Management of Financial Institutions

Management of Financial Institutions
R.G. Saha

Developed by: R.G. Saha
2015
For private circulation Students Study Material of ADDOE.
All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or copied in any form or by
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and the publisher.
Published by: Himalaya Publishing House Pvt. Ltd., for Amity Directorate of Distance & Online Education, Noida
Syllabus
Course Objective:
The aim of the course is to orient the finance students to the change in the financial industry. The financial
industry much like the computer industry is changing rapidly. A course that merely describes the existing
institutions will not prepare the students adequately for the change. Thus, familiarization with institutions of today
and developing an understanding why they are the way they are, and why they are changing is the core aim of the
course. An Indian perspective will be added but conceptually the global frameworks will be used. At the end of this
course, the students will understand:
The role of financial institutions in economic development

The working of Financial Intermediaries
International Banking
The norms governing of Financial Intermediaries in India
The basic principles of Lending and Investments in a Commercial Bank
The working of Developmental Financial Institutions
Course Contents:
Module l:
Introduction
Financial Institutions and Economic Development, Types of Money, Process of Capital
Formation, Technology of Financial System Pooling, Netting, Credit Substitution and
Delegation.
Module II:
Financial Intermediaries
Understanding Financial Intermediaries Commercial Banks, Central Bank, Cooperative Banks,
Banking System in USA and India, International Banking, Banking Operations, Retail and
Wholesale Banking, Near Banks, Universal Banking, NBFCs.
Module III: Norms and Practices in the Banking Industry

Principles of Lending, Study of Borrowers, Balance Sheet Analysis. Project Appraisal Criteria,
Marketing of Bank Services. Prudential Norms Narasimham Committee Recommendations,
Performance Analysis of Banks, Regulatory Institutions, RBI and SEBI, Lenders Liability Act,
Banking Innovations, Basel Committee Recommendations, CAR Risk Weighted Assets and
Risk-based Supervision, Asset Liability Management in Commercial Banks, Corporate Debt
Restructuring, Internet Banking, Mobile Banking, E-Banking Risk, E-finance, Electronic Money
Digital Signatures, RTGS, NEFT, etc.
Module IV: Developmental Financial Institutions
Role of Developmental Banks in Industrial Financing, Resource Mobilization of Developmental
Banks, Project Examination by Developmental Banks.
Module V: Insurance Institutions
Role of Insurance Companies in Industrial Financing, Life Insurance and General insurance,
New Development in Insurance as a Sector in the Indian Financial System, Bancassurance
Models in Europe and India.
Examination Scheme:
Component Codes
H1
H2
H3
EE1
Weightage (%)
10
10
10
70
Contents
Unit 1: Introduction
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
1.18
1.19
1.20
1.21
1.22
1.23
1.24
1.25
1.26
1.27
1.28
1.29
1.30
1.31
1.32
1.33
1.34
1.35
1.36
1.37
Introduction
Financial Institutions
Meaning of Financial Institutions
Benefits of Financial Institutions
Classification of Financial Institutions
Role of Financial Institutions
Functions of Financial Institutions
Types of Non-Banking Financial Institutions
Financial Institutions and Economic Development
Introduction to Money
History of Money
History of Money in India
Meaning of Money
Features of Money
Functions of Money
Types of Money
Role and Significance of Money in a Modern Economy
Monetary System
Capital Formation
Process of Capital Formation
Financial System
Definitions of Financial System
Meaning of Financial System
Meaning of Financial Dualism
Objectives of Financial System
Purpose of Financial System
Functions of Financial System
Structure of Indian Financial System or Components of Financial System
Technology of Financial System
Summary
Check Your Progress
Questions and Exercises
Key Terms
Check Your Progress: Answers
Case Study
Further Readings
Bibliography
Unit 2: Financial Intermediaries

2.1
2.2
2.3
2.4
2.5
1 44
Introduction
Meaning of Financial Intermediary
Classification of Financial Intermediaries
Functions of Financial Intermediaries
Commercial Banks
45 113
2.6
2.7
2.8
2.9
2.10
2.11
2.12
2.13
2.14
2.15
2.16
2.17
2.18
2.19
2.20
2.21
2.22
2.23
2.24
2.25
2.26
2.27
2.28
2.29
2.30
2.31
2.32
2.33
2.34
2.35
2.36
2.37
2.38
2.39
2.40
2.41
2.42
2.43
2.44
2.45
2.46
2.47
2.48
2.49
2.50
2.51
2.52
Definitions of Commercial Bank

Meaning of Commercial Bank
Significance of Commercial Banks
Structure of Commercial Bank in India
Role of Commercial Bank in the Economic Development of India
Functions of Commercial Banks
Classification of Commercial Banks
Central Bank or RBI
History of the Reserve Bank of India
Establishment of RBI
Organizational Structure of RBI
Functional Departments of RBI
Objectives of Reserve Bank of India
Role of Reserve Bank of India
Main Functions of RBI
Monetary Policy of Reserve Bank of India
Objectives of Monetary Policy
Cooperative Banks
History of Cooperative Banking in India
Structure of Cooperative Banking in India
Cooperative Banks Irritants and Future Trends
Major Irritants in the Functioning of the Cooperative Banks
Banking System in USA and India
International Banking
Benefits of Having an International Banking
Banking Operations
Retail Banking
Meaning of Retail Banking
Retail Banking in India
Features of Retail Banking
Scope for Retail Banking in India
Retail Banking Activities
Wholesale Banking
Wholesale Banking in India
Near Banks
Universal Banking
Advantages of Universal Banking
Disadvantages of Universal Banking
Non-Banking Financial Company
Summary
Check Your Progress
Key Terms
Case Study
Further Readings
Bibliography
Unit 3: Norms and Practices in the Banking Industry

3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14
3.15
3.16
3.17
3.18
3.19
3.20
3.21
3.22
3.23
3.24
3.25
3.26
3.27
3.28
3.29
3.30
3.31
3.32
3.33
3.34
3.35
3.36
3.37
3.38
3.39
3.40
3.41
3.42
3.43
3.44
3.45
3.46
3.47
Introduction
Meaning of Bank Lending
Principles of Lending
Five Cs of Lending Principles
Forms of Lending
Types of Lending
Lending Facilities Granted by Banks
Who are the Borrowers?
Study of Borrowers
Balance Sheet Analysis
Goal of Balance Sheet Analysis
How to Perform a Balance Sheet Analysis?
Project Appraisal
Checklist for Project Appraisal
Project Appraisal Criteria
Marketing of Bank Services
Importance of Bank Marketing
Marketing Approach in Banks
Features of Bank Marketing
Prudential Norms
Prudential Guidelines on Restructuring of Advances
Narasimham Committee Recommendations
Recommendations of the Committee
Highlights of Narasimham Committee Recommendations on Banking Reforms in India
Performance Analysis of Banks
Regulatory Institutions in India
Reserve Bank of India
Credit Control
Meaning of Credit Control
Objectives of Credit Control
Need for Credit Control
Methods of Credit Control
RBI Publications
Securities and Exchange Board of India
Organization of SEBI
Management of the Board
Objectives of SEBI
Functions of SEBI
Powers of Securities and Exchange Board of India
Lenders Liability Act
Banking Innovations
Basel Committee Recommendations
Capital Adequacy Ratio (CAR)
Risk Weighted Assets
Risk-based Supervision
Asset Liability Management (ALM) in Commercial Banks
Benefits of ALM
114 178
3.48
3.49
3.50
3.51
3.52
3.53
3.54
3.55
3.56
3.57
3.58
3.59
3.60
3.61
3.62
3.63
3.64
3.65
3.66
3.67
3.68
3.69
3.70
3.71
3.72
3.73
3.74
3.75
Corporate Debt Restructuring

E-Banking
Development of E-Banking in India
E-Banking Services
Internet Banking
Internet Banking in India
Advantages of Internet Banking
Disadvantages of Internet Banking
Telebanking
Online Banking
Core Banking
Mobile Banking
E-Banking Risk
Types of E-Banking Risk
E-finance
Electronic Money
Digital Signatures
How Digital Signatures Work?
RTGS
National Electronic Funds Transfer (NEFT)
Summary
Check Your Progress
Key Terms
Case Study
Further Readings
Bibliography
Unit 4: Developmental Financial Institutions

4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
4.13
4.14
4.15
4.16
4.17
4.18
4.19
Introduction
Developmental Banks
Features of a Developmental Bank
Role of Developmental Banks in Industrial Financing
Types of Developmental Banks in India
Origin of Industrial Developmental Bank of India (IDBI)
Origin of State Financial Corporations (SFCs)
Origin of State Industrial Development Corporations (SIDCs)
Origin of Life Insurance Corporation of India (LICI)
Origin of Export-Import Bank of India (EXIM Bank)
National Bank for Agriculture and Rural Development (NABARD)
Resource Mobilization of Developmental Banks
Project Examination by Developmental Banks
Summary
Check Your Progress
Key Terms
Case Study
179 205
4.20 Further Readings

4.21 Bibliography
Unit 5: Insurance Institutions

5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13
5.14
5.15
5.16
5.17
5.18
5.19
5.20
5.21
5.22
5.23
5.24
5.25
5.26
5.27
5.28
5.29
5.30
5.31
5.32
5.33
5.34
5.35
5.36
5.37
5.38
5.39
5.40
5.41
5.42
5.43
5.44
5.45
Introduction
Meaning of Insurance
Definition of Insurance
Historical Background of Insurance
Historical Background of Insurance in India
Types of Insurance
Role of Insurance Companies
Role of Insurance Companies in Industrial Financing
Principles of Insurance
Life Insurance
Meaning of Life Insurance
Purposes of Life Insurance
The Importance of Life Insurance
Life Insurance Products and Policies
General Insurance
Meaning of General Insurance
Objectives for Practicing of General Insurance
Principles of General Insurance
Features of General Insurance
Functions of General Insurance
General Insurance Corporation of India (GICI)
The General Insurance Business (Nationalization) Amendment Act, 2002 Act No. 40 of 2002
Insurance Sector Reforms in India
Major Policy Changes under IRDA Act
Insurance Companies in India
Protection of the Interest of Policyholders
New Developments in Insurance as a Sector in the Indian Financial System
Bancassurance
Various Models for Bancassurance
Status of Bancassurance in India
Bancassurance Models in Europe
Bancassurance in India
The Major Need for Bancassurance in India
Obstacles in the Success of Bancassurance
Regulating Guidelines of IRDA
Recommendations of Committee Constituted by IRDA on Bancassurance
Bancassurance Models in India
Summary
Check Your Progress
Key Terms
Case Study
Further Readings
Bibliography
206 250
Introduction
Notes
Unit 1:
Introduction
Structure:
1.1 Introduction
1.2 Financial Institutions
1.3 Meaning of Financial Institutions
1.4 Benefits of Financial Institutions
1.5 Classification of Financial Institutions
1.6 Role of Financial Institutions
1.7 Functions of Financial Institutions
1.8 Types of Non-Banking Financial Institutions
1.9 Financial Institutions and Economic Development
1.10 Introduction to Money
1.11 History of Money
1.12 History of Money in India
1.13 Meaning of Money
1.14 Features of Money
1.15 Functions of Money
1.16 Types of Money
1.17 Role and Significance of Money in a Modern Economy
1.18 Monetary System
1.19 Capital Formation
1.20 Process of Capital Formation
1.21 Financial System
1.22 Definition of Financial System
1.23 Meaning of Financial System
1.24 Meaning of Financial Dualism
1.25 Objectives of Financial System
1.26 Purpose of Financial System
1.27 Functions of Financial System
1.28 Structure of Indian Financial System or Components of Financial System
1.29 Technology of Financial System
1.30 Summary
1.31 Check Your Progress
1.32 Questions and Exercises
1.33 Key Terms
1.34 Check Your Progress: Answers
1.35 Case Study
Amity Directorate of Distance and Online Education
Notes

1.37 Bibliography
Objectives
After studying this unit, you should be able to understand:
z
Understand the overview of financial institutions and economic development
Detailed study of types of Money
Detailed study of process of capital formation
Technology of financial system
Understand the Pooling and Netting
Understand the Credit Substitution and Delegation
1.1 Introduction
Financial institution is an institution that provides financial services for its clients or
members. Probably, the most important financial service provided by financial institutions
is acting as financial intermediaries. Most financial institutions are regulated by the
government. Broadly speaking, there are three major types of financial institutions:
(i) Depositary Institutions: Deposit-taking institutions that accept and manage deposits
and make loans, including banks, building societies, credit unions, trust companies, and
mortgage loan companies, (ii) Contractual Institutions: Insurance companies and pension
funds; and (iii) Investment Institutes: Investment Banks, underwriters and brokerage firms.
The Financial Institutions in India, comprising of 15 institutions at the national-level
and 47 institutions at the State-level, have played a significant role in their designated
domain in promoting development in the country. Although primarily engaged in providing
medium- and long-term assistance to industry in the form of project finance, financial
institutions have, over the years, rendered an array of varied industry-related services,
including providing risk capital, underwriting new issues, identifying investment projects,
preparing and evaluating project reports, galvanizing spatially balanced industrial
development (including backward area development), disseminating technical advice and
market-related information and management services. Financial Institutions were also
called upon, particularly in the pre-reform era, to undertake a range of developmental and
promotional activities in tune with contemporaneous national objectives and priorities.
These inter alia included evolution of an enabling institutional infrastructure for
entrepreneurship and broad-based capital market development.
1.2 Financial Institutions

Financial institutions provide services as intermediaries of financial markets. They
are responsible for transferring funds from investors to companies in need of those funds.
Financial institutions facilitate the flow of money through the economy. To do so, savings
are brought to provide funds for loans.
Financial Institutions have expanded their outreach, both geographically and spanning
various segments of the financial system, through a network of subsidiaries/associate
institutions, covering areas such as commercial banking, mutual funds, investor and
custodial services, capital market related services, venture capital financing, infrastructure
financing, registrar and transfer services, credit rating and e-commerce.
Introduction
All India Financial Institutions (AIFI) is a group composed of Development Finance

Institutions (DFI) and Investment Institutions that play a pivotal role in the financial markets.
Also known as financial instruments, the financial institutions assist in the proper
allocation of resources, sourcing from businesses that have a surplus and distributing to
others who have deficitsthis also assists with ensuring the continued circulation of
money in the economy. Possibly of greatest significance, the financial institutions act
as an intermediary between borrowers and final lenders, providing safety and liquidity. This
process subsequently ensures earnings on the investments and savings involved. Financial
institutions include banks, credit unions, asset management firms, building societies, and
stock brokerages, among others. These institutions are responsible for distributing
financial resources in a planned way users.
Notes
There are a number of institutions that collect and provide funds for the necessary
sector or individuals. On the other hand, there are several institutions that act as
middlemen to join the deficit and surplus units. Investing money on behalf of the client
is another variety of functions of financial institutions.
In post-Independence India, people were encouraged to increase savings; a tactic
intended to provide funds for investment by the Indian government. However, there was
a huge gap between the supply of savings and demand for the investment opportunities
in the country.
1.3 Meaning of Financial Institutions

Financial institutions refer to those institutions, which provide financial services and
products which customers need. Financial institutions provide all those services, which
a customer may not be able to get more efficiently on his own. For example, customers
not having skill to invest in equity market efficiently can invest money in Mutual Funds
and can get the benefit of capital market. Financial institutions provide all those financial
services, which are available in financial system.
Financial institution refers to those business organizations who play the role of
surplus mobilizes, credit providers and bodies that provide various financial services.
Financial institutions represent those bodies that basically collect the surplus funds
available (in the form of savings) and make it available to productive outlets.
1.4 Benefits of Financial Institutions

The benefits of financial institutions are as follows:
(a) Financial institutions offer financial services
Financial institutions offer various financial services. Financial institutions provide
service as intermediaries of the capital and debt markets. They are responsible for
transferring funds from investors to companies, in need of those funds. The presence of
financial institutions facilitates the flow of money through the economy. To do so, savings
are pooled to mitigate the risk brought to provide funds for loans. Such is the primary
means for depository institutions to develop revenue.
(b) Financial institutions assist for achieving economy of scale
When financial institutions are carrying out their investment or other activities in large
scale out of pooled funds, they can achieve economy of scale.
Notes
(c) Financial institutions ensure lower transaction cost

Because of economy of scale, the cost of each transaction is much lower than what
it would have been, if that transaction is carried on by individual investor on his own.
(d) It helps for diversification
As financial institutions deal with huge amounts of pooled funds, they diversify their
investments in such a way that the risk involved would reduce considerably.
(e) Financial institutions facilitate open financial exchange services
Open Financial Exchange is the solution to the financial services industrys need
for a simplified way to exchange electronic financial data with consumers and small
businesses. The open, unified specification for the exchange of financial data over the
internet which defines a common way for financial institutions and their customers to
communicate electronically. The result is that open financial exchange has helped
accelerate the adoption of online financial services and enabled financial institutions to
offer their customers safe, secure banking, bills payment, investments and other services
over the Internet.
1.5 Classification of Financial Institutions

Financial Institutions in India are divided as follows:
1. Banking Institutions
Banking institutions consists of all scheduled commercial banks and scheduled
cooperative banks.
(i) Scheduled Commercial Banks
Scheduled Banks in India constitute those banks which have been included in the
Second Schedule of Reserve Bank of India (RBI) Act, 1934. RBI in turn includes only those
banks in this schedule which satisfy the criteria laid down vide section 42(6)(a) of the
Act.
As on 30th June, 1999, there were 300 scheduled banks in India having a total network
of 64,918 branches. The scheduled commercial banks in India comprise of State Bank
of India and its associates (8), nationalized banks (19), foreign banks (45), private sector
banks (32), cooperative banks and regional rural banks.
Scheduled banks in India means the State Bank of India constituted under the State
Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bank
of India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constituted
under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act,
1970 (5 of 1970), or under section 3 of the Banking Companies (Acquisition and Transfer
of Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the
Second Schedule to the Reserve Bank of India Act, 1934 (2 of 1934), but does not include
a cooperative bank.
(ii) Scheduled Cooperative Banks
The Urban Banks Department of the Reserve Bank of India is vested with the
responsibility of regulating and supervising primary (urban) cooperative banks, which are
popularly known as Scheduled Cooperative Banks (UCBs). While overseeing the activities
of 1926 scheduled cooperative banks, the Banks Department performs three main
Introduction
functions: regulatory, supervisory and developmental. The Department performs these

functions through its 17 regional offices.
Notes
2. Non-Banking Institutions
A Non-Bank Financial Institution (NBFI) is a financial institution that does not have
a full banking license or is not supervised by a national or international banking regulatory
agency. NBFIs facilitate bank-related financial services, such as investment, risk pooling,
contractual savings, and market brokering. Examples of these include insurance firms,
pawn shops, cashiers check issuers, check cashing locations, payday lending, currency
exchanges, and micro loan organizations. Alan Greenspan has identified the role of NBFIs
in strengthening an economy, as they provide multiple alternatives to transform an
economys savings into capital investment which act as backup facilities.
(i) Non-Banking Finance Companies
Non-Banking Financial Companies (NBFCs) are financial institutions that provide
banking services without meeting the legal definition of a bank, i.e., one that does not
hold a banking license. These institutions are not allowed to take deposits from the public.
Nonetheless, all operations of these institutions are still exercised under bank regulation.
(ii) Development Financial Institutions
Development Finance Institution (DFI) is generic term used to refer to a range of
alternative financial institutions including microfinance institutions, community development
financial institution and revolving loan funds. These institutions provide a crucial role in
providing credit in the form of higher risk loans, equity positions and risk guarantee
instruments to private sector investments in developing countries. DFIs are backed by
states with developed economies.
DFIs have a general mandate to provide finance to the private sector for investments
that promote development. The purpose of DFIs is to ensure investment in areas where
otherwise, the market fails to invest sufficiently. DFIs aim to be catalysts, helping
companies implement investment plans and especially seek to engage in countries where
there is restricted access to domestic and foreign capital markets and provide risk
mitigation that enables investors to proceed with plans which they might otherwise
abandon. DFIs specialize in loans with longer maturities and other financial products. DFIs
have a unique advantage in providing finance that is related to the design and
implementation of reforms and capacity-building programmes adopted by governments.
All India Financial Institutions (AIFIs) is a group composed of Development Finance
Institutions (DFIs) and Investment Institutions that play a pivotal role in the financial
markets. Also known as financial instruments, the financial institutions assist in the
proper allocation of resources, sourcing from businesses that have a surplus and
distributing to others who have deficitsthis also assists by ensuring the continued
circulation of money in the economy. Possibly of greatest significance, the financial
institutions act as an intermediary between borrowers and final lenders, providing safety
and liquidity. All India Financial Institutions includes, IFCI, IDBI, IIBI, SIDBI, IDFC,
NABARD, EXIM Bank and NHB. The State-level Institutions includes SFCs and SIDCs.
Other Financial Institutions are ECGC and DICGC.
3. Mutual Funds
A mutual fund is a type of professionally-managed collective investment vehicle that
pools money from many investors to purchase securities. While there is no legal definition
Notes
of mutual fund, the term is most commonly applied only to those collective investment
vehicles that are regulated, available to the general public and open-ended in nature. Hedge
funds are not considered a type of mutual fund.
(i) Mutual funds in public sector
Unit Trust of India was the first mutual fund set up in India in the year 1963. In early
1990s, Government allowed public sector banks and institutions to set up mutual funds.
In the year 1992, Securities and Exchange Board of India (SEBI) Act was passed. The
objectives of SEBI are to protect the interest of investors in securities and to promote
the development of and to regulate the securities market.
(ii) Mutual funds in private sector
In spite of being a relatively new entrant, HDFC MF has become the second largest
fund house in India in a span of 10 years. It has grown manifold because of their steady
performance of its schemes like HDFC Top 200, HDFC Equity, etc. One more reason
for the declining market share is that the number of public sector players is shrinking.
Today, there are only 6 players in a market with 40 players. On the other hand, public
sector accounted for 10 out of a total of 31 players in March, 2000.
4. Insurance and Housing Finance Companies
The banks providing the housing finance and related facilities such as Bank of Baroda,
Canara Bank, Corporation Bank, IDBI Bank, Punjab National Bank and State Bank of India.
Companies Act 1956 which primarily transacts or has one of its principal objects and the
main feature of the business is providing finance for housing, whether directly or indirectly.
1.6 Role of Financial Institutions

