Chapter Two: Banking System

2.1 Central Banking System

Central banks conduct monetary policy by adjusting the supply of money, usually through
buying or selling securities in the open market. Open market operations affect short-term
interest rates, which in turn influence longer-term rates and economic activity. When central
banks lower interest rates, monetary policy is easing. When they raise interest rates, monetary
policy is tightening.

A central bank, reserve bank, national bank, or monetary authority is an institution that
manages the currency, financial institutions and monetary policy of a country. In contrast to a
commercial bank, a central bank possesses a monopoly on increasing the monetary base.

2.2 Evolution of Central Banking

(To be given as assignment to students)

2.3 Definition of a Central Bank

A central bank, national bank, reserve bank or monetary authority is a banking institution
granted exclusive privilege to lend a government its currency. It is the apex bank in country.
It is a public institution that manages the currency of a country or group of countries and
controls the money supply. It is a national bank that provides financial and banking services
for its country's government and commercial banking system, as well as implementing the
government's monetary policy and issuing currency.

2.4 Central Banking Functions

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.

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

1. Currency regulator or bank of issue

It has monopoly of notes (legal tender money) issuing rights. This monopoly of issuing notes
has the following benefits:
 Uniformity in the notes issued which helps in facilitating exchange and trade.
 Enhances 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
requirement of the economy.

2. Banker, fiscal agent and advisor to the government

As banker to the government the central bank:

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  Keeps the deposits of the government and makes payments on behalf of the
government.
 Buys and sells foreign currency on behalf of the government.
 Keeps the stock of gold of the government.
 Serve the custodian of government money and wealth.

As fiscal agent of the government, central bank:

 Makes short-term loans to the government.
 Floats loans, pays interest on them and finally repays them on behalf of the
government.
 Manages the entire public debt.

As advisor of the government, central bank:

 Advises the government on such issues as:
o Economic and monetary matters as controlling inflation or deflation.
o Devaluation or revaluation of the currency.
o Deficit financing
o Balance of payment, etc.

3. Custodian of Cash reserve requirement of Commercial Banks

 Commercial banks are required to keep reserve equal to a certain percentage of both
demand, saving and time deposits with the central bank.
 It is on the basis of these reserves that central bank transfers funds from one bank to
another to facilitate clearing of checks.
 The central bank acts as the custodian of the cash reserve requirement of commercial
banks and helps in facilitating their transactions.

4. Custodian and Management of Foreign Exchange

 It keeps and manages the foreign exchange reserve of the country.
 It sells gold at fixed price to the monetary authority of other countries.
 It buys and sells foreign currencies at international prices.
 It fixes the exchange rates.
 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 Last Resort

 Central 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 facility helps such institutions in order to help them in times of stress so as to
save financial structure of the country from collapse.

6. Clearing house for transfer and settlement

 It acts as a clearing house for transfer and settlement of mutual claims of commercial
banks.
 In a clearing house, the representatives of different banks meet and settle the
interbank payments.

7. Controller of credit

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  This is the most important function of central bank in order to control inflation and
deflation.
 Additional controlling functions of central banks include the supervising and
controlling of commercial banks and other financial institutions:
o Issue of licenses.
o The regulation of branch expansion.
o To see that every financial institutions especially commercial bank maintains
the minimum paid up capital and reserve as provided by law.
o Inspection or auditing the accounts of banks.
o To approve the appointment of chairpersons and directors of such banks in
accordance with the rules and qualifications.
o To control and recommend merger of weak banks in order to avoid their
failures and to protect interest of depositors.
o To recommend nationalization of certain banks to the government in public
interest.
o To publish periodical reports relating to different aspects of monetary and
economic policies.

8. Protecting depositors’ interests

 Central bank also needs to keep an eye on the functioning of the commercial banks in
order to protect the interests of depositors.

2.5 Credit Control Methods

Credit control is a function performed by the Central Bank to control the credit, i.e. the
demand and supply of money or say liquidity in the economy. With this function, the central
bank regulates the credit granted by the commercial banks to its customers. It aims to achieve
economic development with stability as well as to manage the inflationary and deflationary
pressure.

