MODULE 1COMMERCIAL BANKS

Banks and Banking

• Banks are institutions that take care of the money of individuals and corporates, provide loans to people for business or personal use. They also offer a wide range of services like exchange of foreign currency, Investment Banking, Mutual Funds, Insurance Business, D-mat services, Online trading of shares, providing public utility services like e-tickets, payment of bills, educative services etc.

Stages in the History of Banking

History of Banking has been divided intoStages like:• Pre-independence stage• Post Independence stage• Nationalization of Banks• Introduction of Financial Sector Reforms• IT revolution in Banks

History of Banking

‘Bank of Hindustan’ – 1770 at Calcutta‘Bank of Calcutta’ – 1806 which soon became ‘Bank of Bengal’

There were three Presidency Banks• Bank of Bengal• Bank of Bombay• Bank of MadrasThese banks were called Presidency Banks.They merged in 1921 to form the Imperial Bank of India, which after independence became State Bank of India (1955).Reserve Bank of India came into existence in 1935 which took the responsibility of regulating Banking sector as Central Bank in India.

Functions/ Services of Commercial Banks

PRIMARY FUNCTION

ACCEPTING DEPOSITS

LENDING MONEY

A. Savings DepositsB. Fixed DepositsC. Current Deposits

A. LoanB. Cash creditC. OverdraftD. Discounting and

Purchasing of bills

ACCEPTING DEPOSITS

LENDING MONEY

ACCEPTING DEPOSITS

LENDING MONEY

A.Savings Deposits

B.Fixed Deposits

C.Current Deposits

D.Recurring Deposit

A.LoanB.Cash creditC.OverdraftD.Discounting

of bills

ACCEPTING DEPOSITS

SECONDARY FUNCTION

AGENCY SERVICE

GENERAL UTILITY SERVICE

• Buying and selling of securities.

• Periodical payments on standing orders

• Collection of cheques, drafts..

• Preparation of IT returns• Trustees• Transfer of funds

• Issue of LC• Accepting valuables for

safe custody• Travellers cheque • Issue of credit cards

Developmental functions• Mobilisation of saving• Extension of financial services to rural areas• Granting loans to the weaker section of the

societyMODERN FUNCTIONS• ATM• Smart cards• Tele-banking• Internet banking• Round the clock banking.

CLASSIFICATION OF BANKS

Criteria:

I. Second schedule of the RBI ActII. DomicileIII. Functions or Specialised areaIV. OwnershipV. Organisation Structure

Second schedule of RBI act

1. Scheduled Bank- • must have paid up capital + reserves of at least Rs. 5

Lakhs • Its affairs should not be detrimental to the interest of

its depositors• Must be a corporation or a co-operative society and

must not be a partnership or a single owner firm.

2. Non- scheduled Bank• Those banks whose names do not appear in the

Second schedule of the RBI Act.

Domicile

1. Foreign Bank• Banks which are registered or incorporated outside

India and having a branch in India. Their principal function is to make credit arrangement for exports and imports of the country.

2. Domestic Bank• Those banks which are registered in India. These

banks are dominant part of total commercial banks.

Ownership

1. Public sector banks: those banks which are owned by Government.

2. Private sector bank: Banks owned and run by individuals or corporations and not by government or co-operatives are included in this category.

3. Co-operative Banks: Banks jointly run by a group of individuals. Principal objective is mutual help of its members. All the shareholders are having equal share in its profits.

Three-tier system in Co-operative Bankinga) Primary credit societies: association of persons

residing in a particular area. It can be started with 10 or more persons. Unlimited liability and lend for short period.

b) Central co-operative banks: organised as a result of Co-operative Societies Act 1912. Main function is to finance, co-ordinate and guide the primary co-operative societies

c) State co-operative banks: federations of Central co-operative Banks in a state. They get funds from deposits of public, from commercial banks and from RBI if necessary. Coordinate, finance and control the central co-operative banks.

FUNCTIONS

I. Savings banksII. Agricultural banksIII. Exchange banksIV. Central bankV. Industrial banksVI. Commercial banks.

ORGANISATION STRUCTURE1. UNIT BANKING : a bank

operates in a specified area, generally small and limited with limited resources having no branches.

DISADVANTAGES2. Lack of specialisation3. Higher remittance cost4. No diversification of risk5. Difficulty in facing

economic crisis6. lack of trained staff

ADVANTAGES

1. Efficient Management

2. Based on local needs

3. Elimination of inefficient

banks

4. Check on monopolies

5. No delay

6. No danger to economy

7. Balanced growth

Branch Banking• A bank render banking

services at two or more places, controlled by head office.

