Financial Institutions, Commercial and Central Bank

CONTENT

1.  Meaning of Financial Institutions

2.  Types of Financial Institutions

3.  Commercial Banks

4.  Characteristics of Commercial Banks

5.  Functions of Commercial Banks

6.  Creation of Credit or Money by the Commercial Banks

7.  Limitations on Ability of Commercial Banks to Create Credit / Money

FINANCIAL INSTITUTIONS:

Financial Institutions- are all business organizations which hold money for individuals and institutions, and may borrow from them in order to give loans or make other investments. Financial institutions which represent the main channel or medium by which funds can flow from lenders to borrowers are very important for the economic development of a nation.

TYPES OF FINANCIAL INSTITUTIONS

Two major financial institutions are:

Banking Financial Institutions, (Central bank, Commercial banks, Merchant banks, Development banks, etc)

Non – Banking Financial Institutions, (Insurance companies, Hire purchase companies, Building societies, etc). The major difference between the two is that the liabilities of the Banking Institutions are counted as part of the total supply of money in circulation, while those of the Non-Banking Institutions are excluded from the money supply.

COMMERCIAL BANK

A commercial bank is a financial institution which accepts deposits and other valuable from the public for safe-keeping, lend money to people and perform other ancillary services with the sole aim of making profit. A commercial bank is owned by private individual organizations or governments. It is a limited liability company.

Characteristics of Commercial Banks

1. They are limited liability companies
2. They are established and owned by individual organizations or government
3. The motive for its establishment is profit making
4. Commercial banks are incorporated under CAMD (1990)
5. They transact business with private individuals organizations and governments
6. They are members of the money market

Functions of Commercial Banks

(a)        Accepting deposits from customers

(b)        Lending to customers – i.e. they grant loans and overdrafts to their customers

(c)        Acting as an agent for payment

(d)       Discounting bills of exchange

(e)        Safekeeping of valuable e.g. wills, jewelleries, certificates etc.

(f)        Offering expert advice to customers

(g)        Acting as executors or trustees

(h)        Acting as business referees / granting of performance bond

(i)         Funds transfer e.g. credit transfer services 

(j)         Issuing of letter of credit   

(k)        Buying and selling of foreign currencies

(l)         Issuance of travelers cheque

EVALUATION

1. Define financial institutions
2. Highlight four functions of commercial bank.

CREATION OF CREDIT OR MONEY BY THE COMMERCIAL BANKS

Credit or Money Creation – refers to the process whereby commercial banks make it possible for more deposits to be made through loans or overdrafts. Bank lending in form of loan or overdraft increases the quantity of money in circulation, which in turn increases the purchasing power of the people. This is because the bank credits the amount borrowed thereby creating new bank deposits.

The total purchasing power increases by the amount loaned out to members of the public and charging interest on them. By so doing, more money is pumped into circulation and this increases the purchasing power of the people.

This is why it is said that bank lending creates credit or money in the following ways:

1. By granting loans to members of the public and charging interests on them.
2. By granting overdrafts to customers having current accounts with the bank, and charging interests on them.
3. By charging the percentage of Cash Ratio, or Liquidity Ratio, or Cash Reserve, which the commercial banks are required by law to keep (% of their deposits) with the Central Bank in order to protect customers’ accounts and prevent bank crisis.
4. By purchasing treasury bills from the government and by discounting bill of exchange. These bank transactions have a direct effect on the commercial banks ‘Excess Reserve’, and other banks’ reserves in determining the ability of the banks to create credit or money.

LIMITATIONS OF ABILITY OF COMMERCIAL BANKS TO CREATE

CREDIT / MONEY

1. The volume of its deposits

2. Central bank regulations – monetary policy dictates

3. The cash ratio / liquidity ratio

4. Availability of collateral security

5. Restrictions imposed by the clearing house

6. Opportunities for investments 

EVALUATION QUESTIONS

1.         Highlight four ways by which commercial banks create money 

2.         List four limitations of ability to create money by the commercial banks

THE CENTRAL BANK

CONTENT

1.  Definition of Central Bank

2.  Characteristics of the Central Bank

3.  Functions of the Central Bank

4.  Monetary Policy

5.  Instruments of Monetary Policy

DEFINITION OF CENTRAL BANK

The central bank is the apex financial institution in a country which is responsible for the management, supervision and control of monetary affairs and financial institutions of the country.  Before independence of most of the British colonized countries of West African (Nigeria, Ghana, Sierra Leone, and Gambia), the West African Currency Board (WACB) with its headquarters in London was responsible for all monetary matters. As soon as each country gained or approached political independence, it established her own central bank. A central bank was established in Ghana in 1957, in Nigeria in 1959, in Sierra Leone in 1964 and in Gambia in 1971.

CHARACTERISTICS OF THE CENTRAL BANK

1. It is owned by the government
2. I is established through Act of Parliament
3. It is the apex financial institution in a country
4. There is only one Central Bank in the country
5. It is not a profit oriented institution
6. It does not transact business with individuals
7. It is the only bank authorized by law to issue currencies

FUNCTION OF THE CENTRAL BANK

1. It serves as a Banker to the Government: The Central Bank keeps all the revenue accounts of the

government and makes payment out of it on behalf of the government. More importantly it leads to the government and also manages the National Debt i.e. the government’s external and internal borrowings.

