Chapter 9: Money and Banking

9.1 Definition of Money

Money is any asset that is generally acceptable as a means of payment to settle transactions as well as a medium of is anything that is generally acceptable for payment of debts. Stages in development of money. Historically, the development of money in the present form has evolved through the following stages:

Commodity money: This is the money that has a value apart from its use as money. In primitive agricultural stages, domestic animal like cattle, goat, horses, cow etc were used as money. These commodities lacked the essentials of durability; homogeneity etc so could be used any more. Later, there was the use of precious metals of gold, silver and copper i.e. metallic money. The uncoined metals as a medium of exchange further created difficulties. People were unable to know the eight and value of pieces of bullion at sight. This led to the replacement of the unstandardized metal ingots with a standardized coinage. The metallic coin had a quarantined weight of value by a competent authority. Thereafter, the coins also proved a failure as a good medium of exchange. They were clipped, abraded and melted down. Efforts were then made to find out a better unit o account.

Convertible paper money: This was the second stage where paper was used to substitute commodity at rate specified on the currency. Before 1914, the bulk of bank notes were convertible into gold. The bank had to pay the bearer a specific amount of gold on demand. In today’s economy the paper notes are convertible notes. They are neither fully or fractional convertible into gold.

Deposit money. This consists of deposit at bank and financial institution which are subject to withdrawals by Cheques are a safe way of transferring the ownership of deposit in financial institutions.

9.2 Characteristics of Money

For a commodity to perform as money it has to have the following characteristics.

  • Acceptability: money must be acceptable to everyone for it to be used as a medium of exchange Durability-should be able to last for a long time without getting torn,defaced or losing its shape and texture. The material used to make money should therefore be of a quality that resists wear and tear. Divisibility-should be easily divisible into smaller denominations but still maintain its value. This enables the buyer to purchase various quantities of goods and services.
  • Cognizability: should be made of a special material that is easily recognizable to minimize risk of forgery and printing of fake notes and mint coins. This cognizability of money enables people to differentiate various denominations of the currency.
  • Homogeneity: should be made using a similar material so that it appears identical e.g. 500 notes should be printed using the same material and have identical security features to eliminate risk of confusion and forgeries. All notes of the same denomination should be identical.
  • Portability: should be convenient to carry even if it has a high face should neither be too bulky to carry around as this would hamper should be light.
  • Stability in value: should last for a long time without changing in value so that it maintains credibility and acceptability. Money that fluctuates in value makes people want to hold their wealth in form of goods.
  • Liquidity: should be easy to convert into other forms of should be able to quickly convert money into properties or other forms of assets.
  • Scarcity: should be relatively scarce in supply. If money was abundant in supply then it would lose value.
  • Malleability: the material used to make currency coins should be easy to cast into required shapes.

9.3 Functions of Money

  • Medium of exchange: money is generally acceptable by everybody in exchange for goods and services. It therefore enables trade to be carried out conveniently hence reducing drawbacks of barter trade
  • Measure of value: when commodities are valued in terms of money, a problem of fixing exchange rate is solved. This is because money provides a common denominator in which the values of various goods and services are expressed.
  • A unit of account: money can be held for no other purpose than accounting. Money is a unit by which goods and services are valued.
  • Store of value: this is because it is easily convertible into other forms of assets. Money can also be kept as savings for future transactions since it is durable and relatively stable in value.
  • Standard of deferred payment: a debt incurred today can be paid at a later date using used to settle future payments.
  • Transfer of immovable properties: using money, we are able to transfer the value of a commodity from one person or place to a piece of land in Mombasa can be sold and the money received used to acquire a piece of land of an equivalent value in another province.
  • Measure of wealth: wealth can be measured in monetary terms.

9.4. Demand and Supply of Money

Demand for Money

Demand for money refers to the tendency or desire by an individual or general public to hold onto money instead of spending is also known as liquidity preference. Money can be hold by individuals in various forms and these include; currency notes and coins, securities e.g. treasury bills and bonds, demand deposits held in current accounts of banks, time deposits held in fixed deposit accounts. Demand for money (desire to keep money instead of assets) depends on three motives:

  • The transaction motive: here one holds money with a motive of meeting normal daily expenses e.g. buying food, entertainment, paying wages, postage, travelling, buying raw materials, etc.
  • The precautionary motive: this is where people tend to hold money to meet expenses that might occur unexpectedly or emergencies e.g. sickness, accident, or loss of property through is obvious that optimistic and risk takers will keep less money while pessimistic/risk averse will keep more money.
  • The speculative motive: Money may be held to be used in future especially when people anticipate that the prices of goods and services will be lower than they are presently and one plans to invest in opportunities that will bring more gains/returns. Such money is said to be held in a speculative motive. Money held for this purpose depends on levels of income and how optimistic/pessimistic people are about future happenings.

