Banking in India31 min average read

/ Uncategorized

Evolution of Banking in India: A Comprehensive Overview

Introduction:

The banking system of a country forms the bedrock of its economy, playing a pivotal role in economic development. In India, the banking sector is a crucial component of the financial landscape, contributing to over 70% of the funds circulating through the financial sector.

Historical Phases:

Phase I – Pre-Nationalisation (Prior to 1955):

  • Banking in India has a rich history dating back to the late 18th century.
  • Notable establishments include the General Bank of India (1786) and Bank of Hindustan (1790), though both are no longer in existence.
  • The East India Company set up Presidency Banks in 1809 (Bank of Bengal/Calcutta), 1840 (Bank of Bombay), and 1843 (Bank of Madras).
  • Additional banks, such as Allahabad Bank (1865) and Punjab National Bank (1894), emerged between 1906 and 1913.
  • The Imperial Bank of India was formed in 1921 by amalgamating presidency banks.
  • The Reserve Bank of India (RBI) was established on April 1, 1935, under the Banking Regulation Act 1934.

Phase II – Era of Nationalisation and Consolidation (1955-1990):

  • In 1955, the Imperial Bank of India was nationalized and renamed the State Bank of India (SBI).
  • Seven subsidiaries of SBI were nationalized in 1959.
  • On July 19, 1969, 14 major commercial banks were nationalized, including Punjab National Bank, Syndicate Bank, and Bank of Baroda.
  • In 1980, six additional banks were nationalized, bringing the total to 20.
  • Narasimhan Committee recommendations in 1993 opened the doors for new private banks.

Phase III – Introduction of Reforms and Partial Liberalisation (1990-2004):

  • The government initiated reforms in response to the Narasimham Committee I recommendations.
  • Measures included allowing new private sector banks, treating public and private sectors equally, establishing an asset reconstruction fund, and abolishing branch licensing.
  • Narasimham Committee II focused on the rehabilitation of weak banks, internationalizing a few large Indian banks, formulating corporate strategy, ensuring capital adequacy, accelerating computerization, and refining the recruitment procedure.

Reserve Bank of India (RBI):

Establishment and Nationalization:

  • Founded on April 1, 1935, as per the RBI Act of 1934, taking over central banking functions from the Imperial Bank of India.
  • Initially, a privately held entity, it underwent nationalization on January 1, 1949, through the Reserve Bank (Transfer to Public Ownership) Act, 1948.

Functions of RBI:

Monetary Authority:

  • Implements and monitors monetary policy with the goal of achieving price stability while fostering economic growth.
  • Manages currency issuance and destruction, excluding specific denominations issued by the Ministry of Finance.
  • It has the sole right to issue currency notes of various denominations except one rupee note which
    is issued by the Ministry of Finance.

Regulator and Supervisor of the Financial System:

  • Establishes comprehensive parameters to govern banking operations, ensuring public trust, and safeguarding depositors’ interests.

Manager of Foreign Exchange:

  • Manages foreign exchange reserves to stabilize the rupee exchange rate.
  • Represents the Government of India in international financial agencies like the IMF and World Bank.

Developmental Role:

  • Plays a pivotal role in the establishment of developmental banks such as IDBI, SIDBI, NABARD, and others.
  • Gradually transfers ownership of these banks from the RBI to the Government of India.

Banker to Banks and Government:

  • Acts as the banker to scheduled banks, maintaining their accounts, and providing funds as the lender of last resort.
  • Performs merchant banking functions for both central and state governments, managing government funds, remittances, and public debt.

Governor of RBI:

Appointment and Term:

  • Appointed by the Central Government based on recommendations from the Financial Sector Regulatory Appointments Search Committee (FSRASC).
  • Holds office for a term not exceeding three years, with eligibility for reappointment.

Qualification and Removal:

  • The RBI Act does not specify any particular qualifications for the Governor.
  • The Central Government retains the authority to remove the Governor.

Subsidiaries of RBI:

  • Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL)
  • Reserve Bank Information Technology Private Ltd. (ReBIT)
  • Indian Financial Technology And Allied Services (IFTAS)
  • Deposit Insurance and Credit Guarantee Corporation (DICGC)

Minimum Reserve System of RBI:

  • Requires a minimum value of government-held gold (₹200 crores), with a specific allocation for gold or gold bullion and the rest in foreign currencies.

Income and Expenditure of RBI:

Income:

  • Derives income from returns on foreign currency assets, interest on rupee-denominated government bonds, interest on overnight lending to commercial banks, and management commission.

Expenditure:

  • Incurs expenses for printing currency, staff expenditure, commission to commercial banks, and commission to primary dealers.

Assets and Liabilities of RBI:

Liabilities:

  • Encompass currency held by the public, vault cash held by commercial banks, government securities, and other liabilities.

Assets:

  • Include foreign currency assets, bill purchases and discounts, collaterals by commercial banks, loans and advances, rupee securities, gold coin bullion.

Some Basic terms related to Banking :

Checking Account:

A type of bank account that allows frequent transactions, typically used for day-to-day expenses. Checks, debit cards, and electronic transfers are common features.

Savings Account:

A type of bank account designed for saving money over time. It usually offers interest on the deposited amount and may have limitations on withdrawals.

Loan:

A sum of money borrowed from a bank or financial institution, which is expected to be paid back with interest over a specified period.

Credit Card:

A payment card issued by a bank, allowing the cardholder to make purchases on credit. The cardholder is expected to repay the borrowed amount with interest.

Overdraft:

A negative balance in a bank account resulting from withdrawals exceeding the available funds. Overdrafts may incur fees or interest.

Collateral:

Assets or property pledged by a borrower to secure a loan. If the borrower fails to repay, the lender may seize the collateral.

FD (Fixed Deposit):

A type of savings account where money is deposited for a fixed period at a specified interest rate, and withdrawal is allowed only after maturity.

SWIFT Code:

A unique code used to identify a specific bank during international transactions. It ensures that the funds are directed to the correct financial institution.

Cheque:

A written order directing a bank to pay a specific amount of money from the account of the person issuing the cheque to another person or entity.

Demand Draft (DD):

A prepaid negotiable instrument issued by a bank, payable on demand, used for making payments within a specific region.

