Financial Institution

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In today’s class, we will be talking about the financial institution. Enjoy the class!

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

Types of financial institutions

Two major financial institutions are:

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

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

Commercial bank:

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

Characteristics of commercial banks

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

Functions of commercial banks

Accepting deposits from customers
Lending to customers – i.e. they grant loans and overdrafts to their customers
Acting as an agent for payment
Discounting bills of exchange
Safekeeping of valuable e.g. wills, jewellery, certificates etc.
Offering expert advice to customers
Acting as executors or trustees
Acting as business referees/granting of a performance bond
Funds transfer e.g. credit transfer services
Issuing of letter of credit
Buying and selling of foreign currencies
Issuance of traveller’s cheque

Creation of credit or money by the commercial banks

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

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

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

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

Limitations of the ability of commercial banks to create credit/money

The volume of its deposits
Central bank regulations – monetary policy dictates
The cash ratio/liquidity ratio
Availability of collateral security
Restrictions imposed by the clearinghouse
Opportunities for investments

Central bank:

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

Characteristics of the central bank

It is owned by the government
It is established through Act of Parliament
It is the apex financial institution in a country
There is only one Central Bank in the country
It is not a profit-oriented institution
It does not transact business with individuals
It is the only bank authorized by law to issue currencies

The function of the central bank

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

Monetary policy:

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

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

Instruments of monetary policy or how the central bank controls the commercial banks

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

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

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

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

Liquidity Ratio / Cash Reserve Ratio: This is a requirement by law to the commercial banks to keep a certain percentage of their total cash / liquid assets or deposits with the central bank. In Nigeria, for example, the Liquidity Ratio is 20%. The central bank uses this ratio in increasing or decreasing the amount of money in circulation. Therefore the higher the cash reserve ratio, the lower the power of commercial banks to grant credit/loans to their customers. This policy of increasing the cash reserve ratio is therefore used to control inflation. The reverse is also true
Special Deposit: This is an instruction to the commercial banks to keep with the central bank special deposits over and above their statutory requirements thereby, curtailing the ability of the commercial banks to create credit. This instrument is used when the use of the cash reserve ratio alone is not adequate to keep down the rate of inflation
Open Market Operations (OMO): This is a method of buying and selling of securities (Treasury Bills) to the public and the commercial banks by the central bank to alter the volume of money in circulation and also to vary the ability of the commercial banks to create credit.

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

Special Directives: These are special instructions which the central bank gives to commercial banks and other financial institutions regarding the size of the loan to give and the areas (sectors of the economy) to which it should direct bank lending e.g agriculture, manufacturing etc
Moral Suasion: This is persuasion based on moral grounds not with the use of force of law by the central bank to the commercial bank as to the kind of lending policy they should adopt regarding the expansion or contraction of the money supply. Failures to comply can thereafter necessitate force of law. Directives and moral suasions are widely used in developing countries
Funding: This is the conversion of short term government securities to long term securities. For example, Treasury Bills (of 91 days maturity) could be converted to bonds (long term securities). If the central bank feels that the conditions of the economy have not yet improved for the short term loans to be repaid e.g. if there is inflation, the short term securities may be converted to long term securities.

Evaluation

Differentiate between fiscal policy and monetary policy
Give two reasons why a monetary policy may not be effective in regulating the Nigerian economy.

In our next class, we will be talking about the Concept of Demand and Supply. We hope you enjoyed the class.

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Financial Institution