THE INSTITUTE OF FINANCE MANAGEMENT

BACHELOR IN BANKING AND FINANCE

First Year _ 2021/2022
Second Semester
Principles of Banking

BFU 07207
Principles of Banking
2.1.1 The Concepts of Central Banking
In
Financial System.
Definition of a Financial System
There are several definitions of a financial system, but for the purpose of this
class, the following will suffice; “Refers to the interaction of policy makers,
monetary system, financial Institutions and financial markets to expedite the flow
of financial capital from savings to investments.” (Norton et al, 2005)

Functions of financial system

The financial system is one of the most important components of the global
economy, it provides essential services without which a modern economic system
could not function.
The basic function of the financial system is to transfer funds from lenders (surplus
units) to borrowers (deficit units).

Besides the main function, there are specific functions of the financial system which
include;
1. Credit Function
The financial system supplies credit to support purchases of goods and services and
to finance capital investments. Investment increases the productivity of society’s
resources and makes possible a higher standard of living and families.
2. Savings Function
The financial system provides a profitable outlet for savings. Individuals and
organizations save today to be able to consume more goods and services tomorrow.
Savings perform an essential function because it releases resources from surplus
units to deficit units.

Through financial system, savers can lend their surplus funds to borrowers and earn
an income in the form of interest, dividends, capital gains and so forth.
When borrowers need additional funds, the financial system sends a signal to savers
in form of higher interest rates, encouraging saving surplus units to save more and
consume less.
On the other hand, when borrowers require a fewer fund, interest rates tend to fall,
and the flow of savings is reduced. Thus, a financial system provides a mechanism
for encouraging savings and providing a flow of funds into investments.
3.Payment and Transferring of money Function
The financial system supplies a mechanism for making payments in forms of
currency, checking accounts and other transactions media. However, in recent years
institutions operating in financial system have developed many new payment
services making payments electronically where funds are moved in microseconds
via satellites, computers, phones and other electronic media.
4. Money creation Function
Through the services of supplying credit and providing a mechanism of making
payments, the financial system makes possible the creation of money. Although
several different definitions and forms of money are in use today, all forms of money
serve as a medium of exchange, standard of unit of account, store of value and
standard of deferred payment.
5. Liquidity Function
The financial markets provide the investors with the opportunity to liquidate
investments whenever they need the fund.
6. Risk Function
Through insurance policies in the financial system there is a control or avoidance of
risks through payment of premiums. The insurance can either be property insurance
life insurance or health insurance.
7.Policy Function
For proper functioning of the financial system the government has to intervene.
The government usually intervenes in the financial system to influence some
macroeconomic variables such as the interest rates or inflation so as to function
efficiently.
8. Marketing Financial Assets
Financial instruments and assets are created and sold through the financial system.
 The general structure of financial systems

Financial system comprises of; Policy Makers, Monetary System, Financial

Institutions and Financial Markets.

Firstly, under the structure of the financial system there must be sets of policy makers
who pass laws and make decisions relating to the fiscal and monetary policies.
Secondly, the financial system needs a body that takes the policies into actions and
sees to its functioning that is the monetary system which consists of the Central
Bank. The Central Bank also creates money

Thirdly, the structure of the financial system consists of the financial institutions and
intermediaries that channel funds from surplus savers to deficit savers and finally,
the financial system has a financial market that facilitates the transfer of financial
assets amongst individuals, institutions, businesses and government.
 Banking financial Institutions vs. Non-Bank Financial Institutions.

The main difference between a bank and a non-bank financial institution.

1. Liabilities of a bank (demand deposits) are accepted as money (as a medium
of exchange) while liabilities of a non-bank financial institutions are not
accepted as a medium of exchange.
2. Banks normally lend short while non-bank lends both long and short.
3. Banks have ability to create money (deposit expansion) while non-banks do
not have the ability to create money.

Financial institutions perform the essential function of channelling funds from

those with surplus funds (suppliers of funds) to those with shortages of funds (users
of funds).
Some of the common financial institutions are;

Financial Institutions
Commercial banks are depository institutions whose major assets are loans and
whose major liabilities are deposits.
Commercial banks’ loans are broader in range, including consumer, commercial, and
real estate loans, than are those of other depository institutions.
Commercial banks’ liabilities include more non-deposit sources of funds, such as
subordinate notes and debentures, than do those of other depository institutions.

