Management of Financial Institutions

R.G. Saha

Management of Financial Institutions


Developed by: R.G. Saha

© 2015

For private circulation Students’ Study Material of ADDOE.

All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or copied in any form or byany means, electronic, mechanical, photographic or otherwise, without the prior written permission of the authorand the publisher.

Published by: Himalaya Publishing House Pvt. Ltd., for Amity Directorate of Distance & Online Education, Noida

Syllabus


Course Objective:The aim of the course is to orient the finance students to the change in the financial industry. The financial

industry much like the computer industry is changing rapidly. A course that merely describes the existinginstitutions will not prepare the students adequately for the change. Thus, familiarization with institutions of todayand developing an understanding why they are the way they are, and why they are changing is the core aim of thecourse. An Indian perspective will be added but conceptually the global frameworks will be used. At the end of thiscourse, the students will understand:

The role of financial institutions in economic developmentThe working of Financial IntermediariesInternational BankingThe norms governing of Financial Intermediaries in IndiaThe basic principles of Lending and Investments in a Commercial BankThe working of Developmental Financial Institutions

Course Contents:Module l: Introduction

Financial Institutions and Economic Development, Types of Money, Process of CapitalFormation, Technology of Financial System – Pooling, Netting, Credit Substitution andDelegation.

Module II: Financial IntermediariesUnderstanding Financial Intermediaries – Commercial Banks, Central Bank, Cooperative Banks,Banking System in USA and India, International Banking, Banking Operations, Retail andWholesale Banking, Near Banks, Universal Banking, NBFCs.

Module III: Norms and Practices in the Banking Industry

Principles of Lending, Study of Borrowers, Balance Sheet Analysis. Project Appraisal Criteria,Marketing of Bank Services. Prudential Norms – Narasimham Committee Recommendations,Performance Analysis of Banks, Regulatory Institutions, RBI and SEBI, Lender’s Liability Act,Banking Innovations, Basel Committee Recommendations, CAR – Risk Weighted Assets andRisk-based Supervision, Asset Liability Management in Commercial Banks, Corporate DebtRestructuring, Internet Banking, Mobile Banking, E-Banking Risk, E-finance, Electronic MoneyDigital Signatures, RTGS, NEFT, etc.

Module IV: Developmental Financial Institutions

Role of Developmental Banks in Industrial Financing, Resource Mobilization of DevelopmentalBanks, Project Examination by Developmental Banks.

Module V: Insurance Institutions

Role of Insurance Companies in Industrial Financing, Life Insurance and General insurance,New Development in Insurance as a Sector in the Indian Financial System, BancassuranceModels in Europe and India.

Examination Scheme:Component Codes H1 H2 H3 EE1

Weightage (%) 10 10 10 70

Contents

Unit 1: Introduction 1 – 441.1 Introduction1.2 Financial Institutions1.3 Meaning of Financial Institutions1.4 Benefits of Financial Institutions1.5 Classification of Financial Institutions1.6 Role of Financial Institutions1.7 Functions of Financial Institutions1.8 Types of Non-Banking Financial Institutions1.9 Financial Institutions and Economic Development

1.10 Introduction to Money1.11 History of Money1.12 History of Money in India1.13 Meaning of Money1.14 Features of Money1.15 Functions of Money1.16 Types of Money1.17 Role and Significance of Money in a Modern Economy1.18 Monetary System1.19 Capital Formation1.20 Process of Capital Formation1.21 Financial System1.22 Definitions of Financial System1.23 Meaning of Financial System1.24 Meaning of Financial Dualism1.25 Objectives of Financial System1.26 Purpose of Financial System1.27 Functions of Financial System1.28 Structure of Indian Financial System or Components of Financial System1.29 Technology of Financial System1.30 Summary1.31 Check Your Progress1.32 Questions and Exercises1.33 Key Terms1.34 Check Your Progress: Answers1.35 Case Study1.36 Further Readings1.37 Bibliography

Unit 2: Financial Intermediaries 45 – 1132.1 Introduction2.2 Meaning of Financial Intermediary2.3 Classification of Financial Intermediaries2.4 Functions of Financial Intermediaries2.5 Commercial Banks

2.6 Definitions of Commercial Bank2.7 Meaning of Commercial Bank2.8 Significance of Commercial Banks2.9 Structure of Commercial Bank in India

2.10 Role of Commercial Bank in the Economic Development of India2.11 Functions of Commercial Banks2.12 Classification of Commercial Banks2.13 Central Bank or RBI2.14 History of the Reserve Bank of India2.15 Establishment of RBI2.16 Organizational Structure of RBI2.17 Functional Departments of RBI2.18 Objectives of Reserve Bank of India2.19 Role of Reserve Bank of India2.20 Main Functions of RBI2.21 Monetary Policy of Reserve Bank of India2.22 Objectives of Monetary Policy2.23 Cooperative Banks2.24 History of Cooperative Banking in India2.25 Structure of Cooperative Banking in India2.26 Cooperative Banks – Irritants and Future Trends2.27 Major Irritants in the Functioning of the Cooperative Banks2.28 Banking System in USA and India2.29 International Banking2.30 Benefits of Having an International Banking2.31 Banking Operations2.32 Retail Banking2.33 Meaning of Retail Banking2.34 Retail Banking in India2.35 Features of Retail Banking2.36 Scope for Retail Banking in India2.37 Retail Banking Activities2.38 Wholesale Banking2.39 Wholesale Banking in India2.40 Near Banks2.41 Universal Banking2.42 Advantages of Universal Banking2.43 Disadvantages of Universal Banking2.44 Non-Banking Financial Company2.45 Summary2.46 Check Your Progress2.47 Questions and Exercises2.48 Key Terms2.49 Check Your Progress: Answers2.50 Case Study2.51 Further Readings2.52 Bibliography

Unit 3: Norms and Practices in the Banking Industry 114 – 1783.1 Introduction3.2 Meaning of Bank Lending3.3 Principles of Lending3.4 Five Cs of Lending Principles3.5 Forms of Lending3.6 Types of Lending3.7 Lending Facilities Granted by Banks3.8 Who are the Borrowers?3.9 Study of Borrowers

3.10 Balance Sheet Analysis3.11 Goal of Balance Sheet Analysis3.12 How to Perform a Balance Sheet Analysis?3.13 Project Appraisal3.14 Checklist for Project Appraisal3.15 Project Appraisal Criteria3.16 Marketing of Bank Services3.17 Importance of Bank Marketing3.18 Marketing Approach in Banks3.19 Features of Bank Marketing3.20 Prudential Norms3.21 Prudential Guidelines on Restructuring of Advances3.22 Narasimham Committee Recommendations3.23 Recommendations of the Committee3.24 Highlights of Narasimham Committee Recommendations on Banking Reforms in India3.25 Performance Analysis of Banks3.26 Regulatory Institutions in India3.27 Reserve Bank of India3.28 Credit Control3.29 Meaning of Credit Control3.30 Objectives of Credit Control3.31 Need for Credit Control3.32 Methods of Credit Control3.33 RBI Publications3.34 Securities and Exchange Board of India3.35 Organization of SEBI3.36 Management of the Board3.37 Objectives of SEBI3.38 Functions of SEBI3.39 Powers of Securities and Exchange Board of India3.40 Lender’s Liability Act3.41 Banking Innovations3.42 Basel Committee Recommendations3.43 Capital Adequacy Ratio (CAR)3.44 Risk Weighted Assets3.45 Risk-based Supervision3.46 Asset Liability Management (ALM) in Commercial Banks3.47 Benefits of ALM

3.48 Corporate Debt Restructuring3.49 E-Banking3.50 Development of E-Banking in India3.51 E-Banking Services3.52 Internet Banking3.53 Internet Banking in India3.54 Advantages of Internet Banking3.55 Disadvantages of Internet Banking3.56 Telebanking3.57 Online Banking3.58 Core Banking3.59 Mobile Banking3.60 E-Banking Risk3.61 Types of E-Banking Risk3.62 E-finance3.63 Electronic Money3.64 Digital Signatures3.65 How Digital Signatures Work?3.66 RTGS3.67 National Electronic Funds Transfer (NEFT)3.68 Summary3.69 Check Your Progress3.70 Questions and Exercises3.71 Key Terms3.72 Check Your Progress: Answers3.73 Case Study3.74 Further Readings3.75 Bibliography

Unit 4: Developmental Financial Institutions 179 – 2054.1 Introduction4.2 Developmental Banks4.3 Features of a Developmental Bank4.4 Role of Developmental Banks in Industrial Financing4.5 Types of Developmental Banks in India4.6 Origin of Industrial Developmental Bank of India (IDBI)4.7 Origin of State Financial Corporations (SFCs)4.8 Origin of State Industrial Development Corporations (SIDCs)4.9 Origin of Life Insurance Corporation of India (LICI)

4.10 Origin of Export-Import Bank of India (EXIM Bank)4.11 National Bank for Agriculture and Rural Development (NABARD)4.12 Resource Mobilization of Developmental Banks4.13 Project Examination by Developmental Banks4.14 Summary4.15 Check Your Progress4.16 Questions and Exercises4.17 Key Terms4.18 Check Your Progress: Answers4.19 Case Study

4.20 Further Readings4.21 Bibliography

Unit 5: Insurance Institutions 206 – 2505.1 Introduction5.2 Meaning of Insurance5.3 Definition of Insurance5.4 Historical Background of Insurance5.5 Historical Background of Insurance in India5.6 Types of Insurance5.7 Role of Insurance Companies5.8 Role of Insurance Companies in Industrial Financing5.9 Principles of Insurance

5.10 Life Insurance5.11 Meaning of Life Insurance5.12 Purposes of Life Insurance5.13 The Importance of Life Insurance5.14 Life Insurance Products and Policies5.15 General Insurance5.16 Meaning of General Insurance5.17 Objectives for Practicing of General Insurance5.18 Principles of General Insurance5.19 Features of General Insurance5.20 Functions of General Insurance5.21 General Insurance Corporation of India (GICI)5.22 The General Insurance Business (Nationalization) Amendment Act, 2002 Act No. 40 of 20025.23 Insurance Sector Reforms in India5.24 Major Policy Changes under IRDA Act5.25 Insurance Companies in India5.26 Protection of the Interest of Policyholders5.27 New Developments in Insurance as a Sector in the Indian Financial System5.28 Bancassurance5.29 Various Models for Bancassurance5.30 Status of Bancassurance in India5.31 Bancassurance Models in Europe5.32 Bancassurance in India5.33 The Major Need for Bancassurance in India5.34 Obstacles in the Success of Bancassurance5.35 Regulating Guidelines of IRDA5.36 Recommendations of Committee Constituted by IRDA on Bancassurance5.37 Bancassurance Models in India5.38 Summary5.39 Check Your Progress5.40 Questions and Exercises5.41 Key Terms5.42 Check Your Progress: Answers5.43 Case Study5.44 Further Readings5.45 Bibliography

Amity Directorate of Distance and Online Education

Introduction 1

Notes

Structure:

1.1 Introduction1.2 Financial Institutions1.3 Meaning of Financial Institutions1.4 Benefits of Financial Institutions1.5 Classification of Financial Institutions1.6 Role of Financial Institutions1.7 Functions of Financial Institutions1.8 Types of Non-Banking Financial Institutions1.9 Financial Institutions and Economic Development

1.10 Introduction to Money1.11 History of Money1.12 History of Money in India1.13 Meaning of Money1.14 Features of Money1.15 Functions of Money1.16 Types of Money1.17 Role and Significance of Money in a Modern Economy1.18 Monetary System1.19 Capital Formation1.20 Process of Capital Formation1.21 Financial System1.22 Definition of Financial System1.23 Meaning of Financial System1.24 Meaning of Financial Dualism1.25 Objectives of Financial System1.26 Purpose of Financial System1.27 Functions of Financial System1.28 Structure of Indian Financial System or Components of Financial System1.29 Technology of Financial System1.30 Summary1.31 Check Your Progress1.32 Questions and Exercises1.33 Key Terms1.34 Check Your Progress: Answers1.35 Case Study

Unit 1: Introduction

2 Management of Financial Institutions


Notes 1.36 Further Readings1.37 Bibliography

Objectives

After studying this unit, you should be able to understand:Understand the overview of financial institutions and economic developmentDetailed study of types of MoneyDetailed study of process of capital formationTechnology of financial systemUnderstand the Pooling and NettingUnderstand the Credit Substitution and Delegation

1.1 Introduction

Financial institution is an institution that provides financial services for its clients ormembers. Probably, the most important financial service provided by financial institutionsis acting as financial intermediaries. Most financial institutions are regulated by thegovernment. Broadly speaking, there are three major types of financial institutions:(i) Depositary Institutions: Deposit-taking institutions that accept and manage depositsand make loans, including banks, building societies, credit unions, trust companies, andmortgage loan companies, (ii) Contractual Institutions: Insurance companies and pensionfunds; and (iii) Investment Institutes: Investment Banks, underwriters and brokerage firms.

The Financial Institutions in India, comprising of 15 institutions at the national-leveland 47 institutions at the State-level, have played a significant role in their designateddomain in promoting development in the country. Although primarily engaged in providingmedium- and long-term assistance to industry in the form of project finance, financialinstitutions have, over the years, rendered an array of varied industry-related services,including providing risk capital, underwriting new issues, identifying investment projects,preparing and evaluating project reports, galvanizing spatially balanced industrialdevelopment (including backward area development), disseminating technical advice andmarket-related information and management services. Financial Institutions were alsocalled upon, particularly in the pre-reform era, to undertake a range of developmental andpromotional activities in tune with contemporaneous national objectives and priorities.These inter alia included evolution of an enabling institutional infrastructure forentrepreneurship and broad-based capital market development.

1.2 Financial Institutions

Financial institutions provide services as intermediaries of financial markets. Theyare responsible for transferring funds from investors to companies in need of those funds.Financial institutions facilitate the flow of money through the economy. To do so, savingsare brought to provide funds for loans.

Financial Institutions have expanded their outreach, both geographically and spanningvarious segments of the financial system, through a network of subsidiaries/associateinstitutions, covering areas such as commercial banking, mutual funds, investor andcustodial services, capital market related services, venture capital financing, infrastructurefinancing, registrar and transfer services, credit rating and e-commerce.


Introduction 3

NotesAll India Financial Institutions (AIFI) is a group composed of Development FinanceInstitutions (DFI) and Investment Institutions that play a pivotal role in the financial markets.Also known as “financial instruments”, the financial institutions assist in the properallocation of resources, sourcing from businesses that have a surplus and distributing toothers who have deficits—this also assists with ensuring the continued circulation ofmoney in the economy. Possibly of greatest significance, the financial institutions actas an intermediary between borrowers and final lenders, providing safety and liquidity. Thisprocess subsequently ensures earnings on the investments and savings involved. Financialinstitutions include banks, credit unions, asset management firms, building societies, andstock brokerages, among others. These institutions are responsible for distributingfinancial resources in a planned way users.

There are a number of institutions that collect and provide funds for the necessarysector or individuals. On the other hand, there are several institutions that act asmiddlemen to join the deficit and surplus units. Investing money on behalf of the clientis another variety of functions of financial institutions.

In post-Independence India, people were encouraged to increase savings; a tacticintended to provide funds for investment by the Indian government. However, there wasa huge gap between the supply of savings and demand for the investment opportunitiesin the country.

1.3 Meaning of Financial Institutions

Financial institutions refer to those institutions, which provide financial services andproducts which customers need. Financial institutions provide all those services, whicha customer may not be able to get more efficiently on his own. For example, customersnot having skill to invest in equity market efficiently can invest money in Mutual Fundsand can get the benefit of capital market. Financial institutions provide all those financialservices, which are available in financial system.

Financial institution refers to those business organizations who play the role ofsurplus mobilizes, credit providers and bodies that provide various financial services.

Financial institutions represent those bodies that basically collect the surplus fundsavailable (in the form of savings) and make it available to productive outlets.

1.4 Benefits of Financial Institutions

The benefits of financial institutions are as follows:

(a) Financial institutions offer financial servicesFinancial institutions offer various financial services. Financial institutions provide

service as intermediaries of the capital and debt markets. They are responsible fortransferring funds from investors to companies, in need of those funds. The presence offinancial institutions facilitates the flow of money through the economy. To do so, savingsare pooled to mitigate the risk brought to provide funds for loans. Such is the primarymeans for depository institutions to develop revenue.

(b) Financial institutions assist for achieving economy of scaleWhen financial institutions are carrying out their investment or other activities in large

scale out of pooled funds, they can achieve economy of scale.



Notes (c) Financial institutions ensure lower transaction costBecause of economy of scale, the cost of each transaction is much lower than what

it would have been, if that transaction is carried on by individual investor on his own.

(d) It helps for diversificationAs financial institutions deal with huge amounts of pooled funds, they diversify their

investments in such a way that the risk involved would reduce considerably.

(e) Financial institutions facilitate open financial exchange servicesOpen Financial Exchange is the solution to the financial services industry’s need

for a simplified way to exchange electronic financial data with consumers and smallbusinesses. The open, unified specification for the exchange of financial data over theinternet which defines a common way for financial institutions and their customers tocommunicate electronically. The result is that open financial exchange has helpedaccelerate the adoption of online financial services and enabled financial institutions tooffer their customers safe, secure banking, bills payment, investments and other servicesover the Internet.

1.5 Classification of Financial Institutions

Financial Institutions in India are divided as follows:

1. Banking Institutions

Banking institutions consists of all scheduled commercial banks and scheduledcooperative banks.

(i) Scheduled Commercial BanksScheduled Banks in India constitute those banks which have been included in the

Second Schedule of Reserve Bank of India (RBI) Act, 1934. RBI in turn includes only thosebanks in this schedule which satisfy the criteria laid down vide section 42(6)(a) of theAct.

As on 30th June, 1999, there were 300 scheduled banks in India having a total networkof 64,918 branches. The scheduled commercial banks in India comprise of State Bankof India and its associates (8), nationalized banks (19), foreign banks (45), private sectorbanks (32), cooperative banks and regional rural banks.

“Scheduled banks in India” means the State Bank of India constituted under the StateBank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bankof India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constitutedunder 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 Transferof Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in theSecond Schedule to the Reserve Bank of India Act, 1934 (2 of 1934), but does not includea “cooperative bank”.

(ii) Scheduled Cooperative BanksThe Urban Banks Department of the Reserve Bank of India is vested with the

responsibility of regulating and supervising primary (urban) cooperative banks, which arepopularly known as Scheduled Cooperative Banks (UCBs). While overseeing the activitiesof 1926 scheduled cooperative banks, the Banks Department performs three main


Introduction 5

Notesfunctions: regulatory, supervisory and developmental. The Department performs thesefunctions through its 17 regional offices.

2. Non-Banking Institutions

A Non-Bank Financial Institution (NBFI) is a financial institution that does not havea full banking license or is not supervised by a national or international banking regulatoryagency. NBFIs facilitate bank-related financial services, such as investment, risk pooling,contractual savings, and market brokering. Examples of these include insurance firms,pawn shops, cashier’s check issuers, check cashing locations, payday lending, currencyexchanges, and micro loan organizations. Alan Greenspan has identified the role of NBFIsin strengthening an economy, as they provide multiple alternatives to transform aneconomy’s savings into capital investment which act as backup facilities.

(i) Non-Banking Finance CompaniesNon-Banking Financial Companies (NBFCs) are financial institutions that provide

banking services without meeting the legal definition of a bank, i.e., one that does nothold a banking license. These institutions are not allowed to take deposits from the public.Nonetheless, all operations of these institutions are still exercised under bank regulation.

(ii) Development Financial InstitutionsDevelopment Finance Institution (DFI) is generic term used to refer to a range of

alternative financial institutions including microfinance institutions, community developmentfinancial institution and revolving loan funds. These institutions provide a crucial role inproviding credit in the form of higher risk loans, equity positions and risk guaranteeinstruments to private sector investments in developing countries. DFIs are backed bystates with developed economies.

DFIs have a general mandate to provide finance to the private sector for investmentsthat promote development. The purpose of DFIs is to ensure investment in areas whereotherwise, the market fails to invest sufficiently. DFIs aim to be catalysts, helpingcompanies implement investment plans and especially seek to engage in countries wherethere is restricted access to domestic and foreign capital markets and provide riskmitigation that enables investors to proceed with plans which they might otherwiseabandon. DFIs specialize in loans with longer maturities and other financial products. DFIshave a unique advantage in providing finance that is related to the design andimplementation of reforms and capacity-building programmes adopted by governments.

All India Financial Institutions (AIFIs) is a group composed of Development FinanceInstitutions (DFIs) and Investment Institutions that play a pivotal role in the financialmarkets. Also known as “financial instruments”, the financial institutions assist in theproper allocation of resources, sourcing from businesses that have a surplus anddistributing to others who have deficits—this also assists by ensuring the continuedcirculation of money in the economy. Possibly of greatest significance, the financialinstitutions act as an intermediary between borrowers and final lenders, providing safetyand liquidity. All India Financial Institutions includes, IFCI, IDBI, IIBI, SIDBI, IDFC,NABARD, EXIM Bank and NHB. The State-level Institutions includes SFCs and SIDCs.Other Financial Institutions are ECGC and DICGC.

3. Mutual Funds

A mutual fund is a type of professionally-managed collective investment vehicle thatpools money from many investors to purchase securities. While there is no legal definition



Notes of mutual fund, the term is most commonly applied only to those collective investmentvehicles that are regulated, available to the general public and open-ended in nature. Hedgefunds are not considered a type of mutual fund.

(i) Mutual funds in public sectorUnit Trust of India was the first mutual fund set up in India in the year 1963. In early

1990s, Government allowed public sector banks and institutions to set up mutual funds.In the year 1992, Securities and Exchange Board of India (SEBI) Act was passed. Theobjectives of SEBI are to protect the interest of investors in securities and to promotethe development of and to regulate the securities market.

(ii) Mutual funds in private sectorIn spite of being a relatively new entrant, HDFC MF has become the second largest

fund house in India in a span of 10 years. It has grown manifold because of their steadyperformance of its schemes like HDFC Top 200, HDFC Equity, etc. One more reasonfor the declining market share is that the number of public sector players is shrinking.Today, there are only 6 players in a market with 40 players. On the other hand, publicsector accounted for 10 out of a total of 31 players in March, 2000.

4. Insurance and Housing Finance Companies

The banks providing the housing finance and related facilities such as Bank of Baroda,Canara Bank, Corporation Bank, IDBI Bank, Punjab National Bank and State Bank of India.Companies Act 1956 which primarily transacts or has one of its principal objects and themain feature of the business is providing finance for housing, whether directly or indirectly.

1.6 Role of Financial Institutions

The various roles of financial institutions are as follows:

(i) Financial institutions facilitates for capital formationCapital formation implies the diversion of the productive capacity of the economy to

the making of capital goods which increases future productive capacity. The process ofCapital Formation involves three distinct but interdependent activities, viz., savings,financial intermediation and investment. However, poor country/economy may be, therewill be a need for institutions which allow such savings, as are currently forthcoming, tobe invested conveniently and safely and which ensure that they are channeled into themost useful purposes. A well-developed financial structure will therefore aid in thecollections and disbursements of investible funds and thereby contribute to the capitalformation of the economy. Indian capital market although still considered to beunderdeveloped has been recording impressive progress during the post-interdependenceperiod.

(ii) Support to the capital marketThe basic purpose of FIs, particularly in the context of a developing economy, is

to accelerate the pace of economic development by increasing capital formation, inducinginvestors and entrepreneurs, sealing the leakages of material and human resources bycareful allocation thereof, undertaking development activities, including promotion ofindustrial units to fill the gaps in the industrial structure and by ensuring that no healthyprojects suffer for want of finance and/or technical services. Hence, the DFIs have toperform financial and development functions on finance functions, there is a provision ofadequate term finance and in development functions there include provision of foreign


Introduction 7

Notescurrency loans, underwriting of shares and debentures of industrial concerns, directsubscription to equity and preference share capital, guaranteeing of deferred payments,conducting techno-economic surveys, market and investment research and rendering oftechnical and administrative guidance to the entrepreneurs.

(iii) Offers the rupee loan facilitiesRupee loans constitute more than 90% of the total assistance sanctioned and

disbursed. This speaks eloquently on FI’s obsession with term loans to the neglect ofother forms of assistance which are equally important. Term loans unsupplemented byother forms of assistance had naturally put the borrowers, most of whom are smallentrepreneurs, on to a heavy burden of debt-servicing. Since term finance is just one ofthe inputs but not everything for the entrepreneurs, they had to search for other sourcesand their abortive efforts to secure other forms of assistance led to sickness in industrialunits in many cases.

(iv) Foreign currency loan facilitiesForeign currency loans are meant for setting up of new industrial projects as also

for expansion, diversification, modernization or renovation of existing units in cases wherea portion of the loan was for financing import of equipment from abroad and technical know-how, in special cases.

(v) Offers subscription to debentures and guaranteesRegarding guarantees, it is well-known that when an entrepreneur purchases some

machinery or fixed assets or capital goods on credit, the supplier usually asks him tofurnish some guarantee to ensure payment of installments by the purchaser at regularintervals. In such a case, FIs can act as guarantors for prompt of installments to thesupplier of such machinery or capital under a scheme called ‘Deferred PaymentsGuarantee’.

(vi) Assistance to backward areasOperations of FIs in India have been primarily guided by priorities as spelt out in

the Five-Year Plans. This is reflected in the lending portfolio and pattern of financialassistance of development financial institutions under different schemes of financing.Institutional finance to projects in backward areas is extended on concessional terms suchas lower interest rate, longer moratorium period, extended repayment schedule and relaxednorms in respect of promoters’ contribution and debt-equity ratio. Such concessions areextended on a graded scale to units in industrially backward districts, classified into thethree categories of A, B and C depending upon the degree of their backwardness. Besides,institutions have introduced schemes for extending term loans for project/area-specificinfrastructure development. Moreover, in recent years, development banks in India havelaunched special programmes for intensive development of industrially least developedareas, commonly referred to as the No Industry Districts (NIDs) which do not have anylarge-scale or medium-scale industrial project. Institutions have initiated industrial potentialsurveys in these areas.

(vii) Promotion of new entrepreneursDevelopment banks in India have also achieved a remarkable success in creating

a new class of entrepreneurs and spreading the industrial culture to newer areas andweaker sections of the society. Special capital and seed capital schemes have beenintroduced to provide equity type of assistance to new and technically skilled entrepreneurswho lack financial resources of their own even to provide promoter’s contribution in viewof long-term benefits to the society from the emergence of a new class of entrepreneurs.



Notes Development banks have been actively involved in the entrepreneurship developmentprogrammes and in establishing a set of institutions which identify and train potentialentrepreneurs. Again, to make available a package of services encompassing preparationof feasibility of reports, project reports, technical and management consultancy, etc. ata reasonable cost, institutions have sponsored a chain of 16 Technical Consultancyorganizations covering practically the entire country. Promotional and developmentfunctions are as important to institutions as the financing role. The promotional activitieslike carrying out industrial potential surveys, identification of potential entrepreneurs,conducting entrepreneurship development programmes and providing technical consultancyservices have contributed in a significant manner to the process of industrialization andeffective utilization of industrial finance by industry. IDBI has created a special technicalassistance fund to support its various promotional activities. Over the years, the scopeof promotional activities has expanded to include programmes for upgradation of skill ofState level development banks and other industrial promotion agencies, conducting specialstudies on important issues concerning industrial development, encouraging voluntaryagencies in implementing their programmes for the uplift of rural areas, village and cottageindustries, artisans and other weaker sections of the society.

(viii) Impact on corporate cultureThe project appraisal and follow-up of assisted projects by institutions through various

instruments, such as project monitoring and report of nominee directors on the Board ofDirectors of assisted units, have been mutually rewarding. Through monitoring of assistedprojects, the institutions have been able to better appreciate the problems faced byindustrial units. It also has been possible for the corporate managements to recognizethe fact that interests of the assisted units and those of institutions do not conflict butcoincide. Over the years, institutions have succeeded in infusing a sense of constructivepartnership with the corporate sector. Institutions have been going through a continuousprocess of learning by doing and are effecting improvements in their systems andprocedures on the basis of their cumulative experience.

1.7 Functions of Financial Institutions

The various functions of financial institutions are as follows:

(i) Raising Finance for ClientsFinancial Institutions help its clients to raise finance through issue of shares,

debentures, bank loans, etc. It helps its clients to raise finance from the domestic andinternational market. This finance is used for starting a new business or project or formodernization or expansion of the business.

(ii) Broker in Stock ExchangeFinancial Institutions act as brokers in the stock exchange. They buy and sell shares

on behalf of their clients. They conduct research on equity shares. They also advise theirclients about which shares to buy, when to buy, how much to buy and when to sell. LargeBrokers, Mutual Funds, Venture Capital Companies and Investment Banks offer merchantbanking services.

(iii) Project ManagementFinancial Institutions help their clients in the many ways. For example, advising about

location of a project, preparing a project report, conducting feasibility studies, making aplan for financing the project, finding out sources of finance, advising about concessionsand incentives from the government.


Introduction 9

Notes(iv) Advice on Expansion and ModernizationFinancial Institutions give advice for expansion and modernization of the business

units. They give expert advice on mergers and amalgamations, acquisition and takeovers,diversification of business, foreign collaborations and joint ventures, technologyupgradation, etc.

(v) Managing Public Issue of CompaniesFinancial Institutions advice and manage the public issue of companies.

They provide following services:

Advise on the timing of the public issue.Advise on the size and price of the issue.Acting as manager to the issue, and helping in accepting applications andallotment of securities.Help in appointing underwriters and brokers to the issue.Listing of shares on the stock exchange, etc.

(vi) Handling Government Consent for Industrial ProjectsA businessman has to get government permission for starting of the project. Similarly,

a company requires permission for expansion or modernization activities. For this, manyformalities have to be completed. Financial Institutions do all this work for their clients.

(vii) Special Assistance to Small Companies and EntrepreneursFinancial Institutions advise small companies about business opportunities,

government policies, incentives and concessions available. It also helps them to takeadvantage of these opportunities, concessions, etc.

(viii) Services to Public Sector UnitsFinancial Institutions offer many services to public sector units and public utilities.

They help in raising long-term capital, marketing of securities, foreign collaborations andarranging long-term finance from term lending institutions.

(ix) Revival of Sick Industrial UnitsFinancial Institutions help to revive (cure) sick industrial units. It negotiates with

different agencies like banks, term lending institutions, and BIFR (Board for Industrial andFinancial Reconstruction). It also plans and executes the full revival package.

(x) Portfolio ManagementA Financial Institutions manage the portfolios (investments) of its clients. This makes

investments safe, liquid and profitable for the client. It offers expert guidance to its clientsfor taking investment decisions.

1.8 Types of Non-Banking Financial Institutions

The various types of non-banking financial institutions are as follows:

1. Risk Pooling Institutions

Insurance companies underwrite economic risks associated with illness, death,damage and other risks of loss. In return to collecting an insurance premium, insurancecompanies provide a contingent promise of economic protection in the case of loss. Thereare two main types of insurance companies: general insurance and life insurance. General



Notes insurance tends to be short-term, while life insurance is a longer-term contract, whichterminates at the death of the insured. Both types of insurance, life and general, areavailable to all sectors of the community.

Although insurance companies don’t have banking licenses, in most countriesinsurance has a separate form of regulation specific to the insurance business and maywell be covered by the same financial regulator that also covers banks. There have alsobeen a number of instances where insurance companies and banks have merged thuscreating insurance companies that do have banking licenses.

2. Contractual Savings Institutions

Contractual savings institutions give individuals the opportunity to invest in collectiveinvestment vehicles (CIVs) as a fiduciary rather than a principal role. Collective investmentvehicles pool resources from individuals and firms into various financial instrumentsincluding equity, debt, and derivatives. Note that the individual holds equity in the CIVitself rather what the CIV invests in specifically. The two most popular examples ofcontractual savings institutions are pension funds and mutual funds.

The two main types of mutual funds are open-end and closed-end funds. Open-endfunds generate new investments by allowing the public to purchase new shares at anytime, and shareholders can liquidate their holding by selling the shares back to the open-end fund at the net asset value. Closed-end funds issue a fixed number of shares in anIPO. In this case, the shareholders capitalise on the value of their assets by selling theirshares in the stock exchange.

Mutual funds are usually distinguished by the nature of their investments. Forexample, some funds specialize in high risk, high return investments, while others focuson tax-exempt securities. There are also mutual funds specializing in speculative trading(i.e., hedge funds), a specific sector or cross-border investments.

Pension funds are mutual funds that limit the investor’s ability to access theirinvestments until a certain date. In return, pension funds are granted large tax breaksin order to incentives the working population to set aside a portion of their current incomefor a later date after they exit the labor force (retirement income).

3. Market Makers

Market makers are broker-dealer institutions that quote a buy and sell price andfacilitate transactions for financial assets. Such assets include equities, government andcorporate debt, derivatives, and foreign currencies. After receiving an order, the marketmaker immediately sells from its inventory or makes a purchase to offset the loss ininventory. The differential between the buying and selling quotes, or the bid-offer spread,is how the market-maker makes profit. A major contribution of the market makers isimproving the liquidity of financial assets in the market.

4. Specialized Sectorial Financiers

They provide a limited range of financial services to a targeted sector. For example,real estate financiers channel capital to prospective home owners, leasing companiesprovide financing for equipment and payday lending companies that provide short-termloans to individuals that are underbanked or have limited resources.


Introduction 11

Notes5. Financial Service Providers

Financial service providers include brokers (both securities and mortgage),management consultants, and financial advisors, and they operate on a fee-for-servicebasis. Their services include: improving informational efficiency for the investors and, inthe case of brokers, offering a transactions service by which an investor can liquidateexisting assets.

1.9 Financial Institutions and Economic Development

Financial institution is an establishment that conducts financial transactions suchas investments, loans and deposits. Economic development is the sustained, concertedactions of policy makers and communities that promote the standard of living andeconomic health of a specific area. Economic development can also be referred to asthe quantitative and qualitative changes in the economy. Financial institutions play a vitalrole for economic development of a country. The roles played by the financial institutionsare given below:

1. The financial systems can support the efficient exchange of goods and servicesby providing payment services and thus reducing transaction costs. Financial services canfoster specialization by enabling more transactions, thus fostering productivity growth.

2. By pooling savings from many individual savers, financial institutions and marketscan help overcome investment indivisibilities and allow exploiting scale economies. Thisdoes not necessarily have to be national financial institutions but can be local coalitionsof investors, as was the case in the early days of the Industrial Revolution for infrastructureprojects.

3. By economizing on screening and monitoring costs and thus allowing moreinvestment projects to be financed and, ex ante, increasing the aggregate successprobability, financial institutions and markets can ultimately have a positive impact oninvestment and resource allocation. Similarly, by identifying the entrepreneurs with themost promising technologies, financial intermediaries can also boost the rate oftechnological innovation and ultimately growth. A similar argument holds for financialmarkets: in larger and more liquid markets, agents have greater incentives to invest inresearch on enterprises and projects, which produces information that can be turned intotrading gains, ultimately improving resource allocation.

4. Both financial institutions and markets can help monitor enterprises and reduceagency problems within firms between management and majority and minorityshareholders, again improving resource allocation. Debt instruments can reduce theamount of free cash available to firms and thus managerial slack, while liquid stockexchanges can allow investors to monitor and discipline enterprises through the threatof takeovers and subsequent dismissal of management.

5. Banks can also help reduce liquidity risk and thus enable long-term investment,as shown by Diamond and Dybvig. By pooling savings of patient and impatient agents,financial institutions can transform short-term liabilities into long-term assets, enablinglong-term investment and ultimately economic growth. Similarly, liquid markets can enableinvestment in long-term investment projects while at the same time allowing investors tohave access to their savings at short-term notice. Financial institutions can also easeliquidity needs of enterprises, enabling long-term investment and R&D activities. Bybuilding long-term relationships, financial institutions can further reduce monitoring costs.



Notes Both financial markets and institutions can thus improve resource allocation andproductivity growth. By reducing control problems of investors vis-à-vis owners andmanagers of enterprises, improved corporate governance can also increase savings andcapital accumulation.

6. Finally, financial institutions and markets allow cross-sectional diversificationacross projects, allowing risky innovative activity while guaranteeing an ex ante contractedinterest rate to savers. Furthermore, aggregate risk that cannot be diversified away at aspecific point in time can be diversified by long-living financial intermediaries over time.

1.10 Introduction to Money

Money is any object or record that is generally accepted as payment for goods andservices for repayment of debts in a given country or socio-economic context. The mainfunctions of money are distinguished as: a medium of exchange; a unit of account; a storeof value; and, occasionally in the past, a standard of deferred payment. Any kind of objector secure verifiable record that fulfills these functions can serve as money.

Money originated as commodity money, but nearly all contemporary money systemsare based on fiat money. Fiat money is without intrinsic use value as a physicalcommodity, and derives its value by being declared by a government to be legal tender;that is, it must be accepted as a form of payment within the boundaries of the country,for “all debts, public and private”. The money supply of a country consists of currency(bank notes and coins) and bank money (the balance held in check accounts and savingsaccounts). Bank money usually forms by far the largest part of the money supply.

1.11 History of Money

The history of money spans thousands of years. Numismatics is the scientific studyof money and its history in all its varied forms. Many items have been used as commoditymoney such as naturally scarce precious metals, cowry shells, barley, beads, etc. aswell as many other things that are thought of as having value.

Modern money and most ancient money is essentially a token, in other words, anabstraction. Paper currency is perhaps the most common type of physical money today.However, objects of gold or silver present many of money’s essential properties.

The Emergence of Money

In the absence of a medium of exchange, non-monetary societies operated largelyalong the principles of gift economics.

The Mesopotamian civilization developed a large scale economy based on commoditymoney. The Babylonians and their neighboring city states later developed the earliestsystem of economics as we think of it today, in terms of rules on debt, legal contractsand law codes relating to business practices and private property. Money was not onlyan emergence, it was a necessity.

The Shekel referred to an ancient unit of weight and currency. The first usage ofthe term came from Mesopotamia circa 3000 BC and referred to a specific mass of barleywhich related other values in a metric such as silver, bronze, copper, etc. A barley/shekelwas originally both a unit of currency and a unit of weight, just as the British Pound wasoriginally a unit denominating a one pound mass of silver.


Introduction 13

NotesCommodity Money

Bartering has several problems; most notably that it requires a ’coincidence of wants’.For example, if a wheat farmer needs what a fruit farmer produces, a direct swap isimpossible as seasonal fruit would spoil before the grain harvest. A solution is to tradefruit for wheat indirectly through a third, “intermediatee”, and commodity: the fruit isexchanged for the intermediate commodity when the fruit ripens. If this intermediatecommodity doesn’t perish and is reliably in demand throughout the year (e.g., copper,gold, or wine) then it can be exchanged for wheat after the harvest. The function of theintermediate commodity as a store-of-value can be standardized into a widespreadcommodity money, reducing the coincidence of wants problem. By overcoming thelimitations of simple barter, commodity money makes the market in all other commoditiesmore liquid.

Many cultures around the world eventually developed the use of commodity money.Ancient China, Africa, and India used cowry shells. Trade in Japan’s feudal system wasbased on the koku a unit of rice. The shekel was an ancient unit of weight and currency.The first usage of the term came from Mesopotamia circa 3000 BC and referred to a specificweight of barley, which related other values in a metric such as silver, bronze, copper,etc. A barley/shekel was originally both a unit of currency and a unit of weight.

Wherever trade is common, barter systems usually lead quite rapidly to several keygoods being imbued with monetary properties. In the early British colony of New SouthWales, rum emerged quite soon after settlement as the most monetary of goods. Whena nation is without a currency it commonly adopts a foreign currency. In prisons whereconventional money is prohibited, it is quite common for cigarettes to take on a monetaryquality, and throughout history, gold has taken on this unofficial monetary function.

Standardized Coinage

From early times, metals, where available, have usually been favored for use as proto-money over such commodities as cattle, cowry shells, or salt, because they are at oncedurable, portable, and easily divisible. The use of gold as proto-money has been tracedback to the fourth millennium BC when the Egyptians used gold bars of a set weight asa medium of exchange, as had been done earlier in Mesopotamia with silver bars. Thefirst known ruler who officially set standards of weight and money was Pheidon. The firststamped money (having the mark of some authority in the form of a picture or words)can be seen in the Bibliothèque Nationale of Paris. It is an electrum stater of a turtlecoin, coined at Aegina Island. This remarkable coin dates about 700 BC. Electrum coinswere also introduced about 650 BC in Lydia.

Coinage was widely adopted across Ionia and mainland Greece during the 6th centuryBC, eventually leading to the Athenian Empire’s 5th century BC, dominance of the regionthrough their export of silver coinage, mined in southern Attica at Laurium and Thorikos.A major silver vein discovery at Laurium in 483 BC led to the huge expansion of theAthenian military fleet. Competing coinage standards at the time were maintained byMytilene and Phokaia using coins of Electrum; Aegina used silver.

It was the discovery of the touchstone which led the way for metal-based commoditymoney and coinage. Any soft metal can be tested for purity on a touchstone, allowingone to quickly calculate the total content of a particular metal in a lump. Gold is a softmetal, which is also hard to come by, dense, and storable. As a result, monetary goldspread very quickly from Asia Minor, where it first gained wide usage, to the entire world.



Notes Using such a system still required several steps and mathematical calculation. Thetouchstone allows one to estimate the amount of gold in an alloy, which is then multipliedby the weight to find the amount of gold alone in a lump. To make this process easier,the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed,so as long as the manufacturer was aware of the origin of the coin, no use of the touchstonewas required. Coins were typically minted by governments in a carefully protected process,and then stamped with an emblem that guaranteed the weight and value of the metal.It was, however, extremely common for governments to assert that the value of such moneylay in its emblem and thus to subsequently reduce the value of the currency by loweringthe content of valuable metal.

Although gold and silver were commonly used to mint coins, other metals could beused. For instance, Ancient Sparta minted coins from iron to discourage its citizens fromengaging in foreign trade. In the early seventeenth century, Sweden lacked more preciousmetal and so produced “plate money”, which were large slabs of copper approximately50 cm or more in length and width, appropriately stamped with indications of their value.

Metal based coins had the advantage of carrying their value within the coinsthemselves on the other hand, they induced manipulations: the clipping of coins in theattempt to get and recycle the precious metal. A greater problem was the simultaneousco-existence of gold, silver and copper coins in Europe. English and Spanish traders valuedgold coins more than silver coins, as many of their neighbors did, with the effect thatthe English gold-based guinea coin began to rise against the English silver based crownin the 1670s and 1680s. Consequently, silver was ultimately pulled out of England fordubious amounts of gold coming into the country at a rate no other European nation wouldshare. The effect was worsened with Asian traders not sharing the European appreciationof gold altogether gold left Asia and silver left Europe in quantities European observerslike Isaac Newton, Master of the Royal Mint observed with unease.

Stability came into the system with national Banks guaranteeing to change moneyinto gold at a promised rate; it did, however, not come easily. The Bank of England riskeda national monetary catastrophe in the 1730s when customers demanded their moneybe changed into gold in a moment of crisis. Eventually London’s merchants saved thebank and the nation with monetary guarantees.

Another step in the evolution of money was the change from a coin being a unitof weight to being a unit of value. a distinction could be made between its commodityvalue and its specie value. The difference is these values are seigniorage.

Trade Bills of Exchange

Bills of exchange became prevalent with the expansion of European trade towardthe end of the middle Ages. A flourishing Italian wholesale trade in cloth, woolen clothing,and wine, tin and other commodities was heavily dependent on credit for its rapidexpansion. Goods were supplied to a buyer against a bill of exchange, which constitutedthe buyer’s promise to make payment at some specified future date. Provided that thebuyer was reputable or the bill was endorsed by a credible guarantor, the seller couldthen present the bill to a merchant banker and redeem it in money at a discounted valuebefore it actually became due.

These bills could also be used as a form of payment by the seller to make additionalpurchases from his own suppliers. Thus, the bills an early form of credit – became botha medium of exchange and a medium for storage of value. Like the loans made by theEgyptian grain banks, this trade credit became a significant source for the creation of


Introduction 15

Notesnew money. In England, bills of exchange became an important form of credit and moneyduring last quarter of the 18th century and the first quarter of the 19th century before banknotes, checks and cash credit lines were widely available.

Tallies

The acceptance of symbolic forms of money opened up vast new realms for humancreativity. A symbol could be used to represent something of value that was available inphysical storage somewhere else in space, such as grain in the warehouse. It could alsobe used to represent something of value that would be available later in time, such asa promissory note or bill of exchange, a document ordering someone to pay a certainsum of money to another on a specific date or when certain conditions have been fulfilled.

In the 12th Century, the English monarchy introduced an early version of the bill ofexchange in the form of a notched piece of wood known as a tally stick. Tallies originallycame into use at a time when paper was rare and costly, but their use persisted untilthe early 19th Century, even after paper forms of money had become prevalent. Thenotches were used to denote various amounts of taxes payable to the crown. Initially,tallies were simply used as a form of receipt to the tax payer at the time of renderinghis dues. As the revenue department became more efficient, they began issuing talliesto denote a promise of the tax assessee to make future tax payments at specified timesduring the year. Each tally consisted of a matching pair one stick was given to theassessee at the time of assessment representing the amount of taxes to be paid laterand the other held by the Treasury representing the amount of taxes be collected at afuture date.

The Treasury discovered that these tallies could also be used to create money. Whenthe crown had exhausted its current resources, it could use the tally receipts representingfuture tax payments due to the crown as a form of payment to its own creditors, whoin turn could either collect the tax revenue directly from those assessed or use the sametally to pay their own taxes to the government. The tallies could also be sold to otherparties in exchange for gold or silver coin at a discount reflecting the length of timeremaining until the taxes was due for payment. Thus, the tallies became an acceptedmedium of exchange for some types of transactions and an accepted medium for storeof value. The Treasury soon realized that it could also issue tallies that were not backedby any specific assessment of taxes. By doing so, the Treasury created new money thatwas backed by public trust and confidence in the monarchy rather than by specific revenuereceipts.

Goldsmith Bankers

Goldsmiths in England had been craftsmen, bullion merchants, money changers andmoneylenders since the 16th century. But they were not the first to act as financialintermediates; in the early 17th century, the scrivener were the first to keep deposits forthe express purpose of relending them. Merchants and traders had amassed huge hoardsof gold and entrusted their wealth to the Royal Mint for storage. In 1640, King CharlesI seized the private gold stored in the mint as a forced loan (which was to be paid backover time). Thereafter merchants preferred to store their gold with the goldsmiths of London,who possessed private vaults, and charged a fee for that service. In exchange for eachdeposit of precious metal, the goldsmiths issued receipts certifying the quantity and purityof the metal they held as a bailee (i.e., in trust). These receipts could not be assigned(only the original depositor could collect the stored goods). Gradually, the goldsmiths tookover the function of the scrivener of relending on behalf of a depositor and also developed



Notes modern banking practices; promissory notes were issued for money deposited which bycustom and/or law was a loan to the goldsmith, i.e., the depositor expressly allowed thegoldsmith to use the money for any purpose including advances to his customers. Thegoldsmith charged no fee, or even paid interest on these deposits. Since the promissorynotes were payable on demand, and the advances (loans) to the goldsmith’s customerswere repayable over a longer time period, this was an early from of fractional reservebanking. The promissory notes developed into an assignable instrument, which couldcirculate as a safe and convenient form of money backed by the goldsmith’s promise topay. Hence, goldsmiths could advance loans in the form of gold money, or in the formof promissory notes, or in the form of checking accounts. Gold deposits were relativelystable, often remaining with the goldsmith for years on end, so there was little risk ofdefault so long as public trust in the goldsmith’s integrity and financial soundness wasmaintained. Thus, the goldsmiths of London became the forerunners of British bankingand prominent creators of new money based on credit.

Demand Deposits

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The primary business of the early merchant banks was promotion of trade. The newclass of commercial banks made accepting deposits and issuing loans their principalactivity. They lend the money they received on deposit. They created additional moneyin the form of new bank notes. The money they created was partially backed by gold,silver or other assets and partially backed only by public trust in the institutions thatcreated it.

Demand deposits are funds that are deposited in bank accounts and are availablefor withdrawal at the discretion of the depositor. The withdrawal of funds from the accountdoes not require contacting or making any type of prior arrangements with the bank orcredit union. As long as the account balance is sufficient to cover the amount of thewithdrawal, and the withdrawal takes place in accordance with procedures set in placeby the financial institution, the funds may be withdrawn on demand

Bank Notes

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The history of money and banking are inseparably interlinked. The issuance of papermoney was initiated by commercial banks. Inspired by the success of the Londongoldsmiths, some of which became the forerunners of great English banks, banks beganissuing paper notes quite properly termed ‘bank notes’ which circulated in the same waythat government issued currency circulates today. In England, this practice continued upto 1694. Scottish banks continued issuing notes until 1850. In USA, this practice continuedthrough the 19th century, where at one time there were more than 5000 different typesof bank notes issued by various commercial banks in America. Only the notes issuedby the largest, most creditworthy banks were widely accepted. The script of smaller, lesserknown institutions circulated locally. Farther from home, it was only accepted at adiscounted rate, if it was accepted at all. The proliferation of types of money went handin hand with a multiplication in the number of financial institutions.


Introduction 17

NotesThese bank notes were a form of representative money which could be convertedinto gold or silver by application at the bank. Since banks issued notes far in excessof the gold and silver they kept on deposit, sudden loss of public confidence in a bankcould precipitate mass redemption of bank notes and result in bankruptcy. The use ofbank notes issued by private commercial banks as legal tender has gradually beenreplaced by the issuance of bank notes authorized and controlled by national governments.The Bank of England was granted sole rights to issue bank notes in England after 1694.In the USA, the Federal Reserve Bank was granted similar rights after its establishmentin 1913. Until recently, these government-authorized currencies were forms ofrepresentative money, since they were partially backed by gold or silver and weretheoretically convertible into gold or silver.

Gold-backed Bank Notes

The term gold standard is often erroneously thought to refer to a currency wherenotes were fully backed by and redeemable in an equivalent amount of gold. The Britishpound was the strongest, most stable currency of the 19th century and often consideredthe closest equivalent to pure gold, yet at the height of the gold standard there was onlysufficient gold in the British treasury to redeem a small fraction of the currency then incirculation. In 1880, US government gold stock was equivalent in value to only 16% ofcurrency and demand deposits in commercial banks. By 1970, it was about 0.5 per cent.The gold standard was only a system for exchange of value between national currencies,never an agreement to redeem all paper notes for gold. The classic gold standard prevailedduring the period 1880 and 1913 when a core of leading trading nations agreed to adhereto a fixed gold price and continuous convertibility for their currencies. Gold was used tosettle accounts between these nations. With the outbreak of World War I, Britain wasforced to abandon the gold standard even for their international transactions. Other nationsquickly followed suit. After a brief attempt to revive the gold standard during the 1920s,it was finally abandoned by Britain and other leading nations during the Great Depression.

Prior to the abolition of the gold standard, the following words were printed on theface of every US dollar: “I promise to pay the bearer on demand, the sum of one dollar”followed by the signature of the US Secretary of the Treasury. Other denominations carriedsimilar pledges proportionate to the face value of each note. The currencies of other nationsbore similar promises too. In earlier times, this promise signified that a bearer could redeemcurrency notes for their equivalent value in gold or silver. The US adopted a silver standardin 1785, meaning that the value of the US dollar represented a certain equivalent weightin silver and could be redeemed in silver coins. But even at its inception, the USGovernment was not required to maintain silver reserves sufficient to redeem all the notesthat it issued. Through much of the 20th century until 1971, the US dollar was ‘backed’by gold, but from 1934 only foreign holders of the notes could exchange them for metal.

Representative Money

An example of representative money, this 1896 note could be exchanged for five USDollars worth of silver. Representative money refers to money that consists of a tokenor certificate made of paper. The use of the various types of money including representativemoney, tracks the course of money from the past to the present. Token money may becalled “representative money” in the sense that, say, a piece of paper might ‘represent’or be a claim on a commodity also. Gold certificates or Silver certificates are a type ofrepresentative money which was used in the United States as currency until 1933.



Notes The term ‘representative money’ has been used in the past “to signify that a certainamount of bullion was stored in a Treasury while the equivalent paper in circulation”represented the bullion. Representative money differs from commodity money which isactually made of some physical commodity. In his Treatise on Money (1930:7), Keynesdistinguished between commodity money and representative money, dividing the latter into“fiat money” and “managed money.”

Fiat Money

Fiat money refers to money that is not backed by reserves of another commodity.The money itself is given value by government fiat or decree, enforcing legal tender laws,previously known as “forced tender”, whereby debtors are legally relieved of the debt ifthey pay it in the government’s money. By law, the refusal of a legal tender (offering)extinguishes the debt in the same way acceptance does. At times in history (e.g., Romeunder Diocletian, and post-revolutionary France during the collapse of the assignats), therefusal of legal tender money in favor of some other form of payment was punished withthe death penalty.

Governments through history have often switched to forms of fiat money in timesof need such as war, sometimes by suspending the service they provided of exchangingtheir money for gold, and other times by simply printing the money that they needed.When governments produce money more rapidly than economic growth, the money supplyovertakes economic value. Therefore, the excess money eventually dilutes the marketvalue of all money issued. This is called inflation. See open market operations.

In 1971, the United States finally switched to fiat money indefinitely. At this pointin time, many of the economically developed countries’ currencies were fixed to the USdollar and so this single step meant that much of the western world’s currencies becamefiat money based. Following the Gulf War, the president of Iraq, Saddam Hussein, repealedthe existing Iraqi fiat currency and replaced it with a new currency. Despite having nobacking by a commodity and with no central authority mandating its use or defendingits value, the old currency continued to circulate within the politically isolated Kurdishregions of Iraq. It became known as the “Swiss dinar”. This currency remained relativelystrong and stable for over a decade. It was formally replaced following the Iraq War.

1.12 History of Money in India

Ancient India, presently modern states of Pakistan and north-western India, was oneof the earliest issuers of coins in the world (circa 6th century BC), along with the Chinesewen and Lydian staters. The origin of the word “rupee” is found in the word rup or rupa,which means “silver” in many Indo-Aryan languages such as Hindi. The Sanskrit wordrupyakam means coin of silver. The derivative word Rupaya was used to denote the coinintroduced by Sher Shah Suri during his reign from 1540 to 1545 CE. The original Rupayawas a silver coin weighing 175 grains troy (about 11.34 grams). The coin has been usedsince then, even during the times of British India. Formerly, the rupee was divided into16 annas, 64 paise, or 192 pies. In Arabia and East Africa, the British India rupee wascurrent at various times, including the paisa and was used as far south as Natal. InMozambique, the British India rupees were overstamped, and in Kenya, the British EastAfrica Company minted the rupee and its fractions as well as piece. It was maintainedas the florin, using the same standard, until 1920. In Somalia, the Italian colonial authorityminted ‘Rupia’ to exactly the same standard, and called the paisa ‘besa’. Early 19thcentury E.I.C. rupees were used in Australia for a limited period. Decimalisation occurred


Introduction 19

Notesin Ceylon (Sri Lanka) in 1872, India in 1957 and in Pakistan in 1961. Among the earliestissues of paper rupees were those by the Bank of Hindustan (1770-1832), the GeneralBank of Bengal and Bihar (1773-75, established by Warren Hastings), the Bengal Bank(1784-91), amongst others.

Historically, the rupee was a silver based currency. This had severe consequencesin the 19th century, when the strongest economies in the world were on the gold standard.The discovery of vast quantities of silver in the US and various European colonies resultedin a decline in the relative value of silver to gold. Suddenly, the standard currency of Indiacould not buy as much from the outside world. This event was known as “the fall of theRupee.” During British rule, and the first decade of independence, the rupee was subdividedinto 16 annas. Each anna was subdivided into either 4 pieces, or 12 pies. In 1957,decimalisation occurred and the rupee was now divided into 100 Naye Paise (Hindi fornew praises). After a few years, the initial “Naye” was dropped. However, many still referto 25, 50 and 75 paise as 4, 8 and 12 annas respectively, not unlike the now largelydefunct usage of “bit” in American English for 1/8 dollar. However, the usage is in decline.

Reserve Bank Issues During British India

Office at Calcutta. Section 22 of the RBI Act, 1934, empowered it to continue issuingGovernment of India notes until its own notes were ready for issue. The bank issued thefirst five rupee note bearing the portrait of George VI in 1938. This was followed by ` 10in February, ` 100 in March and ` 1,000 and ` 10,000 in June 1938. The first ReserveBank issues were signed by the second Governor, Sir James Taylor. In August 1940,the one-rupee note was reintroduced as a wartime measure, as a Government note withthe status of a rupee coin. During the war, the Japanese produced high-quality forgeriesof the Indian currency. This necessitated a change in the watermark. The profile portraitof George VI was changed to his full frontal portrait. The security thread was introducedfor the first time in India. The George VI series continued till 1947 and thereafter as afrozen series till 1950 when post-independence notes were issued.

Republic of India Issues

After Independence of India, the government brought out the new design Re. 1 notein 1949. Initially, it was felt that the King’s portrait be replaced by a portrait of MahatmaGandhi. Finally, however, the Lion Capital of Asoka was chosen. The new design of noteswas largely along earlier lines. In 1953, Hindi was displayed prominently on the new notes.The economic crisis in late 1960s led to a reduction in the size of notes in 1967. Highdenomination notes, like ̀ 10,000 notes were demonetized in 1978. The “Mahatma GandhiSeries” was introduced in 1996. Prominent new features included a changed watermark,windowed security thread, latent image and intaglio features for the visually handicapped.

1.13 Meaning of Money

Money is a token or item which acts as a medium of exchange that has both legaland social acceptance with regards to making payment for buying commodities or receivingservices, as well as repayment of loans.



Notes 1.14 Features of Money

The features of money can be summarized as follows:

1. Durability

Durability means that an item retains the same shape, form, and substance overan extended period of time; that it does not easily decompose, deteriorate, degrade, orotherwise change form. However, durability also extends beyond the physical realm toinclude social and institutional durability.

Durability is critical for money to perform the related functions of medium of exchangeand store of value. People are willing to accept an item in payment for one good becausethey are confident that the item can be traded at a later time for some other good. Anitem works as a medium of exchange precisely because it stores value from onetransaction to the next. And this requires durability.

Refined metals, such as gold, silver, copper, or nickel, have historically taken centerstage as money because they are extremely durable materials. An ounce of gold todaywill be an ounce of gold tomorrow, next week, and a thousand years hence. Organicproducts, such as lettuce, ice cream, or raw meat, are seldom if ever used as moneybecause they are extremely perishable. A crisp leaf of lettuce might not be recognizableas lettuce next week let alone a thousand years hence.

While physical durability has been historically important for money, social andinstitutional durability is also important for modern economies. The durability of modernmoney, especially paper currency and bank account balances, depends on the durabilityof social institutions—especially banks and governments. While government-issued papercurrency might remain physically intact for centuries, its ability to function as moneydepends on the institutional durability of the government.

2. Divisibility

This second characteristic means money can be divided into small increments thatcan be used in exchange for goods of varying values. For an item to function as the mediumof exchange, which can be used to purchase a wide range of different goods with a widerange of different values, then it must be divisible. For an item to function as the mediumof exchange, it must have increments that allow it to be traded for both battleships andbubble gum, and everything in between.

Divisibility is one reason why metals, such as gold, silver, copper, and nickel, havebeen widely used as money throughout history. As pure elements, each can be dividedinto really, really small units, in principle, down to the molecular level. In contrast, livestock,which has seen limited use as money in less sophisticated agrarian societies, neverbecome widely used as money in modern economies. Dividing live water buffalo intoincrements small enough to buy bubble gum is highly impractical.

3. Transportability

This third characteristic means that money can be easily moved from one locationto another when such movement is needed to complete exchanges. When people headoff to the market to make a purchase or two, then they need to bring along their money.But to “bring along their money”, they obviously need to “bring along their money.” Thatis, the money must be transportable. Money that is not transportable is not transported,so it is not used.


Introduction 21

NotesOnce again, transportability has played a key role in the use of metals like gold,silver, copper, and nickel as money. Carrying around a satchel of metal coins was nevermuch of a burden. However, these metals were largely replaced by paper currencies inthe 20th century because paper was lighter and easier to carry. Items such as graniteblocks, radioactive plutonium, and maple syrup come up short on the transportability scale.Items that are physically heavy relative to their value in exchange, or need special handling,are not easily transportable. Heading off to the market with a vat of syrup or a lead canisterof plutonium just does not work.

4. Non-counterfeitability

This fourth characteristic means that money cannot be easily duplicated. A givenitem cannot function as a medium of exchange if everyone is able to “print up,” “whip up,”or “make up” a batch of money any time that they want. Why would anyone accept moneyin exchange for a good, if they can make their own? Money that is easily duplicated ceasesto be the medium of exchange.

Preventing the unrestricted duplication of money is a task that has long beenrelegated to government. In fact, this task is one of the prime reasons why governmentsexist. An economy needs government, absolutely needs government, to regulate the totalquantity of money in circulation. By controlling money duplication, governments are alsoable to control the total quantity in circulation, and this control is what gives money valuein exchange.

While governments try to keep pace with counterfeiters, they are usually a step ortwo behind. Through the years, governments have tried to thwart counterfeiters by stampingimages on coins, using special ink and paper for currency, and generally maintaining highlevels of security surrounding money “production.”

1.15 Functions of Money

The various functions of money are as follows:

1. Static Function

These include the functions performed by money in the static role or as a passivetechnical device. The static functions of money include:

(a) Money as a Medium of ExchangeMoney acts as a medium of exchange and it facilitates the quick and easy exchange

of goods and services. It has help discontinue the barter system and one need not makea simultaneous purchase while making a sale.

(b) Money as a Unit of AccountMoney helps in expressing various things in terms of its value and has hence given

rise to the price system. It acts as a common measure of value and helps in the smoothoperation of the price system in the modern economic society.

(c) Money as a Store of ValueMoney acts as a store of value as it can be held by oneself for present as well as

future use. It is convenient means of holding the income for the purpose of spending, i.e.,it has high liquidity value.



Notes (d) Money as a Standard of Deferred PaymentsIt helps in settlement of debts and future transactions which was not possible in

the barter system.

2. Dynamic Function

(a) Money plays a dynamic role in determining the economic trends.(b) The volume and velocity of money can cause a rise or a fall in the general price

level. It also influences consumption and production.(c) Money encourages the division of labor: Since money acts as the medium of

exchange and gives purchasing power to one; one may not have to producevarious goods and can specialize in producing a particular commodity.

1.16 Types of Money

Money can be categorized into the following types:

1. Commodity Money

This is a type of money which can be utilized both as an exchangeable commodityand a general purpose exchange medium in its own capacity. Whenever any commodityis used for the exchange purpose, the commodity becomes equivalent to the money andis called commodity money. There are certain types of commodity, which are used asthe commodity money. Among these, there are several precious metals like gold, silver,copper and many more. Again, in many parts of the world, seashells, tobacco and manyother items were in use as a type of money and medium of exchange.

2. Fiat Money

Fiat money is that type of money the value of which is ascertained with the helpof legal methods instead of the associated availableness of commodities and services.Fiat money can symbolize government promises or a commodity. The word fiat meansthe “command of the sovereign”. It is the type of money that is issued by the commandof the sovereign. The paper money is generally called as the fiat money. This type of moneyforms a monetary standard. It has been made mandatory by law to accept the fiat money,as an exchange medium, whenever it is offered to anyone.

3. Credit Money

Credit money refers to the claim placed to a legal individual, which can beimplemented to buy goods and services.

4. Soft Money

Soft money refers to the paper currency rather than gold, silver, or any other typesof coined metal.

5. Hard Money

Hard money refers to the value of different gold, silver, or platinum coins (bullion)in circulation in the field of international trade.


Introduction 23

Notes6. Fiduciary Money

Today’s monetary system is highly fiduciary. Whenever any bank assures thecustomers to pay in different types of money and when the customer can sell the promiseor transfer it to somebody else, it is called the fiduciary money. Fiduciary money isgenerally paid in gold, silver or paper money. There are cheques and bank notes, whichare the examples of fiduciary money because both are some kind of token which are usedas money and carry the same value.

7. Commercial Bank Money

Commercial Bank money or demand deposits are claims against financial institutionsthat can be used for the purchase of goods and services. A demand deposit account isan account from which funds can be withdrawn at any time by cheque or cash withdrawalwithout giving the bank or financial institution any prior notice. Banks have the legalobligation to return funds held in demand deposits immediately upon demand (or ‘at call’).Demand deposit withdrawals can be performed in person, via cheques or bank drafts, usingautomatic teller machines (ATMs), or through online banking.

1.17 Role and Significance of Money in a Modern Economy1. Money enables a consumer to maximize his satisfaction.2. Money measure the intensity of desire of consummates.3. Money facilities production by stimulating saving and investment.4. Money gives mobility to capital and helps in capital formation.5. It enables the harnessing various factors of production, so that the entrepreneurs

is able to maximize profit.6. Money facilitates exchange and helps in both trade and commerce both national

and international.7. Money helps price mechanism to allocate resources.8. Money accelerated the process of industrialization.9. Money is an extremely valuable social instrument which has largely contributed

to the growth of national wealth and social welfare.

1.18 Monetary System

Monetary system is a set of mechanisms by which a government provides moneyin a country’s economy. It usually consists of a mint, central bank, and commercial banks.

The Monetary system of India plays a very important role in the economicdevelopment. The monetary system performs a number of functions. Some of the importantfunctions are as follows:

(i) Monetary system is a contributor of liquidityThe term liquidity refers to cash or money and other assets which can be converted

into cash within a short duration. Almost all the activities of a monetary system are liquidityoriented, i.e., there is either provision of liquidity or one can see trading in liquidity.

(ii) It plays the role of a mediumThe monetary system plays the role of a catalyst by creation of credit and providing

finance and credit facilities to different investment opportunities.



Notes (iii) It accelerates the rate of economic developmentMonetary system mobilizes the savings and also the investment. By doing so, capital

formation is achieved which in turn leads to allocating resources to productive activities,which at last leads to the economic development.

(iv) It fosters industrial developmentIt is because of Indian monetary system, institutions like IDBI, IFCI, KSFC, ICICI,

etc. have been developed to foster industrial development. These institutions helpindustries by providing monetary, technical, marketing assistance.

(v) It is a guide for investor’s educationThe monetary system play a very important role of providing all necessary investment

opportunities to the investors. The monetary institutions, banks, etc. from time to timepublish the necessary investors guide with required details about investments to enlightenthe investors.

(vi) It promotes self-employmentThe development banks and monetary institutions are primarily established with the

objective of promoting self-employment. By providing a means of self-employment to youngeducated men and women, it indirectly solves the problem of unemployment.

(vii) It helps in the revival of sick unitsThe monetary institutions in our country have specially designed loans schemes to

assist the revival of sick units. These loans are provided to sick units at reasonable rateof interest.

(viii) It ensures effective distribution of resourcesAn effective monetary system always enables proper allocation of resources to

different investment avenues.

1.19 Capital Formation

Capital formation refers to net additions of capital stock such as equipment, buildingsand other intermediate goods. A nation uses capital stock in combination with labor toprovide services and produce goods; an increase in this capital stock is known as capitalformation.

Saving and investment are essential for capital formation. According to Marshall,saving is the result of waiting or abstinence. When a person postpones his consumptionto the future, he saves his wealth which he utilizes for further production. If all peoplesave like this, the aggregate savings increase which are utilized for investment purposesin real capital assets like machines, tools, plants, roads, canals, fertilizers, seeds, etc.

1.20 Process of Capital Formation

The process of capital formation involves three steps:

1. Increase in the volume of real savings;2. Mobilization of savings through financial and credit institutions; and3. Investment of savings.


Introduction 25

NotesThus, the problem of capital formation becomes two-fold: one, how to save more;and two, how to utilize the current savings of the community for capital formation. Wediscuss the factors on which capital accumulation depends.

1. Increasing Savings

(a) Power and Will to SaveSavings depend upon two factors: the power to save and the will to save.

The power to save of the community depends upon the size of the average income,the size of the average family and the standard of living of the people. Other things beingequal, if the income of the people increases or the size of the family is small or peopleget accustomed to a particular standard of living which does not lean towards conspicuousconsumption, the power to save increases.

The power to save also depends upon the level of employment in the country. Ifemployment opportunities increase and existing techniques and resources are employedfully and efficiently, incomes increase and so do the propensity of the people to save.

Savings also depend upon the will to save. People may themselves foregoconsumption in the present and save. They may do so to meet emergencies, for familypurposes or for social status. But they will save only if certain facilities or inducementsare available.

People save if the government is stable and there is peace and security in the country.People do not save when there is lawlessness and disorder, and there is no security oflife, property and business. The existence of banking and financial institutions paying highrates of interest on different term deposits also induces people to save more.

The taxation policy of the government also affects the savings habits of the people.Highly progressive income and property taxes reduce the incentive to save. But low ratesof taxation with due concessions for savings in provident fund, life insurance, healthinsurance, etc. encourage savings.

(b) Perpetuation of Income InequalitiesPerpetuation of income inequalities had been one of the major sources of capital

formation in 18th century England and early 20th century Japan. In most communities,it is the higher income groups with a high marginal propensity to save that do the majorityof savings. If there is unequal distribution of income, the society’s upper level incomesaccrue to the businessmen, the traders and the landlords who save more and hence investmore on capital formation. But this policy of deliberately creating inequalities is not favourednow either in developed or developing economics when all countries aim at reducing incomeinequalities.

(c) Increasing ProfitsProfessor Lewis is of the view that the ratio of profits to national income should be

increased by expanding the capitalist sector of the economy, by providing variousincentives and protecting enterprises from foreign competition. The essential point is thatprofits of business enterprises should increase because they know how to use them inproductive investment.

(d) Government MeasuresLike private households and enterprises, the government also saves by adopting a

number of fiscal and monetary measures. These measures may be in the form of abudgetary surplus through increase in taxation (mostly indirect), reduction in government



Notes expenditure, expansion of the export sector, raising money by public loans, etc. If peopleare not saving voluntarily, inflation is the most effective weapon. It is regarded as hiddenor invisible tax. When prices rise, they reduce consumption and thus divert resources fromcurrent consumption to investment. Besides, the government can increase savings byestablishing and running public undertakings more efficiently so that they earn larger profitswhich are utilized for capital formation.

(2) Mobilization of Savings

The next step for capital formation is the mobilization of savings through banks,investment trusts, deposit societies, insurance companies, and capital markets. “Thekernal of Keynes’s theory is that decisions to save and decisions to invest are made largelyby different people and for different reasons.” To bring the savers and investors together,there must be well-developed capital and money markets in the country. In order tomobilize savings, attention should be paid to the starting of investment trusts, lifeinsurance, provident fund, banks, and cooperative societies. Such agencies will not onlypermit small amounts of savings to be handled and invested conveniently but will allowthe owners of savings to retain liquidity individually but finance long-term investmentcollectively.

(3) Investment of Savings

The third step in the process of capital formation is the investment of savings increating real assets. The profit-making classes are an important source of capital formationin the agricultural and industrial sectors of a country. They have an ambition for powerand save in the form of distributed and undistributed profits and thus invest in productiveenterprises.

Besides, there must be a regular supply of entrepreneurs who are capable, honestand dependable. To perform his economic function, the entrepreneur requires two things,according to Professor Schumpeter, first, the existence of technical knowledge to producenew products; second, the power of disposal over the factors of production in the formof bank credit.

To these may he added, the existence of such infrastructure as well-developed meansof transport, communications, power, water, educated and trained personnel, etc. Further,the social, political and economic climatic conditions in the country must be conducivefor the emergence of a growing supply of entrepreneurs.

Domestic sources for capital formation are required to be supplemented by externalsources. There are two reasons for external borrowing, according to Professor A.J. Brown.One is that it may be the easiest way of getting hold of capital funds at all, and the otherthat it may be the easiest way of getting foreign currency with which to buy imports whichare needed for development.

