Chapter Two

Financial Institutions and Operations

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 Contents
• Central (National) Banks
• Depository Institutions
– Commercial banks
– Saving and Loan Associations
– Saving Banks
– Credit Unions
• Non-Depository Institutions
– Insurance companies
– Mutual funds
– Pension funds
– Investment Banking Firms

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 Central Banks
• Central bank, reserve bank, or monetary authority
is a banking institution granted the exclusive privilege
to lend a government its currency.
• A central bank is the apex bank in a country.
• It is called by different names in different countries:
• The bank of England
• The federal Reserve System in America
• The Bank of France in France
• National Bank of Ethiopia in Ethiopia
• State Bank of Pakistan
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 Functions of Central Bank
1. Regulator of currency
2. Banker, Fiscal Agent & Advisor to the
Government
3. Custodian of Cash reserve of Commercial Banks
4.Custody and Management of Foreign Exchange
Reserves
5. Lender of Last resort
6. Clearing House for transfer and settlement
7. Controller of Credit

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 1. Regulator of currency

• It is the bank of issue.

It has monopoly of notes (legal tender money) issue.

• This monopoly of issuing notes has the following benefits:

– Uniformity in the notes issued which helps in
facilitating exchange and trade.
– Enhances stability in the monetary system and creates
confidence among the public
– Restrict or expand the supply of cash according to the
requirement of the economy
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 2.Banker, Fiscal Agent and Advisor to the
Government
• As banker to the government the central bank:
– Keeps the deposits of the government and makes
payment on behalf of the government
– But it does not pay interest on government deposits
– It buys and sells foreign currency on behalf of the
government
– It keeps the stock of gold of the government
– Thus, it is the custodian of government money and
wealth.

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2. Banker, Fiscal Agent and Advisor to the Gov’t ….Cont’d

• As fiscal agent of the government, Central

bank:
– Makes short term loans to the government
– It floats loans, pays interest on them, and finally
repays them on behalf of the government.
– Thus, it manages the entire public debt

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 2. Central Bank as Banker, Fiscal Agent and
Advisor to the Gov’t ….Cont’d

• As Advisor of the government, the central bank

– Advises the government on
• Economic and monetary matters as controlling
inflation or deflation,
• Devaluation or revaluation of the currency,
• Deficit financing
• Balance of payment etc

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 3. Custodian of Cash Reserve Requirement of
Commercial Banks
• Commercial Banks are required to keep reserve equal
to a certain percentage of both time and demand
deposits with the Central bank.

• It is on the basis of these reserve that central bank

transfers funds from one bank to another to facilitate
clearing of checks.

• The central bank acts as the custodian of the cash

reserve requirement of commercial banks and helps
in facilitating their transactions.

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 4.Custody and Management of Foreign
Exchange
• It keeps and manages the foreign exchange reserve of
the country

• It sells gold at fixed price to the monetary authority of

other countries
• It buys and sells foreign currencies at international prices
• It fixes the exchange rates.

• It manages exchange control operations by supplying

foreign currencies to importers and persons visiting
foreign countries on business, studies, etc in keeping with
the rules laid down by the government.
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 5.Central Bank Lender of Last resort

• The central bank encourages member banks to

borrow funds from the so-called “discount window”.
• This facilities help such institutions in times of stress
so as to save financial structure of the country
from collapse.

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 6. Clearing House for transfer and
settlement

• It acts as a clearing house for transfer and

settlement of mutual claims of commercial banks

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 7. Controller of Credit

• This is the most important function of central bank in

order to control inflation and deflation.
• Additional controlling functions of Central banks
include the supervising and controlling of commercial
banks:
– Issue of licences
– The regulation of branch expansion
– To see that every bank maintains the minimum paid
up capital and reserve as provided by law
– Inspection or auditing the accounts of banks
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7.Controller of Credit…. Cont’d

• To approve the appointment of chairpersons and

directors of such banks in accordance with the rules
and qualifications
• To control and recommend merger of weak banks
in order to avoid their failures and to protect
interest of depositors
• To recommend nationalization of certain banks
to the government in public interest
• To publish periodical reports relating to different
aspects of monetary and economic policies

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 Central Bank and objectives of Credit
Control
• The credit control is the means to control the lending
policy of Commercial banks by the central bank to
achieve the following objectives.
– To stabilize the internal price level
– To stabilize the rate of foreign exchange
– To protect the outflow of gold
– To control business cycles
– To meet business needs
– To have growth with stability.

