Unit 1

Banking and Finance in the

Modern Economy

Overview
One does not need to be a banker to realise the importance of banking in any economy.
This unit considers the principal role of banks and other financial institutions in
the financial system and the wider economy. We will look at what is money and its
importance to us. Banks accept deposits from people who need to save or offload
excess funds, lend to people who are short of funds (including the government), and
provide many services which keep the economy going. The role of banks in financial
intermediation and credit creation will be examined. We will examine how funds
will get from those who have them to lend, to those who need to borrow. The issue of
finance, which deals with how the banks and others raise their funding and how they
utilise them, will be looked at. In Part 2 of this topic, which we will deal with in Unit 2,
we will discuss what is finance and three aspects of finance. Namely corporate finance,
personal finance and public finance. Corporate or business finance deals with how
companies or corporations raise their funding, while personal finance relates to how
individuals make financing decisions to acquire the various assets or meet their pressing
needs. Finally, public finance will be focussed on, by reviewing how governments and
public sector entities raise money to meet budgetary requirements. Some of the basic
instruments used in finance will also be explored.

Unit 1 Learning Objectives

After completing this unit you should be able to:

• Explain the basic principles of banking

• Lay down the foundation for the understanding of banking in a modern economy
• Explain the role of financial intermediation and the creation money
• Corporate or business; personal and public finance

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 This unit is divided into sessions as follows:

Session 1: The Economy and Banking

Session 2: Money and the Role of Banking

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Session 1
The Economy and Banking

Introduction
An economy can be described as a system in which people make financial choices based
on limited resources. For example we have heard the saying ‘you must cut your garment
according to your cloth’ or ‘You can’t get a quart out of a pint pot’. Just think of the
amount of things we could buy if our salaries or wages were larger–new clothes, new
shoes, new furniture or a better car. The list has no end, for even if these wants were
satisfied, new ones would arise. In this session we will review basic economic principles
and concepts including the economic system and banking, which are based on needs
and wants in our economy.

Objectives
After completing this session you will be able to:

1. Compare the various economic systems

2. Define banking and compare the different types of banks in the region

The Economic System

In the introduction to this session we alluded to the economic problem–unlimited wants
but very limited means. We can never completely overcome this difficulty unless one
is very rich. So here is where banks and other financial institutions come in. But we
have another choice: we can make the most of what we have. This approach is called
economising.

The main problem of choice is the main economic problem the society faces. This
problem arises because of scarcity. The income of an individual and the resources of a
community are both limited, and all wants cannot be satisfied. Goods are scarce relative
to wants: choice must be made.

(a) Problems of an individual which influence choice include:

i) Division of time between work and leisure;

ii) choice of job;

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 iii) how much of one’s income to spend and how much to save;
iv) allocation of expenditure among the various goods and services;
v) in what form to keep wealth (goods, money, shares etc.).

(b) Problems of the community include:

i) what goods and services to produce and in what quantities,

ii) how to allocate the available resources among the production units,
iii) how the product is to be allocated among the members of the community; what
proportion of the goods made shall be capital goods and what proportion shall
be consumption goods.

I said previously that an economy is a system. It consists of the economic system of a

country or area, the labour (people), capital (a factor of production) and land resources,
as well as the economic agents that participate in the production, exchange, distribution
and consumption of goods and services of that area.

What is the Economic System?

We now come to the economic system. What is this? There are broadly speaking three
types of economic system, the main differences between them being who undertakes the
entrepreneurial function, and who owns the means of production. In a capitalist or private
enterprise system there is private ownership of capital, and the consumers, through the
attempt of entrepreneurs to satisfy their demands, really decide what shall be produced
and in what quantities. This is also known as the laisser-faire system.
In a planned economy (communist / socialist system) decisions regarding production and
the actual production itself are undertaken by the State.
In a mixed economy, the entrepreneurial functions are divided between individual
entrepreneurs in the private sector and the State (the public sector).
In a planned economy such as Russia, China or Cuba the means of production are
owned or controlled by the state. While the US economy is said be free enterprise or
market driven there is a substantial amount of government intervention in sectors of the
economy, which represents aspects of a mixed economy. Take for instance the fact that
wheat farmers in the USA are highly subsidised. However, the US economy seems to be
the nearest to a free market enterprise economy.
You can view the following video which discusses different types of economies, on your
course website in the Learning Exchange.

