Study Notes

Banking in India
(Introduction)
Banking in India- Introduction

Introduction

 A Bank is a financial intermediary that accepts deposits and channels those deposits
into lending activities, either directly or through capital markets. A bank connects
customers with capital deficits to customers with capital surpluses.

Role of Banking

 It encourages savings habit amongst people and thereby makes funds

available for productive use.
 It acts as an intermediary between people having surplus money and those
requiring money for various business activities.
 It facilitates business transactions through receipts and payments by cheques
instead of currency.
 It provides loans and advances to businessmen for short term and long-term
purposes.
 It also facilitates import export transactions.
 It helps in national development by providing credit to farmers, small-scale
industries and self-employed people as well as to large business houses
which lead to balanced economic development in the country.Low per capita
income

Types of Banks

1) Central Bank /RBI - A bank which is entrusted with the functions of guiding and
regulating the banking system of a country is known as its Central bank. Such a bank
does not deal with the general public.

2) Scheduled Bank - All banks which are included in the Second Schedule to the Reserve
Bank of India Act, 1934 are scheduled banks. These banks comprise Scheduled
Commercial Banks and Scheduled Cooperative Banks. All most all banks are Scheduled
banks in India.

3) Commercial Banks - Commercial banks may be defined as, any banking organization
that deals with the deposits and loans of business organizations
 They issue bank checks and drafts, as well as accept money on term deposits.
 They also act as moneylenders, by way of installment loans and overdrafts.
 Commercial banks also allow for a variety of deposit accounts, such as checking,
savings, and time deposit.
 Types of Commercial banks: Commercial banks are of three types i.e.- Public
sector banks, Private sector banks and Foreign banks.
I. Public Sector Banks (PSBs): These are banks where majority stake is held
by the Government of India or Reserve Bank of India. Examples of PSBs are:
State Bank of India, Punjab National Bank, Union Bank of India etc.

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Banking in India- Introduction

II. Private Banks: In case of private sector banks majority of share capital of
the bank is held by private individuals. These banks are registered as
companies with limited liability. For example: ICICI Bank, HDFC Bank, Axis
Bank, etc
III. Foreign Banks: These banks are registered and have their headquarters in
a foreign country but operate their branches in our country. Some of the
foreign banks operating in our country are Hong Kong and Shanghai Banking
Corporation (HSBC), Citi Bank, American Express Bank, Standard &
Chartered Bank. The number of foreign banks operating in our country has
increased since the financial sector reforms of 1991.

4) Co-operative Banks: People who come together to jointly serve their common interest
often form a co-operative society under the Co-operative Societies Act. When a co-
operative society engages itself in banking business it is called a Co-operative Bank.
The society has to obtain a licence from the Reserve Bank of India before starting
banking business.
 Any co-operative bank as a society is to function under the overall supervision of
the Registrar, Co-operative Societies of the State.
 As regards banking business, the society must follow the guidelines set and
issued by the Reserve Bank of India.
 Cooperative banks are the primary financiers of agricultural activities, some
small-scale industries and self-employed workers.

5) Regional Rural Banks: Regional Rural Banks were established under the provisions of
an Ordinance promulgated on the 26th September 1975 and the RRB Act, 1976 with an
objective to ensure sufficient institutional credit for agriculture and other rural sectors.
 RRBs are jointly owned by GOI, the concerned State Government and Sponsor
Banks; the issued capital of a RRB is shared by the owners in the proportion of
50%, 15% and 35% respectively.
 NABARD is vested with the responsibility of regulating and supervising
cooperative banks.
 Prathama bank is the first Regional Rural Bank in India located in the city
Moradabad in Uttar Pradesh.

6) Specialized Banks: The main function of specialized banks is to provide unique

services to their customers. Some example of specialized banks are foreign exchange
banks, industrial banks, development banks (DCB, SIDBI, IFCI, SFCs, IDFC etc.), export
import banks (EXIM Bank), Agricultural & Rural Development Bank (NABARD) etc.
Specialized banks also provide financial support to various kinds of projects and
businesses who have to export or import their services or goods.

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Banking in India- Introduction

 Development Banks - Business often requires medium and long-term capital for
purchase of machinery and equipment, for using latest technology, or for
expansion and modernization. Such financial assistance is provided by
Development Banks. They also undertake other development measures like
subscribing to the shares and debentures issued by companies, in case of under
subscription of the issue by the public. Industrial Finance Corporation of India
(IFCI) and State Financial Corporation’s (SFCs) are examples of development
banks in India.