ATM Card/Debit Card:

A plastic card issued by a bank that allows the cardholder to access their account to withdraw cash or make purchases. It is linked to the person’s bank account.

NEFT (National Electronic Funds Transfer):

An electronic funds transfer system that facilitates one-to-one fund transfers between banks on a deferred net settlement basis.

RTGS (Real-Time Gross Settlement):

A funds transfer system where money is moved from one bank to another in real-time and on a gross basis. It is used for high-value transactions.

MICR Code (Magnetic Ink Character Recognition Code):

A unique code printed on a bank’s cheques to facilitate the processing of cheques using computer technology.

Core Banking System:

A centralized system that allows a bank to offer its services from a single unified platform, providing real-time transaction processing.

SWOT Analysis:

An evaluation of a bank’s strengths, weaknesses, opportunities, and threats to formulate effective strategies for growth and risk management.

Lien:

The right to keep possession of property or assets until a debt is repaid. It serves as security for a loan.

Net Demand and Time Liabilities (NDTL):

NDTL is calculated by subtracting a bank’s time liabilities from its demand liabilities.

Net Demand and Time Liabilities (NDTL) is a term used in the context of banking and represents a categorization of a bank’s liabilities based on their nature and maturity. Here’s a breakdown of the components:

  1. Demand Liabilities:
    • Definition: Demand liabilities refer to the funds that customers can withdraw on-demand without any prior notice.
    • Examples: Current deposits, demand drafts, and other deposits that can be withdrawn immediately fall under this category.
  2. Time Liabilities:
    • Definition: Time liabilities are the funds that customers deposit with banks for a specified period, and the bank has an obligation to repay them after the agreed-upon time.
    • Examples: Fixed deposits, recurring deposits, and other term deposits are considered time liabilities.

 

Understanding the Dynamics of Money: Demand, Supply, and Creation

Introduction:

Money, a vital component of any economy, is intricately woven into the fabric of financial systems. This article delves into the multifaceted aspects of money, exploring both its demand and supply, along with the intriguing process of money creation.

Demand for Money:

People’s desire to hold money is driven by three motives, as outlined in Keynes’ Liquidity Preference Theory:

  1. Transaction Motive:
    • Involves holding money to facilitate day-to-day transactions.
  2. Speculative Motive:
    • Arises when holding money is perceived as less risky than lending or investing.
  3. Precautionary Motive:
    • Motivated by the need to meet unforeseen circumstances in the future, such as car accidents or home repairs.

Supply of Money:

The supply of money refers to the total amount of money circulating within an economy. In India, various measures categorize money supply, including M1, M2, M3, and M4, all stemming from the base measure, M0 (Reserve Money). The hierarchy of these measures indicates varying levels of liquidity, with M1 being the most liquid and M4 representing the broadest category.

Money Creation:

Understanding how money is created adds another layer to the financial landscape.

  1. Fractional Banking System:
    • In this system, only a fraction of bank deposits is backed by actual cash on hand, allowing for the creation of money.
  2. Money Multiplier:
    • The money multiplier measures the ability of banks to create deposits with each unit of money reserved.
    • Formula: Money Multiplier (MM) = Broad Money (M3) ÷ Reserve Money (M0).
    • An increase in Reserve Money leads to a corresponding increase in Broad Money.
    • For instance, a money multiplier of 6 signifies that banks can create 6 units of money for every unit held in cash reserves.

Types of Deposits:

Understanding the characteristics of deposits adds nuance to the monetary system.

  1. Demand Deposits:
    • Payable on demand from the account holder, encompassing savings and current accounts, as well as demand drafts.
  2. Time Deposits:
    • Have a fixed maturity period, including fixed deposits, recurring deposits, cash certificates, and staff security certificates.
    • Notably, time deposits exceed demand deposits in banks.

Money Supply Measures:

The total stock of money in circulation, termed Money Supply, is delineated by various measures:

Reserve Money (M0) – Currency in circulation + Bankers’ Deposits with the RBI + ‘Other’ deposits with the RBI.

  1. M1:
    • Currency in circulation with the public (CU) + Demand deposits in commercial banks (DD)+‘Other’ deposits with the RBI.
  2. M2:
    • M1 + Saving deposits held by post office banks.
  3. M3:
    • M1 + Net time deposits held in commercial banks.
  4. M4:
    • M3 + Total deposits with post office banks (excluding national savings certificates).

M1 and M2 fall under narrow money, while M3 and M4 constitute broad money.

Liquidity increases from M4 to M1, with M3 being the popular measure known as Aggregate Monetary Resource.

Factors Affecting Money Supply:

Several factors influence the money supply within an economy:

  1. Currency Deposit Ratio (C.D.R):
    • The ratio of money held in currency to deposits in banks (C.D.R = CU / DD).
  2. Reserve Deposit Ratio:
    • The proportion of total deposits kept in reserves.
  3. Cash Reserve Ratio:
    • A fraction of deposits that banks must keep with the RBI.
  4. Statutory Liquidity Ratio:
    • The fraction of total deposits that banks must keep in liquid assets.
  5. High-Powered Money (M0):
    • The total liability of the monetary authority, including currency in circulation, vault cash with banks, and deposits of commercial banks and the government with RBI.

Money Multiplier Unveiled: Unraveling the Magic of Bank Deposits

The money multiplier, a cornerstone in financial analysis, provides a fascinating glimpse into how banks can exponentially increase the money supply through a carefully orchestrated interplay of reserves and deposits. Let’s delve into the intricacies of this captivating concept, complemented by real-world data and an illustrative example.

Defining the Money Multiplier:

The money multiplier serves as a metric to quantify the extent to which banks can generate additional money, specifically in the form of deposits, based on the reserves they hold. It encapsulates the multiplier effect, showcasing how a single unit of reserved money can give rise to a more substantial increase in the overall money supply.

Calculation Formula:

The formula for the money multiplier is elegantly expressed as:

Money Multiplier (MM)=Broad Money (M3)Reserve Money (M0)

Cause and Effect:

Understanding the cause-and-effect dynamics of the money multiplier is paramount. An increase in Reserve Money initiates a chain reaction, resulting in a proportional escalation in Broad Money. The growth of reserves held by banks directly correlates with the expansion of the economy’s overall money supply.

