Business Studies Form 4 Notes : MONEY AND BANKING

MONEY AND BANKING

Barter Trade

This is a form of trade where goods and services are exchanged for other goods and services.

Benefits

• Satisfaction of wants: An individual is able to get what he or she needs.
• Surplus disposal: An individual or country is able to dispose of its surpluses.
• Social relations: It promotes social links since the communities trade together.
• Specialization: Some communities specialize in a particular commodity.
• Improved living standards: This is enhanced by receiving what one is unable to produce.

Limitations of Barter Trade

• Lack of double coincidence of wants: It is difficult to find two people with the need for each other’s product at the same time.
• Lack of store of value/perishability of some commodities: Some goods are perishable; thus, their value cannot be stored for a long time for future purposes (e.g., one cannot store vegetables for exchange purposes in the future).
• Indivisibility of some commodities: It is difficult to divide some products like livestock into smaller units to be exchanged with other commodities.
• Lack of standard measure of value: It is not easy to determine how much one commodity can be exchanged for a given quantity of another commodity.
• Transportation problem: It is difficult to transport bulky goods, especially when there is no faster means of transport.
• Lack of a standard deferred payment: The exchange of goods cannot be postponed since by the time the payment is made, there could be fluctuation in value, demand for a commodity may not exist, and the nature and quality of a good may not be guaranteed. It may be difficult to decide what to accept for future payment.
• Lack of specialization: Everyone strives to produce all the goods he or she needs due to the problem of double coincidence of wants.
• Lacks unit of account: It is difficult to assess the value of commodities and keep their record.

MONEY SYSTEM

Money is anything that is generally accepted and used as a medium of exchange for goods and services.

Features/Characteristics of Money

For anything to serve as money, it must have the following characteristics:

• Acceptability: The item must be acceptable to everyone.
• Durability: The material used to make money must be able to last long without getting torn, defaced, or losing its shape or texture.
• Divisibility: Money should be easily divisible into smaller units (denominations) but still maintain its value.
• Cognizability: The material used to make money should be easily recognized. This helps reduce chances of forgery and helps people differentiate between various denominations.
• Homogeneity: Money should be made using similar material so as to appear identical. This eliminates any risk of confusion and forgeries.
• Portability: Money should be easy to carry regardless of its value.
• Stability in value: The value of money should remain fairly stable over a given time period.
• Liquidity: It should be easily convertible to other forms of wealth (assets).
• Scarcity: It should be limited in supply. If it is abundantly available, its value will reduce.
• Malleability: The material used to make money should be easy to cast into various shapes.
• Not easy to forge: Money should not be easy to imitate.

Functions of Money

• Medium of exchange: It is generally acceptable by everyone in exchange for goods and services. It thus eliminates the need for double coincidence of wants.
• Store of value: It is used to keep value of assets (e.g., surplus goods can be sold and then money kept for future transactions).
• Measure of value: Value of goods and services are expressed in money form. Performance of businesses is measured in terms of money.
• Unit of account: It is a unit by which the value of goods and services are calculated and records kept.
• Standard of deferred payment: It is used to settle credit transactions.
• Transfer of immovable items (assets): Money is used to transfer assets such as land from one person to another.

DEMAND FOR MONEY

This is the tendency or desire by an individual or general public to hold onto money instead of spending it. It is also referred to as liquidity preference.

Money is held by people in various forms:

• Notes and coins
• Securities and bonds
• Demand deposits such as bank current account balances
• Time deposits such as fixed account balances

REASONS (MOTIVES) FOR HOLDING MONEY

1. Transaction Motive: Money is held with a motive of meeting daily expenses for both firms and individuals. The demand for money for transaction purposes by individuals depends on the following factors:
   • Size/level of individual’s income: The higher the income of an individual, the more the number of transactions, thus high demand for transactions.
   • Interval between pay days/receipt of money: If the interval is long, then a high amount of money will be held for transaction reasons.
   • Price of commodities: If the prices are high, the value of transactions will also increase, thus more money balances required.
   • Individuals’ spending habits: People who spend a lot of money on luxuries will hold more money than those who only spend money on basics.
   • Availability of credit: People who have easy access to credit facilities hold little amount of money for daily transactions than those who do not have easy access to credit.

