Unit 1 - Introduction to Banking

UNIT 1

INTRODUCTION TO BANKING

STRUCTURE

1.1. Objectives

1.2. Meaning and definitions of bank/banking

1.2.1. Definition of bank under British Law

1.2.2. Definition of bank under Indian Law

1.2.3. Definition of bank under USA Law

1.3. Basic Principles of banking

1.3.1. Principle of Intermediation

1.3.2. Principle of Liquidity

1.3.3. Principle of Profitability

1.3.4. Principle of Solvency

1.3.5. Principle of Trust

1.4. Types of banking groups in India

1.4.1. Scheduled and Non‐Scheduled banks

1.4.2. Public sector banks

1.4.3. Private sector and foreign banks

1.4.4. Co‐operative banks

1.4.5. Market share of banking Groups

1.5. Functions of banks

1.5.1. Traditional functions

1.5.2. Modern banking functions

1.5.3. Merchant Banking

1.6. Emerging Trends in banking

1.6.1. Universal banking

1.6.2. Electronic banking

1.6.3. Globalisation of banking

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2 INTRODUCTION TO BANKING

1.7. Let us sum up

1.8. Check your Progress

1.9. Terminal questions

1.10. Answers to ‘Check your Progress’

1.1. OBJECTIVES :

This Unit would give you an introduction to the Basics of Banking by explaining:

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

� Main universal principles of banking

� Main types/groups of banks under Indian banking system

� Traditional and modern functions of banks

� Trends in Indian banking

1.2. 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.” As against this word ‘bankrupt’ in relation to an individual or a corporate entity signifies a status of being “unable to pay what is owed as declared by a Court of Law”, vide Cambridge International Dictionary of English.

The dictionary meaning of these two words indicates mutually opposite connotations ‘bankrupt’ indicates an inability to pay one’s obligation or debt owed to others, while ‘bank’ essentially connotes an ability to pay its obligations to others (its customers) always in time the cash are due.

Another word ‘bank on’ meaning “depend on happening” is derived from the intrinsic quality of a bank, viz. dependability. Therefore, in ordinary parlance, the financial soundness, inherent ability to meet one’s financial obligations, honouring one’s commitments or dependability, are the distinguishing features of a bank.

1.2.1. Definition of Bank under British Law ‐ Gerald Klein of University of London explains ‘bank’ as “a body, corporate or not, that has been recognized by Bank of England under the Banking Act, 1987, to accept deposits as defined by that Act (Dictionary of Banking by Gerald Klein, 1994, page 13). In UK there is no statutory definition of a ‘bank’ or ‘banker’. These concepts have been defined by the jurists and subject experts, based on the decisions of the Courts of England, as follows:

“A banker is one who in the ordinary course of his business, honours cheques drawn upon him by persons from and for whom he receives money on current accounts” (Dr. Herbert L. Hart) “A banker is an individual, partnership or corporation, whose sole pre‐dominant business is banking, that is the receipt of money on current or deposit account;

INTRODUCTION TO BANKING 3

and the payment of cheques drawn by and the collection of cheques paid in by a customer.” (Halsbury)

According to Sir John Paget, an authority on British banking law, 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:

� take deposit accounts,

� take 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’ as per the British banking law, as, even though he lends his own capital to others and charges interest in the course of lending business, he doesn’t take deposits from the public and also doesn’t issue/pay/collect customers’ cheques in the course of business.

1.2.2. Definition of Bank under Indian law ‐ In India ‘banking’ has been defined by a statute, viz., the Banking Regulation Act, 1949 (vide Section 5 b, c) as follows:

“Accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or 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” (section 5 c)

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 other‐ wise as per the terms of the deposits.

1.2.3. Definition of Bank under USA law ‐ In United States of America (USA), the term ‘banking’ has been defined, in one of the earliest Acts of the Congress, as follows (vide Tannan’s Banking Law and Practice, 20th Edition (2002), Ch. VII, page 210):

“By ‘banking,’ we mean the business of dealing in credits and by a ‘bank’ we include every person, firm or company having a place of business where credits are opened by the deposit or collection of money or currency, subject to be paid or remitted on draft, cheque or order; or money is advanced or loaned on stocks, bonds, bullion, bills of exchange; or promissory notes are received for discount or sale.”


banks collect deposits from public by way of demand deposits and term deposits and use these and their own funds, for making loans and advances for business and trade. Banks pay interest only on term deposits and follow the directions issued by the regulatory authorities ‐ Comptroller of the Currency, Federal Reserve and State Banking Commissioners.

