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What is Internal Control System?

 The internal control structure of a company consists of the policies and procedures established to provide reasonable assurance that specific entity objectives will be achieved.

Objectives of Internal Control System

  • To ensure that the business transactions take place as per the general and specific authorization of the
  • To make sure that there is a sequential and systematic recording of every transaction, with the accurate amount in their respective account and in the accounting period in which they take place. It confirms that the financial statement fulfils the relevant statutory
  • To provide security to the company’s assets from unauthorized use. For this purpose, physical security systems are used to provide protection such as security guards, anti-theft devices, surveillance cameras,
  • To compare the assets in the record with that of the existing ones at regular intervals and report to the those charged with governance (TCWG), in case any difference is
  • To evaluate the system of accounting for complete authorization of the
  • To review the working of the organization and the loopholes in the operations and take necessary steps for its
  • To ensure there is the optimum utilization of the firm’s resources, e. men, material, machine and money.
  • To find out whether the financial statements are in alignment with the accounting concepts and principles.

An ideal internal control system of an organization is one that ensures best possible utilization of the resources, and that too for the intended use and helps to mitigate the risk involved in it concerning the wastage of organization’s funds and other resources.

  1. Preventive Controls: These controls are introduced in the firm to stop errors and irregularities from taking
  2. Detective Controls: These controls are implemented to reveal errors and irregularities, once they take
  3. Corrective Controls: These controls are designed to take corrective action for removing errors and irregularities after they are

The type of internal control system implemented in the organization will be based on the company’s nature and requirements.

Internal Control System is important for every organization, for efficient management as well as it also assist in the company’s audit. It includes all the processes and methods to help the company in reaching its ultimate objective.

Components of Internal Control System

1. Controlling the environment

The control environment is the basis of other elements of all other components of the internal control system. Moral values, managerial skills, the honesty of employees and managerial direction, etc. are included in the controlling environment.

2.       Risk assessment

After setting up the objective of business, external and internal risks are to be assessed. The management determines risk controlling means after examining the risks related to every objective.

3.       Control activities

The management establishes a controlling activities system to prevent risk associated with every objective. These controlling activities include all those measures that are to be followed by the employees.

4.       Information and communication

Relevant information for taking decision are to be collected and reported in proper time. The events that yield data may originate from internal or external sources.

Communication is very important for achieving management goals. The employees are to realize what is expected of them and how their responsibilities are related to the activities of others. Communication of the owners with outside parties’ like’s suppliers is also very important.

5.       Monitoring

When the internal control system is in practice, the organization monitors its effectiveness so that necessary changes can be brought if any serious problem arises.

Responsibility for Internal Control System

It is the general responsibility of all employees, officers, management of a company to follow the internal control system.

The under-mentioned three parties have definite roles to make internal control system effective:

1.       Management

Establishment and maintenance of an effective internal control structure mainly depends on the management. Through leadership and example or meeting, the management demonstrates ethical behavior and integrity of character within the business.

2.       Board of directors

The board of directors possessing a sound working knowledge gives directives to the management so that dishonest managers cannot ignore some control procedures. The board of directors stops this sort of unfair activity. Sometimes the efficient board of directors having access to the internal audit system can discover such fraud and forgery.

3.       Auditors

The auditors evaluate the effectiveness of the internal control structure of a business organization and determine whether the business policies and activities are followed properly. The communication network helps an effective internal control structure in execution. And all officers and employees are part of this communication network.

Characteristics of a Proper Internal Control System

 An effective internal control system includes organizational planning of a business and adopts all work-system and process to fulfill the following targets:

  1. Safeguarding business assets from stealing and
  2. Ensuring compliance with business policies and the law of the
  3. Evaluating functions of each employee and officer to increase efficiency in
  4. Ensuring true and reliable operating data and financial

It is to be kept in mind, a business organization, be its small or large, can enjoy the benefits of adopting an internal control system.

Prevention of stealing-plundering and wastage of assets is a part of the internal control system.

Protection of assets

A business organization protects its assets in the following ways:

1.      Segregating the duties of the employees

Segregation of the duties of the employees means that each employee is assigned with specific tasks. The person in charge of assets is not allowed to maintain accounts of the assets.

Some other person maintains the accounts of these assets. Since different employees perform the same nature of transactions, the work of each is automatically checked. Segregation of the duties of the employees of an organization reduces the possibility of stealing assets and if stolen, detection becomes easier.

For example, there is no scope for stealing cash by a cash-receiving employee where cash receipts accounts are maintained by a different employee.

2.      Assigning specific duties to each employee

The employee assigned with a specific duty is held responsible for his assigned activities. If and when any problem arises the manager can immediately identify the person concerned and holds him liable.

Lost documents can easily be detected if the task of maintaining records is assigned to a particular employee and it becomes possible to know the recording process of transactions.

An employee assigned with a particular job can easily provide necessary information regarding that job. Moreover, an employee feels proud if he is assigned a particular job and tries to complete the job using die best of his skill.

3.      Rotating job assignments of the employees

Some organizations rotate job assignments of employees at intervals to avoid fraud-forgery by the employees concerned.

Under this policy, the employee concerned can easily understand that on the placement of somebody else in his place his dishonesty if it is done, will be detected. This ensures the honesty of an employee.

4.      Using mechanical devices

Business concerns adopt various mechanical devices to avoid stealing, destruction, and wastage of assets. Under the mechanical system, cash register, cheque-protectors, time-clock, mechanical-counters, etc. are used as control methods.

Since a cash-register contains locking-tape, each cash sale is recorded here.

The amount of cheque is written on the cheque by the cheque-protector machine to avoid any sort of alteration. Arrival and departure of employees are recorded properly with the help of time- clock.

While maintaining accounts of transactions the accountant is. to preserve the following four documents:

  1. Purchase requisition: Written order placed by the officers of the department concerned to the purchasing department for purchasing a certain quantity of goods is called purchase
  2. Purchase order: Before purchase, the buyer sends a written order to the seller requesting him to send particular goods. This written order is called a purchase order.
  1. Invoice/Chalan: The seller sends an invoice with the sold goods to the buyer wherein the descriptions, quantity, rates of the goods are
  2. Receiving report: It is a purchase document prepared by an officer of the purchasing It is treated as documentary evidence of the goods received.

Three elements of the internal control system are:

  1. Environment control: The attitude, alertness, and work-zeal of directors, managers and shareholders are reflected through environmental
  2. Accounting system: Accounting system means some procedures and recordings with which identification of business transactions, classification, summarization, statement preparation and analysis for timely presentation of correct information are
  3. Control procedure: The additional policies and procedures adopted by the business authority for ensuring the achievement of the specific goal of a business organization are the controlling

These control procedures are:

  • Proper delegation of power,
  • Segregation of responsibility,
  • Preparation and use of documents,
  • Adoption of adequate security measures to protect the properties, and
  • Independent control over the execution of

An internal control system, not only prevent fraud forgery but also fulfills other objects:

  1. The business organization implements its policies complying with the prevailing laws of the
  2. Employees and officers discharge their assigned responsibilities to increase efficiency in the execution of work.
  3. Financial statements provide correct and reliable information maintaining proper

In light of the above discussion, it can be briefly stated that the overall policies and plans adopted by the management for the proper execution of business activities are called the internal control system.

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Definition of Cheque

 A cheque is a type of bill of exchange, used for the purpose of making payment to any person. It is an unconditional order, addressing the drawee to make payment on behalf the drawer, a certain sum of money to the payee. A cheque is always payable on demand, i.e. the amount is paid to the bearer of the instrument at the time of presentment of the cheque. It is always in writing and signed by the drawer of the instrument.

There are three parties involved in case of cheque:

  • Drawer: The maker or issuer of the
  • Drawee: The bank, which makes payment of the
  • Payee: The person who gets the payment of the cheque or whose name is mentioned on the

It should be noted that the issuer must have an account with the bank. There is a specified time limit of 3 months, during which the cheque must be presented for payment. If a person presents the cheque after the expiry of 3 months, then the cheque will be dishonored. The various types of cheques are:

  • Electronic Cheque: A cheque in electronic form is known as an electronic
  • Truncated Cheque: A cheque in paper form is known as truncated

Bill of Exchange:

The legal definition is “A bill of exchange is an instrument in writing containing an unconditional order signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the instrument.” It means that if an order is made in writing by one person on another directing him to pay a certain sum of money unconditionally to a certain person or according to his instructions or to the bearer, and if that order is accepted by the person on whom the order was made, the document is a bill of exchange.

The following is a specimen of bill of exchange:

3. Cheques are also included among negotiable instruments. In the specimen bill of exchange shown above, M/s Lakhmi Chand & Sons are the drawers as well as the payees of the bill of M/s Aggarwal Stores are the drawees and the acceptors of the negotiable instrument. The drawees become habile to pay for the bill of exchange only after they have accepted it. Before acceptance, a bill of exchange is known as a draft.

The following are the advantages of bills:

  • Presumption of consideration:

In a bill, consideration is presumed. In other words, the Court presumes that the acceptor of the bills of exchange or maker of the promissory note is indebted to the drawer of the bill or payee of the promissory note. It is a big advantage. In the absence of the bill, the seller of goods and services or the lender of the money has to prove the indebtedness of the purchaser or borrower in case of a default.

2. No locking of money:

A bill provides the payee an option either to wait for money till the date of maturity of the bill or to get cash at any time by getting the bill discounted with the bank at a reasonable rate of interest. The bill can also be used to discharge the liability to a creditor by endorsing the bill in the creditor’s favour. Thus, the seller need not keep the money locked up for the period of credit allowed by him to the customer.

3. Source of finance:

 Accommodation bills enable the businessmen to obtain funds at a low rate of interest to meet their temporary financial requirements.

4. Safe and convenient means of transmitting money:

 Bill is a safe and convenient means of transmitting money by one person to the other; one can avoid the risk of carrying currency by using a bill.

5. Planning by creditors:

 A bill fixes the exact date of payment. The creditor knows when he is required to make payment and can make arrangements accordingly.

There are three parties involved in the bill of exchange, they are:

  • Drawer: The maker of the bill of
  • Drawee: A person on whom the bill is drawn, e., the person who gives acceptance to make payment to the payee.
  • Payee: The person who gets the

There are three days of grace allowed to the drawee, to make payment to the payee, when it becomes due. You might wonder about the days of grace, let’s understand it with an example: A bill is drawn on 5-10-2014 in the name of X, to make payment to Y after 3 months. The bill will become due on 5-01-2015 while the date of maturity is 8-01- 2015 because of 3 days of grace are added to it. The following are the types of bill of exchange:

  • Inland Bill
  • Foreign Bill
  • Time Bill
  • Demand Bill
  • Trade Bill
  • Accommodation Bill

Key Differences Between Cheque and Bill of Exchange

  1. An instrument used to make payments, that can be just transferred by hand delivery is known as the An acknowledgment prepared by the creditor to show the indebtedness of the debtor who accepts it for payment is known as a bill of exchange.
  2. A Cheque is defined in section 6 while Bill of Exchange is specified in section 5 of the Negotiable Instrument Act, 1881
  3. The drawer and payee are always different in the case of a In general, drawer and payee are the same persons in the case of a bill of exchange.
  4. The stamp is not required in Conversely, a bill of exchange must be stamped.
  5. A cheque is payable to the bearer on As opposed to the bill of exchange, it cannot be made payable to the bearer on demand.
  6. The cheque can be crossed, but a Bill of Exchange cannot be
  7. There is no days of grace allowed in cheque, as the amount is paid at the time of presentment of the cheque. Three days of grace are allowed in the bill of
  8. A cheque does not need acceptance whereas a bill needs to be accepted by the


  • They are Negotiable
  • Addressing the drawee to make
  • Always in
  • Signed by the drawer of the
  • Express order to pay a certain

Promissory Note:

A promissory note is an instrument in writing (not being a bank note or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to, or to the order of, a certain person. This definition given by law means that when a person gives a promise in writing to pay a certain sum of money unconditionally to another person (named) or according to his instructions, the document is a promissory note.

The following is a specimen of promissory note:

In the abovementioned specimen promissory note, M/s Aggarwal Stores are the makers of the promissory note. M/s Lakhmi Chand & Sons are the payees of the note.

Some key features of promissory notes are as follows,

  • It must be in writing
  • It must contain an unconditional promise to
  • The sum payable must be
  • The promissory notes must be signed by the
  • It must be payable to a certain
  • It should be properly

Parties to the Promissory Note

  1. Maker or drawer: Also called the promisor, he/she is the person makes or draws the promissory note to pay the specified the amount as mentioned in the promissory
  2. Payee or drawee: Also called the promise, he/she is the person in whose favour promissory note is Usually, the drawer is also the payee.

Components of a Promissory Notes

  • Principal amount: It is the amount which is given by the payee and taken/borrowed by the maker of the
  • Interest rate: The percentage rate that is multiplied by the principal amount and the period of promissory notes in computing for the
  • Interest: Interest is the revenue/income for the payee for loaning out the principal & is an expense for the maker for borrowing the
  • Maturity date or due date: The date on which final payment is to be done by the maker of the promissory
  • Maturity value: The principal amount due at the maturity date of note in case of non-interest bearing promissory And the sum of principal and interest due at the maturity date of note in the case of interest-bearing promissory notes.
  • Place of issue: The place where the maker executed the promissory

Types of Promissory Notes

  • Non-interest bearing note: They are promissory notes which do not carry any interest rate with The amount that will be paid at the time of maturity is equal to the face value of the promissory note.
  • Interest-bearing Note: Promissory notes which carry an interest rate with The amount that will be paid at the time of maturity is the sum of the face value & interest.

Key Differences Between Bill of Exchange and Promissory

  1. Bill of Exchange is a financial instrument showing the money owed by the buyer towards the seller. Promissory Note is a written document in which the debtor promises the creditor that the amount due will be paid at a future specified
  2. Bill of Exchange is defined in Section 5 of the Negotiable Instrument Act, 1881 whereas Promissory Note is defined in Section
  3. In a bill of exchange, there are three parties while in the case of a promissory note the number of parties is 2.
  1. Creditor creates Bill of On the other hand, Promissory Note is prepared by the debtor.
  2. The liability of the maker of the bill of exchange is secondary and Conversely, the liability of the maker of the promissory note is primary and absolute.
  3. Bill of Exchange can be made in copies, but Promissory Note cannot be made in
  4. In the case of the bill of exchange, the drawer and payee can be the same person which is not possible in case of the Promissory

The notice of dishonor of a bill of exchange must be given to all the parties concerned, however, in the case of promissory note such notice need not be given to the maker.

Crossing of Cheque

Definition: Crossing of a cheque is nothing but instructing the banker to pay the specified sum through the banker only, i.e. the amount on the cheque has to be deposited directly to the bank account of the payee.

Hence, it is not instantly enchased by the holder presenting the cheque at the bank counter. If any cheque contains such an instruction, it is called a crossed cheque.

The crossing of a cheque is done by making two transverse parallel lines at the top left corner across the face of the cheque.

Types of Crossing

The way a cheque is crossed specified the banker on how the funds are to be handled, to protect it from fraud and forgery. Primarily, it ensures that the funds must be transferred to the bank account only and not to encash it right away upon the receipt of the cheque. There are several types of crossing

1.       General Crossing:

When across the face of a cheque two transverse parallel lines are drawn at the top left corner, along with the words & Co., between the two lines, with or without using the words not negotiable. When a cheque is crossed in this way, it is called a general crossing.

2.      Restrictive Crossing:

When in between the two transverse parallel lines, the words ‘A/c payee’ is written across the face of the cheque, then such a crossing is called restrictive crossing or account payee crossing. In this case, the cheque can be credited to the account of the stated person only, making it a non-negotiable instrument.

3.       Special Crossing:

A cheque in which the name of the banker is written, across the face of the cheque in between the two transverse parallel lines, with or without using the word ‘not negotiable’. This type of crossing is called a special crossing. In a special crossing, the paying banker will pay the sum only to the banker whose name is stated in the cheque or to his agent. Hence, the cheque will be honored only when the bank mentioned in the crossing orders the same.

4.     Not Negotiable Crossing:

When the words not negotiable is mentioned in between the two transverse parallel lines, indicating that the cheque can be transferred but the transferee will not be able to have a better title to the cheque.

5.       Double Crossing:

Double crossing is when a bank to whom the cheque crossed specially, further submits the same to another bank, for the purpose of collection as its agent, in this situation the second crossing should indicate that it is serving as an agent of the prior banker, to whom the cheque was specially crossed.

The crossing of a cheque is done to ensure the safety of payment. It is a well-known mechanism used to protect the parties to the cheque, by making sure that the payment is made to the right payee. Hence, it reduces fraud and wrong payments, as well as it protects the instrument from getting stolen or uncashed by any unscrupulous individual.


Promissory notes, bills of exchange and cheques are negotiable instruments. This means that the holder can claim payment on them.

However, this is subject to the conditions that the holder takes them:

  • Without notice of defect in the title of the transferor, e., in good faith
  • For consideration
  • Before If these conditions are fulfilled, it does not matter if the title of the transferor was defective.

Thus, if A steals a bill of exchange and passes it on to B who is not aware of A s mode of acquiring the bill and who takes it for value and before the due date of the bill, B will be entitled to get payment on the bill. Here B is a holder in due course. A holder in due course always gets good title except in case of forgery. Moreover, whoever gets the bill (or promissory note) after the holder in due course, will also get a good title to it; it has been purged of all defects

The instrument is passed on from one person to another by endorsement and delivery. Endorsements on bills of exchange and promissory notes are done in exactly the same manner as those on cheques. The liability of the endorser to subsequent parties is also the same. Thus, if a bill of exchange is dis-honored, that is, if payment is not made on the due date by the promisor (drawer in case of bill of exchange), money can be claimed from any of the previous endorsers, the payee and the maker of the instrument.

