04 – Sources of Bank Funds – Management of Banking and Financial Services, 2nd Edition


Sources of Bank Funds

  • Understand the nature of bank liabilities

  • Learn about the nature of bank deposits

  • Understand deposit pricing strategies

  • Learn about non-deposit funding sources of banks

  • Understand the legal aspects of deposits in India


We have seen in earlier chapters that banks, in their role as financial intermediaries, provide the vital link between savers and users of funds in the economy.

The ability of a bank to attract money from customers and businesses is a vital signal of the bank's acceptance in the market. In today's competitive environment, where returns from the capital markets or mutual funds are more attractive, banks find liability management a challenge. Banks have to constantly innovate—whether it is in product development or customer service.

Liability management plays a critical role in the risk—return profile of banks. In the present deregulated environment, banks have to balance profitability and risks while deciding on their liability mix. For example, if banks price their liabilities higher to lure more depositors, their interest expenses would rise. Further, the deposit rates are also subject to change, which lead to interest rate risk. Deposits could be withdrawn at any time, leading to liquidity risk for the bank. The bank would have created assets out of these deposits and in the event of sudden withdrawal of the deposits, the bank would also be subject to a refinancing risk.

We have seen in an earlier chapter that ‘deposits’ are the primary sources of funds for banks. The other sources of funds for banks are ‘equity and reserves’ and ‘borrowings’.

The sources of funds as described above form the basis for creation of assets by the bank and are hence responsible for the bank's profit and growth. Therefore, it would be prudent for the bank to base its funds requirement and mobilization on some relevant parameters, such as:

  1. Maturity: Deposit holders in a bank are a diverse lot. They are from divergent backgrounds, from small depositors to large corporations, financial institutions and governments. They have different needs and planning horizons and would require their savings back at different points in time. Each instrument would have to be priced differently, in terms of the prevailing regulations and the bank's strategy. The maturity of each debt instrument is vital for the bank, since it has to plan for repayment at the end of the period with no risk of default. Further, it has to forecast the interest rates that could prevail at the end of the period.
  2. Cost of funds: Investors look for reasonable return on their investments when they put their savings into a bank. However, the bank should consider the yield from investing these funds in assets such as loans or investments, so that its target profit can be achieved.
  3. Tax implications: Depositors would prefer to look at post-tax cash flows from their investments. Even if the bank prefers to borrow from a particular source, the availability of funds would be determined by tax rules in force.
  4. Regulatory framework: Regulations in force would very often determine the attractiveness of one source of funds over the other.
  5. Market conditions: The prevailing sentiment in the market and the investors’ attitude towards risk would predominantly determine the amount of funds that would flow into banks.

It is, therefore, evident that a host of dynamic factors would determine the availability and cost of bank funds at any point of time. Preferences and investment objectives of depositors are changing over time and hence, banks may not be able to source the type of funds that they desire in the market.

In the following sections, we will look at the features of bank deposits and other non-deposit borrowings.


Bank deposits are differentiated by the type of deposit customer, the tenure of the deposit and its cost to the bank. On the basis of these parameters, deposits can be broadly classified as follows:

  1. Transaction accounts or payment deposits: These deposits, repayable by the bank on demand from the depositor, represent one of the primary services offered by banks. They can be bifurcated into non-interest bearing and interest bearing demand deposits. Such deposits facilitate transfer of funds by the deposit holder to third parties, primarily through cheques1 and other forms of funds transfer. Cheques are attractive because they provide easy and formal verification and are readily accepted as a recognized mode of payment.

    Non-interest bearing demand deposits are typically held by individuals, businesses or the government. Explicit interest payments on these deposits are prohibited in most countries. However, there are no regulations restraining banks from prescribing minimum balances or transaction charges. Corporate customers prefer these accounts for ease of operation. These are generally large deposits and can be quite volatile sources of funds for the bank.

    Interest bearing demand deposits are preferred by individuals or certain types of organizations. Similar to the non-interest bearing accounts, these deposits are also used for the purpose of transactions by the deposit holders and a major portion of these deposits is likely to be volatile. They are called ‘savings’ accounts in some countries (as in India), since the depositors park their earnings in these accounts to be used for routine and other payments. These deposits carry a low rate of interest (in many countries, this rate of interest is prescribed by the regulator).

  2. Term deposits: These are a form of ‘debt investment’ for a customer, who is willing to lend money to the bank for a specified period of time. In return, the customer receives a stream of cash flows in the form of interest. These deposits typically pay higher interest. A popular variant of large term deposits is the certificate of deposit (CD (see Box 4.1).

Box 4.1 describes some of the prominent types of deposit accounts in select countries.



In the early 1970s, in New England, hybrid checking—savings accounts called negotiable order of withdrawal (NOW) accounts were introduced. These were meant to be interest bearing savings deposits that required the customer to give notice to the bank before withdrawing funds. However, the notice requirement is not insisted upon and the NOW is being used like any other checking account.

In the US, most banks predominantly offer three different transaction accounts—demand deposit accounts (DDAs), interest bearing NOW accounts or automatic transfer from savings (ATS) accounts and money market deposit accounts (MMDAs). Investors seeking relatively low risk investment that can easily be converted into cash go in for CDs. Banks differentiate between these deposits on parameters, such as the minimum balance required, the number of transfers/cheques permitted and the interest rate paid. All deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to USD 100,000 per account.

DDAs are non-interest bearing checking accounts, predominantly held by commercial units, though individuals and the government can also hold such accounts.

A NOW account is an interest bearing demand deposit. An ATS account is similar to a NOW account, with the difference that in the ATS account a customer has both the DDA and savings accounts, with the balance in the DDA account being brought down to ‘nil’ at the end of each day through transfer of funds from the savings account. NOW accounts are priced competitively and can be held only by individuals and non-profit organizations.

MMDAs were primarily introduced to enable banks compete with money market mutual funds offered by large brokerage houses. These are basically ‘term’ deposits and not transaction accounts. Though the average size of an MMDA account could be much larger than a transaction account, cheque usage and transactions are limited.

A CD is a special type of deposit account with a bank that typically offers a higher rate of interest than regular savings account. In a CD, a fixed sum of money, usually large, is invested for a fixed period of time and in exchange, the bank pays interest typically at regular intervals. Though CDs were designed to pay a fixed interest rate until maturity, they now pay variable rates as well. Further, CDs can be issued with special features, such as ‘call’ provisions. Zero coupon CDs ensure long-term funds for banks without periodical interest pay outs. Some banks also issue CDs with yields linked to a stock market index such as S&P 500 to lure investors who could otherwise take their money out of banks.

The UK

The predominant types of deposit accounts are:

  • Current account, which provides a cheque-book but usually pays no interest.

These accounts are primarily used for paying bills.

  • Deposit account, which pays interest and is used primarily for short-term saving.

  • Investment or savings account, which pays a higher rate of interest and is used primarily for long-term saving. Notice of withdrawal must be given in writing.


‘Deposits’ include transaction and non-transaction deposit accounts and CDs.


The predominant types of deposit accounts are savings and cheque accounts, term deposits and guaranteed investment certificates (GICs). GICs are term investments that require depositors to lock in their investment for a set length of time. GICs generally pay higher rates of interest than term deposits but are often not redeemable before maturity. The Canada Deposit Insurance Corporation (CDIC) insures eligible deposits up to a limit of USD 100,000 per depositor in each member institution.


Source: Web sites of the Countries’ Central Banks.

Protecting the Depositor—Deposit Insurance

Deposit insurance is a measure taken by banks in most countries to protect small depositors’ savings, either fully or in part, against any possible risk of a bank not being able to return their savings to these depositors. Deposit insurance institutions are mostly government-established and managed and may or may not form part of a country's central bank.

The US was the first country to initiate an official deposit insurance scheme, triggered by a banking crisis during the Great Depression in 1934. As of 31 March 2009, 103 countries have such schemes in operation.2

Many of the deposit insurance agencies are members of the International Association of Deposit Insurers (IADI). This organization was established in 2002 to promote deposit insurance, help countries without deposit insurance schemes to establish their own institutions for this purpose and promote knowledge and experience exchange between deposit insurers in various countries.

Deposit insurance is being increasingly used by governments as a tool to ensure the stability of the banking system of their countries and protect bank depositors from incurring large losses due to bank failures. Actually, almost all countries have some kind of financial safety nets in place to protect depositors. These could take the form of bank regulation and supervision, lender of last resort facilities from the central bank, bank insolvency resolution procedures or explicit and implicit deposit insurance. Although deposit insurance is used as a popular tool, its desirability is debated by many economists who point to the moral hazard problems and the accompanying excessive risk being taken by banks.

Some countries have more than one deposit insurance scheme in operation. Notable amongst these are the USA, Austria, Canada, Columbia, Cyprus, Germany, Italy and Portugal. Many of them are operated by the government and some by private insurers.

At the end of March 2009, 16 countries were planning or studying the proposal to introduce deposit insurance schemes.3 It is interesting to note that countries such as Australia and New Zealand, which had not implemented a deposit insurance scheme so far, have announced such schemes in October 2008.

The Australian Prime Minister announced on 12 October 2008, that in response to the Economic crisis of 2008, 100 per cent of all deposits would be protected over the subsequent three year period. This is in addition to existing mandates of Australian Prudential Regulation Authority (APRA) and Australian Securities and Investments Commission (ASIC) to monitor Australian banks and deposit taking authorities to ensure that their risks do not compromise the safety of depositors’ funds.

New Zealand announced on 12 October 2008, that an opt-in scheme for retail deposits will be introduced.

Has deposit insurance become more relevant when the world's financial system is undergoing turbulence?

Box 4.2 summarizes the findings of a recent OECD study4 and the ‘Core principles for effective deposit insurance systems’ jointly formulated by the Basel Committee on Banking Supervision (BCBS) and the IADI5:


A recent OECD study notes that in the throes of the continuing financial turbulence, some aspects of deposit insurance have to be looked at closely. One, deposit insurance systems with low or partial levels of insurance coverage may not be effective in preventing bank runs. Two, customers seem to have little understanding of the extent and limits to existing deposit protection schemes. Three, deposit insurers’ responsibilities and powers in a situation of crisis should be clearly delineated and implemented. Finally, the need for a specific bankruptcy regime for banks has to be explored.

On 18 June 2009, the BCBS and the IADI jointly issued the ‘Core principles for effective deposit insurance systems’. The global financial turmoil of 2007–2008 had highlighted the importance of effective depositor compensation arrangements and the need for an internationally approved set of principles for effective deposit insurance systems. The 18 principles in the document address a range of issues that include deposit insurance coverage, funding and prompt reimbursement, as well as issues related to public awareness, resolution of failed institutions and cooperation with other participants such as central banks and supervisory bodies.

What happens when an insured bank fails? The insuring agency typically has the following options in the event of bank failure6: It can invite bids from healthy banks for the sale of the failed bank, in which case the insured depositors’ accounts will be shifted to the new bank rather than being paid off by the agency; it can give financial assistance to the bank interested in acquiring the failed bank, so that depositors of the failed bank can start having accounts with the acquiring bank; it can transfer all insured deposits to a healthy bank; it can take charge and manage the operations of the failed bank till it finds a suitable buyer or it can pay off the depositors up to the maximum allowed.

Deposit Insurance in India

The Deposit Insurance Corporation (DIC), established under the Deposit Insurance Act, 1961, came into being in 1962, following two bank failures (Laxmi Bank and the Palai Central Bank). India was the second country in the world to introduce the Scheme—the first being the United States in 1934. Initially, the system covered exclusively the commercial banks. In 1968, cooperative banks with a minimum size operating in states having pertinent legislation was included in the system. In 1975, coverage was extended to rural banks as well. In 1978, the deposit insurance and credit guarantee functions were integrated to form the Deposit Insurance and Credit Guarantee Corporation (DICGC). But over time the credit guarantee schemes were delinked. The coverage limits have been changed in time as follows: initially Rs. 1,500; Rs. 5,000 in 1968; Rs. 10,000 in 1970; Rs. 20,000 in 1976; Rs. 30,000 in 1980 and Rs. 1,00,000 since 1 May 1993. The system is administered officially. certificates of deposit, government, inter-bank and illegal deposits are not covered. More information on the operational aspects of the scheme is available at www.dicgc.org

India's deposit insurance scheme is compared with other select countries and the world average in Table 4.1.




*Not available for one country

Source: RBI, trends and progress of banking in India, (2006–2007): 211.


The Need to Price with Precision

The pricing of deposits and related services assumes great importance in the present deregulated and highly competitive environment, where deposit rate ceilings do not exist. However, banks have to monitor the cost of their funding sources carefully for the following reasons:

  • Changes in cost of funds would require changes in asset yields to maintain spreads
  • Changes in cost of funds could alter the liability mix of banks and expose the bank to liquidity constraints
  • Changes in cost of funds could render the bank less competitive in the market

It is, therefore, imperative that banks understand how to measure the cost of their funding sources and accordingly price their assets in order to ensure a desired level of profitability. This is done through a pricing policy.

