3.1 Western Banking History
Modern Western economic and financial history is usually traced back to the coffee houses of London. The London Royal Exchange was established in 1565.[i] At that time moneychangers were already called bankers, though the term "bank" usually referred to their offices, and did not carry the meaning it does today. There was also a hierarchical order among professionals; at the top were the bankers who did business with heads of state, next were the city exchanges, and at the bottom were the pawn shops or "Lombard's"[ii]. Some European cities today have a Lombard street where the pawn shop was located.
After the siege of Antwerp, trade moved to Amsterdam. In 1609 the Amsterdamsche Wisselbank[iii] was founded which made Amsterdam the financial centre of the world until the Industrial Revolution.
Banking offices were usually located near centers of trade, and in the late 17th century, the largest centers for commerce were the ports of Amsterdam[iv], London, and Hamburg. Individuals could participate in the lucrative East India trade by purchasing bills of credit from these banks, but the price they received for commodities was dependent on the ships returning (which often didn't happen on time) and on the cargo they carried (which often wasn't according to plan). The commodities market was very volatile for this reason, and also because of the many wars that led to cargo seizures and loss of ships.
3.2 Interest
Interest is a fee paid on borrowed assets. According to oxford Dictionary Interest means the money paid for the use of money lent.[1]It is the price paid for the use of borrowed money, or, money earned by deposited funds.[2]Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money. Interest can be thought of as "rent of money". For example, if you want to borrow money from the bank, there is a certain rate you have to pay according to how much you want loaned to you.[3]
Interest is compensation to the lender for forgoing other useful investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to obtain them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. The amount lent, or the value of the assets lent, is called the principle. This principle value is held by the borrower on credit. Interest is therefore the price of credit, not the price of money as it is commonly believed to be. The percentage of the principle that is paid as a fee (the interest), over a certain period of time, is called the interest rate. [4]
Usuery means according to the Oxford Dintionary “lending of money at interest, esp. at an exorbitant or illegal rate.[5] This difinition makes it clear that the usuary means the interest there is not so much difference between intrest and usury.
Capital and Interest
Historically, the concept of capital has been so closely bound to the concept of interest that it seems wise to take these two topics together, even though in the modern view it is capital and income rather than capital and interest that are the related concepts.
Interest as a form of income may be defined as income that is received as a result of the possession of contractual obligations for payment on the part of another. Interest, in other words, is income that is received as a result of the ownership of a bond, a promissory note, or some other instrument that represents a promise on the part of some other party to pay sums in the future. The obligations may take many forms. In the case of the perpetuity, the undertaking is to pay a certain sum each year or other interval of time for the indefinite future. A bond with a date of maturity usually involves a promise to pay a certain sum each year for a given number of years, and then a larger sum on the terminal date. A promissory note frequently consists of a promise to pay a single sum at a date that is some time in the future.[6]
Simple interest
When an interest is charged on the original amount, or principle amount lent is called simple interest, or when the fee charged for borrowing money is a fixed yearly percentage of the amount borrowed, it is called simple interest. The amount borrowed is called the principal, or the present value of the transaction. The amount owed at the end of the lending period is known as the future value of the principal.[7] The value of the principal is equal to the principal plus the simple interest. The amount of simple interest is a function of three variables, Amount borrowed (lent) or principal amount and interest rate per time period and the number of time periods for which the principal amount is borrowed.[8]
It is calculated as:
SI= P0(i)(n)
SI= Simple interest in Rupees.
P0= Principal, amount borrowed at time period 0
I= interest rate per time period
N=Number of time periods.
Compound Interest
The compound interest is interest paid on any previous interest earned, as well as on the principal borrowed.[9] Interest earned over a period of time is added to the principal amount and the calculation for the next period is based on the total of this principal amount and interest earned. This method, called compounding of interest, enables the interest itself to earn interest. The time interval between successive additions of interest is called a conversion period. If this time interval is one year, interest is said to be compounded, or converted, annually. Similarly, six-month intervals apply to interest compounded semiannually; three-month intervals, interest compounded quarterly; one-month intervals, interest compounded monthly; one-week intervals, interest compounded weekly; one-day intervals, interest compounded daily.[10]
The calculation of compounded value as follows.
