Detailed Summary of Part One: Law of Banking
1. Introduction to Banking Law
The Law of Banking is a specialized area of Commercial Law that governs the operations and
transactions of banks. It encompasses a wide range of legal principles and regulations that
dictate how banks operate, the types of services they provide, and the rights and
responsibilities of both banks and their customers. This area of law is crucial for ensuring the
stability and integrity of the financial system, as banks play a vital role in the economy by
facilitating financial transactions, providing credit, and managing risks.
.2 Definition of Banks
A bank is defined as an institution that deals with money and its substitutes, providing various
financial services such as accepting deposits, making loans, and managing securities. Banks
serve as intermediaries between savers and borrowers, channeling funds from individuals and
businesses that have excess capital to those in need of financing. The primary functions of
banks include:
- Accepting Deposits: Banks accept money from customers, which can be withdrawn on
demand or after a specified period. This forms the basis of their operations, as they use these
deposits to fund loans and investments.
- Making Loans: Banks provide loans to individuals and businesses, charging interest on the
borrowed amount. This is a primary source of income for banks, as they earn a profit from the
difference between the interest paid on deposits and the interest charged on loans.
- Managing Securities: Banks also engage in the buying and selling of securities, providing
investment services to their clients. This includes managing investment portfolios and offering
financial advice.
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3. Development of Banking Systems
Banking has ancient origins, evolving from simple money-changing practices to complex
modern banking systems. The development of banking services in Ethiopia began with the
establishment of the Bank of Abyssinia in 1905, which marked the introduction of modern
banking in the country. Key milestones in the development of banking systems include:
- Early Banking Practices: The earliest forms of banking involved merchants and moneylenders
who provided loans and accepted . These practices laid the groundwork for the formal banking
systems we see today.Another form of early banking activity was the acceptance of deposits
- Establishment of Central Banks: The creation of central banks, such as the National Bank of
Ethiopia, was a significant development in banking history. Central banks regulate the money
supply, implement monetary policy, and oversee the banking system to ensure stability.
- Modern Banking Evolution: Over time, banking systems have evolved to include various types
of banks, each serving different functions within the economy. This includes commercial banks,
investment banks, savings banks, and development banks.
Initially, banks handled physical money. Customers began directing banks to transfer their
credit, leading to the creation of checks. Banks then allowed borrowing via check, either
through a formal loan account (interest on the full amount) or overdrafts (interest only on the
overdrawn amount). A check became a claim against the bank, which had a claim against the
customer. This marked the evolution of checks and modern lending from basic deposit services.
4. Economic Significance of Banks
The economic significance of banks cannot be overstated. They serve as financial
intermediaries, channeling funds from depositors to borrowers, which is essential for economic
growth. A strong banking system is vital for economic growth. Banks channel savings into
investments, boosting production, jobs, and trade. They also fuel demand through consumer
loans. Banks encourage savings with interest, which funds future investment. National banks
influence investment and savings by setting interest rates; rates must balance encouraging
savings and investment. A widespread banking network simplifies business transactions, making
payments easier and safer.
Key points regarding the economic significance of banks include:
- Facilitating Investment: By providing loans to businesses, banks enable investment in capital
projects, which leads to increased production, job creation, and economic development.
- Encouraging Savings: Banks incentivize savings by offering interest on deposits, which helps
individuals and businesses accumulate capital for future investments.
- Supporting Economic Stability: A strong banking system contributes to overall economic
stability by providing a reliable means of payment and facilitating trade and commerce.
- Promoting Financial Inclusion: Banks play a crucial role in promoting financial inclusion by
providing access to financial services for underserved populations, thereby supporting
economic development.
5. Types of Banks
The banking sector comprises various types of banks, each with distinct functions and purposes.
The main types of banks include:
National Bank:
Central banks:Central banks also have other important functions, of a less-general nature.
These typically include acting as fiscal agent of the government, supervising the operations of
the commercial banking system, clearing checks, administering exchange-control systems,
serving as correspondents for foreign central banks and official international financial
institutions, and, in the case of central banks of the major industrial nations.Central banks are
operated for the public welfare and not for maximum profit.
Commercial Banks: Commercial banks are banks with the power to make loans that, at least in
part, eventually become new demand deposits. Because a commercial bank is required to hold
only a fraction of its deposits as reserves, it can use some of the money on deposit to extend
loans. When a borrower receives a loan, his checking account is credited with the amount of
the loan; total demand deposits are thus increased until the loan is repaid. As a group, then,
commercial banks are able to expand or contract the money supply by creating new demand
deposits.These banks accept deposits and provide loans to individuals and businesses. They are
the backbone of the banking system and play a vital role in the economy by creating money
through lending.
Savings Banks: Focused on gathering savings, It channels the savings of individuals who wish to
consume less than their incomes to borrowers who wish to spend more. these banks provide
interest to savers. While savings banks are not yet established in Ethiopia, commercial banks
accept savings deposits.
