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Chapter Two: Banking System

 Banking System
 A banking system is a network of financial institutions, primarily
banks, that provide various financial services to individuals,
businesses, and governments.
 The banking system is an essential part of the modern economy,
providing essential financial services to individuals, businesses,
and governments.
 It plays a vital role in economic growth, financial stability, and
the smooth functioning of the economy.
 These services include:
 Accepting deposits: Banks collect savings from customers,
offering products like savings accounts, checking accounts, and
time deposits.
 Banking System
 Lending money: Banks use the collected deposits to lend money to borrowers,
including individuals for mortgages, businesses for loans, and governments for
financing projects.
 Facilitating transactions: Banks enable the smooth flow of money through
services like:
1. Check clearing: Processing checks for payment.
2. Debit and credit cards: Enabling electronic payments.
3. Online and mobile banking: Providing convenient access to accounts.
 Offering financial products: Banks provide a range of financial
products beyond basic banking, such as:
1. Investment services: Helping customers invest in stocks, bonds,
and mutual funds.
2. Insurance products: Offering life insurance, health insurance,
and property insurance.
3. Wealth management: Providing personalized financial planning
and investment advice
 Types of Banks

 Commercial Banks: These are the most common type, offering

a wide range of services to individuals and businesses.
 Investment Banks: They specialize in investment banking
services like mergers and acquisitions, underwriting securities,
and providing financial advisory services.
 Central Banks: These are government-controlled banks
responsible for monetary policy, regulating the money supply,
and overseeing the banking system.
 Meaning and The Evolution of Central Banking

 A central bank is a financial institution that acts as the primary monetary

authority of a country or monetary union.
 It plays a crucial role in maintaining economic stability and promoting
sustainable growth.
 Early Beginnings
 Goldsmiths and Money Lenders: The concept of banking can be traced back to
ancient civilizations, where goldsmiths and money lenders acted as intermediaries,
storing valuables and lending money.
 Bank of Venice (1407): One of the earliest formal banking institutions, it played
a crucial role in financing trade and government activities.
 The Rise of Modern Central Banking
 Bank of England (1694): Established to finance the British government's war
efforts.
• It became a model for central banks worldwide.
• It introduced key concepts like the lender of last resort and the issuance of
banknotes.
 The Evolution of Central Banking

 19th Century: Central banks emerged in many European

countries, often tied to the gold standard, which linked the value
of currencies to a fixed amount of gold.
 The Federal Reserve System (1913): Established in the
United States to provide a more flexible monetary system.
• it introduced the concept of decentralized central banking
with regional Federal Reserve Banks.
 The 20th Century and Beyond
 The Great Depression and the New Deal: The Great
Depression highlighted the need for strong central bank
intervention to stabilize the economy.
 Central banks expanded their role in regulating the financial
system and implementing monetary policies.
 The Evolution of Central Banking

 Post-World War II and Bretton Woods System:

 The Bretton Woods Agreement established a fixed exchange rate
system, with the US dollar pegged to gold. Central banks played
a crucial role in maintaining this system.
 The End of Bretton Woods and Flexible Exchange Rates:
The collapse of the Bretton Woods system in the early 1970s led
to a shift towards flexible exchange rates, giving central banks
more flexibility in monetary policy.
 Financial Crises and Central Bank Responses: Major
financial crises, such as the 2008 global financial crisis, have led
to significant changes in central banking practices. Central
banks have expanded their toolkits to include unconventional
monetary policies like quantitative easing and negative interest
rates.
 The Evolution of Central Banking
 Key Trends in Modern Central Banking:
• Increased Independence: Central banks are increasingly independent
from political interference, allowing them to make decisions based on
economic considerations.
• Focus on Price Stability: Maintaining price stability remains a core
objective of central banks.
• Financial Stability: Central banks have expanded their role in ensuring
the stability of the financial system.
• Innovation and Technology: Central banks are embracing technological
advancements to improve their operations and implement innovative
monetary policies.
• International Cooperation: Central banks collaborate internationally to
address global economic challenges.
• The evolution of central banking has been driven by economic, political,
and technological factors. As the global economy continues to evolve,
central banks will likely face new challenges and opportunities, requiring
them to adapt and innovate.
 Central Banking Functions
 Central banks are the financial institutions responsible for overseeing a
nation's monetary system.
 Their primary goal is to maintain economic stability and promote sustainable
growth.
 To achieve this, they perform several key functions:
 1. Monetary Policy
 Interest Rate Setting: Central banks influence interest rates to control
the cost of borrowing and stimulate or slow down economic activity.
 Open Market Operations: By buying or selling government securities,
central banks adjust the money supply in the economy.
 Reserve Requirements: They set the minimum amount of reserves that
commercial banks must hold, impacting the amount of money they can
lend.
 2. Currency Issuance
 Central banks have the exclusive right to issue a country's currency,
ensuring its quality and circulation.
 Central Banking Functions

