COMMERCE: FORM THREE: Topic 5 - BANKING

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TOPIC 5: BANKING

Banking

Historical Background of Banking

Explain the historical background of banking

Banking can be defined as the business activity of accepting and safeguarding money owned by other individuals and entities, and then lending out this money in order to earn a profit. However, with the passage of time, the activities covered by banking business have widened and now various other services are also offered by banks. The banking services these days include issuance of debit and credit cards, providing safe custody of valuable items, lockers, ATM services and online transfer of funds across the country / world. It is well said that banking plays a silent, yet crucial part in our day-to-day lives. The banks perform financial intermediation by pooling savings and channelizing them into investments through maturity and risk transformations, thereby keeping the economy’s growth engine revving.

Banking business has done wonders for the world economy. The simple looking method of accepting money deposits from savers and then lending the same money to borrowers, banking activityencourages the flow of money to productive use and investments. This in turn allows the economy to grow. In the absence of banking business, savings would sit idle in our homes, the entrepreneurs would not be in a position to raise the money, ordinary people dreaming for a new car or house would not be able to purchase cars or houses.

What is a bank?

In simple words, we can say that Bank is a financial institution that undertakes the banking activity i.e. accepts deposits and then lends the same to earn certain profit.

HISTORICAL BACKGROUND OF BANKING.

The world bank is said to have been derived from an Italian word ( banco) which means bench.the early bankers transacted their business on benches in market places. when failed, his bench was broken up by people and this has given rise to the word banco rotto or bankrupt..the band industries is nearly as old as civilization.

Modern banking began to develop between the year 1200-1600.in Italy large banking firms were established in Florence,rome,venice and other Italian cities.

ORIGIN OF BANKS IN TANZANIA

In Tanzania the first foreign bank to open its branch was the national bank india which established its business in Zanzibar in year 1892.in year 1915,the standard bank,barcklays bank and grand lays established their services in the country.

The Types and Functions of Banks

Explain the types and functions of banks

TYPES OF BANKS

Central bank: this is a government bank which is established to assist the state in controlling its money. It’s also gives financial advice to the government and acts as a banker for the commercial.

Functions of a Central Bank:

A central bank performs the following functions, as given by De Kock and accepted by the majority of economists.