   The transaction motive can further be divided into:

   • Income motive: Holding money to spend on personal/family needs.
   • Business motive: Holding money to meet business recurring needs such as paying wages, postage, raw materials, etc.
2. Precautionary Motive: Money is held in order to be used during emergencies such as sicknesses.

The amount of money held for this motive will depend on the factors such as:

• Level of income: The higher the income, the higher the amount of money held for precautionary motive.
• Family status: High-class families tend to hold more money for precautionary motive than low-class families.
• Age of the individual: The aged tend to hold more money for precautionary motive than the young since they have more uncertainties.
• Number of dependants: The more dependants one has, the more money they are likely to hold for precautionary motive.
• Individual’s temperament: Pessimists tend to hold more money for precautionary motives than optimists because they normally think things will go wrong.
• Duration between incomes: Those who earn money after a short time are likely to keep less money than those who earn money after a long time.

3. Speculative Motive: Money is held to be used in acquiring assets whose values are prone to fluctuations such as shares or money is held anticipating a fall in prices of goods and services. This depends on the following:
   • The wealth of an individual
   • The rate of interest on government debt instruments
   • Interest on money balances held in the bank
   • How optimistic or pessimistic a person is

SUPPLY OF MONEY

This is the amount of money/monetary items that are in circulation in the economy at a particular period of time. They include the following:

• Total currency i.e., the coins and notes issued by the central bank.
• Total demand deposits: money held in current accounts in banks and are therefore withdrawable on demand.

Factors Influencing Supply of Money

• Government policies: If there is more money in the economy, the government will put in place measures to reduce the supply such as increasing interest rates.
• Policies of commercial banks: The more the loans offered by commercial banks, the more the amount of money in circulation.
• Increase in national income: Increase in national income means that more people will be liquid due to increase in economic activities.
• Increase in foreign exchange: The foreign exchange reserves will increase, thus supply increases.

BANKING

This is the process by which banks accept deposits from the public for safekeeping and lend out the deposits in the form of loans.

A bank is a financial institution that accepts money deposits from the public for safekeeping and lending out in terms of loans.

COMMERCIAL BANKS

These are financial institutions that offer banking services with a profit motive. Their activities are regulated by the Central Bank.

Functions of Commercial Banks

• Accepting deposits: They accept deposits from members of the public in the form of current accounts, savings accounts, and fixed deposit accounts. Such accounts help individuals to keep money safely.
• Provision of safe means of payments: They provide safe and reliable means of payment such as cheques, bank drafts, credit transfers, electronic funds transfers, etc.
• Provision of loan facilities: They provide loans to members in the form of short-term and long-term loans. These loans are repayable with interest, thus income to the banks.
• Facilitates foreign exchange payments: They provide foreign exchange that is used in international trade. They also make payments on behalf of their customers.
• Provision of safekeeping of valuables: They provide security for valuables to their customers at a fee.
• Discounting bills of exchange: This is the process by which a bank accepts bills of exchange and promissory notes from its customers in exchange for cash less than the face value of the bill or note.
• Provision of financial information: They advise their clients on financial matters affecting their businesses such as investment options and wise use of loans.
• Money transfer: They provide varied, safe, and reliable means of money transfer. Such means include cheques, standing orders, credit transfers, bank drafts, letters of credit, credit cards, travelers cheques, etc.
• Act as guarantors and referees: They act as guarantors to their customers who want to acquire credit facilities from other financial institutions.
• Act as intermediaries: They act as a link between the savers and borrowers.
• Credit creation: This is the process of creating money from the customer deposits through lending.
• Provision of trusteeship: They can manage a business on behalf of the client, especially if the client does not have managerial skills. They can also manage the assets of the deceased client if there was no will.

