Chapter Three

Financial Institutions in the Financial System

Classification of Financial Institutions

Though there is no generally accepted method of classification, financial institutions can be

classified as Deposit Taking Institution (DTI) and Non De posit Taking Institution (NDIT).
There are three reasons for this
1. The deposit liabilities of DTIs usually form the bulk of the country’s money supply. The
quantity and growth of these deposits is thus of considerable policy interest to the
government and central bank and so DTIs are often subject to pressures and influences
which do not apply to NDTIs.
2. As deposit liabilities are money, the failure of a DTI means that people lose, at least
temporarily, access to means of payment. This is a serious issue and DTIs are usually
subject to supervision and regulation which is not applied to NDTIs
3. Customers hold deposits for reasons which are rather different from those reasons which
cause them to hold other types of financial products.
Depository InstitutionsDepository
InstitutionsDepository institutions include commercial banks, saving and loan
institutions, saving banks, and credit unions. These financial intermediaries accept deposits.
Deposits represent the liabilities (debt) of the deposit accepting institutions. With the fund rose
through deposits and other funding sources, depository institutions make direct loans to various
entities and also invest in securities. Saving and loan associations, saving banks, and credit
unions are commonly called “thrifts” which are specialized types of depository institutions.
Non – Depository Financial Institutions
The non depository financial institutions include insurance companies, property and casualty
companies, pension funds, and investment companies. Their primary objective is acting as agent
and risk bearing for their customers.

Brief History of Banking It may be said that, Banking in its simplest form, is as old as authentic
history. As early as 2000 B.C., Babylonians had developed a system of banks. In ancient
Greece and Rome the Practice of granting credit was widely prevalent.

Banking had its roots in the earliest time in the villages. The village moneylenders, the
goldsmiths and the merchants were men of honesty, integrity and reliability. They therefore,
became custodians of the spare money of the villagers. Thus, modern banks have their ancestors
of repute, the merchants, the moneylenders and the goldsmith.

Merchants were men of honor and reputation. They were honest men in business. These
qualities put them distinct and they were regarded as trustworthy persons. They were persons to
whom any could be entrusted for safe custody. Accordingly, the practice arose for people who had spare
money to entrust it to merchants for safe custody. In turn, the merchants issued receipts for such money
accepted by them for safe custody. These receipts were purely acknowledgements of abilities, which the
merchants owed to those who entrusted money to them. These receipts were similar to bank notes and
were title to money and were assets to those who possessed them, just as merchants had to honor all
receipts issued by them.

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Money lender as ancestor of commercial banks can be easily understood. The money lender was man of
some reputations in the village. He used to advance loans to the needy public at a nominal rate of
interest. For purposes of lending, he used his own capital and very often-accepted money from the
members of the community who could spare it. Thus, he now becomes a borrower since he borrows from
the public who have money to spare and lent it to the needy. In the same way, commercial banks accept
spare money as deposits and lend it for those who need it.

The goldsmith was also a man of reputation and had means for safekeeping. So he began to attract and
accept spare money as well as valuables for safe custody and issues receipts for the same. This laid a
foundation to the emergence of the modern bank notes. He also undertook the task of transferring funds
from one account to another under oral or written instructions from his clients. This activity has said to
be developed to the modern cheque system.

Generally, banking business has century’s age-old history associated with frequent changes in the
character and content of the banking institutions.

Nature and Classification of Banks/Types of Banks

A classification of financial institutions presents many problems. Banks are different nature. Thus
differences basically emanates from the differences in their functions in a given country. Thus, it is very
problematic and difficult to have a classification of financial institutions that can apply to all conditions as
economic conditions and financial needs vary from country to country. Countries dependent on
agriculture may establish banks operating in encouraging agricultural development while others with
small-scale industrial structure may find it necessary to have industrial development banks. In other
circumstances, they may be given a general and wider name of Development banks. Hence, the nature of
financial institutions, being shaped by the general economic structure of a country considered, varies from
one country to another.

