Economics Chapter 5 Banks Class 12 notes

Economics Chapter 5 Banks Class 12 notes short question, long question, and exercise for 2nd year FA/ fsc notes.

Set A(Questions)

Table of Contents

Q.1) Define Bank, Credit Creation, Cheque, Bill of Exchange, Letter of Credit, Balance Sheet

Answer:

Bank

The bank is a financial institution which is engaged in borrowing and lending of money. Banks get surplus money from the people as deposits and advance the same as loans to those who need it for their business. Banks can also create money. Central banks of a country create money as currency while other banks create credit money.

Credit Creation

Credit creation or Deposit creation

An important function of a modern bank is creation of credit or deposit money. Creation of credit means that banks increase the supply of money through creation of new deposits in the name of borrowers. Credit creation becomes possible as follows:

When people deposit cash, the banks do not keep the whole of such an amount idle with them. They want to earn interest by lending the amount. The banks keep only a small percentage of cash as reserves to meet the demand of the deposits and advance the remaining part as loans. But, while lending money, the banks do not hand over cash to the borrowers. Simply an account is opened in the name of the borrower and the money is credited to his account. The customer can draw the money through cheques. Thus every loan makes a deposit. When the deposit is a demand deposit (current account) it is as good as currency to make purchases or payments by drawing cheque. Since a small amount is kept as reserve against the deposits, the bank is able to create deposits many times more than the cash available. The power of the commercial banks to create deposits lies in the fact that all the depositors (original as well as borrowers) do not withdraw the whole of money from the bank at one time.

Cheque

A cheque is an order by a depositor to a bank for paying the amount stated in the cheque. The payment is made either to the bearer of the cheque or the person mentioned in it.

Bill of exchange

When one businessman (called drawer of the bill) sells goods on credit, he writes a bill of exchange and gets it signed by the buyer (called drawee). This bill (or receipt) is kept by the seller till payment. If the seller of goods needs cash before the promised date of payment, he presents this bill to a bank for discounting. By discounting, we mean that the bank will accept the bill of exchange as security and after deducting a small amount from the total value of the bill makes payment.

Letter of Credit

Letter of credit is a promise by a bank to guarantee payments on behalf of some importer or exporter to get the letter the importer/exporter initially deposits a small percentage of the total amount beforehand. Banks issue letters of credit and guarantees and act as a trustee.

Balance Sheet

A commercial bank’s balance sheet is the statement showing

(a) Bank’s liabilities – demand deposits and time deposits and

(b) Bank’s assets – cash reserves, securities and capital ownership.

A balance sheet of an imaginary bank is shown below:

Q.2) What is a bank? What different types of banks are found in Pakistan?

Answer:

Bank

Bank is a financial institution which is engaged in borrowing and lending of money. Banks get surplus money from the people as deposits and advance the same as loans to those who need it for their business. Banks can also create money. Central banks of a country create money as currency while other banks create credit money.

Kinds of Banks

1. Central bank

Every country has a central bank which is its most important bank. Our central bank is the State Bank of Pakistan. Reserve bank of India, bank of England and Federal Reserve System (FED) are the central banks of India, England and U.S.A. respectively. The central bank is the head, the leader and the supervisor of the banking and monetary system of the country. It has the monopoly to issue currency notes. It also controls the credit money created by commercial banks. It also acts as agent and advisor to the government in monetary matters. It is the custodian of gold and foreign exchange reserves of a country. Generally, a central bank is an autonomous body and its policies are independent of direct government control.

2. Commercial Banks

Commercial banks are the institutions, which perform general banking functions. They receive deposits, advance loans, and credit people. People keep their surplus money in banks, which they can withdraw as and when they need it. They are an integral part of trade and industry. The main commercial banks of Pakistan are National Bank, Habib Bank, United Bank, Allied Bank, Muslim Commercial Bank, Bank of Punjab, Bank of Khyber, Bank Al Falah, Askari Bank. As commerce and industry of a country develops, the commercial banking system expands. The credit (loans) issued by commercial banks form a major part of money supply. In Pakistan more payments are made through credit money (through cheques) than through cash. Central bank controls the volume of credit of commercial banks.

3. Industrial Banks

These banks specialize in advancing short term and long term loans to industry. In Pakistan, examples of such banks are Industrial Development Bank of Pakistan (IDBP) and Pakistan Industrial Credit and Investment Corporation (PICIC). Industrial sector faces many problems which are different from those of other sectors. Special banks are needed to provide loans and other banking services to this sector.