It involves limiting the credit volume created by the commercial bank, regulating the credit
volume, directing credit to productive uses, and implementing measures that strengthen the
structure of banks.

The basic objectives of credit control are:

 To stabilize in the internal price level.
 To stabilize the foreign exchange rates.
 To protect the outflow of gold.
 To control business cycles.
 To meet business needs
 To promote overall economic growth and development.
 To promote national interest.

Methods of Credit Control used by Central Bank

The following points highlight the two categories of methods of credit control by central
bank. The two categories are: I. Quantitative or General Methods II. Qualitative or Selective
Methods.

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Category I. Quantitative or General Methods

1. Bank Rate Policy

It is described as the standard rate at which the central bank is ready to purchase and
rediscount eligible instruments like government-approved bills and commercial papers. It has
a great influence on the availability and cost of credit.

When the central bank increases the bank rate, it may result in a reduction in the volume of
borrowings by the commercial bank from central bank, whereas when the central bank
reduces the bank rate, the borrowings become economical for the commercial bank and thus
encourages credit expansion of the economy.

2. Open Market Operations

It implies trading of eligible securities by the country’s apex bank, i.e. central bank in both
capital market and money market. When the central bank purchases or sells short-term or
long-term securities, it leads to an increase or decrease in the financial resources of the
commercial bank. This will ultimately influence the credit creation of the banks.

3. Variable Cash Reserve Ratio

Under this system the Central Bank controls credit by changing the Cash Reserves Ratio. For
example—If the Commercial Banks have excessive cash reserves on the basis of which they
are creating too much of credit which is harmful for the larger interest of the economy. So it
will raise the cash reserve ratio which the Commercial Banks are required to maintain with
the Central Bank.

This activity of the Central Bank will force the Commercial Banks to curtail the creation of
credit in the economy. In this way by raising the cash reserve ratio of the Commercial Banks
the Central Bank will be able to put an effective check on the inflationary expansion of credit
in the economy.

Similarly, when the Central Bank desires that the Commercial Banks should increase the
volume of credit in order to bring about an economic revival in the country. The Central
Bank will lower down the Cash Reserve ratio with a view to expand the cash reserves of the
Commercial Banks.

With this, the Commercial Banks will now be in a position to create more credit than what
they were doing before. Thus, by varying the cash reserve ratio, the Central Bank can
influence the creation of credit.

4. Repo Methods, i.e. Repurchase Options

Repo or otherwise called Repurchase transactions are carried out by the central bank, to
regulate the money market situation. As per this transaction, the Central bank grants loan to
commercial banks against government-approved securities for a fixed period, at a specified
rate, called as Repo Rate, on a condition that the borrower bank will repurchase the securities
at the predetermined rate, once the period is over. These transactions are undertaken by the
central bank in order to absorb or drain liquidity from the system.

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Category II. Qualitative or Selective Method of Credit Control

The qualitative or the selective methods are directed towards the diversion of credit into
particular uses or channels in the economy. Their objective is mainly to control and regulate
the flow of credit into particular industries or businesses.

The following are the important methods of credit control under selective method

1. Credit Rationing

Under this method the credit is rationed by limiting the amount available to each applicant.
The central bank puts restrictions on demands for accommodations made upon it during times
of monetary stringency.

In this the central bank discourages the granting of loans to stock exchanges by refusing to re-
discount the papers of the bank which have extended liberal loans to the speculators. The
central bank orders the commercial banks to provide loans only for essential purposes and not
for non-essential purposes.

2. Fixation of Margin requirements

In this technique, the central bank determines the margin which commercial banks and
financial institutions need to maintain for the amount extended by them in the form of loans,
against commodities, and shares. The central bank also prescribes margin requirements for
the underlying securities, so as to restrict speculative dealing in stock exchanges.

