Book IV Title III of the Commercial Code of Ethiopia which deals with banking transactions fails to provide a definition of a bank and banking transactions though the latter may be gathered from the various sections governing the various types of transactions undertaken by banks. Therefore, we have to refer to other laws to define and determine what banks and banking transactions are under the Ethiopian legal system.

According to Art 2 (12) of the Monetary and Banking Proclamation No 83/1994, banking business means any operation involving receiving money on deposit, lending money, receiving commercial instruments on deposit, accepting, negotiating/ transferring, discounting commercial instruments and other evidences of debt, and buying and selling of gold and silver notes and  foreign exchange. Similarly, Art 2 (2) of the Licensing and Supervision of Banking Business Proclamation No 84/1994 defines banking business as:

Any business involving acceptance of money on deposit, using such funds or deposits, in whole or in part, for loans or investments on the account of and at the risk of the person undertaking the business, purchasing, selling and deposit of negotiable instruments (shares, bonds and other securities/ and checks, bills and notes, and buying and selling of gold and silver bullions and foreign exchange).

On the other hand, the term bank is defined, under Art 2(1) and (4) of the same proclamation, as a share company whose capital is wholly owned by Ethiopian nationals and/or business organizations wholly owned by Ethiopian nationals and which is registered under Ethiopian laws and which has its head office in Ethiopia and licensed to undertake banking business by the national bank of Ethiopia.

In addition to this, Art 4(2) of the same proclamation clearly prohibits foreign nationals and business organizations from undertaking banking business in Ethiopia. The definition of a bank and this provision exclusively reserve the banking sector to Ethiopian nationals or business organizations wholly owned by Ethiopian nationals mainly on the ground of protection of domestic banks which are at an early stage of development, at least until they develop their financial and manpower capabilities, to be able to compete with foreign banks which have enormous financial strength, experience, technology and knowhow.

Role of Micro Finance Institutions

According to the preamble of Proclamation No. 40/1996, the monetary and banking laws in force do not provide for micro financing institutions catering for the credit needs of peasant farmers and others engaged in small scale production and service activities. So it has become necessary to legislate on the licensing and supervision of the business of micro financing institutions.

So the development of microfinance in Ethiopia should be viewed as (a) an identification of considerable levels of unrealized demand and potential market growth for financial services and (b) a shift by the NGO sector and government from relief assistance to sustainable development which intersects at the point of institutionalization of microfinance provision (Fiona, 1999).

Although the development of microfinance institutions in Ethiopia started very recently, the industry has shown a remarkable growth in terms of outreach particularly in number of clients. Since the issuance of Proclamation 40/1996, which provides the establishment of microfinance institutions, sixteen microfinance institutions (MFIs) have been legally registered by the National Bank of Ethiopia (NBE) and started delivering services, and two more applications by new MFIs are currently being processed.

According to the Micro start Project document of UNDP (1999), the economically active poor in Ethiopia who can potentially access financial services are about 6 million. Out of this, about 8.3% of the active poor have gained access to the licensed microfinance institutions. Despite the obvious disadvantages of the microfinance industry in Ethiopia such as poor communication and infrastructure, weak legal systems, banking sector and technical capacity when compared with other Sub-Saharan countries, the sector has been growing at a significant rate.

The Regulatory Framework for the Microfinance Industry and Micro and Small Enterprises

The delivery of efficient and effective microfinance services to the poor required conducive macroeconomic policies and the establishment and enforcement of legal and regulatory frameworks of a country. An effective financial system provides the foundation for a successful poverty alleviation program. However, regulations in the microfinance industry do not only mean government regulations; it also involves self-regulations and code of conducts introduced by networks or associations.

Regulatory frameworks governing the microfinance industry should ensure that the MFI has a sound portfolio performance; low delinquency or default rate; high diversification to reduce the risk of specializing in the delivery of one loan product; ensure the safety of deposits through equity capital; ensure lower levels of liquidity risk; provide regular and high quality financial information and reduce the risk arising from dependence on subsidy and influence of donor.

There are numerous policies, laws and directives which affect the development of microfinance industry and micro and small enterprise development in Ethiopia. An attempt is made here to review only the most relevant and recent policies affecting the industry. The Monetary and Banking Proclamation No. 83/1994 empowered the National Bank of Ethiopia (NBE) to license, supervise and regulate financial institutions such as banks, insurance companies, microfinance institutions and savings and credit cooperatives. The Licensing and Supervision of Banking Business Proclamation No. 84/1994 allowed for the first time the establishment of private financial institutions, thus breaking the state monopoly. To date, six private banks and eight private insurance companies have been established.

Since micro-credit delivery and savings mobilization in Ethiopia were performed by NGOs, government departments, cooperatives and others in a fragmented and inconsistent way, the government took the initiative to establish the regulatory framework in order to facilitate sound development of the

Microfinance industry Proclamation No. 40/1996, which aims to provide for the licensing and supervision of the business of micro financing clearly indicates the requirements for licensing microfinance institutions by empowering the National Bank of Ethiopia to license and supervise them. According to article 4 of the Proclamation, any institution that needs to engage in microfinance activity should fulfill the following:

1. obtain license from the National Bank of Ethiopia;
2. formed as a company governed by the commercial code of 1960 (a share company owned fully by Ethiopian nationals and having its head office in Ethiopia);
3. deposit the minimum capital required, i.e., 200,000 Birr in a bank;
4. the directors and other officers meet requirements set by the bank.

Furthermore, as to the purpose and duty of macro finance institutions, article 3 of the same proclamation provides:

1. the purpose of micro financing institutions is granting credit, in cash or in kind, the maximum amount of which shall be determined by the bank.
2. subject to conditions set under this Proclamation, a micro finance institution may carry out some or all of the following activities:
   1. accepting savings as well as demand and time deposits;
   2. drawing and accepting drafts payable within Ethiopia;
   3. borrowing money for its business purpose against the security of its assets or otherwise;
   4. purchasing such income generating financial instruments as treasury bills;
   5. acquiring, maintaining and transferring of any moveable and immovable property including premises for carrying out its business;
   6. providing counseling services to its clients;
   7. encouraging income generating projects for urban and rural micro-operators;
   8. rendering managerial, marketing, technical and administrative advice to borrowers and assisting them to obtain services in those fields;
   9. managing funds for micro financing business; and
   10. engaging in other activities customarily undertaken by micro financing institutions.

To realize the above purposes and duties, the National Bank of Ethiopia has also issued 12 directives, which have been consistent with Proclamation No. 40/1996. These included setting a loan ceiling of 5,000 Birr and loan duration of one year. The interest rate has been waived and MFIs are now free to set their own interest rates ceiling. There is also a requirement for re-registration once an MFI mobilizes deposits greater than one million Birr.