1. Regulator of Currency: The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank. Central banks have been following different methods of note issue in different countries. The central bank is required by law to keep a certain amount of gold and foreign securities against the issue of notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between 25 to 40 per cent of the total notes issued. In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the central bank. This system is operative in India whereby the Reserve Bank of India is required to keep Rs 115 crores in gold and Rs 85 crores in foreign securities. There is no limit to the issue of notes after keeping this minimum amount of Rs 200 crores in gold and foreign securities. The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps in facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence among the public. The central bank can restrict or expand the supply of cash according to the requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.
2. Banker, Fiscal Agent and Adviser to the Government: Central banks everywhere act as bankers, fiscal agents and advisers to their respective governments. As banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government. It keeps the stock of gold of the government. Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt. The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc. As pointed out by De Kock, “Central banks everywhere operate as bankers to the state not only because it may be more convenient and economical to the state, but also because of the intimate connection between public finance and monetary affairs.”
3. Custodian of Cash Reserves of Commercial Banks: Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. It is on the basis of these reserves that the central bank transfers funds from one bank to another to facilitate the clearing of cheques. Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in facilitating their transactions. There are many advantages of keeping the cash reserves of the commercial banks with the central bank, according to De Kock. In the first place, the centralisation of cash reserves in the central bank is a source of great strength to the banking system of a country. Secondly, centralised cash reserves can serve as the basis of a large and more elastic credit structure than if the same amount were scattered among the individual banks. Thirdly, centralised cash reserves can be utilised fully and most effectively during periods of seasonal strains and in financial crises or emergencies. Fourthly, by varying these cash reserves the central bank can control the credit creation by commercial banks. Lastly, the central bank can provide additional funds on a temporary and short term basis to commercial banks to overcome their financial difficulties.
4. Custody and Management of Foreign Exchange Reserves: The central bank keeps and manages the foreign exchange reserves of the country. It is an official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary authorities of other countries. It also buys and sells foreign currencies at international prices. Further, it fixes the exchange rates of the domestic currency in terms of foreign currencies. It holds these rates within narrow limits in keeping with its obligations as a member of the International Monetary Fund and tries to bring stability in foreign exchange rates. Further, it manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies, etc. in keeping with the rules laid down by the government.
5. Lender of the Last Resort: De Kock regards this function as a sine qua non of central banking. By granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions, the central bank acts as the lender of the last resort. The central bank lends to such institutions in order to help them in times of stress so as to save the financial structure of the country from collapse. It acts as lender of the last resort through discount house on the basis of treasury bills, government securities and bonds at “the front door”. The other method is to give temporary accommodation to the commercial banks or discount houses directly through the “back door”. The difference between the two methods is that lending at the front door is at the bank rate and in the second case at the market rate. Thus the central bank as lender of the last resort is a big source of cash and also influences prices and market rates.
6. Clearing House for Transfer and Settlement: As bankers’ bank, the central bank acts as a clearing house for transfer and settlement of mutual claims of commercial banks. Since the central bank holds reserves of commercial banks, it transfers funds from one bank to other banks to facilitate clearing of cheques. This is done by making transfer entries in their accounts on the principle of book-keeping. To transfer and settle claims of one bank upon others, the central bank operates a separate department in big cities and trade centres. This department is known as the “clearing house” and it renders the service free to commercial banks. When the central bank acts as a clearing agency, it is time-saving and convenient for the commercial banks to settle their claims at one place. It also economises the use of money. “It is not only a means of economising cash and capital but is also a means of testing at any time the degree of liquidity which the community is maintaining.”
7. Controller of Credit: The most important function of the central bank is to control the credit creation power of commercial bank in order to control inflationary and deflationary pressures within this economy. For this purpose, it adopts quantitative methods and qualitative methods. Quantitative methods aim at controlling the cost and quantity of credit by adopting bank rate policy, open market operations, and by variations in reserve ratios of commercial banks. Qualitative methods control the use and direction of credit. These involve selective credit controls and direct action. By adopting such methods, the central bank tries to influence and control credit creation by commercial banks in order to stabilise economic activity in the country. Besides the above noted functions, the central banks in a number of developing countries have been entrusted with the responsibility of developing a strong banking system to meet the expanding requirements of agriculture, industry, trade and commerce. Accordingly, the central banks possess some additional powers of supervision and control over the commercial banks. They are the issuing of licences; the regulation of branch expansion; to see that every bank maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the accounts of banks; to approve the appointment of chairmen and directors of such banks in accordance with the rules and qualifications; to control and recommend merger of weak banks in order to avoid their failures and to protect the interest of depositors; to recommend nationalisation of certain banks to the government in public interest; to publish periodical reports relating to different aspects of monetary and economic policies for the benefit of banks and the public; and to engage in research and train banking personnel etc..

FUNCTION OF COMMERCIAL BANKS.

The functions of commercial banks are explained below:

Primary functions

• Collection of deposits
• Making loans and advances

Collection of deposits: The primary function of commercial banks is to collect deposits from the public. Such deposits are of three main types: current, saving and fixed.

A current account is used to make payments. A customer can deposit and withdraw money from the current account subject to a minimum required balance. If the customer overdraws the account, he may be required to pay interest to the bank. Cash credit facility is allowed in the current account.

Savings account is an interest yielding account. Deposits in savings account are used for saving money. Savings bank account-holder is required to maintain a minimum balance in his account to avail of cheque facilities.

Fixed or term deposits are used by the customers to save money for a specific period of time, ranging from 7 days to 3 years or more. The rate of interest is related to the period of deposit. For example, a fixed deposit with a maturity period of 3 years will give a higher rate of return than a deposit with a maturity period of 1 year. But money cannot be usually withdrawn before the due date. Some banks also impose penalty if the fixed deposits are withdrawn before the due date. However, the customer can obtain a loan from the bank against the fixed deposit receipt.

Loans and advances: Commercial banks have to keep a certain portion of their deposits as legal reserves. The balance is used to make loans and advances to the borrowers. Individuals and firms can borrow this money and banks make profits by charging interest on these loans. Commercial banks make various types of loans such as:

1. Loan to a person or to a firm against some collateral security;
2. Cash credit (loan in installments against certain security);
3. Overdraft facilities (i.e. allowing the customers to withdraw more money than what their deposits permit); and
4. Loan by discounting bills of exchange..

