CHAPTER 1: Introduction

Banks have played a critical role in the economic development of some developed countries
such as Japan and Germany and most of the emerging economies including India. Banks today
are important not just from the point of view of economic growth, but also financial stability. In
emerging economies, banks are special for three important reasons. First, they take a leading
role in developing other financial intermediaries and markets. Second, due to the absence of
well-developed equity and bond markets, the corporate sector depends heavily on banks to
meet its financing needs. Finally, in emerging markets such as India, banks cater to the needs
of a vast number of savers from the household sector, who prefer assured income and liquidity
and safety of funds, because of their inadequate capacity to manage financial risks.

Forms of banking have changed over the years and evolved with the needs of the economy.
The transformation of the banking system has been brought about by deregulation, technological
innovation and globalization. While banks have been expanding into areas which were
traditionally out of bounds for them, non-bank intermediaries have begun to perform many of
the functions of banks. Banks thus compete not only among themselves, but also with non-
bank financial intermediaries, and over the years, this competition has only grown in intensity.
Globally, this has forced the banks to introduce innovative products, seek newer sources of
income and diversify into non-traditional activities.

This module provides some basic insights into the policies and practices currently followed in
the Indian banking system. The first two chapters provide an introduction to commercial
banking in India and its structure. Bank deposits are dealt with in detail in Chapter 3, lending
and investments in Chapter 4 & Chapter 5 respectively. Chapter 6 deals with other basic
banking activities of commercial banks, while Chapters 7 and 8 explain the relationship between
a bank and its customers and the trends in modern banking respectively.

1.1 Definition of banks

In India, the definition of the business of banking has been given in the Banking Regulation
Act, (BR Act), 1949. According to Section 5(c) of the BR Act, 'a banking company is a company
which transacts the business of banking in India.' Further, Section 5(b) of the BR Act defines
banking as, 'accepting, for the purpose of lending or investment, of deposits of money from
the public, repayable on demand or otherwise, and withdrawable, by cheque, draft, order or
otherwise.' This definition points to the three primary activities of a commercial bank which
distinguish it from the other financial institutions. These are: (i) maintaining deposit accounts
including current accounts, (ii) issue and pay cheques, and (iii) collect cheques for the bank's
customers.1

1
Each of these functions is described in detail in later chapters.

6
1.2 Evolution of Commercial Banks in India
The commercial banking industry in India started in 1786 with the establishment of the Bank
of Bengal in Calcutta. The Indian Government at the time established three Presidency banks,
viz., the Bank of Bengal (established in 1809), the Bank of Bombay (established in 1840) and
the Bank of Madras (established in 1843). In 1921, the three Presidency banks were
amalgamated to form the Imperial Bank of India, which took up the role of a commercial bank,
a bankers' bank and a banker to the Government. The Imperial Bank of India was established
with mainly European shareholders. It was only with the establishment of Reserve Bank of
India (RBI) as the central bank of the country in 1935, that the quasi-central banking role of
the Imperial Bank of India came to an end.

In 1860, the concept of limited liability was introduced in Indian banking, resulting in the
establishment of joint-stock banks. In 1865, the Allahabad Bank was established with purely
Indian shareholders. Punjab National Bank came into being in 1895. Between 1906 and 1913,
other banks like Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian
Bank, and Bank of Mysore were set up.

After independence, the Government of India started taking steps to encourage the spread of
banking in India. In order to serve the economy in general and the rural sector in particular,
the All India Rural Credit Survey Committee recommended the creation of a state-partnered
and state-sponsored bank taking over the Imperial Bank of India and integrating with it, the
former state-owned and state-associate banks. Accordingly, State Bank of India (SBI) was
constituted in 1955. Subsequently in 1959, the State Bank of India (subsidiary bank) Act was
passed, enabling the SBI to take over eight former state-associate banks as its subsidiaries.

