INDIAN BANKING

S.NatarajanDeputy General Manager (Retd.),

Reserve Bank of India,Department of Banking Supervision,

Central Office, Mumbai.

Dr. R.ParameswaranAssociate Professor,

Department of Commerce,T.S.A.A.S.T. College, Perur,

Coimbatore, Tamil Nadu - 641010.

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First Edition 2001Subsequent Editions and Reprints 2002, 2003, 2004, 2005, 2007 (Twice), 2010Thoroughly Revised Edition 2012ISBN : 81-219-2037-X Code : 07A 330 printed in india

By Rajendra Ravindra Printers Pvt. Ltd., 7361, Ram Nagar, New Delhi -110 055 and published by S. Chand & Company Ltd., 7361, Ram Nagar, New Delhi -110 055.

PREFACE TO THE REVISED EDITION

World over, dramatic changes are taking place in banks and banking operations. The global financial integration has brought about a bigger challenge to the Indian banking. Indian banks are bracing up to meet the standards set by supranational bodies like Bank for International Settlements (BIS) with regard to various prudential measures. The complexities of banking operations in the recent years have undergone significant changes due to innovations in the banking products and cross-border dealings.

Although the purpose of this book “Indian Banking (Theory)” is intended to provide basic information and procedures that will enable degree-level students to understand the evolutionary changes in the Indian banking, its structure and purpose, the ongoing developments, etc., the req-uisite information on various aspects of emerging trends in banking operations have been amply provided in this book. Many topics, particularly those relating to traditional banking are covered in a comprehensive fashion to enable the students to understand and appreciate the developments which are taking place in the Indian banking industry.

Numerous tables, figures and examples are used throughout this book. They are most up-to-date data available on the relevant topics. Chapters on Bank Accounts of non-residents have been added. This book also contains chapters on Merchant Banking, Factoring Services and Mutual Funds as, many Indian banks have set up subsidiaries to undertake these functions. These additions and illustrations will enhance the utility of this book. The chapter Banking and Technology is given in detail covering the modern day trends in Banking Industry.

Banks have become a part and parcel of all economic activities in India. The social banking adopted through nationalisation is another example to this. The students who deeply involved themselves in the fields of business and finance are in dire need of knowing about banking and the underlying principles behind their functions. Understanding of the developments of banks, their systems and organisations, basic concepts and their functions is of paramount importance to the students of Commerce, Management and Corporate Secretaryship. On recognising the same, the universities have introduced the subjects “Indian Banking” / “Banking Theory” for students of Commerce/Economics/Banking and other related courses. The authors had this view in mind while preparing the contents of this book. It is also a useful guide to anyone who is desirous of understanding the basic concepts, operations of banking and the emerging trends in the Indian banking industry. Care has been taken to reduce the complex vocabulary to the minimum. Charts and diagrams are also used to enable the students to capture the essence of the concepts and ideas at a glance.

S. NatarajanDr. R. Parameswaran

Disclaimer : While the authors of this book have made every effort to avoid any mistake or omission and have used their skill, expertise and knowledge to the best of their capacity to provide accurate and updated information. The authors and S. Chand do not give any representation or warranty with respect to the accuracy or completeness of the contents of this publication and are selling this publication on the condition and understanding that they will not be made liable in any manner whatsoever. S.Chand and the authors expressly disclaim all and any liability/responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything and everything forming part of the contents of this publication. S. Chand shall not be responsible for any errors, omissions or damages arising out of the use of the information contained in this publication.Further, the appearance of the personal name, location, place and incidence, if any; in the illustrations used herein is purely coincidental and work of imagination. Thus the same should in no manner be termed as defamatory to any individual.

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ACKNOWLEDGEMENT

The authors gratefully acknowledge the valuable efforts, suggestions and clarifications provided by many in bringing out this book to life.

We gratefully acknowledge the valuable guidance and suggestions provided by Shri C.R. Gopalasundaram, Principal, Bankers Training College in bringing out this book.