The various roles of financial institutions are as follows:
(i) Financial institutions facilitates for capital formation
Capital formation implies the diversion of the productive capacity of the economy to
the making of capital goods which increases future productive capacity. The process of
Capital Formation involves three distinct but interdependent activities, viz., savings,
financial intermediation and investment. However, poor country/economy may be, there
will be a need for institutions which allow such savings, as are currently forthcoming, to
be invested conveniently and safely and which ensure that they are channeled into the
most useful purposes. A well-developed financial structure will therefore aid in the
collections and disbursements of investible funds and thereby contribute to the capital
formation of the economy. Indian capital market although still considered to be
underdeveloped has been recording impressive progress during the post-interdependence
period.
(ii) Support to the capital market
The basic purpose of FIs, particularly in the context of a developing economy, is
to accelerate the pace of economic development by increasing capital formation, inducing
investors and entrepreneurs, sealing the leakages of material and human resources by
careful allocation thereof, undertaking development activities, including promotion of
industrial units to fill the gaps in the industrial structure and by ensuring that no healthy
projects suffer for want of finance and/or technical services. Hence, the DFIs have to
perform financial and development functions on finance functions, there is a provision of
adequate term finance and in development functions there include provision of foreign
Introduction
currency loans, underwriting of shares and debentures of industrial concerns, direct

subscription to equity and preference share capital, guaranteeing of deferred payments,
conducting techno-economic surveys, market and investment research and rendering of
technical and administrative guidance to the entrepreneurs.
Notes
(iii) Offers the rupee loan facilities

Rupee loans constitute more than 90% of the total assistance sanctioned and
disbursed. This speaks eloquently on FIs obsession with term loans to the neglect of
other forms of assistance which are equally important. Term loans unsupplemented by
other forms of assistance had naturally put the borrowers, most of whom are small
entrepreneurs, on to a heavy burden of debt-servicing. Since term finance is just one of
the inputs but not everything for the entrepreneurs, they had to search for other sources
and their abortive efforts to secure other forms of assistance led to sickness in industrial
units in many cases.
(iv) Foreign currency loan facilities
Foreign currency loans are meant for setting up of new industrial projects as also
for expansion, diversification, modernization or renovation of existing units in cases where
a portion of the loan was for financing import of equipment from abroad and technical knowhow, in special cases.
(v) Offers subscription to debentures and guarantees
Regarding guarantees, it is well-known that when an entrepreneur purchases some
machinery or fixed assets or capital goods on credit, the supplier usually asks him to
furnish some guarantee to ensure payment of installments by the purchaser at regular
intervals. In such a case, FIs can act as guarantors for prompt of installments to the
supplier of such machinery or capital under a scheme called Deferred Payments
Guarantee.
(vi) Assistance to backward areas
Operations of FIs in India have been primarily guided by priorities as spelt out in
the Five-Year Plans. This is reflected in the lending portfolio and pattern of financial
assistance of development financial institutions under different schemes of financing.
Institutional finance to projects in backward areas is extended on concessional terms such
as lower interest rate, longer moratorium period, extended repayment schedule and relaxed
norms in respect of promoters contribution and debt-equity ratio. Such concessions are
extended on a graded scale to units in industrially backward districts, classified into the
three categories of A, B and C depending upon the degree of their backwardness. Besides,
institutions have introduced schemes for extending term loans for project/area-specific
infrastructure development. Moreover, in recent years, development banks in India have
launched special programmes for intensive development of industrially least developed
areas, commonly referred to as the No Industry Districts (NIDs) which do not have any
large-scale or medium-scale industrial project. Institutions have initiated industrial potential
surveys in these areas.
(vii) Promotion of new entrepreneurs
Development banks in India have also achieved a remarkable success in creating
a new class of entrepreneurs and spreading the industrial culture to newer areas and
weaker sections of the society. Special capital and seed capital schemes have been
introduced to provide equity type of assistance to new and technically skilled entrepreneurs
who lack financial resources of their own even to provide promoters contribution in view
of long-term benefits to the society from the emergence of a new class of entrepreneurs.
Notes
Development banks have been actively involved in the entrepreneurship development

programmes and in establishing a set of institutions which identify and train potential
entrepreneurs. Again, to make available a package of services encompassing preparation
of feasibility of reports, project reports, technical and management consultancy, etc. at
a reasonable cost, institutions have sponsored a chain of 16 Technical Consultancy
organizations covering practically the entire country. Promotional and development
functions are as important to institutions as the financing role. The promotional activities
like carrying out industrial potential surveys, identification of potential entrepreneurs,
conducting entrepreneurship development programmes and providing technical consultancy
services have contributed in a significant manner to the process of industrialization and
effective utilization of industrial finance by industry. IDBI has created a special technical
assistance fund to support its various promotional activities. Over the years, the scope
of promotional activities has expanded to include programmes for upgradation of skill of
State level development banks and other industrial promotion agencies, conducting special
studies on important issues concerning industrial development, encouraging voluntary
agencies in implementing their programmes for the uplift of rural areas, village and cottage
industries, artisans and other weaker sections of the society.
(viii) Impact on corporate culture
The project appraisal and follow-up of assisted projects by institutions through various
instruments, such as project monitoring and report of nominee directors on the Board of
Directors of assisted units, have been mutually rewarding. Through monitoring of assisted
projects, the institutions have been able to better appreciate the problems faced by
industrial units. It also has been possible for the corporate managements to recognize
the fact that interests of the assisted units and those of institutions do not conflict but
coincide. Over the years, institutions have succeeded in infusing a sense of constructive
partnership with the corporate sector. Institutions have been going through a continuous
process of learning by doing and are effecting improvements in their systems and
procedures on the basis of their cumulative experience.
1.7 Functions of Financial Institutions

The various functions of financial institutions are as follows:
(i) Raising Finance for Clients
Financial Institutions help its clients to raise finance through issue of shares,
debentures, bank loans, etc. It helps its clients to raise finance from the domestic and
international market. This finance is used for starting a new business or project or for
modernization or expansion of the business.
(ii) Broker in Stock Exchange
Financial Institutions act as brokers in the stock exchange. They buy and sell shares
on behalf of their clients. They conduct research on equity shares. They also advise their
clients about which shares to buy, when to buy, how much to buy and when to sell. Large
Brokers, Mutual Funds, Venture Capital Companies and Investment Banks offer merchant
banking services.
(iii) Project Management
Financial Institutions help their clients in the many ways. For example, advising about
location of a project, preparing a project report, conducting feasibility studies, making a
plan for financing the project, finding out sources of finance, advising about concessions
and incentives from the government.
Introduction
(iv) Advice on Expansion and Modernization
Notes
Financial Institutions give advice for expansion and modernization of the business
units. They give expert advice on mergers and amalgamations, acquisition and takeovers,
diversification of business, foreign collaborations and joint ventures, technology
upgradation, etc.
(v) Managing Public Issue of Companies
Financial Institutions advice and manage the public issue of companies.
They provide following services:
z
Advise on the timing of the public issue.
Advise on the size and price of the issue.
Acting as manager to the issue, and helping in accepting applications and

allotment of securities.
Help in appointing underwriters and brokers to the issue.
Listing of shares on the stock exchange, etc.
(vi) Handling Government Consent for Industrial Projects

A businessman has to get government permission for starting of the project. Similarly,
a company requires permission for expansion or modernization activities. For this, many
formalities have to be completed. Financial Institutions do all this work for their clients.
(vii) Special Assistance to Small Companies and Entrepreneurs
Financial Institutions advise small companies about business opportunities,
government policies, incentives and concessions available. It also helps them to take
advantage of these opportunities, concessions, etc.
(viii) Services to Public Sector Units
Financial Institutions offer many services to public sector units and public utilities.
They help in raising long-term capital, marketing of securities, foreign collaborations and
arranging long-term finance from term lending institutions.
(ix) Revival of Sick Industrial Units
Financial Institutions help to revive (cure) sick industrial units. It negotiates with
different agencies like banks, term lending institutions, and BIFR (Board for Industrial and
Financial Reconstruction). It also plans and executes the full revival package.
(x) Portfolio Management
A Financial Institutions manage the portfolios (investments) of its clients. This makes
investments safe, liquid and profitable for the client. It offers expert guidance to its clients
for taking investment decisions.
1.8 Types of Non-Banking Financial Institutions

The various types of non-banking financial institutions are as follows:
1. Risk Pooling Institutions
Insurance companies underwrite economic risks associated with illness, death,
damage and other risks of loss. In return to collecting an insurance premium, insurance
companies provide a contingent promise of economic protection in the case of loss. There
are two main types of insurance companies: general insurance and life insurance. General
10
Notes
insurance tends to be short-term, while life insurance is a longer-term contract, which

terminates at the death of the insured. Both types of insurance, life and general, are
available to all sectors of the community.
Although insurance companies dont have banking licenses, in most countries
insurance has a separate form of regulation specific to the insurance business and may
well be covered by the same financial regulator that also covers banks. There have also
been a number of instances where insurance companies and banks have merged thus
creating insurance companies that do have banking licenses.
2. Contractual Savings Institutions
Contractual savings institutions give individuals the opportunity to invest in collective
investment vehicles (CIVs) as a fiduciary rather than a principal role. Collective investment
vehicles pool resources from individuals and firms into various financial instruments
including equity, debt, and derivatives. Note that the individual holds equity in the CIV
itself rather what the CIV invests in specifically. The two most popular examples of
contractual savings institutions are pension funds and mutual funds.
The two main types of mutual funds are open-end and closed-end funds. Open-end
funds generate new investments by allowing the public to purchase new shares at any
time, and shareholders can liquidate their holding by selling the shares back to the openend fund at the net asset value. Closed-end funds issue a fixed number of shares in an
IPO. In this case, the shareholders capitalise on the value of their assets by selling their
shares in the stock exchange.
Mutual funds are usually distinguished by the nature of their investments. For
example, some funds specialize in high risk, high return investments, while others focus
on tax-exempt securities. There are also mutual funds specializing in speculative trading
(i.e., hedge funds), a specific sector or cross-border investments.
Pension funds are mutual funds that limit the investors ability to access their
investments until a certain date. In return, pension funds are granted large tax breaks
in order to incentives the working population to set aside a portion of their current income
for a later date after they exit the labor force (retirement income).
3. Market Makers
Market makers are broker-dealer institutions that quote a buy and sell price and
facilitate transactions for financial assets. Such assets include equities, government and
corporate debt, derivatives, and foreign currencies. After receiving an order, the market
maker immediately sells from its inventory or makes a purchase to offset the loss in
inventory. The differential between the buying and selling quotes, or the bid-offer spread,
is how the market-maker makes profit. A major contribution of the market makers is
improving the liquidity of financial assets in the market.
4. Specialized Sectorial Financiers
They provide a limited range of financial services to a targeted sector. For example,
real estate financiers channel capital to prospective home owners, leasing companies
provide financing for equipment and payday lending companies that provide short-term
loans to individuals that are underbanked or have limited resources.
Introduction
11
5. Financial Service Providers
Notes
Financial service providers include brokers (both securities and mortgage),

management consultants, and financial advisors, and they operate on a fee-for-service
basis. Their services include: improving informational efficiency for the investors and, in
the case of brokers, offering a transactions service by which an investor can liquidate
existing assets.
1.9 Financial Institutions and Economic Development

Financial institution is an establishment that conducts financial transactions such
as investments, loans and deposits. Economic development is the sustained, concerted
actions of policy makers and communities that promote the standard of living and
economic health of a specific area. Economic development can also be referred to as
the quantitative and qualitative changes in the economy. Financial institutions play a vital
role for economic development of a country. The roles played by the financial institutions
are given below:
1. The financial systems can support the efficient exchange of goods and services
by providing payment services and thus reducing transaction costs. Financial services can
foster specialization by enabling more transactions, thus fostering productivity growth.
2. By pooling savings from many individual savers, financial institutions and markets
can help overcome investment indivisibilities and allow exploiting scale economies. This
does not necessarily have to be national financial institutions but can be local coalitions
of investors, as was the case in the early days of the Industrial Revolution for infrastructure
projects.
3. By economizing on screening and monitoring costs and thus allowing more
investment projects to be financed and, ex ante, increasing the aggregate success
probability, financial institutions and markets can ultimately have a positive impact on
investment and resource allocation. Similarly, by identifying the entrepreneurs with the
most promising technologies, financial intermediaries can also boost the rate of
technological innovation and ultimately growth. A similar argument holds for financial
markets: in larger and more liquid markets, agents have greater incentives to invest in
research on enterprises and projects, which produces information that can be turned into
trading gains, ultimately improving resource allocation.
4. Both financial institutions and markets can help monitor enterprises and reduce
agency problems within firms between management and majority and minority
shareholders, again improving resource allocation. Debt instruments can reduce the
amount of free cash available to firms and thus managerial slack, while liquid stock
exchanges can allow investors to monitor and discipline enterprises through the threat
of takeovers and subsequent dismissal of management.
5. Banks can also help reduce liquidity risk and thus enable long-term investment,
as shown by Diamond and Dybvig. By pooling savings of patient and impatient agents,
financial institutions can transform short-term liabilities into long-term assets, enabling
long-term investment and ultimately economic growth. Similarly, liquid markets can enable
investment in long-term investment projects while at the same time allowing investors to
have access to their savings at short-term notice. Financial institutions can also ease
liquidity needs of enterprises, enabling long-term investment and R&D activities. By
building long-term relationships, financial institutions can further reduce monitoring costs.
12
Notes
Both financial markets and institutions can thus improve resource allocation and
productivity growth. By reducing control problems of investors vis--vis owners and
managers of enterprises, improved corporate governance can also increase savings and
capital accumulation.
6. Finally, financial institutions and markets allow cross-sectional diversification
across projects, allowing risky innovative activity while guaranteeing an ex ante contracted
interest rate to savers. Furthermore, aggregate risk that cannot be diversified away at a
specific point in time can be diversified by long-living financial intermediaries over time.
1.10 Introduction to Money

Money is any object or record that is generally accepted as payment for goods and
services for repayment of debts in a given country or socio-economic context. The main
functions of money are distinguished as: a medium of exchange; a unit of account; a store
of value; and, occasionally in the past, a standard of deferred payment. Any kind of object
or secure verifiable record that fulfills these functions can serve as money.
Money originated as commodity money, but nearly all contemporary money systems
are based on fiat money. Fiat money is without intrinsic use value as a physical
commodity, and derives its value by being declared by a government to be legal tender;
that is, it must be accepted as a form of payment within the boundaries of the country,
for all debts, public and private. The money supply of a country consists of currency
(bank notes and coins) and bank money (the balance held in check accounts and savings
accounts). Bank money usually forms by far the largest part of the money supply.
1.11 History of Money

