Unit 2: Banking System April 2023

Chapter Two
Banking System

2.1. Introduction:

The term bank is either derived from the old Italian word “Banca” or the French word “Banque,”
both mean a Bench or money exchange table. Though bank is considered to be an ancient
institution just like money. Its evolution can be traced in the functions of money lender, the
goldsmiths and the merchants. A bank has been often described as an institution engaged in
accepting of deposits and granting loans. It can also be described as an institution which borrows
idle resources, makes funds available to. It does not refer only to a place of lending and
depositing money, but looks after the financial problems of its consumers. In simple words, banking
can be defined as the business activity of accepting and safeguarding money owned by other
individual and entities, and then lending out this money in order to earn a profit. This era is the age
of specialization with the changing situation in the world economy, banking functions have
broadened. Financial institutions which are shaped by the general economic structures of the
country concerned vary from one country to another. Banks are among the most important financial
institutions in the economy and are the principle sources of credit.

2.2. Bank vs. Banking

According to R.P. Kent, “Bank is an institution which collects idle money temporarily from the
public and lends to other people as per need or as “an establishment for custody of money, which it
pays out on customer’s order.” Bank is a financial institution that accepts deposits from the
public and creates a demand deposit while simultaneously making loans. Banks are large and
complex organizations. Their clients range from individuals and institutions, all the way up to the
governments and central banks of entire countries. Banks don't produce physical things. They are
not in the manufacturing business. The work they do simply involves money – their money, their
clients' money: borrowing it, lending it, and many other related activities. The movement of capital
handled by banks allows economies to grow and prosper. Businesses and governments cannot be
completely self-sufficient. They need money to operate, and banks act as intermediaries (like
‘middlemen') between the suppliers of funds and users of funds.

1 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

Bank is an industry that handles cash, credit, and other financial transactions. Banks provide a Safe
place to Store extra cash and credit. They offer savings accounts, Certificates of Deposit, and
checking accounts. Banks use these deposits to make loans. These loans include home mortgages,
business loans, and car loans.
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.
Summary
→ It accepts deposits and advances loans.
→ It also deals with credit; it has the ability to create credit, i.e., the ability to expand its
liabilities as a multiple of its reserves.
→ It is a commercial institution; it aims at earning profit.
→ It is a unique financial institution that creates demand deposits that serve as a medium of
exchange, and as a result, the banks manage the country’s payment system
→ It encourages savings habit amongst people and thereby makes funds available for
productive use
→ It acts as an intermediary between people having surplus money and those requiring money
for various business activities
→ It facilitates business transactions through receipts and payments by cheques instead of
currency
→ It provides loans and advances to businessmen for short term and long-term purposes
→ It also facilitates import export transactions.
→ It helps in national development by providing credit to farmers, small-scale industries and
Self- employed people as well as to large business houses which lead to balanced economic
development in the country
→ It helps in raising the standard of living of people in general by providing loans for purchase
of consumer durable goods, houses, automobiles, etc.

2 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

2.3. Functions of bank

1. Deposit of funds: as their major function, banks deposit money of customers and pay
interests to depositors. Such deposits will be used for borrowings.
2. Bank transfers: money can be transferred from one place to another through bank
transfers
3. Deposit of securities: such deposits include certificates and documents of title. The bank
can act as the agent of a business person in consideration of a commission.
4. Granting of Loans and Advances: the bank advances loans to the business community
and other members of the public. The rate charged is higher than what it pays on deposits
Initial capital of the bank and its deposits will be used for lending clients with some
interest to the bank. Mostly the interest paid to the banks is higher than the interest paid to
depositors that brings profit to the banks.
5. Agency Functions: The bank acts as an agent of its customers. The bank performs several
agency functions, which include: Transfer of Funds, Collection of checks, Portfolio
Management, Periodic Payments
6. Documentary credits: the main documentary instrument is the letter of credit (LC). This
is important in international sales transactions. A contract between a seller and a buyer; the
buyer goes to an issuing bank and opens letter of credit; the issuing bank communicates
with the payee bank; the seller goes to the payee bank and submits bill of lading and other
documents that transfer ownership of the goods; payee bank checks documents and sends
it to issuing bank; seller gets his money from payee bank; buyer gets his documents from
issuing bank; contract is performed. In between there can be an advising/confirming bank
which checks documents (check that documents are not discrepant).

