02 March 2012 Written by  Fasil Alemayehu and Merhatbeb Teklemedhin

Types of Banks

National Bank

Central Banks: General Overview

It refers to an institution, such as the Bank of England, the U.S. Federal Reserve System, the Bank of France, or the Bank of Japan, that is entrusted with the power of regulating the size of a nation’s money supply, the availability and cost of credit, and the foreign-exchange value of its currency. Regulation of the availability and cost of credit may be nonselective or may be designed to influence the distribution of credit among competing uses. The principal objectives of a modern central bank in carrying out these functions are to maintain monetary and credit conditions conducive to a high level of employment and production, a reasonably stable level of domestic prices, and an adequate level of international reserves.

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, participating in cooperative international currency arrangements designed to help stabilize or regulate the foreign-exchange rates of the participating countries.

Central banks are operated for the public welfare and not for maximum profit. The modern central bank has had a long evolution, dating back to the establishment of the Bank of Sweden in 1668. In the process, central banks have become varied in authority, autonomy, functions, and instruments of action. Virtually everywhere, however, there has been a vast and explicit broadening of central-bank responsibility for promoting domestic economic stability and growth and for defending the international value of the currency. There also has been increased emphasis on the interdependence of monetary and other national economic policies, especially fiscal and debt-management policies. Equally, a widespread recognition of the need for international monetary cooperation has evolved, and central banks have played a major role in developing the institutional arrangements that have given form to such cooperation.

The broadened responsibilities of central banks in the second half of the 20th century were accompanied by greater government interest in their policies; in a number of countries, institutional changes, in a variety of forms, were designed to limit the traditional independence of the central bank from the government. Central-bank independence, however, really rests much more on the degree of public confidence in the wisdom of the central bank’s actions and the objectivity of the bank’s leadership than on any legal provisions purporting to give it autonomy or to limit its freedom of action.

Central banks traditionally regulate the money supply by expanding and contracting their assets. An increase in a central bank’s assets causes a corresponding increase in its deposit liabilities (or note issue), and these, in turn, provide the funds that serve as the cash reserves of the commercial banking system—reserves that commercial banks, by law or custom, must maintain, generally in a prescribed proportion of their own deposit liabilities. As banks acquire larger cash balances with the central bank, they are in a position to expand their own credit operations and deposit liabilities to a point where the new, larger cash reserves no longer produce a reserve ratio greater than the minimum set by law or custom. A reverse process occurs when the central bank contracts the volume of its assets and liabilities.

Central banks typically alter the volume of their assets by six ways:


1. “Open-market operations” consist mainly of purchases and sales of government securities or other eligible paper, but operations in bankers’ acceptances and in certain other types of paper often are permissible. Open-market operations are an effective instrument of monetary regulation only in countries with well-developed security markets. Open-market sales of securities by the central bank drain cash reserves from the commercial banks. This loss of reserves tends to force some banks to borrow from the central bank, at least temporarily. Banks faced with the cost of such borrowing, at what may well be a high discount rate, and also faced with the possibility of being admonished by the central bank about their lending policies typically become more restrictive and selective in extending credit. Open-market sales, by reducing the capacity of the banking system to extend credit and by tending to drive down the prices of the securities sold, also tend to raise the interest rates charged and paid by banks. The rise in government security yields and in the interest rates charged and paid by banks forces other financial institutions to offer a higher rate of return on their obligations, in order to be competitive, and, given the reduced availability of bank credit, enables them, like banks, to command a higher rate of return on their loans. Thus, the impact of open-market sales is not limited to the banking system; it is diffused throughout the economy. Conversely, purchases of securities by the central bank tend to lead to credit expansion by the financial system and to lower interest rates, unless the demand for credit is rising at a faster rate than the supply, which normally is the case once an inflationary process gets underway; interest rates then will rise rather than fall.

Changes in domestic money-market rates resulting from central-bank actions also tend to change the prevailing relations between domestic and foreign money-market rates, and this, in turn, may set in motion short-term capital flows into or out of the country.

