Fundamentals of Banking Operations

1. Structure of the Banking System

The banking system forms the backbone of a modern economy by facilitating financial intermediation between surplus and deficit units. It mobilizes savings, allocates credit, supports trade, and stabilizes monetary systems. Without a structured banking system, economic growth, investment, and financial inclusion would be severely constrained.

This chapter examines the institutional architecture of the banking system. It distinguishes between commercial banks, central banks, microfinance institutions, and investment banks, highlighting their respective mandates, operational models, and regulatory environments. Understanding this structure is essential for appreciating how funds circulate within an economy and how monetary policy is transmitted.

1.1. Functions of Commercial Banks

Commercial banks perform critical intermediation functions within the economy.

1. Deposit Mobilization

They collect savings from surplus units (households) and make funds available for lending.

2. Credit Creation

Through fractional reserve banking, commercial banks create credit by lending multiples of their reserves.

3. Payment Facilitation

They operate clearing systems, electronic transfers, cheques, debit/credit cards, and mobile banking.

4. Agency and Utility Services

• Standing orders

• Foreign exchange services

• Custodial services

• Trade finance (letters of credit)

1.2. Types of Banks

The banking system is composed of different institutions that perform specialized financial intermediation roles. Each category operates under distinct regulatory mandates and risk profiles.

1. Commercial Banks

Commercial banks are profit-oriented financial institutions that accept deposits and extend loans to individuals, businesses, and governments.

Core characteristics:

• Accept demand and time deposits

• Provide credit facilities

• Facilitate payment systems

• Offer trade finance services

Examples globally include institutions such as JPMorgan Chase and Barclays.

2. Central Banks

A central bank is the apex monetary authority of a country responsible for monetary policy, currency issuance, and financial system stability.

Functions include:

• Controlling inflation

• Regulating commercial banks

• Managing foreign exchange reserves

• Acting as lender of last resort

Examples include Central Bank of Kenya, Federal Reserve System, and European Central Bank.

3. Microfinance Banks

Microfinance institutions (MFIs) provide financial services to low-income individuals and small enterprises that lack access to conventional banking.

Services:

• Small loans (microcredit)

• Savings products

• Group lending models

• Financial literacy programs

They promote financial inclusion and poverty reduction.

4. Investment Banks

Investment banks specialize in capital market activities rather than retail banking.

Functions:

• Underwriting securities

• Mergers and acquisitions advisory

• Asset management

• Trading and market-making

Examples include Goldman Sachs and Morgan Stanley.

2. Deposit and Credit Management

Deposits and loans constitute the core balance sheet activities of commercial banks. Deposits represent the primary source of funds, while loans and advances represent the principal earning assets. Effective deposit mobilization and prudent credit management are therefore central to profitability, liquidity, and solvency.

This chapter explores the structure of bank liabilities through different deposit products and examines the systematic process of loan appraisal and approval. Emphasis is placed on credit analysis techniques, risk evaluation, and internal control procedures that safeguard financial stability. A sound understanding of deposit and credit management equips banking professionals with the analytical tools necessary to make informed lending decisions

2.1. Loan Processing and Credit Appraisal

Loan processing is a structured risk assessment mechanism.

Step 1: Loan Application

Client submits:

• Identification

• Financial statements

• Business plan (if applicable)

Step 2: Credit Analysis

Banks apply the 5 Cs of Credit:

• Character

• Capacity

• Capital

• Collateral

• Conditions

Step 3: Risk Assessment

Financial ratios assessed:

• Debt-to-income ratio

• Liquidity ratios

• Profitability indicators

Step 4: Loan Approval and Disbursement

Approval is based on risk grading and internal credit policy guidelines.

2.2. Types of Bank Deposits

Deposits form the primary liability of a bank and the main source of funds for lending.

1. Demand Deposits

• Withdrawable on demand

• No fixed maturity

• Examples: Current accounts

2. Savings Deposits

• Earn moderate interest

• Limited withdrawals

• Encourage personal savings

3. Fixed/Time Deposits

• Locked for a specified period

• Higher interest rate

• Early withdrawal penalties

4. Call Deposits

• Withdrawable with short notice

• Often used by corporate clients

3. Risk and Regulatory Framework

Banking is inherently exposed to multiple forms of risk due to maturity transformation, leverage, and information asymmetry between lenders and borrowers. If not properly managed, these risks can threaten not only individual institutions but also the stability of the entire financial system.

This chapter analyzes the primary categories of banking risk—credit risk, liquidity risk, and operational risk—and examines the regulatory frameworks designed to mitigate them. Special attention is given to the supervisory role of central banks and the international standards established under the Basel Accords. A strong regulatory and risk management framework ensures resilience, depositor confidence, and systemic stability.

3.1. Role of the Central Bank and Basel Regulations

Role of the Central Bank

The central bank ensures systemic stability by:

• Setting reserve requirements

• Conducting open market operations

• Supervising commercial banks

• Acting as lender of last resort

In Kenya, this mandate is executed by the Central Bank of Kenya.

Basel Regulations

The Basel framework was developed by the Bank for International Settlements.

Major accords:

• Basel I – Capital adequacy standards

• Basel II – Risk-sensitive capital framework

• Basel III – Strengthened liquidity and capital requirements after the 2008 financial crisis

Objectives:

• Improve bank resilience

• Reduce systemic risk

• Enhance transparency

3.2. Credit Risk, Liquidity Risk & Operational Risk

Risk management is central to banking stability.

1. Credit Risk

Risk of borrower default.

Mitigation:

• Collateralization

• Credit scoring models

• Loan diversification

2. Liquidity Risk

Risk that a bank cannot meet short-term obligations.

Mitigation:

• Maintaining cash reserves

• Asset-liability matching

• Interbank borrowing

3. Operational Risk

Loss arising from internal failures, fraud, or system breakdowns.

Mitigation:

• Internal controls

• Segregation of duties

• IT security frameworks