42. Commercial Banking – Business Environment

42

COMMERCIAL BANKING

In this chapter on commercial banking, we study what is banking, what is a bank, the functions of a commercial bank, the importance of commercial banks, the investment policy of a commercial bank, commercial banking, process of credit creation, the evolution of Indian commercial banks, Indian banking since nationalization, the current situation, the challenges facing Indian banking and the strategic options with banks to cope with the challenges. After reading this chapter, you will make use of this knowledge in your day-to-day life, both for personal as well as official purposes.

Most people do not keep huge amounts of cash with them, as it is very unsafe to do so. They keep only few currency notes and small coins for daily transactions. They keep part of their money with a bank; it is called a bank deposit. They make use of these bank deposits whenever they purchase a commodity of large value or make payments through cheques or debt or credit cards that have come into vogue nowadays. There are thus two types of money in these days: (i) standard money—consisting of metal coins and paper currency notes and (ii) bank money—consisting of bank deposits from which a person can withdraw money at any time he likes, either through cheques or debit/credit cards.

We have seen in the previous chapter while discussing the evolution of money that the adoption of bank money or credit money is the final stage in the evolution of money. Let us discuss the bank money in a detailed manner. But let us first see what a bank is and how many different kinds of banks are there.

WHAT IS A COMMERCIAL BANK?

A bank is an institution which deals with money. A bank can be defined as an institution, whose business is handling other people's money1. According to some experts, the term bank originates from the Indian word banco which means accumulation of money. The earlier bankers were goldsmiths. As the goldsmiths dealt in precious metals like gold and silver, they had to make arrangements for the safety of their treasure. People in the villages used to undertake long journeys which in the absence of adequate transport system might take months. These people wanted to keep their valuable belongings with somebody who would look after them carefully. They turned to the village goldsmith for this purpose. The goldsmiths would issue receipts for the gold or gold ornaments that were received from these “depositors”. Everybody believed in the honesty of the goldsmiths and those very receipts issued by the goldsmiths began to pass from hand to hand for making payments (very few people used to convert these receipts into gold). Business transactions were smooth with the help of these receipts. These receipts were the earliest bank notes.

When goldsmiths found by experience that very few people used to convert receipts into gold, they started issuing receipts several times more than the amount of gold deposited with them. Formerly, the depositors used to give some commission to the goldsmiths for the safety of their previous belongings. Afterwards, when the goldsmiths realized that only a small proportion of the deposits were withdrawn by the depositors, they began to make profit by lending a part of these deposits. They used to charge some interest for such loans. In course of time, the goldsmiths were convinced that this lending business was very profitable. So in order to attract more deposits from the people, the goldsmiths themselves began to pay interest to the depositors. It was in this way that the goldsmiths became the forerunners of the modern commercial banking system. The term bank originally referred to an individual or an organization which exchanged one currency for another. There is reference in the New Testament to the activities of money changers in the temples of Jerusalem during Jesus Christ's lifetime. Today, banks are those institutions which receive funds from the public and give loans to those people in the community who are in need of them.

Banks can profit in such transactions. The main objective of any bank is to secure profit. Other considerations are secondary. The most important bank is a commercial bank. The modern commercial bank is a joint-stock company.

The origin of commercial banks in its modern sense can be found in the necessities created by the industrial revolution and changing requirements of the economic development. The industrial revolution separated the class of investors from the class of savers. Some agency was, therefore, required to bring these two parties together. Modern commercial bank came into existence for this purpose.

The present day banking business implies deals with its own debts of and that of other people. It takes the debt of other people and offers its own debt in exchange. The distinctive function of bankers, says Ricardo, “begins as soon as they use money of others.”2 The commercial bank is also considered as a dealer in money, in claims to money. When a bank accepts deposits, it gets claims over the depositor's money against a future claim on itself; and when it lends, it gets future claim on money against the immediate claim on itself. The commercial bank, thus, may be defined as “an institution whose debts (bank deposits) are widely accepted in settlement of other people's debt to each other”.

FUNCTIONS

Broadly speaking, a commercial bank performs the following transactions:

  1. It receives deposits.
  2. It advances loans.
  3. It discounts the bills of exchange.
  4. It maintains safe-deposit vaults.
  5. It transfers funds.
  6. It performs miscellaneous functions.

 We examine each of these functions in detail in this section.

  1. Banks receive deposits: Banks mainly depend on the money deposited by the public for their working funds. There are two ways in which deposits are realized: (i) People come to the banks to deposit their own savings in legal tender money with the bank, which is considered as “primary deposit.” (ii) Banks give loans, which they credit to the account of the borrower, which is considered as “credit” or “derivative deposit.”

    A deposit is a liability of the bank and it is of three kinds:

    1. Current or demand deposits: These deposits can be withdrawn at any time. There are no restrictions of any sort on the withdrawals. On such deposits, the bank does not pay any interest. Usually, big merchants and institutions can keep such deposits in the bank.
    2. Savings deposits: Such deposits encourage a thrift among the people. Normally, there are certain restrictions on the withdrawals. For instance, saving deposits can be withdrawn once or twice a week or not more than five times a month and so on. Nobody can withdraw more than a stipulated amount per week and so on. Banks pay a certain nominal interest; for example, 3.5 per cent on such deposits in most of the developing economies.
    3. Fixed or time deposits: Depositors keep these deposits for a certain fixed period. Generally, they can be withdrawn only after the expiry of that period. If the depositors want to withdraw them earlier they have to give due notice to the banks. The period varies from 15 days to 5 years. The longer the period, the higher the interest the bank pays to the depositors. An important function of the bank is to attract the savings of the public by means of deposits. The public would have to keep their savings idle if there were no banks in the economy. Banks mobilize these savings and make a productive use of them by lending them to businessmen, industrialists, farmers and so on. Depositors too get certain advantages by keeping the money in the banks. Their money is safe. It gives them certain interest and the use of cheques for small or large payments becomes extremely convenient to them.
  2. Banks advance loans: The bank knows by experience that all depositors do not come at the same time to withdraw all their deposits. However, a certain number of people will always come everyday to withdraw a part of their deposits from the bank. The number of such depositors and the amount that they are likely to withdraw varies from season to season; for example, at times—such as the reopening of schools, Diwali, Christmas and so on—people withdraw more cash than at other times. The banks keep certain cash ready for these people. The banks know by experience the amount of cash needed for this purpose. They can utilize the remaining amount for advancing the loans to persons who need them for their business. The banks not only lend funds from the money that was actually deposited with them by their clients. By creating credit money, they make advances considerably in excess of the sums deposited with them. One can say that the credit creation is a fundamental characteristic of a bank. It distinguishes banks from other financial institutions. While advancing loans, the banks will always see that the borrower needs the amount for a sound purpose. It also insists on the collateral, that is, some tangible security against the loan from the borrower. If the borrower is a client of the bank and the latter has confidence in his repaying capacity, the bank then sanctions the loan on personal security also without asking from him any tangible asset as a collateral.

    A bank advances loans in any of the following ways: (i) Overdraft facility: Interest is charged only if the use of this facility is made and that also only on the amount overdrawn; (ii) Cash credit: In this case, interest is charged on the entire amount of credit, regardless of the amount used; and (iii) Direct loans: They are generally given against collateral securities.

    This is the second major function of the bank. One can imagine a situation in which no bank exists. Then in that case, those who have surplus savings and those who need money for business and production will never come together at all. The savings would remain idle and the business and production would suffer immensely due to the dearth of finance. The bank acts as the intermediary between the savers and the investors. The banks borrow to lend.

  3. Banks discount the bills of exchange: Discounting of the bills is, in fact, lending for short periods. These bills are usually for 90 days and when they mature, the bank collects the money from the drawee of the bill. In this transaction, the bank gets a certain commission. A prudent banker always makes it a point to invest a large amount of funds in discounting the bills of exchange. Every day a certain number of bills go on maturing and simultaneously, the bank too goes on discounting fresh bills of exchange. It facilitates trade and commerce in the country while the commercial bank earns a regular profit.
  4. Banks provide safe-deposit vaults: A commercial bank makes provision for safe-deposit vaults or lockers for its customers. The lockers are used by the customers to keep their valuable articles, for example, ornaments, important documents and so on in safe custody. The lockers are very safe because one key is with the bank and the other with the customer; and unless both the keys are used, the locker cannot be opened. The bank charges a small rent for these lockers.
  5. Banks make the transfer of funds possible: A commercial bank provides facilities for the transfer of funds from one part of the country to another or from one country to another. Any amount of money can be transferred cheaply and quickly. The transfer is made either by cheques or through a bank draft or through “mail transfers.” That is, if a customer requests the bank to transfer his/her money to another person in another town, the bank does so by means of a letter to its branch in that town. Sometimes, a mere letter by a customer to the bank to transfer the amount into the account of someone else is sufficient. Nowadays, people who travel to different places, instead of taking a large amount of cash with them prefer to take “travelers cheques,” which are issued by banks.
  6. Banks perform other miscellaneous functions: Apart from the above functions, a commercial bank acts as an agent for its customers in making the payments to the government or to others; for example, a customer may ask his bank to pay his insurance premium regularly. It may perform a host of other functions on behalf of its customers—such as, issuing letters of credit and travellers' cheques, executing the wills of the deceased clients, acting as trustees and so on.

Thus, the commercial bank is an extremely useful institution. It has come to occupy an important place in the industrial and commercial life of a nation.