2. Loans to banks, generally called “discounts” or “rediscounts,” are short-term advances against commercial paper or government securities to enable banks to meet seasonal or other special temporary needs either for loan-able funds or for cash reserves to replace reserves lost because of shrinkage in deposits. The Bank of England ordinarily deals with discount houses rather than directly with banks, but the effect on bank reserves is similar. The provision of such advances is one of the oldest and most traditional functions of central banks. The rate of interest charged is known as the “discount rate,” or “rediscount rate.” By raising or lowering the rate, the central bank can regulate the cost of such borrowing. The level of and changes in the rate also indicate the view of the central bank on the desirability of greater tightness or ease in credit conditions.

Some central banks, especially in countries that lack a broad capital market, extend medium- and long-term credit to banks and to government development corporations in order to facilitate the financing of domestic economic-development expenditures and to alleviate the deficiency of financial savings. Such longer-term lending is not regarded as an appropriate central-bank activity by many authorities, however, and is considered a dangerous source of inflationary pressures.

3. Direct government borrowing from central banks generally is frowned upon as encouraging fiscal irresponsibility and commonly is subject to statutory limitation; nevertheless, in many countries the central bank is the only large source of credit for the government and is used extensively. In other countries indirect support of government financing operations has monetary effects that differ little from those that would have followed from an equal amount of direct financing by the central bank.

4. Central banks buy and sell foreign exchange to stabilize the international value of their own currency. The central banks of major industrial nations engage in the so-called “currency swaps,” in which they lend one another their own currencies in order to facilitate their activities in stabilizing their exchange rates. Prior to the 1930s, the authority of most central banks to expand the money supply was limited by statutory requirements that restricted the capacity of the central bank to issue currency and (less commonly) to incur deposit liabilities to the volume of the central bank’s international reserves. Such requirements have been lowered or eliminated by most countries, however, either because they blocked expansions of the money supply at times when expansion was considered essential to domestic economic-policy objectives or because they “locked up” gold or foreign exchange needed for payments abroad.

5. Many central banks have the authority to fix and to vary, within limits, the minimum cash reserves that banks must hold against their deposit liabilities. In some countries, the reserve requirements against deposits provide for the inclusion of certain assets in addition to cash. Generally, the purpose of such inclusion is to encourage or require banks to invest in those assets largely than they otherwise would be inclined to do and thus to limit the extension of credit for other purposes. Similarly, especially lower discount rates sometimes are used to encourage specific types of credit, such as agriculture, housing, and small businesses.

6. In periods of intense inflationary pressure and shortage of supplies, especially during wartime and immediately thereafter, many governments have felt a need to impose direct measures to curb the availability of credit for particular purposes—such as the purchase of consumer durables, houses, and nonessential imported goods—and often have had these controls administered by their central banks. Such controls typically establish maximum loan-value to purchase-price ratios and maximum maturities that must be prescribed by lenders. These controls often apply to non-bank lenders as well as to bank lenders, and this is necessary for effectiveness in countries in which non-bank lenders are important sources of the types of credit being curbed. The general experience of central banks with direct credit controls has not been favorable; opportunities for evasion are too easy, especially if overall credit conditions are not extremely tight, and inequities in the impact of the controls become socially and politically troublesome. An early example of selective credit-control authority vested in a central bank and one that, on balance, has worked tolerably well is the authority conferred on the U.S. Federal Reserve Board in 1934 to establish margin requirements on stock-market credit.

The National Bank of Ethiopia

The National Bank of Ethiopia was created by order No 30/1963 and reconstituted by the Monetary and Banking Proclamation No 83/1994 as an autonomous organ, which is engaged in the provision of regular banking services to the government and other banks and insurance companies’. The main purpose of the bank is to forester monetary stability financial system and such other credit and exchange conditions as are conducive to the balanced growth of the economy of Ethiopia. / Art 6/

The bank will have the following powers and duties that will help it to achieve its purpose, /Art 7/

-          Mint coin, print and issue legal tender currency.

