PREPARED BY MRS.A.

LALITHA ASSISTANT PROFESSOR SVCET

Unit ii

Introduction Fundamentals of banking

The term ‘bank’ is derived from the French word ‘Banco’ which means a Bench or Money
exchange table. In olden days, European money lenders or money changers used to display
(show) coins of different countries in big heaps (quantity) on benches or tables for the
purpose of lending or exchanging.
Banking System – Definitions Banking systems refer to a structural network of institutions
that provide financial in a country. It deals with the ownership of banks, the structure of
banking system, functions performed and the nature of business. The elements of the banking
system include: a) Commercial banks b) Investment banks c) Central bank.
The commercial banks accept deposits and lend loans and advances; the investment banks
deal with capital market issues and trading; and the central bank regulates the banking system
by setting monetary policies besides many other functions like currency issue. A banking
system also refers a system provided by the bank which offers cash management services for
customers, reporting the transactions of their accounts and portfolios, throughout the day.
defines a bank as “an establishment for custody of money, which it pays out on customer’s
order.” According to Prof. Sayers, “A bank is an institution whose debts are widely accepted
in settlement of other people’s debts to each other.” In this definition Sayers has emphasized
the transactions from debts which are raised by a financial institution.
According to the Indian Banking Company Act 1949, “A banking company means any
company which transacts the business of banking. Banking means accepting for the purpose
of lending or investment, of deposits of money from the public, repayable on demand or other
wise and withdrawable by cheque, draft or otherwise.”This definition throws light on the
three major functions of a bank.
They are: (i) Accepting of deposits and lending loans
(ii) Issue and pay cheques,
(iii) Collect cheques on behalf of the customers. A bank is a financial institution that provides
banking and other financial services to their customers.
A bank is an institution which provides fundamental banking services such as accepting
deposits and lending loans. As financial intermediaries, banks stand between depositors who
supply capital and borrowers who demand capital. When banks accept deposits its liabilities
increase and it becomes a debtor, but when it makes advances its assets increases and it
becomes a creditor. Banks are a subset of the financial services industry.
The banks are the main participants of the financial system in India. All the banks safeguard
the money and valuables and provide loans, credit, and payment services, such as money
orders, and cheques. The banks also offer investment and insurance products.

Functions of Banks
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The following figure clearly shows the functions of banks: Figure showing the Functions of
Bank The functions of commercial banks can be broadly categorized into a) Primary
functions b) Secondary functions. Primary Functions Following are the primary functions
rendered by banks. Accepting of Deposits The primary function of commercial banks is to
accept money from the people in the form of deposits which are usually repayable on demand
or after the expiry of a fixed period.
For these deposits, the banks pay a rate of interest, which is called as interest expenditure.
Thus, banks act as a custodian of depositors’ funds. The deposits may be of various types
such as savings deposits, current deposits, fixed deposits and recurring deposits. Savings
deposits encourage customers to save money and promote banking habit among the public.
Savings Bank accounts provide a low rate of interest and they have restrictions on the number
of withdrawals by the Accepting Deposits Lending Loans Primary Functions Agency
Functions Utility Function/ Financial Services Secondary Functions
The SB accounts can be opened in single or joint names. People who prefer these savings
bank accounts include salary and wage earners. Now, all the banks allow customers to open a
savings bank account with nil balance.
Current Deposit accounts are opened by business people. These accounts have no restrictions
on the number of withdrawals and are subject to service changes. There is no interest
payment but current account holders can also avail the benefits such as overdraft and cash
credit facilities. Fixed deposits accounts can be opened by any person who wants to deposit a
lump sum funds at one time for a specific time period.
These accounts provide higher rate of interest depending on the time period for which it is
deposited. These accounts do not allow withdrawal before the expiry of the period. Recurring
deposit accounts are normally opened and operated by persons who get regular income such
as salary class and petty shop owners. A specific amount of money is deposited periodically,
say, monthly for a specific period, say, one year.
These accounts provide higher rate of interest and do not allow withdrawal before the expiry
of the period. Lending Loans and Advances The second primary function of commerce bank
is to lend loans and advances to the corporate sector and households. Normally, the rate of
interest levied on these loans and advances is higher than what it pays on deposits. The
interest income is the major source of income for commercial banks.
The difference in the interest rates (Interest Received and Interest Paid) is called Interest
Spread, which contributes to its profitability. Apart from leading, the banks usually keep
some portion of funds to meet the demands of depositors and running expenses. The various
types of loans and advances include overdraft, cash credit, loans, discounting of bills of
exchange.