Secondary functions

• Agency services
• General utility services

Agency Services: The customers may give standing instruction to the banks to accept or make payments on their behalf. The relationship between the banker and customer is that of Principal and Agent. The following agency services are provided by the bankers:

1. Payment of rent, insurance premium, telephone bills, installments on hire purchase, etc. The payments are obviously made from the customer’s account. The banks may also collect such receipts on behalf of the customer.
2. The bank collects cheques, drafts, and bills on behalf of the customer.
3. The banks can exchange domestic currency for foreign currencies as per the regulations.
4. The banks can act as trustees / executors to their customers. For example, banks can execute the will after the death of their clients, if so instructed by the latter.

General Utility Services: The commercial banks also provide various general utility services to their customers. Some of these services are discussed below:

1. Safeguarding money and valuables: People feel safe and secured by depositing their money and valuables in the safe custody of commercial banks. Many banks look after valuable documents like house deeds and property, and jewellery items.
2. Transferring money:Money can be transferred from one place to another. In the same way, banks collect funds of their customers from other banks and credit the same in the customer’s account.
3. Merchant banking: Many commercial banks provide merchant banking services to the investors and the firms. The merchant banking activity covers project advisory services and loan syndication, corporate advisory services such as advice on mergers and acquisitions, equity valuation, disinvestment, identification of joint venture partners and so on.
4. Automatic Teller Machines (ATM): The ATMs are machines for quick withdrawal of cash. In the last 10 years, most banks have introduced ATM facilities in metropolitan and semi-urban areas. The account holders as well as credit card holders can withdraw cash from ATMs.
5. Traveler’s cheque: A traveler’s cheque is a printed cheque of a specific denomination. The cheque may be purchased by a person from the bank after making the necessary payments. The customer may carry the traveler’s cheque while travelling. The traveler’s cheques are accepted in banks, hotels and other establishments.

Credit Cards: Credit cards are another important means of making payments. The Visa and Master Cards are operated by the commercial banks. A person can use a credit card to withdraw cash from ATMs as well as make payments to trade establishments.

A savings bank is a financial institution whose primary purpose is accepting savings deposits and paying interest on those deposits.

They originated in Europe during the 18th century with the aim of providing access to savings products to all levels in the population. Often associated with social good these early banks were often designed to encourage low income people to save money and have access to banking services. They were set up by governments or by or socially committed groups or organisations such as with credit unions. The structure and legislation took many different forms in different countries over the 20th century.

• The advent of internet banking at the end of the 20th century saw a new phase in savings banks with the online savings bank that paid higher levels of interest in return for clients only having access over the web.

The Various Bank Accounts and How they Operate

Identify the various bank accounts and how they operate

TYPES OF BANKING ACCOUNTS

Checking account: A checking account offers easy access to your money for your daily transactional needs and helps keep your cash secure. Customers can use a debit card or checks to make purchases or pay bills. Accounts may have different options or packages to help waive certain monthly service fees. To determine the most economical choice, compare the benefits of different checking packages with the services you actually need.

• Savings account: A savings account allows you to accumulate interest on funds you’ve saved for future needs. Interest rates can be compounded on a daily, weekly, monthly, or annual basis. Savings accounts vary by monthly service fees, interest rates, method used to calculate interest, and minimum opening deposit. Understanding the account’s terms and benefits will allow for a more informed decision on the account best suited for your needs.
• Certificate of Deposit (CD): Certificates of deposit, or CDs, allow you to invest your money at a set interest rate for a pre-set period of time. CDs often have higher interest rates than traditional savings accounts because the money you deposit is tied up for the life of the certificate – which can range from a few months to several years. Be sure you do not need to draw on those funds before you open a CD, as early withdrawals may have financial penalties.
• Money market account: Money market accounts are similar to savings accounts, but they require you to maintain a higher balance to avoid a monthly fee. Where savings accounts usually have a fixed interest rate, these accounts have rates that vary regularly based on money markets. Money market accounts can have tiered interest rates, providing more favorable rates based on higher balances. Some money market accounts also allow you to write checks against your funds, but on a more limited basis.
• Individual Retirement Accounts (IRAs): IRAs, or individual retirement accounts, allow you to save independently for your retirement. These plans are useful if your employer doesn’t offer retirement benefits or you want to save more than your employer-sponsored plan allows. These accounts come in two types: the traditional IRA and Roth IRA. The Roth IRA is popular because the funds can be withdrawn tax-free in many situations. Others prefer traditional IRAs because these contributions are tax-deductible. Both accounts have contribution limits and other requirements you may need to discuss with your tax advisor before choosing your account.