IMPORTANCE

Commercial banks play a very significant role in the economy of a country. But for the commercial banks, the modern industrial economy would not have grown to this extent. The commercial banks make the following important contributions to a country's economy:

  1. Banks are necessary for the growth of trade and industry. Almost all transactions in the sphere of trade and commerce are credit transactions in which banks provide the necessary backing. By offering discount facilities for bills of exchange, banks facilitate internal as well as international trade.
  2. The total volume of money in any economy consists of coins, currency notes and bank money. Coins and currency notes form only a small proportion of the total money supply and it is the bank deposits that really constitute the most important source of money. The credit-creating and credit-curtailing capacity of the commercial banks helps to have elasticity and flexibility in the credit structure and the monetary system of the country. Bank money has made a spectacular contribution to the economic progress of nations in the last 200 years or so.
  3. By advancing loans to industrialists, traders and farmers, banks participate in a big way in the industrialization of the country. Banks encourage entrepreneurship, by helping the established manufacturers to increase their production capacity by adopting new methods and introducing better machinery. In this way, banks help the economy to speed up production and raise the national income. Production in anticipation of demand would have been rather difficult without the help of banks.
  4. Commercial banks encourage savings and accumulation of wealth by the public. By mobilizing the idle and dormant capital of the community, banks direct it to productive channels.
  5. In developing countries like India, the importance of banks cannot be exaggerated. One of the reasons for low-capital formation in these countries is that their banking facilities are quite inadequate. The rural savings, therefore, remain immobilized. The extension of bank facilities will result in the productive use of the idle savings of the well-to-do villagers.

Modern banks hold the strings of community's purse and act as directors in determining the paths along which businessmen and industrialists should walk.

INVESTMENT POLICIES

A casual glance over the balance sheet of a commercial bank tells us its financial position and the working conditions. Generally, a balance sheet “depicts assets owned or controlled by the company on a given date together with the liabilities and owners' equities in the company at that date.”3 A balance sheet of a commercial bank is a statement of its liabilities and assets at a particular time. It shows the main heads under which the bank has acquired assets and has created liabilities.

A study of the balance sheet of a bank gives us an idea about the way in which it utilizes the funds entrusted by its depositor to it. It shows how the bank is safeguarding the interests of its share holders, depositors and of the community as a whole. One can, from the analysis of the investment pattern of the bank, know how the bank is meeting its responsibilities towards its shareholders and its responsibilities towards its clientele, that is, the depositors. The solvency, liquidity and profitability can be found out from the analysis of its balance sheet.

The balance sheet of a commercial bank is usually issued in the form shown in the Table 42.1 at the end of a financial year.

 

Table 42.1 Details of the Balance Sheet of a Commercial Bank

Liabilities Assets
1. Share Capital:
         Paid-up Capital
Cash in hand and balance with the central bank.
2. Reserve Fund Money at call and short notice.
3. Deposits:
         Demand Deposits
         Time Deposits
Bill-discounted investments.
4. Borrowings from Other Banks Loans and Advances-Premises, Furniture and Other Property.

Liabilities

Liabilities show the capital structure of the bank. Every bank gets its funds in three ways: share capital, reserve fund and deposits kept by the general public.

Share capital is collected from the shareholders of the bank. Every year, a bank may plough back a certain portion of its profits. These undistributed profits accumulated over years constitute the reserve fund. These two are long-term liabilities of the bank. The proportion of the paid-up capital and reserve fund in the total liabilities is a measure of the degree of protection a bank affords to its depositors. It also shows the ability of a bank to attract good volume of deposits.

A bank gets a big volume of deposits—demand and time—from the public which forms the biggest proportion of its working funds. The initiative in creating the deposit primarily lies with the public. How far a bank is in a position to make an effective utilization of these deposits to acquire the income-yielding assets generally depends upon the proportion of the time deposits in the total.

Borrowing from the other banks is a temporary liability. Though the different items discussed above constitute the liabilities of the bank as they are to be returned to their owners, they are also its assets, because by making use of these funds, the bank will secure profits.

Assets

Assets are claims which a bank has against someone else. A bank acquires the assets by creating liabilities against itself. Before discussing the different principles and considerations a bank follows in acquiring these assets, let us analyse them in the order in which the bank arranges these assets. The bank arranges these assets in the descending order of liquidity and in the ascending order of profitability. The most liquid but less profitable assets are put first in the order followed by less liquid and illiquid but most profitable assets.

The asset portfolio of the bank is as follows:

  1. Cash in hand and balances with the central bank: This is the first item in the “assets”. It is 100 per cent liquid and, as such it does not yield any profits to the bank. However a bank has to keep adequate cash for its own safety and security. The bank must be ready with adequate cash to honour every cheque presented and every demand made by its depositors.

    The actual amount of cash a bank will be holding depends upon the bank's experience. Usually, a bank holds a very small amount of cash, generally 9 per cent to 11 per cent of the total deposits. However, if needs of its depositors are more, the banking habits are less prevalent among the people, that is, if the people prefer to do their business in cash, if there is lack of well-developed clearing house and if the business conditions are prospering, then a bank will have to hold a fairly large amount of cash in hand.

  2. Money at call and short notice: These are the advances made for a period of 0 to 7 days generally to discount houses and bill brokers. The interest charge on these advances is nominal, and these advances can be called back at any time. In that sense, they are important from the point of meeting a heavy pressure on the bank for cash that is mainly arising out of seasonal changes in the needs of the borrowers and depositors. A bank holds about 18 per cent of the total assets in this form.

    These assets are generally considered as a secondary reserve as against the primary reserve which consists of cash.

  3. Bill-discounted investments: This is the most attractive way of investment for the banks. They are considered as ideal bank assets as they fulfil both the conditions of liquidity as well as profitability.

    These bills are self-liquidating and profitable in nature. They have a high marketability and can be rediscounted with the central bank when the need arises.

    The period of the bill is 01–90 days. A bank, generally, arranges these bills in such a way that a good portion of these bills will mature when the bank expects larger withdrawals of cash. A bank also adjusts these bills in such a way that some of them mature everyday and that repayment is succeeded by a renewal.

    These assets along with money at call and short notices constitute the second line of defence to a commercial bank. Thus, these first three types of assets constitute the liquidity ratio as they are the measure of a bank's liquidity position.

  4. Investments: Commercial banks mainly prefer the investment in a short-dated government and gilt-edged securities, for they are marketable and safe. The speculative type of investment, that is, investment in long-dated securities are generally avoided, and to a limited extent, the investment is made in bonds, shares and the like, provided they are giving a fixed interest. Commercial banks arrange this investment pattern in such a way that every month some securities become mature; funds, thus, collected are invested again in the securities. Nearly 9 to 10 per cent of the total assets are collected in this form. This asset is called the third line of defence.
  5. Loans and advances: This is the most profitable but less liquid, unmarketable and risky asset. It is a bad form of asset from the point of view of liquidity and safety. But since the yield in this asset is high, it, to a certain extent, compensates the risk and other problems associated with it.

Commercial banks generally prefer short-term loans of 1–3 years and see that the advances and loans are diversified. Nearly 50 per cent of the total assets are collected in this form. The remaining assets consist of what is called “frozen and fixed assets,” the liquidity of which is as good as zero. It does not yield, in that sense, any profit to the bank.

Now let us turn to the different principles, which a commercial bank follows in collecting its assets, as the soundness of the bank in the distribution of funds, depends on the different types of assets.

The main principles which a bank has to give all considerations in acquiring the assets are three: (i) liquidity which refers to the capacity of the bank to give cash on demand in exchange of deposits; (ii) profitability; and.(iii) safety. In framing its investment policy, a bank has to maintain sufficient resources in the liquid form (i.e, cash) to meet the requirements of the depositors and at the same time, invest as large a part of the funds possible in the forms of loans and advances. From the point of view of the requirements of liquidity, profitability and safety, it has to diversify its investment portfolio by spreading it out over a variety of different periods of maturity.

It must be remembered that consideration of liquidity and profitability are in a sense contradictory. If the bank keeps a large proportion of cash to provide for liquidity, it will sacrifice the profit—the ability to a certain extent as, it is easy to understand that, cash is a barren asset and it does not bring any income for the bank. At the same time, if the bank uses all its funds in giving loans and advances with a view to getting maximum profits, it will not be able to meet the depositors' demand for cash at all times and in full. As a result, people will lose confidence in the bank which might lead to the failure of the bank. A prudent banker knows how to strike a nice balance between these two contradictory motives. It is, in a sense, a tight-rope walking. Sound banking consists in reconciling these two conflicting considerations and distribute the funds in such a way that both these considerations would be complied with. By maintaining adequate cash balances, a good banker makes such loans and investments which are safe and promise attractive earnings.

The banks in this respect adhere to the following general rules: (a) cash reserve (cash ratio); (b) liquidity ratio, which implies a self- liquidating shiftability nature of asset; and (c) safety. Let us now analyse them to see how a bank resolves to compromise between two opposing desires—a desire to play safe and a desire to make good profit.

Cash Reserve (Cash Ratio)

While the working capital of commercial banks mainly consists of many deposits of people which can be withdrawn at any time without any notice, whereas the loans and advances of the commercial bank are for a particular period only and the commercial bank legally and orally cannot call this back before the completion of the period, if the borrower is following all the conditions. Naturally, if the commercial bank from the point of view of earning profit invests such funds entirely for long periods or keep them blocked, it will be unable to meet the demands of its depositors for cash in exchange of their deposits, with the result that a bank will go into liquidation.

But a bank's experience is that all its depositors do not withdraw all their deposits in cash at the same time; some withdraw their money completely, some in parts, and at the same time, some come with their money to convert it into deposits. The depositors' main objective in depositing money in the bank is to keep it safe and if possible earn something on it, which a bank promises to do for him. And when the depositor is satisfied that a bank can meet his claim on demand, he does not make any attempt to withdraw his money.

The bank, therefore, to strengthen and retain the confidence of depositors, must maintain sufficient cash in hand to produce cash on demand in exchange of deposits. Now this amount of cash must not be too small, as otherwise, the confidence of the public will be shaken; and it should also not be too large, as otherwise, the profitability will be affected, as cash is a barren asset and it brings no profit. The cash reserve or cash ratio is considered as first line of defence in case of “run” on the bank.

Liquidity Ratio

It may so happen that for some reasons the depositors may become panicky and they may withdraw cash more than the average. Again, a bank by experience knows the time of heaviest demand for cash. Some arrangements must be made to conserve the cash so that the bank is in a position to meet this kind of situation. The bank by maintaining a proper liquidity ratio, meets this extra demand of its depositors. This is known as second line of defence.

The bank maintains this liquidity ratio by collecting the assets which are self-liquidating in character and shiftable or marketable in nature. It arranges its business in such a way that a certain amount of cash will flow and go out at regular intervals. The bank, therefore, should first, if possible, make an advance for short duration, say from 0 to 7 days and so on. Now these types of loans are not profitable but they are essential for satisfying the principle of liquidity and safety.

