TOPIC FOUR :COMMERCIAL AND CENTRAL BANKING

Evolution and Origin of Banking

From the topic of evolution and development of money, the goldsmith, whom people deposited
their valuables like gold for safekeeping for a fee were issued negotiable and redeemable
receipts. These receipts were in turn given to sellers of commodities by buyers as substitute for
money (paper money). This shows that the goldsmith’s receipts served as promissory notes and
was then accepted as both a medium of exchange and as a means of payment. The goldsmith
later found out that on the average, the withdrawals of the gold (coins) were much less than the
deposits with him, he then started advancing them on loans to those who wanted them and
charge interests on them. Through such loans the goldsmith-cum-money lender stated
performing two functions of modern banking- that of accepting deposits and advancing loans.
The foregoing reveals that banking development therefore came out of the habit of “safe-keeping
of valuable” for a token payment for the services rendered by the goldsmith.

Definition of a Bank
A bank is defined in either of the following two aspects:
i. Functionality, i.e. functional definition of a bank as “any type of institution that renders
banking services” thus, a bank is an “institution for the keeping, lending and exchanging
of money”.
ii. Legal requirements, i.e. legal definition of a bank. Banking business means the business
of receiving deposits on current accounts or any other similar accounts, and the payments
or deposits of cheques which are drawn by or paid by customers on themselves. The
primary business of banking is the custody services, credit delivery schemes, among
others.
A bank can be defined legally as any financial institution that performs banking services and at
the same time licensed as a bank under the law of the land established by the central bank
Some economists have defined banks and banking business various ways, all pointing to the
functions or services they render.
G. Crowther defines it as “the business of taking debts of other people to offer his own in
exchange, and thereby create money”. R.S. Sayers gives a more detailed definition as “ordinary
banking business consists of changing cash for bank deposits and bank deposits for cash,
transferring bank deposits from one person or corporation (one depositor) to another, giving bank
deposits in exchange for bills of exchange, government bonds, the secured or unsecured
promises of businessmen to repay, etc.”

From the above discussion generally sums up that a bank is a legal institution which accepts
deposits from the public and in turn advances loans by creating credit. This makes it different
from other financial institution in that the later cannot create credit though they may be accepting
deposits and making advances.

Self-assessment exercise
Explain the term bank in relation to the functions it renders in the society.

Types of Banks
In general terms, about seven different types of banks can be identified in an economy. These
are:
i. Commercial Banks (retail banks) means any bank whose business includes the
acceptance of deposits which are withdrawn by cheques.
ii. Exchange banker (bankers that deal with foreign exchange and specialize in financing
foreign trade).
iii. Industrial banks (banks that provide finances to industries and underwrite the debentures
and share of industries).
iv. Agricultural Banks - banks that provide finances to farmers.
v. Corporative banks - banks organized in the principle of cooperation.
vi. Savings banks - banks that help promote small savings.
vii. Central Bank – the apex bank in a country which controls its monetary and banking
structure

Merchants banks receiving deposits on deposit account, provides finances, consultancy and
advisory services relating to corporate and investment matters, makes and manages investments
on behalf of any person or organization.(NB: A deposit account is a time deposit one that has
time frame).
Self-assessment exercise
Identify and explain the various types of banks operating in an economy.

Structure and Functions of Commercial Banks

Commercial banks perform a variety of functions in the economy. Some of their primary
functions are
1. Accepting Deposit (Acceptance and Safe-Keeping of Deposits). It is the oldest function of a
bank, keeping money (valuable) in its custody for a fee (commission). These deposits from
customers are of three kinds nowadays, savings deposits, current account demand deposits and
time or fixed deposits. The rate of interest paid on each kind of deposit depends on the length of
time it stays with the banks and other conditions lay down by the bank.

2. Granting of Loans and Advances

Granting of loans and advances to her customers is one of the primary functions of a commercial
bank. This they do by lending a certain percentage of the cash lying in deposits on a higher
interest rate than it pays on such deposits. In this way, the bank earns profits and carries on its
business. These are in the following forms;
i. Cash credit – against certain securities
ii. Call loans – to bill broker for not more than fifteen days but can be recalled at a very
short notice
iii. Overdraft – allowing customer draw cheques for a sum greater than the balance lying in
his current account
Discounting of bills of exchange held by a customer which matures within 90 days.