The pricing policy of a bank is typically a written document that lays down guidelines for evaluating deposit sources and pricing them effectively. Generally, the following key aspects would be considered before arriving at a pricing decision.

  • Servicing costs versus minimum balance requirements
  • Deposit volumes and their costs in relation to profits
  • Lending and investment avenues and compensating balances
  • Relationship with customers
  • Promotional pricing, if new products are being considered
  • Product differentiation in a competitive market

Therefore, measuring the cost of funds should take into account both explicit and implicit costs associated with sourcing the deposits.

The explicit costs would be interest payments on the deposits and giveaways and gifts to promote the deposit product. However, even in non-interest bearing transaction deposits, where no explicit interest is paid out, there are implicit costs, such as a provision of services like free cheque books to the customer and added convenience for customer transactions, such as provision and maintenance of ATMs and branch offices. To compensate for these transaction costs, some banks levy fees depending on the frequency of cheque usage or ATM usage or prescribe a minimum balance maintenance in customers’ accounts. Table 4.2 depicts some typical explicit and implicit prices and their impact on bank revenues and costs.



Bank cash flows Explicit prices Implicit prices
Bank costs Interest payments Below cost services (e.g., free cheque book issue)
  Gifts to customers More convenience to customers such as branch offices, ATMs and business hours
Bank revenues Service fees such as charges per cheque issued Minimum balance requirements
  Other fees such as on overdrafts Restrictions such as limited cheque writing privileges

Developing a sound deposit pricing methodology is gaining greater importance since banks have to look more to non-core sources for funding their assets. One reason for this is the intense market competition and the other is the changing asset profile of banks that requires sources with different maturities and risk profiles.

The traditional approach to deposit pricing was a ‘supply–side’ approach. Deposit rates reflected what competition was paying for similar products and what the bank could ‘afford’. The most serious drawback of this approach was that it ignored both customer needs and the underlying demand elasticity of deposits. This resulted in specialized competitors like investment banks targeting the most desirable customer segments through product offerings that combine rate and convenience—products that banks could barely match.

Most banks have now, therefore, shifted to the ‘demand side’ approach. This view considers the degree to which customer demand varies with the deposit rate offered. This demand elasticity is analysed and quantified by major products, geographies or customer segments.

For example, deposit rates could be computed separately for large time deposits, non-transaction (excluding large time) deposits and transaction deposits. This allows the evaluation of deposit pricing strategy for these three different classes of deposit investors.

Recent research7 indicates that in reality, deposit customers are fairly tolerant of price changes. The cited report also notes that ‘if they (banks) had more flexibility to price retail products without sparking widespread customer defections, they could boost their bottom-line retail earnings by as much as 5 to 7 per cent’. The research also found that ‘checking account’ customers rated convenience, service quality and relationship with the bank over price increases. More than one-third of these customers were unable to even recall when the last price change occurred and in the end, just 2 per cent of all customers moved their accounts to another bank.

Such analysis could help banks avoid raising rates (and lowering profitability) to attract deposits in customer segments which are known to be price inelastic. Or the information could help in fine tuning the deposit prices in customer segments where better rates would be a deciding factor for a customer to keep deposits in or move them out of a bank. Better informed tradeoffs would enable better use of resources to improve service or convenience than to raise deposit rates.

There are also other drivers to deposit growth. Exogenous factors such as macroeconomic factors or movements in the financial markets may impact the flow of deposits in and out of the banking system. Banks can do little in influencing these factors. However, they need to understand the nature of these flows. For example, when the interest rates are ruling high, customers would gravitate to high interest paying deposits (transitioning from checking accounts which would pay lower) or to the markets. When interest rates move southward, investors may prefer to invest in short-term instruments, such as savings deposits or money market accounts. Such trends can be forecasted reasonably accurately and blended into the pricing strategy of the bank.

The second factor driving deposit growth is endogenous. Banks can attract more deposits by appropriate promotion and pricing strategies and by reflecting a robust value proposition for the long-term. Best practice banks are increasingly analysing customer price elasticities by product, to enable specific quantification of the potential volume and revenue impact associated with a given price position.8 The cited article9 adds, ‘Such an analysis reveals an “area of indifference” around the average market price for each product. Within this zone, consumers are apparently indifferent to small pricing changes. Outside this zone, demand rises dramatically in response to rate increases and then flattens out again. Above a certain point, higher rates do not have a commensurate impact on balances’.

An important point to be noted here is that proper deposit pricing will have a positive effect on the growth of net interest income and net interest margin. Some common practices adopted by banks for improving profitability while pricing deposits are:

  • Setting deposit prices in keeping with the deposit origination cost. For example, the origination cost of two deposits of say, Rs. 100 crores and Rs. 10 crores may be almost the same, but the larger deposit can provide an opportunity for the bank to create an asset that is 10 times larger. Therefore, the pricing could be based on the deposit amount.
  • Paying higher rates for longer term deposits. This again depends on the nature of assets the bank wants to create.
  • Banks prefer adding interest to principal or paying interest by automatic transfer to another internal account, to issue periodic interest payments to the customer. The latter practice is less expensive.

Some Commonly Used Approaches to Deposit Pricing

1. Cost Plus Margin Deposit Pricing

This type of pricing encourages banks to determine the deposit rate as one that would be adequate to cover all costs of offering the service, plus a small profit margin. Banks incur costs such as personnel and management time, material and automation in offering each deposit service. In a deregulated environment, the pressure is on banks’ profitability in terms of higher cost of funds, thinning net interest margins and higher cost of customer solicitation and retention. If deposit pricing is not related to banks’ costs in extending deposit services, the bank could end up exacerbating the pressure on profitability.

Thus, the price of deposit services would typically conform to the following ‘cost plus deposit pricing’ formula:

Unit price charged to the customer per deposit service = Operating expense per unit of deposit service + Estimated overhead expense allocated to deposit function + Planned profit from each deposit unit

Relating deposit prices to costs as above has encouraged banks to match prices and costs more closely and allocate prices to many services that were earlier rendered free. Thus, in most countries today, banks levy fees for excessive withdrawals from transaction deposits, customer balance enquiries, cheques returned without being paid, stop payment orders, ATM operations and so on and also prescribe required minimum deposit balances.

2. Market Penetration Deposit Pricing

This pricing strategy is typically aimed at high growth markets in which the bank is determined to garner a large market share. Therefore, banks are tempted to offer either high interest rates, well above the market level or charge customer fees well below the market standards. Bank managers expect that the large sources of funds and the associated loan business and investment opportunities would offset thinner spreads. Because it is usually costly for a customer to move certain kinds of deposits such as payment accounts, the lower fees on certain deposits initially attracted through penetration pricing which may eventually be raised to a cost-recovery or profit-making level.

3. Conditional Pricing

Conditional pricing can be used by banks as a tool to attract the types of depositors they want as customers. Under this pricing technique, the bank will post a schedule of interest rates or fees for deposits based on size of deposits or account activity. Typically, larger volume deposits carry higher interest rates or lower fees. This strategy is mostly designed to encourage customers to hold high average deposit balances for a given period of time, which, in turn, could be invested in earning assets.

An added advantage of this pricing strategy is that the customer chooses a deposit plan suitable for the customer and not for the bank. This selection process serves as a signal to the markets and the bank itself regarding the behaviour and cost of its deposits.

The following hypothetical example would serve to illustrate how two banks use conditional pricing to attract a certain class of deposit customers.



In the above example, Bank X seems to prefer relatively low activity but high balance transaction and savings accounts, while Bank Y is not averse to smaller accounts. This is evident from the way the service fees are structured. Generally, larger volume deposits carry higher interest returns to the depositor or are assessed lower service charges, encouraging customers to hold high average deposit balances which give the bank more funds to invest in earning assets.

In such cases, banks’ deposit pricing policy is typically sensitive to the customer segments that each bank plans to serve and the costs incurred by the banks in serving different customer segments.

4. Upscale Target Pricing

Upscale target pricing is the use of carefully but aggressively designed deposit advertising programs and deposit pricing schemes to appeal to customers with higher levels of income or net worth, such as business owners and managers, doctors, lawyers and other high income households. The customers being targeted are price sensitive and therefore could respond quickly to the price differentials.

5. Relationship Pricing

Relationship pricing typically ensures that the bank's best customers get the best pricing. It involves basing fees charged to a customer not only on the number of services that the customer purchases from the bank, but also on the intensity of use of these services. The objective is to forge a strong relationship with the customer by selling ‘convenience’ (through multiple services) and thus prevent the customer from moving away from the bank only on pricing concerns. Theoretically, relationship pricing is perceived as promoting customer loyalty to the bank, thus rendering the customer relatively insensitive to prices or other charges.

In all the above deposit pricing approaches, the key parameter that banks should be able to determine is their costs.

At times of sluggish deposit growth, the temptation for banks is to increase rates offered on special deposits such as CDs or new account introductions. Such strategies to increase deposit inflows would put pressure on the banks’ cost of funds and also trigger a market-wide rate war. However, over a period of time, it is possible that the increased rates would not translate into overall increase in deposits or in market share. On the other hand, the banks may be left with increased cost of funds eating into their already thin spreads.

Therefore, before hiking interest rates on some classes of deposits or going on an aggressive campaign to mobilize new deposits, there are two types of analysis that should be considered. The analysis should quantify the actual cost of new deposits and the cost of protecting existing deposits. Such analysis is typically done using the following suggested approaches—the marginal cost of funds approach and the new cost of funds approach.10

The historical average cost rate is called break even because the bank must earn at least this rate on its earning assets (primarily loans and securities) just to meet the total operating costs of raising borrowed funds and the bank's stockholders’ required rate of return. Therefore, the bank will know the lowest rate of return that it can afford to earn on assets it might wish to acquire.

Marginal Cost of Funds Approach

Assume that Bank J has a deposit base of Rs. 1,000 crores, of which about Rs. 250 crores comprises premium deposits perceived as rate sensitive. The bank pays 5 per cent per annum on these deposits at present.

A competitor, Bank L, announces that it is prepared to pay 6 per cent on premium deposits. The objective of the competitor, of course, is to garner more deposit market share.

Should Bank J respond to the threat and revise its deposit rate?

If Bank J does not match the 100 bps rate rise, it would probably lose a portion of its deposits to Bank L. The options before Bank J are to increase the rate on the entire rate-sensitive component of Rs. 250 crores or leave the present rate unchanged and replace the lost deposits. Of course, Bank J has a range of options between the two extremes. For example, it could raise the rate by 50 or 75 bps instead of 100 bps. The question would be: At what cost can it replace the lost deposits as compared to increasing the rate on the entire Rs. 250 crores component? In short, the effective cost of protecting these balances should be compared with the incremental cost of alternative funding sources to replenish the lost funds.

An illustration of the likely impact of two extreme options is presented as follows:



According to the above calculations, if Bank J does not raise the rate to 6 per cent, it is likely to lose Rs. 50 crores of its deposit base. However, it will save Rs. 5 crores in annual interest expense. The marginal cost of holding on to the Rs. 50 crores is therefore 10 per cent (Rs. 5 crores/Rs. 50 crores).

It doesn't seem logical, does it? How can it cost 10 per cent to hold to a deposit that at present costs only 5 per cent to the bank?

The answer to this question is the key to making intelligent pricing decisions on rate sensitive deposit accounts.

There are actually two different costs associated with increasing the deposit rate to 6 per cent. First, Bank J must pay 6 per cent on the rate sensitive deposits of Rs. 50 crores that it expects to lose. This works out to an annual cost of Rs. 3 crores. Second, Bank J must also pay an additional 1 per cent to the remaining customers (Rs. 200 crores) in the rate-sensitive segment. This amounts to an additional cost of Rs. 2 crores. This additional cost will have to be incurred even though the probability that these customers would shift their deposits out of Bank J was minimal. Hence, the total additional expense for the bank aggregates to Rs. 5 crores.

Now that Bank J knows that the ‘marginal cost’ of holding on to Rs. 50 crores of deposit is Rs. 5 crores in annual interest expense, which works out to an annual interest cost of 10 per cent, it can decide on whether to raise the rates.

Of course, the bank will not be able to make the decision based on one scenario alone. Hence, it may want to look at various scenarios of interest rate increases ranging from 0 per cent to even more than 1 per cent if it wants to be very aggressive. It may also want to relate various probabilities of loss of deposits under each of the interest rate scenarios. Typically, the following table would result from the analysis.



The above table identifies the effective marginal cost associated with increasing deposit rates with the objective of minimizing flight of deposits from the bank. For example, the incremental cost of increasing deposit rate by 0.75 per cent to protect the most volatile 20 per cent of the balances is 8.75 per cent. This effective cost is calculated as shown earlier and should be compared with the incremental cost of alternate funding sources for the bank. That is, if Bank J is likely to lose 30 per cent of its deposits due to the competitor's offering of 1 per cent more and can replace these funds at 8.33 per cent or less, it will be better off financially than paying 1 per cent more on the entire rate-sensitive account base.