To better align the banking system to the needs of planning and economic policy, it was
considered necessary to have social control over banks. In 1969, 14 of the major private
sector banks were nationalized. This was an important milestone in the history of Indian
banking. This was followed by the nationalisation of another six private banks in 1980. With
the nationalization of these banks, the major segment of the banking sector came under the
control of the Government. The nationalisation of banks imparted major impetus to branch
expansion in un-banked rural and semi-urban areas, which in turn resulted in huge deposit
mobilization, thereby giving boost to the overall savings rate of the economy. It also resulted
in scaling up of lending to agriculture and its allied sectors. However, this arrangement also
saw some weaknesses like reduced bank profitability, weak capital bases, and banks getting
burdened with large non-performing assets.

To create a strong and competitive banking system, a number of reform measures were initiated
in early 1990s. The thrust of the reforms was on increasing operational efficiency, strengthening
supervision over banks, creating competitive conditions and developing technological and
institutional infrastructure. These measures led to the improvement in the financial health,
soundness and efficiency of the banking system.

7
One important feature of the reforms of the 1990s was that the entry of new private sector
banks was permitted. Following this decision, new banks such as ICICI Bank, HDFC Bank, IDBI
Bank and UTI Bank were set up.

Commercial banks in India have traditionally focused on meeting the short-term financial
needs of industry, trade and agriculture. However, given the increasing sophistication and
diversification of the Indian economy, the range of services extended by commercial banks
has increased significantly, leading to an overlap with the functions performed by other financial
institutions. Further, the share of long-term financing (in total bank financing) to meet capital
goods and project-financing needs of industry has also increased over the years.

1.3 Functions of Commercial Banks2

The main functions of a commercial bank can be segregated into three main areas: (i) Payment
System (ii) Financial Intermediation (iii) Financial Services.

Figure 1.1: Main functions of a commercial bank

(i) Payment System

Banks are at the core of the payments system in an economy. A payment refers to the
means by which financial transactions are settled. A fundamental method by which
banks help in settling the financial transaction process is by issuing and paying cheques
issued on behalf of customers. Further, in modern banking, the payments system also
involves electronic banking, wire transfers, settlement of credit card transactions, etc.
In all such transactions, banks play a critical role.

(ii) Financial Intermediation

The second principal function of a bank is to take different types of deposits from
customers and then lend these funds to borrowers, in other words, financial
intermediation. In financial terms, bank deposits represent the banks' liabilities, while
loans disbursed, and investments made by banks are their assets. Bank deposits serve
the useful purpose of addressing the needs of depositors, who want to ensure liquidity,

2
The functions of commercial banks have been described in detail in later chapters.

8
 safety as well as returns in the form of interest. On the other hand, bank loans and
investments made by banks play an important function in channelling funds into
profitable as well as socially productive uses.

(iii) Financial Services

In addition to acting as financial intermediaries, banks today are increasingly involved

with offering customers a wide variety of financial services including investment banking,
insurance-related services, government-related business, foreign exchange businesses,
wealth management services, etc. Income from providing such services improves a
bank's profitability.

1.4 Competitive Landscape of Banks in India

Banks face competition from a wide range of financial intermediaries in the public and private
sectors in the areas of financial intermediation and financial services (although the payments
system is exclusively for banks). Such intermediaries form a diverse group in terms of size and
nature of their activities, and play an important role in the financial system by not only competing
with banks, but also complementing them in providing a wide range of financial services.
Some of these intermediaries include:

• Term-lending institutions

• Non-banking financial companies

• Insurance companies

• Mutual funds

(i) Term-Lending Institutions

Term lending institutions exist at both state and all-India levels. They provide term loans (i.e.,
loans with medium to long-term maturities) to various industry, service and infrastructure
sectors for setting up new projects and for the expansion of existing facilities and thereby
compete with banks. At the all-India level, these institutions are typically specialized, catering
to the needs of specific sectors, which make them competitors to banks in those areas.3 These
include the Export Import Bank of India (EXIM Bank), Small Industries Development Bank of
India (SIDBI), Tourism Finance Corporation of India Limited (TFCI), and Power Finance
Corporation Limited (PFCL).