3. Credit Creation
Since they aim at earning profits, the commercial banks accept deposits, advance loans by
keeping small cash in reserve for day-to-day transactions. The loanee is not however paid cash
but allowed to draw money by cheque according to his need. In this way the bank creates credit
or deposits.
4. Financing Foreign Trade
They rendered this service to its customer by accepting foreign bills of exchange and collecting
them from foreign banks. They also trade in foreign exchange.

5. Agency Services
They act as agents to their customers by collecting and paying cheques, bills of exchange, drafts,
dividends, among other services.

Other functions of the community bank can be outline as follows:

6. Transferring of funds
7. Management of customer’s investment
8. Executor and trustee of wills.
9. Provisions of facilities for safe-keeping of important documents.
10. Foreign exchange (FOREX) facilities to travelers.
11. Advising customers on insurance matters.
12. Night safe facilities
13. Provision of services to importers and exporters.
14. Providing business status report and reference by writing reports or ensuring inquiries about
the financial standing of the customers when the need arises.

Self assessment exercise

Define a commercial bank and explain its role in any economy

Structure and Functions of Merchant Banks

A merchant bank to mean “a bank whose business includes receiving deposits on deposit
account, provision of finance, consultancy and advisory service relating to corporate and
investment matters, making or managing investment on behalf of any person.” Merchant banks
are generally referred to as “wholesale bankers”, that is, they cater for the needs of corporate or
institutional customers.
The major role of merchant banks in the economy includes the provision of long term finance by
engaging in activities such as equipment leasing, loan syndicating, debt factoring and project
financing. The primary functions of merchants banks is the provision of medium and long-term
finances and issuing of securities. Others can be outlined as below:
1. Banking functions
The banking services rendered by merchant’s banks can be outlined as follows:This is limited
only to corporate customers,, mostly large blocks which are not withdraw able with cheques.
Loans and advances facilities to customers by providing:
 Short term credits covering exports and imports
 Medium term credits for industrial equipment provision
 Long term finance for real estate, industrial agric development
 Loan syndication which helps customers diversifies their risks and loan portfolio
 Equipment leasing
2. Corporate Finance Functions. These include:
 Acting as issuing house at the Nigerian Stock Exchange (NSE) by being involved in the
public equity and debt issues
 Private placement of equity and debt issue
 Stock- broking service at the floor of the NSE
 Project financing
 Equipment financing
 Investment and financial adversary services
 Project management and structuring
3. Operational Services (i.e. international business):
 Documentary and clean credits and collection
 Remittances and receipts of funds
 Foreign Exchange transactions
4. Treasury services: These include:
 Investment in money market assets
 Issue of private sector money market assets
 Issue of negotiable certificates of deposits
Self assessment exercise
Define a merchant bank and explain its role in any economy

Meaning and Features of Credit

In general terms, credit, a word that took its origin from Latin meaning “to believe or trust” has
been adopted as an economic term. As an economic term, credit usually refers to “a promise by
one party to pay another for money borrowed or goods or services received. It is also a medium
of exchange to receive money or goods on demand at some future date. “It can however be
referred to, as many economists do, “as the right to receive payments or the obligation to make
payment on demand at some future time on account of the immediate transfer of goods.”

For credit to successfully satisfy its object, the following essential features must be present:
 Trust and confidence on the part of the borrower or buyer to the lender or seller.
 Time element, when the money or goods will be paid back or returned.
 Transfer of goods and services between the seller and buyer.
 The willingness and ability of the parties concerned, this is hinged on character (honesty),
capacity and capital of the parties in the transaction.
 The purpose of the credit presupposes the credit transaction either production or
consumption purpose.
 Security or collateral which is, in most cases, the base or important element for raising
the credit.

Self assessment exercise

Identify the factors that affect credit creation.

Credit Creation by Commercial Banks

Credit creation, a very important function of commercial banks is the process where they
(Commercial banks) make available to borrowers in the form of loans and overdrafts deposits in
their possession. Bank customers who want to enjoy credit facilities with them usually open and
operate current accounts. They therefore make withdrawal of credits granted them from such
accounts through the use of cheques, in most case, not cash. Credits are therefore credit by the
banks by their making use of cheques and clearing facilities.