TYPES OF ACCOUNTS OFFERED BY COMMERCIAL BANKS

Current Account

This is an account where money deposited can be withdrawn on demand by the customer by means of a cheque. This means that money can be withdrawn at any time during official working hours so long as the account has sufficient funds.

This account is also referred to as demand deposits.

Features/Characteristics of Current Accounts

• Deposits of any amount can be made at any time.
• Balances in this account do not earn any interest.
• The account holder is not required to maintain a minimum cash balance in this account.
• Withdrawals can be made at any time without giving advance notice as long as the customer has sufficient funds.
• Cheque books are issued to the account holder to be used as a means of payment; cheques are usually used to withdraw money from the account.
• Monthly bank statements are issued to the account holder.
• Overdraft facilities are offered to the account holders; i.e., the bank can allow customers to withdraw more money than they have in their accounts.

Advantages of Current Account

• No minimum balance is maintained; hence the account holder can access all his/her money.
• Withdrawals can be made at any time.
• Transactions are made easier by use of cheques; for example, one does not have to go to the bank in order to make payment.
• Overdraft facilities are available.
• It is possible to deposit any amount at any time during office hours.
• Use of cheques as means of payment serves as evidence of payments made.
• Payments can be done even if there are insufficient funds in the account using post-dated cheques.
• The account holder can withdraw any amount at any time without notice as long as there are sufficient funds in the account.

Disadvantages of Current Account

• Lengthy procedures of opening the account.
• The account holder does not earn any income since the balances in the current account do not earn interest.
• Initial deposit when opening the account is usually high, hence discourages prospective customers.
• Customers are not encouraged to save since they can access their money at any time.
• Ledger fees are charged on the account, making the operations of the account expensive.

Savings Account (Deposit Account)

This is an account operated by individuals and firms that have money to save.

Features of Savings Account

• There is a minimum initial deposit that varies from bank to bank.
• A minimum balance is maintained at all times.
• Withdrawals are up to a certain maximum within a given period. Withdrawal above this maximum will require notice.
• Account holders are issued with a passbook or a debit card (ATM card) for deposits and withdrawals.
• Overdraft facilities are not allowed.
• Ordinarily, withdrawals across the counter can only be done by the account holder.
• The balance on the account above a certain minimum earns some interest.

Advantages of Savings Account

• Customers are encouraged to save because of the restricted withdrawals.
• There are relatively low banking charges.
• Initial deposit is usually low as compared to other accounts.
• The balances earn interest to account holder, hence an incentive to save.
• ATM facilities have made account operations very convenient to customers.

Disadvantages of Savings Account

• A minimum balance must be maintained at all times, and the customer is denied access to that money.
• For across-the-counter withdrawals, it is only the account holder who can withdraw cash.
• Withdrawals are restricted, and sufficient notice is required before large amounts are withdrawn.
• The account holders do not enjoy services such as cheque books and overdraft facilities like the current account holders.
• Easy access to the money through ATM cards encourages overdrawals.
• Anybody who knows the PIN of the card (ATM card) can withdraw money from the account.

Requirements for Opening an Account

The following are some of the requirements for opening either a current account or a savings account:

• Photocopies of identification documents such as National Identity Card or Passport.
• Passport size photographs (number varies from bank to bank). Some banks nowadays take the photographs instead of the customers providing them.
• For current account holders, an introductory letter from an existing customer or the prospective customer’s employer.
• Filling in the application form provided by the bank.
• Signing of the specimen signature cards (usually two).

NB: Once these requirements are fulfilled, the bank allocates the customer an account number, upon payment of an initial deposit.

Fixed Deposit Account

This account is also known as Time Deposit Account. It is maintained by those who have money not meant for immediate use.

Once money is deposited, there are no withdrawals until the time expires.

Advantages of Fixed Deposit Account

• Interest earned is relatively high as compared to savings account.
• There are no bank charges to the account holder.
• Money held in fixed deposit account can be used as security to acquire bank loans.
• Restricted withdrawals encourage savings.
• The account holder has time to plan for the deposited money.