The history of money spans thousands of years. Numismatics is the scientific study
of money and its history in all its varied forms. Many items have been used as commodity
money such as naturally scarce precious metals, cowry shells, barley, beads, etc. as
well as many other things that are thought of as having value.
Modern money and most ancient money is essentially a token, in other words, an
abstraction. Paper currency is perhaps the most common type of physical money today.
However, objects of gold or silver present many of moneys essential properties.
The Emergence of Money
In the absence of a medium of exchange, non-monetary societies operated largely
along the principles of gift economics.
The Mesopotamian civilization developed a large scale economy based on commodity
money. The Babylonians and their neighboring city states later developed the earliest
system of economics as we think of it today, in terms of rules on debt, legal contracts
and law codes relating to business practices and private property. Money was not only
an emergence, it was a necessity.
The Shekel referred to an ancient unit of weight and currency. The first usage of
the term came from Mesopotamia circa 3000 BC and referred to a specific mass of barley
which related other values in a metric such as silver, bronze, copper, etc. A barley/shekel
was originally both a unit of currency and a unit of weight, just as the British Pound was
originally a unit denominating a one pound mass of silver.
Introduction
13
Commodity Money
Notes
Bartering has several problems; most notably that it requires a coincidence of wants.
For example, if a wheat farmer needs what a fruit farmer produces, a direct swap is
impossible as seasonal fruit would spoil before the grain harvest. A solution is to trade
fruit for wheat indirectly through a third, intermediatee, and commodity: the fruit is
exchanged for the intermediate commodity when the fruit ripens. If this intermediate
commodity doesnt perish and is reliably in demand throughout the year (e.g., copper,
gold, or wine) then it can be exchanged for wheat after the harvest. The function of the
intermediate commodity as a store-of-value can be standardized into a widespread
commodity money, reducing the coincidence of wants problem. By overcoming the
limitations of simple barter, commodity money makes the market in all other commodities
more liquid.
Many cultures around the world eventually developed the use of commodity money.
Ancient China, Africa, and India used cowry shells. Trade in Japans feudal system was
based on the koku a unit of rice. The shekel was an ancient unit of weight and currency.
The first usage of the term came from Mesopotamia circa 3000 BC and referred to a specific
weight of barley, which related other values in a metric such as silver, bronze, copper,
etc. A barley/shekel was originally both a unit of currency and a unit of weight.
Wherever trade is common, barter systems usually lead quite rapidly to several key
goods being imbued with monetary properties. In the early British colony of New South
Wales, rum emerged quite soon after settlement as the most monetary of goods. When
a nation is without a currency it commonly adopts a foreign currency. In prisons where
conventional money is prohibited, it is quite common for cigarettes to take on a monetary
quality, and throughout history, gold has taken on this unofficial monetary function.
Standardized Coinage
From early times, metals, where available, have usually been favored for use as protomoney over such commodities as cattle, cowry shells, or salt, because they are at once
durable, portable, and easily divisible. The use of gold as proto-money has been traced
back to the fourth millennium BC when the Egyptians used gold bars of a set weight as
a medium of exchange, as had been done earlier in Mesopotamia with silver bars. The
first known ruler who officially set standards of weight and money was Pheidon. The first
stamped money (having the mark of some authority in the form of a picture or words)
can be seen in the Bibliothque Nationale of Paris. It is an electrum stater of a turtle
coin, coined at Aegina Island. This remarkable coin dates about 700 BC. Electrum coins
were also introduced about 650 BC in Lydia.
Coinage was widely adopted across Ionia and mainland Greece during the 6th century
BC, eventually leading to the Athenian Empires 5th century BC, dominance of the region
through their export of silver coinage, mined in southern Attica at Laurium and Thorikos.
A major silver vein discovery at Laurium in 483 BC led to the huge expansion of the
Athenian military fleet. Competing coinage standards at the time were maintained by
Mytilene and Phokaia using coins of Electrum; Aegina used silver.
It was the discovery of the touchstone which led the way for metal-based commodity
money and coinage. Any soft metal can be tested for purity on a touchstone, allowing
one to quickly calculate the total content of a particular metal in a lump. Gold is a soft
metal, which is also hard to come by, dense, and storable. As a result, monetary gold
spread very quickly from Asia Minor, where it first gained wide usage, to the entire world.
14
Notes
Using such a system still required several steps and mathematical calculation. The
touchstone allows one to estimate the amount of gold in an alloy, which is then multiplied
by the weight to find the amount of gold alone in a lump. To make this process easier,
the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed,
so as long as the manufacturer was aware of the origin of the coin, no use of the touchstone
was required. Coins were typically minted by governments in a carefully protected process,
and then stamped with an emblem that guaranteed the weight and value of the metal.
It was, however, extremely common for governments to assert that the value of such money
lay in its emblem and thus to subsequently reduce the value of the currency by lowering
the content of valuable metal.
Although gold and silver were commonly used to mint coins, other metals could be
used. For instance, Ancient Sparta minted coins from iron to discourage its citizens from
engaging in foreign trade. In the early seventeenth century, Sweden lacked more precious
metal and so produced plate money, which were large slabs of copper approximately
50 cm or more in length and width, appropriately stamped with indications of their value.
Metal based coins had the advantage of carrying their value within the coins
themselves on the other hand, they induced manipulations: the clipping of coins in the
attempt to get and recycle the precious metal. A greater problem was the simultaneous
co-existence of gold, silver and copper coins in Europe. English and Spanish traders valued
gold coins more than silver coins, as many of their neighbors did, with the effect that
the English gold-based guinea coin began to rise against the English silver based crown
in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for
dubious amounts of gold coming into the country at a rate no other European nation would
share. The effect was worsened with Asian traders not sharing the European appreciation
of gold altogether gold left Asia and silver left Europe in quantities European observers
like Isaac Newton, Master of the Royal Mint observed with unease.
Stability came into the system with national Banks guaranteeing to change money
into gold at a promised rate; it did, however, not come easily. The Bank of England risked
a national monetary catastrophe in the 1730s when customers demanded their money
be changed into gold in a moment of crisis. Eventually Londons merchants saved the
bank and the nation with monetary guarantees.
Another step in the evolution of money was the change from a coin being a unit
of weight to being a unit of value. a distinction could be made between its commodity
value and its specie value. The difference is these values are seigniorage.
Trade Bills of Exchange
Bills of exchange became prevalent with the expansion of European trade toward
the end of the middle Ages. A flourishing Italian wholesale trade in cloth, woolen clothing,
and wine, tin and other commodities was heavily dependent on credit for its rapid
expansion. Goods were supplied to a buyer against a bill of exchange, which constituted
the buyers promise to make payment at some specified future date. Provided that the
buyer was reputable or the bill was endorsed by a credible guarantor, the seller could
then present the bill to a merchant banker and redeem it in money at a discounted value
before it actually became due.
These bills could also be used as a form of payment by the seller to make additional
purchases from his own suppliers. Thus, the bills an early form of credit became both
a medium of exchange and a medium for storage of value. Like the loans made by the
Egyptian grain banks, this trade credit became a significant source for the creation of
Introduction
15
new money. In England, bills of exchange became an important form of credit and money
during last quarter of the 18th century and the first quarter of the 19th century before bank
notes, checks and cash credit lines were widely available.
Notes
Tallies
The acceptance of symbolic forms of money opened up vast new realms for human
creativity. A symbol could be used to represent something of value that was available in
physical storage somewhere else in space, such as grain in the warehouse. It could also
be used to represent something of value that would be available later in time, such as
a promissory note or bill of exchange, a document ordering someone to pay a certain
sum of money to another on a specific date or when certain conditions have been fulfilled.
In the 12th Century, the English monarchy introduced an early version of the bill of
exchange in the form of a notched piece of wood known as a tally stick. Tallies originally
came into use at a time when paper was rare and costly, but their use persisted until
the early 19th Century, even after paper forms of money had become prevalent. The
notches were used to denote various amounts of taxes payable to the crown. Initially,
tallies were simply used as a form of receipt to the tax payer at the time of rendering
his dues. As the revenue department became more efficient, they began issuing tallies
to denote a promise of the tax assessee to make future tax payments at specified times
during the year. Each tally consisted of a matching pair one stick was given to the
assessee at the time of assessment representing the amount of taxes to be paid later
and the other held by the Treasury representing the amount of taxes be collected at a
future date.
The Treasury discovered that these tallies could also be used to create money. When
the crown had exhausted its current resources, it could use the tally receipts representing
future tax payments due to the crown as a form of payment to its own creditors, who
in turn could either collect the tax revenue directly from those assessed or use the same
tally to pay their own taxes to the government. The tallies could also be sold to other
parties in exchange for gold or silver coin at a discount reflecting the length of time
remaining until the taxes was due for payment. Thus, the tallies became an accepted
medium of exchange for some types of transactions and an accepted medium for store
of value. The Treasury soon realized that it could also issue tallies that were not backed
by any specific assessment of taxes. By doing so, the Treasury created new money that
was backed by public trust and confidence in the monarchy rather than by specific revenue
receipts.
Goldsmith Bankers
Goldsmiths in England had been craftsmen, bullion merchants, money changers and
moneylenders since the 16th century. But they were not the first to act as financial
intermediates; in the early 17th century, the scrivener were the first to keep deposits for
the express purpose of relending them. Merchants and traders had amassed huge hoards
of gold and entrusted their wealth to the Royal Mint for storage. In 1640, King Charles
I seized the private gold stored in the mint as a forced loan (which was to be paid back
over time). Thereafter merchants preferred to store their gold with the goldsmiths of London,
who possessed private vaults, and charged a fee for that service. In exchange for each
deposit of precious metal, the goldsmiths issued receipts certifying the quantity and purity
of the metal they held as a bailee (i.e., in trust). These receipts could not be assigned
(only the original depositor could collect the stored goods). Gradually, the goldsmiths took
over the function of the scrivener of relending on behalf of a depositor and also developed
16
Notes
modern banking practices; promissory notes were issued for money deposited which by
custom and/or law was a loan to the goldsmith, i.e., the depositor expressly allowed the
goldsmith to use the money for any purpose including advances to his customers. The
goldsmith charged no fee, or even paid interest on these deposits. Since the promissory
notes were payable on demand, and the advances (loans) to the goldsmiths customers
were repayable over a longer time period, this was an early from of fractional reserve
banking. The promissory notes developed into an assignable instrument, which could
circulate as a safe and convenient form of money backed by the goldsmiths promise to
pay. Hence, goldsmiths could advance loans in the form of gold money, or in the form
of promissory notes, or in the form of checking accounts. Gold deposits were relatively
stable, often remaining with the goldsmith for years on end, so there was little risk of
default so long as public trust in the goldsmiths integrity and financial soundness was
maintained. Thus, the goldsmiths of London became the forerunners of British banking
and prominent creators of new money based on credit.
Demand Deposits
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The primary business of the early merchant banks was promotion of trade. The new
class of commercial banks made accepting deposits and issuing loans their principal
activity. They lend the money they received on deposit. They created additional money
in the form of new bank notes. The money they created was partially backed by gold,
silver or other assets and partially backed only by public trust in the institutions that
created it.
Demand deposits are funds that are deposited in bank accounts and are available
for withdrawal at the discretion of the depositor. The withdrawal of funds from the account
does not require contacting or making any type of prior arrangements with the bank or
credit union. As long as the account balance is sufficient to cover the amount of the
withdrawal, and the withdrawal takes place in accordance with procedures set in place
by the financial institution, the funds may be withdrawn on demand
Bank Notes
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section by adding citations to reliable sources. Unsourced material may be challenged
and removed.
The history of money and banking are inseparably interlinked. The issuance of paper
money was initiated by commercial banks. Inspired by the success of the London
goldsmiths, some of which became the forerunners of great English banks, banks began
issuing paper notes quite properly termed bank notes which circulated in the same way
that government issued currency circulates today. In England, this practice continued up
to 1694. Scottish banks continued issuing notes until 1850. In USA, this practice continued
through the 19th century, where at one time there were more than 5000 different types
of bank notes issued by various commercial banks in America. Only the notes issued
by the largest, most creditworthy banks were widely accepted. The script of smaller, lesser
known institutions circulated locally. Farther from home, it was only accepted at a
discounted rate, if it was accepted at all. The proliferation of types of money went hand
in hand with a multiplication in the number of financial institutions.
Introduction
17
These bank notes were a form of representative money which could be converted
into gold or silver by application at the bank. Since banks issued notes far in excess
of the gold and silver they kept on deposit, sudden loss of public confidence in a bank
could precipitate mass redemption of bank notes and result in bankruptcy. The use of
bank notes issued by private commercial banks as legal tender has gradually been
replaced by the issuance of bank notes authorized and controlled by national governments.
The Bank of England was granted sole rights to issue bank notes in England after 1694.
In the USA, the Federal Reserve Bank was granted similar rights after its establishment
in 1913. Until recently, these government-authorized currencies were forms of
representative money, since they were partially backed by gold or silver and were
theoretically convertible into gold or silver.
Notes
Gold-backed Bank Notes

The term gold standard is often erroneously thought to refer to a currency where
notes were fully backed by and redeemable in an equivalent amount of gold. The British
pound was the strongest, most stable currency of the 19th century and often considered
the closest equivalent to pure gold, yet at the height of the gold standard there was only
sufficient gold in the British treasury to redeem a small fraction of the currency then in
circulation. In 1880, US government gold stock was equivalent in value to only 16% of
currency and demand deposits in commercial banks. By 1970, it was about 0.5 per cent.
The gold standard was only a system for exchange of value between national currencies,
never an agreement to redeem all paper notes for gold. The classic gold standard prevailed
during the period 1880 and 1913 when a core of leading trading nations agreed to adhere
to a fixed gold price and continuous convertibility for their currencies. Gold was used to
settle accounts between these nations. With the outbreak of World War I, Britain was
forced to abandon the gold standard even for their international transactions. Other nations
quickly followed suit. After a brief attempt to revive the gold standard during the 1920s,
it was finally abandoned by Britain and other leading nations during the Great Depression.
Prior to the abolition of the gold standard, the following words were printed on the
face of every US dollar: I promise to pay the bearer on demand, the sum of one dollar
followed by the signature of the US Secretary of the Treasury. Other denominations carried
similar pledges proportionate to the face value of each note. The currencies of other nations
bore similar promises too. In earlier times, this promise signified that a bearer could redeem
currency notes for their equivalent value in gold or silver. The US adopted a silver standard
in 1785, meaning that the value of the US dollar represented a certain equivalent weight
in silver and could be redeemed in silver coins. But even at its inception, the US
Government was not required to maintain silver reserves sufficient to redeem all the notes
that it issued. Through much of the 20th century until 1971, the US dollar was backed
by gold, but from 1934 only foreign holders of the notes could exchange them for metal.
Representative Money
An example of representative money, this 1896 note could be exchanged for five US
Dollars worth of silver. Representative money refers to money that consists of a token
or certificate made of paper. The use of the various types of money including representative
money, tracks the course of money from the past to the present. Token money may be
called representative money in the sense that, say, a piece of paper might represent
or be a claim on a commodity also. Gold certificates or Silver certificates are a type of
representative money which was used in the United States as currency until 1933.
18
Notes
The term representative money has been used in the past to signify that a certain
amount of bullion was stored in a Treasury while the equivalent paper in circulation
represented the bullion. Representative money differs from commodity money which is
actually made of some physical commodity. In his Treatise on Money (1930:7), Keynes
distinguished between commodity money and representative money, dividing the latter into
fiat money and managed money.
Fiat Money
Fiat money refers to money that is not backed by reserves of another commodity.
The money itself is given value by government fiat or decree, enforcing legal tender laws,
previously known as forced tender, whereby debtors are legally relieved of the debt if
they pay it in the governments money. By law, the refusal of a legal tender (offering)
extinguishes the debt in the same way acceptance does. At times in history (e.g., Rome
under Diocletian, and post-revolutionary France during the collapse of the assignats), the
refusal of legal tender money in favor of some other form of payment was punished with
the death penalty.
Governments through history have often switched to forms of fiat money in times
of need such as war, sometimes by suspending the service they provided of exchanging
their money for gold, and other times by simply printing the money that they needed.
When governments produce money more rapidly than economic growth, the money supply
overtakes economic value. Therefore, the excess money eventually dilutes the market
value of all money issued. This is called inflation. See open market operations.
In 1971, the United States finally switched to fiat money indefinitely. At this point
in time, many of the economically developed countries currencies were fixed to the US
dollar and so this single step meant that much of the western worlds currencies became
fiat money based. Following the Gulf War, the president of Iraq, Saddam Hussein, repealed
the existing Iraqi fiat currency and replaced it with a new currency. Despite having no
backing by a commodity and with no central authority mandating its use or defending
its value, the old currency continued to circulate within the politically isolated Kurdish
regions of Iraq. It became known as the Swiss dinar. This currency remained relatively
strong and stable for over a decade. It was formally replaced following the Iraq War.
1.12 History of Money in India

Ancient India, presently modern states of Pakistan and north-western India, was one
of the earliest issuers of coins in the world (circa 6th century BC), along with the Chinese
wen and Lydian staters. The origin of the word rupee is found in the word rup or rupa,
which means silver in many Indo-Aryan languages such as Hindi. The Sanskrit word
rupyakam means coin of silver. The derivative word Rupaya was used to denote the coin
introduced by Sher Shah Suri during his reign from 1540 to 1545 CE. The original Rupaya
was a silver coin weighing 175 grains troy (about 11.34 grams). The coin has been used
since then, even during the times of British India. Formerly, the rupee was divided into
16 annas, 64 paise, or 192 pies. In Arabia and East Africa, the British India rupee was
current at various times, including the paisa and was used as far south as Natal. In
Mozambique, the British India rupees were overstamped, and in Kenya, the British East
Africa Company minted the rupee and its fractions as well as piece. It was maintained
as the florin, using the same standard, until 1920. In Somalia, the Italian colonial authority
minted Rupia to exactly the same standard, and called the paisa besa. Early 19th
century E.I.C. rupees were used in Australia for a limited period. Decimalisation occurred
Introduction
19
in Ceylon (Sri Lanka) in 1872, India in 1957 and in Pakistan in 1961. Among the earliest
issues of paper rupees were those by the Bank of Hindustan (1770-1832), the General
Bank of Bengal and Bihar (1773-75, established by Warren Hastings), the Bengal Bank
(1784-91), amongst others.
Notes
Historically, the rupee was a silver based currency. This had severe consequences
in the 19th century, when the strongest economies in the world were on the gold standard.
The discovery of vast quantities of silver in the US and various European colonies resulted
in a decline in the relative value of silver to gold. Suddenly, the standard currency of India
could not buy as much from the outside world. This event was known as the fall of the
Rupee. During British rule, and the first decade of independence, the rupee was subdivided
into 16 annas. Each anna was subdivided into either 4 pieces, or 12 pies. In 1957,
decimalisation occurred and the rupee was now divided into 100 Naye Paise (Hindi for
new praises). After a few years, the initial Naye was dropped. However, many still refer
to 25, 50 and 75 paise as 4, 8 and 12 annas respectively, not unlike the now largely
defunct usage of bit in American English for 1/8 dollar. However, the usage is in decline.
Reserve Bank Issues During British India
Office at Calcutta. Section 22 of the RBI Act, 1934, empowered it to continue issuing
Government of India notes until its own notes were ready for issue. The bank issued the
first five rupee note bearing the portrait of George VI in 1938. This was followed by ` 10
in February, ` 100 in March and ` 1,000 and ` 10,000 in June 1938. The first Reserve
Bank issues were signed by the second Governor, Sir James Taylor. In August 1940,
the one-rupee note was reintroduced as a wartime measure, as a Government note with
the status of a rupee coin. During the war, the Japanese produced high-quality forgeries
of the Indian currency. This necessitated a change in the watermark. The profile portrait
of George VI was changed to his full frontal portrait. The security thread was introduced
for the first time in India. The George VI series continued till 1947 and thereafter as a
frozen series till 1950 when post-independence notes were issued.
Republic of India Issues
After Independence of India, the government brought out the new design Re. 1 note
in 1949. Initially, it was felt that the Kings portrait be replaced by a portrait of Mahatma
Gandhi. Finally, however, the Lion Capital of Asoka was chosen. The new design of notes
was largely along earlier lines. In 1953, Hindi was displayed prominently on the new notes.
The economic crisis in late 1960s led to a reduction in the size of notes in 1967. High
denomination notes, like ` 10,000 notes were demonetized in 1978. The Mahatma Gandhi
Series was introduced in 1996. Prominent new features included a changed watermark,
windowed security thread, latent image and intaglio features for the visually handicapped.
1.13 Meaning of Money

Money is a token or item which acts as a medium of exchange that has both legal
and social acceptance with regards to making payment for buying commodities or receiving
services, as well as repayment of loans.
20
Notes
1.14 Features of Money

The features of money can be summarized as follows:
1. Durability
Durability means that an item retains the same shape, form, and substance over
an extended period of time; that it does not easily decompose, deteriorate, degrade, or
otherwise change form. However, durability also extends beyond the physical realm to
include social and institutional durability.
Durability is critical for money to perform the related functions of medium of exchange
and store of value. People are willing to accept an item in payment for one good because
they are confident that the item can be traded at a later time for some other good. An
item works as a medium of exchange precisely because it stores value from one
transaction to the next. And this requires durability.
Refined metals, such as gold, silver, copper, or nickel, have historically taken center
stage as money because they are extremely durable materials. An ounce of gold today
will be an ounce of gold tomorrow, next week, and a thousand years hence. Organic
products, such as lettuce, ice cream, or raw meat, are seldom if ever used as money
because they are extremely perishable. A crisp leaf of lettuce might not be recognizable
as lettuce next week let alone a thousand years hence.
While physical durability has been historically important for money, social and
institutional durability is also important for modern economies. The durability of modern
money, especially paper currency and bank account balances, depends on the durability
of social institutionsespecially banks and governments. While government-issued paper
currency might remain physically intact for centuries, its ability to function as money
depends on the institutional durability of the government.
2. Divisibility
This second characteristic means money can be divided into small increments that
can be used in exchange for goods of varying values. For an item to function as the medium
of exchange, which can be used to purchase a wide range of different goods with a wide
range of different values, then it must be divisible. For an item to function as the medium
of exchange, it must have increments that allow it to be traded for both battleships and
bubble gum, and everything in between.
Divisibility is one reason why metals, such as gold, silver, copper, and nickel, have
been widely used as money throughout history. As pure elements, each can be divided
into really, really small units, in principle, down to the molecular level. In contrast, livestock,
which has seen limited use as money in less sophisticated agrarian societies, never
become widely used as money in modern economies. Dividing live water buffalo into
increments small enough to buy bubble gum is highly impractical.
3. Transportability
This third characteristic means that money can be easily moved from one location
to another when such movement is needed to complete exchanges. When people head
off to the market to make a purchase or two, then they need to bring along their money.
But to bring along their money, they obviously need to bring along their money. That
is, the money must be transportable. Money that is not transportable is not transported,
so it is not used.
Introduction
21
Once again, transportability has played a key role in the use of metals like gold,
silver, copper, and nickel as money. Carrying around a satchel of metal coins was never
much of a burden. However, these metals were largely replaced by paper currencies in
the 20th century because paper was lighter and easier to carry. Items such as granite
blocks, radioactive plutonium, and maple syrup come up short on the transportability scale.
Items that are physically heavy relative to their value in exchange, or need special handling,
are not easily transportable. Heading off to the market with a vat of syrup or a lead canister
of plutonium just does not work.
Notes
4. Non-counterfeitability
This fourth characteristic means that money cannot be easily duplicated. A given
item cannot function as a medium of exchange if everyone is able to print up, whip up,
or make up a batch of money any time that they want. Why would anyone accept money
in exchange for a good, if they can make their own? Money that is easily duplicated ceases
to be the medium of exchange.
Preventing the unrestricted duplication of money is a task that has long been
relegated to government. In fact, this task is one of the prime reasons why governments
exist. An economy needs government, absolutely needs government, to regulate the total
quantity of money in circulation. By controlling money duplication, governments are also
able to control the total quantity in circulation, and this control is what gives money value
in exchange.
While governments try to keep pace with counterfeiters, they are usually a step or
two behind. Through the years, governments have tried to thwart counterfeiters by stamping
images on coins, using special ink and paper for currency, and generally maintaining high
levels of security surrounding money production.
1.15 Functions of Money

The various functions of money are as follows:
1. Static Function
These include the functions performed by money in the static role or as a passive
technical device. The static functions of money include:
(a) Money as a Medium of Exchange
Money acts as a medium of exchange and it facilitates the quick and easy exchange
of goods and services. It has help discontinue the barter system and one need not make
a simultaneous purchase while making a sale.
(b) Money as a Unit of Account
Money helps in expressing various things in terms of its value and has hence given
rise to the price system. It acts as a common measure of value and helps in the smooth
operation of the price system in the modern economic society.
(c) Money as a Store of Value
Money acts as a store of value as it can be held by oneself for present as well as
future use. It is convenient means of holding the income for the purpose of spending, i.e.,
it has high liquidity value.
22
Notes
(d) Money as a Standard of Deferred Payments

It helps in settlement of debts and future transactions which was not possible in
the barter system.
2. Dynamic Function
(a) Money plays a dynamic role in determining the economic trends.
(b) The volume and velocity of money can cause a rise or a fall in the general price
level. It also influences consumption and production.
(c) Money encourages the division of labor: Since money acts as the medium of
exchange and gives purchasing power to one; one may not have to produce
various goods and can specialize in producing a particular commodity.
1.16 Types of Money

Money can be categorized into the following types:
1. Commodity Money
This is a type of money which can be utilized both as an exchangeable commodity
and a general purpose exchange medium in its own capacity. Whenever any commodity
is used for the exchange purpose, the commodity becomes equivalent to the money and
is called commodity money. There are certain types of commodity, which are used as
the commodity money. Among these, there are several precious metals like gold, silver,
copper and many more. Again, in many parts of the world, seashells, tobacco and many
other items were in use as a type of money and medium of exchange.
2. Fiat Money
Fiat money is that type of money the value of which is ascertained with the help
of legal methods instead of the associated availableness of commodities and services.
Fiat money can symbolize government promises or a commodity. The word fiat means
the command of the sovereign. It is the type of money that is issued by the command
of the sovereign. The paper money is generally called as the fiat money. This type of money
forms a monetary standard. It has been made mandatory by law to accept the fiat money,
as an exchange medium, whenever it is offered to anyone.
3. Credit Money
Credit money refers to the claim placed to a legal individual, which can be
implemented to buy goods and services.
4. Soft Money
Soft money refers to the paper currency rather than gold, silver, or any other types
of coined metal.
5. Hard Money
Hard money refers to the value of different gold, silver, or platinum coins (bullion)
in circulation in the field of international trade.
Introduction
23
6. Fiduciary Money
Notes
Todays monetary system is highly fiduciary. Whenever any bank assures the
customers to pay in different types of money and when the customer can sell the promise
or transfer it to somebody else, it is called the fiduciary money. Fiduciary money is
generally paid in gold, silver or paper money. There are cheques and bank notes, which
are the examples of fiduciary money because both are some kind of token which are used
as money and carry the same value.
7. Commercial Bank Money
Commercial Bank money or demand deposits are claims against financial institutions
that can be used for the purchase of goods and services. A demand deposit account is
an account from which funds can be withdrawn at any time by cheque or cash withdrawal
without giving the bank or financial institution any prior notice. Banks have the legal
obligation to return funds held in demand deposits immediately upon demand (or at call).
Demand deposit withdrawals can be performed in person, via cheques or bank drafts, using
automatic teller machines (ATMs), or through online banking.
1.17 Role and Significance of Money in a Modern Economy