Secondly, the bank should acquire the assets which are self-liquidating in character and shiftable or marketable in nature. In case of self-liquidating types of assets, the bank realizes their full value in cash immediately after the completion of the period of maturity. Shiftability means that the assets can be transferred or resold in the market if necessary without any loss in time and value. The extent of bank's liquidity generally depends on its capacity to transfer the assets to the central bank of the country.

The non-cash assets which can be easily converted into cash are money at call, short notice, loans and bills discounted. They constitute more or less a ready source of funds from which a commercial bank can meet large and unexpected withdrawals of cash by depositors.

Safety

The commercial bank generally refrains from risky, long-term types of investments. From the point of security, it is necessary to maintain a judicious mixture of different types of assets for diversifying risk. To attain this, the bank should not go for long-term loans and should not advance a large fund to a single enterprise or industry.

Any investment in government securities of long-term types must be prudently done as the market value of these securities depends on the interest rate and the other policies of the central bank. A commercial bank should also not acquire mortgages as they are frozen assets involving a great risk of loss.

Thus, the commercial bank which is in pursuit of two conflicting goals, that is, of profit and safety must seek a proper balance between these two. This the bank does by following the above principle and arranging the different assets in the descending order of their liquidity and in the ascending order of their profitability. It should acquire the assets, of short period, interest yielding and of high marketability. But all the assets are not of this type. The assets like cash have a cent-per cent liquidity but its profitability is zero. Assets of short duration have a high liquidity but very low capacity to yield income. Although the investment in shares has a high profitability, they are risky and less liquid; and therefore, that bank has to achieve some compromise, by collecting different types of assets of different liquidity periods. The compromise, thus, achieved determines the relative size of earning assets as opposed to highly liquid assets. It is because of this it is said that a constant tug of war between competing aims of liquidity and profitability summarizes the function of a commercial bank.

The way in which a commercial bank distributes its assets and satisfies the principles of sound banking is summarized in the Table 42.2.

 

Table 42.2 Distribution of Assets at a Glance

COMMERCIAL BANKING: A PROCESS OF CREDIT CREATION

The main functions of the banks can be summed up in one sentence: The banks borrow to lend. The distinctive function of a banker, says Ricardo, “begins as soon as he uses money of others.” A bank is a dealer in money that belongs to others, that is, its depositors. Apart from these two main functions, the banks perform a wide variety of useful functions, not only for their clients but also for the community at large. Their functions are as follows: (a) they help in the transfer of funds from one place to another and from one person to another; (b) they provide facilities for the safe custody of ornaments and valuable documents; (c) they act as agents, trustees and bailees of their customers, purchasing and selling stocks and shares on their behalf; and (d) making sundry payments on behalf of their customers—paying rent, insurance premium, electricity bills and the like.

A casual glance over the balance sheet of a commercial bank tells us its financial position. A balance sheet of a commercial bank is a statement of its liabilities and assets at a particular time. The column on the left-hand side gives the liabilities of the bank and on the right its assets. The liabilities of the bank are the items which are to be paid by the bank either to its shareholders or to the depositors. The assets of the bank are those items from which it hopes to get an income; the assets include all the amounts owed by others to the bank. The balance sheet of a commercial bank, which is usually issued at the end of the financial year, is given in the form as shown in Table 42.3.

 

Table 42.3 The Details of a Balance Sheet of a Commercial Bank

Liabilities Assets
Paid-up Capital Cash in hand and with the central bank
Reserve Fund Money at call and short notice
Deposits Bills, discounted investments
Borrowings from Other Banks Loans and advances, premises, furniture and other property

 

Look at the left hand side. Every bank gets its funds in three ways: (a) share capital; (b) reserve fund; and (c) deposits kept by the general public. Share capital is collected from the shareholders of the bank. Every year, a bank may plough back a certain portion of its profits. These undistributed profits accumulated over years constitute the reserve fund. A bank gets a big volume of deposits— current, savings and fixed—from the public which form the biggest proportion of its working funds. These funds are called “liabilities” because they are to be returned to their owners. The first item in the assets does not yield any profits to the bank. However, the bank will have to keep adequate cash for its own safety and security. Some depositors might withdraw a part of their deposits and they may demand hard cash. The bank must be always ready with adequate cash to honour every cheque presented. The last item constitutes the fixed capital assets of a bank. It does not yield any regular profit to the bank; it is merely a property owned by a bank. The remaining four items enable the bank to get certain interest-yielding assets. They will help the bank to earn profits. The funds which constitute the liabilities of the bank are also its assets because, by making use of these funds, the bank will secure profits. The soundness of a bank will be clearly reflected in the distribution of the funds on different types of assets. In framing the investment policy, a bank has to maintain sufficient resources in liquid form (i.e., cash) to meet the requirements of the depositors, while at the same time, investing as large a part of the funds as possible in the form of loans and advances. From the point of view of the requirements of liquidity, profitability and safety, it has to diversify its investment portfolio by spreading it out over a variety of different securities with different periods of maturity.

CREDIT CREATION

The banks function on the presumption that depositors will not simultaneously withdraw their total deposits. Some depositors may withdraw a part of their deposits and in order to meet their demand, banks always keep certain cash reserves with them. As long as each depositor is sure that whenever he approaches his bank, he may get back any amount of money out of his deposit, he is not worried. He withdraws cash only when he needs it badly. Now, this non- withdrawal of deposits enables the bank to erect a vast superstructure of credit on the basis of a small cash reserve. Creation of credit is one of the most important functions of a modern bank. A bank is aptly called a “factory” for the manufacture of credit.

Let us take an interesting example to clarify the basis of credit creation. Suppose that there is a ball-dance programme in a hall between 9.00 p.m. and 1.00 a.m. The programme is attended by 50 couples and all of them come with the overcoats which are of the same size and of the same colour. Those hundred persons deposit their overcoats outside the hall with a watchman who is expected to return them at the end of the programme. Now there is another ball in the nearby hall which starts at 10.00 p.m. and gets over at 12.00 midnight. Let us suppose that couples attending this dance programme also are expected to wear the overcoats. Even if these couples do not possess overcoats, they can meet the watchman of the first hall and borrow them. Our watchman is very shrewd. He knows that by lending the overcoats on rent from 10.00 p.m. to 12.00 midnight, he can get money. At 1.00 a.m. he can keep all overcoats ready. However, he knows by experience that some of the couples (perhaps old) may come out of the hall even earlier and he must be prepared to give back the overcoats to those people. So, by keeping (say) 20 overcoats with him, he may give the remaining 80 overcoats on hire. Thus, in this transaction, he earns income; the need of those people who do not have their own overcoats is fulfilled. Moreover, this bargain does not affect the couples attending the ball in the first hall. A watchman, in this example, performs the function of a banker and the borrowers of overcoats are comparable with the borrowers of money from a bank.

In the above analogy, we saw that the watchman can lend only 80 overcoats by keeping 20 overcoats as reserves. The bank does something more than this. Suppose that a bank possesses INR 1000 million which it can use as the assets. It keeps, for instance, INR 200 million as cash reserve with it and with the central bank. It is not content with advancing loans worth INR 800 million alone but much larger amounts. For instance, it will be able to lend INR 5000 million. How does a bank do it? It creates credit for that purpose. We will examine the process of credit creation in detail as follows.

The banking system of a country plays a vital role in the economic development of that country by financing the trade and industry. This, however, it does by creating credit. It is interesting to understand the nature of process through which the banking system creates credit.

Suppose a customer deposits INR 1,000 in a bank. The bank has to pay him interest and earn profits for itself too. Naturally, the bank must seek a safe and profitable investment for this amount. The bank, first of all, will have to keep certain cash reserves to pay to those of the depositors who need cash and draw cheques for the purpose. Let us assume that this bank keeps 20 per cent cash reserve to meet the demand of the depositors. In that case, it can advance loans up to INR 5,000, which is five times the original amount of the deposit. How does the bank do it? It is here that the credit comes in. The borrower does not have the loan in cash; only an account is opened in his name and the amount is credited to that account. A fresh deposit is created by the bank. The borrower gets a cheque book; he gets the right to draw cheques as and when he needs money. This borrower may draw cheques on this bank to pay his creditors. Let us assume that these creditors are the account holders of the same bank. In that case, they will credit the cheques to their own account and merely by transferring the amount from the borrower's account to their own accounts, the bank can honour those cheques. Even if those creditors have their accounts in other banks, it makes no difference. The banks adjust their mutual obligations through a system of clearing house. (We shall explain the method of clearing the cheques while examining the function of a central bank.) In most of the business transactions, cash is seldom withdrawn.

We may visualize a situation in which an account holder of a bank is in need of a loan of INR 5,000. In this case, the bank gives him the overdraft facilities, that is, the bank allows the account holder to overdraw his current account. Suppose this account holder has only INR 5,000 in his current account and he requires INR 10,000 to meet his obligation. He requires the additional INR 5,000 as a loan. The bank asks the borrower to issue cheques up to INR 10,000; in other words, he is allowed to overdraw his account by INR 5,000. His cheques will be honoured by the bank up to the amount of the loan sanctioned. Thus, in both the above examples, the bank has succeeded in creating a credit of INR 5,000 against a cash reserve of INR 10,000.

The process of credit creation involves three parties— (i) the banking system or the banks; (ii) the public consisting of depositors; and (iii) the borrowers or the business community. In fact, it is the business community which determines the actual volume of credit which the banking system would create. The first two parties determine the maximum amount of credit that could be created by the banking system. It is not always necessary that the actual amount of credit created by the banking system on the basis of demand for credit would be equal to the maximum amount of credit which could be created by the system.

We have seen above that every time a bank makes a loan it creates a fresh deposit. The more loans it makes, the more deposits it will create. An increase in the bank credit loans, causes an expansion or multiplication of the bank deposits. The banks, on the basis of the amount of cash deposits kept by their depositors and the proportion of cash reserves they want to keep, decide about the total volume of deposits. They do so by acquiring assets. These bank assets, described in the balance sheet, may be put under five groups:

  1. Cash in hand and with the central bank
  2. Money at call and short notice
  3. Bill-discounted investments
  4. Advances

The first asset is the barren asset. All other assets bring in income to the bank, which are called “earning assets”. Whenever a bank secures these assets, it creates fresh deposits. These deposits create the volume of credit money in the country.