Supply of Money

This refers to the stock of monetary items that are in circulation in an economy at a particular point in time. These items basically consists of; total currency i.e. notes and coins issued by central bank and the total demand deposits. The following variables affects money supply:

  • Policies of commercial banks: if more loans are offered to individuals and firms, money is released in economy and the vice versa is true.
  • Increase in national income: this increases economic activities resulting to money level in economy to increase and vice versa is true.
  • Increase in foreign exchange: increased export earnings arising from increased export trade leads to an increase in money supply in an economy and the vice versa is true.
  • Coins and notes offered by commercial banks
  • Central bank guidelines to commercial bank on cash reserve requirements.
  • Government policies i.e. can be geared towards expenditure, borrowing which increases money supply,
  • Open market operations activities.
  • Interest rate policies
  • Special deposits requirement by CBK.
  • A change in the public desired cash holdings.
  • Balance of payment equilibrium or disequilibrium: disequilibrium translates to a net outflow of currency which leads to a reduced money supply.

Money supply is best understood through the concept of Monetary Policy. This can be defined as a deliberate move by government through the central bank to manipulate the supply, availability and cost of money in order to achieve the desired economic levels. The following are the various instruments /tools that commercial banks use in conjunction with the central bank to regulate the level of money supply/Methods of credit control.

  • The bank rate policy/bank interest rates: During inflation the Central Bank increases the commercial bank lending rates on loans making borrowing expensive; translating to reduced money supply and during deflation the rates are lowered thus promoting borrowing. Increased rates decrease the amount of currency in circulation while a decrease in rates increase the amount of money in circulation as in individuals are charged low interest rates
  • Open market operation: This refers to sale and purchase of securities in the stock market. During inflation the central bank sells government securities (treasury bills and bonds) to withdraw an amount of money from the general public and during deflation it buys back the securities to increase currency in circulation.
  • Reserve requirements/cash/liquidiy ratio requirement: Central bank requires commercial banks to hold a certain proportion of total deposits in cash form to meet the needs of those customers who may wish to withdraw cash. Cash ratio=cash held/total deposit. If the central bank lowers this ratio then more money will be available for lending and the vice versa is true. This is meant to decrease or increase money in the commercial bank reserves.
  • Rationing of credit: This is based on the size of loans a commercial bank is allowed by the central bank.
  • Margin requirements: The margin refers to the difference between a loan and a collateral security. If the margin is big, loans will be expensive thus the public will shy away from borrowing loans thus money supply will reduce and if the margin is small the loans will be cheap thus many people will be more willing to borrow loans, increasing money supply in the economy.
  • Restricting terms of hire purchase agreement and credit sales: Here the Central bank may encourage or discourage the purchase of commodities on installments. To discourage it, the payment period is decreased and deposit fraction raised to discourage buyers from buying on credit thus releasing some lump sum of money which they could be holding, and the vice versa is true.
  • Direct action, requests, moral persuasion and publicity: CBK directs commercial banks to advance loans to a given amount. Directs the commercial banks to behave in a defined way i.e. expand or contract credit creation activities. Reports on financial matters related to commercial banks encourage banks to change their policies.
  • Compulsory deposit requirements: CBK may require commercial banks to maintain certain amounts of deposits with it in special accounts whose money would stay frozen. This act has effect of reducing amount of money available to commercial banks for lending which implies a reduction in money supply. If the CBK wishes to increase supply of money, it may reduce/release the deposits to commercial banks.
  • Selective credit control: CBK may give special instructions to commercial banks and other money lending instructions as to the type of sectors to give credit to and ones which credit should be restricted to.
  • Loans to banks and discount window: this allows eligible institutions to borrow money from central bank usually to meet short term liquidity needs.
  • Gentlemen’s agreements: these are voluntary agreements between central bank and banks aimed at improving monetary conditions in Tanzania, such agreements have been used between central bank and the largest commercial bank in an effort to lower spread on interest rates.

Limitations of Monetary Policies

  • Commercial banks do not cooperate fully within the central bank
  • A government monetary system may be reduced or increased in size and controlled tightly without deleterious effects on its performance, however monetary system contains commercial banks that are in business for profit.
  • The system may create problems for monetary authorities. This controls may weaken profit and capital positions of banking system and this may in turn make commercial banks less responsive to policies of monetary authorities.
  • Omos are not quite virtually effective in controlling money supply due to less developed money and capital markets and limited range of financial assets (securities) held by C.M.A.
  • On reserve requirement, some commercial banks have access to external lines of credit from partners/their parent companies.
  • Funding-may be effective in controlling liquidity. However since the rate of interest on long term debt is usually much-higher than on short-term loans.

