Growth and Development of Commercial Banks
Money-lending business in India is almost as old as the Rig Vedic Civilization and we can justifiably claim that India knew more about banking, and knew it earlier, than any other country in the world, though we do not know about its methods, dimensions and importance. There are frequent references made to the money-lending activities of the olden days in the various Hindu Scriptures. In Kautilya’s Arthashastra, we get detailed regulations as regards the rate of interest that might be legally charged from different types of borrowers. The Dharma Shastras also laid down that the rate of interest should differ according to the caste of the borrower and that only Vaishyas could take up money-lending as their profession. Meadows Taylor gives a flattering description of ancient Indian banking in the following words: ‘The laws of Manu disclose how thoroughly the science of banking was known 3000 years ago. Then bankers understood and followed the fluctuations of money value; they kept account books, day-books, and ledgers by single and double entry. They charged interest, simple and compound, they made insurances by sea and land, they granted bills of exchange, and in short, they followed the practices of modern times which are little changed from ancient rules.’
From the 12th century onwards, hundis or the indigenous equivalents of bills of exchange were very much in vogue in India. Those who were dealing in these hundis, the indigenous bankers, were financing India’s internal as well as foreign trades. They even advanced loans to the State and ‘no royal court was complete without a state banker, who was often invested with the powers of a minister.’ There was a marked decline in the activities of these money-lenders-cum-traders during the Moghul period as the rapacious rulers were capricious enough to confiscate the money lent to them in good faith. But these losses were compensated by these bankers by mixing the functions of money-lending proper with the profitable business of money-changing, thanks to the large number of coins, both gold and silver, which circulated in different parts of India.
The East India Company, when it was established in India, had to rely on Indian bankers for loans and remittances, and even then, they continued to wield a dominant influence as State financiers. But this arrangement could not be carried on indefinitely due to the great difficulties of language on both the sides, and also owing to the ignorance of the indigenous bankers on the precise methods of Western banking, which the foreigners were accustomed to. Hence the English Agency Houses in Calcutta and Bombay began to conduct banking business in addition to their ordinary commercial transactions. Even though this system worked for some time, it was soon apparent that it could not work for a longer period of time when trade and commerce would assume larger dimensions, as these Agency Houses had to depend entirely on their deposits in the absence of a working capital. Therefore, Joint Stock Banking became a necessity to serve the Company, the civil servants, the European Merchants and also to issue paper money.
Origin and Growth of Joint Stock Banks
The first modern Joint Stock Bank to be established on purely European lines of banking was the Bank of Hindustan, founded in 1700 by Messrs. Alexander and Co., which floundered in 1832 due to a financial crisis. On its ruins arose the Union Bank, a joint-stock bank, created by co-operation among the leading Calcutta houses, but this too breathed its last in 1848. The next stage of Indian banking, started with the establishment of the so-called Presidency Banks of Bengal, Bombay and Madras between the period 1809 and 1850. The East India Company subscribed a portion of the share-capital of these institutions, and they were granted the privilege of note-issue within their jurisdiction, apart from the honour of acting as government banker. In 1862, however, the right of note-issue was taken away from them; though, as a saving grace, the government allowed them to keep its balances, free of any charge. But the Bank of Bombay collapsed in 1868 due to its entanglement in the wild cotton speculation of 1862–65, which made the Company frame regulatory provisions on the activities of the Provincial Banks. Accordingly, the Presidency Banks’ Act was passed prohibiting them from dealing in foreign exchange and foreign borrowing. They were barred from granting loans for more than 6 months, or on the security of immovable property. They, however, retained the monopoly of government banking. With the growth of trade and commerce, the unification of the country and the growing influence of government in the economic sphere sounded the necessity of a comprehensive central bank to look after the banking aspect of the economy, and it was increasingly felt that even if the Presidency Banks strived their best, they could not engulf the lacuna. After protracted considerations and prolonged deliberations, the three Presidency Banks were amalgamated into the Imperial Bank of India in 1920. In spite of the projected prominence, the Imperial Bank of India could not act as a central bank of the country and to cater to the needs of banking community for obvious reasons: first and foremost, it was a commercial bank working as a competitor to other similar institutions and as such it could not inspire the implicit faith and confidence of them as a protector and lender of last resort, which it ought to do, and the powers vested on it led to a plurality of reserves leading to the lack of cohesion and unity in this sphere of the economy. Besides, it was argued that the Bank was predominantly European, and it neither cared to train efficient native officers nor looked after Indian interests. These defects which abounded in the working of the Imperial Bank led to scathing criticism from the public and the final blow came from the Report of the Indian Currency Commission of 1926, popularly known as the Hilton Young Commission, which pointed out ‘inherent weakness of a system in which the control of currency and credit is in the hands of two distinct authorities whose policies may be widely divergent, and in which the currency and banking reserves are controlled and managed separately one from the other’. The Commission recommended ‘the establishment of a Central Bank to be known as the Reserve Bank of India, while the Imperial Bank was to remain as a big commercial bank, divested of all its central banking operations’. This recommendation, coupled with the constitutional changes brought about in 1935, necessitating India’s financial stability, both at home and abroad, led to the institution of the Reserve Bank of India in 1935.