Thus, credit creation requires bank opening a deposit every time they make loan available to
customers. The customers in turn open chequering account through which payments and
withdrawals are made finally effected through the Cheque clearing system. Thus bank loan
creates deposits and it is in this sense that credit is credited by commercial banks. Banks do not
give out all deposit they receive on loans and also depositors do not withdraw their money
simultaneously. They therefore keep small cash in reserve for day-to-day transactions, and then
advance the excess on this reserve on loans. Also, the banks are legally required to keep a fixed
percentage of their deposits in cash, and lend or invest the remaining amount which is called
excess reserves. The entire banking system can lend and create credit upon a multiple of its
original excess reserves. It calculates the maximum amount of money that an initial deposit can
be expanded to with a given reserve ratio – such a factor is called a multiplier.

As a formula, if the reserve ratio is R, then the money multiplier m is the reciprocal, m = 1 / R,
and is the maximum amount of money commercial banks can legally create for a given quantity
of reserves.In the re-lending model, this is alternatively calculated as a geometric series under
repeated lending of a geometrically decreasing quantity of money: reserves lead loans. In
endogenous money models, loans lead reserves, and it is not interpreted as a geometric series.
The money multiplier is of fundamental importance in monetary policy: if banks lend out close
to the maximum allowed, then the broad money supply is approximately central bank money
times the multiplier and central banks may finely control broad money supply by controlling
central bank money, the money multiplier linking these quantities

Bank Constraints in Credit Creation

In its process of credit creation by commercial banks, there exist some inhibiting factors. These
factors that limit the power of commercial banks to credit creation are:
The banking habit of the populace, i.e. the willingness of the people to use the facilities of the
banking system: Where this is high and people adopt and embrace banking habits, more cash/
deposits will be available to the banks, thus more credit creation.
Legal Reserve Ratio: The higher the legal reserve ratio of bank the lower the credit creation
ability of the banks and vice versa.
Security/collateral requirements by banks for loans: Where this is too stringent to borrowers,
their borrowing ability is lowered hence low credit.
The income level in the economy: The larger the income of the people, the greater the bank
deposits, all things being equal, hence higher credit creation
The credit control policy by the central bank. A contractionary credit policy will limit the credit
creation ability of banks, while an expansionary credit policy boosts the capacity.
The level of economic activities: Banks credit creation ability in period of depression is curtailed
because of its attendant consequences. Conversely credit is expanded when the economy is in
full swing; boost periods.
The banking behaviors and policy: The efficiency of the banking cheque clearing system, rate of
interest or (bank charges) for lending money to qualified borrowers and most especially the
bank’s willingness to make loans available to the investors all contribute and limits the credit
creation ability of banks. Leakages from the banking system by way of cash withdrawal for
spending or hoarding at home limits the credit creation ability of banks.The foregoing has
revealed that the commercial banks do not possess unlimited powers in its credit creation, but
there are some variables to be kept in sight and monitored properly, where possible as to keep the
benefits of this their important function in the economy.

Self assessment exercise

1. Identify and explain the various constraints against credit creation by commercial banks.
2. What do you mean by credit? Mention at least five types of credit prevalent in the
economy.
3. Discuss the role of credit in an economy.
4. What is a credit instrument? Mention at least four well know credit instruments.
5. Describe the process of credit creation by commercial bank
6. Outline the constraints that inhibit commercial banks’ power in credit creation.
THE CENTRAL BANK FUNCTIONS AND CREDIT CONTROL

Introduction
Banking transactions are businesses usually carried on by any individual or firm engaged in
providing financial services to consumers, businesses or government enterprises. In the broadest
sense, a bank has been seen as a financial intermediary that performs functions such as
safeguards and transfers funds, lends or facilitates lending, guarantees credit worthiness, and
exchanges money. These services are provided by such institution s as commercial banks, central
banks, savings banks, trust companies, life insurers, and investment banks. All these banks most
frequently organized in corporate form an downed by either private individuals, governments or
a combination of private and government interests are subject to government regulation and
supervision, normally implemented by the nation’s apex bank – central banking authority.