The countries which have borrowed most from abroad for development purposes arethose which have at some stage had a colonial status, have been developed by Europeanimmigrants, or have traded heavily with the highly developed countries, or have satisfiedall these conditions.

1.21 Financial System

Financial system is the set of implemented procedures that track the financialactivities of a country on a regional scale. The financial system is the system that enables


Introduction 27

Noteslenders and borrowers to exchange funds. The global financial system is basically abroader regional system that encompasses all financial institutions, borrowers and lenderswithin the global economy.

A financial system plays a vital role in the economic growth of a country. Itintermediates with the flow of funds between those who save a part of their income tothose who invest in productive assets. It mobilizes and usefully allocates scarce resourcesof a country. The formal financial sector is characterized by the presence of an organized,institutional and regulated system which caters to the financial needs of the modernspheres of economy; the informal financial sector is an unorganized, non-institutional, andnon-regulated system dealing with the traditional and rural spheres of the economy.

A financial system is a complex, well-integrated set of sub-systems of financialinstitutions, markets, instruments, and services which facilitates the transfer and allocationof funds, efficiently and effectively. A high priority should be accorded to the developmentof an efficient formal financial system as it can offer lower intermediation costs and servicesto a wide base of savers and entrepreneurs.

The economic scene in the post-independence period has seen a sea change; theend result being that the economy has made enormous progress in diverse fields. Therehas been a quantitative expansion as well as diversification of economic activities. Theexperiences of the 1980s have led to the conclusion that, to obtain all the benefits ofgreater reliance on voluntary market-based decision-making, India needs efficient financialsystem.

The financial system is possibly the most important institutional and functionalvehicle for economic transformation. Finance is a bridge between the present and the futureand whether it is the mobilization of savings or their efficient, effective and equitableallocation of investment. It is this success with which the financial system performs itsfunctions that sets the pace for the achievement of broader national objectives.

A financial system provides services that are essential in a modern economy. Theuse of a stable, widely accepted medium of exchange reduces the costs of transactions.It facilitates trade and, therefore, specialization in production. Financial assets withattractive yield, liquidity and risk characteristics encourage savings in financial form. Byevaluating alternative investments and monitoring the activities of borrowers, financialintermediaries increase the efficiency of resource use. Access to a variety of financialinstruments enables an economic agent to pool, price and exchange risks in the markets.Trade, the efficient use of resources, savings and risk taking are the cornerstones of agrowing economy. In fact, the country could make this feasible with the active supportof the financial system. The financial system has been identified as the most catalyzingagent for the growth of an economy, making it one of the key inputs for development.

1.22 Definitions of Financial System

According to Robinson, “Financial system is the primary function of the systemwhich is to provide a link between savings and investment for the creation of new wealthand to permit portfolio adjustment in the composition of the existing wealth”.

According to Van Horne, “Financial system is the purpose of financial markets toallocate savings efficiently in an economy to ultimate users either for investment in realassets or for consumption”.

According to Christy, “Financial system is to supply funds to various sectors andactivities of the economy in ways that promote the fullest possible utilization of resources



Notes without the destabilizing consequence of price level changes or unnecessary interferencewith individual desires”.

According to Franklin Allen and Douglas Gale in Comparing Financial Systems,“Financial systems are crucial to the allocation of resources in a modern economy. Theychannel household savings to the corporate sector and allocate investment funds amongfirms; they allow inter-temporal smoothing of consumption by households and expendituresby firms; and they enable households and firms to share risks. These functions arecommon to the financial systems of most developed economies. Yet the form of thesefinancial systems varies widely”.

According to Prof. Prasanna Chandra, “The financial system consists of variety ofinstitutions, markets and instruments related in a systematic manner and provide theprincipal means by which savings are transformed into investments”.

1.23 Meaning of Financial System

Financial system refers to a set of complex and closely connected or interlinkedfinancial institutions or organized and unorganized financial markets, financial instrumentsand services which facilitate the transfer of funds.

A financial system consists of institutional arrangements through which financialsurplus in the economy are mobilized from units having surplus funds and is transferredto units having financial deficit. Financial system is a total of financial institutions, financialmarkets, financial services, financial practices and procedures.

1.24 Meaning of Financial Dualism

Financial systems of most developing countries are characterized by co-existenceand cooperation between the formal and informal financial sectors. This co-existence oftwo sectors is commonly referred to as “Financial dualism.”

1.25 Objectives of Financial System

The various objectives of financial system are as follows:

1. To mobilize the resources.2. To create link between savers and investors.3. To establish a regular smooth and efficient markets.4. To create assets for the use of people.5. To encourage savings and investment.6. To facilitate economic development of the country.7. To facilitate for expansion of financial markets.8. To promote for efficient allocation of financial resources.9. To make sound decisions based on cash flow and available resources.

10. To establish financial control and clear accounting procedures which ensure thatfunds are used for intended purposes.


Introduction 29

Notes1.26 Purpose of Financial System

The several purposes of financial system are as follows:

(a) Financial system is required for mobilization of savings and converting it intoinvestments.

(b) Financial system is essential for providing required capital to the businessorganizations to carry out their activities.

(c) It is required for generating income or profit for both household and corporatesector.

(d) It is necessary for increasing the productivity of capital through efficient andeffective allocation of funds and resources.

(e) It is essential to accelerate the rate of economic growth and development.(f) It is helpful in providing mechanism to control risk and uncertainties in financial

transactions.(g) It is required to transfer the resources from one section or part of the economy

to another through effective allocation of resources to different investmentchannels.

1.27 Functions of Financial System

A good financial system serves in the following ways:

1. Savings Function

Public saving finds their way into the hands of those in production through the financialsystem. Financial claims are issued in the money and capital markets which promisefuture income flows. The funds with the producers result in production of goods and servicesthereby increasing society living standards. The one of the important functions of a financialsystem is to link the savers and investors and thereby help in mobilizing and allocatingthe savings efficiently and effectively. By acting as an efficient conduit for allocation ofresources, it permits continuous upgradation of technologies for promoting growth on asustained basis.

2. Liquidity Function

The term liquidity refers to ready cash or money and other financial assets whichcan be converted into cash without loss of value and time. It provides liquidity in the marketthrough which claims against money can be resold by the investors and thereby assetscan be converted into cash at any time. This function allows for the easy and fastconversion of securities into cash.

Thus, the major function of financial system is the provision of money and monetaryassets for the purpose of production of goods and services. Therefore, all the financialactivities are subjected to either provision of liquidity or trading in liquidity.

3. Payment Function

The financial system offers a very convenient mode for payment of goods andservices. Cheque system, credit card system, etc. are the easiest methods of payments.The cost and time of transactions are drastically reduced. A financial system not onlyhelps in selecting projects to be funded but also inspires the operators to monitor theperformance of the investment. It provides a payment mechanism for the exchange of



Notes goods and services and transfers economic resources through time and across geographicregions and industries.

4. Risk Function

The term risk and uncertainty relates to future which remains unknown for theinvestors who expect future incomes through their savings.

Whenever the mobilized savings are invested into different productive activities, theinvestors are exposed to lower risk. This is mainly because of the benefits of ‘diversification’that is available to even small investors. Every investor’s preference will be influenced byconsiderations such as convenience, lower risk, liquidity, etc.

Financial intermediaries enable the investors to diversify investments widely whichhelps in reducing the risk of capital depreciation and poor dividends. Hence, a combinationof financial assets will help in minimizing risk.

5. Policy Function

The government intervenes in the financial system to influence macroeconomicvariables like interest rates or inflation so if country needs more money government wouldcut rate of interest through various financial instruments and if inflation is high and toomuch money is available in the system, then government would increase the rate ofinterest. It makes available price-related information which is a valuable assistance to thosewho need to take economic and financial decisions.

6. Provides Financial Services

A financial system minimizes situations where the information is an asymmetric andlikely to affect motivations among operators or when one party has the information andthe other party does not. It provides financial services such as insurance, pension, etc.and offers portfolio adjustment facilities.

Example: It provides fee based or advisory based financial services such as issuemanagement, portfolio management, corporate counselling, credit rating, stock broking,etc. and fund based or asset based financial services such as hire purchase, equipmentleasing, bill discounting, housing finance, insurance service, venture capital, etc.

7. Lowers the Cost of Transactions

A financial system helps in the creation of a financial structure that lowers the costof transactions. This has a beneficial influence on the rate of return to savers. It alsoreduces the cost of borrowing. Thus, the system generates an impulse among the peopleto save more.

8. Financial Deepening and Broadening

A well-functioning financial system helps in promoting the process of financialdeepening and broadening. Financial deepening refers to an increase of financial assetsas a percentage of the Gross Domestic Product (GDP). Financial broadening refers tobuilding an increasing number and a variety of participants and instruments.

Financial broadening begins when corporations seek to employ labor and capitalaccording to their relative contribution to production. It can also influence demand for capitalgoods (and the labor to create and employ it) which depends on expected consumer


Introduction 31

Notesdemand in a future period. It also includes profit maximization which aims to produce morewith more productive capital and less labor so that production generally becomesincreasingly more capital intensive.

1.28 Structure of Indian Financial System or Components of FinancialSystem

The following are the four main components of Indian Financial System:

1. Financial Institutions2. Financial Markets3. Financial Intermediaries4. Financial Services

1. Financial Institutions

Financial institutions are the intermediaries which facilitate smooth functioning of thefinancial system by making investors and borrowers meet. They mobilize savings of thesurplus units and allocate them in productive activities promising a better rate of return.Financial institutions also provide services to entities seeking advice on various issuesranging from restructuring to diversification plans. They provide whole range of servicesto the entities who want to raise funds from the markets elsewhere. Financial institutionsact as financial intermediaries because they act as middlemen between savers andborrowers, where these financial institutions may be banking or non-banking institutions.Financial institutions channel the flow of funds between investors and firms. Individualsdeposit funds at commercial banks, purchase shares of mutual funds, purchase insuranceprotection with insurance premiums, and contribute to pension plans. All of these financialinstitutions provide credit to firms by purchasing debt securities or providing loans or othercredit products. In addition, all of these financial institutions except commercial bankspurchase stocks issued by firms.

Meaning of Financial Institutions

Financial institutions or financial intermediaries are those institutions, which providefinancial services and products which customers needs. Financial institutions provide allthose services, which a customer may not be able to get more efficiently on his own.For example, customers not having skill to invest in equity market efficiently can investmoney in Mutual Funds and can avail the benefits of capital market. Financial institutionsprovide all those financial services, which are available in financial system.

Benefits of Financial Institutions

The following benefits are enjoyed by an individual who invests through financialintermediaries than involving directly in financial market.

(a) Economy of ScaleWhen financial institutions are carrying out their investment or other activities in large

scale out of pooled funds, they can achieve economy of scale.

(b) Lower Transaction CostBecause of economy of scale the cost of each transaction is much lower than what

it would have been, if that transaction is carried on by individual investor on his own.



Notes (c) DiversificationAs financial institutions are dealing in huge amounts of pooled funds, they diversify

their investments in such a way that the risk involved would reduce considerably.

2. Financial Markets

A financial market is a market in which people and entities can trade financialsecurities, commodities and other fungible items of value at low transaction costs andat prices that reflect supply and demand. Securities include stocks and bonds, andcommodities include precious metals or agricultural goods.

There are both general markets (where many commodities are traded) andspecialized markets (where only one commodity is traded). Markets work by placing manyinterested buyers and sellers, including households, firms, and government agencies, inone “place”, thus making it easier for them to find each other. An economy which reliesprimarily on interactions between buyers and sellers to allocate resources is known asa market economy in contrast either to a command economy or to a non-market economysuch as a gift economy.

Financial market transactions can be distinguished by whether they involve new orexisting securities, whether the transaction of new securities reflects a public offering ora private placement, and whether the securities have short-term or long-term maturities.New securities are issued by firms in the primary market and purchased by investors.If investors desire to sell the securities that they have previously purchased, they usethe secondary market. The sale of new securities to the general public is referred to asa public offering; the sale of new securities to one investor or a group of investors is referredto as a private placement. Securities with short-term maturities are called money marketsecurities, and securities with long-term maturities are called capital market securities

Finance is a prerequisite for modern business and financial institutions play a vitalrole in an economic system. It is through financial markets the financial system of aneconomy works. The main objectives of financial markets are:

1. To facilitate creation and allocation of credit and liquidity;2. To serve as intermediaries for mobilization of savings;3. To assist process of balanced economic growth;4. To provide financial convenience.

3. Financial Intermediaries

Financial intermediation consists of “channelling funds between surplus and deficitagents”.

4. Financial Services

Financial services are the economic services provided by the finance industry, whichencompasses a broad range of organizations that manage money, including credit unions,banks, credit card companies, insurance companies, consumer finance companies, stockbrokerages, investment funds and some government sponsored enterprises.

Efficiency of emerging financial system largely depends upon the quality and varietyof financial services provided by financial intermediaries. The term financial services canbe defined as “activities, benefits and satisfaction connected with the sale of money thatoffers to users and customers, financial related value”.


Introduction 33

NotesClassification of Financial Service

1. Fee-based ServicesBank Management sets fees and charges for banking services to ensure that the

bank is adequately compensated for the services it provides. When setting fees andcharges, bankers take into consideration the possible exposure to loss, which may beincurred for providing the service, the effort required of the Bank and the amount of timerequired the performing the service properly. Some of the more common fee-based servicesbeing offered by Banks to retail customers today are described in this section.

2. Fund-based ServicesFund-based services include cash credit, overdraft, bill discounting, short-term loans,

and export financing (pre-shipment as well as post-shipment). Fee-based facilities includeletters of credit and bank guarantees.

1.29 Technology of Financial System

Various technologies of Financial System are:

1. Pooling

Pooling is a resource management term that refers to the grouping together ofresources (assets, equipment, personnel, effort, etc.) for the purposes of maximizingadvantage and/or minimizing rise to the users.

Pooling is the grouping together of assets, and related strategies for minimizing risk.Debt instruments with similar characteristics, such as mortgages, can be pooled into anew security, for example:

(i) Asset-backed securities (ABS)An asset-backed security (ABS) is a security whose income payments and hence

value is derived from and collateralized (or “backed”) by a specified pool of underlyingassets. The pool of assets is typically a group of small and illiquid assets which are unableto be sold individually. Pooling the assets into financial instruments allows them to besold to general investors, a process called securitization, and allows the risk of investingin the underlying assets to be diversified because each security will represent a fractionof the total value of the diverse pool of underlying assets. The pools of underlying assetscan include common payments from credit cards, auto loans, and mortgage loans, toesoteric cash flows from aircraft leases, royalty payments and movie revenues.

(ii) Mortgage-backed securities (MBS)Mortgage-backed security (MBS) is a type of asset-backed security that is secured

by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals(a government agency or investment bank) that securitizes, or packages, the loanstogether into a security that investors can buy. The mortgages of an MBS may beresidential or commercial, depending on whether it is an Agency MBS or a Non-AgencyMBS; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be “private-label”,issued by structures set up by investment banks. The structure of the MBS may be knownas “pass-through”, where the interest and principal payments from the borrower orhomebuyer pass through it to the MBS holder, or it may be more complex, made up ofa pool of other MBSs. Other types of MBS include collateralized mortgage obligations(CMOs, often structured as real estate mortgage investment conduits) and collateralizeddebt obligations (CDOs).



Notes (iii) Collateralized debt obligations (CDO)Collateralized debt obligation (CDO) is a type of structured asset-backed security

(ABS). Originally developed for the corporate debt markets, over time CDOs evolved toencompass the mortgage and mortgage-backed security (“MBS”) markets. CDO can bethought of as a promise to pay investors in a prescribed sequence, based on the cashflow the CDO collects from the pool of bonds or other assets it owns. The CDO is “sliced”into “tranches”, which “catch” the cash flow of interest and principal payments in sequencebased on seniority. If some loans default and the cash collected by the CDO is insufficientto pay all of its investors, those in the lowest, most “junior” tranches suffer losses first.The last to lose payment from default are the safest, most senior tranches. Consequently,coupon payments (and interest rates) vary by tranche with the safest/most senior tranchespaying the lowest rates and the lowest tranches paying the highest rates to compensatefor higher default risk.

The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham LambertInc. for the also now-defunct Imperial Savings Association. During the 1990s, the collateralof CDOs was generally corporate and emerging market bonds and bank loans. After 1998,“multi-sector” CDOs were developed by Prudential Securities, but CDOs remained fairlyobscure until after 2000. In 2002 and 2003, CDOs had a setback when rating agencies“were forced to downgrade hundreds” of the securities, but sales of CDOs grew from $69billion in 2000 to around $500 billion in 2006. From 2004 through 2007, $1.4 trillion worthof CDOs were issued.

Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured housing loans, to student loans and credit card debt. Thediversification of borrowers in these “multi-sector CDOs“ was a selling point, as it meantthat if there was a downturn in one industry like aircraft manufacturing and their loansdefaulted, other industries like manufactured housing might be unaffected. Another sellingpoint was that CDOs offered returns that were sometimes 2-3 percentage points higherthan corporate bonds with the same credit rating.

(iv) Collateralized mortgage obligations (CMO)Collateralized mortgage obligation (CMO) is a type of complex debt security that

repackages and directs the payments of principal and interest from a collateral pool todifferent types and maturities of securities, thereby meeting investor needs. CMOs werefirst created in 1983 by the investment banks Salomon Brothers and First Boston for theUS mortgage liquidity provider Freddie Mac.

CMO is a debt security issued by an abstraction – a special purpose entity – andis not a debt owed by the institution creating and operating the entity. The entity is thelegal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issuedby the entity, and they receive payments from the income generated by the mortgagesaccording to a defined set of rules. With regard to terminology, the mortgages themselvesare termed collateral, ‘classes’ refers to groups of mortgages issued to borrowers of roughlysimilar creditworthiness, tranches are specified fractions or slices, metaphoricallyspeaking, of a pool of mortgages and the income they produce that are combined intoan individual security, while the structure is the set of rules that dictates how the incomereceived from the collateral will be distributed. The legal entity, collateral, and structureare collectively referred to as the deal. Unlike traditional mortgage pass-through securities,CMOs feature different payment streams and risks, depending on investor preferences.For tax purposes, CMOs are generally structured as Real Estate Mortgage InvestmentConduits, which avoid the potential for “double taxation.”


Introduction 35

Notes(v) Structured financeStructured finance is a sector of finance that was created to help transfer risk using

complex legal and corporate entities. This transfer of risk, as applied to the securitizationof various financial assets (mortgages, credit card receivables, auto loans, etc.) has helpedprovide increased liquidity or funding sources to markets like housing and to transfer riskto buyers of structured products; it also permits financial institutions to remove certainassets from their balance sheets as well as provides a means for investors to gain accessto diversified asset classes. However, it arguably contributed to the degradation inunderwriting standards for these financial assets, which helped give rise to both theinflationary credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.

(vi) SecuritizationSecuritization is the financial practice of pooling various types of contractual debt

such as residential mortgages, commercial mortgages, auto loans or credit card debtobligations (or other non-debt assets which generate receivables) and selling their relatedcash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from theprincipal and interest cash flows collected from the underlying debt and redistributedthrough the capital structure of the new financing. Securities backed by mortgagereceivables are called mortgage-backed securities (MBS), while those backed by othertypes of receivables are asset-backed securities (ABS).

Off-balance sheet treatment for securitizations coupled with guarantees from theissuer can hide the extent of leverage of the securitizing firm, thereby facilitating riskycapital structures and leading to an underpricing of credit risk. Off-balance sheetsecuritizations are believed to have played a large role in the high leverage level of USfinancial institutions before the financial crisis, and the need for bailouts.

The granularity of pools of securitized assets can mitigate the credit risk of individualborrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If thetransaction is properly structured and the pool performs as expected, the credit risk ofall tranches of structured debt improves; if improperly structured, the affected tranchesmay experience dramatic credit deterioration and loss.

(vii) Intergovernmental risk poolA risk pool is one of the forms of risk management mostly practiced by insurance

companies. Under this system, insurance companies come together to form a pool, whichcan provide protection to insurance companies against catastrophic risks such as floods,earthquakes, etc. The term is also used to describe the pooling of similar risks thatunderlies the concept of insurance. While risk pooling is necessary for insurance to work,not all risks can be effectively pooled. In particular, it is difficult to pool dissimilar risksin a voluntary insurance bracket, unless there is a subsidy available to encourageparticipation.

Risk pooling is an important concept in supply chain management. Risk poolingsuggests that demand variability is reduced if one aggregates demand across locationsbecause as demand is aggregated across different locations, it becomes more likely thathigh demand from one customer will be offset by low demand from another. This reductionin variability allows a decrease in safety stock and therefore reduces average inventory.



Notes 2. Netting

“Netting is a process the National Securities Clearing Corporation (NSCC) uses tostreamline securities transactions. To net, the NSCC compares the entire buy and sellorders for each individual security and matches purchases by clients of one brokeragefirm with corresponding sales by other clients of the firm.”

In the context of credit risk, there are at least three specific types of netting:

(a) Close-out nettingIn the counterparty bankruptcy or any other relevant event of default specified in the

relevant agreement if accelerated (i.e., effected), all transactions or all of a given type arenetted (i.e. set off against each other) at market value or, if otherwise specified in thecontract or if it is not possible to obtain a market value, at an amount equal to the losssuffered by the non-defaulting party in replacing the relevant contract. The alternative wouldallow the liquidator to choose which contracts to enforce and which not to (and thuspotentially “cherry pick”). There are international jurisdictions where the enforceability ofnetting in bankruptcy has not been legally tested.

(b) Netting by novationThe legal obligations of the parties to make required payments under one or more

series of related transactions are canceled and a new obligation to make only the netpayments is created.

(c) Settlement or payment nettingFor cash settled trades, this can be applied either bilaterally or multilaterally and

on related or unrelated transactions.

(i) Bilateral Net Settlement SystemA settlement system in which every individual bilateral combination of participants

settles its net settlement position on a bilateral basis.

(ii) Multilateral Net Settlement SystemA settlement system in which each settling participant settles its own multilateral

net settlement position (typically by means of a single payment or receipt).

3. Credit Substitution

Credit substitution refers to liability transfer between one party to another party. Forexample, a bank substitutes its own credit for the credit of the borrower.

Replacement of credit of one party to a transaction with the (superior) credit of afinancial institution.

4. Delegation

Delegation is the process of appointment of someone to act for other. Delegationhelps to reduces transaction cost for following reasons:

1. Delegation allows specialization.2. The delegate is in a stronger position.3. Revealing information.


Introduction 37

Notes1.30 Summary

Financial institution is an institution that provides financial services for its clients ormembers. Probably, the most important financial service provided by financial institutionsis acting as financial intermediaries. Most financial institutions are regulated by thegovernment.

Financial institutions provide services as intermediaries of financial markets. Theyare responsible for transferring funds from investors to companies in need of those funds.Financial institutions facilitate the flow of money through the economy. To do so, savingsare brought to provide funds for loans.

Non-Bank Financial Institution (NBFI) is a financial institution that does not have afull banking license or is not supervised by a national or international banking regulatoryagency. NBFIs facilitate bank-related financial services, such as investment, risk pooling,contractual savings, and market brokering. Examples of these include insurance firms,pawn shops, cashier’s check issuers, check cashing locations, payday lending, currencyexchanges, and micro loan organizations.

Non-Banking Financial Companies (NBFCs) are financial institutions that providebanking services without meeting the legal definition of a bank, i.e. one that does nothold a banking license. These institutions are not allowed to take deposits from the public.Nonetheless, all operations of these institutions are still exercised under bank regulation.

Capital formation implies the diversion of the productive capacity of the economy tothe making of capital goods which increases future productive capacity. The process ofCapital Formation involves three distinct but interdependent activities, viz., savings financialintermediation and investment. However, poor country/economy may be, there will be aneed for institutions which allow such savings, as are currently forthcoming, to be investedconveniently and safely and which ensure that they are channeled into the most usefulpurposes. A well-developed financial structure will therefore aid in the collections anddisbursements of investible funds and thereby contribute to the capital formation of theeconomy. Indian capital market although still considered to be underdeveloped has beenrecording impressive progress during the post-interdependence period.

Insurance companies underwrite economic risks associated with illness, death,damage and other risks of loss. In return to collecting an insurance premium, insurancecompanies provide a contingent promise of economic protection in the case of loss. Thereare two main types of insurance companies: general insurance and life insurance. Generalinsurance tends to be short-term, while life insurance is a longer-term contract, whichterminates at the death of the insured. Both types of insurance, life and general, areavailable to all sectors of the community.

Contractual savings institutions give individuals the opportunity to invest in collectiveinvestment vehicles (CIV) as a fiduciary rather than a principal role. Collective investmentvehicles pool resources from individuals and firms into various financial instrumentsincluding equity, debt, and derivatives. Note that the individual holds equity in the CIVitself rather what the CIV invests in specifically. The two most popular examples ofcontractual savings institutions are pension funds and mutual funds.

Pension funds are mutual funds that limit the investor’s ability to access theirinvestments until a certain date. In return, pension funds are granted large tax breaksin order to incentives the working population to set aside a portion of their current incomefor a later date after they exit the labor force (retirement income).



Notes Market makers are broker-dealer institutions that quote a buy and sell price andfacilitate transactions for financial assets. Such assets include equities, government andcorporate debt, derivatives, and foreign currencies. After receiving an order, the marketmaker immediately sells from its inventory or makes a purchase to offset the loss ininventory. The differential between the buying and selling quotes, or the bid-offer spread,is how the market-maker makes profit. A major contribution of the market makers isimproving the liquidity of financial assets in the market.

Financial institution is an establishment that conducts financial transactions suchas investments, loans and deposits. Economic development is the sustained, concertedactions of policy makers and communities that promote the standard of living andeconomic health of a specific area. Economic development can also be referred to asthe quantitative and qualitative changes in the economy. Financial institutions play a vitalrole for economic development of a country.

Money is a token or item which acts as a medium of exchange that has both legaland social acceptance with regards to making payment for buying commodities or receivingservices, as well as repayment of loans.

Durability means that an item retains the same shape, form, and substance overan extended period of time; that it does not easily decompose, deteriorate, degrade, orotherwise change form. However, durability also extends beyond the physical realm toinclude social and institutional durability.

Durability is critical for money to perform the related functions of medium of exchangeand store of value. People are willing to accept an item in payment for one good becausethey are confident that the item can be traded at a later time for some other good. Anitem works as a medium of exchange precisely because it stores value from onetransaction to the next. And this requires durability.

Fiat money is that type of money the value of which is ascertained with the helpof legal methods instead of the associated availableness of commodities and services.Fiat money can symbolize government promises or a commodity. The word fiat meansthe “command of the sovereign”. It is the type of money that is issued by the commandof the sovereign. The paper money is generally called as the fiat money. This type of moneyforms a monetary standard. It has been made mandatory by law to accept the fiat money,as an exchange medium, whenever it is offered to anyone.

Credit money refers to the claim placed to a legal individual, which can be implementedto buy goods and services. Soft money refers to the paper currency rather than gold, silver,or any other types of coined metal. Hard money refers to the value of different gold, silver,or platinum coins (bullion) in circulation in the field of international trade.

Commercial Bank money or demand deposits are claims against financial institutionsthat can be used for the purchase of goods and services. A demand deposit account isan account from which funds can be withdrawn at any time by cheque or cash withdrawalwithout giving the bank or financial institution any prior notice. Banks have the legalobligation to return funds held in demand deposits immediately upon demand (or ‘at call’).Demand deposit withdrawals can be performed in person, via cheques or bank drafts, usingautomatic teller machines (ATMs), or through online banking.

Monetary system is a set of mechanisms by which a government provides moneyin a country’s economy. It usually consists of a mint, central bank, and commercial banks.

The Monetary system of India plays a very important role in the economicdevelopment. The monetary system performs a number of functions.


Introduction 39

NotesCapital formation refers to net additions of capital stock such as equipment, buildingsand other intermediate goods. A nation uses capital stock in combination with labor toprovide services and produce goods; an increase in this capital stock is known as capitalformation.

Saving and investment are essential for capital formation. According to Marshall,saving is the result of waiting or abstinence. When a person postpones his consumptionto the future, he saves his wealth which he utilizes for further production. If all peoplesave like this, the aggregate savings increase which are utilized for investment purposesin real capital assets like machines, tools, plants, roads, canals, fertilizers, seeds, etc.

Financial intermediation consists of “channeling funds between surplus and deficitagents”. A financial intermediary is a financial institution that connects surplus and deficitagents. The classic example of a financial intermediary is a bank that consolidates bankdeposits and uses the funds to transform them into bank loans.

Financial services are the economic services provided by the finance industry, whichencompasses a broad range of organizations that manage money, including credit unions,banks, credit card companies, insurance companies, consumer finance companies, stockbrokerages, investment funds and some government sponsored enterprises.

Bank Management sets fees and charges for banking services to ensure that thebank is adequately compensated for the services it provides. When setting fees andcharges, bankers take into consideration the possible exposure to loss, which may beincurred for providing the service, the effort required of the Bank and the amount of timerequired the performing the service properly. Some of the more common fee based servicesbeing offered by Banks to retail customers today are described in this section.

Fund-based services include cash credit, overdraft, bill discounting, short-term loans,and export financing (pre-shipment as well as post-shipment). Fee based facilities includeletters of credit and bank guarantees.

1.31 Check Your Progress

I. Fill in the Blanks

1. Financial institution is an institution that provides financial services for its___________.

2. ___________ is a financial institution that does not have a full banking licenseor is not supervised by a national or international banking regulatory agency.

3. Capital formation implies the diversion of the productive capacity of the economyto the making of capital goods which increases future ___________

4. ___________ is the sustained, concerted actions of policy makers andcommunities that promote the standard of living and economic health of aspecific area.

5. ___________ is that type of money the value of which is ascertained with thehelp of legal methods instead of the associated availableness of commoditiesand services. Fiat money can symbolize government promises or a commodity.



Notes II. True or False

1. Financial institutions facilitate the flow of money through the economy.2. Non-Banking Financial Companies (NBFCs) are financial institutions that provide

banking services without meeting the legal definition of a bank, i.e., one thatdoes not hold a banking license.

3. Investment involves three distinct but interdependent activities, viz., savingsfinancial intermediation and investment.

4. Collective investment vehicles pool resources from individuals and firms intovarious financial instruments including equity, debt, and derivatives.

5. Financial institution is an establishment that conducts financial transactionssuch as investments, loans and deposits.

III. Multiple Choice Questions

1. Which of the following is an institution that provides financial services for itsclients or members?

(a) Financial institution(b) Financial system(c) Non-financial institution(d) All the above

2. Which of the following is a financial institution that does not have a full bankinglicense or is not supervised by a national or international banking regulatoryagency?

(a) Non-Bank Financial Institution (NBFI)(b) Financial system(c) Non-financial institution(d) All the above

3. Which of the following implies the diversion of the productive capacity of theeconomy to the making of capital goods which increases future productivecapacity?

(a) Non-Bank Financial Institution (NBFI)(b) Financial system(c) Non-ffinancial institution(d) Capital formation

4. Contractual savings institutions give individuals the opportunity to invest in___________

(a) Collective Investment Vehicles(b) Investment policy(c) Both (a) and (b)(d) None of these

5. Economic development can be referred to as the ___________(a) Quantitative changes in the economy(b) Qualitative changes in the economy(c) None of these(d) Both (a) and (b)


Introduction 41

Notes1.32 Questions and Exercises

I. Short Answer Questions

1. What is Financial Institution?2. What is Non-Banking Financial Institution?3. Define the term Money.4. State any two functions of Money.5. What is Monetary System?6. What is Capital Formation?7. Give the meaning of Financial System.8. What is Financial System?

II. Extended Answer Questions

1. Discuss benefits of Financial Institutions.2. Explain the classification of Financial Institutions.3. Discuss functions of Financial Institutions.4. Explain various types of Non-Banking Financial Institutions.5. Discuss about financial Institutions and Economic Development.6. Discuss various features of Money.7. Explain functions of Money.8. Discuss various types of Money.9. Explain the process of Capital Formation.

10. Discuss objectives of Financial System.11. Explain various functions of Financial System.12. Discuss the Technology of Financial System

1.33 Key TermsFinancial institution: Financial institution is an institution that providesfinancial services for its clients or members.Non-Bank Financial Institution: Non-Bank Financial Institution (NBFI) is afinancial institution that does not have a full banking license or is not supervisedby a national or international banking regulatory agency.Non Banking Financial Companies: Non Banking Financial Companies(NBFCs) are financial institutions that provide banking services without meetingthe legal definition of a bank, i.e. one that does not hold a banking license.Capital formation: Capital formation implies the diversion of the productivecapacity of the economy to the making of capital goods which increases futureproductive capacity.Contractual savings institutions: Contractual savings institutions that giveindividuals the opportunity to invest in collective investment vehicles (CIV) asa fiduciary rather than a principal role.Money: Money is a token or item which acts as a medium of exchange thathas both legal and social acceptance with regards to making payment for buyingcommodities or receiving services, as well as repayment of loans.



Notes Fiat money: Fiat money is that type of money the value of which is ascertainedwith the help of legal methods instead of the associated availableness ofcommodities and services.Credit money: Credit money refers to the claim placed to a legal individual,which can be implemented to buy goods and services.

1.34 Check Your Progress: AnswersI. Fill in the Blanks

1. Clients or members2. Non-Bank Financial Institution3. Productive capacity4. Economic development5. Fiat money

II. True or False1. True2. True3. False4. True5. True

III. Multiple Choice Questions1. (a) Financial institution2. (a) Non-Bank Financial Institution (NBFI)3. (d) Capital formation4. (a) Collective Investment Vehicles5. (d) Both (a) and (b)

1.35 Case Study

Mr. and Mrs. A both worked in a local factory, earning modest wages. They wereusing the overdraft facility on their current account to its full extent. They also had apersonal loan from their bank and had borrowed from various credit card companies.

In March 2004, realizing they were in financial difficulty but unsure what to do aboutit, they visited their bank. They explained their situation to the lending officer, who toldthem the bank could give them a consolidation loan to cover all their existing debts.

Mr. and Mrs. A were pleased with this suggestion and they took out the loan, whichpaid off all their existing debts and returned their current account into credit. But the bankleft the couple’s overdraft facility in place on their current account, and within a coupleof months Mr. and Mrs. A had begun to go overdrawn again.

In June, having found they were unable to keep within the overdraft limit, Mr. andMrs. A visited the bank to discuss the position. The bank’s lending officer arranged anotherconsolidation loan for them, to cover the overdraft debt.

Again, the bank left the couple’s overdraft facility in place, and within a few monthsMr. and Mrs. A were again in financial difficulties. When they visited the bank in Novemberthey were given a third loan. This covered the debts that the couple had acquired since


Introduction 43

Notestaking out the consolidation loan in June. It also covered an additional £500. The bankagreed to lend them this because they had said they were worried about how they wouldpay for all the “extras” they would need over the Christmas period.

By early 2005, realizing that they were unable to meet their repayment commitments,Mr. and Mrs. A complained to the bank. They said they had asked for help in managingtheir debts but – instead – it had made their situation worse.

Question:1. Discuss how to solve Mr. and Mrs. A’s complaints?

1.36 Further Readings1. Money, Banking and Financial Institutions by Siklos, Pierre, McGraw-Hill

Ryerson.2. Banking Through the Ages by Hoggson, N.F., New York, Dodd, Mead &

Company.3. Investing in Development: Lessons of the World Bank Experience, by Baum

W.C and Tolbert S.M., Oxford University Press.4. Projects, Preparation, Appraisal, Budgeting and Implementation, by Prasanna

Chandra, Tata McGraw Hill, New Delhi.

1.37 Bibliography1. Siklos, Pierre (2001), Money, Banking, and Financial Institutions: Canada in

the Global Environment, Toronto: McGraw-Hill Ryerson, p. 40, ISBN 0-07-087158-2.

2. Hoggson, N.F. (1926), Banking through the Ages, New York, Dodd, Mead &Company.

3. Goldthwaite, R.A. (1995), Banks, Places and Entrepreneurs in RenaissanceFlorence, Aldershot.

4. Mishler, Lon and Cole, Robert E. (1995), Consumer and Business CreditManagement, Homewood: Irwin, pp. 128-129, ISBN 0-256-13948-2.

5. Statistics Department (2001), “Source Data for Monetary and FinancialStatistics”, Monetary and Financial Statistics: Compilation Guide, WashingtonD.C.: International Monetary Fund, p. 24, ISBN 978-1-58906-584-0. Retrieved2009-03-14.

6. “For Banks, Wads of Cash and Loads of Trouble” Article by Eric Lipton andAndrew Martin in The New York Times July 3, 2009 Hampshire, Great Britain,Variorum.

7. Baum W.C. and Tolbert S.M. (1985), Investing in Development: Lessons of theWorld Bank Experience, Oxford: Oxford University Press, p. 8.

8. Choudhary, S. (1988), Project Management, New Delhi: Tata McGraw Hill,p. 3.

9. Harrison, F.L. (1992), Advance Project Management, Metropolitan, New Delhi,p. 13.

10. James, M. Kouzes and Barry Z. Posner (1987), The Leadership Challenge,Jossey Bass, Sans Francisco.

11. Prasanna Chandra (1988), Projects, Preparation, Appraisal, Budgeting andImplementation: Tata McGraw Hill, New Delhi.



Notes 12. Sapru, R.K. (1994), Development Administration, Sterling, New Delhi.13. United Nations Industrial Development Organization (1998), Manual for

Evaluation of Industrial Projects, Oxford and IBH New York.14. T.E. Copeland and J.F. Weston (1988), Financial Theory and Corporate Policy,

Addison-Wesley, West Sussex (ISBN 978-0321223531).15. E.J. Elton, M.J. Gruber, S.J. Brown and W.N. Goetzmann (2003), Modern

Portfolio Theory and Investment Analysis, John Wiley & Sons, New York (ISBN978-0470050828).

16. E.F. Fama (1976), Foundations of Finance, Basic Books Inc., New York (ISBN978-0465024995).

17. Marc M. Groz (2009), Forbes Guide to the Markets, John Wiley & Sons Inc.,New York (ISBN 978-0470463383).

18. R.C. Merton (1992), Continuous Time Finance, Blackwell Publishers Inc. (ISBN978-0631185086).

19. Keith Pilbeam (2010), Finance and Financial Markets, Palgrave (ISBN 978-0230233218).

20. Steven Valdez, An Introduction to Global Financial Markets, Macmillan PressLtd. (ISBN 0-333-76447-1).

21. The Business Finance Market: A Survey, Industrial Systems ResearchPublications, Manchester (UK), New Edition 2002 (ISBN 978-0-906321-19-5).


Financial Intermediaries 45

Notes

Structure:

2.1 Introduction2.2 Meaning of Financial Intermediary2.3 Classification of Financial Intermediaries2.4 Functions of Financial Intermediaries2.5 Commercial Banks2.6 Definitions of Commercial Bank2.7 Meaning of Commercial Bank2.8 Significance of Commercial Banks2.9 Structure of Commercial Bank in India

2.10 Role of Commercial Bank in the Economic Development of India2.11 Functions of Commercial Banks2.12 Classification of Commercial Banks2.13 Central Bank or RBI2.14 History of the Reserve Bank of India2.15 Establishment of RBI2.16 Organizational Structure of RBI2.17 Functional Departments of RBI2.18 Objectives of Reserve Bank of India2.19 Role of Reserve Bank of India2.20 Main Functions of RBI2.21 Monetary Policy of Reserve Bank of India2.22 Objectives of Monetary Policy2.23 Cooperative Banks2.24 History of Cooperative Banking in India2.25 Structure of Cooperative Banking in India2.26 Cooperative Banks – Irritants and Future Trends2.27 Major Irritants in the Functioning of the Cooperative Banks2.28 Banking System in USA and India2.29 International Banking2.30 Benefits of Having an International Banking2.31 Banking Operations2.32 Retail Banking2.33 Meaning of Retail Banking2.34 Retail Banking in India2.35 Features of Retail Banking

Unit 2: Financial Intermediaries



Notes 2.36 Scope for Retail Banking in India2.37 Retail Banking Activities2.38 Wholesale Banking2.39 Wholesale Banking in India2.40 Near Banks2.41 Universal Banking2.42 Advantages of Universal Banking2.43 Disadvantages of Universal Banking2.44 Non-Banking Financial Company2.45 Summary2.46 Check Your Progress2.47 Questions and Exercises2.48 Key Terms2.49 Check Your Progress: Answers2.50 Case Study2.51 Further Readings2.52 Bibliography

Objectives

After studying this unit, you should be able to understand:

lUnderstand the overview of financial intermediariesDetailed overview of Commercial banksDetailed study of Central and Cooperative banksBanking system in USA and IndiaUnderstand the International BankingUnderstand the Banking OperationsDetailed study of Retail, Wholesale and Universal BankingUnderstand the Near BanksDetailed study of NBFCs

2.1 Introduction

A financial intermediary is a financial institution that connects surplus and deficitagents. The classic example of a financial intermediary is a bank that consolidates bankdeposits and uses the funds to transform them into bank loans.

Financial Intermediaries are the firms that provide services and products whichcustomers may not be able to get more efficiently by themselves in final markets. In otherwords, they act as middlemen between investors and borrowers in financial system.

Financial intermediaries may be classified into two:

(i) Capital market intermediariesThose institutions who provide only long-term funds to individual and companies are

called capital market intermediaries, e.g., financial corporations, investing institutions, etc.



Notes(ii) Money market intermediariesThose institutions who provide only short-term funds to individuals and corporate

customers are called money market intermediaries, e.g., commercial banks, cooperativebanks, etc.

2.2 Meaning of Financial Intermediary

Financial intermediary is a financial institution such as bank, building society,insurance company, and investment bank or pension fund. A financial intermediary offersa service to help an individual/firm to save or borrow money. A financial intermediary helpsto facilitate the different needs of lenders and borrowers.

2.3 Classification of Financial Intermediaries

In general, the financial intermediaries in the Indian Financial System are classifiedin the following ways:

(i) Deposit taking organizationsThese organizations accept deposits from investors and lend the same to various

entities. Investors are very familiar with these organizations as they deal with them quiteregularly.

Examples: (i) Banks finance companies and (ii) National savings organizations.

(ii) Contractual savings organizationsThese organizations enter long-term contracts with investors. Typically, the contract

involves receiving a series of periodic payments from investors over a period of time. Thesecompanies manage the amount received carefully to adhere to the terms of the agreementand to meet their part of obligations.

Examples: (i) Insurance companies and (ii) Pension funds.

(iii) Investment type organizationsThese companies accept money from investors to manage money for them on their

behalf. Normally, it involves making a pool of investor’s money and investing it in a portfolioof securities or assets to meet certain common investment objective of the clients.Example: Mutual funds.

(iv) Fee based intermediariesThese intermediaries do not become a party to the fund transfer process, but just

helps in the transfer. They help in providing information to either party about availabilityof funds or need of funds and help in getting a match. They also help investors inunderstanding various investment products, understanding risks, analyzing comparativefacts and making suitable choices in case of multiple options. They do not take thetransactions on their own books.



Notes 2.4 Functions of Financial Intermediaries

The various functions performed by these intermediaries are broadly classified intotwo:

Traditional Functions:

(i) Underwriting of investments in shares/debentures, etc.(ii) Dealing in secondary market activities.(iii) Participating in money market instruments.(iv) Involving in leasing, hire purchase, venture capital, seed capital, etc.(v) Dealing in foreign exchange market activities.(vi) Managing the capital issues.(vii) Making arrangements for the placement of capital and debt instruments with

investing institutions.(viii) Arrangement of funds from financial institutions for the clients’ project.(ix) Assisting in the process of getting all Government and other clearances.

Modern Functions:

(i) Rendering project advisory services.(ii) Planning for mergers and acquisitions and assisting for their smooth carry out.(iii) Guiding corporate customers in capital restructuring.(iv) Acting as trustees to the debenture holders.(v) Structuring the financial collaboration joint venture by identifying suitable partner

and preparing joint venture agreement.(vi) Rehabilitating and reconstructing sick companies.(vii) Hedging of risks by using swaps and derivatives.(viii) Managing portfolio of large public sector corporations.(ix) Undertaking risk management services like insurance service, buyback options,

etc.(x) Advising the clients on best source of funding overall.(xi) Guiding the clients in the minimization of the cost of debt.(xii) Capital market services such as clearing, registration and transfers, safe

custody of securities, collection of income on securities.(xiii) Promoting credit rating agencies.(xiv Recommending suitable changes in the management structure and management

style with a view of achieving better result.

2.5 Commercial Banks

Commercial bank is a profit-seeking business firm, dealing in money and credit. Itis a financial institution dealing in money in the sense that it accepts deposits of moneyfrom the public to keep them in its custody for safety. So, it deals in credit, i.e., it createscredit by making advances out of the funds received as deposits to needy people. It thus,functions as mobilizer of savings in the economy. A bank is, therefore like a reservoirinto which how the savings, the idle surplus money of households and from which loansare given on interest to businessmen and others who need them for investment or



Notesproductive uses. Commercial bank being the financial institution performs diverse typesof functions. It satisfies the financial needs of the sectors such as agriculture, industry,trade, communication, etc. That means they play a very significant role in a process ofeconomic and social needs. The functions performed by banks are changing accordingto changes in time and recently they are becoming customer centric and widening theirfunctions. Generally, the functions of commercial banks are divided into two categories,viz., primary functions and secondary functions.

2.6 Definition of Commercial Bank

According to Crowther, “A Commercial Bank is an institution which collects moneyfrom those who have it to spare or who are saving it out of their income and lends thismoney out to those who require it.

2.7 Meaning of Commercial Bank

Commercial bank refers to a bank that lends money and provides transactional,savings, and money market accounts and that accepts time deposit. A commercial bankis a type of financial institution and intermediary. Commercial banks engage for providingdocumentary and standby letter of credit, guarantees, performance bonds, securities,underwriting commitments and other forms of off-balance sheet exposures.

2.8 Significance of Commercial Banks

Banks play a vital and dynamic role in the economic life of the nation as they keepthe wheels of trade, commerce and industry always revolving. They mobilize the dormantfunds into a productive channel. The economic importance of the Commercial Banks canbe summarized as follows:

(i) Capital formation: Banks facilitate capital formation by promoting savings.(ii) Innovation: Bank credit enables the enterprises to innovate and invest and thus

uplift economic activity.(iii) Monetary policy: A well-developed banking system is required to promote

economic development by controlling a period of inflation and deflation.(iv) Credit creation: Credit creation enables the expansion of business and

mitigation of unemployment and raises production.(v) Encouragement of trade and industry: Banking system encourages trade

and industry by providing long-term loans to traders and industrialists at lowrates.

(vi) Promotion of habit of thrift: Banks encourage savings habit by accepting,deposits and giving interests on it.

(vii) Volume of production: Production volume can be increased by expansion ofcredit by banks.

2.9 Structure of Commercial Bank in India

1. Scheduled Banks

Scheduled Banks in India are those banks which have been included in the SecondSchedule of Reserve Bank of India (RBI) Act, 1934. RBI in turn includes only those banksin this schedule which satisfy the criteria laid down vide section 42(6)(a) of the Act.



Notes As on 30th June, 1999, there were 300 scheduled banks in India having a total networkof 64,918 branches. Scheduled commercial banks in India include State Bank of Indiaand its associates (7), nationalized banks (19), foreign banks (45), private sector banks(32), cooperative banks and regional rural banks.

“Scheduled banks in India” means the State Bank of India constituted under the StateBank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bankof India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constitutedunder 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 Transferof Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in theSecond Schedule to the Reserve Bank of India Act, 1934 (2 of 1934), but does not includea cooperative bank.

(A) Scheduled Banks in India (Public Sector)Public Sector Banks (PSBs) are banks where a majority stake (i.e., more than 50%)

is held by a government. The shares of these banks are listed on stock exchanges. TheCentral Government entered the banking business with the nationalization of the ImperialBank of India in 1955. A 60% stake was taken by the Reserve Bank of India and thenew bank was named as the State Bank of India. The seven other state banks becamethe subsidiaries of the new bank when nationalized on 19 July 1960. The next majornationalization of banks took place in 1969 when the government of India, under PrimeMinister Indira Gandhi, nationalized an additional 14 major banks. The total deposits inthe banks nationalized in 1969 amounted to 50 crores. This move increased the presenceof nationalized banks in India, with 84% of the total branches coming under governmentcontrol.

The following are the Scheduled Banks in India (Public Sector):

(i) Nationalized BanksAllahabad BankAndhra BankBank of BarodaBank of IndiaBank of MaharashtraCanara BankCentral Bank of IndiaCorporation BankDena BankIndian BankIndian Overseas BankOriental Bank of CommercePunjab and Sindh BankPunjab National BankSyndicate BankUCO BankUnion Bank of IndiaUnited Bank of IndiaVijaya Bank



NotesIDBI BankSaurashtra Gramin Bank (RRB) Bank

(ii) SBI and its AssociatesState Bank of IndiaState Bank of Bikaner and JaipurState Bank of HyderabadState Bank of MysoreState Bank of PatialaState Bank of Travancore

(B) Scheduled Banks in India (Private Sector)Private sector banks in India are all those banks where greater parts of stake or

equity are held by the private shareholders and not by government. These are the majorplayers in the banking sector as well as in expansion of the business activities India.The present private sector banks equipped with all kinds of contemporary innovations,monetary tools and techniques to handle the complexities are a result of the evolutionaryprocess over two centuries. They have a highly developed organizational structure andare professionally managed. Thus, they have grown faster and stronger since past fewyears.

Private sector banks have been functioning in India since the very beginning of thebanking system. Initially, during 1921, the private banks like Bank of Bengal, Bank ofBombay and Bank of Madras were in service, which all together formed Imperial Bankof India.

Reserve Bank of India (RBI) came in picture in 1935 and became the centre of everyother bank taking away all the responsibilities and functions of Imperial Bank. Between1969 and 1980, there was rapid increase in the number of branches of the private banks.In April 1980, they accounted for nearly 17.5% of bank branches in India. In 1980, after6 more banks were nationalized, about 10% of the bank branches were those of privatesector banks. The share of the private bank branches stayed nearly same between 1980and 2000. Then from the early 1990s, RBI’s liberalization policy came in picture and withthis the government gave licences to a few private banks, which came to be known asnew private sector banks.

There are three categories of the private sector banks: “old”, “new” and foreign privatebanks:

The old private sector banks have been operating since a long time and may bereferred to those banks, which are in operation from before 1991 and all those banks thathave commenced there business after 1991 are called as new private sector banks.

Housing Development Finance Corporation Limited was the first private bank in Indiato receive license from RBI as a part of the RBI’s liberalization policy of the banking sector,to set up a bank in the private sector banks in India.

(i) Old Private Sector BanksThe banks, which were not nationalized at the time of bank nationalization that took

place during 1969 and 1980 are known to be the old private sector banks. These werenot nationalized, because of their small size and regional focus. Most of the old privatesector banks are closely held by certain communities their operations are mostly restrictedto the areas in and around their place of origin. Their Board of directors mainly consistsof locally prominent personalities from trade and business circles.



Notes One of the positive points of these banks is that, they lean heavily on service andtechnology and as such, they are likely to attract more business in days to come withthe restructuring of the industry round the corner.

List of the Old Private Sector Banks in India

Name of the Bank Year of Establishment1. Bank of Punjab 1943

2. Catholic Syrian Bank 1920

3. City Union Bank 1904

4. Dhanlaxmi Bank 19275. Federal Bank 1931

6. ING Vysya Bank 1930

7. Jammu and Kashmir Bank 1938

8. Karnataka Bank 1924

9. Karur Vysya Bank 191610. Lakshmi Vilas Bank 1926

11. Nainital Bank 1912

12. Ratnakar Bank 1943

13. SBI Commercial and International Bank 1955

14. South Indian Bank 190515. Tamilnad Mercantile Bank Limited 1921

16. United Western Bank 1936

(ii) New Private Sector BanksThe banks, which came in operation after 1991, with the introduction of economic

reforms and financial sector reforms are called “new private sector banks”. Bankingregulation act was then amended in 1993, which permitted the entry of new private- sectorbanks in the Indian banking sector. However, there were certain criteria set for theestablishment of the new private sector banks, some of those criteria being:

The bank should have a minimum net worth of ` 200 crores. The promoters holdingshould be a minimum of 25% of the paid-up capital.

Within 3 years of the starting of the operations, the bank should offer shares to publicand their net worth must increased to ` 300 crores.

List of the New Private Sector Banks in India

Name of the Bank Year of Establishment1. Axis Bank (earlier UTI Bank) 1994

2. Bank of Punjab (actually an old generation privatebank since it was not founded under post-1993 newbank licensing regime) 1989

3. Centurion Bank Ltd. (Merged Bank of Punjab in late2005 to become Centurion Bank of Punjab, acquiredby HDFC Bank Ltd. in 2008) 1994

4. Development Credit Bank 1995



Notes5. HDFC Bank 1994

6. ICICI Bank 1996

7. IndusInd Bank 1994

8. Kotak Mahindra Bank 1985

9. Yes Bank 2005

(iii) Foreign Private Banks Operating in India1. ABN AMRO Bank N.V. (Now merged with RBS)2. Abu Dhabi Commercial Bank3. American Express Bank4. Australia and New Zealand Bank5. Bank International Indonesia6. Bank of America NA7. Bank of Bahrain and Kuwait8. Bank of Ceylon9. Bank of Nova Scotia (Scotia Bank)

10. Bank of Tokyo Mitsubishi UFJ11. Barclays Bank PLC12. BNP Paribas13. Calyon Bank14. Chinatrust Commercial Bank15. Citibank N.A.16. Credit Suisse17. DBS Bank18. DCB Bank now RHB Bank19. Deutsche Bank AG20. FirstRand Bank21. HSBC22. JP Morgan Chase Bank23. Krung Thai Bank24. Mashreq Bank Psc25. Mizuho Corporate Bank26. Royal Bank of Scotland27. Shinhan Bank29. Société Générale30. Sonali Bank31. Standard Chartered Bank32. State Bank of Mauritius33. UBS34. VTB



Notes 2. Non Scheduled Bank in India

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 scheduledbank”. Non-scheduled banks also function in the Indian banking space, in the form of LocalArea Banks (LAB). As at end-March 2009, there were only 4 LABs operating in India.Local area banks are banks that are set up under the scheme announced by thegovernment of India in 1996, for the establishment of new private banks of a local nature;with jurisdiction over a maximum of three contiguous districts. LABs aid in the mobilizationof funds of rural and semi-urban districts. Six LABs were originally licensed, but the licenseof one of them was cancelled due to irregularities in operations, and the other wasamalgamated with Bank of Baroda in 2004 due to its weak financial position. They arenot bound to perform banking services according to the policies and instructions of centralbank, e.g., Bank of Punjab was a non-scheduled bank. These banks do not fulfill therequired qualifications of a scheduled bank as prescribed by the central bank. They alsodo not enjoy the public confidence. In many countries, many non-scheduled banks arealso working.

Non-scheduled banks are depository or lending institutions that do not meet theSecond Schedule of Reserve Bank of India Act. These banks may be legal entities, butthey do not have procedural endorsement of the government. Non-scheduled banks arenot just identified as banks that do not meet the criteria in the Second Schedule of the1934 Act; they are defined in Section 5, clause C of the Banking Regulation Act of 1949.

Many of these banks are similar to savings and loans, credit unions or cooperatives.Though many are organized like a depositor-owned credit union, they are typically for-profit ventures but don’t meet government standards and do not have full public confidence.

2.10 Role of Commercial Bank in the Economic Development of India

Commercial banks play an important and active role in the economic developmentof a country. If the banking system in a country is effective, efficient and disciplined, itbrings about a rapid growth in the various sectors of the economy.

The following is the significance of commercial banks in the economic developmentof a country:

1. Banks promote capital formationCommercial banks accept deposits from individuals and businesses, these deposits

are then made available to the businesses which make use of them for productive purposesin the country. The banks are, therefore, not only the store houses of the country’s wealth,but also provide financial resources necessary for economic development.

2. Investment in new enterprisesBusinessmen normally hesitate to invest their money in risky enterprises. The

commercial banks generally provide short- and medium-term loans to entrepreneurs toinvest in new enterprises and adopt new methods of production. The provision of timelycredit increases the productive capacity of the economy.

3. Promotion of trade and industryWith the growth of commercial banking, there is vast expansion in trade and industry.

The use of bank draft, check, bill of exchange, credit cards and letters of credit, etc. hasrevolutionized both national and international trade.



Notes4. Development of agricultureThe commercial banks particularly in developing countries are now providing credit

for development of agriculture and small scale industries in rural areas. The provision ofcredit to agriculture sector has greatly helped in raising agriculture productivity and incomeof the farmers.

5. Balanced development of different regionsThe commercial banks play an important role in achieving balanced development in

different regions of the country. They help in transferring surplus capital from developedregions to the less developed regions. The traders, industrialist, etc. of less developedregions is able to get adequate capital for meeting their business needs. This in turnincreases investment, trade and production in the economy.

6. Influencing economic activityThe banks can also influence the economic activity of the country through its

influence on (a) availability of credit and (b) the rate of interest. If the commercial banksare able to increase the amount of money in circulation through credit creation or bylowering the rate of interest, it directly affects economic development. A low rate of interestcan encourage investment. The credit creation activity can raise aggregate demand whichleads to more production in the economy.

7. Implementation of monetary policyThe central bank of the country controls and regulates volume of credit through the

active cooperation of the banking system in the country. It helps in bringing price stabilityand promotes economic growth within the shortest possible period of time.

8. Monetization of the economyThe commercial banks by opening branches in the rural and backward areas are

reducing the exchange of goods through barter. The use of money has greatly increasedthe volume of production of goods. The non-monetized sector (barter economy) is nowbeing converted into monetized sector with the help of commercial banks.

9. Export promotion cellsIn order to increase the exports of the country, the commercial banks have

established export promotion cells. They provide information about general trade andeconomic conditions both inside and outside the country to its customers. The banksare therefore, making positive contribution in the process of economic development.

2.11 Functions of Commercial Banks

Commercial bank being the financial institution performs diverse types of functions.It satisfies the financial needs of the sectors such as agriculture, industry, trade,communication, etc.

The commercial bank performs the following functions:

1. Primary Functions

Primary functions of the commercial banks include:

(i) Acceptance of DepositsCommercial bank accepts various types of deposits from public especially from its

clients. These deposits are payable after a certain time period. Banks generally accept



Notes three types of deposits, viz., (a) Current Deposits, (b) Savings Deposits, (c) Fixed Depositsand (d) Recurring Deposit.

(a) Current DepositsThese deposits are also known as demand deposits. These deposits can be

withdrawn at any time. Generally, no interest is allowed on current deposits, and in case,the customer is required to leave a minimum balance undrawn with the bank. Chequesare used to withdraw the amount. These deposits are kept by businessmen andindustrialists who receive and make large payments through banks. The bank levies certainincidental charges on the customer for the services rendered by it.

The Reserve bank of India prohibits payment of interest on current accounts or ondeposits up to 14 days or less except where prior sanction has been obtained. Banksusually charge a small amount known as incidental charges on current deposit accountsdepending on the number of transaction.

(b) Savings DepositsIf the customer wishes to withdraw more than the specified amount at any one time,

he has to give prior notice. Interest is allowed on the credit balance of this account. Therate of interest is greater than the rate of interest on the current deposits and less thanthat on fixed deposit. This system greatly encourages the habit of thrift or savings.

Savings deposit account is meant for individuals who wish to deposit small amountsout of their current income. It helps in safe guarding their future and also earning intereston the savings. A saving account can be opened with or without cheque book facility.There are restrictions on the withdrawals from this account. Savings account holders arealso allowed to deposit cheques, drafts, dividend warrants, etc. drawn in their favour forcollection by the bank. To open a savings account, it is necessary for the depositor tobe introduced by a person having a current or savings account with the same bank.

(c) Fixed DepositsThese deposits are also known as time deposits. These deposits cannot be

withdrawn before the expiry of the period for which they are deposited or without givinga prior notice for withdrawal. If the depositor is in need of money, he has to borrow onthe security of this account and pay a slightly higher rate of interest to the bank. Theyare attracted by the payment of interest which is usually higher for longer period. Fixeddeposits are liked by depositors both for their safety and as well as for their interest. InIndia, they are accepted between three months and ten years.

Fixed deposits are most useful for a commercial bank. Since they are repayableonly after a fixed period, the bank may invest these funds more profitably by lending athigher rates of interest and for relatively longer periods. The rate of interest on fixed depositsdepends upon the period of deposits. The longer the period, the higher is the rate of interestoffered. The rate of interest to be allowed on fixed deposits is governed by rules laid downby the Reserve Bank of India.

(d) Recurring DepositsRecurring deposits are a special kind of term deposits offered by banks in India which

help people with regular incomes to deposit a fixed amount every month into their recurringdeposit account and earn interest at the rate applicable to fixed deposits. It is similarto making FDs of a certain amount in monthly installments, for example ` 1,000 everymonth. This deposit matures on a specific date in the future along with all the depositsmade every month. Thus, recurring deposit schemes allow customers with an opportunityto build up their savings through regular monthly deposits of fixed sum over a fixed periodof time.



NotesThe recurring deposit can be funded by standing instructions which are theinstructions by the customer to the bank to withdraw a certain sum of money from hissavings/current account and credit to the recurring deposit every month.

(ii) Advancing Loans

Loans are made against personal security, gold and silver, stocks of goods and otherassets. The second primary function of a commercial bank is to make loans and advancesto all types of persons, particularly to businessmen and entrepreneurs.

In a demand loan account, the entire amount is paid to the debtor at one time, eitherin cash or by transfer to his savings bank or current account. No subsequent debit isordinarily allowed except by way of interest, incidental charges, insurance premiums,expenses incurred for the protection of the security, etc. Repayment is provided for byinstallment without allowing the demand character of the loan to be affected in any way.There is usually a stipulation that in the event of any installment, remaining unpaid, theentire amount of the loan will become due. Interest is charged on the debit balance, usuallywith monthly rests unless there is an arrangement to the contrary. No cheque book isissued. The security may be personal or in the form of shares, government paper, fixeddeposit receipt, life insurance policies, goods, etc.

The most common way of lending is by:

(a) Overdraft FacilitiesIn this case, the depositor in a current account is allowed to draw over and above

his account up to a previously agreed limit. Suppose a businessman has only ` 6,000/- inhis current account in a bank but requires ` 12,000/- to meet his expenses. He mayapproach his bank and borrow the additional amount of ` 6,000/-. The bank allows thecustomer to overdraw his account through cheques. The bank, however, charges interestonly on the amount overdrawn from the account. This type of loan is very popular withthe Indian businessmen.

As in the case of a demand loan account, the security in an overdraft account maybe either personal or tangible. The tangible security may be in the form of shares,government paper, life insurance policies, fixed deposit receipts etc., i.e., paper securities.A cheque book is issued in an overdraft account.

(b) Cash CreditCash credits are normally granted against the security of goods, e.g., raw materials,

stock in process, finished goods. It is also granted against the security of book debts.If there is good turnover both in the account and in the goods and there are no adversefactors, a cash credit limit is allowed to continue for years together. Of course, a periodicalreview would be necessary.

Under this account, the bank gives loans to the borrowers against certain security.But the entire loan is not given at one particular time, instead the amount is credited intohis account in the bank; but under emergency cash will be given. The borrower is requiredto pay interest only on the amount of credit availed to him. He will be allowed to withdrawsmall sums of money according to his requirements through cheques, but he cannotexceed the credit limit allowed to him. Besides, the bank can also give specified loanto a person, for a firm against some collateral security. The bank can recall such loansat its option.



Notes (c) Discounting Bills of ExchangeBills, clean or documentary, are sometimes purchased from approved customers in

whose favour regular limits are sanctioned. In the case of documentary bills, the draftsare accompanied by documents of title to goods such as railway receipts or bills of lading(BOL). Before granting a limit, the creditworthiness of the drawer is to be ascertained.Sometimes the financial standing of the drawees of the bills are verified, particularly whenthe bills are drawn from time to time on the same drawees and/or the amounts are large.

Although the term “Bills Purchased” seems to imply that the bank becomes thepurchaser/owner of such bills, it will be observed that in almost all cases, the bank holdsthe bills (even if they are indorsed in its favour) only as security for the advance. In additionto any rights the banker may have against the parties liable on the hills, he can alsofully exercise a pledgee’s right over the goods covered by the documents.

This is another type of lending which is very popular with the modern banks. Theholder of a bill can get it discounted by the bank, when he is in need of money. Afterdeducting its commission, the bank pays the present price of the bill to the holder. Suchbills form good investment for a bank. They provide a very liquid asset which can be quicklyturned into cash. The commercial banks can rediscount the discounted bills with thecentral banks when they are in need of money. These bills are safe and secured bills.When the bill matures, the bank can secure its payment from the party which had acceptedthe bill.

Usance bills, maturing within 90 days or so after date or sight, are discounted bybanks for approved parties. In case a bill, say for ` 10,000 due 90 days hence, isdiscounted today at 20% per annum, the borrower is paid ` 9,500, its present worth.However the full amount is collected from the drawee on maturity. The difference betweenthe present worth and the amount of the bill represents earning of the banker for the periodfor which the bill is to run. In banking terminology this item of income is called “discount”.

(d) Money at CallBank also grant loans for a very short period, generally not exceeding 7 days to

the borrowers, usually dealers or brokers in stock exchange markets against collateralsecurities like stock or equity shares, debentures, etc. offered by them. Such advancesare repayable immediately at short notice hence; they are described as money at callor call money.

(e) Term LoansBanks give term loans to traders, industrialists and now to agriculturists also against

some collateral securities. Term loans are so-called because their maturity period variesbetween 1 to 10 years. Term loans; as such provide intermediate or working capital fundsto the borrowers. Sometimes, two or more banks may jointly provide large term loansto the borrower against a common security. Such loans are called participation loans orconsortium finance.

(f) Consumer CreditBanks also grant credit to households in a limited amount to buy some durable

consumer goods such as television sets, refrigerators, etc. or to meet some personalneeds like payment of hospital bills, etc. Such consumer credit is made in a lump sumand is repayable in installments in a short time. Under the 20-point programme, the scopeof consumer credit has been extended to cover expenses on marriage, funeral etc. aswell.



Notes(g) Miscellaneous AdvancesAmong other forms of bank advances there are packing credits given to exporters

for a short duration, export bills purchased/discounted, import finance, advances againstimport bills, finance to the self-employed, credit to the public sector, credit to thecooperative sector and above all, credit to the weaker sections of the community atconcessional rates.

(iii) Creation of Credit

One of the important functions of commercial bank is the creation of credit. Creditcreation is the multiple expansions of banks demand deposits. It is an open secret nowthat banks advance a major portion of their deposits to the borrowers and keep smallerparts of deposits to the customers on demand. Even then the customers of the bankshave full confidence that the depositor’s lying in the banks is quite safe and can bewithdrawn on demand. The banks exploit this trust of their clients and expand loans bymuch more time than the amount of demand deposits possessed by them. This tendencyon the part of the commercial banks to expand their demand deposits as a multiple oftheir excess cash reserve is called creation of credit. Banks supply money to traders andmanufacturers. They also create or manufacture money. Bank deposits are regarded asmoney. They are as good as cash. The reason is they can be used for the purchaseof goods and services and also in payment of debts. When a bank grants a loan to itscustomer, it does not pay cash. It simply credits the account of the borrower. He canwithdraw the amount whenever he wants by a cheque. In this case, bank has createda deposit without receiving cash. That is, banks are said to have created credit. Sayerssays “banks are not merely purveyors of money, but also in an important sense,manufacturers of money.”

The commercial banks create multiple expansions of their bank deposits and dueto this, these are called the factories of credit. The banks advance a major portion of their,deposits to the borrowers and keep a smaller part with them. The customers have fullconfidence on the bank. The banks expand loans by much more than the amount of cashpossessed by them. This tendency on the part of the banks to lend more than the amountof cash possessed by them is called Creation of Credit in Economics. The process of‘Credit Creation’ begins with banks lending money out of primary deposits. Primarydeposits are those deposits which are deposited in banks. In fact banks cannot lend theentire primary deposits as they are required to maintain a certain proportion of primarydeposits in the form of reserves with the RBI under RBI and Banking Regulation Act. Aftermaintaining the required reserves, the bank can lend the remaining portion of primarydeposits. Here, banks lend the money and the process of credit creation starts.

Meaning of Credit Creation

Credit creation is the multiple expansions of banks demand deposits. It is an opensecret now that banks advance a major portion of their deposits to the borrowers and keepsmaller parts of deposits to the customers on demand. Even then the customers of thebanks have full confidence that the depositor’s lying in the banks is quite safe and canbe withdrawn on demand.

Assumptions of Credit Creation

The concept of credit creation is based on the following assumptions:

1. The banks, while granting loans, do not give the amount in cash, instead itcredits the accounts of the customers with the amount of loan.



Notes 2. The customers do not withdraw the entire amount of loan.3. While drawing the money from his account he uses cheque system.4. The persons who are receiving the cheques against their claims from others

also deposit the money into their respective banks.5. The accounts are settled with mere book entries.

Credit Creation by Commercial Banks

The creation of credit or deposits is one of the most vital operations of the commercialbanks. Similar to other corporations, banks aim at earnings profits. For this intention, theyaccept cash in demand deposits and advance loans on credit to customers. When a bankadvances funds, it does not pay the amount in currency notes. However, it introducesa current account in the name of the investor and lets him to withdraw the necessaryamount by cheques. By this way, banks create deposits or credit.

The stability of price level is an essential condition for the economic development.It highly depends upon the demand and supply of money. The supply of money includesthe legal tender money and bank money.

The legal tender money is issued by the Central Bank or the government of thecountry in the form of Bank/Currency notes while the bank money is created by the banks.

The bank money consists of bank deposits. Cheques drawn on bank deposits actas the legal tender money, i.e., with cheques payment obligation can be settled. Thus,banks are not merely purveyors of money but also the manufacturers of money.

The creation of credit or deposits may be arrived in the following two ways:

1. Primary deposits2. Derivative deposits

1. Primary Deposits: It is also known as cash deposit or passive deposit. Whencustomers take actual cash and deposit it with bank, it is known as the primary deposit.

2. Derivative Deposits: It is also called active deposits or creative deposits.Deposits also arise when customers are granted accommodation in the form of loans.These deposits add to the supply of money.

When a bank grants a loan to a customer, it does not usually pay the amount incash, instead it credits an account with the amount of loan. That is, the bank places adeposit at the borrower’s disposal and he can freely withdraw the amount as he likes.

He can draw cheques against the deposits created in his favour for settling histransactions. Thus, cheques against bank deposits become purchasing power in the handsof the public in addition to the legal tender money. But more often, the loan is utilizedover a long time gradually and till such time it forms as deposit.

Hence, the loan which a banker grants to a customer usually large corporate createsadditional deposits, i.e., by advancing loans, banks create deposits and thus, createmoney. So, “Money is said to be created when the banks, through their lending activities,make a net addition to the total supply of money in the economy”.

The customer may retain the loan amount with the bank as deposits or can issuecheques against this deposit to settle his dues. The receiver of the cheque may depositit in the same bank in which case his deposits increase while the givers deposit decreases.In case the borrower has account in some other bank, the deposit of that bank increases.



NotesTechniques of Credit Creation

1. Credit creation by over drafting2. Credit creation by purchase of securities

1. Credit Creation by OverdraftingBy overdrafting, bank creates credit. Secondly, bank purchases the securities and

pays them with its own cheques. The holders of these cheques deposit them in the samebanks. This creates deposit which is nothing other than creation of credit.

According to Benhen, “A bank may receive interest simply by permitting a customerto overdraw their account or by purchasing securities and having for them with its owncheques. Thus, increasing the total bank drafts. One should remember that single bankcreates a very little credit. It is a whole banking system which can expand the credit.”