Some traders often indulge in speculative activities by hoarding goods and services and
creating artificial shortage of goods. This is done with loans taken from commercial banks.
To curb this, the central bank instructs the commercial banks to raise their margin and reduce
the loan amount given to traders. This prevents the traders from indulging in speculative
activities and inflation is curbed.

3. Moral Persuasion

As per this method, the central bank exercises a moral influence on the commercial banks, in
the form of advice, suggestion, guidelines, directives, request and persuasion. In order to
control inflation, the central bank politely appeals to all the commercial banks to provide
lesser loans at a higher rate of interest.

4. Method of Publicity

In order to create awareness and enlighten public about the central bank’s efforts to curb
inflation, they publish reports in all major newspapers, journals, annual reports, websites, etc.

5. Regulation of Consumer’s Credit

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With an aim of regulating consumer credit, the apex bank determines the down payments and
the length of the period over which installments are to be spread. At the time of inflation,
higher restrictions are levied to control the prices by controlling demands, whereas, at the
time of depression, relaxations are provided so as to increase demand for goods.

6. Control through Directives

The central bank issues strict warnings to commercial banks to provide lesser loans at a
higher rate of interest through letters and meetings. This in turn help to control inflation.

It can help in regulating lending policies of the commercial banks or to fix a maximum limit
of credit for specific purposes and also to restrain the flow of bank credit into non-essential
lines. It may result in diverting the credit to productive use.

7. Direct Action

When all else fails, the central bank gives an ultimatum to the commercial banks by refusing
to rediscount bills of exchange, refusing to lend and also threatens to shut down the banks as
a last resort, if they disobey the central bank’s instructions.

2.6. Monetary Policy & its Objectives

Monetary Policy is a set of tools that a nation’s central bank has available to promote
sustainable economic growth by controlling the overall supply of money that is available to
the nation’s bank, its consumers, and its business.

Monetary policy is the control of the quantity of money available in an economy and the
channels by which new money is supplied.

Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry
and sector-specific growth rates influence monetary policy strategy.

A central bank may revise the interest rates it charges to loan money to the nation's banks. As
rates rise or fall, financial institutions adjust rates for their customers such as businesses or
home buyers.

Additionally, it may buy or sell government bonds, target foreign exchange rates, and revise
the amount of cash that the banks are required to maintain as reserves.

Types of Monetary Policy

1. Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by
decreasing interest rates, purchasing government securities by central banks, and lowering the
reserve requirements for banks. An expansionary policy lowers unemployment and stimulates

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business activities and consumer spending. The overall goal of the expansionary monetary
policy is to fuel economic growth. However, it can also possibly lead to higher inflation.

2. Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in the
economy. It can be achieved by raising interest rates, selling government bonds, and
increasing the reserve requirements for banks. The contractionary policy is utilized when the
government wants to control inflation levels.

Impact of Monetary Policy

 Inflation: By controlling the money supply, central banks can influence price levels.
 Economic Growth: Monetary policy can stimulate or dampen economic activity.
 Employment: Monetary policy can impact employment levels by influencing
business investment and consumer spending.
 Exchange Rates: Monetary policy can affect the exchange rate of a currency.

Effective monetary policy is crucial for maintaining economic stability and promoting
sustainable growth. Central banks carefully analyze economic indicators and adjust their
policies to achieve their macroeconomic objectives.

Objectives of Monetary Policy

The primary objectives of monetary policy are:

1. Price stability: This means maintaining low and stable inflation, typically measured
by changes in the Consumer Price Index (CPI). Price stability is crucial for ensuring
the purchasing power of money and fostering economic growth.
2. Economic growth: Monetary policy aims to stimulate economic activity, leading to
increased production, employment, and improved living standards.
3. Full employment: Central banks strive to minimize unemployment rates, which can
be achieved by promoting economic growth and stability.
4. Financial stability: This involves maintaining a healthy and resilient financial
system, preventing financial crises, and ensuring the smooth functioning of financial
markets.
5. Exchange rate stability: In some cases, central banks may also target exchange rate
stability, particularly for countries with fixed or managed exchange rate regimes.
It's important to note that these objectives can sometimes conflict with each other. For
example, policies aimed at stimulating economic growth may lead to higher inflation, while
policies aimed at controlling inflation may slow down economic growth. Central banks must
carefully balance these objectives to achieve overall macroeconomic stability.

