STUDY MATERIAL: 1

Understanding of Banking System:

Banks are the important segment in Indian Financial System. An efficient banking system
helps the nation’s economic development. Various categories of stakeholders of the Society
use the banks for their different requirements. Banks are financial intermediaries between the
depositors and the borrowers. Apart from accepting deposits and lending money, banks in
today’s changed global business environment offer many more value added services to their
clients. The Reserve Bank of India as the Central Bank of the country plays different roles
like the regulator, supervisor and facilitator of the Indian Banking System.

A Brief History and Evolution of Banking System in India:

Indian Banking System for the last two centuries has seen many developments. An
indigenous banking system was being carried out by the businessmen called Sharoffs, Seths,
Sahukars, Mahajans, Chettis, etc. since ancient time. They performed the usual functions of
lending moneys to traders and craftsmen and sometimes placed funds at the disposal of kings
for financing wars. The indigenous bankers could not, however, develop to any considerable
extent the system of obtaining deposits from the public, which today is an important function
of a bank.

Modern banking in India originated in the last decades of the 18th century. The first banks
were The General Bank of India which started in 1786, and the Bank of Hindustan.
Thereafter, three presidency banks namely the Bank of Bengal (this bank was originally
started in the year 1806 as Bank of Calcutta and then in the year 1809 became the Bank of
Bengal) , the Bank of Bombay and the Bank of Madras, were set up. For many years the
Presidency banks acted as quasi-central banks. The three banks merged in 1925 to form the
Imperial Bank of India. Indian merchants in Calcutta established the Union Bank in 1839, but
it failed in 1848 as a consequence of the economic crisis of 1848-49. Bank of Upper India
was established in 1863 but failed in 1913. The Allahabad Bank, established in 1865, is the
oldest survived Joint Stock bank in India. Oudh Commercial Bank, established in 1881 in
Faizabad, failed in 1958. The next was the Punjab National Bank, established in Lahore in
1895, which is now one of the largest banks in India. The Swadeshi movement inspired local
businessmen and political figures to found banks of and for the Indian community during
1906 to 1911. A number of banks established then have survived to the present such as Bank
of India, Corporation Bank, Indian Bank, Bank of Baroda, Canara Bank and Central Bank of
India.

A major landmark in Indian banking history took place in 1934 when a decision was taken to
establish ‘Reserve Bank of India’ which started functioning in 1935. 1949 was the year when
certain rules and regulations were altered with respect to RBI in order to streamline the
system of banking regulation in India having the same line of thought with the central
government. Since then, RBI, as a central bank of the country, has been regulating banking
system.

