Finance for Commerce - The Role and Function of Financial Institutions

The Role and Function of Financial Institutions

Learning Objectives

• Understand the role and function of different financial institutions for commercial operations:
  • Commercial banks
  • Post offices
  • Central banks
• Banking services:
  • Current, deposit, and savings accounts
  • Overdraft facility
  • Night safes
  • ATM services
  • Provision of foreign currency
  • Credit and debit cards
• Trends in banking:
  • Mobile and digital banking
  • Internet banking
  • The cashless society

Subject Vocabulary

• Barter system: A system of exchange where goods are swapped for other goods.
• Deposit account: A bank account used to store money on which interest is paid.
• Overdraft: A borrowing arrangement where a current account holder is allowed to spend more money than there is in the account, up to an agreed limit.
• Post office: An organization responsible for postal services and (in some countries) telecommunications and financial services.
• Savings account: A bank account into which account holders pay a regular amount each month to build up savings. The account pays interest.
• Current account: A cheque account used to handle payments and receipts for account holders.
• Monetary policy: Measures designed to control the money supply in a country (e.g., adjust interest rates). They might be used to control inflation, for example.
• Inflation: A rise in the general price level.
• Night safe: A safe that is accessed through a hole in the wall of a bank. Used to make deposits when banks are shut.
• Bank statement: A document that shows the bank transactions, such as ATM withdrawals, standing orders, and cheque payments, made by an account holder during the month. The bank balance is also shown.
• Issue: To officially give something.
• Accumulate: To get more and more of something gradually over time.
• Phishing: Sending emails, illegally pretending to be from trusted companies in order to trick individuals into disclosing personal information (passwords, bank account numbers, and credit card numbers, for example).
• Short-term finance: Money borrowed for one year or less.
• Long-term finance: Money borrowed for more than one year.
• Flexible: Able to be changed to meet different circumstances.
• Specialist: A person or organization with expert knowledge in a certain area.
• Lease: A source of finance used to acquire land, property, machinery, and equipment. A fee (rent) is paid for the period of use.
• Hire purchase (HP): Buying specific goods with a loan, often provided by a financial institution like a bank.
• Instalment: One of several smaller payments put towards a larger amount.
• Unsecured loan: A loan which is not supported by collateral (i.e., security such as property).
• Secured loan: A loan that is supported by collateral such as property.
• Collateral: Something valuable that you have give to somebody if you cannot pay back what you have borrowed.
• Debenture: A loan to a company that pays a fixed rate per annum for a fixed period of time. Debentures can be traded.
• Crowdfunding: Where a large number of individuals (the crowd) invest in a business venture using an online platform and therefore avoiding a bank.
• External finance: Finance obtained from outside the business.
• Venture capital: Money provided by specialist investors or individuals for business purposes.
• Stake: The proportion of a company owned by a shareholder.
• Business angel: An entrepreneurial individual (usually wealthy) who provides a business with some capital in return for a stake. They may also provide guidance in the development of the business.
• Retained profit: Profit that is kept by the business for future use. It is not distributed to the owners.
• Capital gain: The profit made on the sale of an asset (a share or equity, for example).
• Ordinary share: A share entitling its holder to variable dividends and the right to vote.
• Preference share: A share, usually with no voting rights, which entitles the holder to a fixed dividend, whose payment takes priority over that of ordinary share dividends.
• Initial public offering (IPO): Where shares in a public limited company are sold, and traded on a stock market, for the very first time.
• Stock exchange (stock market): A market for second-hand shares.
• Issuing house: A financial institution (like a merchant bank) that arranges the issuing of new shares on the stock exchange.
• Merchant bank: A specialist bank that conducts underwriting, loan services, financial advising, and fundraising services for large corporations and very wealthy individuals.
• Holdings: The amount of something (e.g., shares or money) that a person has.
• Prosper: To be successful, often financially.
• Reserves: Funds set aside for future use.
• Equities: Another name for shares.
• Yield: The total amount of something that is produced.
• Fundamental value: The worth of a company based on proper financial analysis which considers the value of its assets and the future potential of its products.
• Liquidity: The ease with which an asset can be converted into cash.
• Legal tender: Where a means of payment must be accepted by law.
• Cheque: A document that instructs a bank to transfer funds from one bank account to another.
• Drawer: The person or business making a payment by cheque.
• Payee: The person or business receiving payment by cheque.
• Drawee: The bank that provides the cash in a cheque payment.
• Presented: To give somebody something that needs to be paid.
• Honoured: Where a bank pays the money to the payee as instructed by a cheque.
• Counterfoil: the part of the cheque that you keep for yourself after giving the main part to somebody else
• Bookkeeper: the person responsible for keeping records of business transactions
• Cheque crossing: two parallel, vertical lines drawn across the face of a cheque which means the cheque must be paid into a bank account
• Endorsed: where a cheque is signed on the back to make it payable to someone other than the stated payee or to accept responsibility for paying it