1.3. BASIC PRINCIPLES OF BANKING:

It would be interesting to examine differences in the legal definitions of ‘Bank’ or ‘Banking’ under the British, Indian and USA laws. The British had framed the banking and regulatory laws much before 1947, when India became a democratic republic. Though the Indian model has been largely derived from the British one, there are certain inherent differences between the two. The Indian commercial banking system with branch banking and its regulation by Reserve Bank of India (Reserve Bank of India Act, 1934) as the apex banking authority in the country was patterned on the British banking system having Bank of England as the banking regulator.

The USA banking system, is altogether different from the British and the Indian ones. Yet, certain basic tenets of banking are common to these three, as also the other systems of banking across the world. For, these tenets are so fundamental that the same would characterize almost all banking systems globally. These basic principles of banking are briefly described in this section.

1.3.1. Principle of Intermediation ‐ The word ‘intermediary’ means ‘someone who carries messages between people who are unwilling or unable to meet personally’ (Cambridge International Dictionary of English).

Banks are called ‘financial intermediaries’ because they invest or lend funds of depositors who themselves are unable to lend their funds, due to risk and other factors involved in direct lending. Banks assume the credit risk (arising from default by the borrower) involved in direct lending to those who need funds. (borrowers). They have expertise and abilities to manage such risks. Thus, banks mediate between the depositors (savers of money) and borrowers (users of money) and earn interest spread as a reward for risk taking, meeting the administrative expenses and making provision for some portions of loans that may turn bad or difficult to recover (termed as ‘non‐performing assets’ or NPAs).

1.3.2. Principle of Liquidity ‐ The simultaneous operations of acceptance of deposits (repayable on demand or on certain maturity periods) and lending these funds to borrowers in a manner such that the bank would be able to arrange for the funds demanded by its depositors at any point of time, is called ‘liquidity management’ or ‘asset liability management’. In line with the liquidity principle, a bank must keep a certain portion of its deposit liabilities in liquid form so as to be able to repay the same on demand or maturity dates to the depositors. This principle is reinforced by the regula‐ tory requirements of the Reserve Bank of India (RBI) that every bank has to maintain deposits with the RBI as cash reserve ratio (CRR), which currently


stands at 4.75% of the bank’s demand and time liabilities (DTL) and statutory liquidity ratio (SLR), wherein, every bank has to invest in gilts/government and other approved securities (currently 25% of its DTL). If a bank is cash‐strapped, it can easily trade the SLR securities to generate cash, as the same the most liquid of all.

It is only after meeting the minimum CRR and SLR requirements, that a bank can invest/lend its remaining DTL, by way of loans/advances or other kinds of lending business, to earn and maximize its profits.

1.3.3. Principle of Profitability ‐ Banking business, like any other, has to be profitable in order to sustain the required growth.

Interest income, which represents the interest differential (spread) between its loans and deposits rates, is the main source of profit for a bank. The interest earned by a bank on its lending operations should be higher than the interest paid by it on its deposit operations. The interest spread, along with the volume of its deposits and loans determines the total net interest income of a bank. Interest income along with non‐interest or fee‐based income (e.g. commission on letters of credit, funds remittance; exchange on bank drafts, foreign ex‐ change business) contributes to the bulk of a bank’s profits. The absolute size of a bank’s Gross/Operating/Net Profits considered with ratios like Return on Assets (ROA) and Return on Capital (ROC) are the true financial indicators of a bank’s profits.

1.3.4. Principle of Solvency ‐ Solvency connotes long term financial soundness of a bank, achieved by adherence to prudent policies in lending, retention of some part of profits for business growth, implementation of professional management systems and following the mandatory rules and procedures in day‐to‐day operations. A bank’s financial soundness is judged by analyzing its financial graph of a couple of years and comparing the relevant ratios (e.g. capital adequacy ratio, standard assets ratio and provisions to non‐performing assets ratio) with other banks.

The principle of solvency also embraces liquidity and profitability attributes.

