Fundamentals of Money and Banking

FUNDAMENTALS OF
MONEY AND BANKING

LEVEL BA/ADC/BS
Code: 1414/8593 Units: 11–9
DPARTMENT OF COMMERCE
ALLAMA IQBAL OPEN UNIVERSITY
ISLAMABD
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COURSE TEAM
Dean Faculty of Social

Sciences & Humanities: Prof. Dr. Shahid Iqbal Kamran
Chairman: Prof. Dr. Syed Muhammad Amir Shah
Unit Writer: Moazzam Ali
Unit Reviewer: Prof. Dr. Syed Muhammad Amir Shah
Typeset by: Muhammad Javed
Editor: Fazal Karim
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COURSE INTRODUCTION
This course is divided in two parts; money and banking. In the first part of this
course, the role and functions of money has been discussed. Money plays the
central role in the modern economic system and used as unit of measurement for
exchange of goods and services. From the ancient times, money has been a
medium of exchange and considered as a source of wealth and power. This course
has been developed by keeping in view the historic role of money together with
its application in the modern economies. The first four units of this course
discusses the various forms of money, value of money, financial markets and
international monetary system. In each unit, the basic concepts for understanding
the role and functions of money have been elaborated with examples.
The second part of this course covers the modern banking system in detail. The
modern economic system largely depends on the banks for the movement of funds
among different economic agents. In this part of the course, following concepts of
banking have been discussed in detail;
i. Basics of banking (forms of banks and credit creation)
ii. Functions of commercial banks (for businesses and individuals)
iii. Bank loans and advances (types and comparative analysis)
iv. Role and functions of the central bank in an economy
v. Growth of banking in Pakistan
The objective of this course is to enable students to understand modern financial

and monetary system. The basic terms of money and banking have been explained
in simple language with examples. This course will fulfill the basic requirements
for understanding the advanced level subjects of finance in higher classes.
Moazzam Ali
Assistant Professor
Course Development Coordinator
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CONTENTS
Page #
Unit-1: Introduction to Money ......................................................................... 1
Unit-2: Value of Money ...................................................................................... 9
Unit-3: Financial Markets ................................................................................ 19
Unit-4: International Financial System ............................................................ 29
Unit-5: Banking ................................................................................................. 39
Unit-6: Functions of Commercial Banks ......................................................... 51
Unit-7: Bank Loans and Advances ................................................................... 63
Unit-8: Role of Central Bank ............................................................................ 77
Unit-9: Growth of Banking in Pakistan............................................................ 89
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UNIT–1
INTRODUCTION TO MONEY
Written By: Moazzam Ali

Reviewed By: Prof. Dr. S.M.Amir Shah
1
CONTENTS
Page #
Introduction ................................................................................................................. 3
Objectives ................................................................................................................... 3
1.1. Introduction to Money....................................................................................... 4
1.2. Forms of Money ................................................................................................ 4
1.3. Functions of Money .......................................................................................... 6
1.4. Qualities of Ideal Money................................................................................... 7
Exercise....................................................................................................................... 8
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INTRODUCTION
Money is one of the outstanding greatest inventions of entire history of mankind. Money
is anything that is generally acceptable as a means of exchange, measure and store of
value. In this unit the concept of money, its characteristics and evolution of money will
be discussed. The development of money has progressed through the following stages,
commodity money, metallic money, paper money, credit money, and electronic money.
The purpose of this introductory chapter is to understand the concept of money and its
evolution stages and the role of money in performance of economic activities.
OBJECTIVES
After reading this unit, you will able;
1. to visualize the concept of money and its functions.
2. to perceive the role and importance of money.
3. to identify the stages of evolution of money
4. to understand the ideal qualities of money
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1.1 INTRODUCTION TO MONEY
The word money is derived from Latin word ‘’Monet’’. Money used in economic
transactions and also serve as medium of exchange. Money can be defined as “Money
can be anything that is generally acceptable as a means of exchange that at the same time
acts as a measure of value.’’ (Crowther)
OR
“Money is anything that is generally accepted in payment for goods and services or in the
repayment of debts”. (Mishkin)
In modern world, money is considered as a basic necessity. The benefit of the discovery
of money is to over comes the problems of barter system in which goods were exchanged
against other goods. As goods were of different quality and quality, a simple unit of
measurement was necessary for conducting the economic transactions. With the help of
money people can make payments. Producers buy raw material, plants and heavy
machinery with the help of money. Government realizes taxes, fees, and fines through
money. Economic growth cannot be possible without use of money.
Money is the backbone of capitalistic economy everyone according to his capacity

engaged in economic activities. Individual who owned money has complete right for
production decisions and consumption pattern. Consumers and producers receive money
income in the form of wages, interest etc. Money is a center of a circle and in capitalist
economy money performs the important function of solving the central problem through
price mechanism.
Features of Money:
1. Medium of Exchange: It is accepted as medium of exchange for the settlement of
economic transactions.
2. Legal Tender: It is used as legal tender for repayment of debts, wages, interest,
profit etc.
3. Pricing: It is used as standard in the development of pricing mechanism for
economic activities
4. Unit of Measurement: It is used as accounting measure for different
services/things.
5. Savings: It is used as a tool to save and store purchasing power for future period.
1.2 FORMS OF MONEY

In old times, people used to rely on their own produce goods for living purposes and were
self-sufficient and there was no need of money at that time. With development of
agricultural societies and better tools, excess production was easy to obtain. For this
excess production, different societies developed various exchange mechanism for
meeting individual needs and barter system was developed. Barter system of exchange of
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goods and service without using any medium of exchange like money in payment system.
Different forms of money used in different countries or regions are discussed below;
1. Commodity Money:
Commodity money is made up of valuable commodity like wheat, goats, etc.
people used these commodities for exchange purpose and fulfill their needs. As
time passed on, people faced many problems due to commodity money like storing
value, durability, divisibility etc.
2. Metallic Money or Coins:

The next step in the evolution of money in payment system is metallic money.
Metallic money is made up of precious metal like gold, silver and copper. Metallic
money was introduced to overcome the problem of commodity money in term of
quality and quantity. There were two kind of metals.
a. Un-coined Metals
Metals were not used as coins but as bullion. This creates the problem of measuring
the weight and value.
b. Coined Metal
After the failure of uncoiled metals, standard coins were created. They had a standard a
weight and value. Problems of un-coined metals are solved by the use of coined metals.
3. Paper Money:
Paper currency is made up of paper and used for payment system and also used as a
medium of exchange. It consists of notes issued by the state or central bank. Paper
money can be;
a. Convertible paper money: It is converted into coins on demand e.g. gold and
silver certificates.
b. Fiat paper money: It is not converted into coins on demand and it is accepted in
transaction at its face value due to its unlimited legal tender.
4. Credit Money or Bank Money:

The next step in the evolution of money in payment system is the credit money. It
means the use of different instrument (cheque) issued by the bank as a medium of
exchange. The advantage of bank money is that they are easy and safe to transport
for payment purpose.
5. Electronic Money:
The next stage in the development of payment system is Electronic money replaces
credit or bank money due to the expansion of technology. Electronic money is
consisting of ATM, debit card, credit card and online banking. People can make
payments and receive money through online banking system and save their time.
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1.3 FUNCTIONS OF MONEY
Money is anything that is widely used as a mean of payments and is generally expectable
in settlement of debts.
s. It is also used in economic transactions or medium of exchange
purpose.
Primary Functions:
1. Medium of Exchange
xchange
Money is used as a medium of exchange and the sale and purchase of different
products can be made through money. It is the most important function of money.
People sell their products for money and use that money to purchase different
products to fulfill their needs.
2. Measure of Value
Money as a measure
sure of value means that money works as a common denomination,
the value of all goods and services are expressed in terms of money. As we
measures weight in kilograms or pounds and distance in kilometers, similarly we
measure the value of money in terms of money.
3. Standard of Deferred Payments

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Money also serves as a standard of payment
payment made after a lapse of time to settle
debts and make investments.
4. Store of Value:
Money is the most liquid assets from all the assets therefore it is easier to store
value in the form of money.
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Secondary Functions:
1. Instrument for Lending:
People save money and deposit it in to banks. The banks advance these savings as
loans to businessmen and earn profit by charging interest.
2. Instrument of Economic Policy:

Money is an instrument of an economic policy of the government. Money is the
powerful factor to achieve growth, reduce unemployment and maintain expansion
of economic activity.
3. Tool to Monetary Management:

Money helps in increasing output and employment. Money is also help in
determining the distribution of wealth among the members of society.
4. Aids to Production and Trade:

Barter difficulties can be solved with the help of money. It helps in the production
of goods and services and facilitates expansion of trade.
1.4 QUALITIES OF IDEAL MONEY
The essential attributes of ideal money are as follows;

1. General Acceptability:
The most essential quality of an ideal money material is that it would be acceptable
as a medium of exchange without any objection by others for goods and services.
2. Portability:
Good money has quality of portability means it can be easily and economically
transported from one place to the other. In other words it possesses high value in
small bulk.
3. Durability:
As money is passed from hand to hand and is kept in reserves it must not easily
deteriorate either in itself or as a result of wear and tear.
4. Homogeneity:
All potions of the substance used as money should be homogeneous that is of the
same quality so that equal weights have the same value. It is essential that its units
are similar in all respects.
5. Divisibility:
The money material should be capable of division and the aggregate value of the
mass after division should be almost the same as before.
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6. Malleability:
The money material should be capable of being melted and given convenient
shapes. It should be neither too hard and nor too soft. It should also possess the
attribute of impressionability.
7. Recognizability:
One of the very much important essential of a good money material is that it should
be easily recognizable by the eye, ear or the touch. It should have certain distinct
marks which nobody can mistake.
8. Stability of Value:
Money should not be subject to fluctuations in value. The value of a material which
is used to measure the value of all the other material must be stable.
Exercise
Q. 1 Give short answer to following questions:
1. Define money.
2. Write the functions of money.
3. What is barter system?
4. Write down the features of ideal money.
Q. 2 Collect the foreign currency notes of at-least five different countries and compare
their features.
References (Books)
1. Financial Markets and Institutions by Anthony Saunders
2. Financial Institution Management by Helen P. Lange
3. Financial Institutions and Markets by Meir G. Kohn
4. Financial Markets and Institutions by Frederic Mishkin and Stanley G Eakins
5. Fundamentals of financial institutions management by Marcia Millon Cornett
6. Money and Banking by M.Saeed Nasir
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UNIT–2
VALUE OF MONEY

Reviewed By: Prof. Dr.S.M.Amir Shah
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CONTENTS
Page #
Introduction ................................................................................................................. 11
Objectives ................................................................................................................... 11
2.1. Value of Money ............................................................................................... 12
2.2. Inflation and its Types....................................................................................... 13
2.3. Remedies for Inflation....................................................................................... 14
2.4. Deflation............................................................................................................ 15
2.5. Stagflation ......................................................................................................... 16
2.6. Depreciation and Devaluation of Money .......................................................... 16
Summary .................................................................................................................... 17
Exercise....................................................................................................................... 17
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INTRODUCTION
In the previous unit, we have discussed the main role of money is to facilitate exchange.
This unit will discuss the value of money and different approaches given by the renowned
economists for its measurement. This unit also discusses the change in the value of
money due to inflation, deflation, and stagflation. The target of this unit is to enable
students to understand the concept of value of money and how it affects our daily life in
buying various products.
OBJECTIVES
The study of this unit, will enable you:
1. to understand the value of money
2. to explain the theories about value of money
3. to understand the concepts of inflation, deflation and stagflation
4. to understand the concept of devaluation and depreciation of money
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2.1 VALUE OF MONEY
Value of money means the purchasing power and capacity to exchange the goods and
services. It refers to the strength of money in the market against which we can buy or sell
something. Money is a type of asset in an economy which is used to buy good and service
and it serve as store value in an economy. In daily life, we can observe that mere increase
in the supply of money does not make us rich rather it hurts the purchasing power of
consumers. To know how value of money is determined, we need to understand the
following theories:
1. Quantity Theory of Money:

The quantity theory of money presented by Irving Fisher is a relationship between
the money supply and the price level. Any change in the money creates an exactly
proportionate change in the price level. As per theory, “Other things remaining
unchanged, on the quantity of money in circulation increases, the price level also
increases in direct proportion and the value of money decreases in direct
proportion.
On the other hand if the quantity of money is doubled, the price level will also be
double and the value of money will be one half. If the quantity of money is reduced
by one half, the level will also be reduced by one half and the value of money will
be twice. It is based on the assumption of full employment in the economy.
2. Cash Balance Approach of the Quantity Theory of Money:

The cash balance approach was developed by the group of Cambridge economists
in England which includes Alfred Marshall. A. C. Pigou, Robertson and J. M.
Keynes. The cash balance approach is differing from the Fishers theory as it
focuses on the store of value of function of money.
According to them, the value of money is determined by the demand and supply of
money for a particular time. People want to hold real income in cash balances for
different reasons i.e unexpected expenditures. The demand for money is that
portion of real income that people wants to hold in money form. Therefore, the
value of money depends on the cash holding requirements in a country.
3. Modern Theory of Value of Money:

Milton Friedman and group of economists of university of Chicago explained the
modern theory of value of money. Milton Friedman said that ‘’the quantity theory
is the theory of demand for money. It is not the theory of output or money income
or price level”. According to Friedman wealth includes the source of income or
consumable services. In Friedman views, wealth can be held in the following five
different forms.
a) Money: It includes currency, demand deposits and time deposits.
b) Bonds: Bonds are defined as a claim for payments that are fixed in nominal units.
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c) Equities: Equities are defined as a claim for payment that are fixed in real units.
d) Physical goods: It includes inventories of producer and consumer goods.
e) Human capital: It includes skills, knowledge and experience possessed by an individual.
According to Friedman the demand for money is a function of the following factors:
a) Rate of returns on shares: if rate of return on shares increases, the demand for
money is decreases and vice versa.
b) Rate of return on bonds: If the rate of return on bonds is increased, the demand
for money is decrease and vice versa.
c) Liquidity: It means how quickly the assets can be converted into cash the liquidity
of assets also affects the demand of assets.
d) Degree of risk: Degree of risk is also affecting demand for an asset.
2. 2 INFLATION AND ITS TYPES

Inflation is an increase in the general price level of the goods and services in an economy
over a period. Inflation occurs when general level of prices and cost are rising. Inflation
arises when money income is expending more than proportionate to income earning
activity.
Inflation can be classified on the following basis:

a. Inflation based on Causes: Inflation can be classified on the basis of causes as:
b. Demand Pull Inflation: Demand pull inflation arises in an economy when the
demand for goods and services is increased but on the other hand supply of goods
and services decreases and the general price level rises. There are many factors that
cause the demand pull inflation:
i. Increase in money supply
ii. Increase in the demand for goods and services
iii. Increase in the income level
ii. Cost Push Inflation: Cost push inflation arises when the cost for production and
operations increases. There are many factors that create cost push inflation:
i. Increase in wages.
ii. Increase in cost of raw materials.
iii. Increase in the cost of important components.
b. Inflation based on Employment: Inflation can be classified on the basis of

employment as
i. Partial Inflation: According to J. M. Keynes, when the general price level
increases partly due to an increase in the cost of production of goods and partly due
to rise in supply of money before full employment stage is called partial inflation.
ii. Full Inflation: It arises when the economy has reached at level of full
employment. Increase in money supply and general price level also increase, but
without any increase in production and employment.
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c. Inflation based on Degree of Control: Inflation can be classified on the basis of
control as:
i. Open Inflation: In open inflation, general price level rises day by day and gets out
of control for the government.
ii. Suppressed Inflation: In this type of inflation government should take steps and
measures to control in the rise in general price level through different methods like
rationing.
d. Inflation based on Rate of Inflation: Inflation on the basis of rate of inflation can
be classified as under:
i. Creeping Inflation: In creeping inflation situation the general price rises with slow
rate. In creeping inflation situation the general price level rises up to a rate of 2%
per annum.
ii. Walking Inflation: During walking inflation situation the general price level is
increased at lesser level as compared to the creeping inflation. On this inflation
situation general price level rises approximately 5% annually.
iii. Running Inflation: In running inflation situation the general price level rises
approximately 8% to 10% annually.
iv. Hyperinflation: Keynes calls hyperinflation as the final stage of inflation that type
of inflation arises after the level of full employment attained, but price level
increases rapidly.
e. Other Types of Inflation:

i. Monetary Inflation: Monetary inflation arises in an economy due to rapid increase
in money supply. If money supply increases in an economy the value of money
falls and the economy faces different problems.
ii. Budgetary Inflation: When government of a country overcome the budget deficit
through lending and insurance of new currency, that behavior increase the
purchasing power and also create rise in the general price level that leads to
inflation.
iii. Profit Induced Inflation: Profit induced inflation arises, when the business in
monopoly position they increase their rate of profit on their production, they may
cause inflation in an economy.
2.3 REMEDIES FOR INFLATION

