Uploaded by Bayisa Daksisa

Banking chapter 01

Modern commercial banking, in its present form, is of recent origin. Though bank is considered to be an
ancient institution just like money, its evolution can be traced in the functions of money lender, the
goldsmiths and the merchants. A bank has been often described as an institution engaged in accepting of
deposits and granting loans. It does not refer only to a place of tending and depositing money, but looks
after the financial problems of its consumers.
There seem so be no uniformity amongst the economist about the origin of the word ‘Bank’. It has been
believed that the word ‘Bank’ has been derived from the German word ‘Bank’ which means joint stock
of firm or from the Italian word ‘Banco’ which means a heap or mound. The development of
commercial banking in ancient times was closely associated with the business of money changing.
Bank refers to an institution that deals in money. This institution accepts deposits from the people and
gives loans to those who are in need. Besides dealing in money, bank these days perform various other
functions, such as credit creation, agency job and general service. Bank, therefore is such an institution
which accepts deposits from the people, gives loans, creates credit and undertakes agency work.
1.1. Meaning of Banking
You know people earn money to meet their day to day expenses. They also need money to meet future
expenses. These expenses can be met if some money is saved out of the present income. With this
practice, savings were available for use whenever needed, but it also involved the risk of loss by theft,
robbery and other accidents. Thus, people were in need of a place where money could be saved safely
and would be available when required. Banks are such places where people can deposit their savings
with the assurance that they will be able to withdraw money from the deposits whenever required. Bank
is a lawful organization which accepts deposits that can be withdrawn on demand. It also tends money to
individuals and business houses that need it.
Definitions of Bank
1. Indian Banking Companies Act - “Banking Company is one which transacts the business of banking
which means the accepting for the purpose of lending or investment of deposits money from the public
repayable on demand or otherwise and withdraw able by cheque, draft, and order or otherwise”.
2. Dictionary meaning of the Word ‘Bank’ -The oxford dictionary defines a bank as “an establishment
for custody of money received from or on behalf of its customers. Its essential duty is to pay their drafts
on it. It’s profits arises from the use of the money left employed by them”.
3. The Webster’s Dictionary Defines a bank as “an institution which trades in money, establishment
for the deposit, custody and issue of money, as also for making loans and discounts and facilitating the
transmission of remittances from one place to another”.
4. According to Prof. 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 it required
by them for use”.
The above definitions of bank reveal that bank is a business institution which deals in money and use of
money. Thus a proper and scientific definition of the bank should include various functions performed
by a bank in a proper manner..
1.3 Types of Banking
There are various types of banks which operate in a country to meet the financial requirements of
different categories of people engaged in agriculture, business, profession, etc. On the basis of functions,
the banking institution may be divided as central bank, commercial banks, development banks, cooperative banks, specialized banks, indigenous bankers, rural banking, saving banks, export - import
bank, building societies, credit unions, finance companies and international banks.
1.3.1 Traditional versus modern banking
Under the universal banking model, banking business is broadly defined to include all aspects of
financial service activity - including securities operations, insurance, pensions, leasing and so on.
Traditional banking
Products and services: LIMITED
• Loans
• Deposits
Income sources:
• Net interest income
Modern banking
Products and services: UNIVERSAL
• Loans
• Deposits
• Insurance
• Securities/investment banking
• Pensions
• other financial services
Income sources:
• Net interest income
Competitive environment:
• Restricted
Strategic Focus:
• Assets size and growth
Customer focus:
• Supply led
• Fee and commission income
Competitive environment:
• High competition
Strategic focus:
• Returns to shareholders
• Creating shareholder value (generating Return-onequity, ROE, greater than the cost of capital)
Customer focus:
• Demand led
• Creating value for customers
Universal Banking and the Bancassurance Trend
One area that deserves particular attention regarding the adoption of the universal banking model has
been the increased role of commercial banks in the insurance area. The combination of banking and
insurance is known as ‘banc assurance’ or ‘all finanz’. Banc assurance describes a package of financial
services that can fulfill both banking and insurance needs at the same time. A high street bank, for
example, might sell both mortgages and life insurance policies to go with them (so that if the person
taking out the mortgage dies then the life insurance will pay up to cover the outstanding mortgage).
