Financial Institutions – SS1 Economics Lesson Note (Third Term)

Financial institutions are business organisations that hold money for individuals and institutions, and may borrow from them to give loans or make other investments. They are the main channel through which funds flow from lenders to borrowers, so they are very important for the economic development of a nation.

Behavioural objectives

By the end of the lesson, students should be able to:

• define financial institutions;
• distinguish between banking and non-banking financial institutions;
• state the characteristics and functions of commercial banks;
• explain how commercial banks create credit or money;
• list the limitations on the ability of commercial banks to create credit or money.

What are the types of financial institutions?

There are two major types of financial institution:

1. Banking financial institutions (Central Bank, commercial banks, merchant banks, development banks, etc.)
2. Non-banking financial institutions (insurance companies, hire purchase companies, building societies, etc.)

The major difference between the two is that the liabilities of banking institutions are counted as part of the total supply of money in circulation, while those of non-banking institutions are excluded from the money supply.

What is a commercial bank?

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

Characteristics of commercial banks

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

Functions of commercial banks

1. Accepting deposits from customers
2. Lending to customers, i.e. granting loans and overdrafts to their customers
3. Acting as an agent for payment
4. Discounting bills of exchange
5. Safekeeping of valuables, e.g. wills, jewellery, certificates
6. Offering expert advice to customers
7. Acting as executors or trustees
8. Acting as business referees or granting a performance bond
9. Funds transfer, e.g. credit transfer services
10. Issuing letters of credit
11. Buying and selling foreign currencies
12. Issuing traveller’s cheques

How do commercial banks create credit or money?

Credit or money creation is the process whereby commercial banks make it possible for more deposits to be made through loans or overdrafts. Bank lending in the form of loans or overdrafts 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 interest is charged on the loans.

Bank lending creates credit or money in the following ways:

1. By granting loans to members of the public and charging interest on them.
2. By granting overdrafts to customers who have current accounts with the bank, and charging interest on them.
3. By applying the Cash Ratio, Liquidity Ratio or Cash Reserve, the percentage of their deposits which commercial banks are required by law to keep with the Central Bank to protect customers’ accounts and prevent bank crises.
4. By purchasing treasury bills from the government and by discounting bills of exchange. These transactions have a direct effect on the commercial banks’ excess reserves and other bank reserves, which determine the ability of the banks to create credit or money.

What limits the ability of commercial banks to create credit or money?

1. The volume of its deposits
2. Central Bank regulations and monetary policy directives
3. The cash ratio or liquidity ratio
4. Availability of collateral security
5. Restrictions imposed by the clearing house
6. Opportunities for investment

Evaluation

1. What is a financial institution?
2. State the major difference between banking and non-banking financial institutions.
3. List five functions of commercial banks.
4. Explain how a commercial bank creates money when it grants a loan.

Assignment

1. Highlight four ways by which commercial banks create money.
2. List four limitations of the ability to create money by commercial banks.