However, from academic point of view, it is necessary to classify banks on some arbitrarily fixed
common basis. Accordingly, the possible basis for classifying banks into different types could be their
area of financing. Some banks are meant to finance agriculture, other industry and some other to finance
commence in general. Secondly, common to all of them is their dealing with credits. Most banks receive
deposits or borrow money from the public and in turn lend the same to the public. However in financing
different spheres of the economy, some lend money for short periods while some grant for long periods.

In a broader sense, one can classify banks into two; these who deals with the banks (commercial banks)
and that who deal with financial institution (central bank).

Being this is how banks are classified, central bank posses distinct features from other banks.

In general context, Banks can be classified into various types on the basis of their functions, ownership,
domicile etc.

I. Classification of the basis of Functions:

1. Commercial Banks. The banks which perform all kinds of banking business and generally
finance trade and commerce all called commercial banks. Since their deposits are for a short period,
these banks normally advance short-term loans to the businessmen and traders and avoid medium-
term and long-term lending. However, recently, the commercial banks have also extended their areas
of operation to medium-term and long-term finance. Majority of the commercial banks are in the
public sector. But, there are certain private sectors banks operating as joint stock companies. Hence,
the commercial banks are also called joint stock banks.

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 2. Industrial Banks. Industrial banks, also known as investment banks, mainly meet the medium-term and
long-term financial needs of the industries. Such long-term needs cannot be met by the commercial banks
which generally deal with the short-term lending. The main functions of the industrial banks are: (a) they
accept long-term deposits (b) They grant long-term loans to the industrialists to enable them to purchase land,
construct factory building, purchase heavy machinery. Etc. (c) They help selling or even underwrite the
debentures and shares of industrial firms. (d) They can also provide information regarding the general
economic position of the economy. (In Ethiopia, industrial banks, like Development Bank of Ethiopia is
playing significant role in the industrial development of country.
3. Agricultural Banks. Agricultural credit needs are different from those of industry and trade. Industrial
and commercial banks normally do not deal with agricultural finance. The agriculturists require (a) short-term
credit to buy seeds, fertilizers and other inputs, and (b) long-term credit to purchase land, to make permanent
improvements on land, to purchase agricultural machinery and equipment, etc.
4. Exchange Banks. Exchange banks deal in foreign exchange and specialize in financing foreign trade.
They facilitate international payments through the sale and purchase of bills of exchange and thus play an
important role in promoting foreign trade. (In Ethiopia, these functions performed by selected commercial
banks and foreign banks).

5. Saving Banks. The main purpose of saving banks is to promote saving habits among the general public
and mobilize their small savings. (In India, postal saving banks do this job. They open accounts and issue
postal cash certificates.

6. Central Bank. Central bank is the apex institution which controls, regulates and supervises the monetary
and credit system of the country. Important functions of the central bank are:
(a) It has the monopoly of note issue;

(b) It acts as the banker, agent and financial adviser to the state;

(c) It is the custodian of member banks’ reserves;

(d) It is the custodian of nation’s reserves of international currency;

(e) It serves as the lender of last resort;

(f) It functions as the bank of central clearance, settlement and transfer; and

(g) It acts as the controller of credit.

Besides these functions, (Ethiopia’s Central bank, i.e., the National Bank of Ethiopia, also performs many
developmental functions to promote economic development in the country.

II. Classification on the Basis of ownership:

On the basis of ownership, banks can be classified into three categories:

(1) Public Sector Banks: These are owned and controlled by the government. (In Ethiopia, the Government
bank like Commercial Bank of Ethiopia and some of the Micro Finance Institutions come under these
categories.

(2) Private Sector Banks: These banks are owned by the private individuals or corporations and not by
the government. Example: Bank of Abyssinia.
(3) Co-operative Banks: Cooperative banks are operated on the cooperative lines. (In India, cooperative
credit institutions are organized under the cooperative societies law and play an important role in meeting
financial needs in the rural areas.
III. Classification on the Basis of Domicile:

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

(1) Domestic Banks: These are registered and incorporated within the country.

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 (2) Foreign Banks: These are foreign in origin and have their head offices in the country of
origin. Example: Western Union Bank, Commerzbank etc.