Evolution and Definition of a Central Bank

With the growth and development in the economy in areas of business and trade – internal and
international, there is need for a monetary control and regulations. Again, with the volume of
transactions in the banking sector the question arose regarding where the private banks will keep
their cash reserves, their own vaults were not really safe against a really determined attempt of
robbery. Where were the commercial banks to turn if they had made good loans and investment
that would mature in the future, but were in temporary need of reserves to meet an exceptional
demand to withdraw by their depositors? If banks provided loans to the public against reasonable
security, why should not some other institution provide loans to them against the some sort of
security? The Central Bank, which was itself a natural outcome of the whole system, therefore
emerged in response to these and other needs. At first, they operated as private profit oriented
institutions, providing services to ordinary banks, but their potential to influence the behaviour of
commercial banks was high than that of the whole economy which led them to develop close lies
with their central governments. Hence they became fully government owned, and then refrain
them from being non-profit making institution. The central bank has grown in many nations of
the world to become the apex institution of the monetary and banking structure. The central bank
has been defined in varied ways, each touching only an aspect of its functions. One of the
broadest definitions of the central bank is that credited to De. Kock. It says that a central bank is
a bank which constitutes the apex of the monetary and banking structure of its country and
performs, as best as it can in the national interest, the functions outlined as functions of the
central bank”. This definition can therefore be summed up as “an apex financial institution which
is charged with the responsibility of managing the cost, volume availability and direction of
money and credit in an economy with a view to achieving some desired economic objective”.

Functions of a Central Bank

The central bank is the foremost monetary institution in a market economy; usually government
owned whose responsibility is to the national interest. The functions performed by most central
banks can be broadly grouped as follows:
1. Banker to government
The central bank as banker to the government collects and disburses government incomes and
receipts in an account into which they can make deposits and also draw cheques.
2. Manager of government/public debt
The central bank helps the government with its debt requirements; managing the issues and
redemption of all government debts, advises her on all matters pertaining to financial activities,
and makes loans to the government. The central bank sources funds from various avenues both
internally and externally in form of borrowing, after considering its cost, convenience in
repayment, maturity and its availability.
3. Banker of the banking system
The central bank holds and transfers commercial banks’ deposits/funds among themselves
(cheques clearing system) and supervises their operations. The central bank also acts as “lender
of last resort” to the commercial bank by lending money to them when all other sources failed.
The commercial banks hold their required cash reserves against their outstanding deposit
liabilities in the form of their own deposit at the central bank. The central bank can act as lender
of last resort to the commercial banks, i.e. providing assistance when the banking system is short
of cash either by lending money to the discount house i.e. borrowing against approved financial
assets or buying bills and bonds directly from the commercial banks. The central bank also
provides technical and advisory services to the commercial banks.
4. Supporter of money market
The central bank tries to promote a sound financial structure in the economy through the
management of the money and capital markets. In this process, it creates a number of financial
instruments to keep the market alive; these include treasury bills, treasury certificates, certificates
of deposit, etc.
5. Agent of Monetary policy
The central bank attempts to regulate the economy by regulating the supply of money and the
terms and availability of credit. This they do for both domestic and foreign purposes by using its
variety of direct and indirect control over the financial institutions. This includes prescription of
cash ratio, liquidity ratio, and credit ceilings for the different sectors of the economy. Other tools
include the direct manipulation of the interest and discount rates, open market operation (OMO),
and moral suasion. In most countries, the central bank has the sole power to issue and control her
currency (coins and notes in circulation). These are usually the liability of the central bank.

Self assessment exercise

Identify and explain the functions of a central bank.