MICRO FINANCE DELIVERY MODELS:

MFIs around the world follow a variety of different methodologies for the provision of
financial services to low – income families. These methodologies are overwhelmingly based
on the Principle
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of financial services being related to the cash flows of the low-income client groups and thus
aim to facilitate relatively frequent and very small or Micro – loan and savings transactions.
The focus of such services is on women, based on the observations that in financial matters,
they are more responsible than men particularly since their mobility is restricted by family
responsibilities. MFIs use two basis methods in delivering financial services to their clients.
by Abhay, India Microfinance – MFI‟s use two basic methods in delivering financial services
to their clients.
These are:
(1) Group Method and
(2) Individual method Group Method This is one of the most common methodologies for
providing micro-finance. Group method primarily involves a group of individuals, which
becomes the basic unit of operation for the MFIs. As we have discussed earlier, MFIs have to
provide collateral free loans, group methodologies help in creating social collateral (peer
pressure) that can effectively substitute physical collateral.
Group becomes a basic unit with which MFIs deal. The advantage of group methodology is
that
 Groups are trained to own joint responsibility for loans that are taken by individuals in the
group.
 Groups ensure repayments from all individuals in that group and incase of a default.

 Groups functions as the forum where the credit discipline and other related issues are
discussed.
 Group may have to jointly own the responsibility of defaults and pay on behalf of
defaulting client.  Group also help credit appraisal and provide opinion on creditworthiness
of each individual in the group.
 Groups methodology also helps in controlling cost. This ensures that even without taking
any physical collateral, the MFI is able to manage its credit risk (loan related risk).

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MFIs actually deliver the financial service at the client‟s location which could be a village in
rural areas or a colony/slum in urban area. Having a group helps the MFIs in getting all
clients at one spot rather than visiting each individual‟s house.
This helps the MFI in increasing the efficiency of staff and controlling the cost. Group
methodology creates a forum where individuals come and discuss, can provide opinion, and
exert social pressure. The advantage of Group methodology can easily be appreciated by the
fact if a MFI employee has to visit each individual house in isolation, it would be very
difficult. Also in the absence of a group, if a client refuses to pay there is no forum where
such a case can be discussed or there is no method through which the MFI can expert
pressure on the client.
Group methodology is also important because in case of larger loan defaults a financial
institutions can take recourse o legal action but in small loans legal recourse is not an
economically sound option. An MFI who may have an outstanding or Rs 3,000 at default
cannot apply legal pressure as the cost of recovery through that method can be higher than the
amount to be recovered itself.
Moreover, the clients that the MFIs are dealing with are generally poor and may face genuine
problems at times. Rather than taking an aggressive/legal approach, which such vulnerable
clients it is always better to have more constructive and collective approach, which is
provided by the Groups.
Due to the various advantages, as indicated above provided by groups, this methodology is
widely accepted and used in micro-finance across the world. Self-help Group and Joint
Liability Groups (Grameen model and its variants) are two common credit delivery models in
India
Self –Help Groups (SHGs) Self-help Group concept has its origin in India. SHGs are now
considered to be very important bodies in rural development and are therefore found in
almost all parts of the country and their number is still rapidly growing. SHGs are formed by
Non-Government Organisations as well as Government agencies and are used as channels for
various development programmes.
A Self-Help Group is an association of generally up to 20 members (not exceeding 20
members), preferably from the same socio-economic background. SHGs are facilitated by
Government agencies or NGOs for members to come together for discussing and solving
their common problems either financial or social through mutual help.
An SHG can be all-women group, all-men group, or even a mixed Group. However, it has
been the experience that women‟s groups perform better in all the important activities of
SHGs. Mixed group is not preferred in many of the places, due to the presence of conflicting
interests. Some of the distinct features of SHGs are;
(i) Recognized by government: SHGs are well recognized and accepted by government,
SHGs can open bank accounts in the name of SHG. They can also receive
government grants and funds for development activities.
(ii) SHGs are social intermediaries: SHGs do not restrict their functions only to financial
transactions. SHGs are often involved in many social activities. There are example