We are thankful to our teachers, colleagues and friends for their significant support. Our thanks are also due to Dr. Amarchand of University of Madras and Mrs. Alagammal, Principal, Sri Parasakthi College for Women for their encouragement and advice. We owe a special gratitude to friends in the banking industry particularly the Library Staff of Reserve Bank Staff College and Department of Economic Analysis and Policy (RBI Library), Messrs. L.Ponnudurai (DIT), N.M. Ansari and R.D. Bangar (DRRP) of Reserve Bank of India, P. Krishnamoorthy of Indian Bank and M.V. Ravichandran of Punjab National Bank. We express our grateful thanks to every one who have contributed even in a small way towards successful completion of this book.

We are honoured by the grace and blessings of His Holiness Thavathiru Santhalinga Ramaswamy Adigalar.

We are deeply indebted to the professionals and publishers, S.Chand & Company Ltd., Notably Mrs. Nirmala Gupta, CMD; Shri Navin Joshi, EVP; Mr. D.R. Parab, Assist. Regional Manager; Mr. P. Rajalingam, Senior Branch Manager; Mr. V. Chandrababu, Branch Manager, for their constant encouragement and co-operation throughout the process of bringing out this book successfully.

Mrs.Indubala Natarajan deserves special thanks for her support and encouragement during the preparation of this book.

Suggestions for improvement in the contents and quality of this book will be gratefully acknowledged.

S. Natarajan Dr. R. Parameswaran B-2/66 Snehadhara Associate Professor in Commerce, Dadabhai Cross Road No.3 T.S.A.A.S.T College, Mumbai-400 056 Perur, Coimbatore-641 010

E-mail: SNR _9669@hotmail.com

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CONTENTS

Chapters Page No

1. INTRODUCTION 1–28

1.1. Evolution of Financial System 1 1.1.1. Central Role of Banking in the Economy 3 1.2. Evolution of Banking 4 1.2.1. Banking Company 5 1.2.2. Banking 5 1.3. Development of Banking in India 5 1.3.1. Number of Bank Branches 7 1.3.2. Meaning and Definition of Banking 7 1.3.3. Scheduled Banks 8 1.4 Features of Banking 8 1.5 Classification of Banks 9 1.6 Banking Systems 12 1.6.1. Unit Banking 12 1.6.2. Branch Banking 14 1.6.3. Correspondent Banking System 19 1.6.4. Group Banking 19 1.6.5. Chain Banking 20 1.6.6. Pure Banking and Mixed Banking 21 1.6.7. Relationship Banking 22 1.6.8. Narrow Banking 22 1.6.9. Universal Banking 22 1.6.10. Regional Banking 22 1.6.11. Local Area Banks 23 1.6.12. Retail Banking 23 1.6.13. Wholesale Banking 23 1.6.14. Private Banking 23 1.7 Banks and Economic Development 24 2. NATIONALISATION AND PRIVATISATION OF BANKS 29–37 2.1 Social Control over Banks 29 2.2. Nationalisation of Major Commercial Banks 30 2.3. Reasons for Nationalisation 31 2.4. Criticisms against Nationalisation of the Banks 33 2.5. Achievements after Nationalisation 34 2.6. Privatisation of Banks in India 34