1.3.5. Principle of Trust ‐ The trust that customers ‐ existing and potential‐ repose in a bank is its hallmark as it connotes dependability in the opinion of its customers. Trustworthiness is a function of a bank’s good track record over a fairly long period of time, in terms of liquidity, profitability, financial soundness, and its record of meeting its commitments to all concerned parties. It also reflects the governance quality of the bank. The magnitude of trust reposed in a bank by its customers, by other banks in the country and globally, would vary, according to the parameters of evaluation applied by each. However, for customers and public, trust indicates dependability and safety as they perceive while lodging their deposits with a bank and it is reflected in the rate of growth of its deposits and profits on a sustained basis.


1.4. TYPES OF BANKING GROUPS IN INDIA: 1.4.1. Scheduled and Non‐scheduled banks ‐ Banks can be categorized accord‐ ing 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 in various sub‐ categories 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 certain amount of reserves (CRR as mentioned in paragraph 1.3.2) with RBI, against which these banks enjoy the facility of financial accommo‐ dation and remittance facilities at concessionary rates from RBI. Sche‐ duled banks are classified as:

1.1. Co‐operative banks [both State and Urban Co‐op banks]

1.2. Commercial banks : These are sub‐classified as:

1.2.1. Foreign scheduled banks : 38

1.2.2. Indian scheduled banks : Further sub‐classified as:

(a) private sector scheduled banks: Old and New : 31

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

(i) State Bank and its seven banking subsidiaries : 8

(ii) Nationalized banks : 19

(iii) Regional Rural Banks : 196

(b) Non‐scheduled banks: Non‐scheduled banks are those not included in the 2nd schedule of the Reserve Bank of India Act. Their number has progressively declined over the years.

1.4.2. Public Sector banks:

(a) State Bank Group and Nationalized banks: This group of 27 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, alongwith 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 (Acquisi‐ tion 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 (RRBs) : These too are scheduled banks, but, unlike commercial banks, are small localized banks operating in rural areas limited to specified districts. About 196 RRBs operate exclusively in rural areas for providing credit and banking facilities to small farmers, agricul‐ tural labour, 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.

1.4.3. 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). Majority of these banks are old generation private banks which have a small balance sheet size, limited regional operations and traditional style of management and business activities.

New generation private sector banks, incorporated post‐1994, are tech‐ nology‐driven and have a modern style of functioning, thus achieving a level of parity with that of the foreign banks operating in India. Some of these have expanded to enable country‐wide operations, on account of mergers and acquisitions.

(b) Foreign banks: These are the banks incorporated abroad but granted 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 metropolis/big commercial centres. Their operations are techno‐ logy 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.

1.4.4. Cooperative Banks ‐ The foregoing sub‐groups pertain to commercial banking sector, which principally meet the varied financial needs of industry, trade and commerce.

Cooperative banks form another distinctive banking sector in India. Cooperative banks have two main sub‐groups—rural and urban.

Rural Cooperative banks primarily meet financial needs of agriculture and allied activities in the rural areas, whereas Urban Cooperative Banks meet financial needs of small‐size trade and commerce activities operating in the 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 opera‐ tional 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 are legal, structural and size‐wise differences between the two banking groups as follows:

� Cooperative banks are registered under the Registrar of Cooperatives

and their main regulator is the State Government (or Central Govern‐ ment in 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 is 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 are 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 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, the small scale industries, the small businesses, the exporters, individual housing and education etc., which involve concessionary interest and other terms 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 persons under Differential Rate of Interest (DRI) Scheme at fixed interest rate of 4% p.a.

1.4.5. Market share of Banking Groups ‐ As of end March 2004, the market share in total deposits and total advances of various groups of scheduled commercial banks, in descending order, was as follows:


TABLE 1. MARKET SHARE OF BANKS (in %) (As of end‐March 2004)

Bank‐Group Assets Deposits Advances

2003 2004 2003 2004 2003 2004

(a) (2) (3) (4) (5) (6) (7) Scheduled commercial banks 100.0 100.0 100.0 100.0 100.0 100.0

Public sector banks 75.6 74.5 79.6 77.9 74.2 73.2 Of which, (i) Nationalized banks 46.5 46.7 50.8 50.4 48.6 47.7 (ii) State Bank Group 29.1 27.8 28.8 27.5 25.6 25.5 Private sector banks 17.5 18.6 15.3 17.0 18.8 19.8 Of which, Old private sector banks 6.2 6.1 6.7 6.7 6.7 6.5 New private sector banks 11.3 12.5 8.5 10.4 12.1 13.3 Foreign banks 6.9 6.9 5.1 5.1 7.1 7.0

Source: RBI’s Trend and Progress in Banking, 2004‐05

1.5. 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 centres or metros.

