Financial Institutions SS1 Economics Lesson Note

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:

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 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 valuables from the public for safe-keeping, lends money to people and performs 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

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

Functions of Commercial Banks

1. Accepting deposits from customers 
2. Lending to customers  i.e. they grant 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 etc. 
6. Offering expert advice to customers 
7. Acting as executors or trustees 
8. Acting as business referees/granting of a performance bond 
9. Funds transfer e.g. credit transfer services  
10. Issuing of letter of credit    
11. Buying and selling of foreign currencies 
12. 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 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 charging interest on them. By so doing, more money is pumped into circulation and this increases the purchasing power of the people.

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

1. By granting loans to members of the public and charging interest on them.
2. By granting overdrafts to customers having current accounts with the bank, and charging interest on them.
3. By charging the percentage of Cash Ratio, 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.
4. By purchasing treasury bills from the government and by discounting bills 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

1. The volume of its deposits 
2. Central bank regulations and monetary policy dictates 
3. The cash ratio/liquidity ratio 
4. Availability of collateral security 
5. Restrictions imposed by the clearing house 
6. Opportunities for investments  

ASSIGNMENT 

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