Module III

Commercial and Co-operative Banks

Origin and growth of banks

A bank as an organisation whose principal operations are concerned with the

accumulation of the temporarily idle money of the general public for the purpose of
advancing to others for expenditure. Banks are just one part of the world of financial
institutions, standing alongside investment banks, insurance companies, finance companies,
investment managers and other companies that profit from the creation and flow of money.
As financial intermediaries, banks stand between depositors who supply capital and
borrowers who demand capital. Banks are also among the most heavily regulated businesses
in the world

Sayers gives a detailed definition of a bank thus:

“Ordinary banking business consists of changing cash for bank deposits and bank
deposits for cash; transferring bank deposits from one person or corporation (one
‘depositor’) to another; giving bank deposits in exchange for bills of exchange, government
bonds, the secured or unsecured promises of businessmen to repay, etc.”

Thus a bank is an institution which accepts deposits from the public and in turn advances
loans by creating credit. It is different from other financial institutions in that they cannot
create credit though they may be accepting deposits and making advances.

Banking is a business of accepting deposits and lending money. It is carried out by

financial intermediaries, which performs the functions of safeguarding deposits and providing
loans to the public. In other words, Banking means accepting for the purpose of lending or
investment of deposits of money from public repayable on demand and can be withdrawn by
cheque, draft order and so on.

Banking System is a principal mechanism through which the money supply of the
country is created and controlled. The banking system enables us to understand Commercial
Banks, Secondary Banks, Central Banks, Merchant Bank or Accepting Houses and Discount
Houses but to exclude the Saving Banks and Investment and other intermediaries. Thus
a banking system is considered to be a group or network of institutions that provide financial
services for us.

Origin and growth of banking in India

Banking industry in India has a long history. It has travelled a long path to assume its
present form. The banking industry in Indian started with small money lenders and has now
large joint stock world class banks in its fold. The growth of banks in India is discussed
below over two eras:
1. Pre-Independence Period
2. Post-Independence Period

Pre-Independence Period:
Banking in its crude from is as old as authentic history. All throughout the period of India
history, indigenous bankers and money lenders are recorded to have existed and carried on
the business of banking and money lending on a large scale. Between 2000 and 1400 BC
during the Vedic Period records of deposits and lending are found. Renowned Hindu Law
giver Manu has dealt with the matter of deposits and pledges in section of his work.
Post-Independence Period: After independence, Government has taken most important
steps in regard of Indian Banking Sector reforms. In 1955, the Imperial Bank of India was
nationalized and was given the name “State Bank of India”, to act as the principal agent of
RBI and to handle banking transactions all over the country. It was established under State
Bank of India Act, 1955.

Pre Independence Period (1786-1947)

The first bank of India was the “Bank of Hindustan”, established in 1770 and located in the
then, Indian capital, Calcutta. However, this bank failed to work and ceased operations in
1832. During the Pre Independence period over 600 banks had been registered in the country,
but only a few managed to survive.

Following the path of Bank of Hindustan, various other banks were established in India. They
were:

 The General Bank of India (1786-1791)

 Oudh Commercial Bank (1881-1958)
  Bank of Bengal (1809)
 Bank of Bombay (1840)
 Bank of Madras (1843)

During the British rule in India, The East India Company had established three banks: Bank
of Bengal, Bank of Bombay and Bank of Madras and called them the Presidential Banks.
These three banks were later merged into one single bank in 1921, which was called the
“Imperial Bank of India.”

The Imperial Bank of India was later nationalised in 1955 and was named The State Bank of
India, which is currently the largest Public sector Bank.

Post Independence Period (1947-1991)

At the time, when India got independence, all the major banks of the country were led
privately which was a cause of concern as the people belonging to rural areas were still
dependent on money lenders for financial assistance.

With an aim to solve this problem, the then Government decided to nationalise the Banks.
These banks were nationalised under the Banking Regulation Act, 1949. Whereas, the
Reserve Bank of India was nationalised in 1949.

Candidates can check the list of Banking sector reforms and Acts at the linked article.

Following it was the formation of State Bank of India in 1955 and other 14 banks were
nationalised between the time duration of 1969 to 1991. These were the banks whose national
deposits were more than 50 crores.