While each of the traditional and modern function of banks is discussed in detail in the Courseware elsewhere in the book, we would, in the section ahead, like to give an overview of the banking functions to facilitate understanding of the basics of banking covered in this Courseware.

1.5.1. Traditional Functions: (a) Accepting deposits: A bank accepts money from its customers (members of

the public) and keeps the funds in non‐interest bearing accounts (current accounts) or interest‐bearing accounts (savings, fixed deposits, recurring deposits) as per the choice/preference of customer while opening the account. Deposits constitute the largest portion of a bank’s funds (liabilities), apart from its own capital. Deposits are repayable on demand (like current and savings accounts) or on specific maturity dates (fixed and recurring deposits). In addition to earning interest customers get several benefits in maintaining deposit accounts with banks (viz., safety, liquidity, interest earning, transactions record/statement of account, cheque book facility etc.).


(b) Lending: Another traditional function is lending money to businesses/ customers by way of loans and advances of various kinds. Funds mobilized through deposits are deployed by a bank in making loans and advances to earn profits by way of interest spreads, i.e. the differential between the average interest rates on loans and on deposits. The interest income from loans and advances forms a sizeable chunk of a bank’s operating profit. Undoubtedly, some portion of loans do turn into ‘non‐ performing assets’ (NPAs) which cause loss of income and, in some cases, also of capital to the bank. Hence, lending requires adequate care, caution and supervision/monitoring by the bank’s management at various levels, which helps to act as a buffer against erosion of profits/ capital due to NPAs. The recent example of failure of Global Trust Bank (GTB), a new generation private sector bank in India, shows how the bank’s net worth got substantially eroded due to indiscriminate lending, eventually leading to a temporary moratorium (on withdrawals by the bank’s depositors) declared by the RBI in 2004. GTB eventually was merged with Oriental Bank of Commerce, a strong public sector bank. The Bank of Credit and Commerce (BCCI), an international Bank, and Barings Bank of UK also failed and became bankrupt during 1990’s due to indiscreet lending by the banks, coupled with poor management controls.

(c) Funds remittance: Banks have branch network spread in various cities/ regions/States in the country of their incorporation/operations. Some banks have branches and correspondent banks overseas, as well. Banks remit customers’ funds from one place to another in the same country or overseas through their branches and correspondent banks by mail/ telegraphic/electronic funds transfer or by issuing bank drafts for which a small commission or fee is charged from the remitting person. This mode of fund transfer is fast, safe, secure and economical as compared to others, like post office money order and physical transfer of money.

(d) Miscellaneous services: In addition to the above, banks also render other services, which are useful to businesses and members of the society. These services include issue of credit/debit cards, safe deposit lockers, safe custody of valuables; issuance of traveller’s cheques, letters of credit and guarantees; collection of outstation cheques/bills/hundies; furnish‐ ing opinion reports on their customers; acting as agency services for government business, correspondents; trusteeship and executor’s busi‐ ness. These services are selectively performed by banks through their normal or specialized branches as per the customer needs at the respec‐ tive places. (Banks charge a commission or fee on such services, which provides the bank with non‐interest income and help to augments profits).

1.5.2. 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 undertaken by the banks.

One may note however, that though this is referred to as ‘Universal Banking’ (vide paragraph 1.6.1), all these services do not necessarily come within the ambit of commercial banking. 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 conversion of at least two foreign currencies belonging to the coun‐ tries 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 and these banks designate some of their branches to do foreign exchange business of specified kind. Cross‐border banking is classified as follows:

(i) Cross‐border fund‐raising services

� External commercial borrowing (ECB)

� Global depository receipts (GDRs)/American depository receipts

(ADRs)/International depository receipts (IDRs)

� Non‐resident external (NRE)/Foreign currency Non‐resident (FCNR) Accounts

� Syndication of foreign currency loans

(ii) Cross‐border Banking Services

� import financing/leasing

� export financing/forfeiting/leasing

1.5.3. Merchant banking ‐ Merchant banking refers to dealing with securities on fee basis without 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, imply‐ ing risk‐taking by a bank and earning interest spread. On the contrary, mer‐ chant banking 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.

1.6. 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 has spiralled upwards with major attention given to improvement of customer service. The 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. Banks are also increasing their balance sheet size with mergers and acquisitions and fresh capital issues with a view to reaping economies of scale and achieving larger penetration amongst the target customer segments. Some of these developments have crystallized into broad trends, as summarized in the following paragraphs.

