Unit 2

Money and Banking

Concept of money
Money is the greatest contribution of human beings because it is a measuring rod of economy. Money is
anything that is generally acceptable as a medium of exchange, common measure, and store of value. To give
the precise definition of money is a difficult task. Various economists have given different definitions of money.
Money has been defined differently by different economists.

According to Walker, "Money is that what money does".

According to D.H. Robertson, "Anything which is widely accepted in payment for goods or in discharge of other
kinds of business obligations is called money".

Crowther defines money as "Anything that is generally acceptable as a means of exchange and at the same
time acts as a measure and store of value".

Two important things about money emerge from the above definition. First, money has

been defined in terms of the functions it performs. Secondly, an essential requirement of any kind of money is
that it must be generally acceptable to every member of the society. A complete definition should include all the
important functions of money and also its basic characteristic, i.e., general acceptability. Thus Crowther's
definition may be considered better as it covers both these qualities.

Role / Importance of Money

Money forms various roles in economic life of human beings. It is regarded as the pivot of
monetary system. The role of money can be explained under the following headings.
1. Facility of consumption: Money enables the consumer to spend his limited income on different goods
and services in such a way as to maximize his satisfaction. Consumer can purchase various types of
goods and services with the help of money.
2. Distribution: Money also plays an important role in the process of distribution of national product among
various factors of production in the form of rent, wages, interest, and profits. All these incomes are
measured and received in terms of money.
3. Exchange: One of the primary functions of money is to facilitate exchange of goods and services.
Money facilitates exchange and helps in the development of trade and commerce both national and
international. Money serves as medium of exchange, it
must have the quality of divisibility, value of store etc.
4. Capital formation: The process of capital formation in the modern economy is almost impossible
without money. The financial institutions mobilize savings from the general public and channelize them
into productive uses by advancing loans to the investors. Money is an indispensable tool for the
development of credit market.
5. Public finance: Public finance deals with government income and expenditure. The government
receives income by way of taxes, fees, fines etc., all of which are collected in terms of money. Similarly,
government makes payments of wages, salaries, interests etc., through the medium of money .
Functions of money
In recent days, money play important role in human society. It acts as medium, store, standard of deferred
payment and measure of value. The major functions of money are explained on three broad headings i.e.
primary, secondary, and contingent.
(A) Primary function of money
The primary function of money is supposed to be the major function of money, which covered medium of
exchange and measure of value.
1. Medium of exchange: One of the most important functions of money is to serve as a medium of exchange
for all kinds of goods and services. Money facilitates both buying and selling of goods and services. It promotes
transactional efficiency in exchange by facilitating the multiple exchange of goods and services with minimum
effort and time. It allows freedom of choice in the sense that a person can use his money to buy the things he
wants most, from the people who offer the best bargain and at a time he considers the most advantageous.
2. Measure of value: Another important function of money is that it serves as a common measure of value or
unit of account. It has made transaction easy and simplified the problem of measuring by serving as a common
measure of value.
(B) Secondary Function of Money
The following functions are known as secondary functions which are also highly considered in practical world.
1. Store of value:
Money also serves as a store of value of any goods and services. Money being the most liquid of all assets is a
convenient form to store wealth. It is a repository of purchasing power over time. Money is one such medium in
which one wishes to hold wealth. By acting as a store of value, money provides security to the individuals to
meet unpredictable emergencies and to pay debts that are fixed in terms of money. It also provides assurance
that attractive future buying opportunities can be exploited.
2. Standard of deferred payment
Another function of money is that it serves as a standard of deferred payment. Deferred payments mean those
payments which are to be made in the future. Money serves as the standard of deferred payment with the
introduction of money, borrowing and lending have become easier.
3. Transfer of value:
Money also serves as the common tool to transfer the value of asset, property, and income from person to
person. Money has facilitated the transaction of goods in distance places. For example, it is much easier to
transfer one million rupees through bank draft from person A in Kathmandu to person B in Nepalgunj.
(C) Contingent Function of Money
The economists categorize the following four functions in the contingent function of money.
1. Distribution of national income
Money facilitates the distribution of national income among the people. Total output of the country is jointly
produced by a number of people as workers, land owners, capitalists, and entrepreneurs, and, in turn, it will
have to be distributed among them. Money helps in the distribution of national product through the system of
wage, rent, interest, and profit.
2. Maximisation of satisfaction
Money helps consumers and producers to maximise their benefits. A consumer maximises his satisfaction by
equating the prices of each commodity (expressed in terms of money) with its marginal utility. Similarly, a
producer maximises his profit by equating the marginal productivity of a factor unit to its price.
3. Basis of credit
Credit plays an important role in the modern economic system and money constitutes the basis of credit. People
deposit their money (saving) in the banks and on the basis of these deposits, the banks create credit.
4. Liquidity and uniformity of wealth
Liquidity means transferability of any property from money to wealth and wealth to money as required. Money
imparts liquidity to various forms of wealth. When a person holds wealth in the form of money, he makes it liquid.
In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be converted into money.