1. Money enables a consumer to maximize his satisfaction.
2. Money measure the intensity of desire of consummates.
3. Money facilities production by stimulating saving and investment.
4. Money gives mobility to capital and helps in capital formation.
5. It enables the harnessing various factors of production, so that the entrepreneurs
is able to maximize profit.
6. Money facilitates exchange and helps in both trade and commerce both national
and international.
7. Money helps price mechanism to allocate resources.
8. Money accelerated the process of industrialization.
9. Money is an extremely valuable social instrument which has largely contributed
to the growth of national wealth and social welfare.
1.18 Monetary System

Monetary system is a set of mechanisms by which a government provides money
in a countrys economy. It usually consists of a mint, central bank, and commercial banks.
The Monetary system of India plays a very important role in the economic
development. The monetary system performs a number of functions. Some of the important
functions are as follows:
(i) Monetary system is a contributor of liquidity
The term liquidity refers to cash or money and other assets which can be converted
into cash within a short duration. Almost all the activities of a monetary system are liquidity
oriented, i.e., there is either provision of liquidity or one can see trading in liquidity.
(ii) It plays the role of a medium
The monetary system plays the role of a catalyst by creation of credit and providing
finance and credit facilities to different investment opportunities.
24
Notes
(iii) It accelerates the rate of economic development

Monetary system mobilizes the savings and also the investment. By doing so, capital
formation is achieved which in turn leads to allocating resources to productive activities,
which at last leads to the economic development.
(iv) It fosters industrial development
It is because of Indian monetary system, institutions like IDBI, IFCI, KSFC, ICICI,
etc. have been developed to foster industrial development. These institutions help
industries by providing monetary, technical, marketing assistance.
(v) It is a guide for investors education
The monetary system play a very important role of providing all necessary investment
opportunities to the investors. The monetary institutions, banks, etc. from time to time
publish the necessary investors guide with required details about investments to enlighten
the investors.
(vi) It promotes self-employment
The development banks and monetary institutions are primarily established with the
objective of promoting self-employment. By providing a means of self-employment to young
educated men and women, it indirectly solves the problem of unemployment.
(vii) It helps in the revival of sick units
The monetary institutions in our country have specially designed loans schemes to
assist the revival of sick units. These loans are provided to sick units at reasonable rate
of interest.
(viii) It ensures effective distribution of resources
An effective monetary system always enables proper allocation of resources to
different investment avenues.
1.19 Capital Formation

Capital formation refers to net additions of capital stock such as equipment, buildings
and other intermediate goods. A nation uses capital stock in combination with labor to
provide services and produce goods; an increase in this capital stock is known as capital
formation.
Saving and investment are essential for capital formation. According to Marshall,
saving is the result of waiting or abstinence. When a person postpones his consumption
to the future, he saves his wealth which he utilizes for further production. If all people
save like this, the aggregate savings increase which are utilized for investment purposes
in real capital assets like machines, tools, plants, roads, canals, fertilizers, seeds, etc.
1.20 Process of Capital Formation

The process of capital formation involves three steps:
1. Increase in the volume of real savings;
2. Mobilization of savings through financial and credit institutions; and
3. Investment of savings.
Introduction
25
Thus, the problem of capital formation becomes two-fold: one, how to save more;
and two, how to utilize the current savings of the community for capital formation. We
discuss the factors on which capital accumulation depends.
Notes
1. Increasing Savings
(a) Power and Will to Save
Savings depend upon two factors: the power to save and the will to save.
The power to save of the community depends upon the size of the average income,
the size of the average family and the standard of living of the people. Other things being
equal, if the income of the people increases or the size of the family is small or people
get accustomed to a particular standard of living which does not lean towards conspicuous
consumption, the power to save increases.
The power to save also depends upon the level of employment in the country. If
employment opportunities increase and existing techniques and resources are employed
fully and efficiently, incomes increase and so do the propensity of the people to save.
Savings also depend upon the will to save. People may themselves forego
consumption in the present and save. They may do so to meet emergencies, for family
purposes or for social status. But they will save only if certain facilities or inducements
are available.
People save if the government is stable and there is peace and security in the country.
People do not save when there is lawlessness and disorder, and there is no security of
life, property and business. The existence of banking and financial institutions paying high
rates of interest on different term deposits also induces people to save more.
The taxation policy of the government also affects the savings habits of the people.
Highly progressive income and property taxes reduce the incentive to save. But low rates
of taxation with due concessions for savings in provident fund, life insurance, health
insurance, etc. encourage savings.
(b) Perpetuation of Income Inequalities
Perpetuation of income inequalities had been one of the major sources of capital
formation in 18th century England and early 20th century Japan. In most communities,
it is the higher income groups with a high marginal propensity to save that do the majority
of savings. If there is unequal distribution of income, the societys upper level incomes
accrue to the businessmen, the traders and the landlords who save more and hence invest
more on capital formation. But this policy of deliberately creating inequalities is not favoured
now either in developed or developing economics when all countries aim at reducing income
inequalities.
(c) Increasing Profits
Professor Lewis is of the view that the ratio of profits to national income should be
increased by expanding the capitalist sector of the economy, by providing various
incentives and protecting enterprises from foreign competition. The essential point is that
profits of business enterprises should increase because they know how to use them in
productive investment.
(d) Government Measures
Like private households and enterprises, the government also saves by adopting a
number of fiscal and monetary measures. These measures may be in the form of a
budgetary surplus through increase in taxation (mostly indirect), reduction in government
26
Notes
expenditure, expansion of the export sector, raising money by public loans, etc. If people
are not saving voluntarily, inflation is the most effective weapon. It is regarded as hidden
or invisible tax. When prices rise, they reduce consumption and thus divert resources from
current consumption to investment. Besides, the government can increase savings by
establishing and running public undertakings more efficiently so that they earn larger profits
which are utilized for capital formation.
(2) Mobilization of Savings
The next step for capital formation is the mobilization of savings through banks,
investment trusts, deposit societies, insurance companies, and capital markets. The
kernal of Keyness theory is that decisions to save and decisions to invest are made largely
by different people and for different reasons. To bring the savers and investors together,
there must be well-developed capital and money markets in the country. In order to
mobilize savings, attention should be paid to the starting of investment trusts, life
insurance, provident fund, banks, and cooperative societies. Such agencies will not only
permit small amounts of savings to be handled and invested conveniently but will allow
the owners of savings to retain liquidity individually but finance long-term investment
collectively.
(3) Investment of Savings
The third step in the process of capital formation is the investment of savings in
creating real assets. The profit-making classes are an important source of capital formation
in the agricultural and industrial sectors of a country. They have an ambition for power
and save in the form of distributed and undistributed profits and thus invest in productive
enterprises.
Besides, there must be a regular supply of entrepreneurs who are capable, honest
and dependable. To perform his economic function, the entrepreneur requires two things,
according to Professor Schumpeter, first, the existence of technical knowledge to produce
new products; second, the power of disposal over the factors of production in the form
of bank credit.
To these may he added, the existence of such infrastructure as well-developed means
of transport, communications, power, water, educated and trained personnel, etc. Further,
the social, political and economic climatic conditions in the country must be conducive
for the emergence of a growing supply of entrepreneurs.
Domestic sources for capital formation are required to be supplemented by external
sources. There are two reasons for external borrowing, according to Professor A.J. Brown.
One is that it may be the easiest way of getting hold of capital funds at all, and the other
that it may be the easiest way of getting foreign currency with which to buy imports which
are needed for development.
The countries which have borrowed most from abroad for development purposes are
those which have at some stage had a colonial status, have been developed by European
immigrants, or have traded heavily with the highly developed countries, or have satisfied
all these conditions.
1.21 Financial System

Financial system is the set of implemented procedures that track the financial
activities of a country on a regional scale. The financial system is the system that enables
Introduction
27
lenders and borrowers to exchange funds. The global financial system is basically a
broader regional system that encompasses all financial institutions, borrowers and lenders
within the global economy.
Notes
A financial system plays a vital role in the economic growth of a country. It

intermediates with the flow of funds between those who save a part of their income to
those who invest in productive assets. It mobilizes and usefully allocates scarce resources
of a country. The formal financial sector is characterized by the presence of an organized,
institutional and regulated system which caters to the financial needs of the modern
spheres of economy; the informal financial sector is an unorganized, non-institutional, and
non-regulated system dealing with the traditional and rural spheres of the economy.
A financial system is a complex, well-integrated set of sub-systems of financial
institutions, markets, instruments, and services which facilitates the transfer and allocation
of funds, efficiently and effectively. A high priority should be accorded to the development
of an efficient formal financial system as it can offer lower intermediation costs and services
to a wide base of savers and entrepreneurs.
The economic scene in the post-independence period has seen a sea change; the
end result being that the economy has made enormous progress in diverse fields. There
has been a quantitative expansion as well as diversification of economic activities. The
experiences of the 1980s have led to the conclusion that, to obtain all the benefits of
greater reliance on voluntary market-based decision-making, India needs efficient financial
system.
The financial system is possibly the most important institutional and functional
vehicle for economic transformation. Finance is a bridge between the present and the future
and whether it is the mobilization of savings or their efficient, effective and equitable
allocation of investment. It is this success with which the financial system performs its
functions that sets the pace for the achievement of broader national objectives.
A financial system provides services that are essential in a modern economy. The
use of a stable, widely accepted medium of exchange reduces the costs of transactions.
It facilitates trade and, therefore, specialization in production. Financial assets with
attractive yield, liquidity and risk characteristics encourage savings in financial form. By
evaluating alternative investments and monitoring the activities of borrowers, financial
intermediaries increase the efficiency of resource use. Access to a variety of financial
instruments enables an economic agent to pool, price and exchange risks in the markets.
Trade, the efficient use of resources, savings and risk taking are the cornerstones of a
growing economy. In fact, the country could make this feasible with the active support
of the financial system. The financial system has been identified as the most catalyzing
agent for the growth of an economy, making it one of the key inputs for development.
1.22 Definitions of Financial System

According to Robinson, Financial system is the primary function of the system
which is to provide a link between savings and investment for the creation of new wealth
and to permit portfolio adjustment in the composition of the existing wealth.
According to Van Horne, Financial system is the purpose of financial markets to
allocate savings efficiently in an economy to ultimate users either for investment in real
assets or for consumption.
According to Christy, Financial system is to supply funds to various sectors and
activities of the economy in ways that promote the fullest possible utilization of resources
28
Notes
without the destabilizing consequence of price level changes or unnecessary interference

with individual desires.
According to Franklin Allen and Douglas Gale in Comparing Financial Systems,
Financial systems are crucial to the allocation of resources in a modern economy. They
channel household savings to the corporate sector and allocate investment funds among
firms; they allow inter-temporal smoothing of consumption by households and expenditures
by firms; and they enable households and firms to share risks. These functions are
common to the financial systems of most developed economies. Yet the form of these
financial systems varies widely.
According to Prof. Prasanna Chandra, The financial system consists of variety of
institutions, markets and instruments related in a systematic manner and provide the
principal means by which savings are transformed into investments.
1.23 Meaning of Financial System

Financial system refers to a set of complex and closely connected or interlinked
financial institutions or organized and unorganized financial markets, financial instruments
and services which facilitate the transfer of funds.
A financial system consists of institutional arrangements through which financial
surplus in the economy are mobilized from units having surplus funds and is transferred
to units having financial deficit. Financial system is a total of financial institutions, financial
markets, financial services, financial practices and procedures.
1.24 Meaning of Financial Dualism

Financial systems of most developing countries are characterized by co-existence
and cooperation between the formal and informal financial sectors. This co-existence of
two sectors is commonly referred to as Financial dualism.
1.25 Objectives of Financial System

The various objectives of financial system are as follows:
1. To mobilize the resources.
2. To create link between savers and investors.
3. To establish a regular smooth and efficient markets.
4. To create assets for the use of people.
5. To encourage savings and investment.
6. To facilitate economic development of the country.
7. To facilitate for expansion of financial markets.
8. To promote for efficient allocation of financial resources.
9. To make sound decisions based on cash flow and available resources.
10. To establish financial control and clear accounting procedures which ensure that
funds are used for intended purposes.
Introduction
29
1.26 Purpose of Financial System
Notes
The several purposes of financial system are as follows:

(a) Financial system is required for mobilization of savings and converting it into
investments.
(b) Financial system is essential for providing required capital to the business
organizations to carry out their activities.
(c) It is required for generating income or profit for both household and corporate
sector.
(d) It is necessary for increasing the productivity of capital through efficient and
effective allocation of funds and resources.
(e) It is essential to accelerate the rate of economic growth and development.
(f) It is helpful in providing mechanism to control risk and uncertainties in financial
transactions.
(g) It is required to transfer the resources from one section or part of the economy
to another through effective allocation of resources to different investment
channels.
1.27 Functions of Financial System

A good financial system serves in the following ways:
1. Savings Function
Public saving finds their way into the hands of those in production through the financial
system. Financial claims are issued in the money and capital markets which promise
future income flows. The funds with the producers result in production of goods and services
thereby increasing society living standards. The one of the important functions of a financial
system is to link the savers and investors and thereby help in mobilizing and allocating
the savings efficiently and effectively. By acting as an efficient conduit for allocation of
resources, it permits continuous upgradation of technologies for promoting growth on a
sustained basis.
2. Liquidity Function
The term liquidity refers to ready cash or money and other financial assets which
can be converted into cash without loss of value and time. It provides liquidity in the market
through which claims against money can be resold by the investors and thereby assets
can be converted into cash at any time. This function allows for the easy and fast
conversion of securities into cash.
Thus, the major function of financial system is the provision of money and monetary
assets for the purpose of production of goods and services. Therefore, all the financial
activities are subjected to either provision of liquidity or trading in liquidity.
3. Payment Function
The financial system offers a very convenient mode for payment of goods and
services. Cheque system, credit card system, etc. are the easiest methods of payments.
The cost and time of transactions are drastically reduced. A financial system not only
helps in selecting projects to be funded but also inspires the operators to monitor the
performance of the investment. It provides a payment mechanism for the exchange of
30
Notes
goods and services and transfers economic resources through time and across geographic
regions and industries.
4. Risk Function
The term risk and uncertainty relates to future which remains unknown for the
investors who expect future incomes through their savings.
Whenever the mobilized savings are invested into different productive activities, the
investors are exposed to lower risk. This is mainly because of the benefits of diversification
that is available to even small investors. Every investors preference will be influenced by
considerations such as convenience, lower risk, liquidity, etc.
Financial intermediaries enable the investors to diversify investments widely which
helps in reducing the risk of capital depreciation and poor dividends. Hence, a combination
of financial assets will help in minimizing risk.
5. Policy Function
The government intervenes in the financial system to influence macroeconomic
variables like interest rates or inflation so if country needs more money government would
cut rate of interest through various financial instruments and if inflation is high and too
much money is available in the system, then government would increase the rate of
interest. It makes available price-related information which is a valuable assistance to those
who need to take economic and financial decisions.
6. Provides Financial Services
A financial system minimizes situations where the information is an asymmetric and
likely to affect motivations among operators or when one party has the information and
the other party does not. It provides financial services such as insurance, pension, etc.
and offers portfolio adjustment facilities.
Example: It provides fee based or advisory based financial services such as issue
management, portfolio management, corporate counselling, credit rating, stock broking,
etc. and fund based or asset based financial services such as hire purchase, equipment
leasing, bill discounting, housing finance, insurance service, venture capital, etc.
7. Lowers the Cost of Transactions
A financial system helps in the creation of a financial structure that lowers the cost
of transactions. This has a beneficial influence on the rate of return to savers. It also
reduces the cost of borrowing. Thus, the system generates an impulse among the people
to save more.
8. Financial Deepening and Broadening
A well-functioning financial system helps in promoting the process of financial
deepening and broadening. Financial deepening refers to an increase of financial assets
as a percentage of the Gross Domestic Product (GDP). Financial broadening refers to
building an increasing number and a variety of participants and instruments.
Financial broadening begins when corporations seek to employ labor and capital
according to their relative contribution to production. It can also influence demand for capital
goods (and the labor to create and employ it) which depends on expected consumer
Introduction
31
demand in a future period. It also includes profit maximization which aims to produce more
with more productive capital and less labor so that production generally becomes
increasingly more capital intensive.
Notes
1.28 Structure of Indian Financial System or Components of Financial

System
The following are the four main components of Indian Financial System:
1. Financial Institutions
2. Financial Markets
3. Financial Intermediaries
4. Financial Services
1. Financial Institutions
Financial institutions are the intermediaries which facilitate smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of the
surplus units and allocate them in productive activities promising a better rate of return.
Financial institutions also provide services to entities seeking advice on various issues
ranging from restructuring to diversification plans. They provide whole range of services
to the entities who want to raise funds from the markets elsewhere. Financial institutions
act as financial intermediaries because they act as middlemen between savers and
borrowers, where these financial institutions may be banking or non-banking institutions.
Financial institutions channel the flow of funds between investors and firms. Individuals
deposit funds at commercial banks, purchase shares of mutual funds, purchase insurance
protection with insurance premiums, and contribute to pension plans. All of these financial
institutions provide credit to firms by purchasing debt securities or providing loans or other
credit products. In addition, all of these financial institutions except commercial banks
purchase stocks issued by firms.
Meaning of Financial Institutions
Financial institutions or financial intermediaries are those institutions, which provide
financial services and products which customers needs. Financial institutions provide all
those services, which a customer may not be able to get more efficiently on his own.
For example, customers not having skill to invest in equity market efficiently can invest
money in Mutual Funds and can avail the benefits of capital market. Financial institutions
provide all those financial services, which are available in financial system.
Benefits of Financial Institutions
The following benefits are enjoyed by an individual who invests through financial
intermediaries than involving directly in financial market.
(a) Economy of Scale
When financial institutions are carrying out their investment or other activities in large
scale out of pooled funds, they can achieve economy of scale.
(b) Lower Transaction Cost
Because of economy of scale the cost of each transaction is much lower than what
it would have been, if that transaction is carried on by individual investor on his own.
32
Notes
(c) Diversification
As financial institutions are dealing in huge amounts of pooled funds, they diversify
their investments in such a way that the risk involved would reduce considerably.
2. Financial Markets
A financial market is a market in which people and entities can trade financial
securities, commodities and other fungible items of value at low transaction costs and
at prices that reflect supply and demand. Securities include stocks and bonds, and
commodities include precious metals or agricultural goods.
There are both general markets (where many commodities are traded) and
specialized markets (where only one commodity is traded). Markets work by placing many
interested buyers and sellers, including households, firms, and government agencies, in
one place, thus making it easier for them to find each other. An economy which relies
primarily on interactions between buyers and sellers to allocate resources is known as
a market economy in contrast either to a command economy or to a non-market economy
such as a gift economy.
Financial market transactions can be distinguished by whether they involve new or
existing securities, whether the transaction of new securities reflects a public offering or
a private placement, and whether the securities have short-term or long-term maturities.
New securities are issued by firms in the primary market and purchased by investors.
If investors desire to sell the securities that they have previously purchased, they use
the secondary market. The sale of new securities to the general public is referred to as
a public offering; the sale of new securities to one investor or a group of investors is referred
to as a private placement. Securities with short-term maturities are called money market
securities, and securities with long-term maturities are called capital market securities
Finance is a prerequisite for modern business and financial institutions play a vital
role in an economic system. It is through financial markets the financial system of an
economy works. The main objectives of financial markets are:
1. To facilitate creation and allocation of credit and liquidity;
2. To serve as intermediaries for mobilization of savings;
3. To assist process of balanced economic growth;
4. To provide financial convenience.
3. Financial Intermediaries
Financial intermediation consists of channelling funds between surplus and deficit
agents.
4. Financial Services
Financial services are the economic services provided by the finance industry, which
encompasses a broad range of organizations that manage money, including credit unions,
banks, credit card companies, insurance companies, consumer finance companies, stock
brokerages, investment funds and some government sponsored enterprises.
Efficiency of emerging financial system largely depends upon the quality and variety
of financial services provided by financial intermediaries. The term financial services can
be defined as activities, benefits and satisfaction connected with the sale of money that
offers to users and customers, financial related value.
Introduction
33
Classification of Financial Service
Notes
1. Fee-based Services
Bank Management sets fees and charges for banking services to ensure that the
bank is adequately compensated for the services it provides. When setting fees and
charges, bankers take into consideration the possible exposure to loss, which may be
incurred for providing the service, the effort required of the Bank and the amount of time
required the performing the service properly. Some of the more common fee-based services
being offered by Banks to retail customers today are described in this section.
2. Fund-based Services
Fund-based services include cash credit, overdraft, bill discounting, short-term loans,
and export financing (pre-shipment as well as post-shipment). Fee-based facilities include
letters of credit and bank guarantees.
1.29 Technology of Financial System