9.5 Meaning of Banking

Banking refers to all the activities carried out by financial institutions involving money. This financial institutions include: central bank, commercial banks and non-banking financial institutions e.g. industrial and commercial development corporation (I.C.D.C). Some important terms in banking.

  • Bank statements: This is a list of all transactions made by the bank with or on behalf of the customers of the account holder.  It is issued at the end of each month to current account holders. It enlists all deposits made by the account holder, all cheques paid by the bank out of his account holder, all cheques paid by the bank out of his account and any charges made by the bank.
  • Credit transfers: This is the process where an account holder draws a cheque carrying a wholesome amount to be paid to various people and attaches it to a list of names of the people to be paid.  The cheques and the list are presented to the bank and the bank takes up the responsibility of transferring payments to payees who must be account holders.
  • Standing orders: it is an arrangement between the account holder and his bank to pay a specific amount to a named party at a regular or specific intervals for a given period of time until the agreement is cancelled by the drawer. The system serves best in payment of salaries, rent and rates insurances. A fee is charged by the bank for these services.
  • Traveler’s cheque: Issued to a person after paying for them in advance they are in fixed denominations. It is important to businessmen always on transit.
  • Credit cards: mainly issued by banks. It gives authority to the holder to buy goods and services up to an agreed amount.  The selling party then presents the card to the issuing organization for payment.
  • Cheque guaranteed card: it’s issued by banks to reliable current accounts.  The guarantee card if attached to a personal cheque it guarantees payment against the personal cheque.  In other wards it cannot be dishonored.
  • Clearing house: it’s a central place where different banks meets to settle amounts that become payable to each other as a result of their clients transactions.  The transfer of payments is done by the central bank since it holds all commercial banks accounts.

Categories of Banks

  1. Commercial Banks

Commercial banks are financial institutions that carry out commercial services, accept deposits from the public and advance loans. They are formed with the aim of making profit hence are trading businesses like any other.

9.6 Functions of Commercial Banks

  • Accepting deposits: they play a vital role in economy by mobilizing domestic savings and enabling efficiency and convenience in transactions by accepting deposits i.e. cash items, warrants, E.F.Ts, night safes etc. in three main accounts i.e.
    • Current Accounts
      • Deposits of any amount can be made at any time.
      • Here the deposits may earn interest and the account holder is expected to pay some fee to the bank for services provided e.g. account maintenance.
      • Money deposited in this account is withdrawable on demand by means of cheque.
      • Money can be withdrawn from this account at any time during working hours so long as the account has sufficient funds.
      • No minimum cash balance is required to be maintained.
      • Does not earn interest but instead the bank charges ledger fees for services rendered.
      • The banks may allow customers to withdraw more money than they have in their current accounts and this is known as bank overdraft that carries interest at an agreed rate.
    • Savings Account
      • This are accounts operated by people who have the intentions of saving money (small savers).
      • The balance on the account above a certain minimum earns interest.
      • Funds are not withdrawn by use of cheques.
      • Overdrafts are not usually allowed. In most cases one is required to maintain a certain amount in account.
      • Withdrawal of money exceeding a certain maximum amount might require a notice to be given by the customer of the intended withdrawal.
      • Ordinarily withdrawals can only be made by the account holders themselves.
      • Banks don’t use this money as compared with fixed deposit accounts
    • Time Deposits/Fixed Accounts
      • Do not allow withdrawal/addition of money into the account before the end of a fixed pre-determined period.
      • They are appropriate for people who have money that they have no immediate use for
      • Earns interest at an agreed rate and the rate of interest depends on the amount deposit as well as the period taken by the deposit. Usually higher than savings account
      • There is usually a minimum amount that can be allowed for this type of account
      • On expiry of deposit period, the account holder can withdraw all the money together with interest or even renew the contract for another similar different term.
      • If the account holder withdraws the money before the expiry date of the agreed deposit period he/she not only loses the accrued interest but might also be charged for breach of contract.
      • There are no bank charges to the account holders.
      • The money held in fixed deposits can be used as security for getting a loan.
    • Lending money/provide loan facilities: this can also be offered even in form of overdraft. Others are short term, medium term or long term.
    • Safekeeping of valuable items:g. title deeds, share certificates, jewelry and wills for safe keeping for their customers and they provide safety vaults and lockers and a nominal fee is charged.
    • Provides money transfer facilities: money can be transferred from Nairobi to London via commercial banks. Some employees have their salaries transferred to their accounts from employer’s accounts. This arises mainly through standing orders, credit transfers, telegraphic transfers, cheques, bank overdrafts, letters of credit, credit cards and travelers’ cheques.
    • Provision of foreign exchange/effect foreign exchange payments: a person with foreign currency can convert it into local currency. 13. Provide financial information i.e. giving advice on investment and management of funds – i.e. best shares, saving in a fixed deposit account, as well as information on how to engage in foreign trade.
    • Provide trusteeship (trustee services): banks act as managers on behalf of their clients. The bank also act as a trustee on behalf of a client who dies and there is no person to manage his/her business affairs effectively. Also takes into account property estate
    • Act as guarantors and referees: this usually happens to clients who wish to engage in credit transactions to secure loans from other financial institutions or get goods on credit from new suppliers.
    • Act as intermediary between savers and borrowers: a link is created between savers and borrowers of money and through such a link, economic activities are facilitated.
    • Discounts bills of exchange: banks discount bills of exchange and accept promissory notes from their trusted clients. Discounting a bill means that the bank accepts a bill from its customer and exchanges it for less cash than the amount on the bill because the bill has not yet matured.
    • Provides safer means of payment: commercial banks provide safe and reliable means of payment i.e. cheques, bank overdrafts, credit transfers and other means that are used to make payments.
    • Credit creation: this refers to the process of creating money from the deposits in the customers’ accounts.
    • Helps in financing international trade: i.e. offering mediums of exchanges, promissory notes and letters of credit.
      1. The Central Bank

