Banking System

Objectives:

This Lesson gives you an introduction to the Basics of Banking by explaining

 Meaning and definitions of Banking/Bank under different systems.

 Main universal principle of banking

 Main types/groups of banks under Indian banking system

 Traditional and modern functions of banks

MEANING AND DEFINITIONS OF BANK/BANKING:

Meaning of Bank- The word ‘bank’ means ‚an organization where people and businesses can

invest or borrow money, change it to foreign currency, etc.‛ A banker must perform at least

four essential functions in order to do ‘banking’ business. A person or corporate body cannot be

a ‘banker’ if they do not:

 Open deposit accounts,

 Open current accounts,

 Issue and pay cheques, and

 Collect cheques (crossed and uncrossed) for customers. Thus, a money lender would not

qualify to be a ‘banker’.

Definition of Bank under Indian law- In India ‘banking has been defined by a statute, viz., the

Banking Regulation Act, 1949 (vide Sections 5 b) as follows:

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‚Accepting, for the purpose of lending or investment, of deposits of money from the public,

Repayable on demand or to otherwise, and withdrawal by cheque, draft, and order or

otherwise‛ (section 5 b).

A banking company is ‚a company which transacts the business of banking in India‛ As per the

above definition the following are the core functions of a Bank:

 Acceptance of deposits from the public (customers or members of the society).

 Making deposits of customers withdrawable by cheque or otherwise (withdrawal slip,

letter, voucher) on demand, or repayable on maturity to the customers.

 Lending or investing funds collected from customers, subject to the obligation to repay

the deposits to the customers on demand or otherwise as per the terms of the deposits.

Different Stages of the Development of Indian Banking

In order to make the Reserve Bank of India more powerful, the Indian Government nationalized

it on January 1, 1949. With a view to co-ordinating and regulate Indian Banking, regulation of

Indian Banking. The Indian Banking Act was passed in March 1949. According to this Act, the

Reserve Bank of India was granted extensive powers for the inspection of non-scheduled Banks.

For the development of banking facilities in rural areas the Imperial Bank of India was

nationalized on July 1, 1955, and it was named as the State Bank of India. Along with it, other 8

(at present 5) banks were converted into its associate banks which form what is called as the

State Bank Group. They are as follows:

1. The State Bank of Hyderabad.

2. The State Bank of Bikaner and Jaipur (In the beginning the State Bank of Bikaner and

the State Bank of Jaipur were separate. But they were merged and named as the State

Bank of Bikaner and Jaipur)

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3. The State Bank of Indore. (Merged with SBI on 26th August 2010)

4. The State Bank of Mysore.

5. The State Bank of Saurashtra. (Merged with SBI on 13th August 2008)

6. The State Bank of Patiala.

7. The State Bank of Travancore

In order to have more control over the bank, 14 large commercial banks whose reserves were

more than Rs 50 crore each was nationalized on 19th July 1969. These nationalized banks are as

under:

1. The Central Bank of India

2. Bank of India

3. Punjab National Bank

4. Canara Bank

5. United Commercial Bank

6. Syndicate Bank

7. Bank of Baroda

8. United Bank of India

9. Union Bank of India

10. Dena Bank

11. Allahabad Bank

12. Indian Bank

13. Indian Overseas Bank

14. Bank of Maharashtra

After one decade, on April 15, 1980, 6 private sector banks whose reserves were more than Rs.
200 crore each was nationalized. These banks are:

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1. Andhra Bank

2. Punjab and Sindh Bank

3. New Bank of India

4. Vijaya Bank

5. Corporation Bank

6. Oriental Bank of Commerce

On 4th September 1993 the Government merged the New Bank of India with Punjab

National Bank and as a result of this the total number of nationalized bank got reduced from
20 to 19.

