BANK PRACTICE & PROCEDURE

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CHAPTER TWO

THE ORIGIN AND THE GROWTH OF BANKING

Introduction

If money is essential for development into modem economy, a banking system is almost as important as
money. Nearly a thousand years ago, bankers began holding money for depositors, making loans to
merchants and manufactures, and eventually creating new kinds of money to satisfy the growing needs of
an expanding economy.

"Banking" has come to occupy a pivotal role in nation's economy. According to the modem concept,
banking is a business which not only deals with borrowings, lending, and remittance of funds. But it is also
important for economic growth.

No economy can function without finance and the banks provide it. They work as reservoirs of "savings"
of the community and also lenders or investors fur trade, business and industry. It is therefore absolutely
necessary that banking is properly regulated so that the interest of depositors, borrowers and the nation'
economy can be well protected.

When we assume banks as institution dealing with credit and credit instruments, we have to take
consideration that credit depends in a person's willingness and ability to pay. It refers to honesty, sincerity
and promptness in repayment. Credit is thus an attribute of the borrower. Since commercial banks deal with
credit, it is very essential that they command the confidence of depositors. Depositors must have a belief
in the banks capacity to honor all its liabilities. The banks are able to attract savings because of confidence
of depositors and inducement of interest. The savings thus attracted are in turn used by commercial banks
for purposes of lending, to those who are in need of capital for industrial, agricultural and business
purposes. Modem commercial banks are therefore institutions which deal as financial intermediaries.

This chapter discusses the origins and functions of banking institutions. It is concerned with how banks
help money do its work more smoothly: providing a safe place to store money assets, relieving income
earner of the worry of loss or theft, and transferring funds quickly from buyer to seller and from saver to
spender. It focuses on an important and increasing function of banks: creating new credit money in line
with our nation's growing capacity to produce real wealth. It is through their ability to create money that
banks encourage new production and permit new consumption to take place. It is through their money
creating ability, also, that banks may thwart monetary policy makers in their objectives. How do banks
create money? What determines their money creating ability? How can creating new money help to
improve or worsen our standards of living?

2.1 Definitions of Banking and Banker

What is banking?

A banking company is defined as a company which transacts the business of banking in a country. Here
are a few of definitions which are given by well-known scholars:
• Bank is a manufacturer of credit and machine for facilitating exchanges
• A bank is a person or corporation which holds it out to receive for the public deposits and payable
one demand by check
• Banks are intuitions whose debts usually referred to as ‘Bank Deposits’ are commonly accepted in
final settlement of other’ people depts.
• A bank is an establishment which makes to individuals such advantages of money as may be
required and safely made and to which individuals entrust money when not needed by them for use
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Baking means accepting deposits for the purpose of lending or investment, of deposits of money from the
public, repayable on demand of otherwise and withdraw able by check, draft order or otherwise.

A banker is a person or company carrying on the business of receiving money, and collecting drafts, or
customers subject to the obligation of honoring checks drawn upon them from time to time by the customers
to the extent of the amounts available on their account.

2.2 Evolution of Banking

In fact, banking is an evolutionary concept. It has undergone many changes since the use of money as a
medium of exchange to the present time. From a money changing institution it has developed into a creator
and controller of credit.

Division of labor and surplus production has given way to the development of exchange. The evolutionary
development of exchange was facilitated with the emergence of money which is a back ground to the
modem banking system. Banking had its routes in the historical stages in the rural places.

Banking as a kind of business is of recent origin. But there are some historical indications that could serve
as traces of banking and banking institutions. Banking had its roots in the earliest stages in the villages.
The village money-lender, the gold-smith and the merchants were men of honesty, integrity and reliability.
They, therefore, became custodians of the spare money of the villagers. Thus, modem banks have three
ancestors of repute, the merchant, the goldsmith and the village money-lender.

Merchants were men of honor and reputation. They were honest men in business. These qualities brought
them distinction and they were regarded as trustworthy persons. They were persons to whom anything
could be entrusted for safe custody. Accordingly, the practice arose for people who had extra money to
entrust into merchants for safe custody.