4. Agricultural Banks

These banks specialize in providing loans to agriculture and related activities such as dairy farming, fish farming, bee farming, sheep farming etc. Agriculture sector has a special feature that it is more affected by natural factors and farmers are spread over far flung areas of the country. So the commercial banks take less interest in agricultural loans. The governments create agriculture banks to meet credit needs of farmers. Pakistan has one such bank called Zarai Taraqiati Bank Limited (ZTBL). Most of the co-operative banks in our country also specialize in agricultural credit.

5. Saving Banks

These banks are established for encouraging and collecting savings of the people. In Pakistan, we have special institutions like National Savings Centers and Post Office Saving Bank. All commercial banks also act as saving banks. Savings banks offer various schemes, which are suitable for different groups of people, in which they can invest according to their needs and circumstances. Saving banks do not keep demand deposits (current account)

6. Investment Banks

Investment banks are established to provide funds for long-term projects. They can raise their funds by getting deposits or selling share/stocks, issuing bonds or commercial paper.

7. Exchange Banks

These banks specialize and deal in exchange of foreign currencies. Some of these also finance export and import trade. Although in many countries such banks exist but there is no separate exchange bank in Pakistan.

8. Mortgage Banks

Such banks mortgage land, houses or other property and advance loans. No special bank of this nature is working in Pakistan, although in many countries such banks exist e.g. in India. However, commercial banks, Zarai Taraqiati Bank and cooperative banks are undertaking mortgage activity.

9. Co-operative Banks

These banks are concerned mostly with small business and at local level. These are a form of co-operative societies. Pakistan has many co-operative banks. There is a Federal Bank for Co-operatives. In the past many co-operative finance corporations started illegal banking. But these all failed.

10. Scheduled and Non-Scheduled Banks

The banks, which perform their functions under supervision of the central bank, are called scheduled banks. In Pakistan almost all banks are scheduled.

11. Others

There are other types of banks in Pakistan with some special features e.g.

Microfinance Banks (MFBs) the main function of such banks is to provide small loans to persons of low income. Khushali Bank is a microfinance bank. Microfinance banks are useful as a tool to eradicate poverty and provide access to finance for the poor.

SME bank concentrates on small and medium enterprises only. This is meant to accelerate the growth of small and medium scale industries.

Islamic banks or interest-free banks are established to comply with the Islamic principle of interest-free loans. Meezan Bank is one such bank

Q.3) What is a commercial bank? Discuss its functions.

Answer:

Commercial Banks

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Commercial banks are the institutions, which perform general banking functions. They receive deposits, advance loans, and create a credit for people. People keep their surplus money in banks, which they can withdraw as and when they need it. They are an integral part of trade and industry. The main commercial banks of Pakistan are National Bank, Habib Bank, United Bank, Allied Bank, Muslim Commercial Bank, Bank of Punjab, Bank of Khyber, Bank Al Falah, Askari Bank. As commerce and industry of a country develop, the commercial banking system expands. The credit (loans) issued by commercial banks from the major part of the money supply. In Pakistan, more payments are made through credit money (through cheques) than through cash. The central bank controls the volume of credit of commercial banks.

Functions of Commercial Banks

Commercial banks perform a variety of functions. These are:

1. Receiving deposits

This is the primary function of a commercial bank. People, who have surplus money, deposit it with banks and earn interest (or profit in Pakistan). Deposits are of four kinds:

1) Demand deposits or current accounts

2) Saving deposits

3) Time deposits or fixed deposits

4) Profit and loss sharing deposits (PLS)

Demand deposits provide the facility that the account holder can withdraw an amount at any time in full or in part. Such an account is very suitable for businessmen who want to keep their daily earnings safe.

Saving deposits are suitable for those who want to earn interest on their savings. They have the facility to withdraw the amount as they like, subject to certain restrictions, e.g. they can withdraw the amount within one week.

Time deposits are useful for those who want to invest their surplus money for longer periods. The amount under this deposit cannot be withdrawn before the expiry of the fixed period without due notice. The rate of interest on fixed deposits is higher.

In Pakistan, saving accounts have been changed into profit and loss sharing accounts (PLS). The banks, after six months, announce the rate of profit, which they would pay.