Monetary Policy Control Methods and Instruments

The operation of a nation’s monetary policy, a responsibility of the central bank, attempts to
influence the economy by the control of the monetary magnitudes which in turn checks
inflationary and deflationary pressures within the economy.
The major objectives of the monetary policy include the following:
1. Stabilization of internal price level.
2. Stabilizing the rate of foreign exchange
3. Protection of the outflow of foreign reserve
4. Control of business cycle.
5. Promotion of stable growth in the economy.
6. Meeting the monetary requirement of the business sector.
These could be summed into two:
Influence on aggregate demand and through the national income, employment and price, and
Protection or support on the country’s financial system from the kinds of panics and crashes that
have caused occasional havocs.
The primary instruments of general monetary control by the CBN are discussed hereunder.
(a) Open market operations (OMO)
The open market operations (OMO) refer to a monetary management techniques widely used by
monetary authorities to control the growth of liquidity in an economy.
OMO transaction consists of outright sales/purchases of government securities and is expected to
have a permanent effect on the level of liquidity in the economy.
(b) Cash Reserve Requirement (legal Reserve Ratio)
This is the percentage of deposits that banks must maintain on reserve with the CB whatever
amount that remains with the commercial banks over and above the minimum reserve is known
as excess reserve on whose basis they create credit. When the CB raises the required reserve
ratio, banks excess reserve will be reduced then unable to create as much money as they
previously were able to because a large portion of their assets must be held in reserve.
Conversely, where the reserve ratio is reduced, the banks will be able to create more, money in
the economy. Thus, the larger the cash reserve requirement the smaller the excess reserve and the
lower the ability of banks to create credit and vice versa.
(c) Bank Rate or Discount Rate Operation
Bank rate or discount rate is the rate at which CB rediscounts first class bills of exchange and
government securities when the commercial bank needs to borrow from the apex bank. It is the
interest rate charged by the CB at which it provides rediscount to banks through the discount
window. Thus, the CB can make changes in the discount rate in monetary control. When banks
seek additional reserves by borrowing from the CB, a significant escalation in the discount rate
makes such borrowing more expensive and consequently reduces demands for reserves, hence
contracting credit. Conversely, if the CB wants to expand credit, it lowers the bank rate, making
borrowing from the CB cheap. A discount rate change may, at times, reinforce OMO
(d) Moral Suasion
This involves the use of persuasion by the CB to the commercial banks to comply with the CB
guidelines on any economic problem arising from the banking sector. Such guidelines arose from
a democratic conference of representation of the CB and the banks on such identified problems.
Agreement reached at such conferences on how best to handle the problem becomes the
guidelines banks are asked to implement at their branches. Non-compliance with the provisions
of the guidelines may be punished by the CB.
(e) Liquidity Ratio
The liquidity ratio, the percentage of a bank deposits held in form of cash or eligible liquid assets
in the tills of the bank are also used as a monetary policy instrument. Money supply is reduced
when this liquidity ratio is increased resulting in reduction in the banks excess reserves.
A reduction in the liquidity ratio leads to increase in the excess reserve, thus increase in the
credit supply by banks.

Self-assessment exercise
1. Identify and explain the monetary policy instruments being used in the economy.

THE ROLE OF THE CENTRAL BANK IN A DEVELOPING COUNTRY

Creation and Expansion of the Financial System

The commercial banks that have the function of credit creation in the economy are mostly profit
oriented institutions. They therefore prefer to be localized in the big cities to provide credit
facilities to estates, plantations, big industrial and commercial ventures. The commercial banks
hitherto provide only short-term loans to the aforementioned groups, thus credit facilities in the
rural areas to peasant farmers, small business men/women and traders were mostly nonexistent.
The central bank in its bid to improve the currency and credit system of the country issues
directives to the commercial banks to extend branch banking to rural (i.e. rural banking scheme)
areas to make credit available to the rural business operatives. Also they are directed on the
provision of credit facilities to marginal farmers on short, medium and long term basis. The
central bank also encourages the establishment of community banks and other programmes
through which deposit mobilization and investment s are encouraged in the rural areas. The
central bank also helps in establishing specialized banks and financial corporations in order to
finance large and small industries.

Price Level Stability Role

In units six, seven and eight where we discussed the demand and supply of money and inflations,
you learned about the movement in price level resulting from the imbalance between demand
and supply of money. It is a general economic system that as the economy develops; the demand
for money is likely to go up due to increase in production and price. This if not properly checked
may result in inflation. The central bank controls the uses of policy that will prevent price level
from rising without affecting investment and production adversely.

Interest Rate Policy Stability Role

In developing economies, the existence of high interest rates in different sectors act as an
obstacle to the growth of both private and public investment. Since investors borrow from the
banks and the capital market for purposes of investment, it therefore, behaves the system to
encourage them by ensuring a low interest rate policy. Low interest rate policy is a cheap money
policy, making public borrowing cheap, cost of servicing public debt low and finally
encouraging and financing economic development. The policy becomes more effective if the
central bank operates a discriminatory interest rate, charging high rates for non-essential and
unproductive loans and lower rates for productive loans.