Illustrative Example:

Consider a hypothetical scenario where the money multiplier is 5. This numerical representation is not just theoretical; it mirrors the empirical realities of banking systems. In this context, a money multiplier of 5 implies that for every unit of money meticulously reserved by banks, they have the remarkable capacity to create five units of money in the form of deposits.

For instance, if the initial Reserve Money stands at $1 million, the subsequent Broad Money created by the banks would amount to $5 million. This example vividly illustrates the leveraging power of banks and their pivotal role in contributing to the expansion of the money supply.

Real-World Application:

let’s consider a practical application. Assume that the Reserve Money in a given economy has experienced a 10% increase due to monetary policy adjustments. According to the money multiplier formula, this would result in a 10% expansion in the Broad Money supply, showcasing the direct correlation between changes in reserves and the broader monetary landscape.

Understanding Marginal Propensity to Save and the Paradox of Thrift

Marginal Propensity to Save (MPS) and Marginal Propensity to Consume (MPC):

The Marginal Propensity to Save (MPS) and the Marginal Propensity to Consume (MPC) are key concepts in economics that shed light on how individuals allocate additional income.

  • MPS: It represents the proportion of the total additional income that people in the economy wish to save. Mathematically, MPS is expressed as the change in savings divided by the change in income.
  • MPC: This is the fraction of the total additional income that people wish to consume. It is calculated as the change in consumption divided by the change in income.

The Paradox of Thrift:

The paradox of thrift arises when the people in an economy collectively decide to increase the proportion of their income that they save. While on an individual level, saving is a responsible financial behavior, the aggregate effect on the economy can lead to unexpected outcomes.

Scenario: Increase in Saving Proportion:

If the people of the economy decide to save a higher proportion of their income, it can have a counterintuitive impact on the total value of savings in the economy.

  1. Decrease in Total Savings:
    • Paradoxically, when individuals collectively increase their saving rates, the total value of savings in the economy may decrease. This is because the reduction in consumption can lead to a decrease in overall economic activity, resulting in lower income levels for individuals and, consequently, lower total savings.
  2. No Change in Total Savings:
    • In some cases, the total value of savings may remain the same. The decrease in consumption could be offset by an increase in savings due to higher income levels resulting from increased investment or government spending. However, the overall impact on total savings depends on various economic factors.

Illustrative Example:

Consider an economy where individuals decide to increase their savings from 10% to 15% of their income. Individually, this seems prudent. However, if this behavior is widespread, it might lead to a decline in overall consumption, reduced economic activity, and potentially lower total savings in the economy.

Monetary Policy: Overview, History in India, Objectives, and Limitations

1. Overview of Monetary Policy:

  • Definition: Monetary policy involves actions by a central bank to regulate money supply, interest rates, and credit availability to achieve economic stability and growth.
  • Central Bank Role: The central bank, such as the Reserve Bank of India (RBI), implements monetary policy to influence economic conditions and achieve stability.

2. History of Monetary Policy in India:

  • Pre-Independence: The British government managed India’s monetary system until Independence in 1947, with the RBI established in 1935.
  • Post-Independence: Post-Independence, the RBI gained autonomy, aligning monetary policy with national economic goals.
  • Liberalization (1990s): Economic reforms in the 1990s led to changes in the monetary policy framework, emphasizing market-driven mechanisms.

3. Objectives of Monetary Policy:

  • Price Stability: Controlling inflation to maintain stable prices and preserve the purchasing power of the currency.
  • Full Employment: Promoting economic growth and employment through effective management of interest rates and credit availability.
  • Economic Growth: Supporting sustainable economic development and growth through appropriate monetary measures.
  • Exchange Rate Stability: Ensuring stability in the foreign exchange market to facilitate external trade.

4. Limitations of Monetary Policy:

  • Time Lag: Implementation of monetary policy measures may experience delays in reflecting their impact on the economy.
  • Limited Scope: Monetary policy may have limitations in addressing structural issues, such as supply-side constraints, requiring broader fiscal and structural reforms.
  • Effectiveness During Crisis: In extreme economic crises, monetary policy effectiveness may be constrained, necessitating coordinated fiscal and monetary measures.
  • Global Factors: Economic globalization means that domestic monetary policy can be influenced by international economic conditions and external shocks.

Quantitative Tools of Monetary Policy:

  • Quantitative tools of monetary policy are measures employed by central banks to control the money supply, interest rates, and credit availability at a broader level.
  • These tools operate without discrimination among sectors and aim to regulate the overall volume of credit.
  • Key quantitative tools include interest rates, open market operations, cash reserve ratio (CRR), statutory liquidity ratio (SLR), and direct controls on credit.

Qualitative Tools of Monetary Policy:

  • Qualitative tools, also known as selective credit controls, are methods used by central banks to influence the direction and allocation of credit in the economy.
  • Unlike quantitative tools, qualitative tools focus on specific sectors or types of credit rather than the overall volume.
  • These measures aim to address specific economic issues and promote targeted credit policies.

Quantitative Tools of Monetary Policy: Detailed Analysis

1. Bank Rate:

  • Description: The minimum rate at which the RBI provides a loan to commercial banks.
  • Impact on Economy:
    • Expansionary: Lowering the bank rate encourages borrowing by making loans cheaper, stimulating economic activity.
    • Contractionary: Raising the bank rate increases the cost of borrowing, curbing spending and inflation.

2. Repo Rate:

  • Description: The rate at which the RBI lends to commercial banks to manage short-term liquidity needs, with an agreement to repurchase government securities at a predetermined date and rate.
  • Impact on Economy:
    • Expansionary: Lowering the repo rate makes borrowing cheaper, promoting investment and consumption.
    • Contractionary: Raising the repo rate makes borrowing more expensive, reducing spending and inflation.

3. Reverse Repo Rate:

  • Description: The interest rate at which the RBI absorbs liquidity from banks against eligible government securities under the Liquidity Adjustment Facility (LAF), lower than the repo rate.
  • Impact on Economy:
    • Expansionary: Lowering the reverse repo rate encourages banks to lend, boosting economic activity.
    • Contractionary: Raising the reverse repo rate absorbs excess liquidity, controlling inflation.