The regulatory framework has affected the welfare-oriented NGOs in Ethiopia which focus on welfare programs by providing free or subsidized micro-credit services. They tend to provide credit services at very low interest rate (below market interest rate) focusing on the poorest of the poor (based on humanitarian reasons) rather than on sound credit management principles. As a result, many of the NGOs, providing micro-credit services in Ethiopia, are in a transition from highly subsidized credit programs to a finance based system. Although the initial reactions of the NGOs in Ethiopia to the implementation of the regulatory framework (Proclamation No. 40/96) were negative, they have now realized that the regulatory framework has institutionalized and unified microfinance services in the country.

The required minimum paid-up capital payment for MFI in Ethiopia (about 25,000 US Dollars) is low and affordable. The recent full liberalization of lending interest rates is also a positive development towards implementing an operationally sustainable strategy for MFIs. This assists to adequately price small-scale and risky loans and microfinance operations.

The government has recognized the importance of micro-enterprise development to the overall economic growth of the country and poverty alleviation. It has established the Micro and Small Enterprise Development Agency to co-ordinate and support the sector. According to Proclamation No. 33/1998, the Agency shall be involved in designing policies and strategies for the development and expansion of the micro and small enterprise; study the demand for training and conduct training; establish skill up-grading, technical and demonstration centers in different regions of the country; and disseminate information to the entrepreneurs. However, these enterprises require adequate flow of institutional credit to finance both short-term operating expenses and long-term investment needs.

In addition to addressing poverty and food security issues, micro-enterprises teach the poor new skills and help them generate greater savings for investment and promote inter-sectoral linkages.

The main constraints of micro and small enterprises include lack of finance, business information, business premises, skills and managerial expertise, access to appropriate technology, lack of adequate infrastructure and in some instances discriminatory regulatory practices. In the Ethiopian context, and in terms of partially solving the problem of financial resources, the agency has to integrate its activities with the microfinance industry.

The Federal Government of Ethiopia has produced the Micro and Small Enterprises Development Strategy to address the above problems and create an enabling environment for the growth of these enterprises. It has identified criteria and prioritized the target beneficiaries of the support program. The support program will consider those micro and small enterprises using local raw materials and/or labor intensive technologies, having greater inter-and intra-sectoral linkages; potentially competitive and have objective of exporting their products; and those engaged in facilitating and promoting tourism. The support program focuses on creating an enabling legal framework; streamlining existing regulatory conditions; facilitating access to finance; training in entrepreneurship, technical and management skills; facilitating access to market, raw materials and fostering partnership; and facilitating the availability and access to adequate infrastructure.

Proclamation No. 83/1995 provides for the establishment of primary and secondary agricultural cooperatives on voluntary basis and democratic principles. One of the objectives of the new Proclamation 147/1998. (Co-operatives Societies Proclamation) is to develop and promote saving and credit services for members to participate actively in the free market economic system.

Implementing, Monitoring and Evaluating the Regulatory Framework of the Microfinance Industry

The process of policy formulation, implementation, monitoring and evaluation is, by and large, the same whether it refers to the policy formulated at macro or micro levels. It applies equally to policies formulated by the government, a particular private firm or by an NGO. Just as in a project, the formulation, implementation and monitoring process of financial policy, or any development policy, should follow a defined path. The process starts with the identification of financial policy constraints which impede the achievement of the stated objectives. This is then followed by the analysis of the constraints, formulation of alternative financial policy options or remedial measures, appraisal and approval, implementation and finally monitoring and evaluation of the effects and impacts of the financial policies of the regulatory framework of the microfinance industry. We can call this the financial policy cycle instead of the project cycle.

The search for appropriate change in the regulatory framework and identifying the problems starts when the stated government objectives and targets fail or are failing. The need for financial policy reform or change could also start when concerned government departments (such as the National Bank of Ethiopia) or stakeholders realize that existing regulatory frameworks are having unanticipated negative consequences. The identification of a financial policy reform for the microfinance industry and designing appropriate policy options could start when one of the following situations or a combination of these occur.

1. When the Ethiopian government itself, the National Bank of Ethiopia or the Prime Minister's Office believes that the envisaged financial policy objectives and targets are not met or realized.
2. When the government, with an external pressure e.g., from the IMF or World Bank, considers that current financial policies are not sustainable in the long term.
3. When existing regulatory frameworks result in negative consequences that were not envisaged or the effect has been underestimated at the time of their conception.
4. When the government realizes that there are better financial policy options to bring about an accelerated development in the microfinance industry.
5. When stakeholders such as the practitioners in the microfinance industry demand a change in the current policies or regulatory framework.

Thus, the possible identification of a change in the regulatory framework of the microfinance industry could originate from (a) government line departments; (b) multilateral and bilateral donors; (c) organized and unorganized stakeholders such as the practitioners in the microfinance industry; and (d) research institutes acting as think tanks for policy analysis, financial policy monitoring and evaluation.

In Ethiopia, there is no government department which follows up the overall development of the microfinance industry.  Currently, there are no research institutes involved in microfinance development and policy research which recommend a change in the regulatory framework. There are attempts, however, by the Prime Minister's Office and the Ethiopian Economic Association to establish an Economic Policy Research Institute. In the Ethiopian context, multilateral and bilateral organizations do not have the mandate and responsibility of identifying and changing government policies through direct or indirect pressure. The last option to the microfinance industry is to use the network which is established with the objective of creating a forum to discuss policy issues and problems of the industry and share experiences. The Association of Ethiopian Microfinance Institutions (AEMFI) has created a forum to discuss and review the performance of the regulatory framework and monitor its impact.

The entry point for policy analysis in the financial sector in general and microfinance industry in particular is the review of the existing policies with the view to understanding shortfalls and to assess the extent of overhauling or complete changes required. The analysis involves both quantitative and qualitative approaches.

The progress made in the implementation of the various activities related to policy reforms in light of the reform targets and schedule of achievements should be monitored regularly. Once the implementation of the financial policy is launched, the National Bank of Ethiopia, or stakeholder organizations such as AEMFI should review the progress of the implementation.

The impact monitoring aspect involves measuring the qualitative and quantitative changes brought about as a result of the implementation of the regulatory framework of the microfinance industry. This should be compared against the objectives and targets set for the industry. The National Bank of Ethiopia with full participation of the stakeholders should undertake such impact evaluation or policy monitoring regularly. This involves highlighting the progress so far registered, problems encountered, measures taken, recommendations made for remedial measures, resources required etc.