Disadvantages of Fixed Deposit Account

• Access to money is not allowed until the end of the agreed period.
• Interest is forfeited if there is premature withdrawal.
• The minimum amount of money for this account is high.
• The customer is not allowed to deposit more money in this account.
• A notice is required if the customer wants to terminate the contract before expiry date.
• The customer is denied the use of the deposited funds before the expiry of the period.

REQUIREMENTS TO OPEN AND OPERATE A BANK ACCOUNT

• Identification documents such as National Identification Card, Passport, and Driving License.
• Reference letter from employer or an existing customer.
• Filling an application form giving the information about the customer.
• Submission of a specimen signature to be held by the bank.
• An initial deposit is paid and the account becomes operational.

NON-BANK FINANCIAL INSTITUTIONS

These are financial institutions that offer finances for development purposes to individuals and organizations.

These institutions address themselves to the needs of specific sectors in the economy.

They offer finances in the form of either short-term or long-term loans.

The following are some of the non-bank financial institutions in Kenya:

• Development banks
• Building societies
• Finance houses
• Savings and Credit Co-operative Societies
• Microfinance organizations
• Insurance companies
• Pension Funds’ Organizations
• Hire Purchase Firms

Housing Finance Companies

They are mainly formed to finance housing activities; that is, they either put up houses and sell to individuals or offer mortgage finance to those who wish to put up their own houses. They include Housing Finance Corporation of Kenya (HFCK), National Housing Corporation (NHC).

Development Finance Institutions

These are development banks which are formed mainly to provide medium-term and long-term finances, especially to the manufacturing sector. They perform the following functions:

• Financing people who wish to start either commercial or industrial enterprises, as well as existing enterprises in the above sectors for expansion.
• Offering training services through seminars and workshops to equip entrepreneurs with relevant skills in industrial and commercial sectors.
• Offering advisory services to those wanting to start or expand their businesses.
• Acting as guarantors to people wishing to take loans from other lending institutions to help them expand their business.

They include Kenya Industrial Estates (KIE), Development Finance Company of Kenya (DFCK), Industrial Development Bank (IDB), Industrial and Commercial Development Corporation (ICDC).

Savings and Credit Co-operative Societies

These are co-operative societies formed to enable members to save and obtain loans at the most convenient and favorable conditions. They are formed by those engaged in similar activities. They include Mwalimu Savings and Credit Co-operative Societies; Afya Savings and Credit Societies; Harambee Savings and Credit Societies.

Insurance Companies

These are companies that assist in creating confidence and a sense of security to their clients as well as offering financial assistance. Their functions include:

• Enable policyholders to save through their schemes.
• Provide finances to their policyholders in the form of loans.
• Offer guarantee services to policyholders wishing to obtain loans from other non-bank financial institutions.
• Provide advisory services to policyholders on security matters.
• Provide finances to meet expenses in cases of loans.

They include Stallion Insurance Company; Madison Insurance Company; Blue Shield Insurance Company.

Microfinance Companies

These are financial companies formed to provide small-scale and medium-size enterprises with finance. They also carry out the following functions:

• Offer advisory services to their clients in matters such as business opportunities available and how to operate them.
• Encourage clients to carry out business activities by offering loans.
• Encourage savings by advancing loans to individual members of a certain group.
• Supervise, monitor, and advise those to whom they have given loans.

They include Kenya Women Finance Trust (KWFT), Faulu Kenya.

Agricultural Finance Houses

These are institutions formed to promote the agricultural sector. They carry out the following:

• Giving loans to farmers.
• Offering supervisory and training services to loaned farmers.
• Offering technical and professional advice to loaned farmers.
• Carrying out research and coming up with better ways and means for the agricultural sector.
• Coming up with projects that would open up new areas for agriculture.