Assets of Financial Institutions (Commercial Banks)

Commercial banks are the financial stores of the financial system. The offer a wide array of financial
services than any other financial institution, meeting the credit, payments, and savings needs of
individuals, business and governments.

a) Cash and Due from bank (Primary Reserves)

All commercial bank hold a substantial part of their assets in primary reserves, consisting of cash and
deposits held with other banks, these reserves are the banker’s first line of defense against withdrawals by
depositors and customer demand for loans. Banks generally hold no more than is absolutely required to
meet short–term contingencies because the yield on cash assets is minimal. The deposits held with other
banks do provide an implicit return for, however, because they are a means of ‘paying ‘for correspondent
banking services. In return for the deposits of smaller banks the larger U.S correspondents provide such
important services as clearing checks and processing records by computer. Thousand of smaller bank
across the U.S. invest their excess cash reserves in loans to other banks, called federal funds, with the
help of larger correspondent banks- referred to as federal funds sold.

b) Marketable securities (Secondary Preservers)

Commercial banks hold securities acquired in the open market as investment and as a secondary reserve
to help meet short-term cash needs. Most of the investment securities held by banks are money mark
instruments, which are liquid and have an original maturity of one year or less, or capital market
instruments that the commercial bank intend to hold for one year of less. Theses include bankers’
acceptances, commercial, U.S government securities (Treasury bills, notes, and bonds), U.S government
agency securities, municipal bonds

c) Loans: costumer & industrial loans

The business loans often referred to as C&I loans (commercial and industrial) which fall into four main
categories.

Transaction loans: is negotiated for a specific purchase and is tailored to the particular needs of the
purchaser. The demand for these loans a particular borrower is typically infrequent and hence each loan is
negotiated separately every time. The loan is usually secured by the assets being financed, and repayment
is expected to come from the use of this asset.

Working capital loans: are used by firm to finance routine day to day transactions. Thus, they are
general purpose, short- term borrowing and are often used either to purchase current assets (e.g.,
inventory) or to repay current liabilities incurred in purchasing current assets. These loans are also usually
secured by collateral such as accounts receivable or inventory.

Term loans: they are longer maturity loans used to buy fixed assets requiring large outlay of capital.
Maturities typically run from 3 to 10 years. Repayment is normally amortized because it comes out of the
cash flows generated by the asset financed with the loan.

Combination

Working capital loans often include provisions that permit the conversion of short term borrowings in to
term loans. This is one way banks combine various types of loans to satisfy the especial needs of their
customers.

Consumer loans

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The most important types of consumer loans are direct loans and bank credit card receivables. A direct
consumer loan is typically financing for the purchase of durable goods (e.g., cars and appliances), and is
secured with the asset being purchased. Bank credit card borrowings are a form of short- term, unsecured
credit used to finance almost any time costing less than the customer’s allowed credit limit. Credit cards
were introduced by Franklin National Bank in 1951, but became widely used only in the mid- 1960s.
Credit card lending has proved to be very profitable for banks. This profitability stems from two sources:
(i) the discount at the bank purchases sales slips from merchants which(who) typically ranges from 2% to
6%, and (ii) the interest rate charged to a card user who chooses not to remain current in payments.

Mortgage loans

These are a specialized form of costumer and commercial lending. The purpose of a mortgage loan is to
finance the acquisition or improvement of real estate. These loans are almost a ways secured by the real
estate they finance. The three principal types of mortgage loans are residential, construction and
commercial. Until the advent of securitization, mort age loans were illiquid assets because the uniqueness
of each property, the severity of private information problems, and the uncertain maturity of the loan due
to the possibility of prepayment by the borrower. However, securitization took care of many of theses
impediments to the marketability of mortgages and facilitated the liquidity of these instruments.

Commercial Bank Liabilities

To carry out their extensive lending and investing operations, commercial banks draw on a wide verity
of deposits and non-deposit source of funds. The vast majority of commercial bank liabilities are in the
form of deposits. However, non-deposit sources of funds include federal funds purchased from other
banks, security repurchase agreements (repos), and the issuance of capital notes,

Deposits The bulk of commercial bank funds-more than three-fourths-comes from deposits. There are
three main types of deposits: demand, savings and time.