Various technologies of Financial System are:
1. Pooling
Pooling is a resource management term that refers to the grouping together of
resources (assets, equipment, personnel, effort, etc.) for the purposes of maximizing
advantage and/or minimizing rise to the users.
Pooling is the grouping together of assets, and related strategies for minimizing risk.
Debt instruments with similar characteristics, such as mortgages, can be pooled into a
new security, for example:
(i) Asset-backed securities (ABS)
An asset-backed security (ABS) is a security whose income payments and hence
value is derived from and collateralized (or backed) by a specified pool of underlying
assets. The pool of assets is typically a group of small and illiquid assets which are unable
to be sold individually. Pooling the assets into financial instruments allows them to be
sold to general investors, a process called securitization, and allows the risk of investing
in the underlying assets to be diversified because each security will represent a fraction
of the total value of the diverse pool of underlying assets. The pools of underlying assets
can include common payments from credit cards, auto loans, and mortgage loans, to
esoteric cash flows from aircraft leases, royalty payments and movie revenues.
(ii) Mortgage-backed securities (MBS)
Mortgage-backed security (MBS) is a type of asset-backed security that is secured
by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals
(a government agency or investment bank) that securitizes, or packages, the loans
together into a security that investors can buy. The mortgages of an MBS may be
residential or commercial, depending on whether it is an Agency MBS or a Non-Agency
MBS; in the United States they may be issued by structures set up by governmentsponsored enterprises like Fannie Mae or Freddie Mac, or they can be private-label,
issued by structures set up by investment banks. The structure of the MBS may be known
as pass-through, where the interest and principal payments from the borrower or
homebuyer pass through it to the MBS holder, or it may be more complex, made up of
a pool of other MBSs. Other types of MBS include collateralized mortgage obligations
(CMOs, often structured as real estate mortgage investment conduits) and collateralized
debt obligations (CDOs).
34
Notes
(iii) Collateralized debt obligations (CDO)

Collateralized debt obligation (CDO) is a type of structured asset-backed security
(ABS). Originally developed for the corporate debt markets, over time CDOs evolved to
encompass the mortgage and mortgage-backed security (MBS) markets. CDO can be
thought of as a promise to pay investors in a prescribed sequence, based on the cash
flow the CDO collects from the pool of bonds or other assets it owns. The CDO is sliced
into tranches, which catch the cash flow of interest and principal payments in sequence
based on seniority. If some loans default and the cash collected by the CDO is insufficient
to pay all of its investors, those in the lowest, most junior tranches suffer losses first.
The last to lose payment from default are the safest, most senior tranches. Consequently,
coupon payments (and interest rates) vary by tranche with the safest/most senior tranches
paying the lowest rates and the lowest tranches paying the highest rates to compensate
for higher default risk.
The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert
Inc. for the also now-defunct Imperial Savings Association. During the 1990s, the collateral
of CDOs was generally corporate and emerging market bonds and bank loans. After 1998,
multi-sector CDOs were developed by Prudential Securities, but CDOs remained fairly
obscure until after 2000. In 2002 and 2003, CDOs had a setback when rating agencies
were forced to downgrade hundreds of the securities, but sales of CDOs grew from $69
billion in 2000 to around $500 billion in 2006. From 2004 through 2007, $1.4 trillion worth
of CDOs were issued.
Early CDOs were diversified, and might include everything from aircraft leaseequipment debt, manufactured housing loans, to student loans and credit card debt. The
diversification of borrowers in these multi-sector CDOs was a selling point, as it meant
that if there was a downturn in one industry like aircraft manufacturing and their loans
defaulted, other industries like manufactured housing might be unaffected. Another selling
point was that CDOs offered returns that were sometimes 2-3 percentage points higher
than corporate bonds with the same credit rating.
(iv) Collateralized mortgage obligations (CMO)
Collateralized mortgage obligation (CMO) is a type of complex debt security that
repackages and directs the payments of principal and interest from a collateral pool to
different types and maturities of securities, thereby meeting investor needs. CMOs were
first created in 1983 by the investment banks Salomon Brothers and First Boston for the
US mortgage liquidity provider Freddie Mac.
CMO is a debt security issued by an abstraction a special purpose entity and
is not a debt owed by the institution creating and operating the entity. The entity is the
legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued
by the entity, and they receive payments from the income generated by the mortgages
according to a defined set of rules. With regard to terminology, the mortgages themselves
are termed collateral, classes refers to groups of mortgages issued to borrowers of roughly
similar creditworthiness, tranches are specified fractions or slices, metaphorically
speaking, of a pool of mortgages and the income they produce that are combined into
an individual security, while the structure is the set of rules that dictates how the income
received from the collateral will be distributed. The legal entity, collateral, and structure
are collectively referred to as the deal. Unlike traditional mortgage pass-through securities,
CMOs feature different payment streams and risks, depending on investor preferences.
For tax purposes, CMOs are generally structured as Real Estate Mortgage Investment
Conduits, which avoid the potential for double taxation.
Introduction
35
(v) Structured finance
Notes
Structured finance is a sector of finance that was created to help transfer risk using
complex legal and corporate entities. This transfer of risk, as applied to the securitization
of various financial assets (mortgages, credit card receivables, auto loans, etc.) has helped
provide increased liquidity or funding sources to markets like housing and to transfer risk
to buyers of structured products; it also permits financial institutions to remove certain
assets from their balance sheets as well as provides a means for investors to gain access
to diversified asset classes. However, it arguably contributed to the degradation in
underwriting standards for these financial assets, which helped give rise to both the
inflationary credit bubble of the mid-2000s and the credit crash and financial crisis of 20072009.
(vi) Securitization
Securitization is the financial practice of pooling various types of contractual debt
such as residential mortgages, commercial mortgages, auto loans or credit card debt
obligations (or other non-debt assets which generate receivables) and selling their related
cash flows to third party investors as securities, which may be described as bonds, passthrough securities, or collateralized debt obligations (CDOs). Investors are repaid from the
principal and interest cash flows collected from the underlying debt and redistributed
through the capital structure of the new financing. Securities backed by mortgage
receivables are called mortgage-backed securities (MBS), while those backed by other
types of receivables are asset-backed securities (ABS).
Off-balance sheet treatment for securitizations coupled with guarantees from the
issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky
capital structures and leading to an underpricing of credit risk. Off-balance sheet
securitizations are believed to have played a large role in the high leverage level of US
financial institutions before the financial crisis, and the need for bailouts.
The granularity of pools of securitized assets can mitigate the credit risk of individual
borrowers. Unlike general corporate debt, the credit quality of securitized debt is nonstationary due to changes in volatility that are time- and structure-dependent. If the
transaction is properly structured and the pool performs as expected, the credit risk of
all tranches of structured debt improves; if improperly structured, the affected tranches
may experience dramatic credit deterioration and loss.
(vii) Intergovernmental risk pool
A risk pool is one of the forms of risk management mostly practiced by insurance
companies. Under this system, insurance companies come together to form a pool, which
can provide protection to insurance companies against catastrophic risks such as floods,
earthquakes, etc. The term is also used to describe the pooling of similar risks that
underlies the concept of insurance. While risk pooling is necessary for insurance to work,
not all risks can be effectively pooled. In particular, it is difficult to pool dissimilar risks
in a voluntary insurance bracket, unless there is a subsidy available to encourage
participation.
Risk pooling is an important concept in supply chain management. Risk pooling
suggests that demand variability is reduced if one aggregates demand across locations
because as demand is aggregated across different locations, it becomes more likely that
high demand from one customer will be offset by low demand from another. This reduction
in variability allows a decrease in safety stock and therefore reduces average inventory.
36
Notes
2. Netting
Netting is a process the National Securities Clearing Corporation (NSCC) uses to
streamline securities transactions. To net, the NSCC compares the entire buy and sell
orders for each individual security and matches purchases by clients of one brokerage
firm with corresponding sales by other clients of the firm.
In the context of credit risk, there are at least three specific types of netting:
(a) Close-out netting
In the counterparty bankruptcy or any other relevant event of default specified in the
relevant agreement if accelerated (i.e., effected), all transactions or all of a given type are
netted (i.e. set off against each other) at market value or, if otherwise specified in the
contract or if it is not possible to obtain a market value, at an amount equal to the loss
suffered by the non-defaulting party in replacing the relevant contract. The alternative would
allow the liquidator to choose which contracts to enforce and which not to (and thus
potentially cherry pick). There are international jurisdictions where the enforceability of
netting in bankruptcy has not been legally tested.
(b) Netting by novation
The legal obligations of the parties to make required payments under one or more
series of related transactions are canceled and a new obligation to make only the net
payments is created.
(c) Settlement or payment netting
For cash settled trades, this can be applied either bilaterally or multilaterally and
on related or unrelated transactions.
(i) Bilateral Net Settlement System
A settlement system in which every individual bilateral combination of participants
settles its net settlement position on a bilateral basis.
(ii) Multilateral Net Settlement System
A settlement system in which each settling participant settles its own multilateral
net settlement position (typically by means of a single payment or receipt).
3. Credit Substitution
Credit substitution refers to liability transfer between one party to another party. For
example, a bank substitutes its own credit for the credit of the borrower.
Replacement of credit of one party to a transaction with the (superior) credit of a
financial institution.
4. Delegation
Delegation is the process of appointment of someone to act for other. Delegation
helps to reduces transaction cost for following reasons:
1. Delegation allows specialization.
2. The delegate is in a stronger position.
3. Revealing information.
Introduction
37
1.30 Summary
Notes
Financial institution is an institution that provides financial services for its clients or
members. Probably, the most important financial service provided by financial institutions
is acting as financial intermediaries. Most financial institutions are regulated by the
government.
Financial institutions provide services as intermediaries of financial markets. They
are responsible for transferring funds from investors to companies in need of those funds.
Financial institutions facilitate the flow of money through the economy. To do so, savings
are brought to provide funds for loans.
Non-Bank Financial Institution (NBFI) is a financial institution that does not have a
full banking license or is not supervised by a national or international banking regulatory
agency. NBFIs facilitate bank-related financial services, such as investment, risk pooling,
contractual savings, and market brokering. Examples of these include insurance firms,
pawn shops, cashiers check issuers, check cashing locations, payday lending, currency
exchanges, and micro loan organizations.
Non-Banking Financial Companies (NBFCs) are financial institutions that provide
banking services without meeting the legal definition of a bank, i.e. one that does not
hold a banking license. These institutions are not allowed to take deposits from the public.
Nonetheless, all operations of these institutions are still exercised under bank regulation.
Capital formation implies the diversion of the productive capacity of the economy to
the making of capital goods which increases future productive capacity. The process of
Capital Formation involves three distinct but interdependent activities, viz., savings financial
intermediation and investment. However, poor country/economy may be, there will be a
need for institutions which allow such savings, as are currently forthcoming, to be invested
conveniently and safely and which ensure that they are channeled into the most useful
purposes. A well-developed financial structure will therefore aid in the collections and
disbursements of investible funds and thereby contribute to the capital formation of the
economy. Indian capital market although still considered to be underdeveloped has been
recording impressive progress during the post-interdependence period.
Insurance companies underwrite economic risks associated with illness, death,
damage and other risks of loss. In return to collecting an insurance premium, insurance
companies provide a contingent promise of economic protection in the case of loss. There
are two main types of insurance companies: general insurance and life insurance. General
insurance tends to be short-term, while life insurance is a longer-term contract, which
terminates at the death of the insured. Both types of insurance, life and general, are
available to all sectors of the community.
Contractual savings institutions give individuals the opportunity to invest in collective
investment vehicles (CIV) as a fiduciary rather than a principal role. Collective investment
vehicles pool resources from individuals and firms into various financial instruments
including equity, debt, and derivatives. Note that the individual holds equity in the CIV
itself rather what the CIV invests in specifically. The two most popular examples of
contractual savings institutions are pension funds and mutual funds.
Pension funds are mutual funds that limit the investors ability to access their
investments until a certain date. In return, pension funds are granted large tax breaks
in order to incentives the working population to set aside a portion of their current income
for a later date after they exit the labor force (retirement income).
38
Notes
Market makers are broker-dealer institutions that quote a buy and sell price and
facilitate transactions for financial assets. Such assets include equities, government and
corporate debt, derivatives, and foreign currencies. After receiving an order, the market
maker immediately sells from its inventory or makes a purchase to offset the loss in
inventory. The differential between the buying and selling quotes, or the bid-offer spread,
is how the market-maker makes profit. A major contribution of the market makers is
improving the liquidity of financial assets in the market.
Financial institution is an establishment that conducts financial transactions such
as investments, loans and deposits. Economic development is the sustained, concerted
actions of policy makers and communities that promote the standard of living and
economic health of a specific area. Economic development can also be referred to as
the quantitative and qualitative changes in the economy. Financial institutions play a vital
role for economic development of a country.
Money is a token or item which acts as a medium of exchange that has both legal
and social acceptance with regards to making payment for buying commodities or receiving
services, as well as repayment of loans.
Durability means that an item retains the same shape, form, and substance over
an extended period of time; that it does not easily decompose, deteriorate, degrade, or
otherwise change form. However, durability also extends beyond the physical realm to
include social and institutional durability.
Durability is critical for money to perform the related functions of medium of exchange
and store of value. People are willing to accept an item in payment for one good because
they are confident that the item can be traded at a later time for some other good. An
item works as a medium of exchange precisely because it stores value from one
transaction to the next. And this requires durability.
Fiat money is that type of money the value of which is ascertained with the help
of legal methods instead of the associated availableness of commodities and services.
Fiat money can symbolize government promises or a commodity. The word fiat means
the command of the sovereign. It is the type of money that is issued by the command
of the sovereign. The paper money is generally called as the fiat money. This type of money
forms a monetary standard. It has been made mandatory by law to accept the fiat money,
as an exchange medium, whenever it is offered to anyone.
Credit money refers to the claim placed to a legal individual, which can be implemented
to buy goods and services. Soft money refers to the paper currency rather than gold, silver,
or any other types of coined metal. Hard money refers to the value of different gold, silver,
or platinum coins (bullion) in circulation in the field of international trade.
Commercial Bank money or demand deposits are claims against financial institutions
that can be used for the purchase of goods and services. A demand deposit account is
an account from which funds can be withdrawn at any time by cheque or cash withdrawal
without giving the bank or financial institution any prior notice. Banks have the legal
obligation to return funds held in demand deposits immediately upon demand (or at call).
Demand deposit withdrawals can be performed in person, via cheques or bank drafts, using
automatic teller machines (ATMs), or through online banking.
Monetary system is a set of mechanisms by which a government provides money
in a countrys economy. It usually consists of a mint, central bank, and commercial banks.
The Monetary system of India plays a very important role in the economic
development. The monetary system performs a number of functions.
Introduction
39
Capital formation refers to net additions of capital stock such as equipment, buildings
and other intermediate goods. A nation uses capital stock in combination with labor to
provide services and produce goods; an increase in this capital stock is known as capital
formation.
Notes
Saving and investment are essential for capital formation. According to Marshall,
saving is the result of waiting or abstinence. When a person postpones his consumption
to the future, he saves his wealth which he utilizes for further production. If all people
save like this, the aggregate savings increase which are utilized for investment purposes
in real capital assets like machines, tools, plants, roads, canals, fertilizers, seeds, etc.
Financial intermediation consists of channeling funds between surplus and deficit
agents. A financial intermediary is a financial institution that connects surplus and deficit
agents. The classic example of a financial intermediary is a bank that consolidates bank
deposits and uses the funds to transform them into bank loans.
Financial services are the economic services provided by the finance industry, which
encompasses a broad range of organizations that manage money, including credit unions,
banks, credit card companies, insurance companies, consumer finance companies, stock
brokerages, investment funds and some government sponsored enterprises.
Bank Management sets fees and charges for banking services to ensure that the
bank is adequately compensated for the services it provides. When setting fees and
charges, bankers take into consideration the possible exposure to loss, which may be
incurred for providing the service, the effort required of the Bank and the amount of time
required the performing the service properly. Some of the more common fee based services
being offered by Banks to retail customers today are described in this section.
Fund-based services include cash credit, overdraft, bill discounting, short-term loans,
and export financing (pre-shipment as well as post-shipment). Fee based facilities include
letters of credit and bank guarantees.

I. Fill in the Blanks
1. Financial institution is an institution that provides financial services for its
___________.
2. ___________ is a financial institution that does not have a full banking license
or is not supervised by a national or international banking regulatory agency.
3. Capital formation implies the diversion of the productive capacity of the economy
to the making of capital goods which increases future ___________
4. ___________ is the sustained, concerted actions of policy makers and
communities that promote the standard of living and economic health of a
specific area.
5. ___________ is that type of money the value of which is ascertained with the
help of legal methods instead of the associated availableness of commodities
and services. Fiat money can symbolize government promises or a commodity.
40
Notes
II. True or False

1. Financial institutions facilitate the flow of money through the economy.
2. Non-Banking Financial Companies (NBFCs) are financial institutions that provide
banking services without meeting the legal definition of a bank, i.e., one that
does not hold a banking license.
3. Investment involves three distinct but interdependent activities, viz., savings
financial intermediation and investment.
4. Collective investment vehicles pool resources from individuals and firms into
various financial instruments including equity, debt, and derivatives.
5. Financial institution is an establishment that conducts financial transactions
such as investments, loans and deposits.
III. Multiple Choice Questions
1. Which of the following is an institution that provides financial services for its
clients or members?
(a) Financial institution
(b) Financial system
(c) Non-financial institution
(d) All the above
2. Which of the following is a financial institution that does not have a full banking
license or is not supervised by a national or international banking regulatory
agency?
(a) Non-Bank Financial Institution (NBFI)
(c) Non-financial institution
(d) All the above
3. Which of the following implies the diversion of the productive capacity of the
economy to the making of capital goods which increases future productive
capacity?
(a) Non-Bank Financial Institution (NBFI)
(c) Non-ffinancial institution
(d) Capital formation
4. Contractual savings institutions give individuals the opportunity to invest in
___________
(a) Collective Investment Vehicles
(b) Investment policy
(c) Both (a) and (b)
(d) None of these
5. Economic development can be referred to as the ___________
(a) Quantitative changes in the economy
(b) Qualitative changes in the economy
(c) None of these
(d) Both (a) and (b)
Introduction
41
Notes
I. Short Answer Questions

1. What is Financial Institution?
2. What is Non-Banking Financial Institution?
3. Define the term Money.
4. State any two functions of Money.
5. What is Monetary System?
6. What is Capital Formation?
7. Give the meaning of Financial System.
8. What is Financial System?
II. Extended Answer Questions
1. Discuss benefits of Financial Institutions.
2. Explain the classification of Financial Institutions.
3. Discuss functions of Financial Institutions.
4. Explain various types of Non-Banking Financial Institutions.
5. Discuss about financial Institutions and Economic Development.
6. Discuss various features of Money.
7. Explain functions of Money.
8. Discuss various types of Money.
9. Explain the process of Capital Formation.
10. Discuss objectives of Financial System.
11. Explain various functions of Financial System.
12. Discuss the Technology of Financial System
1.33 Key Terms

z
Financial institution: Financial institution is an institution that provides

financial services for its clients or members.
Non-Bank Financial Institution: Non-Bank Financial Institution (NBFI) is a

financial institution that does not have a full banking license or is not supervised
by a national or international banking regulatory agency.
Non Banking Financial Companies: Non Banking Financial Companies

(NBFCs) are financial institutions that provide banking services without meeting
the legal definition of a bank, i.e. one that does not hold a banking license.
Capital formation: Capital formation implies the diversion of the productive

capacity of the economy to the making of capital goods which increases future
productive capacity.
Contractual savings institutions: Contractual savings institutions that give

individuals the opportunity to invest in collective investment vehicles (CIV) as
a fiduciary rather than a principal role.
Money: Money is a token or item which acts as a medium of exchange that

has both legal and social acceptance with regards to making payment for buying
commodities or receiving services, as well as repayment of loans.
42
Notes

z
Fiat money: Fiat money is that type of money the value of which is ascertained
with the help of legal methods instead of the associated availableness of
commodities and services.
Credit money: Credit money refers to the claim placed to a legal individual,
which can be implemented to buy goods and services.