2.4 Central Bank and its Function in the Economy

Central bank is regarded as an apex financial institution in the banking system. It is considered as
an integral part of the economic and financial system of a nation. The central bank functions as an
independent authority and is responsible for controlling, regulating and stabilizing the monetary and
banking structure of the country. Central banks are responsible for maintaining the financial
stability and economic sovereignty of the country.

3 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

Examples of Central Banks: Some of the well-known central banks across the world are:
 Federal Reserve (USA)
 National Bank of Ethiopia
 Reserve Bank of India (India)
 People’s Bank of China (China)
 Bank of England (UK)
 European Central Bank (EU or European Union)

The functions of a central bank can be discussed as follows:

1. Currency regulator or bank of issue
2. Bank to the government
3. Custodian of Cash reserves
4. Custodian of International currency
5. Lender of last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Protecting depositor’s interests

Currency regulator or bank of issue: Central banks possess the exclusive right to manufacture
notes in an economy. All the central banks across the world are involved in issuing notes to the
economy. This is one of the most important functions of the central bank in an economy and due to
this the central bank is also known as the bank of issue. Earlier all the banks were allowed to
publish their own notes which resulted in a disorganized economy. To avoid this situation the
government around the world authorised the central banks to function as the issuer of currency,
which resulted in uniformity in circulation and balanced supply of money in the economy

Bank to the government: One of the important functions of the central bank is to act as the
bank to the government. The central bank accepts deposits and issues funds to the government. It is
also involved in making and receiving payments for the government. Central banks also offer short
term loans to the government in order to recover from bad phases in the economy.
In addition to being the bank to the government, it acts as an advisor and agent of the government
by providing advice to the government in areas of economic policy, capital market, money market
and loans from the government. In addition to that, the central bank is instrumental in formulation

4 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

of monetary and fiscal policies that help in regulation of money in the market and controlling
inflation.
Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a part
of their cash balances in the form of deposits with the central bank. The commercial banks can draw
that balance when the requirement for cash is high and pay back the same when there are fewer
requirements of cash.
It is for this reason that the central bank is regarded as the banker’s bank. Central bank also plays an
important role in the credit creation policy of commercial banks.
Custodian of International Currency: An important function of the central bank is to maintain
a minimum balance of foreign currency. The purpose of maintaining such a balance is to manage
sudden or emergency requirements of foreign reserves and also to overcome any adverse deficits of
balance of payments.
Lender of last resort: The central bank acts as a lender of last resort by providing money to its
member banks in times of cash crunch. It performs this function by providing loans against
securities, treasury bills and also by rediscounting bills.
This is regarded as one of the most crucial functions of the central bank wherein it helps in
protecting the financial structure of the economy from collapsing.
Clearing house for transfer and settlement: Central bank acts as a clearing house of the
commercial banks and helps in settling of mutual indebtedness of the commercial banks. In a
clearing house, the representatives of different banks meet and settle the interbank payments.
Controller of credit: Central banks also function as the controller of credit in the economy. It
happens that commercial banks create a lot of credit in the economy that increases the inflation.
The central bank controls the way credit creation by commercial banks is done by engaging in open
market operations or bringing about a change in the CRR to control the process of credit creation by
commercial banks.
Protecting depositor’s interests: Central bank also needs to keep an eye on the functioning of
the commercial banks in order to protect the interests of depositors.

Roles of National Bank of Ethiopia

→ The Bank has the following powers and duties: Coins, prints and issues the legal tender
currency, and regulates the country’s money supply

5 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

→ Regulates the applicable interest rate and other cost of money charges.
→ Formulating implements and follows-up the country’s exchange rate policy, and manages
and administers the international reserves of the country
→ Licenses, supervises and regulates the operations of banks, insurance companies and other
financial institutions.
→ Sets limits on gold and foreign exchange assets, which banks, and other financial
institutions authorized to deal in foreign exchange an hold in deposits.
→ Sets limits on the net foreign exchange positions and terms, and the amount of external
indebtedness of banks and other financial institutions.
→ Provides short and long term refinancing facilities to banks and other financial institutions.
→ Accepts deposit of any kind from foreign sources
→ Promotes and encourages the dissemination of banking and insurance services throughout
the country.
→ Prepares periodic economic studies, together with forecasts of the balance of payments,
money supply, prices and other relevant statistical indicators of the Ethiopian economy
useful for analysis and for the formulation and determination by the Bank of monetary,
saving and exchange policies.
→ Acts as banker, fiscal agent and financial advisor to the Government.
→ Represents the country in international monetary institutions and acts consistently with
international monetary and banking agreements to which Ethiopia is a party.
→ Exercises and performs such other powers and activities as central banks customarily
perform.