Normally, money at call and short notice are extremely short- period loans made to speculators and brokers in the money market and the share market. Either the fresh accounts are opened or the overdraft facilities are given to them. In both the cases, a bank creates deposits. A bank acquires the bills of exchange (which mature after 90 days) from a businessman. When a bank discounts a bill of exchange from the businessman, it pays the party by asking him to open the account or by crediting his account by that amount (assuming that a businessman is the account holder of that bank). In both cases, the bank deposits will go up. Investments are made by a bank when it purchases and holds government bonds and other long-term securities. While making payment to the sellers of these securities, a bank creates deposits as described above. Finally, a bank advances loans to industrialists, traders and others, it enables a bank to create new deposits. Thus, every time a bank acquires an earning asset, it creates a deposit in the name of the person or institution from whom the asset is purchased. When a bank creates deposits while discounting bills or making advances, it gives a promise to make payment to the borrowers to that extent. A bank becomes a debtor while a borrower is a creditor. The latter has a right to receive payment from the bank. He gives a promise to the bank to pay the loan within a day or two or may be a promise to pay within three months or even three years. The bank's promise in the form of a deposit constitutes money while the promises given by the borrowers are not money. Expansion of deposits, therefore, means expansion in the volume of money. The banking system has the power to expand such deposits, through the process of advances, investment and the like. This power is known as “credit creation.”

TECHNIQUE

Let us analyse the technique of credit creation in a simplified manner. We will assume that there are a number of banks and every bank has to keep a 10 per cent of cash reserves. Suppose that Shri Sharma keeps a cash deposit of INR 1,000 with the Central Bank of India. Now the position of the Central Bank of India will be as follows:

 

Central Bank of India

 

The fresh cash deposit is a liability as well as an asset to Central Bank of India. The amount belongs to the depositor and the bank will have to return it whenever he demands it. Now, it is an asset for the bank because the latter is going to earn an income out of it. We assume that the bank keeps a 10 per cent of cash reserves against the deposits. In that case, it will keep INR 100 in cash and make use of INR 900 to earn profit. Suppose Varma approaches the Central Bank of India and borrows INR 900 to buy raw materials for his firm from one Patel.

The balance sheet of the Central Bank will be as follows:

 

Central Bank of India

 

Patel, who gets INR 900 from Varma, is an account holder of the Dena Bank. He goes to his bank and deposits the amount in his account. The balance sheet of Dena Bank will be as follows:

 

Dena Bank

 

Dena Bank will have to keep INR 90 as cash reserves. Suppose it purchases a bill of exchange worth INR 810 from a broker in the bill market. Then Dena Bank pays him the amount. Now the position will be thus:

 

Dena Bank

 

The broker takes the cash and deposits it in his own bank, that is, Bank of India, which purchases the securities from D'Souza after keeping INR 81 as cash reserves. The balance sheet of Bank of India will be as follows:

 

Bank of India

 

D'Souza is an account holder of the Punjab National Bank and he credits the amount of INR 729 to his account. The Punjab National Bank, after retaining 10 per cent of cash reserves, lends the remaining amount to some needy person. This process goes on and on till the original cash deposit of INR 1,000 is completely exhausted. This amount enables the entire banking system to create INR 10,000 worth credit (INR 1,000 + INR 900 + INR 810 + INR 729 + INR 656.10 + etc. = INR 10,000). The total amount of deposit expansion (or creation of credit) will be the reverse of the cash- reserve ratio. In the above example, the cash-reserve ratio is 10 per cent, that is, 1/10. Therefore, the credit creation will be 10 times the original deposit; if the cash-reserve ratio is 20 per cent, then the credit creation will be five times (the reverse of 1/5); in case the cash reserve is 25 per cent, then the credit creation will be four times and so on.

The process of credit creation will be the same even if we assume that there is only one bank in an isolated town. Whenever the bank has excess cash reserves, it will lend or invest the same. What is lent out by a bank may come back to the bank by way of new deposits which may again be lent out. Deposits become the basis for loan or investment which again comes back to the bank as fresh deposit, and this fresh deposit, in turn, enables the bank to advance a new loan. This process continues till the original cash deposit is exhausted. Thus, credit creation takes place whether we consider many banking institutions or we consider only one bank in a town.

It is easy to understand how credit contraction takes place. As a new cash deposit of INR 1,000 (with a cash-reserve ratio of 10 per cent) enables the banking system to expand a credit of up to INR 10,000, the withdrawal of cash worth INR 1,000 will, ultimately, contract the credit by INR 10,000. In short, just as there is multiple expansion of credit, there is multiple contraction of bank credit too, when cash is removed from the banking system.

Limitations

From the account of the credit creation given above, it is clear that the banks reap where they have not sown. They advance loans or buy securities without actually paying any cash. The banks make profit on the basis of credit creation. However, it must be remembered that the banks cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake. They do actually apply the brake because they know by experience that it is dangerous to attempt credit expansion beyond a certain limit. The overriding limitations arise out of their obligations to meet the demand of their depositors.

Benham has pointed out three main limitations on the powers of the banks to create credit:

  1. The total amount of cash in the country.
  2. The amount of cash which the public wishes to hold.
  3. The minimum percentage of cash to deposits which the banks consider safe.

In addition to these, there are certain other limitations on the powers of the banks to create credit. We shall explain these limitations in detail as follows:

  1. Amount of cash: As we have seen, credit can be created on the basis of cash. As Crowther puts it, “The bank's cash is the lever with which the whole gigantic system is manipulated.” The larger the cash (i.e., legal tender money), the larger the amount of credit that can be created. But the amount of cash that a bank may have is subject to the control of the central bank. We shall study the functions of a central bank in the next chapter. It may suffice to note at this stage that the central bank has the monopoly of issue of cash. It may increase it or decrease it and the credit will expand or contract accordingly.
  2. Public's desire to hold cash: The second limitation arises from the habits of people regarding the use of cash. In India, people usually use cash and not cheques for their transactions. Whenever a bank sanctions a loan to a borrower, the latter insists on getting cash. This results in the depletion of cash reserves with the bank whose power to create credit correspondingly gets reduced. In advanced countries like the United States, the United Kingdom and other European countries, people make use of cash only sparingly as most of their transactions are on the basis of credit. As a result, the cash reserve is not much drawn upon and their power of creating credit remains unimpaired.
  3. Ratio of reserve to deposits: This limitation arises from the reserve ratio of cash to liabilities, which the banks must maintain to ensure their safety and to retain the degree of liquidity that is considered desirable. The bank goes on advancing loans or investing their assets till the minimum limit or reserve ratio is reached. This limit has been set up by the central bank. Many times, the actual limit is over and above the statutory limit, depending upon the experience of banks. Once that limit is reached, the power of the bank to create further credit comes to an end. We have shown that credit creation will be the reverse of the cash-reserve ratio. The higher the percentage of cash-reserve ratio to be kept, the smaller will be the volume of credit creation.
  4. Nature of business conditions: Credit creation requires three agencies: banks, depositors and borrowers. The initiative is in the hands of the borrowers. If the bank is willing to advance loans but the borrowers are not willing to borrow, then the credit creation will suffer to that extent. In prosperity, the business transactions are brisk and the borrowers are eager to borrow from the banks. The overall optimism in the business world and the possibility of the higher percentage of returns make the banks to lend freely during the periods of prosperity. During depression, however, banks have a big volume of idle-cash reserves with them, but businessmen do not come forward to borrow. To use Crowther's famous analogy, “there is plenty of water but the horse is not thirsty and so, he is unwilling to drink it.” In normal times, we can expect the banks to lend and invest up to the maximum extent permitted by their cash-reserve ratio.
  5. Leakages in credit creation: We have explained the process of credit creation assuming that everything goes on smoothly. In fact, the actual expansion of credit may be much less than the maximum-potential credit expansion. In other words, assuming that the bank secures a new cash deposit of INR 1,000 and it has to keep 10 per cent as cash reserve, the credit expansion may be 10 times the original cash deposit, that is, INR 10,000. However, the actual credit creation may be less than INR 10,000. This happens because of the possible leakages in the process of credit creation. Firstly, the banks may not be able to make use of the surplus funds for advances and investments. For instance, if a bank desires to lend INR 900 of a new cash deposit of INR 1,000 (keeping 10 per cent as liquidity ratio), there is no guarantee that the entire amount of INR 900 may be lent out. To the extent that the actual loan falls short of INR 900, the credit creation will be obviously smaller. Secondly, a borrower may borrow INR 900 but they may keep some cash with themselves. In that case, the remaining amount will come back to the banking system as a fresh deposit, which is lower than the amount of loan advanced to him. To that extent, the credit creation will be smaller.
  6. Capital-deposits ratio: In some countries, there is a legal provision that the total amount of deposits should not exceed a specified multiple of the amount of paid-up capital and reserves. In such cases, the credit creation is limited by the capital-deposit ratio as required by law.

In the modern times, bank credit constitutes a large proportion of the total volume of money in a country. Fluctuations in the volume of money supply have a direct effect on the level of the business activity, prices and wages. An expansion of bank credit will lead to a rise in price and profit margins and consequently an increase in the business and economic activity. On the contrary, contraction of bank credit will result in the contraction of business activity. Thus, any policy designed to stabilize the price level should necessarily include measures to bring about the stability in credit expansion and credit contraction.