Differences between Commercial Banks and Non-Bank Financial Institutions

THE CENTRAL BANK

This is a bank established by the government through an act of parliament to manage and control monetary matters in the country. It was formed to perform the following functions:

• Issue currency in the country: This includes both new notes and coins to replace worn-out ones.
• Banker to the commercial banks: Ensuring that all commercial banks in the country operate an account with them.
• Being the government’s bank: Offering banking services to the government, enabling it to operate an account with them.
• Advisor to the government on financial issues in the economy.
• Controller of the commercial banks: Overseeing how they carry out their functions to ensure customers are served well.
• Provide links with other central banks in other countries: Facilitating financial relationships and providing a link between the country and other financial institutions such as the IMF.
• Maintain stability in the exchange rates between the local currency and foreign currencies.
• Act as the lender of last resort: To commercial banks to enable them to meet their financial obligations when needed.
• Facilitate the clearing of cheques: Between different commercial banks through its clearing house (a department in the central bank).
• Administer public debt: Facilitating receipt and providing means through which the government pays back borrowed money.
• Control the monetary system: Regulating the economy by putting in place various monetary policies that can either expand or depress economic activities.

Monetary policy refers to the deliberate move by the government through the central bank to manipulate the supply and cost of money in the economy to achieve a desirable economic outcome. They do this through various tools of monetary policy, which include: Bank rates; Open Market Operations (OMO); Cash Liquidity Ratio requirement; Compulsory Deposit requirement; Selective Credit Control; Directives; and Requests.

Bank Rates

The central bank may increase or decrease the interest rate at which they lend to commercial banks to influence the rates at which commercial banks lend money to their customers, thereby affecting economic development.

When the central bank increases its lending interest rate, commercial banks also raise their lending rates to consumers, reducing the number of people obtaining loans and thus reducing money supply.

When the central bank decreases its lending interest rate, commercial banks also decrease their lending rates to consumers, increasing the amount of money supplied in the economy.

Open Market Operations (OMO)

This involves regulating the supply of money by either selling or buying government securities (treasury bills or bonds) in the open market.

To increase money supply, the central bank buys securities from the public, increasing money in circulation.

To reduce money supply, the central bank sells government securities to the public, mopping up excess money.

Payments for securities reduce money in individuals’ accounts, while buying securities increases money in accounts.

Cash/Liquidity Ratio Requirement

The central bank requires commercial banks to keep a certain proportion of their total deposits as cash to meet daily needs, while the rest are held in liquid assets.

This proportion can be adjusted to control the amount of money commercial banks can spend, thus influencing money supply.

Cash ratio =

Compulsory Deposit Requirements

Commercial banks are required to maintain a certain amount of deposits with the central bank in a special account where the money stays frozen, reducing the amount available for lending and spending.

The deposit amount may be increased or decreased to control money supply.

Selective Credit Control

The central bank may instruct commercial banks and other financial institutions to lend more in particular sectors to control money reaching the economy. This instruction may be removed if supply needs to be increased.

Directives

The central bank may issue directives to commercial banks on interest rates to charge and margin requirements for borrowing to make it harder or easier for customers to obtain loans.

Margin requirement is the proportion of money expected to be raised by the client to finance a project before being given a loan.

Request (Moral Suasion)

The central bank may appeal to financial institutions to exercise restraint in lending activities to help control money supply.

Trends in Banking

These are positive changes in the banking sector to improve service delivery, including:

• The use of Automatic Teller Machines (ATMs): Allowing customers to access money any time. ATM cards can also be used as debit cards for purchases.
• Networking all branches: Enabling customers to carry out transactions in any branch.
• E-Banking: Banking through the internet, allowing online financial transactions.
• Relaxation of conditions on opening and operating accounts: Making accounts more attractive to customers.
• Offering varieties of products: Including easier credit facilities to attract more customers.
• Liberalization of foreign exchange dealings: Licensing forex bureaus to improve service accessibility.
• Improving customer care services: Some banks have customer care departments for detailed assistance.
• Allowing non-bank financial institutions to offer banking services: Examples include KWFT, SACCOs, FOSA, Faulu Kenya.
• Mobile Banking services (M-Banking): Allowing customers to carry out financial transactions over mobile phones, with benefits including:

Advantages of M-Banking

• Easy transfer of funds between accounts in the same bank (inter-account transfer).
• Easy transfer of money from one’s account to mobile phone for other transactions.
• Ability to check account balance easily.
• Easy monitoring of financial transactions via phone.
• Easy payment of bills such as electricity and DSTV bills.
• Ability to transfer money from one mobile number to another in collaboration with service providers.
• Easy request for new cheque books and bank statements.
• Ability to top up airtime on mobile phones.
• Reduced risk of carrying large sums of money in cash or cheques that may be stolen.