-          Regulate the supply and availability of money and fix the minimum and maximum rates of interest that banks and other financial institutions may charge for different types of loans, advances and other credits and pay on various classes of deposits. (Art 7 and Art 30).

-          Implement exchange rate policy, allocate foreign exchange, manage and administer the international reserve fund of Ethiopia. This reserve fund consists of gold, silver, foreign exchange and securities, which are used to pay for imports into the country and pay foreign international debts and other commitments (Art 50).

-          License, supervise and regulate banks, insurance companies and other financial institutions such as savings and credit associations/co-operatives and postal savings.

-          Set limits on gold and foreign exchange assets that banks and other financial institutions, which are authorized to deal in foreign exchange, can hold in deposits (Art 39).

-          Set limits on the net foreign exchange position and on the terms and the amount of external indebtedness of banks and other financial institutions.

-          Make short and long term refinancing facilities available to banks and other financial institutions.

-          Accept deposits of any type from foreign sources.

-          Act as banker, fiscal agent and financial advisor to the government/Art 24, 25/.

-          Promote and encourage the dissemination of banking and insurance services throughout the country.

-          Prepare periodic economic studies together with forecasts of the balance of payment, money supply, prices and other statistical indicators of the Ethiopian economy used for analysis and for the formulation and determination by the bank of monetary, savings and exchange policies.

Vision, Mission and Goals of the National Bank of Ethiopia

The vision, mission and goals of the National Bank of Ethiopia emanated from the overall vision of the government which is “to see a country, wherein democracy and good governance are prevailed upon the mutual consent and involvement of its people, wherein social justice is reigned, and wherein poverty reduced and income of the citizens reach to a middle economic level”.


1) Vision of the Bank


To be one of the strongest and most reputable central banks in Africa

2) Mission of the Bank


To maintain price and exchange rate stability, to foster a sound financial system and undertake such other functions as are conducive to the economic growth of Ethiopia.

3)      Values of the Bank

A) Core value

-          Promoting financial and monetary discipline

B)   Individual Values

-          Integrity

-          Neatness and good appearance

-          Punctuality

-          Team work spirit

C) Operational Values

-          Commitment to Excellence in Service

-          Confidentiality

-          Continuous Improvement

-          Transparency

-          Accountability

D) Organizational Strategic Values

-        Pursuit of Excellence and Professionalism

4)      Strategic Goals

Goal 1: Carry out extensive and sound institutional transformation tasks.

Goal 2: Maintain price and exchange rate stability.

Goal 3: Maintain adequate international reserves.

Goal 4: Improve the soundness of the financial system.

Goal 5: Play a decisive role in economic research and policy advice to the Government.

Goal 6: Create an efficient Payment System.

Goal 7: Improve the currency management of the Bank.

5)      Objectives

Objectives of Goal 1


Identify and conduct Quick win activities on continuous basis.

Implement BPR studies conducted and ensure their sustainability.

Review and update the SPM document of the Bank every two years.

In 2005/06, devise a result-based scheme that measures the performance evaluation of the work units and individual employees.

Identify and have adequate change agents.

Improve service delivery of the Bank.

Strengthen its service and enhance the computerization process of the Bank.

Enhance the capacity of the Bank.


Objectives of Goal 2


Contain annual core inflation (non-food inflation) within a single digit.

Maintain the exchange rate of Birr close to the equilibrium exchange rate.

Contain the premium between the official and parallel market exchange rate to the level below 1.5 percent.

Maintain the premium of respective buying and selling rates of the USD between the NBE and commercial banks below 2 percent.


Objectives of Goal 3


Ensure that the international reserve of the country is not less than three and a half months of imports of goods and non-factor services.

Manage the country's Foreign Exchange Reserve efficiently and effectively.

Ensure and manage the effective use of the country's Foreign Exchange.

Objectives of Goal 4


Ensure the average level of NPLs of commercial banks is reduced to below 15 percent.

Conduct effective on-site inspection of banks.

Conduct effective on-site inspection of insurance companies.