Demand Deposits Demand deposits, more commonly known as checking accounts, are the principal
means of making payments because they are safer than cash and are widely accepted. Although outside
the U.S smart cards, credit cards, and transfers by electronic means have generally outstripped demand
deposits as payment media. During the past three decades, new forms of demand deposits appeared,
combining the essential features of both demand and savings deposits. These transaction accounts include
NOW accounts (negotiable orders of withdrawal) and automatic transfer services (AST). NOW account
may be drafted to pay bills but also earn interest, while ATS is a pre- authorized payment service in
which the bank transfers funds from an interest- bearing saving account to a checking account as
necessary to cover checks written by customer.

Savings Accounts

Savings deposits generally are in small dollar a mounts they bear a relatively low interest rate but may be
with drawn by the depositor with no notice.

Time DepositsTime deposits carry a fixed maturity and usually the highest rate a bank can pay. Time
deposits may be divided into non-negotiable certificates of deposit (CDs), which are usually small,
consumer-type accounts, and negotiable CDs that may be traded in the open market in million–dollar
amounts and are purchased mainly by corporations.

Non – Deposit sources of funds

One of the most marked trends in commercial banking in recent years is greater use of non- deposit funds,
especially as competition for deposits increases. Principal non- deposit sources of fund for commercial
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banks today include federal funds purchased from other banks, security repurchase agreements where
securities are sold temporarily by the commercial bank and then bought bank later, and the issuance of
capital notes. Capital notes are of particular interest because many of these securities may be counted
under current regulation as capital for purposes of determining a commercial bank’s loan limit. Both state
and federal laws limit the amount of money a commercial bank can lend to any one borrower to a fraction
of the bank’s capital. To be counted as capital, however, capital notes must be subordinated deposits, so
that if a bank is liquidated, the depositors have first claim to its assets.

Commercial Bank Equity capital

Equity capital (or net worth) supplied by a bank’s stockholders only a minor portion (only about 8% on
average) of total funds for most commercial banks today. One of the most important functions of equity
capital is to keep a banks open in the face of operating losses until management can correct its problems.
Recently federal law has mandated minimum capital-to-asset ratios for commercial banks and many
banks have recently expanded their equity capital positions. There is also a set of cooperative
international capital regulations for major banks in the U.S, Great Britain, japans, and the nationals of
Western Europe. The Basle Agreement, reached in 1988, now imposes common minimum capital
requirements on all banks in leading industrialized countries based on the degree of risk exposure that
each banks faces

There are three principal types of equitable that make up the capital account: capital stock (preferred and
common), retained earning and special reserve accounts. Capital stock represents the direct investments
into commercial bank and typically includes par value and surplus. Surplus can be defined as the proceeds
of from the sale of equity in excess of their par value, plus earnings retained until the surplus account
equals the common stock account.

Retained earnings comprise that portion of the bank’s profit that is not paid out to shareholders as
dividends.

Special reserve accounts are set up to cover anticipated losses on loans and investment. They involve no
transfers of funds setting aside of cash, they are merely a form of retained earnings designed to reduce tax
liabilities and stock holders’ claims on current revenues.

Total Revenues The majority of bank revenues come from interest and fees on loans. Recently fee
income from loans has risen faster than interest income as banks have resorted to fewer direct loans to
customers and instead earned fee income by guaranteeing customer borrowing elsewhere or advising and
assisting customers with new security offerings. Interest and dividends on security holdings are the
second most important source of commercial bank revenues after loan income. Other minor sources of
income include earnings from trust (fiduciary) activities and service charges on deposit accounts.

Total Expenses

Bank expenses have risen rapidly in recent years, threatening to squeeze the industry’s operating income.
Greater competition from bank and non bank financial intermediaries has resulted in dramatic increases in
the real cost of raising funds, and the expense of upgrading computer, automated equipment and other
technology has placed an added drain on bank revenues. Interest on deposits and other borrowed funds is
the principal expense item for most commercial banks followed by the salaries and wages of employees.

