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 UNIT I
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THE NATURE OF BANKING

INDUSTRY AND THE
CENTRAL BANKING

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 Presentation Outline
i. Evolution of the banking sector in the world
and Tanzania
ii. Outline theories of banking structure
iii. Explain functions of commercial banks in an
economy
iv. Explain the importance of bank regulation and
supervision

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 History of Banking
 Banks are said to be the oldest and
most familiar of all financial institutions.
† Evolution of commercial banking is
related to the practice of safe-keeping of
gold and other valuables by the people
with merchants/goldsmiths/money-
lenders

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 History of Banking
† In the 17TH century many
people in London held their wealth in
gold.
† During the civil wars people came to
fear loss of their valuable assets due
to theft and expropriation by the
government. They usually looked
around for someone who had vaults
and safes to look after their wealth.
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 History of Banking
† Gold and silver smiths had such
vaults/safe.
† Goldsmiths took these deposits for
safe keeping, issuing a receipt which
acknowledged the deposit for money
and incorporated a promise to return
it on demand.

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 History of Banking
† More and more people came to hold
these receipts and they came to
circulate amongst merchants.
† Originally, merchant A wishing to buy
something from B, would take his
receipt back to the goldsmith
surrender it, and get his money back.
Then he would buy the article from B

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 History of Banking
† This was taking quite longer hence it
was quicker and more convenient for
A to pass the goldsmith’s receipt on
to B, who could either keep it or cash
it at the goldsmith. Where the
goldsmiths name was well known and
his reputation good, such circulation
became common thing.

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 History of Banking
† To pass the right to the ownership of
the receipt to B, A ‘endorsed’ the
receipt before passing it on to B, that
is, he signed his name on the back of
it.
† In time B found it more convenient to
pass the receipt on to C rather than
to cash it.

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 History of Banking
† The receipts came to be issued in
convenient amounts - £5, £10, £100,
etc.
† To facilitate this passing of the
receipts from one hand to another,
the goldsmiths began to write on the
note his personal promise to pay any
bearer.

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 History of Banking
† After circulation of these receipts for
a certain time the need for
endorsement disappeared since the
receipts had the power to pay the
bearer.
† People stopped calling them receipts
and addressed them as ‘goldsmith’s
notes’.

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 History of Banking
† From this it can be noted that the
goldsmiths began to exercise some
of the functions of a banker such
as;
 They kept money and valuables on
safe deposit.
 They issued notes.

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 History of Banking
† And it was no longer before they
developed another important
banking function, that of lending.
† Goldsmith noticed that the
demands of repayment were
always less than the total deposits.
† The goldsmith always had some
cash in hand, and he started to
lend this out, charging interest.
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 History of Banking
† In the beginning, the merchants
always paid commission or a fee on
the deposits.
† But after realising that these business
is profitable they began to offer
interest on deposits, so as to get
more money deposited, which he
could then profitably lend.

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 History of Banking
† In the county side, there were no
banks to go to, it was usual for the
farmer to approach the most
prosperous and best established
trader in the country town, and ask
him if he would lend the money,
which he usually did, of course
charging interest.

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 History of Banking
† The trader thus started to lend but
with time like the goldsmiths they too
encouraged people to deposit money
with them, so that he would have
plenty to lend, and issuing his notes
for such sums deposited. This was
thus the beginning of the country
banks.

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 History of Banking
† However, with time banks became a
very large part of the economy of
various countries.
† The first modern bank was the Bank
of England in 1694.

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Evolution of the Banking Sector
in Tanzania
 The evolution of banking sector in Tanzania can be
broken down into three main phases.
 colonial era and the period before Arusha Declaration
of 1967,
 post Arusha Declaration and the period prior to 1991,
and
 the period after 1991up to date.

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 Colonial Era and the Period Before Arusha
Declaration in 1967
• The development of the banking sector started way back in the early
1900s.

• Commercial banks were the dominant financial institutions in the then

Tanganyika.

• During the German rule there were two commercial banks established in
Tanganyika, namely:
– the Deutsche Ostafrikanische Bank (1905)
– Handels bank fur Ostafrika (1919)
• These banks were mainly for serving colonial rulers and a few
businesses.

• After World War I in 1918, the British took over the control of the
country from the Germans.
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 Colonial Era and the Period
Before Arusha Declaration in
•
1967
Three commercial banks were established in order to replace the
German banks. These banks were:
– the National and Grindlays Bank,
– the Standard Bank and
– the Barclays Bank D.C.O.

• In the early 1950s, other banks from India opened branches in

Tanganyika. These were:
– Bank of India and
– the Bank of Baroda, which opened branches in Dar es Salaam, Moshi
and Mwanza.