Money-lender ancestry of commercial banks can be easily understood. The moneylender was a man of
some reputation in the villages. He used to advance loans to the needy people at the nominal rate of interest.
For the purpose of lending, he used his own money and often accepted money from the members of the
community. Thus, he now becomes a borrower since he borrows from the public and lends it to those who
are needy. In the same way, the banks accept spare money for safe custody and lend it to those who require
it. A money-lender lends what is lent to him; modem banks also lend what is lent to them. Thus, we see a
good deal of money-lender element in modern commercial banks. Money-lenders mobilize savings for
productive loans. So also modern banks channels dormant funds to wards productive use.

The gold-smith ancestry of modem banks is a British legacy. Accordingly, these people are supposed to be
the first ones to have begun the concept of banking operation. Since the gold-smiths were also men of good
reputation and had strong boxes to keep their gold, they began to attract so as to keep in trust money,
ornaments and other valuable articles.

In return to the spare money or valuables received for safe custody the gold-smith issued receipt as
confirmation for the deposit. This is the birth of the modem bank notes, or check which entitle payment for
money. For example, when two persons make transactions with one another and if they use them same
goldsmith for their custody, they could arrange payment by simply transferring the receipts to the
beneficiary. The inter account transfer will be made by the goldsmith. Thus there was no need of pulling
out gold from the goldsmith to effect payment is as long as the receipt serves the same purpose. The task
of transferring funds from one account to another developed to the present day demand deposit accounts

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The goldsmiths were charging small amount of money for their services as custodians. However, in the
long run the goldsmith camel to be aware that most of the spare money deposit was not often withdrawn
by the depositors. Therefore, they started to utilize this resource for lending to the needy on interest basis.
Later, they abandoned the practice of charging money for the deposit kept by them, and by offering a low
interest to depositors they started to attract a lot of depositors. Thus, the need to expand credit gave rise to
saving mobilization.

Hence, modern banking system began in this way more than 500 years ago. It is believed that banking was
practiced by the Assyrians, Babylonians, Athenians and Romans. The oldest recognized bank is supposed
to be the "Bank of Venice" established in 1157 originally it was not a bank in the modern sense being
simply an office for the transfer of public debt.

Present day banking was developed in Greece and Italy in the 15th century. The word "bank" is perhaps
derived from the Italian word "banco", which means bench or counter or place 'of business on which the
money chargers or lenders used to sit in market places to advance money. When the money lenders could
not meet their liabilities at any stage they could break the banco and the money lenders were declared
bankrupt.

2.2.1 Banking in Ethiopia

Due to the low level of economic development, situations did not give rise to the emergence of own
banking. Thus, the practice of banking in Ethiopia is foreign origin. Banking in Ethiopia started under a 50
year franchise agreement with the British Bank owned by the National Bank of Egypt in 1905. This bank
was known as "Bank of Abyssinia".

The agreement to establish this bank was reached between Menilik II and the Governor of the National
Bank of Egypt. According to the agreement:
i. Initial Capital = 500,000.
ii. Issuing notes and casting coins was the duty of the bank. The Notes were exchangeable to gold or
silver.
iii. The Ethiopian Government was supposed to provide land and permit for building offices.
iv. All government funds were supposed to be deposited in the bank and subject to withdrawal using
checks.
v. No other bank will be allowed to operate within the country for a 50 year period.

This bank had branch offices in DireDawa, Gore and Dessie and an agency office in Gambella and Transit
Office in the part of Djibouti.

Despite the agreement, other banks were established soon. Thus from 908-1928 the Sciete Nationale d'
Ethiopia pour le' development de “Agriculture et de commerce, Banque del' Indochine (1915) and
Campagnie del' Afrique orientale (1915) were operating in Ethiopia.

2.2.2 The Bank of Ethiopia

The Bank of Abyssinia was accused of inefficiency and purely profit motive activities and was decided to
liquidate it. Thus, in 1931 an indigenous bank known as the Bank of Ethiopia was established with an initial
capital of 750,000. It had branch offices at Harar and Debre- Tabour in addition to the ones opened by the
Bank of Abyssinia. This bank operated till the Italian colonial occupation in 1936.