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ACTIVITY 1.1

1. BRAINSTORMING ACTIVITY: economic problems arise because of scarcity and choice;

identify:
a) any economic problems an individual faces other than those identified in this
Unit; and
b) the main economic problems of your community.

2. Discussion: Explain how a mixed economy differs from both a planned and
a free market enterprise economy and identify what activities take place in each to
illustrate the differences.

What is a Bank?
A bank is defined by Merriam-Webster’s online dictionary ([Link])
as “an establishment for the custody, loan, exchange, or issue of money, for the extension
of credit, and for facilitating the transmission of funds.”

In the USA a bank is defined as a financial intermediary that accepts deposits and
channels those deposits into lending activities over time and location. The US Congress
later defined a bank as any institution that could qualify for Deposit insurance
administered by the Federal Deposit Insurance Corporation (FDIC). This was to
regulate non-financial institutions (such as J C Penny and Sears) that wanted to either
accepted customers deposits or grant loans and at the same time wanted exemption
from regulation. The bank acts as a middleman between suppliers of funds and users
of funds, substituting its own judgment for that of the ultimate supplier of funds,
collecting those funds from three sources: demand deposits, saving and time deposits,
short term borrowing from other banks; as well as equity capital.

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 In the UK, under the UK Banking ACT 2009 a bank is interpreted as “a UK institution
which has permission under Part 4 of the Financial Services and Market Act 2004 to
carry on regulated activity of accepting deposits. This interpretation does not include
a building society, credit unions, or any other class of institution excluded by an Order
made by the UK Treasury.”

In the Caribbean a bank generally means any financial institution which accepts deposits
on current account, deposit account or other similar account and pays and collects
cheques drawn by customers over a period of time; and which makes loans.

Banks fulfil a valuable role in society by:

• Performing financial intermediation

• Creating financial products and services that benefit business and consumers
• Facilitating the creation of money
• Being involved in the transfer of funds.

What is Banking?
Now that we have attempted to define what a bank is, we could ask what is banking.
Banking can be defined as the “business of banking,” a vibrant business that continually
evolves to meet the latest financial needs and economic conditions. In order to
understand how banking evolves, it is important to gain a broad understanding
of financial concepts, fundamental banking functions and banking business in a
technologically driven world.

Banking business in our region as noted above involves the acceptance of deposits
on current accounts and other forms of deposit taking activity, paying and collecting
cheques to and on behalf of customers and making advances to customers.

Banks undertake different types of banking business. Firstly there is retail banking
business. Retail banking refers to the provision of services where the financial
institutions are dealing with large volumes of low value transactions. This is in contrast
to wholesale banking where the customers are large, often multinational companies,
government or governmental enterprises. The institutions deal in large-valued
transactions usually in small volumes. In practice it is difficult to identify purely retail
banks, limiting themselves to the tapping of the retail deposit market and lending only
in retail loan markets.

Secondly, wholesale banking involves banking services offered to corporations /

companies with sound financial statements, and institutional customers such as
pension funds (USA and the UK) and government agencies. Services include: lending,
commercial mortgages, working capital loans / overdrafts, leasing and trust services.

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Thirdly, universal banking is a system in several European countries where commercial
banks make loans, underwrite corporate debt, and also take equity positions in
corporate securities. For example in Germany commercial banks accept time deposit,
lend money, underwrite corporate stocks, and act as investment advisors to large
corporations. In Germany there has never been any separation between commercial
banks and investment banks as in the United States.

The advantages of this type of banking system have been debated. Universal banking
permits better use of customer information and allows banks to sell more services under
one roof as a financial supermarket. The main disadvantage is that universal banking
permits concentration of economic power in a handful of large banks that hold equity
positions in companies that are also borrowers of the banks.

Finally, unit banking is a system which offers the full range of their services from one
office; though a smaller number of services (such as taking of deposits and cashing of
cheques) may be offered from limited services facilities such as drive up windows and
ATMs. Under this system in the USA branch banking is not permitted as it is extensively
used in Canada and the UK.

ACTIVITY 1.2

Identify the types of banks in our region and what activities they perform. You may
consider the difference between wholesale and retail banks; and universal banks versus
unit banks.

Summary

In this session we explored the concepts of economic system and banking. We contrasted
the planned economy, market economy and mixed economy and discussed the meaning
of banking.

