THE BANKING SYSTEM

It consists of all those institutions which determine the supply of money. The main element
of the Banking System is the Commercial Bank (in Kenya). The second main element of
Banking System is the Central Bank and finally most Banking Systems also have a variety of
other specialized institutions often called Financial Intermediaries.
THE CENTRAL BANK
These are usually owned and operated by governments and their functions are:
i.

Governments banker: Governments need to hold their funds in an account into

which they can make deposits and against which they can draw cheques. Such accounts
are usually held by the Central Bank

ii

Bankers Bank: Commercial banks need a place to deposit their funds; they need to
be able to transfer their funds among themselves; and they need to be able to borrow
money when they are short of cash. The Central Bank accepts deposits from the
commercial banks and will on order transfer these deposits among the commercial
banks. Consider any two banks A and B. On any given day, there will be cheques
drawn on A for B and on B for A. If the person paying and the person being paid bank
with the same bank, there will be a transfer of money from the account or deposit of
the payee. If the two people do not bank with the same bank, such cheques end up in
the central bank. In such cases, they cancel each other out. But if there is an
outstanding balance, say in favour of A, then As deposit with the central bank will go
up, and Bs deposit will go down. Thus the central bank acts as the Clearing House of
commercial banks.

iii. Issue of notes and coins: In most countries the central bank has the sole power to
issue and control notes and coins. This is a function it took over from the commercial
banks for effective control and to ensure maintenance of confidence in the banking
system.
iv. Lender of last resort: Commercial banks often have sudden needs for cash and one
way of getting it is to borrow from the central bank. If all other sources failed, the
central bank would lend money to commercial banks with good investments but in
temporary need of cash. To discourage banks from over-lending, the central bank will
normally lend to the commercial banks at a high rate of interest which the commercial
bank passes on to the borrowers at an even higher rate. For this reason, commercial
banks borrow from the central bank as the lender of the last resort.
v.

Managing national debt: It is responsible for the sale of Government Securities or

Treasury Bills, the payment of interests on them and their redeeming when they mature.

vi. Banking supervision: In liberalized economy, central banks usually have a major role
to play in policing the economy.

vii Operating monetary policy: Monetary policy is the regulation of the economy
through the control of the quantity of money available and through the price of money
i.e. the rate of interest borrowers will have to pay. Expanding the quantity of money
and lowering the rate of interest should stimulate spending in the economy and is thus
expansionary, or inflationary. Conversely, restricting the quantity of money and raising
the rate of interest should have a restraining, or deflationary effect upon the economy.
Monetary policies use by Central Bank to Control credit
a) Open Market Operations: The Central Bank holds government securities. It can sell
some of these, or buy more, on the open market, buying or selling through a stock
exchange or money market. When the bank sells securities to be bought by members of
the public, the buyers will pay by writing cheques on their accounts with commercial
banks. This means a cash drain for these banks to the central bank, represented by a
fall in the item bankers deposits at the central bank, which forms part of the
commercial banks reserve assets. Since the banks maintain a fixed liquidity (or cash)
ratio, the loss of these reserves will bring about multiple contraction of bank loans and
deposits.
By going into the market as a buyer of securities, the central bank can reverse the
process, increasing the liquidity of commercial banks, causing them to expand bank
credit, always assuming a ready supply of credit-worthy borrowers.
Conversely, if the central bank wanted to pursue an expansionary monetary policy by
making more credit available to the public, it would buy bonds from the public. It
would pay sellers by cheques drawn on itself, the sellers would then deposit these with
commercial banks, who would deposit them again with the central bank. This increase
in cash and reserve assets would permit them to carry out a multiple expansion of bank
deposits, increasing advances and the money supply together.
b) Discount Rate (Bank Rate) This is the rate on central bank advances and is also
called official discount rate or minimum lending rate. When commercial banks find
themselves short of cash they may, instead of contracting bank deposits, go to the
central bank, which can make additional cash available in its capacity as lender of last
resort, to help the banks out of their difficulties. The Central Bank can make cash
available on a short-term basis in either of two ways; by lending cash directly, charging a
rate of interest which is referred to as the official discount rate, or by buying
approved short-term securities from the commercial banks. The central bank exercises
regulatory powers as a lender of last resort by making this help both more expensive to
get and more difficult to get. It can do the former by charging a very high penal rate
of interest, well above other short-term rates ruling in the money market. Similarly,
when it makes cash available by buying approved short-term securities, it can charge a
high effective rate of interest by buying them at low prices. The effective rate of
interest charged when central bank buys securities (supplying cash) is in fact a rediscount rate, since the bank is buying securities which are already on the market but at
a discount.

The significance of this rate of interest charged by the central bank in one way or the
other to commercial banks, as a lender of last resort, is that if this rate goes up the
commercial banks, who find that their costs of borrowing have increased, are likely to
raise the rates of interest on their lending to businessman and other borrowers. Other
interest rates such as those charged by building societies on house mortgages, are then
also likely to be pulled up.
c) Variable Reserve Requirement
(Cash and Liquidity Ratios)
The Central Bank controls the creation of credit by commercial banks by dictating cash
and liquidity ratios. The cash ratio is:
Cash Reserves
Deposits
In most countries the Central Bank requires that commercial banks maintain a certain level
of Liquidity Ratio i.e. Cash reserves (in their own vaults and on deposit with the Central
Bank) well in excess of what normal prudence would dictate. This level shall be varied by
the Central Bank depending on whether they want to increase money supply or decrease it.
d)

Supplementary Reserve, Requirements/Special Deposit

If the Central Bank feels that there is too much money in circulation, it can in addition
require commercial banks to maintain over and above cash or liquid assets some
additional reserves in the form of Special Deposits. The commercial banks are asked to
maintain additional deposits in their accounts at the central bank, deposits which cease
to count among their reserve assets as cover for their liabilities.

e)

Direct control and Moral Suasion

Without actually using the above weapons, the central bank can attempt simply to use
moral suasion to persuade the commercial banks to restrict credit when they wish to
limit monetary expansion. Its effectiveness depends on the co-operation of the
commercial banks.

f)

General and Selective Credit Control

These are imposed with the full apparatus of the law or informally using specific
instructions to banks and other institutions. For instance, the central bank can dictate a
ceiling value to the amount of deposits the bank can create. This is more effective in
controlling bank lending than the cash and liquidity ratio. It can also encourage banks
to lend more to a certain sector of the economy (e.g. agriculture) than in another (estate
building). Selective controls are especially useful in less developed investment away
from less important sectors such as the construction of buildings, the commercial
sector, or speculative purchase of land, towards more important areas.
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