INDIAN COMMERCIAL BANKS: EVOLUTION

The Indian joint-stock commercial banks are the important constituents of the Indian money market. A joint-stock bank may be defined as “any company which accepts 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. The joint stock banks are classified by the Reserve Bank of India as scheduled banks and non-scheduled banks. Banks with paid-up capital and reserves of over INR 500,000 and which are included in the second schedule of the Reserve Bank of India Act are known as scheduled banks, while banks which do not fall under this category are known as non-scheduled banks.”4

The early modern banking business was started by the British Agency Houses in Calcutta and Bombay. The Bank of Hindoostan was the first ever bank organized on the basis of modern banking methods and was established in 1770. The first fully Indian-owned bank was the Allahabad Bank, established in 1865. However, at the end of the late 18th century, there was hardly any bank in India in the sense we understand banks today. The Indian banking system had gone through a tumultuous period before independence. There were a number of bank failures and the growth of banking was rather slow and tardy during the first half of the 20th century. Between 1913 and 1918, at least 94 banks failed in India, though the economy was fairing well due to the boost in war-related economic activities.

 

 

By the time the country became free, there was a well-developed and closely-knit banking system with 648 banks and 4,819 branch offices. At the time of independence, the Reserve Bank of India (RBI) was at the top of a number of other banking institutions. Among the commercial banks, there was the Imperial Bank of India which enjoyed a unique position. The other commercial banks included scheduled banks, non-scheduled banks and foreign scheduled banks.

During this period, foreign banks came to Indian shores and made their presence, particularly in Calcutta (now Kolkatta)in the 1860s. The Comptoir d'escompte de Paris opened a branch in Calcutta, followed by another in Bombay in 1862 and branches in Madras (now Chennai) and Pondicherry, which was then followed by a French colony. Calcutta, then the most thriving trading port in the country primarily due to the trade of the British Empire, became a centre for banking.

After independence, despite the initial partition-related problems that adversely impacted the economies of Punjab and West Bengal paralyzing the banking activities for months, the Indian banking system recorded a rapid progress due to several favourable factors such as faster economic growth, increased money supply, growing thriftiness, and banking habit and control and guidance provided by the RBI. The nationalization of the Reserve bank in 1949 was followed by the Government of India nationalizing the Imperial Bank of India in 1955, after which it was rechristened as the State Bank of India. In 1959, the State Bank of India (Associate Banks) Act was passed and eight regional banks were nationalized constituting the State Bank Group. By 1969, almost all commercial banks were mostly in the private sector. In a dramatic shift in its policy, the Government of India nationalized on 19 July, 1969, 14 leading commercial banks which were owned by the leading industrial houses of the country. The government resorted to nationalization on the plea that the commercial banking system controlled by the industrial houses did not play its proper and just role in the planned development of the nation. Small industrial units were totally ignored and starved of funds. Likewise, agricultural credit was not given to farmers. There was also an allegation that privately-owned commercial banks used funds that were collected from small and middle-class investors to support anti-social and illegal activities against the interests of the general public. The Government of India subsequently nationalized six more commercial banks in 1980 taking the total of the nationalized banks altogether to 20, apart from the State Bank of India.

After independence, banking in India had gone through the following four distinct phases:

  1. Foundation phase: During this phase between 1950s and 1960s, Indian banking enjoyed a period of legislative support provided by the government with a view to facilitating the consolidation of the banking system in the country, so as to meet the rising demands for capital funds of the growing Indian economy.
  2. Expansion phase: This phase began in mid-1960s and gained momentum after the nationalization of banks in 1969.
  3. Consolidation phase: This phase saw the Indian banking bringing about a number of changes in its structure and working after 1985. During this period, banks were initiating measures to improve the credit management, house keeping, customer service and employee productivity.
  4. Reforms phase: This phase which began in 1991 witnessed significant initiatives in the sphere of banking system such as adoption of Basel-I norms such as new accounting standards and prudential norms relating to income recognition, provisioning and capital adequacy. This phase also assured banks a greater freedom and autonomy in their operations and functioning which is consistent with the liberalized economy.
INDIAN BANKING SINCE NATIONALIZATION

Nationalization of commercial banks as commented earlier has been a watershed in the history of banking in India. In terms of branch expansion and growth in banking activities there has been an unparalleled development during this period. Branch expansion has multiplied almost by 800 per cent in about three-and-a-half decades, out of which around 48 per cent are rural branches. This has substantially improved the mobilization of savings from the rural areas and as a result, the deposits from them constitute about 15 per cent of all the bank deposits. Moreover, during this period, the priority-sector lending that used to be a mere 14 per cent has gone up to 30 per cent of the total bank credit; the development of banking has been faster especially in the relatively-less developed regions, which, in turn, has helped to reduce regional disparities in the banking business.

However, while these developments of branch expansion and growth in priority-sector lending have been helpful in promoting the development of less-developed regions of the country, there has been a negative side to the saga of rapid banking development. The government-directed investment cum credit-delivery programmes along with rising maintenance and administrative expenditures of commercial banks have completely eroded their profitability. “The new income recognition and provisioning norms, and accounting procedures and formats which were announced in April 1992 and adopted in 1992-93 have revealed the true extent of the deterioration in the profitability of the banks. In 1992-93 while State Bank of India and its associates, seven other public-sector banks and private-sector banks as a group declared small profits, the remaining public-sector banks and foreign banks reported losses.”5 The losing streak continued in 1993–94. However, the profitability of banks improved in the subsequent years till 2003–04. During 2004–05, there was a declining trend in the profitability of banks. The financial year 2008–09 witnessed a robust growth in the business of public-sector banks. The overall business of public-sector banks grew by about 26 per cent. Top five banks including the SBI posted an average growth of more than 40 per cent year-to-year during the last financial year that ended on 31 March, 2009.

Although during the post-nationalization phase, commercial banks in India have seen erosion in their profitability, they have been contributing considerably to the economic growth of the country. With regard to the achievements the commercial banks have made after nationalization, there seems to be a difference of opinion among economists. While C. Rangarajan has been positive about the achievements of the banks after nationalization, there are others who have a different view on the matter. According to him, “The Indian banking system is on the threshold of far-reaching changes. It is at the start of the second banking revolution which besides consolidating the gains of the first revolution ushered in 1969, will make the banking institutions viable and efficient… Our financial system today consists of the vast network of banks and financial institutions offering a wide range of products and services. Banking and other financial facilities have, over the last two and a half decades, come to be extended over a large cross section of people. This is the significant achievement of the banking sector.”6 As opposed to this positive view of Rangarajan, Sankar Acharya, another neo-liberal economist, has a different view altogether. He argues that “More than three decades have passed since Indira Gandhi nationalized the banks. With the benefit of hindsight and painful experience, we can safely conclude that the decision was the major error in economic policy with lasting adverse consequences. Indeed this conclusion has been staring us in the face for a long time.”7 Thus, there seems to be divergent opinions with regard to the after-effects of bank nationalization and its impact on the economy. However, middle opinion believes that the measure has contributed significantly to the development of the banking sector. If more positive improvements in the working of banks have to be achieved, there is a need for second-generation reforms in the banking sector.

The Nationalization of Banks in 1969 has been one of the significant economic, political and social events of post-independent India.8 It has several significant impacts that merit attention as follows:

  1. The intervention of the state in the functioning of the banking sector itself. The ownership of the state gave a new confidence to the savers; and being backed by a sovereign, the normal suspicions associated with the capabilities of the bankers in the private sector were gone.
  2. Banking ceased to be selective. The entry barriers that existed for the customers to bank—such as, social economic and political—were lowered. This resulted in a massive quantitative expansion of the bank-customer base as well as in the nature of services provided.
  3. The reach of banking widened. Absence of concern for profitability and targeting made banks to expand rapidly in unbanked areas, thereby linking the entire country to banking activity.
  4. The expansion of banks also expanded the economy. The entire infrastructure that required was built by themselves or by the citizens for their use.
  5. A large employment base was created. Young men and women mostly from middle and poorer sections of society but qualified with the requisites got into the banking system and we see the results today.
  6. Customers got acquainted with the banking practices more rapidly than it would have otherwise been.
  7. The well-intentioned policies channelled through the banks helped the borrower clientele with a generous disposition.
  8. The savings of the community had an efficient channel which otherwise would not have had the benefit of aiding the transactions.
  9. State intervention to some extent distorted the banking sector. The domination of the state had had a negative effect on the contribution of the banking sector as a whole to the economy. Absence of profitability, non-realization of its potential as a business and also the deterioration in service has all affected citizens.
  10. The intervention by the state and excessive domination and intervention by the bureaucracy and polity into the functioning of banks has led to deterioration on economic efficiency, which runs counter to the principles of a good government.
THE CURRENT SITUATION

Presently, banking in India is generally fairly mature in terms of supply, product range and reach, even though reach in rural India still remains a challenge for the private sector and foreign banks. In terms of quality of assets and capital adequacy, Indian banks are considered to have a clean, strong and transparent balance sheets relative to the other banks in comparable economies in its region.9 The RBI is an autonomous body, with minimal pressure from the government. The stated policy of the bank on the Indian rupee is to manage volatility but without any fixed exchange rate—and this has mostly been true.

With the growth in the Indian economy expected to pick up in the near future, especially in its services sector, the demand for banking services, especially retail banking, mortgages and investment services are expected to be quite robust. It is also expected that mergers and acquisitions, takeovers, and asset sales would also considerably increase.

In March 2006, the RBI allowed Warburg Pincus to increase its stake in Kotak Mahindra Bank (a private-sector bank) to 10 per cent. This is the first time an investor has been allowed to hold more than 5 per cent in a private-sector bank since the RBI announced norms in 2005 that any stake exceeding 5 per cent in the private-sector banks would need to be vetted by them.

Currently, India has 88 scheduled commercial banks (SCBs), 28 public-sector banks, 29 private banks and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 automatic teller machines (ATMs). According to a report by ICRA Limited, a rating agency, the public-sector banks hold over 75 per cent of the total assets of the banking industry, with the private and foreign banks holding 18.2 per cent and 6.5 per cent, respectively.10 Table 42.4 lists the key parameters of the Indian banking sector.

 

Table 42.4 Key Parameters of the Indian Banking Sector, 2006–07

 

* Spread is the differential between the interest earned and the interest expended. Here it is taken as the percentage of assets.

+ Capital-adequacy ratio.