The Interest Margin

First commercial bank income statements record all of their bank’s interest income from loans and
security investments. Then the total interest paid out on borrowed funds is subtracted to derive a
commercial bank’s net interest income or interest margin. This interest margin measures how efficiently a
bank is performing its function of borrowing and lending funds. For many banks the interest margin is the
principal determinant of their profitability.

The Non- interest Margin

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Of increasing importance in the commercial banking industry is the non interest margin, which is the
difference between total non-interest income (e.g., trust department income and service fees on deposits)
and non interest expenses (e.g., employee salaries/wages and occupancy expense- i.e. charge for brick and
mortar). The non-interest margin is growing in importance as a determinant of commercial bank profits
because banks are developing in more new services that generate non-interest fees (e.g., security
underwriting, managing pension plans, and a host of other off-balance sheet activities). Because bankers
face stiff competition they work especially hard minimize their non-interest expenses, particularly
employee costs, by substituting automated equipment and computerization for labor.

Functions of Commercial Banks

In the modern world, banks perform such a variety of functions that it is not possible to make an all-
inclusive list of their functions and services. However, some basic functions performed by the banks are
discussed below:

1. Accepting Deposits. The first important function of a bank is to accept deposits from those who
can save but cannot profitably utilize this saving themselves. People consider it more rational to
deposit their savings in a bank because by doing so they, on the one hand, earn interest, and on the
other, avoid the danger of theft. To attract savings from all sorts of individuals, the banks maintain
different types of accounts:

(i) Fixed Deposit Account. Money in these accounts is deposited for fixed period of
time (say one, two, or five years) and cannot be withdrawn before the expiry of that period. The rate
of interest on this account is higher that that on other types of deposits. The longer the period, the
higher will be the rate of interest. Fixed deposits are also called time deposits or time liabilities.

(ii) Current Deposit Account. These accounts are generally maintained by the traders
and businessmen who have to make a number of payments every day. Money from these accounts
can be withdrawn in as many times and in as much amount as desired by the depositors. Normally,
no interest is paid on these accounts. Rather, the depositors have to pay certain incidental changes to
the bank for the services rendered by it. Current deposits are also called demand deposits or demand
liabilities.

(iii)Saving Deposit Account. The aim of these accounts is to encourage and mobilize small savings
of the public. Certain restrictions are imposed on the depositors regarding the number of withdrawals
and the amount to be with drawn in a given period. Cheque facility is provided to the depositors.
Rate of interest paid on these deposits is low as compared to that on fixed despots.
(iv) Recurring Deposit Account. The purpose of these accounts is to encourage regular
savings by the public, particularly by the fixed income group. Generally money in these accounts is
deposited in monthly installments for a fixed period and is repaid to the depositors along with interest
on maturity. The rate of interest on theses deposits is nearly the same as on fixed deposits
(v) Home Safe Account. Home safe account is another scheme aiming at promoting
saving habits among the people. Under this scheme a safe is supplied to the depositor to keep it at
home and to put his small savings in it. Periodically, the safe is taken to the bank where the amount
of safe is credited to his account.
2. Advancing of loans. The second important function of a bank is advancing of loans to the
public. After keeping certain cash reserves, the banks lend their deposits to the needy borrowers.
Before advancing loans, the banks satisfy themselves about the credit worthiness of the borrowers.
Various types of loans granted by the banks are discussed below:

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(i) Money at Call. Such loans are very short period loans and can be called back by the
bank at a very short notice of say one day to fourteen days. These loans are generally made to other
banks or financial institutions.

(ii) Cash Credit. It is a type of loan which is given to the borrower against his current
assets, such as shares, stocks, bonds, etc. Such loans are not based on personal security. The bank
opens the account in the name of the borrowers and allows him to withdraw borrowed money from
time to time up to a certain limit as determined by the value of his current assets. Interest is charged
only on the amount actually withdrawn from the account
(iii) Overdraft. Sometimes, the bank provides overdraft facilities to its customers though which
they are allowed to withdraw more than their deposits. Interest is charged from the customers on the
overdrawn amount.