The banking scenario prevalent in the country during the period 1948- 1968 presented a
strong focus on class banking on security rather than on purpose. The emphasis of the
banking system during this period was on laying the foundation for a sound banking system
in the country. Banking Regulating Act was passed in 1949 to conduct and control operations
of the commercial banks in India. Another major step taken during this period was the
transformation of Imperial Bank of India into State Bank of India and a redefinition of its role
in the Indian economy, strengthening of the co-operative credit structure and setting up of
institutional framework for providing long term finance to agriculture and industry. Banking
sector, which during the pre—independence India was catering to the needs of the
government, rich individuals and traders, opened its door wider and set out for the first time
to bring the entire productive sector of the economy – large as well as small, in its fold.
During this period number of commercial banks declined remarkably. There were 566 banks
as on December, 1951; of this, number scheduled banks was 92 and the remaining 474 were
non-scheduled banks. This number went down considerably to the level of 281 at the close of
the year 1968. The sharp decline in the number of banks was due to heavy fall in the number
of non-scheduled banks which touched an all-time low level of 210. The banking scenario
prevalent in the country up-to—the year 1968 depicted a strong stress on class banking based
on security rather than on purpose. Before 1968, only RBI and Associate Banks of SBI were
mainly controlled by Government. Some associates were fully owned subsidiaries of SBI and
in the rest; there was a very small shareholding by individuals and the rest by RBI.
Thus, it was clear that, the purpose of imposing the “social control” on banks to remedy the
basic weaknesses of the banking system and to ensure that the banks would cater to the needs
of hitherto neglected and weaker sections of the community was not fruitful. It could not
change the situation that much as was expected. It was felt by the government that, more
imposition would likely to fulfil the needs and that may be regarded as the most important
reason of nationalisation of banks.
As described by Mr. Jay Prakash Narayan, a "masterstroke of political sagacity" was driven
by the government on 19th July 1969 by issuing an ordinance called 'Banking Companies
(Acquisition and Transfer of Undertakings) Ordinance, 1969' and thus nationalizing 14
largest commercial banks having paid up capital more than 50 crore each and having between
themselves aggregate deposit of 2,632 crore and with 4,130 branches all over the country.1
These was challenged in Supreme Court by a petitioner named R.C.Cooper on 21 st, but
before it was heard, government repealed the Ordinance and passed the Banking Companies
(Acquisition and Transfer of Undertaking) Bill, and it received the presidential approval on 9
August 1969. A second dose of nationalization of 6 more commercial banks followed in
1980.
The year 1991 was again a year of changes for not only banking but all other sectors which
are part of economic liberalization policies of the government.
The banking sector reforms, which were implemented as a part of overall economic reforms,
witnessed the most effective and impressive changes, resulting in significant improvements
within a short span. The distinctive features of the reform process may be stated thus:
(i) The process of reforms has all along been pre-designed with a long term vision. The two
Committees on financial sector reforms (Narasimham Committee-I and II) have outlined a
clear long-term vision for the banking segment particularly in terms of ownership of PSBs,
level of competition, etc.
(ii) Reform measures have been all pervasive in terms of coverage of almost all problem
areas. In fact, it can be said that, it is difficult to find an area of concern in the banking sector
on which there has not been a Committee or a group.
(iii) Most of the reform measures before finalization or implementation were passed through
a process of extensive consultation and discussion\ with the concerned parties.
(iv) Most of the reform measures have targeted and achieved international best practices and
standards in a systematic and phased manner.
(v) All the reform measures and changes have been systematically recorded and are found in
the annual reports as well as in the annual publications of RBI on "Trend and Progress of
Banking in India". The banking system, which was over-regulated and over administered,
was freed from all restrictions and entered into an era of competition since 1992. The entry of
modern private banks and foreign banks enhanced competition. Deregulation of interest rates
had also intensified competition. Prudential norms relating to income recognition, asset
classification, provisioning and capital adequacy have led to the improvement of financial
health of banks. Consequent upon prudential norms the most visible structural change has
been improvement in the quality of assets. Further, there has been considerable improvement
in the profitability of banking system. The net profits of SCBs, which were negative in 1992-
93, become positive in 1994-95 and stood at Rs. 17,077.07 Crore by March 2003. The
profitability of the Indian Banking System was reasonably in line with International
experience. It may be pointed out that the banking sector reform is certainly not a one-time
affair. It has evolutionary elements and follows a progression of being and becoming. Form
this point, Indian experience of restructuring banking sector has been reasonably a successful
one. There was no major banking crisis and the reform measures were implemented
successfully since 1992. Some expressed the fear that the reforms will sound a blow to social
banking. The Government did not accept the Narasimham Committee-I recommendation that
advances to priority sector should be brought down from 40 per cent to 10 per cent. The
Banks continued to be directed to lend a minimum of 18 per cent of total banks credit to
agriculture sector. Thus, there are certain positive impacts of reformation which led the
Indian banking sector on a solid floor.
Role of a Banking System in Economy:
Basic role of any banking system is to provide funds for business as well as personal needs of
individuals. They play a significant role in the economy of a nation. Following are some of
the basic roles of the banks:
1. It encourages savings habit amongst people and thereby makes funds available for
productive use.
2. It acts as an intermediary between people having surplus money and those requiring money
for various business activities.
3. It facilitates business transactions through receipts and payments by cheques instead of
currency.
4. It provides loans and advances to businessmen for short term and long-term purposes.
5. It also facilitates import-export transactions.
6. It helps in national development by providing credit to farmers, small-scale industries and
self-employed people as well as to large business houses which lead to balanced economic
development in the country.
7. It helps in raising the standard of living of people in general by providing loans for
purchase of consumer durable goods, houses, automobiles, etc.
Components of Indian Banking System:
The constituents of the Indian Banking System can be broadly listed as under:
 Cooperative Banks:
(i) Short term agricultural institutions
(ii) Long term agricultural credit institutions
(iii) Non-agricultural credit institutions
 Commercial Banks:
(i) Public Sector Banks
(ii) Private Sector Banks
(iii) Foreign Banks
(iv) Regional Rural Banks
(v) Local Area Banks
 Development Banks:
(i) National Bank for Agriculture and Rural Development (NABARD)
(ii) Small Industries Development Bank of India (SIDBI)
(iii) Export and Import Bank (EXIM)
(iv) National Housing Bank (NHB)

