Lecture Notes
SYBCom: Business Economics Paper
II, (II Semester)
Dr. Ranga Sai
[Please follow class room instructions]
Commercial banking
Role
of commercial banking:
The finance sector is an important factor of rapid
development. The role can be explained as follows:
a. Commercial banking aids industrialization
by providing liberal trade credit or working capital.
b. Commercial banks through
their operations of mobilizing deposits and extending advances help in
redistribution of resources across regions.
c. By savings mobilization,
commercial banks help in capital formation.
d. Extensive banking sector can
improve the banking habits of people.
e. Entrepreneurship can be
promoted by commercial banking finance.
f. Commercial banking is looked
upon as an agent of economic growth.
Indian Banking system 12 marks
The Indian banking sector consists of the Reserve Bank
of India (RBI), which is the central bank, commercial banks and co-operative
banks.
Commercial banks are of two types –
1. Scheduled, which are subject to statutory requirements
and
2. Non-scheduled, which are not.
Scheduled banks can be further classified into
a. Public sector banks
comprising of the State bank of
b. Other nationalized banks
b. Regional Rural Banks and
c. Private sector banks,
which can be either domestic or foreign.
Public
Sector Banks
a. State Bank of
b. 20 nationalized banks
c. Regional Rural Banks mainly sponsored by Public Sector
Banks
Private
Sector Banks
a. Old generation private banks
b. New generation private banks
c. Foreign banks in
d. Scheduled Co-operative Banks
e. Non-scheduled Banks
Scheduled and Un-scheduled
Banks
The commercial banking
structure in
- Scheduled Commercial Banks in
- Unscheduled Banks in
·
Scheduled Banks
in
As on
"Scheduled banks in India" means the State Bank of India constituted
under the State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as
defined in the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959), a
corresponding new bank constituted under section 3 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970), or under
section 3 of the Banking Companies (Acquisition and Transfer of Undertakings)
Act, 1980 (40 of 1980), or any other bank being a bank included in the Second
Schedule to the Reserve Bank of India Act, 1934 (2 of 1934), but does not
include a co-operative bank".
"Non-scheduled bank in India" means a banking company as defined in
clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which
is not a scheduled bank".
Regional Rural banks
The Narsimham committee
conceptualized the creation of Regional Rural Banks in 1975 as a new set of
regionally oriented rural banks, which would combine the local feel and
familiarity of rural problems characteristic of cooperatives with the
professionalism and large resource base of commercial banks. Subsequently, the
Regional Rural Banks were set up through the promulgation of RRB Act1 of 1976.
Their equity is held by the Central Government, concerned State
Government and the Sponsor
Bank in the proportion of 50:15:35. Regional Rural Banks were supposed to
evolve as specialized rural financial institutions for developing the rural
economy by providing credit to small and marginal farmers, agricultural
laborers, artisans and small entrepreneurs.
A remarkable feature of
their performance over the past three decades has been the massive expansion of
their retail network in rural areas. From a modest beginning of 6 Regional
Rural Banks with 17 branches covering 12 districts in December 1975, the
numbers have grown into 196 Regional Rural Banks with 14,446 branches working
in 518 districts across the country in March 2004. Regional Rural Banks have a
large branch network in the rural area forming around 43 per cent of the total
rural branches of commercial banks.
During the year 2003-04,
163 Regional Rural Banks earned profits amounting to Rs.953 crore while 33
Regional Rural Banks incurred losses to the tune of Rs.184 crore. Ninety
Regional Rural Banks had accumulated losses as on
Growth of Banking In
Government
took major steps in this Indian Banking Sector Reform after independence. In
1955, it nationalized Imperial Bank of
Seven banks forming subsidiary of State Bank of
Second phase of nationalization Indian Banking Sector Reform was carried out in
1980 with seven more banks. This step brought 80% of the banking segment in
The following are the steps taken by the Government of India to Regulate
Banking Institutions in the Country:
- 1949 : Enactment of Banking Regulation Act.