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Session 2
Money and the Role of Banking

Introduction
In the previous session we defined banking and the economy, setting the context for our
discussion of the role of banking, which is the topic of this session. We will commence
the session with a review of the history of money and then proceed to consider the role
of banking in our economy today.

Objectives
After completing this session you will be able to:

• Identify the functions of money

• Make linkages between the management of money and banking
• Assess the role of banking in the society

Money and Credit

Money is any commodity that is generally accepted as payment for goods and services
and repayment of debts in a given country or society.
Credit is any claim against a physical or legal person that can be used for the purchase of
goods and services. For example, the balance on a bank account, against which cheques
can be issued as payment to satisfy an obligation.

History of Money

Specialization and Exchange

This is an aspect of the history of money. When man was originally self-sufficient, and
he provided all his basic needs, namely food, clothing and shelter, for himself and his
family, there was no need for money.

As soon as specialization took place, however goods had to be exchanged one for
another and this raised the problem of the rate of exchange and the possible need for

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 some medium of exchange. The person who was good at fishing concentrated on that
activity and left the good huntsman to do the hunting. In this way both benefitted, as the
total yield of both fish and meat was likely to be more than if they had both fished and
hunted.

Barter
The exchange of one commodity directly for another, example fish for meat, is called
barter. Whereas this system of direct exchange is possible within a small community in
which the pattern of trade is a simple one, it is hardly conceivable in a modern society.
In fact we would not have our highly complex economy if alternatives to barter had not
been found. Barter raises many problems, which are easy to imagine such as:
• The rate of exchange - how is it to be measured
• Large indivisible units - a live animal, for instance, cannot be divided into small
units to exchange for other small items.
• Consistent quantity.
• Perishable commodities.

Money is the basis of banking. The basis of money is the need for a substitute for directly
bartering for everything we need. Barter can be better defined as trading without the use
of money - and it can be traced back to the very origin of civilization. Can you imagine
how our economy would operate if we did not have money? You would either have to
be completely self-sufficient or have to produce the goods or service that you would
trade for whatever you could not produce yourself. Most of us will spend our time
making almost everything we needed or working at a specialty that others needed so we
could trade for the necessities of life. The specialities would be few. Our technological
advances would be restricted by the incredibly inefficient system of exchange of goods
and services.

Indirect Exchange
Because of the difficulties of the barter system, one or more commodities were valued
above others, because they were scarce or particularly useful, and became the medium
of exchange. These were commodities that were readily acceptable as a means of
payment for goods. For example shells, oxen, salt, spears, amber, cotton cloth, and bags
of grain have at times been used in this way. They were in fact the original forms of
money.

The development of money was a significant advance over barter as a payment system.
But today we have extended the concept of payment systems beyond the original
concept of money. One of the first steps into more sophisticated payment systems was
the development of cheques and the use of current (chequing) accounts.

Money is a symbol of value, and cheques are a symbol of money. We give another
person a cheque when we want to give him or her money. The other person takes the
cheque and sends it through the cheque clearing system so that the money it represents
is transferred to him or her.

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Functions of Money

Medium of Exchange
From what has been considered so far it is clear that the most obvious function of money
is to act as a medium of exchange. It permits indirect exchange, but in order to do so the
money must be readily acceptable by those who have services to sell.

A Unit of Account
In addition to being a medium of exchange, money must act as a unit of account. This
means that it must be a measuring rod by which the values of other commodities can be
assessed. Instead of measuring the value of a commodity in terms of other commodities,
as it is necessary to do in a system of barter, each unit of commodity is valued in terms
of a unit of money. Not only does money enable goods to be indirectly exchanged,
but also the value of the output can be measured and recorded in money terms. The
Gross National Product (GDP) of a country can be quoted in dollars instead of so many
products.

Standard of Deferred Payment

Primarily money can be said to have two functions, a medium of exchange and a unit
of account, but in addition it is desirable that it should be a standard for deferred
payments. In other words, it is a means whereby debts can be measured and recorded.
Without this all transactions would have to be for cash and there would be no need for
the banks and other financial institutions. This implies that money is a store of value
which is the next basic function.