DISADVANTAGES1. Expensive2. Difficulty of

management3. Encouragement of

monopoly4. Branches running

at loss

ADVANTAGES1. Geographical

spreading of risk2. Remittance facilities3. Economy in cash

reserve4. High banking

standard5. Effective credit

control6. Expansion of banking

services7. Easy control by

central bank

CHAIN BANKING

• Banking system where same individual or group of individuals control two or more banks. Every bank has its own identity and independent board of management.

MERITS1. Appropriate use of

limited resources2. Efficient system of

management3. Not too much

expensive

GROUP BANKING

• That banking system where two or more banks operate under the control of a holding company.

DEMERITS• Rigid control• Less mobility• Few branches

MERITS• Efficient

management• Adequate liquidity• Economical• specialisation

Correspondent Banking

• smaller banks carrying deposits with larger banks in exchange for the performance of various services.

Main functions• Procurement of

currency and coins from central bank .

• Clearing and collection of cheques for member banks.

• Domestic and foreign payments.

• Agency services

MERITS• Member banks

retain their independent identity

• Optimal use of limited resources

• Expert services of specialised staff

DEMERITS• Smaller banks

become highly dependent on correspondent banks for their functioning

INVESTMENT BANKS• They provide medium and long-term finance to

industries to meet their fixed capital requirements. (Expansion and modernisation).

• Promote new industries by underwriting the issue of securities

• Provide technical guidance for efficient management of industries.

UNIVERSAL BANKING• Banks engaged in diverse kinds of banking

activities.• Banks do broad based and comprehensive

activities.• Services include:• Loans and advances for long-term• Providing working capital• Corporate advisory services• Insurance• Depository• Brokerage• Venture capital etc

MIXED BANKING• Banking system which combines deposit banking

with investment banking is known mixed banking.

SOURCES & EMPLOYMENT OF FUNDSSOURCES• Deposits• Share equity• DebtEMPLOYMENT OF FUNDS• Cash credit• Overdraft• Loans (term loan, demand loan)• Bills discounted and purchased• Investments • Bank guarantee• Letter of Credit

Liquid assets of a bank1. Cash in hand (factors- growth of banking habits,

conditions of the locality, nature and number of accounts, nature of advance, reserve kept by other banks)

2. Statutory cash balance with the reserve bank: section 42 of RBI Act 1934. (percentage of demand and time liabilities)

3. Balance with other banks4. Money at call and short notice: a short term loan that is

payable immediately and in full upon demand, given to banks and financial institutions. It gives a way to banks to earn interest while retaining liquidity.vthe interest rate on such loans is called as call-loan rate.

5. Investments

EARNING ASSETS• An income-producing investment that is owned by

a business, institution or individual.All advances for short term and long term.Money at call and short noticeInvestment in govt. and semi-govt securitiesDiscounting of bills.

NON- PERFORMING ASSETS• A Non-performing asset (NPA) is defined as

a credit facility in respect of which the interest and/or instalment of principal has remained ‘past due’ for a specified period of time.

• An asset becomes non-performing when it ceases to generate income for the bank.

W. E. F March 31, 2004, a non-performing asset (NPA) shall be a loan or an advance where;• Interest and/or instalment of principal remain

overdue for a period of more than 90 days in respect of a term loan,

• The account remains ‘out of order’ for a period of more than 90 days, in respect of an Overdraft/Cash Credit (OD/CC),

• The bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted,

• Interest and/or instalment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purposes, and

• Any amount to be received remains overdue for a period of more than 90 days in respect of other accounts.

Micro credit - Meaning• Very small loans given to poor people who typically

lack collateral, steady employment and verifiable credit history.

• Also known as “micro-lending” or “micro-loan” (Muhammed Yunus, no collateral, low interest)

IMPORTANCE• Design to support entrepreneurship• Helps in reduction of poverty• Higher employment and higher income• Empowerment of women and upliftment of

community• Better education, improved nutrition.

Islamic Financing• "Islamic capitalism", was developed in eighteenth

century.• A banking system that is based on the principles

of Islamic law (also known Shariah) and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. Collecting interest is not permitted under Islamic law.

Principles of Islamic Banking• Payment and receipt of interest (known as Riba) is

strictly prohibited (haram).• The business is based on profit and loss sharing.• Certain industries, such as alcohol, tobacco, pork, armaments and gambling are “haram” (disallowed by Sharia) and prohibited for investment.

This is why Islamic Banking is also referred to as Ethical banking.