- 1955 : Nationalization of State Bank of
- 1959 : Nationalization of SBI subsidiaries.
- 1961 : Insurance cover extended to deposits.
- 1969 : Nationalization of 14 major banks.
- 1971 : Creation of credit guarantee corporation.
- 1975 : Creation of regional rural banks.
- 1980 : Nationalization of seven banks with deposits over 200
crore.
Reserve Bank of India Act was passed in
1934 & Reserve Bank of India (RBI) was constituted as an apex bank without
major government ownership. Banking Regulations Act was passed in 1949. This
regulation brought Reserve Bank of
In 1955,
RBI acquired control of the Imperial Bank of
RBI was empowered in 1960, to force compulsory merger of weak banks with the
strong ones. The total number of banks was thus reduced from 566 in 1951 to 85
in 1969.
In July 1969,
government nationalized 14 banks having deposits of Rs.50 crores & above.
In 1980, government acquired 6 more banks with deposits of more than Rs.200
crores. Nationalization of banks was to make them play the role of catalytic
agents for economic growth. The Narsimham Committee report suggested wide
ranging reforms for the banking sector in 1992 to introduce internationally
accepted banking practices.
The amendment of Banking Regulation Act in 1993 saw the entry of new private
sector banks.
Nationalization
of Commercial banks 12/6 marks
Before
the steps of nationalization of Indian banks, only State Bank of India (SBI)
was nationalized. It took place in July 1955 under the SBI Act of 1955.
Nationalization of Seven State Banks of India (formed subsidiary) took place on
The State Bank of
After
the nationalization of banks, the branches of the public sector bank
Banking in the sunshine of Government ownership gave the public implicit faith
and immense confidence about the sustainability of these institutions.
The primary objective of bank nationalization in 1969
was to provide assistance at concessional rates of interest to relatively
backward areas. Pursuant to the nationalization, the banking sector became
dominated by a plethora of rules and regulations. Nationalization increased the
scale of banking operations substantially but, at the cost of profitability and
efficiency of the banking system; in many instances, this led to a piling of
Non Performing Assets (Non-performing assets) with the banks, causing major
concern.
The second phase of nationalization of Indian banks took place in the year
1980. Seven more banks were nationalized with deposits over 200 crores. Till
this year, approximately 80% of the banking segment in
After the nationalization of banks in
Major
issues in banking 12
marks
1. Capital Adequacy and Recapitalization of Banks
Out of the 27 public sector banks (Public sector banks), 26 Public sector
banks achieved the minimum capital to risk assets ratio (CRAR) of 9 per cent by
March 2000. Of this, 22 Public sector banks had CRAR exceeding 10 per cent. To
enable the Public sector banks to operate in a more competitive manner, the
Government adopted a policy of providing autonomous status to these banks,
subject to certain benchmarks. As at end-March 1999, 17 Public sector banks
became eligible for autonomous status.
2. Prudential Accounting Norms for Banks
The Reserve Bank persevered with the on-going process of strengthening
prudential accounting norms with the objective of improving the financial
soundness of banks and to bring them at par with international standards. The
RBI guidelines on SACs were aimed at reducing the stock of Non-performing
assets by encouraging the banks to go in for compromise settlements in a
transparent manner.
Recognizing
that the high level of Non-performing assets in the Public sector banks can
endanger financial system stability, the Government in 2001 set up seven more
Debt Recovery Tribunals (DRTs) for speedy recovery of bad loans.
3. Asset Liability
Management (ALM) System
The Reserve Bank advised banks in
1999 to follow ALM system. Banks were expected to cover at least 60 per cent of
their liabilities and assets in the interim and 100 per cent of their business
by
4. Disclosure Norms
Towards greater transparency, banks
were directed to disclose the following additional information since 2000: (i)
maturity pattern of loans and advances, investment securities, deposits and
borrowings, (ii) foreign currency assets and liabilities, (iii) movements in
Non-performing assets and (iv) lending to sensitive sectors as defined by the
Reserve Bank from time to time.