During the 5years colonial occupation a number of Stallion Banks were opened of which Banco di Roma
and Banco di Napoli Continued even after liberation until they were nationalized in 1976.

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2.2.3 State Bank of Ethiopia

This was established in 1943 with an initial capital of Maria Theresa Taller 1,000,000 financed by the
Ministry of finance with 43 employees and a Canadian governor. This bank had a vested power to act both
as a Central Bank and a Commercial Bank. In 1949 it was made a sole dealer of foreign currency and
foreign exchange. It continued operation till 1963 with 21 branches in Ethiopia, 1 branch in Khartoum 1
transit office at the port of Djibouti and 902 employees.

In 1964 the State Bank of Ethiopia gave rise to: a) National Bank of Ethiopia and b) Commercial Bank of
Ethiopia. Both banks were state owned with their, distinct activities. Since then from the point of view of
the legal status of the business entity carrying on banking business

2.3 Organizational Structure of Banks

The typical bank has corporate structure: it is legally chartered business venture, operated for profit with
stockholders, directors and officers. Its chare is granted either by the state where it is organized or by the
federal government through the Office of the Controller of the Currency. The bank’s stockholders elect its
directors where are the active, governing body of the corporation. Directors are responsible for the bank’s
operations, regulatory compliance, and performance; they can be held legally liable for their actions.
Directors appoint the bank’s officers. The board of directors usually functions through various committees,
such as auditing, trust and credit. The bank’s chairman usually is the chief executive officer, responsible
for the basic policies that guide the institutions. The bank’s presidents is typically the chief administrative
officer, responsible for implementing policies and supervising operations, depending on the size and scope
of the institution, various organizational levels may be created so that specific individuals are responsible
for functional areas. Figure 2.1 shows a typical organizational structure of commercial banks.

While name may vary, a typical bank has the following departments:
• The commercial/business banking department delivers loans, deposit, and, payment services to
businesses
• The consumer banking department delivers loans, deposit, and payment services to individuals
• Human resources find, trains, develops, and compensates staff for the bank
• The marketing department studies what customers want and how to deliver and promote products
and services
• The Bate Process/Bookkeeping department provides high-quality informant to the bank and
customers
• Funds management balances the bank’s need for liquidity, safety, and income
• Accounting provides information on how efficiently and profitably the bank is run.
• The Audi/Loan Review function makes sure the bank is sage from risks such as internal and external
fraud and poor-quality loans.
Figure 2.1 Typical commercial bank organizations
Shareholders

Board of directors

Chairman of the board

President

Specific officer positions,

divisions and departments

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Board of directors and Constitution of Board of Directors:

Banking Company shall preferably be managed by board of directors. The board shall preferably include
persons having professional and other experiences. Therefore not less than 51 % of the board of members
shall include persons who satisfy the following conditions.

➢ They shall have special knowledge or practical experience in respect to one or more of the following
matters, such as:
✓ Accounting
✓ Agriculture and rural economy
✓ Banking
✓ Cooperation
✓ Economics
✓ Finance
✓ Law
✓ Small Scale Industry
✓ One approved by the central bank

At least two of the board members are preferably that they have special knowledge and/or experience in
respect to agriculture and rural economy and cooperation or about small-scale industry.

➢ They shall not: 1) have substantial interest or be connected with whether as employee or manager
in any Company being engaged for charitable purposes or for promotion of art, science, religion
etc. Any form engaged in any trade, commerce or industrial concern which in either case is not a
small scale industrial concern and 2) be proprietors of any trading, commercial or industrial concern
not being a small scale industrial concern.
➢ Whole time Chairman shall be professional banker and not an industrialist. He shall be entrusted
with the management of the banking Company subject to the superintendence, control and guidance
of the board of directors.