The Structure of the Indian Banking System
‘The outstanding characteristic of the Indian money market is its dichotomy; it comprises what may be broadly termed as the organized and unorganized market...’ The organized market consists of the Reserve Bank of India and all other financial institutions, based on the Western systems of banking, while the unorganized money market is largely made up of indigenous bankers, money- lenders, traders, commission agents etc., some of whom combine money lending with trade and other activities. The indigenous banker plays a very important role in the monetary organization of the country, being the main source and fount of credit, and is found in every village, town and city in the country, especially in the rural areas where most people are either peasants or ordinary artisans badly in need of money to carry on their day-to-day operations. Generally speaking, indigenous banking is purely a family business conducted along hereditary caste basis. The Nattukottai Chettis of Madras, Sahukars and Mahajans of the Punjab and the UP, Shroffs and Marwaris, and Seths and Baniyas of Bengal are the striking examples of the principal castes engaged in indigenous banking, in the different parts of India. In the ‘good old days’ the credit of these indigenous bankers stood so high that foreign observers have recorded that the domestic bills of exchange or hundis were readily negotiable throughout the country and passed from hands to hands unquestioned, from Travancore to Peshawar, and often beyond the boundaries of India. These banking houses had their accredited agents or gumastas posted all over the country and thus maintained a system of intelligence and information which was truly a marvel for the age.
Indigenous money-lenders, however, should be distinguished from indigenous bankers proper. For, while the indigenous bankers receive deposits and deal in hundis, the money-lenders do not do so; the indigenous bankers finance trade and industry, while the money-lenders mainly advance loans for domestic purposes; the indigenous bankers take particular care about the purpose for which they lend, while the money-lenders are merely concerned with the interest that they get; and in the case of indigenous bankers, the repayment is more punctual and the rate of interest is lower. On the other hand, indigenous money-lenders and bankers are alike in that both are disorganized, both are scattered and ubiquitous, and both are adapted to the different traditions, habits, customs and needs of the people.
While the Reserve Bank Bill, 1933, was in the process of being progressed into an enactment, Sir George Schuster pointed out to the fact that at that time about 90 per cent of the credit of the country was provided by the organization of money-lenders. And even today, in spite of the abundant growth of Westernized joint-stock banks, the indigenous bankers account for the lion’s share of the credit of the country. They discount agricultural paper and hundi bills dealing with internal trade. Their modus operandi is not generally very up-to-date and thus they lend more on personal credit than against what can be regarded as first class bills of security. Their popularity and omnipresence are due to their informal methods. Some of those bankers have also offices and branches in several parts of the country and especially in all the important trade centres. Moreover, though their activities are quite independent, some of them are organized into guilds or associations of ancient origin through which, inter alia, they settle their mutual claims, counter claims, and disputes. Their establishments are thrifty and they spend practically nothing on the training of their children; it is the traditional experience which educates and perfects them on these matters. Their close touch with and personal knowledge of their clients enables them to advance loans more readily than ordinary commercial banks can do. They receive deposits from the public either on current account or for fixed terms, and pay interest on them at rates varying between 3 and 9 per cent. As they seldom fail to make payments whenever demanded, they enjoy a high amount of prestige and esteem among their clients. Some of these bankers, especially the Multanis and the Marwaris, rely more on their own resources than on public deposits. Under all these circumstances, these indigenous bankers are formidable competitors to the big joint-stock banks organized on modern lines. But, this is not to suggest that the indigenous banker has no contact with the modern banking system. In times of emergencies, he borrows funds form commercial joint-stock banks. In many instances, the Indian bankers act as indispensable middlemen. The Babington Smith Committee describes in the following words the manner in which the indigenous financial agency comes into contact with the modern monetary organization. The people with whom the banks deal directly are for the most part large shroffs of good standing in the principal cities. These men operate with their own capital, and generally speaking, it is only when they have laid out all their available capital in purchasing the hundis of other and usually smaller shroffs that they come to the Presidency Banks. The shroffs whose hundis the large shroffs have purchased, have probably also similarly financed other and still smaller shroffs or mahajans, and so on, until we get down to the smallest flea of all, namely, the village bania or grain-dealer or goldsmith. For instance, a shroff at Amristar may purchase a bill drawn by a larger shroff at Lahore, who sells it to the Presidency Bank, which sends it to its Bombay agency for collection, or the bill may be a pure finance bill generally known as a hand, bills as opposed to a ‘trade’ bill, against produce.