However, this development has challenges, including:

Disadvantages of M-Banking

• Registration must be done physically in the banking hall, subjecting customers to queues.
• Only the registered mobile number can carry out transactions, limiting customers to one number.
• Users require a mobile phone with a screen that can display transactions, which some may not afford.
• Mobile phones can be lost or stolen, inconveniencing the owner.
• Bank transaction information may load slowly, making it expensive for users.
• Possibility of transferring funds to wrong accounts due to typing errors.
• Introduction of agency banking, making services accessible even in areas without banking halls.

Agency banking involves retail stores, supermarkets, or other commercial businesses authorized by financial institutions to carry out financial transactions on their behalf. Services offered include:

• Receiving customer deposits
• Offering withdrawal services
• Transfer of funds for customers
• Paying bills for customers
• Balance inquiry services
• Opening new accounts for customers
• Filling loan application forms for customers

Advantages of Agency Banking

• Reduction of setup and delivery costs to banks, which reduces the cost of accessing services for customers.
• Time-saving as agents are located close to customers, allowing other transactions during withdrawals.
• More convenient for customers to bank with local retailers rather than traditional banking halls.
• Enables banks to reach far places within the country.

REVISION EXERCISES

PAPER 1

• Give four advantages of barter trade.
• Highlight four services offered by the Central Bank of Kenya to commercial banks.
• State four methods through which commercial banks can transfer money.
• State any four current developments that have taken place in the banking sector.
• Outline four tools of monetary policy used by the central bank to control money supply.
• Outline four factors that may have led to the downfall of barter trade.
• Highlight two factors that may influence:
  • Transaction motive.
  • Speculative motive.
• Mention four functions of commercial banks in an economy.
• Outline three factors that influence the supply of money.
• Give four characteristics of money.
• The following are some of the accounts available to customers in Kenya banking industry: Current account, Savings account, and Fixed deposit account. Give the account that corresponds to each of the descriptions given below.

  	Description	Type of Account
  (a)	Account holders required to deposit a specific initial amount as well as maintaining a minimum balance.
  (b)	Account holders may deposit and withdraw money whenever they want without maintaining a minimum balance.
  (c)	Banks pay interest on deposits at comparatively higher rates.
  (d)	Money may be deposited at any time and interest is earned if a specific balance is maintained.

• Outline four benefits that accrue to a customer who uses automated teller machine (ATM) banking services.

PAPER 2

• Explain five functions of the Central Bank of Kenya.
• Describe four measures that the government may put in place to reduce the amount of money in circulation.
• Explain five services offered by commercial banks to their customers.
• Explain five ways in which commercial banks facilitate payment on behalf of their customers.
• Explain four services that the Central Bank of Kenya may offer as a banker to commercial banks.
• Explain five ways in which banks contribute to the development of Kenya.
• Outline five reasons why bank current accounts are popular with traders.
• Explain services offered to commercial banks by the Central Bank of Kenya.
• In what ways do the functions of commercial banks differ from those of non-bank financial institutions?
• Explain five ways in which the Central Bank of Kenya may control the supply of money in the country.
• Describe methods which may be used by commercial banks to advance money to customers.
• A businessman wishes to obtain a loan from a commercial bank. Highlight the conditions that he should satisfy before the bank can grant him the loan.
• Explain five services that the Central Bank of Kenya offers to commercial banks.
• Explain four disadvantages of using a bank overdraft as a source of finances.
• Describe four ways in which non-bank financial institutions differ from commercial banks.
• Discuss five reasons why business people prefer to operate bank current accounts.
• Outline the benefits that bank customers get from operating a current account.
• Explain the five services offered by commercial banks to their customers.