 3. Banking Supervision
 They oversee the banking system, ensuring the stability and soundness of
commercial banks.
 They implement regulations to prevent bank failures and protect depositors.
 4. Lender of Last Resort
 In times of financial crisis, central banks can provide liquidity to commercial banks,
preventing a systemic collapse.
 5. Foreign Exchange Reserves
 They manage a country's foreign exchange reserves to stabilize the exchange rate
and facilitate international trade.
 6. Economic Analysis and Research
 Central banks conduct economic research and analysis to inform their policy decisions
and provide insights into economic trends.
 7. Payment Systems
 They oversee and manage the payment systems within a country, ensuring the smooth
functioning of transactions.
 By effectively carrying out these functions, central banks contribute to a stable and
prosperous economy.
 Credit Control Methods

 Central banks employ a variety of tools to control the availability and cost of
credit in an economy.
 These methods are broadly classified into two categories: Quantitative and
Qualitative.
 Quantitative Methods
 These methods focus on the overall volume of credit in the economy.
 Bank Rate:
 This is the official interest rate at which the central bank lends money to
commercial banks.
 By increasing the bank rate, the central bank discourages commercial
banks from borrowing, thereby reducing the money supply.
 Conversely, decreasing the bank rate encourages borrowing, increasing
the money supply.
 Banking System

 Open Market Operations (OMO):

 The central bank buys or sells government securities in the
open market to influence the money supply.
 By buying securities, the central bank injects money into the
economy, increasing the money supply.
 By selling securities, it withdraws money from the economy,
reducing the money supply.
 Cash Reserve Ratio (CRR):
 This is the percentage of deposits that commercial banks must
hold as reserves with the central bank.
 By increasing the CRR, the central bank reduces the amount of
money available for lending, tightening credit.
 By decreasing the CRR, it increases the amount of money
available for lending, easing credit.
 Banking System

 Statutory Liquidity Ratio (SLR):

 This is the percentage of deposits that commercial banks must invest in
government securities.
 By increasing the SLR, the central bank reduces the funds available for
lending, tightening credit.
 By decreasing the SLR, it increases the funds available for lending, easing
credit.
 Qualitative Methods
 These methods focus on the direction of credit flow,
influencing the types of loans and borrowers.
 Moral Suasion:
 The central bank persuades commercial banks to follow
specific lending policies, such as reducing credit to
speculative activities or increasing credit to priority sectors.
 Banking System

 Margin Requirements:
 The central bank sets the minimum margin (down payment)
that borrowers must make when taking loans secured by
assets like stocks and bonds.
 By increasing the margin requirement, the central bank
discourages borrowing and reduces speculative activity.
 Direct Action:
 The central bank can directly instruct commercial banks to
limit lending to specific sectors or individuals.
 By effectively utilizing these tools, central banks can influence
economic activity, control inflation, and promote sustainable
growth. The choice of methods and their intensity depends on
the specific economic conditions and policy objectives.
 Monetary Policy and Its Objectives

 It is a tool used by a country's central bank to control the supply of money in

the economy.
 By manipulating interest rates, reserve requirements, and other tools, central
banks aim to achieve specific economic objectives.
 Key Objectives of Monetary Policy
 Price Stability:
 This is the primary goal of most central banks.
 It involves maintaining a low and stable inflation rate. High inflation erodes
the purchasing power of money, leading to economic uncertainty.
 Full Employment:
 Central banks aim to achieve maximum employment, which means
keeping unemployment rates low.
 By stimulating economic growth, central banks can create jobs and reduce
unemployment.
 Monetary Policy and Its Objectives

 Economic Growth:
 Central banks strive to foster sustainable economic growth. By encouraging
investment and consumption, monetary policy can contribute to long-term
economic expansion.
 Financial Stability:
 Central banks play a crucial role in maintaining financial stability. This involves
preventing financial crises, ensuring the smooth functioning of the financial
system, and protecting the value of the currency.
 Monetary Policy Tools
 Central banks have various tools at their disposal to implement monetary policy:
 Interest Rate Policy:
 By adjusting interest rates, central banks can influence borrowing and lending
costs.
 Expansionary Monetary Policy: Lowering interest rates encourages borrowing
and spending, stimulating economic activity.
 Contractionary Monetary Policy: Raising interest rates discourages borrowing
and spending, slowing down economic activity.
 Monetary Policy and Its Objectives