Negotiability plus this liability of the endorsers make a bill of exchange or promissory note an excellent security. Bills of exchange or promissory notes are, therefore, quite willingly purchased by banks. The bank is sure that within a short time the money advanced on the bill will be returned. Bills of exchange are, therefore, excellent ways of granting or receiving credit. A purchaser of goods may not be able to pay immediately, but the seller may not be able to wait.

A bill of exchange or a promissory note will admirably solve the difficulty. The purchaser promises, in writing, to pay the seller or his order the sum due and hands it over to the seller. The seller goes to die bank and gets the note discounted. The seller thus gets the payment immediately, while the purchaser is not compelled to find money immediately. Bills of exchange or promissory notes, therefore, are excellent lubricating oils to the wheel of commerce.

Although a bill of exchange or a promissory note really amounts to nothing more than a promise that the money will be paid on such and such date or on demand, the willingness of banks to advance money (technically called discounting) makes it a special type of asset only one degree removed from balance at bank, Hence, in business houses, a person is deemed to have cleared his debt when a bill of exchange (duly accepted) or a promissory notes is received from him.

The person who gives a bill of exchange or a promissory note considers that the money due has been paid and debits the creditor’s account accordingly. A person who receives a bill of exchange or promissory note can adopt any one of the three courses.

He can:

  • Keep it till the date of maturity
  • Pass it on to one of his creditors
  • Get it discounted with a bank

Date of Maturity is always calculated by adding three days of grace. Thus, if a bill, dated 8th January is for 2 months after date, the date of maturity will be 11th March. If the due date falls on a holiday, the due date will be the previous day. A bill falling due for payment on August 15 will have to be paid on August 14.

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Different types of bank accounts serve different needs. Depending on your goals, it’s wise to put money into the best account and use the right tools for spending and saving. Doing so allows you to maximize the return from your bank, minimize fees, and manage your money conveniently.

Most banks and credit unions offer the following types of accounts, which we’ll cover in detail below:

  1. Savings accounts
  2. Checking accounts, including interest checking
  3. Money market accounts
  4. Certificates of deposit (CDs)
  5. Retirement accounts

1.       Savings

Savings accounts are typically the first official bank account anybody opens. Children may open an account with a parent to begin a pattern of saving. Teenagers open accounts to stash cash earned from a first job or household chores.

Savings accounts are an excellent place to park emergency cash. Opening a savings account also marks the beginning of your relationship with a financial institution. For example, when joining a credit union, your “share” or savings account establishes your membership.

  • Good For Your first bank account: Kids, adults looking for a place to park savings or extra
  • Drawbacks: Savings accounts typically yield a low-interest rate in comparison to money market accounts and CDs. They do not come with a debit card for purchases, and banks limit some types of withdrawals to six per

Savings Account Tips:

  • Online savings accounts pay the most interest and charge the lowest If local banks and credit unions are too expensive, look at online-only options.
  • To build up your savings account, drop a lump sum of cash into an account or set up automatic monthly deposits into


Checking accounts provide you with a basic account to deposit checks, make withdrawals, and pay bills. Paper checks, though slowly losing popularity, are key features of checking accounts. More recently, the debit card (or check card) has taken over as a primary form of payment from checking accounts. Most banks now offer online bill pay services through checking accounts, helping to streamline payments.

  • Good For: Anyone who needs a place to deposit a paycheck or cash, those who keep a relatively small balance, and people who enjoy the convenience of a check
  • Drawbacks: Checking accounts are subject to a variety of fees, which can become expensive quickly. But many checking accounts let you skip maintenance fees and minimum balance

Checking Account Tips:

  • Balance your checking account every This exercise helps you manage your money, avoid fees, and spot fraud or errors before they cause major problems.
  • Set up direct deposit of your wages into That way you get your money quickly, and you don’t need to visit a bank branch or ATM.
  • For day-to-day spending, you might be better off using a credit card instead of a debit If there’s a problem with your debit card (an erroneous charge or the card number gets stolen, for example), an empty checking account can cause significant problems.

2.       Money Market Accounts

 A money market account earns more interest than either a savings or checking account but combines features of both. For those who tend to carry higher balances in checking accounts, these can be a great option to park cash. The higher rates mean your cash is working for you and earning interest.

  • Good for: People who hold average balances in their account of $5,000 or more and want to earn higher interest rates.
  • Drawbacks: Some money market accounts have significant minimum balance requirements ranging from $5,000 to $10,000. Interest rates can be low, and you need to monitor Withdrawals are typically limited to three or so per month.

Money Market Tips:

  • Money market accounts can be a good place for larger emergency savings You won’t access the money frequently, but it’s there when you need it.
  • If you can’t find an affordable money market account, look at online banks and cash management accounts, which are typically low-cost

3.       Certificate of Deposit (CD)

A CD account usually allows you to earn more than any of the accounts listed above. What’s the catch? You have to commit to keeping your money in the CD for a certain amount of time. For example, you might use a six-month CD or an 18-month CD, which means you have to keep your funds locked up for six or 18 months. Learn more about how CDs work and how to use them.

  • Good for: Money that you don’t need to spend any time You’ll earn more by locking it up for a while.
  • Drawbacks: If you want to pull your funds out early, you’ll have to pay a penalty. That penalty might wipe out everything you earned, and even eat away at your initial deposit. In rare cases, banks refuse to honor early withdrawal requests, and you have to wait until the term ends.

CD Tips:

  • If you’re concerned about locking up all of your money, set up a basic CD ladder that makes a portion of your savings available
  • Some banks offer flexible CDs that let you withdraw money early—without Those products might be a good fit for your needs but learn about the tradeoffs before you use them.

4.       Retirement Accounts

Retirement accounts offer tax advantages. In very general terms, you get to avoid paying income tax on interest you earn from a savings account or CD each year. But you may have to pay taxes on those earnings at a later date. Still, keeping your money sheltered from taxes may help you over the long term. Most banks offer IRAs

(both Traditional IRAs and Roth IRAs), and they may also provide retirement accounts for small businesses.

  • Good for: Saving for your Retirement accounts can make it easier (by easing your tax burden) to save money, and they might result in larger account balances over the long-term.
  • Drawbacks: Any tax benefit you get comes with strings Read up on your account agreement and ask your banker about the rules (including rules for eligibility). Speak with your tax preparer or a CPA to verify how your taxes may be affected (or not) by various options. Finally, you might have to wait a while before you can access your money. If you withdraw funds early, you may have to pay taxes and steep penalties.
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The Central Bank is the banker for the government, encompassing the national government, government ministries, departments & agencies (MDA’S) and county governments. These institutions hold a variety of accounts with the Central Bank, depending on their needs, which allow them to receive deposits and make payments. The Central Bank monitors these accounts to ensure that the institutions aren’t at risk of overdraft, and also advises the institutions on financial matters.

Banking Services to the Government

The Central Bank is the banker for the government, encompassing the national government, government ministries, parastatals and county governments. These institutions hold a variety of accounts with the Central Bank, depending on their needs, which allow them to receive deposits and make payments. The Central Bank monitors these accounts to ensure that the institutions aren’t at risk of overdraft, and also advises the institutions on financial matters.

Kenya Revenue Authority

As a parastatal, the Kenya Revenue Authority (KRA) houses its main tax collection account at the Central Bank. While select commercial banks are authorized to hold collection accounts on behalf of KRA, allowing the general public to conveniently make tax payments, money collected in those accounts is deposited into the main account at the Central Bank.

Because the tax collection account is held at the Central Bank, funds deposited into the account cannot be interfered with. Once payments are deposited into the KRA account, they can only be transferred with permission from the Ministry of Finance.

Banking Services to the County Governments

The County Governments, which comprise the County Executives and County Assemblies also maintain various accounts at the Central Bank of Kenya which include:

  1. Recurrent Accounts
  2. Development Accounts
  3. Deposit Accounts
  4. County Projects Accounts
  5. County Assembly Accounts

These accounts are used to facilitate receipt and payment of funds in accordance with the Public Finance Management Act.

Banking Services to Commercial Banks and Microfinance Banks

 The Central Bank provides the following services to Commercial Banks:

  1. Maintains accounts to enable commercial banks to effect and receive payments from other commercial banks, the government and other external financial institutions in Kenya shillings and foreign
  2. Provides a Real Time Gross Settlement (RTGS) system to enable commercial banks settle their interbank obligations on a real time
  3. Provides liquidity through the Intra-day Liquidity Facility (ILF) and the Overnight Loan These loans are secured by government securities.
  4. Hosts the Kenya Bankers Association’s Automated Clearing House (ACH).
  5. Facilitates completion of commercial banks and microfinance banks external audits by providing confirmation of balances in their clearing accounts and cash reserve ratio accounts in our books to their external
  6. Provision of the Daily Interbank Money Market Report, this is a summary of daily borrowings among commercial banks in the interbank market and guides the industry in pricing interbank loans.

Banking Services to the East African Community

The Central Bank also provides some services for the East African Community currently comprising of Kenya, Uganda, Tanzania, Rwanda and Burundi, facilitating payments, including the exchange of currencies, between countries. Internet Banking

The Central Bank offers Internet Banking services to government ministries, departments & agencies, County Executives & County Assemblies, as well as Commercial & Micro-Finance Banks allowing them to monitor and manage their accounts online.

18 Types of Bank Services

 In the modern world, banks offer a variety of services to attract customers, However, some

However, some basic modern services offered by the banks are discussed below: List of 18 banking services are;

  1. Advancing of
  2. Discounting of Bills of
  3. Check/Cheque Payment
  4. Collection and Payment of Credit Instruments
  5. Foreign Currency
  6. Bank
  7. Remittance of
  8. Credit
  9. ATMs
  10. Debit
  11. Home
  12. Online
  13. Mobile
  14. Accepting
  15. Priority
  16. Private


1.   Advancing of Loans

Banks are profit-oriented business organizations.

So they have to advance a loan to the public and generate interest from them as profit.

After keeping certain cash reserves, banks provide short-term, medium-term and long- term loans to needy borrowers.

2.   Overdraft

Sometimes, the bank provides overdraft facilities to its customers through which they are allowed to withdraw more than their deposits.

Interest is charged from the customers on the overdrawn amount.

3.   Discounting of Bills of Exchange

This is another popular type of lending by 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.

4.   Check/Cheque Payment

 Banks provide cheque pads to the account holders. Account holders can draw cheque upon the bank to pay money.

Banks pay for cheques of customers after formal verification and official procedures.

5.   Collection and Payment of Credit Instruments

 In modern business, different types of credit instruments such as the bill of exchange, promissory notes, cheques etc. are used.

Banks deal with such instruments. Modern banks collect and pay different types of credit instruments as the representative of the customers.

6.   Foreign Currency Exchange

Banks deal with foreign currencies. As the requirement of customers, banks exchange foreign currencies with local currencies, which is essential to settle down the dues in the international trade.

7.   Consultancy

Modern commercial banks are large organizations.

They can expand their function to a consultancy business. In this function, banks hire financial, legal and market experts who provide advice to customers regarding investment, industry, trade, income, tax etc.

8.   Bank Guarantee

Customers are provided the facility of bank guarantee by modern commercial banks.

When customers have to deposit certain fund in governmental offices or courts for a specific purpose, a bank can present itself as the guarantee for the customer, instead of depositing fund by customers.

9.   Remittance of Funds

 Banks help their customers in transferring funds from one place to another through cheques, drafts, etc.

10.    Credit cards

A credit card is cards that allow their holders to make purchases of goods and services in exchange for the credit card’s provider immediately paying for the goods or service, and the cardholder promising to pay back the amount of the purchase to the card provider over a period of time, and with interest.

11.    ATMs Services

ATMs replace human bank tellers in performing giving banking functions such as deposits, withdrawals, account inquiries. Key advantages of ATMs include:

  • 24-hour availability
  • Elimination of labor cost
  • Convenience of location

12.    Debit cards

Debit cards are used to electronically withdraw funds directly from the cardholders’ accounts.

Most debit cards require a Personal Identification Number (PIN) to be used to verify the transaction.

13.    Home banking

Home banking is the process of completing the financial transaction from one’s own home as opposed to utilizing a branch of a bank.

It includes actions such as making account inquiries, transferring money, paying bills, applying for loans, directing deposits.

14.    Online banking

Online banking is a service offered by banks that allows account holders to access their account data via the internet. Online banking is also known as “Internet banking” or “Web banking.”

Online banking through traditional banks enable customers to perform all routine transactions, such as account transfers, balance inquiries, bill payments, and stop- payment requests, and some even offer online loan and credit card applications.

Account information can be accessed anytime, day or night, and can be done from anywhere.

15.    Mobile Banking

 Mobile banking (also known as M-Banking) is a term used for performing balance checks, account transactions, payments, credit applications and other banking transactions through a mobile device such as a mobile phone or Personal Digital Assistant (PDA),

16.    Accepting Deposit

Accepting deposit from savers or account holders is the primary function of a bank. Banks accept deposit from those who can save money but cannot utilize in profitable sectors.

People prefer to deposit their savings in a bank because by doing so, they earn interest.

17.    Priority banking

Priority banking can include a number of various services, but some of the popular ones include free checking, online bill pays, financial consultation, and information.

18.    Private banking

Personalized financial and banking services that are traditionally offered to a bank’s digital, high net worth individuals (HNWIs). For wealth management purposes,

HNWIs have accrued far more wealth than the average person, and therefore have the means to access a larger variety of conventional and alternative investments.

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What is a money transfer?

A money transfer is when you transfer money from your credit card and pay it into your bank or building society account. It will form part of your credit card balance and is subject to repayments as part of your monthly statement balance.

This service is available on some credit cards and is usually quite simple to arrange. Once the money has reached your account you can use it to pay for goods or services, pay off higher interest credit where appropriate, or unexpected bills (for instance, a broken boiler). You’ll usually be charged a money transfer fee on any transfers you make (usually a percentage of the transfer value).

What is remittance?

The term ‘remittance’ derives from the word ‘remit’, which means ‘to send back’. Remittance refers to an amount of money transferred or sent from one party to another, usually overseas.

Remittances can be personal money transfers made to family and friends, as well as business payments.

Today, more remittances are being sent than ever before, and there are two key factors driving this increase:

  • Migration – More people are now choosing to live and work Therefore, many remittances are made by people working and living abroad to family back home.
  • Globally connected businesses – The internet makes it easier than ever for businesses to connect and collaborate with suppliers, clients and employees all around the This has resulted in a sharp increase in overseas remittances paying for business invoices.

How to send a remittance

If you need to pay a remittance, there are several different methods for doing so, including:

·         Wire transfer

  • Cash pick up

·         Mobile money

  • Electronic payment

·         Bank draft

  • Cheque

·         Post

 The cost you need to pay depends on the provider and service that you choose. Generally, banks charge high fees and provide poor exchange rates on remittances.

Offline companies like Western Union or MoneyGram used to be the big player in the past. Recently, people shifted towards online providers like as they offer the best value for money.

At World Remit we make sending remittances online simple, secure and convenient. Our low fees and fair exchange rates are shown upfront; we promise, no hidden fees.

Remittance jargon buster

Ready to send a remittance? Use our handy jargon buster to demystify remittance jargon and simplify the process.

3D Authentication

If your card uses 3D secure, a window will appear on the screen when you are making an online payment asking you to enter an additional security code before the payment can be put through. This extra layer of security is designed by your card provider and helps to protect you from credit and debit card fraud.

ABA Number

Also known as a bank routing number, an ABA number is a nine-digit code used to identify banks in the USA.


ACH (automated clearing house) payments are made through the USA’s ACH network. It’s a network that provides bank transfers between bank accounts in the USA.


AML (anti-money laundering) processes are used by financial institutions to detect and

prevent illegal money laundering activities used by criminals to disguise money they have gained illegally as lawful income.

Card fraud

When goods are purchased, or funds are taken from an individual’s credit or debit card without their permission. Credit and debit card fraud can happen when an individual’s card is lost or stolen, if their card is cloned or copied, or if their card details fall into the wrong hands.

Cash advance

A short-term loan offered by banks and other financial institutions. Cash advances often come with high fees and interest rates.

Cashier’s cheque

A cheque written and guaranteed by a financial institution, usually a bank. Cashier’s cheques are popularly used to make large payments where extra security and protection may be required as they guarantee that the funds will be available when the cheque is cashed.


A chargeback is a way of disputing a card transaction. If a chargeback is successful it will void the card transaction and the bank will remove the funds from the merchant’s account and credit them back onto the cardholder’s account.


Clearing refers to the processes and procedures that take place between requesting to wire money and the point when the transaction is complete.

Electronic wallet

An electronic wallet (sometimes referred to as a digital wallet, mobile wallet, or eWallet) is a virtual system that stores payment cards or money on a mobile device. An electronic wallet can be used to make payments to participating merchants quickly and easily using a mobile device.

Exchange rate

The amount that one currency is worth when compared to another currency. Failed transaction

A transaction that has been declined by your bank or card issuer. FCA

The United Kingdom’s financial regulatory body. The FCA (Financial Conduct Authority) is an independent body that protects consumers and promotes healthy competition between the UK’s financial service providers.

Financial Institution

A company that provides financial services. Examples of financial institutions include banks, building societies, mortgage companies, credit unions, investment banks, insurance companies, pension funds, and money transfer services.


Forex (Foreign exchange market) is an electronic network of banks, brokers, institutions and traders exchanging foreign currencies.


IBAN stands for International Bank Account Number. It is an internationally recognized way for banks around the world to identify an individual’s country, bank, and account when money is being sent overseas. An IBAN comprises up to 34 letters and numbers and can usually be found on your online banking or by contacting your bank.