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where SHGs have taken up social issues and fought against social evils like
alcoholism, violence, against women, dowry, getting into village politics and
being elected as Sarpanch.
(iii)Books of accounts: SHGs maintain their own books of accounts. These are simple
books to keep records of their savings, loans income and expenditures. Strong
SHGs also make their Balance sheets and Income statements.
(iv) Have office bearers: SHGs gave a structure where there is a Group President,
Secretary and Treasure. They are elected by the group.
(iv) SHGs are more autonomous as they decide their own rules and regulations.
(v) SHGs mobilize thrift and rotate it internally.
(vi) SHGs can hold bank account and can also borrow from banks and other financial
institutions. We see that SHGs are groups, which are more autonomous. While
they are involved in financial transactions, their role is not just restricted to it.
SHGs are also involved in various social issues.

Joint Liability Group – Grameen Model Grameen model is based on the concept of joint
liability. It is the brainchild of Prof.. Muhammad Yunus, founder of Grameen Bank in
Bangladesh. Grameen model is the most accepted and prevalent micro-finance delivery
model in the world today. Many MFIs have accepted the model as it has high focus on
standardization and discipline Grameen model, as mentioned, is a joint liability group model.
Here five-member groups are formed and eight such groups form a Center. Hence, in a full-
capacity Center there are 40 members (8 x 5). However, over the years people have
experimented with Centers of different sizes and now there are variations of 5-8 groups
within a Center. Center is the operational unit for the MFI, which means that MFI deals with
a Center as a whole. Meetings also take place only at the Central level and individual groups
do not meet. Group meetings take place only in front of the Field staff of the MFI. A
Grameen model is focused on financial transactions and other social issues are generally not
discussed. The Group and Center are Joint liability Groups, which means that all members
are jointly responsible („liable‟) for the repayment. MFI recovers full money from Center, if
any member has defaulted: the group members have to pool in money to repay to the MFI. If
Group members are unable to do it, Center as whole has to contribute and share the
responsibility.
Some other features of Grammen Model are:
(i) The group meeting take place every week

(ii) Interest rate are charged on flat basis

(iii) MFI staff conducts the meeting

iv) All transactions take place only in Center meetings.

Grameen model is focused on providing financial services to the clients and hence there is an
emphasis on standardization and discipline. The model suggests weekly meeting for frequent

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interaction with the clients to reduce credit risk. The meetings are conducted for carrying out
the financial transactions only. The meetings are conducted systematically in a short-time and
other social issues are not discussed. Flat interest is charged again for making the system
standardized. In flat rate system installment size of repayment remains small for all weeks
and hence is convenient and easier to explain. Also, it is easy to break the loan installment
into the principal and interest component.

Joint Liability Groups (JLG)

Grameen model is a particular form of joint liability Group but in India there are
other forms of Joint liability Groups as well. MFIs, particularly in urban areas,
form JLGs of five-members. These are group of individuals coming together to
borrow from the financial institution. They share responsibility (“liability”) and
stand as guarantee for each other. There is a Group Leader in such JLGs, many
MFIs prefer such group in urban business areas. Such JLGs do not hold periodic
meetings.
Individual Method
So far we have discussed the Group based lending method. However MFIs are
also increasingly providing loans to individuals. In Individual lending method,
MFIs provide loans to an individual based on his/her own personal credit
worthiness. Individual lending is more prevalent with clients who generally need
bigger size loans and have the capacity to produce guarantee and generate enough
comfort to the MFI. MFIs generally base their decision on personal knowledge of
the client, his/her reputation among peers and society, client‟s income sources and
business position. MFIs also ask for individual guarantors or take post-dated
cheques from clients.