Conduct effective on-site inspection of micro finance institutions.

Issue seven new directives within the SPM period.

Amend the existing directives/policies.

Ensure systematic risk management framework for each bank.

Introduce CAMEL rating of banks.


Objectives of Goal 5


Finalize the Ethiopian macro econometric model and start its application

Strengthen the Bank's research and policy advisory capabilities and the dissemination of its findings in terms of published research papers and policy discussion forums by 100% each from 4 and 2 to 8 and 4 respectively.


Objectives of Goal 6


Create a National Payment System framework.

Conduct structural reforms on the existing payment systems.


Objectives of Goal 7


Ensure the availability and distribution of the Birr notes and coins.

Ensure the automatic provision of Birr notes exchange services

Increase the daily note sorting and verification capacity of the bank from the existing Birr 650,000 pcs per day by 60%.

Increase the note destruction capacity of the Bank from the existing Birr 700,000 pcs per day by 30%.

Assess counterfeiting situations.

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.

The name commercial bank was first used to indicate that the loans extended were short-term loans to businesses, though loans later were extended to consumers, governments, and other non-business institutions as well. In general, the assets of commercial banks tend to be liquid and carry less risk than the assets held by other financial intermediaries. The modern commercial bank also offers a wide variety of additional services to its customers, including savings deposits, safe-deposit boxes, and trust services.

The Commercial Bank of Ethiopia and all the privately owned banks in Ethiopia fall under this category as they are primarily engaged in receiving money on deposit and providing loans to the public.

Savings Banks

A savings bank is a financial institution that gathers savings and that pay interest or dividends to savers. It channels the savings of individuals who wish to consume less than their incomes to borrowers who wish to spend more. The savings deposit departments of commercial banks, mutual savings banks or trustee savings banks (banks without capital stock whose earnings accrue solely to the savers), savings and loan associations, credit unions, postal savings systems, and municipal savings banks serve this function. Except for the commercial banks, these institutions do not accept demand deposits. Postal savings systems and many other European savings institutions enjoy a government guarantee; savings are invested mainly in government securities and other securities guaranteed by the government.

Savings banks frequently originated as part of philanthropic efforts to encourage saving among people of modest means. The earliest municipal savings banks developed out of the municipal pawnshops of Italy. Local savings banks were established in The Netherlands through the efforts of a philanthropic society that was founded in 1783, the first bank opening there in 1817. During the same time, private savings banks were developing in Germany, the first being founded in Hamburg in 1778.

The first British savings bank was founded in 1810 as a Savings and Friendly Society by a pastor of a poor parish; it proved to be the forerunner of the trustee savings bank. The origin of savings banking in the United States was similar; the first banks were nonprofit institutions founded in the early 1800s for charitable purposes. With the rise of other institutions performing the same function, mutual savings banks remained concentrated in the northeastern United States.

This type of specialized banking service is not yet introduced in Ethiopia and hence there is no bank, which may be considered as a savings bank. However, the commercial banks accept savings as one form of money deposit.

Investment Banks

Investment bank is a firm that originates, underwrites, and distributes new security issues of corporations and government agencies. The investment-banking house operates by purchasing all of the new security issue from a corporation at one price and selling the issue in smaller units to the investing public at a price sufficiently high to cover expenses of sale and leave a profit. The major responsibility for setting the public offering price rests on the investment bank because it is in close contact with the market, is familiar with current interest rates and yields, and is best able to judge the probable demand for the issue in question.

In the underwriting and distribution of most security issues, a syndicate of investment banking firms is organized. If the amount of capital sought is large enough to prohibit one investment banking firm's undertaking the risk of purchasing the entire issue, the investment bank that initiates the issue with the corporation organizes a group of investment bankers to divide the liability for the purchase, with the originator acting as manager of the group.

If the market coverage that can be obtained by the members of the syndicate is deemed insufficient, selected dealers are used to bring about a wider distribution. Securities are sold to the dealers at a reduction (known as a concession), which reimburses the dealer for his expenses and provides him with a profit if the distribution is performed skillfully.