4. Long Term Repo Operations (LTRO):

  • Description: The RBI provides 1–3 year money to banks at the prevailing repo rate, accepting government securities with matching or higher tenure as collateral.
  • Impact on Economy:
    • Expansionary: LTRO provides long-term funds, supporting credit availability and economic growth.
    • Contractionary: Reduction in LTRO can tighten liquidity, curbing excessive lending.

5. Cash Reserve Ratio (CRR):

  • Description: The percentage of a bank’s Net Demand and Time Liabilities (NDTL) that it must maintain with the RBI in cash.
  • Impact on Economy:
    • Expansionary: Lowering CRR increases funds available for lending, supporting credit expansion.
    • Contractionary: Raising CRR reduces funds available for lending, controlling inflation and excessive credit creation.

6. Liquidity Adjustment Facility (LAF):

  • Description: LAF allows banks to borrow money through repurchase agreements, aiding in adjusting daily fluctuations in liquidity.
  • Impact on Economy:
    • Expansionary: LAF helps banks manage liquidity, ensuring adequate funds for lending.
    • Contractionary: LAF assists in absorbing excess liquidity, preventing inflationary pressures.

7. Open Market Operations (OMOs):

  • Description: The purchase and sale of securities by the RBI.
  • Impact on Economy:
    • Expansionary: Buying securities injects money into the economy, promoting spending.
    • Contractionary: Selling securities removes money, controlling inflation and excessive liquidity.

8. Marginal Standing Facility (MSF):

  • Description: A penal rate at which scheduled banks can borrow money from the RBI beyond the LAF window.
  • Impact on Economy:
    • Ensures Stability: MSF aims to reduce volatility in overnight lending rates in the interbank market.

9. Statutory Liquidity Ratio (SLR):

  • Description: The percentage of deposits that banks must hold in highly liquid government securities.
  • Impact on Economy:
    • Ensures Liquidity: SLR ensures that banks maintain a certain level of liquidity, preventing excessive lending.

Difference Between CRR and SLR:

Cash Reserve Ratio (CRR):

  • Maintained in cash form.
  • No interest is earned on CRR.
  • Helps regulate liquidity in the economy.
  • Calculated on Total Demand and Time Liabilities.
  • Permissible range: 3% to 15%.

Statutory Liquidity Ratio (SLR):

  • Can be maintained in gold, cash, and other approved securities.
  • Interest is earned on SLR.
  • Helps regulate credit facility in the economy.
  • Calculated on Net Demand and Time Liabilities.
  • Upper limit: 40%, lower limit: 23%.

Difference between Repo Rate and Bank rate

Feature Bank Rate Repo Rate
Definition Minimum rate for central bank loans to commercial banks Rate for short-term central bank loans to commercial banks with repurchase agreements
Purpose Regulating long-term lending and borrowing rates, acting as a benchmark Managing short-term liquidity needs, influencing short-term borrowing costs
Loan Type Applicable for long-term loans and advances Applicable for short-term loans, typically overnight
Collateral Generally unsecured loans Secured loans backed by collateral, usually government securities
Duration Relatively stable rate, changes less frequently Short-term rate, subject to more frequent adjustments
Influence on Economy Impacts overall interest rate environment, affecting long-term investment and borrowing Influences short-term borrowing costs, impacting liquidity and spending in the short term
Market Operations Used for discounting or rediscounting of bills of exchange and other commercial papers Used in repurchase agreements where banks pledge government securities
Relationship Generally higher than the repo rate Repo rate is often lower and more flexible, addressing short-term liquidity concerns

Qualitative Tools :

Qualitative tools play a crucial role in controlling the distribution and direction of loans across various sectors of the economy. These measures are essential for maintaining a balanced and controlled lending environment.

Margin Requirements:

  • Description: Margin requirements refer to the difference between the current value of the security offered as collateral for a loan and the actual value of the loan granted.
  • Impact: The higher the margin, the lesser the loan granted. For instance, if the Reserve Bank of India (RBI) aims to allocate more credit to priority sectors like agriculture, it may reduce the margin.
  • Example:
  • Sector: Agriculture
        • Collateral/Loan Applied: Rs 10,000
        • Margin: 10%
        • Loan Given: Rs 9,000
  • Sector: Personal Loan
        • Collateral/Loan Applied: Rs 10,000
        • Margin: 25%
        • Loan Given: Rs 7,500

Credit Rationing:

    • Description: Central banks set limits on the credit amount that each commercial bank can grant, effectively reducing the exposure of banks to unwanted sectors.

Moral Suasion:

    • Description: Moral suasion involves influencing banks through directives, meetings, persuasion, pressure, inspections, and frequent follow-ups.

Direct Action:

    • Description: This measure involves taking direct actions such as imposing fines, banning non-cooperating banks, refusing the rediscounting of their bills, and withholding credit supply.
    • Purpose: Direct actions are implemented to ensure compliance with lending policies and discourage practices that may lead to undesired economic outcomes.

Monetary Policy Transmission and the Role of RBI:

Monetary Policy Transmission:

Monetary policy transmission refers to the process through which changes in a central bank’s monetary policy instruments influence various economic variables such as interest rates, inflation, and ultimately, economic activity. The transmission mechanism plays a crucial role in achieving the objectives of monetary policy, which typically include price stability, economic growth, and employment.

Key Channels of Monetary Policy Transmission:

  1. Interest Rate Channel:
    • Mechanism: Changes in the policy interest rates, such as the repo rate, affect the overall interest rate structure in the economy.
    • Impact: Altered interest rates influence borrowing costs for consumers and businesses, thereby affecting spending and investment decisions.
  2. Credit Channel:
    • Mechanism: Changes in policy rates impact the availability and cost of credit in the economy.
    • Impact: A shift in credit conditions influences the demand for loans, affecting consumer spending and business investment.
  3. Exchange Rate Channel:
    • Mechanism: Changes in interest rates may lead to fluctuations in exchange rates.
    • Impact: Exchange rate movements influence export and import dynamics, affecting trade balances and overall economic activity.
  4. Asset Price Channel:
    • Mechanism: Monetary policy actions can influence asset prices, such as equities and real estate.
    • Impact: Changes in asset prices affect wealth, consumer confidence, and investment decisions.
  5. Expectations Channel:
    • Mechanism: Communication and credibility of the central bank influence expectations of future economic conditions.
    • Impact: Expectations shape current decisions on spending, saving, and investment.