3
A notable exception is the IFCI Ltd, which lends into a variety of sectors.

9
At the state level, various State Financial Corporations (SFCs) have been set up to finance and
promote small and medium-sized enterprises. There are also State Industrial Development
Corporations (SIDCs), which provide finance primarily to medium-sized and large-sized
enterprises. In addition to SFCs and SIDCs, the North Eastern Development Financial Institution
Ltd. (NEDFI) has been set up to cater specifically to the needs of the north-eastern states.

(ii) Non-Banking Finance Companies (NBFCs)

India has many thousands of non-banking financial companies, predominantly from the private
sector. NBFCs are required to register with RBI in terms of the Reserve Bank of India
(Amendment) Act, 1997. The principal activities of NBFCs include equipment-leasing, hire-
purchase, loan and investment and asset finance. NBFCs have been competing with and
complementing the services of commercial banks for a long time. All NBFCs together currently
account for around nine percent of assets of the total financial system.

Housing-finance companies form a distinct sub-group of the NBFCs. As a result of some recent
government incentives for investing in the housing sector, these companies' business has
grown substantially. Housing Development Finance Corporation Limited (HDFC), which is in
the private sector and the Government-controlled Housing and Urban Development Corporation
Limited (HUDCO) are the two premier housing-finance companies. These companies are major
players in the mortgage business, and provide stiff competition to commercial banks in the
disbursal of housing loans.

(iii) Insurance Companies

Insurance/reinsurance companies such as Life Insurance Corporation of India (LIC), General

Insurance Corporation of India (GICI), and others provide substantial long-term financial
assistance to the industrial and housing sectors and to that extent, are competitors of banks.
LIC is the biggest player in this area.

(iv) Mutual Funds

Mutual funds offer competition to banks in the area of fund mobilization, in that they offer
alternate routes of investment to households. Most mutual funds are standalone asset
management companies. In addition, a number of banks, both in the private and public
sectors, have sponsored asset management companies to undertake mutual fund business.
Banks have thus entered the asset management business, sometimes on their own and other
times in joint venture with others.

10
CHAPTER 2: Banking Structure in India

2.1 Banking Structure in India

Banking Regulator

The Reserve Bank of India (RBI) is the central banking and monetary authority of India, and
also acts as the regulator and supervisor of commercial banks.

Scheduled Banks in India4

Scheduled banks comprise scheduled commercial banks and scheduled co-operative banks.
Scheduled commercial banks form the bedrock of the Indian financial system, currently
accounting for more than three-fourths of all financial institutions' assets. SCBs are present
throughout India, and their branches, having grown more than four-fold in the last 40 years
now number more than 80,500 across the country (see Table 2.1). Our focus in this module
will be only on the scheduled commercial banks. A pictorial representation of the structure of
SCBs in India is given in figure 2.1.

Figure 2.1: Scheduled Banking Structure in India

4
Scheduled banks in India are those that are listed in the Second Schedule of the Reserve Bank of India Act, 1934.
RBI includes only those banks in this schedule which satisfy the criteria as laid down vide section 42 (6) (a) of
the Act.

11
Public Sector Banks

Public sector banks are those in which the majority stake is held by the Government of India
(GoI). Public sector banks together make up the largest category in the Indian banking system.
There are currently 27 public sector banks in India. They include the SBI and its 6 associate
banks (such as State Bank of Indore, State Bank of Bikaner and Jaipur etc), 19 nationalised
banks (such as Allahabad Bank, Canara Bank etc) and IDBI Bank Ltd.

Public sector banks have taken the lead role in branch expansion, particularly in the rural
areas. From Table 2.1, it can also be seen that:

• Public sector banks account for bulk of the branches in India (88 percent in 2009).

• In the rural areas, the presence of the public sector banks is overwhelming; in 2009,
96 percent of the rural bank branches belonged to the public sector. The private sector
banks and foreign banks have limited presence in the rural areas.