With the transition to the Indian Economy to a higher growth trajectory, the provision of

adequate and timely availability of bank credit to the productive sectors of the economy has

acquired importance. As public sector banks still own about 71 percent of the assets of the

banking system, they continue to play an important role in responding to the changes in the

economic environment. As the banking regulator and supervisor and as the monitory policy

authority, the Reserve Bank of India (RBI) continue to guide the banking system, including

foreign, private sector and public sector banks, to meet emerging economic challenges. As

certain rigidities and weaknesses were found to have developed in the banking system during

the eighties, the Government felt that these has to be addressed to enable the financial system to

play its role in ushering in a more efficient and competitive economy. According to high-level

committee under the Chairmanship of Shri M. Narasimham on the Financial System, (CFS), was

setup on August 14. 1991 to examine all aspects relating to the structure, organization, functions

and procedures of the financial systems. A high-level Committee, under the Chairmanship of

Shri M. Narasimham, was constituted by the Government of India in December 1997 to review
the record of implementation of financial system reforms recommended by the CFS in 1991 and

chart the reforms necessary in the years ahead.

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At present, we have 26 public sector banks including SBI and it’s 5 subsidiaries.

TYPES OF BANKING GROUPS IN INDIA:

Scheduled and Non-scheduled banks- Banks can be categorized according to their ownership

patterns, functions, and operational coverage. The Indian banking system regulated by the

Reserve Bank of India (RBI) comprises scheduled and non-scheduled banks and these are

classified into various subcategories as follows.

a. Scheduled banks: These are banks which are listed in the 2nd schedule of the Reserve Bank

of India Act, 1934. These banks have paid up capital and reserves of not less than Rs. 5 lacs

and they are successful in convincing the RBI that their affairs are not conducted in a

manner detrimental to their depositors. These banks are required to maintain a certain

amount of reserves (CRR as mentioned in paragraph 1.3.2) with RBI, against which these
banks enjoy the facility of financial accommodation and remittance facilities at

concessionary rates from RBI. Scheduled banks are classified as:

1. Co-operative banks [both State and Urban Co-op banks]

2. Commercial banks: These are sub-classified as:

2.1 Foreign scheduled banks: 38

2.2 Indian scheduled banks: Further sub-classified as:

(a) private sector scheduled banks

(b) public sector scheduled banks: sub-classified as:

(i) State Bank and its five banking subsidiaries: 6

(ii) Nationalized Banks

(iii) Regional Rural Banks

b. Non-scheduled banks: Non-scheduled banks are those not included in the 2 nd schedule of

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the Reserve Bank of India Act. Their number has progressively declined over the years.

Public Sector banks:

(a) State Bank Group and Nationalized banks: This group of 26 banks has the largest

number of branches in metros/urban and rural areas throughout the country. The Group

contributes about 75% of the total deposits and about 70% of total advances of all commercial

banks in India. Most of these banks have a country-wide branch network, along with a large

deposits and assets base and perform all kinds of core and modern banking functions. Some of

these banks have branches/ offices abroad too.

The erstwhile Imperial Bank of India was nationalized in 1955 to create the State Bank of India

in accordance with the State Bank of India Act, 1955. SBI is the largest bank in India in terms of
branch network, assets size, capital, and profits. SBI’s seven subsidiaries were created in 1959 by

nationalizing the regional banks in the princely states as per the State Bank of India (Subsidiary

Banks) Act, 1959. The remaining 19 banks in the public sector were nationalized by the Banking

Companies (Acquisition and Transfer of Undertakings) Act, 1970.

After 1994, most of these banks have made public issues of their shares, thus diluting the

Government share-holdings much below 100%, but above 51%.

(b) Regional Rural Banks (RRB): These too are scheduled banks, but, unlike commercial

banks, are small localized banks operating in rural areas limited to specified districts. About 196

RRB operate exclusively in rural areas for providing credit and banking facilities to small

farmers, agricultural labor, artisans and small entrepreneurs. Each RRB operates in 1 to 5

allotted districts. Their ownership capital is provided jointly by Central Government (50%), the

concerned State Government (15%) and the sponsor public sector bank (35%). There is no local

participation in ownership or administration of these banks. The sponsor bank appoints the

CEO in the constitution with NABARD.