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Common Characteristics of Microfinance Models

In practice, the average microfinance client‟s relationship with an MFI can be defined by a
fairly standard set of obligations.
 Attendance of regular weekly (fortnightly or monthly) meetings of her group.

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 Training in „loan utilisation‟ or participation in discussions of developmentally relevant

issues such as social discrimination, gender awareness, health, sanitation and education.

 Contribution of fixed amounts, termed „savings‟, to a fund managed.

 Either by her group or by the MFI with direct access of the member.

 Limited or even barred.

 Repayment of fixed amounts as instalments on any loan she obtains from the MFI or from
her group.

 What she actually receives in return for fulfilling these obligations are:

 Fixed amounts of loan apparently „for productive activities‟ – with the size of the loan
usually determined by the longevity of her relationship with the MFI rather than by her
financial needs.

Delivering financial services to poor

The Poor and Financial Services
The Economic Environment of the Poor: the Savings, Credit and Insurance
Nexus
The economic environment of the poor has two features that have particular
significance in shaping their use of financial services.
The first is that they operate in a mini-economy in which production,
consumption, trade and exchange, saving, borrowing and income-earning occur in
very small amounts. The effect of this is that transaction costs tend to be high as
the ‘unit’ of transaction is generally minuscule. This has important implications
for the use of formal sector institutions where the charging of any standardised
administrative cost will commonly make transactions unattractive to the poor.
The second characteristic is that there are high levels of insecurity and risk.
These arise because flows of income and expenditure commonly do not coincide,
because of household-specific factors (loss of earnings because of sickness, urgent
medical expenses, premature death, theft, insecure conditions of employment,
difficulties of contract enforcement), and because of broader environmental
factors (natural hazards, harvest failure due to drought or flooding, national
economic crisis). The covariant nature of the risks associated with this latter group
are particularly problematic as they weaken the capacity of community-based
social security networks to provide support.
These characteristics have a number of consequences.
(i) They limit the interactions of poor people with formal sector institutions.

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(ii) They foster strategies of risk-spreading by the poor: these encourage

