Introduction to Banks and Banking in India

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Example of a Household

Consider a family (joint[1] or nuclear[2]) that either has their own business or family members working with other businesses. This family lives in a house that they either own or rent and require money for food, clothing, home furnishing, electricity, water, fuel for cooking, education, own a car or use public transportation and petty cash[3] for other expenses. The money required for such expenses comes from the incomes earned by the family members (either from their own business or from employment). The family members spend a part of their incomes as expenses and the remaining amount is kept aside in a bank. A bank is an establishment or an institution that allows safety of the money the family members have kept aside after spending on food clothing, etc. This money is kept as savings by the bank. Accordingly, a bank can be defined as “…an establishment for the custody, loan, exchange of issue of money, for the extension of credit and for facilitating the transmission of funds” by Merriam-Webster.

The definition implies the following characteristics of a bank:

What is a Bank?

  1. Fixed structure – Banks are fixed building structures that are mostly present around residential homes and commercial offices.
  2. Enable savings – The money kept aside in the bank leads to savings that adds to the existing wealth and thus avoids hoarding of money. Hoarding is an accumulation of goods and money that are not accounted for. Hoarding leads to rise in prices of goods and leads to unequal distribution of wealth.
  3. Enables consistent flow of money – A family can track all the money spend on the requirements on the house and savings with the bank enabling consistent flow of money for the family to sustain all year around
  4. Restores value – A family can restore value of money by appropriately purchasing required goods and services for the family and saving money (in the bank) for future expenditures of the family
  5. Inclusive interest rates – Interest rate is a rate charged (for investment) or paid (for savings) for the use of money. A bank provides different interest rates for savings and investments. For example, State Bank of India (SBI) pays an interest rate of 4% on savings account and charges 10.75% interest on a housing loan.
  6. Enables resource allocation – Banks offer various financial services for individuals, families, small-medium-large businesses, governments, etc. for allocation of resources. For example, businesses, which require loans for machinery, families requiring loans for car or land to build a home or a factory.
  7. Involve banking – Banks are also businesses and act as custodian that is charge of keep the money of all families safely. Banks continuously work towards meeting the financial needs (savings and investment) of customers.

Banking in India

Banking means conducting the business as a bank and caters to financial needs of individuals, businesses and governments. Banking in India has gradually evolved into a highly proactive and dynamic sector. The development of India’s banking system can be divided into three distinct phases: Phase I: Early Phase between 1789 and 1969; Phase II: Structural Reforms between 1969 and 1991 and; Phase III: New Phase from 1991 onwards[4].

Phase I: Early Phase between 1789 and 1969

Phase I

Banking in India was formally introduced with the establishment of General Bank of India followed by the establishment of Bank of Hindustan and Bengal Bank in 1786. The East India Company established the Bank of Bengal in 1809, Bank of Bombay in 1840 and Bank of Madras in 1843 as independent banks and were amalgamated[5] in 1920 to be known as Presidency Banks. Allahabad Bank was also set up in 1865 by a group of Europeans in Allahabad and the Imperial bank of India was also started as a private bank with mostly European shareholders. One of the primary features for banking in India during Phase I was that the banks were started by Europeans (especially the British) for European (non-Indian) traders. However, banks such as Punjab National Bank that was exclusively meant for Indians was introduced in 1894. Other banks that were set up in this phase between 1906 and 1913 included Bank of India, Canara Bank, Indian Bank and the Bank of Mysore. The main highlight of Phase I was the establishment of the Reserve Bank of India (RBI) in 1935 which was constituted as the most important bank and operated as a shareholders’ bank and all bank were required to maintain certain amount of cash balances with the RBI[6]. Another feature of banking in Phase I was that the growth of banks was very slow and banks also experienced failures between 1913 and 1934.

After India’s independence, the new Government of India (GoI) introduced the “Banking Companies Act, 1949” which later changed to “Banking Regulation Act, 1949” and its revised (amended) version Banking Regulation (Amendment) Act, 1965 that provided extensive powers for supervising and regulating the banking sector in India to the RBI. RBI became the central banking authority and this move was directed towards improving public confidence in banks and increasing the mobilization of deposits in banks from people other than traders.