Interchange fee

Every time a merchant takes a credit or debit card payment from a customer, they are charged an interchange fee by the card network.


A KYC (Know Your Customer) process is carried out by financial companies to verify the identity of their customers to prevent their services being used for money laundering and other illegal activities.


Most banks and money transfer services have rules in place that limit the amount of money that you can send in a single transfer or in a certain time period. Limits are usually in place to comply with the laws and regulations of the countries you are sending money from and to.

Local agent

A small, local business that has partnered with a money transfer provider like World Remit to offer international money transfer services in-store.

Money order

A paper document that can be used as a form of guaranteed payment. A money order can be bought or cashed at a variety of locations including banks, post offices, credit unions and some retail stores.

Proof of deposit

A verification or an official confirmation proving that funds were credited do a bank account or received by a recipient.

Peer to Peer service

A platform, like a website or money transfer app, that allows individuals to send money online to each other directly without a bank or foreign exchange provider being involved. World Remit is a peer to peer service.


Preauthorization is a temporary hold of funds on a debit or credit card for a vendor to capture it. Funds are not taken out of the bank account.

Prepaid card

A card that you deposit funds onto and then use in-store or online to make purchases as you would with a debit or credit card. Prepaid cards are a safer alternative to carrying cash and you do not need a bank account to get one. With World Remit, you can pay with a prepaid card as long as it’s issued by Visa, MasterCard or Maestro.

Real-time payments

Real-time payments are electronic payments that can be made 24/7 and are available to the payee immediately, or within seconds.


Trying to recall money is trying to reverse a completed transaction back to the sender. Funds have to be retrieved back via the same channels. This process is lengthy and not always guaranteed.


The individual or business to whom the money is being sent.


The individual or business who is sending the money. Wire transfer

An electronic money transfer sent through a network of banks and money transfer providers around the world.

How can I transfer money overseas from my bank account?

 There are several ways you can use your bank account to fund an overseas money transfer, including:

  • Bank Visit your bank or use its online or mobile banking portal to send an international transfer. You need your recipient’s name and bank account details.
  • Online money transfers Send money overseas using an online money transfer company like Transfer Wise or OFX that let your fund transactions through your bank account.
  • Use your PayPal account to fund your transfer to more than 100 destinations around the world.

Which transfer option could I choose?

The right transfer option for you will depend on your circumstances and other factors, including where you’re sending the money and the urgency of the transfer.

  • Bank transfers. Convenience is its main benefit. You don’t have to register for any new accounts and you can send from your mobile banking However, banks charge higher fees and offer lower exchange rates.
  • International bank An alternative for sending a check, a bank draft converts your money to the currency you want, and sends it to the recipient. However, you’ll pay a transfer fee. And since this is done through the mail, it can take four to six weeks to complete the transaction.
  • Online money transfers You’ll find competitive exchange rates and lower fees than banks and quicker transfer times. However, some companies impose minimum and maximum transfer amounts. And some limit the countries they send to.
  • MoneyGram’s online bank-to-bank transfer service offers fast and secure transfers to overseas bank accounts. The downside is that its exchange rates are not as good as online transfer companies.
  • This online transfer service provides access to more than 100 destinations worldwide. However, the more money you send, the more you’ll pay.

How do I send an international transfer straight from my bank account?

To send money straight from your bank account to an overseas bank account is easy through online banking. The exact process varies depending on the financial institution you are sending the money from, but generally you’ll complete the following steps:

Step by step guide

  1. Log in to your Internet banking
  2. Click on the link to make a
  3. Click the relevant link to create a new payee/recipient.
  4. Enter the country where you want to send the
  5. Enter the details of your recipient’s Depending on the country you are transferring money to, you may have to enter an IBAN (International Bank Account Number) or SWIFT/BIC number.
  6. Enter your beneficiary’s account name and
  7. Select the account you will be transferring the funds
  8. Provide full details of your transaction, including the amount and currency you’re You can also specify whether this is a one-off transfer or whether you are scheduling a recurring transfer.
  9. Review the transfer details and submit your transaction

Once you’ve submitted your transfer request, it usually takes between two and five business days for the transaction to be completed.

What is the cheapest way to send money overseas from my bank account?

Sending money online is usually cheapest with an online transfer specialist. These foreign exchange providers trade in large volumes of foreign currency, and because they’re online businesses they have fewer overhead costs than banks and other bricks- and-mortar businesses. As a result, online transfer companies can offer better exchange rates than banks and other transfer providers. Compare providers to see just how much more value for money you can get.

How do I compare international money transfer providers?

There are several factors to consider when choosing a company to handle your next international money transfer, including:

  • Compare exchange The better the exchange rate, the better value for money you can get on a transfer. Search for the company that offers consistently competitive exchange rates, but remember that there may also be higher transfer fees attached.
  • Check transaction Fees can range from $0 up to $60, so it pays to compare fees across providers. Some online transfer companies also waive their fees when you send large amounts, sometime as high as $10,000.
  • A range of transfer destinations. Check to see whether the country you want to transfer your money to is supported by the transfer provider you select, as well as whether you can send money in the currency you
  • Processing Cash transfers are usually quicker than transferring with a bank account.
  • Transfer Some providers offer one-off transfers only, others allow you to place forward contracts and limit orders to lock in the exchange rate you want and get better value for money.
  • Reliable customer If you ever have a problem with a transfer or need help with your transfer, look for a service that offers customer support that works for you — either through its FAQs, phone, email or online chat.

Main instruments used in making remittances

  1. Foreign Bills of Exchange:

 A foreign bill of exchange is customary form of making international payments.

It is a written request or an order from the drawer to the drawee to pay a certain sum of money either to himself or to the payee as ordered by the drawer on demand or some time hence. A foreign bill of exchange is generally used with the added formality of a letter of credit.

Its working is very simple. The creditors (exporters) of one country draw bills on their debtors (importers) in other countries and have them duly accepted by them. These bills they then sell to the debtors of their own country who desire to send money abroad.

The debtors (importers) send these bills to their creditors in other countries who collect them from the debtors of their own country (who had originally accepted the bills). The following illustration will clarify the point.

Suppose trader A in Bombay imports machinery from trader В in New York and that another businessman С in New York owes the same amount of money to merchant D in Bombay for tea imported by him. In this case, B, the American creditor, will draw a bill for the amount due to him, which A, the Indian debtor, will have to accept. В has, therefore, the right to receive money in India in the form of a bill drawn.

This right he can sell to C, the American debtor, who has to pay money in India. С will send his bill to D his creditor, who through this bank will collect the money from A. However, the mechanism of the bills of exchange makes it necessary that every payment in external exchange in one direction is matched by an equal payment in the other.

2.   Bank Drafts and Telegraphic Transfers:

 A bank draft is an order of a bank to its branch or another bank to pay the bearer on demand a specified amount out of its deposit account. The debtor in an international transaction can get such a bank draft from his bank and send it to his creditor who will collect the sum from the branch or bank of his own country.

3.   Telegraphic Transfer:

It is a telegraphic order by a bank to its correspondent bank abroad to pay a certain sum to a certain person on account out of its deposit account. It is a quicker mode of payment.

4.   Letter of Credit:

A letter of credit is an instrument authorizing a person to draw a bill or a cheque for a specified sum on the issuing bank at a stipulated time. The letter of credit makes the exporter willing to ship the goods to the importer, for the liability for payment is assumed by the bank issuing the letter of credit.

Such letters of credit are also issued to travelers going abroad. Likewise, travelers’ cheques are also issued by the bank, which can be cashed at a branch or correspondent of the bank in a foreign country.

In addition to these means, international payments may also be effected by the use of gold, home currency, personal cheques or international money orders.

Collection of Local and Out Station Cheques

 1. Collection of Local Cheques:

All cheques and other negotiable instruments payable locally are presented through the clearing system prevailing at the center. Cheques deposited at the counters and in collection boxes within the branch premises before the specified cut-off time are normally presented for clearing on the same day.

All the customers’ accounts are credited on the day of clearing settlement (normally next day) but withdrawals are allowed after reckoning the cheque return schedule of the clearing house. Where no clearing house exists local cheques are presented on drawee banks across the counter and proceeds thereof are credited, on realization.

2.       Collection of Out Station Cheques:

 Cheques drawn on other Banks at outstation centers in India are normally collected through local bank’s branches at these centers. Where the bank does not have a branch of its own the cheques are directly sent for collection to the drawee bank or collected through a correspondent bank

National Clearing Center:

In case center of National Clearing Services of Reserve Bank of India exist at the same center, most of the banks collect outstation cheques through National Clearing.

Outstation Cheques Drawn On Banks Own Branches:

Outstation cheques drawn on Banks own branches are collected using inter-branch arrangements in vogue. The branches, which are connected through a centralized processing arrangement and are offering ANYWHERE BANKING services to its customers, provide credit to the accounts of its customer on the same day through the centralized banking system.

Instant Credit of Outstation Cheques:

Branches will, of their own, afford immediate credit of outstation cheques upto and inclusive of Rs.15000 /-tendered for collection by customers for satisfactorily conducted accounts. (The amount of Rs. 15000/- may differ from bank to bank).

For the purpose of this policy, a satisfactorily conducted account shall be the one:

  1. Opened at least six months earlier and complying with KYC
  2. Account is neither dormant nor
  3. Where bank has not noticed any irregular dealings/suspicious transactions in the last 6
  4. Where the bank has not experienced any difficulty in recovery of any amount advanced in the past including cheques returned after giving
  5. Where no adverse features attached to the account/account holders has been brought to the notice of the  facility will be available to all individual deposit account holders without making a distinction about their accounts i.e., Savings Bank/Current Account etc. It will be available at all branches /extension
  6. Normal collection and out of pocket charges are to be recovered for outstation However, no “exchange” will be charged.
  7. In case of outstation cheques, the facility will be restricted to one or more cheques

for aggregate amount not exceeding Rs.15000/ at a time ensuring inter-alia that the liability on account of outstanding of cheques purchased does not exceed Rs. 15000/ at any time. The limit of Rs. 15000/- may differ from bank to bank. Please contact your bank to know this limit.

Bank manager may allow instant Credit for local cheques also subject to charging of some

Cheques Payable in Foreign Countries:

Cheques payable in foreign country where the bank has branch operations/banking operations through a representative, subsidiary etc., are collected through that office. Sometime services of corresponding banks are also utilized at these centers where the bank has no presence.

In case bank has neither a corresponding bank nor its own presence, in such cases the cheques are sent directly to the drawee bank with instructions to credit proceeds to the respective NASTRO ACCOUNT of the bank maintained with one of the corresponding banks.

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What Is a Lender?

Lenders are businesses or financial institutions that lend money, with the expectation that it will be paid back. The lender is paid interest on the loan as a cost of the loan. The higher the risk of not being paid back, the higher the interest rate.

Lending to a business (particularly to a new startup business) is risky, which is why lenders charge higher interest rates and often they don’t give small business loans.

Lenders do not participate in your business in the same way as shareholders in a corporation or owners/partners in other business forms. In other words, a lender has no ownership in your business.

Lenders have a different kind of risk from business owners/shareholders. Lenders come before owners in terms of payments if the business can’t pay its bills or goes bankrupt. That means that you must pay lenders back before you and other owners receive any money in a bankruptcy.

Banks follow the following principles of lending:

  1. Liquidity:

Liquidity is an important principle of bank lending. Bank lend for short periods only because they lend public money which can be withdrawn at any time by depositors. They, therefore, advance loans on the security of such assets which are easily marketable and convertible into cash at a short notice.

A bank chooses such securities in its investment portfolio which possess sufficient liquidity. It is essential because if the bank needs cash to meet the urgent requirements of its customers, it should be in a position to sell some of the securities at a very short notice without disturbing their market prices much. There are certain securities such as central, state and local government bonds which are easily saleable without affecting their market prices.

The shares and debentures of large industrial concerns also fall in this category. But the shares and debentures of ordinary firms are not easily marketable without bringing down their market prices. So the banks should make investments in government securities and shares and debentures of reputed industrial houses.

2.   Safety:

The safety of funds lent is another principle of lending. Safety means that the borrower should be able to repay the loan and interest in time at regular intervals without default. The repayment of the loan depends upon the nature of security, the character of the borrower, his capacity to repay and his financial standing.

Like other investments, bank investments involve risk. But the degree of risk varies with the type of security. Securities of the central government are safer than those of the state governments and local bodies. And the securities of state government and local bodies are safer than those of the industrial concerns. This is because the resources of the central government are much higher than the state and local governments and of the latter higher than the industrial concerns.

In fact, the share and debentures of industrial concerns are tied to their earnings which may fluctuate with the business activity in the country. The bank should also take into consideration the debt repaying ability of the governments while investing in their securities. Political stability and peace and security are the prerequisites for this.

It is very safe to invest in the securities of a government having large tax revenue and high borrowing capacity. The same is the case with the securities of a rich municipality or local body and state government of a prosperous region. So in making investments the bank should choose securities, shares and debentures of such governments, local bodies and industrial concerns which satisfy the principle of safety.

Thus from the bank’s viewpoint, the nature of security is the most important consideration while giving a loan. Even then, it has to take into consideration the creditworthiness of the borrower which is governed by his character, capacity to repay, and his financial standing. Above all, the safety of bank funds depends upon the technical feasibility and economic viability of the project for which the loan is advanced.

3.   Diversity:

In choosing its investment portfolio, a commercial bank should follow the principle of diversity. It should not invest its surplus funds in a particular type of security but in different types of securities. It should choose the shares and debentures of different types of industries situated in different regions of the country. The same principle should be followed in the case of state governments and local bodies. Diversification aims at minimizing risk of the investment portfolio of a bank.

The principle of diversity also applies to the advancing of loans to varied types of firms, industries, businesses and trades. A bank should follow the maxim: “Do not keep all eggs in one basket.” It should spread it risks by giving loans to various trades and industries in different parts of the country.

4.   Stability:

Another important principle of a bank’s investment policy should be to invest in those stocks and securities which possess a high degree of stability in their prices. The bank cannot afford any loss on the value of its securities. It should, therefore, invest it funds in the shares of reputed companies where the possibility of decline in their prices is remote.

Government bonds and debentures of companies carry fixed rates of interest. Their value changes with changes in the market rate of interest. But the bank is forced to liquidate a portion of them to meet its requirements of cash in cash of financial crisis. Otherwise, they run to their full term of 10 years or more and changes in the market rate of interest do not affect them much. Thus bank investments in debentures and bonds are more stable than in the shares of companies.

5.   Profitability:

This is the cardinal principle for making investment by a bank. It must earn sufficient profits. It should, therefore, invest in such securities which was sure a fair and stable return on the funds invested. The earning capacity of securities and shares depends upon the interest rate and the dividend rate and the tax benefits they carry.

It is largely the government securities of the center, state and local bodies that largely carry the exemption of their interest from taxes. The bank should invest more in such securities rather than in the shares of new companies which also carry tax exemption. This is because shares of new companies are not safe investments.

What Are the Types of Commercial Loans?

  • Bank financing for small business start-up and working capital
  • Asset financing for equipment and machinery or business
  • Mortgages
  • Credit card financing
  • Vendor financing (through trade credit)
  • Personal (unsecured) loans

The type of lender you will need for a business loan depends on several factors:

  • Amount of loan: The amount of money you want to borrow influences the type of For larger loans, you may need a combination of types of commercial loans.
  • Assets pledged: If you have business assets you can pledge as collateral for the loan, you can get better terms than if your loan is
  • Type of assets: A mortgage is typically for land and building, while an equipment loan is for financing capital expenditures like
  • Startup or expansion: A startup loan is typically much more difficult to get than a loan for expansion of an existing For a startup, you may have to look at some of the more untraditional types of lenders described below.
  • Term of the loan: How long do you need the money? If you need a short-term loan for a business startup, you will be looking for a different lender than for a long-term loan for land and

What are Different Types of Lenders?

The most common lenders are banks, credit unions, and other financial institutions.

More recently, the term “lender” has been expended to refer to less traditional sources of funds for small business loans, including:

  • Peer-to-peer lenders: borrowing from individuals, through online organizations like Lenders
  • Crowdfunding: through organizations like Kickstarter, and The good thing about these lenders is that they don’t require interest payments!
  • Borrowing from family and friends: There are organizations that help sort out the tricky financial and personal issues involved with these transactions. If you are considering a loan from someone you know, be sure to create a loan These agreements are sometimes called private party loans.
  • Borrowing from yourself: You can also loan money to your business as an alternative to investing in it, but make sure you have a written contract that specifically spells out your role as a lender, with regular payments and consequences if the business defaults.

Types of Loans

Loan types vary because each loan has a specific intended use. They can vary by length of time, by how interest rates are calculated, by when payments are due and by a number of other variables.

Debt Consolidation Loans

A consolidation loan is meant to simplify your finances. Simply put, a consolidation loan pays off all or several of your outstanding debts, particularly credit card debt. It means fewer monthly payments and lower interest rates. Consolidation loans are typically in the form of second mortgages or personal loans.

Student Loans

Student loans are offered to college students and their families to help cover the cost of higher education. There are two main types: federal student loans and private student loans. Federally funded loans are better, as they typically come with lower interest rates and more borrower-friendly repayment terms.


Mortgages are loans distributed by banks to allow consumers to buy homes they can’t pay for upfront. A mortgage is tied to your home, meaning you risk foreclosure if you fall behind on payments. Mortgages have among the lowest interest rates of all loans

Auto Loans

Like mortgages, auto loans are tied to your property. They can help you afford a vehicle, but you risk losing the car if you miss payments. This type of loan may be distributed by a bank or by the car dealership directly but you should understand that while loans from the dealership may be more convenient, they often carry higher interest rates and ultimately cost more overall.