2. Advancing Loans

Banks receive money to lend it. The banks advance the deposited money to those who need funds for business or some other purpose. Banks give both short term and long term loans. Against every loan, banks demand some security in the form of property, bonds, shares, etc. banks advance loans in three ways:

i) Running finance (RF) or allowing overdraft facility (OD)|

ii) Cash credit or cash finance

iii) Discounting bills (short term business loans)

iv) Project Loan (long term loans to establish or expand the business)

In case of running finance (overdraft facility), the customer is allowed to draw a certain amount of money over and above his own deposited amount. Interest is charged only on the amount actually initiated. For the regular customers, the banks fix a limit of OD permanently. Such borrowers need not apply again and again and can draw the amount and time up to the sanctioned limit.

In case of cash credit, a definite amount is credited to the customer’s account. Interest is charged on the whole amount whether it is utilized in part or full. Against such loans, the borrower has to offer some asset as security either a property is mortgaged or some stock of goods is pledged.

3. Discounting Bills of Exchange

Businessmen can also get short-term loans through discounting bills of exchange. When one businessman (called drawer of the bill) sells goods on credit, he writes a bill of exchange and gets it signed by the buyer (called drawee). This bill (or receipt) is kept by the seller till payment. If the seller of goods needs cash before the promised date of payment, he presents this bill to a bank for discounting. By discounting, we mean that the bank will accept the bill of exchange as security and after deducting a small amount from the total value of the bill makes payment.

4. Creation of Credit Monet (Deposit creation)

When commercial banks advance loans, they actually create new deposits, which in turn become reserves for further creation of deposits. In this way banks expand deposits many times the original deposit. This process increases money supply in the country.

5. Transfer of Money

Banks help in transfer of funds from one place to another and from one person to another through the use of cheques, traveler’s cheques, drafts, pay orders telephonic transfers and online transfers.

6. Safe custody of Valuables

Banks provide safe custody for valuables of customers such as jewellery, documents, wills, etc. Thus, many people keep their valuables in bank lockers.

7. Agency Functions

Bank performs miscellaneous agency services. They undertake, on behalf of their customers, the purchase and sale of stocks of shares, collection or payments of bills, dividends, premium, salaries, Zakat etc. They also sell tickets for sports and other events.

8. Advisory Functions

Banks provide expert advice to their clients about financial and investment matters.

9. Other functions

Banks issue letters of credit and guarantees and act as trustees.|

10. Role in Economic Development

Various functions of banks have become an integral part of the working of a modern economy. Progress in trade, industry, agriculture, energy, transport and all other sectors are dependent upon banking facilities. High rate of economic development in a country is linked to the availability of extensive banking structures.

Q.4) Highlight the economic importance of banks in the modern age:

Answer:

Any modern financial system contributes to economic development and the improvement in living standards by providing various services to the rest of the economy. These include clearing and settlement systems to facilitate trade, channeling financial resources between savers and borrowers, and various products to deal with risk and uncertainty.

In principle, these various functions can be provided by banks or other financial institutions or directly through capital markets. Banks and other financial intermediaries exist because they are an efficient response to the fact that information is costly. Banks specialize in assessing the credit worthiness of borrowers and providing an ongoing monitoring function to ensure borrowers meet their obligations. They are rewarded for these services by the spread between the rates they offer to the accumulated pool of savers, and the rates they offer to potential borrowers. This process is known as ‘maturity transformation’ and is at the heart of modern banking. Banks offer a repository for savings, and then transform them into long-lived (illiquid) assets – housing loans and lending to businesses. In addition, banks play a role in providing payment and settlement services which are necessary for households, business and other financial institutions to settle day-to-day transactions.

As a country becomes more developed, one typically sees the capital markets playing a greater role in supplying financial products and services relative to that supplied by the banks. In many advanced economies, for example, raising business debt through securities rivals or exceeds that provided though the banking system.

Q.5) How do commercial banks create credit? What are their limitations in this regard?

Answer:

Credit Creation

Process of Credit Creation

If we consider a single bank out of many, the credit created may be quite small. This is because when this bank gives a loan, the cash drawn by the borrower and spent somewhere may go to other banks. So this bank can create deposits in the first round only.

Below we explain the process of credit creation by the banking system as a whole. Table tells the stages in this process. To consider the table, we assume that

(i) all of the business is transacted through cheques.

(ii) The banks keep cash equal to only 20% of their total deposits or accounts, to meet cash requirements of their customers.

