Chapter One

INTRODUCTION TO BANKING THEORY

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Course: BANKING THEORY & PRACTICES
Course Code: BAFI3211
Specialization: Common
Department of Business Studies
Learning Outcome 1: Distinguish different types and kinds of banks,
understand origin of banking system.

Learning Objectives: After you have studied this chapter, you will:
 Know about the evolution of modern banking system
 Understand the definition of ‘Banker’ and ‘Customer of bank’
 Understand the types and kinds of banks with brief introduction of their
services.

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Learning Outcome 1:
Distinguish different types
and kinds of banks,
understand origin of
banking system.
Contents
- Origin of Banking
- Banker and Customer: Definitions
- Classification of Banking System: -
A. In terms of Ownership
B. In terms of operational Network
C. In terms of Kinds
D. In terms of Business Activities/Transactions
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 Essential Reading
1. B. Santhanam “Banking theory Law and practices” Published by Margam publication India.,5 th
edition 2007
2. K.P.M.Sundharam & Varshney, “Banking Theory Law & Practice”, Published by Sultan Chand
&Sons publication, India 17th edition 2014
 

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Origin of Modern Banking:

 It is probably true to say that the credit of originating the modern banking practices in the world
goes to the Goldsmiths of London.

 The city merchants and other people who had large balances of money, used to keep their cash
with goldsmiths, who in those days had strong rooms and employed watchmen.

 Thus, large sums of money were left with the goldsmiths for safe custody against their signed
receipts, known as “Goldsmiths Notes” containing an undertaking to return the money to the
depositor or to holder on demand.

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 Two developments quickly followed, which were the foundation of modern banking.

 The first was that the Goldsmiths’ Note became payable to bearer. It was payable on
demand, and enjoyed considerable circulation.

 Secondly, Goldsmiths discovered that large sums of money were left in their
keeping for long periods and they thought it safe and profitable to lend out a part of
their customers’ money to other merchants at interest, provided such loans were re-
paid within a fixed time. Further, realizing that the business of loaning of other
people’s money at interest was profitable, and in order to attract larger amounts,
Goldsmiths began to offer interest on money deposited with them, instead of
charging a fee for their safe custody services.

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 The London Goldsmiths transacted their business across their traditional benches in
the market places.

 The word “bank” itself is believed to have been derived from the Latin word
“bancus” or “banque” meaning a bench.

 When Goldsmith failed in returning the money of depositors, his bench‫ مكتبهـ‬was
broken up by people, therefore the word “bankrupt”. The bank or banker is used in
almost all the countries of the world to denote a financial institution dealing in
money.

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This new type of business grew rapidly to such an extent that soon more and more
small business houses were set up in a revolutionary manner offering the services of
safe custody of money and lending of loans out of customers’ money. As a result of
this revolution, we now have a large network of banking companies all around the
world, basically carrying on the same type of business: “Acceptance of deposits of
money from the public and lending of loans and advances”.

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 Banker and Customer: Definitions

It is necessary to understand the meaning and legal significance of the terms

‘banker’ and ‘customer’. To understand the meaning of two terms we can discussed
some definitions of the renowned authors and famous court decisions.
Definitions on Banker:
Dr. H. L. Hart, a famous author on Banking Law says “A banker is one who in the
ordinary course of his business, honors cheques drawn upon him by persons from
and for whom he receives money on accounts”.
According to this definition, the essential function to enable a person, firm, or
institution, to be regarded as a banker or a bank, is that of receiving deposits of money
on accounts against which cheques may be drawn.

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Another famous author Halsbury’s has defined banker as “An individual, partnership
or corporation, whose sole pre-dominating business is banking, that is the receipt of
money on deposit account and the payment of cheques drawn by and the collection of
cheques paid in by a customer”. This definition also lays importance on two important
functions to be performed by a firm or a company to be regarded as banker, namely,
(i) receiving of deposits of money on accounts and
(ii) payment of cheques drawn by the customer.
In conclusion banker or bank is one who has a licence to perform the following two
important functions under modern banking system,
(I) Acceptance of deposits of money from the public on different types of deposit
accounts repayable on demand by cheques or otherwise.
(II) Lending of loans and advances to individuals, traders and other institutions.