5. Technological Developments in Banking
In India, banks as well as other financial entities have entered the domain
of information technology and computer networking in 1999. A satellite-based
Wide Area Network (WAN) would provide a reliable communication framework for
the financial sector. The Indian Financial Network (INFINET) was inaugurated in
June 1999.
6. Revival of Weak Banks
The Reserve Bank had set up a Working
Group to suggest measures for the revival of weak Public sector banks in
February 1999. The Working Group, in its report suggested that an analysis of
the performance based on a combination of seven parameters covering three major
areas of i) solvency (capital adequacy ratio and coverage ratio), ii) earnings
capacity (return on assets and net interest margin) and iii) profitability
(operating profit to average working funds, cost to income and staff cost to
net interest income plus all other income) could serve as the framework for identifying
the weakness of banks. Public sector banks were, accordingly, classified into
three categories depending on whether none, all or some of the seven parameters
were met.
7. Deposit insurance system,
The
Reserve Bank constituted a Working Group (Chairman: Shri Jagdish Capoor) to
examine the issue of deposit insurance which submitted its report in October
1999.
Some
of the major recommendations of the Group are : (i) fixing the capital of the
Deposit Insurance and Credit Guarantee Corporation (DICGC) at Rs.500 crore,
contributed fully by the Reserve Bank, (ii) withdrawing the function of credit
guarantee on loans from DICGC and (iii) risk-based pricing of the deposit
insurance premium in lieu of the present flat rate system.
Recent developments in
financial sector 6 marks
The Public sector banks will play an important role in the industry due to its
number of branches and foreign banks facing the constraint of limited number of
branches. Hence, in order to achieve an efficient banking system, the onus is
on the Deregulation
of banking system
·
Public sector
banks were encouraged to approach the public for raising resources. Recovery of
debts due to banks and the Financial Institutions Act, 1993 was passed, and
special recovery tribunals set up to facilitate quicker recovery of loan
arrears.
·
The RBI has given
licenses to new private sector banks as part of the liberalization process.
·
Government to
encourage the Public sector banks to be run on professional lines.
·
Both banks and
insurance companies have started entering the asset management business
·
Bank lending
norms liberalized and a loan system to ensure better control over credit
introduced.
·
Banks asked to
set up asset liability management (ALM) systems. RBI guidelines issued for risk
management systems in banks encompassing credit, market and operational risks.
·
A credit
information bureau is being established to identify bad risks. Derivative
products such as forward rate agreements (FRAs) and interest rate swaps (IRSs)
introduced.
·
In order to reach
the stipulated capital adequacy norms, substantial capital were provided by the
Government to Public sector banks.
·
Statutory
liquidity ratio (SLR) and cash reserve ratio (CRR) brought down in steps.
·
Interest rates on
the deposits and lending sides almost entirely were deregulated.
New private sector banks were allowed to promote and encourage competition.
Shares of the leading Public
sector banks are listed on the stock exchanges.
Many banks are successfully running in the retail and consumer segments but are
yet to deliver services to industrial finance, retail trade, small business and
agricultural finance.
Central banking
Reserve
Bank of
The Hilton Young Commission
in 1926 originated the idea of Reserve Bank of
Formally, in 1935 RBI was established as an apex
institution and the nation's monetary authority. It had a division of two
separate activities viz. the issue department and the Banking department.
The Banking Regulation Act of 1949 gave RBI the
control and supervision of commercial Banks. The amendments to RBI Act in 1962
provided the RBI right of information from commercial banks regarding their
credit functions.
Currently, RBI has emerged as a potential apex
monetary authority with control over the capital markets, money markets,
foreign exchange markets and the monetary policy.