It is the main duty or objectives of every government to take proper measures and steps to
control the inflation. Two major tools to control the inflation are monetary policy and the
fiscal policy;
i. Monetary Policy:
Monitory policy influences the economy through change of money supply and
availability of credit. Monetary policy is set by the central bank of a country who
adopts following methods to control the money supply i.e.
a. Variation in reserves requirements of commercial banks.
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b. Variation in bank rates for lending.
c. Variation in margin requirements for banks.
d. Credit rationing for allocating capital in various sectors.
ii. Fiscal Policy:

It is the budgetary policy of the government related to the public finance taxes,
borrowing and deficit financing. Fiscal policy states the change in the spending and
taxes to stimulate the economy by the government. The main fiscal measure is:
a. Changes in taxation by lowering tax rates and increasing consumption
b. Public borrowing is curtailed, and funds are saved
c. Control of budget deficit is achieved, and the deficit financing is reduced
d. Adopting a general austerity policy by reducing govt. expenditures
iii. Other Measures:

Some other measures taken by the government to overcome the inflation are as
follows.
a. Control of smuggling as it reduces supply of goods in country.
b. Provisions of subsidies to needy sections of society.
c. Population control to reduce the aggregate demand.
d. Encourage simple living to reduce demand for expensive items.
e. Direct control on the prices of essential items by the government.
f. Encourage Sunday and Friday markets to offer discounts.
2.4 DEFLATION
Deflation is opposite to the term inflation. Deflation is that state of the economy where
the value of money is rising, or prices are falling.
Causes of Deflation:
i. Level of investments decreases negatively affecting the economy as the demand
for goods fall down.
ii. Decrease in the people income also cause deflation in the economy. Due to
reduction in the income level the demand for goods and services decreases that
leads to decrease in price level.
iii. Increase in supply affects demand of goods negatively and the price level falls
down.
Remedies for Deflation:

i. To increase exports for achieving higher incomes and price support
ii. Central bank should reduce interest rate for increasing the level of lending in
economy.
iii. To encourage the private sector investments by giving tax
exemptions/credits/rebates.
iv. To encourage the people for consumption by offering discounts.
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2.5 STAGFLATION
Stagflation is the co-existence of inflation and unemployment. It is a process in which the
economy faces the serious problems at the same time i.e. unemployment and increase in
prices. Stagflation involves inflationary rise in prices and wages at the same time. The
people are unable to find jobs and firms are unable to find customers for what their plants
can produce. is very dangerous for economy then the inflation as output level decreases
and unemployment also decreases.
Causes of Stagflation:
There are many causes that help to create stagflation in an economy. The reduction in the
supply of goods is a main cause of stagflation. When the supply of goods decreases, the
general price level also increases and output and employment level decreases. The
decrease in the supply of goods occurs due to the following factors:
i. Cost of resources is increased due to lesser supply
ii. Shortage of labor due to changes in technology
iii. Rise in taxes especially indirect taxes
Remedies for Stagflation:

i. Encourage development programs especially infrastructure related.
ii. Encourage training programs for labor force.
iii. Reduce taxes on goods and services.
iv. Increase in labor supply and ensure minimum wages
v. Providing raw material at lower rates to the industry
2.6 DEPRECIATION AND DEVALUATION OF MONEY

There are two types of decease in the value of a currency:
i. Devaluation of Currency:
Planned devaluation is come into existence by the government decision to reduce a
relative value of their country currency. Government takes devaluation of currency
against other currencies for the improvement of trading positions.
ii. Depreciation of Currency:
Market driven devaluation does not arise by the government, but it arises due to the
market position. Due to the monetary crises the value of currency automatically
devalued against the other country currencies.
Effects of Depreciation/Devaluation:
Following are the effects of depreciation and devaluation of currency:
i. When the currency is devalued, the imports tend to be more expensive and exports
tend to cheaper.
ii. Devaluation discourages the investors for making investment in that country whose
currency devalued rapidly.
iii. Devaluation makes the country currency less attractive at international level.
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iv. In devaluation exports increases and imports decrease, that make the balance of
payment favorable.
v. The increase in exports and decrease in imports reduced the current account deficit.
Summary:
This unit has discussed the concept of value of money on the basis of two major theories
of finance; quantity theory along with its cash balance approach and modern theory of
value of money. This unit has also described the factors that causes changes in the value
of money; inflation, deflation, devaluation and depreciation of money. The key lesson of
this unit is to understand the value of money that affects the purchasing power of a
consumer. As a consumer, we need to understand the trends in inflation and the
purchasing power of a currency to make correct economic decisions regarding future.
Exercise:
Short Question:
1. What is meant by stagflation?
2. What do you know about the term devaluation of money?
3. Enlist any three types of inflation?
4. What is cash balance approach?
5. Difference between depreciation and devaluation of money.
Long Question:
1. Briefly explain the quantity theory of money.
2. Explain the modern theory of value of money in detail?
3. Describes the devaluation of money in detail.
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References: (Books)
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UNIT–3
FINANCIAL MARKETS

Reviewed By: Prof. Dr. S.M Amir Shah
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CONTENTS
Page #
Introduction ................................................................................................................. 21
Objectives ................................................................................................................... 21
3.1 Financial Assets ................................................................................................ 22
3.2 Financial Markets .............................................................................................. 23
3.3 Differences between Money and Capital Markets ............................................ 24
3.4 Foreign Exchange Rate ..................................................................................... 24
3.5 Trade Cycle ...................................................................................................... 25
Exercise....................................................................................................................... 27
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INTRODUCTION
This unit will discuss the concept of financial assets and financial markets. Within
financial markets money and capital markets play vital role in the financial sector.
Similarly, the exchange rate plays a crucial role in an economy. In this unit, we will
discuss the concept of exchange rate and determination of exchange rate. The theories of
foreign exchange determination and trade cycle will also be discussed in detail.
OBJECTIVES
After reading this unit, you will able to understand;
1. the concept of financial asset
2. the basics of financial markets
3. role of capital market in economy
4. foreign exchange rates and their determination
5. the trade cycles and its determinants
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3.1 FINANCIAL ASSETS
A financial asset is a documentary claim that has a monetary value. In capitalism,
markets offer a mechanism to trade goods and services among the buyers and sellers at an
agreed price. There are many types of markets in an economy; fruits markets, cloth
markets, commodity markets, auto markets etc. The financial market is also a kind of
market that coordinates the activities of all other markets. The financial market is a
mechanism to trade financial assets among the buyers and sellers at a mutually agreed
price. The working in financial market is carried on by the financial institutions, as
mentioned above, to facilitate the buyers and sellers of the financial assets.
There are different types of financial assets traded in financial markets;

i. Shares are the certificates usually bought on a stock exchange that represent the
claim of ownership in a company. The shareholders are entitled to claim of profit
called dividend and they can sale their shares at any time to earn a capital gain.
ii. Bonds are the certificates through which investors provide funds to the businesses
at an interest rate for a specific period. The bonds are issued by companies as an
alternate of shares if they are not willing to share their ownership of business.
iii. Investment Certificates are the term-specific investment tools that offer a periodic
return to their holders and are generally issued by the financial institutions to
finance a specific project.
iv. Commercial papers are short term investment instruments redeemable at maturity
and are purchased by the buyers in order to provide funds to the businesses at an
interest rate.
v. Prize Bonds are financial assets of a fixed value that offer a chance to win a prize
in a lottery. These bonds are redeemable at their original value in case of non-
winning a prize.
vi. Futures are the financial assets that derive their value from an underlying asset
whose price is agreed at present and settlement is made in future.
vii. Treasury Bills are the investment tolls offered by the government for short term
financing requirements that carry an interest rate and are redeemable on maturity.
viii. Trade Notes represent the short-term outstanding amounts payable to the creditors
by a business. These notes can be discounted by the creditors though banks before
maturity or can be used for mutual settlement with another party.
ix. E-Certificates are offered by the modern online form of businesses for investing
funds in their projects. These certificates carry an explicit interest rate or ownership
share claim.
x. Units are the investment tools offered by a mutual fund or another investment
scheme that carry the rights of a unit holder to participate in the profits and gains of
an investment scheme.
xi. Cheque is a modern banking tool that is used to settle outstanding liabilities
through bank accounts. Generally, cheques are not traded but used to clear the
loans and payable amounts.
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3.2 FINANCIAL MARKETS
After going through the various types of financial assets, now, we are able to understand
the working of financial markets. These financial markets can be understood in several
different ways as highlighted below:
i. Classification by Nature of Claim:
a. Debt market is a market where debt instruments like bonds, debentures,
term finance certificates are traded among the buyers and sellers.
b. Equity market is a market where the equity instruments like common
shares, preferred shares etc. are traded among the investors.
ii. Classification by Maturity of Claim.

a. Money market is a market for trading the short-term financial assets like
trade notes, commercial papers, treasury bills etc. in an economy.
b. Capital market is a market where the long-term maturity bearing financial
assets like shares, bonds, certificates are traded among investors.
iii. Classification by Seasoning of Claim.

a. Primary market is a market where a financial asset is offered first time for
trading in the financial system.
b. Secondary market is a market where the trading of financial asset is carried
on after its launching in the primary market.
iv. Classification by Delivery:

a. Cash or spot market is financial market where the financial assets are
traded on spot without involving any reference to future price or delivery.
b. Derivative market is a market that involves the trading of financial assets
whose delivery is expected in future.
v. Classification by Product Type:

a. Commodity market is a type of financial market in which the future
contracts for metals, oil, gas and crops are bought & sold by the investors.
b. Forex market is a financial market that involves the trading of different
currencies of the world in order to earn profit.
c. Equity market is a market where the shares are bought and sold in order to
earn capital gains and dividends.
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3.3 DIFFERENCE BETWEEN MONEY AND CAPITAL MARKETS
Money Market Capital Market
Definition:
Money market used for short term Capital markets are used for long term
borrowings borrowing.
Time period:
Money market lending and borrowing is In capital market lending and borrowing is
for short time one year or less than one made for more than one year.
year.
Instruments:
Commercial papers, Repurchase Stock, shares, debentures, bonds, and
agreement, Certificate of deposit and government securities.
treasury bills
Institutions:
Central bank, commercial bank, National Stock exchange, commercial banks, and
financial institutions. insurance companies etc.
Risk:
In money market risk factor is very small In capital market risk factor is more as
because time period is less than one year. compared to money market the reason
behind this is the time period.
Merit:
Increases liquidity of funds in the Mobilization of saving in the economy.
economy.
Purpose:
To fulfill short term credit needs of the To fulfill long term credit needs of the
business. business.
Return on investment:
Return on money market less as compared Return on capital market is Comparatively
to capital market. high.
3.4 FOREIGN EXCHANGE RATE

Foreign exchange rate also known as FX rate or forex rate is a ratio between the values of
two country currencies. Exchange rate tells the value of domestic currency in terms of
foreign currency. Exchange rate is the price of the currency of a country can be
exchanged for the number of currency of another country. Foreign exchange situation of
a country tells us about the financial position of a country.
Economic experts have developed the theories of exchange rates to explain how the
foreign exchange rate among different currencies is established. There are many theories
for determining the foreign exchange rate and two of these theories are discussed below:
24
i. The Purchasing Power Parity Theory:
The purchasing power parity theory was developed by the Swedish Economist
Gustav Cassel in 1918. Purchasing power parity theory is (PPP) which states that
exchange rate of two currencies are in equilibrium when the purchasing power is
same in each of the two countries. The price level and changes in price level
determine the exchange rate of those countries’ currencies. The purchasing power
parity theory is based on the law of one price. The basic principle of this theory is
that the exchange rate between different countries expresses the purchasing power of
these countries. The change in the price level, means the exchange rate also change.
ii. The Balance of Payment Theory
The balance of payment theory of exchange rate is also known general equilibrium
theory of exchange rate. According to this theory, the exchange rate of a currency
depends upon the demand and supply of that currency in a region or country. The
demand of foreign currency arises from the debit side of balance of payment. It
equals to the payments made to the foreign countries by a country for the
purchase of goods and services. The supply of foreign currency arises from the
credit side of balance of payment. It equals to the payments made by the foreign
countries to a country against sale of goods and services.
The exchange rate is determined by the demand and supply of foreign exchange.
Exchange rate depends upon the debits and credits of a country. If exchange rate falls
below the equilibrium point, it means the balance of payment is unfavorable. On the other
hand, when the exchange rate rises above the equilibrium point it means the balance of
payment is favorable.
Other Factors that Influence the Rate of Exchange:
There are many other factors that influence the exchange rate:
i. Inflation rate affects the value of a currency in an economy thereby affecting the
determination of exchange rates.
ii. Interest rate also has an impact on the level of investments in an economy and
explains the level of investments in an economy. .
iii. Political stability affects the inflows and outflows of investments in an economy.
iv. Recession negatively affects the value of a currency as industrial production and
demand is down.
v. Industrial position: The structure and performance of the industrial sector also
affects the rate of exchange as investments are made or withdrawn on the basis of
economic performance.
3.5 TRADE CYCLE

A trade cycle is composed of periods of good trade, characterizes by rising prices and low
unemployment percentages, shifting with periods of bad trade, characterized by falling
prices and high unemployment percentages.
25
Phases of the Trade Cycle:
There are four phases that involves in the construction of trade cycle .These are as under
i. Recovery.
Recovery is a turning phase in which economy moves toward boom or peak. In
recovery phase the economic activities, gross domestic product and the
employment level increases. This phase attracts the foreigners for making
investments as economy grows rapidly.
ii. Boom or Peak:

The highest level in trade cycle is called boom or peak. This phase began after the
recovery phase. This stage is also known as prosperity stage. During boom period
the production rises rapidly. The economic activities increase to their highest level.
iii. Recession:
The recession phase opens after the ending of boom period. Recession slows down
the economic activities. The level of buying, selling, production and employment is
decreased. The prices of the products rise and wages of the consumers decreases
that leads to decrease in demand. Investors feel hesitation to invest in a country
having recession situation.
iv. Depression:
In this phase, the economic activities fall that leads to decrease in production. In
depression phase, the level of investment decreases sharply, and the employment
level decreases. The demand for consumers and capital goods also falls down that
leads to the lower living standard.
Factors Affecting Trade Cycle:

The theories of trade cycle explain the causes and possible remedies for managing the
trade cycle in an economy.
i. Money Supply affects the trade cycle as the increase in money supply enhances
the buying power of consumers and demand for various products is increased.
However, the decrease in money supply reduces demand and production in an
economy.
ii. Aggregate Demand is the total demand of personal and public goods in a country.
If the income of consumers is rising, then there will be higher demand leading to
the boom period in trade cycle.
iii. Level of Investments: The higher level of investments results in surplus

production that increases the supply in the market. However, a decreasing
investment level moves the trade cycle towards recession period.
iv. Political Situation also affects the future economic events and the investors plan
their production decisions based on political stability in future.
26
v. Uncontrollable Natural Events: Sometimes, earthquakes, epidemic or unusual
flood highly affects the production in an economy and may leads towards the
recession.
Exercise
Short Questions:
1. Define exchange rates.
2. Define money market?
3. What do you know about capital market?
4. Enlist any three financial assets?
Long Questions:
i. Briefly explains the theories for determination of rate of exchange.
ii. What are the financial markets?
iii. Explain in detail the phases of trade cycle.
27
References:
28
UNIT–4
INTERNATIONAL MONETARY
SYSTEM