Given below is the list of these 14 Banks nationalised in 1969:

1. Allahabad Bank
2. Bank of India
3. Bank of Baroda
4. Bank of Maharashtra
5. Central Bank of India
6. Canara Bank
 7. Dena Bank
8. Indian Overseas Bank
9. Indian Bank
10. Punjab National Bank
11. Syndicate Bank
12. Union Bank of India
13. United Bank
14. UCO Bank

In the year 1980, another 6 banks were nationalised, taking the number to 20 banks. These
banks included:

1. Andhra Bank
2. Corporation Bank
3. New Bank of India
4. Oriental Bank of Comm.
5. Punjab & Sind Bank
6. Vijaya Bank

Apart from the above mentioned 20 banks, there were seven subsidiaries of SBI which were
nationalised in 1959:

1. State Bank of Patiala

2. State Bank of Hyderabad
3. State Bank of Bikaner & Jaipur
4. State Bank of Mysore
5. State Bank of Travancore
6. State Bank of Saurashtra
7. State Bank of Indore

All these banks were later merged with the State Bank of India in 2017, except for the State
Bank of Saurashtra, which was merged in 2008 and State Bank of Indore, which was merged
in 2010.
Types of Banks:

Banks are of various types which are explained as under:

1. Commercial Banks:

Commercial banks are those banks which perform all kinds of banking functions such as
accepting deposits, advancing loans, credit creation, and agency functions. They are also
called joint stock banks because they are organised in the same manner as joint stock
companies.

They usually advance short-term loans to customers. Of late, they have started giving
medium term and long-term loans also. In India 20 major commercial banks have been
nationalised, whereas in developed countries they are run like joint stock companies in the
private sector. Some of the commercial banks in India are Andhra Bank, Canara Bank, Indian
Bank, Punjab National Bank, etc.

2. Exchange Banks:

Exchange banks are those banks which deal in foreign exchange and specialise in
financing foreign trade. They are also called foreign exchange banks. In India, these
exchange banks have their head offices located outside India. These banks also render other
services such as collecting and supplying information about the foreign customers, providing
remittance facilities etc.

3. Industrial Banks:

Industrial banks are those banks which provide medium term and long-term finance to
industries for the purchase of land, machinery etc. They underwrite the debentures and shares
of industries and also subscribe to them. In India, there are a number of financial institutions
which perform the functions of industrial banks such as Industrial Development Bank of
India, Industrial Finance Corporation of India, Industrial Credit and Investment Corporation
of India, etc. These institutions are also known as Development Banks.
4. Agricultural Banks:

Agricultural banks are those banks which provide credit to farmers for short-term,
medium-term and long-term needs. In India, commercial banks, regional rural banks and
Agricultural Cooperative Banks provide short-term loans to farmers. Land Development
Bank give medium-term and long-term loans to farmers on the mortgage of their land. The
National Bank for Agriculture and Rural Development (NABARD) provides refinance
facilities to all types of banks which give loans to agriculturists.

5. Cooperative Banks:

Cooperative banks are those financial institutions which are organised on the principle of
cooperation. They provide short-term and medium-term loans to their members. In rural
areas, there are agricultural cooperative banks which accept deposits and give loans to
agriculturists, rural artisans, etc.

In urban areas, there are also cooperative banks which perform the functions of ordinary
commercial banks but give loans to their members only. There is a State Cooperative Bank in
every state of India with its branches at the district level known as the Central Cooperative
Bank. The Central Cooperative Bank, in turn, has is branches both in urban and rural areas.

Every State Cooperative bank is an apex bank which provides credit facilities to the
Central Cooperative Banks. It mobilises financial resources from the richer sections of the
urban population by accepting deposits and creating credit like commercial banks and
borrowing from the money market. It also gets funds from the Reserve Bank of India.

6. Savings Banks:

Savings banks help promote small savings, and mobilise them. They have been very
successful in Japan and Germany. In India, post offices act as savings bank.

7. Central Bank:

The central bank is the apex bank in a country which controls its monetary and banking
structure. It is owned by the government of the country and operates in national interest. It
regulates and issues currency, performs banking and a agency services for the state, keeps
cash reserves of commercial banks, keeps and manages international currency, acts as the
lender of the last resort, acts as a clearing house, and controls of credit. The Reserve Bank of
India is the Central bank in India.