1. Clients or members
2. Non-Bank Financial Institution
3. Productive capacity
4. Economic development
5. Fiat money
II. True or False
1. True
2. True
3. False
4. True
5. True
1. (a) Financial institution
2. (a) Non-Bank Financial Institution (NBFI)
3. (d) Capital formation
4. (a) Collective Investment Vehicles
5. (d) Both (a) and (b)
1.35 Case Study

Mr. and Mrs. A both worked in a local factory, earning modest wages. They were
using the overdraft facility on their current account to its full extent. They also had a
personal loan from their bank and had borrowed from various credit card companies.
In March 2004, realizing they were in financial difficulty but unsure what to do about
it, they visited their bank. They explained their situation to the lending officer, who told
them the bank could give them a consolidation loan to cover all their existing debts.
Mr. and Mrs. A were pleased with this suggestion and they took out the loan, which
paid off all their existing debts and returned their current account into credit. But the bank
left the couples overdraft facility in place on their current account, and within a couple
of months Mr. and Mrs. A had begun to go overdrawn again.
In June, having found they were unable to keep within the overdraft limit, Mr. and
Mrs. A visited the bank to discuss the position. The banks lending officer arranged another
consolidation loan for them, to cover the overdraft debt.
Again, the bank left the couples overdraft facility in place, and within a few months
Mr. and Mrs. A were again in financial difficulties. When they visited the bank in November
they were given a third loan. This covered the debts that the couple had acquired since
Introduction
43
taking out the consolidation loan in June. It also covered an additional 500. The bank
agreed to lend them this because they had said they were worried about how they would
pay for all the extras they would need over the Christmas period.
Notes
By early 2005, realizing that they were unable to meet their repayment commitments,
Mr. and Mrs. A complained to the bank. They said they had asked for help in managing
their debts but instead it had made their situation worse.
Question:
1. Discuss how to solve Mr. and Mrs. As complaints?

1. Money, Banking and Financial Institutions by Siklos, Pierre, McGraw-Hill
Ryerson.
2. Banking Through the Ages by Hoggson, N.F., New York, Dodd, Mead &
Company.
3. Investing in Development: Lessons of the World Bank Experience, by Baum
W.C and Tolbert S.M., Oxford University Press.
4. Projects, Preparation, Appraisal, Budgeting and Implementation, by Prasanna
Chandra, Tata McGraw Hill, New Delhi.
1.37 Bibliography
1. Siklos, Pierre (2001), Money, Banking, and Financial Institutions: Canada in
the Global Environment, Toronto: McGraw-Hill Ryerson, p. 40, ISBN 0-07087158-2.
2. Hoggson, N.F. (1926), Banking through the Ages, New York, Dodd, Mead &
Company.
3. Goldthwaite, R.A. (1995), Banks, Places and Entrepreneurs in Renaissance
Florence, Aldershot.
4. Mishler, Lon and Cole, Robert E. (1995), Consumer and Business Credit
Management, Homewood: Irwin, pp. 128-129, ISBN 0-256-13948-2.
5. Statistics Department (2001), Source Data for Monetary and Financial
Statistics, Monetary and Financial Statistics: Compilation Guide, Washington
D.C.: International Monetary Fund, p. 24, ISBN 978-1-58906-584-0. Retrieved
2009-03-14.
6. For Banks, Wads of Cash and Loads of Trouble Article by Eric Lipton and
Andrew Martin in The New York Times July 3, 2009 Hampshire, Great Britain,
Variorum.
7. Baum W.C. and Tolbert S.M. (1985), Investing in Development: Lessons of the
World Bank Experience, Oxford: Oxford University Press, p. 8.
8. Choudhary, S. (1988), Project Management, New Delhi: Tata McGraw Hill,
p. 3.
9. Harrison, F.L. (1992), Advance Project Management, Metropolitan, New Delhi,
p. 13.
10. James, M. Kouzes and Barry Z. Posner (1987), The Leadership Challenge,
Jossey Bass, Sans Francisco.
11. Prasanna Chandra (1988), Projects, Preparation, Appraisal, Budgeting and
Implementation: Tata McGraw Hill, New Delhi.
44
Notes
12. Sapru, R.K. (1994), Development Administration, Sterling, New Delhi.

13. United Nations Industrial Development Organization (1998), Manual for
Evaluation of Industrial Projects, Oxford and IBH New York.
14. T.E. Copeland and J.F. Weston (1988), Financial Theory and Corporate Policy,
Addison-Wesley, West Sussex (ISBN 978-0321223531).
15. E.J. Elton, M.J. Gruber, S.J. Brown and W.N. Goetzmann (2003), Modern
Portfolio Theory and Investment Analysis, John Wiley & Sons, New York (ISBN
978-0470050828).
16. E.F. Fama (1976), Foundations of Finance, Basic Books Inc., New York (ISBN
978-0465024995).
17. Marc M. Groz (2009), Forbes Guide to the Markets, John Wiley & Sons Inc.,
New York (ISBN 978-0470463383).
18. R.C. Merton (1992), Continuous Time Finance, Blackwell Publishers Inc. (ISBN
978-0631185086).
19. Keith Pilbeam (2010), Finance and Financial Markets, Palgrave (ISBN 9780230233218).
20. Steven Valdez, An Introduction to Global Financial Markets, Macmillan Press
Ltd. (ISBN 0-333-76447-1).
21. The Business Finance Market: A Survey, Industrial Systems Research
Publications, Manchester (UK), New Edition 2002 (ISBN 978-0-906321-19-5).
45
Notes
Unit 2:
Structure:
2.1 Introduction
2.2 Meaning of Financial Intermediary
2.3 Classification of Financial Intermediaries
2.4 Functions of Financial Intermediaries
2.5 Commercial Banks
2.6 Definitions of Commercial Bank
2.7 Meaning of Commercial Bank
2.8 Significance of Commercial Banks
2.9 Structure of Commercial Bank in India
2.10 Role of Commercial Bank in the Economic Development of India
2.11 Functions of Commercial Banks
2.12 Classification of Commercial Banks
2.13 Central Bank or RBI
2.14 History of the Reserve Bank of India
2.15 Establishment of RBI
2.16 Organizational Structure of RBI
2.17 Functional Departments of RBI
2.18 Objectives of Reserve Bank of India
2.19 Role of Reserve Bank of India
2.20 Main Functions of RBI
2.21 Monetary Policy of Reserve Bank of India
2.22 Objectives of Monetary Policy
2.23 Cooperative Banks
2.24 History of Cooperative Banking in India
2.25 Structure of Cooperative Banking in India
2.26 Cooperative Banks Irritants and Future Trends
2.27 Major Irritants in the Functioning of the Cooperative Banks
2.28 Banking System in USA and India
2.29 International Banking
2.30 Benefits of Having an International Banking
2.31 Banking Operations
2.32 Retail Banking
2.33 Meaning of Retail Banking
2.34 Retail Banking in India
2.35 Features of Retail Banking
46
Notes
2.36 Scope for Retail Banking in India

2.37 Retail Banking Activities
2.38 Wholesale Banking
2.39 Wholesale Banking in India
2.40 Near Banks
2.41 Universal Banking
2.42 Advantages of Universal Banking
2.43 Disadvantages of Universal Banking
2.44 Non-Banking Financial Company
2.45 Summary
2.48 Key Terms
2.50 Case Study
2.52 Bibliography
Objectives
z
lUnderstand the overview of financial intermediaries
Detailed overview of Commercial banks
Detailed study of Central and Cooperative banks
Banking system in USA and India
Understand the International Banking
Understand the Banking Operations
Detailed study of Retail, Wholesale and Universal Banking
Understand the Near Banks
Detailed study of NBFCs
2.1 Introduction
A financial intermediary is a financial institution that connects surplus and deficit
Financial Intermediaries are the firms that provide services and products which
customers may not be able to get more efficiently by themselves in final markets. In other
words, they act as middlemen between investors and borrowers in financial system.
Financial intermediaries may be classified into two:
(i) Capital market intermediaries
Those institutions who provide only long-term funds to individual and companies are
called capital market intermediaries, e.g., financial corporations, investing institutions, etc.
47
(ii) Money market intermediaries
Notes
Those institutions who provide only short-term funds to individuals and corporate
customers are called money market intermediaries, e.g., commercial banks, cooperative
banks, etc.
2.2 Meaning of Financial Intermediary

Financial intermediary is a financial institution such as bank, building society,
insurance company, and investment bank or pension fund. A financial intermediary offers
a service to help an individual/firm to save or borrow money. A financial intermediary helps
to facilitate the different needs of lenders and borrowers.
2.3 Classification of Financial Intermediaries

In general, the financial intermediaries in the Indian Financial System are classified
in the following ways:
(i) Deposit taking organizations
These organizations accept deposits from investors and lend the same to various
entities. Investors are very familiar with these organizations as they deal with them quite
regularly.
Examples: (i) Banks finance companies and (ii) National savings organizations.
(ii) Contractual savings organizations
These organizations enter long-term contracts with investors. Typically, the contract
involves receiving a series of periodic payments from investors over a period of time. These
companies manage the amount received carefully to adhere to the terms of the agreement
and to meet their part of obligations.
Examples: (i) Insurance companies and (ii) Pension funds.
(iii) Investment type organizations
These companies accept money from investors to manage money for them on their
behalf. Normally, it involves making a pool of investors money and investing it in a portfolio
of securities or assets to meet certain common investment objective of the clients.
Example: Mutual funds.
(iv) Fee based intermediaries
These intermediaries do not become a party to the fund transfer process, but just
helps in the transfer. They help in providing information to either party about availability
of funds or need of funds and help in getting a match. They also help investors in
understanding various investment products, understanding risks, analyzing comparative
facts and making suitable choices in case of multiple options. They do not take the
transactions on their own books.
48
Notes
2.4 Functions of Financial Intermediaries

The various functions performed by these intermediaries are broadly classified into
two:
Traditional Functions:
(i) Underwriting of investments in shares/debentures, etc.
(ii) Dealing in secondary market activities.
(iii) Participating in money market instruments.
(iv) Involving in leasing, hire purchase, venture capital, seed capital, etc.
(v) Dealing in foreign exchange market activities.
(vi) Managing the capital issues.
(vii) Making arrangements for the placement of capital and debt instruments with
investing institutions.
(viii) Arrangement of funds from financial institutions for the clients project.
(ix) Assisting in the process of getting all Government and other clearances.
Modern Functions:
(i) Rendering project advisory services.
(ii) Planning for mergers and acquisitions and assisting for their smooth carry out.
(iii) Guiding corporate customers in capital restructuring.
(iv) Acting as trustees to the debenture holders.
(v) Structuring the financial collaboration joint venture by identifying suitable partner
and preparing joint venture agreement.
(vi) Rehabilitating and reconstructing sick companies.
(vii) Hedging of risks by using swaps and derivatives.
(viii) Managing portfolio of large public sector corporations.
(ix) Undertaking risk management services like insurance service, buyback options,
etc.
(x) Advising the clients on best source of funding overall.
(xi) Guiding the clients in the minimization of the cost of debt.
(xii) Capital market services such as clearing, registration and transfers, safe
custody of securities, collection of income on securities.
(xiii) Promoting credit rating agencies.
(xiv Recommending suitable changes in the management structure and management
style with a view of achieving better result.
2.5 Commercial Banks

Commercial bank is a profit-seeking business firm, dealing in money and credit. It
is a financial institution dealing in money in the sense that it accepts deposits of money
from the public to keep them in its custody for safety. So, it deals in credit, i.e., it creates
credit by making advances out of the funds received as deposits to needy people. It thus,
functions as mobilizer of savings in the economy. A bank is, therefore like a reservoir
into which how the savings, the idle surplus money of households and from which loans
are given on interest to businessmen and others who need them for investment or
49
productive uses. Commercial bank being the financial institution performs diverse types
of functions. It satisfies the financial needs of the sectors such as agriculture, industry,
trade, communication, etc. That means they play a very significant role in a process of
economic and social needs. The functions performed by banks are changing according
to changes in time and recently they are becoming customer centric and widening their
functions. Generally, the functions of commercial banks are divided into two categories,
viz., primary functions and secondary functions.
Notes
2.6 Definition of Commercial Bank

According to Crowther, A Commercial Bank is an institution which collects money
from those who have it to spare or who are saving it out of their income and lends this
money out to those who require it.
2.7 Meaning of Commercial Bank

Commercial bank refers to a bank that lends money and provides transactional,
savings, and money market accounts and that accepts time deposit. A commercial bank
is a type of financial institution and intermediary. Commercial banks engage for providing
documentary and standby letter of credit, guarantees, performance bonds, securities,
underwriting commitments and other forms of off-balance sheet exposures.
2.8 Significance of Commercial Banks

Banks play a vital and dynamic role in the economic life of the nation as they keep
the wheels of trade, commerce and industry always revolving. They mobilize the dormant
funds into a productive channel. The economic importance of the Commercial Banks can
be summarized as follows:
(i) Capital formation: Banks facilitate capital formation by promoting savings.
(ii) Innovation: Bank credit enables the enterprises to innovate and invest and thus
uplift economic activity.
(iii) Monetary policy: A well-developed banking system is required to promote
economic development by controlling a period of inflation and deflation.
(iv) Credit creation: Credit creation enables the expansion of business and
mitigation of unemployment and raises production.
(v) Encouragement of trade and industry: Banking system encourages trade
and industry by providing long-term loans to traders and industrialists at low
rates.
(vi) Promotion of habit of thrift: Banks encourage savings habit by accepting,
deposits and giving interests on it.
(vii) Volume of production: Production volume can be increased by expansion of
credit by banks.
2.9 Structure of Commercial Bank in India

1. Scheduled Banks
Scheduled Banks in India are those banks which have been included in the Second
Schedule of Reserve Bank of India (RBI) Act, 1934. RBI in turn includes only those banks
in this schedule which satisfy the criteria laid down vide section 42(6)(a) of the Act.
50
Notes
As on 30th June, 1999, there were 300 scheduled banks in India having a total network
of 64,918 branches. Scheduled commercial banks in India include State Bank of India
and its associates (7), nationalized banks (19), foreign banks (45), private sector banks
(32), cooperative banks and regional rural banks.
Scheduled banks in India means the State Bank of India constituted under the State
Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bank
of India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constituted
under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act,
1970 (5 of 1970), or under section 3 of the Banking Companies (Acquisition and Transfer
of Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the
Second Schedule to the Reserve Bank of India Act, 1934 (2 of 1934), but does not include
a cooperative bank.
(A) Scheduled Banks in India (Public Sector)
Public Sector Banks (PSBs) are banks where a majority stake (i.e., more than 50%)
is held by a government. The shares of these banks are listed on stock exchanges. The
Central Government entered the banking business with the nationalization of the Imperial
Bank of India in 1955. A 60% stake was taken by the Reserve Bank of India and the
new bank was named as the State Bank of India. The seven other state banks became
the subsidiaries of the new bank when nationalized on 19 July 1960. The next major
nationalization of banks took place in 1969 when the government of India, under Prime
Minister Indira Gandhi, nationalized an additional 14 major banks. The total deposits in
the banks nationalized in 1969 amounted to 50 crores. This move increased the presence
of nationalized banks in India, with 84% of the total branches coming under government
control.
The following are the Scheduled Banks in India (Public Sector):
(i) Nationalized Banks
z
Allahabad Bank
Andhra Bank
Bank of Baroda
Bank of India
Bank of Maharashtra
Canara Bank
Central Bank of India
Corporation Bank
Dena Bank
Indian Bank
Indian Overseas Bank
Oriental Bank of Commerce
Punjab and Sindh Bank
Punjab National Bank
Syndicate Bank
UCO Bank
Union Bank of India
United Bank of India
Vijaya Bank
z
IDBI Bank
Saurashtra Gramin Bank (RRB) Bank
51
Notes
(ii) SBI and its Associates

z
State Bank of India
State Bank of Bikaner and Jaipur
State Bank of Hyderabad
State Bank of Mysore
State Bank of Patiala
State Bank of Travancore
(B) Scheduled Banks in India (Private Sector)

Private sector banks in India are all those banks where greater parts of stake or
equity are held by the private shareholders and not by government. These are the major
players in the banking sector as well as in expansion of the business activities India.
The present private sector banks equipped with all kinds of contemporary innovations,
monetary tools and techniques to handle the complexities are a result of the evolutionary
process over two centuries. They have a highly developed organizational structure and
are professionally managed. Thus, they have grown faster and stronger since past few
years.
Private sector banks have been functioning in India since the very beginning of the
banking system. Initially, during 1921, the private banks like Bank of Bengal, Bank of
Bombay and Bank of Madras were in service, which all together formed Imperial Bank
of India.
Reserve Bank of India (RBI) came in picture in 1935 and became the centre of every
other bank taking away all the responsibilities and functions of Imperial Bank. Between
1969 and 1980, there was rapid increase in the number of branches of the private banks.
In April 1980, they accounted for nearly 17.5% of bank branches in India. In 1980, after
6 more banks were nationalized, about 10% of the bank branches were those of private
sector banks. The share of the private bank branches stayed nearly same between 1980
and 2000. Then from the early 1990s, RBIs liberalization policy came in picture and with
this the government gave licences to a few private banks, which came to be known as
new private sector banks.
There are three categories of the private sector banks: old, new and foreign private
banks:
The old private sector banks have been operating since a long time and may be
referred to those banks, which are in operation from before 1991 and all those banks that
have commenced there business after 1991 are called as new private sector banks.
Housing Development Finance Corporation Limited was the first private bank in India
to receive license from RBI as a part of the RBIs liberalization policy of the banking sector,
to set up a bank in the private sector banks in India.
(i) Old Private Sector Banks
The banks, which were not nationalized at the time of bank nationalization that took
place during 1969 and 1980 are known to be the old private sector banks. These were
not nationalized, because of their small size and regional focus. Most of the old private
sector banks are closely held by certain communities their operations are mostly restricted
to the areas in and around their place of origin. Their Board of directors mainly consists
of locally prominent personalities from trade and business circles.
52
Notes
One of the positive points of these banks is that, they lean heavily on service and
technology and as such, they are likely to attract more business in days to come with
the restructuring of the industry round the corner.
List of the Old Private Sector Banks in India
Name of the Bank
Year of Establishment
1.
Bank of Punjab
1943
2.
Catholic Syrian Bank
1920
3.
City Union Bank
1904
4.
Dhanlaxmi Bank
1927
5.
Federal Bank
1931
6.
ING Vysya Bank
1930
7.
Jammu and Kashmir Bank
1938
8.
Karnataka Bank
1924
9.
Karur Vysya Bank
1916
10.
Lakshmi Vilas Bank
1926
11.
Nainital Bank
1912
12.
Ratnakar Bank
1943
13.
SBI Commercial and International Bank
1955
14.
South Indian Bank
1905
15.
Tamilnad Mercantile Bank Limited
1921
16.
United Western Bank
1936
(ii) New Private Sector Banks

The banks, which came in operation after 1991, with the introduction of economic
reforms and financial sector reforms are called new private sector banks. Banking
regulation act was then amended in 1993, which permitted the entry of new private- sector
banks in the Indian banking sector. However, there were certain criteria set for the
establishment of the new private sector banks, some of those criteria being:
The bank should have a minimum net worth of ` 200 crores. The promoters holding
should be a minimum of 25% of the paid-up capital.
Within 3 years of the starting of the operations, the bank should offer shares to public
and their net worth must increased to ` 300 crores.
List of the New Private Sector Banks in India
Name of the Bank
Year of Establishment
1.
Axis Bank (earlier UTI Bank)
1994
2.
Bank of Punjab (actually an old generation private

bank since it was not founded under post-1993 new
bank licensing regime)
1989
Centurion Bank Ltd. (Merged Bank of Punjab in late

2005 to become Centurion Bank of Punjab, acquired
by HDFC Bank Ltd. in 2008)
1994
Development Credit Bank
1995
3.
4.
53
5. HDFC Bank
1994
6. ICICI Bank
1996
7. IndusInd Bank
1994
8. Kotak Mahindra Bank
1985
9. Yes Bank
2005
Notes
(iii) Foreign Private Banks Operating in India

1. ABN AMRO Bank N.V. (Now merged with RBS)
2. Abu Dhabi Commercial Bank
3. American Express Bank
4. Australia and New Zealand Bank
5. Bank International Indonesia
6. Bank of America NA
7. Bank of Bahrain and Kuwait
8. Bank of Ceylon
9. Bank of Nova Scotia (Scotia Bank)
10. Bank of Tokyo Mitsubishi UFJ
11. Barclays Bank PLC
12. BNP Paribas
13. Calyon Bank
14. Chinatrust Commercial Bank
15. Citibank N.A.
16. Credit Suisse
17. DBS Bank
18. DCB Bank now RHB Bank
19. Deutsche Bank AG
20. FirstRand Bank
21. HSBC
22. JP Morgan Chase Bank
23. Krung Thai Bank
24. Mashreq Bank Psc
25. Mizuho Corporate Bank
26. Royal Bank of Scotland
27. Shinhan Bank
29. Socit Gnrale
30. Sonali Bank
31. Standard Chartered Bank
32. State Bank of Mauritius
33. UBS
34. VTB
54
Notes
2. Non Scheduled Bank in India