• Issuing of Currency: The Central Bank is the only authority empowered by law to issue all paper money (banknotes) and coins in the country
• It is a Bankers’ Bank: The Central Bank serves as a bank to commercial banks, meaning that by law, the commercial banks are required to keep account (deposits) with the central bank
• The Central Bank serves as the clearing house for the settlement of interbank debts
• Lender of last resort: The Central Bank lends money to commercial banks in serious needs to enable them satisfy or settle their customers demand for cash
• Adviser to the Government: The Central Bank advises the government on monetary matters such as on methods of raising loans particularly foreign loans.
• Management of the National Debt: The arrangements for new borrowings as well as the servicing and rescheduling of existing debts are handled by the Central Bank
• Foreign Monetary Transactions: The Central Bank holds and manages the foreign exchange reserve and advises government on the trends.
• Carrying out or implementation of the government’s Monetary Policies
• The Central Bank maintains close contact with other international financial institutions e.g. IMF, IBRD (World Bank), ADB etc

EVALUATION

1. State four features of Central bank.
2. Explain three functions performed by the central bank.

MONETARY POLICY

Monetary Policy is mainly concerned with varying the money supply in the economy.

The central bank uses some measures like the bank rate, open market operators, special deposits, directives, cash ratio, etc, all to regulate the volume of money in the economy; thereby checking inflation or deflation when necessary.

INSTRUMENTS OF MONETARY POLICY / OR HOW THE CENTRAL BANK CONTROLS THE COMMERCIAL BANKS

The government carries out its monetary policy through the central bank. The central bank itself enforces the monetary policy through the various way by which it controls the ability of the commercial bank to create credit

The central bank controls the commercial bank to implement government monetary policy through the following instruments

1.         Bank Rate / Discount Rate: This is the rate of interest the central bank charges commercial banks and other financial institutions for discounting their bills or the rate at which it lends money to them. The bank rate influences the other interest rates in the economy. A higher bank rate leads to higher interest rate. If there is inflation, the central bank will increase the bank rate. This will curtail the lending power of the commercial banks by making the cost of borrowings by bank customers to be very exorbitant

            If there is deflation in the economy, the Central Bank will reduce the bank rate thereby allowing the commercial banks to create more credit, thereby increasing the supply of money in the economy.

2.         Liquidity Ratio / Cash Reserve Ratio: This is a requirement by law to the commercial banks to keep certain percentage of their total cash / liquid assets or deposits with the central bank. In Nigeria for example the Liquidity Ratio is 20%. The central bank uses this ratio in increasing or decreasing the amount of money in circulation. Therefore the higher the cash reserve ratio, the lower the power of commercial banks to grant credit / loans to their customers. This policy of increasing the cash reserve ratio is therefore used to control inflation. The reverse is also true

3.         Special Deposit: This is an instruction to the commercial banks to keep with the central bank special deposits over and above their statutory requirements thereby, curtailing the ability of the commercial banks to create credit. This instrument is used when the use of cash reserve ratio alone is not adequate to keep down the rate of inflation

4.         Open Market Operations (OMO): This is method of buying and selling of securities (Treasury Bills) to the public and the commercial banks by the central bank to alter the volume of money in circulation and also to vary the ability of the commercial banks to create credit.

            If the Central Bank feels that the money circulation is too small and wants to increase it, it will buy securities in the open market paying with its own cheques. On the other hand, if the volume of money in circulation  is too much and the Central Bank wants to reduce it, it will simply sell securities in the open market to the general public and the commercial banks thereby withdrawing a lot of money from the economy.

5.         Special Directives: These are special instructions which the central bank gives to commercial banks and other financial institutions regarding the size of loan to give and the areas (sectors of the economy) to which it should direct bank lending e.g agriculture, manufacturing etc

6.         Moral Suasion: This is persuasion based on moral grounds not with the use of force of law by the central bank to the commercial bank as to the kind of lending policy they should adopt regarding the expansion or contraction of money supply. Failures to comply can thereafter necessitate force of law. Directives and moral suasions are widely used in developing countries

7.         Funding: This is the conversion of short term government securities to long term securities. For example Treasury Bills (of 91 days maturity) could be converted to bonds (long term securities). If the central bank feels that the conditions of the economy has not yet improved for the short term loans to be repaid e.g if there is inflation, the short term securities may be converted to long term securities.

EVALUATION

1.         Differentiate between fiscal policy and monetary policy

2.         Give two reasons why monetary policy may not be effective in regulating the Nigerian economy.

READING ASSIGNMENT

Amplified and Simplified Economics for SSS by Femi Longe page 321-324

GENRAL EVALUATION

1. Define population census.
2. Why do people prefer to hold money?
3. Explain five reasons why a joint stock is better than a one man business.
4. Describe five problems of distribution in Nigeria.
5. Mention the implication of over population

WEEKEND ASSIGNMENT

1. The lender of last resort in the banking system is the (a) development bank (b) mortgage bank

(c) commercial bank (d) central bank

• To a commercial bank, deposits are ____ (a) assets (b) capital (c) liabilities (d) cash at hand
  • The main channel or medium that hold money and by which funds can flow from lenders to borrowers is ____ (a) industrial institutions (b) commercial institutions (c) financial institutions

(d) investment institutions

• One major function of the central bank is to (a) mint money (b) act as a medium of exchange

(c) create money (d) control and regulate money supply

• Which of the following is a function of commercial banks (a) issuance of bank motes (b) lender of last resort (c) determination of rate of interest (d) accepting deposits?
  • The differentiating factors between banking financial institutions and non-banking financial institutions are their ____ (a) assets (b) capitals (c) liabilities (d) cash at hand

THEORY

1.         Briefly discuss four ways by which commercial banks create money or credit

2.         Explain at least five instruments with which the central bank controls the commercial bank