RBI as an apex institution has the overall control
over the monetary policy. It regulates the monetary economy by sets of
guidelines pertaining to interest rates, liquidity, lending operations of
financial institutions etc. It also promotes financial institutions to augment
Government of India.
The basic functions include:
1. Regulation of issue of banknotes
2. Maintenance of reserves with a view to securing
monetary stability and
3. Operating credit and currency system of the country to
its advantage
Reserve Bank
of
RBI as an apex institution has a variety of
functions in the areas of monetary issue and banking.
1. Issue Functions: Reserve Bank of
RBI issues currency under
the Minimum Reserve system. It maintains a fudiciary reserve system. It
maintains a fudiciary reserve made up Rs.115 Cr. worth of gold and Rs.85 cr.
worth of foreign exchange reserves. The total of Rs.200 cr. of fudiciary
balance constitute the minimum Reserve for the issue of currency. Annually, the
monetary growth is conditioned by monetary resources; but the growth of
monetary resources touch the 18% mark. This is due to the deficit financing
activities undertaken by the Government.
2. Banking for the Government : Reserve Bank of
The recent memorandum of
understanding between RBI and Government pegs the treasury bills to Rs.6000 cr.
per anum. In excess of which, the Government has to indulge in commercial
borrowings.
On behalf of the Government,
RBI maintains the provident fund and small savings accounts. In case of
emergencies these constitute an important source for financing public
expenditure.
RBI also maintains the
public debt. On behalf of the Government, RBI issues instruments of public debt
and redemption. It advises the Government on issues of rescheduling, repayment
and now instruments of Government securities.
3. Bankers' Bank : RBI provides the basic banking functions in addition to control and
regulations. It provides the rediscounting facility. This rediscount rate is
called as the Bank rate. The commercial banks, depending on their liquidity
needs can rediscount the commercial bills already discounted by them. This way
RBI organizes the commercial Bill market. In the reinforcing Indian Bill
market, RBI has a prominent place. At a bank rate of 10%, RBI provides
liquidity, needed by banks.
The commercial banks
rediscount bills in bunches of Rs. 50,000 and denominations of Rs. 5,000. The
Narasimham committee provided the much needed reforms to the Bill market by
stipulating realistic guidelines. For the purpose of bill market operations,
the discounting and finance House of India is being promoted.
RBI maintains the reserves
of the commercial banks. The cash Reserve and statutory liquidity Reserve are
the important stipulation of the functioning of the commercial banks. In this
regard the Narasimham committee suggested that the SLR be reduced to 25%
progressively from the existing 38%. Similarly, the CRR be reduced to 10% from
the existing 15%.
4. Forex Reserves : All international transactions are routed through RBI. Due to this
RBI can maintain the needed forex resources. At any point of time it is
expected to maintain, forex position enough for 45 to 90 days import bill. For
this purpose RBI can advise the Government to seek foreign assistance from IMF,
World Bank or similar sources.
It also actively
participates in the foreign exchange market. The value of rupee is maintained
by RBI. Earlier the value of the currency was administered by exchange
controls. The convertibility of Rupee has given free hand to the exchange
market to determine the value. However, RBI controls convertibility on current
account and capital account in a restricted way.
RBI may also suggest
devaluation to suit the BOP position. At the instance of RBI, in 1991,
devaluation was effected in two rounds, to the tune of 18%.
RBI is the facilitator of
exports in co-ordination with the ministry of commerce. Export promotion
measures are also taken up by RBI. The FERA is effectively implemented by RBI.
5. Credit Control: As the apex authority of monetary policy, RBI controls credit. The
operations of commercial banks are regulated to contain credit. The position in
the capital, money and financial markets is monitored by the credit policy.
It uses a variety of
measures like Bank rate policy, variable reserve policy and open market
operations to control credit. These measures give rise to rediscounting
operations reserve regulations and government securities trading.
Qualitatively, RBI issues
credit regulatory directives to commercial banks to suit monetary policy.
