Home » B. Com. Part II » B.Com. Part II Banking and Finance » Introduction of Banking System

Q.1. Define Bank and explain that banking system of a country helps in its economic development.


Write short notes on, * Industrial Bank, * Agricultural Bank, * Cooperative Bank, * Exchange Bank, * Mortgage Bank, * Savings Bank

Meaning of Bank

It is generally said that the word “BANK” has been originated in Italy. In the middle of 12th century there was a great financial crisis in Italy due to war. To meet the war expenses, the government of that period imposed a forced subscribed loan on citizens of the country at the interest of 5% per annum. Such loans were known as Compara, Mintuo etc. The most common name was Monte. In Germany the word Monte was named as Bank or Banke. According to some writers, the word Bank has been derived from the word Banke.

It is also said that the word Bank has been derived from the word Banco which means a banch. The Jews money lenders in Italy used to transact their business sitting on banches at different market places. When any of them used to feel to meet his obligations, his banco or banch would be broken by the angry creditors. The word Bankrupt seems to be originated from broken banco. Since, the banking system has been originated from money lending business, it is rightly argued that the word Bank has been originated from the world banco.

Today the word bank is used as a comprehensive term for a number institutions carrying on certain kinds of financial business. In practice, the work Bank means which borrows money from one class of people and again lends money to another class of people for interest or profit.

Definition of Bank

Bank is defined in many ways by various authors in the books on economics and commerce. It is very difficult to define a bank, because a bank performs multifarious functions. Different kinds of bank having different functions may be defined in different ways according to their functions. The evolution of different type of banks, each specialization in a particular field, gives emphasis on each and every kind of bank. A general and comprehensive definition to cover all types of banking institutions would be unscientific and probably impossible. Each type of bank should have its own definition explaining its specialized functions. Legislators have understood this difficulty and that is why the Bill of Exchange Act 1882 (England) defines thus A bank includes a body of persons, whether incorporated or not, who carry on the business of banking.

From this definition it is clear to us that any institution which performs the various banking functions may be termed as bank. But in practice it is found that many banking functions vary from time to time and country to country. It is not possible on the part of a single bank to perform all the banking functions at the time. So there originated numbers of specialized banks with the objective of performing one or more functions. As for example, Central Bank, Commercial Bank, Industrial Bank, Agricultural Bank, Co-operative Bank etc., are in the practical field.

Dr. Herbert L. Hart has defined a Banker as A Banker is one who in the ordinary courses of business honours cheques drawn upon him by persons for whome he receives money on current account. According to Sir John Paget No one and no body corporate and otherwise can be a Banker who does not (i) take deposit accounts (ii) take current accounts (iii) issue and pay cheques drawn upon himself (iv) collect cheques crossed and uncrossed for his customers.

Hilton Banking Commission defines Bank or Banker in the following words:

Every person, firm or company using in the description or its title, Bank or Banker or Banking and accepting deposits of money subject to withdrawal by cheque, draft or order.

Banking Ordinance 1962 (Pakistan) defines Banking as Accepting for the purpose of lending or investment of deposits of money from public, repayable on demand or otherwise and withdrawal by cheque, draft, order or otherwise. Vise Sec. 5(1) and 5(B) Banking Co’s Ordinance, 1962.

In view of the above definitions, a simple and short definition can be given as Bank is an institution which deals in money and credit. According to this precise definition A bank accepts deposits of money in savings and current accounts at lower rate of interest or profit and gives on credit to needy persons and businessmen at a higher rate of interest or profit. It also transfers money for the clients from one city or country to another and also performs various other agency services for earnings.

Importance of Banking

Bank play a significant role in the economic development. The overall economic of a country is absolutely dependent on the efficient banking system. Industrial, agricultural and commercial progress of a country is not possible without a good banking system. The importance of banking may be stated as follows:

1. Capital Formation
Economic development depends upon the division of economic resources from consumption to capital formation. Capital grows out of savings. Banks play the prime role in accumulating capital by collecting the scatered savings of the people. Thus banks render a valuable service towards the development of a country by encouraging the growth of capital.

2. Inexpensive Media of Exchange
Modern Banking provides inexpensive media of exchange. Issuing of currency notes is a great achievement of modern banking. In addition the cheques issued on the banks are frequently used instead of money in transacting business. Thus the cheques economise the use of currency notes.