1.6.1 Universal Banking ‐ It refers to the provision of a wide range of financial services by an organization, under one roof e.g. commercial banking, merchant banking (or investment banking), mutual funds and insurance ‐ all by one bank. Universal banking has resulted in the blurring of distinctive functional bound‐ aries 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). Universal banking usually takes one of three forms ‐ in‐house, or through separately capitalized subsidiaries, or through a holding company. Citibank and HSBC are examples 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 Banks 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.

1.6.2. Electronic Banking ‐ In the wake of recent developments in information and communication technologies, 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 upgradation of computerization by banks in India. The comput‐ erization is done for front‐office operations involving interface with customers as well as back‐office operations involving internal house keeping (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 any time banking’ and contributed to speed, accuracy and confidentiality of customers’ transactions while enhancing customers’ convenience. Funds transfer, cheques clearing and collection of bills of ex‐ change are also done electronically with accuracy, speed and safety. Internal house keeping 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.

1.6.3. Globalisation of Banking ‐ In addition to universal banking and electronic banking, globalisation 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 wish to set‐up their offices/branches in India have been granted licenses by RBI on liberal and on reciprocal basis. Their business in India has increased manifold, due to scores of Multinational Corporations setting up their manufacturing/trading bases in India and also due to India’s increased foreign trade.

Similarly, Indian banks are also opening their offices/branches abroad, parti‐ cularly in countries whose banks have opened offices in India.

1.7. LET US SUM UP: There is no statutory definition of ‘bank’ or ‘banking’ under British law. British jurists have defined a banker as one who in the ordinary course of his business honours cheques drawn upon him by persons from and for whom he receives money on current accounts. According to them keeping of deposits, current account and issue/payment/collection of cheques are the pre‐requisites of banking. In India, the Banking Regulation Act, 1949 defines banking as “accepting for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft and order or otherwise”.

The basic universal principles of banking which typically characterize banks are ‐ principles of intermediation, liquidity, profitability, solvency and trust. The principle of intermediation refers to banks acting as intermediary between the depositors or savers of money and borrowers or users of money, by lending the depositors’ money to the businesses and thereby earning interest differen‐ tial as a reward for risk taking on such lending, which the depositors are not ready to undertake (liquidity principle means managing their assets and liabilities in such a manner that the depositors can be paid back their money with interest on their demand. This is a very specialized task.)

Profitability principle refers to earning interest income mainly by way of interest differential between lending/investments and deposit rates as a reward for risk taking, and also fee‐ based income for various services rendered by banks.

Banks plough back a good portion of their profits into the business to enhance their reserves and financial strength, in addition to adhering to regulatory guidelines regarding capital adequacy ratio, asset classification and provision‐ ing for non‐performing assets, etc. This is referred as the principle of solvency. The principle of trust connotes confidence or dependability as perceived by customers and public in relation to a bank. The public confidence in a bank arises from the cumulative result of the policies of liquidity, profitability, and solvency and governance quality followed by each bank over a fairly long period.

The Indian banking system classifies banks into scheduled and non‐scheduled banks, public sector and private sector banks, Indian banks and foreign banks,


and commercial and cooperative banks. Scheduled banks satisfy the pre‐ scribed rules by RBI. RBI regulates the banking sector. Public sector banks are owned (over 51%) by the Central Government/the RBI or other public authori‐ ties and comprise three groups ‐ nationalized banks, SBI group of banks, Regional Rural Banks (RRBs). Private sector banks are owned by private entities and are either Indian banks or foreign banks. Indian private sector banks are further classified in two sub‐groups ‐ old generation (established prior to 1993) and new generation private sector banks (established after 1993). Cooperative banks are small size banks operating mainly for agriculture and allied activities in rural areas and small and tiny businesses in urban. Commercial banks generally concentrate on industry, trade, commerce in the urban centres and they also lend to agricultural and small businesses in the rural areas.

Banking functions are classified as traditional functions and modern functions. Traditional or core functions relate to deposit taking, lending, funds remittance and miscellaneous services, like safe deposit lockers, agency and trustee business. Modern functions of banks encompass a wide range of financial services to meet the customers’ varied requirements under ‘one umbrella’ e.g. cross‐border banking, merchant banking, credit card business, factoring, leasing and insurance. Some of these services are outside the ambit of commercial banking and fall under ‘Universal Banking’.