Role of RBI in Monetary Policy Transmission:

  1. Setting Policy Rates:
    • The RBI, as India’s central bank, sets key policy rates like the repo rate and reverse repo rate to signal its stance on monetary policy.
  2. Open Market Operations (OMOs):
    • The RBI conducts OMOs by buying or selling government securities to manage liquidity in the banking system, impacting interest rates.
  3. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR):
    • The RBI regulates the CRR and SLR, affecting the amount of funds banks must keep in reserve, influencing their lending capacity.
  4. Forward Guidance:
    • The RBI communicates its policy outlook and intentions through forward guidance, guiding market expectations.
  5. Regulatory Measures:
    • The RBI regulates various aspects of banking and financial markets, ensuring the stability and efficiency of the financial system.
  6. Supervision and Monitoring:
    • The RBI monitors economic indicators, financial stability, and inflation, adjusting policies as needed to achieve its objectives.

Types of Banks in India:

Banks in India can be categorized into various types based on their characteristics, ownership, and functions. Here’s an overview of the main types:

  1. Scheduled Banks:
    • Definition: Listed in the 2nd schedule of the Reserve Bank of India Act, 1934.
    • Example: Canara Bank.
    • Features:
      • Eligible for loans from the Reserve Bank of India at the bank rate.
      • Required to deposit Cash Reserve Ratio (CRR) with RBI.
      • Types include Commercial Banks and Cooperative Banks.
  2. Non-Scheduled Banks:
    • Definition: Not listed in the 2nd schedule of the RBI Act, 1934.
    • Features:
      • Depend on RBI discretion.
      • Can maintain CRR with themselves, not with RBI.
      • Many cooperative banks fall under the non-scheduled category.
  3. Commercial Banks:
    • Categories:
      • Public Sector Banks: More than 50% is held by the government.
      • Private Sector Banks: Most of the capital is in private hands.
      • Foreign Banks.
    • Functions: Provide a wide range of banking and financial services to individuals, businesses, and other entities.
  4. Cooperative Banks:
    • Categories:
      • Urban Cooperative Banks.
      • State Cooperative Banks.
      • Multi-State Cooperative Banks.
    • Functions: Primarily focus on meeting the financial needs of their members and promoting cooperative principles.
  5. Differential Banks:
    • Categories:
      • Small Finance Banks.
      • Payments Banks.
      • Regional Rural Banks.
    • Features: Specialized banks catering to specific needs, such as financial inclusion, small-scale banking, and providing payment services.
  6. Development Banks:
    • Examples:
      • NABARD (National Bank for Agriculture and Rural Development).
      • SIDBI (Small Industries Development Bank of India).
      • EXIM Bank (Export-Import Bank of India).
      • NHB (National Housing Bank).
      • IFCI (Industrial Finance Corporation of India).
    • Functions: Promote economic development by providing financial assistance and support to specific sectors like agriculture, small industries, exports, housing, and infrastructure.

Cooperative Banks:

Definition: Cooperative banks are financial institutions that operate on the cooperative principles of self-help and mutual assistance. These banks are owned, governed, and operated by their members, who are usually individuals with a common interest or purpose, such as residents of a specific locality, employees of a particular organization, or individuals involved in a specific trade or profession.

Types of Cooperative Banks:

  1. Urban Cooperative Banks (UCBs):
    • Scope: Operate in urban and semi-urban areas.
    • Membership: Membership is usually open to residents in a specific urban or semi-urban locality.
    • Functions: Provide banking services to meet the financial needs of the local community.
  2. State Cooperative Banks (SCBs):
    • Scope: Operate at the state level.
    • Membership: Comprise district central cooperative banks and primary agricultural credit societies.
    • Functions: Act as central banks for district cooperative banks and provide financial support to the agricultural sector.
  3. Multi-State Cooperative Banks:
    • Scope: Operate in more than one state.
    • Membership: May have members from different states and territories.
    • Functions: Extend banking services across state boundaries, catering to a broader geographical area.

Key Features of Cooperative Banks:

  1. Ownership and Control:
    • Owned by Members: Members, who are also customers, own cooperative banks.
    • One Member, One Vote: Each member has an equal say in the bank’s decision-making, following the principle of “one member, one vote.”
  2. Purpose and Social Objectives:
    • Local Development: Focus on local development and meeting the financial needs of the community.
    • Social Welfare: Aim to promote social welfare and financial inclusion.
  3. Limited Area of Operation:
    • Geographical Constraints: Cooperative banks typically operate in specific localities, serving the needs of the community they are based in.
  4. Targeted Customer Base:
    • Specific Membership Criteria: Membership is often restricted to individuals sharing a common bond, such as residents of a locality, employees of an organization, or individuals in a specific profession.
  5. Interest in Customer Welfare:
    • Customer-Centric Approach: Cooperative banks prioritize the welfare of their members and customers over profit maximization.

Key differences between Cooperative Banks and Commercial Banks across various aspects.

Feature Cooperative Banks Commercial Banks
Ownership Owned and governed by members. Owned by shareholders; ownership based on shares held.
Objective Focus on serving members and local communities. Primarily driven by profit motives and shareholder value.
Area of Operation Typically operate in specific localities or regions. Can have a broader geographical presence, including national and international operations.
Decision-Making Democratic process; each member has an equal vote. Decision-making often based on the number of shares held, giving more influence to larger shareholders.
Regulation Regulated by RBI and NABARD. Regulated by RBI.

Differential Banks in India:

Differential banks refer to a category of specialized banks in India that have unique characteristics and serve specific purposes. These banks are designed to cater to the diverse financial needs of different segments of the population and contribute to financial inclusion.