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3. MONEY MARKET 38–58 3.1. Definition of Money Market 38 3.2. Objectives of Money Market 38 3.3. Features of Money Market 39 3.4. Money Market and Capital Market 39 3.5. Constituents of Money Market 41 3.6. Sub-Markets of the Money Market 42 3.7. Characteristics of Developed Money Market 42 3.8. Importance of a Developed Money Market 44 3.9. Indian Money Market 44 3.9.1. Role of RBI in Indian Money Market 44 3.9.2. Structure of Indian Money Market 45 3.9.3. Money Market Instruments in India 45 3.10. Discount and Finance House of India 55 3.11. Comparison of London, Newyork and Indian Money Market 56 4. COMMERCIAL BANKS 59–80 4.1. General Classification of Banks 59 4.2. Functions of Commercial Banks 60 4.2.1. Primary Functions of Commercial Banks 60 4.2.2. Secondary Functions of Commercial Banks 65 4.2.3. Fee Based Services of Commercial Banks 67 4.3. Lending to Sensitive Sectors 72 4.4. Balance Sheet of Commercial Banks 73 4.5. Off-Balance Sheet Items 78 5. CREDIT CREATION 81–88 5.1. Loans Create Deposits 81 5.2. Simple Credit Creation 81 5.3. Multiple Expansion/Creation of Credit 82 5.4. Scope for Multiple Creation of Credit 84 5.5. Credit Contraction 84 5.6. Limitations on Credit Creation 85 5.7. Criticism of the Theory of Credit Creation 87 6. COMMERCIAL BANKS AND RURAL FINANCING 89–103 6.1. Commercial Banks and Rural Credit 89 6.2. Different Types of Agricultural Advances 91 6.3. Institutional Setup for Rural Credit 95 6.4. Lending to Priority Sectors by Commercial Banks 95 6.5. Priority Sector Advances- Performance 97 6.6. DRI Scheme 102 7. CO-OPERATIVE BANKS AND DEVELOPMENT BANKS 104–138 7.1. Co-Operative Banking in India 104 7.1.1. Differences between Co-operative Banks and Commercial Banks 104

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7.1.2. Co-operative Banking in India (Types) 105 7.1.3. Types of Co-Operative based on Structure 107 7.2. Regional Rural Banks 111 7.2.1. Objectives of Regional Rural Banks: 112 7.2.2. Capital Structure and Sponsorship: 112 7.2.3. Management of Regional Rural Banks: 113 7.2.4. Area of Operation: 113 7.2.5. Functions of RRBs: 113 7.2.6. Factors Influencing the Performance of RRBs 113 7.2.7. Consolidation of RRBs 114 7.2.8. Progress and achievement of RRBs 114 7.3. Development Banks 116 7.3.1. National Bank for Agriculture and Rural Development (NABARD) 118 7.3.2. Industrial Finance Co-operation of India (IFCI) 118 7.3.3. Industrial Development of India (IDBI) 121 7.3.4. Small Industries Development Bank of India (SIDBI) 122 7.3.5. Export-Import Bank of India (EXIM Bank) 122 7.3.6. Service of IFCI 123 7.3.7. Targeted Business Segments 125 7.3.8. Some Sectors that have directly benefited from IFCI include 125 7.3.9. Main Functions of IDBI 126 7.3.10. Schemes of SIDBI 130 7.3.11. ICICI Bank Products & Services 133 7.3.12. Financing and Services of EXIM Bank 135 8. CENTRAL BANKING 139–145 8.1. Definitions of Central Bank 139 8.2. Nature of Central Banking 140 8.3. Central Banking and Commercial Banking 140 8.4. Functions of the Central Bank 141 9. CENTRAL BANKING AND CREDIT CONTROL 146–158 9.1. Meaning of Credit Control 146 9.2. Advantages and Dangers of the Credit Creation 146 9.3. Methods of credit control 147 9.3.1. Quantitative Methods of Credit Control 147 9.3.2. Qualitative/Selective Methods of Credit Control 153 9.4. Monetary Policy of the Central Bank 156 10. RESERVE BANK OF INDIA 159–174 10.1. Objectives for Establishment of RBI 159 10.2. Evolution of the Reserve Bank of India 160 10.3. Management and Administration of Reserve Bank of India 160