In broad terms, bancassurance models can be divided between ‘distribution alliances’ and
‘conglomerates’. The ‘conglomerate’ model goes beyond the traditional bancassurance model of
‘distribution alliances’ which involves simply cross-selling of insurance products to banking customers.
The conglomerate model is where a bank has its own wholly owned subsidiary to sell insurance through
its branches whereas the distribution channel is where the bank sells an insurance firm’s products for a
1.3.2 Retail or Personal Banking
Retail or personal banking relates to financial services provided to consumers and is usually small-scale
in nature. Typically, all large banks offer a broad range of personal banking services including payments
services (current account with cheque facilities, credit transfers, standing orders, direct debits and plastic
cards), savings, loans, mortgages, insurance, pensions and other services. A variety of different types of
banks offer personal banking services which include commercial banks, savings banks, co-operative
banks, building societies, credit unions, and finance companies.
1.3.3 Private banking
Private banking concerns the high-quality provision of a range of financial and related services to
wealthy clients, principally individuals and their families. Typically, the services offered combine retail
banking products such as payment and account facilities plus a wide range of up-market investmentrelated services. Market segmentation and the offering of high quality service provision forms the
essence of private banking and key components include tailoring services to individual client
requirements, anticipation of client needs, long-term relationship orientation, personal contact and
The market for private banking services has been targeted by many large banks because of the growing
wealth of individuals and relative profitability. The CapGemini Merrill Lynch Wealth Report (2005) highlights
various features of the market for high net worth individuals (HNWIs). The bottom end of the market is referred to as the
‘mass affluent’ segment – typically individuals who have up to $100,000 of investable assets. The top end of the market are
often referred to as ‘ultra HNWIs’ with over $50 million in investable assets and in-between lie HNWI’s ($500,000 to $5
million) and very high HNWIs ($5 million to $50 million).
1.3.4 Corporate Banking
Corporate banking relates to banking services provided to companies although typically the term refers
to services provided to relatively large firms. Banking services based on size categories have not clearcut line and some banks do not explicitly distinguish between ‘business banking’ and ‘corporate
banking’. Banking services provided to small and medium-sized firms are in many respects similar to
personal banking services and the range of financial products and services on offer increases and grows
in complexity the larger the company.
There are four main types of banking service on offer to small firms:
1. Payment services: They provide clearing services to businesses and individuals making sure
that current account transactions are processed smoothly; issue credit and debit cards that enable
customers to make payments and offer instant access to cash through their automated teller
machines (ATMs) and branch networks.
2. Debt finance for small firms: Traditional bank loan and overdraft finance are the main sources
of external finance for small firms. With regards to lending to small firms, features can obviously
vary from country to country.
3. Equity finance for small firms: few small firms rely on either public or private equity finance
for their external financing. Private equity finance can be distinguished according to two main
types: formal and informal. Formal equity finance is available from various sources including
banks, special investment schemes, and private equity and venture capital firms. The informal
market refers to private financing by so-called ‘business angels’ – wealthy individuals who
invest in small unquoted companies.
Special financing: There are a plethora of various initiatives aimed at promoting the development of the
small firm sector. Such recent schemes in the UK include initiatives geared to:
Financing small businesses in economically deprived areas;
Financing technology-based small firms; and
Financing ethnic minority firms.
1.3.5 Investment banking
Securities underwriting (including the issue of commercial paper, Eurobonds and other securities) have
traditionally been undertaken by investment banks (or the investment bank subsidiaries of commercial
banks) and relate generally to large-scale or wholesale financing activities. Investment banks mainly
deal with companies and other large institutions and they typically do not deal with retail customers.