7) Investment banks: An investment bank is a financial institution that assists individuals,

corporations and governments in raising capital by underwriting and/or acting as the
client's agent in the issuance of securities.
 An investment bank may also assist companies involved in mergers and
acquisitions, and provide ancillary services such as market making, trading of
derivatives, fixed income instruments, foreign exchange, commodities, and equity
securities.
 These banks, apart from capital raising, also render valuable financial advice to
their various kinds of businesses and customers. Banks like the Bank of America,
Deutsche Bank, Citi Bank, ICICI Bank, Axis Bank, SBI etc. are some examples of
Investment Bank.
 Underwriters and Underwriting- Selling bonds is a complex endeavour. There
are millions and millions of dollars at stake even in the smallest of offerings in the
fixed-income market. Acting either alone or as part of a "syndicate," investment
banks bid for the right to "underwrite" a bond offering -- agreeing to take on all
responsibilities to sell the bonds.
 Underwriters agree to buy all the bonds in an issue and then re-sell them for a
profit. The difference between the price an underwriter pays for a bond and what
it sells the bond for is called the "underwriting spread."

8) Merchant Banks were traditionally banks which engaged in trade finance like accepting
bills arising out of trade, foreign exchange etc. The modern definition, however, refers to
banks which provide capital to firms in the form of shares rather than loans. Unlike
Venture Capital Firms, they tend not to invest in new companies.
 Venture capital (VC) is financial capital provided to early-stage, high-potential,
and growth start up companies.

9) Payments Banks: The Nachiket Mor Panel appointed by RBI has recommended
formation of special category of banks, Called Payment Banks, in order to make
payment services and deposit products available to small businesses & low income
households more effective and meaningful in India.

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Banking in India- Introduction

 Such banks will have a minimum capital entry requirement of Rs 50 crores, one-
tenth of what a full-service bank requires. It will be required to comply with all RBI
guidelines relevant for commercial banks.
 A payment bank, as envisaged by the Mor Committee, will provide transactional
services like opening an account, allowing payments and remittances. However,
it will not extend loans and invest the deposits in government securities.
 The objective of such a bank is to extend primary banking services to the hitherto
unbanked. There have been reports that India Post, one of the aspirants for a
bank licence, would be granted a payments bank licence.

10) Small Finance Banks: SFBs were set up based on recommendation of the Nachiket
Mor committee in November 2014 as new age differentiated banks, along with Payments
Banks. The objective of setting up of Small Finance Banks (SFBs): to further financial
inclusion by:
 provision of savings vehicle primarily to un-served and underserved sections of
the population
 supply of credit to small business units, small & marginal farmers; micro and
small industries and other unorganised sector entities through high technology
and low cost operations

Functions of Commercial Banks

Functions of
Commercial Banks

Primary Secondary
Functions Functions

1) Primary Functions: The two primary functions of the Banks are – Accepting Deposits
and Granting loans/advances.

Accepting Deposits

 The most important activity of a commercial bank is to mobilise deposits from the public.
People who have surplus income and savings find it convenient to deposit the amounts
with banks.

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 Depending upon the nature of deposits, funds deposited with bank also earn interest.
Thus, deposits with the bank grow along with the interest earned. If the rate of interest is
higher, public are motivated to deposit more funds with the bank. There is also safety of
funds deposited with the bank.

 Types of deposits are:

I. Current Deposits/Accounts - It is also known as Demand Deposit Account. These

accounts are used mainly by businessmen and are not generally used for the purpose of
investment.
 These deposits are the most liquid deposits and there are no limits for number of
transactions or the amount of transactions in a day. Most of the current account
are firm / company accounts.
 Cheque book facility is provided and the account holder can deposit all types of
the cheques and drafts in their name or endorsed in their favour by third parties.
 It is a non-interest bearing bank account (No interest is paid by banks on these
accounts). On the other hand, banks charge service charges, on such accounts.
 Current account holder get one important advantage of overdraft facility (bank
charges interest).

II. Saving Deposits/Accounts - These deposits / accounts are one of the most popular
deposits for individual accounts. These are interest - bearing accounts. These accounts
not only provide cheque facility but also have a lot of flexibility for deposits and
withdrawal of funds from the account.
 Most of the banks have rules for the maximum number of withdrawals in a period
and the maximum amount of withdrawal.
 Till 24/10/2011, the interest on these accounts was regulated by Reserve Bank of
India and it was fixed at 4.00% p.a. on daily balance basis. However, wef 25th
October, 2011, RBI has deregulated SF interest rates and banks are now free to
decide the same within certain conditions imposed by RBI.