Insurance companies are financial institutions that protect individuals and

corporations (policyholders) from adverse events.
Life insurance companies provide protection in the event of untimely death, illness,
and retirement. Property casualty insurance protects against personal injury and
liability due to accidents, theft, fire, and so on.

Securities firms and investment banks are financial institutions that help firms
issue securities and engage in related activities such as securities brokerage and
securities trading.

Finance companies are financial intermediaries that make loans to both individuals
and businesses. Unlike depository institutions, finance companies do not accept
deposits but instead rely on short- and long-term debt for funding.

Mutual funds are financial institutions that pool financial resources of individuals
and companies and invest those resources in diversified portfolios of assets.

Pension funds are financial institutions that offer savings plans through which fund
participants accumulate savings during their working years before withdrawing them
during their retirement years.

The Central Bank

A central bank is an independent national authority that conducts monetary policy,
regulates banks, and provides financial services including economic research.
Its goals are to stabilize the nation's currency, keep unemployment low, and
prevent inflation. In Tanzania, we have the Bank of Tanzania, referred to as the
“Bank”.
 The Bank of Tanzania
In accordance with the Bank of Tanzania Act, 2006; "The primary objective of the
Bank shall be to formulate, define and implement monetary policy, directed to the
economic objective of maintaining domestic price stability, conducive to a
balanced and sustainable growth of the national economy of Tanzania".

Apart from the primary function, the Bank of Tanzania has important subsidiary
central banking functions as hereunder; The Bank of Issue, The Bankers' Bank,
The Governments' Bank, The Advisor to the Governments, The Guardian of the
Country's International Reserves, Supervision of Banks and Financial Institutions
and Promotion of Financial Development.
a. The Bank of Issue
The Bank has the sole right to issue notes and coins in Tanzania for the purpose
of directly influencing the amount of currency in circulation outside banks,
thereby providing the economy with sufficient, but if possible, non-inflationary
liquidity.
b. The Bankers' Bank
This function includes; the acceptance of deposits, to act as prudential reserves
for banks (i.e., the Minimum Reserves), the commitment to act as lender of last
resort to these banks. It also involves the provision of central clearance facilities
for interbank transactions.
c. The Governments' Bank
The Bank is the banker and the fiscal agent for the Governments, and may be the
depository of the Government. The Bank may make temporary advances to the
Government through its overdraft facility, subject to repayment within 180 days.
d. The Advisor to the Governments
The Bank may advise the Governments on any matter relating to its functions,
powers, and duties. The Bank may also be requested to advise the Governments on
any matter related to its functions, powers, duties, the credit conditions in Tanzania,
or any proposal, measures, and transactions relating thereto.
e. The Guardian of the Country's International Reserves
The Bank is the depository of the official external assets of Tanzania, including gold
and foreign currency reserves. Guarding international reserves may imply the
determination of buying and selling rates of gold and foreign exchange in foreign
exchange markets and/or the buying and selling of reserve assets for the purpose of
sustaining the national currency's external value.
f. Supervision of Banks and Financial Institutions.
This activity involves ensuring that commercial banks and other financial
institutions conduct their business on a sound prudential basis and according to the
various laws and regulations in force. It includes the supervision of banking conduct
and the licensing of financial institutions.

According to the Banking and Financial Institutions Act of 1991, and the new BOT
Act, the main responsibilities of the Bank of Tanzania are:
 Licensing of banks and financial institutions
 Facilitation and monitoring of a Deposit Insurance Fund, the purpose of which
is the protection of small depositors,
 Implementation of prudential controls concerning capital adequacy, liquidity,
concentration of credit and risk diversification, asset classification and
provisioning, and prohibited activities and
 Modification and monitoring of the Minimum Reserve Requirements and
foreign exchange exposure.
g. Promotion of Financial Development
This refers to the establishment of an effective financial system, with the aid of
which financial transactions necessary for the smooth functioning of the economy
can be carried out with a minimum amount of cost and time involved. In this
connection, the Bank has to be a facilitator of advanced clearing and transfer
systems.

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