Credit Controls:
Selective or qualitative methods of credit control are
meant to regulate and control the supply of credit
among its possible users and uses.
They are different from quantitative or general methods
which aim at controlling the cost and quantity of credit.
 Unlike the general instruments, selective instruments do
not affect the total amount of credit but the amount that
is put to use in a particular sector of the economy.
The aim of selective credit control is to channelise the
flow of bank credit from speculative and other
undesirable purposes to socially desirable and
economically useful uses.
 They also restrict the demand for money by laying down
certain conditions for borrowers. 18
 Monetary Policy & its Objectives
Deals with the money supply
Monetary policy of central banks in a simplified
analysis amounts to the determination of the
“optimal” quantity of money or (in a dynamic sense)
the optimal rate of growth of the money stock.
But there is more to monetary policy than the
determination of the optimal stock or growth rate of
money.
More generally, monetary policy refers to a bundle
of actions and regulatory stances taken by the
central bank including all of the following:
19
 Cont…
 Setting minimum interest rates on deposits or the
rediscount rate charged to Commercial banks
 Setting reserve requirements on various classes
of deposits;
 Increasing or decreasing commercial bank
reserves through open market purchases or sales
of government securities.

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 Cont…
 Regulatory actions to constrain commercial bank
financial activity or to set minimum capital
requirements;
 Intervention in foreign exchange markets to buy
and sell domestic currency for foreign exchange;
 Decide on level of required reserve of
commercial banks total deposit

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 The objectives of Ethiopia’s monetary policy are to:

 Foster monetary, credit and financial conditions

conducive to orderly, balanced and sustained
economic growth and development.
 Preserve the purchasing power of the national
currency – ensuring that the level of money
supply is generally consistent with developments
in the macro- economy and intervening in the
foreign exchange rate market for the purpose of
stabilizing the rate when conditions necessitate.

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 Cont…
 Encourage the mobilization of domestic and
foreign savings and their efficient allocation for
productive economic activities through the
implementation of a prudent market driven
interest rate policy.
 Facilitate the emergence of financial and capital
markets that are capable of responding to the
needs of the economy through appropriate policy
measures.

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Goals of Monetary Policy
• Indeed, price stability, which central bankers define
as low and stable inflation, is increasingly viewed as
the most important goal of monetary policy.
• Although price stability is the primary goal of most
central banks, five other goals are continually
mentioned by central bank officials when they
discuss the objectives of monetary policy: (1) high
employment, (2) economic growth, (3) stability of
financial markets, (4) interest-rate stability, and (5)
stability in foreign exchange markets.

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 Regulation of the financial system
Government's role in financial markets
The government can play one or more of the
following roles in financial markets:
• provide a level playing field for financial
markets by promoting their development.
• participate in the financial markets by running
state-owned financial institutions
• provide a regulatory framework that ensures
safety and soundness of the financial system.
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 Cont

Government regulation
• according to the laissez-faire theorem markets
are efficient ,and hence can operate without any
legal intervention, but in reality they are not.
• the government controls a feature of the
economy that the market mechanisms of
competition and pricing could not manage
without help (market failure theory-where it
cannot fulfill all competitive situation)
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 Cont
Why regulation?
• prevent issuers of securities from defrauding
investors by concealing relevant information
• promote competition and fairness in the
trading of financial securities
• promote stability of financial institutions
• restrict activities of foreign concerns in
domestic markets and institutions
• control the level of economic activity
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 Types of regulations

(1) disclosure regulations-problem of asymmetric

information and agency problem
(2) financial activity regulation-about traders of
securities and trading on financial assets.
Examples. Rules on trading by corporate
insiders- insider trading
(3) regulation of financial institutions- restricting
activities of financial institutions in the area of
lending, borrowing and funding
(4) regulation of foreign participants-limit the roles of
foreign firms on domestic markets and their
ownership control of financial institutions 28
 Arguments against regulation

 Creates moral hazard-causes depositors as

well as banks to behave less cautiously on the
belief that the central bank is there to protect
them
 Agency capture-regulators are ex-
practitioners who share the same value as
practitioners, and hence may be biased
towards banks rather than depositors

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 Arguments against regulation (cont)

 increases cost of financial services-it has cost

and financial institutions may pass it on to
clients
 gives room for monopolies to emerge-cost of
regulation may restrain entry and exit
 leads to market inefficiency-prevents mergers
and acquisitions and allows inefficient firms to
stay in business

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 Financial regulation in Ethiopia
Governments have many objectives when intervening in the financial
Markets.