Table 2.1: Break-up of Bank Branches (as on June 30, 2009)

Type of Bank 1969 2004 2009 Rural Rural

Branches Branches
as on June as % of
30, 2009 all
branches
on June 30,
2009

SBI & Associates 2462 13621 16294 5619 34.4

Nationalised Banks 4553 33359 39703 13425 33.8

Regional Rural Banks … 14486 15199 11644 76.6

Total Public Sector Banks 7015 61466 71196 30688 43.1

Other Scheduled 900 5807 8979 1126 12.5

Commercial banks

Foreign Banks 130 218 295 4 1.4

Non-scheduled 217 32 44 11 25.0

Commercial Banks

Total (All Commercial Banks) 8262 67523 80514 31829 39.5

Source: Economic Survey 2009-10, Government of India.

Regional Rural Banks

Regional Rural Banks (RRBs) were established during 1976-1987 with a view to develop the
rural economy. Each RRB is owned jointly by the Central Government, concerned State

12
Government and a sponsoring public sector commercial bank. RRBs provide credit to small
farmers, artisans, small entrepreneurs and agricultural labourers. Over the years, the
Government has introduced a number of measures of improve viability and profitability of
RRBs, one of them being the amalgamation of the RRBs of the same sponsored bank within a
State. This process of consolidation has resulted in a steep decline in the total number of RRBs
to 86 as on March 31, 2009, as compared to 196 at the end of March 2005.

Private Sector Banks

In this type of banks, the majority of share capital is held by private individuals and corporates.
Not all private sector banks were nationalized in in 1969, and 1980. The private banks which
were not nationalized are collectively known as the old private sector banks and include banks
such as The Jammu and Kashmir Bank Ltd., Lord Krishna Bank Ltd etc.5 Entry of private sector
banks was however prohibited during the post-nationalisation period. In July 1993, as part of
the banking reform process and as a measure to induce competition in the banking sector, RBI
permitted the private sector to enter into the banking system. This resulted in the creation of
a new set of private sector banks, which are collectively known as the new private sector
banks. As at end March, 2009 there were 7 new private sector banks and 15 old private sector
banks operating in India.6

Foreign Banks

Foreign banks have their registered and head offices in a foreign country but operate their
branches in India. The RBI permits these banks to operate either through branches; or through
wholly-owned subsidiaries.7 The primary activity of most foreign banks in India has been in
the corporate segment. However, some of the larger foreign banks have also made consumer-
financing a significant part of their portfolios. These banks offer products such as automobile
finance, home loans, credit cards, household consumer finance etc. Foreign banks in India are
required to adhere to all banking regulations, including priority-sector lending norms as
applicable to domestic banks.8 In addition to the entry of the new private banks in the mid-
90s, the increased presence of foreign banks in India has also contributed to boosting competition
in the banking sector.

5
Some of the existing private sector banks, which showed signs of an eventual default, were merged with state
owned banks.
6
It may be noted that two important erstwhile developmental financial institutions, viz. Industrial Development
Bank of India (IDBI) and Industrial Credit and Investment Corporation of India (ICICI) converted themselves into
commercial banks after the new bank licensing policy was announced in July 1993.
7
In addition, a foreign institution could also invest up to 74% in domestic private bank, in which up to 49% can be
via portfolio investment.
8
Priority sector lending has been described in a later chapter.

13
 Box 2.1: Number of Foreign Banks

At the end of June 2009, there were 32 foreign banks with 293 branches operating in India.
Besides, 43 foreign banks were operating in India through representative offices. Under the
World Trade Organisation (WTO) Agreement, RBI allows a minimum 12 branches of all
foreign banks to be opened in a year.

Source: Report on Trend and Progress of Banking in India 2008-09, RBI.

Co-operative Banks

Co-operative banks cater to the fie op theedhes ofgriculture,gh tail tra, smf ang dustrynd all

14
its functioning. When the RBI was established, it took over the functions of currency issue
from the Government of India and the power of credit control from the then Imperial Bank of
India.