Moreover, as indicated earlier, regulation in the microfinance industry refers to a set of enforceable laws and rules. These rules could be enforced by government departments or associations of practitioners such as AEMFI which, in the later case of the latter, is self-regulation. In the Ethiopian case, there is already an established government regulatory and supervisory department under the National Bank of Ethiopia. What is suggested is to combine implementation of self-regulation by networks and government regulations, as the two approaches to regulate the microfinance industry are not mutually exclusive. Here self-regulation mainly involves drafting the code of conduct for the industry and developing performance indicators or self-rating system.

Commercial Banks

Commercial banks are at the centre of most money markets, as both suppliers and users of funds, and in many markets, a few large commercial banks serve also as intermediaries. These banks have a unique place because it is their role to furnish an important part of the money supply. In some countries, they do this by issuing their own notes, which circulate as part of the hand-to-hand currency. More often, however, it is checking accounts at commercial banks that constitute the major part of the country's money supply. In either case, the outstanding supply of bank money is in a continual circulation, and any given bank may at any time have more funds coming in than going out, while at another time the outflow may be the larger. It is through the facilities of the money market that these net excesses and shortages are redistributed, so that the banking system as a whole can at all times provide the means of payment required for carrying on each country's business.

In the course of issuing money, the commercial banks also actually create it by expanding their deposits, but they are not at liberty to create all that they may wish whenever they wish, for the total is limited by the volume of bank reserves and by the prevailing ratio between these reserves and bank deposits—a ratio that is set by law, regulation, or custom. The volume of reserves is controlled and varied by the central bank (such as the Bank of England, the Bank of France, or the Federal Reserve System in the U.S.), which is usually a governmental institution, always charged with governmental duties, and almost invariably carries out a major part of its operations in the money market.

Central Banks

The reserves of the commercial banks, which are continually being redistributed through the facilities of the money market, are in fact mainly deposit balances that these commercial banks have on the books of the central bank or notes issued by the central bank, which the commercial banks keep in their own vaults. As the central bank acquires additional assets, it pays for them by crediting depositors' accounts or by issuing its own notes; thus the potential volume of commercial bank reserves is enlarged. With more reserves, the commercial banks can make additional loans or investments, paying for them by entering credits to depositors' accounts on their books. And in that way the money supply is increased. It may be reduced by reversing the sequence. The central bank can sell some of its marketable assets in the money market or in markets closely interrelated with the money market; payment will be made by drawing down some of the commercial bank reserve balances on its books; and with smaller reserves remaining, the commercial banks will have to sell or reduce some of their investments or their loans. That, in turn, results in shrinkage of the outstanding money supply. Central bank operations of this kind are called open-market operations.

The central bank may also increase bank reserves by making loans to the banks or to such intermediaries as bill dealers or dealers in government securities. Reduction of these loans correspondingly reduces bank reserves. Although the mechanics of these lending procedures vary widely among countries, all have one feature in common: the central bank establishes an interest rate for such borrowing—the bank rate or discount rate—pivotally significant in the structure of money market rates.

Money market assets may range from those with the highest form of liquidity—deposits at the central bank—through bank deposits to various forms of short-term paper such as treasury bills, dealers' loans, bankers' acceptances, and commercial paper, and including government securities of longer maturity and other kinds of credit instruments eligible for advances or rediscount at the central bank. Although details vary among countries, the touchstone of any money market asset other than money itself is its closeness—i.e., the degree of its substitutability for money. So long as the institutions making use of a money market regard a particular type of credit instrument as a reasonably close substitute—that is, treat it as “liquid”—and so long as the central bank acquiesces in or approves of this approach, the instrument is in practice a money market asset. Thus, no single definition or list can apply to the money markets of all countries nor will the list remain the same through the years in the money market of any given country.

Responsibilities of Central Banks

The principles of central banking grew up in response to the recurrent British financial crises of the 19th century and were later adopted in other countries. Modern market economies are subject to frequent fluctuations in output and employment. Although the causes of these fluctuations are various, there is general agreement that the ability of banks to create new money may exacerbate them. Although an individual bank may be cautious enough in maintaining its own liquidity position, the expansion or contraction of the money supply to which it contributes may be excessive. This raises the need for a disinterested outside authority able to view economic and financial developments objectively and to exert some measure of control over the activities of the banks. A central bank should also be capable of acting to offset forces originating outside the economy, although this is much more difficult.

The first concern of a central bank is the maintenance of a soundly based commercial banking structure. While this concern has grown to comprehend the operations of all financial institutions, including the several groups of non bank financial intermediaries, the commercial banks remain the core of the banking system. A central bank must also cooperate closely with the national government. Indeed, most governments and central banks have become intimately associated in the formulation of policy.

Relations with Commercial Banks

One source of economic instability is the supply of money. Even in relatively well-controlled banking systems, banks have sometimes expanded credit to such an extent that inflationary pressures developed. Such an overexpansion in bank lending would be followed almost inevitably by a period of undue caution in the making of loans. Frequently the turning point was associated with a financial crisis, and bank failures were not uncommon. Even today, failures occur from time to time. Such crises in the past often threatened the existence of financial institutions that were essentially sound, and the authorities sometimes intervened to prevent complete collapse.

The willingness of a central bank to offer support to the commercial banks and other financial institutions in time of crisis was greatly encouraged by the gradual disappearance of weaker institutions and a general improvement in bank management. The dangers of excessive lending came to be more fully appreciated, and the banks also became more experienced in the evaluation of risks. In some cases, the central bank itself has gone out of its way to educate commercial banks in the canons of sound finance. In the United States, the Federal Reserve System examines the books of the commercial banks and carries on a range of frankly educational activities. In other countries, such as India and Pakistan, central banks have also set up departments to maintain a regular scrutiny of commercial bank operations.

The most obvious danger to the banks is a sudden and overwhelming run on their cash resources in consequence of their liability to depositors to pay on demand. In the ordinary course of business, the demand for cash is constant or subject to seasonal fluctuations that can be foreseen. It has become the responsibility of the central bank to protect banks that have been honestly and competently managed from the consequences of a sudden and unexpected demand for cash. In other words, the central bank came to act as the “lender of last resort.” To do this effectively, it was necessary that the central bank be permitted either to buy the assets of commercial banks or to make advances against them. It was also necessary that the central bank has the power to issue money acceptable to bank depositors. However, if a central bank was to play this role with respect to commercial banks, it was only reasonable that it or some related authority be allowed to exercise a degree of control over the way in which the banks conducted their business.

Most central banks now take a continuing day-to-day part in the operations of the banking system. The Bank of England, for example, has been increasingly in the market to ensure that the banks have a steady supply of cash, even during periods of credit restriction. It also lends regularly to the discount houses, supplementing their resources whenever the commercial banks feel the need to call back money they have on loan to them. In the United States, the Federal Reserve System has operated in a similar way by buying and selling securities on the open market and by lending to dealers in government securities based on repurchase agreements. The Federal Reserve may also discount paper submitted by the commercial banks through the Federal Reserve banks. The various techniques of credit control in use are discussed in greater detail below.