Although the activities undertaken by various types of banks are almost the same throughout the world; the
organizational set-up is, however, different in different countries.
❖ From the organizational point of view, various banks have been divided into two types such as:
✓ Branch banking, and
✓ Unit Banking;
❖ From the owner point of view, these banks have also been classified into: (1) chain banking and (2)
Group banking
❖ From the point of view of lending practices, banks have been further divided into:(1) pure banking
and (2) Mixed banking

2.4 Categories of Banking Institutions

Various banking institutions have been classified on the basis functions performed by them. Broadly
speaking, there are following types of banks:

(1) Commercial Banks

These banks generally advance short-term loans to businessmen and traders, because their deposits are only
for a short period. Generally, these banks give loans for a period extending from three months to six months.
These banks do hot give loans on long-term basis to industries. In our country, the majority of banks are
commercial banks which finance trade and commerce.

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(2) Industrial Banks
These are special types of banks, as name itself suggests. They extend long-term loans to industries. They
also help industrial firms in selling and purchasing debentures and shares. They even underwrite the
debentures and shares of big industrial houses. Broadly speaking, these banks perform three types of
functions:
(a) They accept long-term deposits.
(b) They meet the credit requirements of industries. Generally, the credit requirements of industries are of
two types: firstly, they require capital to purchase land, erect buildings and for the purchase of heavy
machinery. Secondly, the industries require short-term loans to buy raw materials and to meet their day-to-
day need. So far as short-term requirements are concerned, they are generally met from the loans received
from the commercial banks, but for their long-term requirements, the industries have to depend on the
industrial banks.
(c) Finally, the industrial banks tender advice to big industrial houses regarding the sale and purchase of
their shares and debentures.
These banks play a very important role in the advanced and highly industrialized countries. In our country,
owing to the absence of industrial banks, the governments at various levels have set up Industrial Finance
Corporations for providing long-term finance to industries.

(3) Agricultural Banks

For meeting the requirements of agricultural community, special types of banks have been set up in
predominantly agricultural countries. The agriculturists and peasants require short-term loans to purchase
various inputs like seeds, fertilizers, plough, etc. for carrying on their agricultural operations. Secondly, the
farm require long term loans to purchase land to effect permanent improvements on the land, to buy
machinery and to provide irrigation works. To fulfill these requirements of the farmers, various types of
agricultural banks have been set up in various countries

(4) Foreign Exchange Banks

These banks specialize in financing foreign trade by making international payments through the purchase
and sale of foreign exchange bills. Foreign trade involves the problem of converting the currency of one
country into that of another. The foreign exchange banks solve this problem. These banks have in stock the
currencies of various countries and for this purpose they open branches in different countries 4.

Categories of Banking Institutions in Ethiopia

There are five commonly known types of banks, namely:

1. Central Bank (National Bank of Ethiopia)
2. Commercial Bank
3. Development Banks
4. Construction and Business Bank(Saving and Housing Bank)
5. Investment Bank
Each of the banks is discussed in detail in the forthcoming section.

1. Central Bank

To define a central bank is a ticklish issue. There has been a great diversity of opinion in regard to its
definition. Each writer has defined it in his own way emphasizing either one of more functions performed
by it. As it is acknowledged by TN Hajela in his book, “Money and Banking & International Trade”, Kent
defined central banking as “an institution which is charged with the responsibility of managing the
expansion and contraction of the general public welfare”. In the same book, Vera Smith says that “the
primary definition of central banking is a banking system in which a single bank has either a complete or
residuary monopoly in the note issue. It was out of monopoly in the note-issue there were derived the
secondary functions and characteristics of our modern central banking.”

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Central bank is a bank which constitute the top of the monetary and banking structure of its country that
exercise full control over the banking system of the country which performs different functions as best as
it can in the national economic interest

Note: The functions of the central bank will be discussed in section 2.4

Why a country needs a central bank?