As the central bank of the country, the RBI performs a wide range of functions; particularly, it:

• Acts as the currency authority

• Controls money supply and credit

• Manages foreign exchange

• Serves as a banker to the government

• Builds up and strengthens the country's financial infrastructure

• Acts as the banker of banks

• Supervises banks

As regards the commercial banks, the RBI's role mainly relates to the last two points stated
above.

RBI as Bankers' Bank

As the bankers' bank, RBI holds a part of the cash reserves of banks,; lends the banks funds
for short periods, and provides them with centralised clearing and cheap and quick remittance
facilities.

Banks are supposed to meet their shortfalls of cash from sources other than RBI and approach
RBI only as a matter of last resort, because RBI as the central bank is supposed to function as
only the 'lender of last resort'.

To ensure liquidity and solvency of individual commercial banks and of the banking system as
a whole, the RBI has stipulated that banks maintain a Cash Reserve Ratio (CRR). The CRR
refers to the share of liquid cash that banks have to maintain with RBI of their net demand and
time liabilities (NDTL).13 CRR is one of the key instruments of controlling money supply. By
increasing CRR, the RBI can reduce the funds available with the banks for lending and thereby
tighten liquidity in the system; conversely reducing the CRR increases the funds available with
the banks and thereby raises liquidity in the financial system.

13
These are mainly deposits. NDTL is discussed in Chapter 3 under section 3.3.

15
RBI as supervisor

To ensure a sound banking system in the country, the RBI exercises powers of supervision,
regulation and control over commercial banks. The bank's regulatory functions relating to
banks cover their establishment (i.e. licensing), branch expansion, liquidity of their assets,
management and methods of working, amalgamation, reconstruction and liquidation. RBI
controls the commercial banks through periodic inspection of banks and follow-up action and
by calling for returns and other information from them, besides holding periodic meetings with
the top management of the banks.

While RBI is directly involved with commercial banks in carrying out these two roles, the
commercial banks help RBI indirectly to carry out some of its other roles as well. For example,
commercial banks are required by law to invest a prescribed minimum percentage of their
respective net demand and time liabilities (NDTL) in prescribed securities, which are mostly
government securities.14 This helps the RBI to perform its role as the banker to the Government,
under which the RBI conducts the Government's market borrowing program.

14
The concept of demand and time liabilities has been explained in Chapter 3.

16
CHAPTER 3: Bank Deposit Accounts

As stated earlier, financial intermediation by commercial banks has played a key role in India
in supporting the economic growth process. An efficient financial intermediation process, as is
well known, has two components: effective mobilization of savings and their allocation to the
most productive uses. In this chapter, we will discuss one part of the financial intermediation
by banks: mobilization of savings. When banks mobilize savings, they do it in the form of
deposits, which are the money accepted by banks from customers to be held under stipulated
terms and conditions. Deposits are thus an instrument of savings.

Since the first episode of bank nationalization in 1969, banks have been at the core of the
financial intermediation process in India. They have mobilized a sizeable share of savings of
the household sector, the major surplus sector of the economy. This in turn has raised the
financial savings of the household sector and hence the overall savings rate. Notwithstanding
the liberalization of the financial sector and increased competition from various other saving
instruments, bank deposits continue to be the dominant instrument of savings in India.

It can be seen from Table 3.1 that gross domestic savings of the Indian economy have been
growing over the years and the household sector has been the most significant contributor to
savings. Household sector saves in two major ways, viz. financial assets and physical assets.
Table 3.2 shows that within the financial savings of the household sector, bank deposits are the
most prominent instrument, accounting for nearly half of total financial savings of the household
sector.

Table 3.1: Gross Domestic Savings

Item Percent of GDP (at current market prices)

2000-01 2006-07 2007-08

1. Household Savings, of which 21.9 24.1 24.3

a) Financial Assets 10.7 11.7 11.7

b) Physical Assets 11.3 12.4 12.6

2. Private corporate sector 4.1 8.3 8.8

3. Public sector -2.3 3.3 4.5

4. Gross domestic saving 23.7 35.7 37.7

Source: Central Statistical Organization.

17