The evolution of those working relations among banks implies a community of outlook that in some countries is relatively recent. The whole concept of a central bank as responsible for the stability of the banking system presupposes mutual confidence and cooperation. For this reason, contact between the central bank and the commercial banks must be close and continuous. The latter must be encouraged to feel that the central bank will give careful consideration to their views on matters of common concern. Once the central bank has formulated its policy after a full consideration of the facts and of the views expressed, however, the commercial banks must be prepared to accept its leadership. Otherwise, the whole basis of central banking would be undermined.

The Central Bank and the National Economy

Relations with Other Countries

Since no modern economy is self-contained, central banks must give considerable attention to trading and financial relationships with other countries. If goods are bought abroad, there is a demand for foreign currency to pay for them. Alternatively, if goods are sold abroad, foreign currency is acquired that the seller ordinarily wishes to convert into the home currency. These two sets of transactions usually pass through the banking system, but there is no necessary reason why, over the short period, they should balance. Sometimes there is a surplus of purchases and sometimes a surplus of sales. Short-period disequilibrium is not likely to matter very much, but it is rather important that there be a tendency to balance over a longer period, since it is difficult for a country to continue indefinitely as a permanent borrower or to continue building up a command over goods and services that it does not exercise.

Short-period disequilibrium can be met very simply by diminishing or building up balances of foreign exchange. If a country has no balances to diminish, it may borrow, but normally it, at least, carries working balances. If the commercial banks find it unprofitable to hold such balances, the central bank is available to carry them; indeed, it may insist on concentrating the bulk of the country's foreign-exchange resources in its hands or in those of an associated agency.

Long-period equilibrium is more difficult to achieve. It may be approached in three different ways: price movements, exchange revaluation (appreciation or depreciation of the currency), or exchange controls.

Price levels may be influenced by expansion or contraction in the supply of bank credit. If the monetary authorities wish to stimulate imports, for example, they can induce a relative rise in home prices by encouraging an expansion of credit. If additional exports are necessary in order to achieve a more balanced position, the authorities can attempt to force down costs at home by operating to restrict credit.

The objective may be achieved more directly by revaluing a country's exchange rate. Depending on the circumstances, the rate may be appreciated or depreciated, or it may be allowed to “float.” Appreciation means that the home currency becomes more valuable in terms of the currencies of other countries and that exports consequently become more expensive for foreigners to buy. Depreciation involves a cheapening of the home currency, thus lowering the prices of export goods in the world's markets. In both cases, however, the effects are likely to be only temporary, and for this reason the authorities often prefer relative stability in exchange rates even at the cost of some fluctuation in internal prices.

Quite often governments have resorted to exchange controls (sometimes combined with import licensing) to allocate foreign exchange more or less directly in payment for specific imports. At times, a considerable apparatus has been assembled for this purpose, and, despite “leakages” of various kinds, the system has proved reasonably efficient in achieving balance on external payments account. Its chief disadvantage is that it interferes with normal market processes, thereby encouraging rigidities in the economy, reinforcing vested interests, and restricting the growth of world trade.

Whatever method is chosen, the process of adjustment is generally supervised by some central authority—the central bank or some institution closely associated with it—that can assemble the information necessary to ensure that the proper responses are made to changing conditions.

Economic Fluctuations

As noted above, monetary influences may be an important contributory factor in economic fluctuations. An expansion in bank credit makes possible, if it does not cause, the relative overexpansion of investment activity characteristic of a boom. Insofar as monetary policy can assist in mitigating the worst excesses of the boom, it is the responsibility of the central bank to regulate the amount of lending by banks and perhaps by other financial institutions as well. The central bank may even wish to influence in some degree the direction of lending as well as the amount.

An even greater responsibility of the central bank is that of taking measures to prevent or overcome a slump. Recessions, when they occur, are often in the nature of adjustments to eliminate the effects of previous overexpansion. Such adjustments are necessary to restore economic health, but at times they have tended to go too far; depressive factors have been reinforced by a general lack of confidence, and, once this has happened, it has proved extremely difficult to stimulate recovery. In these circumstances, prevention is likely to be far easier than cure. It has therefore become a recognized function of the central bank to take steps to preclude, if possible, any such general deterioration in economic activity.

For the central bank to be effective in regulating the volume and distribution of credit so that economic fluctuations may be damped, if not eliminated, it must at least be able to regulate commercial bank liquidity (the supply of cash and “near cash”), because this is the basis of bank lending. Monetary authorities in a number of countries have begun to resort increasingly to the management of monetary aggregates as a basic policy. This does not mean an uncritical acceptance of monetarist philosophy but rather what the U.S. economist and banker Paul A. Volcker has called “practical monetarism.” In addition to the Federal Reserve in the United States, a growing number of western European countries have adopted the practice of setting growth targets for the money supply and sometimes other monetary targets as well (like domestic credit expansion), usually setting some range of allowable variation. Japan has had reservations and has preferred to indicate monetary projections or forecasts, partly because of the difficulty of changing a set target should it become necessary. Nor is there any great degree of consensus as to which target or aggregate to employ. In general terms, the choice of a particular aggregate as a basis for reference would be linked to the theories—more or less explicit—on which the actions of a particular central bank are based and also on the state of the country's economy and its financial environment. Where there are publicly declared targets, these can have an important effect by the very fact of being announced.

There is now little dispute about the broad objectives, though the techniques of control are various and depend to some extent on environmental factors. It would be incorrect to suppose, however, that the actions of the central bank can, unaided, achieve a high degree of stability. It can, by wise guidance, contribute to that end but monetary action is in no sense a panacea; at all times, the degree to which it is likely to be effective depends on the provision of an appropriate fiscal environment.

Supervision and Promotion of Banking Services

Another responsibility of the central bank is to ensure that banking services are adequately supplied to all members of the community that need them. Some areas of a country may be “under-banked” (e.g., the rural areas of India and the northern and more remote parts of Norway), and central banks have attempted, directly or indirectly, to meet such needs. In France, this need underlay the early extension of branches of the Bank of France to the departments. In India, the authorities encouraged the opening of “pioneer” branches by the former Imperial Bank of India and its successor, the State Bank of India, later by all the nationalized banks, and particularly their extension to rural and semi rural areas. In Pakistan, officials of the State Bank of Pakistan played an active part in the foundation of the semipublic National Bank of Pakistan with a similar objective in view.