FVn= P0(1+i)n
FVn= Future compounded value of n period
P0= Principal, amount borrowed at time period 0
n= Number of Period
3.3 Modern Banking
Many of the Lombardy merchants depending on them despite the fact that church were totally against the usury. They dealt with not only keeping the money in safe custody but also changed money for the travelers or merchants engaged in foreign trade[v].
The business of changing money was so lucrative that king Edward.III[vi] established the Office of Royal Exchanger for changing foreign money at a profit for the benefit of the Crown.[11]
The discovery of America brought riches to England and gave a tremendous boost to foreign trade. The merchants now began to hold part of their rich in cash. These transactions however, received a setback in 1640, when King Charles-I seized £ 130,000 and bullion left for safe custody with the city merchants at the Royal Mint.
This shook the confidence of the merchants in the Royal Exchanger and the Royal Mint. Consequently this business was taken over by the goldsmiths who, up to the time, where dealing only in gold and silver. Since these goldsmiths required strong safes for the purpose of their own business, they introduced necessary facilities of safe-keeping of the valuables and cash of their customers. These goldsmiths issued receipts or notes to their depositors in respect of the cash or articles left with the. These were called Goldsmiths Notes, and carried an undertaking to return the money and articles to the depositors in respect of the cash or articles left taking to return the money and articles to the depositors or bearers on demand. There were a considerable number of such Notes in circulation among various classes of merchants; and thus they can be aptly called ‘Bank Notes’ in their earliest from.[12]
Banking as it is now practiced dates from the Banco di Rialto, founded in Venice in 1587. It accepted demand deposits and permitted depositors to transfer their credits by checks. It could not make loans, however, or pay interest on deposits. Its services were free since its expenses were paid by the city. The Banco Giro was formed in Venice in 1619. The two banks merged in 1637 and continued to operate under the name Banco Giro until Napoleon liquidated it in 1806.[13]
3.4 Definition of Bank
A bank is a financial institution that deals with money and credit. It is organized on a joint stock company system primarily for the earning of profit. Commercial bank accepts deposits from individuals, firms and companies at a lower rate of interest and gives at higher rate of interest to those who need them. The difference between the terms at which can be borrowed, and that at which it lends, forms the source of its profit. A bank thus, is a profit earning institute, According to Crowther, “A bank is a firm which collects money from those who have it spare. It lends money to those who require it” in the words of Mr. Parking. “A bank is a firm that takes deposits from households and firms and makes loans to other households and firms” [14]
According to Banking companies ordinance, 1962, Section 5(b) of Pakistan “Banking means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdraw able by cheques, drafts, order or otherwise”[15]
In most English common law jurisdictions there is a Bills of Exchange Act that codifies the law in relation to negotiable instruments, including cheques, and this Act contains a statutory definition of the term banker: banker includes a body of persons, whether incorporated or not, who carry on the business of banking' (Section 2, Interpretation). Although this definition seems circular, it is actually functional, because it ensures that the legal basis for bank transactions such as cheques do not depend on how the bank is organized or regulated.
Paying and Collecting Checks
Since the advent of EFTPOS (Electronic Funds Transfer at Point Of Sale), direct credit, direct debit and internet banking, the cheque has lost its primacy in most banking systems as a payment instrument. This has led legal theorists to suggest that the cheque based definition should be broadened to include financial institutions that conduct current accounts for customers and enable customers to pay and be paid by third parties, even if they do not pay and collect cheques.
3.5 Profitability
A bank generates a profit from the differential between the level of interest it pays for deposits and other sources of funds, and the level of interest it charges in its lending activities. This difference is referred to as the spread between the cost of funds and the loan interest rate. Historically, profitability from lending activities has been cyclical and dependent on the needs and strengths of loan customers. In recent history, investors have demanded a more stable revenue stream and banks have therefore placed more emphasis on transaction fees, primarily loan fees but also including service charges on an array of deposit activities and ancillary services (international banking, foreign exchange, insurance, investments, wire transfers, etc.). Lending activities, however, still provide the bulk of a commercial bank's income. [16]
3.6 Common instrument of Conventional Financing
Banks now a day’s using different products for financing, these types difference usually base on based on the time and maturity. Each bank introduces different type of product according to their policy, which is mainly based on customers demand and Banks profitability. As stated earlier that conventional banks charging interest on in different rate form the borrowers. By conventional banks we mean that the bank, which is practicing the interest, based principles. Banks usually designs product according to the demand of the business. Banks in Pakistan generally lend in the form of cash finance Overdraft and Loans.