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Private sector and foreign banks:

(a) Indian private sector banks: These are incorporated in India and their shares/ ownership is

held by business houses and individuals (public). The majority of these banks are old

generation private banks which have respectively small balance sheet size, limited regional

operations and traditional style of management and business activities.

(b) Foreign banks: These are the banks incorporated abroad but granted a license by RBI to

conduct banking business in India through their Indian branches. While the foreign banks in

India outnumber the private sector banks, the branch network of the former is smaller and

confined mostly to the metros/big commercial centers. Their operations are technology driven

and a good part of their business comprises foreign exchange, trade finance, and merchant
banking, which augments their income/profitability per branch and per worker.

Cooperative Banks:

The foregoing sub-groups pertain to the commercial banking sector, which principally meet the

varied financial needs of industry, trade and commerce.

Cooperative banks from another distinctive banking sector in India. Cooperative banks have

two main groups-rural and urban. Rural Cooperative banks primarily meet financial needs of

agriculture and allied activities in rural areas, whereas Urban Cooperative Banks meet financial

needs of small-size trade and commerce activities operating in urban areas.

Although broadly speaking, the operational thrust of commercial banks is in urban areas, these

banks also lend to the agricultural sector and the small businesses (for e.g. priority sector
advances). Cooperative banks have operational thrust in the rural areas for agriculture, yet the

banks also lend to tiny units, artisans, small businesses, etc. In the urban areas. Basically, there

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are legal, structural and size-wise differences between the two banking groups as follows:

 Cooperative banks are registered with the Registrar of Cooperatives and their main

regulator is the State Government (or Central Government in the case of cooperative

banks operating in more than one State). The commercial banks are registered under the

Banking Regulation Act/Companies Act and are regulated by RBI.

 The organizational structure and management set up of cooperative banks are based on

cooperative principles which are not as formal and professional as in the case of

commercial banks.

 The size of assets/liabilities of the cooperative banks is much smaller in comparison to

commercial banks.

 Cooperative banks operate on ’no profit no loss’ principle of cooperation as opposed to

the commercial banks which operate with a profit motive (for the shareholders).

However, commercial banks need to balance their profit objective with the mandatory

40% of their net bank credit given as priority sector advances (PSAs) to the agriculture,

small scale industries, small businesses, exporters, individual housing as prescribed by

RBI. PSAs include 10% of commercial banks’ credit to weaker/ disadvantaged section of

the society for employment under the government sponsored schemes and 1% of net

bank credit to the very poor people under Differential Rate of Interest (DRI) Scheme at

fixed interest rate of 4% p.a.

FUNCTIONS OF BANKS:

Functions of a bank can be classified as:

(a) Traditional /Core functions: These are performed by almost every bank, irrespective of

its size, ownership pattern and operational area.

(b) Modern functions: These are mostly performed by large sized/modern banks, situated in

commercial centers or metros.

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Modern banking functions – Modern banking is about providing an array of services to

customers, under one roof, so as to enable banking with convenience. The modern commercial

banking function mainly comprises of activities such as cross-border banking, merchant

banking, credit cards, factoring, leasing, and insurance and other financial services.

Cross-border banking refers to banking between two individuals or business entities residing in

two different countries on account of funds remittance or deposit or business dealings. It

necessarily involves, at least, two foreign currencies belonging to the countries where the two

transacting parties are resident. The transactions in cross-border banking, therefore, involve

foreign exchange. In India, foreign exchange transactions are done only by banks designated as

Authorized Dealers (ADs) by the RBI. These banks designate some of their branches to do

foreign exchange business of a specified nature.