2. 5. Types of Bank
There are various types of banks. The necessity for the variety among these banks is because each
bank is specialized in their own field. Each bank has its own principles and policies. Different
rates of interests are also noted among these banks. Banks can be classified into various types on
the basis of their functions, ownership, domicile, etc. The following are the various types of
banks.

2.5.1. Classifications of banks on the Basis of functions

The banks are classified on the basis of function into the following categories.

6 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

1. Central Bank: Central Bank is the bank of banks. Every civilized country now has its own
central bank. The primary function of the central bank is to regulate the flow of money and
credit in order to promote efficiency, stability and growth in the country.
2. Commercial Banks: Commercial banks are those banks which are engaged in performing the
routine duties of banking business. They collect surplus money and make loans and advances in
the form of overdrafts cash credit and discounting bills of exchange. They also provide special
financial services and agency services. Commercial banks in short are considered the lifeblood
of the economic society.
3. Exchange Banks: Exchange banks are mainly deal with international trade. These banks take
the responsibility of settlement of foreign exchange and arrange the foreign businesses.
4. Saving Banks: Saving banks are those banks which collect and keep the small savings of .the
public. They are called thrift promoting institutions. The Saving banks invest the funds in the
safest government securities and offer reasonable rate of profit on saving accounts. Students,
government employees and household women are usually opening such accounts. A prior
notice to bank is necessary for withdrawal of huge amount.
5. Agriculture Banks: The bank is responsible for the development of agriculture sector of the
country. Agriculture banks are set tip to provide financial assistance to the agriculturists and
agro-based industries.
6. Industrial Banks: The Industrial banks provide medium and long-term credit to the industries.
The growth of industries depends on these banks.
7. Co-operative Banks: Cooperative banking is retail and commercial banking organized on a
cooperative basis. Cooperative banking institutions take deposits and lend money in most parts
of the world.
8. Mortgage Banks: A Mortgage bank specializes in originating and/or servicing mortgage loans.
9. Investment Banks: An investment bank is a financial institution that assists corporations and
governments in raising capital by underwriting and acting as the agent in the issuance of
securities. .An investment bank also assists companies involved in mergers and acquisitions,
derivatives, etc.
10. Merchant Banks: In banking, a merchant bank is a financial institution primarily engaged in
offering financial services and advice to corporations and to wealthy individuals. The term can
also be used to describe the private equity activities of banking.

7 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

11. Consortium Banks: A merchant banking subsidiary set up by several banks that may or may
not be of the same nationality. Consortium banks are common in the Euromarkets and are active
in loan syndication.
12. Export-Import Banks: The bank which is related to export and import finance of the country is
called export import bank.
13. School Banks: This type of bank offers special financial feature for the schools. This bank also
gives loans to the administration.
14. Islamic banking: is a banking system that is based on the principles of Islamic or Shariah law.
As such, banks that wish to offer Islamic banking services have to develop products and
services that do not charge or pay interest. Their solution is to offer various profit-sharing-
related products whereby depositors share in the risk of the bank’s lending. Depositors earn a
return (instead of interest) and borrowers repay loans based on the profits generated from the
project on which the loan is lent.
An example of a commonly used profit-sharing arrangement in Islamic banking is known as
Musharakah, which is an arrangement where a bank and a borrower establish a joint
commercial enterprise and all contribute capital as well as labor and management as a general
rule. The profit of the enterprise is shared among the partners in agreed proportions while the
loss will have to be shared in strict pro- portion of capital contributions.
15. World Bank: - It refers to an institution that provides financial assistance to the member
countries of the world. World Bank organized to achieve the following two objectives.
 Reconstructing the war-damage economies, and
 Developing the less developed economies

2.5.2. Classifications of bank on the Basis of Ownership:

On the basis of ownership, banks can be classified into three categories:
a. Public Sector Banks: These are owned and controlled by the government. They usually need
to emphasis on social objective than profitability
b. Private Sector Banks: These banks are owned by the private individuals or corporations and
not by the government or co-operative societies,

2.5.3. Classifications of bank on the Basis of Ownership Basis of Domicile:

On the basis of domicile, the banks are divided into two categories:

8 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

a. Domestic Banks: These are registered and incorporated within the country,
b. Foreign Banks: These are foreign in origin and have their head offices in the country of
origin