2. Credit Creation by Purchase of SecuritiesWhen loans are advanced, it is not given in cash. The bank opens a deposit account

in the name of the borrower and allows him draw to draw whenever required. The loanadvanced by cheques results in the creation of new demand deposits. Sometimes, aquestion arises that it borrowers with draw these deposits for the repayment to otherpersons, then how the banks will create credit. The answer is that other persons whoreceive money may also be the clients of the bank. Naturally, they will also deposit theircash in the bank. The process remains continue. We can explain it by the followingexample:

Example: Suppose a person deposits 1,000 in a bank. According to experience, bankcan keep 20% cash reserve to meet the demands of the depositors, and can lend therest safely to the borrowers. If the entire bank maintains a reserve ratio of 20%, then bankscan succeed in creating a credit a credit of ` 5000 against an original deposit of ` 1,000in cash.

Limitation of Credit Creation

Banks do not have unlimited credit creation powers. There are many restrictionswhich can be discussed as under:

1. Restriction by the Central BankIf the banks have large deposits, they can create more credit and if they have small

deposits then their power of credit creation will be limited. While we know the commercialbank has the monopoly of note issue, if the central bank increases the quantity of moneythe deposits of commercial banks will increase and they will expand the volume of creditin the enquiry. On the other hand, if supply of money decreases, the volume of creditalso of decreases. Any how the credit creation power of the commercial bank is directlyaffected by the policy of the central bank.

2. Habits of the CustomersThe power to create credit by the commercial banks is very much influenced by the

habits of the people living in that country. If the people are habitual in using the cheques,then the volume of credit will expand on the other it will be contracted.

3. Cash RatioEvery bank keeps adequate cash reserves for meeting the cash requirements of its

customers. The bank will not allow its cash ratio to fall below a certain minimum level.When this level is reached, then bank will not advance money.



Notes 4. Collateral Security AvailableThe bank advances loan to the borrowers against some kind of Collateral Security.

If these are not available, then the power of credit creation will be restricted.

(iv) Clearing of Cheques

The commercial banks render an important service by providing to their customersa cheap medium of exchange like cheques. It is found much more convenient to settledebts through cheques rather than through the use of cash. The cheque is the mostdeveloped type of credit instrument in the money market.

(v) Financing Internal and Foreign Trade

The bank finances internal and foreign trade through discounting of exchange bills.Sometimes, the bank gives short-term loans to traders on the security of commercialpapers. This discounting business greatly facilitates the movement of internal and externaltrade.

(vi) Remittance of Funds

Commercial banks, on account of their network of branches throughout the country,also provide facilities to remit funds from one place to another for their customers by issuingbank drafts, mail transfers or telegraphic transfers on nominal commission charges. Ascompared to the postal money orders or other instruments, bank drafts have proved tobe a much cheaper mode of transferring money and have helped the business communityconsiderably.

2. Secondary Functions

Secondary functions of the commercial banks include:

(i) Agency ServicesCommercial banks act as attorney for their clients. They buy and sell shares and

bonds, receive and pay utility bills, premiums, dividends, rents and interest for their clients.Banks also perform certain agency functions for and on behalf of their customers. Theagency services are of immense value to the people at large. The various agency servicesrendered by banks are as follows:

(a) Collection and Payment of Credit Instruments: Banks collect and payvarious credit instruments like cheques, bills of exchange, promissory notesetc. on behalf of their customers.

(b) Purchase and Sale of Securities: Banks purchase and sell various securitieslike shares, stocks, bonds, debentures on behalf of their customers.

(c) Collection of Dividends on Shares: Banks collect dividends and interest onshares and debentures of their customers and credit them to their accounts.

(d) Act as Correspondent: Sometimes banks act as representative andcorrespondents of their customers. They get passports, traveler’s tickets andeven secure air and sea passages for their customers.

(e) Income-tax Consultancy: Banks may also employ income tax experts toprepare income tax returns for their customers and to help them to get refundof income tax.



Notes(f) Execution of Standing Orders: Banks execute the standing instructions oftheir customers for making various periodic payments. They pay subscriptions,rents, insurance premia etc. on behalf of their customers.

(g) Act as Trustee and Executor: Banks preserve the ‘Wills’ of their customersand execute them after their death.

(ii) General Utility ServicesGeneral utility services are those services which are rendered by commercial banks

not only to the customers but also to the general public.

In addition to agency services, the modern banks provide many general utility servicesfor the community as given below:

(a) Safe Deposit VaultsA bank undertakes the safe custody of the customer’s valuables and documents

by providing a safe deposit vault. These are kept in specially constructed strong rooms.There are lockers available to the customer on a nominal charge. There are two keys foreach locker, one is given to the customer and the other remains with the Bank Manager.The locker is opened as well as closed by both the keys one after another. Customerscan keep custody. A register is maintained by the bank in which all the particulars aboutthe valuables and documents are recorded in it. Banks provide the services of safe depositvault on hire basis to the customers.

(b) Collection of Cheques, Bills and Promissory NotesThe customers deposit cheques, bills of exchange and promissory note into their

accounts with the banks. These instruments are collected by the bank on behalf of theircustomers and credited to their accounts. These services are provided by the cheques,bills and promissory notes issued on branches out of the city are collected with somenominal charges for postage, etc. This is a very popular and essential service providedby the banks to their customers.

(c) Issuing Letter of CreditA letter of credit is a commercial instrument of assured payment. It is widely used

by the businessman for various purposes. The bank undertakes to make payment to aseller on production of documents stipulated in the letter of credit. It specifies as to whenpayment is to be made which may be either on presentation of documents by the payingbank or at some future date depending upon the terms stipulated in the letter. There aremany parties involved in the letter of credit. One is the applicant who is the buyer of goodsor importer of goods. He makes an application to a bank who issues the letter of credit.The bank is known as issuing bank. The beneficiary is named in the letter of credit whois the seller of goods or exporter. Other banks are also involved in the transaction suchas negotiating bank, confirming bank and advising bank. There are different types of letterof credit. This is a very important service provided by the banks especially for the importersand exporters.

(d) Bank DraftsA bank draft is an order from one branch to another branch of the same bank to

pay a specified sum of money to a person named therein or to his order. A draft is alwayspayable on demand. Banks issue drafts at the request of the customers on their branchesat the place of destination for remitting money from one place to another place. Any personwho wants to remit money has to purchase a draft from the bank by paying the amountin advance to the bank. The purchaser of the draft then sends the draft to the payee’splace of residence by post or courier for the purpose of encashment at the drawee branch



Notes of the bank. The bank issuing the draft charges some commission depends upon theamount of the draft. The purchaser need not be a customer of the bank.

The bank draft is like a bill of exchange payable on demand. In case the draft islost by a purchaser, he has to report to the issuing banker for loss of the draft withoutany endorsement, the banker may safely refuse to pay the amount of the draft. The bankshould take all the precautions and payment of the draft should be made only when thebanker is fully satisfied about the valid title of the holder. The banker should take anindemnity bond and then issue a duplicate draft to the purchaser. The draft may becancelled by the bank if it is not delivered to the payee. When a bank draft is deliveredto the payee, he acquires a right in the instrument, which cannot be set aside by the‘stop-payment’ order issued by the purchaser. The bank issuing the draft sends an adviceto the drawee branch, intimating about the issue of the draft. The drawee branch afterverifying the signature of the authorized officials makes the payment. However, thepayment of the draft should not be refused because of non-receipt of drawing advice.

(e) Automated Teller Machine (ATM)ATM is a channel of banking service to its customers. It’s traditional and primary

use is to dispense cash upon insertion of a plastic card and its unique PIN, i.e., PersonalIdentification Number. The banks issue ATM card to their customers having current orsavings account holding a certain minimum balance in their accounts. ATM card is aplastic card with a magnetic strip with the account number of the individuals. When thecard is inserted into the machine, the sensing equipment of the machine identifies theaccount holder and asks his PIN. It is a secret number which is known only to the accountholder.

Advantages of ATMFollowing are the advantages of ATM:

1. ATM provides 24 hour service; the customer can withdraw cash up to a certainlimit during 24 hours. It is now called all time money facility.

2. It provides a great deal of convenience to customers. Most of the ATMs arelocated at the convenient place and as such this facility is a boon to customers.ATM machines are installed at suitable locations such as airport, railway station,residential colony, near big malls, etc.

3. ATM facility also reduces pressure on bank staff. The bank staff is free fromthe botheration of keeping large ready cash for withdrawal by people.

4. Here, the work of deposition and withdrawal is handled by the machine. Themachines are perfect and provide accurate service. The human errors are absentwhen operations are performed by machines.

5. Operations through machines provide a kind of privacy and secrecy to bankingbusiness.

Disadvantages of ATMThe various disadvantages of ATM are as follows:

(i) Security: Unlike bank tellers, ATMs do not require the person performing thetransaction to present picture identification. Rather, the person must only inserta bank card and enter a personal identification number. If the bank card is stolenand the number ascertained, an unauthorized person can easily access theaccount.

(ii) Inability to perform complex transactions: ATMs can only perform relativelybasic transactions. This means that people who need to complete these longer



Notestransactions will be forced to use the teller, restricting use of the ATM for peoplewho need to complete simple business. In this sense, the ATM is rather likethe express line in a supermarket faster for some, but unavailable to others.

(iii) Fees: With the advent of ATMs came ATM fees. Not only do banks of whichyou are not a member charge fees for the use of their ATMs, but users areoften charged surreptitious fees by their own banks for using other banks’ ATMsmeaning the customer is docked twice for the same transaction.

(iv) Privacy: Unlike banks, in which security guards and tellers are present toensure the person performing a transaction receives privacy, there is no suchguarantee when using an ATM. People may try to spy on users as delicateinformation appears on the screen, without the user being aware.

(v) Difficulty of use through illiterate people: The performance of business atan ATM is generally quicker than that at a human teller. However, the ATMis incapable of providing personalized instruction to the user in a way that ahuman teller can. This can result in longer wait times if the user currently usingthe machine is struggling to complete a transaction.

f) Debit CardA debit card is a plastic card that provides an alternative payment method to cash

when making purchases. Functionally, it can be called an electronic check, as the fundsare withdrawn directly from either the bank account or from the remaining balance on thecard. In some cases, the cards are designed exclusively for use on the Internet, and sothere is no physical card.

In many countries, the use of debit cards has become so widespread that their volumeof use has overtaken or entirely replaced the check and, in some instances, cashtransactions. Like credit cards, debit cards are used widely for telephone and Internetpurchases and, unlike credit cards, the funds are transferred immediately from the bearer’sbank account instead of having the bearer pay back the money at a later date.

Debit cards may also allow for instant withdrawal of cash, acting as the ATM cardfor withdrawing cash and as a check guarantee card. Merchants may also offer cash backfacilities to customers, where a customer can withdraw cash along with their purchase.

(g) Credit CardA credit card is an instrument of payment. It is a source of revolving credit. The cards

are plastic cards issued by the banks to their customers. The name of the customer,card number and expiry date are printed on the plastic cards. Some banks also use thephotograph of the customers on the credit card. The card holder can buy goods or servicesfrom various merchant establishments where such arrangements exist. The card issuingbank makes the payment to the supplier or seller. The outstanding amount on accountof use of the credit card is payable by the card holder to the bank over a specific periodwhich carries a fixed amount of interest. A debit card is a payment card used to obtaincash, goods and services automatically debiting the payments to the card holder’s bankaccount instantly, in which credit balance exists.

A credit card is more than a simple piece of plastic, it is first and foremost a flexiblepayment tool accepted at 30 million locations worldwide, and if the card balance is paidoff every month, then no interest is charged on purchases made so, essentially, short-term credit is granted without the consumer paying any interest.

Some of the features of Credit Card are:1. Access to unsecured credit (no collateral required against amounts charged).2. Interest-free payment from time of purchase to the end of the billing period.



Notes 3. Instant payment of purchases, allowing for instant receipt of goods and services.4. 24/7 access.5. Fraud protection.

Advantages and Disadvantages of Credit CardAdvantages of Credit Card:

1. Offer free use of funds, provided you always pay your balance in full, on time.2. Be more convenient to carry than cash.3. It helps to establish a good credit history.4. To provide a convenient payment method for purchases made on the Internet

and over the telephone.5. Give you incentives, such as reward points, that you can redeem.

Disadvantages of Credit Card:1. Cost much more than other forms of credit, such as a line of credit or a personal

loan, if you don’t pay on time.2. Damage your credit rating if your payments are late.3. Allow you to build up more debt than you can handle.4. Have complicated terms and conditions.

(h) Tele BankingTelephone banking is a service provided by a Commercial Banks, which allows its

customers to perform transactions over the telephone.

Most telephone banking services use an automated phone answering system withphone keypad response or voice recognition capability. To guarantee security, thecustomer must first authenticate through a numeric or verbal password or through securityquestions asked by a live representative. With the obvious exception of cash withdrawalsand deposits, it offers virtually all the features of an automated teller machine: accountbalance information and list of latest transactions, electronic bill payments, funds transfersbetween a customer’s accounts, etc.

Usually, customers can also speak to a live representative located in a call centreor a branch, although this feature is not always guaranteed to be offered 24/7. In additionto the self-service transactions listed earlier, telephone banking representatives are usuallytrained to do what was traditionally available only at the branch: loan applications,investment purchases and redemptions, cheque book orders, debit card replacements,change of address, etc.

(i) Internet BankingInternet is a channel of service to banking customers. The access to account

information as well as transaction is offered through the world wide web network ofcomputers on the internet. Each account holder is provided with a PIN similar to that ofATM or phone banking. The access to the account is allowed to the customer upon amatch of the account details and PIN entered on the computer system. A higher levelof security may be reached by an electronic fingerprint. Transaction such as e-business,Railway-Air Reservation, payment of bills, transfer of money, etc. can be carried out whilesitting in the house with the help of an internet.

The following is a list of the advantages of internet banking:1. Easy to Set-up: It is easy and fast to set up an internet bank account. All that

users have to do to create an online bank account is complete a short form and then



Notesset the security features such as a password and username. Finally, they just print andsign a form and send it in to the bank.

2. Fewer Costs: There are fewer costs associated with internet banking becauseonline banks do not have the overhead like traditional banks. Because there are fewercosts, internet banks pass the savings on to consumers such as reduced service chargesand increased interest rates for savings accounts. They can even offer reduced lendingrates for their loans.

3. Easy and Convenient Online Bank Comparison: It is easy to research manyinternet banks online allowing to compare such features as interest rates, available creditcards and their interest rates, FDIC Bank rating, and terms and interest rates of theirloans.

4. Easy Bank Account Monitoring: Internet banking and money 24 hours a day,7 days a week. It can track such things as deposits, clearing of checks, account balance.It allows to keep the account from going into the negative.

5. Maintain Accurate Financial Records: It can keep track of the financial recordsby using software programs such as Microsoft Money or Quicken. This will allow to budgetmore efficiently and track the spending.

6. Convenient Banking: Traditional banking has always been slow. With onlinebanking, It will no longer have to stand in long lines to obtain financial information aboutyour account. As well, there is less paperwork and applying for loans is faster, easier,and more convenient.

Disadvantages of Internet Banking1. Security: While banks typically offer secure web pages to conduct customer’s

business transactions, this doesn’t guarantee complete safety. All websites, even secureones, may be susceptible to Internet criminals who try to hack into customer’s accountand gain access to business’s private financial information. This can lead to fraudulentuse of business’s identity and potentially cost the customer’s thousands of rupees.

2. Site Disruption: A technical malfunction could cause the bank’s website to gooffline for a period of time, possibly resulting in problems for customer’s business. Forexample, you may need immediate funds after normal banking hours to make a paymentor emergency business purchase. Routine site maintenance also occurs, although thisnormally takes place during off-peak hours.

3. Site Navigation: If the customers are new to online banking, it may take sometime to get used to it, taking valuable time out of work day. Online banking offers a largenumber of transactions, so frustration may occur while customers are learning to navigatethe site. Banks also update web pages to add new features, requiring additional learningand possibly the need to change account numbers or passwords.

4. User Apprehension: Some business owners may not feel comfortable with theidea of placing vital financial information into an online account, or may be apprehensiveabout using the Internet. If you are a longtime small business owner who is used to doingbanking in person or even by telephone, this hurdle might be difficult to surmount.

5. Accessibility: If customer’s business is located in a rural or remote area, theInternet options could be limited. Depending on the business, this can make conductingtransactions difficult.



Notes 2.12 Classification of Commercial Banks

(A) On the Basis of Commercial Bank Operation

1. Pure or Deposit Bank

The system banking, which involves accepting deposits and lending for short period,is known as pure or deposit banking. It is that system under which the Commercial Banksconfine themselves to the financing of the short-term requirements of industry andcommerce. It is risky for Commercial Banks to grant long-term loans to industries for tworeasons. Firstly, the banks may face the problem of liquidity as the deposits are receivedfor short periods. Secondly, if the borrower fail, in his activities, the bank, may also fail.Thus the fundamental principle of functioning of Commercial Bank is that they confine onlyin short-term lending. The system of pure banking was very popular in UK and India untilrecently. There are two reasons why British banks did not extend long-term loans toindustries. Firstly, the deposits received by the Commercial Banks in Britain are for shortperiod only. Hence, banks in UK confined their lending for short-term duration. Secondly,there is the historical reason why the British bank followed the system of pure banking.The industrial development of Britain was preceded by the expansion of trade and industry.As a result of this commercial expansion, there had come into existence a number ofinstitutions, such as Finance Corporation, issue houses, investment trusts, etc. whichhad specialized in giving long-term loans to industries. Hence, it was no longer necessary,for the Commercial Banks to extend long-term loans to industries.

Deposit banks have connection with the commercial class of people. These banksaccept deposits from the public and lend them to needy parties. Since their deposits arefor short period only, these banks extend loans only for a short period. Ordinarily thesebanks lend money for a period between 3 to 6 months. They do not like to lend moneyfor long periods or to invest their funds in any way in long-term securities. However, after1st World War, the banking system is showing a trend towards mixed banking owing tothe following reasons:

(a) During the great depressions of 1930, the short-term loans granted to industriescould not be recovered by banks. So, these loans were converted into shares anddebentures implying the characteristic feature of mixed banking.

(b) Small industries were closed down during great depression of 1930 and bankswent without the small customers. They were forced to lend to large-scale industries whoserequirements were long-term finance.

(c) The development of Stock Exchanges gave further encouragement for CommercialBanks in UK to provide loans against Stock Exchange securities.

Pure banking enjoys two merits over investment banking, viz., it ensures safety andliquidity of funds. Its serious drawback is it does not encourage industrial development.

2. Investment Bank or Industrial Bank

Industrial Bank is a financial institution with a limited scope of services. Industrialbanks sell certificates that are labeled as investment shares and also accept customerdeposits. They then invest the proceeds in installment loans for consumers and smallbusinesses. These banks are also known as Morris Banks or industrial loan companies.

Industrial banks differ from commercial lenders because they accept deposits. Theyalso differ from commercial banks because they do not offer checking accounts.



NotesFurthermore, the loans offered by industrial banks are often secured by a third party whoacts as guarantor for the loan.

Industries require a huge capital for a long period to buy machinery and equipment.Industrial banks help such industrialists. They provide long-term loans to industries.Besides, they buy shares and debentures of companies, and enable them to have fixedcapital. Sometimes, they even underwrite the debentures and shares of big industrialconcerns. The industrial banks play a vital role in accelerating industrial development. InIndia, after attainment of independence, several industrial banks were started with largepaid up capital. They are, The Industrial Finance Corporation (IFC), The State FinancialCorporations (SFC), Industrial Credit and Investment Corporation of India (ICICI) andIndustrial Developmental Bank of India (IDBI), etc.

Investment banking, otherwise known as industrial banks, provides long-term financeto industries. Germany is considered to be the hometown of investment banking. Thesebanks help the companies, corporations and the Government in issuing and marketingtheir securities. These banks serve as intermediaries in the marketing of securities. Theyhelp in promoting industries. Investment banks act in three different capacities, viz.,(a) As originators, (b) As underwriters and (c) Retailers. As originators, they help in thepromotion of new ventures, as underwriters, they underwrite the new issues and asretailers, they sell securities to the investors.

B. On the Basis of the System of Commercial Bank

1. Branch Bank

This is a system of banking where the business is carried on by a single office witha network of branches spread throughout the country. The Head Office is generally locatedin a big city and the branches operate in different parts of the country. England offersthe best example of Branch banking, wherein the entire Commercial Banking businessis carried out by four major banks, popularly known as the ‘Big four”. The other countriesfollowing this system are Scotland, Australia, and India.

A comparison between unit banking and branch banking is essentially a comparisonbetween large-scale and small-scale operations. Obviously, a bank having branches hassome advantages over the unit bank. However the latter too are efficient in their own way.The advantages of one system of banking incidentally happen to be the disadvantagesof the other.

Merits of Branch Banking

Following are the chief merits of branch banking system:

(i) Large-scale OperationsBranch banking enjoys all the advantages of large-scale operations and reaps the

benefit of division of labor. In comparison of this, the scope for the application ofspecialization in unit banking is comparatively limited.

(ii) Economy in ReservesBranch Banking offers the advantage of keeping lower cash reserves in each branch.

The reserves can be moved from one branch to another in times of necessity. Economyof reserves is of vital consideration to the banker. Unit banks do not possess this advantageand they have to totally depend upon their own reserves.



Notes (iii) Remittance FacilitiesIn the case of branch banks, the cost of making remittance of money is comparatively

low because of the large network of branches, spread all over the country. On the otherhand, the unit banks have to incur high costs. Correspondent banks can to a small extentcut costs.

(iv) Spreading of RiskRisks can be spread out geographically by the branch banking system more

effectively than by unit banks. The bank operating through several branches distributesits assets in different places. On the other hand, the fortunes of unit banks are linkedclosely with the prosperity of the business in the place of its operation, i.e., if that placeis adversely affected the assets of the bank will depreciate and lend the bank in financialtrouble. But a branch bank can sell or transfer its assets to its other branches situatedin places where things are better.

(v) Mobility of Capital and Reducing Disparities in Interest RatesBranch banking facilitates the mobility of capital and brings about uniformity in the

rates of interest over a wide area. Branch banks always transfer funds from areas wherethey are surplus to areas where they are scarce, so as to mitigate the disparities in interestrates. Unit banks cannot do so for obvious reasons.

(vi) High Banking StandardsBranch banks as compared to unit banks can provide better facilities to their

customers because of their comparatively limited member of customers per office andbecause of the efficiency derived through large-scale operations. Branch banks can alsooffer diversified services. The unit banks find it difficult to do so.

(vii) Efficiency in ManagementBranch banks offer greater scope for efficient management. Best men may be recruited

for top management. Branch Managers can be properly selected and given good trainingtoo. On the other hand, the resources of unit banks usually do not permit such facilities.

(viii) Effective Central Banking ControlIt is easy for the Central Bank of the country to have control over the branch banks.

This is because the Central Bank will have to deal with only a few banks having theirheadquarters in major cities. But with unit banks control becomes difficult because thenumber is large and widespread.

(ix) Greater Public ConfidenceA bank with large financial resources and a number of branches spread all over the

country, can command greater public confidence than a small unit bank with limitedresources and one or a few offices located in a particular area of the country.

(x) Better Training to StaffSince the banking work becomes more extensive under branch banking, the

employees and the offices of the bank get better opportunities to acquire knowledge andexperience about the various aspects of banking business in the country.

(xi) Contacts with the Whole CountryUnder this system of banking, the bank maintains contacts with all parts of the

country. This helps it to acquire reliable knowledge about economic conditions in variousparts of the country. This knowledge enables the bank to make a proper and profitableinvestment of its surplus funds.



NotesDemerits of Branch Banking

Following are the chief demerits of branch banking system:

(i) Difficult to ManageSince there are many of branches of a bank under this system, this leads many

difficulties in the management, supervision and control of banking activities. Themanagement of the bank automatically gets concentrated at the Head Office. Very often,a branch has to secure directives from the head this result in avoidable delay in bankingbusiness, particularly in matters of investment.

(ii) Event of FailureIn the event of the failure of the bank, the branch banking system is worst hit as

the entire structure is wiped out.

(iii) Lack of InitiativeThe branches of the bank under this system suffer from a complete lack of initiative

on important banking problems confronting them. No branch of can take decision onimportant problems without first consulting office. This makes the banking system rigidand inelastic in its functioning.

(iv) MonopolyAs the head office controls the activities of all the branches, there is always the

possibility of the emergence of monopoly in banking.

(v) Continuation of Inefficient BranchesThe strong and well to do branch will compensate the weak and unprofitable branches.

Thus, some banks may seek shelter in spite of incurring continuous losses.

(vi) Unnecessary CompetitionBranch expansion may give rise to unnecessary competition among the banks and

indiscriminate opening of branches may end up in overbanking.

(vii) Duplication of Banking FacilitiesThere is unnecessary duplication of banking facilities when the branches of different

banks are opened at the same place.

(viii) ExpensivenessThis system of banking is expensive when compared to unit banking, with more

branches; there arises the problem of coordinating their activities. This requires recruitmentof additional staff, which is expensive.

(ix) Transfer of Funds from One Branch to AnotherThe funds collected in rural areas are transferred to urban areas for the purpose of

earning profit. This hinders the economic development of rural and neglected area.

2. Unit Bank

A unit bank is one, which conducts its banking operations through a single officewithin a strictly limited area or with a limited number of offices in that area. It is essentiallya localized system. Usually the area of operations and the size of the bank is small. Unitbanking flourished in the USA at one time. Unit banks are often linked together by a systemof “correspondent banks”. This is to ease remittance facilities.



Notes Merits of Unit Bank

Following are the main advantages of unit banking:

(i) Convenience of ManagementSince the size of the bank under unit banking is small, its management supervision,

and control are easier and more convenient for the authorities Along with this, the wastageshere can also be controlled more effectively than under branch banking.

(ii) Discontinuance of Inefficient BranchesUnder the branch banking system, strong and profitable branches feed weak and

non-profitable branches. This is not possible under unit banking. If a bank is weak,inefficient and non-profitable, it will automatically cease to exist after some time.

(iii) Check on the Formation of Monopolistic BanksUnder unit banking, the banks are generally of small size. There is complete absence

of big sized banks under unit banking. Hence, there is no possibility of the growth ofmonopolistic banks under this system.

(iv) No Delay in Banking BusinessOne great advantage of unit banking is that there is no delay of any kind in taking

decisions on important problems concerning the unit bank. The reason is that the bankin question has not to wait for directives from the head office. The local officers of theunit bank are competent to take decisions themselves on various problems confrontingthe bank.

(v) Initiative in BusinessSince the bank officers under the units banking system are fully acquainted with

the local problems, they can take initiative in taking important decisions on the variousissues confronting the bank. This makes the banking system more elastic than what itis under the branch banking system.

(vi) No Neglect of Local RequirementThe bank officers of a unit bank are fully acquainted with the local heads; they cannot

neglect the requirements of local development. On the contrary, the requirements of localdevelopment are generally neglected under the system of branch banking.

Demerits of Unit Bank

Following are the disadvantages of unit banking system:

(i) Absence of Division of LaborSince the size of the unit bank is small and its financial resources limited, it cannot

make use of division of labor on any worthwhile scale consequently, it is deprived of theadvantages of division of labor.

(ii) No Geographical Distribution of RisksUnder the unit banking, geographical distribution of the business risks is not possible

because the bank is located at one place.

(iii) Expensiveness and Inconvenience in Remittance of FundsSince the unit bank has no branches at other places in the country, it has to depend

upon the correspondent banks for effecting transfers of funds from one place to another.This makes the movement of funds more expensive and inconvenient for the businessmen.



Notes(iv) Inequality of Interest RatesSince there is no arrangement for the cheap remittance of funds under unit banking

system, there often arises inequality in the rates of interest in different parts of the county.For example, the interest rates are generally lower in big commercial and industrial centersthey are rather high in the backward and under developed areas of the country.

(v) Less Development of Banking in Smaller Towns and CitiesUnit banks are not in a position to open uneconomic branches in small localities

because their financial resources are already limited and they cannot afford to openbranches in small localities.

System Suitable in IndiaThere was predominance of unit banking in India prior to independence because of

the following reasons:

(a) There were many provinces having different laws.(b) Economic interests favored small banks serving a limited area.(c) There was lack of initiative by the banks to open branches outside their local

areas of operation.(d) Due to large number of illiterate people, personal contact and informal

procedures played an important role in dealing with the customers, which waspossible only in case of small regional banks.

Now, the situation has changed totally and the unit banks cannot meet therequirements of our developing economy.

Branch banking is preferred in India because of the following reasons:1. There is a probability of failure of small banks, which causes a serious setback

to the people’s faith in banking. This is evident from the fact they many banksfailed or merged with bigger banks during the early years of independence.

2. India has launched upon an ambitious and extensive programmes of economicdevelopment, which requires adequate capital, which can be provided only bylarge banks having branches.

3. Small banks are not suited to mobilize the savings of rural areas, as they cannotfunction economically. In such areas, only the big banks can afford to opentheir branches in rural areas and can provide financial and other help to the poorpeople to get employment under the self-employment schemes.

4. In order to make the control measures of Central Government and Reserve Bankeffective, branch banking is suitable in India.

3. Group Bank

Group banking is that system of banking under which two or more banks are directlyor indirectly controlled by an association, trust, or corporation. This type of banking isalso known as holding company banking. The holding company holds the majority sharesin the companies under its control and the companies whose shares are held by the holdingcompany are known as subsidiary companies. In our country, the State Bank of Indiais an example of the holding company and its seven subsidiaries, viz., (a) State Bankof Bikaner and Jaipur, (b) State Bank of Indore, (c) State Bank of Hyderbad, (d) StateBank of Patiala, (e) State Bank of Mysore, (f) State Bank of Saurashtra and (g) StateBank of Trivandrum are the subsidiary banks.



Notes Merits of Group Bank

1. Under this system, every member-bank retains its own separate identity andmaintains its own Board of Directors. The central administrative office, controllingthe various members of the group can take steps to improve the level of efficiencyin their day-to-day working.

2. This system ensures liquidity of financial resources. If a member-Bank falls shortof cash, it can be easily transferred to it from the other member-banks.

3. This system also results in an economy in advertising expenditure. Thecorporation controlling the member banks can insert joint advertisement in thenewspapers.

4. Since the corporation controlling the member-bank is a big sized corporation,it can easily obtain the services of experts in the management of the businessof the member-banks. This helps the member banks to place their investmentsand banking business on a sound footing.

5. The group management can also take steps to secure new business for itsconstituent units.

Drawbacks of Group Bank

1. If one member-bank of the group fails due to the adoption of unsound policies,it has its adverse repercussion on the other member banks.

2. This system may not be conducive to the achievement of a high level of efficiencyin management, because the central administrative office is generally not in aposition to enforce codes of discipline on member

3. This system also gives rise to corruption because all the stores the member-banks are purchased by one common purchasing organ, which may succumbto pressures exerted by unscrupulous firms.

4. Chain Bank

This refers to a system where two or more banks are controlled by a single personor group of persons through stock ownership or otherwise. This constitutes in a way aless formal arrangement than group banking and is considerably less important. Thissystem, which developed in America towards the middle of the 19th century, reached thezenith of its popularity around 1900. Since then, it has declined due to the widespreadfailures of many chains. The chain banking system suffers from some drawbacks, as doesthe group banking.

5. Correspondence Bank

Under this system, separately incorporated banks open their accounts by depositingsome money with one another. A bank having the deposits of another bank is known asa “correspondent bank”. The relationship of having accounts and acting as one another’sagent among various banks is known as correspondent banking. The correspondent banksprovide many services to one another. They facilitate the remittance of funds from placeto another and collection of customer’s cheques and bills of exchange. Correspondentbanking allows the unit banks to avail most of the financial branch banking. It also helpsin having connection with the banks in countries. Correspondent banking relations helpin transferring documents and collecting payments in international trade.



Notes6. Savings Bank

A savings bank is a financial institution whose primary purpose is accepting savingsdeposits. It may also perform some other functions. In Europe, savings banks originatedin the 19th or sometimes even the 18th century. Their original objective was to provideeasily accessible savings products to all strata of the population. In some countries,savings banks were created on public initiative, while in others, socially committedindividuals created foundations to put in place the necessary infrastructure. These bankswere specially established to encourage thrift among small savers and therefore, they werewilling to accept small sums as deposits. They encourage savings of the poor and middleclass people. In India, we do not have such special institutions, but post offices performsuch functions. After nationalization, most of the nationalized banks accept the savingdeposits.

7. Agricultural Bank

National Bank for Agriculture and Rural Development (NABARD) is an apexdevelopmental bank in India having headquarters based in Mumbai (Maharashtra) and otherbranches are all over the country. The Committee to Review Arrangements for InstitutionalCredit for Agriculture and Rural Development (CRAFICARD), set up by the Reserve Bankof India (RBI) under the Chairmanship of Shri B. Sivaraman, conceived and recommendedthe establishment of the National Bank for Agriculture and Rural Development (NABARD).It was established on 12 July 1982 by a special act by the parliament and its main focuswas to uplift rural India by increasing the credit flow for elevation of agriculture and ruralnon farm sector and completed its 25 years on 12 July 2007. It has been accredited with“matters concerning policy, planning and operations in the field of credit for agricultureand other economic activities in rural areas in India”. RBI sold its stake in NABARD tothe Government of India, which now holds 99% stake.

Agriculture has its own problems and hence there are separate banks to financeit. These banks are organized on cooperative lines and therefore do not work on theprinciple of maximum profit for the shareholders. These banks meet the credit requirementsof the farmers through term loans, viz., short-, medium- and long-term loans. There aretwo types of agricultural banks,

(a) Agricultural Cooperative Banks, and(b) Land Mortgage Banks. Cooperative Banks are mainly for short periods. For long

periods, there are Land Mortgage Banks. Both these types of banks areperforming useful functions in India.

8. Exchange Bank

Exchange banks are those banks maintain the facilities to finance mostly for theforeign trade of a country. Their main function is to discount, accept and collect foreignbills of exchange. They buy and sell foreign currency and thus help businessmen in theirtransactions. They also carry on the ordinary banking business.

In India, there are some commercial banks which are branches of foreign banks.These banks facilitate for the conversion of Indian currency into foreign currency to makepayments to foreign exporters. They purchase bills from exporters and sell their proceedsto importers. They purchase and sell “forward exchange” too and thus minimize thedifference in exchange rates between different periods, and also protect merchants fromlosses arising out of exchange fluctuations by bearing the risk. The industrial andcommercial development of a country depends these days, largely upon the efficiencyof these institutions.



Notes 2.13 Central Bank or RBI

The financial system in India is regulated by independent regulators in the field ofbanking, insurance, capital market, commodities market, and pension funds. However,Government of India plays a significant role in controlling the financial system in Indiaand influences the roles of such regulators at least to some extent.

The following are the five major financial regulatory bodies in India:

(A) Statutory Bodies via Parliamentary Enactments

1. Reserve Bank of India (RBI)Reserve Bank of India is the apex monetary Institution of India. It is also called as

the Central Bank of the country. The Reserve Bank of India was established on April 1,1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The centraloffice of the Reserve Bank was initially established in Calcutta but was permanently movedto Mumbai in 1937. The central office is where the Governor sits and where policies areformulated. Though originally privately owned, since nationalization in 1949, the ReserveBank is fully owned by the Government of India. It acts as the apex monetary authorityof the country.

2. Securities and Exchange Board of India (SEBI)SEBI Act, 1992: Securities and Exchange Board of India was first established in

the year 1988 as a non-statutory body for regulating the securities market. It became anautonomous body in 1992 and more powers were given through an ordinance. Since then,it regulates the market through its independent powers.

3. Insurance Regulatory and Development Authority (IRDA)The Insurance Regulatory and Development Authority is a national agency of the

Government of India and is based in Hyderabad (Andhra Pradesh). It was formed by anAct of Indian Parliament known as IRDA Act 1999, which was amended in 2002 toincorporate some emerging requirements. Mission of IRDA as stated in the act is “toprotect the interests of the policyholders, to regulate, promote and ensure orderly growthof the insurance industry and for matters connected therewith or incidental thereto.”

(B) Part of Ministries of the Government of India

1. Forward Market Commission India (FMC)Forward Markets Commission headquartered at Mumbai, is a regulatory authority

which is overseen by the Ministry of Consumer Affairs, Food and Public Distribution,Government. of India. It is a statutory body set up in 1953 under the Forward Contracts(Regulation) Act, 1952 This Commission allows commodity trading in 22 exchanges inIndia, out of which three are national level.

2. PFRDA under the Finance MinistryPension Fund Regulatory and Development Authority (PFRDA) was established by

Government of India on 23rd August, 2003. The Government has, through an executiveorder dated 10th October 2003, mandated PFRDA to act as a regulator for the pensionsector. The mandate of PFRDA is development and regulation of pension sector in India.



Notes2.14 History of the Reserve Bank of India

The Reserve Bank of India is the central banking institution of India and controls themonetary policy of the rupee as well as US$ 300.21 billion (2010) of currency reserves.The institution was established on 1 April 1935 during the British Raj in accordance withthe provisions of the Reserve Bank of India Act, 1934 and plays an important part in thedevelopment strategy of the government. It is a member bank of the Asian Clearing Union.

1935-1950:

The Central Bank was founded in 1935 to respond to economic troubles after theFirst World War. The Reserve Bank of India was set up on the recommendations of theHilton-Young Commission. The commission submitted its report in the year 1926, thoughthe bank was not set up for another nine years. The Preamble of the Reserve Bank ofIndia describes the basic functions of the Reserve Bank as to regulate the issue of banknotes, to keep reserves with a view to securing monetary stability in India and generallyto operate the currency and credit system in the best interests of the country. The CentralOffice of the Reserve Bank was initially established in Kolkata, Bengal, but waspermanently moved to Mumbai in 1937. The Reserve Bank continued to act as the centralbank for Myanmar till Japanese occupation of Burma and later up to April 1947, thoughBurma seceded from the Indian Union in 1937. After partition, the Reserve Bank servedas the central bank for Pakistan until June 1948 when the State Bank of Pakistancommenced operations. Though originally set up as a shareholders’ bank, the RBI hasbeen fully owned by the Government of India since its nationalization in 1949.

1950-1960:

Between 1950 and 1960, the Indian government developed a centrally plannedeconomic policy and focused on the agricultural sector. The administration nationalizedand established commercial banks based on the Banking Companies Act, 1949 (latercalled Banking Regulation Act), a central bank regulation as part of the RBI. Furthermore,the central bank was ordered to support the economic plan with loans.

1960-1969:

As a result of bank crashes, the Reserve Bank was requested to establish andmonitor a deposit insurance system. It restored the trust in the national bank system andwas initialized on 7 December 1961. The Indian government founded funds to promotethe economy and used the slogan-developing Banking. The Government of Indiarestructured the national bank market and nationalized a lot of institutes. As a result,the RBI had to play the central part of control and support of this public banking sector.

1969-1985:

Between 1969 and 1980, the Indian government nationalized 6 more commercialbanks, following 14 major commercial banks being nationalized in 1969 (as mentionedin RBI website). The regulation of the economy and especially the financial sector wasreinforced by the Government of India in the 1970s and 1980s. The central bank becamethe central player and increased its policies for a lot of tasks like interests, reserve ratioand visible deposits. The measures aimed at better economic development and had a hugeeffect on the company policy of the institutes. The banks lent money in selected sectors,like agri-business and small trade companies. The branch was forced to establish two



Notes new offices in the country for every newly established office in the town. The oil crisesin 1973 resulted in increasing inflation, and the RBI restricted monetary policy to reducethe effects.

1985-1991:

A lot of committees analyzed the Indian economy between 1985 and 1991. Theirresults had an effect on the RBI. The Board for Industrial and Financial Reconstruction,the Indira Gandhi Institute of Development Research and the Security and Exchange Boardof India investigated the national economy as a whole, and the security and exchangeboard proposed better methods for more effective markets and the protection of investorinterests. The Indian financial market was a leading example for so-called “financialrepression”. The Discount and Finance House of India began its operations on themonetary market in April 1988; the National Housing Bank, founded in July 1988, wasforced to invest in the property market and a new financial law improved the versatilityof direct deposit by more security measures and liberalization.

1991-2000:

The national economy came down in July 1991 and the Indian rupee was devalued.The currency lost 1% relative to the US dollar, and the Narasimham Committee advisedrestructuring the financial sector by a temporal reduced reserve ratio as well as thestatutory liquidity ratio. New guidelines were published in 1993 to establish a privatebanking sector. This turning point reinforced the market and was often called neo-liberal.The central bank deregulated bank interests and some sectors of the financial marketlike the trust and property markets. This first phase was a success and the centralgovernment forced a “diversity liberalization” to diversify owner structures in 1998.

The National Stock Exchange of India took the trade on in June 1994 and the RBIallowed nationalized banks in July to interact with the capital market to reinforce theircapital base. The central bank founded a subsidiary company the Bharatiya Reserve BankNote Mudran Limited in February 1995 to produce Bank Notes.

Since 2000:

The Foreign Exchange Management Act from 1999 came into force in June 2000.It helped in improving the foreign exchange market, international investments in India andforeign transactions. The RBI promoted the development of the financial market in the lastyears, allowed online banking in 2001 and established a new payment system in 2004-2005. The Security Printing and Minting Corporation of India Ltd., a merger of nineinstitutions, was founded in 2006 which produced bank notes and coins.

The national economy’s growth rate came down to 5.8% in the last quarter of 2008-2009 and the central bank promoted the economic development.

2.15 Establishment of RBI

The Reserve Bank of India was established on April 1, 1935 in accordance with theprovisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bankwas initially established in Calcutta but was permanently moved to Mumbai in 1937. TheCentral Office is where the Governor sits and where policies are formulated. Thoughoriginally privately owned, since nationalization in 1949, the Reserve Bank is fully ownedby the Government of India.



NotesThe Preamble of the Reserve Bank of IndiaThe Preamble of the Reserve Bank of India describes the basic functions of the

Reserve Bank as: “To regulate the issue of Bank Notes and keeping of reserves with aview to securing monetary stability in India and generally to operate the currency and creditsystem of the country to its advantage.”

2.16 Organizational Structure of RBI

The RBI Act laid down that the management should be vested with the central boardof directors comprising of 20 members. The Board consists of following: (i) One governorappointed by the Central government, (ii) Four deputy governor appointed by the Centralgovernment, (iii) Four directors nominated by the Central Government one from each ofthe local board, (iv) Ten directors nominated by the central government, (v) One governmentofficial nominated by the central government.

1. Central Board of DirectorsThe Central Board of Directors is the main committee of the Central Bank. The

Government of India appoints the directors for a four-year term. The Board consists ofa governor, four deputy governors, four directors to represent the regional boards, and tenother directors from various fields.

2. GovernorsThe Central Bank till now was governed by 21 governors. The 22nd, Current Governor

of Reserve Bank of India.

3. Supportive BodiesThe Reserve Bank of India has four regional representations: North in New Delhi,

South in Chennai, East in Kolkata and West in Mumbai. The representations are formedby five members, appointed for four years by the central government and server besidethe advice of the Central Board of Directors as a forum for regional banks and to dealwith delegated tasks from the central board. The institution has 22 regional offices.

The Board of Financial Supervision (BFS), formed in November 1994, serves as aCBD committee to control the financial institutions. It has four members, appointed fortwo years, and takes measures to strength the role of statutory auditors in the financialsector, external monitoring and internal controlling systems. The Tarapore Committee wasset up by the Reserve Bank of India under the chairmanship of former RBI deputy governorS.S. Tarapore to “lay the road map” to capital account convertibility. The five-membercommittee recommended a three-year time frame for complete convertibility by 1999-2000.

On 1 July 2006, an attempt was made to enhance the quality of customer serviceand strengthen the grievance redressal mechanism, the Reserve Bank of India constituteda new department Customer Service Department (CSD).

4. Offices and BranchesThe Reserve Bank of India has 4 regional offices, 15 branches and 5 sub-offices.

It has 22 branch offices at most state capitals and at a few major cities in India. Fewof them are located in Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh,Chennai, Delhi, Guwahati, Hyderabad, Jaipur, Jammu, Kanpur, Kolkata, Lucknow,Mumbai, Nagpur, Patna, and Thiruvananthapuram. Besides it has sub-offices at Agartala,Dehradun, Gangtok, Kochi, Panaji, Raipur, Ranchi, Shimla and Srinagar. The bank hasalso two training colleges for its officers, viz., Reserve Bank Staff College at Chennai andCollege of Agricultural Banking at Pune. There are also four Zonal Training Centres atBelapur, Chennai, Kolkata and New Delhi.



Notes 2.17 Functional Departments of RBI

The various functional departments of RBI are as follows:

1. Customer Service Department in RBIThe Customer Service Department was constituted to provide proper focus to the

entire range of customer service related activities of banks and the Reserve Bank of India.The Department started functioning from July 1, 2006. This is acting as a nodal departmentfor the Banking Codes and Standards Board of India. Ensuring redressal of complaintsreceived directly by RBI on customer service in banks. Liaison between banks, IndianBanks Association, BCSBI, Banking Ombudsman offices and the RBI’s regulatorydepartments on matters relating to customer services and grievance redressed.

2. Department of Currency Management in RBIThe department attends to the core statutory function of note and coin issue and

currency management. This involves forecasting the demand for fresh Bank Notes andcoins, placing the indent with four printing presses and mints, receiving supplies againstthose indents and distributing them through its 18 Issue Offices and one Sub office, oneCurrency Chest and a wide network of currency chests, (4428 as on June 30, 2006) andsmall coin depots (4102 as on June 30, 2006). The Department also keeps an accountof bank notes in circulation and also the stocks at RBI offices and currency chests. (Acurrency chest is an extended arm of the Issue department maintained with a commercialbank where the RBI stores fresh and re-issuable bank notes and allows the commercialbanks to withdraw cash for its requirements and deposit its excess cash. A repositoryis an extension of the currency chest wherein a portion of the currency chest balanceis permitted to be held at one or more other local branches of the same bank). Soiledbank notes are also stocked in the chests pending transportation to RBI.

The department administers the Reserve Bank of India Rules. The rules lay downthe circumstances in which value of torn and mutilated bank notes can be refunded. Soiledbank notes, which are unfit for circulation is mopped up from circulation for destruction.

The department reviews various security features of the currency notes forincorporation in the bank notes from time to time. It studies the features of the counterfeitbank notes detected and seized with a view to determining the steps needed to be takento strengthen the integrity of the bank notes. The department also acts as a nodaldepartment for the Bharatiya Reserve Bank Note Mudran Private Ltd.

3. Urban Banks DepartmentPrimary Cooperative Banks, popularly known as Urban Cooperative Banks (UCBs)

are registered as cooperative societies under the provisions of, either the State CooperativeSocieties Act of the State concerned or the Multi State Cooperative Societies Act, 2002.They are regulated and supervised by the Registrar of Cooperative Societies (RCS) of Stateconcerned or by the Central Registrar of Cooperative Societies (CRCS), as the case maybe. The Reserve Bank regulates and supervises the banking functions of UCBs under theprovisions of Banking Regulation Act, 1949 (AACS).

4. Rural Planning and Credit DepartmentThe rural planning and credit department formulates policies relating to rural credit

and monitors timely and adequate flow of credit to the rural population for agriculturalactivities and rural employment programmes. It also formulates policies relating to thepriority sector which includes agriculture, small-scale industries, tiny and village industries,artisans and retail traders, professional and self-employed persons, state sponsoredorganizations for Scheduled Castes and Scheduled Tribes and Government Sponsored



Notescredit-linked programmes like Swarnajayanti Gram Swarojgar Yojana (SGSY), PrimeMinisters Rojgar Yojana (PMRY), etc. It implements and monitors the Lead Bank Schemewhich is aimed at forging a coordinated approach for providing bank credit to achieve overalldevelopment of rural areas in the country. The department also oversees implementationof the Banking Ombudsman Scheme.

5. Foreign Exchange Department in RBIWith the introduction of the Foreign Exchange Management Act 1999, (FEMA) with

effect from June 1, 2000, the objective of the Foreign Exchange Department has shiftedfrom conservation of foreign exchange to “facilitating external trade and payment andpromoting the orderly development and maintenance of foreign exchange market in India”.

The new Act has brought about structural changes in the exchange controladministration. Regulations have been framed for dealing with various types of transactions.These regulations are transparent and have eliminated case-by-case approvals.

(i) The Department ensures timely realization of export proceeds and reviews, ona continuous basis, the existing rules in the light of suggestions received fromvarious trade bodies.

(ii) The Department collects data relating to FOREX transactions from authorizeddealers on a daily basis for exchange rate management and on a fortnightlybasis for monthly quick estimates of balance of payments and quarterly balanceof payments compilation.

(iii) The Department lays down policy guidelines for risk management relating toFOREX transactions in banks.

(iv) The Department is also entrusted with the responsibility of licensing banks/money changers to deal in foreign exchange and inspecting them.

(v) There is a “Standing Consultative Committee on Exchange Control” consistingof representatives from various trade bodies and authorized dealers which meetstwice a year and makes recommendations for policy formulation.

(vi) With a view of further improving facilities available to NRIs and removing irritants,the Department is also engaged, on an ongoing basis, in reviewing andsimplifying the procedures and rules.

6. Financial Markets DepartmentThe Financial Markets Department was constituted on July 6, 2005 with a view to

providing an integrated market interface for the Bank and to bringing about integration inthe Bank’s conduct of monetary operations. The mandated functions of the Departmentare as under: monetary operations such as Open Market Operations (OMO), LiquidityAdjustment Facility (LAF), and Market Stabilization Scheme (MSS); exchange ratemanagement; regulation and development of money market instruments such as call/term/notice money, market repo, collateralized borrowing and lending obligation, CommercialPaper (CP) and Certificate of Deposits (CD); and monitoring of money, governmentsecurities and FOREX markets.

2.18 Objectives of Reserve Bank of India

Main objectives of RBI are as follows:

(i) To manage the monetary and credit system of the country.(ii) To stabilize internal and external value of rupee.(iii) To ensure for balanced and systematic development of banking in the country.



Notes (iv) To help for the development of organized money market in the country.(v) To assist for proper arrangement of agriculture finance.(vi) To assist for proper arrangement of industrial finance.(vii) To assist for proper management of public debts.(viii) To establish monetary relations with other countries of the world and

international financial institutions.(ix) To helps for centralization of cash reserves of commercial banks.(x) To maintain balance between the demand and supply of currency.

2.19 Role of Reserve Bank of India

Reserve Bank of India plays a significant role in the Indian banking and financialsystem that relates to:

(i) Issuer of CurrencyThe Reserve Bank is the sole authority for the issue of currency in India. Since

currency is considered as a base for the expansion of money supply, regulation of currencyis an important element in monetary control of RBI.

(ii) Government BankerThe Reserve Bank is banker to the central bank as well as state governments. All

the current accounts of governments are maintained with RBI. All receipts and paymentsare made on behalf of the government.

(iii) Bankers’ BankThe Reserve Bank is statutory banker to the government of India. It maintains cash

reserves with central government to facilitate clearing operations and with state governmentto facilitate funds for short-term and provides economical central clearing and remittancefacilities.

(iv) Supervising AuthorityRBI is responsible for the development of an adequate and sound banking system

for catering the needs of trade, commerce, industry, agriculture, etc.

(v) Exchange Control AuthorityRBI is the custodian of the foreign exchange reserves of the country. It manages

the exchange control in a very planned and meticulous manner.

(vi) Promoter of the Financial SystemThe Reserve Bank serves as advisor to government on economic planning, resource

mobilization, banking and financial matters. It is responsible for financial policies and otherinitiatives concerning loans, agriculture finance, industrial finance, etc.

(vii) Regulator of Money and CreditRBI controls the money supply and credit in the economy. This helps in achieving

price stability, flul employment, economic growth, equilibrium in the balance of payments,etc.



Notes2.20 Main Functions of RBI

The main functions of Reserve Bank of India are as follows:

1. Monetary Authority

The Reserve Bank of India is the main monetary authority of the country and besidethat the central bank acts as the bank of the national and state governments. It formulatesimplements and monitors the monetary policy as well as it has to ensure an adequateflow of credit to productive sectors. Objectives are maintaining price stability and ensuringadequate flow of credit to productive sectors. The national economy depends on the publicsector and the central bank promotes an expansive monetary policy to push the privatesector since the financial market reforms of the 1990s.

The institution is also the regulator and supervisor of the financial system andprescribes broad parameters of banking operations within which the country’s banking andfinancial system functions. Objectives are to maintain public confidence in the system,protect depositors’ interest and provide cost-effective banking services to the public. TheBanking Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI)for effective addressing of complaints by bank customers. The RBI controls the monetarysupply, monitors economic indicators like the gross domestic product and has to decidethe design of the rupee bank notes as well as coins.

2. Manager of Exchange Control

The central bank manages to reach the goals of the Foreign Exchange ManagementAct, 1999. The objective is to facilitate external trade and payment and promote orderlydevelopment and maintenance of foreign exchange market in India.

3. Issuer of Currency

The bank issues and exchanges or destroys currency and coins not fit for circulation.The objectives are giving the public adequate supply of currency of good quality and toprovide loans to commercial banks to maintain or improve the GDP. The basic objectivesof RBI are to issue bank notes, to maintain the currency and credit system of the countryto utilize it in its best advantage, and to maintain the reserves. RBI maintains the economicstructure of the country so that it can achieve the objective of price stability as well aseconomic development, because both objectives are diverse in themselves.

4. Developmental Role

The central bank has to perform a wide range of promotional functions to supportnational objectives and industries. The RBI faces a lot of inter-sectoral and local inflation-related problems. Some of these problems are results of the dominant part of the publicsector.

5. Related Functions

The RBI is also a banker to the government and performs merchant banking functionfor the central and the state governments. It also acts as their banker.

6. Advisor to the Government

It also acts as adviser to Government on economic and financial matters. In brief,as a banker to the Government, the RBI renders the following functions:



Notes (a) Collects taxes and makes payments on behalf of the Government.(b) Accepts deposits from the Government.(c) Collects cheques and drafts deposited in the Government accounts.(d) Provides short-term loans to the Government.(e) Provides foreign exchange resources to the Government.(f) Keep the accounts of various Government Department.

(g) Maintains currency chests in treasuries at some importance places for theconvenience of the government.

(h) Advises governments on their borrowing programmes.

7. Agent and Adviser of the Government

The RBI acts, as the financial agent and adviser to the Government. It renders thefollowing functions:

(a) As an agent to the Government, it accepts loans and manages public debtson behalf of the Government.

(b) It issues Government bonds, treasury bills, etc.(c) Acts as the financial adviser to the Government in all important economic and

financial matters.

8. Banker to the Banks

The RBI acts as banker to all scheduled banks. Commercial banks including foreignbanks, cooperative banks and RRBs are eligible to be included in the second scheduleof RBI Act subject to fulfilling conditions laid down under Section 42(6) of RBI Act.

RBI has powers to delete a bank from the second schedule if the bank concernedfails to fulfill the laid down conditions such as erosion in paid-up capital below theprescribed limits and the banks’ activities became detrimental to the interest of depositors,etc.

All banks in India, should keep certain percentage of their demand and time liabilitiesas reserves with the RBI. This is known as Cash Reserve Ratio or CRR. At end November1999, it is 3% for RRBs and cooperative banks; 9% for commercial banks.

They also maintain Current Account with RBI for various banking transactions. Thiscentralization of reserves and accounts enables the RBI to achieve the following:

(a) Regulation of money supply credit.(b) Acts as custodian of cash reserves of commercial banks.(c) Strengthen the banking system of the country(d) Exercises effective control over banks in Liquidity Management.(e) Ensures timely financial assistance to the banks in difficulties.(f) Gives directions to the banks in their lending policies in the public interest.

(g) Ensures elasticity in the credit structure of the country.(h) Quick transfer of funds between member banks.

9. Acts as National Clearing House

In India, RBI acts as the clearing house for settlement of banking transactions. Thisfunction of clearing house enables the other banks to settle their interbank claims easily.Further, it facilitates the settlement economically.



NotesWhere the RBI has no offices of its own, the function of clearing house is carriedout in the premises of the State Bank of India. The entire clearing house operations carriedon by RBI are computerized. The inter-bank cheque clearing settlement is done twice aday.

The RBI acts as a lender of last resort or emergency fund provider to the other memberbanks. As such, if the commercial banks are not able to get financial assistance fromany other sources, then as a last resort, they can approach the RBI for the necessaryfinancial assistance.

In such situations, the RBI provides credit facilities to the commercial banks oneligible securities including genuine trade bills which are usually made available at BankRate.

RBI rediscounts bills under Section 17(2) and 17(3) and grants advances againstsecurities under Section 17(4) of RBI Act. However, many of these transactions arepractically carried out through separate agencies like DHFI, Securities Trading Corporationof India, primary dealers.

The RBI now mainly provides refinance facilities as direct assistance. Rediscountingof bills fall under the following categories:

(i) Commercial BillA bill arising out of bonfire commercial or trade transaction drawn and payable in

India and mature within 90 days from the date of purchase or discount is eligible forrediscount.

(ii) Bills for Financing Agricultural OperationsA bill issued for purpose of financing seasonal agricultural operations or the marketing

of crops and maturing within 15 months from the date of purchase or rediscount.

(iii) Bills for Financing Cottage and Small-scale IndustriesBills drawn or issued for the purpose of financing the production and marketing of

products of cottage and small industries approved by RBI and mature within 12 monthsfrom the date of discount.

(iv) RefinanceUnder agricultural and small-scale industries, activities are now provided by NABARD

by obtaining financial assistance from RBI.

(v) Bill for Holding or Trading in Government SecuritiesSuch a bill should mature within 90 days from the date of purchase or rediscounting

and be drawn and payable in India.

(vi) Foreign BillsBonfire bill arising out of export of goods from India and which mature within 180

days from the date of shipment of goods are eligible.

As lender of last resort, the RBI facilitates the following:

(a) Provides financial assistance to commercial banks at the time of financial needs.(b) It helps the commercial banks in maintaining liquidity of their financial resources.(c) Enables the commercial banks to carry out their activities with minimum cash

reserves.(d) As a lender of last resort, the RBI can exercise full control over the commercial

banks.



Notes 10. Acts as the Controller of Credit

The RBI controls the credit creation by commercial banks. For this, the RBI usesboth quantitative and qualitative methods. The important methods used by RBI are:

(i) Bank Rate Policy(ii) Open Market Operation(iii) Variation of Cash Reserve Ratio(iv) Fixing Margin Requirements(v) Moral Suasion(vi) Issue of Directives(vii) Direct Action

By controlling credit, the RBI achieves the following:(a) Maintains the desired level of circulation of money in the economy.(b) Maintains the stability in the price level prevailing in the economy.(c) Controls the effects of trade cycles.(d) Controls the fluctuations in the foreign exchange rate.(e) Channelize credit to the productive sectors of the economy.

11. Custodian of Foreign Exchange Reserves

The RBI acts as the custodian of foreign exchange reserves. Adequate reserves mayhelp maintain foreign exchange rates. In order to minimize the undue fluctuations in therates, it may buy and sell foreign currencies depending upon the situations.

Its purchase and sale of foreign currencies from the market is done like commercialbanks. However, the objective of the RBI will not be profit booking.

It may buy the foreign currency to build up adequate reserves or to arrest unwarrantedrise in the value of rupee which may be due to sudden inflow of foreign currencies intoIndia. It may also buy and sell foreign currencies in international market to switch theportfolio of investments denominated in different international currencies depending uponcircumstances and needs.

These reserves are increased to ̀ 1,38,005 crore in March 1999. The value of foreigncurrency assets of RBI, which form the largest portion in India’s Foreign Currency reserves,is subject to changes even on daily basis depending upon ruling exchange rates, inflowand outflow of currencies, intervention policy of the RBI, etc.

12. Publishes the Economic Statistics and Other Information

The RBI collects statistics on economic and financial matters. It publishesperiodically an analytical account of the operations of joint stock and cooperative banks.It presents the genuine financial position of the government and companies.

The publications like the report on currency and finance, the report on the trend andprogress of banking in India, the review of cooperative movement present a critical accountand a balanced review of banking developments commercial, economic and financialconditions of the country.



Notes13. Fights against Economic Crisis

The RBI aims at economic stability in the country whenever, there is a danger tothe economic stability, it takes immediate measures to put the economy on proper courseby effective policy changes and implementation thereof.

The Reserve Bank of India is the main source of monetary information and data relatedto banking. These information are very much essential for framing the economic policiesand banking policies. It is the duty of the reserve bank to collect and publish the informationregularly in the form of weekly statements, monthly bulletins, annual reports, reports ontrends and progress of banking sector in India, etc.

14. Promotion of Banking Habits

The RBI institutionalizes saving through the promotion of banking habit and expansionof the banking system territorially and functionally.

Accordingly, RBI has set up deposit insurance corporation in 1962, Unit Trust of Indiain 1964, the IDBI in 1964, the Agricultural Refinance Corporation in 1963, IndustrialReconstruction Corporation of India in 1972, NABARD in 1982 and the National HousingBank in 1988, etc.

It has helped to bring into existence several industrial finance corporations such asIndustrial Finance Corporation of India, Industrial Credit and Investment Corporation of Indiafor industrialization of the country. Similarly, sector specific corporations took care ofdevelopment in their respective spheres of activity.15. Provides Refinance for Export Promotion

The RBI takes the initiative for widening facilities for the provision of finance for foreigntrade particularly of exports.

The Export Credit and Guarantee Corporation (ECGC) and Exam Banks render usefulfunctions on this line. To encourage exports, the RBI is providing refinance facilities forexport credit given by commercial banks. Further, the rate of interest on export creditscontinues to be prescribed by RBI at a lower rate.

The ECGC provides an insurance cover on export receivables. EXIM Bank extendslong-term finance to project exporters and foreign currency credit for promotion of Indianexports. Students should know that many of these institutions were part of Reserve Bankearlier although they are currently functioning as separate financial institutions.

16. Facilities for Agriculture

The RBI extends indirect financial facilities to agriculture regularly. Through NABARD,it provides short-term and long-term financial facilities to agriculture and allied activities.It established NABARD for the overall administration of agricultural and rural credit. Indianagriculture would have starved of a cheap credit but for the institutionalization of rural creditby RBI.

The Reserve Bank was extending financial assistance to the rural sector mainlythrough contributions to the National Rural Credit Funds being operated by NABARD. RBIpresently makes only a symbolic contribution of ` 1.00 crore.

It, however, extends cheap indirect financial assistance to the agricultural sector byproviding large sums of money through General Line of Credit to NABARD. The loans andadvances extended to NABARD by RBI and outstanding as on June 1999 amounted to` 5073 crore.



Notes 17. Facilities to Small-scale Industries

The RBI takes active steps to increase the supply of credit to small industries. Itgives directives to the commercial banks regarding the extension of credit facilities tosmall-scale industries. It encourages commercial banks to provide guarantee services toSSI sector. Banks advances to SSI sector are classified under priority sector advances.

SSI sector contributes to a very great extent to employment opportunities and forIndian Exports. Keeping this in view, RBI has directed commercial banks to openspecialized SSI bank branches to provide adequate financial and technical assistance toSSI branches. There are around 30 lakh SSI units operating in India. Meeting their financialneeds is one of the prime concerns of RBI.

18. Helps Cooperative Sector

RBI extends indirect financing to State Cooperative Banks thereby connects thec-operative sector with the main banking system of the country. The finance is mostly,is routed through NABARD. This way the financial needs of agricultural sector are takencare of by RBI.

19. Prescription of Minimum Statutory Requirements for Banks

The RBI prescribes the minimum statutory requirements such as, paid-up capital,reserves, cash reserves, liquid assets, etc. RBI prescribes reserves requirements bothunder Banking Regulation Act and RBI Act to ensure different objectives.

For example, SLR prescription is done to ensure liquidity position of the bank. CRRprescription is done to have effective monetary control and money supply. StatutoryReserves Appropriation is done to ensure sound banking system, etc.

It also asks banks to set aside provisions against possible bad loans. With thesefunctions, it exercises control over the monetary and banking systems of the country toensure growth, price stability and sound banking practices.

20. Supervisory Functions

The Reserve Bank of India performs the following supervisory functions. By thesefunctions, it controls and administers the entire financial and banking systems of the country.

(a) Granting License to BanksThe RBI grants license to the banks, which like to commence their business in India.

Licenses are also required to open new branches or closure of branches. With this power,RBI can ensure avoidance of unnecessary competitions among banks in particular locationevenly growth of banks in different regions, adequate banking facility to various regions, etc.This power also helps RBI to weed out undesirable people from starting banking business.

(b) Function of Inspection and EnquiryRBI inspects and makes enquiry in respect of various matters covered under Banking

Regulations Act and RBI Act. The inspection of commercial banks and financial institutionsare conducted in terms of the provisions contained in Banking Regulation Act.

These refer to their banking operations like loans and advances, deposits, investmentfunctions and other banking services. Under such inspection, RBI ensures that the banksand financial institutions carry on their operations in a prudential manner, without takingundue risk but aiming at profit maximization within the existing rules and regulations.



NotesThis type of inspection is carried on periodically once a year or two covering allbranches of banks. Banks are obliged to take remedial measures on the lapses/deficiencies pointed out during inspection. In addition RBI also calls for periodicalinformation concerning certain assets and liabilities of the banks to verify that the bankscontinue to remain in good health.

(c) Implementing the Deposit Insurance SchemeRBI Implements the Deposit Insurance Scheme for the benefit of bank depositors.

This supervisory function has improved the standard of banking in India due to thisconfidence building exercise. Under this system, deposits up to ` 1.00 lakh with the bankbranch are guaranteed for payment. Deposits with the banking system alone are coveredunder the scheme.

For this purpose, banking system include accounts maintained with commercialbanks, cooperative banks and RRBs. Fixed Deposits with other financial institutions likeICICI, IDBI, etc. and those with financial companies are not covered under the scheme.ICICI is since merged with ICICI Bank Ltd. and IDBI is getting converted into a bank.

(d) Periodical Review of the Working of the Commercial BanksThe RBI periodically reviews the work done by commercial banks. It takes suitable

steps to enhance the efficiency of the banks and make various policy changes andimplement programmes for the well-being of the nation and for improving the bankingsystem as a whole.

(e) Controls the Non-Banking Financial CorporationsRBI issues necessary directions to the Non-Banking financial corporations and

conducts inspections through which it exercises control over such institutions. Deposittaking NBFCs require permission from RBI for their operations.

2.21 Monetary Policy of Reserve Bank of India

The Reserve Bank of India Act, 1934 sets out broadly the objectives of monetarypolicy: “To regulate the issue of Bank notes and the keeping of reserves with a view tosecuring monetary stability in India and generally to operate the currency and creditsystem of the country to its advantage”.

Although there is no explicit mandate for price stability, the objectives of monetarypolicy in India have evolved as maintaining price stability and ensuring adequate flow ofcredit to the productive sectors of the economy to support economic growth. The relativeemphasis placed on price stability and economic growth is modulated according to thecircumstances prevailing at a particular point in time and is spelt out, from time to time,in the policy statements of the Reserve Bank. In the recent period, considerations offinancial stability have assumed an added importance in view of increasing openness ofthe Indian economy.

The Reserve Bank has multiple instruments at its command for implementation ofmonetary policy such as repo and reverse repo rates; cash reserve ratio (CRR); openmarket operations, including LAF and market stabilization scheme (MSS); special marketoperations; sector-specific liquidity facilities; and prudential tools.



Notes Main DutiesMonetary Policy Department is entrusted with the responsibility of designing,

formulating and implementing monetary policy of the Reserve Bank. Accordingly, theDepartment prepares Governor’s Statements on Monetary Policy. The Policy Statementsare currently brought out four times in a year. The Annual Policy (April) and its SecondQuarter Review (October) consist of two parts: Part A: Monetary Policy and Part B:Developmental and Regulatory Policies. The First Quarter Review (July) and the ThirdQuarter Review (January) of Monetary Policy comprise only Part A.

Monetary policy formulation is carried out by the Reserve Bank in consultation withvarious stakeholders such as banks, market participants and industry and tradeassociations. In pursuance of the objective of further strengthening the consultative processof monetary policy formulation, a Technical Advisory Committee (TAC) on Monetary Policyhas been set up, which meets ahead of the Annual Policy and the quarterly reviews, toreview macroeconomic and monetary developments and advise the Reserve Bank on thestance of monetary policy.

Main ActivitiesPreparation of Reserve Bank’s Annual Policy Statement and its Reviews in each

quarter. Conduct of Technical Advisory Committee meetings on Monetary Policy in eachquarter before the announcement of Policy Statement/Reviews or at any other time asand when needed. Conduct of pre-policy consultation meetings with the bankers, marketparticipants, trade bodies, self-regulatory organizations and economists and journaliststo facilitate the policy formulation process.

Definitions of Monetary Policy

According to Prof. Harry Johnson, “Monetary policy is a policy employing the centralbanks control of the supply of money as an instrument for achieving the objectives ofgeneral economic policy is a monetary policy.”

According to A.G. Hart, “Monetary policy is a policy which influences the publicstock of money substitute of public demand for such assets of both that is policy whichinfluences public liquidity position is known as a monetary policy.”

2.22 Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its fiveyear plans. In a nutshell, planning in India aims at growth stability and social justice. Afterthe Keynesian revolution in economics, many people accepted significance of monetarypolicy in attaining following objectives:

(i) To Ensure the Rapid Economic GrowthIt is the most important objective of a monetary policy. The monetary policy can

influence economic growth by controlling real interest rate and its resultant impact on theinvestment. If the RBI opts for a cheap or easy credit policy by reducing interest rates,the investment level in the economy can be encouraged. This increased investment canspeed up economic growth. Faster economic growth is possible if the monetary policysucceeds in maintaining income and price stability.

(ii) To Help for Price StabilityAll the economics suffer from inflation and deflation. It can also be called as Price

Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary



Notespolicy having an objective of price stability tries to keep the value of money stable. It helpsin reducing the income and wealth inequalities. When the economy suffers from recession,the monetary policy should be an ‘easy money policy’ but when there is inflationarysituation there should be a ‘dear money policy’.

(iii) To Assist for Exchange Rate StabilityExchange rate is the price of a home currency expressed in terms of any foreign

currency. If this exchange rate is very volatile leading to frequent ups and downs in theexchange rate, the international community might lose confidence in our economy. Themonetary policy aims at maintaining the relative stability in the exchange rate. The RBIby altering the foreign exchange reserves tries to influence the demand for foreign exchangeand tries to maintain the exchange rate stability.

(iv) To Assist for Balance of Payments (BOP) EquilibriumMany developing countries like India suffer from the Disequilibrium in the BOP. The

Reserve Bank of India through its monetary policy tries to maintain equilibrium in thebalance of payments. The BOP has two aspects, i.e., the ‘BOP Surplus’ and the ‘BOPDeficit’. The former reflects an excess money supply in the domestic economy, while thelater stands for stringency of money. If the monetary policy succeeds in maintainingmonetary equilibrium, then the BOP equilibrium can be achieved.

(v) To Ensure Full EmploymentThe concept of full employment was much discussed after Keynes’s publication of

the “General Theory” in 1936. It refers to absence of involuntary unemployment. In simplewords, ‘Full Employment’ stands for a situation in which everybody who wants jobs getjobs. However, it does not mean that there is Zero unemployment. In that sense, the fullemployment is never full. Monetary policy can be used for achieving full employment. Ifthe monetary policy is expansionary then credit supply can be encouraged. It could helpin creating more jobs in different sector of the economy.

(vi) To Ensure the Neutrality of MoneyEconomist such as Wicksted and Robertson have always considered money as a

passive factor. According to them, money should play only a role of medium of exchangeand not more than that. Therefore, the monetary policy should regulate the supply ofmoney. The change in money supply creates monetary disequilibrium. Thus, monetarypolicy has to regulate the supply of money and neutralize the effect of money expansion.However, this objective of a monetary policy is always criticized on the ground that if moneysupply is kept constant, then it would be difficult to attain price stability.

(vii) To Support for Equal Income DistributionMany economists used to justify the role of the fiscal policy in maintaining economic

equality. However, in recent years, economists have given the opinion that the monetarypolicy can help and play a supplementary role in attaining an economic equality. Monetarypolicy can make special provisions for the neglect supply such as agriculture, small-scaleindustries, village industries, etc. and provide them with cheaper credit for longer term.This can prove fruitful for these sectors to come up. Thus, in recent period, monetary policycan help in reducing economic inequalities among different sections of society.