RBI together with its
subsidiaries plays an important role in the monetary sector. RBI is guided by
the general objectives like controlling inflation, stabilizing investment,
sectoral balance, generation of employment and financing of government projects
and schemes.
6. Development Functions: RBI is the executive head of the monetary policy.
It has an advisory role is framing monetary policy and economic legislation for
smoother functioning of monetary economy. RBI may even develop financial
infrastructure or promote institutions.
Among the prominent
institutions promoted by RBI, important ones are IDBI, NABARD, Agricultural
finance and refinance co-operations etc.
Its publication department
comes out with research reports and data periodically. RBI is actively engaged
in economic research.
It has consultancy function
for various commercial, co-operative banks and term lending institutions.
Thus RBI evolves as a
custodian of Indian monetary system, supporting the policy objectives.
Development
Functions of RBI
With economic growth assuming a new urgency since
Credit
Control 12
marks
Credit created by the commercial banks constitute an
important part of the total money supply in the economy. Any attempt to control
money supply in the economy should necessarily consider methods of controlling
credit as well.
This is the basic objective of monetary policy. Credit control is done by
apex monetary institution viz. the Central bank. The central bank as an important part of its
functions carries out credit control.
Credit control refers to the
activity of regulating the credit being created by the commercial banks. The credit control is done by the apex
monetary institution of the Government viz. the central bank. By credit control
the central bank can increase, decrease, channelize credit from one sector of
the economy to the other.
Credit control can be done
in two ways.
Quantitative
credit control : 12 marks
When the technique of credit control only regulates
the volume of credit it is called as quantitative credit control.
The total credit within the
economy can be regulated by using three techniques. Each method can increase or decreases the
volume of credit.
1. Bank rate policy :
Demand side
Bills
retained
Supply
of credit
Bills
retained
|
|
Supply
of credit |
Supply side
The rate of rediscount of
first class bills by the central bank is called as the bank rate. By changing
the bank rate the volume of credit can be influenced. A change in the bank rate
can influence the supply and the demand of credit, this affects the total
volume of credit.
Working of the Bank Rate Policy: Suppose, there is an increase in the bank
rate, then the following changes take place.
An increase in the bank rate
will discourage the commercial banks to rediscount the bills from the central
bank. This affects the ability of Commercial bank to advance credit. On the
other hand, with an increase in the bank rate the lending rate may increase
which will reduce the demand for credit. Finally, the volume of credit
decreases.
2. Variable Reserve Ratio: The
Commercial banks are required to maintain a statutory reserve for liquidity
purposes. By increasing or decreasing this reserve requirement the creation of
credit can be regulated. It is seen that
with 20 percent reserve the deposit multiplier will be 5 and with a 25 percent
reserve the deposit multiplier decreases to 4. Accordingly, the credit creation
also decreases. Larger the liquidity reserve requirement, lower will be the
capacity of credit creation.
3.
4. Open Market Operations: The
Government securities are purchased by the commercial bank under statutes. The
Central bank stipulates the amount of Government securities to be bought by the
commercial banks. Open market operations deal with purchase and selling of the
Government securities by the Central bank. The buying operations increase the
loanable funds with commercial banks and credit increases. Similarly, the
selling operations decrease the loanable funds with the commercial banks and
the credit creation comes down. The open market operations, thus, take place in
two ways.
Selective
Credit Control: 6 marks
This is also called as the qualitative credit
control. The techniques of selective credit control regulate the usage and also
the volume of credit in various user sectors of credit. The selective credit
control is generally useful in canalizing credit from the less productive
sector to the productive sector. The following are the important techniques of
selective credit control.
1. Margin Requirement:
Commercial banks seek securities for advances. On the value of securities
certain amount is retained as margin and the loan is advanced only on the
remaining value. The share of margin can be used for promoting or reducing
credit among various uses. For encouraging advances lesser margin is sought and
for discouraging, larger margin may be insisted upon.