Personal Loans

Personal loans can be used for any personal expenses and don’t have a designated purpose. This makes them an attractive option for people with outstanding debts, such as credit card debt, who want to reduce their interest rates by transferring balances.

Like other loans, personal loan terms depend on your credit history.

Loans for Veterans

The Department of Veterans Affairs (VA) has lending programs available to veterans and their families. With a VA-backed home loan, money does not come directly from the administration. Instead, the VA acts as a co-signer and effectively vouches for you, helping you earn higher loan amounts with lower interest rates.

Small Business Loans

Small business loans are granted to entrepreneurs and aspiring entrepreneurs to help them start or expand a business. The best source of small business loans is the U.S. Small Business Administration (SBA), which offers a variety of options depending on each business’s needs.

Payday Loans

Payday loans are short-term, high-interest loans designed to bridge the gap from one paycheck to the next, used predominantly by repeat borrowers living paycheck to paycheck. The government strongly discourages consumers from taking out payday loans because of their high costs and interest rates.

Borrowing from Retirement & Life Insurance

Those with retirement funds or life insurance plans may be eligible to borrow from their accounts. This option has the benefit that you are borrowing from yourself, making repayment much easier and less stressful. However, in some cases, failing to repay such a loan can result in severe tax consequences.

Borrowing from Friends and Family

Borrowing money from friends and relatives is an informal type of loan. This isn’t always a good option, as it may strain a relationship. To protect both parties, it’s a good idea to sign a basic promissory note.

Cash Advances

A cash advance is a short-term loan against your credit card. Instead of using the credit card to make a purchase or pay for a service, you bring it to a bank or ATM and receive cash to be used for whatever purpose you need. Cash advances also are available by writing a check to payday lenders

Home Equity Loans

If you have equity in your home – the house is worth more than you owe on it – you can use that equity to help pay for big projects. Home equity loans are good for renovating the house, consolidating credit card debt, paying off student loans and many other worthwhile projects.

Home equity loans and home equity lines of credit (HELOCs) use the borrower’s home as a source of collateral so interest rates are considerably lower than credit cards. The major difference between the two is that a home equity loan has a fixed interest rate and regular monthly payments are expected, while a HELOC has variable rates and offers a flexible payment schedule. Home equity loans and HELOCs are used for things like home renovations, credit card debt consolidation, major medical bills, education expenses and retirement income supplements. They must be repaid in full if the home is sold.

What is a Security?

 A security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally depends on the jurisdiction in which the assets are being traded.

In the United States, the term broadly covers all traded financial assets and breaks such assets down into three primary categories:

  1. Equity securities – which includes stocks
  2. Debt securities – which includes bonds and banknotes
  3. Derivatives – which includes options and futures

Types of Securities

1. Equity securities

 Equity almost always refers to stocks and a share of ownership in a company (which is possessed by the shareholder). Equity securities usually generate regular earnings for shareholders in the form of dividends. An equity security does, however, rise and fall in value in accord with the financial markets and the company’s fortunes.

2.   Debt securities

Debt securities differ from equity securities in an important way; they involve borrowed money and the selling of a security. They are issued by an individual or company and sold to another party for a certain amount, with a promise of repayment plus interest. They include a fixed amount (that must be repaid), a specified rate of interest, and a maturity date (the date when the total amount of the security must be paid by).

Bonds, bank notes (or promissory notes), and Treasury notes are all examples of debt securities. They all are agreements made between two parties for an amount to be borrowed and paid back – with interest – at a previously-established time.

3.   Derivatives

Derivatives are a slightly different type of security because their value is based on an underlying asset that is then purchased and repaid, with the price, interest, and maturity date all specified at the time of the initial transaction.

The individual selling the derivative doesn’t need to own the underlying asset outright. The seller can simply pay the buyer back with enough cash to purchase the underlying asset or by offering another derivative that satisfies the debt owed on the first.

A derivative often derives its value from commodities such as gas or precious metals such as gold and silver. Currencies are another underlying asset a derivative can be structured on, as well as interest rates, Treasury notes, bonds, and stocks.

Derivatives are most often traded by hedge funds to offset risk from other investments.

As mentioned above, they require the seller to own the underlying asset and may only require a relatively small down payment, which makes them favorable because they are easier to trade.

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Credit creation separates a bank from other financial institutions. In simple terms, credit creation is the expansion of deposits. And, banks can expand their demand deposits as a multiple of their cash reserves because demand deposits serve as the principal medium of exchange. In this article, we will talk about credit creation.

he two most important aspects of credit creation are:

  1. Liquidity – The bank must pay cash to its depositors when they exercise their right to demand cash against their
  2. Profitability – Banks are profit-driven enterprises. Therefore, a bank must grant loans in a manner which earns higher interest than what it pays on its

The bank’s credit creation process is based on the assumption that during any time interval, only a fraction of its customers genuinely need cash. Also, the bank assumes that all its customers would not turn up demanding cash against their deposits at one point in time.

Basic Concepts of Credit Creation

  • Bank as a business institution – Bank is a business institution which tries to maximize profits through loans and advances from the
  • Bank Deposits – Bank deposits form the basis for credit creation and are of two types:
  • Primary Deposits – A bank accepts cash from the customer and opens a deposit in his This is a primary deposit. This does not mean credit creation. These deposits simply convert currency money into deposit money. However, these deposits form the basis for the creation of credit.
  • Secondary or Derivative Deposits – A bank grants loans and advances and

instead of giving cash to the borrower, opens a deposit account in his name. This is the secondary or derivative deposit. Every loan crates a deposit. The creation of a derivative deposit means the creation of credit.

  • Cash Reserve Ratio (CRR) – Banks know that all depositors will not withdraw all deposits at the same time. Therefore, they keep a fraction of the total deposits for meeting the cash demand of the depositors and lend the remaining excess CRR is the percentage of total deposits which the banks must hold in cash reserves for meeting the depositors’ demand for cash.
  • Excess Reserves – The reserves over and above the cash reserves are the excess These reserves are used for loans and credit creation.
  • Credit Multiplier – Given a certain amount of cash, a bank can create multiple times credit. In the process of multiple credit creation, the total amount of derivative deposits that a bank creates is a multiple of the initial cash

Credit creation by a single bank

 There are two ways of analyzing the credit creation process:

  1. Credit creation by a single bank
  2. Credit creation by the banking system as a whole

In a single bank system, one bank operates all the cash deposits and cheques.

The limitations of credit creation process (as shown in Figure-3) are explained as follows:

1.    Amount of Cash:

Affects the creation of credit by commercial banks. Higher the cash of commercial banks in the form of public deposits, more will be the credit creation. However, the amount of cash to be held by commercial banks is controlled by the central bank.

The central bank may expand or contract cash in commercial banks by purchasing or selling government securities. Moreover, the credit creation capacity depends on the rate of increase or decrease in CRR by the central bank.

2.   CRR:

Refers to reserve ratio of cash that need to be kept with the central bank by commercial banks. The main purpose of keeping this reserve is to fulfill the transactions needs of depositors and to ensure safety and liquidity of commercial banks. In case the ratio falls, the credit creation would be more and vice versa.

3.   Leakages:

 Imply the outflow of cash. The credit creation process may suffer from leakages of cash.

The different types of leakages are discussed as follows:

  • Excess Reserves:

Takes place generally when the economy is moving towards recession. In such a case, banks may decide to maintain reserves instead of utilizing funds for lending. Therefore, in such situations, credit created by commercial banks would be small as a large amount of cash is resented.

Currency Drains:

Imply that the public does not deposit all the cash with it. The customers may hold the cash with them which affects the credit creation by banks. Thus, the capacity of banks to create credit reduces.

4.   Availability of Borrowers:

Affects the credit creation by banks. The credit is created by lending money in form of loans to the borrowers. There will be no credit creation if there are no borrowers.

5.    Availability of Securities:

Refers to securities against which banks grant loan. Thus, availability of securities is necessary for granting loan otherwise credit creation will not occur. According to Crowther, “the bank does not create money out of thin air; it transmutes other forms of wealth into money.”

6.   Business Conditions:

Imply that credit creation is influenced by cyclical nature of an economy. For example, credit creation would be small when the economy enters into the depression phase.

This is because in depression phase, businessmen do not prefer to invest in new projects. In the other hand, in prosperity phase, businessmen approach banks for loans, which lead to credit creation.

In spite of its limitations, we can conclude that credit creation by commercial banks is a significant source for generating income.

The essential conditions for creation of credit are as follows:

  1. Accepting the fresh deposits from public
  2. Willingness of banks to lend money
  3. Willingness of borrowers to

Process of credit creation

commercial bank has two types of deposits, and the two processes have been discussed below. Once is ‘Loan Creations from Deposit’ and another ‘Deposit Creation through Loan. So stay with us and achieve your required information from here. Also, we have additional info for you. These are the primary functions of commercial banks and the Characteristics of commercial banks.

Loan Creation from Deposit

The commercial banks will pay back the people’s lazy money through various deposits and refund them. But the depositors do not take all the money at the same time.

Occasionally, according to the needs taken. So, without taking all the money deposited by the bank, the profits earned by investing in some profitable sectors can be made from some portion of the bank. Thus, the bank creates debt deposits by making and contracting loans. Through these actions, the commercial banks make loans from deposits so that it called ‘Loan Creation from Deposit’. After all, it is the first process of credit creation by the commercial bank through loan creation from the deposit.

Deposit Creation through Loan

Deposit Creation through Loan is the second process of credit creation by a commercial bank. However, in 5 ways, commercial banks create deposits through debt. So come to the point and justify these 5 ways

1.   Investment

Commercial banks invest money in shares, bonds, securities etc. Since it is deposited in any bank, the bank creates a debt deposit from that deposit. So investment is the first ways of deposit creation through loan.

2.   Loan at call & loan payable at short notice

The commercial bank offers only the demands of borrowers and short-term loans

through current accounting. The borrowers pick up the money as needed. Therefore, the bank makes a loan deposit by repaying it from that money. So the loan at call and loan payable at short notice is the second way of deposit creation through loan.

3.   Bill Discounting

Bill discounting is the third way of the deposit creation through loan. The commercial bank exchanges the bill by purchasing the Bill with an interest. So this check is deposited in any bank. And from there it made the bank debt deposits. Therefore, all these activities are involved with bill discounting.

4.   Purchasing Assets

 Since commercial banks are purchasing the assets and paying them through check, as a result they help in generating credit deposits. The person who sells the wealth will not pick up the money and take it slowly through the check. As a result, debt deposits will be created. Therefore, the purchasing assets are the fourth number of the way from deposit creation through loan.

5.   Through Bank Overdraft

 Bank provides Bank Overdraft credit for the needs of the customers. The loan will also be credited to the credit bank in the form of the amount of loan deposited. The overall process of the bank is managed to generate credit deposits.

However, we coming at the end of the page. I hope, I completed explaining the process of credit creation by commercial banks successfully. Overall have completed the two process loan creation from the deposit and the deposit creation through a loan. If you want to know the additional information, then comment on yourselves.

Limitations on Credit Creation by Banks

  1. Amount of cash:

The credit creation power of banks depends upon the amount of cash they possess. The larger the cash, the larger the amount of credit that can be created by banks.

Image Courtesy: limit.jpg

The amount of cash that a bank has in its vaults cannot be determined by it. It depends upon the primary deposits with the bank. The bank’s power of creating credit is thus limited by the cash it possesses.

2.   Proper securities:

An important factor that limits the power of a bank to create credit is the availability of adequate securities. A bank advances loans to its customers on the basis of a security, or a bill, or a share, or a stock or a building, or some other type of asset. It turns ill-liquid form of wealth into liquid wealth and thus creates credit. If proper securities are not available with the public, a bank cannot create credit. As pointed out by Crowther, “Thus the bank does not create money out of thin air it transmutes other forms of wealth into money.”

3.   Banking habits of the people:

The banking habits of the people also govern the power of credit creation on the part of banks. If people are not in the habit of using cheques, the grant of loans will lead to the withdrawal of cash from the credit creation stream of the banking system. This reduces the power of banks to create credit to the desired level.

4.   Minimum legal reserve ratio:

The minimum legal reserve ratio of cash to deposits fixed by the central bank is an important factor which determines the power of banks of creates credit. The higher this ratio (RRr), the lower the power of banks to create credit; and the lower the ratio, the higher the power of banks to create credit.

5.   Excess reserves:

The process of credit creation is based on the assumption that banks stick to the required reserve ratio fixed by the central bank. If banks keep more cash in reserves than the legal reserve requirements, their power to create credit is limited to that extent. If Bank A of our example keeps 25 per cent of Rs 1000 instead of 20 per cent, it will lend Rs 750 instead of Rs 800. Consequently, the amount of credit creation will be reduced even if the other banks in the system stick to the legal reserve ratio of 20 per cent.

6.   Leakages:

If there are leakages in the credit creation stream of the banking system, credit expansion will not reach the required level, given the legal reserve ratio. It is possible that some persons who receive cheques do not deposit them in their bank accounts, but withdraw the money in cash for spending or for hoarding at home. The extent to which the amount of cash is withdrawn from the chain of credit expansion, the power of the banking system to create credit is limited.

7.   Cheque clearances:

The process of credit expansion is based on the assumption that cheques drawn by commercial banks are cleared immediately and reserves of commercial banks expand and contract uniformly by cheque transactions. But it is not possible for banks to receive and draw cheques of exactly equal amount. Often some banks have their reserves increased and others reduced through cheque clearances. This expands and contracts credit creation of the part of banks. Accordingly, the credit creation stream is disturbed.

8.   Behaviour of other banks:

The power of credit creation is further limited by the behaviour of other banks. If some of the banks do not advance loans to the extent required of the banking system, the chain of credit expansion will be broken. Consequently, the banking system will not be “loaned up”.

9.   Economic climate:

Banks cannot continue to create credit limitlessly. Their power to create credit depends upon the economic climate in the country. If there are boom times there is optimism.

Investment opportunities increase and businessmen take more loans from banks. So credit expands. But in depressed times when the business activity is at a low level, banks cannot force the business community to take loans from them. Thus the economic climate in a country determines the power of banks to create credit.

10.    Credit control policy of the central bank:

The power of commercial banks to create credit is also limited by the credit control policy of the central bank. The central bank influences the amount of cash reserves with banks by open market operations, discount rate policy and varying margin requirements. Accordingly, it affects the credit expansion or contraction by commercial banks.

How the central bank controls credit creation?

The four important methods used by the Central Bank for Credit Control are as follows:

1. Bank Rate or Discount Rate Policy:

The bank rate or the discount rate is the rate fixed by the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. The bank rate is the interest rate charged by the central bank at which it provides rediscount to banks through the discount window. The central bank controls credit by making variations in the bank rate.

If the need of the economy is to expand credit, the central bank lowers the bank rate. Borrowing from the central bank becomes cheap and easy. So the commercial banks will borrow more. They will, in turn, advance loans to customers at a lower rate. The market rate of interest will be reduced.

This encourages business activity, and expansion of credit follows which encourages the rise in prices. The opposite happens when credit is to be contracted in the economy. The central bank raises the bank rate which makes borrowing costly from it. So the banks borrow less. They, in turn, raise their lending rates to customers.

The market rate of interest also rises because of the tight money market. This discourages fresh loans and puts pressure on borrowers to pay their past debts. This discourages business activity. There is contraction of credit which depresses the rise in price. Thus lowering the bank rate offsets deflationary tendencies and raising the bank rate controls inflation.

Limitations of Bank Rate Policy:

 The efficacy of the bank rate policy as an instrument of controlling credit is limited by the following factors:

1.   Market Rates do not change with Bank Rate:

The success of the bank rate policy depends upon the extent to which other market rates of interest change along with the bank rate. The theory of bank rate policy pre- supposes that other rates of interest prevailing in the money market change in the direction of the change in the bank rate. If this condition is not satisfied, the bank rate policy will be totally ineffective as an instrument of credit control.

2.   Wages, Costs and Prices Not Elastic:

The success of the bank rate policy requires elasticity not only in interest rates but also in wages, costs and prices. It implies that when suppose the bank rate is raised wages, costs and prices should automatically adjust themselves to a lower level. But this was possible only under gold standard. Now-a-days the emergence of strong trade unions has made wages rigid during deflationary trends. And they also lag behind when there are inflationary tendencies because it takes time for unions to get a wage rise from employers. So the bank rate policy cannot be a success in a rigid society.

3.   Banks do not approach Central Bank:

The effectiveness of the bank rate policy as a tool of credit control is also limited by the behaviour of the commercial banks. It is only if the commercial banks approach the central bank for rediscounting facilities that this policy can be a success. But the banks keep with them large amounts of liquid assets and do not find it necessary to approach the central bank for financial help.

4.   Bills of Exchange not used:

As a corollary to the above, the effectiveness of the bank rate policy depends on the existence of eligible bills of exchange. In recent years, the bill of exchange as an instrument of financing commerce and trade has fallen into disuse. Businessmen and banks prefer cash credit and overdrafts. This makes the bank rate policy less effective for controlling credit in the country.

5.   Pessimism or Optimism:

 The efficacy of the bank rate policy also depends on waves of pessimism or optimism among businessmen. If the bank rate is raised, they will continue to borrow even at a higher rate of interest if there are boom conditions in the economy, and prices are expected to rise further. On the other hand, a reduction in the bank rate will not induce them to borrow during periods of falling prices. Thus businessmen are not very sensitive to changes in interest rates and they are influenced more by business expectations.