The indigenous bankers finance agricultural operations indirectly through local lenders and traders. They finance internal trade and small industries, while some of them keep a portion of their funds on deposit with textile mills through which they even finance foreign trade. The principal methods by which these indigenous bankers lend money may be enumerated as follows:
- One of their usual methods is to lend money on written demand promissory notes which, in the case of the larger loans, have to be attested by sureties.
- A second method is to obtain receipts signed by the borrowers acknowledging the loans and stating the agreed rate of interest, in place of promissory notes.
- A third method is to give advances against bonds written out on stamped legal forms, which state all the conditions of the loans in detail.
- A fourth method is to make the borrowers put down their signatures in the bankers’ books to which stamps have to be affixed, undertaking to repay the loans, but the conditions of the loans are left to verbal agreement.
- A fifth method is to lend on the mortgage of land, houses and other property.
- Finally, the indigenous bankers draw and discount hundis.
The hundis are either finance bills or trade bills; Finance bills are drawn by merchants who need money on the indigenous bankers’ agents, firms or others with whom arrangements have been made beforehand, or they may be drawn as a convenient form of remittance of money from one place to another. Trade bills, on the other hand, are drawn against produce or goods.
‘The rate at which hundis are discounted by indigenous bankers is known as the bazar-rate, which varies between 4 and 14 per cent according to the pressure of business and the nature of the season. Even in the same period, the hundi rate may differ in different markets, on account of the virtual immobility of the bankers’ funds’.
As pointed out earlier, the indigenous bankers are formidable competitors to joint stock commercial banks, and the relations between the two are none too cordial. In many cases, the commercial banks do not accept cheques drawn on indigenous bankers as the latter do not supply sufficient security, do not publish a balance sheet and also fail to furnish the necessary details, making it difficult for the banks to determine their financial position. Besides, commercial banks have to reject the applications of credit of the indigenous bankers who more often do not comply with the necessary formalities. The indigenous banker also does not get easy discounting facilities for the domestic bills of exchange. When the Imperial Bank of India was at the realm of affairs in the financial field, these Indianized bankers did not get equal rediscounting facilities as the Westernized bankers. Above all, the separatist tendency that prevailed between these two sectors of the money-market led to divergent rates of interest with the result the central bank of the country could not follow a unified credit policy with the help of the Bank Rate and open Market Operations.
Whatever be the merits of the indigenous bankers and however great their contribution to the credit-needs of the people might be, they suffer from certain serious defects, the chief of which are listed below, which call for serious remedial actions: (i) They follow old and antiquated methods of keeping accounts and doing business due to their innate conservatism and lack of education. This sort of business secrecy, which looks like a shrouded mystery to the organized money market, acts as a great barrier to any useful co-operation between the two; (ii) The deposit side of their business is practically nil. They rely on their own funds leaving the savings of the people remain scattered and idle instead of being mobilized and employed usefully. Their own funds are awfully inadequate to meet the needs of trade and industry; (iii) Hundis play a comparatively small part in their total transactions which are largely financed by cash; (iv) There is no proper organization among them which might help in developing their business; and (v) They are virtually unconnected with the modern part of the country’s money market. Consequently, effective credit control by the central bank is impossible.
19.1. What is a commercial bank? What are its main functions? What is the importance of banks in the modern economy?
19.2. Discuss with the help of a balance sheet the investment policy of a commercial bank.
19.3. ‘The functions of commercial banks are reflected in their balance sheets.’ Comment.
19.4. ‘A constant tug of war between the competing aims of liquidity and profitability summarises the function of a commercial bank’. Explain.