• Other banks that established their presence in Tanganyika included

an Anglo-French institution known as the Ottoman Bank, which
operated in Dar es Salaam, Kigoma and Moshi.
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• During the 1950s, specialized Non- Bank Financial Institutions
(NBFIs) started to evolve.

• By the time of independence in 1961, the country’s banking industry

was comprised of the following
– Standard Bank of South Africa,
– National and Grindlays Bank,
– Barclays Bank DCO
– Ottoman Bank.
– Bank of India,
– Bank of Baroda,
– Commercial Bank of Africa, and
– The National Bank of Pakistan.

• NBFIs which were present on the day of independence included:

– Post Office Savings Bank,
– Land Bank,
– Local Development Loan Fund,
– African Productivity Loan Fund
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The colonial banking system was characterized by the
following:
– dominance of foreign owned commercial banks;
– inability to sufficiently mobilize savings and deploying funds
to productive sectors of the economy; and concentration in
urban areas such as Dar es Salaam, Mwanza, Moshi and
Kigoma.

•After independence, the government established new

financial institutions to compliment those existing at that
time.
– The Tanzania Bank of Commerce (TBC) in 1965
– The People’s Bank of Zanzibar in 1966
– Agriculture Credit Agency, in 1962, and later converted to
National Development and Cooperative Bank in 1964.

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 Banking System in Tanzania
† During the colonial period there was no
Central Bank and the EACB used to act
as the Central Bank by controlling over
the supply of currency.
† Originally, EACB operated in Tanzania

Mainland, Kenya, and Uganda.

† Zanzibar adopted its own currency in
1936.

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 Banking System in Tanzania
† After independence the banking
industry still continued to face
numerous changes.
† In 1965 the decision by the East
African authorities was to stop the
functions of EACB and establish
separate Central Banks in Tanzania,
Kenya, and Uganda.

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 Banking System in Tanzania
† The Bank of Tanzania Act, 1965,
was passed by the National
Assembly in December 1965, and
the Bank was opened by the first
President of Tanzania Mwalimu
Julius K. Nyerere on June 14, 1966.

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 Banking System in Tanzania
† The Act empowered the Bank of
Tanzania to perform all the traditional
central banking functions.
† However, within eight months of the
inauguration of the Bank, in February
1967, the Arusha Declaration was
proclaimed, and, with it, the Bank
had to reorient its policies.

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 Banking System in Tanzania
† Following the Arusha declaration of
February 1967, all commercial banks in
Tanzania, with the exception of National
Cooperative Bank (NCB) and the Peoples
of Bank of Zanzibar (PBZ), were
nationalized

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Post Arusha Declaration and the Period Prior
to 1991
• In 1967, following the Arusha Declaration, all private commercial banks
were nationalized and their assets and liabilities were merged resulting
into the establishment of one big commercial bank, namely the National
Bank of Commerce (NBC)

• The period after the Arusha Declaration was marked by rapid

development of non-bank and development financial institutions.

• Tanzania Investment Bank (TIB) was established in 1970;

– to provide development finance to the country’s productive sectors
especially large-scale industry.

• Tanzania Rural Development Bank (TRDB), was established in 1972;

– to provide financing to the rural sector. The bank was later restructured and
changed its name to Cooperative and Rural Development Bank (CRDB).
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 The Period After 1991
• In 1988, the Government formed a Presidential Commission on
Banking under the Chairmanship of the former BOT Governor,
Ambassador Charles Nyirabu.

• The reasons for the formation of this Commission were threefold.

– The banking industry was performing very poorly. Increased losses and
non-performing assets (NPAs) resulted mainly from lending to
financially distressed parastatals and cooperatives.

– There was an increase in the subsidies to the banks which were a burden
to the Government.

– A non-declaration of dividends by the banks. Since the Government had

invested in those banks, it expected to get a return from its investments.

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The Period After 1991

• Following recommendations of the Commission, the Banking and Financial Institutions Act (BFIA)
was enacted in 1991 to govern the conduct of banking business in Tanzania.

– The Act gave the Bank of Tanzania powers to license, regulate and supervise banks and financial institutions.

– It allowed entry of foreign and domestic private banks in the market.

• Some of the early entrants into the banking system with years of entry in brackets were: Meridian
Biao Bank Tanzania Limited (1992) later taken over by Stanbic Bank Tanzania Limited (May 1995),
Standard Chartered Bank Tanzania Limited (December 1993), Eurafrican Bank Tanzania Limited
(November 1994), and Citibank Tanzania Limited (May 1995).