2. Consumer credit regulation :
Consumer credit is considered inflationary. Credit for the purpose of
consumption will increase demand and the prices will increase. Hence controls
on consumer credit can reduce demand and
prices.
3. Rationing of credit : The central bank may impose proportions of
credit going for various sectors. The
proportions are determined depending on the priorities. Larger share can be
apportioned for desirable activities and credit can be reduced for less
desirable sectors.
4. Control by directives : The
central bank may issue directives with regards to credit. Depending on the
policy of the government, the commercial banks are regulated to perform credit
functions.
5. Direct action : The central
bank may impose restrictions on advances. In case the commercial bank violates
the directives, the central bank may take punitive action by way of penal rate
of rediscount or debarring from rediscount facility.
6. Moral suasion : This is a
normative method of credit control. The central bank appeals to the commercial
banks and solicits their cooperation in following the national policy on credit
control and monetary policy.
FINANCIAL MARKETS
A Financial Market
can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for
real goods or services, a financial transaction involves creation or transfer
of a financial asset. Financial Assets or Financial Instruments represents a
claim to the payment of a sum of money sometime in the future and /or periodic
payment in the form of interest or dividend.
Money Market- The money market
ifs a wholesale debt market for low-risk, highly-liquid, short-term
instrument. Funds are available in this market for periods ranging from a
single day up to a year. This market is dominated mostly by government,
banks and financial institutions.
Capital Market - Capital
market is designed to finance the long-term investments. The transactions
taking place in this market will be for periods over a year.
Forex Market - The Forex market
deals with the multicurrency requirements, which are met by the exchange of
currencies. Depending on the exchange rate that is applicable, the
transfer of funds takes place in this market. This is one of the most
developed and integrated market across the globe.
Credit Market- Credit market is
a place where banks, Financial Instituions and Non Bank Finance Companies
purvey short, medium and long-term loans to corporate and individuals.
Nature and characteristics of Indian money markets 12 marks
Money
market deals with the short term financial requirement of Industry, trade and
commerce, The capital markets provide the long term capital needs. The
development banks, stock exchanges and other financial intermediaries provide
the long term finances. As against this, the money markets provide short term
financial resources ranging from a single day to 364 day credit.
In
The
organized money market mostly caters to the needs of the industry, trade and
commerce: the agricultural sector remains isolated. Though agriculture happens
to be a dominant sector, money markets do not cater as an organized activity.
The
dualism in the money markets have parallel institutions. The organized markets
have commercial banks, co-operative banks, regional rural banks, IFCI, IDBI,
RBI etc. The unorganized markets are made of local money lenders, multani bankers, nidhis, chit funds, indigenous bankers etc. Only organized
institutions come under the purview of RBI control and the monetary policy.
Organized
money markets :
The
organized money markets are made up to of registered financial institutions
whose activities are subject to monetary regulations. These financial
institutions work under the guidelines issued by RBI. Organized sector is very
responsive to the changes in the monetary policy. Being, organized
institutions, there is better co-ordination between various agencies and also
with RBI.
The
strength, operations and transactions determine liquidity in the money markets.
There are several policy instruments which can govern liquidity in the organized
money markets.
There
are several instruments operating in the money markets like treasury bills,
trade bills, commercial papers, deposit certificates and other short term
instruments.
The organized markets can be further sub divided into
a.
Call money market,
b.
Treasury bill markets,
c.
Commercial bill market,
d.
Certificates of deposit market, and
e.
Commercial paper market.
1.
Call money markets :
·
The call money market is operated by commercial banks to maintain their
liquidity position. For meeting the liquidity demands of the operations, the
commercial banks transact between them and other institutions.
·
These are the transactions of very short period, of one day. They are
renewable on the next day. This takes place as an inter bank transactions.
·
The rate of interest depends on the market. In
·
Call money markets in mostly confined to
·
State Bank of
·
The markets only caters to the needs of liquidity adjustments of the
commercial banks.