Non-scheduled bank in India means a banking company as defined in clause (c)
of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduled
bank. Non-scheduled banks also function in the Indian banking space, in the form of Local
Area Banks (LAB). As at end-March 2009, there were only 4 LABs operating in India.
Local area banks are banks that are set up under the scheme announced by the
government of India in 1996, for the establishment of new private banks of a local nature;
with jurisdiction over a maximum of three contiguous districts. LABs aid in the mobilization
of funds of rural and semi-urban districts. Six LABs were originally licensed, but the license
of one of them was cancelled due to irregularities in operations, and the other was
amalgamated with Bank of Baroda in 2004 due to its weak financial position. They are
not bound to perform banking services according to the policies and instructions of central
bank, e.g., Bank of Punjab was a non-scheduled bank. These banks do not fulfill the
required qualifications of a scheduled bank as prescribed by the central bank. They also
do not enjoy the public confidence. In many countries, many non-scheduled banks are
also working.
Non-scheduled banks are depository or lending institutions that do not meet the
Second Schedule of Reserve Bank of India Act. These banks may be legal entities, but
they do not have procedural endorsement of the government. Non-scheduled banks are
not just identified as banks that do not meet the criteria in the Second Schedule of the
1934 Act; they are defined in Section 5, clause C of the Banking Regulation Act of 1949.
Many of these banks are similar to savings and loans, credit unions or cooperatives.
Though many are organized like a depositor-owned credit union, they are typically forprofit ventures but dont meet government standards and do not have full public confidence.
2.10 Role of Commercial Bank in the Economic Development of India

Commercial banks play an important and active role in the economic development
of a country. If the banking system in a country is effective, efficient and disciplined, it
brings about a rapid growth in the various sectors of the economy.
The following is the significance of commercial banks in the economic development
of a country:
1. Banks promote capital formation
Commercial banks accept deposits from individuals and businesses, these deposits
are then made available to the businesses which make use of them for productive purposes
in the country. The banks are, therefore, not only the store houses of the countrys wealth,
but also provide financial resources necessary for economic development.
2. Investment in new enterprises
Businessmen normally hesitate to invest their money in risky enterprises. The
commercial banks generally provide short- and medium-term loans to entrepreneurs to
invest in new enterprises and adopt new methods of production. The provision of timely
credit increases the productive capacity of the economy.
3. Promotion of trade and industry
With the growth of commercial banking, there is vast expansion in trade and industry.
The use of bank draft, check, bill of exchange, credit cards and letters of credit, etc. has
revolutionized both national and international trade.
55
4. Development of agriculture
Notes
The commercial banks particularly in developing countries are now providing credit
for development of agriculture and small scale industries in rural areas. The provision of
credit to agriculture sector has greatly helped in raising agriculture productivity and income
of the farmers.
5. Balanced development of different regions
The commercial banks play an important role in achieving balanced development in
different regions of the country. They help in transferring surplus capital from developed
regions to the less developed regions. The traders, industrialist, etc. of less developed
regions is able to get adequate capital for meeting their business needs. This in turn
increases investment, trade and production in the economy.
6. Influencing economic activity
The banks can also influence the economic activity of the country through its
influence on (a) availability of credit and (b) the rate of interest. If the commercial banks
are able to increase the amount of money in circulation through credit creation or by
lowering the rate of interest, it directly affects economic development. A low rate of interest
can encourage investment. The credit creation activity can raise aggregate demand which
leads to more production in the economy.
7. Implementation of monetary policy
The central bank of the country controls and regulates volume of credit through the
active cooperation of the banking system in the country. It helps in bringing price stability
and promotes economic growth within the shortest possible period of time.
8. Monetization of the economy
The commercial banks by opening branches in the rural and backward areas are
reducing the exchange of goods through barter. The use of money has greatly increased
the volume of production of goods. The non-monetized sector (barter economy) is now
being converted into monetized sector with the help of commercial banks.
9. Export promotion cells
In order to increase the exports of the country, the commercial banks have
established export promotion cells. They provide information about general trade and
economic conditions both inside and outside the country to its customers. The banks
are therefore, making positive contribution in the process of economic development.
2.11 Functions of Commercial Banks

Commercial bank being the financial institution performs diverse types of functions.
It satisfies the financial needs of the sectors such as agriculture, industry, trade,
communication, etc.
The commercial bank performs the following functions:
1. Primary Functions
Primary functions of the commercial banks include:
(i) Acceptance of Deposits
Commercial bank accepts various types of deposits from public especially from its
clients. These deposits are payable after a certain time period. Banks generally accept
56
Notes
three types of deposits, viz., (a) Current Deposits, (b) Savings Deposits, (c) Fixed Deposits
and (d) Recurring Deposit.
(a) Current Deposits
These deposits are also known as demand deposits. These deposits can be
withdrawn at any time. Generally, no interest is allowed on current deposits, and in case,
the customer is required to leave a minimum balance undrawn with the bank. Cheques
are used to withdraw the amount. These deposits are kept by businessmen and
industrialists who receive and make large payments through banks. The bank levies certain
incidental charges on the customer for the services rendered by it.
The Reserve bank of India prohibits payment of interest on current accounts or on
deposits up to 14 days or less except where prior sanction has been obtained. Banks
usually charge a small amount known as incidental charges on current deposit accounts
depending on the number of transaction.
(b) Savings Deposits
If the customer wishes to withdraw more than the specified amount at any one time,
he has to give prior notice. Interest is allowed on the credit balance of this account. The
rate of interest is greater than the rate of interest on the current deposits and less than
that on fixed deposit. This system greatly encourages the habit of thrift or savings.
Savings deposit account is meant for individuals who wish to deposit small amounts
out of their current income. It helps in safe guarding their future and also earning interest
on the savings. A saving account can be opened with or without cheque book facility.
There are restrictions on the withdrawals from this account. Savings account holders are
also allowed to deposit cheques, drafts, dividend warrants, etc. drawn in their favour for
collection by the bank. To open a savings account, it is necessary for the depositor to
be introduced by a person having a current or savings account with the same bank.
(c) Fixed Deposits
These deposits are also known as time deposits. These deposits cannot be
withdrawn before the expiry of the period for which they are deposited or without giving
a prior notice for withdrawal. If the depositor is in need of money, he has to borrow on
the security of this account and pay a slightly higher rate of interest to the bank. They
are attracted by the payment of interest which is usually higher for longer period. Fixed
deposits are liked by depositors both for their safety and as well as for their interest. In
India, they are accepted between three months and ten years.
Fixed deposits are most useful for a commercial bank. Since they are repayable
only after a fixed period, the bank may invest these funds more profitably by lending at
higher rates of interest and for relatively longer periods. The rate of interest on fixed deposits
depends upon the period of deposits. The longer the period, the higher is the rate of interest
offered. The rate of interest to be allowed on fixed deposits is governed by rules laid down
by the Reserve Bank of India.
(d) Recurring Deposits
Recurring deposits are a special kind of term deposits offered by banks in India which
help people with regular incomes to deposit a fixed amount every month into their recurring
deposit account and earn interest at the rate applicable to fixed deposits. It is similar
to making FDs of a certain amount in monthly installments, for example ` 1,000 every
month. This deposit matures on a specific date in the future along with all the deposits
made every month. Thus, recurring deposit schemes allow customers with an opportunity
to build up their savings through regular monthly deposits of fixed sum over a fixed period
of time.
57
The recurring deposit can be funded by standing instructions which are the
instructions by the customer to the bank to withdraw a certain sum of money from his
savings/current account and credit to the recurring deposit every month.
Notes
(ii) Advancing Loans

Loans are made against personal security, gold and silver, stocks of goods and other
assets. The second primary function of a commercial bank is to make loans and advances
to all types of persons, particularly to businessmen and entrepreneurs.
In a demand loan account, the entire amount is paid to the debtor at one time, either
in cash or by transfer to his savings bank or current account. No subsequent debit is
ordinarily allowed except by way of interest, incidental charges, insurance premiums,
expenses incurred for the protection of the security, etc. Repayment is provided for by
installment without allowing the demand character of the loan to be affected in any way.
There is usually a stipulation that in the event of any installment, remaining unpaid, the
entire amount of the loan will become due. Interest is charged on the debit balance, usually
with monthly rests unless there is an arrangement to the contrary. No cheque book is
issued. The security may be personal or in the form of shares, government paper, fixed
deposit receipt, life insurance policies, goods, etc.
The most common way of lending is by:
(a) Overdraft Facilities
In this case, the depositor in a current account is allowed to draw over and above
his account up to a previously agreed limit. Suppose a businessman has only ` 6,000/- in
his current account in a bank but requires ` 12,000/- to meet his expenses. He may
approach his bank and borrow the additional amount of ` 6,000/-. The bank allows the
customer to overdraw his account through cheques. The bank, however, charges interest
only on the amount overdrawn from the account. This type of loan is very popular with
the Indian businessmen.
As in the case of a demand loan account, the security in an overdraft account may
be either personal or tangible. The tangible security may be in the form of shares,
government paper, life insurance policies, fixed deposit receipts etc., i.e., paper securities.
A cheque book is issued in an overdraft account.
(b) Cash Credit
Cash credits are normally granted against the security of goods, e.g., raw materials,
stock in process, finished goods. It is also granted against the security of book debts.
If there is good turnover both in the account and in the goods and there are no adverse
factors, a cash credit limit is allowed to continue for years together. Of course, a periodical
review would be necessary.
Under this account, the bank gives loans to the borrowers against certain security.
But the entire loan is not given at one particular time, instead the amount is credited into
his account in the bank; but under emergency cash will be given. The borrower is required
to pay interest only on the amount of credit availed to him. He will be allowed to withdraw
small sums of money according to his requirements through cheques, but he cannot
exceed the credit limit allowed to him. Besides, the bank can also give specified loan
to a person, for a firm against some collateral security. The bank can recall such loans
at its option.
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Notes
(c) Discounting Bills of Exchange

Bills, clean or documentary, are sometimes purchased from approved customers in
whose favour regular limits are sanctioned. In the case of documentary bills, the drafts
are accompanied by documents of title to goods such as railway receipts or bills of lading
(BOL). Before granting a limit, the creditworthiness of the drawer is to be ascertained.
Sometimes the financial standing of the drawees of the bills are verified, particularly when
the bills are drawn from time to time on the same drawees and/or the amounts are large.
Although the term Bills Purchased seems to imply that the bank becomes the
purchaser/owner of such bills, it will be observed that in almost all cases, the bank holds
the bills (even if they are indorsed in its favour) only as security for the advance. In addition
to any rights the banker may have against the parties liable on the hills, he can also
fully exercise a pledgees right over the goods covered by the documents.
This is another type of lending which is very popular with the modern banks. The
holder of a bill can get it discounted by the bank, when he is in need of money. After
deducting its commission, the bank pays the present price of the bill to the holder. Such
bills form good investment for a bank. They provide a very liquid asset which can be quickly
turned into cash. The commercial banks can rediscount the discounted bills with the
central banks when they are in need of money. These bills are safe and secured bills.
When the bill matures, the bank can secure its payment from the party which had accepted
the bill.
Usance bills, maturing within 90 days or so after date or sight, are discounted by
banks for approved parties. In case a bill, say for ` 10,000 due 90 days hence, is
discounted today at 20% per annum, the borrower is paid ` 9,500, its present worth.
However the full amount is collected from the drawee on maturity. The difference between
the present worth and the amount of the bill represents earning of the banker for the period
for which the bill is to run. In banking terminology this item of income is called discount.
(d) Money at Call
Bank also grant loans for a very short period, generally not exceeding 7 days to
the borrowers, usually dealers or brokers in stock exchange markets against collateral
securities like stock or equity shares, debentures, etc. offered by them. Such advances
are repayable immediately at short notice hence; they are described as money at call
or call money.
(e) Term Loans
Banks give term loans to traders, industrialists and now to agriculturists also against
some collateral securities. Term loans are so-called because their maturity period varies
between 1 to 10 years. Term loans; as such provide intermediate or working capital funds
to the borrowers. Sometimes, two or more banks may jointly provide large term loans
to the borrower against a common security. Such loans are called participation loans or
consortium finance.
(f) Consumer Credit
Banks also grant credit to households in a limited amount to buy some durable
consumer goods such as television sets, refrigerators, etc. or to meet some personal
needs like payment of hospital bills, etc. Such consumer credit is made in a lump sum
and is repayable in installments in a short time. Under the 20-point programme, the scope
of consumer credit has been extended to cover expenses on marriage, funeral etc. as
well.
59
(g) Miscellaneous Advances
Notes
Among other forms of bank advances there are packing credits given to exporters
for a short duration, export bills purchased/discounted, import finance, advances against
import bills, finance to the self-employed, credit to the public sector, credit to the
cooperative sector and above all, credit to the weaker sections of the community at
concessional rates.
(iii) Creation of Credit
One of the important functions of commercial bank is the creation of credit. Credit
creation is the multiple expansions of banks demand deposits. It is an open secret now
that banks advance a major portion of their deposits to the borrowers and keep smaller
parts of deposits to the customers on demand. Even then the customers of the banks
have full confidence that the depositors lying in the banks is quite safe and can be
withdrawn on demand. The banks exploit this trust of their clients and expand loans by
much more time than the amount of demand deposits possessed by them. This tendency
on the part of the commercial banks to expand their demand deposits as a multiple of
their excess cash reserve is called creation of credit. Banks supply money to traders and
manufacturers. They also create or manufacture money. Bank deposits are regarded as
money. They are as good as cash. The reason is they can be used for the purchase
of goods and services and also in payment of debts. When a bank grants a loan to its
customer, it does not pay cash. It simply credits the account of the borrower. He can
withdraw the amount whenever he wants by a cheque. In this case, bank has created
a deposit without receiving cash. That is, banks are said to have created credit. Sayers
says banks are not merely purveyors of money, but also in an important sense,
manufacturers of money.
The commercial banks create multiple expansions of their bank deposits and due
to this, these are called the factories of credit. The banks advance a major portion of their,
deposits to the borrowers and keep a smaller part with them. The customers have full
confidence on the bank. The banks expand loans by much more than the amount of cash
possessed by them. This tendency on the part of the banks to lend more than the amount
of cash possessed by them is called Creation of Credit in Economics. The process of
Credit Creation begins with banks lending money out of primary deposits. Primary
deposits are those deposits which are deposited in banks. In fact banks cannot lend the
entire primary deposits as they are required to maintain a certain proportion of primary
deposits in the form of reserves with the RBI under RBI and Banking Regulation Act. After
maintaining the required reserves, the bank can lend the remaining portion of primary
deposits. Here, banks lend the money and the process of credit creation starts.
Meaning of Credit Creation
Credit creation is the multiple expansions of banks demand deposits. It is an open
secret now that banks advance a major portion of their deposits to the borrowers and keep
smaller parts of deposits to the customers on demand. Even then the customers of the
banks have full confidence that the depositors lying in the banks is quite safe and can
be withdrawn on demand.
Assumptions of Credit Creation
The concept of credit creation is based on the following assumptions:
1. The banks, while granting loans, do not give the amount in cash, instead it
credits the accounts of the customers with the amount of loan.
60
Notes
2. The customers do not withdraw the entire amount of loan.

3. While drawing the money from his account he uses cheque system.
4. The persons who are receiving the cheques against their claims from others
also deposit the money into their respective banks.
5. The accounts are settled with mere book entries.
Credit Creation by Commercial Banks
The creation of credit or deposits is one of the most vital operations of the commercial
banks. Similar to other corporations, banks aim at earnings profits. For this intention, they
accept cash in demand deposits and advance loans on credit to customers. When a bank
advances funds, it does not pay the amount in currency notes. However, it introduces
a current account in the name of the investor and lets him to withdraw the necessary
amount by cheques. By this way, banks create deposits or credit.
The stability of price level is an essential condition for the economic development.
It highly depends upon the demand and supply of money. The supply of money includes
the legal tender money and bank money.
The legal tender money is issued by the Central Bank or the government of the
country in the form of Bank/Currency notes while the bank money is created by the banks.
The bank money consists of bank deposits. Cheques drawn on bank deposits act
as the legal tender money, i.e., with cheques payment obligation can be settled. Thus,
banks are not merely purveyors of money but also the manufacturers of money.
The creation of credit or deposits may be arrived in the following two ways:
1. Primary deposits
2. Derivative deposits
1. Primary Deposits: It is also known as cash deposit or passive deposit. When
customers take actual cash and deposit it with bank, it is known as the primary deposit.
2. Derivative Deposits: It is also called active deposits or creative deposits.
Deposits also arise when customers are granted accommodation in the form of loans.
These deposits add to the supply of money.
When a bank grants a loan to a customer, it does not usually pay the amount in
cash, instead it credits an account with the amount of loan. That is, the bank places a
deposit at the borrowers disposal and he can freely withdraw the amount as he likes.
He can draw cheques against the deposits created in his favour for settling his
transactions. Thus, cheques against bank deposits become purchasing power in the hands
of the public in addition to the legal tender money. But more often, the loan is utilized
over a long time gradually and till such time it forms as deposit.
Hence, the loan which a banker grants to a customer usually large corporate creates
additional deposits, i.e., by advancing loans, banks create deposits and thus, create
money. So, Money is said to be created when the banks, through their lending activities,
make a net addition to the total supply of money in the economy.
The customer may retain the loan amount with the bank as deposits or can issue
cheques against this deposit to settle his dues. The receiver of the cheque may deposit
it in the same bank in which case his deposits increase while the givers deposit decreases.
In case the borrower has account in some other bank, the deposit of that bank increases.
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Techniques of Credit Creation
Notes
1. Credit creation by over drafting

2. Credit creation by purchase of securities
1. Credit Creation by Overdrafting
By overdrafting, bank creates credit. Secondly, bank purchases the securities and
pays them with its own cheques. The holders of these cheques deposit them in the same
banks. This creates deposit which is nothing other than creation of credit.
According to Benhen, A bank may receive interest simply by permitting a customer
to overdraw their account or by purchasing securities and having for them with its own
cheques. Thus, increasing the total bank drafts. One should remember that single bank
creates a very little credit. It is a whole banking system which can expand the credit.
2. Credit Creation by Purchase of Securities
When loans are advanced, it is not given in cash. The bank opens a deposit account
in the name of the borrower and allows him draw to draw whenever required. The loan
advanced by cheques results in the creation of new demand deposits. Sometimes, a
question arises that it borrowers with draw these deposits for the repayment to other
persons, then how the banks will create credit. The answer is that other persons who
receive money may also be the clients of the bank. Naturally, they will also deposit their
cash in the bank. The process remains continue. We can explain it by the following
example:
Example: Suppose a person deposits 1,000 in a bank. According to experience, bank
can keep 20% cash reserve to meet the demands of the depositors, and can lend the
rest safely to the borrowers. If the entire bank maintains a reserve ratio of 20%, then banks
can succeed in creating a credit a credit of ` 5000 against an original deposit of ` 1,000
in cash.
Limitation of Credit Creation
Banks do not have unlimited credit creation powers. There are many restrictions
which can be discussed as under:
1. Restriction by the Central Bank
If the banks have large deposits, they can create more credit and if they have small
deposits then their power of credit creation will be limited. While we know the commercial
bank has the monopoly of note issue, if the central bank increases the quantity of money
the deposits of commercial banks will increase and they will expand the volume of credit
in the enquiry. On the other hand, if supply of money decreases, the volume of credit
also of decreases. Any how the credit creation power of the commercial bank is directly
affected by the policy of the central bank.
2. Habits of the Customers
The power to create credit by the commercial banks is very much influenced by the
habits of the people living in that country. If the people are habitual in using the cheques,
then the volume of credit will expand on the other it will be contracted.
3. Cash Ratio
Every bank keeps adequate cash reserves for meeting the cash requirements of its
customers. The bank will not allow its cash ratio to fall below a certain minimum level.
When this level is reached, then bank will not advance money.
62
Notes
4. Collateral Security Available