2.23 Cooperative Banks

A cooperative bank is a financial entity which belongs to its members, who are atthe same time the owners and the customers of their bank. Cooperative banks are often



Notes created by persons belonging to the same local or professional community or sharing acommon interest. Cooperative banks generally provide their members with a wide rangeof banking and financial services (loans, deposits, banking accounts, etc.).

2.24 History of Cooperative Banking in India

The historical roots of the Cooperative Movement in the world days back to daysof misery and distress in Europe faced by common people who had little or no accessto credit to fund their basic needs, in uncertain times. The idea spread when the continentwas faced with economic turmoil which led large populations to live at subsistence levelwithout any economic security. People were forced to poverty and deprivation. It was theidea of Hermann Schulze (1808-83) and Friedrich Wilhelm Raiffeisen (1818-88) which tookshape as cooperative banks of today across the world. They started to promote the ideaof easy availability of credit to small businesses and for the poor segment of society.It was similar to the many microfinance institutions which have become highly popularin developing economies of today. Although this helped spread cooperative movement inmany parts of Europe, in British Isles, it is came from the revivalist Christian movementand found high acceptance with working class and lower middle class segments of society.However, UK and Irish credit unions in 20th century were inspired by US credit unionswhich in turn owe their emergence to Canadian adaptations of the German cooperativebanking concept. These movements were supported by governments of the respectivecountries. This success was achieved due to the failure of the commercial banks to fundand support the needs of small business owners and ordinary people who were outsidethe formal banking net. Cooperative banks helped overcome the vital market imperfectionsand serviced the poorer layers of society. Indian Cooperative Banks was also born outof distress prevalent in Indian society. The Cooperative Credit Societies Act, 1904 led tothe formation of Cooperative Credit Societies in both rural and urban areas. The act wasbased on recommendations of Sir Frederick Nicholson (1899) and Sir Edward Law (1901).Their ideas in turn were based on the pattern of Raiffeisen and Schulze respectively. TheCooperative Societies Act of 1912 further gave recognition to the formation of non-creditsocieties and the central cooperative organizations. In independent India, with the onsetof planning, the cooperative organizations gained more leverage and role with the continuedgovernmental support. Machlagan Committee in 1915, highlighted the deficiencies of incooperative societies which seeped in due to lack of proper education to the masses.He also laid down the importance of Central Assistance by the Government to supportthe movement. The Royal Commission on Agriculture 1928, enumerated the importanceof education of members/staff for effective implementation of cooperative movement.Saraiya Committee, in 1945, further recommended the setting up of a Cooperative TrainingCollege in every state and a Cooperative Training Institute for Advanced Study andResearch at the Central level. Central Committee for Cooperative Training in 1953,constituted by RBI for establishing Regional Training Centres. Rural Credit SurveyCommittee, 1954 was the first committee formed till then to first delve into the problemsof Rural credit and other financial issues of rural society. The cooperative movement andbanking structures soon spread and resonated with the unexpressed needs of the ruralIndian and small scale businesses. Since, 1950s, they have come a long way to supportand provide assistance in activities like credit, banking, production, processing,distribution/marketing, housing, warehousing, irrigation, transport, textiles, dairy, sugaretc. to households.

Extent of Cooperative BankingIndian cooperative structures are one of the largest such networks in the world with

more than 200 million members. It has about 67% penetration in villages and fund 46%



Notesof the total rural credit. It also stands for 36% of the total distribution of rural fertilizersand 28% of rural fair price shops.

2.25 Structure of Cooperative Banking in India

The structure of cooperative network in India can be divided into two broad segments:1. Urban Cooperatives2. Rural Cooperatives

1. Urban Cooperatives

Urban Cooperatives can be further divided into scheduled and non-scheduled. Boththe categories are further divided into multi-state and single-state. Majority of the banksare fall in the non-scheduled and single-state category. Banking activities of UrbanCooperative Banks are monitored by RBI. Registration and Management activities aremanaged by Registrar of Cooperative Societies (RCS). These RCS operate in single-stateand Central RCS (CRCS) operate in multiple state.

2. Rural CooperativesThe rural cooperatives are further divided into short-term and long-term structures.

The short-term cooperative banks are three tiered operating in different states. These are:

(i) State Cooperative Banks: They operate at the apex level in states.(ii) District Central Cooperative Banks: They operate at the district levels.(iii) Primary Agricultural Credit Societies: They operate at the village or grass-root

level.Likewise, the long-term structures are further divided into:

(i) State Cooperative Agriculture and Rural Developmental Banks (SCARDS):These operate at state-level.

(ii) Primary Cooperative Agriculture and Rural Developmental Banks (PCARDBS):They operate at district/block level. The rural banking cooperatives have acomplex monitoring structure as they have a dual control which has led to manyproblems. A Forum called State Level Task Force on Cooperative Urban Banks(TAFCUB) has been set up to look into issues related to duality in control. Allbanking activities are regulated by a shared arrangement between RBI andNABARD. All management and registration activities are managed by RCS.

2.26 Cooperative Banks – Irritants and Future Trends

A cooperative bank is an institution which is owned by its members. They are theculmination of efforts of people of same professional or other community which havecommon and shared interests, problems and aspirations. They cater to services like loans,banking, deposits, etc. like commercial banks but widely differ in their values andgovernance structures. They are usually democratic set-ups where the board of membersis democratically elected with each member entitled to one vote each. In India, they aresupervised and controlled by the official banking authorities and thus have to abide bythe banking regulations prevalent in the country. The basic rules, regulations and valuesmay differ amongst nations but they have certain common features:

1. Customer-owned Democratic structures2. Profits are mainly pooled to form reserves while some amount is distributed to

members



Notes 3. Involved in community development4. Foster financial inclusion by bringing banking to the doorstep of the lowest

segment of societyThese banks are small financial institutions which are governed by regulations like

Banking Regulations Act, 1949 and Banking Laws Cooperative Societies Act, 1965. Theyoperate both in urban and rural areas under different structural organizations. Theirfunctions are decided by the level at which they operate and the type of people they caterto. They greatly differ from the commercial banking entities. These are established underspecific acts of cooperative societies operating in different states unlike mainstreamcommercial banks which are mainly joint-stock companies. They have a tiered networkwith a bank at each level of state, district and rural. The state-level bank forms the apexauthority. Not all sections of banking regulation act are applicable to cooperative banksThe ultimate motive is community participation, benefit and growth as against profitmaximization for commercial banks.

2.27 Major Irritants in the Functioning of the Cooperative Banks

The duality in control by RCS of a state as ‘Cooperation’ is a state subject. However,financial regulatory control by RBI has led to many troubles as there is ambiguity in powerstructure as there is no clear demarcation. Patchy growth of cooperative societies acrossthe map of India. It is said these have grown maximally in states of Gujarat, Maharashtra,Tamil Nadu whereas the other parts of India don’t have a heightened presence. The statepartnership has led to excessive state control and interference. This has eroded theautonomous characters of many of these. Dormant membership has made them moribundas there is a lack of active members and lack of professional attitude. Their main focusbeing credit so they have reduced to borrower-driven entities and majority of membersare nominal and don’t enjoy voting rights. Credit recovery is weak especially in rural areasand it has sustainability crisis in some pockets. There is a lack of risk managementsystems and lack of basic standardized banking models. There is a widening gap betweenthe level of skills and the increasing computerization of banks. The government needsto have a serious look into the issues as they did not show an impressive growth in thelast 100 years.

2.28 Banking System in USA and India

The banking system in India is significantly different from other countries.

Reserve Bank of India is the Central Bank of our country. It was established on1st April 1935 under the RBI Act of 1934. It holds the apex position in the banking structure.RBI performs various developmental and promotional functions.

1. Central Bank

It has given wide powers to supervise and control the banking structure. It occupiesthe pivotal position in the monetary and banking structure of the country. In many countries,central bank is known by different names.

For example, Federal Reserve Bank of USA and Reserve Bank of India in India.Central bank is known as a banker’s bank. They have the authority to formulate andimplement monetary and credit policies. It is owned by the government of a country andhas the monopoly power of issuing notes.



Notes2. Commercial Banks

Commercial bank is an institution that accepts deposit, makes business loans andoffer related services to various like accepting deposits and lending loans and advancesto general customers and business man.

These institutions run to make profit. They cater to the financial requirements ofindustries and various sectors like agriculture, rural development, etc. it is a profit makinginstitution owned by government or private of both.

Commercial bank includes public sector, private sector, foreign banks and regionalrural banks:

(a) Public sector BanksIt includes SBI, seven (7) associate banks and nineteen (19) nationalized banks.

Altogether there are 27 public sector banks. The public sector accounts for 90% of totalbanking business in India and State Bank of India is the largest commercial bank in termsof volume of all commercial banks.

(b) Private Sector BanksPrivate sector banks are those whose equity is held by private shareholders. For

example, ICICI, HDFC, etc. Private sector bank plays a major role in the developmentof Indian banking industry.

(c) Foreign BanksForeign banks are those banks, which have their head offices abroad. CITI Bank,

HSBC, Standard Chartered, etc. are the examples of foreign bank in India.

(d) Regional Rural Banks (RRB)These are state sponsored regional rural oriented banks. They provide credit for

agricultural and rural development. The main objective of RRB is to develop rural economy.Their borrowers include small and marginal farmers, agricultural laborers, artisans, etc.NABARD holds the apex position in the agricultural and rural development.

3. Cooperative Bank

Cooperative bank was set up by passing a cooperative act in 1904. They areorganized and managed on the principal of cooperation and mutual help. The main objectiveof cooperative bank is to provide rural credit.

The cooperative banks in India play an important role even today in rural cooperativefinancing. The enactment of Cooperative Credit Societies Act, 1904, however, gave thereal impetus to the movement. The Cooperative Credit Societies Act, 1904 was amendedin 1912, with a view to broad basing it to enable organization of non-credit societies.

Three tier structures exist in the cooperative banking:

(i) State cooperative bank at the apex level.(ii) Central cooperative banks at the district level.(iii) Primary cooperative banks and the base or local level.



Notes 4. Scheduled and Non-scheduled Banks

A bank is said to be a scheduled bank when it has a paid up capital and reservesas per the prescription of RBI and included in the second schedule of RBI Act 1934. Non-scheduled bank are those commercial banks, which are not included in the secondschedule of RBI Act 1934.

5. Development Banks and Other Financial Institutions

A development bank is a financial institution, which provides a long term funds tothe industries for development purpose. This organization includes banks like IDBI, ICICI,IFCI, etc. State level institutions like SFCs, SIDCs, etc. It also includes investmentinstitutions like UTI, LIC, GIC, etc.

6. Working Hours

Indian banks beat American banks. ICICI offers 8 a.m. to 8 p.m. banking, which isvery convenient during week days. American banks work half day on Saturday and donot work on Sunday. Indian banks work on weekend – very good for people working people.

7. Online Banking

Both are good. However, the Indian banks have edge here. They charge less whenmoney is transferred from one account to another account of another bank. In US, theycharge $3 which is very high.

8. Services

US banks provide good service compared to Indian banks. This would primarilyattribute this to this low population. If you have priority account with Indian bank, thenUS banks are no match.

Indian banks offer lot of utility services for free cost. US banks also offers this, butnot as wider as Indian banks.

9. Cash Withdrawal Limit in ATM

Most Indian banks allow daily cash withdrawal up to ` 25,000/-, which is sufficientin most cases. Here in US, daily cash withdrawal is $500.

10. Credit Cards

In India, if you have decent pay package, then you are eligible for credit card withvery attractive bonus. In US, even if you have good pay package and do not have credithistory, then no bank would offer credit card.

2.29 International Banking

International banking enables people who live or work abroad to manage their financesin one central location. By keeping your money in one place, it allows you to maketransfers and payments in several currencies from a stable and secure offshore jurisdiction.Providing you with a link between all of your banking arrangements, you can be in completecontrol of your money, wherever you are in the world.



Notes2.30 Benefits of Having an International Banking(a) There are many advantages to opening an international bank account with

Standard Bank Isle of Man.(b) Safe and secure global access to your money 24/7.(c) Quick and easy transfers in multiple currencies gives you greater flexibility over

your finances.(d) Simple and convenient to operate and offers one central location for all your

banking requirements.(e) Unlimited access to foreign exchange.(f) Provides security against exchange rate fluctuations.

(g) Grow and protect your money in a stable offshore jurisdiction on the Isle of Man.(h) Confidential service wherever you are in the world.

2.31 Banking Operations

Banking operations are the legal transactions executed by a bank in its dailybusiness, such as providing loans, mortgages and investments, depending on the focusand size of the bank.

Retail banking is the banking that almost every reader will find most familiar. Retailbanking is the business of making consumer loans, mortgages and the like, takingdeposits and offering products such as checking accounts and CDs. Retail bankinggenerally requires significant investment in branch offices, as well as other customerservice points of contact, like ATMs and bank tellers.

Retail banks frequently compete on convenience, the accessibility of branches andATMs for example, cost such as (interest rates, and account service fees, or somecombination of the two. Retail banks also attempt to market multiple services to customersby encouraging customers who have a checking account to also open a savings account,borrow through its mortgage loan office, transfer retirement accounts, and so on.

Business banking is not altogether that different than consumer retail banking;operations still revolve around collecting deposits, making loans and convincing customersto use other fee-generating services.

One of the primary differences is that business customers tend to have somewhatmore sophisticated demands from their banks, often leaning on banks for assistance inmanaging their payables, receivables and other treasury functions. Business banking alsotends to be less demanding in terms of branch networks and infrastructure, but morecompetitive in terms of rates and fees.

Private Banking is the shrinking number of independent financial institutions thatfocus exclusively on private banking, as it is increasingly conducted as a department ofa larger bank. Private banking is a euphemism for banking and financial services offeredto wealthy customers, typically those with more than $1 million of net worth.

In addition to standard bank service offerings, like checking and savings accountsand safe deposit boxes, private banks often offer a host of trust, tax and estate planningservices. Perhaps not surprisingly, the bank secrecy laws of countries like Switzerlandhave made them attractive locations for conducting private banking.



Notes 2.32 Retail Banking

Retail banking is the provision of services by a bank to individual consumers, ratherthan to companies, corporations or other banks. Services offered include savings andtransactional accounts, mortgages, personal loans, debit cards, and credit cards.

All over the world, there is a shift in the economy from the manufacturing to the servicesector. The contribution of banking to the service economy is duly recognized. Bankingindustry includes a number of businesses such as corporate banking, investment banking,wealth management, capital market, etc. Retail banking is another segment of the bankingindustry. It is a typical mass market banking characterized by a large customer baseand a large volume of transactions. There is a high level of cooperation between banks,retailers, customers and consumers in this segment. Retail banking has brought in adrastic make over in the overall banking scenario in India. The exceptional improvementin the banking system in India is a result of strong initiatives taken up by both thegovernment and private companies. Retail Banking has been the new focus of the bankingindustry across the world. The emergence of new economies and their rapid growth hasbeen the most important contributing factor behind this resurgence in Retail Banking.Changing lifestyles, fast improvement in information technology, other service sectors andincreasing levels of income have contributed to the growth of retail banking in countrieslike India that are developing at a good pace. In India, the Retail Banking scenario hasbeen the market changing from a seller’s market to a buyer’s market.

Retail banks offer services like account opening, credit card, debit card, ATM, internetbanking, phone banking, insurance, investment, stock broking and so on. Retail bankingrefers to the dealing of commercial banks with individual customers, both on liabilitiesand assets sides of the balance sheet. Fixed/current/saving accounts on the liabilitiesside, and mortgages loans (e.g., personal, housing, auto and educational on the assetsside, are the important products offered by banks). Related ancillary services include creditcards or depository services. Retail banking refers to provision of banking services toindividuals and small business where the financial institutions are dealing with large numberof low value transactions. This is in contrast to whole sale banking where the customersare large, often multinational companies, governments and government enterprises andthe financial institution deal in small number of high value transaction.

The concept of Retail Banking is not new to banks but is now viewed as an importantand attractive market segment that offers opportunities for growth and profits. Retailbanking and retail lending are often used as synonyms but in fact, the later is just thepart of retail banking. In retail banking, all the needs of individual customers are takencare of in a well integrated manner. Retail banking in the country is characterized bymultiple products, multiple channels and multiple customer groups. This multiplicity ofthe roles to be played by the retail bankers adds to the excitement as well as thechallenges faced by the bankers.

2.33 Meaning of Retail Banking

Retail banking is typically mass market banking where individual customers use localbranches of larger commercial banks. Services offered include savings and checkingaccounts, mortgages, personal loans, debit cards, credit cards and so.



Notes2.34 Retail Banking in India

The Indian Banks are competing with one another to grab a pie of the retail bankingsector, which has tremendous potential as retail loans constitute only 8% of GDP in India,whereas their percentage is about 35 in other Asian economies. Retail bankingenvironment today is changing fast. The changing customer demographics demands thatcreate a differentiated application based on scalable technology, improved service andbanking convenience. Higher penetration of technology and increase in global literacylevels has set up the expectations of the customer higher than never before. Increasinguse of modern technology has further enhanced reach and accessibility. The market todaygives us a challenge to provide multiple and innovative contemporary services to thecustomer through a consolidated window so as to ensure that the bank’s customer gets“Uniformity and Consistency” of service delivery across time and at every touch pointacross all channels. The pace of innovation is accelerating and security threat has becomeprime of all electronic transactions. High cost structure rendering mass-market servicingis prohibitively expensive. Present-day tech-savvy bankers are now more looking atreduction in their operating costs by adopting scalable and secure technology therebyreducing the response time to their customers so as to improve their client base andeconomies of scale. The solution lies to market demands and challenges lies in innovationof new offering with minimum dependence on branches a multi-channel bank, and toeliminate the disadvantage of an inadequate branch network. Generation of leads to crosssell and creating additional revenues with utmost customer satisfaction has become focalpoint worldwide for the success of a Bank. Traditional lending to the corporate are slowmoving along with high NPA risk, treasure profits are now losing importance; hence, RetailBanking is now an alternative available for the banks for increasing their earnings. RetailBanking is an attractive market segment having a large number of varied classes ofcustomers. Retail Banking focuses on individual and small units. Customized and wideranging products are available. The risk is spread and the recovery is good. Surplusdeployable funds can be put into use by the banks. Products can be designed, developedand marketed as per individual needs.

Currently retail banking is helping the banks in boosting their profit. As reported inFinancial Express, ‘the banking sector witnesses during the period ended June 2010, withtheir growth rising at 54.8%’. A rise in commercial and retail lending rates, growth in fee-based income and lower provisioning helped banks boost their profits.

2.35 Features of Retail Banking

One of the prominent features of Retail Banking products is that it is a volume drivenbusiness. Further, Retail Credit ensures that the business is widely dispersed among alarge customer base unlike in the case of corporate lending, where the risk may beconcentrated on a selected few plans. Ability of a bank to administer a large portfolioof retail credit products depends upon such factors:

1. Strong credit assessment capabilityBecause of large volume good infrastructure is required. If the credit assessment

itself is qualitative, then the need for follow up in the future reduces considerably.

2. Sound documentationA latest system for credit documentation is necessary pre-requisite for healthy growth

of credit portfolio, as in the case of credit assessment. This will also minimize the needto follow up at future point of time.



Notes 3. Strong possessing capabilitySince large volumes of transactions are involved, today transactions, maintenance

of backups is required.

4. Regular constant follow- upIdeally, follow up for loan repayments should be an ongoing process. It should start

from customer enquiry and last till the loan is repaid fully.

5. Skilled human resourceThis is one of the most important pre-requisite for the efficient management of large

and diverse retail credit portfolio. Only highly skilled and experienced man power canwithstand the river of administrating a diverse and complex retail credit portfolio.

6. Technological supportThis is yet another vital requirement. Retail credit is highly technological and intensive

in nature. Because of large volumes of business, the need to provide instantaneous serviceto the customer, faster processing, maintaining database, etc. is imperative.

2.36 Scope for Retail Banking in India

Scope for Retail Banking in India can be summarized as follows:

1. All-round increase in economic activity.2. Increase in the purchasing power. The rural areas have the large purchasing

power at their disposal and this is an opportunity to market Retail Banking.3. India has 200 million households and 400 million middle class population more

than 90% of the savings come from the house hold sector. Falling interest rateshave resulted in a shift. “Now People Want to Save Less and Spend More.”

4. Nuclear family concept is gaining much importance which may lead to largesavings, large number of banking services to be provided are day-by-dayincreasing.

5. Tax benefits are available, for example, in case of housing loans the borrowercan avail tax benefits for the loan repayment and the interest charged for theloan.

2.37 Retail Banking Activities

Banks’ activities can be divided into retail banking, dealing directly with individuals;business banking, providing services to mid-size business; corporate banking dealing withlarge business entities; private banking, providing wealth management services to HighNet worth Individuals; and investment banking, relates to helping customers raise fundsin the Capital Markets and advising on mergers and acquisitions.

1. Internet Banking (E-Banking)Internet banking (or E-banking) means any user with a personal computer and

browser can get connected to his banks website to perform any of the virtual bankingfunctions. In internet banking system the bank has a centralized database that is webenabled.

2. Information SystemGeneral purpose information like interest rates, branch location, bank products and

their features, loan and deposit calculations are provided in the banks website.



Notes3. Fully Electronic Transactional SystemThe system provides customer- specific information in the form of account balances,

transaction details and statement of accounts. This system allows bi-directionalcapabilities. Transactions can be submitted by the customer for online update. Thissystem requires high degree of security and control.

4. Automated Teller Machine (ATM)ATM is designed to perform the most important function of bank. It is operated by

plastic card with its special features. The plastic card is replacing cheques, personalattendance of the customer, banking hour’s restrictions and paper based verification.

5. Credit Cards/Debit CardsThe Credit Card holder is empowered to spend wherever and whenever he wants with

his Credit Card within the limits fixed by his bank. Credit Card is a post-paid card. DebitCard, on the other hand, is a prepaid card with some stored value.

6. Smart CardBanks are adding chips to their current magnetic stripe cards to enhance security

and offer new service, called Smart Cards. Smart Cards allow thousands of times ofinformation storable on magnetic stripe cards.

7. Core Banking SolutionsCore Banking Solutions is new jargon frequently used in banking circles. The

advancement in technology especially internet and information technology has led to newway of doing business in banking.

2.38 Wholesale Banking

Wholesale banking is the provision of services by banks to organizations such asmortgage brokers, large corporate clients, mid-sized companies, real estate developersand investors, international trade finance businesses, institutional customers (such aspension funds and government entities/agencies), and services offered to other banks orother financial institutions.

Wholesale banking involves providing banking services to other commercial banks,mortgage brokers, large corporate, mid-size companies, real estate developers,international trading businesses, institutional customers or other corporations. Theservices which come under the net of wholesale banking involves wholesaling, underwriting,market making, consultancy, mergers and acquisitions, joint ventures, fund managementetc. The focus is on high-level clients and high-value transactions.

2.39 Wholesale Banking in India

Wholesale banking in India is set for a period of sharp growth. Revenues fromwholesale banking activities are likely to more than double over the next five years asinfrastructure investment, expansion by Indian companies overseas, and further“Indianization” of multinational businesses, among other trends, drive new business.Foreign players and the country’s domestic banks, however, will find themselves in a toughcommercial environment and must overcome a range of challenges if they are to maintain,or assume, a leading position in the market.

Prospects for India’s wholesale banking market are intriguing. Wholesale bankingrevenues, which in India account for close to 30% of total banking revenues, are expected



Notes to more than double, from roughly $16 billion in fiscal 2010 to between $35 billion and$40 billion by 2015. McKinsey’s analysis shows that returns on equity are typically inthe range of 15% to 30%.

India presents a strong case for the growth of wholesale banking due to continuedglobalization of Indian companies, India being seen as a favorable investment destination,increase in infrastructure spending, stable government, robust markets, stable currency,low deficits, etc. Wholesale banking thus comprises a major share of the banking revenuesdue to the above factors and also due to an increased inclination of government towardsmid-segment companies which have increasing banking requirements. In wholesalebanking too, it is the corporate banking which comprises a lion’s share, i.e., about 85%.Likewise, with the rebound of economy and a positive outlook, the possibility of a growthin investment banking, M&A, etc. is highly likely. Wholesale clientele for banks are highlysignificant for banks to drive business. Banks provide various forms of banking solutionslike project finance, leasing finance, working capital finance, merchant banking,syndication services, etc. are also provided to clients The major advantage in wholesalebanking is that a client can have easy and one-place access to all its finances and theirdetails. This makes internal stock transfers, fund transfers, allocations and distributionssimpler. It however, it increases the risk it poses to the clients as all their funds are parkedin one institution and the businesses depend on the financial health of the bank for smoothrun. In cases of economic downturns, if the banks crash, all the dependent businessescome to a standstill instantly. Thus, businesses usually diversify into several financialinstitutions to remain afloat during any crisis. The major Indian Banks which are involvedin wholesale banking are SBI, ICICI, IDBI Bank, Canara Bank, Bank of India, PunjabNational Bank, Bank of Baroda, Central Bank of India, etc.

Wholesale banking includes high ticket exposures primarily to corporates. Internalprocesses of most banks classify wholesale banking into mid corporates and largecorporates according to the size of exposure to the clients. A large portion of wholesalebanking clients also account for off balance sheet businesses. Hedging solutions forma significant portion of exposures coming from corporates. Hence, wholesale bankingclients are strategic for the banks with the view to gain other business from them. Variousforms of financing, like project finance, leasing finance, finance for working capital, termfinance, etc. form part of wholesale banking transactions. Syndication services andmerchant banking services are also provided to wholesale clients in addition to the varietyof products and services offered.

Wholesale banking is also a well diversified banking vertical. Most banks have apresence in wholesale banking. But this vertical is largely dominated by large Indian banks.While a large portion of the business of foreign banks comes from wholesale banking,their market share is still smaller than that of the larger Indian banks. A number of largeprivate players among Indian banks are also very active in this segment.

2.40 Near Banks

Financial intermediaries are all institutions that accept deposits from individuals,businesses and governments and lend funds to borrowers. They include savings banks,trust and mortgage loan companies, credit unions and caisses populaires. Their functionsare similar to those of the chartered banks; they are often referred to as near banks.



Notes2.41 Universal Banking

Universal Banking is a banking system in which banks provide a wide variety offinancial services, including both commercial and investment services. Universal bankingis common in some European countries, including Switzerland. In the United States,however, banks are required to separate their commercial and investment banking services.Proponents of universal banking argue that it helps banks better diversify risk. Detractorsthink dividing up banks’ operations is a less risky strategy.

Universal banks may offer credit, loans, deposits, asset management, investmentadvisory, payment processing, securities transactions, underwriting and financial analysis.While a universal banking system allows banks to offer a multitude of services, it doesnot require them to do so. Banks in a universal system may still choose to specializein a subset of banking services.

2.42 Advantages of Universal Banking

The advantages of universal banking are:

1. Investors’ TrustUniversal banks hold stakes (equity shares) of many companies. These companies

can easily get other investors to invest in their business. This is because other investorshave full confidence and faith in the Universal banks. They know that the Universal bankswill closely watch all the activities of the companies in which they hold a stake.

2. Economies of ScaleUniversal banking results in economic efficiency. That is, it results in lower costs,

higher output and better products and services. In India, RBI is in favor of universal bankingbecause it results in economies of scale.

3. Resource UtilizationUniversal banks use their client’s resources as per the client’s ability to take a risk.

If the client has a high risk taking capacity then the universal bank will advise him tomake risky investments and not safe investments. Similarly, clients with a low risk takingcapacity are advised to make safe investments. Today, universal banks invest their client’smoney in different types of Mutual funds and also directly into the share market. Theyalso do equity research. So, they can also manage their client’s portfolios (differentinvestments) profitably.

4. Profitable DiversificationUniversal banks diversify their activities. So, they can use the same financial experts

to provide different financial services. This saves cost for the universal bank. Even the day-to-day expenses will be saved because all financial services are provided less than oneroof, i.e., in the same office.

5. Easy MarketingThe universal banks can easily market (sell) all their financial products and services

through their many branches. They can ask their existing clients to buy their other productsand services. This requires less marketing efforts because of their well-established brandname. For example, ICICI may ask their existing bank account holders in all their branches,to take house loans, insurance, to buy their mutual funds, etc. This is done very easilybecause they use one brand name (ICICI) for all their financial products and services.



Notes 6. One-stop ShoppingUniversal banking offers all financial products and services under one roof. One-stop

shopping saves a lot of time and transaction costs. It also increases the speed or flowof work. So, one-stop shopping gives benefits to both banks and their clients.

2.43 Disadvantages of Universal Banking

The disadvantages of universal banking are:

1. Different Rules and RegulationsUniversal banking offers all financial products and services under one roof. However,

all these products and services have to follow different rules and regulations. This createsmany problems. For example, Mutual Funds, Insurance, Home Loans, etc. have to followdifferent sets of rules and regulations, but they are provided by the same bank.

2. Effect of Failure on Banking SystemUniversal banking is done by very large banks. If these huge banks fail, then it will

have a very big and bad effect on the banking system and the confidence of the public.For example, recently, Lehman Brothers a very large universal bank failed. It had verybad effects in the USA, Europe and even in India.

3. MonopolyUniversal banks are very large. So, they can easily get monopoly power in the market.

This will have many harmful effects on the other banks and the public. This is also harmfulto economic development of the country.

4. Conflict of InterestCombining commercial and investment banking can result in conflict of interest. That

is, Commercial banking versus Investment banking. Some banks may give moreimportance to one type of banking and give less importance to the other type of banking.However, this does not make commercial sense.

2.44 Non-Banking Financial Company (NBFC)

Non-banking financial companies, or NBFCs, are financial institutions that providebanking services, but do not hold a banking license. These institutions are not allowedto take deposits from the public. Nonetheless, all operations of these institutions are stillcovered under banking regulations.

NBFCs do offer all sorts of banking services, such as loans and credit facilities,retirement planning, money markets, underwriting and merger activates. The number ofnon-banking financial companies has expanded greatly in the last several years as venturecapital companies, retail and industrial companies have entered the lending business.

Non-banking financial companies (NBFCs) are fast emerging as an importantsegment of Indian financial system. It is an heterogeneous group of institutions (other thancommercial and cooperative banks) performing financial intermediation in a variety of ways,like accepting deposits, making loans and advances, leasing, hire purchase, etc. Theyraise funds from the public, directly or indirectly, and lend them to ultimate spenders.They advance loans to the various wholesale and retail traders, small-scale industries andself-employed persons. Thus, they have broadened and diversified the range of productsand services offered by a financial sector. Gradually, they are being recognized as



Notescomplementary to the banking sector due to their customer-oriented services; simplifiedprocedures; attractive rates of return on deposits; flexibility and timeliness in meeting thecredit needs of specified sectors; etc.

The working and operations of NBFCs are regulated by the Reserve Bank of India(RBI) within the framework of the Reserve Bank of India Act, 1934 (Chapter IIIB) and thedirections issued by it under the Act. As per the RBI Act, a ‘non-banking financial company’is defined as: (i) a financial institution which is a company; (ii) a non-banking institutionwhich is a company and which has as its principal business the receiving of deposits,under any scheme or arrangement or in any other manner, or lending in any manner;(iii) such other non-banking institution or class of such institutions, as the bank may, withthe previous approval of the Central Government and by notification in the Official Gazette,specify.

Under the Act, it is mandatory for a NBFC to get itself registered with the RBI asa deposit taking company. This registration authorizes it to conduct its business as anNBFC. For the registration with the RBI, a company incorporated under the CompaniesAct, 1956 and desirous of commencing business of non-banking financial institution,should have a minimum net owned fund (NOF) of ` 25 lakh (raised to ` 200 lakh w.e.f.April 21, 1999). The term ‘NOF’ means, owned funds (paid-up capital and free reserves,minus accumulated losses, deferred revenue expenditure and other intangible assets) less,(i) investments in shares of subsidiaries/companies in the same group/all other NBFCs;and (ii) the book value of debentures/bonds/outstanding loans and advances, including hire-purchase and lease finance made to, and deposits with, subsidiaries/companies in thesame group, in excess of 10% of the owned funds.

The registration process involves submission of an application by the company inthe prescribed format along with the necessary documents for RBI’s consideration. If thebank is satisfied that the conditions enumerated in the RBI Act, 1934 are fulfilled, it issuesa ‘Certificate of Registration’ to the company. Only those NBFCs holding a valid Certificateof Registration can accept/hold public deposits. The NBFCs accepting public depositsshould comply with the Non-Banking Financial Companies Acceptance of Public Deposits(Reserve Bank) Directions, 1998, as issued by the bank. Some of the important regulationsrelating to acceptance of deposits by the NBFCs are:

(a) They are allowed to accept/renew public deposits for a minimum period of12 months and maximum period of 60 months.

(b) They cannot accept deposits repayable on demand.(c) They cannot offer interest rates higher than the ceiling rate prescribed by RBI

from time to time.(d) They cannot offer gifts/incentives or any other additional benefit to the

depositors.(e) They should have minimum investment grade credit rating.(f) Their deposits are not insured.

(g) The repayment of deposits by NBFCs is not guaranteed by RBI.

The types of NBFCs registered with the RBI are:(i) Equipment leasing company is any financial institution whose principal

business is that of leasing equipments or financing of such an activity.(ii) Hire-purchase company is any financial intermediary whose principal

business relates to hire purchase transactions or financing of such transactions.(iii) Loan company means any financial institution whose principal business is that

of providing finance, whether by making loans or advances or otherwise for any



Notes activity other than its own (excluding any equipment leasing or hire-purchasefinance activity).

(iv) Investment company is any financial intermediary whose principal businessis that of buying and selling of securities.

2.45 Summary

A financial intermediary is a financial institution that connects surplus and deficitagents. The classic example of a financial intermediary is a bank that consolidates bankdeposits and uses the funds to transform them into bank loans.

Financial Intermediaries are the firms that provide services and products whichcustomers may not be able to get more efficiently by themselves in final markets. In otherwords, they act as middlemen between investors and borrowers in financial system.

Financial intermediary is a financial institution such as bank, building society,insurance company, and investment bank or pension fund. A financial intermediary offersa service to help an individual/firm to save or borrow money. A financial intermediary helpsto facilitate the different needs of lenders and borrowers.

Commercial bank is a profit-seeking business firm, dealing in money and credit. Itis a financial institution dealing in money in the sense that it accepts deposits of moneyfrom the public to keep them in its custody for safety. So, it deals in credit, i.e., it createscredit by making advances out of the funds received as deposits to needy people. It thus,functions as mobilizer of savings in the economy. A bank is, therefore like a reservoirinto which how the savings, the idle surplus money of households and from which loansare given on interest to businessmen and others who need them for investment orproductive uses. Commercial bank being the financial institution performs diverse typesof functions. It satisfies the financial needs of the sectors such as agriculture, industry,trade, communication, etc. That means they play a very significant role in a process ofeconomic and social needs. The functions performed by banks are changing accordingto changes in time and recently they are becoming customer centric and widening theirfunctions. Generally the functions of commercial banks are divided into two categories,viz., primary functions and the secondary functions.

Commercial bank refers to a bank that lends money and provides transactional,savings, and money market accounts and that accepts time deposit. A commercial bankis a type of financial institution and intermediary. Commercial banks engage for providingdocumentary and standby letter of credit, guarantees, performance bonds, securitiesunderwriting commitments and other forms of off balance sheet exposures.

Public Sector Banks (PSBs) are banks where a majority stake (i.e., more than50%) is held by a government. The shares of these banks are listed on stock exchanges.The Central Government entered the banking business with the nationalization of theImperial Bank of India in 1955. A 60% stake was taken by the Reserve Bank of Indiaand the new bank was named as the State Bank of India. The seven other state banksbecame the subsidiaries of the new bank when nationalized on 19 July 1960. The nextmajor nationalization of banks took place in 1969 when the government of India, underPrime Minister Indira Gandhi, nationalized an additional 14 major banks. The total depositsin the banks nationalized in 1969 amounted to 50 crores. This move increased thepresence of nationalized banks in India, with 84% of the total branches coming undergovernment control.



NotesPrivate sector banks in India are all those banks where greater parts of stake or equityare held by the private shareholders and not by government. These are the major playersin the banking sector as well as in expansion of the business activities India. The presentprivate sector banks equipped with all kinds of contemporary innovations, monetary toolsand techniques to handle the complexities are a result of the evolutionary process over twocenturies. They have a highly developed organizational structure and are professionallymanaged. Thus, they have grown faster and stronger since past few years.

Private sector banks have been functioning in India since the very beginning of thebanking system. Initially, during 1921, the private banks like bank of Bengal, bank ofBombay and bank of Madras were in service, which all together formed Imperial Bankof India.

Reserve Bank of India (RBI) came in picture in 1935 and became the centre of everyother bank taking away all the responsibilities and functions of Imperial bank. Between1969 and 1980, there was rapid increase in the number of branches of the private banks.In April 1980, they accounted for nearly 17.5% of bank branches in India. In 1980, after6 more banks were nationalized, about 10% of the bank branches were those of privatesector banks. The share of the private bank branches stayed nearly same between 1980and 2000. Then from the early 1990s, RBI’s liberalization policy came in picture and withthis the government gave licences to a few private banks, which came to be known asnew private sector banks.

Loans are made against personal security, gold and silver, stocks of goods and otherassets. The second primary function of a commercial bank is to make loans and advancesto all types of persons, particularly to businessmen and entrepreneurs.

Credit creation is the multiple expansions of banks demand deposits. It is an opensecret now that banks advance a major portion of their deposits to the borrowers and keepsmaller parts of deposits to the customers on demand. Even then the customers of thebanks have full confidence that the depositor’s lying in the banks is quite safe and canbe withdrawn on demand.

ATM is a channel of banking service to its customers. It’s traditional and primary useis to dispense cash upon insertion of a plastic card and its unique PIN, i.e., PersonalIdentification Number. The banks issue ATM card to their customers having current or savingsaccount holding a certain minimum balance in their accounts. ATM card is a plastic cardwith a magnetic strip with the account number of the individuals. When the card is insertedinto the machine the sensing equipment of the machine identifies the account holder andasks his PIN. It is a secret number which is known only to the account holder.

Industrial Bank is a financial institution with a limited scope of services. Industrialbanks sell certificates that are labeled as investment shares and also accept customerdeposits. They then invest the proceeds in installment loans for consumers and smallbusinesses. These banks are also known as Morris Banks or industrial loan companies.

A unit bank is one, which conducts its banking operations through a single officewithin a strictly limited area or with a limited number of offices in that area. It is essentiallya localized system. Group banking is that system of banking under which two or morebanks are directly or indirectly controlled by an association, trust, or corporation. Thistype of banking is also known as holding company banking. The holding company holdsthe majority shares in the companies under its control and the companies whose sharesare held by the holding company are known as subsidiary companies.

Exchange banks are those banks maintain the facilities to finance mostly for theforeign trade of a country. Their main function is to discount, accept and collect foreign



Notes bills of exchange. They buy and sell foreign currency and thus help businessmen in theirtransactions. They also carry on the ordinary banking business.

The Reserve Bank of India is the central banking institution of India and controls themonetary policy of the rupee as well as US$ 300.21 billion (2010) of currency reserves.The institution was established on 1 April 1935 during the British Raj in accordance withthe provisions of the Reserve Bank of India Act, 1934 and plays an important part in thedevelopment strategy of the government. It is a member bank of the Asian Clearing Union.

A cooperative bank is a financial entity which belongs to its members, who are atthe same time the owners and the customers of their bank. Cooperative banks are oftencreated by persons belonging to the same local or professional community or sharing acommon interest. Cooperative banks generally provide their members with a wide rangeof banking and financial services (loans, deposits, banking accounts, etc.).

Urban Cooperatives can be further divided into scheduled and non-scheduled. Boththe categories are further divided into multi-state and single-state. Majority of the banksare fall in the non-scheduled and single-state category. Banking activities of UrbanCooperative Banks are monitored by RBI. Registration and Management activities aremanaged by Registrar of Cooperative Societies (RCS). These RCS operate in single-stateand Central RCS (CRCS) operate in multiple state.

The rural cooperatives are further divided into short-term and long-term structures.The short-term cooperative banks are three tiered operating in different states. These are:State Cooperative Banks – They operate at the apex level in states. District CentralCooperative Banks – They operate at the district levels. Primary Agricultural CreditSocieties – They operate at the village or grass-root level.

International banking enables people who live or work abroad to manage their financesin one central location. By keeping your money in one place, it allows you to maketransfers and payments in several currencies from a stable and secure offshore jurisdiction.Providing you with a link between all of your banking arrangements, you can be in completecontrol of your money, wherever you are in the world.

Retail banking is the provision of services by a bank to individual consumers, ratherthan to companies, corporations or other banks. Services offered include savings andtransactional accounts, mortgages, personal loans, debit cards, and credit cards.

Retail banking is typically mass market banking where individual customers use localbranches of larger commercial banks. Services offered include savings and checkingaccounts, mortgages, personal loans, debit cards, credit cards and so.

Wholesale banking is the provision of services by banks to organizations such asMortgage Brokers, large corporate clients, mid-sized companies, real estate developersand investors, international trade finance businesses, institutional customers (such aspension funds and government entities/agencies), and services offered to other banks orother financial institutions.

Financial intermediaries are all institutions that accept deposits from individuals,businesses and governments and lend funds to borrowers. They include savings banks,trust and mortgage loan companies, credit unions and caisses populaires. Their functionsare similar to those of the chartered banks; they are often referred to as near banks.

Universal Banking is a banking system in which banks provide a wide variety offinancial services, including both commercial and investment services. Universal bankingis common in some European countries, including Switzerland. In the United States,however, banks are required to separate their commercial and investment banking services.



NotesProponents of universal banking argue that it helps banks better diversify risk. Detractorsthink dividing up banks’ operations is a less risky strategy.

Non-banking financial companies, or NBFCs, are financial institutions that providebanking services, but do not hold a banking license. These institutions are not allowedto take deposits from the public. Nonetheless, all operations of these institutions are stillcovered under banking regulations.



1. __________ is a financial institution such as bank, building society, insurancecompany, and investment bank or pension fund.

2. Commercial bank is a profit-seeking business firm, dealing in __________.3. __________ are banks where a majority stake (i.e., more than 50%) is held

by a government.4. Private sector banks in India are all those banks where greater parts of stake

or equity are held by the private shareholders and not by __________.5. __________ banking is that system of banking under which two or more banks

are directly or indirectly controlled by an association, trust, or corporation.6. A cooperative bank is a financial entity which belongs to its members, who are

at the same time the owners and the customers of their __________.

II. True or False

1. A financial intermediary is a financial institution that connects surplus and deficitagents.

2. Commercial bank being the financial institution performs diverse types offunctions.

3. SBI came in picture in 1935 and became the centre of every other bank takingaway all the responsibilities and functions of Imperial bank.

4. Credit Card is the multiple expansions of banks demand deposits.5. Industrial Bank is a financial institution with a limited scope of services.6. The rural cooperatives are further divided into short-term and long-term

structures.7. Retail banking is the provision of services by a bank to individual consumers,

rather than to companies, corporations or other banks.8. Wholesale banking is the provision of services by banks to organizations such

as Mortgage Brokers, large corporate clients, mid-sized companies, real estatedevelopers and investors, international trade finance businesses, institutionalcustomers.


1. Which of the following is a financial institution that connects surplus and deficitagents?

(a) Financial intermediary(b) Banks(c) Industry(d) All the above



Notes 2. A commercial bank is a type of __________.(a) Financial institution(b) Intermediary(c) Both (a) and (b)(d) None of these

3. Public Sector Banks (PSBs) are banks’ stake __________.(a) More than 50%(b) Less than 50%(c) 50% only(d) None of these

2.47 Questions and Exercises


1. What is Financial Intermediary?2. What is Commercial Bank?3. State any two functions of Commercial Banks.4. What is Central Bank?5. What is Cooperative Bank?6. What is International Banking?7. Give the meaning of Retail Banking.8. What is Wholesale Banking?9. What is Near Bank?

10. What is Universal Banking?


1. Discuss the classification of Financial Intermediaries.2. Explain various functions of Financial Intermediaries.3. Discuss the significance of Commercial Banks.4. Explain the structure of Commercial Bank in India.5. Explain the functions of Commercial Banks.6. Discuss the Functional Departments of RBI.7. Explain Banking system in USA and India.8. Discuss the Retail Banking in India.9. Explain various features of Retail Banking.

10. Discuss the Wholesale Banking in India.11. Explain various advantages of Universal Banking.12. Discuss about Non-Banking Financial Company.

2.48 Key TermsFinancial Intermediary: financial intermediary is a financial institution thatconnects surplus and deficit agents.



NotesCommercial Bank: Commercial bank is a profit-seeking business firm, dealingin money and credit.Public Sector Banks: Public Sector Banks (PSBs) are banks where a majoritystake (i.e., more than 50%) is held by a government.Private-sector Banks: Private-sector banks are all those banks where greaterparts of stake or equity are held by the private shareholders and not bygovernment.Credit creation: Credit creation is the multiple expansions of banks demanddeposits. It is an open secret now that banks advance a major portion of theirdeposits to the borrowers and keep smaller parts of deposits to the customerson demand.Group Banking: Group banking is that system of banking under which twoor more banks are directly or indirectly controlled by an association, trust orcorporation.


1. Financial intermediary2. Money and credit3. Public Sector Banks (PSBs)4. Government5. Group6. Bank

II. True or False1. True2. True3. False4. False5. True6. True7. True8. True

III. Multiple Choice Questions1. (a) Financial intermediary2. (c) Both (a) and (b)3. (a) More than 50%

2.50 Case Study

A 20-year old university student, Mr. D, lived at home and worked full-time in a localsupermarket during the vacations. He had a part-time job at the same supermarket duringterm-time.

Mr. D applied successfully to his bank for a loan of £2,500, in order to buy and insurea second-hand motorbike. But as soon as he told his mother about the loan, she



Notes complained to the bank. She said its decision to lend her son the money had been "ill-judged and irresponsible" and that it had taken advantage of her son’s inexperience.

Mrs. D told the bank that her son had planned to go travelling for a year after hegraduated. She was concerned that the loan repayments would not only prevent him fromsaving money for his travels, but also leave him short of cash. She also believed that,by lending him the money, the bank had actively encouraged her son to buy a powerfulmotorbike.

Mrs. D thought the bank should write-off the loan and take the motorbike in exchange.The bank disagreed, so - with her son’s knowledge and agreement – Mrs. D brought thedispute to us on his behalf.

Question:1. As a bank manager, how to rectify the ill-judged and irresponsible?


Ryerson.2. Banking through the Ages by Hoggson, N.F., New York, Dodd, Mead &


W.C and Tolbert S.M., Oxford University Press.4. Projects, Preparation, Appraisal, Budgeting and Implementation, by Prasanna


2.52 Bibliography1. Kem, H.J. (2005), “Global Retail Banking: Changing Paradigms”, Chartered

Financial Analyst, ICFAI Press, Hyderabad, Vol. XI, No. 10, pp. 56-58.2. Neetu Prakash, (2006), “Retail Banking in India”, ICFAI University Press,

Hyderabad pp. 2-10.3. Dhanda Pani Alagiri (2006), “Retail Banking Challenges”, ICFAI University

Press, Hyderabad, pp. 25-34.4. Manoj Kumar Joshi (2007). “Growth Retail Banking in India”, ICFAI University

Press, Hyderabad, pp. 13-24.5. Manoj Kumar Joshi (2007), “Customer Services in Retail Banking in India”, ICFAI

University Press, Hyderabad, pp. 59-68.6. S. Santhana Krishnan (2007), “Role of Credit Information in Retail Banking: A

Business Catalyst”, ICFAI University Press, Hyderabad, pp. 68-74.7. Sunil Kumar (2008), “Retail Banking in India”, Hindustan Institute of

Management and Computer Studies, Mathura.8. Divanna, J.A. (2009), “The Future Retail Banking", Palgrave Macmillan, New

York.9. Birendra Kumar (2009), “Performance of Retail Banking in India”, Asochem

Financial Pulse (AFP), India.10. Sapru R.K. (1994), Development Administration, Sterling, New Delhi.11. United Nations Industrial Development Organization (1998), Manual for

Evaluation of Industrial Projects, Oxford and IBH, New York.



Notes12. T.E. Copeland and J.F. Weston (1988), Financial Theory and Corporate Policy,Addison-Wesley, West Sussex (ISBN 978-0321223531).

13. E.J. Elton, M.J. Gruber, S.J. Brown and W.N. Goetzmann (2003), ModernPortfolio Theory and Investment Analysis, John Wiley & Sons, New York (ISBN978-0470050828).

14. E.F. Fama (1976), Foundations of Finance, Basic Books Inc., New York (ISBN978-0465024995).








Notes

Structure:

3.1 Introduction3.2 Meaning of Bank Lending3.3 Principles of Lending3.4 Five Cs of Lending Principles3.5 Forms of Lending3.6 Types of Lending3.7 Lending Facilities Granted by Banks3.8 Who are the Borrowers?3.9 Study of Borrowers

3.10 Balance Sheet Analysis3.11 Goal of Balance Sheet Analysis3.12 How to Perform a Balance Sheet Analysis?3.13 Project Appraisal3.14 Checklist for Project Appraisal3.15 Project Appraisal Criteria3.16 Marketing of Bank Services3.17 Importance of Bank Marketing3.18 Marketing Approach in Banks3.19 Features of Bank Marketing3.20 Prudential Norms3.21 Prudential Guidelines on Restructuring of Advances3.22 Narasimham Committee Recommendations3.23 Recommendations of the Committee3.24 Highlights of Narasimham Committee Recommendations on Banking Reforms

in India3.25 Performance Analysis of Banks3.26 Regulatory Institutions in India3.27 Reserve Bank of India3.28 Credit Control3.29 Meaning of Credit Control3.30 Objectives of Credit Control3.31 Need for Credit Control3.32 Methods of Credit Control3.33 RBI Publications3.34 Securities and Exchange Board of India3.35 Organization of SEBI

Unit 3: Norms and Practices in theBanking Industry


Norms and Practices in the Banking industry 115

Notes3.36 Management of the Board3.37 Objectives of SEBI3.38 Functions of SEBI3.39 Powers of Securities and Exchange Board of India3.40 Lender’s Liability Act3.41 Banking Innovations3.42 Basel Committee Recommendations3.43 Capital Adequacy Ratio (CAR)3.44 Risk Weighted Assets3.45 Risk Based Supervision3.46 Asset Liability Management (ALM) in Commercial Banks3.47 Benefits of ALM3.48 Corporate Debt Restructuring3.49 E-Banking3.50 Development of E-Banking in India3.51 E-Banking Services3.52 Internet Banking3.53 Internet Banking in India3.54 Advantages of Internet Banking3.55 Disadvantages of Internet Banking3.56 Tele Banking3.57 Online Banking3.58 Core Banking3.59 Mobile Banking3.60 E-Banking Risk3.61 Types of E-Banking Risk3.62 E-finance3.63 Electronic Money3.64 Digital Signatures3.65 How Digital Signatures Work?3.66 RTGS3.67 National Electronic Funds Transfer (NEFT)3.68 Summary3.69 Check Your Progress3.70 Questions and Exercises3.71 Key Terms3.72 Check Your Progress: Answers3.73 Case Study3.74 Further Readings3.75 Bibliography



Notes Objectives


Understand the overview of Principles of LendingDetailed overview of Marketing of bank servicesDetailed study of Narasimham Committee RecommendationsRegulatory Institutions RBI and SEBIUnderstand the Banking InnovationsUnderstand the Capital Adequacy RatioDetailed study of Corporate Debt RestructuringUnderstand the Internet Banking, Mobile Banking, E-Banking Risk and E-FinanceDetailed study of Electronic Money, Digital Signatures, RTGS and NEFT

3.1 INTRODUCTION

The successful banks operating within the financial system are those that considerand coordinate basic principles of lending and monitor the activities of borrowers regularly.The major business of banking company is to grant loans and advances to traders aswell as commercial and industrial establishment.

The most important use of banks money is lending. Yet, there are risks in lending.While lending loans or advances, the banks usually keep such securities and assets assupport so that lending may be safe and secured. Suppose, any particular state is hitby disaster, the bank gets advantage from lending to another states' units. Thus, the effecton the entire business of banking is reduced.

The recent distress in the financial system witnessed more importantly in the bankingsector. Lending limit regulations restrict the total amount of loans and credits that a bankmay extend to a single borrower. This restriction is usually stated as a percentage ofthe bank’s capital or assets.

It is widely held that a bank is an institution that accepts deposits from customersand looks after their money, offers cheque books to customers to enable them to makepayments to others and provides other financial services which include lending. In anutshell, a bank’s major operation is the acceptance of deposits and granting of loansto different kinds of customers.

The commercial banks engage in retail banking services through branch networksand operate with a broad deposit base consisting of demand and time deposit. They provideshort-term lending. On the other hand, merchant banks are licensed to provide wholesalebanking, take deposit and arrange syndicated loan facilities for long term by pooling,sometimes, a consortium of banks, including other financial institutions, to finance capitalintensive projects. From the foregoing, it is realized that banks are generally debtors; theyborrow money in order to lend them out to make profit. No bank can ever survive by justbeing a custodian of deposit, but they exist by lending from the deposit on fixed interestcharged. Money lent on interest is always supposed to be secured on some guaranteesor security.

Since banks depend largely on lending, the need to adhere to the basic principlesof lending is quite inevitable. The principles, if strictly followed, will guarantee depositorsand shareholders’ funds, increase profitability and make a healthy turnover. Such advancesin turn assist in the transformation of rural environment, promote rapid expansion of banking



Noteshabit and improve and boost the nation’s economy. The basic considerations in banklending are the character of the client seeking loan from the bank. The client must bean honest, upright customer whose record of transaction with the financial institution orin the society is remarkable. The information on the character of the borrower could beobtained through a completed form of his guarantor or his statement of account.

3.2 Meaning of Bank Lending

Bank lending refers to the process of disposing of money or property with theexpectation that the same thing will be returned. Credit is the provision of resources (suchas granting a loan) by one party to another party where that second party does notreimburse the first party immediately, thereby generating a debt, and instead arrangeseither to repay or return those resources (or material(s)) of equal value. Where the firstparty would be the banker (lender or creditors) and the second party would be the customer(borrower or debtor).

3.3 PRINCIPLES OF LENDING

Bank lending involves risk; banks need to follow certain basic principles at the timeof lending loans and advances. Some of the principles to be followed are:

1. Principle of SafetySafety is the most important principle of good lending. When a banker lends, he

must feel certain that the advance is safe and the money will definitely come back. Ifthe borrower invests the money in an unproductive or speculative venture, or if the borrowerhimself is dishonest, the advance would be in danger.

2. Principle of LiquidityThe borrower must be in a position to repay within a reasonable time after a demand

for repayment is made. This can be possible only if the money is employed by the borrowerfor short-term requirements and not locked up in acquiring fixed assets, or in schemeswhich take a long time to pay their way. This is the reason why bankers attach as muchimportance to ‘liquidity’ as to ‘safety’ of their funds.

3. Principle of PurposeThe purpose should be productive so that the money not only remain safe but also

provides a definite source of repayment. The purpose should also be short termed so thatit ensures liquidity. Banks should discourage advances for hoarding stocks or forspeculative activities.

4. Principle of ProfitabilityProfitability is a financial benefit that is realized when the amount of revenue gained

from a business activity exceeds the expenses, costs and taxes needed to sustain theactivity. Banks must make profits because they have to pay interest on the depositsreceived by them. They have to deserve expenses on establishment, rent, stationery, etc.

5. Principle of SecurityIt has been the practice of banks not to lend as far as possible except against

security. The banker carefully examines all the different aspects of an advance beforegranting it.



Notes 6. Principle of SpreadThe principle of good lending is the diversification of advances. An element of risk

is always present in every advance. However, secure it might appear to be. In fact, theentire banking business is one of taking calculated risks and a successful banker is anexpert in assessing such risks.

7. Principle of National Interest, Suitability, etc.Even when an advance satisfies all good principles, it may still not be suitable. The

advance may run counter to national interest. The Central Bank may have issued a directiveprohibiting banks to allow a particular type of advance.

8. Principle of Ideal AdvanceL.C. Mather describes an ideal advance as “one which is granted to a reliable

customer for an approved purpose in which the customer has adequate experience, safein the knowledge that the money will be used to advantage and repayment will be madewithin a reasonable period from trading receipts or known maturities due on or about givendates.”

3.4 FIVE CS OF LENDING PRINCIPLES

(a) CharacterThe character of the borrower indicates two things: the ability to pay versus the

willingness to pay. The ability to pay refers to the borrower’s financial credibility to pay.The lender should check on the borrower’s character.

(b) CapacityCapacity refers to the sources of repayment, i.e., the cash flow. The borrower must

be able to meet all his financial obligations on the due dates.

(c) CapitalCapital represents the degree of commitment and the ability to sustain this

commitment during bad times.

(d) ConditionsCondition refers to the macroeconomic environment. For example, if the loan is

needed for setting up a retail business in a particular area, then the lender must makea study of the economic conditions (the degree of propensity to spend by residents inthat locality).

(e) CollateralCollateral is the lender’s second line of defence. If the payback is derived from cash

flows, then the collateral will not be liquidated for repayment.

3.5 FORMS OF LENDING

The Credit Process

Credit is the lifeline of the banking business. The fundamental objective of acommercial bank is to make profitable loans with minimum risk. Bank management shouldtarget specific industries and markets in which lending officers have expertise. However,while competing goals of loan volume and loan quality must be balanced with the banks’



Notesliquidity requirements, capital constraints and rate of return objectives. The credit processrelies on each bank’s system and controls that allow management and credit officers toevaluate risk and return trade-offs. The credit process includes three functions:(a) Business development and credit analysis, (b) Underwriting or credit execution andadministration and (c) Credit review.

A credit policy formalizes lending guidelines that employees follow to conduct bankbusiness. As already pointed out in our previous discussion that it identifies preferred loanqualities and establishes procedures for granting, documenting and reviewing loans.

The management’s credit philosophy determines how much risk the bank will takeand in what form. Here, we need to know a very important concept that is called a bank’scredit culture. This refers to the fundamental principles that drive lending activities andhow management analysis risk. This lending philosophy would differ from bank to bank.

Values Driven

(a) Focus is on credit quality with strong risk management systems and controls.(b) Primary emphasis is on bank soundness and stability and a consistent market

presence.(c) Underwriting is conservative and significant loan concentrations are not allowed.(d) Typical outcome is lower current profit from loans with fewer loan losses.

Current – Profit Driven

(a) Focus is on short-term earnings.(b) Primary emphasis is bank’s annual profit plan.(c) Management is often attracted to high-risk and high-return borrowers.(d) Outcome is typically higher profit in good times, followed by lower profit in bad

times when loan losses increase.

Market Share Driven

(a) Focus is on having the highest market share of loans among competitors.(b) Primary emphasis is on loan volume and growth with the intent of having the

largest market share.(c) Underwriting is very aggressive and management accepts loan concentrations

and above-average credit risk.(d) Outcome is that loan quality suffers over time, while profit is modest because

loan growth comes from below-market pricing and greater risk taking.

3.6 TYPES OF LENDING

A. Fund Based Lending

1. Long-term Loan

(a) Project FinanceTerm Loans and Non-convertible Debentures (NCDs) for projects in the industrial,

Services and infrastructure sectors and diversification, modernization and expansion ofexisting projects:



Notes (i) Funding up to 60% of the cost of the project.(ii) Period up to 6 years for SME sector and 7 years for Infrastructure sector.(iii) Financial assistance from ` 10 million (existing clients), 20 million (new clients)

to 150 million would be offered.

(b) Equipment Finance(i) For purchase of additional or balancing equipments like energy saving devices,

pollution control facilities in an existing project.(ii) Equipment that add value to the existing project.(iii) Corporate (Medium Term) Loan.(iv) Tenure of 1 year to 5 years.(v) Companies having good past record and credit rating are preferred.

2. Short-term Loan

(a) Bill Discounting(i) Ranging from 10 million to 150 million.(ii) Aims at supplementing the working capital sources over and above the limits

sanctioned by the banks for rated companies.

(b) Factoring of ReceivablesFactoring of Receivables ranging from 10 million to 150 million.

B. Non-fund Based Lending

Non-fund based lending facilities are as follows:

(i) Issuance of Bank Guarantee for purchase of machinery or goods on credit(ii) Issuance of Bank Guarantee in lieu of Security Deposit/EMD/Performance

Guarantees(iii) Financial guarantee against collateral securities/cash margin(iv) Issuance/establishing BG/LC on behalf of lottery agents/liquor contractors/

liquor shops with 100% cash marginForward Sales, Forward Purchase Contracts, Letter of Credit with a minimum cash

margin of 25% (inland), Guarantees/Co-acceptance of Usance Bills with minimum 25%cash margin, Discounting of Bills co-accepted by other banks, Partly secured/unsecured/clean guarantee/co-acceptances with minimum of 25% cash margin.

Eligibility: Existing customers of the bank and whose past dealings have been foundsatisfactory. Normally, this type of guarantee is required by the customers when he desiresto purchase machinery or goods on credit. The Deferred Payment Guarantee containsan undertaking on the part of the bank to guarantee due payment of the deferredinstalments by the customers on the due date and declare that in the event of defaultin payment, the bank would make the payment.

Period of Guarantee: For a period up to 5 to years. In exceptional cases, it maybe extended for a maximum period up to 10 years on merits of each case.

Margin: 25% cash margin on the cost of machinery/equipment to be acquired lessinitial advance paid to the supplier plus interest portion, i.e., on the DPG amount.

Rate of Commission: 100 + 0.75% per quarter or part thereof with a minimum of3% is the normal rate of metropolitan, urban and semi-urban branches. For rural branches,



Notesthe rate of commission is 80 + 0.75% per quarter or part thereof with a minimum of 3%.In respect of DPGs secured by 100% cash margin or by 100% term deposits, only 25%of the applicable rate on issue of such guarantee with a minimum of 28 only, are leviable.

Security: Security provided for the guarantee may be in the form of our own depositsor other acceptable tangible security, such as GP Notes, Insurance Policies havingadequate surrender value and easily marketable shares.

Issuance of Bank Guarantee in Lieu of Security Deposit/EMD/Performance Guarantees1. Guarantees in favor of Government departments, such as Railways, PWD, etc.

who may require guarantees from their contractors in lieu of tender money orperformance of contracts to supply goods, etc.

2. Sales tax/Income-tax Authorities in respect of payment of taxes.3. Companies of repute towards payments in respect of supply of materials.4. Suppliers of machinery and plants on deferred payments basis require bank

guarantees in respect of instalments and interest payable by their purchasers.5. Guarantees in favor of the Coffee Board in connection with renewal of the pool

sales permit for participation in the pool sales by dealers.6. Guarantees are issued to Railway Authorities or Shipping Companies to take

delivery of relative goods without production of Railway Receipts (RRs) and Billsof Lading and undertaking to produce them on receipt.

7. Besides the above, several other commercial transactions involve execution ofbank guarantees.

Security: Security provided for the guarantee may be in the form of our own depositsor other acceptable tangible security, such as GP Notes, Insurance Policies havingadequate surrender value and easily marketable shares. Mortgage of immovable propertymay be accepted as security only in exceptional cases where customers are well known,provided at least 25% of the guarantee amount is covered by cash margin.

Commission: 100 plus 0.75% or 0.5% per quarter or part thereof towards financialor performance guarantee respectively.

Financial Guarantee against Collateral Securities/Cash Margin:1. Guarantees on behalf of constituents who are selling agents/lottery tickets/

airline tickets in favour of Government departments, Airlines, and othercompanies in lieu of cash deposit or earnest money.

2. All mobilization guarantees issued on behalf of contractors.3. Guarantees for release of retention money.4. Guarantees for due payment of moneys for goods supplied, services rendered,

etc. (guarantees in favour of oil companies, fertiliser companies, airlines, exciseguarantees, etc.)

5. Guarantees in lieu of sales tax, income tax, excise duties/Government demandsagainst 100% cash deposit.

6. Guarantees given to courts for release of deposits/in lieu of payment to court.7. Deferred Payment Guarantees.

C. Assets Based Lending

Asset based lending provides businesses with immediate funds and ongoing cashflow based on a percentage of the value of the company’s assets such as commercial



Notes accounts receivable, inventory, business equipment and machinery and recurring revenuecontracts. Funds from asset based finance can be used for day-to-day operating expensesor as capital for restructuring, turnarounds, mergers and acquisitions and buyouts. FirstCapital can custom tailor an asset based loan that fits your business needs. Asset basedfinance can be underwritten relatively quickly and easily by First Capital to get the fundingthat need when need it.

3.7 Lending Facilities Granted by Banks1. Loan2. Cash credit3. Overdraft4. Bills discounting5. Letters of credit

1. Loan

Loan is an arrangement in which a lender gives money to a borrower and the borroweragrees to return the money along with interest after a fixed period of time. Examples:Home Loans, Car Loans, Personal Loans, etc.

2. Cash Credit

Cash credit is a short-term cash loan to a company. A bank provides this type offunding, but only after the required security is given to secure the loan. Once a securityfor repayment has been given, the business that receives the loan can continuously drawfrom the bank up to a certain specified amount.

3. Overdraft

Overdraft is the amount by which withdrawals exceed deposits or the extension ofcredit by a lending institution to allow for such a situation.

A bank overdraft is a limit on borrowing on a bank’s current account.

4. Bills Discounting

Bill discounting refers to the trading or selling a bill of exchange prior to the maturitydate at a value less than the par value of the bill. The amount of the discount will dependon the amount of time left before the bill matures and on the perceived risk attached tothe bill.

5. Letters of Credit (LOC)

Letter of Credit refers to a letter from a bank guaranteeing that a buyer’s paymentto a seller will be received on time and for the correct amount. In the event that the buyeris unable to make payment on the purchase, the bank will be required to cover the fullor remaining amount of the purchase. It is a payment term generally used for internationalsales transactions.



Notes3.8 Who are the Borrowers?

Borrowers are the individuals who borrow money via bankers’ loans for short-termneeds or longer-term mortgages to help finance a house purchase. Companies borrowmoney to aid short-term or long-term cash flows. They also borrow to fund modernizationor future business expansion. Governments often find their spending requirements exceedtheir tax revenues. To make up this difference, they need to borrow. Governments alsoborrow on behalf of nationalized industries, municipalities, local authorities and other publicsector bodies.

Public Corporations typically include nationalized industries. These may include thepostal services, railway companies and utility companies. Many borrowers have difficultyraising money locally. They need to borrow internationally with the aid of foreign exchangemarkets. Borrowers having similar needs can form into a group of borrowers. They canalso take an organizational form like Mutual Funds. They can provide mortgage on weightbasis. The main advantage is that this lowers the cost of their borrowings.

3.9 Study of Borrowers

The borrowing structure in an economy comprises of “borrowers” or entities thatfinance their needs through borrowing. The needs of borrowers could involve incurringexpenditures on labor, plant and equipment, constructing residential, industrial orcommercial sites and building additions to inventories. The borrowers include thegovernment sector (central and state level), public sector and private sector corporations.The borrowers provide or supply financial assets to savers by issuing primary securitiesin financial markets, which in turn are reissued by financial intermediaries as secondarysecurities (in financial markets) for the savers as investments. The flow of savings (fromthe savings structure) to the flow of investments (to the borrowing structure) leads to capitalformation or long-term investments.

The flow of money from savings to investments leads to formation of capital stockin the form of equipment, buildings, intermediate goods and inventories. Capital formationreflects the country’s capability of producing and distributing goods and services acrossdifferent sectors and industries thus leading to an increase in the country national incomesof economic growth. National income of a country or economic growth can be measuredby calculating the Gross Domestic Product (GDP) or Gross National Product (GNP) thatcomprises economic activities in sectors like agriculture, industry and services requiringfinancial resources to allocate labor, capital and other factors of production.

Financial markets are used to link savers to borrowers. For example, a businesscan borrow money by selling shares or equity in the stock market. If a saver buys newlyissued shares of a stock in a specific company, this is an example of direct finance. Thesaver's money is going directly to the company that is borrowing the money.

A more typical linkage between savers and borrowers is through a financialintermediary. Examples of financial intermediaries include banks and mutual funds. Banksreceive money from depositors (savers) and loan it out. Mutual funds take in the moneyof savers and select the specific stocks and bonds that savers invest in.

Banks, mutual funds, and other financial intermediaries allow savers to channel theirmoney to borrowers without the saver and borrower coming into direct contact. By poolingthe money of many savers, banks reduce transactions costs, decrease risk and allowsavers to earn a rate of return on their savings. Rather than contacting individual saversfor a loan, borrowers can work with the bank for funds.



Notes A saver who desires the higher average return of stock markets without the researchrequired to make quality stock selections can buy shares in a mutual fund. The mutualfund manager will pool the money of many savers, taking the time and expense to studydifferent companies that trade stock shares. The goal is to make an educated selectionof shares that offer the highest possible return.

3.10 Balance Sheet Analysis

Balance sheet analysis can be defined as an analysis of the assets, liabilities, andequity of a company. This analysis is conducted generally at set intervals of time, likeannually or quarterly. The process of balance sheet analysis is used for deriving actualfigures about the revenue, assets, and liabilities of the company.

3.11 Goal of Balance Sheet Analysis

The balance sheet analysis is helpful for the investors, investment bankers, sharebrokers, and financial institutions, for verifying the profitability of investment for a specificcompany.

3.12 How to Perform a Balance Sheet Analysis?

It is not a difficult task to perform a Balance Sheet Analysis. The main steps include:(a) The primary step involves adding up liabilities and the paid-up equity share

capital. The sum must tally with the sum of total assets. After the process oftallying is done, contrast the total assets with total liabilities. However, thisevaluation does not include the issued shares’ amount in the liabilities. If thetotal assets are exceeding the total liabilities, the financial standing andperformance of the company is considered to be good.

(b) The next step involves looking at the current assets and liabilities. Sometimes,it is considered as a good sign to have more unsecured liabilities.

(c) Another important step is calculating the ROA by dividing the net income byassets. Producer companies feature a high ROA unlike the real estate andleasing companies which feature a low ROA.

(d) The fourth step involves special concern for copyrights and patents. It isimportant to consider the ratio between invested amount for research and theconsequent returns.

(e) Next step involves calculating the debt asset ratio by dividing total liabilities bytotal assets. A lower liability dimension reflects a better performance by thecompany.

(f) Another step includes estimating the receivables turnover ratio which signifiesthe relation between investment in sales and money receivable. A better financialstatus is reflected in high amount of money receivables.

(g) Another important ratio is the inventory turnover ratio which indicates thecompany’s capability of producing goods with available assets.

(h) The final step includes analyzing other features of company including goodwill,credit ratings, and current projects. This analysis is helpful in evaluating thecompany activities in near future.



Notes3.13 Project Appraisal

Project appraisal is the structured process of assessing the viability of a project orproposal. It involves calculating the feasibility of the project before committing resourcesto it. It is a tool that companies use for choosing the best project that would help themto attain their goal. Project appraisal often involves making comparison between variousoptions and this is done by making use of any decision technique or economic appraisaltechnique.

Project appraisal is a tool which is also used by companies to review the projectscompleted by it. This is done to know the effect of each project on the company. Thismeans that the project appraisal is done to know, how much the company has investedon the project and in return how much it is gaining from it. Project appraisal means apre-investment analysis of project to determine whether the project should be implementedor not. There are some inherent differences between the terms Project Appraisal andProject Valuation although they are often used interchangeably. Project appraisal refersto an ex-ante examination of a proposal project to determine whether the same shouldbe implemented or not whereas project evaluation is an ex-post assessment of the impactof an accomplished project.

3.14 Checklist for Project Appraisal

Whether you are involved in a partnership with an appraisal system in place, orstarting to design one from scratch, these questions are worth asking.

