Concepts of Banking Flashcards

Fundamental Definitions and Professional Conceptions of Banking

• Conceptual Overview of a Bank: A bank is a financial institution that identifies and collects society's surplus cash. It utilizes a portion of these funds to provide loans to investors, thereby earning profit. It functions fundamentally as an intermediary between the owners of surplus savings and the investors of deficit capital.

• Profit Mechanism: Banks generate profit through the interest rate spread. This involves receiving interest from borrowers (who seek short-term or long-term loans) and paying a relatively lower interest rate to depositors for the use of their funds.

• Regulatory Authorization: To function legally as a bank, the institution must be authorized by the country's Central Bank.

• Formal Definitions from Authoritative Sources:

  • The Dictionary of Banking & Finance: Defines a bank as an institution registered by the central bank that performs specific activities including: receiving current deposits with cheque withdrawal facilities; receiving term deposits with interest; discounting notes; approving loans; investing in government and credit instruments; collecting cheques, drafts, and notes; issuing drafts; and acting as a trustee under government permission.

  • Professor Gilbert: Describes a banker as a dealer in capital or money. The banker acts as an intermediate party who borrows from one and lends to another, deriving profit from the difference in terms between borrowing and lending.

  • American Institution of Bankers: Defines a bank as a service activity acting as an intermediary between the creditor and the lender.

  • Professor Chamber: Defines a bank as an office or institution for keeping, lending, and exchanging money.

  • Oxford Dictionary of Finance and Banking: Simple defines banking as the activities undertaken by a bank.

The Mechanics of Financial Intermediation

• Surplus vs. Deficit Units:

  • Surplus Units: Individuals or entities that consume less than their income. Their individual savings are small but become substantial when pooled in a bank. They deposit money because they lack the scale to start viable ventures independently.

  • Deficit Units: Individuals or entities that may have significant funds but require even larger sums for their ventures. They often lack direct access to surplus units due to the time required to collect small funds and a lack of established trust.

• The Dealer of Debts: A bank is considered a "dealer of debts." On one side, it acts as a borrower by collecting deposits through various accounts. On the other side, it acts as a lender by offering debts or loans to the public.

• Credit Multiplier and Spread: Banks earn more than their operational costs through the interest-spread and the credit multiplier effect.

• Principle of Collective Stability: Similar to insurance companies operating on the principle that not everyone dies at once, banks function on the principle that not everyone will withdraw their money on the same day.

• Distinguishing Factor: Credit creation is the specific element that distinguishes a bank from a non-banking financial intermediary.

Standard Bank Deposit Accounts

• Fixed Deposits: These funds are withdrawable only after a specified period. The rate of attractiveness of interest typically increases with the length of the deposit period.

• Current Deposits: These are withdrawable at any time by the depositor via cheque. Banks generally do not pay interest on current deposits.

• Savings Bank Deposits: These are subject to certain restrictions regarding the amount that can be received or withdrawn and typically carry a lower rate of interest.

Liquidity and Statutory Requirements

• Liquidity Principle: This refers to a bank's capacity to produce cash on demand. To avoid a "run" (a failure to meet customer cash demands that leads to loss of credibility), banks must keep sufficient cash in their tills and vaults.

• Statutory Liquidity Ratio (SLR): In Bangladesh, all commercial banks are legally required by the central bank to maintain a certain percentage of their deposits as liquidity. Historically, this requirement has been set at $18.5\, \%$

• Cash Reserve Ratio (CRR): Within the total SLR, a portion must be kept in cash with the central bank. Historically, this has been set at $5.5\, \%$, though it is subject to change based on central bank instructions.

• Vault Reserves: Banks also maintain cash in their own vaults and with the central bank to draw upon as necessity arises. Deposits are considered the "life blood" of commercial banks.

Nature and Characteristics of Banking Business

• Financial Institution: Banks deal in money by accepting public deposits for safe custody.

• Commercial Nature: Banking functions are performed with the primary goal of making profit.

• Legal Entity: Banks operate under government or company ownership and are regulated by the central bank.

• Solvency: Banks maintain their own capital alongside public deposits, ensuring they remain solvent.

• Primary Functions: The two pillars of banking are receiving deposits and issuing loans.

• Safety and Secrecy: Banks have a major responsibility to secure depositor funds and keep client financial records top-secret.

• Agency and Utility Services: Beyond core functions, banks act as agents (collecting bills, acting as trustees) and provide utilities like locker facilities, traveler's cheques, and letters of credit.