A different sort of problem arises when the business methods of existing banks are unsatisfactory. In such circumstances, a system of bank inspection and audit organized by the central banking authorities (as in India and Pakistan) or a system of bank “examinations” (as in the United States) may be the appropriate answer. Alternatively, the supervision of bank operations may be handed over to a separate authority, such as France's Banking Control Commission or South Africa's Registrar of Banks.

In developing countries, central banks may encourage the establishment and growth of specialist institutions such as savings institutions and agricultural credit or industrial finance corporations. These serve to improve the mechanism for tapping existing liquid resources and to supplement the flow of funds for investment in specific fields.

National Bank

Central Banks: General Overview

It refers to an institution, such as the Bank of England, the U.S. Federal Reserve System, the Bank of France, or the Bank of Japan, that is entrusted with the power of regulating the size of a nation’s money supply, the availability and cost of credit, and the foreign-exchange value of its currency. Regulation of the availability and cost of credit may be nonselective or may be designed to influence the distribution of credit among competing uses. The principal objectives of a modern central bank in carrying out these functions are to maintain monetary and credit conditions conducive to a high level of employment and production, a reasonably stable level of domestic prices, and an adequate level of international reserves.

Central banks also have other important functions, of a less-general nature. These typically include acting as fiscal agent of the government, supervising the operations of the commercial banking system, clearing checks, administering exchange-control systems, serving as correspondents for foreign central banks and official international financial institutions, and, in the case of central banks of the major industrial nations, participating in cooperative international currency arrangements designed to help stabilize or regulate the foreign-exchange rates of the participating countries.

Central banks are operated for the public welfare and not for maximum profit. The modern central bank has had a long evolution, dating back to the establishment of the Bank of Sweden in 1668. In the process, central banks have become varied in authority, autonomy, functions, and instruments of action. Virtually everywhere, however, there has been a vast and explicit broadening of central-bank responsibility for promoting domestic economic stability and growth and for defending the international value of the currency. There also has been increased emphasis on the interdependence of monetary and other national economic policies, especially fiscal and debt-management policies. Equally, a widespread recognition of the need for international monetary cooperation has evolved, and central banks have played a major role in developing the institutional arrangements that have given form to such cooperation.

The broadened responsibilities of central banks in the second half of the 20^th century were accompanied by greater government interest in their policies; in a number of countries, institutional changes, in a variety of forms, were designed to limit the traditional independence of the central bank from the government. Central-bank independence, however, really rests much more on the degree of public confidence in the wisdom of the central bank’s actions and the objectivity of the bank’s leadership than on any legal provisions purporting to give it autonomy or to limit its freedom of action.

Central banks traditionally regulate the money supply by expanding and contracting their assets. An increase in a central bank’s assets causes a corresponding increase in its deposit liabilities (or note issue), and these, in turn, provide the funds that serve as the cash reserves of the commercial banking system—reserves that commercial banks, by law or custom, must maintain, generally in a prescribed proportion of their own deposit liabilities. As banks acquire larger cash balances with the central bank, they are in a position to expand their own credit operations and deposit liabilities to a point where the new, larger cash reserves no longer produce a reserve ratio greater than the minimum set by law or custom. A reverse process occurs when the central bank contracts the volume of its assets and liabilities.

Central banks typically alter the volume of their assets by six ways:

1. “Open-market operations” consist mainly of purchases and sales of government securities or other eligible paper, but operations in bankers’ acceptances and in certain other types of paper often are permissible. Open-market operations are an effective instrument of monetary regulation only in countries with well-developed security markets. Open-market sales of securities by the central bank drain cash reserves from the commercial banks. This loss of reserves tends to force some banks to borrow from the central bank, at least temporarily. Banks faced with the cost of such borrowing, at what may well be a high discount rate, and also faced with the possibility of being admonished by the central bank about their lending policies typically become more restrictive and selective in extending credit. Open-market sales, by reducing the capacity of the banking system to extend credit and by tending to drive down the prices of the securities sold, also tend to raise the interest rates charged and paid by banks. The rise in government security yields and in the interest rates charged and paid by banks forces other financial institutions to offer a higher rate of return on their obligations, in order to be competitive, and, given the reduced availability of bank credit, enables them, like banks, to command a higher rate of return on their loans. Thus, the impact of open-market sales is not limited to the banking system; it is diffused throughout the economy. Conversely, purchases of securities by the central bank tend to lead to credit expansion by the financial system and to lower interest rates, unless the demand for credit is rising at a faster rate than the supply, which normally is the case once an inflationary process gets underway; interest rates then will rise rather than fall.

Changes in domestic money-market rates resulting from central-bank actions also tend to change the prevailing relations between domestic and foreign money-market rates, and this, in turn, may set in motion short-term capital flows into or out of the country.

2. Loans to banks, generally called “discounts” or “rediscounts,” are short-term advances against commercial paper or government securities to enable banks to meet seasonal or other special temporary needs either for loan-able funds or for cash reserves to replace reserves lost because of shrinkage in deposits. The Bank of England ordinarily deals with discount houses rather than directly with banks, but the effect on bank reserves is similar. The provision of such advances is one of the oldest and most traditional functions of central banks. The rate of interest charged is known as the “discount rate,” or “rediscount rate.” By raising or lowering the rate, the central bank can regulate the cost of such borrowing. The level of and changes in the rate also indicate the view of the central bank on the desirability of greater tightness or ease in credit conditions.

Some central banks, especially in countries that lack a broad capital market, extend medium- and long-term credit to banks and to government development corporations in order to facilitate the financing of domestic economic-development expenditures and to alleviate the deficiency of financial savings. Such longer-term lending is not regarded as an appropriate central-bank activity by many authorities, however, and is considered a dangerous source of inflationary pressures.

3. Direct government borrowing from central banks generally is frowned upon as encouraging fiscal irresponsibility and commonly is subject to statutory limitation; nevertheless, in many countries the central bank is the only large source of credit for the government and is used extensively. In other countries indirect support of government financing operations has monetary effects that differ little from those that would have followed from an equal amount of direct financing by the central bank.

4. Central banks buy and sell foreign exchange to stabilize the international value of their own currency. The central banks of major industrial nations engage in the so-called “currency swaps,” in which they lend one another their own currencies in order to facilitate their activities in stabilizing their exchange rates. Prior to the 1930s, the authority of most central banks to expand the money supply was limited by statutory requirements that restricted the capacity of the central bank to issue currency and (less commonly) to incur deposit liabilities to the volume of the central bank’s international reserves. Such requirements have been lowered or eliminated by most countries, however, either because they blocked expansions of the money supply at times when expansion was considered essential to domestic economic-policy objectives or because they “locked up” gold or foreign exchange needed for payments abroad.