Are appraisals systematic and disciplined with a clear sequence of activitiesand operating rules?Is there an independent assessment of the project by someone who has notbeen involved with the development of the project?Does the appraisal process culminate in clear recommendations that informapproval (or rejection) of the project?Is the approval stage clearly separate?Is the appraisal process well documented, with key documents signed, showingownership and agreement, and allowing the appraisal documentation to act asa basis for future management, monitoring and evaluation?Does the appraisal system comply with any relevant government guidance.Are the right people involved at various stages of the process and, if necessary,how can you widen involvement?

3.15 Project Appraisal Criteria

Appraisal of projects can be done by many ways, but the most common of themare financial and economic appraisal. In case of financial project appraisal, the companyreviews the cost of the project and the expected revenues that will be generated by theproject. This type of appraisal helps the company to prevent overspending on a project.It also helps in finding certain areas where alterations can be done for generating higherrevenues. Under economic appraisal, the company mainly focuses on the total benefitof the project and less on the costs spent on the project. Other than these two typesof appraisal, there are also other types of project appraisal which include technicalappraisal, management or organizational appraisal and marketing and commercialappraisal.



Notes 1. Financial Appraisal

Financial appraisal is an objective evaluation of the profitability and financial strengthof a business unit. Many a times, the terms financial performance appraisal and financialstatement analysis are used as synonymous. The techniques of financial statementanalysis are used for the purpose of financial appraisal.

2. Economic Appraisal

Economic appraisal is a type of decision method applied to a project, programmeor policy that takes into account a wide range of costs and benefits, denominated inmonetary terms or for which a monetary equivalent can be estimated. Economic appraisalis a methodology designed to assist in defining problems and finding solutions that offerthe best value for money (VFM). This is especially important in relation to publicexpenditure and is often used as a vehicle for planning and approval of public investmentrelating to policies, programmes and projects.

The principles of appraisal are applicable to all decisions, even those concerned withsmall expenditures. However, the scope of appraisal can also be very wide. Good economicappraisal leads to better decisions and VFM. It facilitates good project management andproject evaluation. Appraisal is an essential part of good financial management, and itis vital to decision-making and accountability.

3. Technical Appraisal

Technical appraisal is an in-depth study to ensure that a project is: (i) soundlydesigned, (ii) appropriately engineered and (iii) follows accepted standards. Theseconsiderations differ from project to project. But, in any case, the emphasis is on theinputs needed for the project and the resulting outputs of goods and services.

Put another way, such an appraisal determines whether the pre-requisites of asuccessful project have been covered and good choices have been made in regard to(i) location, (ii) plant capacity, (iii) raw materials requirements and (iv) other such factorsas availability of required professional, technicians and workers. In addition, project costsare estimated and subsequently manufacturing costs are worked out. Adverseenvironmental impact, if any, is also visualized and efforts are made to reduce it througha better project design incorporating treatment of effluents and noise abatement.

4. Management or Organizational Appraisal

Management or Organizational Appraisal is a process which can look at anorganization and appraise it in a given context. Some tools appraise an organisation inpreparation of an award, others look at the performance of an organisation in preparationfor a buy-out/buy-in, raising venture capital, etc. Management appraisal is related to thetechnical and managerial competence, integrity, knowledge of the project, managerialcompetence of the promoters, etc. The promoters should have the knowledge and abilityto plan, implement and operate the entire project effectively. The past record of thepromoters is to be appraised to clarify their ability in handling the projects.

5. Marketing Appraisal

Marketing appraisal is an estate agent’s recommendation on how we can achievethe best price for your property in a timescale that suits you. A valuation can only becarried out by a qualified surveyor and is an evidence-based opinion on how much yourproperty is worth.



Notes6. Commercial Appraisal

In the commercial appraisal many factors are coming. The scope of the project inmarket or the beneficiaries, customer-friendly process and preferences, future demand ofthe supply, effectiveness of the selling arrangement, latest information availability on allareas, government control measures, etc. The appraisal involves the assessment of thecurrent market scenario, which enables the project to get adequate demand. Estimation,distribution and advertisement scenario also to be considered here into.

3.16 Marketing of Bank Services

The ongoing process of economic reforms has completely changed the operationalenvironment for the whole banking industry in the country. Banks are now required to copewith stiff competition in business and also the complex regulatory norms regarding capitaladequacy and provisioning. Banks are forced to adopt various marketing techniques andapproaches. Thus, marketing has become imperative for all banks including those in thepublic sector. Marketing in banks can be stated as a new phenomenon that is shapingwell over the past one decade. Public sector bank hardly considered marketing as a toolfor business. The competition, deregulation that followed the reforms has changed theenvironment for banks, where marketing has occupied the place in the business of banks.Today, marketing in the banking industry is characterized by many innovations in productsand services, use of advanced technology in product design, upgradation of deliverysystem, advertising and sales promotion activities, whether in public sector or privatesector. Banks now have a firm that marketing strategies alone can brighten the futureof banking business. Marketing in banks has become synonymous with customer andbanks are found engaged in several activities of discovering, creating and satisfaction ofcustomer needs. Indian banking is at crossroads today. With the deregulation andliberalization process in full swing, the consequent policy changes introduced in the Indianfinancial system in general and banking in particular are effecting unprecedented changesin its functioning. With the emerging changes did spring up new challenges of commercialviability, cost-effectiveness, effective marketing strategy, etc. Market oriented policies alsogave birth to new players like foreign and private sector banks and subsidiaries offeringvaried high tech and cost-effective service. There was an absolute shift from sellers’ intobuyers’ market, establishing the ‘consumer’ as the key factor in the market. The dictum“as the bank exists because of its customers, has become more pronounced and relevantin the present context”. Thus, marketing constitutes the key strategy for banks to retaingood customers and also anticipate their future demands.

3.17 Importance of Bank Marketing

1. Awareness among CustomersModern technology has made customers aware of the developments in the economic

environment, which includes the financial system. Financial needs of the customers havegrown multifold into various forms like quick cash accessibility, money transfer, assetsecurity, increased return on surplus funds, financial advice, deferred payments, etc. Witha wide network of branches, even in a dissimilar banking scenario, customers expect thebanks to offer a more and better service to match their demands and this has compelledbanks to take up marketing in right earnest.

2. Quality as a Key FactorWith the opening up of the economy, fast change has been experienced in every

activity, and banking has been no exemption. Quality is the watchword in the competitive



Notes world, which is market driven and banks have had to face up to this emerging scenario.In fact, it may not be out of place to reiterate that quality in future will be the soledeterminant of successful banking ventures and marketing has to focus on this mostcrucial need of the hour.

3. Growing CompetitionIncreased competition is being faced by the Indian banking industry from within the

system with other agencies both, local and foreign, offering value added services.Competition is no more confined to resource mobilization but also to lending and otherareas of banking activity. The foreign commercial bank with their superior technology,speed in operations and imaginative positioning of their services has also provided thenecessary impetus to the Indian banks to innovate and compete in the marketplace.

4. Technological AdvancesTechnological innovation has resulted in financial product development especially in

the international and investment banking areas. The western experience has demonstratedthat technology has not only made execution of work faster but has also resulted in greateravailability of manpower for customer contact.

3.18 Marketing Approach in Banks

With the need for marketing in banks having evolved out of the changing environmentand constant interplay of various interdependent factors, the importance of a systematicapproach to marketing cannot be overstressed. The application of a marketing approachin banks will therefore involve:

(a) Identifying customers’ financial needs and wants;(b) Developing appropriate banking services to meet these needs;(c) Pricing for the services so developed;(d) Setting up suitable outsells/banks branches;(e) Advertising to promote the services to the existing as well as prospective

customers.

3.19 Features of Bank Marketing

Various features of Bank Marketing are:

1. Banking product cannot be seen or touched like manufactured products(intangibility).

2. In marketing banking products, the product and the seller are inseparable; theytogether define the banking product (inseparability).

3. Banking products are products and delivered at the same time; they cannotbe stored and inspected before delivering (perishability).

4. Standardization of banking product is difficult (variability).



Notes3.20 Prudential Norms

“Prudential norms” are the guidelines and general norms issued by the regulatingbank (the central bank) of the country for the proper and accountable functioning of bankand bank-like establishments.

In recent years, we have across the term ‘prudential norms’ too often particularlyin relation to the non-performing assets of the commercial banks. In the light of theexistence of huge non-performing asset in the balance sheets of the commercial banksleading to the erosion of their capital base, the relevance of these prudential has acquiredparticular significance.

The main elements of prudential norms are income recognition, asset classification,provisioning for loans and advances and capital adequacy. In keeping with latest practicesat the international levels, commercial banks are not supposed to recognize their incomesfrom non-performing assets on an accrual basis and these are to be booked only whenthese are actually received.

If the balance sheet of a bank is to reflect the factual and true financial state of affairsof the bank, it is pragmatic and desirable to have a system of recognition of income,classification of assets and provisioning for sticky debts on a prudential basis. Banks havebeen directed not to charge and take interest on non-performing assets to the incomeaccount and classify their assets under three broad categories of Standard Assets, Sub-standard Assets, Doubtful Assets and Loss Assets. Taking into account the time-lagbetween an account becoming doubtful of recovery, its recognition as such, the realizationof the security and the erosion over time in value of security charged to the banks, banksare required to make provision against sub-standard assets, doubtful assets and loss assets.

The prudential accounting norms which were put into place in 1992-93 have beenfurther strengthened over the years. In respect of accounts where there are potential threatsof recovery on account of erosion in the value of the security or absence of security andother factors such as fraud committed by the borrowers exist, such accounts are to beclassified as doubtful or loss assets irrespective of the period to which these remainedas non-performing. All the members’ banks in a consortium are required to classify theiradvances according to each bank's own record of recovery. Depreciation on securitiestransferred from the current category to the permanent category has to be immediatelyprovided for. Banks should value the specified government securities under ready forwardtransactions at market rates on the balance date.

3.21 Prudential Guidelines on Restructuring of Advances

(i) A restructured account is one where the bank grants concessions, which wouldnot otherwise consider, taking into account the borrower’s financial difficulty. Restructuringinvolves modification of terms of advance/securities, which would generally include, amongothers, alteration of repayment period/repayable amount/the amount of instalments/rateof interest, etc.

(ii) Specified Period means a period of one year from the date when the first paymentof interest or instalment of principal falls due under the terms of restructuring package.

The guidelines on restructuring issued by RBI are grouped in four categories as under:(i) Restructuring of advances extended to industrial units, (ii) Restructuring of advancesextended to industrial units under the Corporate Debt Restructuring (CDR) Mechanism,(iii) Restructuring of advances extended to Small and Medium Enterprises (SMEs) and(iv) Restructuring of all other advances.



Notes 3.22 Narasimham Committee Recommendations

During the decades of the 60s and the 70s, India nationalized most of its banks.This culminated with the balance of payments crisis of the Indian economy where Indiahad to airlift gold to International Monetary Fund (IMF) to loan money to meet its financialobligations. This event called into question the previous banking policies of India andtriggered the era of economic liberalization in India in 1991. Given that rigidities andweaknesses had made serious inroads into the Indian banking system by the late 1980s,the Government of India (GOI), post-crisis, took several steps to remodel the country’sfinancial system. The banking sector, handling 80% of the flow of money in the economy,needed serious reforms to make it internationally reputable, accelerate the pace of reformsand develop it into a constructive usher of an efficient, vibrant and competitive economyby adequately supporting the country’s financial needs. In the light of these requirements,two expert Committees were set up in 1990s under the chairmanship of M. Narasimham(an ex-RBI (Reserve Bank of India) governor) which are widely credited for spearheadingthe financial sector reform in India. The first Narasimham Committee (Committee on theFinancial System – CFS) was appointed by Manmohan Singh as India’s Finance Ministeron 14 August 1991 and the second one (Committee on Banking Sector Reforms) wasappointed by P. Chidambaram as Finance Minister in December 1997. Subsequently, thefirst one widely came to be known as the Narasimham Committee-I (1991) and the secondone as Narasimham-II Committee (1998). This article is about the recommendations ofthe Second Narasimham Committee, the Committee on Banking Sector Reforms.

The purpose of the Narasimham-I Committee was to study all aspects relating tothe structure, organization, functions and procedures of the financial systems and torecommend improvements in their efficiency and productivity. The Committee submittedits report to the Finance Minister in November 1991 which was tabled in Parliament on17 December 1991.

The Narasimham-II Committee was tasked with the progress review of theimplementation of the banking reforms since 1992 with the aim of further strengtheningthe financial institutions of India. It focused on issues like size of banks and capitaladequacy ratio among other things. M. Narasimham, Chairman, submitted the report ofthe Committee on Banking Sector Reforms (Committee-II) to the Finance MinisterYashwant Sinha in April 1998.

3.23 Recommendations of the Committee

The 1998 report of the Committee to the GOI made the following majorrecommendations:

Autonomy in Banking

Greater autonomy was proposed for the public sector banks in order for them tofunction with equivalent professionalism as their international counterparts. For this, thepanel recommended that recruitment procedures, training and remuneration policies ofpublic sector banks be brought in line with the best-market practices of professional bankmanagement. Secondly, the committee recommended GOI equity in nationalized banksbe reduced to 33% for increased autonomy. It also recommended the RBI relinquish itsseats on the Board of Directors of these banks. The committee further added that giventhat the government nominees to the board of banks are often members of parliament,politicians, bureaucrats, etc., they often interfere in the day-to-day operations of the bankin the form of the behest-lending. As such, the committee recommended a review of



Notesfunctions of bank’s boards with a view to make them responsible for enhancing shareholdervalue through formulation of corporate strategy and reduction of government equity.

To implement this, criteria for autonomous status was identified by March 1999(among other implementation measures) and 17 banks were considered eligible forautonomy. But some recommendations like reduction in Government’s equity to 33%, theissue of greater professionalism and independence of the Board of Directors of publicsector banks is still awaiting Government follow-through and implementation.

Reform in the Role of RBI

First, the committee recommended that the RBI withdraw from the 91-day treasurybills market and that inter-bank call money and term money markets be restricted to banksand primary dealers. Second, the Committee proposed a segregation of the roles of RBIas a regulator of banks and owner of bank. It observed that “The Reserve Bank as aregulator of the monetary system should not be the owner of a bank in view of a possibleconflict of interest”. As such, it highlighted that RBI’s role of effective supervision was notadequate and wanted it to divest its holdings in banks and financial institutions.

Pursuant to the recommendations, the RBI introduced a Liquidity Adjustment Facility(LAF) operated through repo and reverse repos in order to set a corridor for money marketinterest rates. To begin with, in April 1999, an Interim Liquidity Adjustment Facility (ILAF)was introduced pending further upgradation in technology and legal/procedural changesto facilitate electronic transfer. As for the second recommendation, the RBI decided totransfer its respective shareholdings of public banks like State Bank of India (SBI), NationalHousing Bank (NHB) and National Bank for Agriculture and Rural Development (NABARD)to GOI. Subsequently, in 2007-08, GOI decided to acquire entire stake of RBI in SBI,NHB and NABARD. Of these, the terms of sale for SBI were finalized in 2007-08themselves.

Stronger Banking System

The Committee recommended for merger of large Indian banks to make them strongenough for supporting international trade. It recommended a three tier banking structurein India through establishment of three large banks with international presence, eight toten national banks and a large number of regional and local banks. This proposal hadbeen severely criticized by the RBI employees’ union. The Committee recommended theuse of mergers to build the size and strength of operations for each bank. However, itcautioned that large banks should merge only with banks of equivalent size and not withweaker banks, which should be closed down if unable to revitalize themselves. Given thelarge percentage of non-performing assets for weaker banks, some as high as 20% oftheir total assets, the concept of “narrow banking” was proposed to assist in theirrehabilitation.

There were a string of mergers in banks of India during the late 90s and early 2000s,encouraged strongly by the Government of India in line with the Committee'srecommendations. However, the recommended degree of consolidation is still awaitingsufficient government impetus.

Non-performing Assets

Non-performing assets had been the single largest cause of irritation of the bankingsector of India. Earlier the Narasimham Committee-I had broadly concluded that the mainreason for the reduced profitability of the commercial banks in India was the priority sector



Notes lending. The committee had highlighted that ‘priority sector lending’ was leading to thebuildup of non-performing assets of the banks and thus it recommended it to be phasedout. Subsequently, the Narasimham Committee-II also highlighted the need for ‘zero’ non-performing assets for all Indian banks with International presence. The 1998 report furtherblamed poor credit decisions, behest-lending and cyclical economic factors among otherreasons for the buildup of the non-performing assets of these banks to uncomfortably highlevels. The Committee recommended creation of Asset Reconstruction Funds or AssetReconstruction Companies to take over the bad debts of banks, allowing them to starton a clean-slate. The option of recapitalization through budgetary provisions was ruledout. Overall the committee wanted a proper system to identify and classify NPAs, NPAsto be brought down to 3% by 2002 and for an independent loan review mechanism forimproved management of loan portfolios. The Committee’s recommendations let tointroduction of a new legislation which was subsequently implemented as theSecuritization and Reconstruction of Financial Assets and Enforcement of SecurityInterest Act, 2002 and came into force with effect from 21 June 2002.

Capital Adequacy and Tightening of Provisioning Norms

In order to improve the inherent strength of the Indian banking system, the committeerecommended that the Government should raise the prescribed capital adequacy norms.This would also improve their risk taking ability. The committee targeted raising the capitaladequacy ratio to 9% by 2000 and 10% by 2002 and has penal provisions for banks thatfail to meet these requirements. For asset classification, the Committee recommendeda mandatory 1% in case of standard assets and for the accrual of interest income to bedone every 90 days instead of 180 days.

To implement these recommendations, the RBI in October 1998, initiated the secondphase of financial sector reforms by raising the banks’ capital adequacy ratio by 1% andtightening the prudential norms for provisioning and asset classification in a phased manneron the lines of the Narasimham Committee-II report. The RBI targeted to bring the capitaladequacy ratio to 9% by March 2001. The Mid-term Review of the Monetary and CreditPolicy of RBI announced another series of reforms, in line with the recommendations withthe Committee, in October 1999.

Entry of Foreign Banks

The committee suggested that the foreign banks seeking to set up business in Indiashould have a minimum start-up capital of $25 million as against the existing requirementof $10 million. It said that foreign banks can be allowed to set up subsidiaries and jointventures that should be treated on a par with private banks.

Implementation of Recommendations

In 1998, RBI Governor Bimal Jalan informed the banks that the RBI had a three tofour year perspective on the implementation of the Committee’s recommendations. Basedon the other recommendations of the committee, the concept of a universal bank wasdiscussed by the RBI and finally ICICI Bank became the first universal bank of India. TheRBI published an “Actions Taken on the Recommendations” report on 31 October 2001on its own website. Most of the recommendations of the Committee have been acted upon(as discussed above) although some major recommendations are still awaiting action fromthe Government of India.



NotesCriticism

There were protests by employee unions of banks in India against the report. TheUnion of RBI employees made a strong protest against the Narasimham II Report. Therewere other plans by the United Forum of Bank Unions (UFBU), representing about1.3 million bank employees in India, to meet in Delhi and to work out a plan of actionin the wake of the Narasimham Committee report on banking reforms. The committee wasalso criticized in some quarters as “anti-poor”. According to some, the committees failedto recommend measures for faster alleviation of poverty in India by generating newemployment. This caused some suffering to small borrowers (both individuals andbusinesses in tiny, micro and small sectors).

3.24 Highlights of Narasimham Committee Recommendations onBanking Reforms in India

The main recommendations of Narasimham Committee (1991) on the Financial(Banking) System are as follows:

(i) Statutory Liquidity Ratio (SLR) is brought down in a phased manner to 25%(the minimum prescribed under the law) over a period of about five years to givebanks more funds to carry business and to curtail easy and captive finance.

(ii) The RBI should reduce Cash Reserve Ratio (CRR) from its present high level.(iii) Directed Credit Programme, i.e., credit allocation under government direction,

not by commercial judgement of banks under a free market competitive system,should be phased out. The priority sector should be scaled down from presenthigh level of 40% of aggregate credit to 10%. Also the priority sector shouldbe redefined.

(iv) Interest rates to be deregulated to reflect emerging market conditions.(v) Banks whose operations have been profitable is given permission to raise fresh

capital from the public through the capital market.(vi) Balance sheets of banks and financial institutions are made more transparent.(vii) Set up special tribunals to help banks recover their debt speedily.(viii) Changes be introduced in the bank structure 3-4 large banks with international

character, 8-10 national banks with branches throughout the country, localbanks confined to specific region of the country, rural banks confined to ruralareas.

(ix) Greater emphasis is laid on internal audit and internal inspection in the banks.(x) Government should indicate that there would be no further nationalization of

banks, the new banks in the private sector should be welcome subject to normalrequirements of the RBI, branch licensing should be abolished and policytowards foreign banks should be more liberal.

(xi) Quality of control over the banking system by the RBI and the Banking Divisionor the Ministry of Finance should be ended and the RBI should be made primaryagency for regulation of banking system.

(xii) A new financial institution called the Assets Reconstruction Fund (ARF). Shouldbe established which would take over from banks and financial institutions aportion of their bad and doubtful debts at a discount (based on realizable valueof assets), and subsequently follow up on the recovery of the dues owed tothem from the primary borrowers.



Notes Follow-up Action(i) Statutory Liquidity Ratio (SLR) on incremental Net Domestic and Time Liabilities

(NDTL) reduced from 38.5% in 1991-92 to 28% by December 1996.(ii) Effective Cash Reserve Ratio (CRR) on the NDTL reduced from 14% to 10%

in January 1997.(iii) In April 1992, the RBI introduced a risk assets ratio system for banks (including

foreign banks) in India as a capital adequacy measure. Under this, banks willhave to achieve a Capital to Risk Weighted Asset ratio (CRAR) of 8%. By March,1996 out of 27 public sector banks 19 banks (including SBI and all itssubsidiaries) have attained 8% CRAR norm. In case of foreign banks, all of themhave already attained these norms.

(iv) New prudential norms for income recognition, classification of assets andprovisioning of bad debts introduced in 1992.

(v) In regard to regulated interest ratio structure: (a) considerable rationalization hasbeen effected in banks lending rates with the number of concessive slabsreduced and some of the ratio have been raised thereby reducing the elementof subsidy; (b) regulated deposit late has been replaced by single prescriptionof not exceeding 13% (revised to 11%) per annum for all deposit maturities of46 days and above.

(vi) The SBI and some other nationalized banks have been allowed to seek capitalmarket access.

(vii) Less strong nationalized banks are being recapitalized by government throughbudget provisions of ` 15000 crore till 1994-95.

(viii) Existing private sector banks given signal for expansion, more private sectorbanks allowed to set up branches provided they confirms to the RBI guidelines.

(ix) Supervision system of the RBI is being strengthened with establishment of newboard for Financial Bank Supervision within the RBI.

(x) Banks given freedom to open new branches and upgrade extension counterson attaining capital adequacy norms and prudential accounting standards. Theyare permitted to close non-viable branches other than in rural areas.

(xi) Rapid computerization of banks being undertaken.(xii) Agreement signed between the public sector bank and RBI to improve their

managerial and quality of performance.(xiii) Recovery of debts due to banks and the Financial Institution Act 1993 recently

passed to facilitate quicker recovery of loans and arrears. Accordingly, sixspecial Debt Recovery Tribunals were set up along with an Appellate Tribunalat Mumbai to expedite the recovery of bank loan arrears.

(xiv) Under the Banking Ombudsmen Scheme 1995, eleven Ombudsmen alreadyfunctioning out of a total of 15 to expedite inexpensive resolution of customers’complaints.

(xv) Ten new private banks have started functioning out of the thirteen “in principle”approvals given for setting up new banks in private sector.

3.25 Performance Analysis of Banks

The performance of 27 PSBs is evaluated during the reform period 1992-93 and2002-03. The analysis is carried out by disaggregating 27 PSBs into 3 groups, namely,SBI (1), Associate Banks (7) and Nationalized Banks (19). The level of efficiency of banks



Noteshas been 106 studied in the context of branches and employees in terms of efficiencyindicators and profitability indicators. In a service industry like banking, it is not possibleto measure physical output in the absence of clear definition. However, most of themeasures that are used to study banks’ performance can be interpreted more correctlyas measuring the banks efficiency target rather than directly measuring their productivity.The level of efficiency of banks is commonly measured at the level of branches andemployees, which are the two important wheels on which banking industry moves.Considering the national priorities, involvement of banks in rural areas and developmentschemes and vast infrastructure developed in terms of branches and manpower resources,it is thought appropriate to assess the efficiency of banks in terms of the performanceat the level of branches and employees. Further, the size of banks varies widely; henceit is more meaningful to study the performance of parameters indicating efficiency at thelevel of branch and employee. In order to measure efficiency at the branch and employeeslevel, the following parameters are employed: (1) Business per Branch, (2) Operatingexpenses per Branch, (3) Profit per Branch, (4) Business per Employee, (5) Establishmentexpenses per Employee, and (6) Profit per Employee. The study, thus, measuresefficiency of a bank at the level of operational units, i.e., branch and employee, Theefficiency of each branch and employee in terms of averages of indicators can be comparedto assess the relative performance of different banks and bank groups.

Financial statements for banks present a different analytical problem than statementsfor manufacturing and service companies. As a result, analysis of a banks’ financialstatements requires a distinct approach that recognizes a banks’ unique risks.

Banks take deposits from savers and pay interest on some of these accounts. Theypass these funds on to borrowers and receive interest on the loans. Their profits are derivedfrom the spread between the rate they pay for funds and the rate they receive fromborrowers. This ability to pool deposits from many sources that can be lent to manydifferent borrowers creates the flow of funds inherent in the banking system. By managingthis flow of funds, banks generate profits, acting as the intermediary of interest paid andinterest received, and taking on the risks of offering credit.

Banking is a highly leveraged business requiring regulators to dictate minimal capitallevels to help ensure the solvency of each bank and the banking system. A bank's primaryregulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency,the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending onthe charter of the bank. Within the Federal Reserve Board, there are 12 districts with12 different regulatory staffing groups. These regulators focus on compliance with certainrequirements, restrictions and guidelines, aiming to uphold the soundness and integrityof the banking system.

As one of the most highly regulated banking industries in the world, investors havesome level of assurance in the soundness of the banking system. As a result, investorscan focus most of their efforts on how a bank will perform in different economicenvironments.

As financial intermediaries, banks assume two primary types of risk as they managethe flow of money through their business. Interest rate risk is the management of the spreadbetween interest paid on deposits and received on loans over time. Credit risk is thelikelihood that a borrower will default on a loan or lease, causing the bank to lose anypotential interest earned as well as the principal that was loaned to the borrower. Asinvestors, these are the primary elements that need to be understood when analyzing abanks’ financial statement.



Notes The primary business of a bank is managing the spread between deposits (liabilities,loans and assets). Basically, when the interest that a bank earns from loans is greaterthan the interest it must pay on deposits, it generates a positive interest spread or netinterest income. The size of this spread is a major determinant of the profit generatedby a bank. This interest rate risk is primarily determined by the shape of the yield curve.

As a result, net interest income will vary, due to differences in the timing of accrualchanges and changing rate and yield curve relationships. Changes in the general levelof market interest rates also may cause changes in the volume and mix of a banks’ balancesheet products. For example, when economic activity continues to expand while interestrates are rising, commercial loan demand may increase while residential mortgage loangrowth and prepayments slow.

Banks, in the normal course of business, assume financial risk by making loansat interest rates that differ from rates paid on deposits. Deposits often have shortermaturities than loans and adjust to current market rates faster than loans. The result isa balance sheet mismatch between assets (loans) and liabilities (deposits). An upwardsloping yield curve is favorable to a bank as the bulk of its deposits are short-term andtheir loans are longer term. This mismatch of maturities generates the net interest revenuebanks enjoy.

3.26 Regulatory Institutions in India


The following are five major financial regulatory bodies in India: (We have given linksfor these bodies. For more details about these, you can click and visit such websites).

(A) Statutory Bodies via Parliamentary Enactments

(i) Reserve Bank of IndiaReserve Bank of India is the apex monetary Institution of India. It is also called as

the central bank of the country.

The Reserve Bank of India was established on April 1, 1935 in accordance with theprovisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bankwas initially established in Calcutta but was permanently moved to Mumbai in 1937. TheCentral Office is where the Governor sits and where policies are formulated. Thoughoriginally privately owned, since nationalization in 1949, the Reserve Bank is fully ownedby the Government of India.

It acts as the apex monetary authority of the country. The Central Office is wherethe Governor sits and is where policies are formulated. Though originally privately owned,since nationalization in 1949, the Reserve Bank is fully owned by the Government of India.The preamble of the Reserve Bank of India is as follows:

“...to regulate the issue of Bank Notes and keeping of reserves with a view to securingmonetary stability in India and generally to operate the currency and credit system ofthe country to its advantage.”



Notes(ii) Securities and Exchange Board of IndiaSEBI Act, 1992: Securities and Exchange Board of India (SEBI) was first established

in the year 1988 as a non-statutory body for regulating the securities market. It becamean autonomous body in 1992 and more powers were given through an ordinance. Sincethen, it regulates the market through its independent powers.

(iii) Insurance Regulatory and Development AuthorityThe Insurance Regulatory and Development Authority (IRDA) is a national agency

of the Government of India and are based in Hyderabad (Andhra Pradesh). It was formedby an Act of Indian Parliament known as IRDA Act 1999, which was amended in 2002to incorporate some emerging requirements. Mission of IRDA as stated in the act is “toprotect the interests of the policyholders, to regulate, promote and ensure orderly growthof the insurance industry and for matters connected therewith or incidental thereto.”

(B) Part of the Ministries of the Government of India

(iv) Forward Market Commission India (FMC)Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory

authority which is overseen by the Ministry of Consumer Affairs, Food and PublicDistribution, Government of India. It is a statutory body set up in 1953 under the ForwardContracts (Regulation) Act, 1952 This Commission allows commodity trading in22 exchanges in India, out of which three are national level.

(v) PFRDA under the Finance MinistryPension Fund Regulatory and Development Authority: PFRDA was established by

Government of India on 23rd August, 2003. The Government has, through an executiveorder dated 10th October 2003, mandated PFRDA to act as a regulator for the pensionsector. The mandate of PFRDA is development and regulation of pension sector in India.

3.27 Reserve Bank of India

(Details explained in the Module II)

3.28 Credit Control

Credit Control is an important tool used by Reserve Bank of India, a major weaponof the monetary policy used to control the demand and supply of money (liquidity) in theeconomy. Central Bank administers control over the credit that the commercial banksgrant. Such a method is used by RBI to bring “Economic Development with Stability”.It means that banks will not only control inflationary trends in the economy but also boosteconomic growth which would ultimately lead to increase in real national income withstability.

3.29 Meaning of Credit Control

Credit control refers to the process of monitoring and collecting the money owedto a business. This includes those measures and procedures adopted by a firm to ensurethat its credit customers pay their accounts.



Notes 3.30 Objectives of Credit Control

Controlling credit in the Economy is amongst the most important functions of theReserve Bank of India. The basic and important objectives of Credit Control in the economyare:

(i) To encourage the overall growth of the “priority sector”, i.e. those sectors ofthe economy which is recognized by the government as “prioritized” dependingupon their economic condition or government interest. These sectors broadlytotals to around 15 in number.

(ii) To keep a check over the channelization of credit so that credit is not deliveredfor undesirable purposes.

(iii) To achieve the objective of controlling “Inflation” as well as “Deflation”.(iv) To boost the economy by facilitating the flow of adequate volume of bank credit

to different sectors.(v) To develop the economy.

3.31 Need for Credit Control

Credit control policy is just an arm of Economic Policy which comes under the purviewof Reserve Bank of India, hence, its main objective being attainment of high growth ratewhile maintaining reasonable stability of the internal purchasing power of money. The basicand important need for Credit Control in the economy is:

(i) Ensure an adequate level of liquidity enough to attain high economic growthrate along with maximum utilization of resource but without generating highinflationary pressure.

(ii) Attain stability in exchange rate and money market of the country.(iii) Meeting the financial requirement during slump in the economy and in the normal

times as well.(iv) Control business cycle and meet business needs.

3.32 Methods of Credit Control

There are two methods that the RBI uses to control the money supply in the economy:

A. Quantitative Methods

1. Bank Rate PolicyAccording to the Reserve Bank of India Act, the Bank Rate is defined as “the standard

rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercialpapers eligible for purchase under the provisions of the Act”.

Thus, the bank rate is the rate of interest at which RBI rediscounts the first-classbills in the hands of commercial banks to provide them with liquidity in case of need.However, presently, RBI does not accept any bills for rediscounting. This function is beingdone by separate financial institutions like DHFI created for similar purposes.

Bank Rate: Whenever the RBI provides refinance or other financial assistance toCommercial Banks, the rate of interest on such assistance is determined with referenceto Bank Rate. The RBI also charges interest with reference to Bank Rate on ‘ways andmeans’ advances to governments.



NotesFor a long period up to 1990-91, the rate remained unchanged at 10%. Later, fromOctober 1991 to April 1997, the rate remained at 12.00%. During 1997-98, the rate wasreactivated to serve as a reference rate for Commercial Banks’ lending rates.

When Reserve Bank wants a reduction in general lending rates of Commercial Banks,it will signify its intention by reducing Bank Rate and vice versa. The Bank Rate waschanged five times during 1997-98. The Bank Rate which was 8% in November 1999 waschanged to 7.00% in April 2001.

It was brought down to 6.50% in October 2001, 6.25% in October 2002 and 6.00%in April 2003. The rate frequently changes these days depending upon immediate monetarypolicy objectives. Of late, the Reserve Bank makes changes in Bank Rate often dependingupon liquidity position of banks, short-term interest level, and inflation of the situation.Ever since, Exchange Rate of rupee was allowed to be determined by market forces inMarch 1993. Bank Rate has been changed a little more often.

The bank rate policy as an instrument of monetary control was not successful inIndia for a long time. The main factors responsible for this are:

(i) Inherent inflexibility involved in the use of this instrument.(ii) The dominance of the public sector whose investment requirements are cost

inelastic.(iii) The higher rate of inflation experienced in the economy.(iv) Restricted availability of refinance facilities to banks.(v) As the government expenditure increase, the tax burden also increases. Under

heavy taxation, the businessmen feel that the interest rate is a minor factor.And the decrease in the importance of interest rate has led to the decline inthe importance of bank rate.

2. Open Market OperationsOpen market operations are conducted by the RBI mainly with a view to manage

short- term liquidity in the market. These operations directly or indirectly affect the reservesof the commercial banks and thereby the extent of credit creation is controlled. Section17(8) of the Reserve Bank of India Act confers legal powers on the Reserve Bank to usethis instrument of monetary policy. Under this section, the Reserve Bank is authorizedto purchase and sell the securities of the Central or State Government of any maturityand the security of a local authority specified by the central government on therecommendation of the banks’ central board.

However, at present, the Reserve Bank deals only in the securities issued by thecentral government and not in those of State Governments and local authorities. It maybe noted that in terms of Section 33 of the Reserve Bank of India Act, securities issuedby the State Governments or local bodies are not eligible to be used as reserve assetsagainst note issue.

The Government securities market in India is narrow and is dominated by financialinstitutions especially by commercial banks. The Reserve Bank of India occupies a pivotalposition in the market. It is continuously in the market, selling government securities ofdifferent maturities on tap; it stands ready to buy them in switch operations. The ReserveBank of India does not ordinarily purchase securities against cash. There are no dealersin the market who are engaged in continuous sale and purchase of securities on theirown account. Incidentally, it may be noted that the Reserve Bank affects purchases andsales from time to time out of the surplus funds of IDBI, EXIM Bank, and NABARD underspecial arrangement.



Notes The market, however, is served by stock brokers who act as intermediaries betweenprospective buyers and sellers of government securities. The Reserve Bank also enliststhe services of brokers, if necessary.

The role of open market operation as an instrument of credit control will assumeimportance in the restructured monetary system. With the interest rate offered ongovernment securities becoming truly competitive, a broad enough securities market mayemerge for the Reserve Bank to use open market operations as an instrument of creditcontrol.

It will sell the securities in open market to drain out excess liquidity from the financialsystem and thereby contraction of credit. When it buys securities, it injects additionalfunds into the market and consequently credit expansion may take place. “Repos” and“Reverse Repos” transactions may be considered a supplementary operation to thissystem.

3. Variation of Cash Reserve RatioUnder this requirement, certain percentage of deposit liabilities of banks is impounded

in cash form with RBI and/or to be maintained in liquid assets like government securities.The reserve requirements were originally evolved as a means for safeguarding the interestsof depositors.

Later, it was developed as an instrument of credit control. The variation in the reserverequirements has the effect of increasing or decreasing the funds available with commercialbanks for lending. In India, the reserve requirements are of two types. They are:

(a) Cash Reserve Ratio, and(b) Statutory Liquidity Ratio.

(a) Cash Reserve RatioUnder the provisions of the RBI Act, the scheduled banks were required to maintain

a minimum amount of cash reserve with the Reserve Bank. The reserve is made out ofdemand and time liabilities at certain percentage fixed by the RBI.

The Cash Reserve Ratio is required to be maintained in cash with RBI, in additionto the percentage to be maintained under the Statutory Liquidity Ratio. The Cash ReserveRatio cannot exceed 15% of the net demand and time liabilities.

The Cash Reserve Ratio at the time of notification of banks was 3% which havingbeen revised a number of times. The flat rate of 15% was introduced in the credit policyfor the first half of 1989-90.

It was observed that the credit control instruments in the hands of RBI have beenused to maintain the economic growth with controlled inflation and as a sharp knife tocurb inflation. RBI has used these flexibilities to ensure that institutional finances forproductive purposes are not lacking.

The CRR is being gradually reduced after initiating banking sector reforms from1994- 95. The rate was 10.5% as on April 1999. It stands reduced to 10.0% from May1999 and from November 1999 it stands further reduced to 9.0%.

Ever since financial sector reforms and market determined exchange for Rupee, theRBI uses this instrument to influence liquidity in money market and thereby exchangerate fluctuations.

In the recent past, when the exchange rate of rupee came under attack from bankspeculators, it increased the CRR thereby impounding excess liquidity in the market. This



Notespolicy helped RBI to maintain stable rate in short-term. The CRR was drastically reducedduring 2001, to 4.75% in November 2002. It stands at 4.50% from June 14, 2003.

(b) Statutory Liquidity RatioUnder Section 24 of the Banking Regulation Act 1949, RBI is empowered to stipulate

the liquid assets every banking company is required to hold against their demand andtime liabilities in addition to cash reserve requirement.

Accordingly, the banks both scheduled and non-scheduled have to maintain liquidassets in cash, gold or unencumbered approved securities amounting to not less than25% of their net demand and time liabilities in India.

This requirement of 25% can be increased by the RBI from time to time by anotification in the Official Gazette. But the ratio so prescribed cannot exceed 40% (Inthe first half of 1986-87, the ratio was 37%), however Regional Rural Banks, Non-scheduledBanks and Cooperative Banks are allowed to maintain Statutory Liquidity Ratio at 25%only. Further, all banks are required to maintain this reserve only at 25% in respect ofNRE accounts.

The prescribed SLR on Commercial Banks in November 1999 stands at 25% of netdemand and time liabilities (NDTL) of each bank. The NDTL is worked out twice in a monthon reporting Fridays. The value of SLR securities for Balance Sheet purposes is determinednot with reference to cost of their acquisition but with reference to their market quotations.

Banks are required to submit position in regard to SLR to the Reserve Bank as onalernate Fridays every month, before the 20th of succeeding month. But the Reserve Bankcan call for daily position in such form as it may prescribe.

The main objects of SLR are:(a) To assure solvency of commercial banks by compelling them to hold low risk

assets up to the stipulated extent,(b) To create or support a market for government securities in the economy which

do not have a developed capital market and(c) To allocate resources to government for augmenting the resources of the Public

Sector.

Banks like Regional Rural Banks may hold entire SLR requirements in the form ofcash with the sponsor banks.

Effects of Statutory Liquidity Ratio

The main purpose of prescribing SLR is to ensure the liquidity position of banks inmeeting the withdrawal requirements of depositors. Since these funds are mostly investedin Government Securities, they are considered to be highly liquid and also no risk of lossof value, i.e., they can be encased at quick notice or immediately.

One of the effects of SLR is to raise or lower the liquidity requirements of banksthus affecting their capacity to lend. In order to discourage the banks from contraveningthe liquidity provisions, the RBI may not allow the defaulting banks access to furtherrefinance and may charge additional interest on their borrowings from it.

It is to be noted that stepping up SLR and CRR have the same effects, viz., theyreduce the capacity of commercial banks to expand credit to business and industry andthey are anti-inflationary.



Notes 4. Fixation of Lending Rates of Commercial Banks

The RBI controls the credit created by the commercial banks by fixing the lendingrates of the banks. When the lending rates are fixed at higher level, the credit becomescostlier and it may lead to contraction of credit. Similarly when the rates are lowered,it may result into expansion of credit.

Besides controlling the rates of interest on the advances made by the banks, theRBI places certain restrictions on the grant of advances against term deposits. These relateto the quantum of advance that can be granted and the rate of interest to be charged.

As such, banks usually grant only up to 75% of deposit value by way of advance.However, after introduction of banking sector reforms in October, 1994, RBI has allowedthe banks to fix their own lending rates. The Reserve Bank no longer decides the lendingrates of Commercial Banks from 1996.

Each bank is however, required to fix a minimum lending rate known as Prime LendingRate (PLR). All loans and advances of each bank is a mark-up over PLR, i.e., the bankwill charge PLR plus 1% to 3% depending upon the customer risk and security offeredfor loan.

The banks are also given freedom in October, 1997 to fix their own rates on depositsaccepted by them. This, is however not applicable to savings bank accounts.

5. Credit Squeeze

When the bank rate policy has not been successful in controlling the expansion ofcredit, the method of credit squeeze is useful. Under this method, the maximum amountof bank credit is fixed at a certain limit. And, the maximum limit for commercial banksborrowing from the RBI is also fixed.

The banks are not allowed to expand the credit beyond these limits. These limitsmay be fixed in general for all credits or may be sector-specific like for steel industry,textile industry, etc.

But it should be noted that a general credit squeeze may make the trade and industrysuffer even for legitimate purposes. Reserve Bank rarely applies credit squeeze these days.

B. Qualitative Credit Control

The selective or qualitative credit control is intended to ensure an adequate creditflow to the desired sectors and preventing excessive credit for less essential economicactivities. The RBI issues directives under Section 21 of the Banking Regulation Act 1949,to regulate the flow of banks’ credit against the security of selected commodities.

It is usually applied to control the credit provided by the banks against certainessential commodities which may otherwise lead to traders using the credit facilities forhoarding and black marketing and thereby permitting spiraling prices of thesecommodities. The selective credit control measures by RBI are resorted to commoditieslike, wheat, sugar, oilseeds, etc.

3.33 RBI Publications1. Annual: Annual Report, Report on Trends and Progress of Banking in India,

Report on Currency and Finance, Report on State Finances.2. Quarterly: Occasional Papers (based on research), Banking Statistics.



Notes3. Monthly: RBI Bulletin, Credit Information Review.4. Weekly: Statistical Supplement.5. Press Releases: Issued every day to convey policy decisions.6. Website: updated daily with all publications, press releases, speeches of

Governor/Deputy Governors.7. Address: www.rbi.org.in

3.34 Securities and Exchange Board of India

The Securities and Exchange Board of India (frequently abbreviated SEBI) is theregulator for the securities market in India. It was established on 12 April 1992 throughthe SEBI Act, 1992.

It was formed officially by the Government of India in 1992 with SEBI Act 1992 beingpassed by the Indian Parliament. SEBI is headquartered in the business district of BandraKurla Complex in Mumbai, and has Northern, Eastern, Southern and Western regionaloffices in New Delhi, Kolkata, Chennai and Ahmedabad.

Controller of Capital Issues was the regulatory authority before SEBI came intoexistence; it derived authority from the Capital Issues (Control) Act, 1947.

Initially, SEBI was a non-statutory body without any statutory power. However, in1995, the SEBI was given additional statutory power by the Government of India throughan amendment to the Securities and Exchange Board of India Act 1992. In April 1998,the SEBI was constituted as the regulator of capital markets in India under a resolutionof the Government of India.

The SEBI is managed by its members, which consists of following: (a) The chairmanwho is nominated by central government; (b) Two members, i.e., officers of central ministry;(c) One member from the RBI and (d) The remaining five members are nominated by thecentral government, out of whom at least three shall be whole-time members.

The office of SEBI is situated at SEBI Bhavan, Bandra Kurla Complex, Bandra East,Mumbai - 400051, with its regional offices at Kolkata, Delhi, Chennai and Ahmedabad.It has recently opened local offices at Jaipur and Bangalore and is planning to open officesat Guwahati, Bhubaneshwar, Patna, Kochi and Chandigarh.

3.35 Organization of SEBI

The affairs of SEBI shall be managed by a Board. The Board shall consist of thefollowing members:

1. A Chairman.2. Two officials of the Central Government from the Ministry of Finance and Ministry

of Law, Justice and Company Affairs.3. One official nominated by the Reserve Bank of India.4. Two other members nominated by the Central Government.

The Chairman and the members should be persons of ability, integrity and standingwho have shown capacity in dealing with problems of the securities market. They arerequired to have good knowledge or experience in the areas of finance, law, economics,accountancy, administration, etc.



Notes 3.36 Management of the Board1. The general superintendence, direction and management of the affairs of the

Board shall vest in Board of members, which may exercise all powers and doall acts and things which may be exercised or done by the Board.

2. Save as otherwise determined by regulations, the Chairman shall also havepowers of general superintendence and direction of the affairs of the Board andmay also exercise all powers and do all acts and things which may be exercisedor done by that Board.

3. The Chairman and members referred to in clauses (a) and (d) of sub-section (1)shall be appointed by the Central Government and the members referred to inclauses (b) and (c) of that sub-section shall be nominated by the CentralGovernment and the respectively.

4. The Chairman and the other members referred to in clauses (a) and (d) of sub-section (1) shall be persons of ability, integrity and standing who have showncapacity in dealing with problems relating to securities market or have specialknowledge or experience of law, finance, economics, accountancy, administrationor in any other discipline which, in the opinion of the Central Government, shallbe useful to the Board.

5. The term of office and other conditions of service of the Chairman and themembers referred to in clause (d) of sub-section (1) of section 4 shall be suchas may be prescribed.

6. Secondary Market Advisory Committee (SMAC).7. Mutual Fund Advisory Committee.8. Corporate Bonds and Securitization Advisory Committee.9. Takeover Panel.

10. SEBI Committee on Disclosures and Accounting Standards (SCODA).11. High Powered Advisory Committee on consent orders and compounding of

offences.12. Derivatives Market Review Committee.13. Committee on Infrastructure Funds.14. Regulation over Financial Terms of Various Authorities.15. Technical Advisory Committee.16. Committee for review of structure of market infrastructure institutions.17. Members of the Advisory Committee for the SEBI Investor Protection and

Education Fund.18. Takeover Regulations Advisory Committee.19. Primary Market Advisory Committee (PMAC).

3.37 Objectives of SEBI

The various objectives of SEBI are given below:

1. To protect the interests of investors through proper education and guidance asregards their investment in securities. For this, SEBI has made rules andregulations to be followed by the financial intermediaries such as brokers, etc.SEBI looks after the complaints received from investors for fair settlement. Italso issues booklets for the guidance and protection of small investors.



Notes2. To regulate and control the business on stock exchanges and other securitymarkets. For this, SEBI keeps supervision on brokers. Registration of brokersand sub-brokers is made compulsory and they are expected to follow certainrules and regulations. Effective control is also maintained by SEBI on theworking of stock exchanges.

3. To make registration and to regulate the functioning of intermediaries such asstock brokers, sub-brokers, share transfer agents, merchant bankers and otherintermediaries operating on the securities market.

4. To provide suitable training to intermediaries. This function is useful for healthyatmosphere on the stock exchange and for the protection of small investors.

5. To register and regulate the working of mutual funds including UTI (Unit Trustof India). SEBI has made rules and regulations to be followed by mutual funds.The purpose is to maintain effective supervision on their operations and avoidtheir unfair and anti-investor activities.

6. To promote self-regulatory organization of intermediaries. SEBI is given widestatutory powers. However, self-regulation is better than external regulation.Here, the function of SEBI is to encourage intermediaries to form theirprofessional associations and control undesirable activities of their members.SEBI can also use its powers when required for protection of small investors.

7. To regulate mergers, takeovers and acquisitions of companies in order to protectthe interest of investors. For this, SEBI has issued suitable guidelines so thatsuch mergers and takeovers will not be at the cost of small investors.

8. To prohibit fraudulent and unfair practices of intermediaries operating onsecurities markets. SEBI is not for interfering in the normal working of theseintermediaries. Its function is to regulate and control their objectionable practiceswhich may harm the investors and healthy growth of capital market.

9. To issue guidelines to companies regarding capital issues. Separate guidelinesare prepared for first public issue of new companies, for public issue by existinglisted companies and for first public issue by existing private companies. SEBIis expected to conduct research and publish information useful to all marketplayers.

10. To conduct inspection, inquiries and audits of stock exchanges, intermediariesand self-regulating organizations and to take suitable remedial measureswherever necessary. This function is undertaken for orderly working of stockexchanges and intermediaries.

11. To restrict insider trading activity through suitable measures. This function isuseful for avoiding undesirable activities of brokers and securities scams.

3.38 Functions of SEBI

According to SEBI Act, 1992, the main functions of SEBI are:

1. Regulating the securities market.2. Recognition and regulation of the Stock Exchanges.3. Registering and regulating the working of various intermediaries including

Merchant Bankers, Registrars, Share Transfer Agents, Stock-brokers, Sub-brokers, Debenture Trustees, Bankers to the Issue, Underwriters, PortfolioManagers, etc.

4. Registering and regulating the functioning of Depositories, Custodians andDepository Participants.



Notes 5. Registration of Foreign Institutional Investors.6. Registering and regulating the working of Venture Capital Funds, Mutual Funds

and other collective investment schemes including plantation schemes.7. Promotion and regulation of Self-regulatory Organizations.8. Prohibiting fraudulent and unfair trade practices relating to securities market.9. Prohibiting insider trading in securities.

10. Regulating substantial acquisition of shares and takeover of companies.11. Promoting investor education and training of intermediaries.12. Conducting research relating to securities market.

3.39 Powers of Securities and Exchange Board of India

The important powers of Securities and Exchange Board of India are as follows:

1. Power relating to stock exchanges and intermediariesSEBI has wide powers regarding the stock exchanges and intermediaries dealing

in securities. It can ask information from the stock exchanges and intermediaries regardingtheir business transactions for inspection or scrutiny and other purpose.

2. Power to impose monetary penaltiesSEBI has been empowered to impose monetary penalties on capital market

intermediaries and other participants for a range of violations. It can even imposesuspension of their registration for a short period.

3. Power to initiate actions in functions assignedSEBI has a power to initiate actions in regard to functions assigned. For example,

it can issue guidelines to different intermediaries or can introduce specific rules for theprotection of interests of investors.

4. Power to regulate insider tradingSEBI has power to regulate insider trading or can regulate the functions of merchant

bankers.

5. Powers under securities contracts actFor effective regulation of stock exchange, the Ministry of Finance issued a

Notification on 13 September, 1994 delegating several of its powers under the SecuritiesContracts (Regulations) Act to SEBI.

SEBI is also empowered by the Finance Ministry to nominate three members onthe Governing Body of every stock exchange.

6. Power to regulate business of stock exchangesSEBI is also empowered to regulate the business of stock exchanges, intermediaries

associated with the securities market as well as mutual funds, fraudulent and unfair tradepractices relating to securities and regulation of acquisition of shares and takeovers ofcompanies.

3.40 Lender’s Liability Act

There is a large volume of reported appellate cases on lender liability and most courtsare eager to decide each case after examining its unique facts. Lenders need tounderstand, before taking action at any stage in the loan relationship, how to avoid legalissues that can lead to costly litigation.



NotesA common theory in lender liability actions is breach of contract, and the first contractthat is considered in the borrower-lender relationship is the loan commitment. This is themost litigated loan contract, whether the initial contract to make the loan or a commitmentto extend or recast the loan as a result of borrower difficulties.

Although the lender has the right to refuse to make a loan, the lender must complywith the laws governing the loan application process. For example, the lender cannotdiscriminate against the borrower on the basis of race, religion, national origin, sex, maritalstatus, or age. The lender also has a duty to process a loan application with reasonablecare. The negligent calculation of the applicant's qualifications under standard industrycriteria may give rise to a cause of action against the lender for failure to use due care.

Processing the application is one thing; protecting the borrower from an improvidentdeal is quite another. In the commercial loan setting, the lender is generally not requiredto protect the inexperienced borrower from a bad business decision. A greater duty mustbe established for the lender to be held liable.

Once the borrower and the lender agree on the terms of a loan, a contract, usuallya conditional contract, is formed. If a party breaches that contract, the usual contractremedies apply. Lender liability is found when the lender breaches its promise to extendfinancing. Similarly, the lender is liable for breach of its promise to forbear from the exerciseof remedies otherwise available to it under the loan documents or failing to honor previouslyagreed-upon loan modification terms.

For example, in one case, a lump sum payment was due under a note. The borrowerhad financial difficulties and agreed with the loan officer to convert the obligation to aninstallment loan.

When the loan officer went out of town, the loan officer’s superior refused to convert thenote, accelerated its due date, and exercised the lender-bank’s offset rights against the otheraccounts of the borrower. The court held the lender liable for the borrower's damages.

This does not mean that the lender as a matter of course is obligated to extendthe loan opening date. Rather, the lender is entitled to demand strict compliance withthe terms of the commitment and upon the borrower’s breach, retain the commitment fee.The lender will not be liable for breach of the covenant of good faith and fair dealing whenthe loan commitment clearly states that the borrower was not entitled to a refund underany circumstances and there was no contractual obligation on the lender to grant anextension of time to perform. Further, the borrower must comply with the requirementsof the loan commitment, notwithstanding alleged oral statements by an officer of the lenderamending commitment requirements.

Although the lender may be liable for damages incurred by the borrower as a resultof the lender’s breach of the loan commitment, punitive damages are generally notrecoverable.

Damages for breach of contract are limited to those necessary to compensate theborrower for the lender’s breach, that is, the excess interest required to be paid onreplacement financing. The old rule that the borrower could not specifically enforce theloan commitment is falling into disfavor and borrowers are being granted the right to doso. The opposite is not true, however; the courts generally do not allow the lender to enforcea long-term commitment against the borrower.

Law of Lender Liability provides a comprehensive explanation of the major legal issuesthat arise between lenders and borrowers at the various stages of the loan relationship.It also provides practical guidance for developing and implementing protective measuresat every stage of the life of the loan.



Notes This manual covers:

(i) Developments regarding federal pre-emption of state banking laws.(ii) Federal agency warnings, guidance and advisories to financial institutions

concerning new types of financial products.(iii) Cases exploring the outer reaches of guarantor liability.(iv) Punitive damages decisions in the appellate courts.(v) Challenges to arbitration clauses.(vi) Court responses to lawsuits alleging breach of the lender’s fiduciary duties.(vii) Statutes and cases breaking new ground on privacy rights.

3.41 Banking Innovations

Innovation derives organization to grow, prosper and transform in sync with thechanges in the environment, both internal and external. Banking is no exception to this.In fact, this sector has witnessed radical transformation of late, based on many innovationsin products, processes, services, systems, business models, technology, governance andregulation. A liberalized and globalized financial infrastructure had provided an additionalimpetus to this gigantic effort. The pervasive influence of information technology hasrevolutionaries banking. Transaction costs have crumbled and handling of astronomicalbrick and mortar structure has been rapidly yielding ground to click and order electronicbanking with a plethora of new products. Banking has become boundaryless and virtualwith a 24 × 7 model. Banks who strongly rely on the merits of relationship was bankingas a time-tested way of targeting and servicing clients have readily embraced CustomerRelationship Management (CRM), with sharp focus on customer centricity, facilitated bythe availability of superior technology. CRM has, therefore, has become a new mantrain service management, which in both relationship based and information intensive. Thanksto the regulatory changes and financial innovation, large banks have now become complexorganizations engaged in wide range of activities. Banking is now a one-stop provider witha high degree of competition and competence. Banking has become a part of financialservices. Risk Management is no longer a mere regulatory issue. Basel-II has accordeda primacy of place to this fascinating exercise by repositioning it as the core banking.We now see the evolution of many novel deferral products like credit risk managementtool that enhances liquidity and market efficiency. The retail revolution with accent on retailloans in the form of housing loans and consumer loans literally dominating the bankingglobally is yet another example of product and service innovation. Various types of creditand debit cards and indeed e-cash itself, which has the potential to redefine the role ofmonetary authorities, are some more illustrious examples.

Over the years, the banking sector in India has seen a number of changes. Mostof the banks have begun to take an innovative approach towards banking with the objectiveof creating more value for customers, and consequently, the banks. Some of the significantchanges in the Indian banking sector are discussed below:

With a majority of the Indian population living in rural areas, rural banking forms avital component of the Indian banking system. Besides, rural banking operations in Indiaare rather different from urban operations, due to the strong disparity that exists betweenurban and rural life, and the needs of these two sections of people.

While traditionally, banking meant ‘borrowing and lending’, in the latter part of the20th century, the word took on a different meaning altogether. Banks no longer restrictedthemselves to traditional banking activities, but explored newer avenues to increasebusiness and capture new markets.



NotesMany analysts predict still more revolutionary changes in the banking sector in India.The chief of these are likely to be the concept of Universal Banks and the introductionof Smart Card technology.

Although the Indian banking sector has made rapid progress particularly in thenumber of innovations introduced, some analysts are skeptical about the efficacy andpractical use of many of these services.

Banking in India has already undergone a huge transformation in the years sinceIndependence. The rate of transformation was particularly high in the 1990s and 2000s,when a number of innovations changed the way banking was perceived.

Information technology is one of the most important facilitators for the transformationof the Indian banking industry in terms of its transactions processing as well as for variousother internal systems and processes. The various technological platforms used by banksfor the conduct of their day-to-day operations, their manner of reporting and the way inwhich inter-bank transactions and clearing is affected has evolved substantially over theyears.

A combination of regulatory and competitive reasons has led to increasing importanceof total banking automation in the Indian Banking Industry. Information technology enablessophisticated product development, better market infrastructure, implementation of reliabletechniques for control of risks and helps the financial intermediaries to reach geographicallydistant and diversified markets. In view of this, technology has changed the contours ofthree major functions performed by banks, i.e., access to liquidity, transformation of assetsand monitoring of risks. Information technology and the communication networkingsystems have a crucial bearing on the efficiency of money, capital and foreign exchangemarkets.

New Technology in Banking

The technological evolution of the Indian banking industry has been largely directedby the various committees set up by the RBI and the Government of India to review theimplementation of technological change. No major breakthrough in technology implementationwas achieved by the industry till the early 80s, though some working groups andcommittees made stray references to the need for mechanization of some bankingprocesses. This was largely due to the stiff resistance by the very strong bank employeesunions. The early 1980s were instrumental in the introduction of mechanization andcomputerization in Indian banks. This was the period when banks as well as the RBI wentvery slow on mechanization, carefully avoiding the use of ‘computers’ to avoid resistancefrom employee unions. However, this was the critical period acting as the icebreaker, whichled to the slow and steady move towards large-scale technology adoption.

The process of computerization marked the beginning of all technological initiativesin the banking industry. Computerization of bank branches had started with installationof simple computers to automate the functioning of branches, especially at high trafficbranches. Total Branch Automation was in use which did not involve bank level branchnetworking and did not mean much to the customer.

Networking of branches are now undertaken to ensure better customer service. CoreBanking Solutions (CBS) is the networking of the branches of a bank, so as to enablethe customers to operate their accounts from any bank branch, regardless of which branchhe opened the account with. The networking of branches under CBS enables centralizeddata management and aids in the implementation of internet and mobile banking. Besides,CBS helps in bringing the complete operations of banks under a single technologicalplatform.



Notes CBS implementation in the Indian banking industry is still underway. The vastgeographical spread of the branches in the country is the primary reason for the inabilityof banks to attain complete CBS implementation.

Satellite banking is also an upcoming technological innovation in the Indian bankingindustry, which is expected to help in solving the problem of weak terrestrialcommunication links in many parts of the country. The use of satellites for establishingconnectivity between branches will help banks to reach rural and hilly areas in a betterway, and offer better facilities, particularly in relation to electronic funds transfers. However,this involves very high costs to the banks. Hence, under the proposal made by RBI, itwould be bearing a part of the leased rentals for satellite connectivity, if the banks useit for connecting the north-eastern states and the underbanked districts.

3.42 Basel Committee Recommendations

The Basel Committee on Banking Supervision (or Basel Committee for short) playsa leading role in standardizing bank regulations across jurisdictions. Its origins can betraced to June 26, 1974, when German regulators forced the troubled Bank Herstatt intoliquidation. That day, a number of banks had released payment of German marks toHerstatt in Frankfurt in exchange for US dollars that was to be delivered in New York.Because of time-zone differences, Herstatt ceased operations between the times of therespective payments. The counterparty banks did not receive their dollar payments.

Responding to the cross-jurisdictional implications of the Herstatt debacle, G-10countries and Luxembourg formed a standing committee under the auspices of the Bankfor International Settlements (BIS). Called the Basel Committee on Banking Supervision,the committee comprises representatives from participant nations’ central banks andregulatory authorities. Over time, the focus of the committee has evolved, embracinginitiatives designed to:

(i) Define roles of regulators in cross-jurisdictional situations;(ii) Ensure that international banks or bank holding companies do not escape

comprehensive supervision by a “home” regulatory authority;(iii) Promote uniform capital requirements so banks from different countries may

compete with one another on a “level playing field.”

The Basel Committee’s does not have legislative authority, but participant countriesare expected to implement its recommendations. Mostly, they do. Also, the committeesometimes allows for flexibility in how local authorities implement recommendations, soeven when recommendations are implemented, national laws vary.

In recent decades, the Basel Committee has focused on developing a uniform systemof bank capital requirements, called the Basel Accords. Work commenced with a 1988Basel Accord, which is today called Basel-I that set minimum capital requirements forbanks’ credit risk. A 1996 amendment added capital charges for market risk. Starting in1999 and continuing into the early 2000s, the Basel Committee developed an overhaulof Basel-I, which is called Basel-II. Implementation of Basel-II was nearing completion whenthe 2008 financial crisis hit. With governments bailing out numerous financial institutions,it was clear the Basel Accords were inadequate. The Basel Committee responded witha number of stopgap measures, which have been called Basel 2.5, followed by a longer-term overhaul of bank capital requirements, which is called Basel-III.

The failure of the Basel Accords to prevent financial crises in either 2000-2001 or2008 raises concerns. Some have come to view the Basel Committee as a bankers’ club,



Notespopulated by central bankers and regulators who either hailfrom or are otherwise beholdento the banking industry. The focus of the Basel Accords has always been on regulatingbank capital and not bank practices. But capital requirements cannot protect against thesorts of abuses that came to light in the two recent financial crises.

The Basel Committee on Banking Supervision's work is organized under four mainsub-committees:

(i) The Standards Implementation Group was originally established to shareinformation on, and promote consistency in, the implementation of the BaselII Framework. In 2009, the Standards Implementation Group’s goals werebroadened to concentrate on implementation of general Basel Committeeguidance and standards.

(ii) The Policy Development Group identifies and reviews emerging supervisoryissues. The Policy Development Group also proposes and develops policiesdesigned to create sound banking systems and supervisory standards.

(iii) The Accounting Task Force helps ensure that international accounting andauditing standards and practices promote risk management at banks. TheAccounting Task Force also develops reporting guidance and takes an activerole in the development of these international accounting and auditing standards.

(iv) The Basel Consultative Group facilitates supervisory dialogue with non-membercountries on new committee initiatives by engaging senior representatives fromvarious countries, international institutions and regional groups of bankingsupervisors that are not members of the committee.

BCBS members include representatives from Argentina, Australia, Belgium, Brazil,Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea,Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa,Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. TheBCBS encourages contact and cooperation between its members and other bankingsupervisory authorities. It also circulates papers providing guidance on supervisory mattersto banking regulators all over the world.

3.43 Capital Adequacy Ratio (CAR)

Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine theadequacy of their capital keeping in view their risk exposures. Banking regulators requirea minimum capital adequacy ratio so as to provide the banks with a cushion to absorblosses before they become insolvent. This improves stability in financial markets andprotects deposit-holders. Basel Committee on Banking Supervision of the Bank ofInternational Settlements develops rules related to capital adequacy which membercountries are expected to follow.

The committee’s latest pronouncement on capital adequacy is Basel-III, issuedDecember 2010, revised June 2011.

The pronouncement requires banks to maintain the following minimum ratios as of1 January 2013:

Common Equity Tier 1 ÷ Risk-weighted Exposures 3.5%

Tier 1 Capital ÷ Risk-weighted Exposures 4.5%

Total Capital ÷ Risk-weighted Exposures 8%

Since such pronouncements are frequently updated, please consult the Bank ofInternational Settlements website for latest guidance.



Notes Formula:

Capital Adequacy Ratio = Tier 1 Capital + Tier 2 Capital Risk-weighted Exposures

Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1

Total Capital = Tier 1 Capital + Tier 2 Capital

Risk-weighted exposures include weighted sum of the bank’s credit exposures(including those appearing on the bank’s balance sheet and those not appearing). Theweights are determined in accordance with the Basel Committee guidance for assets ofeach credit rating slab.

3.44 Risk Weighted Assets

Risk weighted assets is a measure of the amount of a bank’s assets, adjusted forrisk. The nature of a bank’s business means it is usual for almost all of a bank’s assetswill consist of loans to customers. Comparing the amount of capital a bank has with theamount of its assets gives a measure of how able the bank is to absorb losses. If itscapital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent.

By adjusting the amount of each loan for an estimate of how risky it is, we cantransform this percentage into a rough measure of the financial stability of a bank. It isnot a particularly accurate measure because of the difficulties involved in estimating theserisks. These difficulties are exacerbated by the motivation banks have to distort it.

The main use of risk weighted assets is to calculate tier 1 and tier 2 capital adequacyratios.

Risk weighting adjusts the value of a asset for risk, simply by multiplying it be afactor that reflects its risk. Low risk assets are multiplied by a low number, high risk assetsby 100% (i.e., 1).

Suppose a bank has the following assets: 1 billion in gilts, 2 billion secured bymortgages, and 3 billion of loans to businesses. The risk weightings used are 0% for gilts(a risk free asset), 50% for mortgages, and 100% for the corporate loans. The bank’s riskweighted assets are 0 × 1 bn + 50% × 2 bn + 100% × 3 bn = 4 bn.

Basel I used a comparatively simple system of risk weighting that is used in thecalculation above. Each class of asset was assigned a fixed risk weight. Basel II usesa different classification of assets with some types having weightings that depend on theborrower’s credit rating or the bank’s own risk models.

Banks have a motive to take on more risk. If they win their bets, the shareholders(and management) take the profit, if they lose then the loss us likely to be shared withdebt holders or governments (as banks are rarely allowed to fail). Part of the motivationfor Basel-II was that banks were able to work around the Basel-I system by selectingriskier business within each asset class. Given this, it seems remiss to have allowed thebanks to use their own risk models, especially given that model risk was quite high evenwithout the incentives the banks had to manipulate the models to understate risk.

3.45 Risk-based Supervision

“Risk-based supervision’s (RBS) main purpose is to develop a risk profiling ofcommercial banks in India. Post the recent global economic crisis, there has been a shifttowards RBS, and away from the erstwhile CAMELS (Capital adequacy, Asset quality,



NotesManagement, Earnings appraisal, Liquidity and Systems and controls) approach, whichwas more of a transaction testing model. The supervisory stance of RBS will extend toan analysis of a bank’s propensity for failure and its likely impact on the financial system.With banks moving into this uniform methodology of supervision, India will now be at parwith best practices around the world.

RBS can be termed forward looking as it seeks to assess risk buildup by examiningwhether the supervised entity/bank follows regulatory prescriptions, and if its internal riskmanagement practices are aligned with regulatory expectations. In short, its goals areto help banks optimize the utilization of supervisory resources and minimize the impactof crises scenarios in the financial system.”

Risk-based supervision is a supervisory approach that has either been implemented,or is in the process of being implemented, by many supervisory authorities. In addition,risk-based supervision concepts are embedded in the Basel Core principles for effectivebanking supervision and are part of the IMF and World Bank’s Financial SectorAssessment Programs (FSAPs) of countries.

In today’s fast moving and interconnected world, along with carrying out on-site andoff-site activities at banks, supervisors need to be forward-looking, and develop plans forintervening early, if a material problem surfaces at one or more of their domesticsystemically-important banks.

As such, we have designed a comprehensive program, which covers a variety ofcurrent and relevant topics, to assist supervisors in becoming more effective and nimblein their work.

Over 5 days, we plan to cover the following topics:

(a) Key concepts, principles and general approach for an effective risk-basedsupervision framework.

(b) How to identify the significant activities in a bank and, in turn, rate the inherentcredit, market, operational and other risks for these activities.

(c) How to assess and rate the performance of board, senior management and theindependent oversight functions such as internal audit, risk management andcompliance, that oversee a bank.

(d) A walk-through on how FIN-FSA conducts its supervisory planning process aswell as how it carries out its on-site work for credit and liquidity.

(e) Macro prudential activities that enable one to identify and deal with problemsearly.

(f) Cross-border cooperation and supervisory colleges, plus recovery and resolutionplans for Systemically Important Financial Institutions (SIFIs).

(g) Crisis preparedness and the importance of developing a crisis handbook.

3.46 Asset Liability Management (ALM) in Commercial Banks

ALM is a comprehensive and dynamic framework for measuring, monitoring andmanaging the market risk of a bank. It is the management of structure of balance sheet(liabilities and assets) in such a way that the net earnings from interest are maximizedwithin the overall risk preference (present and future) of the institutions. The ALM functionsextend to liquidity risk management, management of market risk, trading riskmanagement, funding and capital planning and profit planning and growth projection.



Notes 3.47 Benefits of ALM

It is a tool that enables bank managements to take business decisions in a moreinformed framework with an eye on the risks that bank is exposed to. It is an integratedapproach to financial management, requiring simultaneous decisions about the types ofamounts of financial assets and liabilities – both mix and volume – with the complexitiesof the financial markets in which the institution operates

The concept of ALM is of recent origin in India. It has been introduced in IndianBanking industry w.e.f. 1st April, 1999. ALM is concerned with risk management andprovides a comprehensive and dynamic framework for measuring, monitoring and managingliquidity, interest rate, foreign exchange and equity and commodity price risks of a bankthat needs to be closely integrated with the banks’ business strategy.

Therefore, ALM is considered as an important tool for monitoring, measuring andmanaging the market risk of a bank. With the deregulation of interest regime in India,the Banking industry has been exposed to the market risks. To manage such risks, ALMis used so that the management is able to assess the risks and cover some of theseby taking appropriate decisions.

The assets and liabilities of the bank’s balance sheet are nothing but future cashinflows or outflows. With a view to measure the liquidity and interest rate risk, banks useof maturity ladder and then calculate cumulative surplus or deficit of funds in different timeslots on the basis of statutory reserve cycle, which are termed as time buckets.

As a measure of liquidity management, banks are required to monitor their cumulativemismatches across all time buckets in their Statement of Structural Liquidity byestablishing internal prudential limits with the approval of the Board/ManagementCommittee.

As per RBI guidelines, commercial banks are to distribute the outflows/inflows indifferent residual maturity period known as time buckets. The Assets and Liabilities wereearlier divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days;181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining periodto their maturity (also called residual maturity). All the liability figures are outflows whilethe asset figures are inflows. In September, 2007, having regard to the internationalpractices, the level of sophistication of banks in India, the need for a sharper assessmentof the efficacy of liquidity management and with a view to providing a stimulus fordevelopment of the term-money market, RBI revised these guidelines and it was providedthat:

(a) The banks may adopt a more granular approach to measurement of liquidity riskby splitting the first time bucket (1-14 days at present) in the Statement of StructuralLiquidity into three time buckets, viz., next day, 2-7 days and 8-14 days. Thus, now wehave 10 time buckets.