Among the emerging trends in the Indian banking system, the main trends that can be identified are : universal banking and electronic banking. As mentioned above, universal banking seeks to converge all kinds of financial services under one umbrella of an organization. ICICI Bank, SBI Group are instances of Universal banks registered in India and HSBC Bank, Citibank are among the foreign banks that are offering universal banking services in India. Internationalization of banking is another major trend in India in the wake of opening up of banking and finance sector for direct foreign investment since 1991. Indian banks are also becoming more global gradually by conducting more international banking business and opening their offices overseas.

1.8. CHECK YOUR PROGRESS:

(A) State whether the following statements are True or False:

(i) There is no statutory definition of ‘bank’ or ‘banker’ under UK law. (ii) According to Banking Regulation Act, 1949, a banking company is

one which transacts the business of banking outside India.

(iii) Interest differential between the interest rates of time deposits and savings bank deposits is termed as ‘interest spread’.

(iv) Solvency connotes long‐term financial soundness of a bank. (v) Regional Rural Banks are included in the category of scheduled

public sector banks.


(vi) ICICI Bank Ltd. is the largest bank in the private sector in India in terms of assets size.

(vii) Cooperative banks operate on profit motive in rural areas. (viii) Foreign banks in India are outside the regulatory control of RBI as

these are incorporated outside India. (ix) Nationalized banks group has the largest market share of total

bank deposits and advances in India.

(x) Traditional functions of banks include merchant banking. (xi) NRE deposits are a kind of domestic banking in India.

(B) (i) According to Sir John Paget, an authority on British Banking, a

banker must take deposits by way of ..............................account and issue/pay/collect ...........................

(ii) Banking Regulation Act defines banking as “accepting for the purpose of lending or investment, of ...................... of money from the public, repayable on .................................... or otherwise, and withdrawal by ..........................., draft, order or otherwise”

(iii) Intermediation principle means that banks mediate between............................... who are savers of money and .................................... who are users of money.

(iv) .............................................Management means the ability of a bank to meet the demand of its depositors and other creditors in time.

(v) A bank’s interest income arises from the interest differential between its .............and ...........................rates of interest.

(vi) Solvency of a bank indicates its ............................... soundness. (vii) The principle of trust shows the ........................... of a bank in the

perception of its .....................................

(viii) Public sector banks in India comprise ......................, ........................... and ............................... .

(ix) SBI was created in ........................... by an Act of.................................... . (x) Merchant banking involves .............based services connected with

capital market ................................

(xi) SBI is the largest ........................... sector bank in India.

(C) Write full form of the following acronyms:

(i) RBI

(ii) SBI

(iii) IDBI

(iv) RRB


(v) ROA

(vi) ROC

(vii) NPA

1.9. TERMINAL QUESTIONS: (i) Explain the essentials of the definition of ‘banking’ under Indian law.

Does the principle of Intermediation has any relevance to this definition and if so, how?

(ii) Explain the principles of liquidity, profitability, solvency and trust. Do these principles show any inter connection/inter se? If so, explain the inter‐relationships.

(iii) Distinguish between:

� commercial and cooperative banks,

� old and new generation private sector banks,

� commercial banking and merchant banking, and

� domestic and cross‐border banking.

(iv) What do you understand by universal banking? Give some examples of universal banks in India.

(v) What do you understand by electronic banking? What areas of banking are covered by information and communication technologies?

1.10. ANSWERS TO ‘CHECK YOUR PROGRESS’:

(A)

(i) True

(ii) False

(iii) False

(iv) True

(v) True

(vi) True

(vii) False

(viii) False

(ix) True

(x) False

(xi) False

(B)

(i) current cheques

(ii) deposits, demand, cheques


(iii) depositors, borrowers

(iv) liquidity

(v) loans deposits

(vi) financial

(vii) dependability, customers

(viii) nationalized banks, SBI Group and RRBs

(ix) 1955, Parliament

(x) fee, securities

(xi) public sector

(C)

(i) Reserve Bank of India

(ii) State Bank of India

(iii) Industrial Development Bank of India

(iv) Regional Rural Bank

(v) Return on Assets

(vi) Return on Capital

(vii) Non‐Performing Asset

Unit 1 - Introduction to Banking

Documents

Transcript of Unit 1 - Introduction to Banking