5. Many central banks have the authority to fix and to vary, within limits, the minimum cash reserves that banks must hold against their deposit liabilities. In some countries, the reserve requirements against deposits provide for the inclusion of certain assets in addition to cash. Generally, the purpose of such inclusion is to encourage or require banks to invest in those assets largely than they otherwise would be inclined to do and thus to limit the extension of credit for other purposes. Similarly, especially lower discount rates sometimes are used to encourage specific types of credit, such as agriculture, housing, and small businesses.

6. In periods of intense inflationary pressure and shortage of supplies, especially during wartime and immediately thereafter, many governments have felt a need to impose direct measures to curb the availability of credit for particular purposes—such as the purchase of consumer durables, houses, and nonessential imported goods—and often have had these controls administered by their central banks. Such controls typically establish maximum loan-value to purchase-price ratios and maximum maturities that must be prescribed by lenders. These controls often apply to non-bank lenders as well as to bank lenders, and this is necessary for effectiveness in countries in which non-bank lenders are important sources of the types of credit being curbed. The general experience of central banks with direct credit controls has not been favorable; opportunities for evasion are too easy, especially if overall credit conditions are not extremely tight, and inequities in the impact of the controls become socially and politically troublesome. An early example of selective credit-control authority vested in a central bank and one that, on balance, has worked tolerably well is the authority conferred on the U.S. Federal Reserve Board in 1934 to establish margin requirements on stock-market credit.

The National Bank of Ethiopia

The National Bank of Ethiopia was created by order No 30/1963 and reconstituted by the Monetary and Banking Proclamation No 83/1994 as an autonomous organ, which is engaged in the provision of regular banking services to the government and other banks and insurance companies’. The main purpose of the bank is to forester monetary stability financial system and such other credit and exchange conditions as are conducive to the balanced growth of the economy of Ethiopia. / Art 6/

The bank will have the following powers and duties that will help it to achieve its purpose, /Art 7/

-          Mint coin, print and issue legal tender currency.

-          Regulate the supply and availability of money and fix the minimum and maximum rates of interest that banks and other financial institutions may charge for different types of loans, advances and other credits and pay on various classes of deposits. (Art 7 and Art 30).

-          Implement exchange rate policy, allocate foreign exchange, manage and administer the international reserve fund of Ethiopia. This reserve fund consists of gold, silver, foreign exchange and securities, which are used to pay for imports into the country and pay foreign international debts and other commitments (Art 50).

-          License, supervise and regulate banks, insurance companies and other financial institutions such as savings and credit associations/co-operatives and postal savings.

-          Set limits on gold and foreign exchange assets that banks and other financial institutions, which are authorized to deal in foreign exchange, can hold in deposits (Art 39).

-          Set limits on the net foreign exchange position and on the terms and the amount of external indebtedness of banks and other financial institutions.

-          Make short and long term refinancing facilities available to banks and other financial institutions.

-          Accept deposits of any type from foreign sources.

-          Act as banker, fiscal agent and financial advisor to the government/Art 24, 25/.

-          Promote and encourage the dissemination of banking and insurance services throughout the country.

-          Prepare periodic economic studies together with forecasts of the balance of payment, money supply, prices and other statistical indicators of the Ethiopian economy used for analysis and for the formulation and determination by the bank of monetary, savings and exchange policies.

Vision, Mission and Goals of the National Bank of Ethiopia

The vision, mission and goals of the National Bank of Ethiopia emanated from the overall vision of the government which is “to see a country, wherein democracy and good governance are prevailed upon the mutual consent and involvement of its people, wherein social justice is reigned, and wherein poverty reduced and income of the citizens reach to a middle economic level”.

1) Vision of the Bank

To be one of the strongest and most reputable central banks in Africa

2) Mission of the Bank

To maintain price and exchange rate stability, to foster a sound financial system and undertake such other functions as are conducive to the economic growth of Ethiopia.

3)      Values of the Bank

A) Core value

-          Promoting financial and monetary discipline

B)   Individual Values

-          Integrity

-          Neatness and good appearance

-          Punctuality

-          Team work spirit

C) Operational Values

-          Commitment to Excellence in Service

-          Confidentiality

-          Continuous Improvement

-          Transparency

-          Accountability

D) Organizational Strategic Values

-        Pursuit of Excellence and Professionalism

4)      Strategic Goals

Goal 1: Carry out extensive and sound institutional transformation tasks.

Goal 2: Maintain price and exchange rate stability.

Goal 3: Maintain adequate international reserves.

Goal 4: Improve the soundness of the financial system.

Goal 5: Play a decisive role in economic research and policy advice to the Government.

Goal 6: Create an efficient Payment System.

Goal 7: Improve the currency management of the Bank.

5)      Objectives

Objectives of Goal 1

Identify and conduct Quick win activities on continuous basis.

Implement BPR studies conducted and ensure their sustainability.

Review and update the SPM document of the Bank every two years.

In 2005/06, devise a result-based scheme that measures the performance evaluation of the work units and individual employees.

Identify and have adequate change agents.

Improve service delivery of the Bank.

Strengthen its service and enhance the computerization process of the Bank.

Enhance the capacity of the Bank.

Objectives of Goal 2

Contain annual core inflation (non-food inflation) within a single digit.

Maintain the exchange rate of Birr close to the equilibrium exchange rate.

Contain the premium between the official and parallel market exchange rate to the level below 1.5 percent.

Maintain the premium of respective buying and selling rates of the USD between the NBE and commercial banks below 2 percent.

Objectives of Goal 3

Ensure that the international reserve of the country is not less than three and a half months of imports of goods and non-factor services.

Manage the country's Foreign Exchange Reserve efficiently and effectively.

Ensure and manage the effective use of the country's Foreign Exchange.

Objectives of Goal 4

Ensure the average level of NPLs of commercial banks is reduced to below 15 percent.

Conduct effective on-site inspection of banks.

Conduct effective on-site inspection of insurance companies.

Conduct effective on-site inspection of micro finance institutions.

Issue seven new directives within the SPM period.

Amend the existing directives/policies.

Ensure systematic risk management framework for each bank.

Introduce CAMEL rating of banks.

Objectives of Goal 5

Finalize the Ethiopian macro econometric model and start its application

Strengthen the Bank's research and policy advisory capabilities and the dissemination of its findings in terms of published research papers and policy discussion forums by 100% each from 4 and 2 to 8 and 4 respectively.

Objectives of Goal 6

Create a National Payment System framework.

Conduct structural reforms on the existing payment systems.

Objectives of Goal 7

Ensure the availability and distribution of the Birr notes and coins.

Ensure the automatic provision of Birr notes exchange services

Increase the daily note sorting and verification capacity of the bank from the existing Birr 650,000 pcs per day by 60%.