3. Development of Trade and Industry
Bank utilise their collected funds by advancing loans to commercial and industrial undertakings. In respect of foreign trade also, banks render a valuable service by issuing letter of credit etc.

4. Reservoirs of Funds
Banks acts as the reservoirs of money in the country. In times of economic, crisis the bankers come forward to help the Government by purchasing the Government securities or by advancing loans.

5. Transfer of Funds
Banks facilitate the transfer of funds from one place to another safely and at a very cheap cost through bank drafts, mail transfers, telegraphic transfer, travellers cheque etc.

6. Dealing in Foreign Exchange
Banks deal in foreign exchange by purchasing and selling foreign currencies and by issuing letters of credit. Foreign remittances of funds are possible only through banks.

7. Money Market Operations
The structure and ups and downs of money market in the country are largely dependent on the bankers activities. Under the guidance of the central bank all the banks in the country do their best for the sound management of money market.

8. Service to Customers
Banks perform various agency services on behalf of their customers. They collect or make payments of bills of exchange, dividend, insurance premium etc, on behalf of their customers. They act as the trustees ore executors of documents etc. They also extend financial advises to their customers.

Functions of Modern Bank

The following is the list of functions or services rendered by a modern bank:

1. Bank provides inexpensive media of exchange through its cheques etc.

2. Bank keeps deposits of public.

3. Bank finances trade and industry.

4. Bank keeps in capital formation by economic savings.

5. Bank acts as Reservoir of funds.

6. Bank deals in foreign exchange and finances foreign trade.

7. Central Bank issues notes and controls money supply.

8. Central Bank controls credites, exchange and the money market.

9. All the banks participate in the development of money market.

10. Bank facilitates the transfer of funds from one place to another.

11. Specialized banks helps in the development of agriculture and industry.

12. Banks acts as the custodian of customers valuables.

13. Bank acts as underwriters for raising capital or loan by Government, Public Bodies and Campanies.

14. Bank acts as trustees and Executor of will and documents on behalf of their customers.

15. Bank acts as the correspondent and representative of its customers, other banks and financial institutions.

16. The Bank collects and makes payments of Bills of Exchange on behalf of its customers.

17. The bank makes payments and collects in respect of subscriptions, insurance premiums, rents, salaries etc, and also receives pension dividends and payment of utilities bills on behalf of their customers.

18. Bank advances loans and extend financial advices to its customers.

19. Bank Discounts Bills.

20. Bank purchases and sells stock exchange securities.

Qualities of Good Banking System

Every bank is a dealer in money and credit. It generally deals in with others money and not with its own money. It takes deposits from the public and again lends to its customers for the sake of interest or profit.

Thus, the operation of banking business is very risky one. A bank must have some qualities in operating its functions efficiently and successfully. The qualities of good banking may be summarized as below”

1. Adequate Capital
A banker must have adequate amount of capital. A large scale operation and execution of various functions of a modern bank require large amount of capital at the initial stage. Thus, without sufficient capital no large scale banking can flourish.

2. Good Reputation
Reputation is the most important factor in the progress of a bank. To be successful, a bank must have ample reputation in the money market. Reputation of a bank depends upon the qualifications of the directors and on the efficiency of management and workers.

3. Liquidity.
Money which is dealt in by a bank is not its own, so a banker must always keep himself ready to meet the claims of his depositors. He should keep sufficient amount of cash reserve and should keep some assets in such a way that these can be encashed at any moment. He should not block his fund by advancing loans for long periods rather he should always prefer short term credits.

4. Security and Safety
In respect of advancing loans safety should be the main guiding principle for a bank. The loans advanced by the banker must be secured. The persons to whom the advance is to be made, must be studied carefully before the lending of money. According to R.S. Sayers, The good banker is one who can distinguish the sound from the unsound borrower.

5. Economy
Economy in expenditure should be maintained for the proper operation of banking business. A good banker will always try to maximise his profit at a minimum cost.

6. Effective Publicity
A bank should adopt various scientific methods of advertisement for the proper publicity of business.

7. Localization
Good locality of a bank is another quality. The bank should be located in the business centre so that it can flourish its business successfully.

8. Speciality
To be successful, a bank should be specialized in any one or more fields of banking. An agricultural bank always aim at financing the formers for agricultural purposes. Industrial bank provides long terms credits to the industries. The individual commercial banks are also specialized in different fields of banking.

9. Good Show within the Office
The bank office should be well equiped with modern aminities proper sitting arrangement should be made within the bank office for its customers.