# Non-performing assets as a per centage of net advances.

  1. Rapid branch expansion: The Indian banking system has gone through a mammoth branch expansion (see Table 42.5), following nationalization of banks in 1969. In 1969, there were only 8,260 urban and semi-urban branches and 1,860 rural branches which increased to 68,500 and 32,070, respectively by the year 2005. In a matter of 33 years after the nationalization of banks, the growth of banks was over 800 per cent in terms of the number of branches. “The single striking feature of the post-nationalization banking scene is the rapidity with which the branch network has multiplied itself. The rate of branch expansion has been unparalleled any where else in the world.”11
  2. Banks in the public sector: As a result of the nationalization of banks and the tremendous amount of branch expansion, public- sector banks accounted for 79 per cent of the total deposits and 72 per cent of the total advances of all banks in India at the end of March 2003. Some of the public-sector banks have really grown tremendously. The State Bank of India and its allied group have exceeded 13,000 branches and are still growing. Business-wise, “the top five state-owned banks (SBI, Punjab National Bank, Canara Bank, Bank of Baroda and Bank of India ) posted an average growth of more than 40 per cent year- on-year in their net profit.”12 in the year 2008-09. However, none of the smaller banks could rise to such levels. In fact, in the case of some of them, the profit growth has nosedived. The profit of Allahabad Bank declined by 19 per cent in FY 2009 after growing by 30 per cent in FY 2008, while Dena Bank's net profit growth declined to 18 per cent in FY 2009 when compared to 79 per cent a year earlier. A similar trend was also perceptible in the case of other public sector smaller banks such as Bank of Maharashtra, Corporation Bank, Indian Overseas Bank and Karnataka Bank.13
  3. Banks in the private sector: The scope for the growth of private-sector banks was considerably diluted after two instalments of bank nationalization. However, the new economic policy opened new vistas of growth for the private banks. The RBI granted permission to promoters on a selective basis to launch new banks and open branches. Foreign banks too were permitted to open branches in the metropolitan cities. Presently, there are 32 private-sector banks including 10 new ones with 5,620 branches accounting for 12.7 per cent of the equity in the Indian banking industry, 21.5 per cent of the reserves, 17.5 per cent of the deposits, 13.8 per cent of incomes and 15.4 per cent of the total profits earned by the industry.
  4. Deposit mobilization: There has been an appreciable increase in the deposit mobilization of commercial banks in recent years triggered by a planned economic growth, deficit financing and an increase in the issue of currency by the RBI. There has also been a parallel development wherein the banks have been promoting banking habits among people through sustained publicity, extensive branch banking, attractive interest rates, and prompt and modern banking services such as opening of ATMs, anywhere banking and so on. The spurt in deposit mobilization has been substantial after the nationalization of banks. For instance, during a period of 20 years between 1971 and 1991, the deposit mobilization has multiplied 32.6 times, from INR 59.10 billion to INR 1,925.40 billion. However, whatever progress the Indian banking has achieved is only a fraction of what can be achieved, given the fact that there are 500,000 and more villages lacking banking services, and even among the banked areas, there is so much more deposits that can be mobilized.
  5. Expansion of bank credit: Along with the phenomenal growth in the bank deposits, there has been a corresponding increase in bank credit, reflecting the rapid growth in industries, agriculture and trade. For instance, commercial banks extended credit to these three sectors to the tune of INR 47,000 million in 1970-71, which shot up to INR 1,50,70,800 in the financial year 2005-06. In the more recent years, the bank credit has been growing at more than 20 per cent per annum.

 

Table 42.5 Branch Expansion of All Commercial Banks

 

Source: Economic Survey, 2005–06, the data for 2009–10 is based on information from the Reserve Bank of India.

 

The Economic Survey, 2007–08 identifies the following factors for this spurt in the bank credit:

  1. Since the public-sector banks still own approximately 71 per cent of the assets of the banking system, they continue to play a decisive role in responding to the dynamic changes in the economic environment, ably guided by the RBI.
  2. The policy initiatives of the Ministry of Finance and the RBI to make the banking system address the needs for an inclusive growth through measures such as (a) permitting the use of appropriate agencies for credit delivery; (b) augmentation of credit flow to agriculture and other priority sectors; (c) simplification of systems and procedures; (d) judicious use of IT to address the last mile problem; and (e) providing greater operational flexibility to the Regional Rural Banks (RRBs).
  3. Since there is a vast majority of poor people in rural areas having no bank accounts or accounts with low-cash balances, banks and RRBs have been advised to extend to them limited overdraft facilities or “no-frills” accounts without any collateral. Banks have been advised to enhance their outreach either through business correspondents or using the wide network of post offices.
  4. Efforts have also been intensified to expand the credit- delivery mechanism.
  5. All the State Level Bankers' Committee's (SLBC) convener banks were advised on 8 May, 2007 to review their institutional arrangements to deliver credit speedily to the Small and Medium Enterprises (SME) sector.
  6. With a view to ensuring a steady flow of credit to the various segments of Small Scale Industry (SSI), new instructions were given twice in 2007.
  7. The revised priority-sector guidelines for the foreign banks directed that if they had a shortfall in lending the target then they should contribute that amount to the Small Enterprises Development Fund that is to be set up by the SIDBI.
  8. The government had also directed in 2006–07 that farmers be given a short-term credit at 7 per cent interest on loans up to INR 300,000 on the principal amount. The government also gave an interest rate subvention of 2 per cent per annum in 2006–07 and against 2007–08 to public-sector banks and RRBs in respect of the short-term production credit up to INR 300,000 provided to farmers.

Apart from all these measures, the RBI stipulates that both domestic and foreign banks operating in India are required to provide 40 per cent and 32 per cent, respectively, of their adjusted net bank credit to priority sectors such as agriculture and exports. There were numerous other efforts and agencies through which the credit needs of these sectors are met, such as EXIM bank and NABARD.

INDIAN BANKING: CHALLENGES

Indian banking has to meet certain challenges in the current highly competitive scenario, if it has to maintain and speed up its tempo of growth. Some of these challenges include the role of financial instrumentation in different phases of the business cycle, adoption of new technology in the banking operations, skill building and intellectual capital formation in the banking industry, emerging compulsions of the new prudential norms as per Basel-II, and benchmarking and aligning their work culture and functioning against the international standards and best practices.

  1. Financial intermediation: The long-held view that the role of banks in the economy is that of a “catalyst” in mobilizing the resources for growth has undergone a transformation in the current fast-paced dynamic world. They are now expected to play their role in the financial intermediation efficiently. Financial intermediation is the ability of the banks to intermediate between the savers and investors, to set economic prices for capital and allocate resources among the competing demands. In the wake of the current developments in the economy, the intermediation role assumes an even greater relevance. Banks are eminently suitable for this service by virtue of their experience and superior credit assessment expertise of the investment proposals and, thus, can play a significant role in identifying and nurturing the growth impulse in the commodity-and-service-producing sectors in the economy.
  2. Market discipline: Transparency and disclosure norms as part of internationally accepted corporate governance practices are assuming greater importance in the emerging environment. Banks are expected to be more responsive and accountable to the investors. Banks have to disclose in their balance sheets a plethora of information on the maturity profiles of assets and liabilities, lending to sensitive sectors, movements in NPAs, capital, provisions, shareholdings of the government, value of investment in India and abroad, operating and profitability indicators, the total investments made in the equity shares, units of mutual funds, bonds, debentures, aggregate advances against shares and so on.

    Efforts are also afoot to set up a credit information bureau to collect and share the information on borrowers and improve the credit appraisal of banks and financial institutions.

  3. Adopting international standards: The fallout of Asian crisis and more recently, the global financial meltdown have prompted regulators to set up universally acceptable standards and codes for benchmarking with the view to strengthening of domestic financial systems up to the international standards. The global financial meltdown and the resultant losses suffered by some Indian banks, especially ICICI Bank and the SBI, for instance, have highlighted the lurking risk involved in the financial integration worldwide and the need for strategic-risk analysis. The RBI has also set up an advisory group to draw a roadmap for implementation of appropriate standards and codes in the light of the existing levels of compliance, cross-country experience and the existing legal and institutional infrastructure. Due to vast variations in the size, asset-liability profiles of the banks differ and it becomes very difficult for some of them to meet the new benchmark of the global standards. That being the case, each bank has to draw its own strategy to work out its own codes and standards.
  4. Technology banking: Technological innovations and world-wide revolution in information and communication technology are the catalysts of productivity growth. The relationship between IT and Banking is basically symbiotic. It is expected to reduce costs, increase volumes and facilitate the customized products. Technology adoption is a dire necessity for the public-sector banks to compete with the new-generation private sector and foreign banks. It is a “compulsion” rather than a “choice.” Retention of the existing customer is the primary concern of majority of the banks today.14

    The major challenge for banks in the area of technology is to fall in line with the emerging scenario and adopting the requirement of technology to provide state-of-the-art services to customers. The introduction of online, inter-connected ATMs, telephone banking, anywhere banking and anytime banking, online bill payment and Internet banking are some of the high-tech facilities banks have to provide in order to survive in the present as well the emerging competitive scenario. Technology should ultimately result in a better customer service, low cost of operations and quick delivery.

    There is an imperative need for not mere technology upgradation alone but also its integration with the general way of functioning of banks to give them an edge in respect of services provided to their constituents, better housekeeping, optimizing the use of funds and building up of Management Information Systems (MIS) for a better decision making, better management of assets and liabilities and the risks assumed which, in turn, have a direct impact on the balance sheets of the banks as a whole. Technology has demonstrated its potential to change the methods of marketing, advertising, designing, pricing and distributing the financial products and services and cost savings in the form of an electronic, self-service, product-delivery channel. All these challenges require a new, more dynamic, aggressive and challenging work culture to match the demands of customer relationships, product differentiation, brand values, reputation, corporate governance and regulatory prescriptions. In this context, the future success of Indian banks lies in a superior and cutting-edge technology.

    A paradigm shift in the banking industry has been created by Internet, wireless technology and global straight-through processing. The scorching growth of both the Internet and mobile and wireless technology is transforming the way the financial industry runs its business. The overall wireless technology market is expected to grow tremendously in the coming years.