Banking
Meaning Of Bank
The global definition of bank has not developed yet. Since, a modern bank performs various types of function it
is difficult to give its precise and general definition. It is because of this reason different economists give different
definitions of the bank. The main definition of bank given by economist and monetarist are as follows;
(1) Definition based on deposit collection
The definition of bank based on deposit collection falls under this definition. These definitions oriented on deposit
collection define bank only as a financial institution which accepts money as deposits and makes payment to the
consumers on short notice or request. According to World Bank, "Banks are financial institutions that
accept funds in the form of deposits repayable on demand or in short notice."
According to Prof Mart, "A banker is one who in the ordinary course of his business, receives money which is
repaid by honouring cheque of persons from whom or on whose account he receives it."
(2) Definition based on both deposit and loan
Under this definition some economists define bank as a financial institution which accepts deposit and issues
loans. According to Crowther, "A banker is a dealer in debts. The banker's business is to take the debts of other
people to offer his own in exchange and thereby to create money."
According to Kinley, "A bank is an establishment which makes to individuals such advances of money as may
be required and safely made and to which individuals entrust money when not required by them for use."
In short, the term bank in the modern times refers to an institution having the following features;
(i) It deals with money; it accepts deposits and advances loans.
(ii) It deals with credit; it has the ability to create credit.
(iii) It is commercial institution; it aims at earning profit.
(iv) It is a unique financial institution that creates demand deposits which serve as a
medium of exchange and as a result, the bank manages the payment system of the country.
Types of Banks
The modern banks can be classified on the basis of their functions, ownership, and
purposes of establishment. Broadly, the banks can be classified into following types.
(1) Central bank
The establishment of a central bank in a modern economy is essential as it is the apex institution of a country's
financial as well as monetary system. Its action affects money supply, the volume of credit, interest rates etc. All
these have direct impacts not only on financial markets but also on national output and inflation. Thus the central
bank plays an important role in any economy. In fact, every independent country must have a central bank for
organizing, running, supervising, regulating and developing the monetary financial system of a country.
Implementation of the government's economic policies requires the presence of the central bank, which stands
as the undisputed leader of the money market. The first central bank is Bank of London, which was established
in 1694 AD. The central bank of Nepal is Nepal Rastra Bank which was established in 2013BS under the NRB
act 2012 BC.
(2) Commercial bank
The banks which perform all kinds of banking business and generally finance trade and commerce are called
commercial banks. Commercial bank is regarded as the oldest financial institution in the history of bank. The
main objective of this bank is to earn profit.
The modern commercial banks collect deposit in various types of accounts, provide short-term, medium and
long-turn credit. The difference between the rates of interest on deposits and loans is the main source of its
income. Nepal Bank Limited was the first commercial bank of Nepal, which was established in the year 1994 BS.
There are 28 commercial banks working in Nepal at present.
(3) Development bank
Development bank which is established to meet the short term and medium-term financial needs of the investor
is termed as development bank. In the context of Nepal development bank is called the B class financial
institution.
(4) Finance company
Finance Companies are licensed by Nepal Rastra Bank in 'Class C'. Finance companies are those
intermediaries, which link the savers and users of capital. They collect small and scattered saving of the
individuals and mobilize it in the productive sectors in the form of investment or loan. The history of the finance
companies began with the establishment of the Nepal Housing Development Finance Company Limited in 1992.
(5) Micro Finance
Micro finance is the financial institutional which are established to provide banking services to the rural poor. The
concept of Rural Development Bank was developed in Bangladesh in 1976 AD. Generally, such bank provides
the short term loan in income generating activities without tangible deposit. Rural Development Bank in Nepal
was introduced in 2049 BS. There are five regional rural development banks in Nepal.