When new securities are to be issued, an investment firm having close contact with the corporation is likely to be asked to originate the issue. This process often is called private negotiation. An alternative arrangement is competitive bidding, under which the corporation itself settles upon the terms of the issue to be offered and then invites all banking firms to submit bids. The issue will be sold to the highest bidder.

The fact that Ethiopia is a predominantly agrarian state and business in general is limited to a small scale under takings by individuals, the idea of investment through purchase of stocks/ shares and bonds is common. Further, more, the very few companies that were established to wards the end of the imperial era, were nationalized by the military government which adopted the Socialist ideology and economic system, which does not allow private ownership of big manufacturing, agricultural and service providing undertakings or businesses. This fact has prevented the introduction of investment banking in Ethiopia. Though a market economic policy has been adopted after the fall of the military government and business in general and companies in particular are expanding, companies have not started offering their shares to the public and hence there was no conducive environment for the establishment and operation of these types of banks in Ethiopia.

Development Banks

It refers to a national or regional financial institution designed to provide medium- and long-term capital for productive investment, often accompanied by technical assistance, in less-developed areas.

The number of development banks has increased rapidly since the 1950s; they have been encouraged by the International Bank for Reconstruction and Development and its affiliates. The large regional development banks include the Inter-American Development Bank, established in 1959; the Asian Development Bank, which began operations in 1966; and the African Development Bank, established in 1964. They may make loans for specific national or regional projects to private or public bodies or may operate in conjunction with other financial institutions. One of the main activities of development banks has been the recognition and promotion of private investment opportunities. Although the efforts of the majority of development banks are directed toward the industrial sector, some are also concerned with agriculture.

Development banks fill a gap left by undeveloped capital markets and the reluctance of commercial banks to offer long-term financing. Development banks may be publicly or privately owned and operated, although governments frequently make substantial contributions to the capital of private banks. The form (share equity or loans) and cost of financing offered by development banks depends on their cost of obtaining capital and their need to show a profit and pay dividends.

The Development Bank of Ethiopia is established with the purpose of providing long-term loans to agricultural and industrial undertakings, which are considered crucial in the development of the economy. It was intended to serve as the major financer for the various co-operatives and government owned farms and factories. Now it also provides long-term loans to private investors who are engaged in agricultural and manufacturing activities.


Islamic Banking

General Overview of Islamic Banking

"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 that 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. In line with this, in the late 20th century a number of Islamic banks were established.

The Meaning of Riba

The word riba literally means increase or excess. It covers both usury and interest. In Quranic verses it essentially refers to the practice of lending money for predetermined rate of return or interest. Riba can also be interpreted as the addition to the principal sum advanced through loan from the lender to the borrower. The Shariah disallow riba and there is now a general consensus among Muslim economists that riba is not restricted to usury but encompasses interest as well. The Quran is clear about the prohibition of riba. You who believe fear Allah almighty and give up that remains of your demand for usury if you are indeed believer.

Muslim scholars have accepted the word riba to mean any fixed or guaranteed interest payment on cash advance or on deposits. Several Quranic verses expressly admonish the faithful to shun interest.

History of Islamic Banking

The history of interest free banking could be divided into two parts. First, when it still remained an idea; second when it became a reality by private initiative in some countries and by law in others.

A, Interest Free Banking as an Idea

Interest free banking seems to be of very recent origin especially in our country. But the earliest reference to the reorganization of banking on the basis of profit sharing written by Anwar Qureshi (1946), Naiem Siddiq (1948) and Mohamed Ahmed (1952). In the last forties it was followed by more elaborate exposition by Mawdudi in (1950).2 They have all recognized the need of commercial banks that use in profit and lose sharing mechanism and have proposed a banking system based on the concept of mudarabh (profit and loss sharing). In the next two decades interest free banking attracted more attention because of the emergence of young Muslim economists. The first such works emerged in that of Muhammed vzair (1955). Another set of works emerged in the late sixties and early seventies, Abdullah al-araby (1967), Nejatullah Siddigi (1961.1969), Al Najjar (1971) and Baqir al-sadr (1961, 1974) were the main contributors.