Now, to start with let one of the commercial banks receive a new deposit of Rs.10 Million. Due to this, the amount of cash with the bank increases. As the bank needs to keep only 20% of cash, it finds a surplus amount of Rs.8 million (80% of 10 million) which is lent to some borrower by creating a deposit in his name. This is the first round of lending. Now this amount, according to our assumption. Will be retained within the banking system. The cash lent will be either kept in this bank or transferred to some other bank in the system. Suppose, the amount goes to another bank. The bank receiving this amount will find its reserves increased by Rs.8.0 million. Following 20 cash-deposit ratio, it becomes possible for the second bank to keep only 1.6 million as cash reserve and lend the rest. Thus the second round of lending gives rise to yet another deposit of Rs.6.4 million. This process continues in different rounds as follows:

Round of lending	Deposits (Rs. In Million)	Required reserve (Rs. In million)	Amount lent by banks (Rs. In million)
First	10	10 x 1/5 = 2	10 – 2 = 8
Second	(10 x 4/5) = 8	8 x 1/5 = 1.6	8 – 1.6 = 6.4
Third	6.4	1.28	5.12
:	:	:	:
:	:	:	:
:	:	:	:
Total	50	10	40

Various accounts holders of these 50 million rupees will be issuing cheques according to their requirements. And, only with 10 million cash, the banks will have no problem honoring all cheques.

The total deposits created in the banking system can be summed as under:

Total deposits = 10 + 10 (4/5) + 10 (4/5 x 4/5) + ……

= 10 + 10 (4/5) + 10 (4/5)² + …..

= 10 (1 + 4/5 + (4/5)² + ……….)

= 10 ( 1/1 – 4/5)

= 50

We see that on the basis of 10 million of initial deposit, total deposits have become Rs.50 million.

Q.6) What role commercial banks play in the development of an economy like Pakistan?

Answer:

Commercial banks play an important role in the process of economic development, which is clear from the following points:

1) Capital Accumulation or Formation

Capital formation refers to the increase in the existing stock of capital goods in an economy. Commercial banks remove the capital deficiency by encouraging saving and investment. The commercial banks can promote capital formation in the country by moving the resources to the productive uses. Rate of capital formation is 5 % in Pakistan.

2) Mobilization of Savings

There is a vicious circle of poverty in developing countries like Pakistan. So, savings remain at the lowest level. Savings of people are very low due to the international demonstration effect in Pakistan. Banks are playing an important role in the mobilization of saving by introducing a variety of saving schemes. Banks induce the people to earn interest through saving and it provides various facilities in a country to create a will and power to save. Domestic savings are 9.5 % of GDP of Pakistan.

3) Availability of Funds

An additional point of role of banks is more availability of funds. Poor population has poor resources for economic development in poor countries like Pakistan. the activities like inventions and innovations, research and development and initiatives (effectiveness in responding to challenges) are impossible due to insufficiency of funds in these countries. Banks remove the deficiency of capital by providing different types of funds that leads to economic development.

4) Attaining Self Sufficiency

A major problem faced by the developing countries is the burden of foreign debts and dependence on other countries. Commercial banks provide incentive for the entrepreneurs to take risks and to use idle resources for more and better production. So, banks are helpful in attaining self-sufficiency. Banks provide loans to develop the various economic sectors. It results in reduction in imports and increase in exports. Accordingly, banks are very important to achieve self-sufficiency.

5) Implementation of Modern Technology

Economic development without use of advanced and the most up-to-date technology is impossible. Almost in all the economic sectors backward techniques of productions are used due to poverty in third world countries like Pakistan. Commercial banks provide more funds to people to make it possible to use the modern techniques of production. Due to implementation of modern technology, there is an increase in production level, decrease in cost and save in time.

6) Development of Agriculture Sector

All the regions and all the sectors of the economy are not equally efficient and developed in an economy. There is a big need to develop backward regions and sectors for economic development. Rural areas and agricultural sectors are still backward in Pakistan. Banks are playing an important role in the development of the rural and agriculture sector. A special bank ZTBL has a major role in development of the rural and agriculture sector. Growth rate of the agricultural sector is 1.2 %.

7) Development of Industrial Sector

Industrial sector is the backbone of their economies in rich nations. It is still backward in Pakistan and other poor countries. Commercial banks provide different types of loans for the development of the industrial sector. Some special industrial development commercial banks i. e., PICIC, IDBP etc. are providing their remarkable services for the development of the industrial sector. Industrial development leads to agricultural development and it results in economic development. Growth rate of industries is 1.7%.