After such an exercise, each bucket of assets is matched with the correspondingbucket of the liability. When in a particular maturity bucket, the amount of maturingliabilities or assets does not match, such position is called a mismatch position, whichcreates liquidity surplus or liquidity crunch position and depending upon the interest ratemovement, such situation may turn out to be risky for the bank. Banks are required tomonitor such mismatches and take appropriate steps so that bank is not exposed to risksdue to the interest rate movements during that period.

(b) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14days and 15-28 days buckets should not exceed 5%, 10%, 15% and 20% of the cumulative



Notescash outflows in the respective time buckets in order to recognize the cumulative impacton liquidity.

The Board’s of the banks have been entrusted with the overall responsibility for themanagement of risks and is required to decide the risk management policy and set limitsfor liquidity, interest rate, and foreign exchange and equity price risks.

Asset-Liability Committee (ALCO) is the top most committee to oversee theimplementation of ALM system and it is to be headed by CMD or ED. ALCO considersproduct pricing for deposits and advances, the desired maturity profile of the incrementalassets and liabilities in addition to monitoring the risk levels of the bank. It will have toarticulate current interest rates view of the bank and base its decisions for future businessstrategy on this view.

3.48 Corporate Debt Restructuring

Debt restructuring is a process that allows a private or public company, or a sovereignentity facing cash flow problems and financial distress to reduce and renegotiate itsdelinquent debts in order to improve or restore liquidity so that it can continue itsoperations.

Corporate Debt Restructuring (“CDR”) mechanism is a voluntary non statutorymechanism under which financial institutions and banks come together to restructure thedebt of companies facing financial difficulties due to internal or external factors, in orderto provide timely support to such companies.

The intention behind the mechanism is to revive such companies and also safeguardthe interests of the lending institutions and other stakeholders. The CDR mechanism isavailable to companies who enjoy credit facilities from more than one lending institution.The mechanism allows such institutions, to restructure the debt in a speedy andtransparent manner for the benefit of all.

3.49 E-Banking

World over banks are reorienting their business strategies towards new opportunitiesoffered by e-banking. E-banking has enabled banks to scale borders, change strategicbehavior and thus bring about new possibilities. E-banking has moved real banking behaviorcloser to neoclassical economic theories of market functioning. Due to the absolutetransparency of the market, clients both business as well as retail can compare theservices of various banks more easily. For instance, on the internet, competitors are onlyone click away. If clients are not happy with the products, prices or services offered bya particular bank, they are able to change their banking partner much more easily thanin the physical or real bank-client relationship. From the banks’ point of view, use of theinternet has significantly reduced the physical costs of banking operations.

Around the world electronic banking services, whether delivered online or throughother mechanisms, have spread quickly in recent years. It must be noted that the impactof e-banking is not limited to industrial and advanced emerging economies. Even incountries with underdeveloped banking systems, E-banking has offered many newbusiness opportunities.

E-business is a monolithic term encompassing the various business processes thataim to integrate the vendors or traders with the consumers and suppliers using the Internet.The entire process of setting up a website, helping the prospective customers navigatethrough the website, showing them the available products, offering discounts and vouchers



Notes and doing everything possible to woo the prospective clients and converting them intocustomers, comes under the purview of e-business. E-commerce, on the other hand, isa subset of e-business and refers to online transactions that can be accounted for inmonetary terms. For instance, accepting credit card payment for products sold toconsumers or making payments for shopping online are examples of e-commerce. In otherwords, e-commerce refers to the last stage of e-business, which involves collectingpayments for the goods sold by the business firm.

Meaning of E-Banking

E-banking is defined as the automated delivery of new and traditional bankingproducts and services directly to customers through electronic, interactive communicationchannels.

3.50 Development of E-Banking in India

In India, e-banking is of fairly recent origin. The traditional model for banking hasbeen through branch banking. Only in the early 1990s, there has been start of non-branchbanking services. The good old manual systems on which Indian Banking depended uponfor centuries seem to have no place today. The credit of launching internet banking inIndia goes to ICICI Bank. Citibank and HDFC Bank followed with internet banking servicesin 1999.

Several initiatives have been taken by the Government of India as well as the ReserveBank to facilitate the development by e-banking in India. The Government of India enactedthe IT Act, 2000 with effect from October 17, 2000 which provided legal recognition toelectronic transactions and other means of electronic commerce. The Reserve Bank ismonitoring and reviewing the legal and other requirements of e-banking on a continuousbasis to ensure that e-banking would develop on sound lines and e-banking relatedchallenges would not pose a threat to financial stability.

A high level Committee under chairmanship of Dr. K.C. Chakrabarty and membersfrom IIT, IIM, IDRBT, Banks and the Reserve Bank prepared the “IT Vision Document –2011-17”, for the Reserve Bank and banks which provides an indicative road map forenhanced usage of IT in the banking sector.

To cope with the pressure of growing competition, Indian commercial banks haveadopted several initiatives and e-banking is one of them. The competition has beenespecially tough for the public sector banks, as the newly established private sector andforeign banks are leaders in the adoption of e-banking.

3.51 E-Banking Services

Indian banks offer to their customers following e-banking products and services:

(i) Automated Teller Machines (ATMs)(ii) Internet Banking(iii) Mobile Banking(iv) Tele Banking(v) Electronic Fund Transfer(vi) Standing Instructions(vii) Online Mutual Fund Investment(viii) Smart Cards



Notes(i) Automated Teller Machines (ATMs)ATM is a modern device introduced by the banks to enable the customers to have

access to money day-in/day-out without visiting the bank branches in person. The systemis known as “Any Time Money” or “Any Where Money” because it enables the customersto withdraw money from the bank from any of its ATMs round the clock.

(ii) Internet BankingInternet banking is an electronic payment system that enables customers of a

financial institution to conduct financial transactions on a website operated by theinstitution. Internet banking does offer many benefits for both banks and their customers.So, the banks are doing what they can to encourage customers to try it.

(iii) Mobile BankingMobile banking is a system that allows customers of a financial institution to conduct

a number of financial transactions through a mobile device such as a mobile phone ortablet. With the use of a mobile device, the user can perform mobile banking via call,text, website or applications. It utilizes the mobile connectivity of telecom operators andtherefore does not require an internet connection. With mobile banking, users of mobilephones can perform several financial functions conveniently and securely from their mobile.

(iv) Tele BankingTelephone banking is a service provided by a bank or other financial institution that

enables customers to perform financial transactions over the telephone, without the need tovisit a bank branch or automated teller machine. Telephone banking times can be longer thanbranch opening times, and some financial institutions offer the service on a 24 hour basis.

(v) Electronic Fund TransferElectronic Funds Transfer (EFT) is a system of transferring money from one bank

account directly. Transactions are processed by the bank through the Automated ClearingHouse (ACH) network. The benefits of EFT include reduced administrative costs, increasedefficiency, simplified bookkeeping and greater security.

(vi) Standing InstructionsStanding instructions are a way of making an automatic payment of a fixed amount

to a loan, bill or credit card at the same time every week or month. It can be made fromdeposit account and is most commonly used to make payments to a mortgage, car loanor to pay bills.

(vii) Online Mutual funds InvestmentMutual fund is a professionally-managed trust that pools the savings of many

investors and invests them in securities like stocks, bonds, short-term money marketinstruments and commodities such as precious metals. Investors in a mutual fund havea common financial goal and their money is invested in different asset classes inaccordance with the fund’s investment objective. Indian banks and financial institutionsoffer online mutual fund investment facilities.

(viii) Smart CardsThe banking industry enjoyed the benefits of magnetic stripe card technology for a

long time. This technology has revolutionized the payment card industry and increasedthe level of card security. These cards use encryption and authentication technology whichis more secure than other methods associated with payment system. Example: StateBank Smart Payout Card can be used for cash withdrawal at ATMs, for purchasetransactions at merchant establishments and for e-Commerce.



Notes 3.52 Internet Banking

Internet banking system is a method in which a personal computer is connectedby a network service provider directly to a host computer system of a bank such thatcustomer service requests can be processed automatically without need for interventionby customer service representatives. The system is capable of distinguishing betweenthose customer service requests which are capable of automated fulfillment and thoserequests which require handling by a customer service representative. The system isintegrated with the host computer system of the bank so that the remote banking customercan access other automated services of the bank.

Meaning of Internet Banking

Internet banking refers to a system allowing individuals to perform banking activitiesat home, via the internet. Internet banking allows customers to conduct financialtransactions on a secure website operated by their retail or virtual bank.

3.53 Internet Banking in India

The Reserve Bank of India constituted a working group on Internet Banking. The groupdivided the internet banking products in India into three types based on the levels of accessgranted. They are:

(i) Information Only SystemGeneral purpose information like interest rates, branch location, bank products and

their features, loan and deposit calculations are provided in the bank’s website. There existfacilities for downloading various types of application forms. The communication is normallydone through e-mail. There is no interaction between the customer and bank’s applicationsystem. No identification of the customer is done. In this system, there is no possibilityof any unauthorized person getting into production systems of the bank through internet.

(ii) Electronic Information Transfer SystemThe system provides customer-specific information in the form of account balances,

transaction details, and statement of accounts. The information is still largely of the ‘readonly’ format. Identification and authentication of the customer is through password. Theinformation is fetched from the bank’s application system either in batch mode or offline.The application systems cannot directly access through the internet.

(iii) Fully Electronic Transactional SystemThis system allows bi-directional capabilities. Transactions can be submitted by the

customer for online update. This system requires high degree of security and control. Inthis environment, web server and application systems are linked over secure infrastructure.It comprises technology covering computerization, networking and security, inter-bankpayment gateway and legal infrastructure.

3.54 Advantages of Internet Banking

The various advantages of internet banking are as follows:

Internet banking does offer many benefits for both banks and their customers. So,the banks are doing what they can to encourage customers to try it.

1. An internet banking account is simple to open and use. One just enter a fewanswers to questions in a form while sitting comfortably in your own home or



Notesoffice. To access the account, the customer has to establish security measuressuch as usernames and passwords. To complete the set up of account,customer has to just print, sign and send in a form.

2. Internet banking costs less. Because there are fewer buildings to maintain, andless involvement by salaried employees, there is a much lower overhead withonline banks. These savings allow them to offer higher interest rates on savingsaccounts and lower lending rates and service charges. Even traditional brickand mortar banks offer better deals such as free bill paying services to encouragetheir customers to do their banking online.

3. Comparing internet banks to get the best deal is easy. In a short time,customers can visit several online banks to compare what they offer in savingsand checking account deals as well as their interest rates. Other things thatcan be easily done is research about credit cards availability, credit card interestrates, loan terms and the banks own rating with the FDIC.

4. Bouncing a cheque (accidentally) should be a thing of the past because it canbe monitored in the account online any time, day or night. Customers can trackyour balance daily, see what cheques have cleared and when and know whenautomatic deposits and payments are made. This is all possible by simply goingonline to the bank’s website and logging into your account.

5. Banks keep the account balanced using computer and the monthly statement.Customers’ bank account information can be downloaded into softwareprograms such as Microsoft Money or Quicken; making is easy to reconcilewith the account with just a few mouse clicks. The convenience of the datacapture online makes it much easier to budget and track where the money goes.The internet bank account even allows to view copies of the cheques that havebeen written each month.

6. With the ability to view the account at anytime, it is easier to catch fraudulentactivity in the account before much damage is done. As soon as the customerlogs into the account, he will be able to quickly see whether there is anythingamiss when there is a cheque on deposits and debits. If anyone writes a chequeor withdraws funds from the account and customer is known, it wasn’t theintended person. This lets the customer to get started on correcting the problemimmediately rather than having to wait a month, even if it has a clue, it ishappening as would be the case with a traditional bank.

7. Internet banking offers a great deal more convenience than from a conventionalbank. Customers aren’t bound by ‘banker’s hours’ and don’t have to go therephysically. Time is not wasted when there is work to do because the customercan do office’s banking without leaving the office. No matter wherever we areor what time it is, customer can easily manage the money.

3.55 Disadvantages of Internet Banking

Internet banking or electronic banking allows customers to access their accountsat any time from any computer or smart phone. This banking style has a lot of advantages,including 24-hour account monitoring, the ability to bank from anywhere and fasttransactions. However, this system has some distinct disadvantages, too.

1. Identity ConfirmationThe regulations require that financial institutions confirm each customer’s identity.

This may present a logistical issue, as copying and faxing documents is sometimesnecessary.



Notes 2. Security ConcernsWith hacking and identity theft on the rise, Internet banking customers have to place

a certain amount of trust in the bank that their account information and personal informationare safe.

3. Customer ServiceIf the customer banks at a traditional bank, they can go to the bank and speak to

someone face to face about their problem but, with an Internet bank, they will likely spenda lot of time on the phone being passed around and placed on hold.

4. AccessibilityIf the Internet goes down in the area or the area of the banking office, the customer

will be unable to access the accounts. This includes being unable to withdraw moneyfrom ATMs or to use the debit card.

5. FeesMany Internet banks don’t have ATMs, which means the customer will have to pay

ATM fees. This can cost more money than paying the regular monthly fees at a brickand mortar bank.

3.56 Tele Banking

A system which enables banking transactions to be carried out by means of atelecommunications network, most commonly achieved through a view data system oran interactive computer link, or sometimes over an interactive cable TV network, withprovision for the user to send signals to the bank.

Undertaking a host of banking related services including financial transactions fromthe convenience of customers chosen place anywhere across the GLOBE and any timeof date and night has now been made possible by introducing online tele banking services.By dialing the given tele banking number through a landline or a mobile from anywhere,the customer can access his account and by following the user-friendly menu, entirebanking can be done through Interactive Voice Response (IVR) system.

With sufficient numbers of hunting lines made available, customer call will hardlyfail. The system will be bilingual and has following facilities offered:

(i) Automatic balance voice out for the default account.(ii) Balance inquiry and transaction inquiry in all.(iii) Inquiry of all term deposit accounts.(iv) Statement of account by fax, e-mail or ordinary mail.(v) Cheque book request.(vi) Stop payment which is online and instantaneous.(vii) Transfer of funds with CBS which is automatic and instantaneous.(viii) Utility Bill Payments.(ix) Renewal of term deposit which is automatic and instantaneous.(x) Voice out of last five transactions.

3.57 Online Banking

Online banking refers to the computerized service that allows a bank’s customersto get online with the bank via telephone lines to view the status of their account(s) and



Notestransaction history. It usually also allows them to transfer funds, pay bills, request chequebooks, etc.

History of Online Banking

The precursor for the modern home online banking services were the distance bankingservices over electronic media from the early 1980s. The term online became popular inthe late 80s and referred to the use of a terminal, keyboard and TV (or monitor) to accessthe banking system using a phone line. ‘Home banking’ can also refer to the use of anumeric keypad to send tones down a phone line with instructions to the bank. Onlineservices started in New York in 1981 when four of the city’s major banks (Citibank, ChaseManhattan, Chemical) offered home banking services using the videotex system. Becauseof the commercial failure of videotex, these banking services never became popular exceptin France where the use of videotex was subsidized by the telecom provider and the UK,where the Prestel system was used.

Features of Online Banking

Online banking facilities offered by various financial institutions have many featuresand capabilities in common, but also have some that are application specific. The commonfeatures fall broadly into several categories. A bank customer can perform some non-transactional tasks through online banking, including:

(i) Viewing account balances.(ii) Viewing recent transactions.(iii) Downloading bank statements, for example in PDF format.(iv) Viewing images of paid cheques.(v) Ordering cheque books.(vi) Download periodic account statements.(vii) Downloading applications for M-banking, E-banking etc.(viii) Funds transfers between the customer’s linked accounts.(ix) Paying third parties, including bill payments (see, e.g., BPAY) and telegraphic/

wire transfers.(x) Investment purchase or sale.

3.58 Core Banking

Core banking is services provided by a group of networked bank branches. Bankcustomers may access their funds and other simple transactions from any of the memberbranch offices. Core Banking is the meeting point of the largest banking servicessegments, cutting edge Information Technology and the ever advancing CommunicationTechnology. It is all about providing the banking customers with the right products at theright time through the right channels 24 hours a day, 7 days a week through a multi-location, multi-branch network.

Core Banking is normally defined as the business conducted by a banking institutionwith its retail and small business customers. Many banks treat the retail customers astheir core banking customers, and have a separate line of business to manage smallbusinesses. Larger businesses are managed via the corporate banking division of theinstitution. Core banking basically is depositing and lending of money.



Notes Nowadays, most banks use core banking applications to support their operationswhere CORE stands for “centralized online real-time environment”. This basically meansthat all the bank’s branches access applications from centralized datacenters. This meansthat the deposits made are reflected immediately on the bank’s servers and the customercan withdraw the deposited money from any of the bank’s branches throughout the world.These applications now also have the capability to address the needs of corporatecustomers, providing a comprehensive banking solution.

A few decades ago, it used to take at least a day for a transaction to reflect in theaccount because each branch had their local servers and the data from the server in eachbranch was sent in a batch to the servers in the datacenter only at the end of the day(EoD).

Normal core banking functions will include deposit accounts, loans, mortgages andpayments. Banks make these services available across multiple channels like ATMs,Internet banking, and branches.

Core banking functions differ depending on the specific type of bank. Retail banking,for example, is geared towards individual customers; wholesale banking is businessconducted between banks; and securities trading involves the buying and selling of stocks,shares and so on. Core banking systems are often specialized for a particular type ofbanking. Products that are designed to deal with multiple types of core banking functionsare sometimes referred to as universal banking systems.

History of Core Banking

The major objectives of bank automation are better customer service, flawless bookkeeping and prompt decision-making that leads to improved productivity and profitability.The concept of bank automation started in the year 1981, but it was during the period1984-1987 banks in India started the branch level automation, making use of the thenavailable MSDOS based stand-alone computers. This initiative was taken by the bankson the basis of “First Rangarajan Committee Report” on bank computerization submittedin the year 1984. ALPMs (Advance Ledger Posting Machines) were the fashion in thosedays. However, the pace of bank automation was very slow in the banks primarily owingto the lack of trade union consensus on bank automation.

Another committee was in 1988 under the chairmanship of Dr. C. Rangarajan, thethen Deputy Governor of RBI to slate down a perspective plan on automation of banksfor a five year period. This paved way to the implementation of multi-user Total BranchAutomation packages running on a LAN (Local Area Network), either on a Network ora UNIX operating system. With the implementation of TBA, banks started to offer thefacilities of exclusive Customer Terminal, Single window transaction, online and off-siteATMs, Tele Banking, etc.

But with the advent of new generation, private sector banks in India during 1994-1996, the real era of bank marketing started and these banks started to offer anywhereand anytime banking facilities to its customers. This was possible for them mainly owingto the fact that they opted for the implementation of a WAN (Wide Area Network) basedcentralized banking solution rather than a LAN based banking solution to network theirlimited number of branch outlets.

The old generation banks in India hesitated to follow this banking fashion on accountof its large network of branches on one hand and the then prevailing exorbitant IT coston the other hand. But with the globalization and liberalization of Indian market and withthe enactment of TRAI (with a mission to create and nurture conditions for growth of



Notestelecommunications in the country in a manner and at a pace which will enable India toplay a leading role in emerging global information society) during the late nineties, therehappened a drastic reduction in IT cost.

Improved telecommunication facilities and reduction in hardware as well asnetworking cost changed the mindset of the banks in India to try the CBS option. Thisalso equipped them with the required technology products and services, as those offeredby their new generation competitors.

Meaning of Core Banking

Core banking is a general term used to describe the services provided by a groupof networked bank branches. Bank customers may access their funds and other simpletransactions from any of the member branch offices. Core banking solution is acomprehensive, integrated yet modular business solution. It provides the much-neededflexibility to banks to adapt to a dynamic environment.

Examples: Core banking products include Infosys’ Finacle, Nucleus FinnOne andOracle’s Flexcube application (from their acquisition of Indian IT vendor i-flex).

3.59 Mobile Banking

Mobile banking is a term used to refer to systems that allow customers of a financialinstitution to conduct a number of financial transactions through a mobile device suchas a mobile phone or tablet.

Mobile banking typically operates across all major mobile providers in the US throughone of three ways: SMS messaging; mobile web; or applications developed for iPhone,Android or Blackberry devices.

Mobile text and alert is the simplest, allowing the user to transfer funds or accessaccount information via text message. Texting terminology varies from bank to bank, butthe overall function is generally the same. For example, texting “Bal” will obtain the accountbalance while “Tra” will allow inter-account transfers. Users need to first register and verifytheir phone numbers with their bank, but once that’s completed, they can also set upalerts to let them know about negative balances or deposit confirmations.

Mobile web is the second mobile banking option. Similar to online account accessfrom a home-based computer, this option allows for checking balances, bill payment andaccount transfers simply by logging into the user’s account via a mobile web browser.

Mobile banking applications for Android, iPhone and Blackberry, connect the userdirectly to the bank server for complete banking functionality without having to navigatea mobile web browser. These applications can be downloaded either through the bank’swebsite or through the iTunes store.

Advantages of Mobile Banking

(a) It utilizes the mobile connectivity of telecom operators and therefore does notrequire an internet connection.

(b) With mobile banking, users of mobile phones can perform several financialfunctions conveniently and securely from their mobile.

(c) You can check your account balance, review recent transaction, transfer funds,pay bills, locate ATMs, deposit cheques, manage investments, etc.



Notes (d) Mobile banking is available round the clock 24/7/365, it is easy and convenientand an ideal choice for accessing financial services for most mobile phoneowners in the rural areas.

(e) Mobile banking is said to be even more secure than online/internet banking.

Disadvantages of Mobile Banking

(a) Mobile banking users are at risk of receiving fake SMS messages and scams.(b) The loss of a person’s mobile device often means that criminals can gain access

to your mobile banking PIN and other sensitive information.(c) Modern mobile devices like smartphones and tablets are better suited for mobile

banking than old models of mobile phones and devices.(d) Regular users of mobile banking over time can accumulate significant charges

from their banks.

3.60 E-Banking Risk

E-banking has unique characteristics that may increase an institution’s overall riskprofile and the level of risks associated with traditional financial services, particularlystrategic, operational, legal, and reputation risks. These unique e-banking characteristicsinclude:

(a) Speed of technological change,(b) Changing customer expectations,(c) Increased visibility of publicly accessible networks (e.g., the Internet),(d) Less face-to-face interaction with financial institution customers,(e) Need to integrate e-banking with the institution’s legacy computer systems,(f) Dependence on third parties for necessary technical expertise, and

(g) Proliferation of threats and vulnerabilities in publicly accessible networks.

3.61 Types of E-Banking Risk

1. Strategic Risk

A financial institution’s board and management should understand the risksassociated with E-banking services and evaluate the resulting risk management costsagainst the potential return on investment prior to offering E-banking services. PoorE-banking planning and investment decisions can increase a financial institution’s strategicrisk. On strategic risk, E-banking is relatively new and, as a result, there can be a lackof understanding among senior management about its potential and implications. Peoplewith technological, but not banking, skills can end up driving the initiatives. E-initiativescan spring up in an incoherent and piecemeal manner in firms. They can be expensiveand can fail to recoup their cost. Furthermore, they are often positioned as loss leaders(to capture market share), but may not attract the types of customers that banks wantor expect and may have unexpected implications on existing business lines. Banks shouldrespond to these risks by having a clear strategy driven from the top and should ensurethat this strategy takes account of the effects of E-banking, wherever relevant. Such astrategy should be clearly disseminated across the business, and supported by a clearbusiness plan with an effective particular, become more significant requiring additionalprocesses, tools, expertise, and testing. Institutions should determine the appropriate level



Notesof security controls based on their assessment of the sensitivity of the information to thecustomer and to the institution and on the institution’s established risk tolerance level.

2. Credit Risk

Generally, a financial institution’s credit risk is not increased by the mere fact thata loan is originated through an E-banking channel. However, management should consideradditional precautions when originating and approving loans electronically, includingassuring management information systems effectively track the performance of portfoliosoriginated through E-banking channels. The following aspects of online loan originationand approval tend to make risk management of the lending process more challenging.If not properly managed, these aspects can significantly increase credit risk.

Verifying the customer’s identity for online credit applications and executing anenforceable contract;

Monitoring and controlling the growth, pricing, underwriting standards and ongoingcredit quality of loans originated through E-banking channels;

Monitoring and over sight of third-parties doing business as agents or on behalf ofthe financial institution (for example, an Internet loan origination site or electronic paymentsprocessor);

Valuing collateral and perfecting liens over a potentially wider geographic area;

Collecting loans from individuals over a potentially wider geographic area;

Monitoring any increased volume of, and possible concentration in, out-of-arealending.

Liquidity, interest rate, price/market risks – Funding and investment-related riskscould increase with an institution’s E-banking initiatives depending on the volatility andpricing of the acquired deposits. The Internet provides institutions with the ability to markettheir products and services globally. Internet-based advertising programs can effectivelymatch yield-focused investors with potentially high-yielding deposits. But Internet-originated deposits have the potential to attract customers who focus exclusively on ratesand may provide a funding source with risk characteristics similar to brokered deposits.An institution can control this potential volatility and expanded geographic reach throughits deposit contract and account opening practices, which might involve face-to-facemeetings or the exchange of paper correspondence. The institution should modify itspolicies as necessary to address the following E-banking funding issues:

Potential increase independence on brokered funds or other highly rate-sensitivedeposits;

Potential acquisition of funds from markets where the institution is not licensed toengage in banking, particularly if the institution does not establish, disclose, and enforcegeographic restrictions;

Potential impact of loan or deposit growth from an expanded Internet market,including the impact of such growth on capital ratios;

Potential increase in volatility of funds should E-banking security problems negativelyimpact customer confidence or the market’s perception of the institution.

3. Reputational Risks

This is considerably heightened for banks using the Internet. For example, theInternet allows for the rapid dissemination of information which means that any incident,



Notes either good or bad, is common knowledge within a short space of time. The speed ofthe Internet considerably cuts the optimal response times for both banks and regulatorsto any incident. Any problems encountered by one firm in this new environment may affectthe business of another, as it may affect confidence in the Internet as a whole. Thereis, therefore, a risk that one scoundrel E-bank could cause significant problems for allbanks providing services via the Internet. This is a new type of systemic risk and is causingconcern to E-banking providers. Overall, the Internet puts an emphasis on reputationalrisks. Banks need to be sure that customer’ rights and information needs are adequatelysafeguarded and provided for.

4. Transaction/Operations Risk

Transaction/Operations Risk arises from fraud, processing errors, system disruptions,or other unanticipated events resulting in the institution’s inability to deliver products orservices. This risk exists in each product and service offered. The level of transaction riskis affected by the structure of the institution’s processing environment, including the typesof services offered and the complexity of the processes and supporting technology.

3.62 E-finance

E-finance is defined as “the provision of financial services and markets usingelectronic communication and computation”. The term ‘E-Finance’ is used differently bydifferent people. It can be defined as a provisioning of financing instruments to businessorganizations using electronic tools and technology for the lengthwise process and thisincorporates the use of electronic channels for mobilizing e-finance services and electronicmethods to set up proper finance conditions and deal with the risk related to the financeitself. E-finance, in simple words, is use of Internet and technologies in financial services.It has enabled the people to have any financial transactions without any human interaction.It saves time, reduces paperwork and chances of fraudulent. Nowadays, with theemergence of e-commerce, E-finance has become a buzzword among the entrepreneur,business firms and investors. Due to the increasing awareness about the use of internetand computer technology in commercial purpose, E-finance has emerged as solution tosimplify the complexions involved in dealing with finance. It is somewhat the shift of systemof financial service from the real world to a virtual one. E-Finance to banking services hasbeen more varied across countries. It allows countries to establish a financial systemwithout first building a fully functioning financial infrastructure by its much cheaper sinceit lowers processing costs for providers and search and switching costs for consumers.Internet banking and e-commerce is changing the finance industry, having the major effectson banking relationships. Banking is now no longer confined to the branches where onehas to approach the branch in person, to withdraw cash or deposit a cheque or requesta statement of accounts. In true, Internet banking is increasingly becoming a “need tohave” than a “nice to have” service. The net banking, thus, now is more of a norm ratherthan an exception in many developed countries due to the fact that it is the cheapestway of providing banking services. As of 2013, there are more than 15 million online bankingusers in India and 53 banks are providing ATM facilities across the country.

The facility of e-banking can be provided solely through the internet without havingany physical office. The adoption of mobile banking has increased substantially in thepast year, in a world nearly 28% of mobile phone users in the survey report that theyused mobile banking in the past 12 months. E-banking provides enormous benefits toconsumers in terms of ease and cost of transactions, either through the Internet, telephoneor other electronic delivery. Electronic finance (E-finance) has become one of the most



Notesessential technological changes in the financial industry. E-finance as the provision offinancial services and markets using Electronic communication and computation inpractice e-finance includes e-payment, e-trading, and e-banking. Three major factorsimpacting financial services are globalization, deregulation (geographic and product),advances in information technology, massive cost reductions in technology andcommunications cost. In the B2C (retail) category are included single e-shops, shoppingmalls, e-broking, e-auction, e-banking, service providers like travel related services,financial services, etc., education, entertainment and any other form of business targetedat the final consumer.

Banking plays a vital role in E-financing which allows countries to establish a financialsystem without functioning financial infrastructure. In India, the position of E-finance isstill in its initial stage and has a lot to grow up, counted in one of the newest digitalizedpart of E-commerce. It has put a great impetus on the other parts of business likeinternational market and financial accounting. It is a tool to overcome the lacuna of physicaldelivery of financial services and has been proved as an aid for SMEs and developingcountries.

3.63 Electronic Money

Electronic money, or e-money, is the money balance recorded electronically on astored-value card. These cards have microprocessors embedded which can be loaded witha monetary value.

E-money is electronic money which is exchanged electronically over a technicaldevice such as a computer or mobile phone. E-money in circulation operates as a prepaidbearer instrument. The best known example of e-money is the Bitcoin, which can be boughtwith real money and traded on an exchange like any other currency.

Advantages of Electronic Money

(a) Most money in today’s world is electronic, and tangible cash is becoming lessfrequent. With the introduction of internet/online banking, debit cards, online billpayments and internet business, paper money is becoming a thing of the past.

(b) Banks now offer many services whereby a customer can transfer funds,purchase stocks, contribute to their retirement plans (such as Canadian RRSP)and offer a variety of other services without having to handle physical cash orchecks. Customers do not have to wait in lines; this provides a lower-hassleenvironment.

(c) Debit cards and online bill payments allow immediate transfer of funds from anindividual’s personal account to a business’s account without any actual papertransfer of money. This offers a great convenience to many people andbusinesses alike.

Disadvantages of Electronic Money

(a) Although there are many benefits to digital cash, there are also many significantdisadvantages. These include fraud, failure of technology, possible tracking ofindividuals and loss of human interaction.

(b) Fraud over digital cash has been a pressing issue in recent years. Hacking intobank accounts and illegal retrieval of banking records has led to a widespreadinvasion of privacy and has promoted identity theft.



Notes (c) There is also a pressing issue regarding the technology involved in digital cash.Power failures, loss of records and undependable software often cause a majorsetback in promoting the technology.

(d) Privacy questions have also been raised; there is a fear that the use of debitcards and the like will lead to the creation by the banking industry of a globaltracking system. Some people are working on anonymous e-cash to try toaddress this issue.

3.64 Digital Signatures

Digital signature is a mathematical technique used to validate the authenticity andintegrity of a message, software or digital document.

The digital equivalent of a handwritten signature or stamped seal, but offering far moreinherent security, a digital signature is intended to solve the problem of tampering andimpersonation in digital communications. Digital signatures can provide the addedassurances of evidence to origin, identity and status of an electronic document, transactionor message, as well as acknowledging informed consent by the signer.

3.65 How Digital Signatures Work?

Digital signatures are based on public key cryptography, also known as asymmetriccryptography. Using a public key algorithm such as RSA, one can generate two keysthat are mathematically linked: one private and one public. To create a digital signature,signing software (such as an e-mail program) creates a one-way hash of the electronicdata to be signed. The private key is then used to encrypt the hash. The encrypted hash– along with other information, such as the hashing algorithm – is the digital signature.The reason for encrypting the hash instead of the entire message or document is thata hash function can convert an arbitrary input into a fixed-length value, which is usuallymuch shorter. This saves time since hashing is much faster than signing.

The value of the hash is unique to the hashed data. Any change in the data, evenchanging or deleting a single character, results in a different value. This attribute enablesothers to validate the integrity of the data by using the signer’s public key to decrypt thehash. If the decrypted hash matches a second computed hash of the same data, it provesthat the data hasn’t changed since it was signed. If the two hashes don’t match, the datahas either been tampered with in some way (integrity) or the signature was created witha private key that doesn’t correspond to the public key presented by the signer(authentication).

A digital signature can be used with any kind of message whether it is encryptedor not simply so the receiver can be sure of the sender’s identity and that the messagearrived intact. Digital signatures make it difficult for the signer to deny having signedsomething (non-repudiation) assuming their private key has not been compromised as thedigital signature is unique to both the document and the signer, and it binds them together.A digital certificate, an electronic document that contains the digital signature of thecertificate-issuing authority, binds together a public key with an identity and can be usedto verify a public key belongs to a particular person or entity.

Most modern e-mail programs support the use of digital signatures and digitalcertificates, making it easy to sign any outgoing e-mails and validate digitally signedincoming messages. Digital signatures are also used extensively to provide proof ofauthenticity, data integrity and non-repudiation of communications and transactionsconducted over the Internet.



Notes3.66 RTGS

The acronym ‘RTGS’ stands for Real Time Gross Settlement, which can be definedas the continuous (real-time) settlement of funds transfers individually on an order by orderbasis (without netting). ‘Real Time’ means the processing of instructions at the time theyare received rather than at some later time. Settlement in “real time” means paymenttransaction is not subjected to any waiting period. The transactions are settled as soonas they are processed. ‘Gross Settlement’ means the settlement of funds transferinstructions occurs individually (on an instruction by instruction basis). “Gross settlement”means the transaction is settled on one-to-one basis without bunching with any othertransaction. Considering that the funds settlement takes place in the books of the ReserveBank of India, the payments are final and irrevocable. This is the fastest possible moneytransfer system through the banking channel.

Features of RTGS

1. The RTGS system is primarily meant for large value transactions. The minimumamount to be remitted through RTGS is ` 2 lakh. There is no upper ceiling forRTGS transactions.

2. Under normal circumstances, the beneficiary branches are expected to receivethe funds in real time as soon as funds are transferred by the remitting bank.The beneficiary bank has to credit the beneficiary’s account within two hoursof receiving the funds transfer message.

3. The RTGS service window for customer’s transactions is available from 9.00hours to 16.30 hours on weekdays and from 9.00 hours to 13.30 hours onSaturdays for settlement at the RBI end. However, the timings that the banksfollow may vary depending on the customer timings of the bank branches.

4. With a view to rationalize the service charges levied by banks for offering fundstransfer through RTGS system, a broad framework has been mandated as under:

(a) Inward transactions – Free, no charge to be levied.(b) Outward transactions – ` 2 lakh to ` 5 lakh not exceeding ` 30 per

transaction. Above ` 5 lakh – not exceeding ` 55 per transaction.5. The remitting customer has to furnish the following information to a bank for

effecting a RTGS remittance:(a) Amount to be remitted.(b) Remitting customer’s account number which is to be debited.(c) Name of the beneficiary bank.(d) Name of the beneficiary customer.(e) Account number of the beneficiary customer.(f) Sender to receiver information, if any.

(g) The IFSC Number of the receiving branch.

3.67 National Electronic Funds Transfer (NEFT)

NEFT is electronic funds transfer system, which facilitates transfer of funds to otherbank accounts in over several bank branches across the country. This is a simple, secure,safe, fastest and cost-effective way to transfer funds especially for retail remittances.



Notes Features and Benefits

1. Customers can remit any amount using NEFT: Customer intending to remitmoney through NEFT has to furnish the following particulars:

(i) IFSC (Indian Financial System Code) of the beneficiary Bank/Branch(ii) Full account number of the beneficiary(iii) Name of the beneficiary.

2. The facility is also available through online mode for all internet banking andmobile banking customers.

3. For corporate customers, bulk upload facility is also available at branches.

Timings1. Customers can use this facility between 8 a.m. and 7 p.m. on all weekdays

and between 8 a.m. and 1 p.m. on Saturday. There are twelve hourly settlementsbetween 8 a.m. and 7 p.m. on all weekdays and six hourly settlements between8 a.m. and 1 p.m. on Saturdays.

2. The money will be credited to the beneficiary’s account on the same day orat the most next day in case the message is sent during the last batch ofsettlement. Union Bank offers NEFT facility to its customers through all itsbranches.

Charges` 5/ per transaction if the transaction amount is less than ` 1 lakh` 25/- per transaction if the transaction amount is more than ` 1 lakh

3.68 Summary

Bank lending refers to the process of disposing of money or property with theexpectation that the same thing will be returned. Credit is the provision of resources (suchas granting a loan) by one party to another party where that second party does notreimburse the first party immediately, thereby generating a debt, and instead arrangeseither to repay or return those resources (or material(s) of equal value, where the firstparty would be the banker (lender or creditors) and the second partly would be the customer(borrower or debtor).

Loan is an arrangement in which a lender gives money to a borrower and the borroweragrees to return the money along with interest after a fixed period of time. Examples:Home Loans, Car Loans, Personal Loans, etc.

Cash credit is a short-term cash loan to a company. A bank provides this type offunding, but only after the required security is given to secure the loan. Once a securityfor repayment has been given, the business that receives the loan can continuously drawfrom the bank up to a certain specified amount.

Overdraft is the amount by which withdrawals exceed deposits or the extension ofcredit by a lending institution to allow for such a situation.

Letter of Credit refers to a letter from a bank guaranteeing that a buyer’s paymentto a seller will be received on time and for the correct amount. In the event that the buyeris unable to make payment on the purchase, the bank will be required to cover the fullor remaining amount of the purchase. It is a payment term generally used for internationalsales transactions.



NotesBorrowers are the individuals borrow money via bankers’ loans for short-term needsor longer-term mortgages to help finance a house purchase. Companies borrow moneyto aid short-term or long-term cash flows. They also borrow to fund modernization or futurebusiness expansion. Governments often find their spending requirements exceed their taxrevenues. To make up this difference, they need to borrow. Governments also borrow onbehalf of nationalized industries, municipalities, local authorities and other public sectorbodies.

Balance sheet analysis can be defined as an analysis of the assets, liabilities, andequity of a company. This analysis is conducted generally at set intervals of time, likeannually or quarterly. The process of balance sheet analysis is used for deriving actualfigures about the revenue, assets, and liabilities of the company.

Project appraisal is the structured process of assessing the viability of a project orproposal. It involves calculating the feasibility of the project before committing resourcesto it. It is a tool that company’s use for choosing the best project that would help themto attain their goal. Project appraisal often involves making comparison between variousoptions and this done by making use of any decision technique or economic appraisaltechnique.

Management or Organizational Appraisal is a process which can look at anorganization and appraise it in a given context. Some tools appraise an organization inpreparation of an award others look at the performance of an organization in preparationfor a buy-out/buy-in, raising venture capital, etc.

Marketing appraisal is an estate agent’s recommendation on how we can achievethe best price for your property in a timescale that suits you. A valuation can only becarried out by a qualified surveyor and is an evidence-based opinion on how much yourproperty is worth.

Technological innovation has resulted in financial product development especially inthe international and investment banking areas. The western experience has demonstratedthat technology has not only made execution of work faster but has also resulted in greateravailability of manpower for customer contact.

“Prudential norms” are the guidelines and general norms issued by the regulatingbank (the central bank) of the country for the proper and accountable functioning of bankand bank-like establishments.

The prudential accounting norms which were put into place in 1992-93, have beenfurther strengthened over the years. In respect of accounts where there are potential threatsof recovery on account of erosion in the value of the security or absence of security andother factors such as fraud committed by the borrowers exist, such accounts are to beclassified as doubtful or loss assets irrespective of the period to which these remainedas non-performing. All the members’ banks in a consortium are required to classify theiradvances according to each bank’s own record of recovery.


Reserve Bank of India is the apex monetary Institution of India. It is also called asthe central bank of the country. The Reserve Bank of India was established on April 1,1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The CentralOffice of the Reserve Bank was initially established in Calcutta but was permanently movedto Mumbai in 1937. The Central Office is where the Governor sits and where policies are



Notes formulated. Though originally privately owned, since nationalization in 1949, the ReserveBank is fully owned by the Government of India.

Credit Control is an important tool used by Reserve Bank of India, a major weaponof the monetary policy used to control the demand and supply of money (liquidity) in theeconomy. Central Bank administers control over the credit that the commercial banksgrant. Such a method is used by RBI to bring “Economic Development with Stability”.It means that banks will not only control inflationary trends in the economy but also boosteconomic growth which would ultimately lead to increase in real national income withstability.

Innovation derives organization to grow, prosper and transform in sync with thechanges in the environment, both internal and external. Banking is no exception to this.In fact, this sector has witnessed radical transformation of late, based on many innovationsin products, processes, services, systems, business models, technology, governance andregulation.

Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine theadequacy of their capital keeping in view their risk exposures. Banking regulators requirea minimum capital adequacy ratio so as to provide the banks with a cushion to absorblosses before they become insolvent. This improves stability in financial markets andprotects deposit-holders. Basel Committee on Banking Supervision of the Bank ofInternational Settlements develops rules related to capital adequacy which membercountries are expected to follow.

Risk weighted assets is a measure of the amount of a bank’s assets, adjusted forrisk. The nature of a bank’s business means it is usual for almost all of a bank’s assetswill consist of loans to customers. Comparing the amount of capital a bank has with theamount of its assets gives a measure of how able the bank is to absorb losses. If itscapital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent.

Debt restructuring is a process that allows a private or public company, or a sovereignentity facing cash flow problems and financial distress to reduce and renegotiate itsdelinquent debts in order to improve or restore liquidity so that it can continue itsoperations.

Corporate Debt Restructuring (“CDR”) mechanism is a voluntary non-statutorymechanism under which financial institutions and banks come together to restructure thedebt of companies facing financial difficulties due to internal or external factors, in orderto provide timely support to such companies.

E-banking is defined as the automated delivery of new and traditional bankingproducts and services directly to customers through electronic, interactive communicationchannels.

Internet banking system is a method in which a personal computer is connectedby a network service provider directly to a host computer system of a bank such thatcustomer service requests can be processed automatically without need for interventionby customer service representatives. The system is capable of distinguishing betweenthose customer service requests which are capable of automated fulfillment and thoserequests which require handling by a customer service representative. The system isintegrated with the host computer system of the bank so that the remote banking customercan access other automated services of the bank.

Internet banking refers to a system allowing individuals to perform banking activitiesat home, via the internet. Internet banking allows customers to conduct financialtransactions on a secure website operated by their retail or virtual bank.



NotesMobile banking is a term used to refer to systems that allow customers of a financialinstitution to conduct a number of financial transactions through a mobile device suchas a mobile phone or tablet.

E-banking has unique characteristics that may increase an institution’s overall riskprofile and the level of risks associated with traditional financial services, particularlystrategic, operational, legal, and reputation risks.

Electronic money, or e-money, is the money balance recorded electronically on astored-value card. These cards have microprocessors embedded which can be loaded witha monetary value.

E-money is electronic money which is exchanged electronically over a technicaldevice such as a computer or mobile phone. E-money in circulation operates as a prepaidbearer instrument.

Digital signature is a mathematical technique used to validate the authenticity andintegrity of a message, software or digital document. The digital equivalent of a handwrittensignature or stamped seal, but offering far more inherent security, a digital signature isintended to solve the problem of tampering and impersonation in digital communications.

The acronym ‘RTGS’ stands for Real Time Gross Settlement, which can be definedas the continuous (real-time) settlement of funds transfers individually on an order by orderbasis (without netting). ‘Real Time’ means the processing of instructions at the time theyare received rather than at some later time. Settlement in “real time” means paymenttransaction is not subjected to any waiting period.

National Electronic Funds Transfer (NEFT) is electronic funds transfer system, whichfacilitates transfer of funds to other bank accounts in over several bank branches acrossthe country. This is a simple, secure, safe, fastest and cost-effective way to transfer fundsespecially for retail remittances.



1. ____________ refers to the process of disposing of money or property with theexpectation that the same thing will be returned.

2. Loan is an arrangement in which a lender gives money to a borrower and theborrower agrees to return the money along with interest after a ____________.

3. ____________ is the amount by which withdrawals exceed deposits or theextension of credit by a lending institution to allow for such a situation.

4. ____________ refers to a letter from a bank guaranteeing that a buyer’s paymentto a seller will be received on time and for the correct amount.

5. Project appraisal is the structured process of assessing the viability of a____________

6. ____________ norms are the guidelines and general norms issued by theregulating bank (the central bank) of the country for the proper and accountablefunctioning of bank and bank-like establishments.

7. ____________ is a specialized ratio used by banks to determine the adequacyof their capital keeping in view their risk exposures.

8. ____________ is defined as the automated delivery of new and traditionalbanking products and services directly to customers through electronic,interactive communication channels.



Notes II. True or False

1. A bank provides this type of funding, but only after the required security is givento secure the loan.

2. Lenders are the individuals borrow money via bankers’ loans for short-term needsor longer-term mortgages to help finance a house purchase.

3. Technological Appraisal is a process which can look at an organization andappraise it in a given context.

4. Marketing appraisal is an estate agent’s recommendation on how we canachieve the best price for your property in a timescale that suits for the customer.

5. Risk weighted assets is a measure of the amount of a bank’s assets, adjustedfor risk.

6. Internet banking system is a method in which a personal computer is connectedby a network service provider directly to a host computer system of a bank.

7. Mobile banking is a term used to refer to systems that allow customers of afinancial institution to conduct a number of financial transactions through amobile device such as a mobile phone or tablet.

8. Digital signature is a mathematical technique used to validate the authenticityand integrity of a message, software or digital document.


1. Which of the following refers to the process of disposing of money or propertywith the expectation that the same thing will be returned?

(a) Bank lending(b) Borrowing(c) Depositing(d) All the above

2. Overdraft is the amount by which ____________(a) Withdrawals exceed deposits(b) The extension of credit by a lending institution(c) Both (a) and (b)(d) None of these

3. Which of the following refers to a letter from a bank guaranteeing that a buyer’spayment to a seller will be received on time and for the correct amount?

(a) Overdraft(b) Letter of Credit(c) Bank lending(d) All the above



1. Give the meaning of bank lending.2. State various types of lending.3. Who are the Borrowers?



Notes4. What is Balance Sheet Analysis?5. What is Project Appraisal?6. What is Bank Service?7. Give the meaning of Bank Marketing.8. What is Prudential Norm?9. What is Reserve Bank of India?

10. What is Credit Control?11. What is Securities and Exchange Board of India?12. What is Lender’s Liability Act?13. Give the meaning of Banking Innovation.14. What is Basel Committee?15. What is Capital Adequacy Ratio (CAR)?16. What is Risk-based Supervision?17. What is RTGS?18. What is National Electronic Funds Transfer (NEFT)?


1. Discuss various principles of Lending.2. Explain various types of Lending.3. Discuss lending facilities granted by Banks.4. Explain about study of Borrowers.5. How to perform a Balance Sheet Analysis? Discuss.6. Discuss Project Appraisal Criteria.7. Explain importance of Bank Marketing.8. Discuss prudential guidelines on Restructuring of Advances.9. Discuss Narasimham Committee Recommendations.

10. State various objectives of Credit Control.11. Discuss objectives and functions of SEBI.12. Explain the Basel Committee Recommendations.13. Discuss about E-Banking Risk.14. Write note on: E-finance and Electronic Money.

3.71 Key TermsBank lending: Bank lending refers to the process of disposing of money orproperty with the expectation that the same thing will be returned.Loan: Loan is an arrangement in which a lender gives money to a borrowerand the borrower agrees to return the money along with interest after a fixedperiod of time.Cash Credit: Cash credit is a short-term cash loan to a company. A bankprovides this type of funding, but only after the required security is given tosecure the loan.Overdraft: Overdraft is the amount by which withdrawals exceed deposits orthe extension of credit by a lending institution to allow for such a situation.



Notes Letter of Credit: Letter of Credit refers to a letter from a bank guaranteeingthat a buyer's payment to a seller will be received on time and for the correctamount.Balance sheet analysis: Balance sheet analysis can be defined as an analysisof the assets, liabilities, and equity of a company.Mobile banking: Mobile banking is a term used to refer to systems that allowcustomers of a financial institution to conduct a number of financial transactionsthrough a mobile device such as a mobile phone or tablet.National Electronic Funds Transfer: National Electronic Funds Transfer(NEFT) is electronic funds transfer system, which facilitates transfer of fundsto other bank accounts in over several bank branches across the country.


1. Bank lending2. Fixed period of time3. Overdraft4. Letter of Credit5. Project or proposal6. Prudential7. Capital adequacy ratio (CAR)8. E-banking

II. True or False1. True2. False3. False4. True5. True6. True7. True8. True

III. Multiple Choice Questions1. (a) Bank lending2. (c) Both (a) and (b)3. (b) Letter of Credit

3.73 Case Study

The State Bank of India is the oldest and largest bank in India, with more than $250billion (USD) in assets. It is the second-largest bank in the world in number of branches;it opened its 10,000th branch in 2008. The bank has 84 international branches locatedin 32 countries and approximately 8,500 ATMs. Additionally, SBI has controlling orcomplete interest in a number of affiliate banks, resulting in the availability of bankingservices at more than 14,600 branches and nearly 10,000 ATMs. SBI traces its heritageto the 1806 formation of the Bank of Calcutta. The bank was renamed the Bank of Bengal



Notesin 1809 and operated as one of the three premier “presidency” banks (the presidency bankshad the exclusive rights to manage and circulate currency and were provided capital toestablish branch networks). In 1921, the government consolidated the three presidencybanks into the Imperial Bank of India.

Question:1. Do you think the SBI is self-sufficient to provide maximum satisfaction to

customers? Discuss.




W.C and Tolbert S.M., Oxford University Press4. Projects, Preparation, Appraisal, Budgeting and Implementation, by Prasanna


3.75 Bibliography1. Kem, H.J. (2005), “Global Retail Banking: Changing Paradigms”, Chartered

Financial Analyst, ICFAI Press, Hyderabad, Vol. XI, No. 10, pp. 56-58.2. Neetu Prakash (2006), “Retail Banking in India”, ICFAI University Press,

Hyderabad, pp. 2-10.3. Dhanda Pani Alagiri (2006), “Retail Banking Challenges”, ICFAI University Press,

Hyderabad, pp. 25-34.4. Manoj Kumar Joshi (2007), “Growth Retail Banking in India”, ICFAI University



Business Catalyst”, ICFAI University Press, Hyderabad, pp. 68-74.7. Sunil Kumar (2008), “Retail Banking in India”, Hindustan Institute of Management

and Computer Studies, Mathura.8. Divanna, J.A. (2009), “The Future Retail Banking", Palgrave Macmillan, New


Financial Pulse (AFP), India.10. Sapru R.K. (1994), Development Administration, Sterling, New Delhi.11. United Nations Industrial Development Organization (1998), Manual for

Evaluation of Industrial Projects, Oxford and IBH, New York.12. T.E. Copeland and J.F. Weston (1988), Financial Theory and Corporate Policy,


Portfolio Theory and Investment Analysis, John Wiley & Sons, New York (ISBN978-0470050828).



Notes 14. E.F. Fama (1976), Foundations of Finance, Basic Books Inc., New York (ISBN978-0465024995).

15. Marc M. Groz (2009), Forbes Guide to the Markets, John Wiley & Sons, Inc.,New York (ISBN 978-0470463383).






Developmental Financial Institutions 179

Notes

Unit 4: Developmental Financial Institutions

Structure:

4.1 Introduction4.2 Developmental Banks4.3 Features of a Developmental Bank4.4 Role of Developmental Banks in Industrial Financing4.5 Types of Developmental Banks in India4.6 Origin of Industrial Developmental Bank of India (IDBI)

4.6.1 The Present Scenario of IDBI4.6.2 Objectives of Industrial Developmental Bank of India4.6.3 Functions of Industrial Developmental Bank of India4.6.4 Services of Industrial Developmental Bank of India

4.7 Origin of State Financial Corporations (SFCs)4.7.1 Features of State Financial Corporations4.7.2 Objectives of State Financial Corporations4.7.3 Financial Resources of the SFCs4.7.4 Functions of State Financial Corporations4.7.5 SFCs – Contributory to Development of Small-scale Industries in the

Indian Economy4.8 Origin of State Industrial Developmental Corporations (SIDCs)

4.8.1 Objectives of State Industrial Developmental Corporations4.8.2 Functions of State Industrial Developmental Corporations

4.9 Origin of Life Insurance Corporation of India (LICI)4.9.1 Milestones in the Life Insurance Business in India4.9.2 Milestones in the General Insurance Business in India4.9.3 Objectives of Life Insurance Corporation of India4.9.4 Features of Life Insurance Corporation of India4.9.5 Functions of Life Insurance

4.10 Origin of Export-Import Bank of India (EXIM Bank)4.10.1 Capital of Export-Import Bank4.10.2 Objectives of Export-Import Bank of India4.10.3 Functions of Export-Import Bank of India

4.11 National Bank for Agriculture and Rural Development (NABARD)4.11.1 Objectives of NABARD4.11.2 Role and Functions of NABARD

4.12 Resource Mobilization of Developmental Banks4.13 Project Examination by Developmental Banks4.14 Summary



Notes 4.15 Check Your Progress4.16 Questions and Exercises4.17 Key Terms4.18 Check Your Progress: Answers4.19 Case Study4.20 Further Readings4.21 Bibliography

Objectives


Understand the role of Developmental Banks in Industrial FinancingDetailed study of Resource Mobilization of Developmental BanksUnderstand the Project Examination by Developmental Banks

4.1 Introduction

Developmental Finance Institutions (DFIs) are national and international institutionsthat provide loans, grants and other investments for projects and activities around the world.While banks have traditionally met short-term working capital requirements of industry,developmental finance institutions (DFIs) have mainly catered to the medium to long-termfinancing requirements. Industrial Finance Corporation of India (IFCI) was the first DFI whichwas established to extend long-term finance to industry. This was followed by theestablishment of several DFIs, both in public and private sector. DFIs can be classifiedas: (i) term lending institutions such as Industrial Investment Bank of India (IIBI) Ltd.,Export-Import Bank of India (EXIM) and Tourism Finance Corporation of India (TFCI) Ltd.which provide long-term finance to various sectors; and (ii) refinance institutions such asNational Bank for Agriculture and Rural Development (NABARD), Small IndustriesDevelopmental Bank of India (SIDBI) and National Housing Bank (NHB) which providefinance to banking as well as non-banking financial intermediaries.

All the DFIs were government-owned; their operations were marked by near absenceof competition up to 1990. Moreover, DFIs were extended funds at concessional ratesin the form of Long-term Operations Fund of the RBI and government guaranteed bondson a long-term basis, with their maturity ranging from 10-15 years. Despite this, theoperations of DFIs became less profitable over the years. Thus, in order to impart marketorientation to operations of DFIs, various reform measures such as gradual phase out ofthe market borrowing allocations of government guaranteed bonds and discontinuing theaccess to low cost funds of RBI were announced in 1990s. Apart from this, prudentialnorms pertaining to capital adequacy, income recognition, asset classification andprovisioning were recommended in 1994.

Between the period 1993 to 1998, DFIs took several measures such as offeringinnovative products and diversification of activities into new areas of business, viz.,investment banking, stock broking and custodial services to cope with the increasedcompetition. However, softening of interest rates and slowdown in industrial activity in thesecond half of 1990s had adverse impact on the asset quality of DFIs. With declininginterest rates, high cost of funds raised by DFIs in the past became a cause of concern.Despite increase in cost of funds, DFIs had to lend at a very competitive rate due toincreased competition from banks which ventured into project financing, in turn, resultingin decline in spread and profitability of DFIs. Further, in January 2001, the RBI permitted



Notesreverse merger of ICICI with its commercial bank subsidiary. This was followed byconversion of IDBI into a banking company on October 1, 2004. The conversion of thesetwo large DFIs into banking companies led to the decline in share of DFIs in infrastructureproject finance. The earlier mentioned developments led to substantial decline in financialassistance sanctioned and disbursed by DFIs during initial years of the current decade.On an average, the financial assistance sanctioned and disbursed by DFIs declined to` 389.1 billion during FY02-FY07 as compared with ` 836.8 billion during FY96-FY01.The financial assistance sanctioned by DFIs, however, witnessed an upturn during FY08-FY09 owing to increased sanction by investment institutions (especially LIC). During FY09,the financial assistance sanctioned by DFIs witnessed an increase of 70.2% (y-o-y) whiledisbursements witnessed an increase of almost 93.3%.

The intensification of global financial crisis and consequent liquidity crunch in thedomestic financial system led the RBI to take a slew of measures in order to provideliquidity support to DFIs. For instance, the RBI provided refinance facility of ` 160 billion(includes ` 70 billion for SIDBI, ` 50 billion for EXIM Bank and ` 40 billlion for NHB) toDFIs to facilitate on-lending to Housing Finance Companies (HFCs), NBFCs, mutual fundsand exporters. Under the refinance facility, ` 213.98 billlion were drawn up to June 26,2009, while total disbursements amounted to ` 153.12 billion (up to June 26, 2009). Therefinance facility had as many as 5,283 beneficiaries including 33 State FinanceCorporation and Banks, 22 NBFCs and 14 HFCs. In addition to this, the ceiling onaggregate resources mobilized by SIDBI, NHB and EXIM Bank was raised to 12 timesof net owned funds (NOF) for SIDBI and NHB and 13 times of NOF for EXIM Bank. Thisled to a 9.1% increase in resource mobilization by DFIs during FY09. Further, the ‘umbrellalimit’ was raised for EXIM Bank and NHB and select DFIs were allowed to offer marketrelated yield to maturity.

4.2 Developmental Banks

Developmental Bank is a financial institution dedicated to fund new and upcomingbusinesses and economic developmental projects by equity capital or loan capital.Developmental banks are those financial institutions engaged in the promotion anddevelopment of industry, agriculture and other key sectors.

Developmental bank is essentially a multi-purpose financial institution with a broaddevelopmental outlook. A developmental bank may, thus, be defined as a financialinstitution concerned with providing all types of financial assistance (medium- as well aslong-term) to business units, in the form of loans, underwriting, investment and guaranteeoperations, and promotional activities – economic development in general, and industrialdevelopment, in particular.

4.3 Features of a Developmental Bank

Following are the main characteristic features of a developmental bank:

1. It is a specialized financial institution.2. It provides medium- and long-term finance to business units.3. Unlike commercial banks, it does not accept deposits from the public.4. It is not just a term-lending institution. It is a multi-purpose financial institution.5. It is essentially a developmental-oriented bank. Its primary object is to promote

economic development by promoting investment and entrepreneurial activity ina developing economy. It encourages new and small entrepreneurs and seeksbalanced regional growth.



Notes 6. It provides financial assistance not only to the private sector but also to thepublic sector undertakings.

7. It aims at promoting the saving and investment habit in the community.8. It does not compete with the normal channels of finance, i.e., finance already

made available by the banks and other conventional financial institutions. Itsmajor role is of a gap-filler, i.e., to fill up the deficiencies of the existing financialfacilities.

9. Its motive is to serve public interest rather than to make profits. It works in thegeneral interest of the nation.

4.4 Role of Developmental Banks in Industrial Financing

Various roles of Developmental Banks in Industrial Financing are:

1. Assistance for Small-scale Industries (SSI)Developmental banks play an important role in the promotion and development of

the small-scale sector. Government of India (GOI) started Small Industries DevelopmentBank of India (SIDBI) to provide medium- and long-term loans to Small-scale Industries(SSI) units. SIDBI provides direct project finance, and equipment finance to SSI units.It also refinances banks and financial institutions that provide seed capital, equipmentfinance, etc. to SSI units.

2. Development of Housing SectorDevelopmental banks provide finance for the development of the housing sector. GOI

started the National Housing Bank (NHB) in 1988. NHB promotes the housing sector inthe following ways:

1. It promotes and develops housing and financial institutions.2. It refinances banks and financial institutions that provide credit to the housing

sector.3. Large-scale Industries (LSI)

Developmental banks promote and develop large-scale industries (LSI). Developmentfinancial institutions like IDBI, IFCI, etc. provide medium- and long-term finance to thecorporate sector. They provide merchant banking services, such as preparing projectreports, doing feasibility studies, advising on location of a project, and so on.

4. Agriculture and Rural DevelopmentDevelopmental banks like National Bank for Agriculture and Rural Development

(NABARD) helps in the development of agriculture. NABARD started in 1982 to providerefinance to banks, which provide credit to the agriculture sector and also for ruraldevelopment activities. It coordinates the working of all financial institutions that providecredit to agriculture and rural development. It also provides training to agricultural banksand helps to conduct agricultural research.

5. Enhance Foreign TradeDevelopmental banks help to promote foreign trade. Government of India started

Export-Import Bank of India (EXIM Bank) in 1982 to provide medium- and long-term loansto exporters and importers from India. It provides Overseas Buyers Credit to buy Indiancapital goods. It also encourages abroad banks to provide finance to the buyers in theircountry to buy capital goods from India.



Notes6. Review of Sick UnitsDevelopmental banks help to revive (cure) sick-units. Government of India (GOI)

started Industrial investment Bank of India (IIBI) to help sick units.

IIBI is the main credit and reconstruction institution for revival of sick units. It facilitatesmodernization, restructuring and diversification of sick units by providing credit and otherservices.

7. Entrepreneurship DevelopmentMany developmental banks facilitate entrepreneurship development. NABARD, State

Industrial Developmental Banks and State Finance Corporations provide training toentrepreneurs in developing leadership and business management skills. They conductseminars and workshops for the benefit of entrepreneurs.

8. Regional DevelopmentDevelopmental banks facilitate rural and regional development. They provide finance

for starting companies in backward areas. They also help the companies in projectmanagement in such less developed areas.

9. Contribution to Capital MarketsDevelopmental banks contribute the growth of capital markets. They invest in equity

shares and debentures of various companies listed in India. They also invest in mutualfunds and facilitate the growth of capital markets in India.

4.5 Types of Developmental Banks in India

Developmental banks in India are classified into following four groups:

1. Industrial Developmental BanksIt includes, for example, Industrial Finance Corporation of India (IFCI), Industrial

Developmental Bank of India (IDBI), and Small Industries Developmental Bank of India(SIDBI).

2. Agricultural Developmental BanksIt includes, for example, National Bank for Agriculture and Rural Development

(NABARD).

3. Export-Import Developmental BanksIt includes, for example, Export-Import Bank of India (EXIM Bank).

4. Housing Developmental BanksIt includes, for example, National Housing Bank (NHB).

4.6 Origin of Industrial Development Bank of India (IDBI)

The Industrial Development Bank of India (IDBI) was established on 1 July 1964 underan Act of Parliament as a wholly owned subsidiary of the Reserve Bank of India. On16 February 1976, the ownership of IDBI was transferred to the Government of India andit was made the principal financial institution for coordinating the activities of institutionsengaged in financing, promoting and developing industry in the country. AlthoughGovernment shareholding in the Bank came down below 100% following IDBI’s public issuein July 1995, the former continues to be the major shareholder (current shareholding:65.14%). IDBI provides financial assistance, both in rupee and foreign currencies, for



Notes greenfield projects as also for expansion, modernization and diversification purposes. Inthe wake of financial sector reforms unveiled by the government since 1992, IDBI alsoprovides indirect financial assistance by way of refinancing of loans extended by State-level financial institutions and banks and by way of rediscounting of bills of exchangearising out of sale of indigenous machinery on deferred payment terms.

IDBI has played a pioneering role, particularly in the pre-reform era (1964-91), incatalyzing broad based industrial development in the country in keeping with itsGovernment-ordained ‘developmental banking’ charter.

In September 2003, IDBI diversified its business domain further by acquiring the entireshareholding of Tata Finance Limited in Tata Home Finance Ltd., signaling IDBI’s forayinto the retail finance sector. The fully owned housing finance subsidiary has since beenrenamed ‘IDBI Home Finance Limited’. In view of the signal changes in the operatingenvironment, following initiation of reforms since the early nineties, Government of Indiahas decided to transform IDBI into a commercial bank without eschewing its seculardevelopment finance obligations. The migration to the new business model of commercialbanking, with its gateway to low-cost current, savings bank deposits, would help overcomemost of the limitations of the current business model of development finance whilesimultaneously enabling it to diversify its client/asset base. Towards this end, the IDBIAct 2003 was passed by Parliament in December 2003.

IDBI Bank, with which the parent IDBI was merged, was a new generation bank.The Private Bank was the fastest growing banking company in India. The bank was pioneerin adapting to policy of first mover in tier 2 cities. The Bank also had the least NPA andthe highest productivity per employee in the banking industry.

The immediate fallout of the merger of IDBI and IDBI Bank was the exit of employeesof IDBI Bank. The cultures in the two organizations have taken its toll. The IDBI Banknow is in a growing fold. With its retail banking arm expanding further after the mergerof United Western Bank.

IDBI would continue to provide the extant products and services as part of itsdevelopment finance role even after its conversion into a banking company. In addition,the new entity would also provide an array of wholesale and retail banking products,designed to suit the specific needs and cash flow requirements of corporate and individuals.In particular, IDBI would leverage the strong corporate relationships built up over the yearsto offer customized and total financial solutions for all corporate business needs, singlewindow appraisal for term loans and working capital finance, strategic advisory and “hand-holding” support at the implementation phase of projects, among others.

IDBI’s transformation into a commercial bank would provide a gateway to low-costdeposits like Current and Savings Bank Deposits. This would have a positive impact onthe bank’s overall cost of funds and facilitate lending at more competitive rates to its clients.The new entity would offer various retail products, leveraging upon its existing relationshipwith retail investors under its existing Suvidha Flexi-bond schemes.

The responsibility for maintaining standards of corporate governance lies with itsBoard of Directors. Two Committees of the Board, viz., the Executive Committee and theAudit Committee are adequately empowered to monitor implementation of good corporategovernance practices and making necessary disclosures within the framework of legalprovisions and banking conventions.



Notes4.6.1 The Present Scenario of IDBI

Today, IDBI Bank is counted amongst the leading public sector banks of India, apartfrom claiming the distinction of being the 4th largest bank, in overall ratings. It is presentlyregarded as the tenth largest developmental bank in the world, mainly in terms of reach.This is because of its wide network of 509 branches, 900 ATMs and 319 centers. Apartfrom being involved in banking services, IDBI has set up institutions like The National StockExchange of India (NSE), The National Securities Depository Services Ltd. (NSDL) andthe Stock Holding Corporation of India (SHCIL).

4.6.2 Objectives of Industrial Development Bank of India

The main objectives of IDBI are to serve as the apex institution for term finance forindustry in India. Its objectives include:

(i) To grant loans to any industrial concern.(ii) To guarantee deferred payment due from any industrial concern.(iii) To guarantee loans raised by industrial concerns in the market or from

institutions.(iv) To provide consultancy and merchant banking services in or outside India.(v) To provide technical, legal, marketing and administrative assistance to any

industrial concern or person for promotion, management or expansion of anyindustry.

(vi) To act as trustee for the holders of debentures or other securities.

4.6.3 Functions of Industrial Development Bank of India

The IDBI has been established to perform the following functions:

(i) Coordination, regulation and supervision of the working of other financialinstitutions such as IFCI, ICICI, UTI, LIC, Commercial Banks and SFCs.

(ii) Supplementing the resources of other financial institutions and thereby wideningthe scope of their assistance.

(iii) Planning, promotion and development of key industries and diversification ofindustrial growth.

(iv) Devising and enforcing a system of industrial growth that conforms to nationalpriorities.

(v) It grants loans and advances to IFCI, SFCs or any other financial institutionsby way of refinancing of loans granted by such institutions which are repayablewithin 25 years.

(vi) It grants loans and advances to scheduled banks or state cooperative banksby way of refinancing of loans granted by such institutions which are repayablein 15 years.

(vii) It contributes loans and advances to IFCI, SFCs, other institutions, scheduledbanks and state cooperative banks by way of refinancing of loans granted bysuch institution to industrial concerns for exports.

(viii) It underwrites or subscribes to shares or debentures of industrial concerns.(ix) It subscribes to or purchase stock, shares, bonds and debentures of other

financial institutions.(x) It grants line of credit or loans and advances to other financial institutions such

as IFCI, SFCs, etc.



Notes (xi) It ensures the planning, promoting and developing industries to fill up gaps inthe industrial structure in India.

4.6.4 Services of Industrial Developmental Bank of India

In order to increase its customer base, the Industrial Developmental Bank of Indiaoffers a number of customized and innovative banking services. The services are meantto offer cent per cent satisfaction to the customers. Some of the well-known servicesoffered by the bank are:

1. Wholesale Banking ServicesWholesale banking service is the provision of services by banks to the likes of

Mortgage Brokers, large corporate clients, mid-sized companies, real estate developersand investors, international trade finance businesses, institutional customers (such aspension funds and government entities/agencies), and services offered to other banks orother financial institutions. The wholesale banking services form a major part of the bankingservices of the bank.

The services that are offered under the wholesale division are:

(i) Cash Management(ii) Transactional services(iii) Finance of working capital(iv) Agro based business transactions(v) Trade services

The wholesale banking services are an important source of income in a number ofinfrastructure projects such as power, transport, telecom, railways, roadways, andlogistics and so on.

2. Retail Banking ServicesRetail banking service is banking activity in which banking institutions execute

transactions directly with consumers, rather than corporations or other banks. Servicesoffered include savings and transactional accounts, mortgages, personal loans, debitcards, and credit card.

The Industrial Development Bank of India is also a leader in the retail bankingservices. The Net Interest Income amounted to around ̀ 2166 crores while the Net Profitamounted to around ` 187 crores. The main objective of the retail services is to providehigh quality financial products to the target market to give that one-stop solution to thebanking needs.

The retail products offered by the banks include:

(i) Housing loans(ii) Personal loans(iii) Securities loans(iv) Mortgage loans(v) Educational loans(vi) Merchant establishment overdrafts(vii) Holiday travel loans(viii) Commercial property loans



Notes3. Treasury Facilities and ServicesThe net interest income of this sector amounts to around ` 1283 crores while the

net profit amounts to around ` 44.8 crores. One can get an array of financial productssuch as cash management services, deposit, treasury products, trade finance servicesand so on.

The three segments in this sector are:

(i) Local Currency Money Market.(ii) Debt Securities and Equities.(iii) Foreign Exchange and Derivatives.

4. Other Services of Industrial Development Bank of IndiaIn addition to these, IDBI also offers some allied services and financial solutions to

cater to the target audience. To cater to the capital market, the bank has floated the IDBICapital Market Services Limited, also known as IDBI Capital.

The various services offered in this section are:

(i) Corporate advisory services.(ii) Financial product distribution.(iii) Pension fund management.(iv) Corporate and retail services.(v) Debt management services.

The IDBI Home Finance Limited is also a subsidiary of the Industrial DevelopmentBank of India. It is used for the purpose of providing long-term loans and other financialbenefits to various companies of the industrial sector.

In addition to these, there is also the IDBI Intech Limited which is a trusted namein the field of system support and implementation, applications, server hosting, systemintegration and other related services. Another subsidiary of the Industrial DevelopmentBank of India is the IDBI Gilts Limited. The main services of this segment is trading ofbonds, offering insurance, auction underwriting and so on.

4.7 Origin of State Financial Corporations (SFCs)

State authorized each state of the Indian union to establish an SFC. PunjabGovernment took the lead in organizing financial corporation and set up State FinancialCorporation in 1953. Gradually, financial corporations were established in different states.By now, there are 18 SFCs functioning in different states in India. Of these, 17 were setup under the SFCs Act, 1951. Tamil Nadu Industrial Investment Corporation Ltd. wasestablished in 1949 under the Companies Act as Madras Industrial Investment CorporationLtd. also functions as SFC. These institutions are closely modeled on the lines of theIFCI with the difference in scope of their activity. While the IFCI limits its financialassistance to larger industrial concerns. SFCs are intended to extend financial help tosmaller enterprises. Normally, the area of operations of an SFC is confined to one state.However, activities of some of the State Financial Corporations cover the neighbouringStates/Union territories, which do not have SFCs of their own. With a view to reachingthe small-scale units spread out in their areas of operations, SFCs have opened a numberof regional/branch offices.