Key Tools of Monetary Policy

1. Interest Rate Adjustments

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The central bank may change the interest rates (at which commercial banks borrow from the
central bank and the interest rates charged by banks to their customers. By adjusting these
rates, the central bank can influence borrowing and lending activity, affecting economic
activity.

2. Open Market Operations

In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or
sells additional bonds to investors to change the number of outstanding government securities
and money available to the economy as a whole.
The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term
interest rates and that affect other interest rates.

3. Reserve Requirements
Authorities can manipulate the reserve requirements, the funds that banks must retain as a
proportion of the deposits made by their customers to ensure that they can meet their
liabilities.

Lowering this reserve requirement releases more capital for the banks to offer loans or buy
other assets. Increasing the requirement curtails bank lending and slows growth.

2.7. Regulations of Financial System

Financial regulation refers to the rules and laws firms operating in the financial industry, such
as banks, credit unions, insurance companies, financial brokers and asset managers must
follow. However financial regulation is more than just having rules in place - it's also about
the ongoing oversight and enforcement of these rules.

All of us depend on the financial system in one way or another. For example, savers rely on
banks to have their money available when they need it. Businesses need to be able to borrow
to maintain and develop their business. Consumers taking out a mortgage or insurance may
need to get advice on the best product for them. In the case of insurance companies,
policyholders rely on getting claims paid when something goes wrong.

Importance of Financial Regulation

 Protecting consumers: Financial regulation helps to protect consumers from unfair
practices, such as predatory lending and misleading investment advice.
 Ensuring financial stability: By maintaining the stability of the financial system,
financial regulation helps to prevent financial crises and economic downturns.
 Promoting economic growth: A well-regulated financial system can promote
economic growth by facilitating investment and innovation.
 Maintaining public trust: Financial regulation helps to maintain public trust in the
financial system, which is essential for its functioning.

Key aspects of financial regulation include:

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  Prudential regulation: This focuses on ensuring that financial institutions have
sufficient capital and liquidity to withstand financial shocks and operate safely.
 Consumer protection: This aims to protect consumers from unfair practices,
misleading information, and predatory lending.
 Market integrity: This involves ensuring that financial markets operate fairly and
efficiently, without manipulation or fraud.
 Systemic risk management: This focuses on identifying and mitigating risks that
could threaten the stability of the entire financial system.

Who regulates the financial system?

Financial regulation is typically carried out by a combination of government agencies and
independent regulatory bodies. These bodies may include central banks, securities
commissions, and banking regulators.

Types of financial regulations include:

 Capital requirements: Banks and other financial institutions are required to maintain
a certain level of capital to absorb potential losses.
 Liquidity requirements: Financial institutions must maintain sufficient liquidity to
meet their obligations.
 Disclosure requirements: Financial institutions are required to disclose information
about their financial condition and operations.
 Consumer protection laws: These laws protect consumers from unfair practices,
such as deceptive advertising and predatory lending.
In conclusion, financial regulation plays a crucial role in maintaining the stability and
integrity of the financial system. By protecting consumers, promoting fair competition, and
mitigating systemic risk, financial regulation helps to ensure the long-term health of the
economy.

The Pros & Cons of Financial Regulations

Financial regulations are rules and laws designed to ensure the stability, fairness, and
transparency of the financial system. They are essential for protecting consumers, businesses,
and the overall economy. However, like any set of rules, financial regulations come with both
advantages and disadvantages. Here's a breakdown of the pros and cons.