Debt Management Role

In developing economies in particular and every economy in general, the central bank manages
the domestic and foreign debts on the instruction of the Federal Ministry of Finance. Debt
management involves debt service payments and participation in debt restructuring through
rescheduling, debt refinancing, as well as debt conversion to ensure that the debt is reduced to a
manageable size. The aim of the bank in this results in areas of proper timing and issuing of
government bonds and securities, stabilizing their prices and also minimizing the cost of
servicing the public debt. In order to achieve this role, it becomes essential that the central bank
should ensure a low interest rate policy on these bonds to make them more attractive. Thus, for
this role of debt management to be successful, the central bank will ensure and encourage the
existence of well developed money and capital markets where both short and long-term
securities abound.

Momentary Stability
Monetary policy–the credit control measures adopted by the central bank of a country, is of vital
importance in the process of development. This is important because of how they influence the
pattern of investment and production through the conscious action taken by the bank in the
control of the supply of money. This mechanism in effect, when the proper mix of the control
instrument is adopted effectively, controls inflationary pressures arising in the process of
development. These instruments as we saw in the previous unit include – open market
operations, required reserve, ratio, bank rate or discount rate, among others.

Foreign Exchange Management Role

The central bank manages and controls the foreign exchange resources of a nation – its
acquisition and allocation in order to reduce destabilizing short-term capital flows. The bank thus
monitors the use of scarce foreign exchange resource to ensure that foreign exchange
disbursement and utilization are in line with the economic priorities at the same time in line with
economic priorities and within the foreign exchange budget. In this regard the central bank
further acts as the technical adviser to the government on foreign exchange policy, especially in
maintaining a stable foreign exchange rate. This, the bank still achieves this through exchange
controls and variations in the bank rates (discount rates). This role generally helps in achieving a
balance of payment equilibrium; a problem prevalent in the developing economies.

Central Bank of Kenya

The Central Bank of Kenya was established in 1966 through an Act of Parliament - the Central
Bank of Kenya Act of 1966.The establishment of the Bank was a direct result of the desire
among the three East African states to have independent monetary and financial policies. This
led to the collapse of the East Africa Currency Board (EACB) in mid 1960s.

Structure of the Bank

Responsibility for determining the policy of the Central Bank is given by the Central Bank of
Kenya Act to the Board of Directors. The Board consists of eight members:-
 The Governor, who is also its chairman
 The Deputy Governor, who is the deputy chairman
 The Permanent Secretary to the Treasury who is a non-voting member
 Five other non executive directors
All members are appointed by the President to hold office for a term of four years and are
eligible for reappointment. In the case of the Governor, appointment is for a maximum of two
terms of four years each and can only be terminated by a tribunal appointed by the President to
investigate his conduct. The executive management team comprises the Governor, the Deputy
Governor and fifteen heads of department who report to the Governor. The Bank operates from
its head office in Nairobi and has branch offices in Mombasa, Kisumu and Eldoret. The Bank
also owns the Kenya School of Monetary Studies (KSMS) which is headed by an executive
director answerable to the Governor.

The Central Bank Act and its relations with the Government
The Central Bank of Kenya Act of 1966 set out objectives and functions and gave the Central
Bank limited autonomy. Since the amendment of the Central Bank of Kenya Act in April 1997,
the Central Bank operations have been restructured to conform to ongoing economic reforms.
There is now greater monetary autonomy. Though required to support the general economic
policy of the Government, the Central Bank has independence in exercising the powers conferred
on it by the Central Bank of Kenya (Amendment) Act, 1996. However, both the Government and
the Central Bank make mutual consultations on important policy issues. The Central Bank, for
example, is required to advise the Government on monetary and fiscal policy issues and other
economic issues that may have important ramifications on the Bank’s monetary policy.

Mission of the Bank

The Central Bank plays a unique role in the economy and performs various functions not
normally carried out by commercial banks. Over time the functions of the Bank have evolved
with the changing economic conditions. As stipulated in the Central Bank of Kenya (Amendment
Act), 1996 its main task is that of "maintaining price stability and fostering liquidity, solvency
and proper functioning of a stable market-based financial system". It is therefore responsible for
formulating and executing monetary policy, supervising and regulating depository institutions,
assisting the Government’s financing operations and serving as Government banker, in line with
contemporary central banking practice the world over.