UNIT 1

BANKING SYSTEM
UNIT 1 BANKING SYSTEM

 Introduction – Role of Commercial Banks – Functions of Commercial

Banks –Bank involvement in circular flow of money; Different types of
Banks and their functions; Investment policy of Commercial Banks;
Distinction between NBFC and Banks, Evolution of banking in India,
Small finance banks- meaning, features, Payments banks- meaning and
features. Regulatory & operational framework- RBI, Organisation &
Functions, Mechanism of supervision and regulation; Instructions of
credit policy and monetary policy
COMMERCIAL BANKS

 Banker--According to Sec. 2 of the Bill of Exchange Act, 1882, ‘banker includes a

body of persons, whether incorporated or not, who carry on the business of
banking.’

 Banking-- “Banking' means accepting, for the purpose of lending or

investment, of deposits of money from the public repayable on
demand or otherwise and withdrawable by cheque, draft, order or
otherwise."
Role of commercial banks
 Mobilizing Saving of public
 Capital Formation
 Financing-> Industry, trade, agriculture sectors
 Facilitating payment mechanism
 Creation of employment
 Development of economy
 FUNCTIONS OF
COMMERCIAL
BANK

PRIMARY SECONDARY
FUNCTIONS FUNCTION

GENERAL
AGENCY
UTILITY
SERVICES
SERVICES
 PRIMARY FUNCTIONS SECONDARY FUNCTIONS SECONDARY FUNCTIONS
Primary Services Agency Services General utility Services

• Accepting Deposits • Payment and collection of • Safe custody function

• Savings cheque,bills • Issue of letter of credit
• Fixed • purchase and sale of • Travelers’ cheque
• current securities • Merchant Banking
• Acting as Executor, • Foreign Exchange function
• Reccurring
Administrator &
• Leasing
• Lending Money • Housing Finance
• loans • Acting as Attorney
• Underwriting of shares
• overdraft • Tax consultancy
• Cash credit • Credit cards
• discounting bills • Gift Cheques
• Remittance Of Fund • Consultancy functions
• Credit Creation
• Teller System
• Factoring
Accepting deposits
It is the most important function of CB. The main kinds of deposits are:
 Savings account -Savings deposit account is meant for individuals who wish to deposit small amounts
out of their income which can be opened with minimum of rs 5000-10,000. given cheque facility to
withdraw money from their acc but some restrictions are imposed in the number and amount of
withdrawals.

 Current account –Businessmen generally open current accounts with banks. Current accounts do not
carry any interest as the amount deposited in these accounts is repayable on demand without any
restriction.

 Fixed account -It is deposit made for fixed period of time and repayable after the expiry of a specified
period. The rate of interest depends upon the period of deposits. These account holders do not enjoy
cheque- able facility.

 Recurring account -Under this type of deposit, the depositor is required to deposit a fixed amount of
money in instalments, every month for a specific period of time. After the completion of the specified
period, the customer gets back all his deposits along with the cumulative interest accrued on the
deposits. Also “ cumulative deposit acc”
Types of lending
 Loan- it is a financial arrangement under which a lump sum amount is
granted by a bank to a borrower. A loan may short, medium or long term.
Eg home loan, educational loan, etc
 Over-draft- it is a financial arrangement where a current account holder is
permitted by a bank to withdraw any amount credit upon an agreed limit
and interest is charged only for actual withdrawn amount.
 Cash credit- it is a financial arrangement under which a borrower is
allowed an advance under a separate account called cash credit account.
borrower can withdraw the amount in installments as and when he needs
and interest is charged on actual withdrawal
 Discounting of bills of exchange- here the bank takes a Bills Of Exchange
maturing from the customer and pays him 90 – 95 percentage of bill
amount
Remittance of Funds
 Commercial banks provide the facility of fund transfer from
one place to another, on account of the interconnectivity of
branches. The transfer of funds is administered by using bank
drafts, pay orders or mail transfers, online fintech platforms
on which the bank charges a nominal commission.
Credit creation
 Every loan is created by a deposit. The creation of a derivative
deposit means the creation of credit
Derivative deposits also known as secondary deposits are
the deposits in excess of the minimum cash reserves to be held
by the banks. These deposits are used to grant loans to the
borrowers. In this way, derivative deposits form the basis of
credit creation by the commercial banks
Agency functions of Bank
 : Agency functions are those services that banks provide to their
customers for which they receive some income. Thus, these functions
add to the income of banks. Acting on behalf of the customer.
Payment and Collection of Cheques : The bank will send the cheque to
its branch at that centre and get the amount collected for a small fee.
The amount of cheque / draft will be deposited in your account, and
the fee will be deducted separately from the account

