UNIT 2

ETHIOPIAN BANKING SECTOR

2.1. Organization and Structure of Ethiopian Banking Industry

2.1.1. Banks
Banking is defined as the accepting, for the purpose of lending, or investment of deposits, money
from the public, repayable on demand or otherwise and withdraws by cheque, draft, or order.
Thus, we can say that a bank is a financial institution which deals with deposits and advances
and other related services. It receives money from those who want to save in the form of deposits
and it lends money to those who need it. It bridges the gap between the savers and borrowers.
The provision of deposit and loan products normally distinguishes banks from other types of
financial firms. Deposit products pay out money on demand or after some notice.

Deposits are liabilities for banks, which must be managed if the bank is to maximize profit.
Likewise, they manage the assets created by lending. Thus, the core activity is to act as
intermediaries between depositors and borrowers. Other financial institutions, such as
stockbrokers, are also intermediaries between buyers and sellers of shares, but it is the taking of
deposits and the granting of loans that singles out a bank, though many offer other financial
services.

Banks are large and complex organizations. Their clients range from individuals and institutions,
all the way up to the governments and central banks of entire countries. Banks don't produce
physical things. They are not in the manufacturing business. The work they do simply involves
money – their money, their clients' money: borrowing it, lending it, and many other related
activities. The movement of capital handled by banks allows economies to grow and prosper.
Businesses and governments cannot be completely self-sufficient. They need money to operate,
and banks act as intermediaries (like ‘middlemen') between the suppliers of funds and users of
funds.

Banking occupies one of the most important positions in the modern economic world. It is
necessary for trade and industry. Hence it is one of the great agencies of commerce. Although
banking in one form or another has been in existence from very early times, modern banking is
of recent origin. It is one of the results of the Industrial Revolution and the child of economic
necessity. Its presence is very helpful to the economic activity and industrial progress of a
country.

2.1.2. Microfinance Institutions

2.1.3. Saving and Credit Associations

2.2. Functions and Classifications of Banks In Ethiopia

Characteristics of Banks
 Dealing in Money: Bank is a financial institution which deals with other people's money
i.e. money given by depositors.
 Acceptance of Deposit: A bank accepts money from the people in the form of deposits
which are usually repayable on demand or after the expiry of a fixed period. It gives
safety to the deposits of its customers. It also acts as a custodian of funds of its
customers.
 Giving Advances: A bank lends out money in the form of loans to those who require it for
different purposes.
 Payment and Withdrawal: A bank provides easy payment and withdrawal facility to its
customers in the form of cheques and drafts; it also brings bank money in circulation.
This money is in the form of cheques, drafts, etc.
 Agency and Utility Services: A bank provides various banking facilities to its customers.
They include general utility services and agency services.
 Profit and Service Orientation: A bank is a profit seeking institution having service
oriented approach.
 Connecting Link: A bank acts as a connecting link between borrowers and lenders of
money. Banks collect money from those who have surplus money and give the same to
those who are in need of money.
 Banking Business: A bank's main activity should be to do business of banking which
should not be subsidiary to any other business.
Functions of Banks
Banks have to perform a variety of functions. These functions of banks can be broadly divided
into two categories:
1) Primary functions and
 2) Secondary functions.
1) Primary Functions of Banks
The primary functions of a bank are also known as banking functions. They are the main
functions of a bank. Thus the two essential functions that make banks as financial institutions are
accepting deposits from the public and lending.
a) Accepting Deposits
The most important activity of a commercial bank is to mobilize deposits from the public. People
who have surplus income and savings find it convenient to deposit the amounts with banks.
Depending upon the nature of deposits, funds deposited with bank also earn interest. Thus,
deposits with the bank grow along with the interest earned. If the rate of interest is higher, public
are motivated to deposit more funds with the bank. There is also safety of funds deposited with
the bank. These deposits can be of different types, such as: Fixed/Time Deposits, Saving
Deposits, Current Deposits and Recurring Deposits.
1) Fixed/Time Deposits
Fixed deposits or Time deposits are with the bank for a specified period of time and they can be
withdrawn only after the expiry of the said period. The interest rate depends on the time agreed
upon. The longer the maturity period, the higher the interest rate and vice versa. Form the point
of view of safety and interest, fixed deposits are preferable.
2) Saving Deposits
Savings deposits are those deposits received subject to certain restrictions. For instance, the
interest is normally lower on savings deposits; withdrawals may be made once or twice a week.
3) Current Deposits
Current deposit or demand deposits as they often called are those deposits withdraws by the
depositor at any time without any prior notice by means of cheques. The banks do not pay any
interest on demand deposits, but in fact make a small charge on customers with current account.
4) Recurring Deposits
Recurring deposits are those deposits received by the banks in equal monthly premium for a
certain number of years the total of which will be paid to the depositor with interest due thereon
after the expiry of the date of maturity.
b) Granting of Loans and Advances
The second important function of a commercial bank is to grant loans and advances. Such loans
and advances are given to members of the public and to the business community at a higher rate
of interest than allowed by banks on various deposit accounts. The difference in the interest rates
(lending rate and the deposit rate) is its profit. The rate of interest charged on loans and advances
varies according to the purpose and period of loan and also the mode of repayment. The types of
bank loans and advances are: overdraft, cash credits, loans and discounting of bill of exchange.
Loans
A loan is granted for a specific time period. Generally commercial banks provide short-term
loans. But term loans, i.e., loans for more than a year may also be granted. The borrower may be
given the entire amount in lump sum or in installments. Loans are generally granted against the
security of certain assets. A loan is normally repaid in installments. However, it may also be
repaid in lump sum.
Advances
An advance is a credit facility provided by the bank to its customers. It differs from loan in the
sense that loans may be granted for longer period, but advances are normally granted for a short
period of time. Further the purpose of granting advances is to meet the day-to-day requirements
of business. The rate of interest charged on advances varies from bank to bank. Interest is
charged only on the amount withdrawn and not on the sanctioned amount.
Types of Advances
Banks grant short-term financial assistance by way of cash credit, overdraft and bill discounting.
(i) Cash Credit
Cash credit is an arrangement whereby the bank allows the borrower to draw amount up to a
specified limit. The amount is credited to the account of the customer. The customer can
withdraw this amount as and when he requires. Interest is charged on the amount actually
withdrawn. Cash Credit is granted as per terms and conditions agreed with the customers.
(ii) Overdraft
Overdraft is also a credit facility granted by bank. A customer who has a current account with the
bank is allowed to withdraw more than the amount of credit balance in his account. It is a
temporary arrangement. Overdraft facility with a specified limit may be allowed either on the
security of assets, or on personal security, or both.
(iii)Discounting of Bills
Banks provide short-term finance by discounting bills that is, making payment of the amount
before the due date of the bills after deducting a certain rate of discount. The party gets the funds
without waiting for the date of maturity of the bills. In case any bill is dishonored on the due
date, the bank can recover the amount from the customer.