6.   Power to Control Deflation Limited:

Another limitation of the bank rate policy is that the power of a central bank to force a reduction in the market rates of interest is limited. For instance, a lowering of bank rate below 3 per cent will not lead to a decline in the market rates of interest below 3 per cent. So the bank rate policy is ineffective in controlling deflation. It may, however, control inflationary tendencies by forcing an increase in the market rates of interest.

7.   Level of Bank Rate in relation to Market Rate:

The efficacy of the discount rate policy as an instrument of credit control depends upon its level in relation to the market rate. If in a boom the bank rate is not raised to such an extent as to make borrowing costly from the central bank, and it is not lowered during a recession so as to make borrowing cheaper from it, it would have a destabilizing effect on economic activity.

8.   Non-Discriminatory:

The bank rate policy is non-discriminatory because it does not distinguish between productive and unproductive activities in the country.

9.   Not Successful in Controlling BOP Disequilibrium:

The bank rate policy is not effective in controlling balance of payments disequilibrium in a country because it requires the removal of all restrictions on foreign exchange and movements of international capital.

2. Open Market Operations:

Open market operations are another method of quantitative credit control used by a central bank. This method refers to the sale and purchase of securities, bills and bonds of government as well as private financial institutions by the central bank. But in its narrow sense, it simply means dealing only in government securities and bonds.

There are two principal motives of open market operations. One to influence the reserves of commercial banks in order to control their power of credit creation. Two to affect the market rates of interest so as to control the commercial bank credit.

Its method of operation is as follows. Suppose the central bank of a country wants to control expansion of credit by the commercial banks for the purpose of controlling inflationary pressures within the economy. It sells government securities in the money market amounting to, say, Rs 10 crores.

The latter give the central bank cheques for this amount drawn against the commercial banks in which the public have their accounts. The central bank reduces this amount in their accounts with it. This applies equally if the commercial banks have also purchased securities from the central bank.

The sale of securities in the open market has thus reduced their cash holdings with the central bank. This tends to reduce the actual cash ratio of the commercial banks by Rs. 10 crores. So the banks are forced to curtail their lending.

Limitations of Open Market Operations:

The effectiveness of open market operations as a method of credit control is dependent upon the existence of a number of conditions the absence of which limits the full working of this policy.

1.   Lack of Securities Market:

The first condition is the existence of a large and well-organized security market. This condition is very essential for open market operations because without a well- developed security market the central bank will not be able to buy and sell securities on a large scale, and thereby influence the reserves of the commercial banks. Further, the central bank must have enough saleable securities with it.

2.   Cash Reserve Ratio Not Stable:

The success of open market operations also requires the maintenance of a stable cash- reserve ratio by the commercial bank. It implies that when the central bank sells or buys securities, the reserves of the commercial banks decrease or increase accordingly to maintain the fixed ratio. But usually the banks do not stick to the legal minimum reserve ratio and keep a higher ratio than this. This makes open market operations less effective in controlling the volume of credit.

3.   Penal Bank Rate:

According to Prof. Aschheim, one of the necessary conditions for the success of open market operations is a penal bank rate. If there is no penal discount rate fixed by the central bank, the commercial banks can increase their borrowings from it when the demand for credit is strong on the part of the latter. In this situation, the scale of securities by the central bank to restrict monetary expansion will be unsuccessful. But if there is a penal rate of discount, which is a rate higher than the market rates of interest, the banks will be reluctant to approach the central bank for additional financial help easily.

4.   Banks Act Differently:

Open market operations are successful only if the people also act the way the central bank expects them. When the central bank sells securities, it expects the business community and financial institutions to restrict the use of credit. If they simultaneously start dishoarding money, the act of selling securities by the central banks will not be a success in restricting credit. Similarly, the purchase of securities by the central bank will not be effective if people start hoarding money.

5.   Pessimistic or Optimistic Attitude:

Pessimistic or optimistic attitude of the business community also limits the operation of open market policy. When the central bank purchases securities and increases the supply of bank money, businessmen may be unwilling to take loans during a depression because of the prevailing pessimism among them.

As aptly put by Crowther, banks may place plenty of water before the public horse, but the horse cannot be forced to drink, if it is afraid of loss through drinking water. On the other hand, if businessmen are optimistic during a boom, the sale of securities by the central bank to contract the supply of bank money and even the rise in market rates cannot discourage them from getting loans from the banks. On the whole, this policy is more successful in controlling booms than depressions.

6.   Velocity of Credit Money not Constant:

The success of open market operations depends upon a constant velocity of circulation of bank money. But the velocity of credit money is not constant. It increases during periods of brisk business activity and decreases in periods of falling prices. Thus a policy of contracting credit by the sale of securities by the central bank may not be successful by increased velocity of circulation of bank credit.

Despite these limitations, open market operations are more effective than the other instruments of credit control available with the central bank. This method is being successfully used for controlling credit in developed countries where the securities market is highly developed.

3. Variable Reserve Ratio:

Variable reserve ratio (or required reserve ratio or legal minimum requirements), as a method of credit control was first suggested by Keynes in his Treatise on Money (1930) and was adopted by the Federal Reserve System of the United States in 1935.

Every commercial bank is required by law to maintain a minimum percentage of its deposits with the central bank. The minimum amount of reserve with the central bank may be either a percentage of its time and demand deposits separately or of total deposits. Whatever the amount of money remains with the commercial bank over and above these minimum reserves is known as the excess reserves.

It is on the basis of these excess reserves that the commercial bank is able to create credit. The larger the size of the excess reserves, the greater is the power of a bank to create credit, and vice versa. It can also be said that the larger the required reserve ratio, the lower the power of a bank to create credit, and vice versa.

When the central bank raises the reserve ratio of the commercial banks, it means that the latter are required to keep more money with the former. Consequently, the excess reserves with the commercial banks are reduced and they can lend less than before.

Limitations of Variable Reserve Ratio:

The variable reserve ratio as a method of credit control has a number of limitations.

1.   Excess Reserves:

The commercial banks usually possess large excessive reserves which make the policy of variable reserve ratio ineffective. When the banks keep excessive reserves, an increase in the reserve ratio will not affect their lending operations. They will stick to the legal minimum requirements of cash to deposits and at the same time continue to create credit on the strength of the excessive reserves.

2.   Clumsy Method:

It is a clumsy method of credit control as compared with open market operations. This is because it lacks definiteness in the sense that it is inexact and uncertain as regards changes not only in the amounts of reserves but also the place where these changes can be made effective. It is not possible to tell “how much of active or potential reserve base” has been affected by changes in the reserve ratio. Moreover, the changes in reserves involve far larger sums than in the case of open market operations.

3.   Discriminatory:

It is discriminatory and affects different banks differently. A rise in the required reserve ratio will not affect those banks which have large excess reserves. On the other hand, it will hit hard the banks with little or no excess reserves. This policy is also discriminatory in the sense that non-banking financial intermediaries like co-operative societies, insurance companies, building societies, development banks, etc. are not affected by variations in reserve requirements, though they compete with the commercial banks for lending purposes.

4.   Inflexible:

This policy is inflexible because the minimum reserve ratio fixed by the central banks is applicable to banks located in all regions of the country. More credit may be needed in one region where there is monetary stringency, and it may be superfluous in the other region. Raising the reserve ratio for all banks is not justified in the former region though it is appropriate for the latter region.

5.   Business Climate:

The success of the method of credit control also depends on the business climate in the economy. If the businessmen are pessimistic about the future, as under a depression, even a sizable lowering of the reserve ratio will not encourage them to ask for loan. Similarly, if they are optimistic about profit expectations, a considerable rise in the variable ratio will not prevent them from asking for more loans from the banks.

6.   Stability of Reserve Ratio:

The effectiveness of this technique depends upon the degree of stability of the reserve ratio. If the commercial banks are authorized to keep widely fluctuating ratio, say between 10 per cent to 17 per cent and change in the upper or lower limit will have no effect on the credit creation power of the banks.

7.   Other Factors:

The reserve ratio held by the commercial banks is determined not only by legal requirements but also by how much they want to hold in relation to their deposits in addition to such requirements. This, in turn, will depend upon their expectations about future developments, their competition with other banks, and so on.

8.   Depressive Effect:

The variable reserve ratio has been criticized for exercising a depressive effect on the securities market. When the central bank suddenly directs the commercial banks to increase their reserve ratios, they may be forced to sell securities to maintain that ratio. This widespread selling of securities will bring down the prices of securities and may even lead to an utter collapse of the bond market.

9.   Rigid:

It is rigid in its operations because it does not distinguish between desired and undesired credit flows and can affect them equally.

10.    Not for Small Changes:

This method is more like an axe than a scalpel. It cannot be used for day-to- day and week-to-week adjustments but can be used to bring about large changes in the reserve positions of the commercial banks. Thus it cannot help in ‘fine tuning’ of the money and credit systems by making small changes.

4. Selective Credit Controls:

Selective or qualitative methods of credit control are meant to regulate and control the supply of credit among its possible users and uses. They are different from quantitative or general methods which aim at controlling the cost and quantity of credit. Unlike the general instruments, selective instruments do not affect the total amount of credit but the amount that is put to use in a particular sector of the economy.

The aim of selective credit control is to channelize the flow of bank credit from speculative and other undesirable purposes to socially desirable and economically useful uses. They also restrict the demand for money by laying down certain conditions for borrowers.

They therefore, embody the view that the monopoly of credit should in fact become a discriminating monopoly. Prof. Chandler defines selective credit controls as those measures “that would influence the allocation of credit, at least to the point of decreasing the volume of credit used for selected purposes without the necessity of decreasing the supply and raising the cost of credit for all purposes.” We discuss below the main types of selective credit controls generally used by the central banks in different countries.

  Regulation of Margin Requirements:

This method is employed to prevent excessive use of credit to purchase or carry securities by speculators. The central bank fixes minimum margin requirements on loans for purchasing or carrying securities. They are, in fact, the percentage of the value of the security that cannot be borrowed or lent. In other words, it is the maximum value of loan which a borrower can have from the banks on the basis of the security (or collateral).

For example, if the central bank fixes a 10 per cent margin on the value of a security worth Rs 1.0, then the commercial bank can lend only Rs 900 to the holder of the security and keep Rs 100 with it. If the central bank raises the margin to 25 per cent, the bank can lend only Rs 750 against a security of Rs 1.0. If the central bank wants to curb speculative activities, it will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces the margin requirements.

Its Merits:

This method of selective credit control has certain merits which make it unique.

  1. It is non-discriminatory because it applies equally to borrowers and Thus it limits both the supply and demand for credit simultaneously.
  2. It is equally applicable to commercial banks and non-banking financial
  3. It increases the supply of credit for more productive
  4. It is a very effective anti-inflationary device because it controls the expansion of credit in those sectors of the economy which breed
  5. It is simple and easy to administer since this device is meant to regulate the use of credit for specific

But the success of this technique requires that there are no leakages of bank credit for non-purpose loans to speculators.

Its Weaknesses:

 However, a number of leakages have appeared in this method over the years.

  1. A borrower may not show any intention of purchasing stocks with his borrowed funds and pledge other assets as security for the loan. But it may purchase stocks through some other source.
  2. The borrower may purchase stocks with cash which he would normally use to purchase materials and supplies and then borrow money to finance the materials and supplies already purchased, pledging the stocks he already has as security for the
  3. Lenders, other than commercial banks and brokers, who are not subject to margin requirements, may increase their security loans when commercial banks and brokers are being controlled by high margin Further, some of these non-regulated lenders may be getting the funds they lent to finance the purchase of securities from commercial banks themselves.

Despite these weaknesses in practice, margin requirements are a useful device of credit control.

Regulation of Consumer Credit:

This is another method of selective credit control which aims at the regulation of consumer instalment credit or hire-purchase finance. The main objective of this instrument is to regulate the demand for durable consumer goods in the interest of economic stability. The central bank regulates the use of bank credit by consumers in order to buy durable consumer goods on instalments and hire-purchase. For this purpose, it employs two devices: minimum down payments, and maximum periods of repayment.

Suppose a bicycle costs Rs 500 and credit is available from the commercial bank for its purchase. The central bank may fix the minimum down payment to 50 per cent of the price, and the maximum period of repayment to 10 months. So Rs 250 will be the minimum which the consumer will have to pay to the bank at the time of purchase of the bicycle and the remaining amount in ten equal instalments of Rs 25 each. This facility will create demand tor bicycles.

The bicycle industry would expand along with the related industries such as tyres, tubes, spare parts, etc. and thus lead to inflationary situation in this and other sectors of the economy. To control it, the central bank raises the minimum down payment to 70 per cent and the maximum period of repayment to three installments. So the buyer of a bicycle will have to pay Rs 350 in the beginning and remaining amount in three installments of Rs 50 each. Thus if the central bank finds slump in particular industries of the economy, it reduces the amount of down payments and increases the maximum periods of repayment.

Reducing the down payments tends to increase the demand for credit for particular durable consumer goods on which the central bank regulation is applied. Increasing the maximum period of repayment, which reduces monthly payments, tends to increase the demand for loans, thereby encouraging consumer credit. On the other hand, the central bank raises the amount of down payments and reduces the maximum periods of repayment in boom.

The regulation of consumer credit is more effective in controlling credit in the case of durable consumer goods during both booms and slumps, whereas general credit controls fail in this area. The reason is that the latter operate with a time lag. Moreover, the demand for consumer credit in the case of durable consumer goods is interest inelastic. Consumers are motivated to buy such goods under the influence of the demonstration effect and the rate of interest has little consideration for them.

But this instrument has its drawbacks.

 It is cumbersome, technically defective and difficult to administer because it has a narrow base. In other words, it is applicable to a particular class of borrowers whose demand for credit forms an insignificant part of the total credit requirements. It, therefore, discriminates between different types of borrowers. This method affects only persons with limited incomes and leaves out higher income groups. Finally, it tends to malallocate resources by shifting them away from industries which are covered by credit regulations and lead to the expansion of other industries which do not have any credit restrictions.

Rationing of Credit:

Rationing of credit is another selective method of controlling and regulating the purpose for which credit is granted by the commercial banks. It is generally of four types. The first is the variable portfolio ceiling. According to this method, the central bank fixes a ceiling on the aggregate portfolios of the commercial banks and they cannot advance loans beyond this ceiling. The second method is known as the variable capital assets ratio. This is the ratio which the central bank fixes in relation to the capital of a commercial bank to its total assets. In keeping with the economic exigencies, the central bank may raise or lower the portfolio ceiling, and also vary the capital assets ratio.

Rationing of credit has been used very effectively in Russia and Mexico. It is, therefore, ‘a logical concomitant of the intensive and extensive planning adopted in regimented economies.’ The technique also involves discrimination against larger banks because it restricts their lending power more than the smaller banks. Lastly, by rationing of credit for selective purposes, the central bank ceases to be the lender of the last resort.

Therefore, central banks in mixed economies do not use this technique except under extreme inflationary situations and emergencies.

Direct Action:

 Central banks in all countries frequently resort to direction action against commercial banks. Direction action is in the form of “directives” issued from time to time to the commercial banks to follow a particular policy which the central bank wants to enforce immediately. This policy may not be used against all banks but against erring banks.

For example, the central bank refuses rediscounting facilities to certain banks which may be granting too much credit for speculative purposes, or in excess of their capital and reserves, or restrains them from granting advances against the collateral of certain commodities, etc. It may also charge a penal rate of interest from those banks which want to borrow from it beyond the prescribed limit. The central bank may even threaten a commercial bank to be taken over by it in case it fails to follow its policies and instructions.

But this method of credit suffers from several limitations which have been enumerated by De Kock as “the difficulty for both central and commercial bank to make clear-cut distinctions at all times and in all cases between essential and non-essential industries, productive and unproductive activities, investment and speculation, or between legitimate and excessive speculation or consumption; the further difficulty of controlling the ultimate use of credit by second, third or fourth parties; the dangers involved in the division of responsibility between the central bank and commercial bank for the soundness of the lending operations of the latter; and the possibility of forfeiting the whole-hearted and active co-operations of the commercial banks as a result of undue control and intervention.”

Moral Suasion:

Moral suasion in the method of persuasion, of request, of informal suggestion, and of advice to the commercial bank usually adopted by the central bank. The executive head of the central bank calls a meeting of the heads of the commercial banks wherein he explains them the need for the adoption of a particular monetary policy in the context of the current economic situation, and then appeals to them to follow it. This “jawbone control” or “slaps on the wrist” method has been found to be highly effective as a selective method of credit control in India, New Zealand, Canada and Australia, though it failed in the USA.

Its Limitations: 

Moral suasion is a method “without any teeth” and hence its effectiveness is limited.

  1. Its success depends upon the extent to which the commercial banks accept the central bank as their leader and need accommodation from
  2. If the banks possess excessive reserves they may not follow the advice of the central bank, as is the case with the commercial banks in the
  3. Further, moral suasion may not be successful during booms and depressions when the economy is passing through waves of optimism and pessimism The bank may not heed to the advice of the central bank in such a situation.
  4. In fact, moral suasion is not a control device at all, as it involves cooperation by the commercial banks rather than their

It may, however, be a success where the central bank commands prestige on the strength of the wide statutory powers vested in it by the government of the country.


The central bank also uses publicity as an instrument of credit control. It publishes weekly or monthly statements of the assets and liabilities of the commercial bank for the information of the public. It also publishes statistical data relating to money supply, prices, production and employment, and of capital and money market, etc. This is another way of exerting moral pressure on the commercial bank. The aim is to make the public aware of the policies being adopted by the commercial bank vis-a-vis the central bank in the light of the prevailing economic conditions in the country.

It cannot be said with definiteness about the success of this method. It presupposes

the existence of an educated and knowledgeable public about the monetary phenomena. But even in advanced countries, the percentage of such persons is negligible. It is, therefore, highly doubtful if they can exert any moral pressure on the banks to strictly follow the policies of the central bank. Hence, publicity as an instrument of selective credit control is only of academic interest.