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 Monetary Policy (MP)
• Monetary policy is the setting of the money supply
by policymakers in the central bank.
• MP refers to credit control measures adopted by
central banks of a country
• MP refers to a policy employing central bank’s
control of the supply of money as an instrument for
achieving the objective of general economic policy.
• MP is any conscious action undertaken by the
monetary authorities to change the quantity,
availability, or cost of money.

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 Money Supply
• The money supply (or money stock): the quantity of
money available in the economy

• Assets considered part of the money supply:

– Currency: the paper bills and coins in the hands
of the (non-bank) public
– Demand deposits: balances in bank accounts that
depositors can access on demand by writing a
check
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 Measures of the Money Supply

• M1: currency, demand deposits, traveler’s checks,

and other checkable deposits.

M2: everything in M1 plus savings deposits, small

time deposits, money market mutual funds, and a few
minor categories.

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 Objectives of MP

• The Principal objectives of Monetary Policy:

1. Price Stability
2. Economic Growth
3. Balance of Payment
4. Full Employment
Mission of the National Bank of Ethiopia:
To maintain price and exchange rate stability, to foster
a sound financial system and undertake such other
functions as are conducive to the economic growth of
Ethiopia (http://www.nbe.gov.et)
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 1. Price Stability objective of Central Banks

• Price Stability means relative controlling of inflation or

deflation.
• Deflationary price level raises increasing unemployment and
falling level of out put and income. It ultimately leads to
depression.
• Inflation is unjust and ruins the general economic welfare of
the community
• The goal of price stabilization is the average price level as
measured by the whole sale price index or consumers’
price index should not be allowed to vary beyond narrow
margins.
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 2. Economic Growth Objective

• Economic growth can be defined as the process whereby

the real per capita income of a country increases over a
long period of time.
• It is measured by the increase in the amount of goods
and services produced in a country.

• Monetary Policy contribute to Economic Growth

through:
– Management of Aggregate Demand
– Encouragement to saving and Investment
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 3. Balance of Payment objective

• A balance of payment is the difference between the

amount paid by a national government to other
countries and the amount it receives from them.

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 4. Full Employment Objective

• Full employment is a situation in which every

body who wants to work get work ( Keynes).

• It should be noted that full employment is not an end in

itself. It is a precondition for maximum social welfare.

• Along with the full employment of labor, other economic

resources must be used with maximum efficiency and
productivity.

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 Instruments of Monetary Policy
• The instruments use by monetary authority to achieve the
objectives of MP divides in to two categories:
1. Quantitative, general or indirect includes:
• Bank rate variations,
• Open market operations, and
• Changing reserve requirements.
– They are meant to regulate the overall level of credit
controls in the economy through commercial banks.
2. Qualitative, selective or direct includes
• Changing margin requirement, and
• Regulation of consumer credit.
– They aim at controlling specific types of credit. 24
1. BANK RATE POLICY: AS INSTRUMENT OF
MP
• The bank rate is the minimum lending rate of the
central bank at which it rediscounts first class bill of
exchange and government securities held by
Commercial Banks (CBs).

• When there is inflation in the economy the central bank

raises the bank rate which affects the cost of credit:
– Borrowing from the Central bank becomes costly
and commercial banks borrow less from it.
– The Commercial Banks in turn raise their lending to
the business communities and borrowers borrow less
from CBs.
– There is contraction of credit and prices are checked
from rising further 25
 Bank rate Policy: as Instrument of MP

• When prices are depressed, the central bank lowers the

bank rate:
– It is cheap to borrow from national bank (NB) on the
part of the CBs.
– The latter also lower their lending rates.
– Business people are encouraged to borrow more.
– Investment is encouraged.
– Output, employment, income and demand start rising
and the downward movement of prices is checked.

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 2. Open Market Operation: as instrument of MP

• Open market operation refers to sale and purchase of

securities in the money market by central bank.
– With rising price (inflation), the NB sells securities.
• The reserve of CBs are reduced and they are not
in a position to lend more to business people.
Further investment is discouraged and the rise in
prices is checked.
– When recessionary forces start in the economy, the
NB buys securities.
• The reserves of CBs are raised. They lend more.
Investment, output, income and demand rise, and
fall in price is checked.
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 3. Change in reserve ratio: as Instrument of MP

• Every bank is required by law to keep a certain percentage

of its total deposits in the form of a reserve fund in its vault
and also a certain percentage with the central bank (NB).
– For instance, when prices are rising, the NB raises the
reserve ratio.
• Banks are required to keep more with the central
bank.
• Their reserves are reduced and they lend less.
• The volume of investment, output, and employment
are adversely affected

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 4. Selective Credit Controls
• These controls are used to influence specific types of
credit for particular purpose.

– When there is rapid speculative activity in the

economy or in particular sector in certain
commodity, and prices are rising, the NB raises
margin loans against specified securities.