 Open Market Operations:

 Central banks buy or sell government securities in the open market to influence
the money supply.
 Expansionary Policy: Buying securities injects money into the economy,
increasing the money supply.
 Contractionary Policy: Selling securities withdraws money from the economy,
reducing the money supply.
 Reserve Requirements:
 Central banks can adjust the percentage of deposits that commercial banks must
hold as reserves.
 Expansionary Policy: Lowering reserve requirements frees up funds for lending,
increasing the money supply.
 Contractionary Policy: Raising reserve requirements reduces the funds available
for lending, decreasing the money supply.
 By effectively using these tools, central banks can fine-tune the economy and promote
economic well-being. However, it's important to note that monetary policy is not a
panacea
 Central Banking System in Ethiopia

 The central banking system in Ethiopia is overseen by the

 National Bank of Ethiopia (NBE). Established in 1963, the NBE is
responsible for maintaining price stability
 Key Functions of the NBE:
 Monetary Policy:
 Sets monetary policy to control inflation and stimulate economic growth.
 Implements monetary tools such as interest rate adjustments and open
market operations.
 Currency Issuance:
 Has the sole authority to issue the Ethiopian Birr, the country's official currency.
 Banking Supervision:
 Oversees and regulates the banking sector to ensure financial stability and
protect consumer interests.
 Licenses and supervises commercial banks, development banks, and other
financial institutions.
 Central Banking System in Ethiopia
 Foreign Exchange Management:
 Manages the country's foreign exchange reserves.
 Regulates foreign exchange transactions and exchange rate policies.
 Payment Systems:
 Oversees and manages the payment systems in Ethiopia, including the
national payment system.
 Challenges and Reforms:
 The Ethiopian banking system has undergone significant reforms in recent
years. However, it still faces challenges such as:
 Limited Financial Inclusion: A significant portion of the population,
particularly in rural areas, still lacks access to formal financial services.
 Credit Constraints: Access to credit, especially for small and medium-sized
enterprises, remains limited.
 Economic Shocks: The economy is vulnerable to external shocks, such as
fluctuations in commodity prices and global economic downturns.
 Central Banking System in Ethiopia

 To address these challenges, the NBE has been implementing

various reforms, including:
 Promoting Financial Inclusion: Encouraging the use of digital
financial services to reach underserved populations.
 Strengthening Banking Supervision: Enhancing regulatory
frameworks to mitigate risks and promote sound banking
practices.
 Developing the Capital Market: Fostering the development of
the capital market to diversify financing options.
 Improving Payment Systems: Enhancing the efficiency and
security of payment systems.
The NBE plays a crucial role in shaping Ethiopia's economic landscape.
By effectively implementing monetary policy and regulatory
measures, it aims to contribute to sustainable economic growth and
financial stability.
 Commercial Banking System in Ethiopia
 The commercial banking system in Ethiopia is a vital component of the
country's financial landscape.
 It plays a crucial role in mobilizing savings, providing credit, and facilitating
economic growth.
 Key Features of the Ethiopian Commercial Banking System
 Dominance of State-Owned Banks:
 The Commercial Bank of Ethiopia (CBE) is the largest and most dominant
commercial bank in the country. It holds a significant market share and plays a key
role in financing the economy.
 Other state-owned banks also operate in the market, further solidifying the
government's influence on the banking sector.
 Emergence of Private Banks:
 In recent years, there has been a gradual increase in the number of private
commercial banks. These banks offer a wider range of financial services and
compete with state-owned banks.
 However, the state-owned banks still maintain a significant market share.
 Central Banking System in Ethiopia

 Challenges and Opportunities:

 Financial Inclusion: Expanding financial inclusion to
underserved populations, particularly in rural areas, remains a
major challenge.
 Credit Risk: Assessing and managing credit risk, especially
in a developing economy with limited credit history, is a
significant concern.
 Technological Advancements: Adopting and leveraging
technology to improve efficiency, reduce costs, and enhance
customer experience is crucial.
 Regulatory Framework: A robust regulatory framework is
essential to ensure the stability and soundness of the banking
system.
 Central Banking System in Ethiopia