8) Expansion of Market

Commercial banks help in the expansion of the market. They help in the formation of sound economic infrastructure in order to raise living standards and to expand trade and commerce of an economy. Commercial banks cause development of the industrial as well as agriculture sector. Accordingly, there is expansion of the market that results in economic development.

9) Research and Development

Commercial banks, sometimes, provide finances for research and development, which leads to inventions and innovations. Various institutes in Pakistan are operating by the loan provided by the banks. Modern techniques are established and these are applied to economics in research institutes. Due to use of modern techniques of production, better quality and more quantity is produced which leads to improve the living standard of the population.

10) Essential for Foreign Trade

Foreign trade is one of the most important needs of all the countries of the world. Today international trade, without involving banks, is so difficult. International trade is necessary for economic development. Commercials banks are helpful in increasing international trade through following ways:

i. Provision of credit facilities

ii. Low rate of interest for the exporters|

iii. Opening of letter of credit (L/C)|

iv. Arrangement of foreign exchange

v. Opening of foreign currency accounts

vi. Commercial banks have $ 2.2571 billion of foreign exchange

reserves

11) Remove Budget Deficits|

The commercial banks are very helpful for the government. Nowadays, the government has to face the budget deficits because of increased expenditures and falling revenues. In this situation, the government has to depend upon deficit financing to meet the budget deficits. To cover the gap between the expenditures and revenues, the government borrows from the banks. As a result, the development process can be started through borrowed money from banks. Budget deficit is 5.3 % of GDP.

12) Optimum Utilization of Resources

Commercial banks help in the just and optimum allocation of resources. Some mega projects cannot be started due to the lack of capital. Commercial banks provide loans and remove the problem of deficiency of capital. Due to use of resources in an economy, there is an increase in production, income and employment etc. Increase in these things leads to economic development. Natural resources contribute to GDP just less than 1 %.

13) Surplus in Balance of Payment

Developing countries are facing the problem of deficit in their balance of payment. Commercial banks are helpful to overcome this problem. Due to commercial banks, a country can improve its economy and attain self-sufficiency. All this causes a favorable balance of trade. So, banks are helpful for the surplus in balance of payment.

14) Creators and Distributors of Money

Creation of money and distribution of money are the two main objectives of commercial banks. Commercial banks move the finances toward productive uses. There are a lot of problems in the way of economic development like inflation, deflation, low investment and saving etc. All these problems are possible to remove through creation and distribution of money by commercial banks. So, fluctuation in the supply of money can attain economic development.

15) Provision of Valuable Services|

The commercial banks are providing a lot of valuable services for economic development. Some of the most important services provided by commercial banks are as under:

i. Due to use of credit instruments like cheques, drafts and bills of exchange, banks have reduced the use of currency at the cheapest costs and in the safest manner.

ii. Banks serve as business and commercial agents of their customers.

iii. Banks provide locker facilities.

iv. Banks accept the various utility bills.

v. They guide the investors while making investment decisions.

vi. Banks advance loans for education in foreign countries.

16) Modern Facilities

Now commercial banks are providing various modern facilities like:

i. PC & Internet banking since 2003, PC banking available to all HBL customers in 14 cities.

ii. ATM & Online facilities & Balance ready cash etc.

iii. Mobile Banking and Call Centres, Smart Card and Debit Card.

iv. DD issuance, Statement inquiry and credit cards.

Summing up:

We conclude from the above discussion that finance is the life-blood of production and the banks are the departmental stores of finance. Commercial banks enjoy a very typical and dominated position in the present day economic world. We conclude that economic development, without a banking system, is impossible.

Q.7) Explain the concept and use of Bill of Exchange (Hundi)

Answer:

Bills of Exchange (Hundi)

Bill of exchange is a convenient credit instrument for availing short term credit for commercial transactions. Suppose a businessman purchases some goods from a seller on credit and promises to make the payment after 3 months. The seller (called drawer of the bill) will write a bill of exchange in the name of the buyer (called drawee), mentioning the time of payment. This bill is delivered to the buyer along with goods. The buyer signs it and returns to the seller.

“a bill of exchange is a written promise by the buyer of goods to pay the seller a sum of money at a specified time in future”

Bills of exchange are of 3 types:

i)Sight bill is used to make payments when it is presented to the buyer, usually at the time of delivery of goods. The seller sends the goods through railway, truck or other means of transport; draws the bill and hands it over to some bank, with the advice, that goods may be delivered to the buyer against payment of the amount mentioned in the bill.

ii)Time bill in this kind of bill, instead of immediate payment, the amount is cleared after a specified period of time.

iii)Foreign exchange bill is used for import or export of goods. It is like an internal bill of exchange except that it is between residents of different countries.