Another interpretation of the table is that as the proportion of non-rate sensitive customers in a segment increases, so does the marginal cost of paying up to retain rate sensitive customers in the segment.

This interpretation would explain why a bank would be more likely to push up its rates for CDs in a rising rate environment, rather than on its transaction accounts. The CD customers are perceived as more rate sensitive. And the more the rate sensitive customers in a segment, the less are the non-rate sensitive customers that will receive a higher rate determined in order to retain the rate sensitive customers.

The second issue that arises in the above analysis is the worth of the customers’ relationship to the bank. Using the table generated above with different rate scenarios and expected protection of deposit loss, a new question can be formed: If the bank fails to match the 6 per cent rate being offered by the competitor, what could be the maximum deposit loss? Let us assume that 20 per cent of Bank J's customers in the segment threaten to withdraw their deposits if the bank did not match the competitor's offering. Would the bank be willing to increase the rate to keep them? Or what if 40 per cent were to demand a rate hike? The bank's decision would depend on how much these deposit relationships are worth to the bank, since for retaining 20 per cent or 40 per cent of its customers, the bank is actually willing to pay up to 10 per cent or 7.5 per cent, as the case may be.

A strategy that can be employed here is convincing the rate sensitive customers to move their balances into some other account in the same bank. For example, the bank can convince the customers wanting higher interest income to move to, say, higher yielding short-term deposits. Let us assume that these instruments yield an average of 5.75 per cent. The customers would be satisfied, as they are earning more on their deposits. Bank J will also be happy that it need not incur the marginal cost ranging from 6.5 per cent to 12.5 per cent to retain the relationship with these customers.

A third issue is that the bank should be satisfied that the yields it receives on assets supported by the Rs. 250 crores deposit accounts is more than the marginal cost of retaining rate sensitive deposits. This implies that the bank's average yield on assets should be more than 7 per cent to 15 per cent, if the deposit rate increase contemplated is 1 per cent. For example, if only 20 per cent of the customers were rate sensitive in the segment and the bank fears that its comparable asset yield may be less than 10 per cent (see table above), it will be better off selling the assets and using the sale proceeds to fund the outgo of deposits. It is to be noted that the asset yields being used in the comparison would be net of any adjustments and servicing costs. For example, the yield on a credit card may dip from, say, 20 per cent to 12 per cent after adjusting for operational costs and charge offs.

New Cost of Funds Analysis

Let us now assume that Bank J wants to offer a new deposit product at 5.75 per cent to expand its market share. The bank is interested in tapping entirely new deposit clientele and not in conversion from its existing deposit base. The bank reviews the performance of the new product after 2 months and finds that only about a quarter of the deposits mobilized were fresh ones, the remaining being existing deposits of the bank converted to the new scheme.

The bank can use the marginal costing method as outlined above to analyse the effectiveness of the pricing strategy in attracting new customers. If the strategy has resulted more in conversions from the bank's own existing deposit base that had earlier been sourced at a much lower cost, the bank may end up paying more as marginal cost for the new deposits, as well as merely retaining the existing market share rather than growing it. In this case too, the marginal cost of new money should be compared to the incremental cost of alternative funding sources.

Another approach helps in setting the interest rate that banks can offer for new accounts. Let us assume that Bank J now estimates that it can raise fresh deposits of Rs. 25 crores from the market if it offered the rate of 6 per cent offered by Bank L. Bank J also estimates that if it beat the competitor's offering by 0.5 per cent, i., e., it offered an interest rate of 6.5 per cent, it can double the fresh deposit inflow to Rs. 50 crores. If Bank J pushed up the deposit rate further to 7 per cent, the fresh deposit inflow estimate would swell to Rs. 75 crores, while at 7.5 per cent and 8 per cent, the fresh deposits would increase to Rs. 100 crores and Rs. 150 crores, respectively.

The new deposits can be used by Bank J to invest in assets that would have an average yield of 10 per cent.

The following table illustrates the analysis using marginal cost to choose the optimum interest rate that can be offered to deposit customers.



It can be observed from the above table that the bank is able to improve its profits as long as marginal revenue exceeds the marginal cost up to a deposit interest rate of 7.5 to 8 per cent. At this point, the spread is highest at Rs. 2.5 crores. Beyond this point, even if the bank raises deposit rates to garner more deposits, it cannot benefit, since the average yield is estimated at 10 per cent.

Note that with the above analysis, we have gone a step further and incorporated loan or asset pricing into deposit pricing.


Research has indicated that deposit growth has a significant impact on bank stock prices. What could be the reasons for this relationship?

One, deposits lower a bank's risk. Core deposits, which include transaction and savings accounts, time deposits and money market accounts, are a cheap source of funding. As a result, banks with a high percentage of core funding don't have to take as much risk in their loan portfolio to generate a strong return.

Two, growing deposits help the balance sheet since equity need not be added, as in the case of loans. Banks have to raise adequate equity before they make loans.

Three, a high proportion of transaction accounts is an advantage to the bank. Transaction accounts (commonly known as CASA (Current account savings account) in India act as ‘hub’ accounts in most retail banking relationships. Industry studies show that banks are more successful in cross-selling additional financial products to their transaction account customers. The typical customer views the transaction account as the core of his banking relationship. Hence, banks get better deposits and a much larger role with these customers than with mortgages or CDs.

Finally, industry experts believe that deposits are universally valuable regardless of the environment and in most rate environments, deposit growth can pay exponentially.

Deposits and Interest Rate Risk13

Even in the 1990s, banks considered ‘core’ deposits insensitive to interest rate movements. However, a declining interest rate environment thereafter threw up some challenges. Bank customers started looking for alternate investment avenues and banks were forced to revisit their pricing strategies. Analysts are now of the opinion that bank deposits carry some interest rate risk, measuring which is not easy in practice.

In theory, measurement of interest rate risk of deposit liabilities is similar to the techniques used for the measurement of bond investments. The steps to be followed are forecasting cash flows, balances and interest; discounting future cash flows to arrive at the present value; calculating duration14 and interest rate elasticity; and stress testing. However, the application of bond valuation methodologies to deposits would require added assumptions or information due to some unique features of bank deposits.15

Box 4.4 presents the similarities and differences between bonds and bank deposits.



  • Both bonds and deposits are financial instruments. They form part of the holders’ assets and makers’ liabilities.
  • Both create interest income to the holder and interest expense to the maker.
  • Bonds and some classes of deposits have a predetermined maturity date.
  • Both have economic value, whether traded or not in the financial markets.
  • Both can carry embedded options.


  • Typically, banks are holders of bonds and makers of deposits.
  • Hence, both impact the financial performance and condition of banks in similar but opposite directions (since bonds are typically assets and deposits are liabilities).
  • Deposits can have stated maturity dates and also be payable on demand.

Before looking to quantify interest rate risk, we should appreciate a fundamental difference between banks and other financial firms—that under deposit insurance, banks issue a class of liabilities for which most balances are fully insured by most governments across the world. The resulting market structure could create complications for the implementation of risk management models.

First, deposit insurance insulates the deposit investor from the credit risks of the bank, which are assumed by the deposit insurer. In essence, when a bank issues a deposit it engages in two transactions: it issues a risk-free (government insured) liability to a depositor and it purchases an insurance contract from the insurer to cover the credit risks associated with the priority position of the deposit claim. Thus, the economic value of a deposit depends upon the market yield on a comparable risk-free claim, as well as the pricing of deposit insurance relative to the market pricing of credit risk.

Second, for small depositors, bank search and switch costs, convenience value, information costs and simply limited alternatives make adjusting to changing market conditions difficult.16

The impact of interest rate changes on a bank can be viewed from two possible perspectives—the earnings perspective and the capital perspective.

For viewing the impact from an earnings perspective, we should remember that bank deposits include some that have no direct interest cost for the bank and some that bear interest at rates that could have been administered by managerial decisions not directly linked to market rate movements. Also, research finds that retail deposit markets are characterized by sluggish behaviour in both interest rates and deposit issuance in response to changing market conditions. Since, by definition, competitive markets respond immediately and completely to changing circumstances, it appears that there is no comparable competitively priced instrument that could be used as a reference for deposit profit.

Hence, to measure the ‘earnings-at-risk’ related to deposits, the way in which deposit interest expense reacts to changes in market rates must be known (or assumed). Some movements in market rates may be too insignificant to have any perceptible impact on deposit interest rates, while other market rate movements may be large enough to influence managerial pricing of deposit rates. Such changes in pricing are bound to impact both the deposit balances with and the cost of deposits for the bank.

From the longer term perspective, while demand deposits, by definition, are repayable on demand, much of these deposits could also be held as ‘idle balances’ by customers who prefer convenience or financial security or liquidity. These idle balances form part of the ‘core deposits’ for the bank. Interestingly, research has found that banks’ access to such core deposits forms one of the foundations of ‘relationship lending’, where banks can afford to fund their key borrowers at less than market rates, in order to sustain their relationship.17

Since all types of deposits do not react in a similar fashion to market rate changes, current interest rate shocks translate into changes in profitability over time thus impacting the bank's ‘value’. From the ‘capital’ perspective, the current economic value of deposits held by a bank is typically measured by the current interest rate paid on the deposits and the cost of alternative funding sources for the bank based on assumptions of maturity or repayment of these balances. For better understanding, if we treat demand deposits as continuously-maturing financial contracts, the existence and magnitude of current deposit base is an indicator of profitable deposit growth in future. Hence, ‘equity at risk’ related to deposits for the bank would be measured by the current economic value of its core deposits and estimates of how the core deposits would change with changes in market rates.


Over the last three decades or so, banks have been increasingly turning to non-deposit funding sources (also called ‘wholesale funding’ sources).

For example, in the United States of America, prior to the 1970s, domestic deposits made up 80 per cent or more of total bank assets. In the 1970s, however, financial markets changed in response to inflation and higher interest rates, resulting in banks taking on larger amounts of non-deposit liabilities. By 1980, domestic deposits made up only 64 per cent of total assets. During the 1990s, banks’ reliance on domestic deposits for funding continued to decrease as banks increased their usage of borrowed funds, foreign deposits and other liabilities. At the end of 2000, the ratio of domestic deposits to total assets stood at 55.6 per cent. Banks had come to rely more heavily on foreign deposits, fed funds, repurchase agreements, Federal Home Loan Bank (FHLB) advances (described in Annexure I) and other forms of borrowing than they did during the first few decades of the FDIC's existence.18

The Funding Gap

The funding gap is calculated as the difference between current and projected credit and deposit flows. If the difference shows the projected need for credit exceeding the expected deposit flows, the bank has to raise additional resources either from deposit or non-deposit sources. If the difference shows the projected credit requirements falling short of resources, the bank will have to find profitable investment avenues for the surplus resources.

Assume Bank X has made the following projections for the ensuing week.

  • New credit off take: Rs. 300 crores
  • Drawings by existing borrowers from credit sanctions already made, but not utilized: Rs. 500 crores
  • New deposits inflow: Rs. 700 crores
  • Planned investments in government and corporate securities: Rs. 400 crores

The projected funding gap for Bank X would be:

  Need for funds = 300 + 500 + 400 = Rs. 1,200 crores
      Deposit funds expected = Rs. 700 crores

The funding gap for Bank X for the following week is expected to be Rs. 500 crores.

If Bank X wants to bridge the funding gap with non-deposit sources, it would have to weigh the following factors in choosing among the various options available.

  • The relative cost of each funding source.
  • The relative risk of each funding source.
  • The period for which the funding is required.
  • The size of Bank X.
  • The regulations governing each of the funding sources being considered.

Other factors held constant, management will seek out the lowest cost non-deposit funding sources available, subject to availability and the expected interest rate risk.

Let us further assume that Bank X has the following options to bridge the funding gap of Rs. 500 crores.

Alternative funding source Market interest rate (per cent) Cost of access (per cent)
Central bank funds 6.0 0.10
CDs 8.0 0.20
Foreign funds 10.0 0.30
Other money market funds 6.5 0.25

If Bank X plans to raise Rs. 600 crores this week, of which Rs. 500 crores will be used to meet the investment and loan commitments made, the effective annual cost of each of the sources would work out as follows:



*Effective cost of funds is worked out as= [(market rate × 600) + (cost of access × 600)]/500


Bank X will have to compare the effective cost of each type of funds with the cost of getting fresh deposits in the market and the yield it expects to earn on deployment of the funds into loans and investments. It can also consider a mix of various sources of funds, subject to availability and other factors listed above.

The Indian Scenario19

The international experience of decelerating deposit growth is being witnessed in India as well. During 2007–2008 and 2008–2009, there was a continuing moderation on the demand and savings deposit growth rate, while time deposits too slowed down after a perk up during 2006–2007. This was in contrast to the trend in previous years, when current and savings deposits increased substantially to fund growing credit demand.

According to the RBI, several factors contributed to the accelerated growth in term deposits during 2006–2007. First, there was a clear shift from postal savings to term deposits of banks due to favourable interest rate differentials and extension of tax benefits to long term bank deposits. Another reason was that cash rich and high profit companies parked their surplus funds with banks. Non-resident deposits also grew significantly during 2006–2007. The overall deceleration in deposit growth rate in 2007–2008 had been attributed by the RBI to moderate growth in term deposits.