 Execution of Standing Instructions :A standing order is an instruction

an account holder gives to his bank to pay a set amount at regular
intervals to another account.
Acting as a Trustee :Banks also act as trustees for various
requirements of the corporate, government and accepted by
him for the benefit of another or of the owner
 Executor OR Attorney :

The settlement of the will requires specialised knowledge. A

bank undertakes these complicated duties of such customers
who may desire to nominate bank in such capacities. A bank
charges a small fee for this act or function.
Bank involvement in circular flow of money
 The circular flow model is an economic model that presents
how money, goods, and services move between sectors in an
economic system. The flows of money between the sectors
are also tracked to measure a country’s national income or
GDP, so the model is also known as the circular flow of
income.
Functions
 The major functions of banks are almost the same but the set of people each
sector deals with may differ. Given below the functions of the banks in India:
 Acceptance of deposits from the public
 Provide demand withdrawal facility
 Lending facility
 Transfer of funds
 Issue of drafts
 Provide customers with locker facilities
 Dealing with foreign exchange

there are various other utility functions also need to be performed by the
various banks
Investment Policy of Commercial Banks
 Liquidity-The actual meaning of liquidity is the ability of a bank to give cash on its customer demand. A bank

should choose such securities for investment which contain more liquidity. For eg: Government bonds and

securities etc. The main objective is to easily sell liquid assets and repay money to its customers.

 Profitability-The most important objective of a commercial bank is to earn maximum profit to satisfy its all

expenses and to make payments to its customers as interest. Therefore a commercial bank will invest its funds in

such a manner to extract sufficient income with minimum cost.

 Safety-a bank must ensure their investments are safe by estimating the amount of risk attached to various types

of available assets and compare estimated risk with other investments.

 Diversity- The commercial bank should invest its funds in different types securities for minimizing the risk. If a

commercial bank choose only a single sector to invest funds it will not make profitable. So a commercial bank has

to diversity its fund in different types of sector.

Basis NBFC’s Commercial banks
Definition An NBFC company is a company that Commercial banks are government
provides services to people that is authorized financial institutions
similar to banking services without having a proper license to operate.
holding a license from RBI.

Incorporation under the Companies Act, 1956 under the Banking Regulation Act,
and RBI Act. 1949 and RBI Act.
Payment settlement Is not a part of system It is an essential part of the
System
system
Foreign Investment It is allowed up to 100% It is allowed 74% by a Private
Bank.

Acceptance of demand deposits is

NBFC cannot accept deposits
Demand deposit one of the main functions of
repayable on demand.
banks.
Small Finance Banks
 Small Finance Banks is a specific segment of banking created
by RBI under the guidance of Government of India with an
objective of furthering financial inclusion of un-served and
underserved sections by providing them with basic banking
facilities. including small business units and marginal
farmers, micro and small industries and unorganized entities.
Objectives provision of savings vehicles, and
supply of credit to small business units, small and marginal farmers,
micro and small industries and other unorganised sector entities,
through high technology-low cost operations.

Eligible Resident individuals/professionals with 10 years of experience in

promoters banking and finance;
Companies and societies owned and controlled by residents will be
eligible to set up small finance banks.
Existing Non-Banking Finance Companies (NBFCs), Micro Finance
Institutions (MFIs), and Local Area Banks (LABs) that are owned and
controlled by residents can also opt for conversion into small finance
banks.
Scope of The small finance bank shall primarily undertake basic banking
activities activities of acceptance of deposits and lending to unserved and
underserved sections including small business units, small and
marginal farmers, micro and small industries and unorganised sector
Capital The minimum paid-up equity capital for small finance banks shall be Rs.
requirement 100 crore.

Promoter's The promoter's minimum initial contribution to the paid-up equity capital of
contribution such small finance bank shall at least be 40 per cent and gradually brought
down to 26 per cent within 12 years from the date of commencement of
business of the bank.
Foreign The foreign shareholding in the small finance bank would be as per the
shareholding Foreign Direct Investment (FDI) policy for private sector banks as amended
from time to time.