10. Good Personnel and Efficiency
The officers and the employees of the bank must be efficient in their work. They should be well trained in different fields of banking. Furthermore they should be well behaved and polite in the manner and must possess pleasing personality.

Classification of Banks

The banks can be classified on the following three basis:
1. Structural Classification of banking.
2. Operational Classification of banks.
3. Functional Classification of banks.

1. Structural Classification
Banks can be classified on the basis of their structure or constitution. According to structural classification, banking may be classified as (a) Branch Banking (b) Unit Banking

(a) Branch Banking
Under branch banking system, banking business is carried on through a network of branches in the same town or country under the guidance and control of one single head office. These branches may also be located in outside of the country. This system of banking was originated in the United Kingdom. Now-a-days this system if followed by many countries of the world including Pakistan.

(b) Unit Banking
Under unit banking system the banking operations are carried through a single office without any branch. Remittances and foreign exchange etc, are dealt through correspondence between banks of two places. The U.S.A is the home of unit banking.

Advantages of Branch Banking

1. Large Scale Operation
Branch banking system enjoys all the advantages of large scale operation. Proper division of labour is applied successfully and the employees become specialized in different banking fields.

2. Economy of Reserves
Under this type of banking, the funds can easily be transferred from one branch to another. So full economy in maintaining cash reserve can be secured by a banking having number of branches.

3. Remittances of Funds
This system facilitates easy remittances of funds from one place to another through its number of branches in different places.

4. Spreading Risk Geographically
The bank having many branches can spread its risk geographically or territorially. In case of losses incurred by branch in an area can be offset by profits of the branches of other areas.

5. Parity in the Rate of Interest
By making easy movement of funds from one place to another branch banking system can maintain parity in the rate of interest in different parts of the same country or of the world.

6. Wise Banking Policy
The bank can formulate a wise banking policy. As it has got a good number of branches throughout the country. It can study money and credit position correctly. Loans and advances are made on merits and not on other consideration. Applications for large amount of loan are passed on to the higher authorities in head office.

7. Investment of Idle Funds
Under branch banking system a branch can transfer its idle funds to other branches where this can be invested on profitable terms.

8. Foreign Exchange
As it has got foreign branches it is easier to operate foreign exchange for a branch banking.

9. Superior Management and Personnel Training
Branch banking system having large scale operations attracts superior personnel and offers wide scope for the training of the personnel.

Disadvantages of Branch Banking

The critics of the branch banking mentioned the following disadvantages:

1. Loose Control and Management
Under branch banking system, it becomes very difficult for a single head office to manage and control a number of branches much effectively.

2. Red Tapism
Red-Tapism and delay is common due to lack of sufficient authority to branch managers. They are also not allowed to stay for long in one branch, so they do not have the chance of becoming familiar with local needs.

3. Relationship Between Management and the Employees
Due to large number of branches the relationship between the employers and employees is not close and cordial.

4. Late Decision
A branch banking a large organisation, can take neither quick decision nor prompt action in case of emergencies.

5. Concentration of Financial Lesources
In branch banking system large financial resources are concentrated in the hands of small number of authorities of bank.

Advantages of Unit Banking

1. Easy Management and Control
Under unit banking system, it becomes very easy for a single office to manage and control efficiently.

2. Close Management and Workers Relationship
Under unit banking system, there prevails a close and cordial relationship between employer and employees.

3. Quick Decision
The owners or the management of unit banks can take quick decision and prompt action in times of emergencies.

4. Use of Local Resources
Local financial resources are used for local development.

5. Lesser Fraud and Irregularities
Due to the less scattered affairs of the bank, there are very little possibilities of fraud and irregularities.

Disadvantages of Unit Banking

1. Limited Size of Operation
Unit bank business can not be operated on large scale because of its limited area. Being the small organisation, division of labour can not be applied.

2. No Economy of Reserves
Under unit banking, bank can not transfer its funds to any other branch. So economy in cash reserve can not be secured under this system.

3. Limited Financial Resources
A unit bank has limited financial resources so it is not able to provide full and adequate banking facilities to the industry and trade of the area.

4. Investment of Idle Funds
A unit bank having no other branches, can not utilize its idle funds in profitable ways.

5. Disparity in the Rate of Interest
Under the system, there prevails a great disparity in the rate of interest in the same country as the management of different banks are separate from each other.