The need for a central bank arises from the vast expansion of monetary, fiscal and trade activities of the
government and the people and the concomitant result of its activities produced on the economy. With the
vast expansion of commerce and international trade, it has been necessary that commercial banks provide
financial facilities for daily operations. The commercial banks perform this duty by creating credit.
Indiscriminate expansion of credit or its contraction leads to fluctuation in the level of economic activity
in the economy and all such fluctuations are bad for the health of the country’s economy. Hence, some
institutions must be there to exercise control on the credit creation activities of the commercial banks and
this institutions has been the central bank. Again, after the disappearance of precious metals from the
currency system and after the adoption of the paper currency, it has become extremely essential that the
issuing of notes is undertaken by a single authority. And this task has been assigned in all countries to the
central bank. The central bank issues paper currency only according to the needs and requirements of the
country. And since it is also a controller of credit, it can easily feel the pulse of the economy and withdraw
notes issued in excess of requirement or issues more notes, whenever required. Thirdly, a central bank is
also needed to help the commercial banks in times of need or economic crises. And that is why; the central
bank has been called as a lender of the last resort. And finally, the central bank is a hand-maiden of the
government and carves out its policy morally and sincerely. This has been possible only because the central
band exercises full control over the banking system of the economy

2. Commercial Banks

These banks are primarily established generally to advance short-term, medium-term and long-term loans
to businessmen and traders by accepting deposits of various types from the public. At this point, it is
discussed the brief history and function of commercial bank of Ethiopia with regard to its establishment
under the Ethiopian law. It is hoped; examining of it will give insight students about the major functions
of all the other commercial banks.

Brief History of the Commercial Bank of Ethiopia

The Commercial Bank of Ethiopia (S.C) was incorporated as a share company on December 16, 1963 as
per proclamation no. 207-1955 of October 1963 to take over the commercial banking activities of former
State Bank of Ethiopia. Under this name, it began operation on January 1, 1964, with a capital of Eth. Br.
20 million and served for about 16 years. The bank was wholly owned by the State and operated as an
autonomous institution under the Commercial Code of Ethiopia.

The Commercial Bank of Ethiopia Share Company and Addis Bank had identical objectives, powers and
duties. Hence, it was necessary to merge them, in order to eliminate the duplication of efforts and bring
them under a centralized banking structure. Consequently, the present day Commercial Bank of Ethiopia
was established under proclamations No. 184 of August 2, 1980.

The Functions of Commercial Banks

The acceptance of deposits of various types for the purpose of lending or for investment, banks are
permitted to engage in some other forms of business, such as collection of checks, bills and other

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instruments, remittance of funds, opening Letter of Credit (L/C), issuing traveler checks, accepting articles
for safe custody, executors and trustees, underwriting the issue of shares, debentures, and so forth.

The following business may be undertaken by a commercial bank. These Businesses can be broadly
categorized into four:

i) Main Functions of Commercial Bank

The major functions of Commercial Bank include the following.

a) Receiving deposits: the primary function of commercial Banks is accepting deposits from the
public. Banks maintain deposits account for their customers and convert deposit money into
cash and vise versa, at the discretion of the latter.
b) Making loans and advances: lending money is one of the important functions of the bank. This
lending or advancing of money can be either upon or without security. Banks accept deposits
form these who have surplus money and grant loans and advance to those who need them. Banks
charge comparatively higher rate of interest on the amount advanced as a loan. Loans are
advanced by the bank in such a ways as: overdrafts, discount of bills, short notice loans, and
various forms of direct loans to traders and producers.
c) The drawing , making , accepting, discounting, buying-selling, collecting and dealing in bill of
exchange, promissory notes, coupons, drafts, Bill of Lading ,Railway receipts , Warrantees,
Debentures, certificate, scripts and other instruments, and securities whether transferable or
negotiable or not.
d) The granting and issuing of Letter of Credit, travelers’ checks and circular notes
e) Commercial Banks also render important services by providing an expensive medium of
exchange such as checks. In modern business transitions, the use of checks to debts is found to
be much more convenient than the issue of cash.
f) The colleting and transmission of money and securities.
g) The providing of safe deposits vaults for custody of valuable s of customers
h) The buying, selling and dealing in bullion (i.e. gods or gods bars) and the like
i) The buying and selling of foreign exchange, including foreign bank notes.
j) The negotiating of loans and advances
k) The receiving of all kinds of bonds, valuables on deposit or for safe custody of otherwise.
l) The purchasing and selling of bonds, other forms of securities, other forms of securities on
behalf of constituents of other, and
m) The acquiring , holding, issuing on commission, underwriting, and dealing in stock, funds,
debentures, debenture stocks, bonds obligation, securities, and investments of all kinds.