Investment Banks: Specializing in underwriting and distributing new securities, investment
banks facilitate capital raising for businesses and provide advisory services.
Developmen Banks: These banks provide long-term financing for productive investments,
particularly in less-developed areas, and support economic development.
Islamic Banks: Operating in accordance with Islamic law, these banks prohibit interest (riba)
and focus on profit-sharing arrangements."Islamic banking refers to a system of banking activity
that is consistent with the Islamic law (Sheria). It is guided by principles of Islamic economics. At
this juncture, it is important to note tha Islamic law prohibits usury, that is, the collection and
payment of interest which is commonly known as riba in Islamic discourse. In addition, Islamic
law prohibits investing in businesses that are considered unlawful, or harem (such as businesses
that sell alcohol or dork or Business that produce media such as gossip columns or pornography
which are contrary to Islamic values.
6. Banking Transactions
Various banking transactions are governed by the Law of Banking, including:
- Deposit of Funds: A contract where a depositor transfers ownership of money to the bank,
which agrees to repay it under agreed conditions. This transaction results in the opening of an
account in the name of the depositor.
- Bank Transfers: A method of transferring money from one account to another upon the
written order of the transferor. This transaction requires the existence of two separate
accounts.
- Deposit of Securities: A contract where securities are deposited with a bank for safekeeping
and management. The bank has a duty to handle the securities and collect any entitlements
arising from them.
- Hiring of Safes: Banks provide safe deposit boxes for customers to store valuables securely.
This service is essential for protecting customers' assets.
- Discounting: Banks pay holders of commercial instruments a lesser amount than their face
value, acquiring rights to collect the full amount at maturity.
- Bank Lending: Banks provide loans to customers, assessing creditworthiness and requiring
collateral. This is a fundamental function of banks that supports economic growth.
7.Banks and Banking Transactions in Ethiopia.
In Ethiopia, the definition of a bank and banking transactions is not explicitly provided in the
Commercial Code, necessitating reference to other laws for clarity. According to the
Monetary and Banking Proclamation No 83/1994, banking business encompasses activities
such as accepting deposits, lending money, handling commercial instruments, and trading in
gold, silver, and foreign exchange. The Licensing and Supervision of Banking Business
Proclamation No 84/1994 further defines banking business as involving the acceptance of
deposits for loans or investments, as well as the buying and selling of negotiable instruments
and foreign exchange.
A bank is defined as a share company fully owned by Ethiopian nationals or organizations,
registered in Ethiopia, and licensed by the National Bank of Ethiopia. Additionally, foreign
nationals and organizations are prohibited from engaging in banking business in the country.
This restriction aims to protect domestic banks, which are still developing, from competition
with foreign banks that possess greater financial resources and expertise.
8. Responsibilities of Central Banks :-
Central banks have several key responsibilities, including:
- Regulating the Banking System: Central banks oversee commercial banks to ensure they
operate safely and soundly, maintaining public confidence in the financial system.
- Formulating Monetary Policy: Central banks implement monetary policy to control inflation,
stabilize the currency, and promote economic growth.
- Acting as Lender of Last Resort: In times of financial crisis, central banks provide emergency
funding to commercial banks to prevent systemic failures.
- Managing Foreign Exchange Reserves: Central banks manage the country's foreign exchange
reserves to ensure stability in international trade and finance.
Central banks emerged to manage economic fluctuations in market economies, largely
stemming from banks' ability to create money. While individual banks focus on liquidity, a
central bank provides objective oversight to control the money supply and offset external
economic forces. The primary concern of a central bank is maintaining a stable banking system,
particularly commercial banks, and working closely with the government in policymaking.
Commercial banks can cause instability through excessive lending, leading to inflation and
eventual loan contraction, often triggered by financial crises and bank failures. Central banks
support commercial banks during crises, particularly after improvements in bank management
and risk evaluation. Central banks educate commercial banks in sound finance and scrutinize
their operations. The central bank acts as the "lender of last resort," protecting well-managed
banks from sudden cash demands by buying assets or making advances, and by issuing money
acceptable to depositors.
9. Role of Microfinance Institutions
Microfinance institutions (MFIs) provide financial services to underserved populations,
promoting financial inclusion and supporting small-scale enterprises. Key points regarding the
role of MFIs include:
- Providing Access to Credit: MFIs offer small loans to individuals and businesses that may not
qualify for traditional bank loans, helping to stimulate economic activity.
- Supporting Small Enterprises: By providing financial services tailored to the needs of small
businesses, MFIs contribute to job creation and economic development.
-Regulatory Framework: A robust regulatory framework is essential for the growth and
sustainability of MFIs, ensuring they operate effectively and meet the needs of their clients.
CHAPTER TWO: MAJOR BANKING TRANSACTIONS.