Operational Classification of Banks

On the basis of nature of operation, banks can be classified into the following two categories.

(a). Correspondent Banks
The unit banks, having no branch are linked together by correspondent bank system. Under this system, a unit bank of a village or small town deposits a portion of its cash reserve with another bank in the nearest city. And this superior bank of city also deposits with another greater bank of big city. These unit banks are linked through correspondence. Remittances of funds of home and foreign trade transactions are made through these correspondent banks. The unit banks are completely independent of each other no doubt, but these are connected with one another through correspondent system.

(b). Specialized Banks
The bank which performs one or more special functions is known as specialized bank. As for example an agricultural bank takes up the special responsibility of financing agricultural activities. Industrial banks specially finance the industrial undertakings. Japan is the home of specialized banks where different types of specialized banks are working with their special functions.

The specialized banks have a great role in the economic development of a country, specially of a developing country like Pakistan.

In our country, Agricultural Development Bank of Pakistan is helping financially in the development of agricultural sector of our economy. The Industrial Development Bank of Pakistan is another specialized bank who is financing large scale industries in Pakistan.

Functional Classification Of Banks

Banks may be classified according to their functions. Different kinds of banks, with different functions may be summarized as follows:

(a) Central Bank
A central bank is the most important institution in the banking system of a country established with the objective of regulating the banking and monetary system of the country. It issues notes and currencies within the country and is entrusted with responsibility of maintaining the price level in the country stable. It acts as banker to the Government and it directly or indirectly controls the activities of all other banks. State Bank of Pakistan is Central Bank of our country.

(b) Commercial Bank
Such type of bank is cheerfully engaged in financing internal trade. It deals in short term credit. It takes deposit from public through different type of deposit accounts and invests that collected fund in advances and loan of short period to the trading and commercial undertaking. This type of bank is familiar in most of the world. In our country, for example, National Bank of Pakistan, Habib Bank Limited, United Bank Limited, Muslim Commercial Bank Limited and Allied Bank Limited are the commercial banks.

(c) Industrial Bank
Such institution specialises in financing industry. It provides long term credit to people who carry on industrial enterprises. Industrial Development Bank of Pakistan (IDBP) and Pakistan Industrial Credit and Investment Corporation (PICIC) are the examples of industrial banks.

(d) Agricultural Bank
Such bank provides long and short term finance to agriculturists for their agricultural purposes. Long term capital is required for acquisition and improvement of land and purchase of heavy machinery and equipments. Short period capital is required by the farmers for current expenditure on seed, manures, wages etc. Agricultural Development Bank of Pakistan (ADBP) is the best example of agricultural bank in our country who provides long term, medium term and short term loans to the agriculturists.

(e) Exchange Bank
Exchange bank deals mainly in the finance of the foreign trade of the country. It deals in foreign exchange. On otherwards, the main function of such bank is to buy and sell foreign currencies, rather titles to foreign currencies in the form of bills of exchange, drafts, telegraphic transfers etc. It purchases the bill of exchange which arise in connection with the import and export trade of the country and they deal in exchange. The exchange banks liquidate the international indebtiness by exporting and importing precious metals and securities, if necessary, they purchase bills in the international money market and deposit them with their banking agents inbig commercial centres like London, Paris, New York etc. They draw and sell their own drafts on these deposit accounts.

(f) Cooperative Bank
This type of bank is organised mutually by the persons of similar occupations within the objectives of providing banking and credit facilities to the members. Generally in every country. Government patronises co-operative banks in order to encourage the cultivators, fisherman, workers in the factories etc.

(g) Mortgage Bank
Mortgage bank advances long term credits against securities of immovable properties like, agricultural lands, buildings and machinaries etc. Generally, credit is give to the agriculturist, small industries or house builders. This type of bank is essential in an under developed country where capital supply is very limited. In our country, House Building Finance Corporation is functioning as mortgage bank providing long term loans to house builders against securities of building and land property.

(h) Savings Bank
Such banks provides facilities to people to save money. This type of bank is established with the objective of promoting the thrift or saving habits among the people of small incomes. It takes deposits from the public and lands the collected funds to traders. Depositers are allowed to withdraw money from their deposits twice in a week. Post offices in Pakistan carry on functions of saving bank. Of course commercial and other bank also accept saving deposits.

Fahim Patel

By Fahim Patel

Fahim Patel is the Content Manager of guesspapers.net. A graduate from Karachi University, he has intensive experience in content production.