However, CDs have been growing rapidly from Rs. 43,568 crores at end March 2006 to Rs. 1,98,487 crores in mid April 2009, taking advantage of increases in interest rates offered. This trend is understandable given that interest (discount) rates on CDs, which were in the range of 4.40–7.75 per cent at the beginning of 2006, have increased to 5.90–11.50 per cent in April 2009. The RBI, in its report on the ‘Trend and progress of banking in India (2006–2007)’ has noted that ‘the flexibility of return that can be offered by the cash-strapped banks to attract bulk deposits made CDs the preferred route for mobilizing resources. Private sector banks and foreign banks with limited branch network and limited retail customer base continued to be the major issuers of CDs’.

Non-Deposit Sources of Funds Non-deposit sources of funds, reflected under the head ‘borrowings’, had grown by about 25 per cent during 2007–2008. While borrowings lend liquidity to the banking system, they can be volatile sources of funds for banks in a scenario where global liquidity is under strain. Up to 24 October, 2008, non-deposit sources of funds have been growing steadily, the increase so far in 2008–2009 nearly three times of that during the same period in 2007–2008. It is also noteworthy that in spite of the global slowdown, banks have been able to increase their borrowings from non-deposit sources—as shown by a year on year growth up to October 2008 that is almost 8 times the year on year growth during the same period in 2007.20

However, resources raised by banks from the capital market in the form of public issues of equity and debt declined sharply to Rs. 1,066 crores during 2006–2007 from Rs. 11,067 crores during 2005–2006. But this trend reversed during 2007–2008, when these resources showed substantial growth of Rs. 30,455 crores. This growth has been attributed by the RBI to four factors21: (a) good performance of bank stocks in the secondary market, (b) strong financial results of banks, (c) need to raise more capital and (d) ensuing implementation of Basel 2 norms and the tightening of capital adequacy for sensitive sectors.

Figure 4.1 depicts the changing pattern over the years in the non-deposit resources of banks in India. Clearly, non-deposit borrowings are playing an increasingly major role in bank liabilities.




Source: RBI, ‘Trend and Progress of Banking in India’, Chart I, Box III.1(2006–2007): 65.


Borrowings by banks showed substantial increase in 2007–2008 (22.4%) over the previous year (19.6%). Two significant sources of borrowings in recent years have been (a) subordinated debt, issued to augment banks’ Tier 2 capital22 in the domestic capital market and (b) increase in foreign currency borrowings.

Over the last couple of years, foreign currency borrowings had been one of the largest contributors to non-deposit sources of funds for banks in India. It is noteworthy that foreign currency borrowings, along with other liabilities arising out of issue of American Depository Receipts (ADRs) and Global Depository Receipts (GDRs), have been large contributors (growth rate 92.8 per cent in a single year) to the international liabilities of banks in India. However, there is a noticeable slowdown in the international liabilities over the last couple of years (8.4 per cent growth during 2007–2008 as compared with 17.6 per cent and 20.2 per cent in the previous two years), caused primarily due to decline in foreign currency borrowings and lower growth in deposits of non-resident Indians. The decelerating trend during the current year can be attributed to negative global developments.

Table 4.3 shows the position of International liabilities of banks over the last three years.




* Inter-bank borrowings in India and from abroad and external commercial borrowings of banks.

Note: Figures in parentheses are percentages to total.

Source: 1. Locational Banking Statistics.

        2. RBI, trends and progress of banking in India, Table III.4 (2007–2008): 92.


The recent decelerating trend in growth of international liabilities as a proportion of total bank liabilities is pictorially depicted in Figure 4.2.




Source: RBI, trend and progress of banking in India, chart III.3 (2007–2008): 93.


What impact have these shifts in bank liability composition had on banks’ profitability? Table 4.4 provides the answer. Non-deposit sources cost less to banks (even though of late the cost is seen to be increasing). This could be one reason why banks could retain spreads at almost the same level in spite of falling interest rates. Another interesting observation pertains to bank groups. Foreign banks have the highest cost of borrowing and the lowest cost of deposits among the bank groups, while the yields on advances and investments remain comparable. Yet, their spread is the highest among the bank groups.




Source: RBI, ‘trend and progress of banking in India, Table III.22 (2007–2008): 111

Notes: 1. Cost of deposits = Interest paid on deposits/deposits

2. Cost of borrowings = Interest paid on borrowings/borrowings

3. Cost of funds = (Interest paid on deposits Interest paid on borrowings)/(deposits borrowings)

4. Return on advances = Interest earned on advances /advances

5. Return on investments = Interest earned on investments /investments.

6. Return on funds = (Return on advances Return on investments)/(investments advances).


The RBI has provided explicit guidelines on mobilizing certain types of non-deposit sources such as (a) call and notice money, (b) external commercial borrowing (ECB) and (c) a special type of refinance such as ‘export refinance’. The salient features are summarized in Annexure I.

Are Non-Deposit Sources More Costly and Risky? Borrowings from the market are generally perceived to be more expensive than deposit sources. Where banks tend to rely on borrowings to fund their lending operations, they are exposed to market risks—the cost of such borrowings and their availability may also fluctuate. In contrast, there are quite a large number of deposit customers who put an extremely high value on the safety and accessibility of insured deposits and keep their money with banks even when alternate investments offer more attractive returns.

Generally depositors, whose deposits with banks are insured, may not be very concerned about the financial health of the bank they invest in. However, other lenders who do not enjoy insurance protection would seek interest rates commensurate with the risk profile of the borrowing bank and also expect the bank to match market interest rates.

However, apart from the cost aspect, wholesale funding is not without its risks. Non-deposit sources lack the stability of deposit, especially core deposit sources. Banks accessing wholesale funding markets must develop the capability to not only access the appropriate type of funds at short notice, but also repay them on due date. This implies that these banks would have to ensure back up measures, such as short-term investment in government securities, which can be sold at short notice. Such measures may affect the banks’ profitability since liquid securities yield lower returns. Banks may also have to invest in personnel with the requisite expertise in managing sourcing and repayment of such funds in the market.

On the other hand, such wholesale borrowings may be cheaper at the margin than deposits, even if the rates paid on non-deposit funds are actually higher. One reason would be the lower transaction costs for raising bulk wholesale funds, which banks often raise with a mere phone call. In doing so, banks save on branch, personnel and system costs. Another reason would be that banks need not alter their deposit rates for accessing wholesale funds. As discussed in the earlier section, if a bank has to attract more deposits only by offering higher rates, the overall cost of funds for the bank might increase substantially.

In fact, banks have been finding new funding sources from the money markets, long term and international markets. Of late, loan sale23 (such as securitization) mechanisms have also become a popular means of augmenting banks’ liquidity. Moreover, banks active in the non-deposit funding market are increasingly finding that some wholesale fund lenders are willing to sculpt their repayment schedule to banks’ cash inflows from asset liquidation.


‘Banking’ Defined

Banking is defined under Section 5(b) of the Banking Regulation Act, 1949. It means ‘accepting, for the purpose of lending or investment, deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise’. Some important interpretations follow from the above definition.

  • ‘Banking’ means performing two essential functions of (a) accepting deposits from the public and (b) lending or investing the deposits. It, therefore, follows that if the purpose of accepting deposits is not to lend or invest, it cannot be called ‘banking business’. For example, companies accepting deposits from the public for financing their business cannot be said to be doing banking business.
  • The banker accepts deposits of ‘money’ from the ‘public’ that offers its money as deposit. But it is not mandatory that the banker has to accept all such deposits offered. The banker can refuse to accept money from undesirable elements of society such as thieves, smugglers or terrorists.
  • The deposit could be payable on demand (such as transaction deposits, savings deposits) or payable after a fixed term as in the case of term deposits. The essential point to note here is that the bank need not repay the deposit without a ‘demand’ being made by the depositor, even after expiry of the contracted period of deposit. Withdrawal of deposit balances are to be done through cheques, drafts, etc. This implies that a written demand is necessary to end the contract and seek repayment of the depositor's balances.

It is thus clear that accepting deposits and maintaining deposit accounts is the core activity of any bank.

Annexure II provides a brief overview of some of the important legal provisions that affect banking operations in India.

Who is a Customer?

You will be surprised to know that the term ‘customer’ of a bank is not defined by law. Typically, any person or entity transacting with a bank through a deposit or borrowing account is considered its customer.

From a summary of past important judicial decisions, the following characteristics can be attributed to a customer.

  • A customer is one who maintains a deposit account with the bank.
  • Duration of the account is immaterial.
  • State of the account, that is whether it is in debit or credit, is immaterial.
  • Banker–customer relationship would exist even between two banks if one maintains accounts with the other and cheques etc. are collected through that account.
  • Merely visiting a bank frequently for purchasing a draft or for encashing a cheque etc. does not confer on the visitor the status of a customer, i.e., maintenance of a deposit account is mandatory to be eligible to be termed a ‘customer’.
  • A customer of one branch does not automatically become a customer of another branch of the same bank where he does not maintain an account.
  • Even an agreement to open an account would make a prospective depositor a customer of the bank.

In modern banking, the vital determinant of the ‘customer’ status of a person or entity is the nature of dealings with the bank. Such dealings should be in the nature of ‘banking business’. Accordingly, the person or entity that does not deal with the bank in respect of its core banking functions—accepting deposits and lending or investing the deposits—but avails of other services from the bank, is not deemed a ‘customer’.


Which of the following transactions indicate that X is a customer of Bank A?

  • deposits cash with Bank A to be credited to the Insurance company on whose behalf A accepts payments.
  • deposits cash to purchase a demand draft from Bank A.
  • X brings a cheque in his name to Bank A for encashment.
  • X brings a cheque in his name to Bank A for crediting to his savings account with A.
  • X deposits documents in Bank A's safe deposit vault.

The primary relationship between a banker and customer is therefore of ‘debtor and creditor’. However, under special circumstances and on the customer's request, the banker can also act as ‘trustee’ (e.g., holding a designated deposit of the customer for the purpose of paying a third person or holding the customer's valuables in safe deposit lockers) or as an ‘agent’ (e.g., buying and selling securities on behalf of the customer, making insurance and utilities payments on due date as specified by the customer).

Who is Eligible to be a Customer?

In their role as financial intermediaries, banks are bound to accept public savings as deposits. However, they can enter into legally valid contracts for this purpose only with certain sections of the society.

Thus, deposit accounts can be opened only by those who (a) are capable of entering into a valid contract, (b) follow the banks’ prescribed procedures while entering into the contract and (c) accepts the banks’ terms and conditions while doing so. Thus, banks retain the right to reject an application for opening deposit accounts.

The legal position of some special classes of banks’ customers is outlined in Annexure III.

General Guidelines for Opening Deposit Accounts

The importance of proper introduction and verification of new deposit accounts has been embodied in the Know Your Customer (KYC) guidelines of the RBI.24 These guidelines advise banks to put in place systems and procedures to prevent financial frauds, identify money laundering and suspicious or criminal activities and for scrutiny/ monitoring of large value cash transactions, including transactions in foreign currency.

The KYC guidelines of the RBI are modelled on international best practices. Both the World Bank and the IMF have been involved in international efforts to strengthen financial sector supervision and promote good governance, in an effort to reducing financial crime and enhancing the integrity of the international financial system. Since 2001, anti-money laundering (AML) and combating the financing of terrorism (CFT) measures have come into sharper focus. Both the World Bank and the IMF have worked closely with the Financial Action Task Force (FATF) on money, the standard setting body in this area, to develop a methodology for assessing the observance of international standards on the legal, institutional and operational framework for AML–CFT.

The BCBS, International Association of Insurance Supervisors (IAIS) and International Organization of Securities Commissioners (IOSCO) have each issued broad supervisory standards and guidelines on a wide range of supervisory issues, including money laundering as it relates to banking, insurance and securities. FATF incorporates those standards and guidelines in its 40 recommendations.

Salient features of the international and the RBI guidelines on AML and KYC are presented in Annexure IV.

Termination of Banker–Customer Relationship

The banker–customer relationship is determined by the contract between them. The relationship can be terminated by any one of them, by giving notice of the intention to terminate to the other party.

Apart from the stated intention, compulsions of law may also force the banker to terminate the relationship.

The rights and obligations of the banker in this respect are summarized below. A banker can terminate his relationship with the customer (with due notice) under the following circumstances:

  • When the customer directs the banker in writing to close his deposit and other accounts with the bank.
  • When the account has not been operated for a long time and the customer is not traceable in spite of the banker's efforts. Such deposit balances are usually parked in an ‘unclaimed deposit’ account and the account is closed. If the depositor is traced later, the balance (net of applicable charges) can be paid after verification.
  • When the banker finds the customer's dealings no longer satisfactory—say, the customer is convicted for forgery or fails to keep up commitments to repay loans and overdrafts.
  • When the banker is informed of the customer's death.
  • When the banker receives proof of the customer's insanity.
  • When the customer is insolvent or goes into liquidation.
  • When the banker receives a garnishee order25 from the court.