29
CONTENTS
Page #
Introduction ................................................................................................................. 31
Objectives ................................................................................................................. 31
4.1 International Monetary System ........................................................................ 32
4.2 International Monetary Fund ............................................................................ 32
4.3 International Bank for Reconstruction of Development ................................... 34
4.4 Asian Development Bank ................................................................................. 34
4.5 Islamic Development Bank ............................................................................... 36
4.6 Asian Infrastructure Investment Bank .............................................................. 36
Summary ................................................................................................................. 37
30
INTRODUCTION
International monetary system is a set of internationally agreed rules, conventions and
supporting institutions that facilitate international trade & investments across borders.
This unit will explain the concept of international monetary systems and its functions. As
the global financial system is a broader framework in which the domestic financial
system works, there is a need to understand the working of the international financial
system in order to know the links between the domestic monetary system and the global
financial system. We will discuss the role of international financial institutions i.e IMF,
World Bank, Asian Development Bank, Islamic Development Bank and Asian
Infrastructure Investment Bank.
OBJECTIVES
After reading this unit you will able to;
1. know the international monetary system
2. understand the working and functions of IMF
3. know the working and functions of the World Bank
4. understand the working and functions of Asian Development Bank
5. know the functions of the Islamic Development Bank.
6. know the functions of the Asian Infrastructure Investment Bank
31
4.1 INTERNATIONAL MONETARY SYSTEM
The international monetary system is a set of agreed rules and frameworks that determine
the flow of funds among the different nations. These rules help to set the foreign
exchange rate for different currencies of the world. As the global trade and investments
occurs among different nations, the exchange of one currency against the other requires
setting commonly agreed rules. To overcome this problem, each country has introduced
the foreign exchange rate. Foreign exchange rate help to determine the value of Pakistani
currency with the other countries currency.
There are three types of foreign exchange rate system in the world:
i. Fixed Exchange Rate System:
Fixed exchange rate system is also known as pegged exchange rate system. In fixed
exchange system, exchange rate for currency is fixed by the government of a
country. The basic purpose of adopting this system is to maintain the stability in
foreign trade. In this system value of domestic currency is tied to the value of gold.
This system was based on the gold standards from 1880 to 1913. In this system,
countries value their currency according to the rate of gold.
ii. Floating Exchange Rate System: In flexible exchange rate system, the exchange
rate is determined by the forces of demand and supply of different currencies in
foreign market. The value of national currency is allowed to move freely with
respect to the demand and supply of other currencies. Exchange rate is not
influenced by the government. The value of currency is fluctuated according to the
change in demand and supply of the foreign exchange.
iii. Managed Floating System: In managed floating system, the exchange rate is
determined by the forces of market (demand and supply) and interventions of the
government or central bank. In this system the government and central bank
intervenes in the foreign exchange market to restrict the fluctuation in the exchange
rate within certain limits. This system was adopted by the world since 1971. Many
developing countries re using managed floating system in which central bank
intervenes to guide currency.
4.2 INTERNATIONAL MONETARY FUND

During the early years of the 20th century the world suffered though the great depression.
This happened during 1930 and World War I & II has weakened the international
payments system. In July 1944, 730 delegates from the 44 major countries met at the
Mount washing hotel. The primary purpose of that conference was about the
establishment of an institution that take care of the international finances on the other
hand that institution could help the member countries during any emergency or crises.
The institution will work like a bank.
32
Formation of the IMF:
During the Bretton Wood Conference, a lot of agreements were signed to establish
General Agreement on Tariffs and Trade (GATT), the International Bank for
Reconstruction and Development (IBRD) and the International Monetary Fund (IMF).
The international monetary fund was founded on 27thDecember 1945 by an agreement
signed by the 29 member countries. The IMF started their financial operations on
1stMarch 1947. The establishment purpose of IMF was to give financial assistance and
overcome the crises in any member country. Now the IMF has approximately 188
member countries.
How IMF Works?

The member countries deposit some amount of money as subscription fee. The member
countries are also responsible for the rules and regulations made by the organization IMF.
The basic function of the establishment of the international monetary funds was to help
out those countries that face financial crises. IMF lend loan to these countries on some
low interest policies. The decision making in the IMF is done by the board of governor
considered as general body of IMF. They are responsible for the formation of general
policies of IMF on the other hand the board of executives responsible for day to day
management of funds. For each country in IMF the lending quota depends on the
contribution made by a country, number of votes it has and the maximum limit of
borrowing based on the following points.
Functions of IMF:
i. To Promote Exchange Stability: The IMF has the objective to promote exchange
rate stability and overcome the problems arises in the world trade system.
ii. Borrowing Facility: IMF provides borrowing facility to the member countries. If
member countries face any problem or crises. IMF provides loans according to the
IMF policies and overcome the member countries problems.
iii. Balance of Payment Stability: IMF helps the member nations to eliminate
disequilibrium in the balance of payment by selling and lending foreign currencies
to the member countries.
iv. Technical assistance: IMF also provides technical assistance to the member
countries by providing services of experts to the members of IMF on economic and
financial matters.
v. International monetary cooperation: IMF also helps to establish monetary
cooperation between member countries, and it provides assistance to solve
international monetary problems.
IMF and Pakistan

The Pakistan became a member of IMF in 1956.The basic purpose of IMF was to
maintain the stability of world monetary system. Pakistan has faced many problems i.e.
natural disasters, population growth, deficit budget, more expenditure with respect to
revenue and terrorism issues etc. These issues had created financial issues for Pakistan; to
overcome these issues Pakistan borrow money from IMF. Since joining IMF as member,
Pakistan has taken more than 15 times loans from the IMF.
33
4.3 INTERNATIONAL BANK FOR RECONSTRUCTION AND
DEVELOPMENT (IBRD)
International bank for Reconstruction and Development is also known as the World
Bank. IBRD was established in 1944 and became operational in 1946 as the original
institution of the World Bank group. The IBRD head quarter is in Washington DC, USA
and approximately 15000 staff from the member countries. The structure of IBRD is like
cooperative society that is operated for the benefits of 188 member countries. All powers
of the bank are vested in its board of governors. The board meets annually in annual
board meeting. The board of Governors delegated most of its authorities to the executive
directors and the bank president elected by the executive directors.
Objectives of IBRD:
i. To assist the member countries.
ii. To promote foreign investment.
iii. To promote balanced growth of international trade.
iv. To provide loans for reduce poverty
Membership:
All the IMF members are also members of IBRD. A country to want to hold its
membership must subscribe to the charter of the bank. If any country wants to resigns its
membership that country pay back all loans with interest to IBRD.
IBRD Fund Sources:

i. Member countries contribute according to their Quota in IMF, that contribution is a
source of fund for IBRD.
ii. Sometimes IBRD raises their funds through selling of bonds in the international
capital market and increased their funds.
iii. IBRD advance loans to the member countries and received back loan amount with
interest as well, that also helps IBRD to raise their funds.
IBRD Role in Pakistan:

IBRD has helped Pakistan many times and provided loans and technical assistance for;
i. Poverty reduction
ii. Social development
iii. Infrastructural development
iv. Capacity development of govt. institutions
4.4 ASIAN DEVELOPMENT BANK (ADB)

The Asian Development Bank (ADB) is a regional development bank established on
December 19, 1966 with an authorized capital of 58 billion dollars which is
headquartered in Manila, Philippines. The basic purpose of ADB is to promote social and
34
economic development. The bank has a board of governors, a board of directors, a
president and a vice president.
At the time of establishment 31 members, but ADB now have 67 members of which 48
members are from within Asia and the pacific and 19 outsides. The voting system is
distributed in proportion with member’s capital subscription. At the end of 2014, Japan
holds maximum proportion of share at 15.7%. The ADB lends loan to the member
countries and promote social and economic development
Sources of Finance:
i. ADB raises fund through bond issues in the world capital markets.
ii. Member’s contribution as subscription fee and raises the funds of ADB.
iii. ADB raises fund through lending operation, and the repayment of loans.
Functions of ADB:
i. ADB promote investment in the region of public and private capital for
development process.
ii. It provides loans for economic and social development of the member countries of
the region.
iii. It helps member countries in coordinating their development policies and plans.
iv. It provides technical assistance for the preparation, financing and executive of
development projects and program.
v. It provides financial and technical assistance to member countries for
environmental protection.
vi. It supports public resources mobilization and management to member countries.
vii. It acts as financial intermediary by transferring resources from global capital
markets to developing countries.
viii. It cooperates with the United Nations for getting investment and assistance.
ADB and Pakistan:

ADB remains one of the largest development partners and has provided more than 23
billion dollars in loans and over 531 million dollars in grants. The ADB has helped
Pakistan many times and has provided technical and financial assistance in the following
sectors:
i. Educational sector development
ii. Energy and health sector development and capacity development
iii. Industry and trade development
iv. Information and communication technology
v. Public sector financial and technical management
vi. Social protection and poverty alleviation
vii. Transport and water infrastructure development
viii. Agriculture sector development
ix. Development of capital markets
35
4.5 ISLAMIC DEVELOPMENT BANK (IDB)
The Islamic development bank (IDB) is a multilateral development financing institution
located in Jeddah, Saudi Arabia. It was founded in 1973 by the finance ministers at the
Islamic conference (now called the Organization of Islamic Cooperation OIC) with the
support of the King Faisal of Saudi Arabia and started its activities on 20 October 1975.
There are 56 shareholding member states. In 2013 IDB tripled its authorized capital to
150 billion dollars to better serve Muslims in member and nonmember Countries.
The basic condition for membership is that the member country should be member of
organization of Islamic corporation (OIC), Saudi Arabia holds one quarter of the bank
paid up capital. The purpose of IDB is to foster the economic development and social
progress of member countries and Muslim communities individually as well as jointly in
accordance with the principles of Shariah i.e. Islamic law. The DB has a board of
governors, board of executive directors, president, Vice president and officers and staff.
The purpose of IDB is to foster the economic development and social progress of
member countries and Muslim communities individually as well as jointly in accordance
with the principles of Shariah i.e. Islamic law. The DB has a board of governors, board of
executive directors, president, Vice president and officers and staff.
IDB Groups
IDB has group of five entities;
i. Islamic Development Bank (IDB)
ii. Islamic Research and Training Institute. (IRTI)
iii. Islamic Corporation for Development of the Private Sector. (ICD)
iv. Islamic Corporation for Insurance of Investment and Export Credit (ICIEC)
v. International Islamic Trade Finance Corporation. (ITFC)
Functions of IDB:
i. To invest in economic and social infrastructure projects in member countries.
ii. To provide loans to private and public sector for the financing of productive
projects.
iii. To assist in the promotion of foreign trade.
iv. To provide technical assistance for economic growth in members countries.
v. To conduct operations according to the principles of Shariah i.e. Islamic law.
vi. To corporate with all international institutions having similar purpose.
vii. To participate in the productive projects in the member countries. To promote
savings and investments.
4.6 ASIAN INFRASTRUCTURE INVESTMENT BANK (AIIB)

The Asian Infrastructure Investment Bank (AIIB) is a multilateral development
bank that aims to support the building of infrastructure in the Asia-Pacific region The
bank was proposed by China in 2013 and the initiative was launched at a ceremony in
36
Beijing in October 2014. Presently it has 102 members and headquarter of the bank is in
Beijing. The bank started operation after the agreement entered into force on 25
December 2015, after ratifications were received from 10 member states holding a total
number of 50% of the initial subscriptions of the Authorized Capital Stock. The
Authorized Capital Stock of the bank is 100 billion US Dollars, divided into 1 million
shares of 100 000 dollars each. The allocated shares are based on the size of each
member country's economy (calculated using GDP Nominal (60%) and GDP
PPP (40%)), whether they are an Asian or Non-Asian Member, and the number of shares
determines the fraction of authorized capital in the bank. The ‘One Belt One Road’
program of China
Functions of the AIIB:

i. Development of physical infrastructure in emerging economies
ii. Financing for large scale investment projects in low to medium income countries
iii. Enhancing trade and bilateral cooperation among member countries
iv. Development of modern technological networks for emerging economies
v. Providing equity and debt support for large scale infrastructure projects
AIIB and Pakistan:

Pakistan has been a traditional ally of China and the establishment of AIIB has further
strengthened this bond. The AIIB has provided financing for the following projects:
i. Development of Motorways
ii. Development of Hydro Power Plants
There are many other areas for cooperation in the AIIB framework for social and
economic development of Pakistan. Many other infrastructure related projects are funded
by China in Pakistan through debt and equity investments besides AIIB financing.
Summary
International monetary system binds together different nations to settle their transactions
as per commonly agreed rules. The IMF has mandate to facilitate member countries in
addressing their foreign exchange issues and balance of payments crises. The
International Bank for Reconstruction and development (IBRD) has been explained.
IBRD is established in 1944 and operational in 1946 as the original institution of the
World Bank group. Asian Development Bank (ADB) is a regional development bank
established on December 19, 1966 with an authorized capital of 58 billion dollars which
is headquartered in Manila, Philippines. The basic purpose of ADB is to promote social
and economic development in low income countries of Asia. Further the role of IDB and
AIIB has been explained to improve the understanding of students on multilateral bodies.
Short Questions:
i. What do you know IMF?
ii. Write three objectives of IBRD.
iii. Differentiate between AIIB and ADB.
iv. Write any three functions of IDB.
37
Long Questions:
1. Briefly explain IDB.
2. Briefly explain the organizational structure of ADB.
References: (Books)
References (Websites):
1. IMF Website www.imf.org
2. World Bank Website www.worldbank.org
3. ADB Website www.adb.org
4. AIIB Website www.aiib.org
38
UNIT–5
BANKING

39
CONTENTS
Page #
Introduction ................................................................................................................. 41
Objectives ................................................................................................................. 41
5.1 Introduction to Banking .................................................................................... 42
5.2 Evolution of Banking ........................................................................................ 43
5.3 Kinds of Banking .............................................................................................. 44
5.4 Credit Instruments ............................................................................................. 46
5.5 Credit Creation .................................................................................................. 48
5.6 Role of Banking in Economic Development .................................................... 48
Summary ................................................................................................................. 49
Exercise ................................................................................................................. 49
40
INTRODUCTION
A bank is a financial institution that accepts deposits and lends advances and provides
other related services. Banking sector plays very important role in the development of a
country. In this unit, the concept of banking, evolution of banking and characteristic of
banks will be discussed. Broadly speaking, banking system is a chain of financial
institution that provides financial services accepting deposits and lending to individual
and institution. Banks are divided into different kinds according to their functions they
perform. Banking system plays the role of an intermediary between the ones saving and
the ones who borrow money for investments.
OBJECTIVES
The study of this unit will therefore enable you;
1. to understand the banking and its core concepts
2. to recognize stages of evolution of modern banking system
3. to know the different kinds of banks.
4. to explain the role of banks in economic development
5. to know the concept of credit creation and credit instruments
41
5.1 INTRODUCTION TO BANKING
The banking system is a lifeline of an economy and as it plays very important role in the
development of any country. Banking sector have a significant influence in supporting
economic development through financial services. A bank is an institution which accepts
deposits and lends advances. It accepts deposits from general public and institutions and
lend money to the eligible investors for productive purposes. Protection of deposited
money of people is the major responsibility of banks.
A general definition of a bank is “Bank is an institution which gets loans to lend and, in
this way, creates credit”.
A bank is an intermediate party between the borrower and lender. It borrows from one
party and lends to another”.
Generally, a bank performs the following functions:

i. Acceptance of deposits.
ii. Advancement of loan.
iii. Issues and pays cheque.
iv. Transfer money from one place to another.
Banking plays an important role in economic growth of any country. Major Development
for a country depends on banking sector as bank maintain the currency value and stability
of foreign exchange. People trust banks and deposit their surplus money in bank accounts
which banks used it for investment and making loans to needy.
Functions of Bank:
i. Acceptance of deposits:
Banks accepts money from the people in the form of deposits which are usually
repayable on demand and pays interest on deposited money after specific time
period.
Advancing money:
The funds collected as deposits are then given as loan to the businesses and
individuals as per their requirements.
ii. Agency Services:

The agency services include transfer of funds from one account to another, regular
periodic payments, collecting cheques, managing investment accounts etc. The
banks charge fee to their clients for performing these services.
iii. Utility Services:

The utility services offered by a bank include services accepting utility bills
payments, Govt. dues acceptance, distributing govt. prescribed funds etc.
42
Banks are useful in following ways:
i. Money deposits in banks is safe and other precious good and documents in bank
locker.
ii. Banks provide credit facilities to needy people.
iii. Bank encourage the habit of saving by offering interest against deposited money.
iv. Bank provides safe way of transferring money from one place to other.
v. Foreign trade constantly increases through banks.
5.2 EVOLUTION OF BANKING