Limitations of Selective Credit Controls:

Though regarded superior to quantitative credit controls, yet selective credit controls are not free from certain limitations.

1.   Limited Coverage:

Like general credit controls, selective credit controls have a limited coverage. They are only applicable to the commercial banks but not to non-banking financial institutions. But in the case of the regulation of consumer credit which is applicable both to banking and non-banking institutions, it becomes cumbersome to administer this technique.

2.   No Specificity:

Selective credit controls fail to fulfill the specificity function. There is no guarantee that the bank loans would be used for the specific purpose for which they are sanctioned.

3.   Difficult to distinguish between Essential and Non-Essential Factors:

It may be difficult for the central bank to distinguish precisely between essential and non-essential sectors and between speculative and productive investment for the purpose of enforcing selective credit controls. The same reasoning applies to the commercial banks for the purpose of advancing loans unless they are specifically laid down by the central bank.

4.   Require Large Staff:

The commercial banks, for the purpose of earning large profits, may advance loans for purposes other than laid down by the central bank. This is particularly so if the central bank does not have a large staff to check minutely the accounts of the commercial banks. As a matter of fact, no central bank can afford to check their accounts. Hence selective credit controls are liable to be ineffective in the case of unscrupulous banks.

5.   Discriminatory:

Selective controls unnecessarily restrict the freedom of borrowers and lenders. They also discriminate between different types of borrowers and banks. Often small borrowers and small banks are hit harder by selective control than big borrowers and large banks.

6.   Misallocation of Resources:

Selective credit controls also lead to misallocation of resources when they are applied to selected sectors, areas and industries while leaving others to operate freely. They place undue restrictions on the freedom of the former and affect their production.

7.   Not Successful in Unit Banking:

Unit banks being independent one-office banks in the USA operate on a small scale in small towns and meet the financial needs of the local people. Such banks are not affected by the selective credit controls of the FRS (central bank of the USA) because they are able to finance their activities by borrowing from big banks. So this policy is not effective in unit banking

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Financial institutions are needed to resolve the problems of imperfect markets. They receive requests from surplus and deficit units on what securities are to be sold. They use this requests to match up buyers and sellers of securities in this markets. However financial institutions in order to provide for divisibility, they may at times un-bundle the securities by spreading them across several investors until the entire amount is sold.

Without financial institutions, transaction costs and information cost would be expensive and prohibitive.


Depository institutions accept deposits from surplus units or savers and provide credit to deficit units or borrowers through loans and purchase of securities.

The importance of depository institutions in the financial market includes the following;

  • They offer deposit accounts that can accommodate the amounts and liquidity characteristics desired by most savers.
  • They package funds received from deposits to provide loans of the sizes and maturity desired by
  • They accept the risks on loans provided
  • They have more expertise than most individual surplus units in assessing the credit worthiness of deficit units
  • They diversify their loans among numerous deficit units and therefore they can absorb defaulted loans better than individual surplus units

The importance of depository institutions can be appreciated if we consider what would happen if the institutions were not there.

Role of commercial banks as depository Institutions.

Commercial banks are the most dominant depository institutions. They offer a wide range of deposit accounts. They transfer the deposits to deficit units through loans, advances, overdrafts, letters of credit, letters of guarantee and they can also buy debt securities. Commercial banks serve both private and public. Their services are utilized by households, businesses and government.

Savings institutions

These institutions are also called thrift institutions. They include; savings and loans (S&L) and savings banks. Like commercial banks, S&L offer depository facilities to

surplus units they then channel these surplus to deficit units. S&L concentrates on residential mortgage loans unlike commercial banks who concentrate on commercial loans

Credit unions

These institutions differ from commercial banks and savings institutions in that they are

  • Nonprofit making organizations,
  • Restrict their credit to the credit union members who share a common bond g. common employer, common business, common geographical location etc. they use most of their funds to advance loans to their members (these are normally referred to as savings and credit organizations. Examples include Mwalimu Saco Nakuru

Role of non-depository financial institutions

None depository financial institutions generate funds from other sources other than deposits. But also play a major role in financial intermediation. These institutions include:

·         Finance companies

Most finance companies obtain funds from issuing securities then lend the money to individuals and small businesses. Although the functioning of finance companies overlap those of depository institutions, each type of institution concentrates on a particular segment of the financial market. Many large finance companies are owned by multinational corporations

·         Mutual funds

These types of companies sell shares to surplus units and use these funds to buy a portfolio of securities. The Kenyan capital market is still in its infancy and such companies are not very common. Some mutual funds concentrate their investment in capital market securities, such as stocks or bonds. Others Known as money market mutual funds concentrate in the money market securities.

·         Security firms

Securities firms use their information sources to act as brokers, executing securities transactions between two parties. In order to ease the securities trading process the transactions are normally in multiples of 100 shares and the delivery procedure is somewhat standard. Brokers earn their profits by charging a brokerage fee by differentiating between bid and asking prices. Small or unique transactions are likely to have a higher commission due to time taken to complete the transactions. Securities firms also provide investment banking services. Securities firms also underwrite new issues for government and private companies. Securities firms also act as dealers in which case they i.e. they can make a market for a specific security by adjusting their portfolio inventory.

Securities firms also provide investment banking services which include advisory services on mergers and other forms of corporate restructuring. And also execute the change in the firm’s capital structure by placing the securities issued by the firm.

Insurance companies

They provide insurance services to individuals and other firms that reduce the financial burdens associated with death illness and damage to properties including theft.

Insurance companies charge premiums in exchange of the insurance that they provide. The funds collected in form of premiums, is invested (mainly in stocks or bonds issued by companies or bonds issued by the government) by the insurance companies until the funds are required to pay for the risks insured when it happens.

Pension funds

The working population, know very well that their energy to work is limited. To guard themselves against the eventuality, employers and employees save for old age where they contribute periodically. Such funds are available for a long time i.e. until retirement. The pension funds manage the funds until they are required when the employee retires. The money saved is normally invested in securities and bonds issued by corporations and governments. This way they pension savings are used to finance the deficit units thus acting as intermediaries.

The Features of Central Bank:

 The features or natures of central bank are as follows –

1.       Single Organization:

 In a country there has only one central bank exist. In the world, there has been no existence of two or more central bank in any country. So central bank can be called as single organization. For this reason, it does not require to compete with other banks.

2.       Legal entity:

Central bank is established by the special act of Government. As a result, legal entity of central bank is much more strong than other banks. This strong legal entity gives special privilege to other banks.

3.       Nature ownership:

The ownership of central bank can be fully government or joint venture of government and private ownership. But the reality said that government owned central bank is maximum in the world.

4.       Difference in objective:

 Because the operations of the central bank are such as profoundly to affect the monetary and credit situation, they cannot be undertaken solely for the purpose of making profit. The profit motive should only be a secondary consideration, and not the primary motive for central banking operations.

5.       Note issue:

 The issue of note is the most important function of a central bank. In fact, the practical experience shown that the central bank is the most suitable and appropriate medium for the issue of note.

6.       Control:

 In the present century, central bank has become as part of the economic set up in a country. All over the world, Central bank is under the control of government particularly it has been work under the direction of department of finance or treasury.

7.       Relation with Govt.:

The central bank is closely related to the government as its banker and the financial adviser. It is generally an organ of the government and performing the banking operations of government. Central bank represents the government not only in country but also the outside of the country as well.

8.       Guardian of the money market:

An effective monetary management requires a centralized country over both currency and credit. Being in close and intimate contact with the money market a central bank is in a position to know best when and to what extent to expand or to contract currency and credit to meet the changing requirements of the money market.

9.       Banker and controller of other banks:

The central bank functions as a banker’s bank. It also controls and regulates the cameral bank and other financial institutions. For effective control central bank prescribes different rules and regulations and it is mandatory to maintain these rules by other banks.

10.   Lender of the last Resort:

 As a lender or the resort central bank provides rediscounts and advances to the commercial banks in times of credit stringency. It also gives loan to the govt. when requires.

11.   Controller of Foreign Exchange:

The central bank maintains the foreign exchange reserves of the country and attempts to stability in the exchange rates.

Functions of Central Bank

  1. Bank of Issue:

Central bank now-a-days has the monopoly of note-issue in every country. The currency notes printed and issued by the central bank are declared unlimited legal tender throughout the country.

Central bank has been given exclusive monopoly of note-issue in the interest of uniformity, better control, elasticity, supervision, and simplicity. It will also avoid the possibility of over-issue by individual banks.

The central banks, thus, regulate the currency of country and the total money-supply in the economy. The central bank has to keep gold, silver or other securities against the notes issued. The system of note-issue differs from country to country.

The main objects of the system of currency regulation in general are to see that:

  • People’s confidence in the currency is maintained,
  • Its supply is adjusted to demand in the

Thus, keeping in view the aims of uniformity, elasticity, safety and security, the system of note-issue has been varying from time to time.

Banker, Agent and Adviser to the Government:

 Central bank, everywhere, performs the functions of banker, agent and adviser to the government.

“The central bank operates as the government’s banker, not only because it is more convenient and economical to the government, but also because of the intimate connection between public finance monetary affairs.”

As banker to the government, it makes and receives payments on behalf of the government. It advances short-term loans to the government to tide over difficulties.

It floats public loans and manages the public debts on behalf of the government. It keeps the banking accounts and balances of the government after making disbursements and remittances. As an adviser to the government it advises the government on all monetary and economic matters. The central bank also acts as an agent to the government where general exchange control is in force.

2.       Custodian of Cash Reserves:

 All commercial banks in a country keep a part of their cash balances as deposits with the central bank, may be on account of convention or legal compulsion. They draw during busy seasons and pay back during slack seasons. Part of these balances is used for clearing purposes. Other member banks look to it for guidance, help and direction in time of need.

It affects centralization of cash reserves of the member banks. “The centralization of cash reserves in the central bank is a source of great strength to the banking system of any country. Centralized cash reserves can at least serve as the basis of a large and more elastic credit structure than if the same amount were scattered amongst the individual banks.

It is obvious, when bank reserves are pooled in one institution which is, moreover, charged with the responsibility of safeguarding the national economic interest, such reserves can be employed to the fullest extent possible and in the most effective manner during periods of seasonal strain and in financial crises or general emergencies…the centralization of cash reserves is conducive to economy in their use and to increased elasticity and liquidity of the banking system and of the credit structure as a whole.”

3.       Custodian of Foreign Balances:

 Under the gold standard or when the country is on the gold standard, the management of that standard, with a view to securing stability of exchange rate, is left to the central bank.

After World War I, central banks have been keeping gold and foreign currencies as reserve note-issue and also to meet adverse balance of payment, if any, with other countries. It is the function of the central bank to maintain the exchange rate fixed by the government and manage exchange control and other restrictions imposed by the state. Thus, it becomes a custodian of nation’s reserves of international currency or foreign balances.

4.       Lender of Last Resort:

Central bank is the lender of last resort, for it can give cash to the member banks to strengthen their cash reserves position by rediscounting first class bills in case there is a crisis or panic which develops into ‘run’ on banks or when there is a seasonal strain. Member banks can also take advances on approved short-term securities from the central bank to add to their cash resources at the shortest time.

This facility of turning their assets into cash at short notice is of great use to them and promotes in the banking and credit system economy, elasticity and liquidity.

Thus, the central bank by acting as the lender of the last resort assumes the responsibility of meeting all reasonable demands for accommodation by commercial banks in times of difficulties and strains.

De Kock expresses the opinion that the lending of last resort function of the central bank imparts greater liquidity and elasticity to the entire credit structure of the country. According to Hawtrey, the essential duty of the central bank as the lender of last resort is to make good a shortage of cash among the competitive banks.

5.       Clearing House:

Central bank also acts as a clearing house for the settlement of accounts of commercial banks. A clearing house is an organization where mutual claims of banks on one another are offset, and a settlement is made by the payment of the difference. Central bank being a bankers’ bank keeps the cash balances of commercial banks and as such it becomes easier for the member banks to adjust or settle their claims against one another through the central bank.

Suppose there are two banks, they draw cheques on each other. Suppose bank A has due to it Rs. 3,000 from bank B and has to pay Rs. 4,000 to B. At the clearing house, mutual claims are offset and bank A pays the balance of Rs. 1,000 to B and the account is settled. Clearing house function of the central bank leads to a good deal of economy in the use of cash and much of labour and inconvenience are avoided.

6.       Controller of Credit:

The control or adjustment of credit of commercial banks by the central bank is accepted as its most important function. Commercial banks create lot of credit which sometimes results in inflation.

The expansion or contraction of currency and credit may be said to be the most important causes of business fluctuations. The need for credit control is obvious. It mainly arises from the fact that money and credit play an important role in determining the level of incomes, output and employment.

According to Dr. De Kock, “the control and adjustment of credit is accepted by most economists and bankers as the main function of a central bank. It is the function which embraces the most important questions of central banking policy and the one through which practically all other functions are united and made to serve a common purpose.”

Thus, the control which the central bank exercises over commercial banks as regards their deposits, is called controller of credit.

7.       Protection of Depositors Interests:

 The central bank has to supervise the functioning of commercial banks so as to protect the interest of the depositors and ensure development of banking on sound lines.

The business of banking has, therefore, been recognized as a public service necessitating legislative safeguards to prevent bank failures.

Legislation is enacted to enable the central bank to inspect commercial banks in order to maintain a sound banking system, comprising strong individual units with adequate financial resources operating under proper management in conformity with the banking laws and regulations and public and national interests.

Features of commercial banks

  1. ownership

 Commercial banks can be formed on the basis of any ownership, such as a proprietorship, partnership or company. If it is formed on a partnership basis, its membership will be up to 10 people. If formed as a company, then it has to be formed according to the law of 1994. Ownership is the best characteristic of the commercial bank. It’s a first and the best feature of the bank. It works look like the Bank of America Hialeah.

2.       Taking Deposit

 One of the main features of the commercial bank is to take the savings of people’s money through different types of accounts. People can open their accounts according to their convenience and submit their accumulated money to the bank. These accounts are the current accounts, savings accounts, and permanent accounts.

3.       Encourage to Savings

A prominent feature of the commercial bank is that people are more interested in saving through extensive publicity. This ensures that more saving storage is collected. It is possible to form capital in the country. Encourage saving is the most effective characteristics of a commercial bank. Increasing the attractiveness of the customer’s mind has resulted in an increase in the amount of storage.

4.       Creation of Medium of Exchange

Although the commercial bank does not introduce money or currency, it is one of the characteristics of creating a medium of exchange through Checks, Hundi, Pay Orders, Traveler Checks, and Certificates etc. As a result, the customers of the bank do not have the risk of carrying cash. This is the biggest opportunity for the customers of the commercial bank. So the creation of the medium of exchange characteristic is more popular.

5.       Collection of saving and formation of Capital

The bank helps in building the necessary capital for the country by collecting human money and scattered savings from different areas of the country and which was later invested in profitable and developing sectors. So the collection of saving and formation of capital is another best characteristic of the commercial bank.

6.       Maintain Liquidity

It is a special feature of commercial banks. The depositor may seek the refund of his deposit at any time. With the request of the bank, the bank will always keep the liquidity necessary for the bank to meet the depositor’s demand. They keep a part of the deposit money from depositor as liquidity, and the rest is invested in different sectors. All these activities are called maintain liquidity characteristic the of commercial bank.

7.       Management & Operation

Did you know before about the management & operation characteristics the of commercial bank? If yes, then well. On the other hand, follow mindfully. Commercial banks are operated according to the prevailing banking laws and organizational regulations in every country. If the branch is a bank then it is managed according to the direction of a central office. So it is a management and operation characteristics the of commercial bank.

8.       Investment and Sanction of Loan

Invest is the king of making money more. Commercial banks save apart from savings collected as liquidity and the remaining money is invested in a lucrative sector and short -term lending. From the reserved liquidity, the bank fulfills the daily claims of the depositors. Thus, the commercial banks are benefited through investment and lending. And according to the management for investment and sanction of loan, the commercial bank has been benefited.

9.       Creation of Loan Deposits

Without a bank loan services, the bank cannot maintains money heavily. So the creation of loan deposits is another best characteristic of a commercial bank. Commercial banks do not only provide short-term loans. One of the key features of the commercial bank is to ensure the use of indigenous currency, mobilization of currency, and investment through the creation of credit money by creating innovative ways.

Functions of commercial banks

  1. Accepting Deposits:

 Banks attract the idle savings of people in the form of deposits. These deposits may be of any of the following types:

2.   Demand deposits, also known as current accounts:

 These are repayable on demand without any notice. Usually no interest is paid on them, because the bank cannot utilize short-term deposits, and must, therefore, keep almost cent per cent reserve against them. On the other hand, a little commission is charged for the services rendered. Occasionally, however, a small interest is paid to people who keep large balances.

3.   Fixed Deposits or Time Deposits:

 These deposits can be withdrawn only after the expiry of the period for which these deposits have been made. Higher interest is paid on them—the rate rising with the length of the period and the amount of deposit. The usual rate in India today varies between 6 per cent and 110 per cent, depending upon the time-period for which deposits are made.

4.   Savings Bank Deposits:

These deposits stand midway between current and fixed accounts. These deposits are not as freely withdraw-able as current accounts. One or two withdrawals up to a limit of one-fourth of the deposit but not more than Rs. 1,000 are generally allowed in a week. The rate of interest is less than that on the Fixed Deposits.

5.   Giving Loans:

But receiving of deposits is not the whole story about a bank’s functions. If that were so, how could a bank pay interest? Hence, after collecting money by way of deposits, a bank invests it or lends it out. Money is lent to businessmen and traders usually for short periods only. This is so because the bank must keep itself ready to meet the demands of the depositors, who have deposited money for short periods.