Role of Central Bank

1. Control of the money supply
2. Stabilizing the money and capital market.
3. Lender of last resort.
4. Maintaining and improving the payment mechanism.
5. Maintaining a sound banking and financial system
6. Carrying out monetary policy.
7. Providing information to the publics.
8. Monetization of the economy.
9. Capital formation.
10. Promotion of entrepreneurship etc.

Functions of Central Bank

The central bank generally performs the following functions;
(A) Traditional Functions
(1) Note issue
The central bank has the sole monopoly of note issue in almost every country. While issuing notes it must be
backed by assets of equal value. These assets consist of gold coin and bullions, foreign securities, coins and
government securities. Present 'currency standard' in Nepal is proportional reserve system in which NRB
requires to hold 50 percent assets in terms of gold (coin and bullion) and foreign securities and remaining 50
percent in the form of Nepali coin and securities while issuing notes. Till now, Nepal Rastra Bank has issued the
notes of Rs. 1, Rs. 2, Rs. 5, Rs.10, Rs.20, Rs. 25, Rs. 50, Rs.100, Rs.250, Rs.500 and Rs. 1000 in Nepal.

(2) Government's banker, agent and adviser

The central bank functions as a banker, agent and financial advisor to the government. As the government's
banker, central bank conducts the banking accounts of all governmental departments and offices, it makes
temporary advances to the government in anticipation of the tax collection and it carries out the government's
transactions involving purchase or sales of foreign currencies. Central bank also functions as the government's
financial agent, and financial adviser. As a government's banker, its responsibility is to manage government
borrowing - from the public or from abroad.
(3) Bankers banks
As a banker's bank, central bank holds a part of the cash reserves of commercial banks and lends those funds
for short periods. It also provides facilities to interbank transaction through centralized clearing mechanism.
Besides, it is the only government institution which gives permission to open new banks and finance companies
as well as extend branches.
(4) Controller of foreign exchange and custodian of foreign currency
Central bank regulates foreign exchange operations and it has the authority to hold foreign currency. It directs
and regulates the uses of foreign currency. To make international transaction easier and reliable, it helps to
maintain foreign exchange rate within a specified limits.
(5) Lender of the last resort
Central bank is the apex body of financial institutions. It serves as a lender of last resort to commercial banks.
Central bank has the responsibility of meeting financial demands of commercial banks in times of need and
emergency. It provides loan to other banks by charging some interest rate, called the discount rate.
(6) Controller of credit and money supply
Another important function of Central bank is to control bank credit and overall money supply. Excessive credit
and money supply may have strong effect on general price level. The excessive credit and money supply result
into inflation in terms of sustained rising prices. Thus, it is necessary to control such rising prices, and is
possible, to some extent, through control of money supply and credit. To keep commercial banks' credit within
desirable limits, central bank adopts various instruments like open market operations, interest rate and discount
rate policies.
(7) Clearing house function
The central banks acts a clearing house for member banks. As the central banks becomes the custodian of the
cash reserves of central banks , it is an easy and logical steps for it to act as a settlement bank or a clearing
house for other banks. As all banks have accounts with the central banks, simple transfer from and to their
accounts settles the claims of banks agents one another
(7) Authority of central clearance
In the banking system, commercial banks keep their cash reserve with central bank. Thus, inter-bank transaction
becomes easier through the central bank's clearing house mechanism. Bank's transactions can be adjusted by
means of debit and credit entries in their respective accounts with the central bank. In addition to above
mentioned seven functions of central bank, there are additional functions as well. To mobilize country's scarce
savings, central bank directs other commercial banks to establish their branches in the remote rural areas of the
country. To carry out such program, central bank provides some incentives to such commercial banks. It also
directs commercial banks to lend some portion of their funds to certain specified productive and priority areas.
The seven primary functions of central bank are summarized below:
· The sole right of note issue and regulation of currency.
· The performance of general banking and agency services for the government.
· The custodian of the cash reserves of the commercial banks.
· Authority of foreign reserve management.
· Authority of providing credit facilities to commercial banks and the general acceptance of the responsibility of
lender of the last resort.
· Authority of clearing balance between the banks.
· Authority of credit control in accordance with the needs of business and economy in general and for the
purpose of implementing government's monetary policy.