(iv) Discounting of Bills of Exchange. This is another popular type of lending by the modern
banks. Through this method, a holder of a bill of exchange can get it discounted by the bank. In a
bill of exchange the debtor accepts the bill drawn upon him by the creditor (i.e., holder of the bill) and
agrees to pay the amount mentioned on maturity. After making some marginal deductions (in the
form of commission), the bank pays the value of the bill to the holder. When the bill of exchange
matures, the bank gets its payment from the party which had accepted the bill. Thus, such a loan is
self-liquidating.
(v) Term Loans. The banks have also started advancing medium-term loans. The
maturity period for such loans is more than one year. The amount sanctioned is either paid or
credited to the account of the borrower. The interest is charged on the entire amount of the loan and
the loan is repaid either on maturity or in installments.
3. Credit Creation. A unique function of the bank is to create credit. In fact, credit creation is the
natural outcome of the process of advancing loan as adopted by the banks. When a bank advances a
loan to its customer, it does not lend cash but opens an account in the borrower’s name and credits the
amount of loan to this account. Thus, whenever a bank grants a loan, it creates an equal amount of
bank deposit. Creation of such deposits is called credit creation which results in a net increase in the
money stock of the economy. Banks have the ability to create credit many times more than their
deposits and this ability of multiple credit creation depends upon the cash-reserve ration of the banks.

4. Promoting Cheque System. Banks also render a very useful medium of exchange in the form of
cheques. Through a cheque, the depositor directs the bakers to make payment to the payee. Cheque
is the most developed credit instrument in the money market. In the modern business transactions,
cheques have become much more convenient method of settling debts than the use of cash
5. Agency Functions. Banks also perform certain agency functions for an on behalf of their
customers:
(i) Remittance of Funds. Banks help their customers in transferring funds from one
place to another through cheques, drafts, etc.

(ii) Collection and Payment of Credit Instruments. Banks collect and pay various credit
instruments like cheque, bills of exchange, promissory notes, etc.
(iii) Execution of Standing Orders. Banks execute the standing instructions of their customers for
making various period payments. They pay subscriptions, rents, insurance premium, etc. on behalf of
their customers.
(iv) Purchasing and Sale of Securities. Banks undertake purchase and sale of various securities like
shares, stocks, bonds, debentures etc. on behalf of their customers. Banks neither give any advice to
their customers regarding these investments nor levy any charge on them for their service, but simply
perform the function of a broker.

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 (v) Collection of Dividends on Shares. Banks collect dividends, interest on shares and
debentures of their customers.
(vi) Income Tax Consultancy. Banks may also employ income-tax experts to prepare income-tax
returns for their customers and to help them to get refund of income-tax.
(vii) Acting as Trustee and Executor. Banks preserve the wills of their customers and execute them
after their death
(viii) Acting as Representative and Correspondent. Sometimes the banks act as representatives and
correspondents of their customers. They get passports, traveler’s tickets, book vehicles, plots for their
customers and receive letters on their behalf.

6. General Utility Function. In addition to agency services, the modern banks provide many
general utility services as given below:
(i) Locker Facility. Banks provide locker facility to their customers. The customers can
keep their valuables and important documents in these lockers for safe custody.

(ii) Traveler’s Cheques. Banks issue traveler’s Cheques to help their customers to travel
without the fear of theft or loss of money. With this facility, the customers need not take the risk of
carrying cash with them during their travels.
(iii) Letter of Credit. Letters of credit are issued by the banks to their customers certifying their
creditworthiness. Letters of credit are very useful in foreign trade
(iv) Collection of Statistics. Banks collect statistics giving important information relating to
industry, trade and commerce, money and banking. They also publish journals and bulletins
containing research articles on economic and financial matters.
(v) Underwriting Securities. Banks underwrite the securities issued by the government,
public or private bodies. Because of its full faith in banks, the public will not hesitate in buying
securities carrying the signatures of a bank.
(vi) Gift Cheques. Some banks issue cheques of various denominations to be used on auspicious
occasions.
(vii) Acting as Referee. Banks may be referred for seeking information regarding the financial
position, business reputation and respectability of their customers.
(viii) Foreign Exchange Business. Banks also deal in the business of foreign currencies. Again,
they may finance foreign trade by discounting foreign bills of exchange.
(ix) Role of commercial banks in a developing Economy