Notes 4.7.1 Features of State Financial Corporations

The main features of the State Financial Corporations are:

(i) The bill provides that the state government may, by notification in the officialgazette, establish a financial corporation for the state.

(ii) The share capital shall be fixed by the State government but shall not exceed` 2 crores. The issue of the shares to the public will be limited to 25% of theshare capital and the rest will be held by the State Governments, the ReserveBank, Scheduled Banks, Insurance Companies, Investment Trusts, CooperativeBanks and other financial institutions.

(iii) Shares of the corporation will be guaranteed by the State government as to therepayment of principal and the payment of a minimum dividend to be prescribedin consultation with the central government.

(iv) The corporation will be authorized to issue bonds and debentures for amountswhich together with the contingent liabilities of the corporations shall not exceedfive times the amount of the paid-up share capital and the reserve fund of thecorporations. These bonds and debentures will be guaranteed as to paymentof the principal and payment of interest at such rate as may be fixed by theState government.

(v) The corporation may accept deposits from the public repayable after not lessthan five years, subject to the maximum not exceeding the paid-up capital.

(vi) The corporation will be managed by a board consisting of a majority of Directorsnominated by the State governments, The Reserve Bank and the IndustrialFinance Corporation of India.

(vii) The corporation will be authorized to make long-term loans to industrial concernswhich are repayable within a period not exceeding 25 years. The Corporationwill be further authorized to underwrite the issue of stocks, shares, bonds ordebentures by industrial concerns, subject to the provision that the corporationwill be required to dispose of the shares, etc. This is acquired by it in fulfillmentof its underwriting liability within a period of 7 years.

(viii) Until a reserve fund is created equal to the paid-up share capital of theCorporation and until the State Governments has been repaid, all amounts paidby them, if any, in fulfillment of the guarantee liability, the rate of dividend shallnot exceed the rate guaranteed by the state government. Under nocircumstances shall the dividend exceed 5% p.a. and surplus profits will berepayable to the State governments.

(ix) The corporation will have special privileges in the matter of enforcement of itsclaims against borrowers.

4.7.2 Objectives of State Financial Corporations

The various objectives of SFCs are as follows:

(i) To provide medium and long-term financial assistance to small industrialenterprises particularly in circumstances when normal banking facilities are notavailable.

(ii) To assist for satisfying medium- and long-term capital requirements.(iii) To underwrite the issue of shares, bonds and debentures of industrial concerns.(iv) To subscribe to shares, bonds and debentures of industrial concerns.



Notes(v) To provide assistance to new as well as existing industrial concerns for thepurpose of establishment, modernization, renovation, expansion anddiversification.

4.7.3 Financial Resources of the SFCs

The SFCs mobilize their financial resources from the following sources:

1. Their own share capital.2. Income from investment and repayment of loans.3. Sale of bonds.4. Loans from IDBI.5. Borrowings from the Reserve Bank of India.6. Deposits from the public.7. Loans from State Governments.

4.7.4 Functions of State Financial Corporations

The SFCs provide the following types of assistance to industrial units in theirrespective states:

1. The SFCs while giving loans to industrial units see to it that loans are securedby a Pledge, Mortgage, Hypothecation of movable and immovable property orother tangible assets or guarantee by the state government or scheduledcommercial bank. They also accept personal pledge by the entrepreneur. SFCsdon’t give loans on the basis of second mortgage.

2. Grant loans or advances to industrial concern repayable within a period notexceeding 20 years.

3. Providing guarantee for loans raised by industrial units from commercial banksand state cooperative banks.

4. Providing guarantee for deferred payments in cases where industrial units havepurchased capital goods on a deferred payment basis.

5. Guarantee loans raised by industrial concerns which is repayable within a periodnot exceeding 20 years and which are floated in the public market.

6. SFCs grant loans to industrial units for the purchase of fixed capital assets likeland, machinery, etc. In some exceptional cases, some SFCs also provide loansfor working capital requirements in combination with loans for fixed capital.

7. SFCs provide loans in foreign currency for the import of machinery and technicalknow-how, under the IDA (International Development Association) and WorldBank tie-up.

8. SFCs, however, are prohibited from subscribing directly to the shares or stockof any company having limited liability except for underwriting purposes andgranting any loans or advance on the security of its own shares.

4.7.5 SFCs – Contributory to Development of Small-scale Industries in the IndianEconomy

There are at present 18 State Financial Corporations and almost every state hasa financial corporation of its own. During 2000-2001, SFCs had sanctioned loansaggregating to ` 2,800 crores and disbursed ` 2,000 crores. Their assistance in the formof loans has declined subsequently due to the existence of a large amount of Non-



Notes performing assets. Over 70% of the total assistance sanctioned and disbursed by all SFCsis provided to small-scale industries. Attempts are now being made to strengthen the roleof SFCs as regional developmental banks. The SFCs sanctioned seed capital assistanceunder the seed capital schemes introduced and operated by IDBI. This assistance isavailable to promoters of small business units. Since June 1989, SFCs have also beenimplementing special schemes of seed capital assistance to women entrepreneurs.Assistance is extended in the form of loan or grant or a combination of both to voluntaryagencies working for women in decentralized industries.

4.8 Origin of State Industrial Development Corporations (SIDCs)

The State Industrial Development Corporations act as catalyst for the promotion anddevelopment of medium and large enterprises in their respective states. In tune with thechanging business environment and the challenges emanating from it, SIDCs are makingefforts to diversify their activities to cover a range of fee-based activities besides wideningthe scope of fund-based activities.

The State Industrial Development Corporations (SIDCs) were established under theCompanies Act, 1956 as wholly owned undertakings of the state governments with thespecific objectives of promoting and developing medium and large industries in theirrespective states/union territories. These corporations extend financial assistance in theform of rupee loans, underwriting and direct subscriptions to shares/debentures,guarantees, intercorporate deposits and also opens letters of credit on behalf of itsborrowers. SIDCs undertake a range of promotional activities including preparation offeasibility reports, conducting industrial potential surveys, entrepreneurship training anddevelopment programmes and developing industrial areas/estates. Some SIDCs also offera package of developmental services that include technical guidance, assistance in plantlocation and coordination with other agencies. With a view to providing infrastructuralfacilities for the establishment of industrial units, SIDCs are involved in the setting up ofindustrial growth centres. To keep pace with the changing economic environment, SIDCshave initiated various measures to expand the scope of their activities and have enteredinto various fee-based activities. Of the 28 SIDCs in the country, those in Andaman andNicobar, Arunachal Pradesh, Daman and Diu and Dadra and Nagar Haveli, Goa, Manipur,Meghalaya, Mizoram, Nagaland, Tripura, Pondicherry and Sikkim also act as SFCs toprovide assistance to small and medium enterprises and act as promotional agencies forthis sector.

4.8.1 Objectives of State Industrial Development Corporations

The various objectives of State Industrial Development Corporations are as follows:

(i) To liaise with and to represent to the Central and State Governments, termlending and other financial institutions on the common problems and issues ofmember corporations.

(ii) To promote coordination, collaboration, joint participation and generalunderstanding among the member corporations, etc.

(iii) To render assistance to member corporations in their efforts to improve efficiencyof operations of their assisted and sponsored units.

(iv) To organize common service facilities, training courses, seminars, meetings andstudy tours for the benefit of the member corporations.

(v) To sponsor studies, surveys, research and development projects pertaining toindustries.



Notes(vi) To establish and maintain at the Registered Office a commercial and technicallibrary and information centre for use of member corporations.

4.8.2 Functions of State Industrial Development Corporations

The various functions of State Industrial Development Corporations are as follows:

1. State Industrial Development Corporations provide the financial assistance tothe state level organizations to develop the organizational activities.

2. They are involved in developing industrial infrastructure like industrial estates,industrial parks and setting up industrial projects either on their own or in thejoint sector in collaboration with private entrepreneurs or as wholly ownedsubsidiaries.

3. SIDCs exist in all the States and have developed industrial infrastructure facilitiesto enable prospective entrepreneurs to set up their industries in the states.

4. These corporations render technical assistance to the entrepreneurs in theformulation of the project reports and also provide common facilities in theindustrial estates.

5. These corporations provide loans and advances to the industrial units in themedium and large sectors to the maximum of ` 400 lakhs.

6. State Industrial Development Corporations ensures the interest rate rangesbetween 13.5% to 17% depend upon the size of the loan.

4.9 Origin of Life Insurance Corporation of India (LICI)

The nationalization of insurance business in the country resulted in the establishmentof Life Insurance Corporation of India (LIC) in 1956 as a wholly owned corporation of theGovernment of India. The broad objectives of LIC are to serve people through financialsecurity by providing products and services of aspired attributes with competitive returns,and by rendering resources for economic development. With a view to spreading lifeinsurance across the country, particularly, in the rural areas and to the socially andeconomically backward classes, LIC currently offers over 50 plans to cover life at variousstages through a network of 2048 branches, all of which are fully computerized. LIC hasinstalled ‘information kiosks’ at select locations for dissemination of information on itsproducts as also for accepting premium payments. It has also installed Interactive VoiceResponse Systems in 59 urban centers, enabling its customers to get select informationabout their policies.

With a view to widening its reach in the prevalent competitive and deregulatedbusiness environment, and following the internationally prevalent Bank Assurance Model.LIC issues ‘Corporate Agency’ licenses to several public and private sector banks in Indiafor marketing its policies to corporate houses through their combined branch network.

Besides conducting insurance business, LIC, in pursuance of Government guidelines,invests a major portion of its funds in Central and State Government securities and otherapproved securities, including special deposits with Government of India. In addition, LICextends assistance to develop infrastructure facilities like housing, rural electrification,water supply and sewerage and provides financial assistance to the corporate sector byway of term loans, underwriting of and direct subscription to shares and debentures. LICalso provides resource support to financial institutions through subscription to their shares/bonds and by way of term loans.



Notes 4.9.1 Milestones in the Life Insurance Business in India

Some of the important milestones in the life insurance business in India are:

1818: Oriental Life Insurance Company, the first life insurance company on Indiansoil started functioning.

1870: Bombay Mutual Life Assurance Society, the first Indian life insurance companystarted its business.

1912: The Indian Life Assurance Companies Act enacted as the first statute toregulate the life insurance business.

1928: The Indian Insurance Companies Act enacted to enable the government tocollect statistical information about both life and non-life insurance businesses.

1938: Earlier legislation consolidated and amended to by the Insurance Act with theobjective of protecting the interests of the insuring public.

1956: 245 Indian and foreign insurers and provident societies are taken over by theCentral Government and nationalized. LIC formed by an Act of Parliament, viz., LIC Act,1956, with a capital contribution of ` 5 crores from the Government of India.

The General insurance business in India, on the other hand, can trace its roots tothe Triton Insurance Company Ltd., the first general insurance company established inthe year 1850 in Calcutta by the British.

4.9.2 Milestones in the General Insurance Business in India

Some of the important milestones in the general insurance business in India are:

1907: The Indian Mercantile Insurance Ltd. set up the first company to transact allclasses of general insurance business.

1957: General Insurance Council, a wing of the Insurance Association of India, framesa code of conduct for ensuring fair conduct and sound business practices.

1968: The Insurance Act amended to regulate investments and set minimum solvencymargins and the Tariff Advisory Committee set up.

1972: The General Insurance Business (Nationalization) Act, 1972 nationalized thegeneral insurance business in India with effect from 1st January 1973. 107 insurersamalgamated and grouped into four companies, viz., the National Insurance Company Ltd.,the New India Assurance Company Ltd., the Oriental Insurance Company Ltd. and theUnited India Insurance Company Ltd. GIC incorporated as a company.

4.9.3 Objectives of Life Insurance Corporation of India

The various objectives of LICI are as follows:

(a) To carry on capital redemption business, annuity certain business orreinsurance business insofar as such reinsurance business relating to lifeinsurance business;

(b) To invest the funds of the Corporation in such manner as the Corporation maythink fit and to take all such steps as may be necessary or expedient for theprotection or realization of any investment; including the taking over of andadministering any property offered as security for the investment until a suitableopportunity arises for its disposal;



Notes(c) To acquire, hold and dispose of any property for the purpose of its business;(d) To transfer the whole or any part of the life insurance business carried on outside

India to any other person or persons, if in the interest of the Corporation it isexpedient to do so;

(e) To advance or lend money upon the security of any movable or immovableproperty or otherwise;

(f) To borrow or raise any money in such manner and upon such security as theCorporation may think fit.

(g) To carry on either by itself or through any subsidiary any other business in anycase where such other business was being carried on by a subsidiary of aninsurer whose controlled business has been transferred to and vested in theCorporation by this act;

(h) To carry on any other business which may seem to the Corporation to becapable of being conveniently carried on in connection with its business andcalculated directly or indirectly to render profitable the business of theCorporation; and

(i) To do all such things as may be incidental or conducive to the proper exerciseof any of the powers of the Corporation.

4.9.4 Features of Life Insurance Corporation of India

The main features of LIC are given below:

1. Saving InstitutionLife insurance both promotes and mobilizes saving in the country. The income tax

concession provides further incentive to higher income persons to save through LICpolicies. The total volume of insurance business has also been growing with the spreadof insurance-consciousness in the country. The total new business of LIC during 1995-96 was ` 51815 crore sum assured under 10.20 lakh policies. The LIC business can growat still faster speed if the following improvements are made:

(i) The organizational and operational efficiency of the LIC should be increased.(ii) New types of insurance covers should be introduced.(iii) The services of LIC should be extended to smaller places.(iv) The message of life insurance should be made more popular.(v) The general price level should be kept stable so that the insuring public does

not get cheated of a large amount of the real value of its long-term saving throughinflation.

2. Term Financing InstitutionLIC also functions as a large term financing institution (or a capital market) in the

country. The annual net accrual of investible funds from life insurance business (aftermaking all kinds of payments liabilities to the policyholders) and net income from its vastinvestment are quite large. During 1994-95, LIC’s total income was ` 18,102.92 crore,consisting of premium income of ` 1152,80 crore investment income of ` 6336.19 crore,and miscellaneous income of ` 238.33 crore.

3. Investment InstitutionLIC is a big investor of funds in government securities. Under the law, LIC is required

to invest at least 50% of its accruals in the form of premium income in government andother approved securities. LIC funds are also made available directly to the private sector



Notes through investment in shares, debentures, and loans. LIC also plays a significant role indeveloping the business of underwriting of new issues.

4. Stabilizer in Share MarketLIC acts as a downward stabilizer in the share market. The continuous inflow of new

funds enables LIC to buy shares when the market is weak. However, the LIC does notusually sell shares when the market is overshot. This is partly due to the continuouspressure for investing new funds and partly due to the disincentive of the capital gainstax.

4.9.5 Functions of Life Insurance

The various functions of a Life Insurance Corporation are given below:

(a) Life Insurance Corporation carries on capital redemption business, annuitycertain business or reinsurance business insofar as such reinsurance businessrelating to life insurance business;

(b) It invests the funds of the Corporation in such manner as the Corporation maythink fit and to take all such steps as may be necessary or expedient for theprotection or realization of any investment; including the taking over of andadministering any property offered as security for the investment until a suitableopportunity arises for its disposal;

(c) It acquires, holds and disposes of any property for the purpose of its business;(d) It transfers the whole or any part of the life insurance business carried on outside

India to any other person or persons, if in the interest of the Corporation itis expedient so to do;

(e) It advances or lends money upon the security of any movable or immovableproperty or otherwise;

(f) It borrows or raises any money in such manner and upon such security as theCorporation may think fit;

(g) It carries on either by itself or through any subsidiary any other business inany case where such other business was being carried on by a subsidiary ofan insurer whose controlled business has been transferred to and vested in theCorporation by this act;

(h) It carries on any other business which may seem to the corporation to becapable of being conveniently carried on in connection with its business andcalculated directly or indirectly to render profitable the business of theCorporation.

4.10 Origin of Export-Import Bank of India (EXIM Bank)

Export-Import Bank of India was set up in 1982 by an Act of Parliament for thepurpose of financing, facilitating and promoting India’s foreign trade. It is the principalfinancial institution in the country for coordinating the working of institutions engaged infinancing exports and imports. EXIM Bank is fully owned by the Government of India andthe Bank’s authorized and paid-up capital are ` 10,000 crore and ` 2,300 crorerespectively.

EXIM Bank lays special emphasis on extension of Lines of Credit (LOCs) to overseasentities, national governments, regional financial institutions and commercial banks. EXIMBank also extends Buyer’s credit and Supplier’s credit to finance and promote country’sexports. The Bank also provides financial assistance to export-oriented Indian companies



Notesby way of term loans in Indian rupees or foreign currencies for setting up new productionfacility, expansion/modernization or upgradation of existing facilities and for acquisitionof production equipment or technology. EXIM Bank helps Indian companies in theirglobalization efforts through a wide range of products and services offered at all stagesof the business cycle, starting from import of technology and export product developmentto export production, export marketing, pre-shipment and post-shipment and overseasinvestment.

The Bank has introduced a new lending programme to finance research anddevelopment activities of export-oriented companies. R&D financed by Exim Bank is inthe form of term loan to the extent of 80% of the R&D cost. In order to assist in the creationand enhancement of export capabilities and international competitiveness of Indiancompanies, the Bank has put in place an Export Marketing Services (EMS) Programme.Through EMS, the Bank pro-actively assists companies in identification of prospectivebusiness partners to facilitating placement of final orders. Under EMS, the Bank alsoassists in identification of opportunities for setting up plants or projects or for acquisitionof companies overseas. The service is provided on a success fee basis.

EXIM Bank supplements its financing programmes with a wide range of value-addedinformation, advisory and support services, which enable exporters to evaluate internationalrisks, exploit export opportunities and improve competitiveness, thereby helping them intheir globalization efforts.

4.10.1 Capital of Export-Import Bank

The authorized capital of the EXIM Bank is ` 200 crore and paid-up capital is ` 100crore, wholly subscribed by the Central Government. The bank can raise additionalresources through:

(i) Loans/grants from Central Government and Reserve Bank of India;(ii) Lines of credit from institutions abroad;(iii) Funds rose from Euro Currency markets;(iv) Bonds issued in India.

4.10.2 Objectives of Export-Import Bank of India

The various objectives of Export-Import Bank of India are:

(i) To translate national foreign trade policies into concrete action plans.(ii) To provide alternate financing solutions to the Indian exporter, aiding him in his

efforts to be internationally competitive.(iii) To develop mutually beneficial relationships with the international financial

community.(iv) To initiate and participate in debates on issues central to India’s international

trade.(v) To forge close working relationships with other export development and financing

agencies, multilateral funding agencies and national trade and investmentpromotion agencies.

(vi) To anticipate and absorb new developments in banking, export financing andinformation technology.

(vii) To be responsive to export problems of Indian exporters and pursue policyresolutions.



Notes (viii) To ensure the provision of financial‚ technical and administrative assistance inthe export-import sectors;

(ix) To make the planning‚ promotion‚ development and financing of export orientedconcerns;

(x) To ensure the undertaking and financing research‚ surveys and techno-economicstudies in connection with the promotion and development of foreign trade.

4.10.3 Functions of Export-Import Bank of India

The main functions of the EXIM Bank are as follows:

(i) Financing of exports and imports of goods and services, not only of India butalso of the third world countries;

(ii) Financing of exports and imports of machinery and equipment on lease basis;(iii) Financing of joint ventures in foreign countries;(iv) Providing loans to Indian parties to enable them to contribute to the share capital

of joint ventures in foreign countries;(v) It helps to undertake limited merchant banking functions such as underwriting

of stocks, shares, bonds or debentures of Indian companies engaged in exportor import; and

(vi) It ensures to provide technical, administrative and financial assistance to partiesin connection with export and import.

4.11 National Bank for Agriculture and Rural Development (NABARD)

NABARD has been established as an apex development bank with a mandate forfacilitating credit flow for the promotion and development of agriculture, small-scaleindustries, cottage and village industries, handicrafts and other rural crafts. It is alsomandatory for NABARD to support all other allied economic activities in rural areas,promote integrated and sustainable rural development and secure prosperity of the ruralareas.

4.11.1 Objectives of NABARD

(a) To plan operational aspects in the field of credit for the promotion of agriculture,small-scale industries, cottage and village industries, handicrafts and other ruralcrafts and other allied economic activities in rural areas.

(b) To serve as a refinancing institution for institutional credit such as long-term,short-term for the promotion of activities in the rural areas.

(c) To provide direct lending to any institution as may approved by the CentralGovernment.

4.11.2 Role and Functions of NABARD

(a) It is accredited with all the matters concerning policy planning and operationsin the field of credit for agriculture and other economic activities in the rural areas.

(b) It act as a refinancing agency for the institutions providing investment andproduction credit for the promoting the various development activities in rural areas.

(c) It takes measures towards institution building for improving absorptive capacityof the credit delivery system, including monitoring, formulation of rehabilitationschemes, restructuring of credit institutions, training of personnel, etc.



Notes(d) It coordinates the rural financing activities of all the institutions engaged indevelopmental work at the field level and maintains liaison with Government ofIndia, State Governments, Reserve Bank of India and other national levelinstitutions concerned with policy formulation.

(e) It prepares, on an annual basis, rural credit plans for all districts in the country.(f) It undertakes monitoring and evaluation of projects refinanced by it.

(g) It promotes research in the fields of rural banking, agriculture and ruraldevelopment.

4.12 Resource Mobilization of Developmental Banks

The Bank is authorized to assist in the financing of development projects in itsregional developing member countries by means of the following types of operations:

1. Lending operations2. Technical cooperation;3. Assistance in obtaining additional external financing to meet project needs;4. Guarantees extended by the IDB for loans from other sources.

The Bank will not finance a project in a member country if the government of thecountry objects to same.

1. Lending OperationsUsing its own resources and funds that it administers, the Bank participates in the

financing of lending operations in the developing member countries as described below:

Loans for Specific Projects are designed to finance one or more specific projectsor subprojects that are wholly defined at the time the Bank’s loan is approved.Loans for Multiple Works Programmes are designed to finance groups of similarworks which are physically independent of each other and whose feasibility doesnot depend on the execution of any given number of the works projects.Global Credit Loans are granted to intermediary financial institutions (IFIs) orsimilar agencies in the borrowing countries to enable them to onlend to end-borrowers (sub-borrowers) for the financing of multi-sector projects.Sector Adjustment Loans provide flexible support for institutional and policychanges on the sector or sub-sector level, through fast-disbursing funds. At therequest of the borrower, a sector adjustment loan may include an investmentcomponent, in which case it becomes a Hybrid Loan.Time Slice Operations are investment loans in which the investment programmefor a sector or sub-sector is adjusted from time to time within the general criteriaand global objectives agreed upon with the Bank for a project.The Project Preparation Facility provides funding for supplementary activitiesnecessary to prepare a project. The basic objective is to strengthen the projectpreparation stage and shorten the time required, thus facilitating Bank approvalof the loan and execution of the project.Small Projects Financing is intended to make credit available to individuals andgroups that generally do not have access to commercial or development loanson regular market terms. In these cases, the Bank finances operations throughintermediary institutions which then channel the funds to the final beneficiaries.Direct Lending to the Private Sector, without sovereign guarantees, in eachinstance with the concurrence of the government of the member country. At



Notes the outset, this financing would be targeted exclusively towards infrastructureand public utility projects providing services usually performed by the publicsector.The Emergency Reconstruction Facility has the objective to make availableresources to the country stricken by catastrophic disaster to cover theimmediate expenses of restoring basic services to the population. It is importantto understand that what drives the utilization of this facility is the urgency ofhaving resources of the ground in the first few hours after the disaster take place.

2. Technical CooperationThe Bank finances technical cooperation activities to transfer technical know-how

and expertise for the purpose of supplementing and strengthening the technical capacityof entities in the developing member countries. The financing is determined largely on thebasis of the field of activity into which a project falls and the relative development statusof the region, country, or countries involved. It may take one of the following forms:

Technical cooperation with Non-reimbursable Funding, which is a subsidygranted by the Bank to a developing member country to finance technicalcooperation activities. This cooperation is particularly targeted to the least-developed countries of the region and/or those which have insufficient markets.Technical cooperation with Contingent Recovery Resources, whereby the Bankfinances technical cooperation activities where there exists a reasonablepossibility of a loan either from the Bank or another lending institution. If thebeneficiary should obtain a loan from any source for the project for which thetechnical cooperation was provided, the borrower is obligated to reimburse thefunding received from the Bank.Technical cooperation with Reimbursable Resources, which is a loan financedby the Bank to carry out technical cooperation activities.

3. Assistance for the Mobilization of Other Financial ResourcesThe Bank considers that as a complement to the financing it provides out of its own

resources and the funds it administers, it is called upon to act as a Catalyst in themobilization of additional funds from external sources for financing specific projects in itsregional developing member countries. To this end, the Bank encourages and cooperateswith the borrowers in securing additional external financing from different sources. Theprincipal forms of mobilizing additional resources are:

Export Credit, in which, at the request of borrowing institutions, the Bankfurnishes advisory assistance and cooperates with them in arranging for creditsfrom specialized agencies in the advanced industrialized countries to financethe procurement of goods and services required for projects for which the Bankhas made loans.Parallel Credit from Other Public Financial Institutions, in which the Bankcoordinates its activities with national and international public financialinstitutions with an interest in offering financing for projects or programmes inthe regional developing member countries. To facilitate COFINANCING for suchprojects, the Bank is prepared to perform studies and undertake missions inconjunction with other organizations for project identification and evaluation andto enter into agreements with those organizations to administer financinggranted by them on their behalf.Other Parallel Credits, in which at the request of borrowers, the Bank cooperateswith them in obtaining parallel loans from banks or institutional investors of othercountries.



Notes4. Bank’s GuaranteesAccording to the Agreement establishing the Bank, and to promote the investment

in the borrowing countries, the Bank can guarantee loans made by private financial sourcesto public and private sectors.

The Bank can provide guarantees with or without counter-guarantees of the borrowingcountry’s government. Guarantees to private sector lenders without government counter-guarantee of the borrowing country, in whose territory the project is to be carried out,will not exceed 25% of the total cost of the project or $75 million, whichever is less.

The guarantees could be used for any kind of investment project, although the initialemphasis in guarantee operations will be on infrastructure projects.

Other Financing

Export Financing, in which the Bank grants national agencies in the borrowingcountries a revolving line of credit to finance intra-regional exports ofnontraditional goods.The Bank may carry out other forms of financing with Funds under Administrationthat it manages on behalf of third parties, in accordance with the terms of thecontracts they have signed for the administration of said funds, for example,loans for the purchase of shares and direct equity investments.

4.13 Project Examination by Developmental Banks

Developmental Bank is a polygonal development finance institution devoted toimproving the social and monetary development of its associate nations. Its main emphasisis the welfare of the people. For example, the Asian Developmental Bank’s overarchinggoal is to decrease poverty in Asia and the Pacific. It helps improve the value of people’slives by providing loans and scientific support for a broad variety of development activities.New types of activities that generate fee income include securities brokerage, filmfinancing, equity participation in business, real estate brokerage services, real estatedevelopment, real estate equity participation, and insurance brokerage activities. Banksalso receive fee income from a number of off-balance sheet items including loancommitments, note issuance facilities, letters of credit, foreign exchange services, andderivative activities (contracts for futures, forwards, interest rate swaps, and other derivativecontracts).

The essential function of a bank is to provide services related to the storing of valueand the extending credit because bank is a financial institution that provides banking andother financial services. Banks can differ markedly in their sources of income. Some focuson business lending, some on household lending, and some on fee-earning activities.Increasingly, however, most banks are diversifying into fee-earning activities. Traditionally,fee income has been very stable; but, also traditionally, it has been a small part of theearnings stream of most banks.

Although the type of services offered by a bank depends upon the type of bank andthe country, services provided usually include:

(i) Directly take deposits from the general public and issue Savings accounts andCurrent accounts.

(ii) Earning specials like the fixed deposits, recurring deposits.(iii) Lend out money to companies and individuals.



Notes (iv) Issue credit cards, ATM, and debit cards.(v) Online banking and Internet banking.(vi) Storage of valuables, particularly in a safe deposit box.(vii) Granting loans.

4.14 Summary

Development Finance Institutions (DFIs) are national and international institutionsthat provide loans, grants and other investments for projects and activities around the world.While banks have traditionally met short-term working capital requirements of industry,development finance institutions (DFIs) have mainly catered to the medium- to long-termfinancing requirements. Industrial Finance Corporation of India (IFCI) was the first DFI whichwas established to extend long-term finance to industry.

Developmental Bank is a financial institution dedicated to fund new and upcomingbusinesses and economic development projects by equity capital or loan capital.Developmental banks are those financial institutions engaged in the promotion anddevelopment of industry, agriculture and other key sectors.

Developmental bank is essentially a multi-purpose financial institution with a broaddevelopment outlook. A developmental bank may, thus, be defined as a financial institutionconcerned with providing all types of financial assistance (medium as well as long term)to business units, in the form of loans, underwriting, investment and guarantee operations,and promotional activities — economic development in general, and industrial development,in particular.

Developmental banks play an important role in the promotion and development ofthe small-scale sector. Government of India (GOI) started Small industries DevelopmentalBank of India (SIDBI) to provide medium- and long-term loans to Small-scale Industries(SSI) units. SIDBI provides direct project finance, and equipment finance to SSI units.It also refinances banks and financial institutions that provide seed capital, equipmentfinance, etc. to SSI units.

Developmental banks provide finance for the development of the housing sector. GOIstarted the National Housing Bank (NHB) in 1988.

Developmental banks promote and develop large-scale industries (LSI). Developmentfinancial institutions like IDBI, IFCI, etc. provide medium- and long-term finance to thecorporate sector. They provide merchant banking services, such as preparing projectreports, doing feasibility studies, advising on location of a project, and so on.

Developmental banks like National Bank for Agriculture and Rural Development(NABARD) helps in the development of agriculture. NABARD started in 1982 to providerefinance to banks, which provide credit to the agriculture sector and also for ruraldevelopment activities. It coordinates the working of all financial institutions that providecredit to agriculture and rural development. It also provides training to agricultural banksand helps to conduct agricultural research.

Developmental banks help to promote foreign trade. Government of India startedExport-Import Bank of India (EXIM Bank) in 1982 to provide medium- and long-term loansto exporters and importers from India. It provides Overseas Buyers Credit to buy Indiancapital goods. It also encourages abroad banks to provide finance to the buyers in theircountry to buy capital goods from India.



NotesDevelopmental banks help to revive (cure) sick-units. Government of India (GOI)started Industrial investment Bank of India (IIBI) to help sick units.

IIBI is the main credit and reconstruction institution for revival of sick units. It facilitatesmodernization, restructuring and diversification of sick units by providing credit and otherservices.

Developmental banks facilitate rural and regional development. They provide financefor starting companies in backward areas. They also help the companies in projectmanagement in such less developed areas.

Developmental banks contribute the growth of capital markets. They invest in equityshares and debentures of various companies listed in India. They also invest in mutualfunds and facilitate the growth of capital markets in India.

State authorized ea6ch state of the Indian Union to establish an SFC. PunjabGovernment took the lead in organizing financial corporation and set up State FinancialCorporation in 1953. Gradually, financial corporations were established in different states.By now, there are 18 SFCs functioning in different states in India. Of these, 17 were setup under the SFCs Act, 1951. Tamil Nadu Industrial Investment Corporation Ltd. wasestablished in 1949 under the Companies Act as Madras Industrial Investment CorporationLtd. also functions as SFC.

The State Industrial Development Corporations act as catalyst for the promotion anddevelopment of medium and large enterprises in their respective states. In tune with thechanging business environment and the challenges emanating from it, SIDCs are makingefforts to diversify their activities to cover a range of fee-based activities besides wideningthe scope of fund-based activities.

The nationalization of insurance business in the country resulted in the establishmentof Life Insurance Corporation of India (LIC) in 1956 as a wholly owned corporation of theGovernment of India. The broad objectives of LIC are to serve people through financialsecurity by providing products and services of aspired attributes with competitive returns,and by rendering resources for economic development. With a view to spreading lifeinsurance across the country, particularly, in the rural areas and to the socially andeconomically backward classes, LIC currently offers over 50 plans to cover life at variousstages through a network of 2048 branches, all of which are fully computerized. LIC hasinstalled ‘information kiosks’ at select locations for dissemination of information on itsproducts as also for accepting premium payments. It has also installed Interactive VoiceResponse Systems in 59 urban centers, enabling its customers to get select informationabout their policies.

Export-Import Bank of India was set up in 1982 by an Act of Parliament for thepurpose of financing, facilitating and promoting India’s foreign trade. It is the principalfinancial institution in the country for coordinating the working of institutions engaged infinancing exports and imports. EXIM Bank is fully owned by the Government of India andthe Bank’s authorized and paid up capital are ̀ 10,000 crore and ̀ 2,300 crore respectively.

NABARD has been established as an apex developmental bank with a mandate forfacilitating credit flow for the promotion and development of agriculture, small-scaleindustries, cottage and village industries, handicrafts and other rural crafts. It is alsomandatory for NABARD to support all other allied economic activities in rural areas,promote integrated and sustainable rural development and secure prosperity of the ruralareas.



Notes 4.15 Check Your Progress


1. ______________ are national and international institutions that provide loans,grants and other investments for projects and activities around the world.

2. Developmental bank is essentially a multi-purpose financial institution with abroad ______________

3. Development financial institutions like IDBI, IFCI, etc. provide medium- and long-term finance to the ______________

4. NABARD started in the year ______________ to provide refinance to banks,which provide credit to the agriculture sector and also for rural developmentactivities.

5. ______________ Bank of India was set up in 1982 by an Act of Parliamentfor the purpose of financing, facilitating and promoting India’s foreign trade.

II. True or False

1. Developmental banks are those financial institutions engaged in the promotionand development of industry, agriculture and other key sectors.

2. Developmental banks play an important role in the promotion and developmentof the small-scale sector.

3. Government of Karnataka started Small industries Development Bank of India(SIDBI) to provide medium- and long-term loans to Small-scale Industries (SSI)units.

4. Developmental banks like National Bank for Agriculture and Rural Development(NABARD) helps in the development of agriculture.

5. Government of India started Export-Import Bank of India (EXIM Bank) in 1982to provide medium- and long-term loans to exporters and importers from India.

6. The IDBI acts as catalyst for the promotion and development of medium andlarge enterprises in their respective states.


1. Which of the following is the national and international institution that providesloans, grants and other investments for projects and activities around the world?

(a) Development Finance Institution(b) RBI(c) SEBI(d) All the above

2. Government of India (GOI) started Small industries Development Bank of India(SIDBI) to provide ______________

(a) Medium-term loans(b) Long-term loans(c) Both (a) and (b)(d) None of these

3. Developmental banks facilitate ______________(a) Rural Development(b) Regional Development



Notes(c) Both (a) and (b)(d) None of these



1. What is Developmental Bank?2. State any two features of a Developmental Bank.3. What is Industrial Development Bank of India (IDBI)?4. What is State Financial Corporations (SFCs)?5. What is the origin of State Industrial Development Corporations (SIDCs)?6. What is the origin of Life Insurance Corporation of India (LICI)?7. What is Export-Import Bank of India (EXIM Bank)?8. What is National Bank for Agriculture and Rural Development (NABARD)?


1. State various features of a Developmental Bank.2. Discuss various types of Developmental Banks in India.3. State objectives of Industrial Developmental Bank of India.4. Discuss functions of Industrial Developmental Bank of India.5. Explain objectives and functions of State Financial Corporation.6. Discuss various functions of State Industrial Development Corporations.7. Explain various functions of Life Insurance.8. Discuss objectives and functions of Export-Import Bank of India.9. Explain the role and functions of NABARD.

10. Discuss the resource mobilization of Developmental Banks.

4.17 Key TermsDevelopment Finance Institutions: Development Finance Institutions (DFIs)are national and international institutions that provide loans, grants and otherinvestments for projects and activities around the world.Developmental Bank: Developmental Bank is a financial institution dedicatedto fund new and upcoming businesses and economic development projects byequity capital or loan capital.State Industrial Development Corporations: The State Industrial DevelopmentCorporations act as catalyst for the promotion and development of medium andlarge enterprises in their respective states.Export-Import Bank of India: Export-Import Bank of India was set up in 1982by an Act of Parliament for the purpose of financing, facilitating and promotingIndia’s foreign trade.NABARD: NABARD has been established as an apex developmental bank witha mandate for facilitating credit flow for the promotion and development ofagriculture, small scale industries, cottage and village industries, handicraftsand other rural crafts.



Notes 4.18 Check Your Progress: AnswersI. Fill in the Blanks

1. Development Finance Institutions (DFIs)2. Development outlook3. Corporate sector4. 19825. Export-Import

II. True or False1. True2. True3. False4. True5. True6. False

III. Multiple Choice Questions1. (a) Development Finance Institution2. (c) Both (a) and (b)3. (c) Both (a) and (b)

4.19 Case Study

The bank faced several extraordinary challenges in implementing a centralized coreprocessing system. These challenges included finding a new core system that couldprocess approximately 75 million accounts daily – a number greater than any bank inthe world was processing on a centralized basis. Moreover, the bank lacked experiencein implementing centralized systems, audits large employee base took great pride inexecuting complex transactions on local branch in 2002-2009. The Tower Group Inc. maynot be reproduced by any means without express permission. All rights reserved systems.This practice led some people to doubt that the employees would effectively use the newsystem.

Another challenge was meeting SBI’s unique product requirements that would requirethe bank to make extensive modifications to a new core banking system. The productsinclude gold deposits (by weight), savings accounts with overdraft privileges, and anextraordinary number of passbook savings accounts.

Question:1. Discuss about major challenges for SBI?



Company.3. Investing in Development: Lessons of the World Bank Experience by Baum W.C

and Tolbert S.M., Oxford University Press.4. Projects, Preparation, Appraisal, Budgeting and Implementation by Prasanna




Notes4.21 Bibliography1. Kem, H.J. (2005), “Global Retail Banking Changing Paradigms”, Chartered

Financial Analyst, ICFAI Press, Hyderabad, Vol. XI, No. 10, pp. 56-58.2. Neetu Prakash (2006), “Retail Banking in India”, ICFAI University Press,

Hyderabad, pp. 2-10.3. Dhanda Pani Alagiri (2006), “Retail Banking Challenges”, ICFAI University Press,

Hyderabad, pp. 25-34.4. Manoj Kumar Joshi (2007), “Growth Retail Banking in India”, ICFAI University



Business Catalyst”, ICFAI University Press, Hyderabad, pp. 68-74.7. Sunil Kumar (2008), “Retail Banking in India”, Hindustan Institute of Management

and Computer Studies, Mathura.8. Divanna, J.A. (2009), “The Future Retail Banking”, Palgrave Macmillan, New


Financial Pulse (AFP), India.10. Sapru, R.K. (1994), Development Administration, Sterling, New Delhi.11. United Nations Industrial Development Organization (1998), Manual for

Evaluation of Industrial Projects, Oxford and IBH, New York.12. T.E. Copeland and J.F. Weston (1988), Financial Theory and Corporate Policy,


Portfolio Theory and Investment Analysis, John Wiley & Sons, New York(ISBN 978-0470050828).

14. E.F. Fama (1976), Foundations of Finance, Basic Books Inc., New York(ISBN 978-0465024995).


16. R.C. Merton (1992), Continuous Time Finance, Blackwell Publishers Inc.(ISBN 978-0631185086).

17. Keith Pilbeam (2010), Finance and Financial Markets, Palgrave(ISBN 978-0230233218).





Notes

Structure:

5.1 Introduction5.2 Meaning of Insurance5.3 Definition of Insurance5.4 Historical Background of Insurance5.5 Historical Background of Insurance in India5.6 Types of Insurance

5.6.1 Life Insurance5.6.2 General Insurance

5.7 Role of Insurance Companies5.8 Role of Insurance Companies in Industrial Financing5.9 Principles of Insurance

5.10 Life Insurance5.11 Meaning of Life Insurance5.12 Purposes of Life Insurance5.13 The Importance of Life Insurance5.14 Life Insurance Products and Policies5.15 General Insurance5.16 Meaning of General Insurance5.17 Objectives for Practicing of General Insurance5.18 Principles of General Insurance5.19 Features of General Insurance5.20 Functions of General Insurance5.21 General Insurance Corporation of India (GICI)5.22 The General Insurance Business (Nationalization) Amendment Act, 2002 Act

No. 40 of 20025.23 Insurance Sector Reforms in India5.24 Major Policy Changes under IRDA Act5.25 Insurance Companies in India5.26 Protection of the Interest of Policyholders5.27 New Developments in Insurance as a Sector in the Indian Financial System5.28 Bancassurance5.29 Various Models for Bancassurance5.30 Status of Bancassurance in India5.31 Bancassurance Models in Europe5.32 Bancassurance Models in India5.33 The Major Need for Bancassurance in India

Unit 5: Insurance Institutions


Insurance Institutions 207

Notes5.34 Obstacles in the Success of Bancassurance5.35 Regulating Guidelines of IRDA5.36 Recommendations of Committee Constituted by IRDA on Bancassurance5.37 Bancassurance Models in India5.38 Summary5.39 Check Your Progress5.40 Questions and Exercises5.41 Key Terms5.42 Check Your Progress: Answers5.43 Case Study5.44 Further Readings5.45 Bibliography

Objectives


Understand the role of Insurance companies in Industrial FinancingDetailed study of Life Insurance and General InsuranceUnderstand New developments in insurance as a sector in the Indian FinancialSystemDetailed study of Bancassurance Models in Europe and India

5.1 Introduction

Insurance is a contract between two parties whereby one party agrees to undertakethe risk of another in exchange for consideration known as premium and promises to paya fixed sum of money to the other party on happening of an uncertain event (death) orafter the expiry of a certain period in case of life insurance or to indemnify the other partyon happening of an uncertain event in case of general insurance.

Insurance provides financial protection against a loss arising out of happening of anuncertain event. A person can avail this protection by paying premium to an insurancecompany. A pool is created through contributions made by persons seeking to protectthemselves from common risk. Premium is collected by insurance companies which alsoact as trustee to the pool. Any loss to the insured in case of happening of an uncertainevent is paid out of this pool.

Insurance works on the basic principle of risk-sharing. A great advantage of insuranceis that it spreads the risk of a few people over a large group of people exposed to riskof similar type. Insurance is the equitable transfer of the risk of a loss, from one entityto another in exchange for payment. It is a form of risk management primarily used tohedge against the risk of a contingent, uncertain loss.

An insurer, or insurance carrier, is a company selling the insurance; the insured,or policyholder, is the person or entity buying the insurance policy. The amount of moneyto be charged for a certain amount of insurance coverage is called the premium. Riskmanagement, the practice of appraising and controlling risk, has evolved as a discretefield of study and practice.

The concept behind insurance is that a group of people exposed to similar risk cometogether and make contributions towards formation of a pool of funds. In case a person



Notes actually suffers a loss on account of such risk, he is compensated out of the same poolof funds. Contribution to the pool is made by a group of people sharing common risksand collected by the insurance companies in the form of premiums.

Insurance may be described as a social device to reduce or eliminate risk of lifeand property. Under the plan of insurance, a large number of people associate themselvesby sharing risk, attached to individual. The risk, which can be insured against includefire, the peril of sea, death, incident and burglary. Any risk contingent upon these maybe insured against at a premium commensurate with the risk involved.

Insurance is actually a contract between two parties whereby one party called insurerundertakes in exchange for a fixed sum called premium to pay the other party on happeningof a certain event. Insurance is a contract whereby, in return for the payment of premiumby the insured, the insurer pays the financial losses suffered by the insured as a resultof the occurrence of unforeseen events. With the help of Insurance, large number of peopleexposed to similar risks makes contributions to a common fund out of which the lossessuffered by the unfortunate few, due to accidental events, are made good. An insurer isa company selling the insurance; an insured or policyholder is the person or entity buyingthe insurance. The insurance rate is a factor used to determine the amount to be chargedfor a certain amount of insurance coverage, called the premium.

5.2 Meaning of Insurance

Insurance refers to a contract or policy in which an individual or entity receivesfinancial protection or reimbursement against losses from an insurance company. Thecompany pools clients’ risks to make payments more affordable for the insured.

5.3 Definition of Insurance

According to J.B. Maclean, “Insurance is a method of spreading over a large numberof persons a possible financial loss too serious to be conveniently borne by an individual”.

According to Oxford Dictionary, “Insurance is an arrangement by which a companyor the State undertakes to provide a guarantee of compensation for specified loss, damage,illness, or death in return for payment of a specified premium”.

5.4 Historical Background of Insurance

Insurance concept started by considering the methods of transferring or distributingrisk were practiced by Chinese and Babylonian traders as long ago as the 3rd and 2ndmillennia BC, respectively. Chinese merchants travelling treacherous river rapids wouldredistribute their wares across many vessels to limit the loss due to any single vessel’scapsizing. The Babylonians developed a system which was recorded in the famous Codeof Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants. Ifa merchant received a loan to fund his shipment, he would pay the lender an additionalsum in exchange for the lender’s guarantee to cancel the loan should the shipment bestolen.

Achaemenian monarchs of Ancient Persia were the first to insure their people andmade it official by registering the insuring process in governmental notary offices. Theinsurance tradition was performed each year in Nowruz (beginning of the Iranian New Year);the heads of different ethnic groups as well as others willing to take part, presented giftsto the monarch. The most important gift was presented during a special ceremony. When



Notesa gift was worth more than 10,000 Derrik (Achaemenian gold coin) the issue was registeredin a special office. This was advantageous to those who presented such special gifts.For others, the presents were fairly assessed by the confidants of the court. Then theassessment was registered in special offices.

A thousand years later, the inhabitants of Rhodes (an island in Greece) created the‘general average’, which allowed groups of merchants to pay to insure their goods beingshipped together. The collected premiums would be used to reimburse any merchantwhose goods were jettisoned during transport, whether to storm or sinkage. The ancientAthenian “maritime loan” advanced money for voyages with repayment being cancelledif the ship was lost. In the 4th century BC, rates for the loans differed according to safeor dangerous times of year, implying an intuitive pricing of risk with an effect similar toinsurance.

The Greeks and Romans introduced the origins of health and life insurance c. 600BCE when they created guilds called “benevolent societies” which cared for the familiesof deceased members, as well as paying funeral expenses of members. Guilds in theMiddle Ages served a similar purpose. The Talmud deals with several aspects of insuringgoods. Before insurance was established in the late 17th century, “friendly societies”existed in England, in which people donated amounts of money to a general sum thatcould be used for emergencies.

Separate insurance contracts (i.e., insurance policies not bundled with loans or otherkinds of contracts) were invented in Genoa (a city and important seaport in northern Italy)in the 14th century, as were insurance pools backed by pledges of landed estates. Thefirst known insurance contract dates from Genoa in 1343, and in the next century maritimeinsurance developed widely and premiums were intuitively varied with risks. These newinsurance contracts allowed insurance to be separated from investment, a separation ofroles that first proved useful in marine insurance. The first printed book on insurance wasthe legal treatise on Insurance and Merchants’ Bets by Pedro de Santarém (Santerna),written in 1488 and published in 1552. Insurance as we know it today can be traced tothe Great Fire of London, which in 1666 devoured 13,200 houses. In the aftermath of thisdisaster, Nicholas Barbon opened an office to insure buildings. In 1680, he establishedEngland’s first fire insurance company, “The Fire Office,” to insure brick and frame homes.The concept of health insurance was proposed in 1694 by Hugh the Elder Chamberlenfrom the Peter Chamberlen family. In the late 19th century, “accident insurance” beganto be available, which operated much like modern disability insurance. This payment modelcontinued until the start of the 20th century in some jurisdictions (like California), whereall laws regulating health insurance actually referred to disability insurance.

The first insurance company in the United States underwrote fire insurance and wasformed in Charles Town (modern-day Charleston), South Carolina in 1732, but it providedonly fire insurance.

The sale of life insurance in the US began in the late 1760s. The Presbyterian Synodsin Philadelphia and New York founded the Corporation for Relief of Poor and DistressedWidows and Children of Presbyterian Ministers in 1759; Episcopalian priests created acomparable relief fund in 1769. Between 1787 and 1837, more than two dozen life insurancecompanies were started, but fewer than half a dozen survived.

5.5 Historical Background of Insurance in India

In India, insurance has a deep-rooted history. It finds mention in the writings of Manu(Manusmrithi), Yagnavalkya (Dharmasastra) and Kautilya (Arthasastra). The writings talk



Notes in terms of pooling of resources that could be redistributed in times of calamities suchas fire, floods, epidemics and famine. This was probably a precursor to modern-dayinsurance. Ancient Indian history has preserved the earliest traces of insurance in theform of marine trade loans and carriers’ contracts.

Insurance in India has evolved over time heavily drawing from other countries, Englandin particular. 1818 saw the advent of life insurance business in India with the establishmentof the Oriental Life Insurance Company in Calcutta. This Company, however, failed in 1834.In 1829, the Madras Equitable had begun transacting life insurance business in the MadrasPresidency. 1870 saw the enactment of the British Insurance Act and in the last threedecades of the nineteenth century, the Bombay Mutual (1871), Oriental (1874) and Empireof India (1897) were started in the Bombay Residency. This era, however, was dominatedby foreign insurance offices which did good business in India, namely Albert LifeAssurance, Royal Insurance, Liverpool and London Globe Insurance and the Indian officeswere up for hard competition from the foreign companies.

In 1914, the Government of India started publishing returns of Insurance Companiesin India. The Indian Life Assurance Companies Act, 1912 was the first statutory measureto regulate life business. In 1928, the Indian Insurance Companies Act was enacted toenable the Government to collect statistical information about both life and non-lifebusiness transacted in India by Indian and foreign insurers including provident insurancesocieties. In 1938, with a view to protecting the interest of the Insurance public, the earlierlegislation was consolidated and amended by the Insurance Act, 1938 with comprehensiveprovisions for effective control over the activities of insurers.

The Insurance Amendment Act of 1950 abolished Principal Agencies. However, therewere a large number of insurance companies and the level of competition was high. Therewere also allegations of unfair trade practices. The Government of India, therefore, decidedto nationalize insurance business.

An Ordinance was issued on 19th January, 1956 nationalizing the Life Insurancesector and Life Insurance Corporation came into existence in the same year. The LICabsorbed 154 Indian, 16 non-Indian insurers as also 75 provident societies, 245 Indianand foreign insurers in all. The LIC had monopoly till the late 90s when the Insurancesector was reopened to the private sector.

The history of general insurance dates back to the Industrial Revolution in the westand the consequent growth of sea-faring trade and commerce in the 17th century. It cameto India as a legacy of British occupation. General Insurance in India has its roots in theestablishment of Triton Insurance Company Ltd. in the year 1850 in Calcutta by the British.In 1907, the Indian Mercantile Insurance Ltd. was set up. This was the first company totransact all classes of general insurance business.

1957 saw the formation of the General Insurance Council, a wing of the InsuranceAssociation of India. The General Insurance Council framed a code of conduct for ensuringfair conduct and sound business practices.

In 1968, the Insurance Act was amended to regulate investments and set minimumsolvency margins. The Tariff Advisory Committee was also set up then.

In 1972 with the passing of the General Insurance Business (Nationalization) Act,general insurance business was nationalized with effect from 1st January, 1973. 107 insurerswere amalgamated and grouped into four companies, namely National Insurance CompanyLtd., the New India Assurance Company Ltd., the Oriental Insurance Company Ltd. andthe United India Insurance Company Ltd. The General Insurance Corporation of India wasincorporated as a company in 1971 and it commence business on January 1st 1973.



NotesThis millennium has seen insurance come a full circle in a journey extending to nearly200 years. The process of reopening of the sector had begun in the early 1990s and thelast decade and more has seen it been opened up substantially. In 1993, the Governmentset up a committee under the chairmanship of R.N. Malhotra, former Governor of RBI,to propose recommendations for reforms in the insurance sector. The objective was tocomplement the reforms initiated in the financial sector. The committee submitted its reportin 1994 wherein, among other things, it recommended that the private sector be permittedto enter the insurance industry. They stated that foreign companies are allowed to enterby floating Indian companies, preferably a joint venture with Indian partners.

Following the recommendations of the Malhotra Committee report, in 1999, theInsurance Regulatory and Development Authority (IRDA) was constituted as anautonomous body to regulate and develop the insurance industry. The IRDA wasincorporated as a statutory body in April, 2000. The key objectives of the IRDA includepromotion of competition so as to enhance customer satisfaction through increasedconsumer choice and lower premiums, while ensuring the financial security of theinsurance market.

The IRDA opened up the market in August 2000 with the invitation for applicationfor registrations. Foreign companies were allowed ownership of up to 26%. The Authorityhas the power to frame regulations under Section 114A of the Insurance Act, 1938 andhas from 2000 onwards framed various regulations ranging from registration of companiesfor carrying on insurance business to protection of policyholders’ interests.

In December, 2000, the subsidiaries of the General Insurance Corporation of Indiawere restructured as independent companies and at the same time, GIC was convertedinto a national reinsurer. Parliament passed a bill delinking the four subsidiaries from GICin July, 2002.

Today, there are 24 general insurance companies including the ECGC and AgricultureInsurance Corporation of India and 23 life insurance companies operating in the country.The insurance sector is a colossal one and is growing at a speedy rate of 15-20%. Togetherwith banking services, insurance services add about 7% to the country’s GDP. A well-developed and evolved insurance sector is a boon for economic development as it provideslong-term funds for infrastructure development at the same time strengthening the risktaking ability of the country.

The insurance sector in India has completed all the facets of competition – from beingan open competitive market to being nationalized and then getting back to the form ofa liberalized market once again. The history of the insurance sector in India reveals thatit has witnessed complete dynamism for the past two centuries approximately.

5.6 Types of Insurance

Different types of insurance are used to cover different properties and assets suchas vehicles, home, health care, etc. Basically, an insurance policy can also be knownas a protection net which secures from any financial losses in future. The Insurance canbe broadly classified into two categories such as:

1. Life Insurance2. Non-life Insurance or General Insurance



Notes 5.6.1 Life Insurance

Life Insurance refers to the insurance which gives a protection against the loss ofincome that would result if the insured passed away. The named beneficiary receives theproceeds and is thereby safeguarded from the financial impact of the death of the insured.

Types of Life InsuranceLife insurance protection comes in many forms and not all policies are created equal.

While the death benefit amounts may be the same, the costs, structure, durations, etc.vary tremendously across the types of policies.

(i) Whole Life InsuranceWhole life insurance provides guaranteed insurance protection for the entire life of

the insured, otherwise known as permanent coverage. These policies carry a “cash value”component that grows tax deferred at a contractually guaranteed amount usually a lowinterest rate until the contract is surrendered. The premiums are usually level for the lifeof the insured and the death benefit is guaranteed for the insured’s lifetime.

With whole life payments, part of your premium is applied toward the insuranceportion of your policy, another part of your premium goes toward administrative expensesand the balance of your premium goes toward the investment, or cash, portion of yourpolicy.

(ii) Universal Life InsuranceUniversal life insurance is a variation of whole life insurance. Like whole life, it is

also a permanent policy providing cash value benefits based on current interest rates.The feature that distinguishes this policy from its whole life cousin is that the premiums,cash values and level amount of protection can each be adjusted up or down during thecontract term as the insured’s needs change. Cash values earn an interest rate that isset periodically by the insurance company and is generally guaranteed not to drop belowa certain level.

(iii) Variable LifeVariable life insurance is designed to combine the traditional protection and savings

features of whole life insurance with the growth potential of investment funds. This typeof policy is comprised of two distinct components: the general account and the separateaccount. The general account is the reserve or liability account of the insurance provider,and is not allocated to the individual policy. The separate account is comprised of variousinvestment funds within the insurance company’s portfolio, such as an equity fund, amoney market fund, a bond fund, or some combination of these. Because of this underlyinginvestment feature, the value of the cash and death benefit may fluctuate, thus the name“variable life”.

(iv) Variable Universal LifeVariable universal life insurance combines the features of universal life with variable

life and gives the consumer the flexibility of adjusting premiums, death benefits and theselection of investment choices. These policies are technically classified as securitiesand are therefore subject to Securities and Exchange Commission (SEC) regulation andthe oversight of the State Insurance Commissioner. Unfortunately, all the investment risklies with the policy owner; as a result, the death benefit value may rise or fall dependingon the success of the policy’s underlying investments. However, policies may provide sometype of guarantee that at least a minimum death benefit will be paid to beneficiaries.



Notes(v) Term LifeTerm insurance can help protect your beneficiaries against financial loss resulting

from your death; it pays the face amount of the policy, but only provides protection fora definite, but limited, amount of time. Term policies do not build cash values and themaximum term period is usually 30 years. Term policies are useful when there is a limitedtime needed for protection and when the dollars available for coverage are limited. Thepremiums for these types of policies are significantly lower than the costs for whole life.They also (initially) provide more insurance protection per dollar spent than any form ofpermanent policies. Unfortunately, the cost of premiums increases as the policy ownergets older and as the end of the specified term nears.

5.6.2 General Insurance

General insurance or non-life insurance policies, including automobile andhomeowners policies, provide payments depending on the loss from a particular financialevent. General insurance typically comprises any insurance that is not determined to belife insurance.

Types of General Insurance(i) Motor Insurance Plans

A standard motor insurance or better known as a car insurance policy is usuallythe insurance coverage mandated by law to drive on the road. Thus, it primarily coversyou against liability damages and unexpected repairs. These liability damages can beof two types. First is when a bodily injury has been caused to a third person. Secondis where the property of a third person and own car.

(ii) Health InsuranceHealth is insurance against the risk of incurring medical expenses among individuals.

By estimating the overall risk of health care and health system expenses among a targetedgroup, an insurer can develop a routine finance structure, such as a monthly premiumor payroll tax, to ensure that money is available to pay for the health care benefits specifiedin the insurance agreement. The benefit is administered by a central organization suchas a government agency, private business, or not-for-profit entity.

(iii) Marine InsuranceMarine Insurance and marine cargo insurance cover the loss or damage of vessels

at sea or on inland waterways, and of cargo in transit, regardless of the method of transit.When the owner of the cargo and the carrier are separate corporations, marine cargoinsurance typically compensates the owner of cargo for losses sustained from fire,shipwreck, etc., but excludes losses that can be recovered from the carrier or the carrier’sinsurance. Many marine insurance underwriters will include “time element” coverage insuch policies, which extends the indemnity to cover loss of profit and other businessexpenses attributable to the delay caused by a covered loss.

(iv) Travel InsuranceTravel insurance is insurance that is intended to cover medical expenses, financial

default of travel suppliers, and other losses incurred while travelling, either within one’sown country, or internationally. Temporary travel insurance can usually be arranged atthe time of the booking of a trip to cover exactly the duration of that trip, or a “multi-trip” policy can cover an unlimited number of trips within a set time frame.



Notes (v) Aviation InsuranceAviation Insurance grants protection against the loss of or damage to the aircraft

as also the legal liability to third parties and to passengers arising out of the operationof the aircraft.

It covers Freight liability, Airmail liability, Personal accident insurance and Loss oflicense insurance. Aviation insurance protects aircraft hulls and spares, and associatedliability risks, such as passenger and third-party liability. Airports may also appear underthis sub-category, including air traffic control and refueling operations for internationalairports through to smaller domestic exposures.

(vi) Personal Accident InsuranceThis policy provides that if the insured shall sustain any bodily injury resulting solely

and directly from accident caused by external violent and visible means, then the companyshall pay to the insured or his legal representative, the sum or sums set forth in the policy.

Statistics reveal that at least thirteen people die every hour in road accidents in India.Accident can make a terrible impact on finances with increased spending towardstreatment and disrupting income until recovery. In such a bumpy scenario, it is personalaccident insurance that can be vital to keep finances smooth and sailing.

(vii) Disability InsuranceDisability Insurance policies provide financial support in the event of the policyholder

becoming unable to work because of disabling illness or injury. It provides monthly supportto help pay such obligations as mortgage loans and credit cards. Short-term and long-term disability policies are available to individuals, but considering the expense, long-termpolicies are generally obtained only by those with at least six-figure incomes, such asdoctors, lawyers, etc. Short-term disability insurance covers a person for a period typicallyup to six months, paying a stipend each month to cover medical bills and other necessities.

Long-term disability insurance covers an individual’s expenses for the long term, upuntil such time as they are considered permanently disabled and thereafter. Insurancecompanies will often try to encourage the person back into employment in preference toand before declaring them unable to work at all and therefore totally disabled.

Disability overhead insurance allows business owners to cover the overheadexpenses of their business while they are unable to work.

Total permanent disability insurance provides benefits when a person is permanentlydisabled and can no longer work in their profession, often taken as an adjunct to lifeinsurance.

Workers’ compensation insurance replaces all or part of a worker’s wages lost andaccompanying medical expenses incurred because of a job-related injury.

(viii) Crime InsuranceThis is a form of casualty insurance that covers the policyholder against losses

arising from the criminal acts of third parties. For example, a company can obtain crimeinsurance to cover losses arising from theft or embezzlement.

Crime insurance is insurance to manage the loss exposures resulting from criminalacts such as robbery, burglary and other forms of theft. It is also called “fidelity insurance”.Many businesses purchase crime insurance that allows them to file claims for employeetheft or other offenses with the potential to cause financial ruin.



NotesBecause crime insurance loss exposures can vary significantly among policyholdersand require special underwriting skills, insurers prefer to insure certain types of crimeinsurance loss under separate Commercial Crime Insurance forms. These forms alloworganizations to cover crime losses that are not insured under other insurance policies.

Briefly described, commercial crime insurance covers money, securities and otherproperty against a variety of criminal acts, such as employee theft, robbery, forgery,extortion and computer fraud. Many insurers use Insurance Service Offices’ (ISOs)commercial crime forms.

5.7 Role of Insurance Companies

Insurance companies are a special type of financial institution that deals in thebusiness of managing risk. A corporation periodically gives them money and, in return,they promise to pay for the losses the corporation incurs if some unfortunate event occurs,causing damage to the well-being of the organization.

Here are a few terms you need to know when considering insurance companies:

Deductible: The amount that the insured must pay before the insurer will payanything.Premium: The periodic payments the insured makes to ensure coverage.Co-pay: An expense that the insured pays when sharing the cost with theinsurer.Indemnify: A promise to compensate one for losses experienced.Claim: The act of reporting an insurable incident to request that the insurerpay for coverage.Benefits: The money the insured receives from the insurance company whensomething goes wrong.

5.8 Role of Insurance Companies in Industrial Financing

The economic crisis of late 2007 and early 2008 highlighted the growing importanceof the role of the world’s financial sectors in ensuring global financial stability. The financeindustry, however, is not homogenous. Insurers, in particular, have a distinct profile withinthe industry. This was the subject of leading speakers at the ‘Role of Insurance in GlobalFinancial Stability’ event, held at the Swiss Re Centre for Global Dialogue, 29 June 2010.Among other qualities, insurers receive premiums upfront, so are not subject to a run ofwithdrawals; and through matching liabilities with assets, are long-term stabilizinginvestors. There are also distinct challenges in regulating the insurance industry. Someof these were discussed by John Maroney, of the International Association of InsuranceSupervisors.

The International Association of Insurance Supervisors (IAIS) in Basel lastSeptember, one of the key tasks has been to assist the IAIS (via its Financial StabilityCommittee) to develop its views on the implications of the global financial crisis for possiblechanges to insurance supervision. The insurance industry is an important part of the globalfinancial system and economy. As the international standard setter for insurance, the IAIShas been analyzing the potential for financial instability in this sector to determine what,if any, regulatory and supervisory action might be appropriate. Many risks andcircumstances where systemic risk might apply to the insurance sector have beenexamined, regardless of whether these circumstances emanate from the insurance sectoror are merely transmitted to the insurance sector from another financial sector.



Notes The IAIS has presented its position on key financial stability issues in insurance,initially in November 2009 and more recently in June, as described in this article. As partof the analysis, the basic insurance business model is described. Following this, thepotential for systemic risk to emerge in the insurance sector is discussed. Then theapplicability to insurance of recognized systemic characteristics and insurance resolutionis considered, followed by some proposals by the IAIS for insurance supervisoryenhancements.

Insurance Business Model

Traditionally, the primary purpose of insurance is to indemnify policyholders (bothindividuals and corporations) from claims associated with adverse events (e.g., propertydamage, premature death, liability claims, etc.) and to provide stable long-term savings,including during the future lifetimes of retirees and other policyholders. Diversification ofrisk is the main tool used in the insurance process; diversification takes place by poolingpolicyholders’ risks, by insuring a wide variety of policyholder pools, by underwriting indifferent geographic areas and by diversifying across different types of risks (such asunderwriting and investment risk).

To the extent that risk remains after diversification, further mitigation techniques areused by insurers, including reinsurance, hedging, insurance linked securities and the useof certain life insurance products (whereby policyholders take most or all investment risk,often via separate accounts). Generally, insurers incorporate strong risk managementpractices, including asset-liability management, to mitigate asset and liability mismatches.In addition, supervisory processes and regulatory requirements (such as capital and claimprovisioning requirements) help to maintain solvency in the industry. In many parts of theworld, there is a strong involvement by the actuarial profession in insurance riskmanagement, with statutory requirements in some jurisdictions for insurers to obtainappropriate actuarial advice and reports.

In spite of such strong risk management practices, insurers sometimes becomefinancially distressed and, in a competitive market, financial distress and insolvencies mayoccur from time to time. The financial distress of an insurer usually plays out over a longtime horizon. That is, assets of the insurer do not need to be liquidated until claims orbenefits under the policies need to be paid, and this will not occur until months or evenyears in the future. Accordingly, regulators usually have the time to intervene to reducepotential losses to policyholders from the insolvency, although this will not always be thecase.

Insurers and banks share some common characteristics and risks because they areboth financial intermediaries (for example, financial guarantee insurance bears somesimilarity to banking type products); however, the roles of banks and insurers in theeconomy differ substantially. That is, banks are part of the payment and settlement systemand are involved in the transmission of monetary policy, while insurers are not. Bankstend to rely to a larger extent on short-term borrowed money, and hence are exposedto liquidity risk; on the other hand, insurers receive premium payments in advance of claimsso that liquidity risk is not usually an issue but can be so if large borrowings have beenutilized to finance acquisitions or rapid organic growth.

Systemic Relevance and Systemic Risk

The insurance sector is susceptible to systemic risks generated in other parts ofthe financial sector. For most classes of insurance, however, there is little evidence ofinsurance either generating or amplifying systemic risk, within the financial system itself



Notesor in the real economy. This is because of the fundamentally different role of insurers inthe economy as compared to banks. It is also important to note the stabilization role thatthe insurance sector typically plays in the economy may help to limit systemic risk. Thisstabilization role was an important factor during the financial crisis, as the majority ofinsurers were able to withstand the fluctuations in capital markets, without having to resortto fire-sales of assets or similar drastic actions.

The G20, International Monetary Fund (IMF), Financial Stability Board (FSB) andBank for International Settlements (BIS) reports have focused on three characteristics ofsystemically important financial institutions: size, interconnectedness and substitutability.These characteristics warrant careful inspection from an insurance perspective.

By itself, size is not a particularly good measure for assessing the potential forsystemic risk in insurance. In fact, size has a beneficial effect for most insurers by allowingfor greater diversification of risk (via the law of large numbers). Also, because premiumsare funded in advance of claims, insurers typically are required by operation of the businessmodel and regulatory requirements to have a large amount of assets on hand relative toliabilities in comparison to banks, which can be critical in the event of insolvency.

Reinsurance activities help redistribute risks among insurers; but also contribute tointerconnectedness within the insurance sector. Hypothetically, failure of a large reinsurerand/or a reinsurance spiral could conceivably have a significant impact on capacity amongprimary insurers and cause disruption to the real economy (although neither suchoccurrence has occurred to date). IAIS monitors these potential risks with its GlobalReinsurance Market Report, which has shown that reinsurance risk exposures have sofar been well managed and diversified.

Insurers are interconnected with financial and non-financial firms, including throughequity shareholdings, corporate debt holdings, other investments, treasury operations andsecurities lending. However, whether these interconnections are of systemic importancewould depend on how much the total exposure of insurers’ investments account for inthe overall economy. Further, as already indicated, immediate liquidation of an insurer’sinvestments does not occur when an insurer becomes insolvent. Hence, a fire-sale of largeblocks of investments which might depress asset prices does not typically occur in theinsolvency of an insurer.

Lack of substitutability in the insurance sector may lead to market disruptions,especially when insurance coverage is necessary to conduct business. For example, amarket disruption can occur when compulsory or widely used insurance products becomeunavailable. This occurred in Australia following the failure of the country’s second largestinsurer, HIH, in 2001; and to some extent after the World Trade Centre attacks in 2001.Also, insurance against catastrophes can become unavailable or extremely costly aftera catastrophic event. There is also a possibility that a market failure will occur whereinsurance capacity disappears in a particular segment of the insurance market, such thatparts of the real economy are disrupted and government intervention is required. Marketdisruptions or failures of this nature are typically relatively short term, as new insurersand/or reinsurers can usually move into the affected region to create capacity for theproduct(s) in question, although this is not always the case. An effective regime ofregulation and supervision can help mitigate this possibility.

An important part of the IAIS analysis has been exploring ways in which insurersmay amplify systemic risk under certain circumstances. For example, the participationof life insurers in capital markets can contribute to selling pressure, if the insurerscollectively hold significant positions in equities, bonds or hedging instruments and needto liquidate their positions simultaneously in a falling market.



Notes Of course, as conditions change in the future, in theory, the possibility exists thatinsurers may become systemically important. Some cases where insurers might generatesystemic risk include: (1) widespread distribution of financial products that contain aminimum guarantee and/or distribution of other types of banking-like products;(2) widespread (naked) derivatives trading, especially extensive distribution of credit defaultswaps (CDSs); (3) expansive offering of financial guarantee insurance; and (4) insurersusing regulatory arbitrage to offer products or services that end up being systemicallyimportant.

Indeed, the nature of the insurance industry has already been changing. Some partsof the industry have been growing in complexity, diversity and global reach. Financialinnovation and the rapidly changing financial environment have contributed to the formationof some insurance entities and groups spanning jurisdictional borders and/or sectors. Inlight of continuing financial instability since 2007, there has been an increased focus, bymany parties, on issues of financial stability and the risks associated with large andcomplex financial organizations operating on a cross-border and/or cross-sector basis.This is a major concern of the FSB and G20 discussions and will be one of the key issuesconsidered by G20 Leaders during their summit in Seoul in November.

Of particular concern has been the potential risks emerging from non-regulatedentities of financial conglomerates (as in the case of AIG) and some insurance activities(such as financial guarantee insurance) which can generate or amplify systemic risk andmay be instrumental to contagion within conglomerates or between sectors. Further,contagion effects might also occur if a member of a group exhibits financial distress.

Resolvability

The ease with which an insolvent insurer can be resolved depends on many factors,including the role of insurance guarantee schemes, where they exist. For insurers (unlikebanks), there can be ‘life after death’. That is, failed insurers often can be managed throughorderly run-off, and sometimes even brought back to life with new capital.

All insurers are regulated at the solo entity (company) level. However, there iswidespread recognition that the resolvability of internationally operating financial entities,groups, or conglomerates poses significant legal challenges. Enhanced supervisoryoversight for such entities is underway and cooperation with other sectors will be required.

Again, this is another major concern of the FSB and G20 discussions and will beconsidered by G20 Leaders in November, when they focus on how to better controlsystemically important financial institutions.