Prudential norms maintenance of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio
(SLR)..
75 per cent of its Adjusted Net Bank Credit (ANBC) to the sectors eligible for
classification as priority sector lending (PSL) by the Reserve Bank.
List
 Ujjivan Small Finance Bank.
 Janalakshmi Small Finance Bank.
 Equitas Small Finance Bank.
 A U Small Finance Bank.
 Capital Small Finance Bank.
 ESAF Small Finance Bank.
 Utkarsh Small Finance Bank.
 Suryoday Small Finance Bank.
 Fincare Small Finance Bank.
Payments banks
 Payments banks are a type of differentiated bank introduced
by the RBI for promoting financial inclusion and facilitating
payments and remittance flows. They are different types of
banks compared to the conventional universal banks as the
Payments banks can concentrate in only two types of activities
– accepting demand deposits and facilitating payments.
Objectives

 To enhance financial inclusion by providing

 (i) small savings accounts and

 (ii) payments/remittance services to: migrant labour

workforce, low income households, small businesses, other
unorganised sector entities and other users.
Eligible promoters

 (1) Existing non-bank Prepaid Payments Instrument (PPI) issuers

 (2) NBFCs Corporate Business Correspondents,

 (3) Mobile phone Companies, super market chains, public

sector entities etc. Prompter can set a joint venture with a
commercial bank to start a payments bank.

 Fit and proper criterial applicable for promoters.

Functions

 (1) Acceptance of demand deposits, with a maximum balance of Rs 100000 per

individual.

 (2) Issuance of ATM/Debit cards; but can’t issue credit cards

 (3) Payments and remittances through various channels

 (4) Can act as Business Correspondent of another bank

 (5) can distribute non -risk sharing simple financial products like mutual funds
and insurance products.
 Features Payments banks (PBs)

Objectives To enhance financial inclusion by providing

(i) small savings accounts and
(ii) payments/remittance services to: migrant labour workforce, low income
households, small businesses, other unorganised sector entities and other users.

Eligible promoters (1) Existing non-bank Prepaid Payments Instrument (PPI) issuers
(2) NBFCs Corporate Business Correspondents,
(3) Mobile phone Companies, super market chains, public sector entities etc.
Prompter can set a joint venture with a commercial bank to start a payments
bank.
Fit and proper criterial applicable for promoters.

Activities (1) Acceptance of demand deposits, with a maximum balance of Rs 100000 per
individual.
(2) Issuance of ATM/Debit cards; but can’t issue credit cards
(3) Payments and remittances through various channels
(4) Can act as BC of another bank
(5) can distribute non -risk sharing simple financial products like mutual funds
and insurance products.
Fund deployment (1) No lending
(2) CRR applicable
(3) SLR of 75% -comprising of upto one year maturity GSecs/T-bills
and the remaining (25%) in deposits with other Scheduled Commercial
Banks.

Capital/Net Owned minimum paid-up equity capital Rs 100 crores

Fund
Prudential
Regulation
CRR Applicable as in Commercial Banks
SLR 75%
Capital Adequacy Ratio 15 %

KYC application Electronic authentication and most of the KYC norms to banks are
applicable to PBs.
Credit and Monetary policy
 Credit and Monetary policy is the macroeconomic policy laid
down by the central bank. It is the regulatory policy in order
to maintain its control over money supply and interest rate
and is the demand side economic policy used by the
government of a country to achieve macroeconomic objectives
like inflation, consumption, growth and liquidity

 The main instruments of the monetary policy are Cash

Reserve Ratio, Statutory Liquidity Ratio, Bank Rate, Repo Rate,
Reverse Repo Rate, and Open Market Operations.
Monetary policy instruments /methods
 a. Bank Rate Policy:

The bank rate is the minimum lending rate of the central bank at which it rediscounts
first-class bills of exchange and government securities held by the commercial banks.
When the central bank finds that inflation has been increasing continuously, it raises the
bank rate so borrowing from the central bank becomes costly and commercial banks
borrow less money from it (RBI).

 b. Open Market Operations:

Open market operations refer to the sale and purchase of securities in the money market
by the central bank of the country. When prices start rising and there is a need to control
them, the central bank sells securities. The reserves of commercial banks are reduced
and they are not in a position to lend more to the business community or general public
Monetary policy instruments
 Change in Margin Money:

The result is that the borrowers are given less money in loans against specified securities.
For instance, raising the margin requirement to 70% means that the pledger of securities
of the value of Rs 10,000 will be given 30% of their value, i.e. Rs 3,000 as a loan. In case
of a recession in a particular sector, the central bank encourages borrowing by lowering
margin requirements.
 CASH RESERVE RATIO (CRR)

This is the percentage of a bank’s total deposit that need to be kept as cash with the RBI.
The central bank can change the ratio to a limit. A high percentage means banks have
less to lend, which curbs liquidity; a low CRR does the opposite.
 Statutory Liquidity Ratio (SLR)

Apart from CRR, the banks in India are required to maintain liquid assets in the form of
gold, cash and approved securities. The increase/decrease in SLR affects the availability
of money for credit with banks.
 Repo Rate: It is the interest rate at which the Reserve Bank
provides overnight liquidity to banks against the collateral of
government and other approved securities under the liquidity
adjustment facility (LAF)
 Reverse Repo Rate: The (fixed) interest rate at which the

Reserve Bank absorbs liquidity, on an overnight basis, from

banks against the collateral of eligible government securities
under the LAF
 Moral Suasion

The central bank persuades the commercial banks to regulate the

credit growth through oral and verbal communication.
The main objectives of Monetary Policy are

 To maintain price stability.

 To ensure adequate flow of credit to productive sectors
 Arrangement of full employment.
 Expansion of credit facility
 Promotion of Fixed Deposit.
 Equitable distribution of Credit.
 To maintain money supply in the economy
 RESERVE BANK OF INDIA

 The Reserve Bank of India is the central bank of the country

 The Reserve Bank of India was set up on the basis of the

recommendations of the Hilton Young Commission.

 The Reserve Bank of India Act, 1934 (II of 1934) provides the

statutory basis of the functioning of the Bank, which

commenced operations on April 1, 1935
 monetary supervisory development
functions functions functions
• Issue Of Note • Provide License • Bank Expansion
• Banker To Govt • Liquidation Of • Provides
• Bankers Bank Weak Banks Training
• • Transparency • to Publish
Custodian Of
Norms Statistical
Forex • Corporate Information
• credit control • Miscellaneous
Governance
• Audit ,Inspectio Functions
n
Monetary functions
Note Issue:
 The Reserve Bank has the monopoly of note issue in the country. It has the sole right to issue

currency notes of all denominations except one-rupee notes and coins. Uniformity in note
circulation. Monetary liability
Banker to Government
 The Reserve Bank acts as the banker, agent and adviser to Government of India:
 Banker- maintain all current acc for cash bal
 Agent – responsibility to maintain public debt
 Advisor- advise time to time

Banker's Bank
 supervision and control over the banking system
 provide financial assistance to the scheduled banks
 act as the lender of the last resort

Custodian of Exchange Reserves:

 It maintains and stabilises the external value of the rupee, administers restrictions imposed by

the government, and manages the foreign exchange reserves.

Controller of Credit
 Bank regulates the money supply in accordance with the changing requirements of the economy.
 The Reserve Bank makes extensive use of various quantitative and qualitative techniques to

effectively control and regulate credit in the country

supervisory Functions

 The RBI has been endowed with powers for supervising the
banking system in the country. It has powers to issue license
for setting up new banks, to open new branches, to decide
minimum reserves, to inspect functioning of commercial
banks and to guide and direct them. It can have periodical
inspections and audit of the commercial banks.
Promotional and Developmental Functions
 By encouraging the commercial banks to expand their branches in the
semi-urban and rural areas
 the Reserve Bank has been mating efforts to promote institutional

agricultural credit
 The Reserve Bank also helps to promote the process of industrialisation

in the country
 it also undertakes measures for developing bill market in the country

Banker's Training College has been set up to extend training facilities to

supervisory staff of commercial banks.
 The Reserve Bank collects and publishes statistical information relating

to banking, finance, credit, currency, etc.

 It also publishes the results of various studies and review of economic

situation of the country in its monthly bulletins and periodicals.