Summarizing the main features of the phase:

  • Banks introduced by Europeans in India followed by banks established exclusively for Indians
  • Initially, RBI was introduced in 1935 without any major government involvement but after independence the GoI vested extensive powers of supervision and regulation of banks in India through Banking Regulation Act, 1949 and its amended act in 1965.
  • Many banks experienced failures during Phase I, thus reflecting less popularity about banks among Indian public.
  • Most customers of banks were traders
  • Presence of local money lenders who provided instant money but charged high interest rates

Phase II: Structural Reforms between 1969 and 1991

The Indian government initiated structural reforms in banking through nationalization of the Imperial Bank of India as the State Bank of India (SBI). The Imperial bank had extensive banking facilities especially in semi-urban and rural areas of India and was formed as SBI to act as a principal agent of RBI and to handle banking transactions of the Union and the State governments of the country. Accordingly, 7 subsidiary banks of SBI were nationalized in 1969 followed by nationalization of 14 major private commercial banks – Central Bank of India, Bank of Maharashtra, Dena Bank, Punjab National Bank, Syndicate Bank, Canara Bank, Indian Bank, Indian Overseas Bank, Bank of Baroda, Union Bank, Allahabad Bank, United Bank of India, UCO Bank and Bank of India.

Nationalization of banks is the primary feature during Phase II. Nationalization means that a private company’s assets or operations are taken over by the government for which the company may or may not be compensated for loss of assets. Nationalization is one of protectionist reforms aimed at rescuing ailing[7] industries. Accordingly, banks were gradually nationalized during Phase II due to the following reasons:

  • To generate public faith
  • To provide ease in credit
  • To reduce poverty and unemployment
  • To encourage growth of self-employed units like agricultural laborers, marginal farmers, village artisans, small businesses, household enterprises, Small-Scale Industries (SSIs)
  • To avoid bank failures and crisis
  • To ensure the sustainability of banks in India through regulation[8]

The GoI had taken the following steps to regulate banking institutions in India:

  • Enactment of Banking Regulation Act (in 1949)
  • Nationalization of SBI (in 1955)
  • Nationalization of SBI subsidiaries (in 1959)
  • Insurance cover extended to deposits (1961) – to protect deposits of depositors, ensure financial stability, encourage confidence in the banking system and mobilize savings[9]
  • Nationalization of 14 major private banks
  • Creation of Credit Guarantee Corporation – to cater to credit needs of neglected sectors / industries and weaker sections of the country.
  • Creation of Regional Rural Banks or RRBs (in 1975) – RRBs provide credit to weaker sections of rural areas especially small and marginal farmers, agricultural labourers, artisans and small entrepreneurs.
  • Nationalization of seven more banks with deposits over Rs 200 crore (in 1980)

The result of the nationalization process was positive. Branches of public sector banks in India rose to approximately 800% in deposits, advances took a huge jump by 11000% and there was immense public faith generated towards public sector[10] banks. Local money lenders also continued to exist during this phase and the ill-effects spread across weaker sections of the society who were unable to pay their debt and lost property, wealth and other assets thus ending up in poverty.

Phase III: New Phase from 1991 onwards.

India experienced a major balance of payment crisis in 1991 that led to economic liberalization during Phase III[11]. Balance of payment crisis refers to inability of a country to pay for all international (or external) debt accumulated for a specific period of time, which also requires payment in terms of relevant foreign currencies. Some of the reasons for India’s inability to pay for international debt and transactions are listed below:

  • Restrictive and protectionist trade policies that emphasized on import substitution (replacing imports with domestic production that attempts to reduce its dependency on foreign countries)
  • Elaborate licenses and regulations that included tiresome bureaucratic and corrupt practices
  • Monopoly of the public sector units and businesses that discouraged healthy competition and fairness across industries

The result of the balance of payment crisis was initiation of the new and ongoing economic reforms and some of the changes are listed below:

  • Mortgaging India’s gold with the Bank of England in return for paying the foreign debt and devaluing the Indian currency under the advice of International Monetary Fund (IMF)
  • Openness in international trade and foreign investment that led the way for various foreign countries to set up businesses in India. For example, Nestle, Pepsi Coca-Cola, etc invested money and set up businesses in India and also banks like Hong Kong and Shanghai Banking Corporation (HSBC), Bank of America (BOA), etc. began operations in India during Phase III.
  • Enabling privatization and private sector participation in India
  • Initiating structured and transparent tax reforms and inflation controlling measures
  • Devaluing[12] currency, pegging[13] it to the US dollar and regulating the flow of currencies

India’s banking sector during Phase III equally benefited from the economic liberalization with the introduction of innovative banking facilities and practices. For example, the presence of Automated Telling Machines (ATMs) that enabled money withdrawal without visiting a bank and involving paperwork, phone banking[14], net banking[15], etc. The banking sector had grown strong with the new economic reforms during this period and remained unaffected with the bad-effects of the Asian Financial Crisis of 1997. After the end of the Asian crisis, banking sectors of Japan and Brazil had sought advice from the Indian banks to be able to avoid the ill-effects of any economic or financial crisis on the banking sector in the future. The banking models considered by these countries are broadly based on the banking model considered in India.