Contd.• Banks may not lease or lend any product that

they do not wholly own.• Trading in debt is also not allowed, which is why Banks do not deal in traditional bonds; rather they have their own version of such instruments called Sukuk (Islamic Bond).• Interest free loans (Qard Hasan) are encouraged to spread financial inclusion.

challenges• Regulatory framework• Support infrastructure• Death of Islamic banking professionals• Lack of awareness

Financial instruments of Islamic finance

MOBILISING FUNDS• Current accounts• Savings account• Investment accounts• Sukuk (Islamic) bonds

UTILISING FUNDS• Mudaraba• Musharaka• Murabaha

CURRENT ACCOUNTS

Islamic banks Conventional Banks

( In terms of deposits and withdrawing funds)

Islamic bank Conventional Bank

(in terms of paying Interest)

Savings account

Islamic banks Conventional Banks

(Deposits are repayable on demand)

Islamic bank Conventional Bank

(Return profit/ Loss) (Return- Interest)

INVESTMENT ACCOUNT• Alternative to the Fixed Account of Conventional

Banks• Return - depends upon the dealing of business

projects of the bank.

SUKUK BONDS • Issuer of a sukuk sells an investor group the

certificate, who then rents it back to the issuer for a pre-determined rental fee. The issuer also makes a contractual promise to buy back the bonds at future date at par value.

Utilising fund: MUDARABA (partnership)

BANK-CAPITALENTREPRENEUR- KNOWLEDGE &

EXPERIENCE

ENTREPRENEURSHIP

RETURN – PROFITS/ LOSSES

Musharaka (Joint Venture)

BANK- W.C, assets, technical & Managerial

experiences

CLIENT- W.C, assets, technical & Managerial

experiences

JOINT VENTURE

• RETURN – PROFITS/ LOSSES• (shared according to the

agreement)

Murabaha (Mark-up On Sales)

• CLIENT PAYMENT- may pay on delivery of goods or in instalments.

BANK- buy the goods requested

by the client.Ex. Maxhinery, raw material..

COST + MARK UP

BUY THE GOODS TO RESELL .

Instruments of Islamic Finance• Murabahah is a form of trade credit for asset

acquisition that avoids the payment of interest. Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a price that includes an agreed mark-up

for profit.• Mudaraba is essentially like equity finance in

which the bank and the customer share any profits. The bank will provide the capital, and the borrower, using their expertise and knowledge, will invest the capital. Profits will be shared according to the finance agreement,

• Musharaka is a joint venture or investment partnership between two parties. Both parties provide capital towards the financing of projects and both parties share the profits in agreed proportions.

• Primary deposits: people deposit their cash with the banking system. They convert their cash into bank deposits. The initiative of creating such deposit is taken by the public.

• Derivative deposits: whenever bank buys assets from the market (bill, bonds, debentures etc..) or lend to certain parties, it does not provide cash to them directly but creates demand deposits in their name.

• They are secondary because they are based on or derived from the primary deposits.

• The initiative comes from the banking system.

Bank loans create bank deposits• Money at call and short notice: (to speculators, brokers) credits the speculator’s account speculator uses the deposit to pay off the creditor, creditor who receives the cheque credits to his account.Thus as a result of loan made by the bank, to speculators and others for short period, deposits equal to the value of the loans have been created.

• Bills discounted credits the holder of bill’s

account.• Investments in government bonds

creates a deposit in the name of the seller.• Bank advances (made by banks to

industrialists and others) allows the borrower to issue cheque up to the amount sanctioned to pay off his creditors. Will be credited in creditors account.

Credit creation• The power of commercial banks to expand

deposits through expanding their loans and advances is known as credit creation.

• Bank credit means bank loans and advances and Credit creation literally means multiplication of loans and advances.

• Every bank loan creates an equivalent deposit, credit creation by bank implies also multiplication of bank deposits.; multiplication of loans and advances.

• Every time a bank acquires an asset ( loans and

advances), it creates a deposit in the name of the

person or institution from whom the asset is

purchased.

• More bank loans imply more bank deposits.

• Banks have the power to expand or contract demand deposits and they exercise this power through granting more or less loans and advances.

•

• creates

• becomes basis of

• creates

•

BANK CREDIT BANK DEPOSITS

BANK CREDIT

BANK CREDIT

BANK DEPOSITS

Credit Contraction• Just as there is multiple expansion of deposits,

there is multiple contraction of bank deposits too when the cash is removed from the bank system.

• The contraction of credit adversely affects the money supply. The contraction of bank credit may take place due to many visions. For example the bank may recall loans or due to political uncertainty or due to fall in price borrower may stop the borrowing.

Limitations of credit creation• Adequate cash reserve• Quantity of money in circulation• Attitude of people• Policy of the central bank• Nature of business condition• Leakages• Behaviour of other banks• Use of cheque

Sound Commercial Banking Principles

I. ProfitabilityII. LiquidityIII. SafetyIV. Social Good