Types of Deposit Accounts

1. Term Deposit Accounts

At the time of entering into the deposit contract, the customer agrees to retain the deposit amount for a fixed term with the bank. This type of deposit is called a ‘term’ deposit. The term of the deposit is chosen by the depositor according to his convenience.

Term deposit accounts can be opened by individuals/partnership firms/private and public limited companies/ HUFs/specified associates/societies/trusts, etc.

The rate of interest on such deposits would vary from bank to bank in the present deregulated environment. The interest rates on these deposits can be ‘fixed’ (fixed for the entire term at the time of entering into the contract) or ‘floating’ (fixed in relation to a varying benchmark rate at the time of entering into the contract).

Banks can offer various innovative schemes to suit the needs of the customer segments they serve. How they design these deposit schemes will be outlined in the next section with illustrative examples.

The term deposit account is opened on a written request from the depositor in a prescribed format. The term deposit ‘receipt’ from the bank acknowledges receipt of the depositors’ funds into the bank.

Other salient features related to term deposits are as follows:

  • Existing term deposits can be renewed before maturity at the depositor's request, without any penalty provided the period of renewal is longer than the period of the original deposit.
  • Though interest is payable at the contracted rate on maturity of the term deposit, banks can pay quarterly or half-yearly interest on request by the depositor.
  • Beyond maturity date, term deposits held with the bank are classified as ‘overdue deposits’. Legally, interest ceases to accrue on overdue term deposits. However, banks have the discretion to allow interest if the entire deposit amount or a part of it is renewed from the date of maturity till some future date. The rate of interest prevailing on the maturity date would be applicable on the renewal, with the proviso that such interest will not exceed the appropriate rate for the period for which the deposit is to be renewed.
  • Banks have the discretion to pay the term deposit before the due date. However, if large deposits are withdrawn before maturity, the bank's asset liability management26 may be adversely impacted. Similarly, loan may be granted to the depositor against the security of the term deposit.
  • In the case of deposits in joint names, all the depositors should agree for premature payment or loan against the term deposit.

2. Current Deposits

Current deposits are part of the demand deposit portfolio of the bank, with the primary objective of providing ‘convenience’ of operation to the customer. It is essentially a running and actively operated account, with very little restriction on the number and amount of drawings. They are part of ‘demand deposits’, since the banker is obligated to repay these liabilities on demand from the customer.

Current accounts can be opened by individuals/partnership firms/private and public limited companies/HUFs/ specified associates/societies/trusts, etc.

The primary objective of operating a current deposit for these types of customers is ‘convenience’, since it dispenses with the risk of handling cash.

Since the bank satisfies the ‘convenience’ need of such depositors by undertaking payment and collection services on a daily basis, the ‘transaction costs’ for the bank are quite substantial. For example, the frequent transactions in the current account would entail personnel and system costs of a high order. Hence, it is customary for banks not to pay any interest on current account balances. In fact, the RBI specifically prohibits payment of any interest on current account balances.

Many banks insist on ‘compensating balances’ meant to offset the transaction costs involved. Some banks deliberately discourage non-remunerative accounts where the balances maintained are too low to compensate the transaction cost involved. Some banks apply graded service charges for the range of services offered.

For borrower–depositors, loans and advances are not disbursed as cash, but routed through the current account. Thus, there is a close link between current account depositors and borrowers for a bank. Hence, banks use the current account as a disciplining tool for its credit customers as well.

Typically, banks carry out due diligence before opening current accounts. Banks in India usually insist that the account holder declare all the credit limits availed at other banks. The account opening bank not only verifies the customer's bonafides before opening the account, but also insists on ‘no objection certificates’ from the customer's other bankers.

3. Savings Deposits

Savings deposits or savings bank (SB) accounts are targeted at those customers who wish to save a part of their current income and also earn from such savings. Savings bank accounts can be opened by any eligible person/persons and certain organizations/agencies (as advised by the RBI from time to time).

Since the scheme is meant for a major part of the country's populace, the central bank continues to regulate the interest rates offered by banks on such deposits.

Some of the salient features are as follows:

  • Many banks place restrictions on the number of withdrawals per period.
  • Minimum balances are prescribed by many banks, primarily to offset the cost of maintaining and servicing such deposits.
  • Savings accounts cannot be opened in the name of a trading or business firm. Similarly, government departments, bodies receiving government grants/subsidies, municipal corporations, panchayat samitis, state housing boards, water and sewerage boards, state text book publishing corporation, metropolitan development authority and state or district level co-operative housing societies are some of the other entities prohibited from opening SB accounts.

4. certificates of Deposit

CDs were introduced in 1989 in India with the objective of further widening the range of money market instruments and giving investors greater flexibility in deployment of their short-term surplus funds.

CDs are negotiable money market instruments issued in dematerialized form or as usance promissory notes for funds deposited at a bank (or at certain designated financial institutions) for a specified period. Guidelines for issue of CDs are governed by periodic directives issued by the RBI.27

Banks can issue CDs with a minimum amount of Rs. 1 lakh per subscriber and can be issued in multiples of Rs. 1 lakh. CDs can be issued to individuals, corporations, companies, trusts, funds, associations and also to nonresident Indians (non-repatriable and cannot be endorsed to another NRI in the secondary market).

Since CDs are money market instruments, their maturity cannot exceed 1 year. The minimum period of issue would be not less than 7 days.

CDs are to be issued at a discount on face value. Banks can also issue floating rate CDs, with interest rates to be reset periodically based on a predetermined formula indicating the spread over an objective, transparent and market-based benchmark. There is no minimum lock in period and CDs are freely transferable by endorsement and delivery (or as applicable to demat securities).

The funds flowing in from issue of CDs are subject to reserve requirements28 (Cash Reserve Ratio and Statutory Liquidity Ratio). It is also to be noted that banks cannot grant loans against CDs or buy their own CDs back before maturity.

5. Deposit Schemes for Non-Resident Indians (NRIs)

In order to make deposits under the schemes intended for NRIs, a depositor should meet any one of the following criteria.

  • He should be an Indian citizen staying in a foreign country either for employment or for carrying on business or vocation or for any other purpose, under circumstances indicating an indefinite period of stay outside India.
  • He should be an Indian citizen working in a foreign country with international organizations such as the United Nations and the IMF.
  • He should be an employee of the Indian central or state government or a public sector unit in India, deputed to a foreign country on a temporary assignment.
  • He should be a person of Indian origin. A person is considered to be of Indian origin if he has held an Indian passport at any time in the past or he or either of his parents or any of his grandparents were Indian citizens or his/her spouse is an Indian citizen or of Indian origin.
  • Overseas corporate bodies (OCBs) can also maintain deposit accounts with Indian banks. An OCB is defined as a company, partnership firm, society or any other corporate body, owned directly or indirectly to the extent of at least 60 per cent by NRIs. It also includes trusts in which at least 60 per cent irrevocable beneficial interest is held by NRIs.

The principles underlying the concept of ‘time value of money’29 are prevalently used in designing deposit schemes. Simply stated, the future value is the value of an investment today at some period in future, while the ‘present value’ is the value today of cash flow receivable at some period in future.

Recurring Deposit Scheme (RD)

General Features Under the scheme, a fixed sum agreed upon by the banker and customer will be deposited every month for a pre-determined period. At the end of the period, the depositor will be paid the total amount of deposit installments with interest. Minimum and maximum deposit periods are usually 12 and 120 months, respectively.

Advantages to the Depositor This is intended to be a variant of the savings deposit account with the objective of inculcating regular savings habit.

Calculating the Maturity Amount While operating these accounts, banks should ensure that the effective interest rates on such accounts are identical with those being paid for other similar deposits.

To arrive at the amount on maturity, the future value of annuity should be computed as follows:


Maturity of RD = RD installment (FVIFAn, k)


where, n and k are the number of periods and the rate of interest, respectively.


What is the maturity value of a monthly recurring deposit of Rs. 1,000 per month for 12 months, if the contracted interest at 9 per cent per annum is compounded quarterly?



Therefore the monthly interest rate = 0.78%



Reinvestment Deposit Scheme

General Features In this scheme, a lump sum amount is invested for a fixed period and repaid with interest on maturity. Interest on the deposit is reinvested at the end of each quarter and hence, there is interest on interest. The minimum and maximum durations for such schemes are generally 6 and 120 months, respectively, though the (minimum) period could differ among banks.

Advantages to the Depositor The depositor can withdraw the interest plus the principal at the end of the tenure. Since the interest is not withdrawn during the deposit period, the maturity value would be higher than in the case of similar schemes.

Calculating the Maturity Amount The maturity amount in a re-investment scheme would be the initial deposit multiplied by the effective rate.

Maturity amount = Initial deposit (1 + r)n

where, r = Effective rate =

        n = Number of years


Bank B offers the following interest rates on its term deposits—8.5 per cent for one year, 10 per cent for 2 years and 12 per cent for 3 years. What will be the maturity amount for an investment of Rs. 1,00,000 for a period of 2 years, if the depositor does not want periodic interest to be paid out during the period and the bank reinvests the amount quarterly?

The amount at the end of the re-investment period would be = 100,000 (l + r)2

On quarterly re-investment, the effective rate for 2 years would be



Hence, the maturity amount = 1,00,000 (1 + 0.1038)2 = Rs. 1,21,840

Fixed Deposit Scheme

General Features Under this scheme, a specific amount is deposited for a fixed term during which the amount cannot generally be withdrawn. However, at the request of the depositor, interest can be paid out on a monthly/quarterly/half-yearly/annual basis. Since interest on term deposits is payable at quarterly (or longer) rests, for monthly deposit schemes, interest is calculated for the quarter and paid monthly at discounted value.

Advantages to Depositor Depositors seeking regular income from their fixed investment would prefer this scheme.

Calculating the Interest Rate to be Quoted By periodically withdrawing the interest, the depositor can actually earn a return on this interest amount by reinvesting it. Moreover, if monthly interest is withdrawn for reinvestment, the returns earned will be more than those for a quarterly repayment. To recognize this, the interest rate that is paid for a monthly withdrawal scheme should be such that on reinvestment it shall not yield more than the quarterly returns. That is,


Quarterly interest paid out Y = X (l + r/6) + X (l + r/12) + X


where, X = Monthly interest amount

       r = Reinvestment rate for the monthly interest

Simplifying the above equation by multiplying by 4.




Discounted monthly interest =


where, P = Principal/fixed deposit amount

       R = Contracted interest rate

       r = Reinvestment rate for the monthly interest

In the above expression, it can be observed that the first month's interest amount is re-invested for 2 months and the second month's interest for 1 month. To these amounts, when the third month's interest is added, it should give interest that equals the quarterly interest amount.


A 2-year fixed deposit of Rs. 50,000 with Bank L carries a contracted interest rate of 10.5 per cent.

(a) What should be the interest amounts if payment is made on a quarterly, half-yearly and annual basis?

(b) What would be the effective interest rate if the interest is withdrawn every month and transferred to the savings bank account? Assume a re-investment rate at.04.


  1. Quarterly interest amount = 50,000 × 0.105/4 = Rs. 1,312.50

    Half-yearly interest amount = 50,000 = 0.105/2 = Rs. 2,625

    Annual interest amount = 50,000 × 0.105 = Rs. 5,250

  2. Discount monthly interest = = Rs. 436.04

    Thus, the effective interest rate that the bank pays on the Rs. 50,000 FD, if the interest amounts are withdrawn every month will be 10.46 per cent (i.e., 436.04 = 12/50,000).

It can also be inferred from the above illustration that the interest that can be paid for a monthly withdrawal FD scheme will be slightly lower to the rate paid for the other interest payment periods.

Cash certificates

General Features This is a variation of the re-investment deposit scheme, where the maturity value will be a pre-determined lump sum. The amount of initial deposit will be the issue price of the cash certificate and will be computed based on the maturity amount or the face value of the cash certificate and the tenure of the deposit. The interest is re-invested quarterly and hence, there will be interest on interest. The minimum and maximum maturity periods are generally similar to the re-investment scheme.

The issue price can be arrived at using the ‘present value’ principle.


Issue price = PV = Face Value (PVIFAn, k)32



A depositor requires Rs. 1 lakh after 1 year. If the current interest rate is 12 per cent per annum what should be the issue price of the cash certificate that would give the investor the required amount in a year's time?



Issue price (PV) for Rs. 1,00,000 = Face value (PVIEn, k)



Therefore, for obtaining Rs. 1 lakh after a year, the depositor will have to invest Rs. 88,850 at present.