Indian Banks are classified into commercial banks and Co-operative banks. Commercial
banks comprise: (1) Schedule Commercial Banks (SCBs) and non-scheduled commercial
banks. SCBs are further classified into private, public, foreign banks and Regional Rural
Banks (RRBs); and (2) Co-operative banks which include urban and rural Co-operative
banks.

The Indian banking industry has its foundations in the 18th century, and has had a varied
evolutionary experience since then. The initial banks in India were primarily traders’ banks
engaged only in financing activities. Banking industry in the pre-independence era developed
with the Presidency Banks, which were transformed into the Imperial Bank of India and
subsequently into the State Bank of India.
The initial days of the industry saw a majority private ownership and a highly volatile work
environment. Major strides towards public ownership and accountability were made
with Nationalisation in 1969 and 1980 which transformed the face of banking in India. The
industry in recent times has recognised the importance of private and foreign players in a
competitive scenario and has moved towards greater liberalisation.

Commercial Banks in India

Commercial banks provide banking services to businesses and consumers through a

network of branches. These banks are in business to make a profit for their owners and they
are usually public limited companies managed by shareholders. In India, however, most of
the top commercial banks are owned by the government. But many private commercial banks
have been established in the recent years.

Commercial banks are all-purpose banks that perform a wider range of functions such as
accepting demand deposits, issuing cheques against saving and fixed deposits, making short-
term business and consumer loans, providing brokerage services, buying and selling foreign
exchange and so on.
Functions of Commercial Banks

The functions of commercial banks are explained below:

Primary functions

 Collection of deposits

 Making loans and advances

Collection of deposits

The primary function of commercial banks is to collect deposits from the public. Such
deposits are of three main types:

 current,

 saving and

 fixed.

A current account is used to make payments. A customer can deposit and withdraw
money from the current account subject to a minimum required balance. If the customer
overdraws the account, he may be required to pay interest to the bank. Cash credit facility is
allowed in the current account.

Savings account is an interest yielding account. Deposits in savings account are used for
saving money. Savings bank account-holder is required to maintain a minimum balance in his
account to avail of cheque facilities.

Fixed or term deposits are used by the customers to save money for a specific period of
time, ranging from 7 days to 3 years or more. The rate of interest is related to the period of
deposit. For example, a fixed deposit with a maturity period of 3 years will give a higher rate
of return than a deposit with a maturity period of 1 year. But money cannot be usually
withdrawn before the due date. Some banks also impose penalty if the fixed deposits are
withdrawn before the due date. However, the customer can obtain a loan from the bank
against the fixed deposit receipt.

Loans and advances

 Commercial banks have to keep a certain portion of their deposits as legal reserves. The
balance is used to make loans and advances to the borrowers. Individuals and firms can
borrow this money and banks make profits by charging interest on these loans. Commercial
banks make various types of loans such as:

1. Loan to a person or to a firm against some collateral security;

2. Cash credit (loan in installments against certain security);

3. Overdraft facilities (i.e. allowing the customers to withdraw more money than what their
deposits permit); and

4. Loan by discounting bills of exchange..

Secondary functions

 Agency services

 General utility services

Agency Services:

The customers may give standing instruction to the banks to accept or make payments on
their behalf. The relationship between the banker and customer is that of Principal and Agent.
The following agency services are provided by the bankers:

1. Payment of rent, insurance premium, telephone bills, installments on hire purchase, etc.
The payments are obviously made from the customer’s account. The banks may also
collect such receipts on behalf of the customer.

2. The bank collects cheques, drafts, and bills on behalf of the customer.

3. The banks can exchange domestic currency for foreign currencies as per the regulations.

4. The banks can act as trustees / executors to their customers. For example, banks can
execute the will after the death of their clients, if so instructed by the latter.

General Utility Services:

The commercial banks also provide various general utility services to their customers.
Some of these services are discussed below:
 1. Safeguarding money and valuables: People feel safe and secured by depositing their
money and valuables in the safe custody of commercial banks. Many banks look after
valuable documents like house deeds and property, and jewellery items.