HUNDI

Nowadays, many Pakistanis working in the Middle East send the amounts to their relatives in Pakistan through an underground method called HUNDI. What they actually do is that instead of approaching the bank, they go to some money dealer or a middleman having links in Pakistan to transfer the amount. He gives a written note. The dealer writes that he has received the value (in foreign currencies) from the person and promises to pay the amount in Pakistan in rupees to someone nominated by the sender. The dealer earns a commission in this transfer. Since the rate of foreign currencies offered by HYUNDAI dealers is higher than the rate offered by banks, many Pakistanis prefer this method. But it is illegal. The government does not receive this foreign exchange. It is used to finance smuggling of goods into Pakistan. From the Middle East, an amount is sent through HAWALA. It is the same as HUNDI.

Q.8) Write a note on interest free banking.

Answer:

Interest free banking

Since 1 January 1981, interest-free (Islamic) banking and interest-free insurance was introduced in Pakistan to Islamize the economic system. Interest had been eliminated and a profit or loss sharing system was introduced. According to this system the account holder becomes the partner with the bank in its profit or loss and shares it according to his investment in the bank.

The bank invests the money, deposited by the clients, in different industrial and commercial projects and the account holder is informed of the profit or loss the bank has accrued on its various industrial & commercial concerns. Accordingly account holders share profit & loss with the bank at the end of the year.|

This partnership technically is called Mudarba which forms the conceptual basis of interest-free banking. However, the old system of interest in the banking system is also at work.

Set B(Questions)

Q.1) Define the central bank and discuss its functions

Answer:

Central Bank

The central bank is the most important in a country. It is the symbol of financing sovereignty and stability of the country. It is the head of banking and monetary system. The principles on which a central bank operates are different from those of the commercial banks. It does not work for profit motive. It acts in the national interest and earning of profit is only a secondary consideration. It does not compete with other banks: rather it is their supervisor. It follows an active policy for safeguarding the country’s economy. For this purpose, it enjoys vast powers. The central bank must be independent of political influence.

Functions

A central bank usually performs the following functions:

1. Note Issuing Monopoly

In the early periods of banking development, all banks used to issue their notes. This caused confusion and frequent trouble. Notes were over issued causing high inflation and economic crisis. Modern practice is to entrust the responsibility of note-issuing to only the central bank.

Usually, two systems of note issuing are followed:

Fixed Fiduciary System Under this system the central bank issue notes up to a certain limit without keeping any reserves of precious metals or foreign currencies. But if the bank intends to issue currency over and above this limit, it has to keep 100% reserves against every note issued.

Proportional Reserve System Under this system the central bank keeps reserves in the form of gold, silver or foreign currencies in a fixed proportion against issuing of notes. Most countries follow this system. The system has the merit that it is flexible and the supply of money can be changed easily.

2. Banker to the Government

Every central bank

· Manages receipts and payments of money on behalf of the government. It keeps cash balances, receives tax money and makes payments for the government.

· Provide short term loans to the government.

· Acts as advisor to the government in financial and monetary matters.

· Implements exchange control rules on behalf of the government.

· Represents the government in international organizations like the IMF (international monetary fund). The government consults the bank in all matters about money.

3. Bankers’ Bank

The central bank acts as the bankers’ bank. It:

· Keeps the cash reserves of banks. All banks are required by law to keep a percentage of their deposits with the central bank as a cash reserve

· Providing them loans by the rediscounting facility

· Controls supervises and regulates all activities of commercial banks. Every commercial bank sends a weekly statement of its assets and liabilities to the central bank. The central bank also makes on-site inspection of branches.

4. Lender of Last Resort

It means that whenever the banks are short of funds and are unable to get help from anywhere, it is the central bank, which provides them, loans and brings them out of trouble. A commercial bank gets loans from other banks in a normal routine. But when they do not get such help, they approach the central bank.

5. Clearing House

The central bank also performs the functions of a clearinghouse. Since the central bank holds the cash reserves of other banks, it can easily settle their mutual payments.

6. Controller (or Custodian) of Money Market

An important function of a central bank is the regulation and control of bank loans. Nowadays, a large part of the money supply in a country consists of bank advances. Using different methods like discount rate policy, open market operations and variation in reserve ratio the central bank controls volume of credit and money supply. It is the duty of the central bank that neither the economy is deprived of funds nor there is over the expansion of money supply causing inflation.