6.   By allowing an Overdraft:

Customers of standing are given the right to overdraw their accounts. In other words, they can get more than they have deposited, but they have to pay interest on the extra amount which has to repaid within a short period. The amount of permissible over-draft varies with the financial position of the borrower.

7.   By Creating a Deposit:

Cash credit is another way of lending by the banks. When a person wants a loan from a bank, he has to satisfy the. manager about his ability to repay, the soundness of the venture and his honesty of purpose. In addition, the bank may require a tangible security, or it may be satisfied with the borrower’s personal security.

Usually such security is accepted as can be easily disposed of in the market, e.g., government securities or shares of approved concerns. Then details about time and rate of interest are settled and the loan is advanced. A borrower rarely wants to draw the whole amount of his loan in cash. Usually he opens a current account with that amount the bank, if he already has not got an account with this bank.

Now it is exactly as if that sum had been deposited by him. This is how a deposit is ‘created’ by a bank. That is why it is said “every loans creates a deposit.” A cheque book is given to the borrower with the right to draw cheques up to the full amount of the loan, but interest is charged on the whole sum even though only a part is withdrawn. After the period, for which the money has been borrowed, is over, the borrower returns the amount with interest to the bank. Banks make most of their profits thus by giving loans.

8.   Discounting Bills:

The discounting of bills by a bank is another way of lending money. The banks purchase these bills through bill-brokers and discount; companies of discount them directly for the merchants. These bills provide a very liquid asset (i.e., an asset which can be easily turned into cash). The banks immediately any cash for the bill after deducting the, discount (interest), and wait for the bill to mature when they get back its full value.

The investment in bills is considered quite safe, because a bill beats the security of two businessmen, the drawer as well as the drawer, so that if one proves dishonest or fails, the bank can claim the money from the other. This is regarded as the best investment by the banks. It is liquid, lucrative and safe. That is why it is said that a good bank manager knows the difference between a bill and a mortgage.

9.   Remitting Funds:

Banks remit funds-for their customers through bank draft to any place where they have branches or agencies. This is the cheapest way of sending money. It is also quite safe. Funds can also be remitted to foreign countries.

11.    Safe Custody:

Ornaments and valuable documents can be kept in safe deposit with a bank, in its strong room fitted with lockers, on payment of a small sum per year. Thus the risk of theft is avoided.

12.    Agency Functions:

 The bank works as an agent of their constituents. They receive payments on their behalf. They collect rents, dividends on shares, etc. They pay insurance premia and make other payments as instructed by their depositors. They accept bills of exchange on behalf of their customers. They pass bills of lading or railway receipts to the purchasers of goods when they pay for them. This amount is passed on to the suppliers of goods.

13.    References:

They provide references about the financial position of their customers when required. They supply this information confidentially. This is done when their customers want to establish business connections with some new firms within or outside the country.

14.    Letters of Credit:

In order to help the travelers, the banks issue letters of credit travelers’ cheques. A man going on a tour takes with him a letter of credit from his bank. It is mentioned there that he can be paid sums up to a certain limit. He shows this letter to banks in other places which make the payment to him and debit the bank which has issued the letter of credit.

Key Features of Financial Institutions

 Financial institutions provide financing,   facilitate   economic   transactions,   issue   funds, offer insurance and hold deposits for businesses and individuals. Financial institutions are private or public organizations that serve as an intermediary between savers and borrowers of funds. The two primary types of financial institutions are credit unions or depository banks and non-depository mutual funds and insurance companies. Banks and equity markets are the fundamental institutions in most financial systems.

Depository banks and credit unions provide private and commercial loans for individuals and businesses. These financial institutions also hold deposits and issue certificates for investments. Non-depository financial institutions, such as insurance companies,

collect funds by selling policies or units to the public. These institutions provide returns to their investors in the form of benefits, dividends and/or profit payouts. Non- depository financial institutions are critical in mitigating risk for businesses and consumers.

Financial institutions fuel the economy by issuing credit, which comes in the form of loans, mortgages and credit cards, to allow individuals and businesses to purchase goods and services, homes, attend college, start a business, etc. Financial institutions also serve as direct providers of liquidity through demand deposits and credit lines.

Financial institutions, through processing transactions and purchasing and selling large volumes of securities, play a fundamental role in the equity markets.


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History of banking

Earliest Banking Systems

It is impossible to say exactly when banking properly began. We do, however, have evidence that it may have started to properly occur around 8000 BC, although these were not banking in the way that we see things now. It was more record keeping of trades that were being made. There may have been specific institutions developed specifically for banking, but we can’t possibly know for sure. All we have records of are people making trades and record their trades down in a log.

The Earliest ‘Proper’ Banks

The first proper banks would have sprung up in ancient Mesopotamia. We have evidence that there were temples and palaces throughout Babylonia and other cities which provided lending activities. Although, a lot of this was not in the form of financial lending. Instead, banks would lend out seeds and the like. The idea is that by lending out seeds, farmers would have products that they could work with. When it came to the harvest, the farmers would pay back their seed loan from the harvest.

There are also records of credit from around this time. In fact, we have a history of credit and other banking activities throughout Asian civilization. The Temple of Artemis, for example, was a deposit for cash and there were records of debts held here. Mark Anthony plays a major role in these banks. He is said to have stolen cash from these banks.

Banks During the Medieval Period

Banks really started to come into their own during the medieval period. Most of these banks were merchant banks, however. Again, this was a lot about crop loan and for financing expeditions across the silk routes. Some of the earliest forms of brokering took place in these banks.

It is actually from around this time that bankruptcy started to spring up. The earliest banks were in Italy. Bankrupt comes from the word ‘banca rotta’ in Italian. When a trade failed to deliver on their promised route, then they would have been declared ‘banca rotta’.

Modern Banking in the 17th to 19th Centuries

Perhaps the biggest changes to the world of banking came in the 17th to 19th centuries, particularly in London. In fact, the way in which banks work will be based completely around these banking concepts, i.e. issuing bank debt, allowing deposits to be made into banks etc.

The first ‘proper’ bank could be said to be the Goldsmiths of London. It is now a bank, but back then it was more a series of vaults which charged a fee for their services.

People would deposit their precious materials into these vaults, and they would be able to collect them. Over time, Goldsmiths started to provide loans.

The first bank to offer banknotes was the Bank of England. Bank notes were, initially, promissory notes. You would deposit cash into the bank and be offered a note to say that it was there. Over time, the bank started to offer cheques, overdrafts, and traditional banking services. This was important when the Industrial Revolution in the United Kingdom was starting to get into ‘full swing’.


International financing in the 19th Century took hold due to the Rothschilds. They got started by loaning money to the Bank of England and purchasing stocks. Over time, the Rothchild family (still the richest family in history), started to invest in multiple projects around the world and financing military efforts. They were also taking in deposits from people and creating new banks.

20th Century

It was in the 20th Century when banks started to pop up in the way we know them properly. Post-World War II, banks started to lend money to countries as a whole, and retail banking started to become a proper ‘thing’. In fact, a lot of the technology that was developed throughout the 20th Century is still in use today, e.g. the ATM systems and SWIFT payments.

Evolution of Kenyan banking system

The banking sector in Kenya is ever evolving. Despite the numerous economic challenges that have been witnessed within the sector, the industry remains strong and vibrant. At the moment, three banks have been placed under receivership with only one having recovered and back to operations. Kenya currently has 44 banks. 31 of the banks are locally owned while the remaining 13 are foreign owned. Among the 31 locally owned banks, the government of Kenya has a shareholding in three of them, 27 of them are commercial banks and one is a mortgage finance institution, known as Housing Finance.

When did the banking journey in Kenya start?

The treacherous financial journey in Kenya dates back to the colonial times. The British Empire declared Kenya a British Sphere of Influence and established the East African Protectorate in the year 1865 and officially declared Kenya as a colony in the year 1920. During that 19th Century, the East African region engaged in trading activities and there was need for the use of currency. That was when the revolution in the banking sector kicked off.

In 1986, a year after the establishment of the British Administration in Kenya, National Bank of India came into being. Many people think that the British were the first people to establish banks in the country but the first bank ever in Kenya came from India; National Bank of India.

In 1910, Standard Bank of South Africa came into being. Six years after coming to Kenya, the National Bank of South Africa merged with Anglo-Egyptian Bank Ltd to form Barclays Bank. Barclays Bank was, therefore, born in 1910 as a merger between National Bank of South Africa and Anglo-Egyptian Bank Ltd. In 1951, General Bank of Netherlands was set up. In 1953, Bank of India and Bank of Baroda were set up. In 1956, Habib Bank (overseas) Ltd was set up.

In the year 1955, the Ottoman Bank and the Commercial Bank of Africa were established. Cooperative Bank of Kenya opened its doors in the year 1968. In 1968 National Bank of Kenya took over the Ottoman Bank. In 1971, Kenya Commercial Bank was formed as a result of the merger between National and Grindlays Bank with the governing owning a stake of 60 percent. The Merchant Bank division of Grindlays was merged with Grindlays Bank International Ltd and formed Stanbic Bank. 1971 saw Barclays Bank change its name to Barclays Bank International Ltd while in the year 1974, National Bank of Chicago and City Bank of New York were formed.

The Merchant Bank division was incorporated into a new bank, Grindlays Bank International Ltd, which has changed to Stanbic Bank. In 1971, Barclays Bank (DC) changed its name to Barclays Bank International Ltd and became a wholly owned subsidiary of Barclays Bank Ltd based in Britain. In 1974, the American Banks were established in Kenya i.e. first National Bank of Chicago and first National City Bank of New York.

How long these eleven banks have been in operation in Kenya

Barclays Bank of Kenya has been in operation in Kenya for 97 years, CFC Stanbic Bank has been up and kicking for the last 58 years, Diamond Trust Bank Kenya has been breathing the atmosphere in Kenya for 70 years while Equity Group Holdings Ltd has been in existence for 32 years.

Housing Finance has been in Kenya for 51 years, I&M Holdings for 44 years, Kenya Commercial Bank for 41 years under the brand, National Bank of Kenya for 53 years, NIC Bank of Kenya for 57 years, Standard Chartered Bank for 47 years while Co- operative Bank of Kenya has been into existence for 51 years though it went public as a bank in the year 2008.


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 According to R.P. Kent, “Money is anything that is commonly used and generally accepted as a medium of exchange, or as a standard of value.”

According to Marshall, “All those things which are (at any time and place) generally accepted without doubt or special enquiry as a means of purchasing commodities and services and defraying expenses are included in the definition of money.”

According to Geoffry Crowther, “Money can be defined as anything that is generally accepted as a means of exchange and at the same time acts as a measure and as a store of value.”

Money is derived from a Latin word, Moneta, which was another name of Goddess Juno in Roman history.

The term money refers to an object that is accepted as a mode for the transaction of goods and services in general and repayment of debts in a particular country or socio- economic framework.

Different Approaches of Money:

Economists have given a number of approaches to explain the concept of money. They have defined the concept of money off on the basis of different aspects of money.

However, in recent time, there has been a controversy on which aspects of money should be included in the definition of money.


The different approaches of money (as shown in Figure-2) are explained below:

1.       Conventional Approach:

The conventional approach is considered as one of the oldest approach for defining the concept of money. It takes into consideration only two functions of money, namely, medium of exchange and measure of value. Therefore, as per this approach, any good or service that fulfills these two functions is termed as money, regardless of the fact that money is always a subject of authentication by the government.

According to this approach, commodities that serve the purpose of money are cattle (cow, sheep, horse, and bull), grains (wheat, jowar, and rice), stones and metals (copper, brass, silver, and gold). These commodities considered as money as long as they fulfilled the two conditions of money.

Some of the definitions of money given by economists who support conventional approach are as follows:

According to R.P. Kent, “Money is anything that is commonly used and generally accepted as a medium of exchange, or as a standard of value.”

According to Marshall, “All those things which are (at any time and place) generally accepted without doubt or special enquiry as a means of purchasing commodities and services and defraying expenses are included in the definition of money.”

According to Geoffry Crowther, “Money can be defined as anything that is generally accepted as a means of exchange and at the same time acts as a measure and as a store of value.”

2.       Modern Approach:

 Over a passage of time, it was realized that conventional approach provides a restrictive definition of money. In addition, the functions of money are not only confined to medium of exchange and measure of value rather it performs a large number of functions.

The modern approach of money is broadly classified into three categories, which are as follows:

  • Chicago Approach:

 Lays emphasis on extending the definition of money given in conventional approach. This approach was given by Milton Friedman and his associates in Chicago University. They have extended the definition of money given in conventional approach by including three more concepts, namely, currency, checkable demand deposits, and time deposits.

However, economists having conventional viewpoint of money were against the addition of the concept time deposit in the definition of money. According to conventional approach, time deposits are not available easily in liquid form or spent directly; therefore, do not serve the purpose of money. However, the Chicago school of thought has given two points emphasizing the importance of time deposits in the definition of money.

These two points are as follows:

1. Advocated that national income and money are interrelated to each other and this interlink can be more strengthen if time deposits are included in money

2. Propounded that definition of money should include the close substitutes of money and time deposit is one of those substitutes

However, both of the explanations are not strong enough to include time deposits in the definition of money.

3.   Gurley-Shaw Approach:

Includes the liabilities of non-banking financial intermediaries in the definition of money. The main contributors of this approach were John G. Gurley and Edward S. Shaw. Gurley and Shaw, while explaining the concept of money, highlighted the substitution relationship among various factors, such as currency, demand deposits, time deposits, and saving bank deposits.

These factors act as the sources for storing value. Therefore, according to Gurley-Shaw, money can be defined as the weighted sum of currency, demand deposits, and other deposits and claims against the financial intermediaries. The weights should be allotted on the basis of substitutability of currency.

However, the practical implication of this approach is not possible as it is difficult to determine the degree of substitutability of deposits and claims against the financial intermediaries. Moreover, assigning weights to measure the money supply is a challenging task.

4.   Central Bank Approach:

Constitutes the broader view of the whole concept of money. The function of the central bank is to control and regulate the flow of money in an economy. Therefore, the central bank formulates and implements a monetary policy to achieve its goals and objectives.

For this purpose, it needs to determine all the sources and modes of payment and flow of credit in the economy, which are treated as money. According to the central bank view, currency and all other assets that can be converted into money (realizable assets) are included in the money supply.

Radcliffe Committee of United States endorsed the central bank approach. According to this committee, “the similarity between currency and other realizable assets or means of purchasing to the point of rejecting money in favor of some broader concept, measurable or immeasurable.”

In other words, money can be any form through which the borrowers receive credit. On the basis of monetary policy and policy targets, the central bank implements different measures to control money supply.

There are three broad motives on the basis of which money is required by people, which are as follows:

  • Transaction Motive:

 Refers to the demand for money to fulfill the present needs of individuals and businesses. Individuals require money to fulfill their current requirements, which is termed as income motive. On the other hand, businesses need money for carrying out their business activities, which is known as business motive.

These two motives of money are discussed as follows:

  • Income Motive:

 Refers to the motive of individuals who demand money for fulfilling the needs of themselves as well as their family. Generally, individuals hold cash for bridging the gap between the receipt of income and its expenditure.

The income is received once in a month but the expenditure takes place every day. Therefore, it is required to hold some part of income to make current payments. The holding amount depends on the amount of an individual’s income and interval of receiving income.

5. Business Motive:

 Refers to the requirement of money by businesses in liquid form to meet the current requirements. Businesses require money for procuring raw material and paying transport charges, wages, salaries, and other expenses. The money demanded by businesses depends on their turnover. The higher turnover indicates the requirement of higher amount of money to cover up expenses.

6. Precautionary Motive:

Refers to the longing of individuals to hold money for various contingencies that may take place in future. These contingencies can include unemployment, sickness, and accidents. The amount of money need to be held for the precautionary motive depends on the nature of a person and his/her living conditions.

7.  Speculative Motive:

Refers to the motive of individuals for holding cash to make out benefit from the movements of market regarding the change in interest rate in future. The precautionary and speculative motive acts as the store of value with different purposes.

Development of money Stages of Evolution of Money

Some of the major stages through which money has evolved are as follows:

  1. Commodity Money
  2. Metallic Money
  3. Paper Money
  4. Credit Money
  5. Plastic Money.

Money has evolved through different stages according to the time, place and circumstances.

1. Commodity Money:

In the earliest period of human civilization, any commodity that was generally demanded and chosen by common consent was used as money.

Goods like furs, skins, salt, rice, wheat, utensils, weapons etc. were commonly used as money. Such exchange of goods for goods was known as ‘Barter Exchange’.

2. Metallic Money:

With progress of human civilization, commodity money changed into metallic money. Metals like gold, silver, copper, etc. were used as they could be easily handled and their quantity can be easily ascertained. It was the main form of money throughout the major portion of recorded history.

3. Paper Money:

It was found inconvenient as well as dangerous to carry gold and silver coins from place to place. So, invention of paper money marked a very important stage in the development of money. Paper money is regulated and controlled by Central bank of the country (RBI in India). At present, a very large part of money consists mainly of currency notes or paper money issued by the central bank.

4. Credit Money:

 Emergence of credit money took place almost side by side with that of paper money.

People keep a part of their cash as deposits with banks, which they can withdraw at their convenience through cheques. The cheque (known as credit money or bank money), itself, is not money, but it performs the same functions as money.

5. Plastic Money:

 The latest type of money is plastic money in the form of Credit cards and Debit cards. They aim at removing the need for carrying cash to make transactions.

The development of money has passed through various stages in accordance with time, place and circumstances with the progress of economic civilsation of mankind.