A Store of Value
The value of money must remain relatively constant otherwise people would not wish
to hold it. This is what is meant by a store of value. Even during periods of severe
inflation when the value of money has fallen quite rapidly, it has continued to function
as money. But there is a limit beyond which confidence in a currency will be maintained;
so much so that holders of it will switch to commodities as soon as possible. When
such a situation gets out of hand, the country is said to have hyperinflation and the
consequence is certain to be that the supply of money will have to be replaced. This
happened in Germany in 1922-23 and in Hungary after the Second World War. Until a
new form of money is issued, the community will devise its own form of money using
commodities of its own choice as a medium of exchange and a unit of account.

Money and the Price Mechanism

In a free society money, through the price mechanism, determines the allocation of
goods and services. Apart from the limited number of goods which are controlled by
the government, e.g., drugs and firearms, for which some authority or licence must
be obtained, the price mechanism and our willingness and ability to pay the prices

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 determines who is going to have the goods or services. At the other extreme in a
complete totalitarian state, all the goods and services are produced and distributed by
the State and it is just conceivable that the community could manage without money,
though this would not be very practical in our modern world.
The price mechanism is a system which determines the supply and consumption of
goods and services based on the prices buyers are willing and able to pay. Through its
four functions, money thus plays a vital role in society.

Money in a Modern Society

Deposit Banking
Money in a modern society consists mainly of deposits in banks either by the creation of
deposit or direct deposits made by customers. A very small amount, about 20 %, consists
of notes and coins.

The term “deposit banking” was coined to describe the system whereby banks accept
deposits but make loans by permitting their customers to draw cheques in excess of
their balance. They either overdrew their current accounts up to prescribed limits or loan
accounts were opened and their current accounts credited with the sum of money. The
ability of the banks to create credit was therefore not limited by the availability of bank
notes issued, though they still had to ensure that they kept adequate balances to satisfy
the reserve requirement and depositors demand for cash.
Without the system of deposit banking and the creation of the pyramid of credit,
industry and commerce and hence the national income of the country could not have
developed in the way it has in many countries.

The Present Day Money Supply

Cash and Bank Deposit.

In most developed economies cash and cheques are generally acceptable means of
payment for transactions. By cash we mean notes and coins in circulation. Such notes
and coins are defined by law as legal tender, i.e., they must be acceptable within certain
limits for the payment of goods and services.
Cheques on the other hand cannot be classified as legal tender or part of the money
supply, but they are a means of transferring the ownership of money. The form of money
which they transfer is in fact bank deposits, and it is these that account for the major part
of the money supply. As to precisely which bank deposits should be included as part of
the money supply, it is uncertain. For example, should time deposits e.g., term deposit
accounts as distinct from current account balances be included in the money supply? It
could be argued that anyone who has a time deposit may feel at liberty to draw a cheque
overdrawing his current account knowing that a switch can be made from his deposit
account if necessary. What about the person who has an overdraft facility and draws
a cheque in the knowledge that he can overdraw his account. Should the total of the
overdraft limits be included in the money supply?

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Because of the difficulties inherent in distinguishing exactly which set of assets most
nearly accords with definition of money, a number of different ways of measuring the
money supply have been commonly used in recent years.
The most usual way of classifying the money supply, as suggested by the International
Monetary Fund (IMF), and used by different countries, is M0, M1, and M2. Other
countries such the UK, USA, and Canada have different variations. The above can be
defined as follows:

MO = currency in the hands of the public, statutory reserves held with the Central Bank
and banks’ cash reserves.

M1 = Currency held outside the banking system and current account deposit liabilities
of commercial banks held for transaction purposes.

M2 = M1 + short-term (usually one year and under) savings and time deposits,
certificate of deposits and foreign currency deposits and repurchase agreements.

Note: A Repurchase agreement is a form of short-term borrowing for dealers in

government securities. The dealer sells the government securities to investors, usually
on an overnight basis, and buys them back the following day. For the party selling the
security (and agreeing to repurchase it in the future) it is a repo; for the party on the
other end of the transaction, (buying the security and agreeing to sell in the future) it is a
reverse repurchase agreement.

The Role of Banking in a Modern Society

Banks play a major role in all the economic and financial activities in modern society.
All trade and commerce would slow down badly if the banks were not there to handle
their financial transactions. The economic development of a modern society depends
on industrial growth and modernization of agriculture. The banks promote both these
activities; they mobilize small deposits from the public and provide financial resources
to big industries. Thus the banks perform the major task of capital formation. They
motivate and lure the common people to save money and earn interest. This money
otherwise would be wasted or hoarded and lie unused in iron safes. Banks mop up the
funds lying idle in every home.