  • Liability management plays a critical role in the risk-return profile of banks. In the present deregulated environment, banks have to balance profitability and risks while deciding on their liability mix.
  • ‘Deposits’ are the primary source of funds for banks. The other sources of funds for banks are ‘equity and reserves’ and borrowings. ‘These sources of funds form the basis for creation of assets by the bank and are hence responsible for the bank's profit and growth. Therefore, it would be prudent for the bank to base its funds requirement and mobilization on some relevant parameter such as (a) maturity, (b) cost of funds, (c) tax implications, (d) regulatory framework and (e) market conditions.
  • Bank deposits are differentiated by the type of deposit customer, the tenure of the deposit and its cost to the bank. On the basis of these parameters, deposits can be broadly classified as transaction accounts or payment deposits and term deposits. Transaction accounts can be further classified into interest bearing and non-interest bearing deposits. A popular variant of large term deposits is CDs.
  • Deposit insurance is a measure taken by banks in most countries to protect small depositors’ savings, either fully or in part, against any possible risk of a bank not being able to return their savings to these depositors. Deposit insurance is being increasingly used by governments as a tool to ensure the stability of the banking system of their countries and protect bank depositors from incurring large losses due to bank failures.
  • The pricing of deposits and related services assumes great importance in the present deregulated and highly competitive environment where deposit rate ceilings do not exist. It is, therefore, imperative that banks understand how to measure the cost of their funding sources and accordingly price their assets in order to ensure a desired level of profitability. This is done through a pricing policy.
  • Analysis of depositors’ profile and preferences would help banks avoid raising rates (and lowering profitability) to attract depositors in customer segments which are known to be price inelastic. Second, the information could help in fine tuning deposit prices in customer segments where better rates would be a deciding factor for a customer to keep deposits in or move them out of a bank. Better informed tradeoffs would enable better use of resources to improve service or convenience than to raise deposit rates. Proper deposit pricing will have a positive effect on the growth of net interest income and net interest margin.
  • Some common pricing methodologies adopted by banks for improving profitability while pricing deposits are: (a) cost plus margin pricing, (b) market penetration deposit pricing, (c) conditional pricing, (d) upscale target pricing, and (e) relationship pricing and so on.
  • Further, before hiking interest rates on some classes of deposits or going on an aggressive: campaign to mobilize new deposits, two types of analysis are typically considered. The analysis quantifies (a) the actual cost of new deposits and (b) the cost of protecting existing deposits. Such analysis is typically done using the following approaches—the marginal cost of funds approach and the new cost of funds approach.
  • In theory, measurement of interest rate risk of deposit liabilities is similar to the techniques used for the measurement of bond investments. The steps to be followed are: (a) forecasting cash flows, balances and interest, (b) discounting future cash flows to arrive at the present value, (c) calculating duration33 and interest rate elasticity and (d) stress testing. However, in practice, such application would require added assumptions or information due to some unique features of bank deposits.
  • Last three decades or so, banks have been increasingly turning to non-deposit funding sources (also called ‘wholesale funding’ sources). The funding gap that is generally calculated as the difference between current and projected credit and deposit flows is bridged though additional resources either from deposit or non-deposit sources. Banks have been finding new funding sources from the money markets, long-term and international markets. Of late, loan sale (such as ‘securitization’) mechanisms have also become a popular means of augmenting banks’ ‘liquidity’.
  • In India, ‘Banking’ is defined under Section 5(b) of the Banking Regulation Act, 1949. The provisions of the Act make it clear that accepting deposits and maintaining deposit accounts is the core activity of any bank. The primary relationship between banker and customer is therefore of ‘debtor and creditor’. However, under special circumstances and on the customer's request, the banker can also act as ‘trustee’ or as an ‘agent’. The banker–customer relationship is determined by the contract between them. The relationship can be terminated by any one of them, by giving notice of the intention to terminate to the other party.
  • The importance of proper introduction and verification of new deposit accounts has been embodied in the KYC guidelines of the RBI. These guidelines advise banks to put in place systems and procedures to prevent financial frauds, identify money laundering and suspicious or criminal activities and for scrutiny/monitoring of large value cash transactions, including transactions in foreign currency. The KYC guidelines of the RBI are modelled on the international best practices.
  • The principles underlying the concept of ‘time value of money’ are prevalently used in designing deposit schemes of banks.
  1. Bank U has the following schedule of fees for its savings and current accounts.
    1. If the average monthly account balance is over Rs. 10,000, there are no charges levied for withdrawals by cheque. The monthly service charges are also waived.
    2. If the average monthly account balance is between Rs. 5,000 and Rs. 10,000, a charge of Rs. 5 is levied for every withdrawal by cheque. The bank also levies a monthly service charge of Rs. 50.
    3. If the average monthly account balance falls below Rs. 5,000, the charge per withdrawal by cheque is Rs. 10. Further, the monthly service charge is Rs. 100.

    What is the type of deposit pricing that Bank U is resorting to? What is the strategic objective of Bank U in implementing this pricing schedule? What could be the problems with such a pricing strategy in a country like India?

  2. Rank the following bank liabilities according to their typical levels of liquidity risk. The highest rank is to be awarded to the liability with the highest liquidity risk.
    1. Transaction/Current deposits
    2. Term deposits
    3. certificates of deposit
    4. Savings deposits
    5. Borrowings from banks
    6. Borrowings from bond markets
    7. Equity
    8. Borrowings in foreign currency
  3. If you were to rank the liabilities shown in question 2 in the order of their interest rate risk, would the ranking change? What would be the changes in the ranking?
  4. If you were to rank the liabilities shown in question 2 in the order of their cost to the bank, how do you think the ranking would change? Give reasons.
  5. Bank N expects to attract fresh term deposits with 2 years maturity and renew existing deposits if it offers the following interest rates per annum—at 6 per cent Rs. 5 crores, at 6.5 per cent Rs. 10 crores, at 7 per cent Rs. 16 crores, at 7.5 per cent Rs. 20 crores and at 8 per cent Rs. 23 crores. The bank looks to an average yield of 9 per cent on investing these deposits in new loans or market investments. What is the optimum deposit rate the bank should offer if it wants to maximize its profit?
  6. Bank M requires that its savings account depositors maintain a minimum balance of Rs. 5,000. The services offered costs the bank Rs. 3 per depositor per month and the bank estimates a monthly cost of Rs. 2 per depositor in overhead expenses. The bank requires a minimum profit of Rs. 2 per month on such transactions.
    1. What should be the monthly fee that the bank charges its savings account customers?
    2. The bank further estimates that it saves about 2 per cent in operating expenses for each Rs. 1,000 held as deposits above the minimum balance of Rs. 5,000. What would be the appropriate fee for a customer holding an average minimum balance of Rs. 15,000?
  7. Why is introduction necessary to open a current account with an Indian bank? Is introduction necessary for opening a savings account with an Indian bank under the following circumstances?
    1. Where no cheque operations are permitted.
    2. Where only withdrawals by cheque are permitted.
    3. Where both deposit of and withdrawal by cheques is permitted, including deposit of other instruments.
  8. A CD with a face value of Rs. 1 crore and a term of 6 months is issued at a discounted price of Rs. 97,08,740. The bank incurs a stamp duty of 0.15 per cent per quarter on the transaction. Further, the bank has to maintain a reserve of 5 per cent as cash reserve on this amount as per central bank directives, on which it will earn no interest.
    1. What is the cost to the bank for issuing the CD?
    2. What is the return to the investor in the CD?
  9. In which of the following situations should a bank use the marginal cost of funds approach?
    1. Calculating the bank's profitability.
    2. Deciding whether to tap fresh deposits or borrow from the market.
    3. Calculating the rate to be charged for a new loan.
    4. Calculating the profitability of a customer to the bank.
  10. Bank V has a liability mix consisting of deposits and equity only. Average deposits of the bank amount to Rs. 16,000 crores and average equity to Rs. 2,000 crores. The bank has to maintain reserves of 30 per cent on the deposits. The remaining funds can be deployed as credit and investment in securities on which the bank earns an average yield of 12 per cent per annum. Income on investments, including interest on reserves, is about 20 per cent of the bank's total income. The overhead expenses of the bank amount to about 6 per cent of average deposits. If the bank wants to earn a profit of Rs. 200 crores for the year, what should be the rate the bank can pay on its deposits?
  • Take a sample of banks (private sector, public sector and foreign banks in India) and examine how their liability mix has changed over the last few years. What has been the impact on the cost of funds for these banks and their profitability?
  • Analyse the non-deposit sources of funds of the above banks. Which source is the cheapest for the bank? Which source is the most risky for the bank? Take into consideration both liquidity and interest rate risks.
  • Examine the maturity pattern of deposits as given in the above banks’ balance sheets as part of ‘notes on accounts’. Is there a marked shift in the maturity pattern? Is there a significant difference in the shift among bank categories—private sector, public sector and foreign banks? What conclusions could be drawn from the results?

Indian Banks

Call/Notice Money34

This is a money market instrument. The money market is a market for short-term (maturities from 1 day to 1 year) financial assets.

Money market instruments are considered ‘near cash’ investments since they are highly liquid. They also carry the advantages of the ability to be turned over at a low cost, with borrowing and lending rates being determined by demand and supply of funds in the market.

The call/notice money market forms an important segment of the Indian money market under the call money market, funds are transacted on overnight basis and under the notice money market, funds are transacted for the period between 2 days and 14 days. The other features of the market are:

  • Participants in call/notice money market currently include banks (excluding regional rural banks), all cooperative banks (other than land development banks) and primary dealers (PDs), both as borrowers and lenders.
  • In the case of banks borrowing in this market, the outstanding borrowing should not exceed 100 per cent of the bank's capital funds (tier 1 + tier 2 capital),35 on a fortnightly average basis.
  • In the case of banks lending in this market, the fortnightly average lending should not exceed 25 per cent of the banks’ capital funds.
  • Non-bank institutions cannot operate in this market (w.e.f. 6 August 2005).
  • Interest rates are market-determined and their calculation is to be based on FIMMDA's (Fixed Income Money Market and Derivatives Association of India) Handbook of Market Practices.
  • All deals, irrespective of the size, have to be reported on the Negotiated Dealing System (NDS).36

External Commercial Borrowings, Foreign Currency Convertible Bonds and Foreign Currency Exchangeable Bonds37

ECBs are typically commercial loans in the form of bank loans, buyers’ credit, suppliers’ credit38 or securitized instruments such as floating rate notes and fixed rate bonds, taken from non-resident lenders with a minimum maturity of 3 years.

Foreign Currency Convertible Bonds (FCCBs) are bonds issued by an Indian company expressed in foreign currency, whose principal and interest payments are also in foreign currency. They are convertible to ordinary shares of the issuing company in accordance with the rules in force. The policy for FCCBs is similar to the policy for ECBs.

Foreign Currency Exchangeable Bonds (FCEBs) are bonds expressed in foreign currency, whose principal and interest payments are also in foreign currency. They are issued by an ‘issuing company’, subscribed to by residents outside India and exchangeable into equity shares of another company, called the ‘Offered company’, in accordance with the rules in force. The guidelines and rules governing ECBs are also applicable to FCEBs.

ECBs can be accessed through two routes, the automatic and approval routes.

The salient features of ECBs are summarized in Table 4.5.




Source: RBI ‘Master Circular on External Commercial Borrowings and Trade Credits’ dated 1 July, 2009, and subsequent amendment dated 9 December, 2009.

Export refinance from the RBI39

There is another important and prevalent source of wholesale funds for banks—refinancing. Various institutions offer refinancing for credit extended by banks to sectors of the economy identified as critical or priority. For example, apex institutions such as Small Industries Development Bank of India (SIDBI), National Bank for Agriculture and Rural Development (NABARD) and Infrastructure Development Finance Corporation (IDFC) provide refinance to banks making loans to the SME, agriculture and infra structure sectors, respectively. Banks have the option of sourcing funds from the refinancing agencies when they have extended credit to eligible borrowers in these sectors.

The RBI provides export credit refinance facility to banks under Section 17(3A) of the Reserve Bank of India Act, 1934, in order to encourage banks to extend more credit to exporters. This facility is given on the basis of banks’ eligible outstanding rupee export credit both at the pre-shipment and post-shipment stages. The quantum of refinance is fixed from time to time based on the stance of monetary and credit policy of the RBI. However, export credit deployed in foreign currency (PCFC) would not be refinanced against. Banks can also rediscount export bills with Export Import Bank of India (EXIM Bank).

Banks can take refinance to the extent of 15 per cent of the outstanding export credit eligible for refinance on a specified date (at the end of the second preceding fortnight). The refinance is priced at the repo rate40 under the liquidity adjustment facility (LAF). The amount of refinance can be repaid to the RBI on specified dates that, in any case, cannot exceed 180 days. The RBI grants the refinance against a demand promissory note from the bank seeking the funds, which, in any case, has to be a minimum of Rs. 1 lakh or multiples of this amount. Banks would be penalized if they are found to: (a) utilize refinance that exceeds the total amount of export credit given to borrowers or (b) misreport or miscalculate the amount of the eligible refinance or (c) do not repay the refinance within the stipulated time period or (d) delay reporting excess utilization to the RBI.

Some Non-Deposit Sources of Bank Funds in the USA41

IRA and KEOGH Plans These are long-term sources of funds for banks. They act as custodians for personal pension plans that individuals may use to defer federal income taxes on contributions and subsequent investment earnings. Both IRAs are allowed under the Taxpayer Relief Act of 1997.