Different banking experts have different opinion about the beginning of word “Bank’’.
The word bank is derived from Italian word “Banque’’. Whereas German experts says
that it is originated from German word “Back” It denoted to a bench for keeping, lending
and exchange of money or coins in the market place by money lender and money
exchangers. The Bank of Venice in 1157 was the first public banking institution. The
Bank of Barcelona was established in 1401.
There are three stages of evolution of banking:

i. Merchants:
Merchants were first inventor of the banking system as they were considered as
trustworthy and responsible people because of their strong financial background
and repute of dealings in money. In 14thcentury, Italian traders emerged in the
business of lending money to people on interest basis. Due of their fair dealings
and financial position, even the king can borrow money from them. With the
passage of time their business expended and they begum to give written
acknowledgment against which people withdraw money from friends or any agent
of merchants.
ii. Goldsmiths:
The next stage in the evolution of banking system was goldsmith who were also
considered as the trustworthy people due to their strong financial position and
heaving safe places or strong iron safe for the safety of valuable metals. Because of
these safety measures, people keep their metals like (gold, silver) with them. Most
of deposits with them rested idle and needy people requested them for money on
interest basis. Goldsmith started lending money to the needy people against interest
and with the passage of time they issued written receipts to depositor to get their
valuable back. These receipts are transferred from one to another for the settlement
of different transactions. The modern type of that receipt is now called cheque.
iii. Money Lenders:

The next stage in development of banking system was money lenders who lend
their excess money or own resources to the people who need money by charging
interest against loan. Initially, they started lending with their own capital but with
the expansion of business they started borrowing money from those who have in
excess at lower interest rate and lend to those who need it at high interest rate.
43
Gradually, this practice evolved over the time and shaped the modern form of
banking as present today.
5.3 KINDS OF BANKS

With the increase in population and people interest in banking sectors the banks perform
many other different functions to facilitate different economic sectors. By increasing
demand of banks, it becomes difficult for banks to perform all functions properly. So,
banks were divide into different types based on their functions:
Kinds of Banks
Consumer Bank Industrial Bank
Saving Bank Commercial Bank
Mortgage Bank Saving Bank
Agricultural Bank Exchange Bank
Central Bank Cooperative Bank
i. Central Bank:
Central bank does not deal directly with general public but acts as regulator of
other bank. Its main function is to regulate the monetary policy and to control the
working of all commercial bank for the proper regulation of monetary and
economic policy. A central bank has sole authority of issuing currency.
ii. Commercial Bank:

A commercial bank main objective is to earn profit by lending to the eligible
businesses. Bank receives deposits from people and pay interests and lends
apportion of those deposits to the people who need it and charge high interest.
Commercial banks also perform functions like collecting cheque, safe locker,
transfer of money.
iii. Exchange Bank:

Exchange bank provides foreign exchange to importers and exporters of country.
Main functions of exchange bank are as: discounting of foreign bills, helping
import and export trade and transfer of money from one country to another.
44
iv. Industrial Bank:
These banks are established for the promotion of industrial sector of country.
Provide loan for the setup of new industries or the extension of already existing
industries. Industrial development bank of Pakistan (IDBP) is an example of the
industrial banks in Pakistan.
v. Mortgage Bank:
These banks provide financing for buying property i.e. houses, flats, shops, etc. on
installment basis and charge interest on them. House Building Finance Corporation
(HBFC) is the major example of mortgage bank in Pakistan.
vi. Investment Bank:

Investment banks are a bank which deals in sale and purchase of securities and
financing long term projects against higher interest rates. These banks work mainly
in the capital markets for facilitating customers for buying securities.
vii. Agriculture Bank:

Agriculture banks are formed for the development of agriculture sector by
providing finance for the purchase of machinery and other tools. Zarai Tarqiati
Bank of Pakistan is working as agricultural bank in Pakistan.
viii. Consumer Bank:

It is the modern form of bank. It provides loan for purchase of consumer goods.
The basic purpose is to provide short term loans for basic consumer goods i.e.
electronics items.
ix. Foreign Bank:

Foreign bank are owned by foreign based shareholders and they provide services in
another country.
x. Domestic Bank:
These are owned by local shareholders and provide services in their own country of
origin as commercial or other type of bank.
xi. Saving Bank:

These banks are established for collecting saving through collection of money that
is lying idle with people. Directorate of National Savings is working in Pakistan on
this pattern for promoting savings.
xii. Cooperative Bank:

These banks are formed to facilitate the small formers or workers to increase their
income level. Usually, governments support these types of banks by providing
subsidized credit.
45
5.4 CREDIT INSTRUMENTS
Credit instrument is a document which is used as an evidence of debts. It is issued to
meet the deficiency of money, because currency money and metallic money are not
enough to meet the modern business requirements. It provides a written proof for future
references and acts as money for buying and selling purposes. It may specify the payment
process and parties involves in it. Cheque, bill of exchange, and bank draft etc. are used
as credit instruments.
Features of Credit Instruments:

i. It is a written evidence of transaction
ii. It is used as a substitute of money
iii. It should be unconditional
iv. It reduces risk of theft.
v. Credit instruments facilitates large size trade.
Cheque:
Cheque is a credit instrument used in the banking system. It is a form of money through
which payments can be made to other parties thorough the banks. Banks issue cheque
books to their customers for using them instead of dealing in cash.
“Cheque is a bill of exchange drawn on a specified bank and not expressed to be

payable otherwise than on demand’’
Parties to a Cheque:
Drawer: A drawer is the person who draws cheque upon a bank. He is account holder of
the bank who uses a cheque to withdraw amount from its accounts. The one who sign the
cheque is drawer who directed the bank to pay certain amount.
Drawee: A drawee is the branch of bank upon which cheque is drawn for payment. It is
the party to whom customers order to pay specific amount in the name of person written
on cheque or to the bearer of cheque.
Payee: A payee is the person who receives the payment from bank against cheque. He
might be drawer itself or any third party whose name is written on cheque. Other parties
involved in cheque are;
Holder: Holder is the person who has legal authority to receive amount of cheque. This
person may be bearer or any other party.
Endorser: Endorser is the person who transfers the rights of a cheque to other, transfer of
rights is also called endorsement.
Endorsee: An endorsee is that person to whom endorser transfer the rights of cheque.
46
Elements of Cheque:
i. Name of bank is written on the cheque.
ii. Cheque number is printed on the cheque in a series.
iii. The name of the person to whom cheque is to be paid is written on it. If cheque is
drawn by account holder itself, it should be write self.
iv. Date should be mentioned on cheque
v. Amount to paid write in figures and in words clearly.
vi. Account number is also printed on the cheque.
vii. At the end name of account holder is written where drawer sign the cheque.
Requirements of a Valid Cheque:

i. Cheque must be in written form. An oral order cannot be constituted by bank.
ii. A cheque should be drawn on specified branch with whom drawer has account.
iii. Cheque cannot be payable conditionally. It should be unconditional to pay a certain
amount written on cheque.
iv. Cheque cannot be accepted without signature of account holder and date.
v. Validity period of cheque must be checked as postdated cheque cannot accepted by
bank.
vi. The drawer must direct the bank for the mode of payment, i.e. by making the
cheque ‘’bearer’’, ‘’crossed’’ or ‘’order’’.
Types of Cheque:
There are four basic kinds of cheque.
i. Order Cheque:
Order cheque is payable to particular person. The name of payee must be clearly
written on cheque. The order cheque is only paid by bank to payee if the bank is
satisfied about the identity of payee.
ii. Open Cheque:

Open cheque is one against which cash is receive over the customer. The holder of
cheque can receive payment of transfer to any third party by signing on the back of
the cheque.
iii. Bearer Cheque:

Bearer cheque is the cheque which is paid to the bearer of the cheque. A bearer
cheque does not need endorsement.
iv. Crossed Cheque: Holder of crossed cheque cannot enchased at counter of the
bank. The payment of crossed cheque is only made by credited the amount in the
account of payee whose name is written on cheque. Two parallel lines are drawn
across top left corner of the cheque.
47
5.5 CREDIT CREATION
Credit creation is the major function of a commercial bank. A bank can create credit by
advancing loans to a person and it results in increase in money in circulation. Usually, a
bank acts as a factory for the manufacturer of credit in a modern economy. The process
of credit creation is the central pillar of modern economies and therefore banking has got
a key position in the modern economic system. Without credit creation through banks,
the economic transactions in a modern economy will be reduced by at-least 70%-80%.
Methods of Credit Creation:

i. By Loan: Bank provides loan facility to customer against securities. Bank do not
provide loan in form of cash. It open account in the name of customer cannot draw
money by itself only it may issue cheque to other person for payment who may
deposit the cheque in his account through which process of credit creation starts.
ii. Discounting of Bills: Banks creates credit through discounting of bills of
exchange. When bank discount bill it credits the amount in customers account who
draws through cheque. Through these measures banks creates deposits equal to bill
amount.
iii. Through Investment: A bank creates credit by making investment by purchasing
government securities and payment is made through cheque to central bank. Every
cheque deposited in a bank enables it to create more credit.
5.6 ROLE OF BANKS IN THE ECONOMIC DEVELOPMENT

i. Capital Accumulation:
Banks plays important role in capital accumulation which is important for
economic development of a country. They mobilize the saving of people from all
over the country and made it available for businesses for productive use.
ii. Channelizing Funds for Productive Use:
Banks invested the save amount for productive purpose. Capital accumulation is
not the only function of commercial bank. Accumulated saving should be
distributed among different sectors of economy with a view to increasing the
productive capacity of country.
iii. Development of Agriculture and Industrial Sectors:
Bank provides loan for purchase of machinery, modern tools, fertilizers and
pesticides etc. which makes the economy self-sufficient of food. Moreover,
commercial banks also provide loam to industrialists resulting in increase in
economic development.
iv. Market Expansion:
Generally, businessmen lack funds for investing in new and risky enterprises.
Banks provides short- and long-term loans to entrepreneurs to invest in new market
and use modern technology.
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v. Level of Employment Increase:
A country economic development depends on the promotion of trade, agriculture,
industrial and communication sectors. Bank finance these sectors through
investment and it automatically generate employment opportunities.
vi. Promotion of Foreign Trade:

Foreign trade is an important element of economic development. Commercial bank
helps businessmen of two countries to do work with each other, i.e. letters of credit
and banks discount foreign bills of exchange and issue LOC.
Summary
Banking sectors plays an important role in growth and development of an economy by

providing funds to businesses and companies. Modern banking is evolved from different
stages of evolution as merchants, money lender and goldsmiths have acted as banks in the
past. A modern bank is an institution which gets loans to lend and, in this way, creates
credit. Banks are of different types and cater to the diverse segment of economy by
developing profitable savings and investment schemes.
Exercise:
Question No.1: Short questions:

1. What are the commercial banks?
2. What is an investment bank?
3. Define credit creation.
4. What is a cheque?
Question No.2: Long questions:

1. Detailed note on Evolution of Banking system.
2. Discuss in detail the concept of cheque.
49
References

50
UNIT–6
FUNCTIONS OF
COMMERCIAL BANK

51
CONTENTS
Page #
Introduction ................................................................................................................. 53
Objectives ................................................................................................................. 53
6.1 Functions of a Commercial Bank ...................................................................... 54
6.1.1. Primary Functions ............................................................................... 54
6.1.2. Secondary Functions ........................................................................... 56
6.1.3. General Functions ................................................................................ 56
6.2 Bank Accounts .................................................................................................. 57
6.2.1. Types of Banks Accounts .................................................................... 57
6.2.2. Procedure for Opening of Accounts ..................................................... 57
6.3 Banker Customer Relationship ......................................................................... 58
6.3.1. Rights and Duties of Customer ............................................................ 59
6.3.2. Rights and Duties of Banker ................................................................ 59
6.3.3. Nature of Banker-Customer Relationship ........................................... 59
6.3.4. Kinds of Bank Customers .................................................................... 60
Summary ................................................................................................................. 61
Exercise ................................................................................................................. 62
52
INTRODUCTION
A commercial bank is a financial institution that is authorized by law to accept deposits
from businesses and individuals and lend money to them. The commercial baking is the
backbone of economy. Different types of accounts are offered by bank to attract
customers by offering attractive interest rates and saving schemes. They also perform
different services provides such as receiving money, advancing loan, and other agency
services on behalf of customer. Credit instruments are used instead of money like cheque,
bill of exchange and promissory note for the settlement of transactions in the commercial
baking. Generally, regarded as the central pillars of modern economy, commercial banks
are vital for economic growth and development.
OBJECTIVES
After reading this unit you will able;
1. to understand commercial banking and its scope
2. to know the functions of commercial banks
3. to know the different accounts offered by the commercial banks
4. to understand rights and duties of banker and customer
53
6.1 FUNCTIONS OF COMMERCIAL BANKS
Commercial banks receive money from those who have surplus and lend it to those who
need them. The role of commercial banks is to provide financial intermediation services
to general public and business, ensuring economic and social stability of the economy. In
this respect, "credit creation" is the most important function of commercial banks. While
advancing loan to a customer, they do not provide cash to the borrower.
borrower. Instead, they
open a deposit account from which the borrower can withdraw. In other words, while
sanctioning a loan, they automatically create deposits, known as a "credit creation from
commercial banks". The central
entral bank is responsible for the oversight of the commercial
banking system of their respective countries. They will impose a number of conditions on
the banks that they regulate such as keeping bank reserves.. In Pakistan there are many
commercial bank e.g. National bank, Habib bank, Bank of Punjab, United ba bank, Allied
Bank etc. (A complete list is given at the end of the unit.)
6.1.1 Primary Functions: Primary functions of commercial banks are as follows;
Accepting Loans (Deposits):

(Deposits)
The primary function of commercial bank is receiving funds from people who have
surplus money but do not use it for production purpose. Bank accepts money and pay
interest to the depositors.. It attracts the saving of people by offering different types of
accounts and schemes. A commercial bank usually receives funds from general public
and businesses in the following way;
i. Current Account: Current account is suitable for business, because withdrawal

and deposits are made at any time without any limit. Usually
Usually bank does not pay
interest on current account. Account holder receives cheque book and bank
54
statement on annual or semiannual basis which shows the details of deposit and
withdrawal during specific period.
ii. Saving Account: People with excess money deposit their money in saving
account. Bank pays interest on saving accounts. However, the banks normally
restricted account holder on their withdrawal. Zakat is deducted from saving
account.
iii. Fixed Account or Term Deposits: In fixed account money is deposited for fixed
time period. People who want to deposit their excessive money for long period
prefer the fixed account. Terms and condition and time period decided at the
beginning to avoid any misunderstanding.
iv. Recurring Deposits:

The commercial banks allow businesses to deposit and withdraw funds
continuously throughput the year as per their needs in order to meet their financing
needs.
Advancing of Money: Bank receives deposit to lend it to the businesses and individuals
who want to fulfill their financing needs. Advancing money is more important function as
the strength of a bank is judged through soundness of its advances. Bank demands
different kinds of securities against loan i.e. shares, documents of property, gold, or
silver. The advancing of money may be in following ways;
i. Call Loans:
Call loans are the loans which can be recalled or demanded by the bank at any
time. Call loans are mostly advanced to those who have strong financial position.
Usually the time period of call loan is seven to fourteen days.
ii. Short Term Loans:

Short term loans are issued to meet day to day needs and requirements of
businesses for the period of thirty to ninety days.
iii. Long Term Loans:

Long term loans are issued for the purpose of making investment or purchase of
assets. Time period for long term loan is three to ten years under some conditions.
iv. Overdraft:
An overdraft is the extension of credit from bank to its customer when an account
is reached at zero balance. Overdraft means that banks allow its customer to borrow
a set amount of money. The interest is charged only on the negative balance which
the customers’ deposits back in time.
55
v. Discounting of Bills:
Banks provide loan to their customer by discounting their bills before the date of
maturity. Discounting the bills means bank accept bills as a security of loan by
deducting nominal amount as discounting charges from the total amount in order to
make payments.
6.1.2 Secondary Functions
Agency Services:
i. Transfer of Funds:
Banks helps its customer by transferring funds many from one place/person to
another with the help of credit instruments like cheques, drafts, mail transfer,
telephone transfer etc.
ii. Cheque Collection:

Commercial bank collect cheques, bills, dividend, promissory notes, rents and
other receipts on the behalf of their customer and make payment like insurance
premium, rent according to instructions of customer.
iii. Facilitation of Foreign Trade: Central bank authorizes some commercial bank to
deal in foreign exchange. Commercial bank sale and purchase foreign exchange on
behalf of customer which is helpful for promotion of international trade.
iv. Periodic Payments:

Banks receive and pay various periodic payments like salaries and pensions on the
instructions of their clients as per the agreed terms and conditions.
6.1.3 General Functions:
Utility Services:
i. Locker Facility:
Commercial bank provides locker facility to its customer for safe custody of
valuable, documents, gold, and silver. Bank charge commission against locker
facility.
ii. Draft:
Commercial bank provides the facility of traveler’s cheques to their customer to
avoid the risk of taking cash with them. Bank also issue Letter of credit which is a
security and surety of making payments to foreign traders by bank.
iii. Underwriters:
Commercial bank acts as an agent for sale and purchase shares & securities on the
behalf of its customer and charge nominal commission for its services.
56
iv. Govt. Services:
Banks also perform numerous other services that include accepting Govt. dues,
utility bills collection, Hajj applications collection, accepting tax payments etc.
6.2 BANK ACCOUNTS

Bank accounts refer to a financial arrangement between an account holder and a bank.
People put their money in their accounts for different purposes and banks use deposits for
investment purpose or for loan making. Depending on the duration of deposits and the
terms and conditions attached with an account, a commercial bank can open various types
of personal and corporate accounts to provide services to different persons.
6.2.1 Types of Bank Accounts
Saving Account: Saving account are suitable for salaried person. It is an interest-bearing
account. Banks may limit the number of withdrawals from saving account.
Features:
i. Account holder can use cheque for the withdrawal of money.
ii. Bank pays profit after every six months.
iii. Bank issued passbook and cheque book.
iv. Zakat is deducted on saving account.
v. Certain withdrawal rules are determined by bank on saving account.
vi. Bank issued statement of account after regular interval.
Current Account: Current account is also known as running account. Current account is
generally suitable for businessmen because they withdraw money without notice. It is an
active account for frequent deposit and withdrawal by cheque.
i. Current account is suitable for businessmen.
ii. It is open with minimum amount fixed by bank.
iii. Cheques are used to withdraw money.
iv. There is no restriction of withdrawal.
v. Bank does not pay profit on current account.
vi. Overdraft facility is provided to current account holder on interest.
vii. Zakat is not deducted.
Fixed Deposit Account: The person who has surplus money for long period can deposit
it in fixed account. Banks offer high rate of interest on deposited amount. Amount can
only be withdrawn after maturity of fixed date.
i. It is suitable for people who have surplus money for long period.
ii. The amount deposited remains fixed for maturity period.
iii. Term deposit receipt issued to customer who contain amount and terms of deposit.
iv. Bank pay higher rate of interest as compared to other schemes.
v. Further deposits are not allowed amount is deposited and withdrawn only once.
57
Business Accounts: These accounts are offered to the corporate customers for providing
them various agency and facilitation services. Depending on the terms and conditions of
various schemes, business accounts can be customized as per the needs of individual
corporate customers to provide them better services. As corporate customers provide high
amounts to the banks, extra care and services are provided to these customers.
6.2.2. Procedure for Opening of a Bank Account:
i. Selection of Accounts: There are different types of accounts. People open accounts
according to their needs, current account, fixed term account or saving account.
ii. Getting Application Form: Printed form is issued by bank to customer for
account opening. It is different for different accounts. It contains following.
a. Name of the bank.
b. Name of applicant.
c. Address and phone number of applicant
d. Identity card number of applicant
e. Profession
f. Name, identity card number, address, profession of introducer.
g. Nature of account.
h. Amount to be deposited by applicant.
i. Account opening date.
j. Signature.
iii. Documents required: Individual should attach copy of identity card with
application form. In case of partnership copies of all partners identity card, copy of
registration form of partnership is attached. In case of company Memorandum of
association, articles of association. List of directors and approvals for account
opening and certificate of incorporation are attached with application form.
iv. Specimen Signature Card (SSC): Bank issued specimen signature card and
obtain signature of account holder for future use. It contains name of bank,
Account number, and title of account, current date and account holder signature.
v. Deposit Slip: Deposit slip is a document which is used for the purpose of deposit
in the bank. Account holder makes initial deposit in bank when account is opened.
It contains title of account, account number, Deposited amount, date and signature
of depositor.
vi. Issuance of Cheque Book: When account is opened bank officer issued cheque
book. A cheque is in printed form heaving name, account number, date, and Bank
name on it. It is used by the customer for withdrawal or for payment purpose.
6.3 BANKER-CUSTOMER RELATIONSHIP

A bank and its customers are bounded by the laws of the land regarding banking
operations. As customers put their funds at the disposal of banks, regulations are
58
developed to safeguard the interests of the customers. Similarly, a bank is also legally
protected against all the frauds and other illegal means which a customer can inflict on it.
Therefore, both banker and customer are protected by the rules and regulations to ensure
their smooth functions.
6.3.1 Rights and Duties of Customer:
Rights of customer of a bank are as follows:
Rights of Customer:
i. Customer has right to draw a cheque to the extent of his credit balance.
ii. Customer has right to receive statement of account after regular interval.
iii. Customer can sue a bank for dishonoring cheque by mistake.
iv. Customer has right to correct its record in case of wrongly debit or credit.
Duties of Customer:
i. Customer must present the cheque or any other instrument during banking hours.
ii. Customer should present the cheque within due date.
iii. A customer should keep his cheque book in safe place to prevent its misuse by
unauthorized person.
iv. Customer immediately tells bank if any cheque is lost or stolen for stop of
payment.
6.3.2 Rights and Duties of Banker:
Rights and duties of bank are as follows:
Duties of Banker:
Its duty of banker to make payment on customer behalf and should honor the cheque for
payment issued by customer.
i. Bank performs agency services on customer behalf according to customer
instruction.
ii. It is the duty of bank not to disclose the financial position of customer to any other.
iii. Sale and purchase of securities on customer behalf as directed by him/her.
Rights of Customer:
i. Bank has right to charge interest on overdraft or any other facility.
ii. Bank has right to retain the securities until customer pays his debts.
iii. Bank has right to adjust debit and credit balances of customer.
6.3.3 Nature of Banker Customer Relationship:
The kind of relationship between bankers and customer are of different forms and
includes;
59
i. Debtor and Creditor: The relationship between bank and customer is like debtor
and creditor customer deposit money in bank and withdraw at any time. The bank
is known as debtor and customer is creditor. The relationship is inverse when bank
advances loans.
ii. Bailer and Bailee: When customer deposit valuable in bank for safe custody the
bank become bailer and customer is bailee.
iii. Principal and Agent: The customer deposits cheque, drafts etc. for collection. He
also give instructions to the bank to purchase securities, payment of insurance
premium on customer behalf. When bank perform agency services for customer he
become an agent and customer is principal.
iv. Mortgager and Mortgagee: When bank accept immovable property as a security
against loan advance to customer. The customer becomes the mortgager and banker
is mortgagee.
v. Pawner and Pawnee: When customer pledges goods and documents as a security
against loan then he became Pawner and bank become Pawnee. Goods or document
are returns when debts are paid.
vi. Lessor and Lessee: When bank provides advances to customer based on lease
financing then customer become lessee and banker lessor.
vii. Trustee and Agent: The banks act as trustee when customer deposits his securities
for safe custody and when bank sells securities on customer acting as agent of the
customer.
6.3.4 Kinds of Bank Customers:
Following are the major kinds of banks customer.
1. Individual Customer: Account with name of person and operated by account

holder himself individual customer and it may include following types of persons;
i. Minor: Minor is a person who do not attain the age of 18 years. Bank can only
open minor account after the prior permission of guardian court. Court authorized a
person (Guardian) who operate the account and give his specimen signature. He
can withdraw after court permission and may not enjoy full banking services.
ii. Lunatic: Lunatic is a term used for person who is mentally ill. If he already have
account with bank. Bank immediately stop payment ad suspends account when
bank comes to know that customer lunatic. Account can only be operated after the
court evidence received from court.
iii. Illiterate Person: Illiterate person is one who cannot read or write. Illiterate person
can use thumb impression as a specimen signature. Photographs of customer are
posted on the signature card. Illiterate person do not make payment through cheque
he can only withdraw amount from account by himself.
iv. Purdah Nasheen Women: Purdah nasheen women are one who remains in
complete hijab. Bank is very careful while opening Purdah nashee women account.
A very close reference is required in case of married women his husband is used as
reference and natural guardian in case of unmarried girl.
60
v. Married Women: Married women can open account as other people. She can
perform all the function and operate account, but she has to write her husband
name and earning of her husband.
2. Joint Account: Joint account is an account which can be open and operated by two
or more person. And may include following
i. Partnership Firm: Partnership is an arrangement in which two or more people are
agreed to share profit of business. Partnership firm can open joint account of all the
partners. The account open and operated at the name of the firm not at individual
name. Bank obtains signature of all partners’ ad deceleration and consent of all that
who can operate the account. In case loan is obtained, the banker must require sign
document which shows the consent of all partners.
ii. Joint stock Company: Joint stock company can open current account company
nominates the directors who are authorizes to deal with the bank. Two or three
directors have to sign specimen signature card for future correspondence. They
provide name, phone number, identity card number, and address of director who
operate account, Memorandum of Association, Articles of Association, Certificate
of Incorporation, Certificate of Commencement and copy of resolution submitted
by partnership firm to bank.
iii. Trustee: Trustee is a person to whom property is legally committed to be
administered of any other person. Account should be opened in the name of trust
and opening form should contain signature of the entire trustee with a copy of trust
deed. Bank gets clear instruction that who can operate account. In case of death of
trustee, the power will be decided according to trust deed.
iv. Non-Profit Institutions: Individuals with activities other than trade is called
nonprofit institutions. E.g. clubs, hospitals, and college etc. Bank open account of a
society which is registered as corporative body under corporative society act. A
copy of memorandum of association and article of association should be submitted
to bank which help the banker to know the objectives and rues of society. A copy
of resolution which indicates that society authorized person for operating account
should also be submitted in bank.
Summary
This unit has explained the key concept of commercial banks and their functions.
Commercial banks perform many functions at the same time. They receive money from
those who have surplus and lend it to those who need it. Commercial banks contribute to
the growth of the economic development of any country by advancing loans to
underdeveloped sectors like agriculture, industrial sectors. This unit has also described
the various types of bank accounts offered by commercial banks to their customers. The
lasts section of the unit has discussed the banker-customer relationship, Duties and rights
of banker & customer in detail.
61
Exercise:
Question No. 1: Short Questions

1. Define bank? Write any four functions of banks.
2. Write duties and rights of customer.
3. Write types of individual customers.
4. What is a saving account?
Question No. 2: Long Questions

1. Define bank and discuss its functions in detail.
2. Discuss the types of bank customers in detail.
3. Discuss rights and duties of banker and customer.
References (Books):
References: (Reports)
1. State of Economy Report, SBP, 2019
2. Economic Survey of Pakistan, 2019-2020
62
UNIT–7
BANK LOANS AND ADVANCES

63
CONTENTS
Page #
Introduction .............................................................................................................. 65
Objectives .............................................................................................................. 65
7.1 Bank Credit Analysis ........................................................................................ 66
7.2 Bank Advances ................................................................................................. 67
7.2.1 Running/Revolving Finance. ............................................................... 67
7.2.2 Cash Finance ........................................................................................ 68
7.2.3 Demand Finance .................................................................................. 69
7.3 Bank Loans ....................................................................................................... 71
7.3.1 Medium-Long Term Loans .................................................................. 71
7.3.2 Letter of Credits ................................................................................... 71
7.4 Principles of Bank Lending............................................................................... 73
7.5 Process of Bank Loan........................................................................................ 74
Summary ..................................................................................................................... 75
64
INTRODUCTION
In the previous unit you have learnt the function of commercial banks and its features.
The commercial banks accept deposit and lend money to the people who require it for the
various purposes. This unit will introduce the concepts of bank loans and advances. The
bank loan and advances granted by the commercial banks are highly beneficial to the
individual, firms and companies meeting their financing needs. The growth of business is
affected to a large extent by the quantity and quality of financing available on time.
OBJECTIVES
i. to understand the concept of running finance.
ii. to know the concept of cash and demand finance.
iii. to differentiate running finance, cash finance, and demand finance.
iv. to understand the precautions and procedure of loan/advances.
v. to understand letter of credit and its major types.
65
7.1 BANK CREDIT ANALYSIS
Primary function of a bank is to receive deposits and advances loans. Bank accepts money
from the holders of surplus funds and lends it to the needy people or invests for productive
purpose. Bank collects funds from different sources; deposits, paid-up capital, loans etc.
and distribute it to the eligible investors as per the agreed terms and conditions. Credit
analysis by a lender is used to determine the risk associated with making a loan. Regardless
of the type of financing needed, a bank or lending institution will be interested in both your
business and personal financials. While giving credit to a person or business, a bank
conducts the credit analysis in order to make the appropriate lending decisions.
Credit Analysis is governed by the “5 Cs:” character, capacity, condition, capital and
collateral.
i. Character: Banks need to know the borrower and guarantors are honest and have
integrity. Additionally, the banker needs to be confident the applicant has the
background, education, industry knowledge and experience required to successfully
operate the business. Lending institutions may require a certain amount of
management and/or ownership experience. As history is the best predictor of the
future, a lender will examine the personal credit of all borrowers and guarantors
involved in the loan.
ii. Capacity (Cash flow): The banks want to know that a business is able to repay the
loan. The business should have sufficient cash flow to support its business
expenses and debts comfortably while also providing principals’ salaries sufficient
to support personal expenses and debts. Examining the payment history of current
loans and expenses is an indicator of the borrower’s reliability to make loan
payments.
iii. Condition: The lender will need to understand the condition of the business, the
industry, and the economy, which is why it is important to work with a lender who
understands the particular industry. The lender will want to know if the current
conditions of the business will continue, improve or deteriorate. Furthermore, the
lender will want to know how the loan proceeds will be used- working capital,
renovations, additional equipment, etc.
iv. Capital: The bank will ask what personal investment you plan to make in the
business. Not only does injecting capital decrease the chance of default, but
contributing personal assets also indicates that a person is willing to take a personal
risk for the sake of his business.
v. Collateral: A banker will consider the value of the business’ assets and the
personal assets of the guarantors as a secondary source of repayment. Collateral is
an important consideration, but its significance varies depending on the type of
loan. A lender will be able to explain the types of collateral needed for a loan.
The five components that make up a credit analysis help the lender understand the owner
and the business and determine credit worthiness. By knowing each of the “5 Cs,” a
business will have a better understanding of what is needed and how to prepare for the
loan application process.
66
Important Terms Used in Bank Credit:
i. Pledge:
Pledge means actual delivery of rights as well as possession of goods as security
against loan. Subject of pledge is returned to the customer when he has been paid.
In case of nonpayment bank has right to sell security to recover its losses.
ii. Mortgage:
It is a written agreement between mortgager and mortgagee. Customer transfer
legal rights of property to bank but possession of goods is remains with customer.
iii. Lien:
It is a right of the bank to retain the possession of property against loan until
customer repay loan along with interest.
iv. Hypothecation:
Under hypothecation neither ownership nor possession of goods transfer to bank. It
is just an agreement between banker and customer but in case of failure of
repayment bank approach court of law to receive full rights of selling the
hypothecated property.
7.2 BANK ADVANCES

A bank advance is provided to a borrower for meeting small level financing needs. These
advances are usually payable within one to three months period and carries interest rate
along with other terms and conditions. The advances are classified as running finance,
cash finance, and short-term demand finance.
7.2.1 Running/Revolving Finance

Running finance is a short-term loan facility from commercial banks to its account
holders. If account holder bill are greater than its account balance he requested bank
manager to overdrawn his account by specific amount for short period. Once finance
limit is approved then account holder can borrow money to extent of that limit but pays
mark up on amount, he drawn on monthly basis. Running finance is also known as
revolving finance. It is only allowed to current account holder. Overdraft facility is
provided against security of deposit receipt or shares.
Features of Running Finance are;

i. Current account holder:
Running finance facility is only provided to his current account holders.
ii. Contract:
Contract is made between bankers and its account holder on the maximum amount.
iii. Security:
In running finance most of the time personal security is taken as security against
overdraft facility. It is in form of credit worthiness of account holder and sometime
bank may demands security in form of another financial asset.
iv. Withdrawal rule:
Account holder can withdraw access amount at full or in installments.
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v. Time period:
Time period for running finance is short may be number of days 30-90.
vi. Interest:
Bank charges interest on the amount which is withdrawn in access.
Benefits of Running Finance:
i. Easy Access to Funds:

Sometime account holder makes payments but balance in account is not enough, so
he requested bank to allow him to withdraw access money for short period due to
which it manages money.
ii. Timely payments
Timely payments are made from bank accounts even balance is not enough due to
overdraft facility.
iii. Minimize paperwork
In running finance paperwork is reduced as compared to other advancing facilities
offered by bank.
Limitations of Running Finance

Following are the limitations of running finance;
i. Current account holder
Running finance facility is only availed by current account holder. All other
account holder is excluded.
ii. Higher interest
Interest rate is higher as compare to other borrowing facilities/schemes is charged.
iii. Reduction of limit
Overdraft facility is a temporary advance facility. There is a risk of decrease in
limit of access borrowing from account may also reduce if the performance of
company is not good.
7.2.2. Cash Finance

Cash finance is also known as cash credit. It is process through which bankers allow its
customer to borrow certain sum of money up to limit fixed by commercial banks.
Security should be provided by customers against such loans. As compared to running
finance, cash finance is issued for longer period. Mostly banks provide cash finance
facility to current account holders. Bank allows customers to withdraw either in lump
sum or installments. So, customer can used money according to his/her requirements.
Features of Cash Finance:

i. Current account holder
Cash finance facility is provided to current account holder only.
ii. Time period
Time period for cash credit is not as long but its time period is more than running
finance.
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iii. Interest/Mark Up:
Bank charges interest against amount withdrawn. If customer does not withdraw up
to allowed limit. Then he has to pay interest on half of total amount or quarter of
amount. If customer withdraw half or more than half amount from sanction limit
than he has to pay full interest.
iv. Separate Cash Finance Deposit Account:
Bankers do not gave amount in form of cash. It open new account with the name of
cash finance deposit and transfers amount in that account and customer withdraw
money through cheque in lump sum or installments.
v. Security
Bank provides cash finance facility against security. If bank provide loan at
personal security than loan may be in secured and bank may face losses if customer
refuse to repay. Secured securities are demanded by bank to secured loan in case of
nonpayment.
vi. Repayment of loan
Loan may be repaid in lump sum or in installment within due date as per the agreed
terms and conditions.
Limitations of Cash Finance:
Limitations of cash finance are;
i. Time period
Time period for cash finance is short for further loan customer has to renew his
deposit by bank.
ii. Interest/mark up
Customer must pay interest if he used only little amount of loan than pay interest
on half or quarter amount.
iii. Current account holder
Cash finance facility is only provided to current account holders. Other account
holder like saving and fixed deposits should not avail this facility.
7.2.3 Demand Finance
Demand finance is formal form of bank loan. Bank advances large amount for fixed
period. Loan is repaid after fixed time period or on demand.
Features of Demand Loan

i. Nature of Deposit
As compare to running finance and cash finance, demand loan is granted to all
account holders who wanted loan.
ii. Securities:
Acceptable securities against loan are government securities, and tangible goods etc.
iii. New Account:
Bank never gave money to customer while advancing loan. It open separate new
account in the name of customer and customer can withdraw amount through
cheque which helps in credit creation.
iv. Time period:
Demand loan is repayable on demand. It depends on the terms and conditions of
the bank.
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v. Interest:
Interest is paid on whole/full amount of loan doesn’t matter either customer
withdraw whole amount or not.
vi. Purpose of Demand Loan:
Usually, the purpose of demand finance is to meet the requirements of working
capital.
Limitations of Demand Finance

Limitations of demand finance are as follows;
a. Interest
The customer must pay full amount of interest against loans no matters that
withdraw half or full amount.
b. Renewal
The loan is not is renewed if customer has additional loan requirements.
c. Security
Security should be provided against loan if one cannot provide security it may not
avail loan facility.
Comparison among running finance, cash finance and demand finance.

Feature Running Finance Cash Finance Demand Finance
Time period Time period for Cash finance is also Demand finance is
running Finance if short time but more issued for longer
very short as number than running finance. period.
of days.
Interest Interest is only paid Interest is paid on Interest is charged on
on amount drawn. amount withdrawn if full amount of loan.
withdrawn amount is
very little than bank
charges interest on
quarter or half amount.
Type of It is only provided to It is only provided to Demand finance is
Account current account current account holders. issued to all account
holder. holder not restricted
to current accounts.
Renewal At maturity renewal At maturity it also Demand finance
facility is available. renewed as running cannot be renewed.
finance at customers New request should
request. be made.
Security Personal security is Personal and material Material security is
enough. security against loan. required.
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7.3 BANK LOANS
Medium- and long-term loans are called term finance. Term finance is issued for more
than one year and payment of this loan is spread over larger period. These loans are
advances for the purpose of starting new business or the expansion of existing business.
Term finances are secured against mortgage of property or machinery.
7.3.1 Medium-Long Term Loans
i. It is issued in both local and foreign currency.

ii. Terms loan are granted against securities/collateral.
iii. Bank imposes restrictions on borrower for recovering interest.
iv. Term finance is repaid after semiannual of annual intervals.
i. Car Finance:
Car finance is issued for financing a car for individual and corporate customers
usually for a period of one to five years. These loans are provided against secured
streams of incomes (i.e. salary) to the individual customers and carry an interest rate.
ii. House Finance: House finance loan is provided for building or renovating a house
to the eligible customers. Generally, the house loans are provided for longer period
i.e. five to ten years and carries higher rates of interest. The repayment schedule
and installment are worked out at the start of the loan period and the house remains
property of the bank till the repayment of all installments with interest.
iii. Asset Finance: Asset finance facility is provided to the corporate clients for
meeting the financing needs for new plant, machinery, vehicles, buildings etc. As
these assets require huge amount of funds, banks finance businesses for their longer
term needs on higher rate of interest along with other terms and conditions.
iv. Infrastructure Finance: A bank also support the development of physical
infrastructure i.e bridges, roads, airports, seaports, large govt. projects etc.
Generally, in infrastructure finance, a bank works jointly with other banks by
forming a syndicate or consortium and jointly advance funds to the clients based on
their needs.
7.3.2 Letter of Credit
A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller
will be received at proper time and against correct amount. In case buyer unable to make
payment on purchases the bank will be required to cover the full or remaining amount of
the purchase. It is a document issued by third party to make sure that in case of failure of
payment by buyer it may liable for payments. Banker’s letter of credit is of two types.
i. Commercial LOC.
ii. Personal LOC.
Commercial letter of credit is issued for business purposes.
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Kinds of Commercial Letter of Credit
Kinds of commercial letter of credit are as follows.
i. Clean LOC:
It is letter of credit in which no conditions are attached.
ii. Documentary LOC:
It is letter of credit which requires document to be attached with it.
iii. Fixed LOC:
Letter of credit issued for some specific transaction and automatically cancels after
those transactions.
iv. Revolving LOC:
Revolving letter of credit is renewed automatically after payment of transaction.
v. Confirmed LOC:
It is letter of credit which is properly attested by bank and after its issuance bank is
liable for payment to exporter in any condition.
vi. Revocable LOC:
Revocable letters of credit may be canceling at any point due to any reason.
vii. Negotiable LOC:
Negotiable letter of credit is one whose receiver has right to transfer it to any other
party and instruct its bank to transfer rights in partial of full.
Personal Letter of Credit

People who visit foreign countries avoid taking cash with them to avoid chance of theft.
Bank issues personal letter of credit to facilitate those people which are known as
personal letter of credit. Any person can avail this facility by deposit amount in bank.
Kinds of Personal Letter of Credit;

i. Traveler’s Letter of Credit:
Travelers letter of credit issued by bank to facilitates its customer. Bank order all
its branches and offices in other countries to pay particular amount to a specific
person.
ii. Circular Note:
Circular note is issued by bank to its branches and offices in other countries to
facilitate traveler during their journey. Circular note is nonnegotiable instrument.
iii. Travelers Cheque:
Bank takes the signature of travelers it is drawn on different branches of bank in
foreign country. When customer wants to encased traveler’s cheque officers take
signature is it match then payment is made.
Advantages of Commercial Letter of Credit
i. Increase in Bank Income:

Through letter of credit income increased because bank charges interest against
issuance of letter of credit.
72
ii. Facility for Importer:
It is the bank who pay debts to exporters the importer does not worry about
payment at spot he can make payment in installment. Burden is lowered Importer
has to pay interest against letter of credit facility.
iii. Facility for Exporter: Exporter also facilitated through letter of credit because it is
assured that payment is made against goods he/she sold which is not possible
without involving bank
7.4 PRINCIPLES OF BANK LENDING

While advancing money to any party bank should observe certain strict rules to avoid
future losses. Following precautions are taken for advancing money.
i. Diversification of Loans: Diversification of loans means to advance loan to

different sector. Someone truly quoted that ‘. Due to granting of loan to different
people risk is divided and chances of loss are minimized as compare to advance
huge amount to single person.
ii. Profit Margin: Bank earns profit by making loan. While grated loan it should be
checked that a loan is a secured source of reasonable profit.
iii. Liquidity of Loan: Loan should be easily recoverable in case of emergency. Bank
mostly preferred liquid nature advances.
iv. Custody of Goods and Documents: Goods taken as security should be in bank
custody and banker may demand documents of title to that property to secured
loan.
v. Value of Security: Banker must search market value of security because increasing
value goods are accepted as securities otherwise there may be chance of loss.
vi. Financial Position of Bank: Financial position of the bank should be checked, and
appropriate reserves funds should be allocated for the running of day to day
operations.
vii. Amount and Duration of Loan: Bank is more careful about advancing large
amount for loan and short duration is preferred for repayment and it generally
avoids long term loans.
viii. Directions of the Central Bank: While granting loans, directions of the central
bank are followed for allocating capital to various sectors of economy as per the
policy guidelines.
ix. Determination of Interest Rate: As every loan carries interest rate, it is
determined as per the prevailing economic situations, risks in transactions and
required returns.
x. Compliance with Applicable Laws: While granting loans, compliance with all
applicable taxation and business laws is required to avoid any legal action against
the bank.
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7.5 PROCESS OF OBTAINING BANK LOANS
The loan process refers to those set of activities which are required to be performed by
the lender to grant the loan. When a business wants to obtain a loan from a bank or any
other financial institution, it has to fulfill certain procedures to get the required funds.
These tasks are performed by the business to raise the desired debt capital activities.
These include the necessary steps to be taken by the business to get the loan from a
financial institutional. A set of these activities is given below to understand the steps and
documents required for a loan application:
Funds Demand
Products Information
Bank Selection
Documents Preparation
Loan Approval
Step 1: Finance Requirements:

The first step to acquire loan by a business is to estimate the requirements of funds for the
business in the upcoming period. If the existing funds are not sufficient to meet the
operational needs of a business, then the option for obtaining a loan is considered
generally from a bank. The finance manager in a business estimates the requirements for
cash in the coming months to avert any situation in which a business is unable to make
payments to its creditors and other bills.
Step 2: Products Information:

The second step for obtaining a loan is to gather the required information from the market
for different options to obtain the loan. This information includes the maximum amount
of loan that the business can obtain, the rate of interest on the loan, repayment period,
conditions for obtaining the loan and the security or guarantee required for obtaining the
loan. A business should avail the maximum possible information from all the banks
operating in the area before selecting a bank for obtaining the loan.
Step 3: Bank Selection:

At third step, after the examination of all available information regarding different banks,
a business selects a bank for getting the loan. The selection of a bank depends on the
74
analysis performed by the finance manager to obtain the loan. The selection of a bank is
generally made by comparing the terms and conditions of the loan with the other banks
and the most favorable bank are selected for applying the loan.
Step 4: Documents Preparation:

In the next step, the required documents for the loan application are prepared by the
finance manager. These documents include the present financial position of the business,
owners details, security details, estimated profit and loss account and the loan repayment
plan. Further, any other detail of the assets or liabilities can be requested by the bank to
verify the eligibility of the applicant. The documents for making a loan application
should be verified and submitted in a timely manner for processing to the bank.
Step 5: Loan Approval:

At last step, the loan application of a person is approved by considering the various
factors: repayment capacity of the business, amount of loan, rate of interest and other
terms and conditions. The loan application of a person is approved by the manager of a
bank by evaluating it as per the defined criteria. Once a loan application is approved, the
amount of loan is credited in the account of the business which it can use for meeting the
functional needs of the business.
Summary
This unit has elaborated the concept of bank advances and loans. Bank advances are
usually of short term nature and include cash finance, running finance and demand
finance which carries lower interest rates with shorter maturity periods. The bank loans
are medium to long term financing arrangements and include car finance, house finance,
asset finance, infrastructure finance etc. Both bank advances and loans are given by a
bank after careful credit analysis and observing the principles of lending.
Test Questions
1. Write a detail note on running finance.
2. Write about characteristics of cash finance.
3. Detail note on principle of bank lending.
4. What is credit analysis?
75
References (Books):
4. Financial Markets and Institutions by Frederic Mishkin and Stanley G
Eakins.
5. Fundamentals of Financial Institutions Management by Marcia Million
Cornett
References (Reports):
1. State of Economy Report, SBP, 2019-2020
2. Economic Survey of Pakistan, 2019-2020
76
UNIT–8
ROLE OF CENTRAL BANK

77
CONTENTS
Page #
Introduction ................................................................................................................. 79
Objectives ................................................................................................................... 79
8.1. Introduction to a Central Bank .......................................................................... 80
8.2. Functions of a Central Bank ............................................................................. 80
8.3. Monetary Policy ................................................................................................ 81
8.3.1 Objectives of Monetary Policy ............................................................ 82
8.3.2 Instruments of Monetary Policy. .......................................................... 82
8.4. State Bank of Pakistan (SBP) ............................................................................ 83
8.5. Banking Services Corporation (SBP-BSC) ....................................................... 85
Summary ..................................................................................................................... 86
Exercise....................................................................................................................... 87
78
INTRODUCTION
Central bank is a bank which manages the money supply, national currency and interest
rates in a country along with overseeing the commercial banking system. A central bank
controls monetary policy and flow of currency within country and maintains value of
local currency in foreign exchange market. It sets rules and regulations for all commercial
bank and all banks are required to follows instructions of central bank. A central bank
also provides different facilities to commercial banks in the form of liquidity support and
inter-institutional transactions. The State Bank of Pakistan is the central bank of Pakistan
and in this unit we will describe its key functions.
OBJECTIVES
i. to understand monetary policy and instruments of monetary policy.
ii. to explain central bank and its functions.
iii. to know the difficulties in controlling credit in economy
iv. to elaborate the role of the state bank of Pakistan
79
8.1 INTRODUCTION TO CENTRAL BANK
A central bank is an independent institution that manages a state currency money supply
and interest rates. The goal of central bank is to stabilize the national currency by keeping
unemployment low and inflation at lowest possible levels. A central bank has authority to
supervise the activities of the commercial bank.
Definitions
“Central bank is defined as an institution charged with the responsibility of managing

the expansion and contraction of the volume of money in the interest of the general public
welfare’’ (R. P. Kent)
“A central bank is to help, control and stabilized the monetary and banking system’’
(Hawtrey)
“A bank which controls credit”. (W. A. Shaw)
In simple words central bank is the bank which controls the monetary policy and
regulates the banking sector in a country. It is owned by the government of country in
which it established. Central bank has sole authority of note issue. It made policies for
commercial banks and give advices to government which in important for economic
development. It can contract or expand supply of money in economy to control inflation
or deflation. Central bank provide many other services to banks like clearing house, cash
reserve etc.
8.2 FUNCTIONS OF A CENTRAL BANK

i. Sole Authority of Currency Issuance:
A central bank has sole right to issue currency in a country. This sole authority to
central bank is given to maintain the uniformity of notes and to efficiently regulate
the currency within a country. There are two principles used by a central bank
while issuing currency;
a. Fixed Fiduciary System:
It means the currency issuance criterion is fixed. A central bank can issue currency
up to a certain fixed limit. If there is need for more currency, then the central bank
should maintain 100% reserves in the form of gold or foreign currency against it.
b. Proportional System:
c. It means issuance of currency according to the economic requirements of a country.
Under proportional system, proportional reserve is made in form of gold or other
metal and foreign exchange while remaining reserve is in the form of trade bills
and government securities. Issuance of currency can be made without any such
reserves in the proportional system and it is called deficit financing.
80
ii. Bank of Government:
A central bank acts as a banker of government. The govt. makes deposit with the
central bank. It provides loan to government for different developing purpose. It
makes payment on the behalf of government. A central bank also gives different
advices to government to improve economic development. Central bank represents
government in international market.
iii. Authority to Regulate Commercial Banks:

Central bank keeps a proportion of the deposits of all registered commercial banks.
The central bank controls the working of all the commercial bank. The commercial
banks are required to obtain approvals from the central bank for opening new
branches. They got permission of central bank for doing it. It gives the facility of
discounting of bills to commercial banks. It provides loans to other banks for
meeting liquidity requirements.
iv. Regulator of Foreign Exchange:

Acentral bank manages the foreign exchange rate and maintains the value of local
currency in foreign market. It also made foreign reserve for importers help and also
for making of balance of payment favorable.
v. Custody of Monetary Reserves:

Monetary reserves are kept by central bank, it either in form of Gold, Silver or
foreign currency. The purpose of making reserve is to maintain the value of local
currency. In emergency situation these reserves are disposed to meet the
requirements.
vi. Clearing House:

A central bank acts as a clearing agent for all the commercial bank by settlement of
their mutual obligations. Every bank has reserve with central bank so it shifts the
reserve from one to other for the settlement and clearing of bills.
vii. Lender of Last Resort for Banks:

A central bank acts as a lender of last resort to other banks which means if any
commercial bank faces liquidity problem central bank provides help in form of
rediscounting of bills or in the form of loan.
8.3 MONETARY POLICY

The primary function of the central bank is to regulate and control money supply in the
country to achieve the targets of economic policy set by the government. For this
purpose, the central banks develop monetary policy and determine the policy/bank rate
for the banking sector that affects all economy.
81
Definitions:
“Monetary policy is the attitude of the political authority towards the monetary system of
the community under its control”. (Paul Einzing)
“It is a policy of central bank to control the supply of money with the aim of achieving
macroeconomic stability’’ (Harry G. Johnson)
8.3.1 Objectives of Monetary Policy
i. Promoting High Employment:

Employment level in the country is affected due to unstable price and value of
money. The objective of monetary policy is not only to maintain the money value
and employment but also create more employment opportunities with the help of
responsive private sector investments.
ii. Economic Development

Stable monetary policy plays key role for the growth of economic development by
providing loan to the productive sector. The objective of policy is to regulate the
credit to ensure their effective and productive use in different sectors of economy.
iii. Maintain Price Stability:

One of the objectives of the monetary policy is to maintain stable price level to
avoid inflation and deflation situation in an economy.
iv. Exchange Rate Stability:

It means to maintain the stability of exchange rate as it affects the prices of imports
and exports in a country.
v. Investment Increased:
Through changes in interest rates in the monetary policy a central bank encourage
both private and public sectors for investment which is helpful for the growth of
economic development.
8.3.2 Instruments of Monetary Policy:
There are following two methods that control monetary policy.
Quantitative Controls:
i. Change in Bank/Policy Rate:

A policy or bank rate refers to the rate at which central bank rediscounted the bills
of commercial bank. A central bank may change the policy rate for increasing or
decreasing the flow of money for the commercial banks.
82
ii. Open Market Operations:
It means sale and purchase of securities in the financial market. When central bank
wants to increase the volume of money it purchases securities from open markets
and for reduction of volume of money supply, the central bank sales the securities.
iii. Change in Reserve Ratio:
Central bank affects the supply of money by changing the reserve ratio. Every bank
has to maintain the specific reserve ratio (in the form of cash) with central bank. A
central bank may increase or decrease the reserve ratio to change the money supply
in the economy.
iv. Credit rationing:

This method of credit is used by central bank is case of financial crisis. The central
bank fixed the rationed credit ratio for each bank and also specifies its sector-wise
allocation in the economy.
Qualitative Controls:
i. Margin Requirements:
It is the difference between value of securities and the value of loan advanced by
the central bank. The rate of margin may affect the amount of loans disbursed by a
commercial bank.
ii. Direct action
If commercial banks do not follow the directions and orders of the central bank
then the central bank may take direct action in the following situations;
a. By refusing to discount bills
b. Does not provide the facility of clearing house.
c. May increase the cash reserve ratio.
d. May charges fine or penalties
iii. Moral Persuasion

A central bank advises the commercial banks not to involve in any illegal activities
and should work in best way i.e. issuance of loans only for productive or investing
purpose.
iv. Publicity for Awareness

Central bank published the policies and function through media which enables the
people and other banks to understand the economic condition of the country.
8.4 STATE BANK OF PAKISTAN

After independence in 1947, there was many problems arises but the major problem for
Pakistan was to establish the central bank as old Indian currency and the British-era
Reserve Bank of India were dominating the financial sector of Pakistan. The purpose of
the establishment of the State Bank of Pakistan was the issuance of independent currency
and controls the flow of money supply. The Governor General of Pakistan’ ’Quaid-e-
83
Azam Muhammad Ali Jinnah’’ issued the order for the establishment of State Bank of
Pakistan on 1st, July 1948. This order has been substituted by the State Bank of Pakistan
Act 1956.
Management of the SBP:

The State Bank of Pakistan was established to regulate the money supply and commercial
banking in Pakistan. The board which regulates the policies consists of one Governor,
one deputy governor and nine directors. There is also an executive committee of the bank
which empower to work on behalf of the director, central bank has 14 different
departments with almost 5000 employees. The departments are accounts department,
administrative department, exchange department, inspection department, and many other
departments for performing different functions.
Role of State Bank:

i. Regulator for Commercial Banks:
The SBP supervises the working of all commercial bank. It provides facility of
clearing house and acts as the lender of last resort by providing loan in difficult
situation. It also helps to stable credit worthiness for banks. The policies developed
by the SBP are compulsory to be followed by the commercial banks.
ii. Assistance to Government:

A central bank acts as the advisor for government. It provides loan to government
for different financing needs. The SBP represents the government in international
market. The SBP ALSO advises the government to make policy according to
existing monetary and economic situation.
iii. Controller of Money Supply:

The SBP supervises the monetary system and controls the supply of money to cater
inflation or deflation. It also maintains the value of currency for price stability in
country. In inflationary situation in country central bank contracts the supply of
money in circulation and in deflation central bank expands the supply of money.
iv. Stability in Exchange Rate:

The SBP is responsible to maintain the exchange rate for the stable value of money
for price stability. When exchange rate of currency is stabilized the purchasing
power of general public enhanced and overall economy grows.
v. Distribution of Credit:
The SBP develops policies for the allocation of credit among different sectors of
economy to develop a balanced economy. It also helps government to implement is
credit plans and goals. It advances subsidized loans through other banks for the
development of underdeveloped areas in country.
84
vi. Training
Staff training is very important for stable growth of banking industry. The SBP
through its training institution, National Institute of Banking and Finance, provides
training to employees according to modern technology requirements.
8.5 STATE BANK OF PAKISTAN -BANKING SERVICES

CORPORATION (SBP-BSC)
The SBP Banking Services Corporation (SBP-BSC) was established as a wholly owned
subsidiary of State Bank of Pakistan in January, 2002, under the SBP Banking Services
Corporation Ordinance 2001.As an operational arm of the Central Bank, SBP Banking
Services Corporation is engaged in managing currency, foreign exchange operations and
foreign exchange adjudication; providing banking services to the federal and provincial
governments and financial institutions regulated by State Bank of Pakistan, conducting
development finance activities in support of the development finance group of the SBP,
implementing export refinance schemes, and performing agency functions like sale/
purchase of national prize bonds including managing prize money draws, sale and purchase
of national saving schemes or any other functions assigned by State Bank of Pakistan.
Management Structure of the SBP-BSC:

The Managing Director (MD) is the Chief Executive Officer of SBP BSC and controls
the affairs of the Bank on behalf of the Board of Directors. The Managing Director has
been empowered to conduct business and manage the affairs of the Bank except for the
matters that fall, specifically, under the purview of the Board. The Managing Director is
assisted by a team of Group Heads / Regional Heads / Heads of Departments and Chief
Managers.
Functions of the Regional/Field Offices of SBP-BSC:
Regional / Field Offices of the Bank typically provide the following Banking Services:
i. Currency Management Services (Issuance, Exchange & Destruction of Currency
Notes).
ii. Coins Management (Supply & Receipt).
iii. Receipts of Governments’ Taxes & Levies.
iv. Management of Governments’ Payments (Salaries, Pensions & Suppliers).
v. Public Debt Management (Management of National Prize Bonds & SSCs/DSCs
Schemes on behalf of Central Directorate of National Savings (CDNS), National
Savings, Ministry of Finance, Government of Pakistan, Islamabad.
vi. Provision of Governments’ Funds Transfer Facility.
vii. Locker facilities to the Government for Safe Deposit of Articles.
viii. Customers’ Facilitation for General Banking Complaints.
ix. Other Banking Services as and when required by the Government Departments.
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Regional Offices:
The sixteen (16) Field Offices of the BSC-Bank are structured into the following three
Regions:
S. No. Regions Regional / Field Offices

Karachi
North Nazimabad
Southern Region
1. Hyderabad
(5 Field Offices)
Sukkur
Quetta
Lahore
Faisalabad
Central Region Sialkot
2.
(6 Field Offices) Gujranwala
Multan
Bahawalpur
Islamabad
Rawalpindi
Northern Region
3. Peshawar
(5 Field Offices)
D.I. Khan
Muzaffarabad
Summary
In this unit central bank and its functions has been explained. Central bank control and
stabilized the monetary and banking system. The central bank plays vital role in
economic development of country. One of the fundamental responsibilities of the
central bank is regulation and supervision of the financial system to ensure its
soundness and stability as well as to protect the interests of depositors. The central
bank acts through the issuance of the monetary policy to affect the growth of the money
supply. The purpose of establishment of State Bank of Pakistan was the issuance of
independent currency and controls the flow of that currency. The SBP performs many
functions it provides services to all banks as well as government and it controls the
working of all commercial banks.
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Exercise:
Question no: 1. Long Questions:

1. Define central bank. Explain its function in detail.
2. Define monetary policy. Explain the tools of monetary policy.
Question No: 2. Short Questions:

1. Define bank.
2. Write any three objectives of monetary policy.
3. What is credit rationing?
4. List down four functions of a central bank.
5. What is SBP-BSC?
87
References (Books):

Reference (Reports):
1. SECP Annual Report (latest) available on www.secp.gov.pk

2. Economic Survey of Pakistan (Latest ) available on www.finance.gov.pk
3. State of Economy Annual Report, State Bank of Pakistan (Latest) available on
www.sbp.gov.pk
88
UNIT–9
GROWTH OF BANKING IN
PAKISTAN

89
CONTENTS
Page #
Introduction ................................................................................................................. 91
Objectives ................................................................................................................... 91
9.1. Early Years of Banking in Pakistan ................................................................. 92
9.2. Nationalization of Banks ................................................................................... 92
9.3. Privatization of Banks ....................................................................................... 93
9.4. Development Finance Institutions .................................................................... 94
9.5. Zarai Taraqiati Bank of Pakistan ..................................................................... 95
9.6. Microfinance Banks in Pakistan ....................................................................... 96
9.7. Islamic Banking in Pakistan .............................................................................. 97
9.8. Electronic Banking in Pakistan ........................................................................ 98
Summary ................................................................................................................. 100
Exercises ................................................................................................................. 100
90
INTRODUCTION
In this last unit, the growth and development of banking sector in Pakistan will be
discussed. Starting from the 1947 when banking sector was in its infant phase, the
commercial banking made a lot of progress in 1950s and 60s. Then came the he
nationalization program in 1972 with the vision to promote the economic democracy,
liberalization and maintain goal to put Pakistan in line with state modernism. Reversing
nationalization, the privatization of banking sector was made with objectives of making it
efficient and responsive. Lastly, the new trends of Islamic banking, micro-finance banks
and digital banking will also be discussed briefly.
OBJECTIVES
i. to know the history of banking in Pakistan
ii. to understand the objectives of nationalization
iii. to know the objectives of privatization
iv. to understand the evolution of Islamic banking in Pakistan
v. to know the growth of digital banking in Pakistan
91
9.1. EARLY YEARS OF BANKING IN PAKISTAN
Banks plays an important role in the economic development of a country. The banking
system in India was started during the time of British colonialism. When Pakistan was
declared a separate state in 14th August 1947 large number of non-Muslims migrated
from Pakistan to India which negatively affected the number of bank branches in
Pakistan. Habib Bank Limited and Allied Bank Limited were major private sector banks
of that time. Later on National Bank of Pakistan was created. As the business of banking
was controlled by Hindus, their emigration to India left the banking sector of Pakistan in
shambles. The Govt. sector cooperative banks were ill-equipped to deal with such
situations.
In this situation Quaid-e-Azam inaugurated State Bank of Pakistan on Friday July 1,

1948. The state bank starts with Rs. 30 million paid up capital. In which government held
51% share and 49% was held by private sector. The primary motive of state bank was to
replace the Reserve Bank of India as a central bank. The first Pakistani notes were issued
in October 1948. Later on, other private sector banks were formed in Pakistan and the
State Bank of Pakistan played an active role for the development of banking in Pakistan
as the number of branches was increased significantly.
9.2 NATIONALIZATION OF BANKS

In early years of Pakistan banks plays very important role in economic development of
Pakistan. But afterward it was felt that bank did not advance loan/funds to needy people.
Banking sector was nationalized under bank nationalization act 1974.There were 13
scheduled banks with 2906 branches in Pakistan. Government of Pakistan took control of
all banks under bank nationalization act 1974 and merge financially weaker bank with
financially strong banks and make five nationalized banks.
1. National Bank of Pakistan. 4. United Bank Limited.
2. Habib Bank Limited. 5. Muslim Commercial Bank
3. Allied Bank Limited. Limited.
Rights of ownership and management of nationalized banks were transferred to federal

government. Objectives of nationalization were as follows:
i. Directing banking activities toward national economic development
ii. Achieving fair distribution of resources by bank
iii. Ensuring the safety of depositor money
iv. Availability of credit for agriculture sector
v. Controlling Unproductive expenditures
vi. Availability of credit for small entrepreneur
vii. Improving the efficiency of banking sector
92
Effects of Nationalization of Banks:
i. Low Efficiency of Bank Employee: Due to nationalization employee efficiency

was decreased as there was no check and balance on the working with relaxed
environment and system of punishment or reward for dealing with customers.
ii. Low Competition: Competition was very low between nationalized bank because
all banks were state owned.
iii. Favoritism/Nepotism: Political parties influenced the hiring of staff and loans
were allocated on political basis without economic rationale.
iv. Increase in Corruption: Nationalized institutions are under government control
due to which level of corruption increased and people at higher positions misused
their authorities.
v. Private Sector Discourage: The nationalization policy discouraged private sector
which leads to decrease in level of investment. People abstained from investing
their money in private institution due to the fear of nationalization.
9.3 PRIVATIZATION OF BANKS

Privatization is process of transferring of business from public to private ownership. It is
also defined as ‘’Privatization is the denationalization of an industry’’. Government of
Pakistan was not satisfied with the performance of nationalized banks as the quality of
banking services was decrease. Government therefore decided to privatize the banks.
Privatization commission was formed on 22nd January 1991. Commission transferred two
banks Allied Bank Limited and Muslim Commercial Bank Limited to the private sector.
Objectives of Privatization:
i. To provide better standard of services to general public.
ii. To improve performance of banking sector improved.
iii. To promote competition among different sectors.
iv. To develop capital market
v. To increase deposits and saving habits.
Advantages of Privatization:
i. Efficiency Improved: Efficiency and productivity of banking sector was improved
as private sector strives for profit and cuts cost.
ii. High competition: Competition is improved in private sector that results in
improved service standards and improved customers dealings
iii. Political interference Decrease: Privatization decreased the political interference
as private banks are not fully owned by state. People have concern about profit and
quality services so they cannot take any government pressure.
iv. Pressure of shareholders: private sector has pressure of shareholders to perform
efficiently because if firm is inefficient than firm could be takeover.
v. Quick decision: Quick decision making is only possible through private sector
banking that improves credit allocation and improves customer satisfaction.
93
9.4 DEVELOPMENT FINANCE INSTITUIONS (DFIs)
“An institution which carries on any activity, whether for profit or
otherwise, with or without any Government funding, with the purpose of
promoting development in the industrial, agricultural, commercial or other
economic sector, including the provision of capital or other credit facility;
and for the purposes of this definition, “development” includes the
commencement of any new industrial, agricultural, commercial or other
economic venture or the expansion or improvement of any such existing
venture”.
As specialized institutions, DFIs provide a range of specialized financial products and

services to suit the specific needs of the targeted strategic sectors. Ancillary services in
the form of consultation and advisory services are also provided by DFIs to nurture and
develop the identified sectors. DFIs therefore complement the banking institutions and
act as a strategic conduit to bridge the gaps in the supply of financial products and
services to the identified strategic areas for the purpose of long-term economic
development. The DFIs have, to a large extent, contributed to the development and
growth of the targeted sectors. DFIs are created with a key objective to boost trade and
economic relationship between the sponsoring country and Pakistan.
Development Financial Institutions in Pakistan:
House Building Finance Company Limited (HBFCL) - It is Pakistan's leading housing

finance institution. JCR-VIS Credit Rating Company Limited has assigned initial
medium to long-term entity rating of 'A' (single A) and short –term rating of 'A-2' (A-
Two) to HBFCL.
Investment Corporation of Pakistan - It was founded in February 1966 through an