Cross-border banking is classified as follows:

(i) Cross-border fund-raising services

 External commercial borrowing (ECB)

depository receipts (IDRs)

 Non-resident external (NRE) Foreign currency Non-resident (FCNR) Accounts

 Syndication of foreign currency loans

(ii) Cross-border Banking Services

 Letter of Credit

 Import Financing / Leasing

 Export Financing / Forfeiting / Leasing

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 Standby Letter of Credit

outlay of funds to the clients. Commercial banking, on the other hand, mostly involves fund-

based functions and these are reflected on the assets side (loans and investments) and liabilities

side (deposits and other borrowings apart from owned capital) of a bank’s balance sheet.

Commercial banking involves intermediary role between depositors and borrowers, implying

risk-taking by a bank and earning an interest spread. Merchant Banking, on the contrary,

involves dis-intermediation, as it helps savers to invest directly in the shares of companies,

instead of depositing their savings with banks. Merchant banking provides lucrative fee-based

business for modern banks but is done mainly by specialized subsidiaries of banks.

EMERGING TRENDS IN BANKING:

Ever since the banking sector in India was deregulated and opened to global competition and

investment under the New Economic Policy (1991), it has undergone a great metamorphosis.

The overall performance and productivity have spiraled upwards with major attention given to

the improvement of customer service. Banks are becoming competitive and technology driven.

An outcome of these factors has been an expansion of their product range coupled with

improvements in product delivery and pricing.

Universal Banking – It refers to the provision of a wide range of financial services to an

organization, under one roof e.g. commercial banking, merchant banking (or investment

banking), mutual funds and insurance- all of one bank. Universal banking has resulted in the

blurring of distinctive functional boundaries. Areas that once existed between the providers of

these financial services –viz. commercial banks (short/medium-term credit providers),

development banks or financial institutions (long-term credit providers), merchant banks

(dealing in securities), insurance companies (dealing with risk to the insured) have minimized.

Universal banking usually takes one of three forms – in-house or through separately capitalized

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subsidiaries, or through a holding company. Citibank and HSBC are an example of Universal

banks in USA and UK respectively and both these banks have global operations in a wide range

of modern banking services. In India, examples of Universal Bank are State Bank of India

(through its several non-banking subsidiaries/affiliates dealing in long-term project finances,

leasing, factoring, securities, credit cards, life insurance etc., apart from commercial banking)

and ICICI Bank. ICICI, after its reverse merger in 2002, has become a Universal Bank providing

commercial banking, long-term project finance, merchant banking, credit card, insurance etc.

Electronic Banking – In the wake of recent development in information and communication

technologies, the majority of banking operations have been computerized by most of the

commercial banks, both in the private and the public sectors especially in the last ten years and

the process is still on for extension and up-gradation of computerization by banks in India.

Computerization is done for front-office operations involving interface with customers as well

as back-office operations involving internal housekeeping (accounting and books balancing),

external accounting and settlement with other branches and banks/institutions. Electronic

banking provides a bouquet of new channels like internet banking, telephone banking, ATM

banking – which are different from the traditional ‘brick and mortar’ branch banking and which

have made possible ‘anywhere and anytime banking’ and contributed to speed, accuracy, and

confidentiality of customers’ transactions while enhancing customers’ convenience. Funds

transfer, cheques clearing, and collection of bills of exchange are also done electronically with

accuracy, speed and safety. Internal housekeeping is done accurately and much faster through

programmed packages/software at the branch and also at centralized platforms involving

several branches of a region or zone.

Globalization of Banking – In addition universal banking and electronic banking, globalization

has emerged as a prime mover in the Indian banking system. This has come about as a result of

the policy of liberalization and opening up of banking and other sectors pursued after 1991 in
India. Foreign banks that wished to set-up their offices/branches in India have been granted a

license to service scores of Multinational Corporations setting up their manufacturing/trading

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bases in India and also due to India’s increased foreign trade.

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