3. The Development Bank

There is no precise definition of Development Bank, William Diamond and Shirley Bosky consider
industrial finance and development corporations as ‘Development Banks’. Fundamentally, a Development
Bank is a term-lending institution.

Development Bank is essentially a multi-purpose financial institution with a broad development outlook.
A Development Bank may, thus, be defined as a financial institution concerned with providing all types of
financial assistance ( medium as will as long-term) to business units, in the form of loans , underwriting,
investment and guarantee operations, and promotional activities-economic development in general, and
industrial development, in particular. In short, a Development Bank is a development- oriented bank.

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Features of a Development Bank

The following are the main characteristics features of a Development Bank:

a. It is a specialized financial institution
b. It provides medium and long-term finance to businesses units
c. Unlike Commercial Banks, it does not accept deposits from the public
d. It is not just a term-lending institution; it is a multi –purpose financial intuition
e. It is essentially a development oriented bank its primary objective is to promote economic
development by promoting investment and entrepreneurial activities in a developing economy.
It encourages new and small entrepreneurs and seeks balanced regional growth
f. It provides financial assistance not only to the private sector but also to the public sector
undertakings
g. It aims at promoting the saving and investment habit in the community
h. It does not compete with the normal channels of finance, ice finance already made available by
the banks and their conventional financial intuitions. This major role is of a gap-filler, i.e. to fill
p\up the deficiencies of the existing financial facilities
i. Its motive is to serve public interest rather than to make profit. It works in the general interests
of the public

4. Construction and Business Bank

2. 5 Central Banking and Its Functions

Economists and financial experts lack in unanimity about the functions of a national/ central bank.
According to kitsch and Elkin “the essential function of central bank is the maintenance of the stability of
the monetary standard.” De Kock has removed the confusion by mentioning the seven following functions
of a national bank in his well-known book central banking. According to him, a central bank is a:
1. Bank of issue
2. Banker, agent and financial advisor to the government
3. Custodian of commercial banks’ cash reserves
4. Custodian of nation’s foreign exchange reserves
5. Lender of last resort
6. Band of central settlement and transfer acting as a clearinghouse
7. Controller of credit

The functions of a central bank are different from those of commercial banks due to the following three
major reasons:

Firstly, a central bank is established for public service rather than for private profit. Unlike the commercial
banks, its operations are not basically guided by profit motive. Secondly, a central bank has special
relationship with the government of the country. Since the central bank acts as the banker to the
government, the latter informally influences its activities.

Thirdly, a central bank generally does not deal directly with the public as doing so would amount to take
over the functions of commercial.

Major Functions of National Bank include the following.

1. A Bank of Issue

Central bank enjoys the monopoly of bank note issue, i.e., no bank other than the central bank is authorized
by law to printing currency notes. Printing of paper currency is one of the most important functions of a

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modern central bank. The following are the main reasons for granting the exclusive monopoly right of note
issue to the central bank:
i. As the use of deposit money created by the commercial banks increased and with this as the growing
need for credit control by the central bank was felt, it was realized that the monopoly of note issue
allowed to the central bank made its control over the excessive credit expansion by the commercial
bank more effective.
ii. The inherence of the right of note issue in on single bank , particularly when the payment of notes
is guaranteed by the government, imparts the notes guaranteed by the government, imparts the
notes a distinctive prestige that is absent in the notes issued by the several banks
iii. When notes are issued by the central bank they carry with them the advantage of uniformity.
Although uniformity can also be achieved by means of direct state issues of notes, many examples
of depreciation of government notes in pals have by shaking the public confidence caused the state
to vest the right of note issue in the central bank.
iv. If the right of note issue is exclusively granted to the central bank it is easier r for the stare to
supervise and control the irregularities and malpractices committed by the central bank in issuing
notes.
v. Since the central bank handles the complicated matters relating to monetary management, it is
better-equipped to solve effectively the problems related to the issuing of notes.