Co-operative Banking System:

Cooperative banks play an important role in the Indian Financial System, especially at the
village level. The growth of Cooperative Movement commenced with the passing of the Act
of 1904. A cooperative bank is a cooperative society registered or deemed to have been
registered under any State or Central Act. If a cooperative bank is operating in more than one
State, the Central Cooperative Societies Act is applicable. In other cases the State laws are
applicable. Apart from various other laws like the Banking Laws (Application to Co
operative Societies) Act, 1965 and Banking Regulation (Amendment) and Miscellaneous
Provisions Act, 2004, the provisions of the RBI Act, 1934 and the BR Act, 1949 would also
be applicable for governing the banking activities.
These cooperative banks cater to the needs of agriculture, retail trade, small and medium
industry and self-employed businessmen usually in urban, semi urban and rural areas. In case
of co-operative banks, the shareholders should be members of the co-operative banks. The
share linkage to borrowing is a distinctive feature of a co-operative bank. Rural cooperative
sector in India plays a vital role in fulfilling the credit requirements of rural agricultural
sector of India. At recent times, the rural credit flow through rural cooperative sector has
risen substantially in order to keep pace with the growing demand for credit in the rural parts
of India.
Commercial Banks:
Commercial Banks are banking institutions that primarily accept deposits and grant short-
term loans and advances to their customers. In addition to giving short-term loans,
commercial banks also give medium-term and long-term loan to business enterprises. Now-a-
days some of the commercial banks are also providing housing loan on a long-term basis to
individuals. There are also certain ancillary functions discharged by these banks depending
upon their individual capacity.
Types of Commercial banks:
 Public Sector Banks: These are banks where majority stake is held by the
Government of India or Reserve Bank of India. Examples of public sector banks are:
State Bank of India, Corporation Bank, Bank of Baroda and Dena Bank, etc.
 Private Indian Banks: In case of private sector banks majority of share capital of the
bank is held by private individuals. These banks are registered as companies with
limited liability. For example: Axis Bank, HDFC Bank, Indusind Bank.
 Foreign Private Banks: These banks are registered and have their headquarters in a
foreign country but operate their branches in our country. Some of the foreign banks
operating in our country are Hong Kong and Shanghai Banking Corporation (HSBC),
Citibank, American Express Bank, Standard & Chartered Bank, Gridley’s Bank, etc.
The number of foreign banks operating in our country has increased since the financial sector
reforms of 1991. According to a report by RBI there are 47 Foreign Banks branches in India
as on March 31, 2013.
 Regional Rural Bank: In 1975, a new set of banks called the Regional Rural Banks,
were setup based on the recommendations of a working group headed by Shri
Narasimham, to serve the rural population in addition to the banking services offered
by the co-operative banks and commercial banks in rural areas. Inception of regional
rural banks (RRBs) can be seen as a unique experiment as well as experience in
improving the efficacy of rural credit delivery mechanism in India. With joint
shareholding by Central Government, the concerned State Government and the
sponsoring bank, an effort was made to integrate commercial banking within the
broad policy thrust towards social banking keeping in view the local peculiarities.
 RRBs were expected to play a vital role in mobilizing the savings of the small and
marginal farmers, artisans, agricultural labourers and small entrepreneurs and
inculcate banking habit among the rural people. These institutions were also expected
to plug the gap created in extending the credit to rural areas by largely urban-oriented
commercial banks and the rural cooperatives, which have close contact with rural
areas but fall short in terms of funds.
 Local Area Banks: Local Area Banks with operations in two or three contiguous
districts were conceived in the 1996 Union budget to mobilise rural savings and make
them available for investments in local areas. They are expected to bridge the gaps in
credit availability and enhance the institutional credit framework in rural and semi-