(B) Development Functions

a) It helps to spread banking facilities in the ruler areas of the country.
b) It helps to mobilizes resources into productive sectors by issuing different bills like treasury bills ,
development bonds etc.
c) It conducts various researches and collect various information regarding actual economic conditions and
publishes them.
d) It establishes relationships with international agencies like WB , IMF ,ADB etc.
e) It provides training facilities staff workers of the various banking institutions.
Commercial Bank
Meaning of Commercial Bank
The banks which perform all kinds of banking business and generally finance trade and commerce are called
commercial banks. In other words, it is an institution which is established with a view to profit motive is called
commercial bank. Nepal Bank Limited is the first commercial bank of Nepal.
Functions of Commercial Banks
Commercial banks render various financial services to their customers. Types of services differ from bank to
bank depending mainly on the size and type of banks. However, following are some important functions of
commercial banks;

1. Primary function
The collection of deposits in various accounts and lending money as a loan in different ways are the primary
functions of commercial banks. Following are the primary function of commercial banks.
(A) Accept money as deposits from the public
An important function of commercial banks is to accept money as deposits from the general public. Deposits are
of three types;
(i) Current account deposits
Such deposits are short-term in nature and can be withdrawn at any time. There is no restriction to withdraw
such deposits. There is no provision of interest for such deposits because a bank cannot freely utilize such
deposits.
(ii) Fixed deposits
Money in these accounts is deposited for fixed period of time and cannot be withdrawn before expiry of that
period. The rate of interest varies according to the period of maturity, the shorter the period, the lower the
interest rates, and the longer the period, the higher the interest rates. Under some circumstances, banks allow a
depositor to withdraw deposits before its specified date under the condition of losing some interest.
(ii) Saving account deposits
These deposits have some features of current account deposits as well as fixed deposits. Money can be
withdrawn from saving account on demand and also withdrawal by cheque. But such chequing facilities are
limited and banks do not allow too many cheques in a short period. Additionally, saving account deposits earn
interest. But the interest rate is lower than the fixed deposits.
(B) Lending money (deposits) as loans
Another important function of commercial bank is to lend money as loans. Such lending activities have been
done against gold and silver (bullion), government securities, company shares and debentures, bills of exchange
etc. Majority of lending is made to the business activities, productive investment and so on. Banks charge
interest to the borrowers and such lending rates are always higher than deposit rates. Such differences between
lending and deposit rates are the source of banks' profits.
(i) Money at call
Such loans are very short period loans and can be called back by the bank at a very short notice. These loans
are generally made to other banks or financial institution.
(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.
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.
(iii) Over draft
Commercial bank provides overdraft facilities to their customers, through which they are allowed to withdraw
more than their deposits. Certain interest is charged from the customers on the overdrawn amount. These type
of services are given to those who are more trustworthy.
(iv) Term loans
The banks have also started advancing medium and long-term loans. The maturity period of such loans is more
than one year. The interest is charged on the entire amount of the loan and the loan is repaid either on maturity
or in instalment.
2. Secondary function
Commercial banks also perform certain secondary functions for and on behalf of their customers. The bank