Structural Classification of Banks

• Unit Banking:

  • Definition: Banking operations carried out through a single office in a particular area.

  • Context: The USA is the homeland of unit banking, where approximately $85\, \%$ of banks are unit banks.

  • Features: Small size, limited capital, efficient management due to scale, and rapid decision-making.

  • Disadvantages: Lack of solvency, difficulty in fund transfer, and limited investment capacity.

• Branch Banking:

  • Definition: A system where a single bank operates through a network of branches across a country or internationally.

  • Context: Originated in the United Kingdom; popular in Asia and Africa.

  • Features: Central office control, high capital requirements ($100\, \text{crore}$ paid-up capital for scheduled banks), and efficient risk distribution.

  • Disadvantages: Complex management, potential for delayed decisions, and political/local influence.

• Chain Banking:

  • Definition: Multiple weak banks agreeing to operate under the direction of a single manager or a single individual/family to increase profit and goodwill. Each bank retains its individual legal entity. Historically found in the USA before $1920$. No such system exists in Bangladesh.

• Group Banking:

  • Definition: Two or more banks controlled by a holding company which holds the majority of voting power. Members can pool resources and reduce idle cash.

• Mixed Banking: A combination of commercial banking (short-term financing) and investment banking (long-term financing). Commercial banks must keep assets liquid to meet demand deposits, whereas investment banks procure longer-duration resources.

Ownership and Functional Classifications

• Ownership Categories:

  • Public Bank: Government-owned and directed (e.g., Sonali Bank Limited, Janata Bank Limited).

  • Private Bank: Established under private or joint ownership (e.g., Jamuna Bank Limited, Trust Bank Limited).

  • Joint Ownership Bank: Owned by both government and non-government entities (e.g., Bangladesh Commerce Bank Limited).

  • Autonomous Bank: Government-owned but self-regulated with minimal interference.

• Functional Categories:

  • Central Bank: The top controlling bank (e.g., Bangladesh Bank). Holds a monopoly on issuing currency and acts as the banker's bank.

  • Commercial Bank: Focuses on short-term credit for trade and industry. There are approximately $50$ to $51$ commercial banks in Bangladesh.

  • Specialized Banks: Focus on specific sectors like industry (Industrial Banks), agriculture (Agricultural Banks), or co-operatives (Co-operative Banks).

  • Merchant Bank: Focuses on managing securities, underwriting, project counseling, and corporate advisory services.

  • Investment Bank: Assists organizations in raising long-term capital by selling shares/bonds and acting as underwriters.

  • Grameen Bank: Founded by Professor Muhammad Yunus. It removes collateral requirements, serving the rural poor to fight poverty through mutual trust and accountability.

  • Other Specialized Banks: Includes Transportation Banks (modernizing transport), Mortgage Banks (long-term loans against land), and Savings Banks.

Detailed Comparison: Bank vs. Banking

• Nature: A bank is a financial intermediary institution; banking is the summation of all activities (collection of deposits, granting loans, etc.).

• Structure: A bank has an organizational structure (proprietorship, partnership, etc.); banking has no organogram.

• Entity: An individual bank has a separate legal entity; banking has no separate entity and is based on the bank's entity.

• Success and Dependency: The success of a bank depends on the banker's efficiency; the success of banking depends on the bank's size and form. Banking is dependent on the bank.

Scheduled vs. Non-Scheduled Banks in Bangladesh

• Scheduled Banks:

  • Definition: Banks included in the list maintained by the central bank under the Bangladesh Bank Order-1972 (Article 32).

  • Requirements: Must have a paid-up capital and reserves totaling $400\, \text{crore}$ and must maintain a statutory liquidity ratio ($18\, \%$ mentioned as currently required in specific contexts).

  • Privileges: Enlistment allows clearing system access and rediscounting of bills from the central bank.

  • Current Count: There are total $51$ scheduled banks currently in Bangladesh.

• Non-Scheduled Banks:

  • Definition: Banks not included in the central bank schedule. They are established for specific objectives.

  • Limitations: No direct central bank control, no clearing system privileges, and they must clear cheques through scheduled banks.

  • Examples: As of the current period, Grameen Bank is a non-scheduled bank. Others include Ansar VDP Unnayan Bank, Karmashangosthan Bank, and Probashi Kollyan Bank.

The Banking System and Regulation in Bangladesh

• System Type: Bangladesh employs a mixed banking system dominated by commercial banking.

• Regulatory Body: Bangladesh Bank is the top regulatory authority under the Bank Company Act-1991 (Amended 2003) and the Bangladesh Bank Order-1972.