Proposed Supervisory Enhancements

The IAIS agrees that it is necessary for insurers and insurance groups to besupervised on a solo entity basis and on a group-wide basis. Group supervision shouldinclude consideration of non-regulated entities and/or non-operating holding companieswithin a group. Other supervisory enhancements are under consideration and/ordevelopment (particularly in cooperation with the Joint Forum) to reduce the potential forregulatory arbitrage. These enhancements should reduce the probability and potentialimpact of future insolvencies and insurance market failures. The enhancements shouldincrease the role of insurers as stabilizers and decrease their potential susceptibility tosystemic risk or their roles as potential transmitters or amplifiers of systemic risk. Theenhanced insurance supervisory framework should contribute to financial stability andshould also improve micro-prudential supervision and policyholder protection.



NotesSince interdependencies between the sectors may increase in the future throughproducts, markets and conglomerates, the IAIS is promoting enhancements to supervisionand supervisory processes, combined with stronger risk management and enhancedapproaches to resolvability to minimize adverse externalities. These enhancements includegroup-wide supervision and the development of a Common Framework for the Supervisionof Internationally Active Insurance Groups (ComFrame). The IAIS is also promoting cross-sectoral macro-prudential monitoring of potential build-up of systemic risk and planningto develop measures for national authorities to assess degrees of systemic risk.

In particular, ComFrame will develop methods of operating group-wide supervisionof Internationally Active Insurance Groups in order to make group-wide supervision moreeffective and more reflective of actual business practices; establish a comprehensiveframework for supervisors to address group-wide activities and risks and also set groundsfor better supervisory cooperation in order to allow for a more integrated and internationalapproach; and foster global convergence of regulatory and supervisory measures andapproaches.

Clearly, there are many challenges on the insurance regulatory reform agenda in themonths and years ahead. Hopefully, these challenges will be successfully faced both bysupervisors and insurers and both policyholder protection and financial stability will beenhanced.

5.9 Principles of Insurance

The seven principles of insurance are:

1. Principle of Utmost Good Faith2. Principle of Insurable Interest3. Principle of Indemnity4. Principle of Contribution5. Principle of Subrogation6. Principle of Loss Minimization, and7. Principle of Causa Proxima (Nearest Cause).

1. Principle of Utmost Good FaithThe Principle of Utmost Good Faith is a very basic and first primary principle of

insurance. According to this principle, the insurance contract must be signed by bothparties (i.e., insurer and insured) in an absolute good faith or belief or trust. The persongetting insured must willingly disclose and surrender to the insurer his complete trueinformation regarding the subject matter of insurance. The insurer’s liability gets void (i.e.,legally revoked or cancelled) if any facts, about the subject matter of insurance are eitheromitted, hidden, falsified or presented in a wrong manner by the insured.

2. Principle of Insurable InterestThe principle of insurable interest states that the person getting insured must have

insurable interest in the object of insurance. A person has an insurable interest when thephysical existence of the insured object gives him some gain but its non-existence willgive him a loss. In simple words, the insured person must suffer some financial loss bythe damage of the insured object.

For example: The owner of a taxicab has insurable interest in the taxicab becausehe is getting income from it. But, if he sells it, he will not have an insurable interest leftin that taxicab.



Notes 3. Principle of IndemnityIndemnity means security, protection and compensation given against damage, loss

or injury. According to the principle of indemnity, an insurance contract is signed onlyfor getting protection against unpredicted financial losses arising due to futureuncertainties. Insurance contract is not made for making profit, else its sole purpose isto give compensation in case of any damage or loss. In an insurance contract, the amountof compensations paid is in proportion to the incurred losses. The amount ofcompensations is limited to the amount assured or the actual losses, whichever is less.The compensation must not be less or more than the actual damage. Compensation isnot paid if the specified loss does not happen due to a particular reason during a specifictime period. Thus, insurance is only for giving protection against losses and not for makingprofit. However, in case of life insurance, the principle of indemnity does not apply becausethe value of human life cannot be measured in terms of money.

4. Principle of ContributionPrinciple of Contribution is a corollary of the principle of indemnity. It applies to all

contracts of indemnity, if the insured has taken out more than one policy on the samesubject matter. According to this principle, the insured can claim the compensation onlyto the extent of actual loss either from all insurers or from any one insurer. If one insurerpays full compensation, then that insurer can claim proportionate claim from the otherinsurers.

For example: Mr. John insures his property worth ` 100,000 with two insurers “AIGLtd.” for ` 90,000 and “MetLife Ltd.” for ` 60,000. John’s actual property destroyed isworth ` 60,000, then Mr. John can claim the full loss of ` 60,000 either from AIG Ltd.or MetLife Ltd., or he can claim ` 36,000 from AIG Ltd. and ` 24,000 from MetLife Ltd.

So, if the insured claims full amount of compensation from one insurer, then he cannotclaim the same compensation from other insurer and make a profit. Secondly, if oneinsurance company pays the full compensation, then it can recover the proportionatecontribution from the other insurance company.

5. Principle of SubrogationSubrogation means substituting one creditor for another. Principle of Subrogation is

an extension and another corollary of the principle of indemnity. It also applies to allcontracts of indemnity. According to the principle of subrogation, when the insured iscompensated for the losses due to damage to his insured property, then the ownershipright of such property shifts to the insurer.

This principle is applicable only when the damaged property has any value after theevent causing the damage. The insurer can benefit out of subrogation rights only to theextent of the amount he has paid to the insured as compensation.

For example: Mr. John insures his house for ̀ 1 million. The house is totally destroyedby the negligence of his neighbour Mr. Tom. The insurance company shall settle the claimof Mr. John for ` 1 million. At the same time, it can file a law suit against Mr. Tom for` 1.2 million, the market value of the house. If insurance company wins the case andcollects ` 1.2 million from Mr. Tom, then the insurance company will retain ` 1 million(which it has already paid to Mr. John) plus other expenses such as court fees. The balanceamount, if any will be given to Mr. John, the insured.

6. Principle of Loss MinimizationAccording to the Principle of Loss Minimization, insured must always try his level

best to minimize the loss of his insured property, in case of uncertain events like a fire



Notesoutbreak or blast, etc. The insured must take all possible measures and necessary stepsto control and reduce the losses in such a scenario. The insured must not neglect andbehave irresponsibly during such events just because the property is insured. Hence, itis a responsibility of the insured to protect his insured property and avoid further losses.

For example: Assume, Mr. John’s house is set on fire due to an electric short-circuit.In this tragic scenario, Mr. John must try his level best to stop fire by all possible means,like first calling nearest fire department office, asking neighbors for emergency fireextinguishers, etc. He must not remain inactive and watch his house burning hoping, “Whyshould I worry? I’ve insured my house.”

7. Principle of Causa Proxima (Nearest Cause)Principle of Causa Proxima (a Latin phrase), or in simple English words, the Principle

of Proximate (i.e., Nearest) Cause, means when a loss is caused by more than onecauses, the proximate or the nearest or the closest cause should be taken intoconsideration to decide the liability of the insurer. The principle states that to find outwhether the insurer is liable for the loss or not, the proximate (closest) and not the remote(farest) must be looked into.

For example: A cargo ship’s base was punctured due to rats and so sea water enteredand cargo was damaged. Here, there are two causes for the damage of the cargo ship– (i) The cargo ship getting punctured because of rats, and (ii) The sea water enteringship through puncture. The risk of sea water is insured but the first cause is not. Thenearest cause of damage is sea water which is insured and therefore the insurer mustpay the compensation.

However, in case of life insurance, the principle of Causa Proxima does not apply.Whatever may be the reason of death (whether a natural death or an unnatural death),the insurer is liable to pay the amount of insurance.

5.10 Life Insurance

Life insurance is a way of providing income replacement for financial dependents (thebeneficiaries) after the insured person dies. It is intended to replace lost income and payfor any additional expenses that are experienced by those left behind when a familymember who contributes income or services to a household is lost. It can also be usedfor final expenses like medical bills or funeral costs that survivors would have to pay whena death occurs. Life insurance is an important part of financial planning for families andindividuals.

A life insurance policy is a legal contract between the insured person and the lifeinsurance company, and like all contracts, it is enforceable by law and shouldn’t be enteredinto lightly. Both parties have certain rights and obligations which are explained in thepolicy. So, it is critical that anyone buying protection read the contract and its fine printbefore signing it.

There may be exclusions in the contract for certain causes of death, such as suicide,where the company can legally refuse to pay the death benefit. Additionally, deathsoccurring within 2 years of purchasing coverage, also known as the “exclusionary period”,may not be eligible for a death benefit payout and may result in your carrier returningyour premiums instead.



Notes 5.11 Meaning of Life Insurance

Life insurance is a contractual agreement between a policyholder and a life insurancecompany. Policyholders agree to make premium payments to the company and thecompany agrees to pay the beneficiaries a sum of money if he/she dies. A life insurancepolicy provides a stated benefit upon the holder’s death, provided that the death occurswithin a certain specified time period.

5.12 Purposes of Life Insurance

The purpose of life insurance is to maintain the financial security and well-being ofone’s family or dependents in case of a wage-earner’s death. However, life insurance canalso be used for the following reasons:

(i) Mortgage Protection – to cover your mortgage loan or payments.(ii) Retirement – the savings, cash value build-up or investment opportunity help

build a family’s net worth or nest egg.(iii) Childcare – to replace a home-maker’s contribution.(iv) Estate Protection – to help cover estate taxes.(v) Protect Business – to protect a business against the loss of a key employee,

known as keyman life insurance.(vi) Employee Benefits – typically offered as group life insurance through your

employer.

5.13 The Importance of Life Insurance

The importance of Life Insurance can be summarized as follows:

(i) An essential part of financial planning is creating provisions for your family andloved ones following your death. Life insurance can ensure financial securityto those who mean the most to you, such as your spouse, children anddependent parents. A carefully executed life insurance policy can help preparefor life’s uncertainties and give peace of mind knowing that the future of thosewho rely on you is secure.

(ii) Life insurance pays for immediate expenses. Bills can start accumulating fastin the event of a death. Life insurance can be used to pay for immediateexpenses, such as funeral services, unsettled hospital and medical bills,mortgage payments, business commitments and meeting college expenses forchildren.

(iii) It’s a cash resource. Life insurance gives access to cash to pay for grocerybills and other daily expenses. It also helps secure your estate by providingtax-free cash to pay estate and other obligations.

(iv) Your family’s standard of living can be maintained. With the right coverage, yourfamily’s lifestyle and standard of living can be sustained, adding much needednormalcy during a difficult time.

(v) You have a wide range of options. There are two basic types of life insurance:term life and whole life. Term life policies offer death benefits. So, if you die,you will get money back, but if you live past the pre-determined length of thepolicy, you get no benefits. Whole life or permanent insurance is moreexpensive, but these policies are open-ended and also accumulate a cash value



Notesthat the policyholder can earn dividends and borrow against or cash-in uponsurrendering the policy.

(vi) Customize your policy and coverage. If you have dependent children, a spouseand parents to care for, you’d want a policy that would protect them after death.Typically, policies are opened for the breadwinner of the family, but a stay-at-home spouse’s contributions are often overlooked. You might consider a policyto cover childcare, carpooling and household chore expenses in the event ofa stay-at-home spouse’s death. On the flip side, as you get older and childrenor parents are no longer dependent on you for income, you can reduce yourcoverage or drop it entirely.

(vii) Adequate coverage makes a difference. An old school rule of thumb is that yourlife insurance policy equals five to ten times your annual income. Nowadays,advisors will look at the number of dependents you have, how long they willbe dependent upon you, and the lifestyle they expect to live after your death.It’s not a simple equation, but in general, you will need more coverage thana typical plan offered by an employer, which usually totals one or two yearsof your gross salary.

(viii) You can improve your credit rating. A life insurance policy is considered afinancial asset and may increase your credit score, which could be beneficialwhen trying to obtain medical insurance or a home or business loan.

(ix) Life insurance may be exempt from bankruptcy. Most life insurance plans willnot be affected by bankruptcy and will remain intact if you claim bankruptcy.However, you’ll need to confer with a bankruptcy expert, as each case is unique.

(x) Life insurance is not a simple product. It’s wise to talk to an expert who canwalk you through the pros and cons of available plans and help choose coveragethat works best for your individual situation, now and in the future.

5.14 Life Insurance Products and Policies

1. Term InsuranceThis type of life insurance policy is a contract between the insured and the life

insurance company to pay the persons he/she has given entitlement to receive the money,in the case of his/her death, after a certain period of time. These policies can be takenfor 5, 10, 15, 20 or 30 years.

2. Endowment PolicyIn an endowment policy, periodic premiums are received by the insured person and

a lump sum is received either on the death of the insured or once the policy period expires.

3. Moneyback Life Insurance PolicyThis policy offers the payment of partial survival benefits (moneyback), as is

determined in the insurance contract, while the insured is still alive. In case the insureddies during the period of the policy, the beneficiary gets the full sum insured without thededuction of the moneyback amount given so far.

4. Group Life InsuranceThis is when a group of people have been named under a single life insurance policy.

It is popular for an employer or a company to add employees under the same policy.Each member of the group has a certificate as legal evidence of insurance.



Notes 5. Unit Linked Insurance PlanULIPs (Unit Linked Insurance Plan) offer the insured the double benefit of protection

from risk and investment opportunities. ULIPs are linked to the market where the insured’smoney is invested to help earn additional monetary benefits.

5.15 General Insurance

General Insurance comprises of insurance of property against fire, burglary, etc.,personal insurance such as Accident and Health Insurance, and liability insurance whichcovers legal liabilities. There are also other covers such as Errors and Omissions insurancefor professionals, credit insurance, etc.

Non-life insurance companies have products that cover property against fire and alliedperils, flood storm and inundation, earthquake and so on. There are products that coverproperty against burglary, theft, etc. The non-life companies also offer policies coveringmachinery against breakdown, there are policies that cover the hull of ships and so on.A Marine Cargo Policy covers goods in transit including by sea, air and road. Further,insurance of motor vehicles against damages and theft forms a major chunk of non-lifeinsurance business.

In respect of insurance of property, it is important that the cover is taken for theactual value of the property to avoid being imposed a penalty should there be a claim.Where a property is undervalued for the purposes of insurance, the insured will have tobear a ratable proportion of the loss. For instance, if the value of a property is ` 100 andit is insured for ` 50/-, in the event of a loss to the extent of say ` 50/-, the maximumclaim amount payable would be ` 25/– (50% of the loss being borne by the insured forunderinsuring the property by 50%). This concept is quite often not understood by mostinsureds.

Personal insurance covers include policies for Accident, Health, etc. Productsoffering Personal Accident cover are benefit policies. Health insurance covers offered bynon-life insurers are mainly hospitalization covers either on reimbursement or cashlessbasis. The cashless service is offered through Third Party Administrators who havearrangements with various service providers, i.e., hospitals. The Third Party Administratorsalso provide service for reimbursement claims. Sometimes, the insurers themselvesprocess reimbursement claims.

Accident and health insurance policies are available for individuals as well as groups.A group could be a group of employees of an organization or holders of credit cards ordeposit holders in a bank, etc. Normally, when a group is covered, insurers offer groupdiscounts.

Liability insurance covers such as Motor Third Party Liability Insurance, Workmen’sCompensation Policy, etc. offer cover against legal liabilities that may arise under therespective statutes – Motor Vehicles Act, The Workmen’s Compensation Act, etc. Someof the covers such as the foregoing are compulsory by statute. Liability Insurance notcompulsory by statute is also gaining popularity these days. Many industries insureagainst Public liability. There are liability covers available for products as well.

There are general insurance products that are in the nature of package policiesoffering a combination of the covers mentioned above. For instance, there are packagepolicies available for householders, shopkeepers and also for professionals such asdoctors, chartered accountants, etc. Apart from offering standard covers, insurers alsooffer customized or tailor-made ones.



NotesSuitable general insurance covers are necessary for every family. It is important toprotect one’s property, which one might have acquired from one’s hard earned income.A loss or damage to one’s property can leave one shattered. Losses created bycatastrophes such as the tsunami, earthquakes, cyclones, etc. have left many homelessand penniless. Such losses can be devastating but insurance could help mitigate them.Property can be covered, so also the people against Personal Accident. A HealthInsurance Policy can provide financial relief to a person undergoing medical treatmentwhether due to a disease or an injury.

Industries also need to protect themselves by obtaining insurance covers to protecttheir building, machinery, stocks, etc. They need to cover their liabilities as well. Financiersinsist on insurance. So, most industries or businesses that are financed by banks andother institutions do obtain covers. But are they obtaining the right covers? And are theyinsuring adequately are questions that need to be given some thought. Also organizationsor industries that are self-financed should ensure that they are protected by insurance.Most general insurance covers are annual contracts. However, there are few products thatare long-term. It is important for proposers to read and understand the terms and conditionsof a policy before they enter into an insurance contract. The proposal form needs to befilled in completely and correctly by a proposer to ensure that the cover is adequate andthe right one.

5.16 Meaning of General Insurance

General insurance refers to the insurance contracts that do not come under the fieldof life insurance. The different forms of general insurance are fire, marine, motor, accidentand other miscellaneous non-life insurance.

Explanation: The tangible assets are susceptible to damages and a need to protectthe economic value of the assets is needed. For this purpose, general insurance productsare bought as they provide protection against unforeseeable contingencies like damageand loss of the asset. Like life insurance, general insurance products come at a pricein the form of premium.

5.17 Objectives for Practicing of General Insurance

The practices of General Insurance are having the following objectives:

(i) To provide for the acquisition of the shares of the existing general insurancecompanies.

(ii) To serve the needs of the economy by development of general insurancebusiness.

(iii) To establish the GIC by the Central Government under the provisions of theCompanies Act of 1956, with an initial authorized share capital of seventy-fivecrores.

(iv) To aid, assist, and advise the companies in the matter of setting up of standardsin the conduct of general insurance business.

(v) To encourage healthy competition amongst the companies as far as possible.(vi) To ensure that the operation of the economic system does not result in the

concentration of wealth to the common detriment.(vii) To ensure that no person shall take insurance in respect of any property in India

with an insurer whose principal registered office is outside India.



Notes (viii) To carry on of any part of the general insurance business if it thinks it is desirableto do so.

(ix) To advice the companies in the matter of controlling their experience andinvestment of funds.

(x) To provide need-based and low-cost general insurance covers to rural population.(xi) To administer a crop insurance scheme for the benefit of the farmers.(xii) To develop and introduce covers with social security benefits

5.18 Principles of General Insurance

The important principles of General Insurance are as follows:

1. Principles of Utmost Good FaithUtmost Good Faith can be defined as “A positive duty to voluntarily disclose,

accurately and fully all facts material to the risk being proposed whether requested foror not”. In insurance contracts, Utmost Good Faith means that “each party to the proposedcontract is legally obliged to disclose to the other all information which can influence theothers decision to enter the contract”.

In Fire Insurance: The construction of the building, the nature of its use, i.e., whetherit is of concrete or Kucha having thatched roofing and whether it is being used for residentialpurposes or as a godown, whether firefighting equipment is available or not.

In Motor Insurance: The type of vehicle, the purpose of its use, its age (model),cubic capacity and the fact that the driver has a consistently bad driving record.

In Marine Insurance: Type of packing, mode of carriage, name of carrier, natureof goods, the route, etc.

In Personal Accident Insurance: Age, height, weight, occupation and previousmedical history if it is likely to increase the choice of an accident, bad habits such asdrinking, etc.

Burglary Insurance: Nature of stock, value of stock, type of security precautionstaken, etc.

2. Principle of Insurable InterestOne of the essential ingredients of an Insurance Contract is that the insured must

have an insurable interest in the subject matter of the contract. Insurance without insurableinterest would be a mere wager and as such unenforceable in the eyes of law.

The subject matter of the Insurance Contract may be a property, or an event thatmay create a liability but it is not the property or the potential liability which is insuredbut it is the pecuniary interest of the insured in that property or liability which is insured.

Insurable Interest is defined as the legal right to insure arising out of a financialrelationship recognized under the law between the insured and the subject matter ofInsurance.

There are four essential components of Insurable Interests:

1. There must be some property, right, interest, life, limb or potential liabilitycapable of being insured.

2. Any of these above, i.e., property, right, interest, etc. must be the subject matterof Insurance.



Notes3. The insured must stand in a formal or legal relationship with the subject matterof the Insurance. Whereby he benefits from its safety, well-being or freedomfrom liability and would be adversely affected by its loss, damage existenceof liability.

There are a number of ways by which Insurable Interest arises or is restricted.

(a) By Common Law: Cases where the essential elements are automaticallypresent can be described as Insurable Interest having arisen by common law.Ownership of a building, car, etc. gives the owner the right to insure the property.

(b) By Contract: In some cases, a person will agree to be liable for somethingwhich he would not be ordinarily for. A lease deed for a house, for example,may make the tenant responsible for the repair and maintenance of the building.Such a contract places the tenant in a legally recognized relationship with thehouse or the potential liability and this gives him the insurable interest.

(c) By Statute: Sometimes, an Act of the Parliament may create an insurableinterest by granting some benefit or imposing a duty and at times removing aliability may restrict the Insurable Interest.

Marine Insurance Insurable InterestIn Marine Insurance, Insurable Interest must exist at the time of loss/claim and it

is not required at the time of inception.

Property and Other Insurance Insurable InterestIn Property and other Insurance, Insurable Interest must exist at the time of inception

as well as at the time of loss/claims.

3. Principle of IndemnityIn Insurance, the word indemnity is defined as “financial compensation sufficient to

place the insured in the same financial position after a loss as he enjoyed immediatelybefore the loss occurred.”

Indemnity, thus, prevents the insured from recovering more than the amount of hispecuniary loss. It is undesirable that an insured should make a profit out of an event likea fire or a motor accident because if he was able to make a profit, there might well bemore fires and more vehicle accidents.

As in the case of Insurable Interest, the principle of indemnity also relies heavilyon the financial evaluation of the loss but in the case of life and disablement it is notpossible to be precise in terms of money.

The Insurers normally provide indemnity in the following manner and the choice isentirely of the insurer:

1. Cash Payment2. Repairs3. Replacement4. Reinstatement

1. Cash Payment: In majority of the cases, the claims will be settled by cashpayment (through cheques) to the assured. In liability claims, the cheques are madedirectly in the name of the third party thus avoiding the cumbersome process of the Insurerfirst paying the Insured and he in turn paying to the third party.



Notes 2. Repair: This is a method of Indemnity used frequently by insurer to settle claims.Motor Insurance is the best example of this where garages are authorized to carry outthe repairs of damaged vehicles. In some countries, Insurance companies even owngarages and Insurance companies spend a lot on research on motor repairs to arrive atbetter methods of repair to bring down the costs.

3. Replacement: This method of Indemnity is normally not preferred by Insurancecompanies and is mostly used in Glass Insurance where the insurers get the glassreplaced by firms with whom they have arrangements and because of the volume ofbusiness they get considerable discounts. In some cases of Jewellery loss, this systemis used specially when there is no agreement on the true value of the lost item.

4. Reinstatement: This method of Indemnity applies to Property Insurance wherean insurer undertakes to restore the building or the machinery damaged substantially tothe same condition as before the loss. Sometimes, the policy specifically gives the rightto the insurer to pay money instead of restoration of building or machinery.

5.19 Features of General Insurance

The insurance has the following characteristics which are, generally, observed in caseof life, marine, fire and general insurances:

1. Sharing of RiskInsurance is a device to share the financial losses which might befall on an individual

or his family on the happening of a specified event. The event may be death of a bread-winner to the family in the case of life insurance, marine perils in marine insurance, firein fire insurance and other certain events in general insurance, e.g., theft in burglaryinsurance, accident in motor insurance, etc. The loss arising from these events if insuredare shared by all the insured in the form of premium.

2. Cooperative DeviceThe most important feature of every insurance plan is the cooperation of large number

of persons who, in effect, agree to share the financial loss arising due to a particular riskwhich is insured. Such a group of persons may be brought together voluntarily or throughpublicity or through solicitation of the agents.

An insurer would be unable to compensate all the losses from his own capital. So,by insuring or underwriting a large number of persons, he is able to pay the amount ofloss. Like all cooperative devices, there is no compulsion here on anybody to purchasethe insurance policy.

3. Value of RiskThe risk is evaluated before insuring to charge the amount of share of an insured,

herein called, consideration or premium. There are several methods of evaluation of risks.If there is expectation of more loss, higher premium may be charged. So, the probabilityof loss is calculated at the time of insurance.

4. Payment at ContingencyThe payment is made at a certain contingency insured. If the contingency occurs,

payment is made. Since the life insurance contract is a contract of certainty, becausethe contingency, the death or the expiry of term, will certainly occur, the payment iscertain. In other insurance contracts, the contingency is the fire or the marine perils, etc.may or may not occur. So, if the contingency occurs, payment is made, otherwise noamount is given to the policyholder.



NotesSimilarly, in certain types of life policies, payment is not certain due to uncertaintyof a particular contingency within a particular period. For example, in term insurance,payment is made only when death of the assured occurs within the specified term, maybe one or two years. Similarly, in Pure Endowment, payment is made only at the survivalof the insured at the expiry of the period.

5. Amount of PaymentThe amount of payment depends upon the value of loss occurred due to the particular

insured risk provided insurance is there up to that amount. In life insurance, the purposeis not to make good the financial loss suffered. The insurer promises to pay a fixed sumon the happening of an event.

If the event or the contingency takes place, the payment does fall due if the policyis valid and in force at the time of the event, like property insurance, the dependents willnot be required to prove the occurring of loss and the amount of loss. It is immaterialin life insurance what was the amount of loss at the time of contingency. But in the propertyand general insurances, the amount of loss as well as the happening of loss, are requiredto be proved.

6. Large Number of Insured PersonsTo spread the loss immediately, smoothly and cheaply, large number of persons

should be insured. The cooperation of a small number of persons may also be insurancebut it will be limited to smaller area. The cost of insurance to each member may be higher.So, it may be unmarketable.

Therefore, to make the insurance cheaper, it is essential to insure large number ofpersons or property because the lesser would be cost of insurance and so, the lower wouldbe premium. In past years, tariff associations or mutual fire insurance associations werefound to share the loss at cheaper rate. In order to function successfully, the insuranceshould be joined by a large number of persons.

7. Insurance is Not a GamblingThe insurance serves indirectly to increase the productivity of the community by

eliminating worry and increasing initiative. The uncertainty is changed into certainty byinsuring property and life because the insurer promises to pay a definite sum at damageor death.

From a family and business point of view, all lives possess an economic value whichmay at any time be snuffed out by death, and it is as reasonable to ensure against theloss of this value as it is to protect oneself against the loss of property. In the absenceof insurance, the property owners could at best practice only some form of self-insurance,which may not give him absolute certainty.

Similarly, in absence of life insurance, saving requires time; but death may occurat any time and the property, and family may remain unprotected. Thus, the family isprotected against losses on death and damage with the help of insurance.

From the company’s point of view, the life insurance is essentially non-speculative;in fact, no other business operates with greater certainties. From the insured point of view,too, insurance is also the antithesis of gambling. Nothing is more uncertain than life andlife insurance offers the only sure method of changing that uncertainty into certainty.

In fact, insurance is just the opposite of gambling. In gambling, by bidding, the personexposes himself to risk of losing; in the insurance, the insured is always opposed to risk,and will suffer loss if he is not insured.



Notes By getting insured his life and property, he protects himself against the risk of loss.In fact, if he does not get his property or life insured, he is gambling with his life on property.

8. Insurance is Not CharityCharity is given without consideration but insurance is not possible without premium.

It provides security and safety to an individual and to the society although it is a kindof business because in consideration of premium it guarantees the payment of loss. Itis a profession because it provides adequate sources at the time of disasters only bycharging a nominal premium for the service.

5.20 Functions of General Insurance

The various functions of General Insurance are:

1. Primary Functions2. Secondary Functions3. Indirect Functions

1. Primary Functions

(i) Provide ProtectionsThe most important function of insurance is to provide protection against risk of loss.

(ii) Provide CertaintyWe know future is totally uncertain. Any misfortune happening may occur at any

stage of life. The amount of loss and time of losses both are uncertain. No doubt, betterplanning and administration can reduce the chances of happening these types of accidentsbut it requires lots of attention towards strengths and weaknesses, special knowledgeof the field after all these precautions, the uncertainty remains steady. Insurance providescertainly towards the losses. The policyholders pay the premium to by certainty.

(iii) Distribution of RiskIt is a cooperative effort where the risk is distributed among the group of people.

Thus, no one have to bear the losses occurred due to uncertainty.

2. Secondary Functions

(i) Helps in Economic ProgressInsurance plays an important role in economic progress. It gives full certainty to the

industrialists towards the risks. The entrepreneurs can more concentrate on innovativeand profitable techniques of the production. They should not require thinking over the risks.The industrialists can establish new industries in environment. Thus, industries have gotdevelopment in economic and commerce of the nation.

(ii) Prevents Losses Insurance plays a vital role in preventing the losses. The amount of premium can

be minimized by using such appliances like the fire extinguisher. If one uses interiormachinery which may be caused for misfortune, the amount of premium will be high. Thus,indirectly, insurance provides help to minimize the chances of risks. It will be useful forthe agencies which are directly related with the same functions like:

(a) Loss Prevention Association of India.



Notes(b) The Salvage Crops of Loss Prevention Association of India.(c) Survey and Inspection of Risks, etc.

3. Indirect Functions

(i) A Forced SavingsLife Insurance is also a method of savings in India. Income Tax Act gives relief in

payment of income tax because government wants to habituate general public to savemoney. It encourages the habit of thrift and savings among the people. Thus, it becomescompulsory savings to people of nation.

(ii) Promote Foreign TradeIt is compulsory to take marine insurance policy in foreign trade in India. Foreigners

cannot issue the foreign trade bill unless the cargo is fully insured. Thus, foreign tradetotally depends upon the insurance sector of the nation. It gives relief to entrepreneursfrom the uncertainty of foreign trade.

(iii) OthersInsurance provides certainties towards risks in entrepreneurship. It gives confidence

in general public. It is one of the important source of investment which develops the tradeand commerce of the nation.

5.21 General Insurance Corporation of India (GICI)

The entire general insurance business in India was nationalized by General InsuranceBusiness (Nationalization) Act, 1972 (GIBNA). The Government of India (GOI), throughnationalization, took over the shares of 55 Indian insurance companies and theundertakings of 52 insurers carrying on general insurance business.

General Insurance Corporation of India (GIC) was formed in pursuance of Section9(1) of GIBNA. It was incorporated on 22 November 1972 under the Companies Act, 1956as a private company limited by shares.

GIC was formed for the purpose of superintending, controlling and carrying on thebusiness of general insurance. As soon as GIC was formed, GOI transferred all the sharesit held of the general insurance companies to GIC.

Simultaneously, the nationalized undertakings were transferred to Indian insurancecompanies. After a process of mergers among Indian insurance companies, fourcompanies were left as fully owned subsidiary companies of GIC:

(i) National Insurance Company Limited(ii) The New India Assurance Company Limited(iii) The Oriental Insurance Company Limited(iv) United India Insurance Company Limited.

The next landmark happened on 19th April 2000, when the Insurance Regulatory andDevelopment Authority Act, 1999 (IRDAA) came into force.

This Act also introduced amendment to GIBNA and the Insurance Act, 1938. Anamendment to GIBNA removed the exclusive privilege of GIC and its subsidiaries carryingon general insurance in India.



Notes In November 2000, GIC was renotified as the Indian Reinsurer and throughadministrative instruction, its supervisory role over the four subsidiaries was ended. Withthe General Insurance Business (Nationalization) Amendment Act 2002 (40 of 2002)coming into force from March 21, 2003, GIC ceased to be a holding company of itssubsidiaries.

The ownership of the four erstwhile subsidiary companies and also of the GeneralInsurance Corporation of India was vested with Government of India. GIC Re is a whollyowned company of Government of India.

5.22 The General Insurance Business (Nationalization) AmendmentAct, 2002 Act No. 40 of 2002

Section 1: Short title and commencement.—(1) This Act may be called the GeneralInsurance Business (Nationalization) Amendment Act, 2002. (2) It shall come into forceon such date as the Central Government may, by notification in the Official Gazette,appoint.

Section 2: Amendment of section 9.—In section 9 of the General Insurance Business(Nationalization) Act, 1972 (57 of 1972) (hereinafter referred to as the principal Act),—(a) in sub-section (1), the following proviso shall be inserted, namely:—‘Provided that onand from the commencement of the General Insurance Business (Nationalization)Amendment Act, 2002, the provisions of this sub-section shall have effect as if for thewords “superintending, controlling and carrying on the business of general insurance”, thewords “carrying on reinsurance business” had been substituted.’; (b) in sub-section (2),the following proviso shall be inserted, namely: “Provided that the Central Government may,by notification, increase or reduce the authorized capital or subscribed capital, as thecase may be, as it deems fit.”

Section 3: Insertion of new section 10A.—After section 10 of the principal Act, thefollowing section shall be inserted, namely:—“10A. Transfer to Central Government ofshares vested in Corporation.—All the shares in the capital of the acquiring companies,being — (a) the National Insurance Company Limited; (b) the New India AssuranceCompany Limited; (c) the Oriental Insurance Company Limited; (d) the United IndiaInsurance Company Limited, and vested in the Corporation before the commencement ofthe General Insurance Business (Nationalization) Amendment Act, 2002 shall, on suchcommencement, stand transferred to the Central Government.”

Section 4: Amendment of section 18.—In section 18 of the principal Act,—(a) insub-section (1), after clause (e), the following proviso shall be inserted, namely: —”Provided that all the functions of the Corporation specified in this sub-section, on andfrom the commencement of the General Insurance Business (Nationalization) AmendmentAct, 2002, shall be performed by the Central Government.”; (b) in sub-section (2), for theword “Corporation”, the words “Central Government” shall be substituted.

Section 5: Amendment of section 19.—In section 19 of the principal Act, in sub-section (3), for the word “Corporation”, the words, brackets and figures “Central Governmentor the Insurance Regulatory and Development Authority established under sub-section (1)of section 3 of the Insurance Regulatory and Development Authority Act, 1999 (41 of 1999)”shall be substituted.

Section 6: Amendment of section 22.—In section 22 of the principal Act, for thewords “The Corporation may at any time transfer any officer”, the words “The CentralGovernment or any person authorized by it may at any time transfer any officer” shallbe substituted.



NotesSection 7: Amendment of section 24A.—In section 24A of the principal Act, thefollowing proviso shall be inserted, namely:—“Provided that the Corporation shall, on andfrom the commencement of the General Insurance Business (Nationalization) AmendmentAct, 2002, cease to carry on general insurance business.”

Section 8: Amendment of section 39.—In section 39 of the principal Act, in sub-section (2), for clause (b), the following clauses shall be substituted, namely:—“(b) theconditions, if any, subject to which the Corporation shall carry on reinsurance business;(ba) the conditions, if any, subject to which the acquiring companies shall carry on generalinsurance business.”

5.23 Insurance Sector Reforms in India

In 1993, Malhotra Committee headed by former Finance Secretary and RBI GovernorR.N. Malhotra was formed to evaluate the Indian insurance industry and recommend itsfuture direction.

The Malhotra Committee was set up with the objective of complementing the reformsinitiated in the financial sector. The reforms were aimed at “creating a more efficient andcompetitive financial system suitable for the requirements of the economy keeping in mindthe structural changes currently underway and recognizing that insurance is an importantpart of the overall financial system where it was necessary to address the need for similarreforms…”

In 1994, the committee submitted the report and some of the key recommendationsincluded:

1. StructureGovernment stake in the insurance Companies to be brought down to 50%.Government should take over the holdings of GIC and its subsidiaries so thatthese subsidiaries can act as independent corporations.All the insurance companies should be given greater freedom to operate.

2. CompetitionPrivate Companies with a minimum paid-up capital of ` 1 bn should be allowedto enter the industry.No Company should deal in both Life and General Insurance through a singleentity.Foreign companies may be allowed to enter the industry in collaboration withthe domestic companies.Postal Life Insurance should be allowed to operate in the rural market.Only one State-level Life Insurance Company should be allowed to operate ineach state.

3. Regulatory BodyThe Insurance Act should be changed.An Insurance Regulatory body should be set up.Controller of Insurance (currently a part from the Finance Ministry) should bemade independent.

4. InvestmentsMandatory Investments of LIC Life Fund in government securities to be reducedfrom 75% to 50%.



Notes GIC and its subsidiaries are not to hold more than 5% in any company (Theircurrent holdings to be brought down to this level over a period of time).

5. Customer ServiceLIC should pay interest on delays in payments beyond 30 days.Insurance companies must be encouraged to set up unit linked pension plans.Computerization of operations and updating of technology to be carried out inthe insurance industry.

The Committee emphasized that in order to improve the customer services andincrease the coverage of the insurance industry should be opened up to competition.

But at the same time, the Committee felt the need to exercise caution as any failureon the part of new players could ruin the public confidence in the industry. Hence, it wasdecided to allow competition in a limited way by stipulating the minimum capitalrequirement of ` 100 crores. The Committee felt the need to provide greater autonomyto insurance companies in order to improve their performance and enable them to act asindependent companies with economic motives. For this purpose, it had proposed settingup an independent regulatory body.

5.24 Major Policy Changes under IRDA Act

Insurance sector has been opened up for competition from Indian private insurancecompanies with the enactment of Insurance Regulatory and Development Authority Act,1999 (IRDA Act). As per the provisions of IRDA Act, 1999, Insurance Regulatory andDevelopment Authority (IRDA) was established on 19th April, 2000 to protect the interestsof holder of insurance policy and to regulate, promote and ensure orderly growth of theinsurance industry. IRDA Act 1999 paved the way for the entry of private players into theinsurance market which was hitherto the exclusive privilege of public sector insurancecompanies/corporations. Under the new dispensation, Indian insurance companies inprivate sector were permitted to operate in India with the following conditions:

Company is formed and registered under the Companies Act, 1956;The aggregate holdings of equity shares by a foreign company, either by itselfor through its subsidiary companies or its nominees, do not exceed 26%, paid-up equity capital of such Indian insurance company;The company’s sole purpose is to carry on life insurance business or generalinsurance business or reinsurance business.The minimum paid-up equity capital for life or general insurance business is` 100 crores.The minimum paid-up equity capital for carrying on reinsurance business hasbeen prescribed as ` 200 crores.

The Authority has notified 27 Regulations on various issues which includeRegistration of Insurers, Regulation on Insurance Agents, Solvency Margin, Reinsurance,Obligation of Insurers to Rural and Social Sector, Investment and Accounting Procedure,Protection of Policyholders’ Interest, etc. Applications were invited by the Authority witheffect from 15th August, 2000 for issue of the Certificate of Registration to both life andnon-life insurers. The Authority has its headquarter at Hyderabad.



Notes5.25 Insurance Companies in India

IRDA has so far granted registration to 12 private life insurance companies and9 general insurance companies. If the existing public sector insurance companies areincluded, there are currently 13 insurance companies in the life insurance business and13 companies operating in general insurance business. General Insurance Corporation hasbeen approved as the “Indian reinsurer” for underwriting only reinsurance business.Particulars of the life insurance companies and general insurance companies includingtheir web address is given below:

LIFE INSURERS Websites

Public Sector

Life Insurance Corporation of India www.licindia.com

Private Sector

Allianz Bajaj Life Insurance Company Limited www.allianzbajaj.co.in

Birla Sun-Life Insurance Company Limited www.birlasunlife.com

HDFC Standard Life Insurance Co. Limited www.hdfcinsurance.com

ICICI Prudential Life Insurance Co. Limited www.iciciprulife.com

ING Vysya Life Insurance Company Limited www.ingvysayalife.com

Max New York Life Insurance Co. Limited www.maxnewyorklife.com

MetLife Insurance Company Limited www.metlife.com

Om Kotak Mahindra Life Insurance Co. Ltd. www.omkotakmahnidra.com

SBI Life Insurance Company Limited www.sbilife.co.in

TATA AIG Life Insurance Company Limited www.tata-aig.com

AMP Sanmar Assurance Company Limited www.ampsanmar.com

Dabur CGU Life Insurance Co. Pvt. Limited www.avivaindia.com

GENERAL INSURERS

Public Sector

National Insurance Company Limited www.nationalinsuranceindia.com

New India Assurance Company Limited www.niacl.com

Oriental Insurance Company Limited www.orientalinsurance.nic.in

United India Insurance Company Limited www.uiic.co.in

Private Sector

Bajaj Allianz General Insurance Co. Limited www.bajajallianz.co.in

ICICI Lombard General Insurance Co. Ltd. www.icicilombard.com

IFFCO-Tokio General Insurance Co. Ltd. www.itgi.co.in

Reliance General Insurance Co. Limited www.ril.com

Royal Sundaram Alliance Insurance Co. Ltd. www.royalsun.com

TATA AIG General Insurance Co. Limited www.tata-aig.com



Notes Cholamandalam General Insurance Co. Ltd. www.cholainsurance.com

Export Credit Guarantee Corporation www.ecgcindia.com

HDFC Chubb General Insurance Co. Ltd.

REINSURER

General Insurance Corporation of India www.gicindia.com

5.26 Protection of the Interest of Policyholders

IRDA has the responsibility of protecting the interest of insurance policyholders.Towards achieving this objective, the Authority has taken the following steps:

IRDA has notified Protection of Policyholders’ Interest Regulations 2001 toprovide for: policy proposal documents in easily understandable language;claims procedure in both life and non-life; setting up of grievance redressalmachinery; speedy settlement of claims; and policyholders’ servicing. TheRegulation also provides for payment of interest by insurers for the delay insettlement of claim.The insurers are required to maintain solvency margins so that they are in aposition to meet their obligations towards policyholders with regard to paymentof claims.It is obligatory on the part of the insurance companies to disclose clearly thebenefits, terms and conditions under the policy. The advertisements issued bythe insurers should not mislead the insuring public.All insurers are required to set up proper grievance redressal machinery in theirhead office and at their other offices.The Authority takes up with the insurers any complaint received from thepolicyholders in connection with services provided by them under the insurancecontract.

5.27 New Developments in Insurance as a Sector in the IndianFinancial System

The insurance industry of India consists of 52 insurance companies of which 24 arein life insurance business and 28 are non-life insurers. Among the life insurers, LifeInsurance Corporation (LIC) is the sole public sector company. Apart from that, amongthe non-life insurers there are six public sector insurers. In addition to these, there is solenational reinsurer, namely, General Insurance Corporation of India. Other stakeholders inIndian Insurance market include agents (individual and corporate), brokers, surveyors andthird party administrators servicing health insurance claims.

Out of 28 non-life insurance companies, 5 private sector insurers are registered tounderwrite policies exclusively in health, personal accident and travel insurance segments.They are Star Health and Allied Insurance Company Ltd., Apollo Munich Health InsuranceCompany Ltd., Max Bupa Health Insurance Company Ltd., Religare Health InsuranceCompany Ltd. and Cigna TTK Health Insurance Company Ltd. There are two morespecialized insurers belonging to public sector, namely, Export Credit GuaranteeCorporation of India for Credit Insurance and Agriculture Insurance Company Ltd. for cropinsurance.



NotesMarket Size

India’s life insurance sector is the biggest in the world with about 36 crore policieswhich are expected to increase at a compound annual growth rate (CAGR) of 12-15%over the next five years. The insurance industry plans to hike penetration levels to 5%by 2020, and could top the US$ 1 trillion mark in the next seven years.

The total market size of India’s insurance sector is projected to touch US$ 350-400billion by 2020 from US$ 66.4 billion in FY13.

The general insurance business in India is currently at ` 77,000 crore (US$ 12.41billion) premium per annum industry and is growing at a healthy rate of 17%.

The ` 12,606 crore (US$ 2.03 billion) domestic health insurance business accountsfor about a quarter of the total non-life insurance business in the country.

Investment corpus in India’s pension sector is anticipated to cross US$ 1 trillion by2025, following the passage of the Pension Fund Regulatory and Development Authority(PFRDA) Act 2013, according to a joint report by CII-EY on Pensions Business in India.

Indian insurance companies are expected to spend ` 117 billion (US$ 1.88 billion)on IT products and services in 2014, an increase of 5% from 2013, as per Gartner Inc.Also, insurance companies in the country could spend ` 4.1 billion (US$ 66.11 million)on mobile devices in 2014, a rise of 35% from 2013.

Investments

Insurance sector of India needs capital infusion of ` 50,000 crore (US$ 8.06 billion)to expand, maintain a healthy capital base and improve solvency standards, accordingto Insurance Regulatory Development Authority (IRDA).

The following are some of the major investments and developments in the Indianinsurance sector.

Life Insurance Corporation of India (LIC) has earmarked a total of around ` 1trillion (US$ 16.12 billion) for investments in bonds, including non-convertibledebentures (NCDs), certificates of deposit (CDs), commercial papers (CPs) andcollateralized borrowing and lending obligations (CBLOs), with primary focus oninfrastructure and real estate in the year to March 31, 2015.Aditya Birla Financial Services Group has signed an agreement to form a healthinsurance joint venture (JV) with MMI Holdings of South Africa. The two will enterinto a formal JV in which the foreign partner will hold a 26% stake.South African Financial Services Group Sanlam plans to increase stake in itsIndian JV Shriram Life Insurance from 26% to 49%.JLT Independent plans to develop India as a service hub for all countries thatare a part of South Asian Association for Regional Cooperation (SAARC),according to Mr. Sanjay Radhakrishnan, CEO, JLT Independent.Kotak Mahindra Bank became the first bank to get the permission from ReserveBank of India (RBI) to set up a wholly-owned non-life insurance company.

Government Initiatives

The Government of India has taken a number of initiatives to boost the insuranceindustry. Some of them are as follows:

The Reserve Bank of India (RBI) has allowed banks to become insurance



Notes brokers, permitting them to sell policies of different insurance firms subject tocertain conditions.The select committee of the Rajya Sabha gave its approval, permitting 49%composite foreign equity investment in insurance companies. A broadagreement has also been achieved with the states on most of the issuesconcerning the implementation of the single goods and services tax (GST),which is scheduled to be rolled out from April 1, 2016.The Government of India plans to implement a ̀ 1,900 crore (US$ 306.41 million)e-governance project called ‘Panch Deep’ to automate transactions of theEmployees State Insurance Corporation (ESIC), said Mr. Bandaru Dattatreya,Union Minister for Labour and Employment with Independent Charge,Government of India. Under the project, enterprise resource planning (ERP)solution would be installed across the country which will give a unique card tothe employees and facilitate clearance of third party bills.The Government of India plans to launch a new insurance scheme to protectfarmers and their incomes against production and price risks.

• Under the Pradhan Mantri Jan Dhan Yojana, it has been decided that even thoseaccounts which had been opened prior to August 28, 2014 and have zerobalance will get ` 100,000 (US$ 1,612.55) insurance cover.

Road Ahead

India’s insurable population is anticipated to touch 75 crore in 2020, with lifeexpectancy reaching 74 years. Furthermore, life insurance is projected to comprise 35%of total savings by the end of this decade, as against 26% in 2009-10.

The future looks interesting for the life insurance industry with several changes inregulatory framework which will lead to further change in the way the industry conductsits business and engages with its customers.

Demographic factors such as growing middle class, young insurable population andgrowing awareness of the need for protection and retirement planning will support thegrowth of Indian life insurance.

Exchange Rate Used: INR 1 = US$ 0.016 as on February 25, 2015

5.28 Bancassurance

Bancassurance is a French term referring to the selling of insurance through a bank’sestablished distribution channels. In other words, we can say Bancassurance is theprovision of insurance (assurance) products by a bank. The usage of the word picked upas banks and insurance companies merged and banks sought to provide insurance,especially in markets that have been liberalized recently. It is a controversial idea, andmany feel it gives banks too great a control over the financial industry. In some countries,bancassurance is still largely prohibited, but it was recently legalized in countries likeUSA when the Glass Steagall Act was repealed after the passage of the Gramm LeachBililey Act.

Bancassurance is the selling of insurance and banking products through the samechannel, most commonly through bank branches. Selling insurance means distributionof insurance and other financial products through banks. Bancassurance conceptoriginated in France and soon became a success story even in other countries of Europe.In India, a number of insurers have already tied up with banks and some banks have alreadyflagged off bancassurance through select products.



NotesBancassurance has become significant. Banks are now a major distribution channelsfor insurers, and insurance sales a significant source of profits for banks. The latter partlybeing because banks can often sell insurance at better prices (i.e., higher premiums) thanmany other channels, and they have low costs as they use the infrastructure (branchesand systems) that they use for banking.

Bancassurance primarily rests on the relationship the customer has developed overa period of time with the bank. And pushing risk products through banks is a much morecost-effective affair for an insurance company compared to the agent route, while, forbanks, considering the falling interest rates, fee based income coming in at a minimumcost is more than welcome.

5.29 Various Models for Bancassurance

Various models are used by banks for bancassurance:

(a) Strategic Alliance ModelUnder this model, there is a tie-up between a bank and an insurance company. The

bank only markets the products of the insurance company. Except for marketing theproducts, no other insurance functions are carried out by the bank.

(b) Full Integration ModelThis model entails a full integration of banking and insurance services. The bank sells

the insurance products under its brand acting as a provider of financial solutions matchingcustomer needs. Bank controls sales and insurer service levels including approach toclaims. Under such an arrangement, the Bank has an additional core activity almost similarto that of an insurance company.

(c) Mixed ModelsUnder this model, the marketing is done by the insurer’s staff and the bank is

responsible for generating leads only. In other words, the database of the bank is soldto the insurance company. The approach requires very little technical investment.

5.30 Status of Bancassurance in India

Reserve Bank of India (RBI) has recognized “bancassurance” wherein banks areallowed to provide physical infrastructure within their select branch premises to insurancecompanies for selling their insurance products to the banks’ customers with adequatedisclosure and transparency, and in turn earn referral fees on the basis of premia collected.This would utilize the resources in the banking sector in a more profitable manner.

Bancassurance can be an important source of revenue. Fee based income can beincreased through hawking of risk products like insurance.

There is enormous potential for insurance in India and recent experience has shownmassive growth pace. A combination of the socio-economic factors is likely to make theinsurance business the biggest and the fastest growing segment of the financial servicesindustry in India.

However, before taking the plunge into this new field, banks as insurers need to workhard on chalking out strategies to sell risk products especially in an emerging competitivemarket. However, future is bright for bancassurance. Banks in India have all the rightingredients to make Bancassurance a success story. They have large branch network,huge customer base, enjoy customer confidence and have experience in selling non-



Notes banking products. If properly implemented, India could take leadership position inbancassurance all over the world

Government of India Notification dated August 3, 2000, specified ‘Insurance’ as apermissible form of business that could be undertaken by banks under Section 6(1)(o)of the Banking Regulation Act, 1949. Then onwards, banks are allowed to enter theinsurance business as per the guidelines and after obtaining prior approval of Reserve Bankof India.

5.31 Bancassurance Models in Europe

The growth of bancassurance has been one of the most significant movements acrossthe European financial services industry over the last three decades. Powerful forces ofcompetition and consolidation are evident in the reconstruction of the conventional barriersbetween the supply and demand of financial products and services. The developmentstowards the homogenized bancassurance phenomenon have been determined by changesacross a broad spectrum of regulatory, political, economic, behavioural and culturalcharacteristics. Driven by a deregulatory and increasingly integrated marketplace, theEuropean banking and insurance sectors have acknowledged the necessity for innovationand a re-evaluation of their operations.

The aim of this discussion is to review the major developments behind bancassurancein Europe. The phenomenon has been primarily European, but few studies have attemptedto draw together the fragmented literature pertaining to the region as a whole and toindividual nation states. Examining the relevant academic literature, publicly availableresearch, the financial press and market activity, this article analyses the historical trends,strategic issues and the likely future of bancassurance in Europe.

This will be a three-part analysis of bancassurance, focusing on Europe. Variousparts were written as a standalone academic study prior to the onset of the financial crisis.Part three is currently being researched and will attempt to draw together and analyzemore recent post-crisis developments when the data and information is available. This isan overview of the European market environment, discusses the strategic issues in thebancassurance market with an emphasis on life insurance, followed by the key modelsof development and a descriptive analysis of the regulatory and legal developments inEurope. This introduces a comparative analysis of national markets in Continental Europe,discussing both the development and rationale behind domestic activities, and evaluatesthe outlook and realities for the industry in Europe. This will bring the discussion up todate in the context of the global financial crisis, evolving economic and regulatory trends,and the changing roles and activities of banks and insurers.

The motive behind the microeconomic integration of financial services is ultimatelya matter of bringing certain advantages to at least one party involved in the transaction.One of the forces underlying the convergence of banks and insurers is the compatibilityof these industries. For instance, both banks and insurance companies operate in theasset accumulation business and in some cases, both cater to the individuals’ financialservices needs. The distribution channels they use may be complementary and when theyoverlap they may provide cost synergies. These similarities provide depth to the rationalefor bringing these institutions together.

The Association of British Bankers defines bancassurers as ‘insurance companiesthat are subsidiaries of banks and building societies and whose primary market is thecustomer base of the bank or building society’. Accordingly, a bank may own an insurancecompany, may only operate as an intermediary, distributing insurance products



Notesconstructed by another, or may have a joint venture with an insurer, sharing capabilitiesin distribution and manufacturing. The magnitude of the operations may also differ. Theinsurance business may provide a marginal concern for the banking institution or representa significant share of total revenue and income. The benefits earned by each participantmust, therefore, be assessed carefully before arriving at any conclusion as to the successof bancassurance activities. Pertinent considerations include how a bank benefits fromany insurance practices, how an insurer or insurance operation benefits from itsassociation with the bank, the links between the businesses and if the grouping will evergenerate an operation greater than the mere sum of its parts.

5.32 Bancassurance in India

In India, banking and insurance sectors are regulated by two different entities. Thebanking sector is governed by Reserve Bank of India and the insurance sector is regulatedby Insurance Regulatory and Development Authority (IRDA). Bancassurance, being thecombination of two sectors comes under the purview of both the mentioned regulators.Each of them has elaborate and descriptive rules, restrictions and guidelines.

5.33 The Major Need for Bancassurance in India(a) Now, banks have realized that by entering into the product value services in

insurance sector, they can meet client expectations and earn more profit whilecarrying on their banking business.

(b) In an insurance product, there is a periodic nature of premium deposit whichis positive for the bank.

(c) Banks have also realized that customer’s loyalty increases profit.(d) Banks are projected as a ‘shoppers’ stop’ to provide all kind of financial services.(e) Insurance sector is in the extensive need to use the bank’s distribution network,

large client base and huge customer database, which are helpful in selling theirproducts.

(f) It reduces the cost of distribution of insurance products in comparison to thetraditional agency channel.

5.34 Obstacles in the Success of Bancassurance(a) There are some cultural differences between the bank and insurance company

which are hurdles in the way of success of bancassurance.(b) There may be a problem at the time of implementation of banassurance

partnership.(c) Poor manpower management is one of the biggest hurdles in this area.(d) Lack of sales culture and no involvement of branch manager.(e) Insufficient product promotions and failure to integrate marketing plans.(f) The most important in all of them is the negative attitude of the bank staff towards

insurance and unwieldy marketing strategy.(g) Besides that, following are the specific cultural differences between both of them.(h) Banks provides tangible services whereas an insurance company provides

intangible services.(i) Banks sell its product on good faith. On the other hand, insurance companies

sell their products on utmost good faith.



Notes (j) Banks provided services are ‘immediate’ whereas insurance provided servicesare ‘futuristic’.

(k) Bank provides short-term finance whereas insurance companies provide long-term finance.

(l) Banks generally deal with their customers directly whereas insurancecompanies deals with their customers through intermediaries.

(m) Bank customers have their accounts in banks whereas insurance customersunaware of their accounts.

(n) Dealing with banks is highly personal whereas dealing with insurance is lesspersonal.

(o) The Reserve Bank of India in its 2009-2010 circular made it mandatory for bankto disclose in the “Notes to Accounts” from the year ending March 31, 2010,the details of fees or remuneration received in respect of bancassurancebusiness undertaken by them.

5.35 Regulating Guidelines of IRDA

Insurance Regulation and Development Authority Act 1999 provides the entry normsfor any new company for operation in insurance sector. Any such new company musthave:

(a) Minimum paid-up capital of ` 100 crores;(b) Investment of policyholders’ fund only in India;(c) Restriction of foreign companies to minority equity holding of 26%;(d) Following are Bancassurance Models approved for business;(e) Insurance business carried out by banks;(f) It allows any scheduled bank to undertake life or non-life insurance business

on specified fee basis but without any risk participation.

Joint Venture by Bank

Banks after satisfying required criteria are allowed to set up a joint venture companyfor undertaking insurance business with risk participation subject to certain safeguards.The maximum equity which a bank is allowed to hold in such joint venture is 52% of thepaid-up capital of the insurance company on a selective basis. However, in certain caseswith the permission of RBI, the bank can initially invest more than 52% but there mustbe reduction of equity to the statutory level. For example, ICICI Prudential Life Insurancecompany does nearly 20% of the life insurance sale through the Bancassurance channel.SBI, HDFC and ICICI Banks are the subscribers of their respective holding companies.Banks are also tying up with regional rural banks to make the benefit out of rural andsemi-urban region . Similarly, AVIVA Insurance has its tie-up with more than 21 bankingcompanies which includes private, public and foreign sector banks.

Restriction on Subsidiaries

A subsidiary of a bank or another bank shall not normally be allowed to join theinsurance company on risk participation basis. Subsidiaries means and includes here banksubsidiaries undertaking merchant banking securities, mutual fund, leasing finance andhousing finance business, etc.



NotesInvesting in an Insurance Company

Banks which are not eligible for joint venture can invest in an Insurance companywithout risk participation. Currently, banks can invest up to 10% of the net worth of thebank, or ` 50 crores, whichever is lower.

Merger and Acquisition

This model is not very popular in India due to various national laws forbidding mergersbetween banks and insurance sectors. In this model, either a bank acquires the insurancecompany or merges with it or vice versa.

Organic Start-up

Under this model instead of merger or acquisition of the bank or insurance company,believe in building skills organically. The advantage of this model is that it reduces thechance of cultural differences between the Bank and insurance company.

5.36 Recommendations of Committee Constituted by IRDA onBancassurance

The banks are not allowed to sell insurance products of more than one insurancecompany. But due to persistent request from the side of various life and general insurancecompanies from the IRDA led to formation of a seven-member committee in the mid of2009 to look after the matter. The committee had to submit its report and to examinethe desirability for a differential treatment of insurance intermediation by banks under theBancassurance model consistent with intermediation best practices and modified suitablyto meet domestic regulatory requirements. The committee submitted its recommendationon 26th May, 2011.

Following are some of the recommendations of the Committee: channel and thereforethere is need to enact a comprehensive legislation to cover all aspects of the workingof the Bancassurance activities:

Banks should be allowed to tie up with any of the following two sets of insurers:(b) Two in life insurance sector(c) The Committee admitted that at present there is ambiguity on the organization

and practices of the Bancassurance(d) Two in non-life insurance sector excluding health(e) Two in health insurance sector(f) ECGC and AIC.

Efforts should be made to more use of information technology which would reducethe manpower requirement and would increase more structured, transparent and efficientorganization.

The tenure of the agreement between the banker and insurer is normally one to threeyears at present. This makes the relationship between the two unstable. Therefore, theminimum period of the agreement between the banker and the insurer shall not be lessthan five years. Here, the Committee also made a very significant point that theresponsibility of servicing of the policies issued already through the bank or subsidiaryor special purpose vehicle shall remain with the bancassurance partner even if thetie-up ends and the said partner shall receive the renewal commission on per renewed



Notes policy basis. For all this purpose, there is need of proforma for memorandum of agreementbetween bank and insurer with minimum requirement.

As far as inspection and supervision is concerned, the proposed regulation mustcontain separate provision which empowers IRDA and RBI to inspect any of theBancassurance partner.

The regulation must have provisions of maintaining accounts and certification whichshould be furnished in periodical returns to the authority. Corporate governance normsregarding disclosure should be complied by the banks treating bancassurance as integralpart of bank’s business operation.

Regulations should make it mandatory that the bank staff be fully trained in handlinginsurance products so that the sale process is transparent and the policyholder gets fulldisclosure of the features of the product.

The Committee gave the green light for multiple insurers but only if a bank fulfillsall other conditions specified in the Committee’s recommendations. The Committeerecommended abolition of the referral system of bancassurance because it is costlier thancorporate agent model. The reason behind the high cost is that the insurer has not onlyto pay the higher amount of first year premium as referral fee but also has to deploy staffand infrastructure in the bank premises.

5.37 Bancassurance Model in India

Referral Model

This model of Bancassurance India is regulated by Insurance Regulatory andDevelopment Authority (Sharing of Database for Distribution of Insurance Products)Regulations, 2010. Any commercial bank can undertake insurance business as an agentof insurance company on fee basis. The bank does not participate in risk under thiscategory. This is also known as referral model. In this model, a ‘referral arrangement’ isdone between ‘Referral Company’ and insurer for selling of insurance products. The referralcompany only shares the database of its customers and does not directly indulge insoliciting or selling of insurance product through agent or corporate agent or insuranceintermediaries. In other words, the actual transaction is done by the staff of the insurancecompany either at the bank premise or elsewhere. The bank charges only fees orcommission for every business from their customers.

5.38 Summary

Insurance is a contract between two parties whereby one party agrees to undertakethe risk of another in exchange for consideration known as premium and promises to paya fixed sum of money to the other party on happening of an uncertain event (death) orafter the expiry of a certain period in case of life insurance or to indemnify the other partyon happening of an uncertain event in case of general insurance.

Insurance provides financial protection against a loss arising out of happening of anuncertain event. A person can avail this protection by paying premium to an insurancecompany. A pool is created through contributions made by persons seeking to protectthemselves from common risk. Premium is collected by insurance companies which alsoact as trustee to the pool. Any loss to the insured in case of happening of an uncertainevent is paid out of this pool.



NotesInsurance refers to a contract or policy in which an individual or entity receivesfinancial protection or reimbursement against losses from an insurance company. Thecompany pools clients’ risks to make payments more affordable for the insured.

Insurance concept started by considering the methods of transferring or distributingrisk were practiced by Chinese and Babylonian traders as long ago as the 3rd and 2ndmillennia BC, respectively. Chinese merchants travelling treacherous river rapids wouldredistribute their wares across many vessels to limit the loss due to any single vessel’scapsizing. The Babylonians developed a system which was recorded in the famous Codeof Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants. Ifa merchant received a loan to fund his shipment, he would pay the lender an additionalsum in exchange for the lender’s guarantee to cancel the loan should the shipment bestolen.

The sale of life insurance in the US began in the late 1760s. The Presbyterian Synodsin Philadelphia and New York founded the Corporation for Relief of Poor and DistressedWidows and Children of Presbyterian Ministers in 1759; Episcopalian priests created acomparable relief fund in 1769. Between 1787 and 1837, more than two dozen life insurancecompanies were started, but fewer than half a dozen survived.

Insurance in India has evolved over time heavily drawing from other countries, Englandin particular, 1818 saw the advent of life insurance business in India with the establishmentof the Oriental Life Insurance Company in Calcutta. This Company, however, failed in 1834.In 1829, the Madras Equitable had begun transacting life insurance business in the MadrasPresidency. 1870 saw the enactment of the British Insurance Act and in the last threedecades of the nineteenth century, the Bombay Mutual (1871), Oriental (1874) and Empireof India (1897) were started in the Bombay Residency. This era, however, was dominatedby foreign insurance offices which did good business in India, namely Albert LifeAssurance, Royal Insurance, Liverpool and London Globe Insurance and the Indian officeswere up for hard competition from the foreign companies.

Life Insurance refers to the insurance which gives a protection against the loss ofincome that would result if the insured passed away. The named beneficiary receives theproceeds and is thereby safeguarded from the financial impact of the death of the insured.

General insurance or non-life insurance policies, including automobile andhomeowners policies, provide payments depending on the loss from a particular financialevent. General insurance typically comprises any insurance that is not determined to belife insurance.

Insurance companies are a special type of financial institution that deals in thebusiness of managing risk. A corporation periodically gives them money and, in return,they promise to pay for the losses the corporation incurs if some unfortunate event occurs,causing damage to the well-being of the organization.

The economic crisis of late 2007 and early 2008 highlighted the growing importanceof the role of the world’s financial sectors in ensuring global financial stability. The financeindustry, however, is not homogenous. Insurers, in particular, have a distinct profile withinthe industry. This was the subject of leading speakers at the ‘Role of Insurance in GlobalFinancial Stability’ event, held at the Swiss Re Centre for Global Dialogue, 29 June 2010.

The principle of insurable interest states that the person getting insured must haveinsurable interest in the object of insurance. A person has an insurable interest when thephysical existence of the insured object gives him some gain but its non-existence willgive him a loss. In simple words, the insured person must suffer some financial loss bythe damage of the insured object.



Notes Indemnity means security, protection and compensation given against damage, lossor injury. According to the principle of indemnity, an insurance contract is signed onlyfor getting protection against unpredicted financial losses arising due to futureuncertainties. Insurance contract is not made for making profit, else its sole purpose isto give compensation in case of any damage or loss.

Insurance sector has been opened up for competition from Indian private insurancecompanies with the enactment of Insurance Regulatory and Development Authority Act,1999 (IRDA Act). As per the provisions of IRDA Act, 1999, Insurance Regulatory andDevelopment Authority (IRDA) was established on 19th April 2000 to protect the interestsof holder of insurance policy and to regulate, promote and ensure orderly growth of theinsurance industry. IRDA Act 1999 paved the way for the entry of private players into theinsurance market which was hitherto the exclusive privilege of public sector insurancecompanies/corporations.

IRDA has so far granted registration to 12 private life insurance companies and9 general insurance companies. If the existing public sector insurance companies areincluded, there are currently 13 insurance companies in the life insurance business and13 companies operating in general insurance business. General Insurance Corporation hasbeen approved as the ”Indian reinsurer” for underwriting only reinsurance business.

Bancassurance is a French term referring to the selling of insurance through a bank’sestablished distribution channels. In other words, we can say Bancassurance is theprovision of insurance (assurance) products by a bank. The usage of the word picked upas banks and insurance companies merged and banks sought to provide insurance,especially in markets that have been liberalized recently. It is a controversial idea, andmany feel it gives banks too great a control over the financial industry. In some countries,bancassurance is still largely prohibited, but it was recently legalized in countries likeUSA when the Glass Steagall Act was repealed after the passage of the Gramm LeachBililey Act.



1. Insurance provides financial protection against a loss arising out of happeningof an _____________.

2. _____________ refers to the insurance which gives a protection against the lossof income that would result if the insured passed away.

3. _____________ policies, including automobile and homeowners policies,provide payments depending on the loss from a particular financial event.

4. Insurance companies are a special type of financial institution that deals in thebusiness of _____________.

5. General Insurance Corporation has been approved as the “Indian reinsurer” forunderwriting only ____________.

II. True or False

1. Insurance is a contract between two parties whereby one party agrees toundertake the risk of another in exchange for consideration known as premiumand promises to pay a fixed sum of money.

2. The sale of life insurance in the US began in the late 1760s.



Notes3. Life Insurance refers to the insurance which gives a protection against the lossof income that would result if the insured passed away.

4. The economic crisis of late 2007 and early 2008 highlighted the growingimportance of the role of the world’s financial sectors in ensuring global financialstability.

5. The principle of insurable interest states that the person getting insured musthave insurable interest in the object of insurance.


1. Which of the following is a contract between two parties whereby one partyagrees to undertake the risk of another in exchange for consideration?

(a) Insurance(b) Banking(c) Lending(d) All the above

2. Insurance concept started by considering the methods of transferring ordistributing risk were practiced by _____________

(a) Chinese traders(b) Babylonian traders(c) Both (a) and (b)(d) None of these

3. The sale of life insurance in the US began in the late _____________(a) 1750s(b) 1760s(c) 1740s(d) 1780s



1. Give the meaning of Insurance.2. What is Life Insurance?3. What is General Insurance?4. State any two purposes of Life Insurance.5. What is the origin of General Insurance Corporation of India (GICI)?6. What is IRDA Act?7. What is Bancassurance?8. State any two Regulating Guidelines of IRDA.


1. Discuss the historical background of Insurance.2. Explain various types of Insurance.3. Discuss role of Insurance companies in Industrial Financing.4. Explain various principles of Insurance.



Notes 5. Discuss features of General Insurance.6. Explain about Insurance sector reforms in India.7. Discuss about new developments in insurance as a sector in the Indian Financial

System.8. Discuss various models for Bancassurance.

5.41 Key TermsInsurance: Insurance is a contract between two parties whereby one partyagrees to undertake the risk of another in exchange for consideration knownas premium and promises to pay a fixed sum of money to the other party onhappening of an uncertain event.Life Insurance: Life Insurance refers to the insurance which gives a protectionagainst the loss of income that would result if the insured passed away.General insurance: General insurance or non-life insurance policies, includingautomobile and homeowners’ policies, provide payments depending on the lossfrom a particular financial event.Principle of Utmost Good Faith: The Principle of Utmost Good Faith is a verybasic and first primary principle of insurance.Principle of insurable interest: The principle of insurable interest states thatthe person getting insured must have insurable interest in the object ofinsurance.Bancassurance: Bancassurance is a French term referring to the selling ofinsurance through a bank’s established distribution channels.


1. Uncertain event2. Life Insurance3. General insurance or non-life insurance4. Managing risk5. Reinsurance business

II. True or False1. True2. True3. True4. True5. True

III. Multiple Choice Questions1. (a) Insurance2. (c) Both (a) and (b)3. (b) 1760s



Notes5.43 Case Study

Recognizing the need for large-scale centralized systems expertise, SBI soughtproposals from a number of vendor consortiums that were headed by the leading systemsintegrators. From these proposals, the bank narrowed down the potential solutions tovendor consortiums led by IBM and TCS. The TCS Group included Hewlett-Packard,Australia-based Financial Network Services (FNS), and China Systems (for trade finance).Although SBI favoured the real-time processing architecture of FNS’s BaNCS system overthat of the IBM consortium’s memo post/batch update architecture, the bank had severalconcerns about the TCS consortium proposal. They included the small size and relativelyweak financial strength of FNS (TCS would eventually purchase FNS in 2005) and theability of the UNIX-based system to meet the scalability requirements of the bank.Therefore, it was agreed that TCS would be responsible for the required systemsmodifications and ongoing software maintenance for SBI. Additionally, scalability testswere performed at HP’s lab in Germany to verify that the system was capable of meetingthe bank’s scalability requirements. These tests demonstrated the capability of TCSBaNCS to support the processing requirements of 75 million accounts and 19 million dailytransactions. Tata Consultancy Services and TCS BaNCs Tata Consultancy Services,headquartered in Mumbai, India, is one of the world’s largest technology companies withparticular expertise in systems integration and business process outsourcing. Thecompany has more than 130,000 employees located in 42 countries and achieved revenuesof $ 5.7 billion in fiscal 2008. Although TCS has long been a leader in core systemsintegration services for banks, after it purchased FNS in 2005, the company also becamea leading global provider of core banking software for large banks. The BaNCS systemis based on service-oriented architecture (SOA) and is platform and database independent.In addition to SBI, TCS BaNCS clients include the Bank of China (installation in process),China Trust, Bank Negara Indonesia, India’s Bank Maharashtra, National CommercialBank (Saudi Arabia), and Koram Bank (Korea). TCS has also expanded its US footprintwith the opening of its largest resource delivery center in North America (near Cincinnati,Ohio) that can house 20,000 personnel. The company is seeking to license and implementthe BaNCS system in North America and recently completed a major part of an effortto ensure that the BaNCS system meets US regulatory and compliance requirements.

Question:1. Do you think the Vendor Consortium Selection is up to the mark? Discuss.



Company.3. Investing in Development: Lessons of the World Bank Experience by Baum W.C

and Tolbert S.M., Oxford University Press.4. Projects, Preparation, Appraisal, Budgeting and Implementation by Prasanna


5.45 Bibliography1. Adams, J. (2012), The Impact of Changing Regulation on the Insurance Industry,

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Ltd. (ISBN 0-333-76447-1)22. The Business Finance Market: A Survey, Industrial Systems Research

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Documents

Management of Financial Institutions