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10.4. Functions of Reserve Bank of India 162 10.4.1. Traditional Functions 163 10.4.2. Promotional Functions 169 10.4.3. Supervisory Functions 171 10.5. RBI Balance Sheet 171 11. RESERVE BANK OF INDIA AND CREDIT CONTROL 175–188 11.1. Methods of Credit Control 175 11.1.1. Quantitative Credit Control by RBI 176 11.1.2. Qualitative/Selective Credit Control by RBI 185 12. RBI- AGRICULTURAL AND INDUSTRIAL FINANCE 189–200 12.1. Reserve Bank of India and Agricultural Finance 189 12.1.1. Agricultural Credit Department 189 12.1.2. Funds for Agricultural Development 190 12.1.3. Financial Assistance to co-operative sector 190 12.1.4. Establishment of Agricultural Credit Board 191 12.1.5. Establishment of NABARD: 191 12.1.6. National Agricultural Insurance Scheme 194 12.2. Reserve Bank of India and Industrial Finance 195 12.2.1. Establishment of Institutional Framework for Industrial Finance: 195 12.2.2. Transfer of Loan Accounts from one Bank to Another 196 12.2.3. Bridge Loan 196 12.2.4. Prompt Settlement of Bills of Small Scale Industrial Units 196 12.2.5. Role of RBI in Rehabilitation of Sick Industrial Units 196 12.2.6. High Level Committee on Credit to SSI 196 12.2.7. Export Finance 196 12.2.8. Foreign Exchange Benefits 197 13. STATE BANK OF INDIA 201–216 13.1. Evaluation of State Bank of India 201 13.2. Nationalisation of the Imperial Bank 201 13.3. Management of the Bank 203 13.4. Structure and Organisation of the Bank 204 13.5. Functions of State Bank of India 205 14. CREDIT CARDS 217–226 14.1. Meaning and Definition of Credit Card 217 14.2. Mechanism of Credit Card Operation 218 14.3. Types of Credit Cards 219 14.4. Advantages of Credit Cards 220 14.4.1. Benefits to the Bank 221 14.4.2. Benefits to the Cardholder 222 14.4.3. Benefits to the Merchant Establishments 222 14.5. Limitations of Credit Cards 223 14.6. Farmers’ Credit Card 223

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15. MERCHANT BANKING 227–241 15.1. Definition of Merchant Bankers 227 15.2. Reasons for the Growth of Merchant banking in India 228 15.3. Objectives of Merchant Banking 228 15.4. Features of Merchant Bankers 229 15.5. Difference between Merchant banking and Commercial Banking 230 15.6. Types of Merchant Banking Organizations 230 15.7. Functions of Merchant Bankers 231 15.8. Merchant Banking in India-SEBI Guidelines on Merchant Banking 238 16. FACTORING SERVICE 242–252 16.1. Factoring: Conceptual Frame work 242 16.2. Definition of Factoring 243 16.3. Features of Factoring Service 243 16.4. Mechanism of Factoring 243 16.5. Factoring –Combination of Services 245 16.6. Factoring and Bill Discounting 245 16.7. Types of Factoring 246 16.7.1. Domestic Factoring 247 16.7.2. International Factoring 248 16.8. Benefits of Factoring service 249 16.8.1. Benefits to the Clients 249 16.8.2. Benefits to the Banks 250 16.9. Limitations of Factoring 250 16.10. Factoring in India 251 17. MUTUAL FUNDS 253–266 17.1. Meaning of Mutual Fund 253 17.2. Concept of operation of mutual funds 253 17.3. Organisation of Mutual Fund 254 17.4. Types of Mutual Fund Schemes 257 17.5. Regulation of Mutual Funds in India 260 17.6. Net Asset Value of a Mutual Fund Scheme 262 17.7. Advantages of Mutual Funds 262 17.8. Risks Involved In Mutual Funds 264 18. ACCOUNTS OF NON-RESIDENTS 267–272 18.1. Foreign Exchange Management Act 1999 267 18.2. Non-Resident Indians (NRIs) 267 18.3. Types of NR Accounts 267 18.3.1. Rupee Accounts 268 18.3.2. Foreign Currency Accounts 269 18.4. Foreign Currency Accounts of Residents 269 18.5. Importance of NR Accounts 271