In cash finance a borrower is allowed to borrow money from the Bank up to a certain limit, either at once or as and when required. Finance paying markup/service charges only on the amount he actually utilizes.[vii] In Overdraft form of Principle the banker allows to withdrawal on his account in excess of the balance which the borrowing customer has in credit in Bank. Loan is the third form of lending borrower has to repay either in periodic installment or in lump sum a fixed amount at a fixed future time. Some banks allows loan against collateral. This type of loan is called “Secured loan” when bank provides loan without collateral it is called “clean Loan”[17]
1. Term Financing:
Commercial Banks using usually term financing, there are two features of a Term financing which distinguishes it form the other types of financing. The First think is this type of loan has maturity more than one year of final maturity. The second thing is it is extendible under a formal mutual agreement among borrower and the Bank.[18] This type of loan is availed by the borrower to acquire fixed assets (immovable properties i.e. land and buildings and vehicles for commercial use). The loan carries a predetermined length of time (tenure), with repayments done in installments.
2. Lease Financing:
This type of facility helps the borrowers to acquire equipments and machineries for their businesses on lease. This type of finance is long Term in nature and as such, the repayment is made in installments.
3. Overdraft (OD):
This is the most common form of financing Borrower requires temporary accommodation , his bank allows withdrawals on his account in excess of the balance which the borrowing customer has in credit, and an overdraft thus occurs. This is usually allowed against collateral securities. When against collateral securities, is called “Secured Overdraft.”[19]This is a short term facility which is granted to the borrower to enable him meeting his day to day funding needs; like payment of salaries, utilities and purchases of inventories etc. An agreed limit is sanctioned by the bank and the borrower is allowed to draw that amount through his current account.
4. Revolving Credit:
This type of loan is also short-term in nature and is used to meet short-term funding requirements of the borrowers. This type of loan does not have a fixed number of payments, as in the case of installment loan.
Cash Finance and Running Finance are types of revolving loans. Once the loan limit is approved, then the borrower is free to withdraw amounts to the extent of that limit. The borrower can withdraw and repay the amount as many times as he wishes to; but he has to pay mark-up on the amount which he has actually used.
5. Letter of Credit (LC) or Documentary Credit (DC):
Letter of Credit is a written undertaking by a financial institution in favor of the supplier/seller to pay him the amount of imported/purchased goods, in case the actual importer/buyer fails to pay the liability. It is a facility which enables a customer to import/purchase goods without making advance or immediate payment from his own resources; i.e. the payment is made by the importer only on receipt of documents and actual goods.
6. Bills of Exchange Purchased (BEP):
A short term facility that is provided to exporters against purchase of export bills on discounted price.
7. Finance against Imported Merchandize (FIM):
This is a short term facility which is granted by banks normally to the importers against the security of Trust Receipt (Letter of Trust). Through signing the Trust Receipt, the borrower undertakes to repay the loan as soon as the he sells the goods. It is noteworthy that the default by the borrower is treated as breach of the trust, and is considered as criminal offense under the law.
8. Clean/unsecured financing:
Unsecured/clean loans are those where the banks do not demand tangible securities such as land, building, fixed/current assets, tradable inventory etc. as security; whereas, in secured financing, the banks demand any of the security as mentioned above. Secured financing is also called collateralized financing.
