CHAPTER ONE

AN OVERVIEW OF BANKS AND THEIR FUNCTION

1.1. Introduction
Banks have become part and parcel of modern day living. But what is a bank? Bank is an
institution, which deals with money. Bank may be compared to a lake. From one side lot of
money will be flowing into it in the form of deposits and from another side lot of money will be
flowing out of it in the form of loans. Every day many people go to a bank to deposit their
savings and to get some money from the bank. In one word, bank is a market where money is
sold and money is purchased. It may be said that, Banking in its simplest form, is as old as
authentic history. As early as 2000 B.C., Babylonians had developed a system of banks. In
ancient Rome and Greece the Practice of granting credit was widely prevalent. Banking had its
roots in the earliest time in the villages. The village moneylenders, the goldsmiths and the
merchants were men of honesty, integrity and reliability. They therefore, became custodians of
the spare money of the villagers. Thus, modern banks have their ancestors of repute, the
merchants, the moneylenders and the goldsmith. Merchants were men of honor and reputation.
They were honest men in business. These qualities put them distinct and they were regarded as
trustworthy persons. They were persons to whom any could be entrusted for safe custody.
Accordingly, the practice arose for people who had spare money to entrust it to merchants for
safe custody In turn, the merchants issued receipts for such money accepted by them for safe
custody. These receipts were purely acknowledgements of abilities, which the merchants owed
to those who entrusted money to them. These receipts were similar to bank notes and were title
to money and were assets to those who possessed them, just as merchants had to honor all
receipts issued by them. In many ways the origin of capitalism as we see it today lie in the
operation of Italian merchant and banking groups in the 13 th, 14th and 15th century. Italian states
like Lombardy and Florence were dominant economic powers. It is Italian who claim the oldest
bank in the world, Monte dei Paschi of Siena (1472). For long period, Florence was a major
center, As result many coins end up with names based on Florence. Italian bankers had a long
relationship with the British crown. The first banker to lend money in London came from
Lombardy and still London has ‘Lombard Street’ at the hearth of financial area.

Origin of Banks in Ethiopia

Banking is relatively new concept in Ethiopia. The history of banking can be traced back to 1905
with the establishment of Abyssinia bank on 15th February 1906 in the premises of Ras
Mekonnen, the present University campus of Addis Ababa. In the beginning the bank has
suffered major setbacks. It had to pass through difficulty for years together because it was
operating in barter system; the money economy was not yet operating. The banking concept was
unknown to public, the merchant community was a small group, even the king and the
government treasury preferred to hoard rather than to deposit in banks. The bank was not able to
earn profits for a period of eight years, its reported profits for the year 1914 and then its 1919 and
1920. By the end of 1924 it started earning substantial and steady profits. The reasons for poor
performance was basically the economy was not money economy there were three types of
exchanges in operations. Among them barter system was at the local level. For transactions that
involved important commodities, crude media of exchange were used such as bars of salt
(traditionally called amole), bullets, country shells and other related items silver coins called
Maria, Theresa, Thalers were used for significant transactions such as land, finearms etc. In
addition to this societies like the Harari. Amorite and the coastal trading communities used their
own coins or used coins imposed from neighboring countries like the Indian rupee. It is evident
that the overall economy was in primitive stage. In fact, the last quarter of the century witnessed
an increase in foreign trade and modernization, as a result of the policy of the then ruler of the
country. Emperor Menilik II. The idea came up as early as 1890 for discussion to start a bank in
the country on foreign capital or as an affiliation of a foreign bank. In view of other factors, some
how the matter has been pending for a period and the leaders in 1903 have decided to invite the
British government to support the idea of Ethiopian government plans to establish a bank. After
two years the national bank of Egypt, an affiliate of the Bank of England, which was given
monopoly position in banking with regard to other foreign banking companies and other
privileges. It was to set up a bank in Ethiopia to be called the Bank of Abyssinia.

The bank of Abyssinia's headquarter in a new building was inaugurated on 1st January, 1910 and
expansion of branches took place in Harar 1906, DireDawa 1908, and Gore 1912. They never
had Ethiopian qualified staff until their liquidation in 1931.