Increase the note destruction capacity of the Bank from the existing Birr 700,000 pcs per day by 30%.

Assess counterfeiting situations.

Commercial Banks

Commercial banks are banks with the power to make loans that, at least in part, eventually become new demand deposits. Because a commercial bank is required to hold only a fraction of its deposits as reserves, it can use some of the money on deposit to extend loans. When a borrower receives a loan, his checking account is credited with the amount of the loan; total demand deposits are thus increased until the loan is repaid. As a group, then, commercial banks are able to expand or contract the money supply by creating new demand deposits.

The name commercial bank was first used to indicate that the loans extended were short-term loans to businesses, though loans later were extended to consumers, governments, and other non-business institutions as well. In general, the assets of commercial banks tend to be liquid and carry less risk than the assets held by other financial intermediaries. The modern commercial bank also offers a wide variety of additional services to its customers, including savings deposits, safe-deposit boxes, and trust services.

The Commercial Bank of Ethiopia and all the privately owned banks in Ethiopia fall under this category as they are primarily engaged in receiving money on deposit and providing loans to the public.

Savings Banks

A savings bank is a financial institution that gathers savings and that pay interest or dividends to savers. It channels the savings of individuals who wish to consume less than their incomes to borrowers who wish to spend more. The savings deposit departments of commercial banks, mutual savings banks or trustee savings banks (banks without capital stock whose earnings accrue solely to the savers), savings and loan associations, credit unions, postal savings systems, and municipal savings banks serve this function. Except for the commercial banks, these institutions do not accept demand deposits. Postal savings systems and many other European savings institutions enjoy a government guarantee; savings are invested mainly in government securities and other securities guaranteed by the government.

Savings banks frequently originated as part of philanthropic efforts to encourage saving among people of modest means. The earliest municipal savings banks developed out of the municipal pawnshops of Italy. Local savings banks were established in The Netherlands through the efforts of a philanthropic society that was founded in 1783, the first bank opening there in 1817. During the same time, private savings banks were developing in Germany, the first being founded in Hamburg in 1778.

The first British savings bank was founded in 1810 as a Savings and Friendly Society by a pastor of a poor parish; it proved to be the forerunner of the trustee savings bank. The origin of savings banking in the United States was similar; the first banks were nonprofit institutions founded in the early 1800s for charitable purposes. With the rise of other institutions performing the same function, mutual savings banks remained concentrated in the northeastern United States.

This type of specialized banking service is not yet introduced in Ethiopia and hence there is no bank, which may be considered as a savings bank. However, the commercial banks accept savings as one form of money deposit.

Investment Banks

Investment bank is a firm that originates, underwrites, and distributes new security issues of corporations and government agencies. The investment-banking house operates by purchasing all of the new security issue from a corporation at one price and selling the issue in smaller units to the investing public at a price sufficiently high to cover expenses of sale and leave a profit. The major responsibility for setting the public offering price rests on the investment bank because it is in close contact with the market, is familiar with current interest rates and yields, and is best able to judge the probable demand for the issue in question.

In the underwriting and distribution of most security issues, a syndicate of investment banking firms is organized. If the amount of capital sought is large enough to prohibit one investment banking firm's undertaking the risk of purchasing the entire issue, the investment bank that initiates the issue with the corporation organizes a group of investment bankers to divide the liability for the purchase, with the originator acting as manager of the group.

If the market coverage that can be obtained by the members of the syndicate is deemed insufficient, selected dealers are used to bring about a wider distribution. Securities are sold to the dealers at a reduction (known as a concession), which reimburses the dealer for his expenses and provides him with a profit if the distribution is performed skillfully.

When new securities are to be issued, an investment firm having close contact with the corporation is likely to be asked to originate the issue. This process often is called private negotiation. An alternative arrangement is competitive bidding, under which the corporation itself settles upon the terms of the issue to be offered and then invites all banking firms to submit bids. The issue will be sold to the highest bidder.

The fact that Ethiopia is a predominantly agrarian state and business in general is limited to a small scale under takings by individuals, the idea of investment through purchase of stocks/ shares and bonds is common. Further, more, the very few companies that were established to wards the end of the imperial era, were nationalized by the military government which adopted the Socialist ideology and economic system, which does not allow private ownership of big manufacturing, agricultural and service providing undertakings or businesses. This fact has prevented the introduction of investment banking in Ethiopia. Though a market economic policy has been adopted after the fall of the military government and business in general and companies in particular are expanding, companies have not started offering their shares to the public and hence there was no conducive environment for the establishment and operation of these types of banks in Ethiopia.

Development Banks

It refers to a national or regional financial institution designed to provide medium- and long-term capital for productive investment, often accompanied by technical assistance, in less-developed areas.

The number of development banks has increased rapidly since the 1950s; they have been encouraged by the International Bank for Reconstruction and Development and its affiliates. The large regional development banks include the Inter-American Development Bank, established in 1959; the Asian Development Bank, which began operations in 1966; and the African Development Bank, established in 1964. They may make loans for specific national or regional projects to private or public bodies or may operate in conjunction with other financial institutions. One of the main activities of development banks has been the recognition and promotion of private investment opportunities. Although the efforts of the majority of development banks are directed toward the industrial sector, some are also concerned with agriculture.

Development banks fill a gap left by undeveloped capital markets and the reluctance of commercial banks to offer long-term financing. Development banks may be publicly or privately owned and operated, although governments frequently make substantial contributions to the capital of private banks. The form (share equity or loans) and cost of financing offered by development banks depends on their cost of obtaining capital and their need to show a profit and pay dividends.

The Development Bank of Ethiopia is established with the purpose of providing long-term loans to agricultural and industrial undertakings, which are considered crucial in the development of the economy. It was intended to serve as the major financer for the various co-operatives and government owned farms and factories. Now it also provides long-term loans to private investors who are engaged in agricultural and manufacturing activities.

Islamic Banking

General Overview of Islamic Banking

"Islamic banking refers to a system of banking activity that is consistent with the Islamic law (Sheria). It is guided by principles of Islamic economics. At this juncture, it is important to note that Islamic law prohibits usury, that is, the collection and payment of interest which is commonly known as riba in Islamic discourse. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or harem (such as businesses that sell alcohol or dork or business that produce media such as gossip columns or pornography which are contrary to Islamic values. In line with this, in the late 20th century a number of Islamic banks were established.

The Meaning of Riba

The word riba literally means increase or excess. It covers both usury and interest. In Quranic verses it essentially refers to the practice of lending money for predetermined rate of return or interest. Riba can also be interpreted as the addition to the principal sum advanced through loan from the lender to the borrower. The Shariah disallow riba and there is now a general consensus among Muslim economists that riba is not restricted to usury but encompasses interest as well. The Qur^’an is clear about the prohibition of riba. You who believe fear Allah almighty and give up that remains of your demand for usury if you are indeed believer.