Federal Funds Federal funds are short-term unsecured transfers of immediately available funds between depository institutions for one business day (i.e., overnight loans). Federal funds are best suited for institutions short of reserves to meet their legal reserve requirements or to satisfy customer loan demand. It satisfies this demand by tapping immediately usable funds. Deposits held by the US banks at Federal Reserve Banks, deposits with correspondent banks and demand deposit balances of security dealers and governments are also used for short-term funding.

Borrowing from the Federal Reserve This is seen as a viable alternative to the Federal funds market. There are three types of loans available based on the bank's needs. Each type of loan comes at a different price. They could take the form of: (a) adjustment credit, where the loan is for a few days only and is intended to provide immediate aid in meeting statutory reserve requirements, (b) seasonal credit, where the loan has a longer maturity and is meant for banks with seasonal swings in business and (c) extended credit, where the loan is intended for banks experiencing longer-term funding problems.

Repurchase Agreements Repurchase agreements contract to sell (typically high quality and usually government securities) securities temporarily by a borrower of funds to a lender of funds with the borrower agreeing to buy back the securities at a predetermined price on an agreed date in the future. These could take the form of overnight loans, term loans or continuing contracts. These agreements are collateralized loans and thus, the lender is not exposed to credit risk as they are with federal funds transactions. They are therefore seen as low cost and low risk way of borrowing funds for short periods of time (usually 3 or 4 days). They are low risk because they are collateralized by the securities that are sold as part of the agreement.

Non-Deposit Funds These are money market liabilities purchased for relatively short time periods to adjust liquidity demands. The use of these purchased funds came into existence due to tight money periods in which deposit rate ceilings caused banks to develop alternative sources of funds. Unlike deposit funds, these are exempt from federal reserve requirements, interest rate ceilings and FDIC insurance assessments.

Negotiable CDs These were initially developed to attract large corporate deposits and savings from wealthy individuals. They are interest-bearing receipts evidencing deposit of funds in the bank for a specified time period, at a specified interest rate. However, since they also have the legal attributes of deposits, negotiable CDs are considered ‘hybrid’ accounts. There are four identifiable types of negotiable CDs: (a) domestic CDs issued by domestic banks in the US, (b) Euro CDs, being dollar-denominated CDs issued outside the US and (c) Yankee CDs issued by foreign banks in the US and (d) thrift CDs issued by large savings loans and other non-banks in the US. Moreover, these funds are highly interest rate sensitive and are often withdrawn on maturity, unless management aggressively bids in terms of yield to keep the CDs.

Discount Window Advances The 12 regional Federal Reserves operate discount windows42 from which banks can borrow (subject to Regulation A rules). A discount window loan must be secured by collateral acceptable to a Federal Reserve (usually US government securities). Most banks keep government securities in the vaults of the Federal Reserve for this purpose. The Federal Reserve Bank will also accept some government agency securities and high-grade commercial paper as collateral.

Eurocurrency Deposits These were originally developed in Western Europe to provide liquid funds for financial institutions to lend to one another or to customers. These are dollar-denominated deposits placed in banks outside US territory. Many Eurodollar deposits arise from US balance-of-payments deficits that give foreigners claims on US assets and form the need to pay in dollars for some international commodities (such as oil) mostly denominated in US dollars.

Bankers’ Acceptances These are time drafts drawn on a bank by either an exporter or importer to finance international business transactions. The bank may discount the acceptance in the money market to (in effect) finance the transaction.

Commercial Papers These are high quality short-term debt obligations (unsecured promissory notes) issued by corporations with strong credit ratings to meet the firm's working capital needs. Banks can issue such paper through their affiliated or holding companies. Typically, the maturities range from 3 or 4 days to 9 months.

Federal Home Loan Bank Borrowings Under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989, FHLBs can provide discount window services to banks. FHLBs function as special lending facilities for the housing finance industry. These government-sponsored enterprises increase the liquidity of mortgage markets by lending against the security of banks’ mortgage portfolios. These loans are very popular as funding sources, because of their stability and the below-market lending rates offered.

Long-Term Non-Deposit Sources These include mortgages to fund the construction of new buildings, capital notes and debentures. Generally, the interest costs on these funds, though substantially higher than money market loans, are more stable.

  • The RBI Act, 1934 envisages major functions for the RBI as a central banker, a promoter and a regulator.
  • The Banking Regulations Act, 1949 primarily deals with the administrative and functional aspects of governance of banks. The act also confers the RBI with powers of supervision over commercial banks.
  • The Negotiable Instruments (NI) Act, 1881 is acclaimed as one of the most comprehensive and well-drafted enactments that have stood the test of time with only 25 minor revisions. The NI Act defines the nature, functions and limitations of several negotiable instruments with comprehensive coverage of cheques. It demarcates the rights and obligations of various parties to negotiable instruments and offers transactional clarity to minimize the areas of disputes between parties. The Act also lays down the procedure for claims against dishonour of instruments and punishments for breach of legal provisions. A later amendment titled Negotiable Instruments (Amendments and Miscellaneous Provisions) Act, 2002 addresses various issues emerging out of e-commerce and tightens the prosecution procedure for dishonour of cheques.
  • The Companies Act, 1956 is important for banks, since companies incorporated under the Act form the major customers for banks.
  • The Indian Contract Act, 1872 is of great relevance as bankers have to enter into relationships with their customers as debtors, creditors, agents or bailee. The Act determines the capacity of parties to the contracts and validity of transactions arising out of contracts. The Act also covers special contracts such as contracts of guarantee, bailments, pledge and agency.
  • The I.T. Act 2000 is relevant for banks since it addresses issues emerging out of electronic banking transactions and provides protection against possible abuse and misuse of services.
  • The Limitation Act, 1963 aims to prevent unduly stale legal claims and reduce long-winded court procedures. It is necessary for bankers to protect their documents from getting time barred, since legal remedy also lapses with the expiry of the limitation period. The Act also provides some safeguards to protect the documents from getting time barred.
  • The Indian Stamp Act, 1899 seeks to raise revenue by making payment of stamp duty statutory to establish validity of certain transactions. The Act is important for banks as certain unstamped documents are inadmissible as evidence in a court of law.
  • The Registration Act, 1908 is aimed at preserving and protecting title to property. The Act imposes serious disqualifications and penalties for non-observance of regulations. It also determines the priority of validity of transactions based on their registration. Banks must take into account various aspects of the Act for opening of accounts, execution of documents and enforcing securities.
  • The Transfer of Property Act, 1882 sets out the rights and liabilities of the transferor and transferee in respect of various transactions. Since the transfer of interests and rights involves registration and payment of stamp duty, this law should be read along with the Registration Act and the Indian Stamp Act. Mortgage of immoveable property is one of the popular modes of obtaining security and hence, bankers have to ensure compliance with the provisions of this Act.
  • The Sale of Goods Act, 1930 deals with rights and obligations of sellers and buyers apart from conditions and warranties covering the sale of goods. The provisions of this Act are relevant to bankers who often act as agents for collecting bills accompanied by documents of title to goods and as holder for value while discounting the bills. The Act also offers remedies for breach of agreements of sale.
  • The Consumer Protection Act, 1986 (as amended in December 2002), protects the interests of the consumers and establishes dispute redressal agencies at district, state and national levels. A bank customer can be considered a ‘consumer’ since banking services are hired for consideration. The growing awareness among customers of their rights and responsibilities, fixed by the Act on banks for deficiency of service, have made it important for banks to be informed of the various provisions of the Act.
  • International laws pertaining to international trade and commerce are necessary tools for banks to operate in the present globalized environment.
  • Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 empowers the banks to seize the assets of non-performing advances and securitize the assets to realize the dues.
  • The Prevention of Money Laundering Act, 2002 makes it obligatory for banks to verify and maintain records of identity pertaining to all its customers for prescribed value of transactions. The Act lays rigorous punishments for aiding and promoting domestic and international crimes.
  • The Competition Act, 2002 was enacted to address market realignment strategies of large companies. The important provisions of the Act could influence the business strategy of banks.

How Banks in India Have to Deal with Some Special Classes of Bank Customers

  • Under the Indian Contract Act, 1872, a ‘minor’ (one who has not completed 18 years of age) cannot enter into a valid contract and such a contract, even if entered into, is considered void. A contract for supply of goods and services necessary for the minor to live, however, is a valid contract. All other contracts can be repudiated by the minor. Therefore, banks should be extremely cautious while opening and operating accounts on behalf of minors. Even if the bank opens the minor's deposit account after following all the prescribed legal procedures, care should be taken to ensure that no ‘overdraft’ 43 is permitted in such an account. If such a loan is granted, even inadvertently, the bank has no legal remedy for recovery. Even if the assets of the minor are charged to the bank, the legal remedy is non-existent since the minor cannot enter into a contract to charge his assets. Similarly, even if the advance granted to the minor is backed by a counterparty guarantee, the contract of guarantee is invalid on the grounds that the contract between the debtor and the creditor (minor) itself is invalid. However, if a minor posing as a major enters into the contract and later seeks to nullify the contract on the grounds of his having been a minor at the time of entering the contract, the minor is liable to restore to the bank the benefits derived by him under the false contract44 The bank should also be cautious while dealing with a negotiable instrument, in which a minor is one of the signatories. Under Section 26 of the Negotiable Instruments Act, a minor can issue or negotiate a cheque or Bill of Exchange, but cannot be sued in respect of the instrument.
  • A married woman can enter into a valid contract and the husband cannot be made liable for her actions except under the following circumstances—a loan is taken with the husband's consent and authority, or the loan has been taken to supply the wife with necessities for her sustenance, since the husband has failed in his duty to provide her with basic amenities. While entering into a contract with a married woman, the banker should ascertain that she has assets of her own.
  • The banker should enter into a contract with a ‘pardanashin’ woman only after taking precautions to establish her identity.
  • In the case of illiterate persons, bankers take thumb impressions in lieu of signatures, along with photographs of depositors as proof of identity.
  • The banker should avoid opening an account in the name of a person of unsound mind. According to the Indian Contract Act, a contract with a person of unsound mind is invalid. If a person has been sane while entering into the contract with the bank, but turns insane later, the banker should suspend all operations in the account subsequent to the customer's lunacy. Operations can be resumed only on receiving proof of sanity or is served with an order of the court.
  • The banker should also take precautions while opening accounts in the names of Trustees. According to Section 3 of the Indian Trusts Act, 1882, a ‘Trust’ is an obligation annexed to the ownership of property and arising out of a confidence reposed in and accepted by the owner for the benefit of another. The author of the trust is the person who reposes the confidence and the ‘trustee’ is the person in whom the confidence is reposed. The person for whose benefit the trust is formed is called the ‘beneficiary’. A trust is formed through a document called the ‘trust deed’. The banker should thoroughly scrutinize the trust deed to ascertain that the trustees are authorized to act in the interest of the beneficiaries. The trustees can borrow or mortgage the trust property only if the trust deed specifically confers such powers on them.
  • The banker should also take precautions while opening and operating accounts in the name of a joint Hindu family. The banker should be familiar with the provisions of the Hindu Law and Succession Act while doing so.
  1. Varshney, P. N. (2004), Banking Law and Practice, Chapters 3, 4 and 5. New Delhi: Sultan Chand & Sons.

III-Effects of Money Laundering on the Economy

Money laundering can have potentially negative consequences for a country's macro-economic performance, can impose welfare losses and may also have negative cross-border externalities. It can distort allocation of economic resources and distribution of wealth. In most cases, it is costly and difficult to detect and eradicate.

Some manifestations of the economic impact of money laundering could be as follows:

  • Impaired banking system soundness
  • Potentially large fiscal liabilities
  • Reduced ability to attract foreign investment
  • Increased volatility of international capital flows and exchange rates
  • Difficulty in national tax collection and law enforcement.

More seriously, over and above the direct abuse of the financial system, the country runs a reputation risk in international circles, which, in turn, could impair global willingness to conduct business (such as foreign investment into the country and banking correspondent relationships) with that country.

Overall, the ‘trust’ that underpins the development and existence of vibrant financial markets would be adversely affected. Effective functioning of financial markets is heavily based on the fundamental expectation that high professional, legal and ethical standards would be observed and enforced. A reputation for integrity—soundness, honesty and adherence to standards and codes—is one of the most valued assets by global investors and financial institutions. Money laundering and terrorist financing would compromise the reputation of financial institutions, undermine investors’ trust in those institutions and therefore, ultimately weaken the financial system.

International Standards to Deal with Money Laundering and Terrorism Financing

Money laundering can be simply defined as ‘transfer of illegally obtained money or investments through an outside party to conceal the true source’.47 Money launderers may also operate outside financial systems—e.g., through alternative remittance systems.

The World Bank and the IMF have been working closely since 2001 with the FATF41 on money laundering, the standard setting body in this area, to develop a methodology for assessing the observance of international standards on the legal, institutional and operational framework for AML and CFT.