2. Government Banker, Fiscal Agent and Advisor

Central banks in all countries act as the fiscal agent, banker and adviser on all important financial matters
to governments of their countries. As government bank, the central bank manages the banking accounts of
government department and enterprises. It gives short-term loans to governments in anticipation of
collection of taxes of the raising of loans from the public

3. Custodian of Commercial Banks’ Cash Reserves

It keeps the cash reserves of commercial and other bankers in the economy and thus acts as the custodian
of the ultimate reserves of the country, which supports its credit and banking system. The central bank
discounts bills for the commercial basks making available to them credits based on these ultimate reserves.
It provides able and effective leadership to the banking system in the country. Other banks look to it for
guidance sand directing in shaping their policy in accordance with its directions. It effects centralization of
cash reserves of member banks in the country. It is obvious that when bank reserves are pooled in one
institution, which is moreover charged with the responsibility of safeguarding the national economical
interests, such reserves can be employed to the fullest extent possible land in the most effective manner
during periods of seasonal train and in financial crises or general emergencies

4. Custodian of Nation’s Foreign Exchange Reserves

This function of the central bank is derived from its functions as the band of issue and the custodian of
member banks’ cash reserves. The essential purpose behind entrusting the custody of nation’s foreign
exchange reserves to the central bank is the meeting of adverseness at any time in country’s balance of
payments positions and the maintenance of exchange rate stability. To the extent, however, a central bank
is required by law to maintain a minimum reserve against both its note and deposit liabilities, its holdings
of gold and foreign exchange are immobilized and are not available for keeping equilibrium of the balance
of international payments

5. Lender of the Last Resort

The central bank also acts as lender of the last resort. In its capacity of lender of last resort the central bank
meets directly or indirectly all reasonable demands for financial accommodation from the commercial

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banks, discount houses and other credit institutions subject to certain terms and conditions which
constitutor its discount rate policy.

6. Bank of Central Clearance, Settlement and Transfer

Since commercial banks keep their surplus cash reserves on deposit with the central bank is far easier to
clear and settle claims between them by making transfer entries in their accounts maintained with the
central bank than if each commercial bank entered into separate clearance and settlement transactions with
other banks individually. Much labor and inconvenience experienced in the individual system of clearance
and settlement is avoided when central bank enters in ton the picture as a central clearing agency. The
process of effecting settlement between the banks on the books of central bank while comparatively simple
to pirate is of great convenience to the banking community as it economizes the use of money in banking
operations.

7. Control of Credit

Control of credit is the most important function of a central bank and it embraces the most important aspects
of the central banking policy. It is through this function that all their functions are united and serve a
common purpose. So important is this function that is finds place in the law of all central banks. The need
for controlling credit is obvious. Unwarranted fluctuations in the volume of credit by causing wide
fluctuations in the value of money cause great social and economic unrest in the country. The experience
of last one hundred years is a testimony of the need for controlling credit in order to maintain the economic
and political stability in the country.

Summary

Banking has undergone many changes since the use of money as a medium of exchange to the present
time. From a money changing institution it has developed into a creator and controller of credit.

Various banking institutions have been classified on the basis functions performed by them. Broadly
speaking, there are following types of banks: commercial, industrial, agricultural, and foreign exchange
banks. The organizational set-up of these banks is determined by their main functions they perform

The central bank of a country provides such main functions as: bank of issue, banker, agent and financial
advisor to the government, custodian of commercial banks’ cash reserves, custodian of nation’s foreign
exchange reserves, lender of last resort, band of central settlement and transfer acting as a clearinghouse
and controller of credit

BY:ENDALKACHEW M. 11