Getting Started

• Financial institutions are crucial for facilitating trade.
• Without them, the barter system (swapping goods) would be necessary, which is inefficient.
• Commercial banks play a key role in facilitating the exchange of goods and services.

Case Study: Maung Maung Min

• Maung Maung Min rears chickens and sells them at the market.
• He kept his earnings in a tin, which was stolen.
• A friend advised him to open a bank account for safety and other benefits like interest, electronic payments, ATM access, and credit cards.

Advantages of Having a Bank Account

1. Safety of money
2. Potential to earn interest
3. Electronic payment options
4. ATM accessibility
5. Potential for credit card use

How Traders Exchange Goods If Money Did Not Exist

• Traders would have to exchange goods using the barter system.

The Role and Function of Financial Institutions

Commercial Banks

• Key aid to trade.
• Large public limited companies.
• Profit by keeping customers' money safe, lending money, and offering financial services.
• Authorized by the government to receive money and make payments on behalf of depositors.
• Collect payments on behalf of depositors.
• Ensure money passes freely between buyers and sellers, facilitating a smooth economy.
• Direct funds from savers to businesses for investment, e.g., using deposit accounts to provide loans and overdrafts.
• Lend to individuals for purchases like cars or houses.

Post Offices

• Perform two supporting roles in commerce: contributing to the financial system and providing a communication network.

Financial Role

• Valued, especially in rural communities.
• Offer various financial services:
  • Payments: Money transfer via debit/credit cards or cash delivery. Postal orders (like cheques without needing a bank account).
  • Savings accounts: Interest on deposits, access to money on demand.
  • Current accounts: Similar to bank current accounts (in some countries).
  • Loans and mortgages: Borrowing money, including long-term property loans.
  • Foreign currency: Purchase over the counter or delivery.
  • Credit cards: Similar to bank-issued cards, allowing users to buy goods and pay later.
  • Insurance: Policies for motor or house insurance.

Communications

• Often important community centers, especially in rural areas.
• Provide important means of communication through the postal system.
• Responsible for collecting and delivering letters and parcels.
• Postal service costs depend on size, weight, distance, and service speed.

Postal Services

• Mail delivery: Two-tier system for faster services.
• Registered mail: For valuable items, compensation if lost, requires recipient signature.
• Recorded delivery: Cheaper than registered mail, signature required, lower compensation for lost post.
• Express delivery: Fast services with guarantees and online tracking.
• Airmail: For sending letters and parcels by air, requires a written declaration of contents for parcels.
• Poste restante: Mail sent to a named post office for collection by travelers with no fixed address.
• PO Boxes: Secure private boxes at a post office with 24-hour access.
• Courier service: Door-to-door delivery for letters and parcels.
• Bulk posting: Business service for large amounts of post using a franking machine.

Case Study: India Post

• Largest postal network with over 155,000 branches.
• Provides a range of services including mail, parcel, money transfer, banking, insurance, retail services, and government services (e.g., pension payments).
• Aims to provide value-for-money, reliable services, and maintain a link between people and the government.