Muslim scholars have accepted the word riba to mean any fixed or guaranteed interest payment on cash advance or on deposits. Several Quranic verses expressly admonish the faithful to shun interest.

History of Islamic Banking

The history of interest free banking could be divided into two parts. First, when it still remained an idea; second when it became a reality by private initiative in some countries and by law in others.

A, Interest Free Banking as an Idea

Interest free banking seems to be of very recent origin especially in our country. But the earliest reference to the reorganization of banking on the basis of profit sharing written by Anwar Qureshi (1946), Naiem Siddiq (1948) and Mohamed Ahmed (1952). In the last forties it was followed by more elaborate exposition by Mawdudi in (1950).² They have all recognized the need of commercial banks that use in profit and lose sharing mechanism and have proposed a banking system based on the concept of mudarabh (profit and loss sharing). In the next two decades interest free banking attracted more attention because of the emergence of young Muslim economists. The first such works emerged in that of Muhammed vzair (1955). Another set of works emerged in the late sixties and early seventies, Abdullah al-araby (1967), Nejatullah Siddigi (1961.1969), Al Najjar (1971) and Baqir al-sadr (1961, 1974) were the main contributors.

The early seventies saw the institutional involvement that is conference of the finance Ministers of the Islamic countries held in Karachi in 1970, the Egyptian study in 1972, the first international conference on Islamic Economics in Mecca in 1976 etc.

B, the Coming in to Being of Interest Free Bank

“The institutional and governmental involvement led to the application of theory to practice and resulted in the establishing of the first interest free banks”.³ The Islamic development bank, an inter-governmental bank established in (1975) was born of this process. The first private interest free bank is the Dubai Islamic bank; it was set up in 1975. Before this modern bank experiment, Islamic banking was undertaken in Egypt without projecting on Islamic image for fear of being seen as manifestation of Islamic fundamentalism that was an anathema to the political regime. The pioneering effort led by Ahmed El-Najjar took the form of saving bank based on profit sharing in the Egyptian town of Mit Ghamr in 1963. By this time there were Nine (9) such banks in the country. In ten years, since the establishment of the first private commercial bank in Dubai, more than 50 interest free banks have come into being. In most countries the establishment of interest free banking had been by private; in Iran and Pakistan, however, it was undertaken by government initiative and covered all banks in the country.

Principles of Islamic Banking

“The Islamic beliefs prevent the believer from dealing that involves usury or interest (riba). Yet Muslims need banking service as much as anyone else and for many purposes to finance new business ventures to buy a house, car, to facilitate capital investment, to undertake trading activities, and to offer a safe place for savings”.¹³

Islamic banking based on the Quranic prohibition of charging interest has moved from a theoretical concept to embrace more banks operating in 45 countries with multi-billion dollar deposit world-wide. Islamic banking is widely regarded as the fastest growing sector. An estimated $ US 70 billion worth of funds are now managed according to shariah^.14

The best known feature of Islamic banking is the prohibition of interest. The Quran forbids the charging of riba on money lent. The Sharia disallow riba and there is now a general consensus among Muslim economists that riba is not restricted to usury but encompasses interest as well.

Let us look at the rule regarding Islamic finance, which is simple and can be summed up as follows:

1. 1. Any predetermined payment over and above the actual amount of principal for any is prohibited. Islam allows only one kind of loan and that is qard-el hassan (literally good loan), where the lender does not charge any interest or additional amount over the money lent.
2. 2. The lender must share in the profits or losses arising out of the enterprise for which the money was lent for the business. Islam encourages Muslims to invest their money and to become partners in order to share profits and risk in the business instead of becoming creditors.

As defined in the Shari'ah or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share benefit and the risk of business ventures. Translated into banking terms the depositor, bank and the borrower should all share the risk and the rewards of financing business ventures. This is unlike the interest based commercial banking system, where all the pressure is on the borrower, who must pay back his loan, with the agreed interest regardless of the success or failure of his enterprise.

The principle, which thereby emerges, is that Islamic Law encourages investments in order that the community may benefit. It is not instilling to allow a loophole to exist for those who do not wish to invest and take risks but rather content with hoarding money in bank in return for receiving an increase on these funds for no risk.¹⁴ Accordingly, either people invest with risk or suffer loss through  devaluation by inflation by keeping their money idle.

^3. Making money from money is not Islamically acceptable; money is only a medium of exchange, a way of defining the value of a thing it has no value in itself and should not be all owed to give rise to more money through fixed interest payments, simply by being put in a bank or lent to someone else. "Muslim jurists consider money as a potential capital rather than capital, meaning that money becomes capital only when it is invested in business" ¹⁵

Gharar (uncertainty risk or speculation) is also prohibited; and any transaction entered into should be free from uncertainty risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions.

 

Investments should only support practice or products that are not forbidden. Trade in alcohol, for example would not be financed by an Islamic bank, a real estate loan could not be made for the construction of a casino and the bank could not lend money to other banks at interest, even if it is profitable.

• Banks through acceptance of deposit of money from persons who do not need it at the present and lending it to persons who want it for investment, serve as financial intermediaries thereby providing ideal source of fund for investment that is crucial in increasing production, exports, creation of jobs and foreign exchange earnings of the country.

• Similarly bank lending to customers who need the money for consummation, purchase of various goods  and services, construction of houses,  and education increases demand for those goods and services, thereby encouraging producers and service  providers to expand their undertakings and increase production. Expansion and increase in production requires employment of additional workers, thereby creating new jobs, encourage producers and suppliers of raw materials to increase their production and supply.

• Banks also play a positive role in encouraging savings by providing an incentive to save through payment of interest on deposits/savings and providing safety and security. Saving is also an important source of future investment and the improvement of the living standards of the society.

• The power of the national bank in fixing interest rates is particularly crucial in both investment and saving. If the rate of interest fixed by the bank on deposits /i.e. the interest banks pay on money deposited on saving and other accounts / is attractive, it will encourage people to save their money rather than spend it. However, such interest should not discourage people from investment and productive activities and turn them to rent collection /potential investors may decide to deposit their money and collect interest/. If the rate of interest charged by banks on money given on loan to borrowers is lower, it may encourage potential borrowers and investors to borrow and invest, thereby contributing their part in the expansion and increase of production of goods and services, creation of employment opportunities, increase in exports and foreign exchange earnings of the country.

• The existence of a network of banks covering all parts of a country facilities business transactions in the country by making payments easier, safer and cheaper. Payment through banks also avoids the risk of loss or theft of money.