Commercial Banks
Commercial Banks are institutions that offer deposit and credit services as well as a growing list of
newer services as investment advice, security underwriting, selling insurance and financial
planning. Unlike the name “commercial”, commercial banks expanded their services to consumers
and Government units to be a financial department store of the financial system. Commercial
Banks manage the customers' current and savings accounts, pay out checks that have been drawn on
the bank by account holders, and also perform the collection of checks deposited in their customers'
accounts. Banks implement a number of other procedures for payments to customers, such as:
ATM's (Automated Teller Machines), telegraphic transfer, and EFTPOS (Electronic Funds Transfer
at the Point of Sale), or Debit Cards.

Role of Commercial Banks in the Economic Development

Commercial banks play an important and active role in the economic development of a country. If
the banking system in a country is effective, efficient and disciplined it brings about a rapid growth
in the various sectors of the economy.

The following are the significance of commercial banks in the economic development of a
country:

1. Banks promote capital formation: Commercial banks accept deposits from individuals and
businesses, these deposits are then made available to the businesses which make use of them for
productive purposes in the country. The banks are, therefore, not only the store houses of the
country’s wealth, but also provide financial resources necessary for economic development.

2. Investment in new enterprises: Businessmen normally hesitate to invest their money in risky
enterprises. The commercial banks generally provide short and medium term loans to
entrepreneurs to invest in new enterprises and adopt new methods of production. The provision
of timely credit increases the productive capacity of the economy.

9 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

3. Promotion of trade and industry: With the growth of commercial banking, there is vast
expansion in trade and industry. The use of bank draft, check, bill of exchange, credit cards and
letters of credit etc has revolutionized both national and international trade.

4. Development of agriculture: The commercial banks particularly in developing countries are now
providing credit for development of agriculture and small scale industries in rural areas. The
provision of credit to agriculture sector has greatly helped in raising agriculture productivity and
income of the farmers.

5. Balanced development of different regions: The commercial banks play an important role in
achieving balanced development in different regions of the country. They help in transferring
surplus capital from developed regions to the less developed regions. The traders, industrialist,
etc. of less developed regions are able to get adequate capital for meeting their business needs.
This in turn increases investment, trade and production in the economy.

6. Influencing economic activity: The banks can also influence the economic activity of the
country through its influence on availability of credit and the rate of interest. If the commercial
banks are able to increase the amount of money in circulation through credit creation or by
lowering the rate of interest, it directly affects economic development. A low rate of interest can
encourage investment. The credit creation activity can raise aggregate demand which leads to
more production in the economy.

7. Implementation of Monetary policy: The central bank of the country controls and regulates
volume of credit through the active cooperation of the banking system in the country. It helps in
bringing price stability and promotes economic growth within the shortest possible period of
time.

8. Monetization of the economy: The commercial banks by opening branches in the rural and
backward areas are reducing the exchange of goods through barter. The use of money has greatly
increased the volume of production of goods. The non monetized sector (barter economy) is now
being converted into monetized sector with the help of commercial banks.

9. Export promotion cells: In order to increase the exports of the country, the commercial banks
have established export promotion cells. They provide information about general trade and

10 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

economic conditions both inside and outside the country to its customers. The banks are
therefore, making positive contribution in the process of economic development.

♥ Role of Banks in 21st Century: The commercial banks are now not confined to local
banking. They are fast changing into global banking i.e, understanding the global customer,
using latest information technology, competing in the open market with high technology
system, changing from domestic banking to investment banking etc. The commercial banks
are now considered the nerve system of all economic development in the country.

♥ Virtual Banking: Providing the banking services through extensive use of information
technology without direct recourse to the bank by the customer is called virtual banking.
The principal types of virtual banking services include automated teller machines (ATM’s),
phone banking and most recently internet banking. With the increasing use of internet
banking there is greater reliance now on information technology and the decrease of
physical bank branches to deliver the banking services to the customer.