A. Small Finance Banks (SFBs):

Small Finance Banks are a category of financial institutions in India that operate with the primary objective of providing financial services to underserved and unserved segments of the population, including small farmers, micro and small enterprises, and low-income households. These banks were introduced to address the gaps in financial inclusion and promote inclusive growth. Here are key aspects of Small Finance Banks:

Key Features:

  1. Objective:
    • The primary goal of Small Finance Banks is to extend banking services to sections of the population that have limited or no access to formal banking channels.
  2. Target Customers:
    • SFBs focus on serving small businesses, micro and small enterprises (MSEs), small and marginal farmers, and low-income households in rural and semi-urban areas.
  3. Products and Services:
    • While Small Finance Banks offer a range of banking services, they often emphasize basic banking products such as savings accounts, fixed deposits, and remittance services. They also provide microcredit and small loans to cater to the credit needs of their target customers.
  4. Geographical Focus:
    • SFBs are mandated to serve a specific region or limited area of operation, typically rural and semi-urban areas, to ensure effective financial inclusion.
  5. Regulation:
    • Small Finance Banks are regulated by the Reserve Bank of India (RBI), and they need to comply with the regulatory guidelines set by the central bank. These guidelines define the eligibility criteria, capital requirements, and operational norms for SFBs.
  6. Promotion of Microfinance:
    • SFBs play a crucial role in promoting microfinance activities by providing small-ticket loans to individuals and microenterprises. This facilitates financial empowerment at the grassroots level.
  7. Technology Integration:
    • Many Small Finance Banks leverage technology to enhance outreach and provide digital financial services. This includes the use of mobile banking, internet banking, and other technological solutions to reach remote areas.
  8. Financial Inclusion Mandate:
    • Small Finance Banks are required to fulfill a financial inclusion mandate by allocating a portion of their loan portfolio to priority sectors, such as agriculture and micro, small, and medium enterprises (MSMEs).
  9. Rural Development:
    • By focusing on rural and semi-urban areas, SFBs contribute to the overall development of these regions. They provide access to formal banking services, which is essential for economic development and poverty alleviation.

Challenges and Opportunities:

  1. Challenges:
    • Limited banking history of the target population.
    • Asset quality concerns due to the risk associated with serving the unbanked.
    • Ensuring sustainability while catering to economically weaker sections.
  2. Opportunities:
    • Growing market potential in untapped rural and semi-urban areas.
    • Leveraging technology for cost-effective operations.
    • Enhancing financial literacy and inclusion.

Prominent Small Finance Banks in India (As of January 2022):

  1. Ujjivan Small Finance Bank
  2. Equitas Small Finance Bank
  3. AU Small Finance Bank
  4. Jana Small Finance Bank
  5. ESAF Small Finance Bank

B. Payment Banks in India:

Introduction:

Payment Banks are a specialized category of banks in India that focus on providing a limited range of financial services, primarily centered around digital and electronic transactions. These banks were introduced to promote financial inclusion and facilitate digital payments, especially for individuals who do not have access to traditional banking services. Here are key aspects of Payment Banks in India:

Key Features:

  1. Scope of Operations:
    • Payment Banks are authorized to undertake a restricted set of banking activities. They cannot engage in lending activities like traditional banks.
    • Their primary focus is on facilitating digital transactions, remittances, and providing payment services.
  2. Services Offered:
    • Payment Banks can offer the following services:
      • Accepting deposits (up to a specified limit).
      • Issuing prepaid payment instruments, such as mobile wallets and prepaid cards.
      • Facilitating domestic and cross-border remittances.
      • Providing payment and settlement services for individuals and businesses.
  3. Target Customer Base:
    • Payment Banks are designed to target individuals who are unbanked or underbanked, promoting financial inclusion.
    • They cater to customers who need basic banking services, especially those who may not have access to traditional banking infrastructure.
  4. Deposit Limits:
    • Payment Banks can accept deposits up to a specified limit from each customer.
    • Till January 2022, the maximum balance per customer cannot exceed ₹2 lakh.
  5. No Lending Activities:
    • Payment Banks are prohibited from engaging in lending activities, including issuing loans or credit cards.
    • This restriction helps them maintain a focus on their core services and objectives.
  6. Technology-Driven Operations:
    • Payment Banks heavily rely on technology to offer digital financial services. They often leverage mobile and internet banking platforms to reach a wider customer base.
  7. Partnerships and Collaborations:
    • Many Payment Banks collaborate with other financial institutions, telecom companies, and technology providers to enhance their service offerings and outreach.
  8. Regulation and Oversight:
    • Payment Banks are regulated by the Reserve Bank of India (RBI). They need to comply with regulatory guidelines and periodic reviews to ensure their operations align with the intended objectives.

Prominent Payment Banks in India (As of January 2022):

  1. Airtel Payments Bank
  2. Paytm Payments Bank
  3. India Post Payments Bank (IPPB)
  4. Fino Payments Bank
  5. Jio Payments Bank

Challenges and Opportunities:

  1. Challenges:
    • Building trust among customers, especially those unfamiliar with digital banking.
    • Maintaining cybersecurity and data protection to ensure the security of digital transactions.
    • Meeting regulatory compliance requirements.
  2. Opportunities:
    • Tapping into the vast unbanked and underbanked population in India.
    • Leveraging technology to provide convenient and accessible financial services.
    • Contributing to the government’s vision of a cashless and digital economy.

Difference between payment banks and small finance banks 

Feature Payments Bank Small Finance Bank
Basis of Establishment Recommendations from Usha Thorat formed the basis. Establishment rooted in the recommendations of Nachiket Mor.
Deposit Limit Accepts deposits up to Rs 2 lakh per individual customer. Accepts deposits of any amount, providing flexibility.
Lending Activities Not involved in any form of lending activities. Permitted to lend, with a specific focus on small lending.
Savings Accounts Offers small savings accounts for customers. Extends support to small businesses, farmers, MSMEs, and unorganized sector entities.
Remittance Services Provides remittance services to customers. Offers both remittances and credit card services.
Cards Issuance Authorized to issue ATM/debit cards to customers. Permitted to issue both ATM and debit cards for customer convenience.
Credit Cards Issuance Prohibited from issuing credit cards to customers. Required to ensure that 50% of the loan portfolio constitutes advances of up to Rs. 25 lakh.
Distribution of Financial Products Can distribute various financial products, including mutual funds, insurance, and third-party loans. Authorized to distribute financial products such as mutual funds, insurance, pension schemes, etc.

Regional Rural Banks (RRBs):

Introduction:

Regional Rural Banks (RRBs) are financial institutions in India that were established with the primary objective of catering to the rural and agricultural credit needs of the country. RRBs play a crucial role in rural development by providing banking and financial services to the rural population, including farmers, artisans, small entrepreneurs, and the economically weaker sections. Here are key aspects of Regional Rural Banks:

Establishment:

  • RRBs were established under the provisions of the Regional Rural Banks Act, 1976.
  • They are a result of recommendations made by the Narasimham Working Group.