2. Transferring money: Money can be transferred from one place to another. In the
same way, banks collect funds of their customers from other banks and credit the same in the
customer’s account.

3. Merchant banking: Many commercial banks provide merchant banking services to

the investors and the firms. The merchant banking activity covers project advisory services
and loan syndication, corporate advisory services such as advice on mergers and acquisitions,
equity valuation, disinvestment, identification of joint venture partners and so on.

4. Automatic Teller Machines (ATM): The ATMs are machines for quick withdrawal
of cash. In the last 10 years, most banks have introduced ATM facilities in metropolitan and
semi-urban areas. The account holders as well as credit card holders can withdraw cash from
ATMs.

5. Traveler’s cheque: A traveler’s cheque is a printed cheque of a specific

denomination. The cheque may be purchased by a person from the bank after making the
necessary payments. The customer may carry the traveler’s cheque while travelling. The
traveler’s cheques are accepted in banks, hotels and other establishments.

6. Credit Cards: Credit cards are another important means of making payments. The
Visa and Master Cards are operated by the commercial banks. A person can use a credit card
to withdraw cash from ATMs as well as make payments to trade establishments.

In developing countries like India commercial banks perform certain promotional

(developmental) activities. For example, nationalized banks in India provide credit to the top
priority sectors of the economy such as agriculture, and small-scale and cottage industries. In
this way commercial banks help to promote the socio-economic development of the country.
Role of Commercial Banks in Economic Development

Commercial Banks play vital role in Economic Development of countries like India.
Important roles are discussed below
Mobilising Savings for Capital Formation:

People in developing countries have low incomes but the banks induce them to save by
introducing variety of deposit schemes to suit the needs to individual depositors. To mobilize
dormant savings and to make them available to the entrepreneurs for productive purposes, the
development of a sound system of commercial banking is essential.

Existence of a Large Non-monetized Sector:

A developing economy is characterized by the existence of a large non-monetized sector,

particularly, in the backward and inaccessible areas of the country. The existence of this non-
monetized sector is a hindrance in the economic development of the country. The banks by
opening branches in rural and backward areas can promote the process of monetization in the
economy.

Financing Industrial Sector:

Commercial Banks provide short-term and medium- term loans in the industry. In India, they
undertake financing of small scale industries and also provide hire-purchase finance. These
banks not only provide finance for industry but also help in developing the capital market
which is underdeveloped in such countries.

They Help in Monetary Policy:

The Commercial Banks help the economic development of a country by following the
monetary policy of the Central Bank. The Central Bank is dependent upon those Commercial
Banks for the success of the monetary management in keeping with requirements of a
developing economy.
Commercial Banks Help in Financing Internal and External Trade:

The banks provide loans to wholesalers and retailers to stock goods in which they deal. They
also help in the movement of goods from one place to another by providing all types of
facilities such as discounting and accepting bills of exchange, providing overdraft facilities,
issuing drafts etc. They help by giving finance both exports and imports of developing
countries.

Provision for Long-term Finance for the Improvement of Agriculture:

Normally, commercial banks grant short-term loans to the trade and industries in developed
countries. But in developing countries new businesses and improvement in agriculture need
long-term loans for proper development. Therefore, the commercial banks should change
their policies in favour of granting long-term loans to trade and industries.

They Help in Financing various Consumers’ Activities:

People in developing countries do not possess sufficient financial resources to buy costlier
goods like house, scooter, refrigerator etc. They help by giving loans to purchase these items
which raises the standard of living of the people in developing countries

Need for Sound Banking System:

For the improvement of the banking system in a developing country the following points
need special stress:

(i) In developing countries, there should be proper facility of cheap remittance facilities to
enable the movement of funds from one place to another, so as to meet the requirements of
trade and industry.

(ii) It should always be remembered that in developing countries loans should be given for
productive purposes only and not for consumption and speculative purposes.

(iii) It will be better and encouraging if long-term credit is given to agriculture and small
scale industries.

(iv) The use of cheques, drafts etc. is popularized among the people.
If the above written facts are taken into consideration commercial banks can play a useful
role in promoting the economic development in developing countries.