  5. Rural banking: Government-owned banks, having committed a 75 per cent of their branches network to serving the rural and semi-urban population, have to adopt a financially sound approach to rural banking. Moreover, rural banking has its own problems such as overcoming distances, lesser savings from farmers, intense competition from the rural-based indigenous bankers and money lenders, inadequate infrastructure facilities, and reluctant and unwilling workforce transferred to work in rural branches from their urban habitats.
  6. Deregulation: The banking industry in India is undergoing a major transformation due to changes in the economic conditions and continuous deregulation. These multiple changes happening one after the other has a ripple effect on a bank which is trying to graduate from a completely regulated sellers market to a completed deregulated customers market.

    Deregulation has made the banking market extremely aggressive, even while they enjoy a greater autonomy, operational flexibility, and decontrolled interest rate and liberalized norms for foreign exchange. Deregulation of the industry on the one hand and decontrol in the interest rates on the other hand has led to the entry of a number of players in the banking industry. Simultaneously, reduced corporate credit off-take due to sluggish economy has resulted in a large number of competitors battling for the same pie.

  7. Increasing efficiency: Intense competition and pressure on profit has made it necessary to look for efficiencies in the business. Banks need to access the low-cost funds and simultaneously improve their efficiency. The banks are facing pricing pressure, squeeze on spread and have to give thrust on the retail assets. These challenges can be successfully overcome only if banks can increase their efficiency by using technology and through training and development of their staff.
  8. Diffused customer loyalty: Intense competition will definitely impact customer preferences, as they are bound to be choosy in terms of the value-added offerings. With customers becoming more demanding with greater available choices, their loyalties are diffused. There are multiple choices; the wallet share is reduced per bank with emphasis on flexibility and customization. Customer-retention calls for customized service and hassle-free, flawless service delivery in the context of the relatively-low switching costs.
  9. Employee-related problems: So many fast-paced changes are creating challenges, especially since employees are made to adapt to the changing conditions. Employees tend to resist such changes whenever they are inconvenienced or their jobs are at stake and the seller-market mindset coupled with fear of uncertainty and control orientation need to be changed. However, technology is slowly creeping in as it is more productive and easier to handle, but the utilization is not maximized. Maximization and its success are possible only when people with the right skill are placed at the right space at the right time. The competency gap needs to be addressed simultaneously as, otherwise, there will be missed opportunities as people will be focused on doing work, but not finding and offering solutions on the increasing problems rather than solving them, and on disposing the customers instead of using the opportunity to cross-sell.

    There will be a sea change for employees too. Contractual appointments, for a specified period of time, will replace secure jobs. As a result, the unions will lose their bargaining strength and bank managements will be able to have their own ways. This will lead to a faster turnover of personnel in banks. In such a scenario, skilled manpower from other disciplines will enter banks laterally or as probationers in increasing numbers. As of now, even smaller banks have started recruiting MBA graduates to place them laterally in the middle-management positions.

    Factors such as skills, attitudes and knowledge of the human capital play a crucial role in determining the competitiveness of the financial sector.15 A high quality of human resources is absolutely necessary to enable the banks to deliver value to customers. While capital and technology are replenishable, the human capital cannot be. Therefore, it needs to be considered as a highly valuable resource for achieving a competitive edge.

    Business model, which consists of a very wide range of business solutions delivered through a unique balance of portfolio and relationship management must be incorporated.

    The growth of the retail financial-services sector has been a key development on the market front. Indian banks will not only be keen to tap the domestic market but also to compete in the global market place. New foreign banks will be equally keen to gain a foothold in the Indian market.16

  10. Growing competition and convergence of services call for customer-retention strategies: If one were to say that the future of banking in India is bright, it would be a gross understatement. With the growing competition and convergence of services, the customers stand only to benefit more to say the least. At the same time, emergence of a multitude of complex financial instruments is foreseen in the near future, which is bound to confuse the customer more than ever unless one spends hours to understand the same. Thus, there is likely to be an increasing trend towards the importance of the relationship managers. The success of any bank would depend not only on tapping the untapped customer base, but also on the effectiveness in retaining the existing base.
  11. Innovative services: With the advancement of technology and the increasing number of competitions, banks are in the race of becoming the best in the country. With enhanced efforts towards customer satisfaction policy they are providing better services with the minimum hazards. Some examples are worth mentioning. Banks such as ABN AMRO have introduced banking with a coffee. ABN AMRO made a tie- up with one of the best coffee bar in the country, Barista and remained open till late evening for customers, with a set-up of a coffee bar in the premises. Few banks such as SBI and ICICI have introduced world-wide ATM card to make visitors and tourists across the globe more safe and secure. Many others are trying to popularize Internet and Phone Banking.
  12. Consolidation: Consolidation, which has been on the counter over the last year or so, is likely to gather momentum in the coming years. Post April 2009, with the restrictions on operations of foreign banks, the banking landscape is expected to change dramatically. Foreign banks, which currently account for 5 per cent of the total deposits and 8 per cent of the total advances, are devising new business models to capture the Indian market. Their freer entry is expected to transform the business of banking into more modern and advanced in terms of greater breadth of products, depth in delivery channels and efficiency in operations.

    Thus, Indian banks have less than a year to consolidate their position. Despite the stiff opposition from certain sections of stakeholders, future growth is possible only with consolidation. This view is strengthened by the following factors:

    • Due to greater scale and size, consolidation can help save costs and improve operational efficiency.
    • Banks will also have to explore diverse avenues for raising capital to meet capital adequacy norms under Basel-II.
    • Due to the diversified operations and credit profiles of merging banks, consolidation is likely to serve as a risk-mitigation exercise as much as a growth engine.

    Although there is some amount of rethinking on the matter, sooner than later, there is a prospect of consolidation involving banks such as Union Bank of India, Bank of India, Bank of Baroda, Dena Bank, State Bank of Patiala, and Punjab and Sind Bank. Further, the case for merger between stronger banks has also gained ground which is a clear and prudent deviation from the past when only weak banks were merged with the stronger banks. There is a justification being made for the mergers between banks with a distinct geographical presence coming together to leverage their respective strengths.

  13. Globalization/Overseas expansion: Growing integration of economies and the markets around the world is making global banking a reality. The rushing forward in globalization of finance has already started to gain momentum with the technological advancements, which has effectively overcome the national boundaries in the financial-services business. Extensive use of Internet banking will broaden the frontiers of global banking and make the marketing of financial products and services on a worldwide basis possible and even necessary. With globalization spreading further because of the opening up of financial services under WTO, global banking will become inevitable. Moreover, India being one of the 104 signatories of Financial Services Agreement (FSA) of 1997 gives India's financial sector including banks an opportunity to expand their business on a quid pro quo basis.

    According to “Banking Industry Vision 2010” an Indian Banks' Association report, there would be shortly a greater presence of international players in the Indian financial system, and some of the Indian banks would become global players in the not too distant a future. So, the new growth driver for Indian banks is to go global in search of new markets, customers and profits.

  14. Risk management and Basel-II: The future of banking will unquestionably rest on the risk-management dynamics. Only those banks that have an efficient risk management system will endure in the marketplace in the long run. The effective management of credit risk is a decisive component of comprehensive risk management which is indispensable for the long-term success of a banking institution.

    Although capital serves the purpose of meeting the unexpected losses, it cannot be a substitute for an inadequate decontrol or risk-management systems. Future will witness banks striving to create a sound internal control or risk- management processes. With the focus on regulation and risk management in the Basel-II system becoming important, the post-Basel-II era will rightly belong to the banks that manage their risks successfully. The banks with a proper risk management system would gain a competitive advantage by way of lower regulatory capital charge and would add value to the shareholders and other stakeholders by properly pricing their services, adequate provisioning and maintaining a robust financial structure. “The future belongs to bigger banks alone, as well as to those which have minimized their risks considerably.”

    Basel-II norms are recommendations on banking laws and regulations issued by the Basel Committee on the banking supervision, in order to create international standards. It is based on three pillars: (i) the maintenance of regulatory capital calculated for three risks, namely, credit, operational and market risk; (ii) supervisory review to bridge the gap between the regulatory and economic capital requirements; and (iii) the regulation on disclosures to be made by banks for market discipline. The reasons why Indian banks should adopt Basel-II norms are that it will facilitate the introduction of new complex financial products in the banking sector and there is a requirement for a risk-sensitive framework or management of risks and the new rules will provide a range of options for estimating the regulatory capital and will reduce the gap between regulatory capital and economic capital. The three pillars of the norms require certain preparatory factors. The RBI advises Indian banks to keep a standardized credit measurement, basic-indicator approach for assessing operational risks, lower risk weights for short-term assets, skill development both at the RBI as well as bank levels, improved supervisory methods, comprehensive disclosure requirements supported by IT structure with technological focus on scalability, availability, security and generation of management information system. The Indian banks operating in foreign countries and the foreign banks operating in India implemented the Basel-II norms by March 2009. Of all under Basel-II norms, the big banks will have the marked advantage over the small and the medium banks.

  15. Challenging role of regulators: India has witnessed a sea change in the way banking is done in the past more than two decades. Since 1991, the RBI took steps to reform the Indian banking system at a measured pace, so that growth could be achieved without exposure to any macro-environment and systemic risks. Some of these initiatives were deregulation of interest rates, dilution of the government stake in public- sector banks, guidelines being issued for risk management, asset classification and provisioning. Technology has made a highly favourable impact on banking. “Anywhere banking” and “anytime banking” have become commonplace now. “The financial sector now operates in a more competitive environment than before and intermediates relatively large volume of international financial flows.”17 In the wake of greater financial deregulation and global financial integration, the biggest challenge before the regulators is of avoiding volatility in the financial system.

The RBI's approval for banks to raise funds abroad through innovative capital instruments holds a great significance. Such fund-raising like preference shares will not just substitute equity; it could have unintentional consequences on the strategies of banks and their profitability. While the cost of raising money through such instruments is likely to be higher, the resulting higher leverage on equity funds is likely to result in the expansion of return on net worth. This is because the same amount of capital supports a high volume of business, generating greater profits.