Difference between the Main Means of Payments: Cheques; Bills of Exchange; Promissory Notes; Postal Orders

Differentiate the main means of payments: Cheques; Bills of exchange; Promissory notes; Postal orders

Cheque is an instrument in writing containing an unconditional order, addressed to a banker, sign by the person who has deposited money with the banker, requiring him to pay on demand a certain sum of money only to or to the order of certain person or to the bearer of instrument."

Characteristics Of Cheque

1. An Unconditional Order The drawer or the depositor should not lay down any condition in the cheque.
2. Drawn upon A Specified Banker The drawer issues cheque directing to a particular bank having deposit in it to pay the amount of cheque.
3. Signed By The Maker The cheque should be signed by the account holder.
4. Amount In Words And Figures The amount of cheque should be mentioned in words and figures.
5. Payable On Demand The amount of cheque must be paid by the bank as soon as it is presented at its counter.

Different Kinds / Types of Cheques

1. Bearer Cheque; When the words "or bearer" appearing on the face of the cheque are not cancelled, the cheque is called a bearer cheque. The bearer cheque is payable to the person specified therein or to any other else who presents it to the bank for payment. However, such cheques are risky, this is because if such cheques are lost, the finder of the cheque can collect payment from the bank.
2. Order Cheque; When the word "bearer" appearing on the face of a cheque is cancelled and when in its place the word "or order" is written on the face of the cheque, the cheque is called an order cheque. Such a cheque is payable to the person specified therein as the payee, or to any one else to whom it is endorsed (transferred).
3. Uncrossed / Open Cheque; When a cheque is not crossed, it is known as an "Open Cheque" or an "Uncrossed Cheque". The payment of such a cheque can be obtained at the counter of the bank. An open cheque may be a bearer cheque or an order one.
4. Crossed Cheque; Crossing of cheque means drawing two parallel lines on the face of the cheque with or without additional words like "& CO." or "Account Payee" or "Not Negotiable". A crossed cheque cannot be encashed at the cash counter of a bank but it can only be credited to the payee's account.
5. Anti-Dated Cheque; If a cheque bears a date earlier than the date on which it is presented to the bank, it is called as "anti-dated cheque". Such a cheque is valid upto three months from the date of the cheque.
6. Post-Dated Cheque; If a cheque bears a date which is yet to come (future date) then it is known as post-dated cheque. A post dated cheque cannot be honoured earlier than the date on the cheque.
7. Stale Cheque; If a cheque is presented for payment after three months from the date of the cheque it is called stale cheque.

BILLS OF EXCHANGE :A written, unconditional order by one party (the drawer) to another (the drawee) to pay a certain sum, either immediately (a sight bill) or on a fixed date (a term bill), for payment of goods and/or services received. The drawee accepts the bill by signing it, thus converting it into a post-dated check and a binding contract.

A bill of exchange is also called a draft but, while all drafts are negotiable instruments, only "to order" bills of exchange can be negotiated. According to the 1930 Convention Providing A Uniform Law For Bills of Exchange and Promissory Notes held in Geneva (also called Geneva Convention) a bill of exchange contains: (1) The term bill of exchange inserted in the body of the instrument and expressed in the language employed in drawing up the instrument.

What is a 'Promissory Note'

• A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on demand or at a specified future date. A promissory note typically contains all the terms pertaining to the indebtedness by the issuer or maker to the note's payee, such as the amount, interest rate, maturity date, date and place of issuance, and issuer's signature. The 1930 international convention that governs promissory notes and bills of exchange also stipulates that the term “promissory note” should be inserted in the body of the instrument and should contain an unconditional promise to pay.