Pros of Financial Regulations

 Consumer Protection: Financial regulations safeguard consumers by preventing
fraudulent activities, ensuring fair practices, and protecting their investments.
 Market Stability: Well-regulated markets are less prone to crashes and panics.
Regulations help maintain financial stability by reducing risks and promoting
responsible lending and investing.
 Investor Confidence: Regulations increase investor confidence by ensuring
transparency and fair dealing. This encourages investment and economic growth.
 Systemic Risk Reduction: Regulations help mitigate systemic risks, which are risks
that can destabilize the entire financial system.
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  Fair Competition: Regulations promote fair competition by preventing monopolies
and anti-competitive practices.

Cons of Financial Regulations

 Increased Costs: Regulations can increase costs for financial institutions, which may
be passed on to consumers in the form of higher fees or reduced services.
 Reduced Innovation: Strict regulations can stifle innovation and hinder the
development of new financial products and services.
 Regulatory Burden: Complex regulations can create a significant regulatory burden
for financial institutions, requiring them to allocate resources to compliance efforts.
 Regulatory Capture: In some cases, regulators may be influenced by the industries
they regulate, leading to regulations that benefit the industry rather than consumers.
 Unintended Consequences: Sometimes, regulations can have unintended
consequences that harm the economy or create new problems.
Balancing Act
The key to effective financial regulation is finding the right balance between protecting
consumers and businesses while fostering innovation and economic growth. It's important to
have regulations that are clear, consistent, and proportionate to the risks involved.

2.8. Central Banking System in Ethiopia

The central banking system in Ethiopia is overseen by the National Bank of Ethiopia (NBE).
It was established in 1963 and is responsible for maintaining price stability, ensuring the
safety and soundness of the financial system, and promoting economic growth.

Key functions of the NBE are:

 Monetary policy: NBE is responsible for formulating and implementing monetary
policy to ensure price stability and economic growth. This includes setting interest
rates, controlling the money supply, and managing inflation.
 Banking supervision: NBE regulates and supervises the banking sector to ensure the
safety and soundness of financial institutions. This involves licensing banks, setting
capital adequacy requirements, and monitoring their financial health.
 Foreign Exchange Management: NBE manages Ethiopia's foreign exchange
reserves and oversees foreign exchange transactions. This includes setting exchange
rates, regulating foreign investment, and promoting international trade.
 Issuing Currency: NBE is responsible for issuing and circulating the Ethiopian Birr,
the country's official currency.
 Acting as Banker to the Government: NBE provides banking services to the
Ethiopian government, including managing government accounts, issuing government
bonds, and facilitating government transactions.
 Economic Research and Analysis: NBE conducts economic research and analysis to
inform its policy decisions and provide guidance to the government and the public.
These are the core functions of the National Bank of Ethiopia. By performing these functions,
NBE plays a crucial role in maintaining financial stability, promoting economic growth, and
fostering a sound financial system in Ethiopia.

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Recent Developments
In recent years, the Ethiopian government has implemented various reforms to modernize the
financial sector. This includes strengthening the regulatory framework, promoting financial
inclusion, and encouraging the growth of private banks.

Challenges
Despite these reforms, the Ethiopian banking sector still faces challenges, including:
 Limited access to finance: A significant portion of the population, particularly in
rural areas, still lacks access to formal financial services.
 High levels of non-performing loans: Some banks have struggled with high levels of
non-performing loans, which can impact their financial stability.
 Corruption and fraud: Corruption and fraud remain significant challenges in the
Ethiopian banking sector.
The NBE is working to address these challenges and promote the development of a sound
and efficient financial system in Ethiopia.

2.9. Commercial Banking System

A commercial bank is a financial institution that provides various financial services to

individuals, businesses, and other organizations. These services include:
 Accepting Deposits: Commercial banks accept deposits from customers, such as
savings accounts, checking accounts, and time deposits.
 Granting Loans: They provide loans to individuals and businesses for various
purposes, including home mortgages, auto loans, business loans, and personal loans.
 Offering Investment Services: Some commercial banks offer investment services
like mutual funds, stocks, and bonds.
 Providing Payment Services: They facilitate payments through checks, debit cards,
and online banking.
 Foreign Exchange Services: They offer foreign exchange services, such as currency
exchange and international money transfers.
How Commercial Banks Make Money

Commercial banks primarily generate revenue through:

 Interest Income: They earn interest on loans they provide to customers.
 Fees and Charges: They charge fees for various services, including account
maintenance, overdraft fees, and transaction fees.
 Investment Income: They earn income from investments in securities, such as bonds
and stocks.
Types of Commercial Banks

There are three different types of commercial banks.