• The NBC was restructured in 1997 and three separate entities were formed, namely:
– NBC (1997) Limited,
– the National Microfinance Bank Limited and
– Consolidated Holdings Corporation.
• The Cooperative and Rural Development Bank was also restructured into a private bank in 1996 and
renamed CRDB (1996) Bank Limited. This bank later changed its name to CRDB Bank PLC
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 The Period After 1991
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 The situation is now different

- Commercial banks – 34
- Development banks – 2
- Microfinance banks – 5
- Community banks - 5

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 ii. Theories of Banking
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 There are three theories of banking, these are ;

 The financial intermediation theory of banking
 The credit creation theory of banking.
 The fractional reserve theory of banking

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 The Financial Intermediation Theory of Banking
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 The financial intermediation theory of banking is based on

the theory of informational asymmetry and the agency theory.

 The studies regarding informational asymmetry approach

especially the problematic of relationships between bank and
creditors, respectively bank and debtors.

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 The Financial Intermediation Theory of Banking
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 In the relationship between bank and borrower the main

aspect analyzed is the function of the selection bank and the
tracking of the granted loans; problems of adverse selection
and moral hazard.
 In the relationship between bank and depositors (creditors) a
special attention is given to the factors that determine
depositors to withdraw their money before due date.

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 The Financial Intermediation Theory of Banking
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 As regards the agency theory, the process of performing their duties as

intermediaries serve as agent to the suppliers of funds, they must maintain the
liquidity and profitability status of the stakeholders via monitoring services, risk
management, insurance services, creating liquidity and transforming durations.
 Agency costs are the principal economic dead-weight costs to the intermediary for
providing solutions in-order to retain assurance of performance of customer’s
contracts.

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 Credit Creation Theory of Banking
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 Money within the economy can take several forms;

 Cash (notes and coins) accounts for only 3% of the money
in circulation,
 While 97% of the money in circulation comprises of credit
money that has been created by banks.

(Ryan-Collins, Greenham, Werner & Jackson, 2011).

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 Credit Creation Theory of
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Banking
 Credit creation theory of banking suggests that individual
banks can create money, and banks do not solely lend out
deposits that have been provided to the bank.
 Instead, the bank creates bank deposits because of bank
lending.

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 Credit Creation Theory of
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Banking
 A bank’s ability to create new money, which is
referred to as ‘credit money’, is a result of a range
of factors;
 Non-cash transactions account for more than 95% of all transactions
conducted within the economy,
 Non-cash transactions being settled through non-cash transfers
within the banking system.

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 Credit Creation Theory of
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Banking
 Consequently, the amount of money that a bank can create is
not constrained by their deposit taking activities, and the act
of bank lending creates new purchasing power that did not
previously exist.
 Banks’ ability to create credit money arises from combining
lending and deposit taking activities.

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 The Fractional Reserve Theory of Banking
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 Fractional Reserve Banking refers to the policy that requires

banks to keep a portion of their deposits “in reserve”, rather
than loan them all out.
 The policy is stipulated by Central Banks as part of its overall
role in implementing monetary policy.

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 The Fractional Reserve Theory of Banking
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 The amount of money that banks are required to hold back is set by
the Central Bank as a percentage of total deposits and the Central
bank changes the reserve requirement periodically to ensure the
safety of the banking system as well as to influence the money
supply.
 Since the amount of money available can affect inflation, interest
rates, and other economic variables, the Central Bank changes the
reserve requirement at banks when necessary to help keep those

variables under control.

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 iii. Functions of Commercial Banks in an
Economy
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 The modern financial system is composed of many

institutions in which individuals and groups can put their
funds.
 Commercial banks, Saving banks, Mortgage banks,
Investment banks, Industrial banks, Agricultural banks, etc.
 When the word bank stands / used alone, means a particular
type of an institution, a Commercial bank.

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 Functions of Commercial Banks in an Economy
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 A commercial bank has many features, but the most

important one is that it is the only institution that accepts
funds from the public repayable on demand and withdrawable
by cheque.
 The money which is accepted from the public by commercial
banks is used to give loans to those who need it.

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 Functions of Commercial Banks in an Economy
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 Commercial banks play a significant role in economic

activities of an economy hence regarded as instruments of
economic growth with social justice.
 They mobilize the savings of the community and channel
them into socially productive investments.

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 Functions of Commercial Banks in an Economy
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 To understand the economic significance banks, it worth to

analyze the various functions performed by commercial
banks.
 Generally, these functions are classified into two categories;
 Primary functions, and
 Secondary functions.

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 Functions of Commercial Banks in an Economy
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 Primary Functions:

1. Acceptance of Deposits
 From the standpoint of withdrawal, deposits accepted by
banks fall into two categories;
 Demand deposits, and
 Time deposits.

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 Functions of Commercial Banks in an Economy
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 Demand / Current deposits; are payable on demand and can

be withdrawn without previous notice to the bank.
 These deposits are maintained by the depositors who have
need for liquid balances.