1.3.6 Universal versus specialist banking
. However, it should be recognized that financial institutions may provide a wide range of other services
trading in financial assets on behalf of their customers, i.e., acting as brokers or agents for clients;
trading in financial assets for their own accounts, i.e., acting as proprietary dealers;
helping to create financial assets for their customers and then selling these assets to others in the
market, for example underwriting and issuing new shares;
providing investment advice to personal customers or business advice to firms on mergers and
fund management, for example managing the whole or part of a pension fund; and
Insurance services.
In fact, the largest financial institutions nowadays offer a plethora of products and services incorporating
all the finance types undertaken by different sorts of financial institutions. This is a reflection of the
universal banking trend where large financial firms benefit from scale, scope and other economies
associated with the production and distribution of a wide range of products & services.
1.3.7 Islamic banking
Islamic Shariah law prohibits the payment of riba or interest but does encourage entrepreneurial
activity. As such, banks that wish to offer Islamic banking services have to develop products and
services that do not charge or pay interest. Their solution is to offer various profit-sharing-related
products whereby depositors share in the risk of the bank’s lending. Depositors earn a return (instead of
interest) & borrowers repay loans based on profits generated from the project on which the loan is lent.
An example of a commonly used profit-sharing arrangement in Islamic banking is known as
Musharakah, which is an arrangement where a bank and a borrower establish a joint commercial
enterprise and all contribute capital as well as labor and management as a general rule. The profit of the
enterprise is shared among the partners in agreed proportions while the loss will have to be shared in
strict proportion of capital contributions.
There are a wide variety of Islamic banking products and services based on various profit sharing and
other forms of arrangements that enable financial intermediation without the use of interest. Globally
there are around 100 Islamic banks and financial institutions working in the private sector, excluding
those in the three countries, namely, Pakistan, Iran and Sudan, which have declared their intention to
convert their entire banking sector to Islamic banking. The development of Islamic banking has also
been a growing interest from Western banks in developing such services for their customers.
1.4 Banking issues in 21stcentury
Structural and conduct deregulation:
Financial deregulation essentially consists of removing controls and rules that in the past have
protected financial institutions, especially banks.
Structural deregulation, more generally, refers to the opening up, or liberalization, of financial
markets to allow institutions to compete more freely. Specifically, this process encompasses structure
and conduct rules deregulation (such as the removal of branch restrictions and credit ceilings,
Deregulation is typically undertaken to improve the performance of the industry being deregulated. If
efficiency is raised, the improvement in resource allocation will benefit society and may lead to price
reductions and/or service expansion for consumers if competition is sufficient. However, in many cases
deregulation is initiated less by a desire to benefit consumers than by a need to improve the competitive
viability of the industry.
Supervisory re-regulation:
One consequence of the process of deregulation has been the increased perceived riskiness of the
banking business. In such a context, even strongly market-oriented systems needed to strengthen
supervision in improving the safety and soundness of the overall financial sector.
Re-regulation can, therefore, be defined as the process of implementing new rules, restrictions and
controls in response to market participants’ efforts to circumvent existing regulations. Alternatively, it
can be viewed as a response to minimize any potential adverse effects associated with excessive
competition brought about through structural deregulation. Capital adequacy convergence will become a
central issue in the need to help level the ‘playing fields’ on which international banks compete. This has
occurred in the context of a gradual shift from direct forms of control to more indirect and objective
types of controls.
The process of supervisory re-regulation has been shaped by global pressures. The first efforts to
encourage convergence towards common approaches and standards at the international level were
initiated by the Basle Committee on Banking Supervision in the 1970s. Since then capital adequacy
standards and associated risk regulation have been important policy issues and fundamental components
of bank prudential re-regulation.
Before the deregulation process, in most countries, banks were characterized by relatively high levels of
government controls and restrictions that inhibited competition and maintained a protected banking
environment. For instance, interest rate restrictions and capital controls were widespread, and branching
restrictions existed in many countries. The main purpose of these controls was to ensure stability in the
system and prevent banking crises. In most advanced economies banks now are free to set the prices for
their services (loans, deposits & other products such as insurance) & they compete with other banks
(domestic and foreign) as well as non-bank financial intermediaries. Technological advances &
innovations in the payment systems have helped to reduce barriers to cross-border trade in banking
services, thereby also promoting greater competition.