A well-developed banking system is a necessary pre-condition for economic development in a

modern economy. Besides providing financial resources for the growth of industrialization, banks
can also influence the direction in which these resources are to be utilized. In the developing
countries, not only the banking facilities are limited to a few developed urban areas, but also the
banking activities are limited mostly to trade and commerce, paying little attention to industry and
agriculture. Structural as well as functional reforms in the banking system are needed to enable
the banks perform developmental role in developing countries.

Banks and Economic Development

In a modern economy, banks are to be considered not merely as dealers in money but also the leaders in
development. Commercial banks can contribute to a country’s economic development in the following
way.
1. Capital Formation: Capital formation is the most important determinant of economic
development and banks promote capital formation. Capital formation has three well-
defined stages: (a) generation of savings, (b) mobilization of saving, and(c) canalization
of saving in productive uses. Banks play a crucial role in all the three stages of capital
formation: (a) They stimulate savings by providing a number of incentives to the savers,
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 such as, interest on deposits, free and cheap remittance of funds, safe custody of
valuables, etc. (b) By expanding their branches in different areas and giving various
incentives, they succeed in mobilizing the savings generated in the economy.
2. Encouragement to Entrepreneurial Innovations. In underdeveloped countries, entrepreneurs
generally hesitate to invest in new ventures and undertake innovations largely due to lack of
funds. Facilities of bank loans enable the entrepreneurs to step up their investment and
in9gsnovational activities, adopt new methods of production and increase productive capacity of
the economy.
3. Monetization of Economy. Monetization of the economy is essential for accelerating
trade and economic activity. Banks help the process of monetization in two ways: (a)
They monetize debts. In other words, they buy debts (i.e., securities which are not
acceptable as money) and , in exchange, create demand deposits (which are acceptable as
money). (b) By spreading their branches in the rural and backward areas, the banks
convert the non-monetized sectors of the economy into monetized sectors.
4. Influencing Economic Activity. Banks can directly influence economic activity on (a) the rate of
interest, and (b) the availability of credit.
(i) Variations in Interest Rates. A reduction in the interest rates makes the investment
more profitable and stimulates economic activity. An increase in the interest rate, on the
other hand, discourages investment and economic activity.
(ii) Availability of Credit. Bankers can also influence economic activity by the
availability of credit. Credit creation is an important function of banks and bank credit forms
the major portion of money supply.
5. Implementation of Monetary Policy. Economic development needs an appropriate monetary
policy. But, a well-developed banking system is a necessary pre-condition for the effective
implementation of the monetary policy.
6. Promotion of Trade and Industry. Economic progress in the industrially advanced countries
in the last two hundred years or so is mainly due to expansion in trade and
industrialization which could not have been made possible without the
development of banking system. The use bank cheque, the bank draft and the bill
of exchange has revolutionized the internal and international trade, which, in turn,
has encouraged specialization and accelerated the pace of industrialization.
7. Encouragement to Right Type of Industries. By granting loans (particularly medium-term
and long term) the banks can provide financial resources to the right type of
industries to secure necessary material, machines and other inputs, In a planned
economy, it is necessary that the banks should formulate their loan policies in
accordance with the broad objectives and strategy of industrialization as adopted
in the plan. This will promote right type of industrialization in the economy.
8. Regional Development. Banks can also play an important role in achieving balanced
development in different regions of the economy. They can transfer surplus
capital from the developed regions to the less-developed regions where it is scarce
and most needed. This reallocation of funds between regions will promote
economic development in underdeveloped areas of the economy.
9. Development of Agriculture and Other Neglected Sectors. Underdeveloped economies are
primarily agricultural economies and majority of the population in these
economies live in rural areas. Therefore, economic development in these
economies requires the development of agriculture and small-scale industries in
rural areas. Thus, Necessary structural and functional reforms in the banking
system of the underdeveloped countries should be made in order to encourage the
banks to play developmental role in these economies.
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