7. Controller of Foreign Exchange

The whole business of controlling foreign exchange control and financing of international trade is done by the central bank. It is the function of the central bank to see that the exchange rate does not change undesirably. It prepares the balance of payments statement of a country. If there is a deficit in the balance of payments, the central bank suggests the government about what action should be taken to correct the situation.

8. It manages the national debt, makes interest payments and raises new loans on behalf of the government. The account of foreign aid is also maintained by the central bank.

9. Custodian of Monetary Reserves

All monetary reserves of a country are kept by the central bank. The reserves are in the form of gold or foreign currencies.

10. Role in Economic Development

In developing countries, the central bank, through its various policies, directly and indirectly, promotes development efforts. It provides funds to financial institutions so that they can provide credit to all sectors of the economy.

Q.2) Discuss the principles of Note-issue. Which principle of note issue is being followed by the State Bank of Pakistan?

Answer:

Usually, two systems of note issuing are followed:

STATE BANK USES THE PROPORTIONAL RESERVE SYSTEM

Q.3) What methods a central bank adopts in controlling the money market of a country?

Answer:

Monetary Policy

(Credit Control)

The changes in money supply by the central bank to influence interest rate and achieve some other economic objectives are called the monetary policy. Bank credit is the dominant part of the money supply, so control of money supply, practically, means control of bank credit issued by commercial banks. Again, credit is the lifeblood of a modern business so, for the economic stability of a country, its volume must be controlled. If the banks issue too much credit money, it leads to inflation. On the other hand, tight control over this money may cause depression and unemployment.

The objectives of credit control are:

i) Regulate money supply

ii) To stabilize interest rates

iii) To increase investment

iv) To increase employment opportunities

v) To control the price level

The central banks use the following methods to control credit.

a) Quantitative Controls. These includes:

i) Discount rate policy

ii) Open market operations (OMO)

iii) Variation in the reserve requirement

iv) Credit rationing

b) Qualitative Controls. These include:

i) Change in margin requirement

ii) Regulation of consumer’s credit

iii) Moral persuasion

iv) Direct action

1. Discount Rate Policy

The discount rate is the rate of interest at which a central bank provides loans to commercial banks. If the central bank makes some change in the discount rate, it immediately affects the rate of interest charged by commercial banks and this in turn affects the loans issued by them.

If a central bank wants to increase the money supply in the economy, it lowers the discount rate. This step encourages commercial banks to borrow more from the central bank. The banks also lower their rates of interest which encourages people to borrow more. The result is the increase in the money supply. On the other hand, the central bank desires to reduce the money supply, it raises the discount rate, which is followed by commercial banks and they also raise the rate of interest. This causes a decrease in the money supply. In this way, the discount rate charged by the central bank is the tool which the central bank can use to control and regulate the supply of money bank loans and the structure of interest rates in the country.

2. Open Market Operations (OMO)

Sale and purchase of government securities in the open money market by the central bank are called open market operations. When the central bank sells securities the amount of cash with the people and the banks is reduced. Then with fewer amounts of cash, the commercial banks have less lending power. In this way, the money in circulation is reduced. If the central bank purchases securities, it means it is paying out cash. The result is that the money supply increases. Banks sell securities to the central bank and their cash reserves increase. They are in a position to expand credit. Thus, open market operations (OMO) are a tool in the hands of the central bank to regulate the currency circulation. Among all the methods of credit control, the central bank uses open market operations (OMO) more frequently than others. It is thus a regular weekly or fortnightly type operation.

In Pakistan

a) The most important instrument of the state bank to control the money supply is open market operations

b) Sale and purchase of Treasury Bills (T. bills) are the main instruments of OMO.

3. Variation in Reserve Requirement

Every member bank keeps a percentage of its deposits with the central bank. Whenever, the central bank desires to decrease the money supply, it raises the reserve requirement. In this way, the other banks are left with lesser amounts to lend. If the central bank feels that the money supply should be expanded, it lowers the reserve requirement.

4. Credit Rationing

Sometimes the central bank fixes the limit up to which it can give loans to its member banks. This step is useful to control the money supply.

5. Change in Margin Requirement

Whenever a bank extends loan against security, it keeps a margin, i.e. it gives less amount than the value of the security. When the central bank wants to reduce the money supply, it asks the member banks to increase margin requirements. In this way, the amount of loans decreases.