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 Definitions on Customer:
According to Sir John Paget, “to constitute a customer there must be some
recognizable course or habit of dealing in the nature of regular banking business.”
As per his definition, to constitute a customer of a bank a person had to satisfy two
conditions.
Firstly, that there was to be some recognizable course or habit of dealing between him
and the bank.
Secondly, that the transactions were to be in the nature of regular banking business.
This definition lays emphasis on the duration of dealings between banker and
customer, therefore, this theory popularly known as “Duration Theory”. According to
this theory, merely opening of an account with a bank does not make a person a
customer of the bank. But the account should have been operated upon for quite some
time or there must have been a series of transactions between them in the nature of
regular banking business. This theory was heavily criticized.
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Lord Denedin’s Ruling: In the famous legal decision in Commissioner of Taxation v.
English Scottish and Australian Bank, (1920) Lord Dunedin who delivered the
judgment said, “The word ‘customer’ signifies a relationship in which duration is not
of the essence.
According to this ruling, “A person, whose money has been accepted by the bank on
the footing that the bank undertakes to honor cheques up to the amount standing to
his credit, is a customer of the bank irrespective of whether his connection is of long
or short standing.”
The ruling of this case became very popular and was supported in various other
rulings.
Moreover, with this ruling it is also cleared that even a single deposit in the account is
enough to designate the person as a customer of the bank.

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Therefore, to constitute a customer the following essential requisites must be
fulfilled:
(i) A bank account – saving, current or term deposit must be opened in his/her the
name by making necessary deposit of money; and
(ii) The dealing between the banker and the customer must of the nature of banking
business.

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Classification of Banking System:

Figure (1): Classification of Banking System

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A. In terms of Ownership

Figure (2): Classification of Banking System in Term of Ownership

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1. Public Sector Banks: Banks in a country, if fully owned by the government is known public sector bank.
The word “The” and “Limited” will not feature in their names .This is because their ownership rests with the
government and the liability is unlimited (Examples, Central Bank of Oman, Oman Development Bank, Oman
Housing Bank).

2. Private Sector Banks: Private sector banks are those which are owned by group of shareholders who elect
their directors for managing the bank (e.g. Bank Muscat, Bank Dhofar and etc.)

3. Cooperative Banks: Cooperative bank are owned by their client and follow the cooperative principles of ‘one
person, one vote’. In Oman such types of banks do not exist.

4. Foreign Banks: Foreign banks are banks belonging to foreign countries, having their branches in Oman are
Foreign Banks. Foreigners contribute the entire share capital (e.g. Bank Melli, Bank Saderat, State Bank of India,
Habib Bank, etc.).

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B. In terms Operational Network

In terms of Operational Network

Unit Chain Correspondent

Branch Banks Group Banks
Banks Banks Banks

Figure (3): Classification in terms of Operational Network

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1. Unit Banking System: Unit banking is single small bank that provides the financial services to its local
community. The unit bank confines its operation to a town or a city. A unit bank is independent and does not
have any connecting bank branches in other areas.

2. Branch Banking System: Unlike unit bank, branch bank is a business operations of the bank are carried by
these branches spread throughout the town state or country or even throughout the world. The policy decisions
for running the branch bank system is taken by the head office and it gives directions to its branches. The
branches are run by the branch managers who assisted by the clerical staff. England adopted this system of
banking operations. In Oman Bank Muscat, Bank Dhofar, National Bank of Bank, Sohar International, etc. are
offering banking services in almost every city and town through large network of their branches.

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3. Group Banking System: In group banking system the holding company is the controlling authority to
subsidiary companies which are in banking business. Thus, the banking business is controlled by the
holding company. In certain cases the holding company is a banking company and the subsidiary companies
are also banking companies. The holding company will be having control over the subsidiary banking
companies by:

(a) Controlling majority of shares in the subsidiary companies.

(b) Controlling majority of voting rights in the subsidiary companies.
(c) Having power to appoint majority of directions in the subsidiary companies.
For example, Bank Muscat is holding company of two subsidiary Meethaq Islamic Bank and Muscat
Capital LLL

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4. Chain Banking System: In this banking system two or more different banks are controlled by common
shareholders or by the inter-locking of director. The banks which are controlled are called chain banks. They
have common directors by which they may have common management policy.

5. Correspondent Banking System: When two banks of different stature or size are linked by another bank,
the bank with which these banks linked is called a correspondent bank. For example, for many of the foreign
banks, there is certain local banks act as correspondent bank.

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C. In Terms of Kinds

In terms of Kinds

Agriculture
Commercial Industrial Cooperative Savings Exchange Central
Banks Banks & Develop. Banks Banks Banks
Banks
Banks

Figure (3): Classification in terms of Kinds

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1. Commercial Banks: These type of banks provides financial services such as accepting deposits, providing
loans and advances and offering basic investment products for making profit. A commercial bank is where
there most people do their banking.
Examples; Bank Muscat, Bank Dhofar, Bank Nizwa, National Bank of Oman, etc.

2. Industrial Banks: When banks provide long term loans to industries they are called Industrial Bank or
Investment Bank. As Investment Banks, they take part of the share capital of companies. They even promote
companies by underwriting shares which enables the public to purchase the shares of these companies. Thus
the presence of these banks promotes industrial activity in the country. The banks are also responsible for the
development of back-ward areas through promoting industries in those places.
Examples; Al Madina Financing and Investment Company, Oman and Emirates Investment Holding
Company, and all commercial banks.