Central Banks

• Key role in a nation's financial system, maintaining financial stability.

Functions of Central Banks

1. The government's bank:
   • Handles government payments and receipts.
   • Manages government debt and borrowing and makes interest payments.
   • Advises the government on economic matters.
   • Implements monetary policy, including controlling inflation.
   • Manages the nation's reserves of foreign currency.
2. The banker's bank:
   • Commercial banks have accounts with the central bank.
   • Commercial banks must hold a certain amount of money with the central bank by law which helps control lending and stabilize the financial system.
   • Accounts are used to settle debts between banks.
3. Issues notes and coins:
   • Authorized to issue all notes and coins.
   • Responsible for printing money and ensuring faith in the currency.
   • Notes must be designed to prevent forgery.
4. Lender of last resort:
   • Commercial banks can borrow from the central bank if they run out of money.
   • Provides stability in the financial system.
   • Provides the government with funds if needed, buying government assets.

Case Study: The Central Bank of Sri Lanka (CBSL)

• Head of the financial sector in Sri Lanka, established in 1950.
• Objectives: maintain economic and price stability and maintain stability in the nation's financial system.
  • Sole authority to issue notes and coins.
  • Sets interest rates.
  • Advises on economic affairs.
  • Banker to the government.
  • Manages the Employees' Provident Fund and public debt.
  • Provides exchange control services.
  • Manages foreign- and government-funded credit schemes.

Banking Services

• Facilitate payment systems, primarily through current accounts.

Bank Accounts

Current Accounts

• Also called sight deposits or cheque accounts.
• Used for depositing cash receipts (wages, revenue).
• Account holders receive a cheque book, a paying-in book, and a debit card.
• Cheques facilitate payments, paying-in books deposit cash and cheques, and debit cards withdraw money or make payments.
• Payments are often made directly bank to bank.
• May have charges, and often do not receive interest, though some banks are beginning to offer low rates.

Deposit Accounts

• Also known as time or term deposits.
• Used to store money safely and attract interest.
• Higher interest if prior notice is given before withdrawal (e.g., 90 days, six months).

Savings Accounts

• Designed for people who want to accumulate cash holdings over time.
• Suitable for regular savers who deposit money on a regular basis.
• Interest rates can be attractive, particularly for long-term deposits.
• Instant access savings accounts usually offer lower rates.

Overdraft Facilities

• Allows current account holders to spend more money than they have in their account up to a certain limit.
• Flexible form of borrowing, especially for businesses.
• Banks must give permission - have an agreed overdraft facility (limit).
• Exceeding the limit attracts severe penalty charges.
• Interest paid on overdrafts is always higher than that received on deposit or savings accounts.

Night Safes

• Used by business customers to deposit revenue when banks are closed.
• Found in the walls of banks near ATMs, accessed with a key.
• Cash is dropped into the safe and processed the next morning.
• Reduces the need to keep large amounts of cash on business premises overnight.

ATM Services

• Found outside banks and in convenient locations.
• Used mainly for withdrawing cash with a debit or credit card and a PIN.
• Some offer additional services:
  • Paying-in facilities
  • Balance inquiries and statements
  • Mobile phone top-ups
  • Making payments
  • Transferring money between accounts
  • Changing PINs
• Some ATMs charge fees for withdrawals.
• Convenient for account holders, saves labor costs and reduces queues for banks.

Provision of Foreign Currency

• Most banks offer foreign currency exchange.
• Individuals can buy currencies over the counter which can be used by individuals or small businesses.
• Charges may not be the lowest on the market.

Credit and Debit Cards

• Debit cards are issued when a current account is opened.
• They can be used to withdraw cash from ATMs, make payments in shops, and for online transactions.
• Credit cards are issued after an application has been made a financial institution.
• Using credit cards to withdraw cash incurs interest immediately.
• Allow users to buy goods and services and delay payment.