19.5. How does a commercial bank reconcile the conflicting claims of shareholders and clientele?
19.6. ‘Commercial banks borrow long and lend short.’ Explain the statement with the help of a typical balance sheet of the commercial bank.
19.7. Explain fully the importance of liquidity and profitability. What principles a commercial bank follows to ensure both?
19.8. ‘A single bank can safely lend only an amount equal to its 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?
19.9. Explain the process of credit creation. What are the limits to the ability of a commercial bank to create credit?
19.10. Explain and discuss the following statements:
(i) Loans create deposits.
(ii) Banks not only supply money but also create it.
(iii) A banker can only lend what is deposited with him.
(iv) Commercial banks create credit, but they cannot create money.
(v) Legal cash ratio indicates, other things being equal, the maximum capacity of a commercial bank to create credit.
(vi) In making advances, a bank is concerned only with the likely profitability.
(vii) Commercial banks arrange their assets in the ascending order of profitability and in the descending order of liquidity.
19.11. Answer the following:
(i) 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?
(ii) A bank has INR 240 as cash, INR 660 as other liquid assets, INR 500 as investments and INR 1600 as advances. What is the bank’s cash ratio and liquidity ratio?
19.12. How can a bank maintain a 10 per cent cash ratio without altering its investments or advances?
19.13. What is meant by ‘liquidity’ of commercial banks? How does a commercial bank achieve it?
19.14. How does a bank create credit? Examine the limitations on the power of a bank to create credit.
19.15. Discuss the effect of nationalization of the major commercial banks in India in the structure of bank credit.
19.16. Is the working of the Indian commercial banking system satisfactory or is there an urgent need for a thorough reform?
19.17. Review the progress and problems of the nationalized commercial banks in India.
19.18. Would you agree that the objectives of bank nationalization have been largely achieved?
19.19. What are the principal weaknesses of India’s banking and financial sector which need to be removed now?
19.20. 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?
19.21. In what ways the banks in India diversified their functions and adopted new technologies since their nationalization?
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19.3. Angadi, V. B. (1987), ‘Integrated Approach to Study Bank’s ‘Profitability’,’ Prajnan, October–December, 1987.
19.4. Arora, U. and Verma, R. (2005), ‘Banking Sector Reforms and Performance Evaluation of Public Sector Banks in India,’ Punjab Journal of Business Studies. 1(1) (April-September): 11–25.
19.5. Bhatt, P. R. (1999), ‘Profitability of Commercial Banks in India,’ Indian Journal of Economics, March 1999.
19.6. Ghosh, D. N. (1988), ‘Commercial Banking: Lessons from Indian Experience,’ SBI Monthly Review. November 1988. Joshi, N. C. (1988), Indian Banking (New Delhi: Ashish Publishing House).
19.7. Kohli, V. S. (2001), ‘Indian Banking Industry: Emerging Challenges,’ IBA Bulletin, 23(3), March 2001.
19.8. Mohan, R. (2003), ‘Transforming Indian Banking: In search of a Better Tomorrow,’ RBI Bulletin. 2003.
19.9. Ojha, J. (1997), ‘Productivity and Profitability of Public Sector Banks in India: An International Comparison,’ SBI Monthly Review. July 1997.
19.10. Pai, D. T. (2001), ‘Indian Banking—Changing Scenario,’ IBA Bulletin, 23(3), March 2001.
19.11. Panandikar, S. G. (1975), Banking in India (Mumbai, India: Orient Longman).
19.12. Rao, N. V. (2000), ‘Changing Indian Banking Scenario: A Paradigm Shift,’ IBA Bulletin, 23(1).
19.13. Satya, (1984), ‘Banks: Improving Productivity and Profitability,’ The Journal of the Indian Institute of Bankers. September 1984.
19.14. Satyamurty, B. A. (1994), ‘Study on Interests Spread Management in Commercial Banks in India,’ National Institute of Bank Management, Working Paper.
19.15. Sham, L. (1978), ‘Performance of Commercial Banks Since Nationalization of Major Banks: Promise and Reality,’ Economic and Political Weekly. August 1978.
19.16. Singh, R. P. (1988), ‘Working on Profit Planning,’ Mumbai, India: Bankers Training College, RBI.
19.17. Singh, S. (1989), ‘Profitability in Commercial Banks in India,’ PNM Monthly Review, October 1989.
19.18. Vittal, N. (2001), ‘The Emerging Challenges: Strategies and Solutions for Indian Banking’, IBA Bulletin, 23(3), March 2001.