urban areas. Although the geographical area of operation of such banks is limited,
they are allowed to perform all functions of a scheduled commercial bank. The
Raghuram Rajan Committee had envisaged these local area banks as private, well-
governed, deposit-taking small-finance banks.
Development Banks:
Business often requires medium and long-term capital for purchase of machinery and
equipment, for using latest technology, or for expansion and modernization. Such financial
assistance is provided by Development Banks. They also undertake other development
measures like subscribing to the shares and debentures issued by companies, in case of under
subscription of the issue by the public. Industrial Finance Corporation of India (IFCI) and
State Financial Corporations (SFCs) are examples of development banks in India.
History of development Banking in India can be traced to the establishment of the Industrial
Finance Corporation of India in 1948. Subsequently, with the passing of State Financial
Corporation Act, 1951, several SFCs came into being. With the introduction of financial
sector reforms, many changes have been witnessed in the domain of development banking.
Following four are considered as the major development banks in India:
NABARD
National Bank for Agriculture and Rural Development (NABARD) was established in July
1982 by an Act of Parliament based on the recommendations of CRAFICARD. It is the apex
institution concerned with the policy, planning and operations in the field of agriculture and
other rural economic activities. NABARD has evolved several refinance and promotional
schemes over the years and has been making constant efforts to liberalize, broad base and
refine/ rationalize the schemes in response to the field level needs. The refinance provided by
NABARD has two basic objectives:
(i) Supplementing the resources of the cooperatives banks and RRBs for meeting the credit
needs of its clientele, and
(ii) Ensuring simultaneously the build up of a sound, efficient, effective and viable
cooperative credit structure and RRBs for purveying credit.
SIDBI:
Small Industries Development Bank of India (SIDBI) was established in October 1989 and
commenced its operation from April 1990 with its Head Office at Lucknow as a development
bank. It is the principal and exclusive financial institution for the promotion, financing and
development of the Micro, Small and Medium Enterprise (MSME) sector and for co-
ordination of the functions of the institutions engaged in similar activities. It is a central
government undertaking. The prime aim of SIDBI is to support MSMEs by providing them
the valuable factor of production finance. Many institutions and commercial banks supply
finance, both long-term and short-term, to small entrepreneurs. SIDBI coordinates the work
of all of them.
NHB:
National Housing Bank was set up in July, 1988 as the apex financing institution for the
housing sector with the mandate to promote efficient, viable and sound Housing Finance
Companies (HFCs). Its functions aim at to augment the flow of institutional credit for the
housing sector and regulate HFCs. NHB mobilizes resources and channelizes them to various
schemes of housing infrastructure development. It provides refinance for direct housing loans
given by commercial banks and non-banking financial institutions. The NHB also provides
refinance to Housing Finance Institutions for direct lending for construction/purchase of new
housing/dwelling units, public agencies for land development and shelter projects, primary
cooperative housing societies, property developers.
At present, it is a wholly owned subsidiary of Reserve Bank of India which contributed the
entire paid-up capital.
EXIM Bank:
Export-Import Bank of India was set up in 1982 by an Act of Parliament for the purpose of
financing, facilitating and promoting India’s foreign trade. It is the principal financial
institution in the country for coordinating the working of institutions engaged in financing
exports and imports. EXIM Bank is fully owned by the Government of India and the Bank’s
authorized and paid up capital are ‘10,000 crore and ‘2,300 crore respectively. EXIM Bank
supplements its financing programmes with a wide range of value-added information,
advisory and support services, which enable exporters to evaluate international risks, exploit
export opportunities and improve competitiveness, thereby helping them in their globalisation
efforts.