III. Recurring Deposits/Accounts - These kind of deposits are most suitable for people
who do not have lump sum amount of savings, but are ready to save a small amount
every month. Normally, such deposits earn interest on the amount already deposited
(through monthly installments) at the same rates as are applicable for Fixed Deposits /
Term Deposits.
 Such accounts are normally allowed for maturities ranging from 6 months to 120
months.
 A Pass book is usually issued wherein the person can get the entries for all the
deposits made by him / her and the interest earned.
 Premature withdrawal of accumulated amount permitted is usually allowed
(however, penalty may be imposed for early withdrawals).

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 The bank provides the loan facility. The loan can be given upto 75% of the amount
standing to the credit of the account holder. These accounts can be opened in
single or joint names. Nomination facility is also available.

IV. Fixed Deposits/Accounts or Term Deposits: All Banks offer fixed deposits schemes
with a wide range of tenures for periods from 7 days to 10 years. The term "fixed" in
Fixed Deposits (FD) denotes the period of maturity or tenor.
 The rate of interest on such deposits keeps on varying with the prevalent market
rates i.e. it will go up if market interest rates goes and it will come down if the
market rates fall.

Sweep-in Facility

o If there is any deficit in your Savings or Current Account for a purchase or transaction, it is
taken care of by the bank. The Bank credits the exact value from your Fixed Deposit
without affecting interest rate in your Fixed Deposit
o Deposits are broken down in units of Rs 1/-thereby minimizing Interest Loss
o Effective 22nd Feb 2014, Sweep-in of funds from your Fixed Deposit (FD) to Saving/
Current account will trigger on Last in First out basis (LIFO)

Granting Loans and Advances

The second important function of a commercial bank is to grant loans and advances. Such
loans and advances are given to members of the public and to the business community at a
higher rate of interest than allowed by banks on various deposit accounts. The rate of interest
charged on loans and advances varies according to the purpose and period of loan and also the
mode of repayment.

I. Loans: A loan is granted for a specific time period. Generally commercial banks provide
short-term loans. But term loans, i.e., loans for more than a year may also be granted.
The borrower may be given the entire amount in lump sum or in instalments. A loan is
normally repaid in instalments. However, it may also be repaid in lump sum.

 Secured or Collateral Loan: A secured loan is one where the borrower provides a
certain property or asset as collateral against the loan. The main condition of these
loans is that if the loan remains unpaid, the bank has the right to use the property in
any way they like to realize the outstanding amount.
 Unsecured Loan: Unsecured loans have no collateral and therefore command higher
interest rates. There are a variety of unsecured loans available today and these
include credit cards, credit facilities such as a lines of credit, corporate bonds, and
bank overdrafts.

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 Mortgage Loans: Mortgage loans that are provided by commercial banks are similar
to secured loans but are used specifically to buy real estate property (immovable
property). In most of these cases, the banks hold a lien on the title to the particular
property purchased with the loan. If the borrower is unable to pay the loan back, the
bank leverages this item against the loan to generate funds or recover the principal.
 A mortgage is an agreement that allows a lender to seize property when a
borrower fails to pay.

 Reverse mortgage is a financial product that enables senior citizens (60 +) who own
a house to mortgage their property with a lender and convert part of the home equity
into tax-free income without having to sell the house.
 Benefits of a reverse mortgage: It aims at partially meeting the financial
needs of senior citizens without selling the property and enables recurring
funds inflows to the senior citizens during their life time. After the death of the
senior citizen, the surviving spouse can continue to occupy the property till
his/her demise

 Pledge: Pledge is another type of secured loan, used when the lender (pledgee)
takes actual possession of assets (i.e. certificates, goods ). Such securities or goods
are movable securities.
 In this case the pledgee (the bank) retains the possession of the goods until
the pledgor (i.e. borrower) repays the entire debt amount.
 In case there is default by the borrower, the pledgee has a right to sell the
goods in his possession and adjust its proceeds towards the amount due (i.e.
principal and interest amount).
 Some examples of pledge are Gold /Jewellery Loans, Advance against
goods/stock, Advances against National Saving Certificates etc.