diversification of economic activities and the development of financial 6
relationships with networks of individuals, groups and agencies.
(iii) They lead to the use of savings and credit mechanisms by the poor as
substitutes for insurance (Platteau and Abraham, 1984; Alderman and Paxson,
1992; Fafchamps, 1992) so that savings, credit and insurance have to be treated in
a unified way
The Money Management of the Poor:
Towards A Typology Historically (and contemporarily, as well) the provision of
financial services to the poor has often been seen as means to achieve some other
‘greater’ end. Such ambitions have included rescuing people from the exploitation
of moneylenders, rehabilitation in the wake of natural disasters, promotion of co-
operation among villagers, teaching people the virtues of thrift, poverty
alleviation, the adoption of HYV technologies or empowerment. McGregor
(1991) rightly points out that when colonial governments introduced rural credit
projects, their intentions were often more moral and didactic than financial.
We can categorise these needs into three main groups. Life-cycle needs: In South
Asia, the dowry system makes marrying daughters an expensive matter. In parts of
Africa, burying deceased parents is very costly.
These are just two examples of ‘life-cycle’ events for which the poor need to
amass relatively large lump sums. Other such events include childbirth, education,
homebuilding, widowhood and old-age generally, and the desire to bequeath a
lump sum to heirs.
There are also recurrent festivals like Eid, Christmas, or Diwali. In each case the
poor need to be able to access sums of money which are much bigger than the
amounts of cash which are normally found in the household. Many of these needs
can be anticipated, even if their exact date is unknown. The awareness that such
outlays are looming on the horizon is of great anxiety for many poor people.
Emergencies: Emergencies that create a sudden and unanticipated need for a
large sum of money come in two forms - personal and impersonal. Personal
emergencies include sickness or injury, the death of a bread-winner, the loss of
employment, and theft. Impersonal ones include events such as war, floods, fires
and cyclones, and - for slum dwellers - the bulldozing of their homes by the
authorities. Each creates a sudden need for more cash than can normally be found
at home. Finding a way to insure themselves against such events could help
millions of poor people.
Opportunities: As well as needs for accessing large sums of cash, there can be
opportunities when such access is important. There may be opportunities to invest
in an existing or new business, or to buy land or other productive assets. The lives
of some poor people can be transformed if they can afford to pay a bribe to get a
permanent job (often in government service). One opportunity– the setting up of a
new business or expanding an existing one - has recently attracted a lot of
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attention from the aid industry and from the new generation of banks that work
with the poor. But business investment is in fact just one of many needs and
opportunities that require the poor to access lump sums of cash at short notice.
The first method - the sale of assets - is usually a straightforward matter that does
not ordinarily require any ‘financial services’. However, poor people sometimes
sell, in advance, assets that they do not currently have but expect to hold in the
future. The most common example is the advance sale of crops. These ‘advances’
are a form of financing, since the buyer provides, in effect, a loan secured against
the yet-to-be harvested crop. The advance may be spent on financing the farming
costs required to provide that crop. But they may equally be used on any of the
other needs and opportunities identified earlier. The second method - mortgage
and pawn - enables poor people to convert assets into cash and back again. It is
the chance (not always realised) to regain the asset that distinguishes this second
method from the first. As with the straightforward sale of assets, such services
require the user to have a stock of wealth in the form of an asset of some sort.
They allow the user to exploit their ownership of this stock of wealth by
transforming it temporarily into cash. The most common examples are the pawn
shop in urban areas and mortgaging land in the countryside.
This requires the users to have a flow of savings, however small or irregular. It
allows them to exploit their capacity to make savings through a variety of
mechanisms by which these savings can be transformed into lump sums.
The three main mechanisms are:
• Savings deposit, which allow a lump sum to be enjoyed in future in exchange
for a series of savings made now
• Loans which allow a lump sum to be enjoyed now in exchange for a series of
savings to be made in the future (in the form of repayment instalments), and
• Insurance, which allows a lump sum to be enjoyed at some unspecified future
time in exchange for a series of savings made both now and in the future

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Governance, ownership and Microfinance Performance:

An important topic in the microfinance governance literature deals with the
question whether the type of ownership of MFIs explains the performance. The
microfinance sector is characterized by various organization types, such as banks,
Non-Bank Financial Institutions (NBFI), credit unions and non-Governmental
Organizations (NGO). The category banks includes rural banks and banks which
can be both publicly owned or privately owned (Mersland, 2009). Also among
banks in developed countries we observe various organizational types. For
example, the Dutch cooperative bank Rabobank ranks among the world’s 25
largest banks and in Germany the ownerless Sparkassen holds more than 40% of
the banking market. Nevertheless, the many organizational types in microfinance
can be a particular challenge since they operate in markets with normally limited
competition and under different regulatory regimes (Merland, 2009). Table 1
presents a characterization of different MFI ownership types.

MFI governance and risk taking

This section deals with the impact of MFI governance on risk. Governance risk is an

underestimated topic in the banking literature. The current financial crises shows that bank

governance did not protect banks from taking excessive risks, so good governance is

especially important for investors. The success of microfinance has induced more commercial

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debt and equity holders to invest in microfinance. Commercial investors are typically more

concerned about investment risks than traditional, non-profit–driven microfinance investors.

In addition, there are strong indications that the current financial crisis has severely affected

MFI performance, which in turn has induced managers in MFIs to take excessive risks.

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