2.1 Deposit of Funds
A deposit of funds is a contract where a depositor transfers ownership of a specified amount of
money to a bank, which agrees to repay the funds under agreed conditions or upon demand.
The bank can use the deposited money for its operations, such as lending or investing.
However, if the deposit involves coins or unique tokens to be returned in kind, the bank does
not acquire ownership of those items.
The bank opens an account for the depositor, recording all transactions. There are different
types of accounts:
1. Current Account: Allows immediate access to funds and does not earn interest.
2. Savings Account: Interest-bearing, with potential restrictions on withdrawals.
3. Time Deposit:Funds cannot be withdrawn before a specified period and typically earn
interest.
Depositors cannot withdraw more than their account balance unless there is a special
agreement allowing overdrafts. Overall, the depositor's right to demand repayment is limited to
the amount held in their account.
2.2 Bank Transfers.
A bank transfer is a transaction where a depositor (transferor) instructs the bank, in writing, to
debit their account and credit another account (transferee) with a specified amount. This
process allows the transferor to fulfill financial obligations. If the intended beneficiary does not
have an account, the transfer can be made through another person's account.
Transfers can be internal (within the same branch) or external (between different branches).
The transferor can only transfer amounts up to their account balance unless a special
agreement for an overdraft is in place. The transferee gains ownership of the funds when the
transferor's account is debited, but the underlying obligations remain until the transferee's
account is credited. This protects the transferee's interests, especially in cases of the
transferor's bankruptcy. The transferor can cancel the transfer before their account is debited,
but loses this right once the order is handed to the beneficiary.
3 Deposit of Securities.
A contract of deposit of securities is an agreement where the owner deposits securities (like
shares, bonds, or other rights) with a bank for safe custody and management. The bank is
responsible for handling these securities, collecting yields (such as dividends and interest), and
managing transactions on behalf of the depositor.
The bank must exercise a high degree of care, similar to that of a paid bailee, meaning it is liable
for losses due to negligence. It must also take necessary actions to preserve the rights
associated with the securities and notify the depositor of important decisions. Upon
termination of the contract, the bank must return the securities to the depositor or their agent,
even if registered in a third party's name. However, the law lacks specific rules for the deposit
of other types of property, such as valuables or documents.
2.4 Hiring of Safes
Banks offer safekeeping services for customers' valuables, such as jewelry and important
documents, through two main methods: accepting items for safe custody or renting out safe
deposit boxes. In safe custody, customers hand over their valuables to the bank, which records
and stores them securely. In safe deposit arrangements, customers retain control of their items,
placing them in rented boxes that the bank provides.The bank is responsible for maintaining
the security of the safe deposit area but is not liable for any loss or damage to the contents.
Customers must pay rental fees and can only store non-dangerous items. Contracts for safe
deposit services can be terminated for various reasons, including non-payment of rent or the
death of the customer. If a customer fails to pay rent, the bank can terminate the contract and
open the safe in the presence of a court official to document its contents.
2.5 Discount
A discount is a contract where a bank pays a holder of a commercial instrument an amount less
than its face value in exchange for the instrument, which has a future payment date. The holder
accepts this lesser amount due to an immediate need for cash. The bank charges a commission
and interest based on the instrument's value and time until maturity.When the bank discounts
the instrument, it acquires all rights to demand payment from the liable parties. If the bank
receives full payment at maturity, the discount obligation ends. If not, the bank can pursue
payment from the liable parties or the beneficiary of the discount, limited to the amount it paid
plus any fees.
2.6 Bank Lending
Bank lending is a key function of banks that supports economic development. A loan contract
involves a lender providing a borrower with a certain amount of money or fungible goods, with
the expectation that the borrower will return the same amount and quality. Loans do not
require a specific form but must be documented if they exceed 500 Birr.Banks can also allow
customers to overdraw their accounts as a form of credit, typically for business purposes. These
loans can be for a limited or unlimited period, and banks can cancel them under certain
conditions, such as the borrower's death or gross negligence.Before granting loans, banks
assess the borrower's creditworthiness and may require collateral, such as property or other
assets, to secure the loan.
2.7 Documentary Credits.
A documentary credit is a financial instrument used in foreign trade, allowing importers to pay
for goods in foreign exchange through letters of credit issued by banks. When an importer
applies for a letter of credit, the bank opens it and communicates it to a correspondent bank
near the seller. The correspondent bank pays the seller upon receiving required documents
(like invoices and bills of lading) that confirm the terms of the credit.
There are two types of documentary credits: 1. Revocable Credits: These can be modified or
canceled by the opening bank at any time before payment.
2. Irrevocable Credits: These represent a binding commitment by the bank to pay the seller, and
they can be confirmed by the correspondent bank, creating a liability for that bank as well.The
opening bank retains the right to hold and dispose of the goods until the importer pays the
equivalent amount plus any fees.