Commercial Banking Services

Commercial banks perform a variety of functions which can be divided as: 1) accepting deposits;
(2) advancing loans; (3) credit creation; (4) financing foreign trade; (5) agency services; and (6)
miscellaneous services to customers. These functions are discussed as follows:
1. Accepting Deposits
This is the oldest function of a bank and the banker used to charge a commission for keeping the
money in its custody when banking was developing as an institution, Nowadays a bank accepts
three kinds of deposits from its customers. The first is the savings deposits on which the bank pays
small interest to the depositors who are usually small savers. The depositors are allowed to draw
their money by cheques up to a limited amount during a week or year. Businessmen keep their
deposits in current accounts. They can withdraw any amount standing to their credit in current
deposits by cheques without notice. The bank does not pay interest on such accounts but instead
charges a nominal sum for services rendered to its customers. Current accounts are known as
demand deposits. Deposits are also accepted by a bank in fixed or time deposits. Savers who do not
need money for a stipulated period from months to longer periods ranging up to 10 years or more
are encouraged to keep it in fixed deposit accounts. The bank pays a higher rate of interest on such

11 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

deposits. The rate of interest increases with the length of the time period of the fixed deposit. But
there is always the maximum limit of the interest rate which can be paid.

2. Advancing Loans
One of the primary functions of a commercial bank is to advance loans to its customers. A bank
lends a certain percentage of the cash lying in deposits on a higher interest rate than it pays on such
deposits. This is how it earns profits and carries on its business. The bank advances loans in the
following ways:
(a} Cash Credit. The bank advances loans to businessmen against certain specified securities. The
amount of the loan is credited to the current account of the borrower. In case of a new customer a
loan account for the sum is opened. The borrower can withdraw money through cheques according
to his requirements but pays interest on the full amount.
(b) Call Loans. These are very short-term loans advanced to the bill brokers for not more than
fifteen days. They are advanced against first class bill of securities. Such loans can be recalled at a
very short notice. In normal times they can also be renewed.

(c) Overdraft. A bank often permits a businessman to draw cheques for a sum greater than the
balance lying in his current account. This is done by providing the overdraft facility up to a specific
amount to the businessman. But he is charged interest only on the amount by which his current
account is actually overdrawn and not by the full amount of the overdraft sanctioned to him by the
bank.

(d) Discounting bills of Exchange. If a creditor holding a bill of exchange wants money
immediately, the bank provides him the money by discounting the bill of exchange. It deposits the
amount of the bill in the current account of the bill-holder after deducting its rate of interest for the
period of the loan which is not more than 90 days. When the bill of exchange matures, the bank gets
its payment from the banker of the debtor who accepted the bill.

3. Credit Creation
Credit creation is one of the most important functions of the commercial banks. Like other financial
institutions, they aim at earning profits. For this purpose, they accept deposits and advance loans by
keeping small cash in reserve for day-to-day transactions. When a bank advances a loan, it opens an
account in the name of the customer and does not pay him in cash but allows him to draw the
money by cheque according to his needs. By granting a loan, the bank creates credit or deposit.

12 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

4. Financing Foreign Trade

A commercial bank finances foreign trade of its customers by accepting foreign bills of exchange
and collecting them from foreign banks. It also transacts other foreign exchange business and buys
and sells foreign currency.
5. Agency Services
A bank acts as an agent of its customers in collecting and paying cheques, bills of exchange, drafts,
dividends, etc. It also buys and sells shares, securities, debentures, etc. for its customers. Further, it
pays subscriptions, insurance premia, rent, electric and water bills, and other similar charges on
behalf of its clients. It also acts as a trustee and executor of the property and will of its customers.
Moreover, the bank acts as an income tax consultant to its clients. For some of these services, the
bank charges a nominal fee while it renders others free of charge.

6. Miscellaneous Services
Besides the above noted services, the commercial bank performs a number of other services. It acts
as the custodian of the valuables of its customers by providing them lockers where they can keep
their jewelry and valuable documents. It issues various forms of credit instruments, such as
cheques, drafts, travellers' cheques, etc. which facilitate transactions. The bank also issues letters of
credit and acts as a referee to its clients. It underwrites shares and debentures companies and helps
in the collection of funds from the public. Some commercial banks also publish journals which
provide statistical information about the money market and business trends of the economy.

Difference between Central Bank and Commercial Bank

A central bank is basically different from a commercial bank in the following ways:
1. The central bank is the apex institution of the monetary and banking structure of the country
whereas commercial bank is one of the organs of the money market.
2. The central bank is a non-profit institution which implements the economic policies of the
government. But the commercial bank is a profit-making institution.
3. The central bank is owned by the government, whereas the commercial bank is owned by
shareholders.
4. The central bank is a banker to the government and does not engage itself in ordinary
banking activities. The commercial bank is a banker to the general public.