 The Role of Commercial Banks in Ethiopia's Economy

 Mobilizing Savings: Commercial banks collect savings from
individuals and businesses, which are then used to finance
investments.
 Providing Credit: They extend loans to individuals, businesses,
and government entities, fueling economic activity and job
creation.
 Facilitating Payments: Commercial banks provide various
payment services, such as check clearing, electronic funds transfer,
and credit card services.
 Foreign Exchange Services: They offer foreign exchange
services, enabling international trade and investment.
 Financial Advisory Services: Commercial banks provide financial
advice and consultancy services to their clients.
 By effectively performing these functions, commercial banks
 Challenges and Opportunities in Ethiopian Commercial Banking

 Challenges
 Limited Financial Inclusion: A significant portion of the population, especially in
rural areas, still lacks access to formal banking services.
 This limits economic opportunities and hinders financial development.
 Credit Risk: Assessing and managing credit risk, particularly for small and
medium enterprises (SMEs), remains a challenge.
 Limited credit history and high default rates can deter banks from lending.
 Operational Efficiency: Many banks still rely on traditional banking methods,
which can be inefficient and costly.
 Adopting modern technologies and digital solutions can improve efficiency and
reduce operational costs.
 Regulatory Framework: While the regulatory framework has improved, there is
still room for further development to ensure a conducive environment for banking
operations.
 Economic Volatility: Ethiopia's economy can be susceptible to external shocks,
such as fluctuations in commodity prices and global economic downturns.
 This can impact the stability of the banking system.
 Challenges and Opportunities in Ethiopian Commercial Banking

 Opportunities
 Digital Banking and Fintech: The increasing adoption of digital
technologies offers significant opportunities for banks to improve their
services and reach a wider customer base. Mobile banking, internet
banking, and digital payment solutions can enhance financial inclusion.
 SME Financing: Focusing on SME financing can boost economic growth
and job creation. By developing specialized products and services, banks
can cater to the unique needs of SMEs.
 Agricultural Financing: Investing in agricultural financing can contribute
to food security and rural development. Banks can provide loans to
farmers for purchasing seeds, fertilizers, and equipment.
 International Partnerships: Collaborating with international financial
institutions can provide access to funding, technology, and expertise.
 Regulatory Reforms: Continued regulatory reforms can create a more
conducive environment for banking operations and attract foreign
investment.
 Challenges and Opportunities in Ethiopian Commercial Banking

 To address these challenges and capitalize on the opportunities, the Ethiopian

banking sector needs to:
 Promote Financial Inclusion: Expand branch networks, promote digital
banking, and offer innovative financial products to reach underserved
populations.
 Strengthen Risk Management: Implement robust risk management
practices to mitigate credit, market, and operational risks.
 Invest in Technology: Embrace digital technologies to improve
efficiency, reduce costs, and enhance customer experience.
 Foster Innovation: Encourage innovation and develop innovative
financial products and services.
 Strengthen Corporate Governance: Implement strong corporate
governance practices to ensure transparency, accountability, and ethical
behavior.
 By addressing these challenges and seizing the opportunities, the
Ethiopian banking system can play a vital role in driving economic growth
and development in the country.
 Domestic and International Banking Operations in Ethiopia

 Domestic banking operations in Ethiopia are primarily conducted

by commercial banks, both state-owned and private.
 These banks offer a range of services to individuals and
businesses, including:
 Deposit Services:
 Savings accounts
 Current accounts
 Fixed deposit accounts
 Lending Services:
 Personal loans
 Business loans
 Mortgage loans
 Domestic and International Banking Operations in Ethiopia

 Payment Services:
 Check clearing
 Electronic fund transfers (EFT)
 Mobile banking
 Debit and credit cards
 Foreign Exchange Services:
 Currency exchange
 Remittance services
International Banking Operations:
 While Ethiopia has been relatively closed to foreign banks, recent reforms have opened
up the sector to greater international participation.
 However, the level of international banking operations in Ethiopia is still limited
compared to other countries.
 Domestic and International Banking Operations in Ethiopia

 Key International Banking Activities in Ethiopia:

 Trade Finance:
 Letters of credit
 Documentary credits
 Export and import financing
 Remittances:
 Facilitating the transfer of funds from overseas Ethiopians to their
home country
 Foreign Exchange Transactions:
 Dealing in foreign currencies
 Providing foreign exchange services to individuals and businesses

 Liaison Offices:
 Some foreign banks have established liaison offices in Addis Ababa
to facilitate business activities and provide advisory services.
End