Credit multiplier

Credit multiplier measures the amount of money that the banks are able to create in the form
of deposits with every initial deposit. Higher the credit multiplier, higher will be the
total credit created and vice – versa. The total amount of deposits created by the banking
system as a whole as a multiple of the initial increase in the primary deposit is called
the credit multiplier

Assume that
the increase in primary deposit is 400 and
the total deposit created by the entire commercial banks is Rs. 2000,
then,
credit multiplier = 2000/400 = 5.

Credit creation

Credit creation separates a bank from other financial institutions. In simple terms, credit creation
is the expansion of deposits. And, banks can expand their demand deposits as a multiple of their
cash reserves because demand deposits serve as the principal medium of exchange. Credit
creation is the expansion of deposits. And, banks can expand their demand deposits as a
multiple of their cash reserves because demand deposits serve as the principal medium of
exchange. Credit creation separates a bank from other financial institutions.

Demand deposits are an important constituent of money supply and the expansion of demand
deposits means the expansion of money supply. The entire structure of banking is based on
credit. Credit basically means getting the purchasing power now and promising to pay at
some time in the future. Bank credit means bank loans and advances. A bank keeps a certain
part of its deposits as a minimum reserve to meet the demands of its depositors and lends out
the remaining to earn income. The loan is credited to the account of the borrower. Every bank
loan creates an equivalent deposit in the bank. Therefore, credit creation means expansion of
bank deposits.

Formula for determining the Credit creation

The following formulae can be used to determine the total credit creation

Total Credit Creation = Original Deposit ✕ Credit Multiplier Coefficient

Where,

Credit multiplier coefficient= 1 / r

r = Cash reserve requirement also known as Cash Reserve Ratio (CRR)

Let’s understand this with an example

If the money deposited in bank is Rs.10000 and the bank has a CRR of 10%, then Credit
multiplier coefficient will be

Credit multiplier coefficient = 1 / 10%

= 1/ 0.1

= 10

Total Credit Creation = 10000 ✕ 10 = 100000

Similarly, if CRR = 20 %

Then

Credit multiplier coefficient = 1 / 20%

= 1/ 0.2

=5

Therefore, Total Credit Creation = 10000 ✕ 5 = 50000

From the above values we can understand that low CRR value results in high credit creation
and high CRR results in less credit creation. Therefore, with the help of credit creation,
money gets multiplied in the economy.
However, commercial banks face many challenges and limitations while performing the
credit creation in an economy which is discussed below.

Process of credit creation

The process of credit creation can be better understood with the help of the following numerical
example. For simplicity, let us assume that the entire commercial banking system is a single unit
called 'banks'. Suppose, initially the public deposited Rs.1000 with the banks. The banks kept a
portion of these deposits with themselves as cash reserves (in accordance with CRR and SLR)
and extend the rest as loans to the borrowers.

Let us assume that the Legal Reserve Ratio (LRR) is 20% or 0.20 and the banks have maintained
exactly the same amount as cash reserves (i.e. neither more nor less) This implies that banks will
keep 20% of the deposits received as reserves and the rest is given out as loans. In other words,
out of Rs.1000 (initial deposits), banks kept Rs.200 with themselves as reserves and the balance
amount of Rs.800(Rs.1,000−Rs.200) is given as loans. Also, suppose that all the transactions
taking place in the economy are routed only through banks. Thus, the money spent by the
borrowers again comes back to the banks as deposits. Hence, there is an increment in the demand
deposits with the banks by Rs.800 (in the second round). Therefore, now the total deposits with
the banks rises to Rs.1,800 (Rs.1,000+Rs.800).
Now, out of the new deposits of Rs.800, the banks will keep 20% as reserves and the remaining
amount is lent out i.e. Rs.160 is kept as reserves and the remaining Rs.640 is extended as loans
When the borrower spends this borrowed amount either by cheques, demand drafts, etc. this
amount is routed through the banks. Therefore, the money spent by the borrower comes back to
the bank and the total deposits increase to Rs.2,440(i.e.Rs.1800+Rs.640).
The same process continues and with each round the total deposits with the banks increases.
However; in every subsequent round the cash reserves diminishes. The process comes to an end
when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become
equal to the initial deposits of Rs.1,000 that was initially held by the banks.