The liquidation of Bank of Abyssinia

The liquidation of bank of Abyssinia took place in 1931 in order to give the way for the
establishment of first national bank of Ethiopia called the Bank of Ethiopia in August 1931.
Even this was formed with the support of bank itself and National Bank of Egypt. The bank of
Ethiopia was given all the powers and responsibilities of a central bank. This was a national
bank. Modernization of currency was given more priority. Paper notes were used a year after.
The remarkable progress of the bank was made when the country was invaded by the Fascist
Italy in 1935 and left in 1941 leaving the bank in a complete vacuum. However, the Italian
period saw the introduction of Italian banks and insurance companies in the country. The money
economy was further expanded in the five year of rule. Banking and insurance also witnessed
considerable expansion. All this is due to the large investment that the fascist government made
in the infrastructure Building and huge amount of money was spent in the country.

In view of the above, the Imperial regim which was between 1941to 1974 had to start from the
scratch and the banking industry undergone dynamic growth. The exercise of establishing central
bank and designing currency notes as well as formulating a monetary reforms were few sensitive
issues having direct impact on the sovereignty of the country. Emperor Haile Selassie along with
his economic departments, leaders of the state had to move very carefully. Finally, they
maneuvered the British in such a way that without their knowledge a State Bank of Ethiopia was
set up in 1942, and designed a new currency pegged to the dollar. The years following the
liberation of the country Fascist Italians rule were devoted to the rehabilitations of the economy.
This can be observed by the steady expansion of the modern sector of the economy and a steady
growth of the money economy that was the reverse of the last decline of barter.

In 1945, Agricultural Bank was established to help the rehabilitation of the agricultural sector.
Four years later the same was changed as agricultural and commercial bank. On the
recommendation and assistance at the predecessor of the world bank the bank was further
converted in 1951 into the development bank of Ethiopia.

In the year 1963, it was felt in view of the increased operations of State Bank of Ethiopia to
restrict to make it more effective. It was split into the National Bank of Ethiopia and Commercial
Bank of Ethiopia dividing the responsibilities between the two banks. Parallel development took
place in the insurance sector and financial sector specially in banking sector. By the time
revolution broke out there were four commercial banks in operations mainly Commercial Bank
of Ethiopia, (wholly government owned) Addis Ababa Bank (a private bank) Banco di Roma and
Banco di Napoli. In 1975 the provisional Military Administrative Council (Derg Government)
nationalized privately owned financial institutions including three commercial banks and thirteen
insurance companies and two non-banking financial intermediaries. While National Bank of
Ethiopia was retained as a separate institution, all other commercial banks were merged with the
commercial bank through an act. In the recent past several changes took place in banking sector.
Many private banks entered into fray and compete with government banks. At present there are
diferent private banks are in operations they are Dashen Bank, United Bank, Abyssinia Bank,
Wegagen Bank, Awash Bank, Nibe Bank, Lion International Bank(LIB), United Bank ,
Cooperative bank of Oromia and others.

1.2. Meaning of Banking

Bank is an institution, which deals with money. Bank may be compared to a lake. From one side
lot of money will be flowing into it in the form of deposits and from another side lot of money
will be flowing out of it in the form of loans. Every day many people go to a bank to deposit
their savings and to get some money from the bank. In one word, bank is a market where money
is sold and money is purchased.

Functions of Banks
In the modern world, banks perform such a variety of functions that it is not possible to make an
all-inclusive list of their functions and services. However, some basic functions performed by
the banks are discussed below

I. Accepting Deposits: The first important function of a bank is to accept deposits from
those who can save but cannot profitably utilize this saving for themselves. People
consider it more rational to deposit their savings in a bank because by doing so they, on
the one hand, earn interest, and on the other, avoid the danger of theft. To attract savings
from all sorts of individuals, the banks maintain different types of accounts
II. Advancing of loans: The second important function of bank is advancing of loans to the
public after keeping certain cash reserves, the banks lend their deposits to the needy
borrowers. Before advancing loans, the banks satisfy themselves about the credit
worthiness of the borrowers
III. Credit Creation: A unique function of the bank is to create credit. In fact, credit
creation is the natural outcome of the process of advancing loan as adopted by the banks.
When a bank advances a loan to its customer, it does not lend cash but opens an account
in the borrower’s name and credits the amount of loan to this account. Thus, whenever a
bank grants a loan, it creates an equal amount of bank deposit
IV. Promoting Cheque System: Banks also render a very useful medium of exchange in the
form of cheques. Through a cheque, the depositor directs the bakers to make payment to
the payee. Cheque is the most developed credit instrument in the money market. In the
modern business transactions, cheques have become much more convenient method of
settling debts than the use of cash.
V. Agency Functions: Banks also perform certain agency functions for an on behalf of
their customers
VI. General Utility Function. In addition to agency services, the modern banks provide
many general utility services