Financial innovation and the adoption of new technologies:
The definition of ‘innovation’ includes both the concept of invention (the ongoing research and
development function) and diffusion (or adoption) of new products, services or ideas.
Financial innovation is an ongoing process whereby private parties experiment to try to differentiate
their product and services, responding to both sudden and gradual changes in the economy. Financial
innovation can be defined as the act of creating and then popularizing new financial instruments as well
as new financial technologies, institutions and markets. Specifically, we can distinguish:
 Financial system/institutional innovations: Such innovations can affect the financial sector as
a whole; they relate to business structures, to the establishment of new types of financial
intermediaries, or to changes in the legal and supervisory framework.
 Process innovations: These include the introduction of new business processes leading to
increased efficiency, market expansion, etc.
 Product innovations: Such innovations include the introduction of new credit, deposit,
insurance, leasing, hire purchase, derivatives and other financial products. Product innovations
are introduced to respond better to changes in market demand or to improve efficiency.
Progress in information technology affects all aspects of banking and can be regarded as one of the main
driving forces generating change in the sector. Rapid innovation contributes to the dynamic efficiency of
the financial sector, which ultimately affects the overall growth of the economy.
Technology reduces significantly the costs of information management (i.e., collection, storage,
processing and transmission) and information asymmetries in financial transactions. On the customers’
side, technological innovation introduces automated channels (e.g., remote banking) that allow the
provision of banking services without face-to-face contact between the bank employee and the customer.
In terms of products and services supplied to customers, the most typical innovations in modern banking
concern the payment systems and include the use of a wide range of automated channels for supplying
and delivering various banking services and activities. Common examples include developments in the
use of debit and credit cards, standing orders and direct debits, automatic teller machines (ATMs) and
EFTPOS (electronic funds transfer at the point-of-sale) terminals, internet and PC banking,
telephone/mobile banking and digital TV banking.
One of the main current trends for global banks is financial innovation in risk management where
sophisticated approaches have developed such as the use of credit derivatives and securitization. Such
complex financial instruments are used as part of the banking business and end-products for customers.
The widespread use of technology is not without risks. Strategically, banks run the risk of investing in
IT resources that could quickly become outdated. Legal risk is related to the uncertainty surrounding the
applicable laws and regulations on a number of aspects relating to technology (e.g., the legal status of
remote banking, validity and proof of transactions, the respect of customers’ privacy).
Another issue relates to the increase in operational risk (that is the risk associated with the potential of
systems failure) as banks may tend not to upgrade their systems of internal control to cope with the new
operational environment. The possibility of systemic risk may increase since technology increasingly
links banks to each other through alliances and joint ventures, standardization and the possibility of
using similar software and hardware. As a consequence, technological developments in banking also
have important consequences for prudential regulation and supervision.
As a result of structural deregulation many banks now compete with non-banking financial
intermediaries. The erosion of demarcation lines between the various types of financial institutions has
caused the distinctions between different types of banks (and other financial sector institutions) to
become blurred, creating greater homogeneity between the services and products offered.
In response to these pressures, many banks have been forced to increase in size, either through mergers
or through internally generated growth, in order to compete. The trend towards consolidation, through
M&A activities and conglomeration, can be interpreted as a response to increasing pressures to realize
potential scale and scope economies, and also to reduce labor and other costs in an attempt to eliminate
inefficiencies. Globalization is expected to increase competition in most areas of financial services, and
it may also be able to realize economies of scale and scope. Even if banks remain nationally based, they
will be subject to international market developments and national tendencies will increasingly be
influenced by international developments. Hence new regulatory structures will likely be necessary as
banks become bigger in size and more exposed to risks originating from abroad, as well as risks to