Preference capital can be used as the means for acquisition. The advantage for public-sector banks is that they need not worry about the government stake falling below 51 per cent. “Banks such as Dena Bank, Oriental Bank of Commerce and Andhra Bank are most likely to benefit from this move.”18

STRATEGIC OPTIONS TO COPE WITH THE CHALLENGES

Several major banks have initiated a series of strategic and tactical steps to sustain industry leadership. Some of these initiatives include:

  • Making substantial investment in avant-garde technology as the backbone of systems to offer dependable service delivery to their customers.
  • Using effectively their branch network and sales personnel with a view to attracting and retaining low cost current and savings deposits.
  • Making vigorous thrusts in the retail advances of home- and personal-loan segments.
  • Starting organization-wide initiatives connecting people, process and technology with a view to reducing the fixed costs and the cost per transaction.
  • Focusing on fee-based income to compensate for reduced spread due to intense competition.
  • Innovative products to attract customer “mind share” to begin with, and later the wallet share.
  • Improving the asset quality as stipulated under Basel-II norms.

The growth in the Indian Banking industry has been qualitative rather than quantitative and it is likely to remain the same in the days to come. “India Vision 2020”, a report prepared by the Planning Commission for the Draft Tenth Plan, forecasts that the pace of expansion in the balance sheets of banks is likely to decelerate with the total assets of all SCBs estimated at INR 40,900.00 billion by end-March 2010, comprising roughly 65 per cent of GDP at current prices. “Bank assets are expected to grow at an annual composite rate of 13.4 per cent during the rest of the decade as against the growth rate of 16.7 per cent that existed between 1994-95 and 2002-03. It is expected that there will be large additions to the capital base and reserves”.19

A strong and vigorous banking system is very important for the speedier growth of any economy even while remaining aligned to an increasingly global business environment. The Indian banking system has witnessed a series of reforms in the past, such as deregulation of interest rates, dilution of government stake in PSBs, and increased participation of private-sector banks. It has recently gone through vast changes, reflecting a number of fundamental developments. This trend has created both competitive threats and new opportunities. Given the competitive market, banking will increasingly become a process of choice and convenience. The future of banking lies in the degree and extent of integration achieved in the banking industry. This is already becoming a reality with new-age banks such as YES Bank and others adopting such a strategy. Geography will no longer be an inhibitor, but technology will prove to be one in the short-term. The dynamic environment will soon lead to its saturation and what will ultimately be the key to success will be a better-relationship management. The Indian banking industry is confronted with newer challenges in terms of narrowing spreads, new banking products and players, and mergers and acquisitions. “Adoption of risk management tools and new information technology is now no more a choice but a business compulsion. Technology product innovation, sophisticated risk management systems, generation of new income streams, building business volumes and cost efficiency will be the key to success of the banks in the new era”.20 In the present environment where change is invisible, it is not enough if banks change with the change, but they have to change before the change. They should perceive what the customer wants and accordingly structure their products and services.

SUMMARY
  • A bank is an institution which deals with money. The main business of a bank is to earn profit by advancing loans to the needy people in a community. A bank attracts deposits from the public and makes use of these for lending. A commercial bank (i) receives deposits from the public; (ii) advances loans; (iii) discounts bills of exchange; (iv) maintains safe-deposit vaults; (v) transfers funds from one place to another place; and (vi) performs certain miscellaneous functions for its customers.
  • Commercial banks play a very significant role in the economy of a country. They are necessary for the growth of trade and industry and are important to the process of industrialization of a country and encourage saving and accumulation of wealth by the public. They are extremely important in the underdeveloped countries.
  • A balance sheet of a commercial bank reflects the working of a bank. It is a statement which shows the way in which the bank created funds by creating liabilities and has invested them by acquiring the assets. The main liabilities are paid-up capital, reserve fund, deposits and borrowings from the other banks. The main forms of assets are cash in hand and balances with central bank, money at call and short notice, bill-discounted investment, loans and advances and so on. Cash is most liquid but yields no profit. Loans and advances are less liquid but highly profitable.
  • To reconcile the conflicting aims of liquidity and profitability, a bank acquires the assets by following: (a) the rules of cash ratio and liquidity ratio, that is, the collection of assets which are self-liquidating, shiftable and marketable in nature; (b) the rule of safety which involves diversifying the assets according to the nature and duration; and (c) it arranges these assets in the descending order of their liquidity and in the ascending order of their profitability.
  • A bank creates credit by creating deposits and liabilities against it. This the bank does by making loans and advances. In this sense, we say, loans create deposits. The total credit which a bank can create depends on the excess cash reserve available. Therefore, we say that the credit-creating capacity of a bank is equal to the multiples of the reciprocal of the cash ratio. This capacity is limited by the factors such as the amount of cash, the public's desire to hold cash, the ratio of reserve to deposits, the nature of business conditions, the leakages in credit creation, and the capital-deposit ratio. Stability in the credit expansion and contraction is essential for an economic stability.
KEY WORDS
assets portfolio balance sheet bills of exchange
call and short notice credit contraction credit creation
delivery mechanism demand deposits deposit mobilization
fresh deposit investment policy liquidity ratio
overdraft facility reserve fund safe deposit
savings deposits self-liquidating standard money
temporary liability time deposits working funds
DISCUSSION QUESTIONS
  1. What is commercial bank? What are its main functions? What is the importance of banks in the modern economy?
  2. Discuss with the help of a balance sheet the investment policy of a commercial bank.
  3. “The functions of commercial banks are reflected in their balance sheets.” Comment.
  4. “A constant tug of war between the competing aims of liquidity and profitability summarises the function of a commercial bank”. Explain.
  5. How does a commercial bank reconcile the conflicting claims of shareholders and clientele?
  6. “Commercial banks borrow long and lend short.” Explain the statement with the help of a typical balance sheet of the commercial bank.
  7. Explain fully the importance of liquidity and profitability. What principles a commercial bank follows to ensure both?
  8. “A single bank can safely lend only an amount equal to it excess reserve but the commercial banking system can lend by a multiple of its excess reserves.” Explain. Why is the multiple by which the banking system can lend equals to the reciprocal of its reserve ratio?
  9. Explain the process of credit creation. What are the limits to the ability of a commercial bank to create credit?
  10. Explain and discuss the following statements:
    1. Loans create deposits.
    2. Bank not only supply money but also create it.
    3. A banker can only lend what is deposited with him.
    4. Commercial banks create credit, but they cannot create money.
    5. Legal cash ratio indicates, other things being equal, the maximum capacity of a commercial bank to create credit.
    6. In making advances, a bank is concerned only with the likely profitability.
    7. Commercial banks arrange their assets in the ascending order of profitability and in the descending order of liquidity.
  11. Answer the following:
    1. With an initial primary deposit of INR 10,000, what will be the final increase in the money supply, assuming that the bank maintains a 20-per cent cash ratio.
    2. A bank has INR 240 as cash, INR 660 as other liquid assets, INR 500 as investments and INR 1,600 as advances. What is the bank's cash ratio and liquidity ratio?
  12. How can a bank maintain a 10-per cent cash ratio without altering its investments or advances.
  13. What is meant by “liquidity” of commercial banks? How does a commercial bank achieve it?
  14. How does a bank create credit? Examine the limitations on the power of a bank to create credit.
  15. Discuss the effect of nationalization of the major commercial banks in India in the structure of bank credit.
  16. Is the working of the Indian Commercial Banking System satisfactory or is there an urgent need for a thorough reform.
  17. Review the progress and problems of the nationalized commercial banks in India.
  18. Would you agree that the objectives of bank nationalization have been largely achieved?
  19. What are the principal weaknesses of India's banking and financial sector which need to be removed now?
  20. Enumerate the recommendations of the Committee on Banking Sector Reforms (1998) in India. What follow-up actions have been undertaken by the government for implementing these recommendations?
  21. In what ways the banks in India diversified their functions and adopted new technologies since their nationalization.
SUGGESTED READINGS

Agarwal, B. P. Commercial Banking in India New Delhi: Classical Publishing Company, 1979.

Angadi and Devaraj. “Productivity & Profitability of Banks in India,” Economic and Political Weekly, Vol. 33, No. 4, pp. 936–954.

Angadi, V. B. “Integrated Approach to Study Bank's ‘Profitability',” Prajnan, October-December, 1987.

Arora, U. and Verma, R. “Banking Sector Reforms and Performance Evaluation of Public Sector Banks in India,” Punjab Journal of Business Studies, Vol. 1, No. 1, April-September, 2005, pp.11–25.

Bhatt, P. R. “Profitability of Commercial Banks in India,” Indian Journal of Economics, March 1999.

Ghosh, D. N. “Commercial Banking: Lessons from Indian Experience,” SBI Monthly Review, November 1988.

Joshi, N. C. Indian Banking, New Delhi: Ashish Publishing House, 1978.

Kohli, V. S. “Indian Banking Industry: Emerging Challenge,” IBA Bulletin, Vol. XXIII, No. 3, March 2001.

Mohan, R. “Transforming Indian Banking: In search of a Better Tomorrow,” RBI Bulletin, 2003.

Ojha, J. “Productivity and Profitability of Public Sector Banks in India: An International Comparison,” SBI Monthly Review, July 1997.

Pai, D. T. “Indian Banking—Changing Scenario,” IBA Bulletin, Vol. XXIII, No. 3, March 2001.

Panandikar, S. G. Banking in India, Mumbai, India: Orient Longman, 1975.

Rao, N. V. “Changing Indian Banking Scenario: A Paradigm Shift,” IBA Bulletin, Vol. XXIV, No. 1, 2000.

Satya, “Banks: Improving Productivity and Profitability,” The Journal of the Indian Institute of Bankers, September 1984.

Satyamurty, B. A. “Study on Interests Spread Management in Commercial Banks in India,” National Institute of Bank Management, Working Paper, 1994.

Sham, L. “Performance of Commercial Banks Since Nationalization of Major Bank: Promise and Reality,” Economic and Political Weekly, August 1978.

Singh, R. P. “Working on Profit Planning,” Mumbai, India: Bankers Training College, RBI, 1988.

Singh, S. “Profitability in Commercial Banks in India,” PNM Monthly Review, October 1989.

Vittal, N. “The Emerging Challenges: Strategies and Solutions for Indian Banking,” IBA Bulletin, Vol. XXIII, No. 3, March 2001.