Banks and Economic Development

In a modern economy, banks are to be considered not merely as dealers in money but also the
leaders in development. Banks can contribute to a country’s economic development in the
following way

1. Capital Formation: Capital formation is the most important determinant of economic

development and banks promote capital formation. Capital formation has three well-
defined stages: (a) generation of savings, (b) mobilization of saving, and(c) canalization
of saving in productive uses. Banks play a crucial role in all the three stages of capital
formation: (a) They stimulate savings by providing a number of incentives to the savers,
such as, interest on deposits, free and cheap remittance of funds, safe custody of
 valuables, etc. (b) By expanding their branches in different areas and giving various
incentives, they succeed in mobilizing the savings generated in the economy.
2. Encouragement to Entrepreneurial Innovations. In underdeveloped countries,
entrepreneurs generally hesitate to invest in new ventures and undertake innovations
largely due to lack of funds. Facilities of bank loans enable the entrepreneurs to step up
their investment and innovational activities, adopt new methods of production and
increase productive capacity of the economy.
3. Monetization of Economy. Monetization of the economy is essential for accelerating
trade and economic activity. Banks help the process of monetization in two ways: (a)
They monetize debts. In other words, they buy debts (i.e., securities which are not
acceptable as money) and , in exchange, create demand deposits (which are acceptable as
money). (b) By spreading their branches in the rural and backward areas, the banks
convert the non-monetized sectors of the economy into monetized sectors.
4. Influencing Economic Activity. Banks can directly influence economic activity on (a)
the rate of interest, and (b) the availability of credit.
(i) Variations in Interest Rates. A reduction in the interest rates makes the investment
more profitable and stimulates economic activity. An increase in the interest rate, on
the other hand, discourages investment and economic activity.
(ii) Availability of Credit. Bankers can also influence economic activity by the
availability of credit. Credit creation is an important function of banks and bank
credit forms the major portion of money supply.
5. Implementation of Monetary Policy. Economic development needs an appropriate
monetary policy. But, a well-developed banking system is a necessary pre-condition for
the effective implementation of the monetary policy.
6. Promotion of Trade and Industry. Economic progress in the industrially advanced
countries in the last two hundred years or so is mainly due to expansion in trade and
industrialization which could not have been made possible without the development of
banking system. The use bank cheque, the bank draft and the bill of exchange has
revolutionized the internal and international trade, which, in turn, has encouraged
specialization and accelerated the pace of industrialization.
7. Encouragement to Right Type of Industries. By granting loans (particularly medium-
term and long term) the banks can provide financial resources to the right type of
industries to secure necessary material, machines and other inputs, In a planned economy,
it is necessary that the banks should formulate their loan policies in accordance with the
broad objectives and strategy of industrialization as adopted in the plan. This will
promote right type of industrialization in the economy.
8. Regional Development. Banks can also play an important role in achieving balanced
development in different regions of the economy. They can transfer surplus capital from
the developed regions to the less-developed regions where it is scarce and most needed.
This reallocation of funds between regions will promote economic development in
underdeveloped areas of the economy.
9. Development of Agriculture and Other Neglected Sectors. Underdeveloped
economies are primarily agricultural economies and majority of the population in these
economies live in rural areas. Therefore, economic development in these economies
requires the development of agriculture and small-scale industries in rural areas. Thus,
Necessary structural and functional reforms in the banking system of the underdeveloped
 countries should be made in order to encourage the banks to play developmental role in
these economies.