The FATF standards draw on and complement a wide range of United Nations (UN) conventions and resolutions that promote international cooperation in preventing and containing drug trafficking, organized crime, corruption and efforts to finance terrorism.

In addition, all financial supervisory standards have core principles to enhance KYC rules, suspicious transactions reporting and other due diligence requirements that help to support AML–CFT regimes.

The BCBS, IAIS and IOSCO have each issued broad supervisory standards and guidelines on a wide range of supervisory issues, including money laundering as it relates to banking, insurance and securities.

The contents of the above mentioned standards and guidelines are summarized in the following section. It is noteworthy that FATF has incorporated these standards and guidelines in its 40 recommendations.

The Basel Committee Guidelines The BCBS has issued three documents covering money laundering issues.

1. Statement on prevention of criminal use of the banking system for the purpose of money laundering

This statement contains essentially four principles that should be used by banking institutions.

  • Proper customer identification.
  • High ethical standards and compliance with laws and regulations.
  • Cooperation with law enforcement authorities.
  • Policies and procedures to be used to adhere to the statement.

2. Core principles for effective banking supervision

These principles set out a comprehensive blueprint for supervisory issues, which cover a wide range of topics. Core Principle 15 deals with money laundering by stipulating that bank supervisors must determine that banks have adequate policies and procedures in place, including strict KYC rules.

3. Customer due diligence for banks

This paper provides extensive guidance on appropriate standards for banks to use in identifying their customers. The paper was issued in response to a number of deficiencies noted on a global basis with regard to the KYC procedures noted above. In addition, the standards go beyond the fight against money laundering and are intended to help protect banks in terms of safety and soundness.

IAIS Guidelines This association has issued its Guidance Paper 5, ‘Anti-Money Laundering Guidance Notes for Insurance Supervisors and Insurance Entities’, which parallels the BCBS's statement on prevention.

It contains four principles that should be followed by insurance entities.

  • Comply with anti-money laundering laws.
  • Have KYC procedures in place.
  • Cooperate with all law enforcement authorities.
  • Have internal anti-money laundering policies, procedures and training programs for employees.

International Organization of Securities Commissioners (IOSCO) Guidelines IOSCO in its ‘Resolution on Money Laundering’ proposes seven specific areas for security regulators in individual countries to consider while establishing requirements for firms under their jurisdiction.

  • The extent of customer identifying information with a view towards enhancing the ability of authorities to identify and prosecute money launderers
  • The adequacy of record-keeping requirements to reconstruct financial transactions
  • Whether an appropriate manner is used to address the reporting of suspicious transactions
  • What procedures are in place to prevent criminals from obtaining control of securities businesses and to share information with foreign counterparts
  • Whether means are appropriate for monitoring compliance procedures designed to deter and detect money laundering
  • The use of cash and cash equivalents in securities transactions, including documentation to reconstruct transactions
  • Whether means are appropriate to share information to combat money laundering

Salient Features of the RBI's KYC Norms48

Central banks of most countries, including the RBI, have been reiterating the need for banks to ‘know’ their customers. In November 2004, the RBI issued revised KYC guidelines in line with the recommendations made by the FATF on AML standards and CFT. Banks were required to frame their KYC policies with the approval of their boards and ensure compliance with its provisions by 31 December 2005.

The salient features of the policy relate to the procedure prescribed with regard to customer acceptance, customer identification, risk management and monitoring as required under Prevention of Money Laundering Act (PMLA), 2002. Additionally, banks had to follow the provisions of the Foreign Contribution (Regulation) Act, 1976 in respect of acceptance of foreign donations on behalf of associations/organizations maintaining accounts with them.

The KYC principle has the following objectives:

  • To enable proper identification of depositors and other customers
  • To help institute systems and procedures that would enable prevention of financial frauds, identification of money laundering and other suspicious and antisocial activities
  • To enable monitoring large value cash transactions and foreign currency transactions

Some important aspects of the RBI guidelines are summarized as follows. (RBI Master circular dated 1 July 2009 and subsequent amendments)

  • Banks’ KYC policies should incorporate the following key aspects: (a) customer acceptance policy (CAP), (b) customer identification procedures (CIP), (c) monitoring of transactions and (d) risk management.(Detailed description of these aspects can be found in the quoted RBI circular).
  • The antecedents of any individual or corporate customer opening a new account with a bank should be thoroughly checked. This would also entail verification through an introductory reference from an existing account holder/a person known to the bank or on the basis of documents provided by the customer.
  • The Board of Directors of the bank should put in place adequate policies that establish procedures to verify the bonafides of new customers and monitor transactions of suspicious nature in accounts, as well as have systems to conduct due diligence and reporting of such transactions.
  • In respect of customer identification, the KYC framework has the following objectives—to ensure appropriate customer identification and to monitor transactions of a suspicious nature. Banks should obtain all information necessary to establish the identity/legal existence of each new customer, based preferably on disclosures by customers themselves. Typically, easy means of establishing identity would be documents such as passports and driving licenses. However, where such documents are not available, verification by existing account holders or introduction by a person known to the bank may also suffice. In implementing the guidelines, it should be ensured that the procedure adopted does not lead to denial of access to the general public for banking services.
  • Banks have to also follow the guidelines emerging from the ‘Report on Anti- Money Laundering Guidelines for Banks in India’ prepared by a working group, set up by the Indian Banks’ Association (IBA). The report has suggested formats for customer profile, account opening procedures, establishing relationship with specific categories of customers, as well as an illustrative list of suspicious activities.
  • Even in the case of existing customers, banks should keep their customer information updated.

Introduction of New Depositors

Opening an account with a bank signifies the beginning of the banker–customer relationship. The special features of this relationship impose obligations and responsibilities on both parties. More so in the case of bankers, whose vigilance in opening of and operations in the accounts would entitle them to legal protection under Section 131 of the Negotiable Instruments Act, 1881 (the NI Act).

The NI Act governs payment and collection of negotiable instruments and provides certain kinds of rights, liabilities (obligations) and protection to the issuers/drawers, payees, endorsees, drawers, collecting banks and paying/ drawer banks that will be available, only if the bank makes or receives payment of a cheque/draft payable to order in ‘due course’. Any payment or collection of a negotiable instrument is deemed to be in ‘due course’ only when the bank has, for its customer, acted without negligence and in good faith.

The due diligence process, while opening a deposit account will involve verifying the person's identity, address, occupation and source of income. An important part of the process is obtaining introduction of the prospective depositor from a person acceptable to the bank.

Why is Introduction Necessary?

  • To gain protection for the banker under Section 131 of the NI Act.
  • To enable proper identification of the person opening an account and ensure that the customer can be traced later if required.
  • To guard against accounts being opened by socially undesirable persons or in fictitious names with the objective of, inter alia, to deposit unaccounted money.

‘Proper’ Introduction

  • Generally an account is opened only after a meeting between the banker and the prospective customer.
  • The prospective depositor has to be ‘introduced’ by an existing account holder or a respectable member of the local community, who is also a customer or well known to the bank. The guidelines indicate that the introducer should have been the bank's customer for at least 6 months, during which interval the bank should have been satisfied with the conduct of the introducer's account. This is required for opening all types of deposit accounts.
  • The bank should additionally take steps to ascertain the identity of its depositors and not rely solely on the credentials presented by the introducer. The above duty of the banker was reiterated by the Madras High Court, when it ruled that the bank had indeed been negligent in making its own investigation into the depositor's antecedents.49
  • Generally, the bank's employees are discouraged from providing the introduction for new accounts.
  • In cases where the introducer is not able to be physically present to introduce the account, a confirmation of the introduction should be obtained in writing. It is advisable to allow operations in the new account, only after the bank is convinced about the antecedents of the new depositor.
  • Some of the key risks for the bank in opening accounts without proper introduction are as follows.

    The banker will lose statutory protection under Section 131 of the NI Act. Briefly stated, under this section, the collecting banker for cheques, bills and other negotiable instruments whose title is defective, will not be liable to the true owner of the instrument, provided the banker has acted in good faith and without negligence. The banker stands to lose this vital protection if the account holder sends a forged or stolen instrument for collection and it transpires that the miscreant had been allowed to open the account without proper introduction. In such cases, the banker remains liable to the true owner of such instruments.

    In case the bank allows an overdraft50 in a deposit account that has not been properly introduced, the bank has to bear the credit risk51 if the overdraft is not repaid.

    In case the banker has permitted, without proper verification, an ‘undischarged insolvent’52 to open a deposit account, the balances in this account run the risk of attachment by the court.

Other Procedures for Opening Deposit Accounts

  • It is mandatory to obtain recent photographs of the deposit account holders at the time of opening almost all new accounts, except where exempted by the guidelines in force.53 The photographs have to be affixed on the account opening forms submitted by the new customers.
  • Specimen signatures of the persons, authorized to operate the accounts and sign cheques and other instruments, have to be obtained and preserved. Every transaction in the account has to be scrutinized by the bank to ensure that it is the account holder who is authorizing the transaction. In case the signature on the instrument authorizing a transaction is different from the specimen signature, the bank can refuse to go through with the transaction.
  • Genuine address of the account holders should be verified at the time of opening the account and updated periodically.
  • Other safeguards include obtaining the PAN/GIR number of the new deposit customer and completion of account opening documentation formalities at the bank.
  • Deposit accounts can be opened by an individual in his own name (known as an account in a single name) or by more than one individual in their own names (known as a joint account). Savings bank account can also be opened by a minor, jointly with natural guardian or with mother as the guardian (known as a minor's account). Minors above the age of 14 will also be allowed to open and operate savings bank account independently.
  • When a bank opens a ‘joint’ account, any of the following mandates will have to be provided to the bank for disposal of the balance in the deposit accounts—‘either or survivor’ or ‘anyone or survivor/s’. Any modification in the mandate can be carried out only with the consent of all the account holders. ‘Either or survivor’ accounts will be held by two persons and in the event of death of any of the account holders, the balance will be paid to the survivor. Where the account is held by more than two persons, ‘anyone or survivor/s’ mandate will operate. The exception to this is the joint deposit account on behalf of a minor, where only the natural guardian can operate the account.

Nomination Facility for Deposit Accounts

The Banking Laws Amendment Act, 1983 inserted a new Section 45 ZA in the Banking Regulation Act, 1949 to provide for nomination by bank deposit holders.

Legal Status of Nominee Does the nominee become the absolute owner of the deposit money received under the nomination on death of the principal depositor? What is the status of legal heirs in the face of nomination?

These are some of the questions that arise when depositors are required to make a nomination in respect of the deposit amounts held by them with banks.

A Supreme Court judgment54 makes the position of the nominee clear:

‘A mere nomination made… does not have the effect of conferring on the nominee any beneficial interest in the amount payable. The nomination only indicates the hand which is authorized to receive the amount… The amount, however, can be claimed by the heirs… in accordance with the Law of Succession governing them’.

It is thus clear that the nominee cannot become the absolute owner of the amount received by him. The law of succession will have to ultimately prevail.

Other points to be noted in respect of nomination of deposit accounts are as follows:

  • A single depositor or many depositors (in the case of joint accounts) together, can nominate a person to whom, in the event of death of the deposit customers, the balance in the deposit account may be paid. The nominee's right to receive these balances arises only after the death of all the depositors.
  • Only individuals can be nominees. This implies that organizational bodies such as associations, trusts or their office bearers cannot be designated nominees.
  • The nominee has the right to receive the deposit amount to the exclusion of all other interested persons. The nominee can also request the bank to close a term deposit before maturity.55
  • If the nominee is a minor, the depositors can name any person to receive the deposit amount in the event of the depositors’ death while the nominee continues to be a minor.
  • The nomination can be varied or cancelled by the depositor/s at any time. In the case of a joint account, all depositors should agree in writing to the change in nomination.
  • Once it makes payment to the designated nominee after due diligence, the bank is fully discharged from its liability in respect of the deposit. Such payment shall not be bound by any claim made by a person other than the nominee.
  • Mere renewal of the deposit does not cancel nomination or cause any variation in the nomination.
  • Nomination facility is available to all types of deposit accounts irrespective of the nomenclatures used by different banks.
  • If the customer prefers not to nominate, the fact should be recorded.
  • Nomination rules apply to cases where the bank is operating as a trustee or agent, as for example, articles entrusted to the bank for safe custody. For example, while releasing contents of safe deposit lockers to the nominee or nominees and surviving hirers, banks need not open sealed/ closed packets found in the locker. In case the locker has been hired jointly, on the death of any one of the joint hirers, the contents of the locker can be removed (jointly by the nominee and the survivors) after an inventory is taken. Thereafter, the nominee and surviving hirer(s) may still keep the entire contents with the same bank, if they so desire by entering into a fresh contract for hiring a locker.
  1. Indian Institute of Bankers, 2005, ‘Legal Aspects of Banking operations’, Chapter 1, Macmillan India Ltd, New Delhi.
  2. Varshney, P N, 2004, ‘Banking Law and Practice’, Chapters 3, 4, and 5, Sultan Chand & Sons, New Delhi.