A Central Bank is an institution established by the government of a given country to manage and control the supply of and demand for money in the country’s economy. It can also be defined as the highest institution in a country’s banking system which regulates and controls the economy financial activity to ensure stability and prosperity.

Objectives of Monetary Control by the Central Bank

  • Facilitate rapid and steady economic growth.
  • Stabilize prices of commodities
  • Ensure balanced development.
  • Enhance equilibrium in balance of payments.
  • Foreign Exchange rate stability.
  • Moop out excess liquidity
  • Control business cycles.
  • Interest rate stability.
  • Financial market stability.

Functions of the Central Bank

  • Issuance of currency: this is usually in notes and coins, in correct amounts to check on inflation.
  • Acts as government’s banks:e. keeps governments accounts, manages government borrowing as well as a financial advisor to the government.
  • Bankers to commercial banks (banks banker):
    • Acts as a custodian of the reserves held by commercial banks.
    • Supervises the operations of commercial banks.
    • Advises commercial banks on financial matters.
    • Offers a central clearing house-this is where banks settle debts due to each one of them which arise from their daily operations.
    • Statutory management during financial crisis.
    • Licensing operations of commercial banks.
    • Repatriation of excess foreign currency/profits on behalf of commercial banks.
    • Acts as a lender of last resort
  • Controlling commercial banks: central bank controls commercial banks and other financial institutions by giving instructions to them on lending procedures and proper banking practices to prevent overexploitation of clients.
  • Lender of last resort: this means that commercial banks may obtain loans from the central bank to meet their daily financial obligations when need arises.
  • Exchange control (maintaining stability in exchange): it is responsible for maintaining a suitable exchange rate between the local currency and foreign official agent to government dealings.
  • Act as link bank to external financial institutions: this facilitates international financial relationships as well as linking financial institutions e.g. the I.M.F with the World Bank.
  • Facilitates clearing of cheques: it facilitates clearing of cheques between different commercial banks through its clearing house.
  • Administering public debt: it is responsible for management and repayment of the debt (internally or externally) when it matures.
  • Implementation of monetary system/policy: this is so as to regulate the economy by using several instruments of monetary policy to either expand economic activities or depress them i.e. O.M.Os, bank rates, cash ratio, margins, deposits, selective credit control and directives.

The Role of the Central Bank in an Economy

  • Spurring economic growth and development: investments being made by savings made by clients and others offered to businesses and individuals as loans.
  • Currency and economic stability: it ensures that the value of a country’s currency is stable in relation to other countries’ currencies.
  • Smooth operation of the money market: short term finances required by businesses by buying or selling securities and bonds
  • Equitable development: it ensures that credit is available to all the sectors of the economy.
  • Regulating and financing banks and other financial institutions: this ensures stability in the country’s economic environment.
  • Regulating money supply: it plays an important role in ensuring that adequate money is available in the economy to ensure expansion of economic activities.