1.3. Types of Banks

A classification of financial institutions presents many problems. Banks are different in nature.
Thus differences basically emanates from the differences in their functions in a given country.
Thus, it is very problematic and difficult to have a classification of financial institutions that can
apply to all conditions as economic conditions and financial needs vary from country to country.
Countries dependent on agriculture may establish banks operating in encouraging agricultural
development while others with small-scale industrial structure may find it necessary to have
industrial development banks. In other circumstances, they may be given a general and wider
name of Development banks. Hence, the nature of financial institutions, being shaped by the
general economic structure of a country considered, varies from one country to another.
However, from academic point of view, it is necessary to classify banks on some arbitrarily fixed
common basis. Accordingly, the possible basis for classifying banks into different types could
be their area of financing. Some banks are meant to finance agriculture, other industry and some
other to finance commence in general. Secondly, common to all of them is their dealing with
credits. Most banks receive deposits or borrow money from the public and in turn lend the same
to the public. However in financing different spheres of the economy, some lend money for
short periods while some grant for long periods.

In a broader sense, one can classify banks into two; these who deals with the banks (commercial
banks) and that who deal with financial institution (central bank). Being this is how banks are
classified, central bank posses distinct features from other banks. In general context, Banks can
be classified into various types on the basis of their functions, ownership, domicile etc.
I. Classification of the basis of Functions
(i) Commercial Banks. The banks which perform all kinds of banking business and
generally finance trade and commerce all called commercial banks. Since their deposits
are for a short period, these banks normally advance short-term loans to the businessmen
and traders and avoid medium-term and long-term lending. However, recently, the
commercial banks have also extended their areas of operation to medium-term and long-
term finance. Majority of the commercial banks are in the public sector. But, there are
 certain private sectors banks operating as joint stock companies. Hence, the commercial
banks are also called joint stock banks
(ii) Industrial Banks. Industrial banks, also known as investment banks, mainly meet the
medium-term and long-term financial needs of the industries. Such long-term needs
cannot be met by the commercial banks which generally deal with the short-term lending.
The main functions of the industrial banks are: (a) they accept long-term deposits (b)
They grant long-term loans to the industrialists to enable them to purchase land, construct
factory building, purchase heavy machinery. Etc. (c) They help selling or even
underwrite the debentures and shares of industrial firms. (d) They can also provide
information regarding the general economic position of the economy. (In Ethiopia,
industrial banks, like Development Bank of Ethiopia is playing significant role in the
industrial development of country
(iii) Agricultural Banks. Agricultural credit needs are different from those of
industry and trade. Industrial and commercial banks normally do not deal with
agricultural finance. The agriculturists require (a) short-term credit to buy seeds,
fertilizers and other inputs, and (b) long-term credit to purchase land, to make permanent
improvements on land, to purchase agricultural machinery and equipment, etc
(iv)Exchange Banks. Exchange banks deal in foreign exchange and specialize in financing
foreign trade. They facilitate international payments through the sale and purchase of
bills of exchange and thus play an important role in promoting foreign trade. (In Ethiopia,
these functions performed by selected commercial banks and foreign banks).
(v) Saving Banks. The main purpose of saving banks is to promote saving habits among the
general public and mobilize their small savings. (In India, postal saving banks do this
job. They open accounts and issue postal cash certificates
(vi) Mortgage bank: The main purpose of saving banks is to promote saving habits for
home construction.
(vii) Central Bank. Central bank is the apex institution which controls, regulates and
supervises the monetary and credit system of the country.

II. Classification on the Basis of ownership

 (i) Public Sector Banks: These are owned and controlled by the government. (In
Ethiopia, the Government bank like Commercial Bank of Ethiopia and some of the
Micro Finance Institutions come under these categories
(ii) Private Sector Banks: These banks are owned by the private individuals or
corporations and not by the government. Example: Bank of Abyssinia
(iii) Co-operative Banks: Cooperative banks are operated on the cooperative lines.
(In India, cooperative credit institutions are organized under the cooperative societies
law and play an important role in meeting financial needs in the rural areas
III. Classification on the Basis of Domicile:
On the basis of domicile, the banks are divided into two categories:
(i) Domestic Banks: These are registered and incorporated within the country.
(ii) Foreign Banks: These are foreign in origin and have their head offices in the country
of origin. Example: Western Union Bank, Commerzbank etc