13 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

5. The central bank has the monopoly of note issue, while the commercial bank can issue only
cheques. The notes are legal tender. But the cheques are in the nature of near-money.
6. The central bank is the banker's bank. As such, it grants accommodations to commercial
banks in the form of rediscount facilities, keeps their cash reserves, and clears their
balances. On the other hand, the commercial bank advances loans to and accepts deposits
from the public
7. The central bank controls credit in accordance with the needs of business and economy. The
commercial bank creates credit to meet the requirements of business.
8. The central bank helps in establishing financial institutions so as to strengthen money and
capital market in a country. On the other hand, the commercial bank helps industry by
underwriting shares and debentures, and agriculture by meeting its financial requirements
through cooperatives or individually
9. Every country has only one central bank with its offices at important centers of the country.
On the other hand, there are many commercial banks with hundreds of branches within and
outside the country
10. The central bank is the custodian of the foreign currency reserves of the country while the
commercial bank is the dealer of foreign currencies

Essentials of a Sound Banking System

The essentials of a sound banking system are usually regarded as liquidity and profitability. As
pointed out by Crowther, the secret of successful banking is to distribute resources between the
various forms of assets in stich a way as to get a sound balance between liquidity and profitability,
so that there is cash (on hand or quickly realizable) to meet every claim, and at the same time
enough income for the bank to pay its way and earn profits for its shareholders. But modern
bankers also consider a few other essentials which are discussed below.
1. Liquidity
One of the essentials of a sound banking system is to have a high degree of liquidity. The bank
holds a small proportion of its assets in cash. Therefore, its other assets must possess the criterion of
liquidity so that they may be turned into such easily. A commercial bank is under an obligation to
pay its depositors cash on demand. This is only possible if the bank possesses such securities which
can be easily liquidated. Central banks have made it obligatory on the commercial banks to keep a
certain proportion of their assets in cash to ensure liquidity.

14 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

2. Safety
Another essential of a sound banking system is that it must be safe. Since the bank keeps the
deposits of the people, it must ensure the safety of their money. So it should make safe loans and
investments and avoid unnecessary risks. If the debtors of the bank do not repay the loans in time
and it loses on its investments, the bank shall become insolvent. As a result, its depositors lose
money and suffer hardships. Thus the bank must ensure the safety of its deposits.
3. Stability
A sound banking system must be stable. It should operate rationally. There should neither be undue
contraction nor expansion of credit. If the bank restricts the creation of credit when trade and
industry need it the most, it will harm the interests of the business community. On the other hand, if
it expands credit when the economic conditions do not permit, it will lead to boom and inflation. So
the banking system should follow a stable lending policy. The central bank of the country can help
in achieving stability in the banking operations of the commercial banks by a judicious credit
control policy.

4. Elasticity
The stability of banking operations should not be interpreted as rigidity. Rather, the banking system
should have sufficient elasticity in its lending operations. It should be in a position to expand and
contract the supply of loanable funds with ease in accordance with the directives of the central bank
of the country.

5. Profitability
A sound banking system should be able to earn sufficient profits. Profits are essential for it to be
viable. It has to pay the corporation tax like any other company, pay interest to its depositors,
dividend to shareholders, salaries to the staff and meet other expenses. So unless the bank earns, it
cannot operate soundly. For this purpose, it must adopt judicious loan and investment policies.

6. Reserve Management
Sound banking system must follow the principle of efficient reserve management. A bank keeps
some amount of money in reserve for meeting the demand of its customers in case of emergency.
Though the money kept in reserve is idle money, yet the bank cannot afford the risk of keeping a
small amount in reserve. There are, however, some statutory limits laid down by the central bank in
maintaining minimum reserves with itself and with the bank. But how much reserve money should

15 of 15 Management of Financial Institutions Tujuba A.

Unit 2: Banking System April 2023

a bank maintain is governed by its own wisdom, experience and the size of the bank. The bank
should manage its reserve policy effectively and efficiently without keeping too much or too little
cash. It has to balance between profitability and safety.

7. Expansion
A sound banking system must be spread throughout the country. It should not be concentrated only
in big towns and cities but in rural areas and backward regions. It is only by widespread expansion
of the banking system that the deposits can be mobilized and credit facilities can be made available
to trade, industry agriculture, etc. This is especially the case in a developing country where the
banking system must provide these facilities through its expansion in all areas. This is essential for
capital formation and economic growth.

16 of 15 Management of Financial Institutions Tujuba A.