2) Secondary Functions of Banks

In addition to the primary functions of accepting deposits and lending money, banks perform a
number of other secondary functions, which are also called non-banking functions. These
important secondary functions of banks are explained below.

Agency Functions
The bank acts as an agent of its customers. The bank performs a number of agency functions for
its customers in return for a commission. The agency services provided by the banks are:
(i) Transfer of funds – the bank provides facility for cheap and easy remittance of funds
from place to place via instruments such as the demand drafts, mail transfers,
telegraphic transfers, etc.
(ii) Collection of funds – the bank undertakes to collect funds on behalf of its customers
through instruments such as cheques, demand drafts, bills, etc.
(iii) Purchase and sale of shares and securities on behalf of customers.
(iv) Collection of dividends and interest on shares and debentures on behalf of customers.
(v) Payment of bills and insurance premium as per customer’s directions.
(vi) Acting as executors and trustees of wills.
(vii) Provision of income tax consultancy and acceptance of income tax payments of
customers.
(viii) Acting as correspondent, agent or representative of customers as well as securing
documentation for air and sea passage.

General Utility Functions

In addition to agency services, the modern banks provide many general utility services such as:
(i) Locker Facility: Banks provide locker facility to their customers. The customers can
keep their valuables and important document in these lockers for safe custody.
 (ii) Traveler’s cheques: Banks issue traveler’s cheques to help their customers to travel
without the fear of theft or loss of money. With this facility, the customers need not take
the risk of carrying cash with them during their travels.
(iii)Letter of Credit:
(iv) Statistics giving important information relating to industry, trade and commerce, money
and banking. They also publish journals and bulletins containing research articles on
economic and financial matters.
(v) Underwriting Securities: Banks underwrite the securities issued by the government,
public or private bodies (agreeing to partly or fully purchase the whole or the unsold
portion respectively of new issue of securities) and private placement of securities
(selling securities not through the open market, but privately to selected entities)
Because of its full faith in banks, the public will not hesitate in buying securities carrying
the signatures of a bank.
(vi) Acting as Reference: Banks may be referred for seeking information regarding the
financial position, business reputation and respectability of their customers.
(vii) Foreign Exchange Business: Banks also deal in the business of foreign
currencies. Again, they may finance foreign trade by discounting foreign bills of
exchange.
2.3. Regulations of Commercial Banks
Contemporary bank regulations are intended to limit bank failures and to protect bank depositors
from losses stemming from such failures. Numerous other regulations apply to concerns such as
the privacy of bank customers and fair lending practices.