Deposits
Loans Extended Cash Resrves
Rounds Received
B C=10020×A
A
Initial 1,000 800 200
Round I 800 640 160
 Round II 640 512 128
Round III - - -
Round IV - - -
- - - -
- - - -
Round N - - -
Total 5,000 4,000 1,000

In the schedule, it should be noted that the total amount of deposits recived, i.e. Rs. 5,000 is
ascertained by the formula of money multiplier. Money multiplier is defined as the inverse of the
Legal Reserve Ratio (LRR).

Algebraically, Mm=LRR1

Mm=0.201=5 times

As the money multiplier is 5 times, so this implies that the total deposits (Rs.5,000) increased by
5 times the initial deposit (Rs.1,000) through the process of credit creation. This can be
interpreted as the commercial banks have created money of Rs.5,000 from the deposits
of Rs.1,000

Limitations of Credit Creation

Credit creation is the expansion of deposits. There are specific limitations on the power to
create deposits. While banks would prefer an unlimited capacity for creating credit to
increase profits, there are many limitations. These limitations make the process of creating
credit non-profitable. Therefore, a bank continues to create additional credit as long as:

a) There is a negligible chance of the loans turning into bad debts

b) The interest rate that banks charge on loans and advances is greater than the interest that
the bank gives to depositors for the money deposited in the bank. Various draw backs are:
1. Cash Reserve Ratio: The credit creation power of banks depends upon the amount of cash
they possess. The larger the cash, the larger the amount of credit that can be created by banks.
Thus, the bank’s power of creating credit is limited by the cash it possesses.

2. Availability of Adequate and Proper Securities: If proper securities are not available with
the public, a bank cannot create credit. As Crowther has written—”the bank does not create
money out of thin air, it transmutes other forms of wealth into money.”

3. Keeping of Reserve with the Central Bank: Every affiliated and attached bank has to keep
certain reserves with the Central Bank of the country. The Central Bank keeps on changing
the percentages of these reserves from time to time. When the Central Bank increases the
percentages of these reserves, then the power of the commercial banks to create credit is
reduced in the same proportion.

4. Banking Habits of the People: The banking habits of the people are an important factor
which governs the power of credit creation on the part of banks. If people are not in the habit
of using cheques, the grant of loans will lead to the withdrawal of cash from the credit
creation stream of the banking system. This reduces the power of banks to create credit to the
desired level.

5. Volume of Currency in Circulation: Volume of currency in circulation is an important

factor of creation of credit. If the primary deposits are large, then the derivative deposits
created on their basis will also be large. But the volume of primary deposits is closely
connected with the actual volume of currency in circulation.

6. If heavy with-drawl of Cash by the Borrowers: If the borrowers will withdraw money in
cash, then the balance of deposits will be disturbed. With the withdrawal of cash, the excess
reserves of the banks are automatically reduced. This reduces the power of credit creation.

7. Existence of Cash Transactions in the Economy: This system of doing transaction sets
another limitation on the power of the banks to create credit. In under-developed area most of
the transactions have to be effected in cash. This puts a question as to what extent banks
power to create credit is reduced.

8. Economic Conditions of Trade and Business: Banks cannot continue to create credit
limitlessly. Their power to create credit depends upon the economic climate present in the
country. If there are boom times, there is a greater scope of profitable investment and thus
greater demand for bank loans on the part of businessmen.

9. If Good Collateral Securities are not Available: We are aware that every loan made by the
bank must be backed by some valuable security like stocks, shares, bills and bonds etc. If
these collateral securities are not available in sufficient number the banks cannot expand their
lending activities and consequently cannot expand credit in the economy.

10. It is Essential to Maintain Statutory Liquidity Ratio: The Commercial Banks under law
are required to maintain a second line of defence in the form of the liquid assets. The liquid
assets have been considered as government bonds and securities, treasury bills and other
approved securities which can be en-cashed quite easily in emergency. Such restrictions
reduce the lendable resources with the banks and curtail their power to create credit to that
extent.

11. If the Behaviour of Other Banks is Not Co-operative: If some of the banks do not advance
loans to the extent required of the banking system, the chain of credit expansion will be
broken. The effect will be that the banking system will not operate properly