In the post Independence period, the banks have played a substantial role in the
development of rural economy and small-scale industries. Almost all the banks are
reaching out to non-urban areas with new branches and other banking facilities,
attracting term deposits from small businesses, like farmers and financing them also
when necessary. They are also helping the artisans and small farmers. Banks combat
unemployment and poverty by sanctioning small loans for self-employment. They are
thus the instruments to disburse social justice. They help the educated and technically
trained unemployed persons to setup their own businesses. These loans are recovered
in easy instalments. Banks mop up foreign exchange and finance exports as well. In this
way they play a major role in the economic reconstruction of a developing country.

Two elements of banking are financial intermediation and credit creation.

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 Financial Intermediation
Financial intermediation is an important role in banking. The term means accepting
funds from one source (such as savings customers) and using the money to make loans
or other investments. Essentially financial intermediation means acting as a go-between
for individuals or businesses that have extra money and individuals or businesses that
want to borrow money.

Each person or business with extra funds could try to find a borrower on its own, but the
process would be time consuming and difficult. Can you imagine how difficult it would
be to find another person?

The term financial intermediary may refer to an institution, firm or individual who
performs intermediation between two or more parties in a financial context. Typically
the first party is a provider of a product or service and the second party is a consumer or
customer.

Financial intermediaries (FIs) are banking and non-banking institutions which transfer
funds from economic agents with surplus funds (surplus units) to economic agents
(deficit units) that would like to utilize those funds. FIs are basically two types: Bank
Financial Intermediaries, BFIs (Central banks and Commercial banks) and Non-Bank
Financial Intermediaries, NBFIs (insurance companies, mutual trust funds, investment
companies, pensions funds, discount houses and bureaux de change).

Financial intermediaries can be:

• Banks;
• Building Societies;
• Credit Unions;
• Financial adviser or broker;
• Insurance Companies;
• Life Insurance Companies;

• Mutual Funds; or

• Pension Funds.

The borrower who borrows money from the Financial Intermediaries/Institutions pays
higher amount of interest than that received by the actual lender and the difference
between the Interest paid and Interest earned is the Financial Intermediaries/Institutions
profit.

Credit Creation
Banks play a most critical role in the creation of money. The creation of credit does not
mean the printing of notes and minting of coins. The financial system creates money by
expanding the money supply through deposits and loan transactions.

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 Example of Creation of Credit
Assume that John James puts $1000.00 in a chequing account at his Central Street
Bank. The bank must set aside part of his money as reserves and can loan out the
remainder.

The Central Bank establishes a reserve requirement. The reserve for Central
Banks is fairly low for instance, at the Eastern Caribbean Central Bank (ECCB) it
is 6%, but for this example, assume the reserves is 20% of the deposit. This would
mean the $800.00 of deposit could be loaned out.

Glenville Paul, a Central Street Bank customer, needs to borrow money and
draws on a line of credit in the amount of $800.00. He writes a cheque for the
$800.00 and gives it to the local plumbing supply vendor to purchase materials
for a bath-room remodelling project he has been hired to complete.

The plumbing supply vendor deposits the cheque to his chequing account
at RBTT Bank. RBTT Bank can also lend out these funds (after setting aside a
portion for reserves).

Bill Hensley, a customer of RBTT Bank draws on his home equity line of credit
in the amount of $640.00. He uses the funds to purchase furniture from Home
Furnishings & Co.

Home Furnishings & Co then deposits in his chequing account at RBC Bank.

The cycle of deposits and loans continues to create additional credit with each
set of transactions. The initial deposit of $1000.00 generated new credit in the
amount of $1440.00 ($800.00 deposits + $640.00) in the financial system.

ACTIVITY 1.3

Capital formation is said to be facilitated by financial intermediation. Describe the way in

which this process takes place and illustrate it with an example.

Summary

In this session we explored the concepts of money and banking, we looked at the history
of money, the functions, money in a modern society, and the role of banking, including
credit creation and financial intermediation. In Session 3 we will explore the issue of
Finance in the Economy.

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 Wrap Up
Banks fulfil a valuable role in society by performing the function of financial
intermediary, creating financial products and services, facilitating the creation of money
and being involved in the transfer of funds. In this unit we reviewed the role of money
and banking. In Unit 2 we will explore the issue of finance in the economy.

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