Ordinance with the objectives to broaden the base of investments and developing the
capital market in Pakistan.
Pakistan Kuwait Investment Company (Private) Limited (PKIC) - It is Pakistan's

leading Development Financial Institution (DFI) engaged in investment and development
banking activities in Pakistan. PKIC was founded as a joint venture between the
Governments of Pakistan and Kuwait in 1979.
PAΪR Investment Company Limited (PICL) - It was formed as a result of a joint

venture between the Governments of Pakistan and Iran. PICL came into existence in
2007 as a company operating in Pakistan registered under the Companies Ordinance,
1984 and classified as a “Development Finance Institution” under the regulatory control
of the State Bank of Pakistan.
Pak Brunei Investment Company - It is an Investment Finance Company established as

a joint venture between Government of Pakistan and Brunei Investment Agency (BIA).
94
The Company started operations in August 2007 after its notification as a Development
Finance Institution.
Pak China Investment Company Limited (PCICL) - It is a Development Financial

Institution formed under the initiatives taken by Government of Pakistan and Peoples
Republic of China for promotion of Trade, Investment and Economic Growth of
Pakistan.
Pak Libya Holding Company (Pvt.) Limited - It is a joint venture between Pakistan
and Libya symbolizing the ever strengthening relationship between the two countries. It
was founded as a joint stock company on 14 October 1978.
Pak Oman Investment Company Limited - It is a specialised Financial Institution

formed as a joint venture between the Governments of Pakistan and Sultanate of Oman in
July 2001.
Saudi Pak Industrial and Agricultural Investment Company Limited - It was

incorporated in 1981 under a joint venture agreement signed between the governments of
Islamic Republic of Pakistan and Kingdom of Saudi Arabia. It provides a full range of
financial products and services including Project Financing, Working Capital Loan, Term
Finance Certificates and Leasing Facilities.
9.5 ZARAI TARQIATI BANK OF PAKISTAN

Pakistan economy is largely dependent on agriculture sector. Agriculture includes
production or processing of crops, livestock, dairy products and poultry activities. To
meet the financial needs of the agriculture sector, the government of Pakistan formed
Agriculture Development Bank of Pakistan in 1957 with the objective to provide credit
facilities to agriculture sector in the form of short- and long-term loan. This specialized
institution is also working as commercial bank too and is now called the Zarai Taraqiati
Bank Limited (ZTBL).
Functions of ZTBL:
i. Financing for technology: ZTBL provides different types of medium and long
term loans for technological upgrading the agricultural sector.
ii. Financing for purchase of input: ZTBL provides short term loans to farmer for
the period of less than one year for the purchase of input like seeds, fertilizers etc.
iii. Finance for fishery and forestry: ZTBL also provides loan for fishery, poultry
and forestry to improve the conditions of rural areas which helps to increase the
employment level.
iv. Finance to agriculture related industries: ZTBL provides loan to industries
which are directly or indirectly related or interlinked with agriculture sector.
v. Advance loan for storage houses: ZTBL provides loans to farmers for the
construction of storage houses which enables the farmer to produce excess amount
of production.
95
9.6 MICRO FINANCE BANKS
The micro-finance institutions are established to provide the financial support in the
form of small loans and other financial services to the economically poor segments of the
society. Generally, a micro-finance institution works to extend the micro loans to the
poor on easy conditions in order to enhance their incomes. Unlike the commercial banks,
the micro-finance banks do not ask for some security or pledge of an asset to seek a loan.
Instead of this, microfinance institution has designed some other criteria to secure the
repay ability of the granted loan. For seeking loan from a micro-finance institution, a
poor person has to declare his/her conditions openly with a promise to utilize the amount of
loan in a productive manner to ensure its timely repayment. The structure of a micro-
finance institution may be the in form of a non-government organization or a bank. In case
of micro-finance bank, it will have to get license from the State Bank of Pakistan and all
operations of the micro-finance banks are monitored by the State Bank of Pakistan.
The Functions of Micro Finance Banks (MFB):
i. Loans to the Poor:

The MFB extend small loans to the poor individuals to enable them to start their
own micro businesses for generating a reasonable income. In the absence of MFBs,
the poor individuals and micro businesses are unable to obtain loans from the
commercial banks and other financial institutions. The presence of MFBs provides
a forum to the poor to access the required funds with minimum efforts.
ii. Investment Opportunities:

The presence of MFBs in the financial markets encourages the investors to pay
attention to the needs of the micro enterprises. The presence of MFBs in the poor
localities facilitates the partnership between the large size businesses and micro
enterprises for variety of low value-added tasks resulting in increase of overall
business activities.
iii. Income Opportunities:

The poor individuals with lack of funds are unable to generate sufficient income for
their families. The MFBs fulfill this gap by providing micro loans on easy terms
and conditions to the micro enterprises who utilizes these funds to start small
businesses or expand their existing income earning activities.
iv. Support to Micro Businesses:

The provision of funds to the micro businesses by the MFBs enhances the volume
of operations of these businesses and provides them necessary capital to expand
their business operations. The micro businesses are generally vulnerable to the
economic shocks and their access to the funds in the formal financial system is
limited. The MFBs ensures the level playing field to the small businesses enabling
them to meet their capital deficiencies.
96
v. Financial Inclusion:
The participation of poor individuals and micro enterprises in the financial system
through the MFBs provides a way for enhancing the financial inclusion in the
country. A large majority of poor has no bank account in Pakistan and this impacts
their ability to access the formal financial markets. The MFBs fills this gap and
increases the overall financial inclusion of the poor in the financial system.
9.7 ISLAMIC BANKING IN PAKISTAN

Islamic banking is consistent with the principles of Sharia and its practical application
through the development of Islamic economic. Islamic Shariah Law prohibits acceptance
of amount in the form of interest which is also known as Riba. According to constitution
of 1973: ‘’Islam was declared state religion “steps should be taken to enables the Muslim
to manage their lives in accordance with the teaching of Islam as set by Islam and
Sunnah”. The process of wide Islamization of the banking system in Pakistan was started
after a declaration in February 1979. Government has taken following steps for removing
of interest from economy;
i. In February 1979 the operation of three institutions, Investment corporation of
Pakistan (ICP), National investment trust (NIT), and House building finance
corporation (HBFC) were targeted to re oriented for elimination of interest.
ii. In 1981, government directed all banks to open profit and loss sharing accounts
along with interest bearing accounts and its open choice for customers either
deposit their money in profit and loss Sharing account or interest bearing.
iii. 1981, ordinance promulgated for the establishment of Modaraba companies and
flotation of Modaraba certificates.
iv. July, 1, 1982 under technique of Musharaka banks can provide finance to trade and
industry for meeting working capital requirement.
v. July 1, 1985 all banks in Pakistan were made interest free. No bank could receive
deposits other than interest free. Existing deposits were also converted based on
profit and loss sharing.
Governor of State bank of Pakistan has stated that interest free Islamic banking and
interest-based banking are run parallel and it up to customer that either go for Islamic
interest free banking or deposit money under interest-based banking. A Shariah Board
was established at SBP which advises SBP about regulations pertaining to Islamic
banking. This board consists of five members; two Shariah scholars, one chartered
accountant, one lawyer and one banker. Its responsibility is to review the instruments of
SBP for conducting banking under Islamic modes.
Main Modes of Islamic Financing:
Musharaka:
Musharaka is a non-interest-based agreement between two or more parties who agree to
combine their resources for profit making. This agreement is between bank and its
clients for carrying a business for specific agreed time period. Profit and losses are shares
according to the ratio as per the agreement. Key features of Musharaka are;
i. Capital: Capital contributed by partners should be clearly mentioned in agreement
because further working and profit is distributed based on investment made by
partners.
97
ii. Management: According to Musharaka principles all partners have a right to take
part in its management and work for partners. But it depends on partners if they
agreed that affairs of management are managed by one of them than other partner’s
only share profit up to their investment.
iii. Distribution of Profit or Loss: The ratio of profit or loss for each partner must be
determined according to profit or loss earned by business. Fixed lump sum is not paid
to anyone. Sharing is made according to agreed ratio fixed at the time of agreement.
Modaraba: Modaraba means a business in which some partners contribute capital and
the Modarab (manager) contribute his managerial skills. Profit sharing among partners is
done according to the contribution made by each partner and the ratio mentioned in the
agreement.
Key Features of Modaraba:

i. It is an agreement where one party provides managerial skills and other provides
capital.
ii. It is registered under Modaraba Companies Ordinance 1980.
iii. Profit/loss shared according to agreed ratio.
iv. Modaraba Management Company is regulated by registrar of Modaraba, SECP and
religious board.
v. Clearance certificate must be obtained from religious board that business is not
against Islamic laws.
Ijarah (Leasing): Ijarah is an agreement of Islamic banking. It is long term investment.

Here an owner (Lessor) leases its assets to lessee for some specific time and pay rent.
Ownership of asset is remained with lessor. Lessee has only right to use the property
against charges to pay. In context of Islamic banking it is a lease contract under which
bank lease equipment or building to their clients against a fixed charges (rent).
Features of Ijarah:
i. Tangible asset: To lease the specific goods or assets like property and transport etc.
ii. Labor: To lease out the Self Skills. Workers that work only for the interest of
particular employer or contractor and does not have rights to work for other during
that time.
iii. Description of assets: Asset is described in advance. Asset is not available during
contract it must be delivered at some specific date.
9.8 ELECTRONIC BANKING IN PAKISTAN

Electronic banking is also known as internet banking. It enables its customer to conduct
financial transaction through financial institution websites. With the help of E. banking
customer can conduct various transactions from any place. It not only provides the ATM
facility but also provides all other banking facilities like payment etc.
Now customer demands 24 hours banks at anywhere. Due to internet technology entire
banking structure has been changed. Banking services become economical due to
98
technology. There is a saving time and money by using E. banking. Online banking
facility has been provided by large number of commercial bank. All banks provides
number of facilities to attract customer. The banks are quite aware the changing needs of
customers. They realize that if they compete they shall provide facilities of electronic
banking to their customers.
Forms of E-Banking:
i. Internet Banking:
It refers to the provision of funds receipts and payments services through internet
on the particular website of the bank. In this age of IT, almost all commercial
banks have developed the interactive websites for facilitating customers to access
their accounts through website from their homes and make desired transactions in
online mode.
ii. Mobile App Based Banking:
Mobile application-based banking is modern concept of digital banking in which a
specialized mobile application is developed and customers can install that
application on their mobile phones. This application enables the customers to
access their accounts from their mobiles and receipts and payments can be made
through this mode.
iii. Phone Banking:
Phone banking enables customers to access their accounts from mobiles through
special interfaces developed with the help of telecom companies. It is relatively
older concept than the app-based banking and majority of banks are now shifting
their digital operations towards app-based mobile banking discussed above.
iv. ATM:
The Automated Teller Machines (ATM) are used for many banking services. Usually
installed at bank branches and shopping malls, these machines disburse cash to the
desired customers and funds can be transferred through them in an easy way.
Benefits of Electronic Banking:
Internet banking is also called online or home banking. It is started with the use of
proprietary software. Following are the advantages of electronic banking.
i. Reduction of Paperwork: Generally, banking work is paper based. Electronic

banking has reduced the use of paper resulting in lower costs.
ii. Time Saving: By using electronic banking, time and cost of customer is saved.
Burden of work on bank employees are reduces which increases their productivity.
iii. Number of Customer Increased: Electronic banking is expanding due to modern
technology. It attracts large number of customer as it offers ease and less costly.
iv. Checking of Balance: Every customer can check its account balance by sitting at
home and can make payment through internet banking without visiting the banks.
99
v. Payment of Utility Bills: Utility bills like gas bill, electricity bills and telephone
bills paid to the concerned department even sitting in any other country through
internet banking.
vi. Market Expansion: Due to electronic banking, both national and international
market has expended as we can make payment through internet by purchasing
anything from other countries.
Summary
This unit has briefly discussed the concepts of nationalization of banks in 1970s and their
privatization in 1990s. A comparative analysis has been made for both nationalization
and privatization programs. DFIS and Micro-Finance banks and their functions have been
discussed to improve the students’ ability to understand different forms of banking.
Lastly, Islamic banking and digital banking concepts have been discussed. All these
banking forms have increased the capacity of banking sector and have improved services
for the customers.
Exercise:
Short Questions:
1. Define Islamic banking.
2. Explain any four advantages of nationalization.
3. What are the DFIS?
4. What are the MFBs?
Long Questions:
1. Detail note on Islamic banking and its modes.
2. Why Islamic banks are important for Pakistan development?
References (Books):
References (Reports):
1. SECP Annual Report (latest) available on www.secp.gov.pk
2. Economic Survey of Pakistan (Latest ) available on www.finance.gov.pk
3. State of Economy Annual Report, State Bank of Pakistan (Latest) available on
www.sbp.gov.pk
100

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FUNDAMENTALS OF

MONEY AND BANKING

Code: 1414/8593 Units: 11–9

Dean Faculty of Social

Chairman: Prof. Dr. Syed Muhammad Amir Shah

Unit Writer: Moazzam Ali

Unit Reviewer: Prof. Dr. Syed Muhammad Amir Shah

Typeset by: Muhammad Javed

Editor: Fazal Karim

The objective of this course is to enable students to understand modern financial

Unit-1: Introduction to Money ......................................................................... 1

Unit-2: Value of Money ...................................................................................... 9

Unit-3: Financial Markets ................................................................................ 19

Unit-4: International Financial System ............................................................ 29

Unit-5: Banking ................................................................................................. 39

Unit-6: Functions of Commercial Banks ......................................................... 51

Unit-7: Bank Loans and Advances ................................................................... 63

Unit-8: Role of Central Bank ............................................................................ 77

Unit-9: Growth of Banking in Pakistan............................................................ 89

Written By: Moazzam Ali

1.1. Introduction to Money....................................................................................... 4

1.2. Forms of Money ................................................................................................ 4

1.3. Functions of Money .......................................................................................... 6

1.4. Qualities of Ideal Money................................................................................... 7

After reading this unit, you will able;

1. to visualize the concept of money and its functions.

2. to perceive the role and importance of money.

3. to identify the stages of evolution of money

4. to understand the ideal qualities of money

Money is the backbone of capitalistic economy everyone according to his capacity

1.2 FORMS OF MONEY

2. Metallic Money or Coins:

4. Credit Money or Bank Money:

3. Standard of Deferred Payments

2. Instrument of Economic Policy:

3. Tool to Monetary Management:

4. Aids to Production and Trade:

1.4 QUALITIES OF IDEAL MONEY

The essential attributes of ideal money are as follows;

2. Financial Institution Management by Helen P. Lange

3. Financial Institutions and Markets by Meir G. Kohn

4. Financial Markets and Institutions by Frederic Mishkin and Stanley G Eakins

5. Fundamentals of financial institutions management by Marcia Millon Cornett

6. Money and Banking by M.Saeed Nasir

Written By: Moazzam Ali

2.1. Value of Money ............................................................................................... 12

2.2. Inflation and its Types....................................................................................... 13

2.3. Remedies for Inflation....................................................................................... 14

2.5. Stagflation ......................................................................................................... 16

2.6. Depreciation and Devaluation of Money .......................................................... 16

The study of this unit, will enable you:

1. to understand the value of money

2. to explain the theories about value of money

3. to understand the concepts of inflation, deflation and stagflation

4. to understand the concept of devaluation and depreciation of money