9.5 Non-Banking Financial Institutions

Non-banking financial institutions (NBFIs) are institutions that address themselves to the financial needs of particular sectors of the economy which commercial banks have not been able to cater for adequately. The examples of non-banking financial institutions in Kenya include:

  • Development finance institutions: primary goal is to promote and aid growth and development of commerce and industry in an economy. E.g. the Kenya Industrial Estates (KIE), Industrial Development Bank (IDB) and Small Enterprise Finance Company.
  • Housing finance companies/building societies: mainly involved in financing housing activities and may either put up houses which they sell to individuals and organisations or provide mortgage finance to qualified people who wish to put up their own houses, e.g. H.F.C.K-Housing Finance Company of Kenya, E.A.B.S-East African Building Society.
  • Savings and credit co-ooperatives societies (saccos): they are formed mainly to enable members save and also obtain loans most conveniently and at favourable conditions. Usually formed by people who are engaged in similar activities or are under one employer, e.g. Mwalimu Savings and Credit Cooperative Society, Afya Savings and credit society, Harambee Savings and credit cooperative society
  • Insurance companies and pension funds: they provide finance to commercial organisations as well as to individuals and also assist in creating confidence and a sense of security to their clients, e.g. Kenya National Assurance, N.S.S.F.
  • Long term finance companiesg. I.C.D.C., I.D.G., A.F.C. Finance house and hire purchase firms e.g. D.F.C.K-development finance company of Kenya.

Roles of Non-Bank Financial Institutions

  • They stimulate competition with commercial banks over deposit and other credit markets hence stimulate efficiency in terms of improved services to borrowers in the financial market.
  • They have enhanced the development of financial market through the introduction of great variety of financial instruments e.g. investment deposit account, mortgages deposit account.
  • Offer services beyond the scope of the commercial banks.
  • Through its expansion, it has created an additional vehicle for the more effective execution of the government monetary policy.
  • Helps in purchasing of durable consumer and capital goods through hire-purchase houses.
  • They provide financial advice to their client.
  • Offer credit facilities to risky borrowers at higher rate of interest.
  • Offers financial advice to various individuals and institutions in an economy.
  • Increase employment facilities which leads to full employment due to the increased demand.

Differences between Commercial Banks and non-banking financial institutions

  • Commercial banks provide current accounts, savings and fixed accounts but NBFIs mainly operate savings and fixed deposit accounts.
  • Commercial banks normally provide short and medium term finance while NBFIs provide medium and long term finance.
  • Commercial banks provide finance that is not restricted to any particular activity while NBFIs provide finance for specified purpose
  • Commercial banks provide foreign exchange transactions to their customers while NBFIs do not.
  • Commercial banks are the key participants in money market of an economy-a market for short term loans, bank overdrafts and government treasury bills whereas NBFIs are key participants in capital market-a market dealing with long term finances e.g. bonds and mortgages.
  • Commercial banks are members of clearing house operated by the central bank where banks exchanges cheques drawn against them by their clients whereas NBFIs do not provide cheques to their customers for use in transactions.
  • Commercial banks are usually involved in credit creation activities while NBFIs are not involved in this activities.
  • Commercial banks are used by the central bank to regulate the quantity of money supply in the economy while NBFIs are not under the direct control of central bank and can’t be used to regulate money supply in an economy.
  • Commercial banks operate bank account with the central bank of Kenya which is the bankers bank whereas NBFIs intermediaries do not have this facilities.

The Development of Credit and Debit Cards as Means of Payments

Credit cards usually enables the holder to obtain goods and services on credit from specified suppliers. They also enable the holder to obtain money from specific banks and other specified financial institutions. They are available to adults of approved credit worthiness locally and internationally. The companies offering this cards include; Barclays card, American express, access card and visa card.

Advantages of Credit Cards

  • Enables the holder to get goods and services from specified sellers without paying immediately.
  • Usually convenient to carry around.
  • Enables the holder to get money from specified banks
  • Increases credit rating of an individual.
  • It is safer to carry the card around than to carry cash
  • Some are internationally acceptable.

Disadvantages of Credit Cards

  • To acquire the card the applicant is required to have an established credit record.
  • The holder is charged high interest rate by the card company.
  • It is prone to abuse through fraud.
  • The interest is charged if there is delay in repayment.
  • A minimum age of 18 years is required for one to become a holder.
  • The holder may be tempted to overspend
  • Their use is limited to only specific areas (urban areas).
  • Faces competition from other means of payment e.g. cheques, money orders and postal orders.
  • Only few businesses accept cards.
  • Long procedures are involved in getting the card.
  • The cards can only be afforded by people with high income.