Structure:

  • RRBs operate in a three-tier structure, with the following entities involved:
    1. Sponsor Banks: Commercial banks or public sector banks act as sponsors for RRBs and provide financial and managerial support.
    2. Regional Rural Banks: The RRBs themselves, which operate at the regional or state level.
    3. National Bank for Agriculture and Rural Development (NABARD): NABARD plays a role in providing financial assistance, monitoring, and coordinating the activities of RRBs.

Objective:

  • The primary objective of RRBs is to promote financial inclusion and provide credit facilities to the rural and agricultural sectors.
  • They aim to bridge the gap between formal banking services and rural communities, fostering rural development.
  • As per RBI guidelines, the RRBs have to provide 75% of their total credit under PSL (Priority Sector Lending)

Functions:

  1. Credit Services:
    • RRBs provide credit facilities to farmers, agricultural laborers, artisans, and other rural clients for agricultural and allied activities.
    • Loans are extended for crop production, animal husbandry, fisheries, rural industries, and other income-generating activities.
  2. Savings and Deposit Products:
    • RRBs offer various savings and deposit products tailored to the needs of rural customers. These may include savings accounts, recurring deposits, fixed deposits, and other customized savings schemes.
  3. Remittance Services:
    • RRBs facilitate remittance services for rural customers, allowing them to transfer funds securely and conveniently.
  4. Government Schemes:
    • RRBs play a crucial role in implementing various government-sponsored schemes related to rural development, agriculture, and poverty alleviation.
  5. Financial Inclusion:
    • RRBs contribute significantly to financial inclusion by providing banking services to unbanked and underbanked rural areas.

Challenges and Initiatives:

  1. Challenges:
    • Limited resource base and capitalization.
    • Exposure to agricultural and rural risks.
    • Ensuring the financial viability of RRBs.
  2. Initiatives:
    • Recapitalization: Periodic recapitalization by the government to strengthen the capital base of RRBs.
    • Technological Integration: Embracing technology for efficient banking operations, including digital services.

Regulation:

  • RRBs are regulated by the National Bank for Agriculture and Rural Development (NABARD) and are subject to the regulatory guidelines of the Reserve Bank of India (RBI).

Development Banks in India:

1. Industrial Finance Corporation of India (IFCI):

  • Established in 1948 under the Industrial Finance Corporation Act to cater specifically to the term finance needs of large industries.
  • Pioneering institution that played a crucial role in fostering industrial growth in India.
  • Focus on providing financial support to industries for their development and expansion.

2. National Bank for Agriculture & Rural Development (NABARD):

  • Apex development financial institution dedicated to agriculture and rural development.
  • Established in 1982 based on B. Sivaraman Committee recommendations to address the financial needs of the agricultural sector.
  • Operates as a statutory body under the NABARD Act, 1981, with its headquarters in Mumbai.
  • Fully owned by the Government of India, demonstrating a strong commitment to rural development.

NABARD Functions:

  • Monitors and evaluates projects it refinances, ensuring effective implementation.
  • Regulatory role extends to cooperative banks and Regional Rural Banks (RRBs).
  • Serves as a refinancing institution for other financial entities supporting rural development.
  • Offers training facilities to institutions engaged in rural upliftment, contributing to skill development.

NABARD Refinance Facility Available to:

State Co-operative Agriculture and Rural Development Banks (SCARDBs), State Co-operative Banks (SCBs) ,Regional Rural Banks (RRBs), Commercial Banks (CBs) etc.

3. Small Industries Development Bank of India (SIDBI):

  • Statutory body established on April 2, 1990, under an Act of the Indian Parliament.
  • Recognized as the Principal Financial Institution for the promotion, financing, and development of the Micro, Small, and Medium Enterprise (MSME) sector.
  • Implements key schemes like Pradhan Mantri MUDRA Yojana and the credit-linked capital subsidy scheme to boost MSME growth.

4. Export-Import Bank of India (EXIM Bank):

  • Established in 1982 as a wholly-owned entity of the Government of India.
  • Focuses on financing, facilitating, and promoting foreign trade activities to strengthen India’s global economic presence.
  • Integral in fostering international trade relationships and supporting exporters.

5. National Housing Bank (NHB):

  • Established in 1988 under the National Housing Bank Act (1987) to address housing finance and related needs.
  • Regulatory role in overseeing and refinancing social housing programs.
  • Diversifies its activities to include research, contributing to informed policymaking in the housing and related sectors.

Non-Performing Assets (NPA): An In-depth Analysis

Definition: Non-Performing Assets (NPAs) are financial assets in the form of loans or advances that have stopped generating income for a lending institution. Specifically, a loan or advance is classified as an NPA when the borrower fails to make principal or interest payments for a specified period, usually exceeding 90 days. NPAs are indicative of financial stress and pose significant challenges to the health and stability of financial institutions.

Categorization of NPAs:

  1. Substandard Assets:
    • An asset is classified as substandard when it remains as an NPA for 12 or more months. This classification signifies that the financial condition of the borrower has deteriorated over time.
  2. Doubtful Assets:
    • Doubtful assets are those that remain classified as substandard for an extended period, typically 12 months or more. The classification implies a high level of uncertainty regarding the full recovery of the loan.
  3. Loss Assets:
    • A loan becomes a loss asset when it is deemed uncollectable with little or no salvage value. This classification represents an irreversible financial loss for the lending institution.
  4. Loan Write Off:
    • Loan write-off is a strategic accounting measure where the loan is removed from the asset side of the balance sheet. It does not absolve the borrower from the obligation to repay, but it acknowledges the impracticality of recovery.

Identification of NPAs:

The identification and classification of NPAs follow a systematic approach, often involving the following key criteria:

  • Overdue Period: Loans are classified as NPAs when the principal or interest payments remain overdue for a period exceeding 90 days. This period may vary depending on the type of loan and sector.
  • Agriculture Loan Criteria: In the context of agriculture loans, specific criteria are applied. For short duration crop loans, NPAs are declared if the loan installment or interest remains unpaid for two crop seasons. For long-duration crops, the NPA classification occurs if the payment is overdue for one crop season from the due date.