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3. Co-operative Banks: These banks established to help economically weak community. Co-operative Banks
have more service motive as the interest rate charged for the loans will be less and the majority of borrowers
belong to the economically weaker sections. Co-operative Banks are usually operating in rural and semi–urban
areas, providing enormous loans to the people in rural areas.

4. Agricultural Development Bank: Similar to the Co-operative Banks, these banks help by providing loans to
the weaker sections but they provide long term loans for agriculture which will enable the borrower:
a. Purchasing new lands.
b. Purchasing soil conservation and land reclamation.
c. Purchasing heavy agriculture machinery such as tractor.
As the bank is promoting the growth of agriculture it is called Agricultural Development Bank.

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5. Savings Bank: Savings bank as such are not commercial banks in real term. There are some institutions
such as post offices and other government agencies promote the thrift and saving habits among the people.
They attract savers by good return on their savings. At same time they discourage the people of withdrawing
money on regular interval since the saving duration is fixed with them.

6. Foreign Banks or Exchange Banks: Banks which are incorporated outside the country but doing banking
business in Oman are called Exchange Banks. They provide foreign exchange, subject to the rules and
regulations of the country in which they are located. They help in exports and imports. The exporter will be
able to receive his payment without much delay when he processes his trade documents through exchange
banks. Similarly, the importer will be able to obtain letter of credit, a guarantee for importing goods. Thus,
exchange banks help in promotion of foreign trade.

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7. Central Banks: Central bank is a leader of all the banks operating in a country. It is not only regulatory bank
but also protects by helping them whenever they are in difficulty. The Central Bank is also responsible for
controlling the price level. It has the authority to issue money. It also maintains the foreign exchange reserve.
Through this, it controls the exchange rate. The development of banking industry in any country depends on
the efficiency of the Central Bank. The Central Bank helps the government by providing loans whenever they
are in difficult. It maintains the government account. Whenever the government is in need of funds, it can raise
loan through the central bank by issuing treasury bills in the money market.

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D. In terms of Business Activities:

D. In terms of Business Activities

Deposit Investment Mixed Wholesale Retail Universal Banking

Figure (3): Classification in terms of Business Activities

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1. Deposits Banking: When a bank accepts deposits and lends for a short period, subject to a maximum of
twelve months it is called deposit banking. The bank will be mainly concentrating on commercial activities and
it cannot afford to give long-term loans. Most of its deposits received are of short duration and hence deposit
banks will be lending only for short period.

2. Investment Banking: Contrary to Deposit Banking, investment banks are those which promote long term
investments by either contributing to share capital of companies or by providing long term loans to industries
for the purchase of fixed assets.

3. Mixed Banking: When banking companies combine deposit banking activity with investment banking
activities, they are called Mixed Banking. Thus, banks will be in a position to not only provide short-term loans
but also medium and long-term loans.

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4. Wholesale Banking: Wholesale concentrates on corporate customers consist of different types of
companies. These banks will have very few clients, but they undertake large scale of business operations and
turnover, which result in more substantial profits.

5. Retail Banking: These are quite opposite to wholesale banking. The bank concentrates on individual
customers and has it business operations in residential areas and gives more consumer loans to improve their
standard of living i.e. these banks operates more on service motive with more number of customers.
Compared to wholesale banking, the volume of business of retail banking will be less, but they concentrate
more on the requirements of individual customers. So, in retail banking there may not be much profit margin.
However, they will have more clients; thus these banks give more importance to customer’s interests.

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6. Universal Banking: Apart from banking activity, when a bank undertakes, other activities, connected with
financial dealings - such as leasing, factoring, mutual fund, portfolio investment, foreign investment etc., - it is
known as Universal Banking. In fact the bank does not confine itself with traditional activity but engages in
modern activities which include extending credit card facility to the customer. Banks also promote companies by
undertaking merchant banking activities.

Review Questions:
1. Who is a banker according to Halsbury?
2. Who is a customer according to the modern theory of lord Denedin’s Ruling ?
3. What is a bank? What are the functions of a bank?
4. Classify banks and bring out a clear idea about each of them.
5. What is meant by branch banking system?
6. Discuss in detail the relative merits and demerits of branch banking and Unit banking. Which system would
you recommend to Oman?
7. Write short notes on: 1. Group Banking 2. Kinds of Banks
 

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References:

1. B. Santhanam “Banking theory Law and practices” Published by Margam publication India.,5 th
edition 2007
2. K.P.M.Sundharam & Varshney, “Banking Theory Law & Practice”, Published by Sultan Chand
&Sons publication, India 17th edition 2014
 

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CONTACT INFORMATION:

Name of the Staff

Office: …..
Email: …..@hct.edu.om

VERSION HISTORY

Version No Date Approved Changes incorporated

02 Sem. (I) 2020/2021 All figures related to classification
of banking system are edited.

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