– The result is that the borrowers are given less

money in loans against specific securities.

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 Types of financial institutions
• Financial institutions can be classified in many different
ways.
• The standardInstitutions
Depository classification, however, will be as follows:
Non-Depository
Institutions

Commercial Banks Insurance Companies

Savings and Loan Pension Funds

Associations
Credit Unions Investment Banking firms

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 Depository Institutions (DIs)
• DIs accept deposits from economic agents (liability to
them) and then lend these funds to make direct loans or
invest in securities (assets)

• Income of DIs:

– Income generated from loans

– Income generated from investment in securities, and

– Fee income
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 Asset/ Liability Problems of DIs
• Spread Income (margined Income)= Income from loan and
Investment Less cost of its funds (deposit)
• DIs face the following risks:
– Credit (Default) risk- the risk that a borrower will default
on a loan obligation or that the issuer of the security that
the DIs holds will default.
– Regulatory risk - the risk that regulators will change the
rules and affect the earnings of the institutions
unfavourably.
– Funding risk (interest rate risk) - the risk that the
interest rate movement may move in such a manner that
profits will be adversely affected.
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 A. Commercial Banks

• Commercial Banks are those FIs which accept

deposit from the public repayable on demand and
lend them for short periods.

• Functions of Commercial Banks

1. Primary Functions (Accepting deposits and lending
money)
2. Secondary Functions (agency services and general
utility service)

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 Primary Functions of Commercial Banks

1. Accepting deposits
– Current or demand deposits
– Saving deposits
– Fixed or time deposits
2. Lending Money
– Overdrafts
– Loans and Advances
– Discounting of bill of Exchange

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 Secondary Functions: Agency service

– Conduct of stock exchange transaction such as

purchase and sale of securities for the customers,

– Acting as executor and trustee,

– Providing income tax services,

– Conduct of foreign exchange business

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Secondary Functions: General Utility service

• Safe keeping of valuables

• Issue of Commercial letters of credit and travellers’

cheque,

• Collecting trade information from foreign countries

for their customers

• Arrange business tours

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Regulation of Commercial Banks
Types of Regulations of CBs
1. Safety and soundness regulation,
2. Monetary policy regulation,
3. Credit allocation regulation,
4. Consumer protection regulation,
5. Investor protection, and
6. Entry and chartering regulation,

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 1. Safety and Soundness Regulation

• The objective of this regulation is to protect

depositors and borrowers against the risk of
commercial banks failure.
• These regulation include:
Layer 1 protection:
Commercial banks should diversify their assets-
• In US banks are prohibited from making loans
exceeding 10% of their own equity capital
fund to any one company or borrower.

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 1. Safety and soundness regulation (cont’d)
Layer 2 protection:
– Stockholders’ equity to the total fund of the banks
should be adequate in such a way that it protects liability
claim holders against insolvency risk.
– The higher the proportion of capital contributed by
owners the greater the protection.
Layers 3 protection:
– Provision of guarantee fund
– Deposit insurance mitigates a rational incentive
depositors otherwise have to withdraw their funds at the
first hint of trouble.
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 2. Monetary Policy Regulation

• In most countries, regulators commonly impose a

minimum level of required cash reserve to be held
against deposits.

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 3. Credit Allocation Regulation

• Credit allocation regulation supports the commercial

bank’s lending to socially important sectors as
housing, farming etc.
• For example;
– a commercial bank may be required to hold a
minimum amount of assets (loan) in one particular
sector of the economy.
– The regulator may set maximum interest rate, price
or fees to subsidize certain sectors

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 4. Consumer Protection Regulation
• This regulation is concerned about the discrimination
on the basis of age, race, sex, of income (Banks should
not discriminate on such grounds).
– CBs shall submit reports to regulators summarizing
their lending on a geographic basis, showing the
relationship between the demographic area to
which they are lending and the demographic data
(such as income and percentage of minority
population) for that location.
– CBs must report the reason that they granted or
denied credit.

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 5. Investor Protection Regulation

• Various laws protect investors against abuse such as

insider trading, lack of disclosure, outright, and
breach of fiduciary responsibilities.

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 6. Entry and Chartering Regulation

• The entry of Commercial Banks is regulated, as their

activities once they have been established.
• Increasing or decreasing the cost of entry into a financial
sector affects the profitability of firms already competing
in that industry.
• Thus, the industries heavily protected against new entries
by high direct costs (e.g. through capital requirements) and
high indirect costs (e.g. by restricting the type of
individuals who can establish CBs) of entry, produce larger
profits for existing firms than those in which entry is
relatively is easy
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END OF CHAPTER TWO

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