Economists have recognized five such stages in the evolution of money:

  1. Animal Money
  2. Commodity Money
  3. Metallic Money
  4. Paper Money
  5. Credit Money

1.  Animal Money:

Animals were being used as a common medium of exchange in the primitive hunting stage. History records that cattle occupied a place of pride as money in the earliest period of human civilization.

In temperate regions of Europe, Asia and Africa cattle was regarded as the most standard unit of barter for quite a long time in the primitive era.

In the ancient Indian civilization, the concept of Go-Dhan (cattle wealth) as a form of money is also referred to in Arth-Veda. In the fourth century B.C., the Roman State had officially recognized cows and sheep as money to collect fines and taxes.

2.  Commodity Money:

In certain communities, early primitive money, in its crudest sense, also took the form of commodity money. A large number of commodities from axes to yarn have been adopted as money.

The particular commodity chosen to serve as money depended upon various factors like location of the community, climatic environment of the ‘region, cultural and economic standard of society, etc.

For example, people living by the seashore adopted shells and dried fish as money. People of the cold regions in Alaska and Siberia preferred skins and furs as a medium of exchange.

African people used ivory and tiger jaws as money. Besides, commodities such as precious stones, rice, tea, tobacco, etc. also served as money during the primitive days of human civilization. Professor Paul Einzig has recorded some 17 commodities in the list of primitive money.

Animal and commodity money, however, suffered from such drawbacks as:

  1. Lack of uniformity and standardization;
  2. Inefficient store of value due to the problem of storing and loss of value with the lapse of time;
  3. Lack of easy transferability due to difficulties of portability; and

3. Metallic Money:

Commodity money gradually transformed into metallic money when precious metals like gold, silver, copper, bronze, etc. were discovered and used as a medium of exchange with the growth of economic civilization from the pastoral to the commercial stage of society.

Use of metals as money in the course of time paved the way for the development of coinage system in the economy.

As historian Toynbee narrates, the coin age began around 700 B.C. in Lylia, a Greek city state. Imperfections of the metallic money in size, shape and weight, etc. have been removed with the minting of coins by states.

Metallic money had, however, the following drawbacks:

  1. On account of its bulkiness, a large sum of money in terms of coins was not easily
  2. It was unsafe to carry and could be easily lost or
  3. Rapid transactions were not feasible by using coins as a mode of
  4. The coin era, however, lasted till the 17th

4.  Paper Money:

In the 17th and 18th centuries, paper currency emerged as “token money.” In modern era, paper money has become popular. It originally came as paper receipts against metallic money which was found unsafe to carry by itinerant merchants.

Then with the shortage of metals, state authorities thought of introducing paper currency a representative paper money which was convertible.

In the later stages, however, it became “fiat money”, i.e., inconvertible legal tender. Being representative money, paper currencies, thus, economies the use of standard coins or metals.

5.  Bank Money:

In the final stage, along with paper money, another form of convertible money developed in the form of credit money or bank money, owing to the growth of banking institutions and credit creation activities and cheque system of payments in modern era.

In modern commerce large transactions are carried on through cheques and only small transactions are managed through currency money.

In modern economy, coins, paper notes and bank money, i.e., cheques issued against demand deposit, all serve as money. But even today, sometimes other things have also served as money.

In Germany, for example, in the post-war period (1945-46), cigarettes and cognac were used as money when its financial and economic condition had greatly deteriorated.

Sometime ago, due to shortage of token coins in India, coupons and stamps were used as money.

In short, anything and everything can serve and has served as money provided it is generally recognized and accepted as means of payment. But all things cannot serve as good money.

Good money should possess the attributes of general acceptability, recognisability, portability, divisibility, malleability, durability, uniformity, adequacy and stability of value.

Functions of money 

  1. A Medium of Exchange:

The only alternative to using money is to go back to the barter system. However, as a system of exchange the barter system would be highly impracticable today.

For example, if the baker who supplied the green-grocer with bread had to take payment in onions and carrots, he may either not like these foodstuffs or he may have sufficient stocks of them.

The baker would, therefore, have to re-sell the product which would take time and be very inconvenient. By replacing these complicated sales by the use of money it is possible to save a lot of trouble. If the baker accepts payment in money this can be spent in whatever way the baker wishes. The use of money as a medium of exchange overcomes the drawbacks of barter.

Thus, money provides the most efficient means of satisfying wants. Each consumer has a different set of wants. Money enables him (her) to decide which wants to satisfy, rank the wants in order of urgency and capacity (income) and act accordingly.

This type of system also enables specialization to extend. Take, for example, a person who performs only a single task in a shoe factory. He has not actually produced anything himself. So what could he exchange if a barter system were in operation? With money system the problem is removed. He can be paid in terms of money and can use that money to buy what he wants.

2.   A Measure of Value:

Under the barter system, it is very difficult to measure the value of goods. For example, a horse may be valued as worth five cows or 100 quintals of wheat, or a Maruti car may be equivalent to 10 two- wheelers. Thus one of the disadvantages of the barter system is that any commodity or service has a series of exchange values.

Money is the measuring rod of everything. By acting as a common denominator it permits everything to be priced, that is, valued in terms of money. Thus, people are enabled to compare different prices and thus see the relative values of different goods and services.

This serves two basic purposes:

  • Households (consumers) can plan their expenditure and
  • Business people can keep records of income and costs in order to work out their profit and loss

3.   A Store of Value (Purchasing Power):

A major disadvantage of using commodities — such as wheat or salt or even animals like horses or cows — as money is that after a time they deteriorate and lose economic value. They are, thus, not at all satisfactory as a means of storing wealth. To realise the problems of saving in a barter economy let us consider a farmer. He wanted to save some wheat each week for future consumption. But this would be of no use to him in his old age because the ‘savings’ would have gone off.

Again, if a coal miner wanted to set aside a certain amount of coal each week for the same purpose, he would have problems of finding enough storage space for all his coal.

By using money, such problems can be overcome and people are able to save for the future. Modern form of money (such as coins, notes and bank deposits) permit people to save their surplus income.

Thus money is used as a store of purchasing power. It can be held over a period of time and used to finance future payments. Moreover, when people save money, they get the assurance that the money saved will have value when they wish to spend it in the future. However, this statement holds only if there is no severe inflation (or deflation) in the country.

In other words, it is quite obvious that money can only act effectively as a store of value if its own value is stable. If, for example, most people feel that their savings would become worthless very soon, they would spend them at once and save nothing. For the last few years the value (or the purchasing power) of money has been falling in India.

Yet in the short run—for day-to-day purposes—money has sufficient stability of value to serve quite well as a store of value.

4.   The Basis of Credit:

Money facilitates loans. Borrowers can use money to obtain goods and services when they are needed most. A newly married couple, for example, would need a lot of money to completely furnish a house at once. They are not required to wait for, say ten years, so as to be able to save enough money to buy costly items like cars, refrigerators, T.V. sets, etc.

5.   A Unit of Account:

An attribute of money is that it is used as a unit of account. The implication is that money is used to measure and record financial transactions as also the value of goods or services produced in a country over time. The money value of goods and services produced in an economy in an accounting year is called gross national product.

According to J. R. Hicks, gross national product is a collection of goods and services reduced to a common basis by being measured in terms of money.

6.   A Standard of Postponed Payment:

This is an extension of the first function. Here again money is used as a medium of exchange, but this time the payment is spread over a period of time. Thus, when goods are bought on hire-purchase, they are given to the buyer upon payment of a deposit, and he then pays the remaining amount in a number of installments.

Under the barter system this type of transaction could involve problems. Imagine a farmer buying a video-recorder and agreeing to pay for it in terms of a fixed amount of wheat each week for a certain number of weeks. After a few weeks the seller of the video recorder might have more than enough wheat.

Yet he will have to receive more wheat in the coming weeks. If money had been used, the seller could then use it to buy whatever he wanted, whether it is wheat or something else—now or in future. In other words, the use of money permits postponement of spending from the present to some future occasion.

History of the kenya currency Kenyan Currency Through the Years

  • After the launch of the new currency in Kenya by president Uhuru Kenyatta at the

Narok stadium on Saturday we look back at the history of money in Kenya and its evolution.

Early use of currency in Kenya commenced with the Arab influence who were among the first to use currency as we know it.

In Muscat, they used a silver coin called the Maria Theresa Thaler (MT$), first minted in Austria in 1741 and, not surprisingly, they continued using it when the Sultanate moved to Zanzibar in 1832.

The different approaches of money can broadly be grouped into two categories, which are shown in Figure-2:

Around the same period, the silver rupee minted by the British East India Company (1600-1858) was increasingly being used along the Indian Ocean coast as the monsoon-dependent dhow trade with India expanded.

The British chartered company, the Imperial British East Africa Company (IBEA), got the concession to trade in the area referred to as Kenya today. They then issued the Pice, Rupees and Annas as the currency of the region.

After IBEA went bankrupt a single coin, the copper Pice was minted and was the only piece of currency to bear the name East Africa Protectorate and unlike the Imperial British East Africa (IBEA) coinage which used Latin on the face.

Penetration of coins and notes only started when construction of the railway commenced in Mombasa in May 1896, to reach Port Florence – present day Kisumu – in December 1901.

After world war one a decision was made in 1919 to replace the Mombasa Currency Board with a London based East African Currency Board (EACB) which would cater for the existing Protectorates as well as the newly acquired responsibility of providing currency to the Tanganyika Trust Territory.

The newly established EACB introduced an intermediate currency based on the English Florin with the thought that it would ease the transformation from Rupee to Shilling.

This then became the advent of the shilling in Kenya.

The shilling was however interchangeably used with the pound at a rate of twenty

As the East African territories became independent in sequence from 1962 the EACB ceased to issue notes with the image of the monarch and removed her name from the coinage.

For the banknotes, the interim currency was commonly known as the “Lake Issue” currency because of the background of Lake Victoria on the notes.

The Lake Victoria designed notes were in the denominations of 5,10, 20 and 100 shillings.

Kenya began printing and minting its own currency under the mandate given to the Central Bank of Kenya in the Central Bank of Kenya Act cap 491.

Banknotes for the Central Bank of Kenya, although not yet issued, were legalized under Legal Notice number 252 of 1966 dated July 1, 1966. Coins were issued in April 1967. EACB banknotes ceased to be legal tender in September 1967 while the EACB coins were demonetized in April 1969.

The initial issue of Kenya shilling notes were in the denominations of Ksh 5, Ksh 10, Ksh 20, Ksh 50 and Ksh 100, all bearing the portrait of the first President of Kenya, Mzee Jomo Kenyatta, in the front, and diverse scenes of economic activities in Kenya at the back. These notes were the first using the double title of Banki Kuu ya Kenya and Central Bank of Kenya

On April 10, 1967, new Kenya shilling coins were issued in the denominations of 5 cents, 10 cents, 25 cents, 50 cents and Ksh 1.

The coins were minted by the Royal Mint of U.K. and made from cupro-nickel. Like the notes, the obverse featured the portrait of Kenya’s founding father, Mzee Jomo Kenyatta.

The reverse, however, featured the Kenyan coat of arms, a theme that has remained a dominant feature to the present series of coins.

To mark some national and central banking events, the Central Bank of Kenya has and continues to issue special commemorative currencies.

These special currencies are limited in number and are specifically printed or minted to celebrate an event or in honour of a person.

They form a historical reference point and memento for the country.

Due to their specialty and use of precious materials like gold or silver, these currencies become very unique attracting demand from numismatic collectors or other individuals.

In 1980, a portrait of Daniel Arap Moi replaced Kenyatta until 2005, when the central bank introduced a new coin series that restored the portrait of Kenyatta. The coins are 50 cents and Ksh 1 in stainless steel and bi-metallic of Ksh 5, Ksh 10 and Ksh 20.

Ksh 5 notes were replaced by coins in 1985, with the same happening to Ksh 10 and Ksh 20 in 1994 and 1998. In 1986, Ksh 200 notes were introduced, followed

by Ksh 500 in 1988 and Ksh 1000 in 1994.

The banknotes are printed in Nairobi by British security printer De La Rue.

On December 11, 2018, Central Bank governor Patrick Njoroge and President Uhuru Kenyatta launched the new generation coins that were in line with the 2010 constitution of the Republic of Kenya dropping the images of the former presidents and embracing wildlife.


They launched the Ksh 1, Ksh 5, Ksh 10 and Ksh 20 coins

New generation coins launched on December 11, 2018

The new generation notes to replace the ones with presidential photos were launched on June 1, 2019, at the Narok stadium by the duo also abolishing the old Ksh 1000 notes.

Denominations of the launched currencies were between Ksh 50 and Ksh 1000.

Forms of money in the Kenya context

  1. Money of Account:

 Money of account is the monetary unit in terms of which the accounts of country are kept and transactions settled, i.e., in which general purchasing power, debts and prices are expressed. The rupee is, for instance, our money of account; sterling is the money of account of Great Britain and marks that of Germany. Money of account need not however be actually circulating in the country.

During 1922-24 the mark in Germany depreciated to such an extent that it ceased to be money of account. The paisa in India has not in circulation and yet it is money of account. In the circulation and yet it is money of account. In the words of Keynes, “Money of account is the description of little title money is the thing which answers to the description.”

2.   Limited and Unlimited Legal Tender:

Coins may be limited legal tender or unlimited legal tender. A legal tender currency is one in terms of which debts can be legally paid. It is an offence to refuse to accept payment in legal tender money. A currency is unlimited legal tender when debts up to any amount can be paid through it.

It is limited legal tender when payments only up to a given limit can be made by means of it. For instance, rupee coins and rupee notes are unlimited legal tender in India. And so is the half-rupee coin. But coins of lower denominations are only limited legal tender. They are legal tender only up to ten rupees.

When a coin is worn out and become light beyond a certain limit, then it ceases to be a legal tender. When one rupee and half-rupee coins are more than 20% below the standard weight they are not long in legal tender. A Government may take away the legal tender quality of a currency.

For instance, the old rupee coins of one hundred and eighty grains 11/12 fine are no longer legal tender in India. In 1978 the Government declared currency notes of rupees one thousand denomination and above as no longer legal tender, it is usually done to bring such currency out of the hoards. However, recently notes of Rs. 1000 have again been issued by Reserve Bank of India and have unlimited legal tender status.

3.   Standard Money:

 Standard money is that in which the value of goods as well as all other forms of money are measured. Thus, in India all prices of goods are measured in terms of rupees.

Moreover, the other forms of money such as two-rupee notes, ten rupee notes, hundred rupee notes and one half rupee coin are expressed in terms of rupees. Thus rupee is the standard money of India. Standard money is always made the unlimited legal tender money.

In old days the standard money was & full- bodied money, i.e., its face value was equal to the real or intrinsic worth of the metal it contained. But now-a-days in almost all countries of the world, even the standard money is only a token money i.e., the material contained in it is very much less than the face value written on it.

Thus, the rupee in India is available in the form of paper notes which have no intrinsic worth. Even the rupee coin has a metallic value much less than its face value. Rupee coin has been called a ‘note printed on nickel’ (Rupee coin these days is made of nickel).

4.   Token Money:

The token money is that the metallic value of which is much less than the real or intrinsic worth of the metal it contains. Rupee and all other coins in India are all token money.

5.   Bank Money:

Demand deposits of banks are usually called bank money. Bank deposits are created when somebody deposits money with them. Banks also create deposits when they advance loans to the businessmen and traders. Today these demand deposits are the important constituent of the money supply in the country.

It is important to note that bank deposits are generally divided in two categories: demand deposits and time deposits. Demand deposits are those deposits which are payable on demand through cheques and without any serving prior notice to the banks. On the other hand, time deposits are those deposits which have a fixed term of maturity and are not withdraw able on demand and also cheques cannot be drawn on them.

Clearly, it is only the demand deposits which serve as a medium of exchange, for they can be transferred from one person to another through drawing a cheque on them as and when desired by them. However, since even time or fixed deposits can be withdrawn by foregoing some interest and can be used for making payments, they are included in the concept of broad money, generally called M3. It may be noted that latest addition to the forms of money are credit cards issued by the banks which are these days extensively used for making purchases.

The characteristics of money are

  1. Durability

 Durability of money is such that it can be used over and over again; hence it must survive wear and tear for long periods. In business you cannot always rely on paper money coming in so branch out and allow for online transactions. In other words the fact that we cannot always deal with paper money is an opportunity to expand your business beyond the paper and achieve greater durability through online transactions.

2.       Portability

Portability is that money must be able to go wherever such that it is easy to transport as people travel. Why not ensure that your business products can be accessed wherever money is portable. Enable pay pal, visa transactions and any other transaction platforms that are possible in your country that encourage the portability of money. So make your goods available to the extent of the portability of money.

3.       Divisibility

 This aspect deals with the fact that money must be easily divided to enable a person to buy different products. When you own a shop make sure that the shop offers different products which allow for different denominations. So if a person walks in wanting something for a dollar there should be something in it for them. So let your goods and services allow or encourage customers to spend different denominations. Think little extras which have different values.

4.       Uniformity

Uniformity of money calls for a standardization of money so that it looks the same. Ensure that your products have a specific branding standard which is recognized in different parts. Let you products be uniform so that they are easily recognizable.

5.       Limited supply

Limited supply states that money is only valuable if it is in limited supply. Once in a while in business provide products that allow for high demand. This will improve sales for some sections of your products. Produce some goods in limited quantities so that they become more valuable to people.

6.       Generally Acceptable

This deals with the fact that the form of currency must be acceptable. If we are to do business, then we must ensure that the business enables that the exchange that occurs is acceptable in terms of the value that we are to receive. Only sell a product or service that is going to return to you a currency whose value is acceptable to the survival of the business. If the currency is not acceptable to what you need to achieve then branch out to a new market with an acceptable currency