SPECIAL MENTION ACCOUNTS (SMA) 

Special Mention Accounts (SMAs) play a pivotal role in the proactive management of potential bad asset quality, offering insights into early stress detection:

  • Standard Accounts: Loans where both principal and interest payments are consistently made on time.
  • SMA – NF (Non-Financial): Identifying accounts displaying non-financial signs of stress.
  • SMA 0: Addressing loans with principal or interest unpaid for 1-30 days from the due date.
  • SMA 1: Managing loans with principal or interest unpaid for 31-90 days.
  • SMA 2: Focusing on loans unpaid for 61-90 days.
  • SMA 3: Introducing a new category for loans with non-payment extending beyond 90 days but still in the early stages of distress.
  • NPA: Exploring the category where loans remain unpaid for more than 90 days.

Impact of NPAs on Financial Institutions:

  1. Erosion of Profitability: NPAs lead to a decline in interest income, impacting the profitability of financial institutions.
  2. Capital Adequacy Concerns: Accumulation of NPAs reduces the capital adequacy ratio, affecting a bank’s ability to absorb losses.
  3. Credit Crunch: Increased NPAs can result in a reluctance to lend, contributing to a credit crunch in the economy.
  4. Risk Management Challenges: Managing and mitigating the risks associated with NPAs require robust risk management practices and proactive measures.

Strategies for Identifying, Rectifying, and Addressing Non-Performing Assets (NPAs): A Holistic Approach

Non-Performing Assets (NPAs) pose significant challenges to the financial health and stability of lending institutions. Robust measures and comprehensive strategies are essential for effective identification, rectification, and management of NPAs. Here’s a detailed overview combining various measures and incorporating a 3R framework:

Identification of NPAs: Enhancing Transparency and Vigilance

  1. Asset Quality Review (AQR):
    • Regulatory authorities conduct AQRs to assess the quality of assets comprehensively. This ensures transparency in reporting and identifies potential NPAs.
  2. Regular Monitoring and Reporting:
    • Implementing robust systems for regular monitoring enables the timely identification of accounts showing signs of stress or non-compliance with repayment schedules.
  3. Risk-Based Internal Audits:
    • Internal audit teams conduct risk-based audits, evaluating the credit risk associated with loans. This proactive approach aids in early detection of potential NPAs.
  4. Credit Scoring Models:
    • Utilizing credit scoring models helps assess the creditworthiness of borrowers, identifying accounts that may pose a higher risk of becoming NPAs.
  5. Early Warning Systems (EWS):
    • Implementation of EWS allows for the early identification of accounts showing signs of financial stress, enabling preventive measures to avoid slipping into the NPA category.

Rectification and Resolution Measures: Strategic Steps Toward Recovery

  1. Restructuring and Rescheduling:
    • In cases of temporary financial difficulties, restructuring or rescheduling loans can be considered. This involves modifying terms to make repayments more manageable for borrowers.
  2. Asset Reconstruction Companies (ARCs):
    • Selling NPAs to specialized ARCs helps in managing and recovering distressed assets, facilitating a cleanup of the lending institution’s balance sheet.
  3. Corporate Debt Restructuring (CDR):
    • The CDR mechanism allows for the restructuring of debt obligations for larger corporate accounts through negotiations between borrowers and lenders.
  4. Insolvency and Bankruptcy Code (IBC):
    • IBC provides a legal framework for resolving insolvency cases, ensuring a time-bound and efficient process for restructuring or liquidation.
  5. One-Time Settlement (OTS):
    • Offering borrowers a one-time settlement option allows them to repay a reduced amount, closing outstanding loans through a negotiated settlement.
  6. Asset Quality Review (AQR):
    • Periodic AQRs not only identify but guide lending institutions in rectification measures, such as provisioning adequately for potential losses.

Preventive Measures: Strengthening the Foundation

  1. Due Diligence in Loan Approval:
    • Rigorous due diligence before loan approval identifies potential risks, ensuring borrowers have the capacity to meet repayment obligations.
  2. Risk Management Practices:
    • Implementing robust risk management practices, including stress testing and scenario analysis, proactively identifies potential stress points and guides preventive actions.
  3. Credit Monitoring Systems:
    • Utilizing advanced credit monitoring systems allows real-time tracking of borrower behavior and repayment patterns, indicating indicators of financial stress.
  4. Stringent Loan Recovery Policies:
    • Clear and stringent policies for loan recovery, including collateral realization and legal recourse, act as deterrents against defaults.

Comprehensive Strategies: The 3R Framework

The 3R framework, incorporating rectification, restructuring, and recovery, plays a crucial role in revitalizing stressed assets and maintaining banking sector stability:

  1. Rectification: Conducting Asset Quality Review (AQR):
    • A thorough AQR assesses the quality of assets, emphasizing the significance of timely reviews for restructuring loans impacted by external factors.
  2. Restructuring: Various Strategic Approaches:
    • Strategic Debt Restructuring (SDR), Scheme for Sustainable Structuring of Stressed Assets (S4A), and Joint Lenders Forum contribute to coordinated decision-making and financial restructuring.
  3. Recovery: Legal Frameworks and Mechanisms:
    • Legal frameworks like SARFAESI Act, 2002, and Insolvency and Bankruptcy Code, 2016, provide avenues for recovery, ensuring a time-bound and efficient resolution process.

Additional Strategies and Mechanisms:

  1. Sustainable Structuring of Stressed Assets (S4A):
    • An optional framework evaluates and converts unsustainable debt into equity without a change in ownership, promoting financial restructuring.
  2. Bad Banks:
    • Proposed entities like the Public Sector Asset Rehabilitation Agency (PARA) could function as bad banks, addressing the ‘balance sheet syndrome.’
  3. Prompt Corrective Action (PCA):
    • PCA frameworks impose restrictions on banks falling below certain norms, ensuring capital adequacy, asset quality, and profitability.
  4. Asset Reconstruction Companies (ARCs):
    • Specialized institutions, as recommended by the Narasimham Committee, facilitate the cleanup of balance sheets by purchasing NPAs from banks.
  5. Debt Recovery Tribunal (DRT):
    • Legal avenues like DRTs provide recovery certificates, enabling lenders to recover dues by taking possession of properties.