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19. CUSTOMER SERVICE AND OMBUDSMAN SCHEME 273–281 19.1. Customer Orientation 273 19.2. Basic Aspects of Customer Service 274 19.3. Know Your Customer (KYC) Policy 275 19.4. Banking Ombudsman Scheme 278 20. RECENT TRENDS IN INDIAN BANKING 282–295 20.1. Types of Financing 282 20.2. Repayment Methods 285 20.3. Venture Capital 285 20.4. Banknet 286 20.5. Deposit Insurance Scheme 286 20.6. Gold Deposit Scheme 287 20.7. Core Banking Systems 288 20.8. Bancassurance 288 20.9. Multi-Dimensional Developments of Commercial Banking in India 289 21. BANKING AND TECHNOLOGY 296–319 21.1. Importance of Technology in Banking Industry 297 21.2. Delivery Channels of Banking Sector 298 21.3. Internet Banking 305 21.4. E-Banking 306 21.5. Electronic Banking in India 312 21.5.1. RTGS -Electronic Payment System 313 21.5.2. NEFT -National Electronic Funds Transfer 314 21.5.3. Cheque Truncation 315 21.5.4. NSS- National Settlement System 315 21.5.5. SFMS -Structured Financial Messaging System 315 21.5.6. SWIFT-Receiving Payments from Outside India 316 21.6. Computerisation of Bank Branches 316ANNEXURE-I 320 Banking Sector Reforms- Second Narasimham Committee Report; Financial Markets –Reform Measures. ANNEXURE-II 325 Indian Banks AssociationANNEXURE-III 326 List of Commercial Banks in IndiaModel Question Papers 328

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1.1 EVOLUTION OF FINANCIAL SYSTEMBefore examining the evolution and importance of banking, we must know the meaning of

money. Money cannot originate by order of the Government or by some sort of social agreement by the people and it must always originate in the processes of the free market. Before the coin/cur-rency system, there was barter system. Goods were produced by the people who were familiarize in that production, and their surpluses if any were exchanged for the goods produced by others. Every product had its exchange price in terms of all other products. Thus, their needs were fulfilled with the process of exchange ie., barter system. It was carried on the basis of mutually beneficial exchanges.

In barter, there were certain basic limitations:

1

CHAPTER

1INTRODUCTION

2 Indian Banking

At the first, the barter system makes it difficult the creation of market where the merchants buy stocks of goods in exchange for value of something in common. Under barter system merchants cannot go on buying all kinds of commodities in anticipation of future sales.

Regarding the second problem the scope of barter system is very limited and hinders the pro-cess of exchange. For example, if a meat dealer wanted to buy cloths, he had to find a weaver who wanted to buy meat at the same time. If the weaver had sufficient meat with him already, how was the meat dealer going to buy cloth ? He was not sure that he could find a weaver who needed meat. This feature of barter system is called the double coincidence of wants.

The third problem is due to indivisibility nature of some goods. For example a person owns a house would like to sell it and instead, purchase a motor vehicle, household furniture and the like. How can the person get those things under barter system ? He could not split his house into different segments and exchange each one for other products. Since the house is indivisible and lose all of their value if it gets split in to different segments, we face unsolvable problems. The same would be true of motor cars, machines, and other large-sized products. If houses or motorcars or machines can not easily be bartered, they are not produced in large quantity. The next severe problem with the barter system is that it is difficult to compute business results. Business firms must be able to calculate whether they are making or losing income in each of their transactions. But in the barter system, computation of profit or loss would be a very difficult task.

Therefore barter system could not manage modern industrial economies. And to overcome the limitations of barter system the money was invented. Thus, money is the advancement in the history of civilization and in man’s economic progress. Money as an element of exchange permits people to overcome all the difficulties of barter system. It should be noted that by the introduction of money the act of sale is separated from the act of purchase. Now to have a better living, man struggles hard to earn money–the medium of exchange. When he earns more to his requirements, he wanted to employ those surplus funds. The flows of money facilitate lending and borrowing transactions in the economy. This obviously encourages economic development and paves the way for the efficient financial system in the economy.

The financial system of an economy includes financial institutions and financial markets. From the following diagram we can easily understand the roles of a financial system.