Trends in Banking

Mobile and Digital Banking

• Service allowing customers to conduct financial transactions using a mobile device.
• Growing globally with significant regional variations.
• Advantages and disadvantages are similar to Internet banking.
• Can be conducted anywhere with an Internet connection.

Internet Banking

• Increasing number of people use the Internet for banking.
• Easy access with a username and password.
• Transactions include making payments, checking balances, managing standing orders, applying for loans, and transferring money.

Advantages of Internet Banking

For Customers

• Access accounts anytime, anywhere with Internet access.
• Reduces the need to visit branches in person, saving time.
• Business customers can collect payments, transfer funds, manage payments, organize payrolls, and conduct other transactions online.

For Banks

• Reduces costs by reducing the need for buildings, equipment, and staff.
• Call centers deal with customer inquiries, many dealt with online.
• Can offer most services at any time and use websites to advertise products, with targeted ads.

Disadvantages of Internet Banking

• Technical faults can block access to accounts.
• Risk of fraud through hacking or phishing scams.
• Cannot be used to withdraw or pay in cash making ATMs and branches necessary.

Cashless Society

• Increasing use of bank cards, mobile phones, and the Internet for payments.
• Cash use is declining, though unlikely to disappear completely.
• Sweden is closest to a cashless society, with only 19% of transactions in cash (2018).

Advantages of a Cashless Society

• Less crime: Cash is easy to steal, and criminal transactions would be harder to track.
• More transparency: All non-cash transactions are recorded, making it harder to evade tax.
• More convenient: Non-cash payments are more convenient for shoppers, reducing queues and ATM use.
• More efficient payments: Eliminates the cost of printing, storing, and replacing money.
• Higher spending levels: People spend more with non-cash methods, boosting economic growth.
• Easier international payments: No need to obtain foreign currency when travelling.

Disadvantages of a Cashless Society

• Inclusion: Some people prefer or can only use cash; businesses risk losing customers in developing countries.
• Trust: People trust cash, with no third parties involved, offering clarity.
• Reliable: Cash does not need IT systems; outages cannot occur.
• Accessibility: Cash is readily available without additional charges.
• Confidentiality: Cash transactions are private, with no electronic record.
• Efficient: Cash is still cost-effective for some businesses, like market traders.
• Increase debt: Non-cash methods may result in increased private debt.

Methods of Payment

• Cash is still used to make payments all over the world, alternative payment methods are being used more and more.
• Cash is legal tender so by law it must be accepted by debt as a method of settling a debt.
• For a business cash may be used to finance low value transactions however when it comes to paying for expensive items such as commercial property, machinery, equipment and suppliers cash is not likely to be used. One of the methods outlined below is more likely to be used.

Cheques

• A cheque is not legal tender, it's a document that instructs a bank to transfer money from one bank account to another.
• The money is transferred from the drawers account to the payees account when the cheque is presented at the bank.
• The drawer is the person or business making the payment and the payee is the person or business receiving the payment.
• Cheques are a flexible method of payment because different amounts can be paid using the same standard document.
• They also have the advantage of providing proof of payment because the transaction is recorded on a bank statement.
• Cheques are a secure means of payments because they cannot be easily cashed by unauthorized people.

Disadvantages of Cheques

• The payee cannot be certain that the cheque will be honored by the bank
• The transaction may take up to five working days for the money to be transferred between accounts.

Terms related to cheques

• The Drawer - Weston LTD: Means the money will be transferred from Weston LTD's bank account.
• Payee - Horsely Catering LTD: This is the business that will receive the money when the cheque is paid in.
• Drawee - NorthWest Bank: This is where Weston LTD has its bank account.
• Counterfoil (or cheque stub): This is kept by the drawer as a record of the payment.
• Branch sort code: Identifies the bank's address.
• Cheque Crossing: Two parallel which means the cheque must be paid into a bank account.
• Endorsed: This means that it can be signed on the back by the payee and then paid into another bank account.