9. Demand Finance:
Demand Finance may either be short term or long term; however, its repayment is done normally through installments. [20]
References
[i] The Royal Exchange in the City of London was founded in 1565 by Sir Thomas Gresham to act as a centre of commerce for the city. The site was provided by the City of London Corporation and the Worshipful Company of Mercers, and is roughly triangular, formed by the converging streets of Cornhill and Thread needle Street. The design was inspired by a bourse Gresham had seen in Antwerp. http://en.wikipedia.org/wiki/Royal_Exchange_(London)
[ii] Lombard banking refers to the historical use of the term 'Lombard' for a pawn shop in the Middle Ages, a type of banking that originated with the prosperous northern Italian region of Lombardy (hence the name). http://en.wikipedia.org/wiki/Lombard_banking
[iii] The Bank of Amsterdam (Amsterdamsche Wisselbank in Dutch) was an early commercial bank, vouched for by the city of Amsterdam, established in 1609. http://en.wikipedia.org/wiki/Amsterdamsche_Wisselbank
[iv] Amsterdam is the capital and largest city of the Netherlands, located in the province of North Holland in the west of the country.
[v] Bank and banking. (2009). Britannica Student Library. Encyclopedia Britannica 2009 Student and Home Edition. Chicago: Encyclopedia Britannica.
[vi] (Born 1312, ruled 1327–77) became king at the age of 15 when his father, Edward II, was overthrown. He proved himself a chivalrous knight rather than a great ruler. He loved warfare, like so many of his line, and tried to give it the glamour of the “good old days” by setting up a Round Table at Windsor Castle in imitation of King Arthur. He also organized the most famous of the English chivalric orders of knighthood, the Order of the Garter.
[vii] In some form of financing borrower makes agreement with bank for some of money but he actually not utilizes all money in his business, borrower not allowed to take all amount form the bank. Some portion of this he deposits in his account in bank, and the Bank entitled to receive markup on this amount.
[1] The pocket Oxford Dictionary (2005) Oxford University press London UK
[2] Astronomy.com “Accrued interest Absolute” Exploring the world of knowledge http://www.absoluteastronomy.com/topics/Accrued_interest
[3] Banking history.(2009) Wikipedia the free inciclopedia. [Online] Junuary 2009. [Cited: 4 3, 2009.] www.vikipidia.com/bnaking/interest
[4] Ibid
[5] The pocket Oxford Dictionary (2005) Oxford University press London UK
[6] Capital and interest. (2009) Encyclopedia Britannica. Encyclopedia Britannica 2009 Student and Home Edition. Chicago: Encyclopedia Britannica.
[7] Percentage and interest. (2009). Britannica Student Library. Encyclopedia Britannica 2009 Student and Home Edition. Chicago: Encyclopedia Britannica.
[8] Jams C Vanhorne, John M Wachowicz,Jr(1998) ” Fundamental of Financial Management” Tenth edition. Prentice-Hall , Incorporation ISBN Page- 37
[9] Ibid page-7
[10] Percentage and interest. (2009). Britannica Student Library. Encyclopædia Britannica 2009 Student and Home Edition. Chicago: Encyclopædia Britannica
[11] Interest .(2009) “Wikipedia the free inciclopedia”. [Online] Junuary 2009. [Cited: 4 3, 2009.] www.vikipidia.com/bnaking/interest
[12] History of Banking.(2009) Wikipedia the free incyclopedia. [Online] 2008. [Cited: 4. 15, 2009.] www.wikipedia.org/wiki/history-of-banking.
[13] Bank and banking. (2009). Britannica Student Library. Encyclopedia Britannica 2009 Student and Home Edition. Chicago: Encyclopædia Britannica.
[14] Saeed, Prof M. "Money Banking and Finance.”: Govt college of Commerce Islamabad., 2009.
[15] Asrar H Siddiqi (1998) “Practice and law of Banking in Pakistan” Sixth revised and enlarged Edition. United Bank Ltd. P-39
[16] Capital and interest. (2009). Encyclopedia Britannica. Encyclopedia Britannica 2009 Student and Home Edition. Chicago: Encyclopedia Britannica.
[17] Asrar H Siddiqi (1998) “Practice and law of Banking in Pakistan” Sixth revised and enlarged Edition. United Bank Ltd.
[18] James C Van Horne. (1998) “Fundamental of Financial Management” Temth Edition Prentice- Hall Incorporation ISBN Page-562
[19] Ibid P-255
[20] Siddiqi, Mansoor Hassan.(2008) SME department. State Bank of Pakistan. [Online] 2008. [Cited: 4 15, 2009.] www.sbp.pk/index.asp.
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