Introduction 3

Here, the expected return is a claim for a certain sum of money at some future date..The important roles of the financial system include the following:

(i) Facilitate lending and borrowing (3) (ii) Enable Households to adjust their investment portfolio in financial markets (iii) Provides payments mechanism (2)

1.1.1 Central Role of Banking in the EconomyTo facilitate this circular flow of funds, we need financial intermediaries. In all types of econo-

mies, both developed and developing, banks play a vital role in their respective financial system. Especially, in developing economies, where the middle income and lower income groups forms majority, the role of banks is inevitable to move the economy to the next stage.

The main reasons for the existence of banks as financial intermediary include the following: (a) Diversified needs of funds for borrowers and returns for lenders. (b) Transaction costs associated with search of funds

(a) Diversified needs of funds for borrowers and returns for lenders:Firms borrowing funds to finance their investment proposals, aim to repay the borrowing over

the expected life of the investment. The perceived problem associated with direct lending is that the securities issued by the firms may have a default risk depending on the nature of business invest-ment. Thus, the lenders generally prefer to lend to the investments which are relatively liquid and low-risk. The expectations of borrowers and lenders are contradictory in nature. To reconcile these contradictory requirements of lenders and borrowers banks as financial intermediaries perform the basic function of accepting deposits from households and lending loans and advances to firms by minimizing the risks to investors.

(b) Transaction costs associated with search of Funds:The transaction costs associated with the search of funds makes it very difficult for a potential

lender to find an appropriate borrower. The transaction costs relating to this includes the following: (i) Cost of Searching for Borrowers and Lenders: It is the cost arising out of searching for the

suitable borrowers\lenders and for collecting information about them.

4 Indian Banking

(ii) Cost of Verification: To avoid risks lenders need to verify the accuracy and authenticity of the information provided by borrowers.

(iii) Monitoring costs: After the provision of loans, the lenders to avoid the default risk must monitor the activities of the borrowers.

(iv) Cost of Enforcement: Such costs arise when there is a breach of contract or any default done by the borrower. In such a situation, the lender may have to enforce the terms of the contract agreed upon initially, or to recover the debt in case of default.

All these costs are minimized by the existence of banking institutions and their efficient opera-tions in the economy. Banks as financial intermediaries contribute to risk management by monitor-ing borrowers to whom credit has been extended. Bankers play very important role in the economic life of the nation. The health of the economy is closely related to the soundness of its banking system. Although banks create no new wealth but their borrowing, lending and related activities facilitate the process of production, distribution, exchange and consumption of wealth. In this way they become very effective partners in the process of economic development.

1.2 EVOLUTION OF BANKING The development of ‘Banking’ is evolutionary in nature. There is no single answer to the ques-

tion of what is banking. Because, a bank performs a multitude of functions and services which cannot be comprehended into a single definition. For a common man, a bank means a storehouse of money, for a businessman it is an institution of finance and for a worker it may be a depository for his savings.

It may be explained in brief as “Banking is what a bank does”. But it is not clear enough to understand the subject in full. The Oxford Dictionary defines a bank as “an establishment for the custody of money which it pays out on a customer’s order”. But this definition is also not enough, because it considers the deposit accepting and repayment functions only. The meaning of the bank can be understood only by its functions just as a tree is known by its fruits. As any other subjects, it has its own origin, growth and development . Let us briefly trace the evolution of Banking.

It is interesting to trace the origin of the word ‘bank ’ in the modern sense, to the German word ‘‘Banck” which means, heap or mound or joint stock fund. From this, the Italian word “Banco” meaning heap of money was coined.

Some people have the opinion that the word “bank” is derived from the French words “ban-cus” or “banque” which means a ‘bench’. Initially, the bankers, the Jews in Lombardy, transacted their business on benches in the market place and the bench resembled the banking counter. If a banker failed, his ‘banque’ (bench) was broken up by the people, hence the word “bankrupt” has come. In simple term, bankrupt means a person who has lost all his money, wealth or financial resources.

Thus, the origin of the word bank can be traced as follows.

Indian Banking

Publisher : SChand Publications ISBN : 9788121920377Author : S.Natarajan, Dr.R.Parameswaran

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