 Private bank: It is a type of commercial banks where private individuals and
businesses own a majority of the share capital. All private banks are recorded as
companies with limited liability.

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  Public bank: It is a type of bank that is nationalized, and the government holds a
significant stake.
 Foreign bank: These banks are established in foreign countries and have branches in
other countries.

Role of Commercial Banks in the Economy

Commercial banks play a crucial role in the economy by:

 Facilitating Economic Growth: By providing loans to businesses, banks help
stimulate economic activity and job creation.
 Mobilizing Savings: They collect savings from individuals and businesses, which
are then channeled into productive investments.
 Providing Payment Services: They facilitate smooth transactions, enabling efficient
economic activity.
 Managing Risk: Banks assess creditworthiness and manage risk to ensure the
stability of the financial system.
Challenges Faced by Commercial Banks
 Economic Cycles: Economic downturns can lead to increased loan defaults and
reduced profitability.
 Technological Disruption: The rise of fintech companies and digital banking
challenges traditional banking models.
 Regulatory Compliance: Banks must adhere to complex regulations to prevent
financial crises.
 Cybersecurity Threats: Banks are increasingly vulnerable to cyberattacks, which
can lead to significant financial losses and reputational damage.
In conclusion, commercial banks are essential institutions that play a vital role in the
economy. By providing a range of financial services, they contribute to economic growth, job
creation, and overall financial stability.

2.10. Domestic and International Banking Operations

Domestic Banking Operations

Domestic banking operations refer to the activities conducted by a bank within its home
country. These typically include:

Retail Banking
 Accepting deposits (savings, checking, time deposits)
 Granting loans (mortgages, auto loans, personal loans)
 Providing payment services (checks, debit cards, online banking)
Commercial Banking
 Offering loans and credit facilities to businesses
 Providing cash management services
 Issuing letters of credit

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Investment Banking
 Underwriting securities
 Mergers and acquisitions advisory
 Asset management
International Banking Operations

International banking operations involve cross-border activities. Banks may engage in these
operations directly or through subsidiaries and branches. Some common international
banking activities include:

Trade Finance
 Issuing letters of credit
 Financing export and import transactions
 Providing working capital facilities to international businesses
Foreign Exchange
 Trading foreign currencies
 Providing hedging services against currency fluctuations
 Offering currency exchange services
International Lending
 Extending loans to foreign borrowers
 Syndicating loans with other banks
Investment Banking
 Advising on cross-border mergers and acquisitions
 Underwriting international securities offerings

Key Differences between Domestic and International Banking

Feature Domestic Banking International Banking
Regulatory Subject to domestic Subject to multiple regulatory
Environment regulations regimes
Currency risk Minimal or no currency risk Significant currency risk
Political Risk Lower political risk Higher political risk, especially in
emerging markets
Operational Simpler operations More complex operations due to
Complexity cross-border transactions and
regulatory differences

Challenges in International Banking

 Regulatory Complexity: Different countries have varying regulations, making it
challenging to comply with all requirements.
 Political Risk: Political instability and changes in government policies can impact
operations.
 Currency Risk: Fluctuations in exchange rates can impact profitability.

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  Credit Risk: Assessing the creditworthiness of foreign borrowers can be more
difficult.
 Operational Risk: Cross-border transactions and different time zones can increase
operational risks.
To mitigate these challenges, international banks often employ sophisticated risk
management techniques, such as hedging, diversification, and credit analysis. Additionally,
they rely on strong relationships with correspondent banks to facilitate cross-border
transactions.

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