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 Functions of Commercial Banks in an Economy
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 Saving deposits; are used by banks to pool the small savings

of low- and middle-income groups.
 Certain restrictions are imposed on saving deposits and they
vary from bank to bank.

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 Functions of Commercial Banks in an Economy
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 Time deposits; are not repayable on demand, they are deposit

which are repayable on a fixed date or after a period of notice.
 Such deposits include Fixed Deposits and Short Term
Deposits.

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 Functions of Commercial Banks in an Economy
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2. Lending or Investment

Lending


 Short term loans and advances

Investments


 Long term and medium term investments

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 Functions of Commercial Banks in an Economy
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 Secondary Functions
 Besides the primary functions, banks also carry out other
functions termed as Secondary or Auxiliary functions, these
are of two types;
 Agency Services, and
 General or Miscellaneous Services

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 Functions of Commercial Banks in an Economy
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 Agency Services;
 Colleting and payment of cheques
 Buying and selling of the securities
 Trustee and Executor services
 Collection and payment of bills
 Standing instructions
 Etc.

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 Functions of Commercial Banks in an Economy
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 General or Miscellaneous Services;

 Advisory services
 Safe custody of valuables
 Provision of ATM, debit / credit cards
 Insurance services

Etc.

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 iv. Bank Regulation and Supervision
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 Bank regulation and bank supervision are two terms which are
sometimes used interchangeably, but they are different.
 Bank regulation: This refers to the written rules that define
acceptable behaviour and conduct for financial institutions.
 Bank supervision refers to the enforcement of these rules.

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Bank Regulation

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Arguments for Regulation
 Several economic and non-economic reasons have been
given to justify banking regulations. These include:
 To protect depositors,
 To assure the safety and soundness of banks,
 To avoid (or to limit) the effects of bank failures,
 To maintain monetary stability,
 To protect the payment system and
 To encourage efficiency and competition in the
financial system and in the economy.

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 Arguments Against Regulation
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 Several arguments suggest that regulation can itself be a source of

costs, negative effects and instability.
 Costs involved;
 The administrative costs of the regulatory authorities
 The administrative costs of the regulated banks
 The cost of dedicated capital to comply with capital requirements
 The contribution to funds needed to compensate the clients of other
banks which have failed.

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 Arguments Against Regulation
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 Danger of excessive regulation which may reduce

competition;
 Regulation constrains banks’ diversification by limiting their
portfolio choices or by restricting branching,
 Regulation raises costs and thus reduces profitability and it
lowers the rate of financial innovation.

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 Arguments Against Regulation
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 Regulation can create moral hazard.

 Banks may take more risk if they know they are likely to be bailed
out if they get into difficulties.
 Depositors are less likely to monitor what banks are doing if they
know there is a regulator monitoring on their behalf and there is a
deposit insurance scheme to pay them.
 The danger that excessive regulation imposed in one centre will
lead to the movement of the activity to centres where regulation is
lighter.

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 .
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Bank Supervision

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 Introduction
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 Bank supervision aims at overseeing those who operate

banks, and how the banks are operated.
 It helps to reduce moral hazard and adverse selection in the
banking industry through restrictions on entry and bank
examinations.

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 Restrictions on Entry and Bank Examination
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 To operate as a bank, a firm must obtain a banking license.

 A banking license will only be issued to a firm;
 Well capitalized (paid-up capital and reserves ),
 Has an adequate system of liquidity, internal control and good
quality of management.

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 Restrictions on Entry and Bank Examination
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 An internationally recognized framework used by bank examiners

to evaluate banks is the CAMELS system which stands for;
1. Capital adequacy
2. Asset quality
3. Management quality
4. Earnings’ performance
5. Liquidity
6. Sensitivity to market risk.

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 International Banking Regulation
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 While regulators can closely supervise the operations of

domestic banks in their own country, they have problems in
examining the foreign operations of domestic banks or
foreign banks with domestic branches
Who supervises who?
 A bank may exploit this by obtaining its license in a country
with weak regulation but conduct most of its operations in
other countries.
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 International Banking Regulation
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 In July 1992 the Bank for International Settlements (and in

particular, the Basel Committee) issuing a new set of
minimum standards for the supervision of international
banking.
 A bank operating in many countries will be supervised by a
single home-country regulator, which can ‘capably perform
consolidated supervision’, with enhanced powers to acquire
information.
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 International Banking Regulation
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 Where a regulator believes that the home country regulation

of a bank is not effective, it can restrict the operations of the
foreign bank.
 Following this development, cooperation among regulators in
different countries and standardization of regulatory
requirements represent the new trend in banking regulation.

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Any Issues for Clarification?

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 69

Thank you for Listening

End

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