charges minimum fees for undertaking these functions. The secondary functions are as follows;
(i) Foreign currency transactions
Foreign currency transaction is the main secondary function of commercial bank. Commercial banks can sell
and buy foreign currencies based on demand and supply (market mechanism) of such currencies.
(ii) Remittance of money
Remittance of money is another important function of commercial banks. They issue drafts, mail transfer, and
telegraphic transfers in order to transfer their clients' money from one place to another. This function of the
commercial bank is useful for transferring money from one place to another.
(iii) Credit creation
Credit creation is a process in which banks increase the volume of their lending by an amount greater than the
increase in reserves. Credit creation by banks operates on fractional reserve ratios. It requires the presence of
demand for loans by creditworthy borrowers (usually business houses), and the extent of credit creation is
limited by the size of the reserve ratio. In Nepal, such loans (credit) are deposited in borrowers' account and are
allowed to draw when required under the instalment basis.
(iv) Issue letter of credit (LC)
Letters of credit are used largely in association with bills of exchange which help to promote and ease foreign
trade. Nepalese importers open letters of credit in Nepalese banks in favour of exporters from other countries
and payment is made to exporter by banks.
3. Additional/Contingent functions
Commercial banks have been performing the following additional functions;
· Collection of cheques, drafts, bills for their clients.
· Purchase and sale of securities
· Issue travellers cheque
· Keeping valuable metals
· To guarantee and underwrite share and debenture

Non-banking financial institution

A non-banking financial institution (NBFI) is a financial institution that does not have a full banking
license and cannot accept deposits from the public. However, NBFIs do facilitate alternative financial
services, such as investment (both collective and individual), risk pooling, financial consulting,
brokering, money transmission, and check cashing. NBFIs are a source of consumer credit (along with
licensed banks). Examples of nonbank financial institutions include insurance firms, venture capitalists,
currency exchanges, some microloan organizations, and pawn shop. These non-bank financial
institutions provide services that are not necessarily suited to banks, serve as competition to banks,
and specialize in sectors or groups.

Role in financial system

NBFIs supplement banks in providing financial services to individuals and firms. They can provide
competition for banks in the provision of these services. While banks may offer a set of financial
services as a package deal, NBFIs unbundle these services, tailoring their services to particular
groups. Additionally, individual NBFIs may specialize in a particular sector, gaining an informational
advantage. By this unbundling, targeting, and specializing, NBFIs promote competition within the
financial services industry.

Having a multi-faceted financial system, which includes non-bank financial institutions, can protect
economies from financial shocks and recover from those shocks. NBFIs provide multiple alternatives
to transform an economy's savings into capital investment, which act as backup facilities should the
primary form of intermediation fail.

However, in countries that lack effective regulations, non-bank financial institutions can exacerbate the
fragility of the financial system. While not all NBFIs are lightly regulated, the NBFIs that comprise the
shadow banking system are. In the runup to the recent global financial crisis, institutions such as
hedge funds and structured investment vehicles, were largely overlooked by regulators, who focused
NBFI supervision on pension funds and insurance companies. If a large share of the financial system
is in NBFIs that operate largely unsupervised by government regulators and anybody else, it can put
the stability of the entire system at risk. Weaknesses in NBFI regulation can fuel a credit bubble and
asset overpricing, followed by asset price collapse and loan defaults.