 Hypothecation: Hypothecation is used for creating charge against the security of

movable assets, but here the possession of the security remains with the borrower
itself. Thus, in case of default by the borrower, the lender (i.e. to whom the goods /
security has been hypothecated) will have to first take possession of the security and
then sell the same.
 The best example of this type of arrangement are Car Loans. In this case Car
/ Vehicle remains with the borrower but the same is hypothecated to the bank /
financer.
 In case the borrower, defaults, banks take possession of the vehicle after
giving notice and then sell the same and credit the proceeds to the loan
account.

II. Advances: Banks grant short-term financial assistance by way of cash credit, overdraft
and bill discounting.

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Banking in India- Introduction

 Cash Credit: Cash credit is an arrangement whereby the bank allows the borrower to
draw amount upto a specified limit. The amount is credited to the account of the
customer. The customer can withdraw this amount as and when he requires. Interest
is charged on the amount actually withdrawn. Cash Credit is granted as per terms and
conditions agreed with the customers.
 A credit line or line of credit is money available for you to borrow. Instead of
borrowing a specific amount of money and paying it back over time, the bank
allows you to borrow any amount you need (up to your credit limit), whenever
you need it. You can borrow a little bit today and come back tomorrow for a
little bit more. The concept is similar to a credit card.

 Overdraft: Overdraft is also a credit facility granted by bank. A customer who has a
current account with the bank is allowed to withdraw more than the amount of credit
balance in his account. It is a temporary arrangement. Overdraft facility with a
specified limit may be allowed either on the security of assets, or on personal security,
or both.
 Discounting of Bills: Banks provide short-term finance by discounting bills, that is,
making payment of the amount before the due date of the bills after deducting a
certain rate of discount/commission. The party gets the funds without waiting for the
date of maturity of the bills. In case any bill is dishonoured on the due date, the bank
can recover the amount from the customer.

2) Secondary Functions: In addition to the primary functions of accepting deposits and

lending money, banks perform a number of other functions, which are called secondary
functions. These are as follows:
 Issuing letters of credit, traveller’s cheque, etc.
 Undertaking safe custody of valuables, important document and securities by
providing safe deposit vaults or lockers.
 Providing customers with facilities of foreign exchange dealings.
 Transferring money from one account to another; and from one branch to
another branch of the bank through cheque, pay order, demand draft.
 Standing guarantee on behalf of its customers, for making payment for
purchase of goods, machinery, vehicles etc.
 Collecting and supplying business information.
 Providing reports on the credit worthiness of customers.
 Providing consumer finance for individuals by way of loans on easy terms for
purchase of consumer durables like televisions, refrigerators, etc.
 Educational loans to students at reasonable rate of interest for higher studies,
especially for professional courses.
 Bancassurance facilities

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Balance Sheet of Commercial Banks – Liabilities and Assets

 Bank’s Liabilities: Bank's liabilities constitute five major items.

 The share capital, the contribution which shareholders have contributed for
starting the bank.
 Reserve funds are the money, which the bank has accumulated over the
years from its undistributed profits.
 Deposits are the money owned by customers and therefore it is a liability of a
bank. There can be various kinds of deposits and recurring deposits.
 Apart from these items a bank can borrow from central and other commercial
banks. These borrowings are also treated as bank's liabilities.

 Bank’s Assets: Bank's assets comprise cash, money at short notice, bills and
securities discounted, bank's investments, loans sanctioned by the bank, etc. Bank's
cash in hand, cash with other banks and cash with central bank (RBI) are its assets.
When a bank makes money available at short notice to other banks and financial
institutions for a very short period of 1-14 days it is also treated as bank's asset.
Apart from these items bank always make money available to people in the form of
loans and advances. They are also become bank's assets.

Banking Codes and Standards Board of India (BCSBI)

 The Banking Codes and Standards Board of India (BCSBI) is an independent banking
industry watchdog that protects consumers of banking services in India.
 The board oversee compliance with the "Code of Bank's Commitment to Customers".
 It is not a compensation mechanism and looks into an individual complaint only to the
extent it points to any systemic compliance failure.
 It is an independent and autonomous body, registered as a separate society under the
Societies Registration Act, 1860 on February 18, 2006.
 The Reserve Bank of India extended financial support to the Board, meeting its
expenses for the first five years.
 Its main aim is to plan, evolve, prepare, develop, promote and publish voluntary,
comprehensive Codes and Standards for banks, to provide fair treatment to their
customers.

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