6. Moral Suasion (Moral Persuasion)

The central bank also exercises moral pressure so that the banks do not act against the interest of the country. Being the head of the banking system, it regularly advises and guides the member banks to follow a particular policy for loans.

7. Publicity

Central banks undertake publicity about its policies. This also helps to make other banks realize the monetary needs of the country. State Bank of Pakistan issues weekly statements on money and banking positions.

8. Direct Action

As a last resort, if some bank refuses to act by the policy of the central bank, it takes direct action against the bank. It can impose fine and penalty. It no longer accommodates such a bank. For example, In Pakistan, many finance Corporations were established. But they were not following correct policies. The State Bank took action and those were closed.

Q.4) Write note (a) Bank Rate Policy, (b) Open Market Operations, (c) Reserve ratio

Answer:

A) Bank rate policy

B) Open Market Operations (OMO)

In Pakistan

· The most important instrument of the state bank to control the money supply is open market operations

· Sale and purchase of Treasury Bills (T. bills) are the main instruments of OMO.

C) Reserve Ratio

The reserve requirement (or cash reserve ratio) is a central bank regulation employed by most, but not all, of the world’s central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out)

Q.5) Write a note on interest-free banking.

Answer:

From 1960 to 1977, the Council of Islamic Ideology (CII) created a strong case against Riba and forwarded it to the Govt. of Pakistan, in which it proved that the interest-based system that was running in Pakistan was completely against the Islamic teachings and come under the term RIBA, which is HARAAM (prohibited) in Islam.

In the 1980s various attempts were made to Islamize the overall banking system in Pakistan, which made quite a few changes to take place in the Banking Companies Ordinance.

Some of the key changes that took place during this period are as under:

1979

2 of the most popular Govt. owned mutual funds, the ICP & NIT, began the process of eliminating interest from their overall financial operations by abstaining from investing the funds in interest-based securities. ICP launched a new Investor scheme in October 1980, which was solely based on the system of Profit and Loss sharing.
The HBFC (House Building Finance Corporation) which was run by Govt. also eliminated the interest from their operations on July 1, 1979.

1980 – 1981

Participation Term Certificate (PTC) was launched, which was a new interest-free corporate financing instrument.
A two-Tier Fund structure was launched in 1981, which introduced the concept of Modaraba. A new law was formed for this, namely: Modaraba Companies and Modaraba Ordinance, whose sole purpose was to promote Sharia-compliant businesses.
Most nationalized commercial banks started separate counters for Interest-Free products to offer the customers an option of depositing their amounts on profit & loss sharing basis, which kick-started the Islamic Financing in Pakistan.

1984 – 1985

7 major amendments were made in the LAW with the name of Banking & Financial Services Ordinance, 1984.
Banking Tribunals Ordinance, 1984 was approved, which provided a new way to ensure recovery of non-interest based financed amounts.
SCB issued BCD Circular No. 13 of 1984 which tried to enforce the removal of Riba from the overall banking system of Pakistan. Hence on 1st Jan 1985, all the Provincial & Federal Govts. Public Sector Corporations, Joint Stock Companies were all directed to become Interest-Free.
The clear indication of how the trend of Islamic Banking in Pakistan escalated is the fact that the percentage of total deposits in PLS (Profit & Loss Share) deposits rose from 9.2% to 61.6% from 1981 to 1985.
All these measures worked towards a grand country-wide roll-out of the Role of Islamic Banking in Pakistan. However, of-course the transition was not smooth enough as it can be imagined; since the banks and financial institutions were not prepared and needed to fully understand the Islamic system of banking and financing.
The Federal Sharia Court had to challenge some of the Islamic Banking products in Pakistan initially as they did not fulfil the Sharia Law completely. The Supreme Court and Federal Sharia Court worked towards providing the banks and financial institutions guidelines to resolve the issues.
2002 is marked as a year when the first Islamic Bank in Pakistan was given the license to offer a complete range of Islamic products and offered.

Types of Economic Systems

Traditional economic system
Command economic system
Market economic system
Mixed system

Mixed Economic system

Mixed systems command market characteristics and economic systems. For this cause, the mixed system is also understood as the dual system. The duration is sometimes used to describe a market system under strict regulatory control.

Many Western countries have a mixed system. Most industriousness is private, while the rest, mainly public services, are under government control.

Mixed systems are commonplace globally. Thinking, a mixed system combines the best features of the market and the command system. In practice, however, mixed economies face the challenge of finding the right balance between free markets and government control. Governments control more than they need to.