The early seventies saw the institutional involvement that is conference of the finance Ministers of the Islamic countries held in Karachi in 1970, the Egyptian study in 1972, the first international conference on Islamic Economics in Mecca in 1976 etc.

B, the Coming in to Being of Interest Free Bank

“The institutional and governmental involvement led to the application of theory to practice and resulted in the establishing of the first interest free banks”.3 The Islamic development bank, an inter-governmental bank established in (1975) was born of this process. The first private interest free bank is the Dubai Islamic bank; it was set up in 1975. Before this modern bank experiment, Islamic banking was undertaken in Egypt without projecting on Islamic image for fear of being seen as manifestation of Islamic fundamentalism that was an anathema to the political regime. The pioneering effort led by Ahmed El-Najjar took the form of saving bank based on profit sharing in the Egyptian town of Mit Ghamr in 1963. By this time there were Nine (9) such banks in the country. In ten years, since the establishment of the first private commercial bank in Dubai, more than 50 interest free banks have come into being. In most countries the establishment of interest free banking had been by private; in Iran and Pakistan, however, it was undertaken by government initiative and covered all banks in the country.

Principles of Islamic Banking

“The Islamic beliefs prevent the believer from dealing that involves usury or interest (riba). Yet Muslims need banking service as much as anyone else and for many purposes to finance new business ventures to buy a house, car, to facilitate capital investment, to undertake trading activities, and to offer a safe place for savings”.13

Islamic banking based on the Quranic prohibition of charging interest has moved from a theoretical concept to embrace more banks operating in 45 countries with multi-billion dollar deposit world-wide. Islamic banking is widely regarded as the fastest growing sector. An estimated $ US 70 billion worth of funds are now managed according to shariah.14

The best known feature of Islamic banking is the prohibition of interest. The Quran forbids the charging of riba on money lent. The Sharia disallow riba and there is now a general consensus among Muslim economists that riba is not restricted to usury but encompasses interest as well.

Let us look at the rule regarding Islamic finance, which is simple and can be summed up as follows:

  1. 1. Any predetermined payment over and above the actual amount of principal for any is prohibited. Islam allows only one kind of loan and that is qard-el hassan (literally good loan), where the lender does not charge any interest or additional amount over the money lent.
  2. 2. The lender must share in the profits or losses arising out of the enterprise for which the money was lent for the business. Islam encourages Muslims to invest their money and to become partners in order to share profits and risk in the business instead of becoming creditors.

As defined in the Shari'ah or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share benefit and the risk of business ventures. Translated into banking terms the depositor, bank and the borrower should all share the risk and the rewards of financing business ventures. This is unlike the interest based commercial banking system, where all the pressure is on the borrower, who must pay back his loan, with the agreed interest regardless of the success or failure of his enterprise.

The principle, which thereby emerges, is that Islamic Law encourages investments in order that the community may benefit. It is not instilling to allow a loophole to exist for those who do not wish to invest and take risks but rather content with hoarding money in bank in return for receiving an increase on these funds for no risk.14 Accordingly, either people invest with risk or suffer loss through  devaluation by inflation by keeping their money idle.

3. Making money from money is not Islamically acceptable; money is only a medium of exchange, a way of defining the value of a thing it has no value in itself and should not be all owed to give rise to more money through fixed interest payments, simply by being put in a bank or lent to someone else. "Muslim jurists consider money as a potential capital rather than capital, meaning that money becomes capital only when it is invested in business" 15

Gharar (uncertainty risk or speculation) is also prohibited; and any transaction entered into should be free from uncertainty risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions.

 

Investments should only support practice or products that are not forbidden. Trade in alcohol, for example would not be financed by an Islamic bank, a real estate loan could not be made for the construction of a casino and the bank could not lend money to other banks at interest, even if it is profitable.

Last modified on Wednesday, 02 May 2012 13:05