Reserve Bank of India (RBI)

The economic liberalization of 1991 led to more responsibilities for the RBI as a central authority and regulator of banking sector in India[16]. Following are some characteristics of RBI:

    1. RBI is the highest authority and advisory for banking sector in India. Banks in India are regulated by the RBI and must follow the rules and regulations set by the RBI
    2. RBI is responsible for issuance of currency in India and controls the overall supply of money in India
    3. RBI controls and closely monitors the flow and trade of Indian rupee against foreign currencies (US dollar, British Sterling Pound, German Deustche and Europe’s euro) and manages the value of Indian currency in accordance to the demand and supply of foreign trade and investment.
    4. RBI prescribes and monitors reserves (especially foreign reserves) of the country. The main reason for the 1991 crisis were imbalances in foreign exchange reserves that led to mortgaging country’s gold with IMF. Though India has retrieved the gold from IMF, RBI continuously strives to maintain and prescribes a minimum amount of foreign exchange reserves with RBI and other financial institutions to avoid future crisis. Foreign exchange reserves are foreign currency deposits and bonds held by RBI and other financial institutions that provide ease in trade and investment with foreign countries.
    5. RBI is also known as the banker’s bank. According to the regulation described under the ‘Banking Companies Act of 1949’ and its amendment in 1962 every bank is required to maintain a cash reserves equal to 3% of its deposit liabilities with the RBI and the minimum cash requirement can be changed by the RBI. Cash reserves are money reserved for short-term stable investments of banks. Banks can also borrow money from RBI in case they are not able to maintain the cash reserves. RBI is known as the banker’s bank because banks can seek financial assistance from RBI in case of crisis.
    6. RBI is the controller of credit. It controls the flow and availability of credit through the following monetary policies*:
      • Interest rates – RBI can regulate and change the bank rate depending upon the economic conditions of the country. Bank rate is the rate at which RBI lends money to other banks. For example, slow growth or negative growth (recession) in an economy leads to constrained supply of money and to increase money supply, RBI reduces the bank rate that allows banks to provide credit to consumers. Similarly, an economic boom leads to inflation or rise in prices and to curb high inflationary pressures, RBI increases the bank rate so that banks can lend less credit to people.
      • Open Market Operations (OMO) – RBI can increase money supply in an economy directly by buying and selling government securities in the market. Government securities are bonds issued by government in the money market where people loan (or invest) money to the government for a certain period a time (maturity period) on an interest rate. After the maturity period is over, people get back the amount invested with interest rate added in installments. For example, you purchase a 2-year government bond with an interest rate of 5% for a principal amount of Rs 1000. Most bonds pay back on semi-annual basis and you will receive payments 4 times in 2 years of Rs 125 each time (5% of Rs 1000 is Rs 500 and Rs 500 divided by 4). Thus, you will receive a total of Rs 1500 (principal amount Rs 1000 plus interest rate Rs 500) from the government bond after 2 years
    7. RBI also controls and supervises banks in India. Each bank has to apply for a license or permission from the RBI to conduct banking business. This includes permission for introducing new banking products or services or setting up new branches in India or abroad. Every bank is supposed to also provide a weekly update to RBI showing the details of assets and liabilities

    *ATTENTION: There are more monetary policies considered by RBI which will be studied later in class

[1] Families living together with members across generations (grandparents, parents, uncles, aunts, cousins, parents, siblings)

[2] Families living among parents and children

[3] Petty cash is small amount of cash kept aside for small purchases like buying vegetables, milk, etc

[4] Modern Banking: Theory and Practice by Muralidharan

[5] Amalgamation is the process of combining multiple businesses into one

[7] Ailing means poor health

[8] Regulations are official and compulsory rules implemented by a central authority (like the RBI) that governs procedures or behaviour

[10] Public sector banks or companies or business units refer to government owned or government managed or government regulated institutions

[11] Modern Banking: Theory and Practice by Muralidharan

[12] Drop in the value of currency. For example, the Indian currency devalued from Rs 36 per US dollar to Rs 45 per US dollar

[13] Pegged to the US dollar means fixing the value of the currency to the US dollar.

[14] Phone banking in India aims at providing information on banking products and services  and perform certain transactions via the phone (landline or mobile)

[15] Internet banking aims at accessing private accounts, providing information on banking products and services and performing certain transactions via Internet

[16] Modern Banking: Theory and Practice by Muralidharan