These include:

–a. Promoting financial stability

–b. To provide protection for investors against fraud or the dissemination of

misleading or inadequate information.
• c. Desire to promote fair and healthy competition to ensure competitive
price for consumers
• d. To control the activities of FIs in order to exert some degree of control
over the level of economic activities, particularly with respect to monetary
policy.
• Refer directives and regulations issued by NBE
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Central banking system in Ethiopia
 A central bank is a financial institution that is owned by the
government, which has a central role of managing the
currency.
 National bank of Ethiopia is the central bank
 The National Bank of Ethiopia established by Order No.
30/1963 shall continue to exist as an autonomous institution
 have its own juridical personality, and, in particular, the
capacity to
a) contract;
b) sue and be sued; and
c) acquire, own, possess and to dispose its property by
sale or in any other manner.
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Purposes of NBE

The purpose of the National Bank is

to maintain stable rate of price and exchange,

to foster a healthy financial system and

 to undertake such other related activities that

are conducive to rapid economic development
of Ethiopia.

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 Cont…
1. coin, print or cause to be coined, printed and
circulated the legal tender currency;
2/ dispose or cause to be disposed coins and notes
issued legally;
3/ issue its own debt and payment instruments;
4/ regulate and determine the supply and
availability of money and credit as well as the
applicable interest rates and other charges;
5/ formulate and implement exchange rate policy;
6/ manage and administer the international
reserves of Ethiopia;
34
 Cont…
7/ license and supervise banks, insurers and other
financial institutions;
8/ create favorable conditions for the expansion of
banking, insurance and other financial services;
9/ set limits on gold and silver bullion and foreign
exchange assets which banks and authorized dealers can
hold;
10/ set limits on the net foreign exchange position and on
the terms and the amount of external indebtedness of
banks and other financial institutions;
11/ make short term and long term refinancing facilities
available to banks and other financial institutions as
might be necessary; etc.. 35
Commercial Banking system
A banker or bank is a financial institution that acts as a
payment agent for customers, and borrows and lends
money.
Banks borrow money by accepting funds deposited on
current account, accepting term deposits and by issuing
debt securities such as banknotes and bonds. Banks lend
money by making advances to customers on current
account, by making installment loans, and by investing
in marketable debt securities .
Banks provide almost all payment services, and a bank
account is considered indispensable by most businesses,
individuals ,and governments.
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Definition of commercial bank:

An institution which accepts deposits, makes

business loans, and offers related services.
 Commercial banks also allow for a variety of
deposit accounts, such as checking, savings, and
time deposit.
These institutions are run to make a profit and
owned by a group of individuals.
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Functions of commercial banks
The functions of commercial banks are divided
into two categories as follows:

1- Traditional functions:

2- Modern functions:

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Traditional functions:
1. Accepting different types of Deposits.
2. Making different types of loans and advances to
customers.
3. Bank guarantees and letters of guarantee
4. Financing foreign trade through opening
documentary bills of credit.
5. Dealing with securities sale and purchase; either
for or on behalf of their clients.
6. Dealing with foreign exchange and transfer
money.

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Modern functions:
1. Credit card services
2. Mortgages
3. Financial advisors
4. Management of investment funds
5. Savings deposit
6. Foreign exchange transaction
7. Provision of credits

40
 Cont…
9. Portfolio management
10. Equipment leasing
11. Venture capital loans
12. Assets management services for firms like:
Investment banking

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Commercial banking services
Although the basic type of services offered by a
bank depends upon the type of bank and the
country, services provided usually include:
1. Taking deposits from their customers and issuing
current or checking accounts and savings
accounts to individuals and businesses.
2. Extending loans to individuals and businesses.
3. Cashing cheque
4. Facilitating money transactions such as wire
transfers and cashier's checks
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 Cont…
5. Issuing credit cards, ATM cards, and debit cards
6. Storing valuables, particularly in a safe deposit
box
7. Consumer & commercial financial advisory
services
8. Pension & retirement planning

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Domestic and international banking operation
What do you think? Students activity

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End of Chapter 2

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