Entry and Branching Restrictions

Historically, many countries restricted entry into the banking business by granting special
charters to select firms. While the practice of granting charters has become obsolete, many
countries effectively limit or prevent foreign banks or subsidiaries from entering their banking
markets and thereby insulate their domestic banking industries from foreign competition.

Interest Rate Controls

One of the oldest forms of bank regulation consists of laws restricting the rates of interest
bankers are allowed to charge on loans or to pay on deposits. Ancient and medieval Christians
held it to be immoral for a lender to earn interest from a venture that did not involve substantial
risk of loss. However, this injunction was relatively easy to circumvent: interest could be
excused if the lender could demonstrate that the loan was risky or that it entailed a sacrifice of
some profitable investment opportunity. Interest also could be built into currency-exchange
charges, with money lent in one currency and repaid (at an artificially enhanced exchange rate)
in another. Finally, the taint of usury could be removed by recasting loans as investment-share
sale and repurchase agreements—not unlike contemporary overnight repurchase agreements.
Over time, as church doctrines were reinterpreted to accommodate the needs of business, such
devices became irrelevant, and the term usury came to refer only to excessive interest charges.

Islamic law also prohibits the collection of interest. Consequently, in most Muslim countries
financial intermediation is based not on debt contracts involving explicit interest payments but
on profit-and-loss-sharing arrangements, in which banks and their depositors assume a share of
ownership of their creditors’ enterprises. (This was the case in some medieval Christian
arrangements as well.) Despite the complexity of the Islamic approach, especially with regard to
contracts, effective banking systems developed as alternatives to their Western counterparts. Yet
during the 1960s and early ’70s, when nominal market rates of interest exceeded 20 percent in
much of the world, Islamic-style banks risked being eclipsed by Western-style banks that could
more readily adjust their lending terms to reflect changing market conditions. Oil revenues
eventually improved the demand for Islamic banking, and by the early 21st century hundreds of
Islamic-style financial institutions existed around the world, handling hundreds of billions of
dollars in annual transactions. Consequently, some larger multinational banks in the West began
to offer banking services consistent with Islamic law.

The strict regulation of lending rates—that is, the setting of maximum rates, or the outright
prohibition of interest-taking—has been less common outside Muslim countries. Markets are far
more effective than regulations at influencing interest rates, and the wide variety of loans, all of
which involve differing degrees of risk, make the design and enforcement of such regulations
difficult. By the 21st century most countries had stopped regulating the rate of interest paid on
deposits.

Mandatory Cash Reserves

Minimum cash reserves have been a long-established form of bank regulation. The requirement
that each bank maintain a minimum reserve of base money has been justified on the grounds that
it reduces the bank’s exposure to liquidity risk (insolvency) and aids the central bank’s efforts to
maintain control over national money stocks (by preserving a more stable relationship between
the outstanding quantity of base money, which central banks are able directly to regulate, and the
outstanding quantity of bank money).

A third objective of legal reserve requirements is that of securing government revenue. Binding
reserve requirements contribute to the overall demand for basic money—which consists of
central bank deposit credits and notes—and therefore enhance as well the demand for
government securities that central bank banks typically hold as backing for their outstanding
liabilities. A greater portion of available savings is thus channeled from commercial bank
customers to the public sector. Bank depositors feel the effect of the transfer in the form of
lowered net interest earnings on their deposits. The higher the minimum legal reserve ratio, the
greater the proportion of savings transferred to the public sector.

Capital Standards
Bank capital protects bank depositors from losses by treating bank shareholders as “residual
claimants” who risk losing their equity share if a bank is unable to honour its commitments to
depositors. One means of ensuring an adequate capital cushion for banks has been the imposition
of minimum capital standards in tandem with the establishment of required capital-to-asset
ratios, which vary depending upon a bank’s exposure to various risks.

Deposit insurance
Most countries require banks to participate in a federal insurance program intended to protect
bank deposit holders from losses that could occur in the event of a bank failure. Although bank
deposit insurance is primarily viewed as a means of protecting individual (and especially small)
bank depositors, its more subtle purpose is one of protecting entire national banking and
payments systems by preventing costly bank runs and panics.

Deposit insurance eliminates or reduces depositors’ incentive to stage bank runs. In the simplest
scenario, where deposits (or deposits up to a certain value) are fully insured, all or most deposit
holders enjoy full protection of their deposits, including any promised interest payments, even if
their bank does fail. Banks that become insolvent for reasons unrelated to panic might be quietly
sold to healthy banks, immediately closed and liquidated, or (temporarily) taken over by the
insuring agency.