• Institution Count:

  • State-Owned Commercial Banks (SOCBs): $4$ (Sonali, Janata, Agrani, Rupali).

  • Specialized Banks (SDBs): $4$ or $5$ depending on the specific list (e.g., Bangladesh Krishi Bank, BASIC Bank).

  • Private Commercial Banks (PCBs): $39$.

  • Foreign Commercial Banks (FCBs): $9$ (e.g., Standard Chartered, HSBC).

• Minimum Capital Standards: All banks must have a minimum capital of $400\, \text{crore}$, with at least $200\, \text{crore}$ as paid-up capital.

• Modernization Initiatives: Establishment of the Bangladesh Automated Clearing House (BACH) and the National Payment Switch Bangladesh (NPSB) to facilitate ATMs, POS, and mobile banking.

• Supervisory Systems: Bangladesh Bank uses off-site and on-site supervisory systems. Inspection Wings 1 and 2 conduct audits to ensure stability and legal compliance.

Basel II Framework

• Definition: Recommendations on banking laws and regulations by the Basel Committee on Banking Supervision intended to create an international standard for risk and capital management.

• The Three Pillars:

  • Pillar 1: Minimum Capital Requirements: Deals with maintaining regulatory capital against credit, operational, and market risks.

  • Pillar 2: Supervisory Review: Provides regulators with tools to deal with systemic, concentration, strategic, reputational, and liquidity risks.

  • Pillar 3: Market Discipline: Focuses on disclosure requirements to allow market participants to assess the capital adequacy of an institution.

Bank-Customer Relationships and KYC

• Relationship Categories:

  • Debtor-Creditor: The primary relationship. When a customer deposits, the customer is the creditor and the bank is the debtor.

  • Creditor-Debtor: Occurs when a bank provides a loan; the bank is the creditor and the customer is the debtor.

  • Principal-Agent: Occurs when the bank collects cheques or pays insurance premiums on behalf of the customer.

  • Bailor-Bailee: Occurs when a bank receives gold or documents for safe custody.

  • Trustee: Occurs when money is deposited for a specific purpose or during the collection of a cheque.

• Know Your Customer (KYC):

  • Objectives: Appropriate customer identification and monitoring of suspicious transactions to prevent money laundering, forgery, and illegal transfers.

  • Form Usage: Required during account opening, updates for supplementary accounts, locker facilities, change of signatories, or large transactions by non-account holders.

• Garnishee Order: A court order instructing a bank (the garnishee) to freeze funds of a debtor (judgment debtor) and potentially pay a sum to a creditor (judgment creditor).

Etymology and Historical Evolution

• Origin of "Bank":

  • German: "Banke" meaning a joint stock firm.

  • Italian: "Banco" meaning a heap or mound.

  • Greek: "Banque" meaning a bench.

• Origin of "Bankrupt": Derived from the Italian "Banca Rotta" (broken bench). In early Italy, if a banker could not pay their debts, their bench in the marketplace was broken.

• Historical Timeline:

  • Ancient Civilization: Evidence of banking functions in Greece, Rome, and Egypt around $5000\, \text{B.C.}$. Babylonian priests received deposits to lend. Baidik civilization ($2000$-$1000\, \text{B.C.}$) recorded interest in the "Bedth".

  • Modern Banking Ancestors: The Goldsmiths (introduced deposit slips), the Merchants (introduced traveler's cheques and letters of credit), and the Money-Lenders (focused on lending and asset collection).

  • The First Banks: The Bank of Venice ($1157$ AD) in Italy; the Bank of England ($1694$ AD); and Hindustan Bank ($1700$ AD) in Kolkata.

  • Electronic Evolution: In $1961$, the National City Bank of New York introduced the Electronic Fund Transfer System (EFTS).

Questions & Discussion

• How is a bank defined in the context of being a "dealer in debts"?

• What is the difference between bank and banking?

• What are the features, advantages, and disadvantages of unit banking versus branch banking?

• How does the liquidity principle protect a bank from a "run"?

• What are the three pillars of Basel II, and how do they ensure banking stability?

• Explain the roles of Goldsmiths, Merchants, and Money-lenders as the ancestors of modern banking.

• What are the specific conditions required for a bank to be scheduled by the central bank in Bangladesh?

• Define and describe the scope of merchant banking, offshore banking, and mutual funds.

• What are the six viewpoints from which the qualities of a good bank can be discussed?

• Explain the significance of Grameen Bank in the context of collateral-free banking.