The bank advances loan to the borrowers against some kind of Collateral Security.
If these are not available, then the power of credit creation will be restricted.
(iv) Clearing of Cheques
The commercial banks render an important service by providing to their customers
a cheap medium of exchange like cheques. It is found much more convenient to settle
debts through cheques rather than through the use of cash. The cheque is the most
developed type of credit instrument in the money market.
(v) Financing Internal and Foreign Trade
The bank finances internal and foreign trade through discounting of exchange bills.
Sometimes, the bank gives short-term loans to traders on the security of commercial
papers. This discounting business greatly facilitates the movement of internal and external
trade.
(vi) Remittance of Funds
Commercial banks, on account of their network of branches throughout the country,
also provide facilities to remit funds from one place to another for their customers by issuing
bank drafts, mail transfers or telegraphic transfers on nominal commission charges. As
compared to the postal money orders or other instruments, bank drafts have proved to
be a much cheaper mode of transferring money and have helped the business community
considerably.
2. Secondary Functions
Secondary functions of the commercial banks include:
(i) Agency Services
Commercial banks act as attorney for their clients. They buy and sell shares and
bonds, receive and pay utility bills, premiums, dividends, rents and interest for their clients.
Banks also perform certain agency functions for and on behalf of their customers. The
agency services are of immense value to the people at large. The various agency services
rendered by banks are as follows:
(a) Collection and Payment of Credit Instruments: Banks collect and pay
various credit instruments like cheques, bills of exchange, promissory notes
etc. on behalf of their customers.
(b) Purchase and Sale of Securities: Banks purchase and sell various securities
like shares, stocks, bonds, debentures on behalf of their customers.
(c) Collection of Dividends on Shares: Banks collect dividends and interest on
shares and debentures of their customers and credit them to their accounts.
(d) Act as Correspondent: Sometimes banks act as representative and
correspondents of their customers. They get passports, travelers tickets and
even secure air and sea passages for their customers.
(e) Income-tax Consultancy: Banks may also employ income tax experts to
prepare income tax returns for their customers and to help them to get refund
of income tax.
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(f) Execution of Standing Orders: Banks execute the standing instructions of

their customers for making various periodic payments. They pay subscriptions,
rents, insurance premia etc. on behalf of their customers.
Notes
(g) Act as Trustee and Executor: Banks preserve the Wills of their customers
and execute them after their death.
(ii) General Utility Services
General utility services are those services which are rendered by commercial banks
not only to the customers but also to the general public.
In addition to agency services, the modern banks provide many general utility services
for the community as given below:
(a) Safe Deposit Vaults
A bank undertakes the safe custody of the customers valuables and documents
by providing a safe deposit vault. These are kept in specially constructed strong rooms.
There are lockers available to the customer on a nominal charge. There are two keys for
each locker, one is given to the customer and the other remains with the Bank Manager.
The locker is opened as well as closed by both the keys one after another. Customers
can keep custody. A register is maintained by the bank in which all the particulars about
the valuables and documents are recorded in it. Banks provide the services of safe deposit
vault on hire basis to the customers.
(b) Collection of Cheques, Bills and Promissory Notes
The customers deposit cheques, bills of exchange and promissory note into their
accounts with the banks. These instruments are collected by the bank on behalf of their
customers and credited to their accounts. These services are provided by the cheques,
bills and promissory notes issued on branches out of the city are collected with some
nominal charges for postage, etc. This is a very popular and essential service provided
by the banks to their customers.
(c) Issuing Letter of Credit
A letter of credit is a commercial instrument of assured payment. It is widely used
by the businessman for various purposes. The bank undertakes to make payment to a
seller on production of documents stipulated in the letter of credit. It specifies as to when
payment is to be made which may be either on presentation of documents by the paying
bank or at some future date depending upon the terms stipulated in the letter. There are
many parties involved in the letter of credit. One is the applicant who is the buyer of goods
or importer of goods. He makes an application to a bank who issues the letter of credit.
The bank is known as issuing bank. The beneficiary is named in the letter of credit who
is the seller of goods or exporter. Other banks are also involved in the transaction such
as negotiating bank, confirming bank and advising bank. There are different types of letter
of credit. This is a very important service provided by the banks especially for the importers
and exporters.
(d) Bank Drafts
A bank draft is an order from one branch to another branch of the same bank to
pay a specified sum of money to a person named therein or to his order. A draft is always
payable on demand. Banks issue drafts at the request of the customers on their branches
at the place of destination for remitting money from one place to another place. Any person
who wants to remit money has to purchase a draft from the bank by paying the amount
in advance to the bank. The purchaser of the draft then sends the draft to the payees
place of residence by post or courier for the purpose of encashment at the drawee branch
64
Notes
of the bank. The bank issuing the draft charges some commission depends upon the
amount of the draft. The purchaser need not be a customer of the bank.
The bank draft is like a bill of exchange payable on demand. In case the draft is
lost by a purchaser, he has to report to the issuing banker for loss of the draft without
any endorsement, the banker may safely refuse to pay the amount of the draft. The bank
should take all the precautions and payment of the draft should be made only when the
banker is fully satisfied about the valid title of the holder. The banker should take an
indemnity bond and then issue a duplicate draft to the purchaser. The draft may be
cancelled by the bank if it is not delivered to the payee. When a bank draft is delivered
to the payee, he acquires a right in the instrument, which cannot be set aside by the
stop-payment order issued by the purchaser. The bank issuing the draft sends an advice
to the drawee branch, intimating about the issue of the draft. The drawee branch after
verifying the signature of the authorized officials makes the payment. However, the
payment of the draft should not be refused because of non-receipt of drawing advice.
(e) Automated Teller Machine (ATM)
ATM is a channel of banking service to its customers. Its traditional and primary
use is to dispense cash upon insertion of a plastic card and its unique PIN, i.e., Personal
Identification Number. The banks issue ATM card to their customers having current or
savings account holding a certain minimum balance in their accounts. ATM card is a
plastic card with a magnetic strip with the account number of the individuals. When the
card is inserted into the machine, the sensing equipment of the machine identifies the
account holder and asks his PIN. It is a secret number which is known only to the account
holder.
Advantages of ATM
Following are the advantages of ATM:
1. ATM provides 24 hour service; the customer can withdraw cash up to a certain
limit during 24 hours. It is now called all time money facility.
2. It provides a great deal of convenience to customers. Most of the ATMs are
located at the convenient place and as such this facility is a boon to customers.
ATM machines are installed at suitable locations such as airport, railway station,
residential colony, near big malls, etc.
3. ATM facility also reduces pressure on bank staff. The bank staff is free from
the botheration of keeping large ready cash for withdrawal by people.
4. Here, the work of deposition and withdrawal is handled by the machine. The
machines are perfect and provide accurate service. The human errors are absent
when operations are performed by machines.
5. Operations through machines provide a kind of privacy and secrecy to banking
business.
Disadvantages of ATM
The various disadvantages of ATM are as follows:
(i) Security: Unlike bank tellers, ATMs do not require the person performing the
transaction to present picture identification. Rather, the person must only insert
a bank card and enter a personal identification number. If the bank card is stolen
and the number ascertained, an unauthorized person can easily access the
account.
(ii) Inability to perform complex transactions: ATMs can only perform relatively
basic transactions. This means that people who need to complete these longer
65
transactions will be forced to use the teller, restricting use of the ATM for people
who need to complete simple business. In this sense, the ATM is rather like
the express line in a supermarket faster for some, but unavailable to others.
Notes
(iii) Fees: With the advent of ATMs came ATM fees. Not only do banks of which
you are not a member charge fees for the use of their ATMs, but users are
often charged surreptitious fees by their own banks for using other banks ATMs
meaning the customer is docked twice for the same transaction.
(iv) Privacy: Unlike banks, in which security guards and tellers are present to
ensure the person performing a transaction receives privacy, there is no such
guarantee when using an ATM. People may try to spy on users as delicate
information appears on the screen, without the user being aware.
(v) Difficulty of use through illiterate people: The performance of business at
an ATM is generally quicker than that at a human teller. However, the ATM
is incapable of providing personalized instruction to the user in a way that a
human teller can. This can result in longer wait times if the user currently using
the machine is struggling to complete a transaction.
f) Debit Card
A debit card is a plastic card that provides an alternative payment method to cash
when making purchases. Functionally, it can be called an electronic check, as the funds
are withdrawn directly from either the bank account or from the remaining balance on the
card. In some cases, the cards are designed exclusively for use on the Internet, and so
there is no physical card.
In many countries, the use of debit cards has become so widespread that their volume
of use has overtaken or entirely replaced the check and, in some instances, cash
transactions. Like credit cards, debit cards are used widely for telephone and Internet
purchases and, unlike credit cards, the funds are transferred immediately from the bearers
bank account instead of having the bearer pay back the money at a later date.
Debit cards may also allow for instant withdrawal of cash, acting as the ATM card
for withdrawing cash and as a check guarantee card. Merchants may also offer cash back
facilities to customers, where a customer can withdraw cash along with their purchase.
(g) Credit Card
A credit card is an instrument of payment. It is a source of revolving credit. The cards
are plastic cards issued by the banks to their customers. The name of the customer,
card number and expiry date are printed on the plastic cards. Some banks also use the
photograph of the customers on the credit card. The card holder can buy goods or services
from various merchant establishments where such arrangements exist. The card issuing
bank makes the payment to the supplier or seller. The outstanding amount on account
of use of the credit card is payable by the card holder to the bank over a specific period
which carries a fixed amount of interest. A debit card is a payment card used to obtain
cash, goods and services automatically debiting the payments to the card holders bank
account instantly, in which credit balance exists.
A credit card is more than a simple piece of plastic, it is first and foremost a flexible
payment tool accepted at 30 million locations worldwide, and if the card balance is paid
off every month, then no interest is charged on purchases made so, essentially, shortterm credit is granted without the consumer paying any interest.
Some of the features of Credit Card are:
1. Access to unsecured credit (no collateral required against amounts charged).
2. Interest-free payment from time of purchase to the end of the billing period.
66
Notes
3. Instant payment of purchases, allowing for instant receipt of goods and services.
4. 24/7 access.
5. Fraud protection.
Advantages and Disadvantages of Credit Card
Advantages of Credit Card:
1. Offer free use of funds, provided you always pay your balance in full, on time.
2. Be more convenient to carry than cash.
3. It helps to establish a good credit history.
4. To provide a convenient payment method for purchases made on the Internet
and over the telephone.
5. Give you incentives, such as reward points, that you can redeem.
Disadvantages of Credit Card:
1. Cost much more than other forms of credit, such as a line of credit or a personal
loan, if you dont pay on time.
2. Damage your credit rating if your payments are late.
3. Allow you to build up more debt than you can handle.
4. Have complicated terms and conditions.
(h) Tele Banking
Telephone banking is a service provided by a Commercial Banks, which allows its
customers to perform transactions over the telephone.
Most telephone banking services use an automated phone answering system with
phone keypad response or voice recognition capability. To guarantee security, the
customer must first authenticate through a numeric or verbal password or through security
questions asked by a live representative. With the obvious exception of cash withdrawals
and deposits, it offers virtually all the features of an automated teller machine: account
balance information and list of latest transactions, electronic bill payments, funds transfers
between a customers accounts, etc.
Usually, customers can also speak to a live representative located in a call centre
or a branch, although this feature is not always guaranteed to be offered 24/7. In addition
to the self-service transactions listed earlier, telephone banking representatives are usually
trained to do what was traditionally available only at the branch: loan applications,
investment purchases and redemptions, cheque book orders, debit card replacements,
change of address, etc.
(i) Internet Banking
Internet is a channel of service to banking customers. The access to account
information as well as transaction is offered through the world wide web network of
computers on the internet. Each account holder is provided with a PIN similar to that of
ATM or phone banking. The access to the account is allowed to the customer upon a
match of the account details and PIN entered on the computer system. A higher level
of security may be reached by an electronic fingerprint. Transaction such as e-business,
Railway-Air Reservation, payment of bills, transfer of money, etc. can be carried out while
sitting in the house with the help of an internet.
The following is a list of the advantages of internet banking:
1. Easy to Set-up: It is easy and fast to set up an internet bank account. All that
users have to do to create an online bank account is complete a short form and then
67
set the security features such as a password and username. Finally, they just print and
sign a form and send it in to the bank.
Notes
2. Fewer Costs: There are fewer costs associated with internet banking because
online banks do not have the overhead like traditional banks. Because there are fewer
costs, internet banks pass the savings on to consumers such as reduced service charges
and increased interest rates for savings accounts. They can even offer reduced lending
rates for their loans.
3. Easy and Convenient Online Bank Comparison: It is easy to research many
internet banks online allowing to compare such features as interest rates, available credit
cards and their interest rates, FDIC Bank rating, and terms and interest rates of their
loans.
4. Easy Bank Account Monitoring: Internet banking and money 24 hours a day,
7 days a week. It can track such things as deposits, clearing of checks, account balance.
It allows to keep the account from going into the negative.
5. Maintain Accurate Financial Records: It can keep track of the financial records
by using software programs such as Microsoft Money or Quicken. This will allow to budget
more efficiently and track the spending.
6. Convenient Banking: Traditional banking has always been slow. With online
banking, It will no longer have to stand in long lines to obtain financial information about
your account. As well, there is less paperwork and applying for loans is faster, easier,
and more convenient.
Disadvantages of Internet Banking
1. Security: While banks typically offer secure web pages to conduct customers
business transactions, this doesnt guarantee complete safety. All websites, even secure
ones, may be susceptible to Internet criminals who try to hack into customers account
and gain access to businesss private financial information. This can lead to fraudulent
use of businesss identity and potentially cost the customers thousands of rupees.
2. Site Disruption: A technical malfunction could cause the banks website to go
offline for a period of time, possibly resulting in problems for customers business. For
example, you may need immediate funds after normal banking hours to make a payment
or emergency business purchase. Routine site maintenance also occurs, although this
normally takes place during off-peak hours.
3. Site Navigation: If the customers are new to online banking, it may take some
time to get used to it, taking valuable time out of work day. Online banking offers a large
number of transactions, so frustration may occur while customers are learning to navigate
the site. Banks also update web pages to add new features, requiring additional learning
and possibly the need to change account numbers or passwords.
4. User Apprehension: Some business owners may not feel comfortable with the
idea of placing vital financial information into an online account, or may be apprehensive
about using the Internet. If you are a longtime small business owner who is used to doing
banking in person or even by telephone, this hurdle might be difficult to surmount.
5. Accessibility: If customers business is located in a rural or remote area, the
Internet options could be limited. Depending on the business, this can make conducting
transactions difficult.
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Notes
2.12 Classification of Commercial Banks

(A) On the Basis of Commercial Bank Operation
1. Pure or Deposit Bank
The system banking, which involves accepting deposits and lending for short period,
is known as pure or deposit banking. It is that system under which the Commercial Banks
confine themselves to the financing of the short-term requirements of industry and
commerce. It is risky for Commercial Banks to grant long-term loans to industries for two
reasons. Firstly, the banks may face the problem of liquidity as the deposits are received
for short periods. Secondly, if the borrower fail, in his activities, the bank, may also fail.
Thus the fundamental principle of functioning of Commercial Bank is that they confine only
in short-term lending. The system of pure banking was very popular in UK and India until
recently. There are two reasons why British banks did not extend long-term loans to
industries. Firstly, the deposits received by the Commercial Banks in Britain are for short
period only. Hence, banks in UK confined their lending for short-term duration. Secondly,
there is the historical reason why the British bank followed the system of pure banking.
The industrial development of Britain was preceded by the expansion of trade and industry.
As a result of this commercial expansion, there had come into existence a number of
institutions, such as Finance Corporation, issue houses, investment trusts, etc. which
had specialized in giving long-term loans to industries. Hence, it was no longer necessary,
for the Commercial Banks to extend long-term loans to industries.
Deposit banks have connection with the commercial class of people. These banks
accept deposits from the public and lend them to needy parties. Since their deposits are
for short period only, these banks extend loans only for a short period. Ordinarily these
banks lend money for a period between 3 to 6 months. They do not like to lend money
for long periods or to invest their funds in any way in long-term securities. However, after
1st World War, the banking system is showing a trend towards mixed banking owing to
the following reasons:
(a) During the great depressions of 1930, the short-term loans granted to industries
could not be recovered by banks. So, these loans were converted into shares and
debentures implying the characteristic feature of mixed banking.
(b) Small industries were closed down during great depression of 1930 and banks
went without the small customers. They were forced to lend to large-scale industries whose
requirements were long-term finance.
(c) The development of Stock Exchanges gave further encouragement for Commercial
Banks in UK to provide loans against Stock Exchange securities.
Pure banking enjoys two merits over investment banking, viz., it ensures safety and
liquidity of funds. Its serious drawback is it does not encourage industrial development.
2. Investment Bank or Industrial Bank
Industrial Bank is a financial institution with a limited scope of services. Industrial
banks sell certificates that are labeled as investment shares and also accept customer
deposits. They then invest the proceeds in installment loans for consumers and small
businesses. These banks are also known as Morris Banks or industrial loan companies.
Industrial banks differ from commercial lenders because they accept deposits. They
also differ from commercial banks because they do not offer checking accounts.
69
Furthermore, the loans offered by industrial banks are often secured by a third party who
acts as guarantor for the loan.
Notes
Industries require a huge capital for a long period to buy machinery and equipment.
Industrial banks help such industrialists. They provide long-term loans to industries.
Besides, they buy shares and debentures of companies, and enable them to have fixed
capital. Sometimes, they even underwrite the debentures and shares of big industrial
concerns. The industrial banks play a vital role in accelerating industrial development. In
India, after attainment of independence, several industrial banks were started with large
paid up capital. They are, The Industrial Finance Corporation (IFC), The State Financial
Corporations (SFC), Industrial Credit and Investment Corporation of India (ICICI) and
Industrial Developmental Bank of India (IDBI), etc.
Investment banking, otherwise known as industrial banks, provides long-term finance
to industries. Germany is considered to be the hometown of investment banking. These
banks help the companies, corporations and the Government in issuing and marketing
their securities. These banks serve as intermediaries in the marketing of securities. They
help in promoting industries. Investment banks act in three different capacities, viz.,
(a) As originators, (b) As underwriters and (c) Retailers. As originators, they help in the
promotion of new ventures, as underwriters, they underwrite the new issues and as
retailers, they sell securities to the investors.
B. On the Basis of the System of Commercial Bank
1. Branch Bank
This is a system of banking where the business is carried on by a single office with
a network of branches spread throughout the country. The Head Office is generally located
in a big city and the branches operate in different parts of the country. England offers
the best example of Branch banking, wherein the entire Commercial Banking business
is carried out by four major banks, popularly known as the Big four. The other countries
following this system are Scotland, Australia, and India.
A comparison between unit banking and branch banking is essentially a comparison
between large-scale and small-scale operations. Obviously, a bank having branches has
some advantages over the unit bank. However the latter too are efficient in their own way.
The advantages of one system of banking incidentally happen to be the disadvantages
of the other.
Merits of Branch Banking
Following are the chief merits of branch banking system:
(i) Large-scale Operations
Branch banking enjoys all the advantages of large-scale operations and reaps the
benefit of division of labor. In comparison of this, the scope for the application of
specialization in unit banking is comparatively limited.
(ii) Economy in Reserves
Branch Banking offers the advantage of keeping lower cash reserves in each branch.
The reserves can be moved from one branch to another in times of necessity. Economy
of reserves is of vital consideration to the banker. Unit banks do not possess this advantage
and they have to totally depend upon their own reserves.
70
Notes
(iii) Remittance Facilities

In the case of branch banks, the cost of making remittance of money is comparatively
low because of the large network of branches, spread all over the country. On the other
hand, the unit banks have to incur high costs. Correspondent banks can to a small extent
cut costs.
(iv) Spreading of Risk
Risks can be spread out geographically by the branch banking system more
effectively than by unit banks. The bank operating through several branches distributes
its assets in different places. On the other hand, the fortunes of unit banks are linked
closely with the prosperity of the business in the place of its operation, i.e., if that place
is adversely affected the assets of the bank will depreciate and lend the bank in financial
trouble. But a branch bank can sell or transfer its assets to its other branches situated
in places where things are better.
(v) Mobility of Capital and Reducing Disparities in Interest Rates
Branch banking facilitates the mobility of capital and brings about uniformity in the
rates of interest over a wide area. Branch banks always transfer funds from areas where
they are surplus to areas where they are scarce, so as to mitigate the disparities in interest
rates. Unit banks cannot do so for obvious reasons.
(vi) High Banking Standards
Branch banks as compared to unit banks can provide better facilities to their
customers because of their comparatively limited member of customers per office and
because of the efficiency derived through large-scale operations. Branch banks can also
offer diversified services. The unit banks find it difficult to do so.
(vii) Efficiency in Management
Branch banks offer greater scope for efficient management. Best men may be recruited
for top management. Branch Managers can be properly selected and given good training
too. On the other hand, the resources of unit banks usually do not permit such facilities.
(viii) Effective Central Banking Control
It is easy for the Central Bank of the country to have control over the branch banks.
This is because the Central Bank will have to deal with only a few banks having their
headquarters in major cities. But with unit banks control becomes difficult because the
number is large and widespread.
(ix) Greater Public Confidence
A bank with large financial resources and a number of branches spread all over the
country, can command greater public confidence than a small unit bank with limited
resources and one or a few offices located in a particular area of the country.
(x) Better Training to Staff
Since the banking work becomes more extensive under branch banking, the
employees and the offices of the bank get better opportunities to acquire knowledge and
experience about the various aspects of banking business in the country.
(xi) Contacts with the Whole Country
Under this system of banking, the bank maintains contacts with all parts of the
country. This helps it to acquire reliable knowledge about economic conditions in various
parts of the country. This knowledge enables the bank to make a proper and profitable
investment of its surplus funds.
71
Demerits of Branch Banking
Notes
Following are the chief demerits of branch banking system:

(i) Difficult to Manage
Since there are many of branches of a bank under this system, this leads many
difficulties in the management, supervision and control of banking activities. The
management of the bank automatically gets concentrated at the Head Office. Very often,
a branch has to secure directives from the head this result in avoidable delay in banking
business, particularly in matters of investment.
(ii) Event of Failure
In the event of the failure of the bank, the branch banking system is worst hit as
the entire structure is wiped out.
(iii) Lack of Initiative
The branches of the bank under this system suffer from a complete lack of initiative
on important banking problems confronting them. No branch of can take decision on
important problems without first consulting office. This makes the banking system rigid
and inelastic in its functioning.
(iv) Monopoly
As the head office controls the activities of all the branches, there is always the
possibility of the emergence of monopoly in banking.
(v) Continuation of Inefficient Branches
The strong and well to do branch will compensate the weak and unprofitable branches.
Thus, some banks may seek shelter in spite of incurring continuous losses.
(vi) Unnecessary Competition
Branch expansion may give rise to unnecessary competition among the banks and
indiscriminate opening of branches may end up in overbanking.
(vii) Duplication of Banking Facilities
There is unnecessary duplication of banking facilities when the branches of different
banks are opened at the same place.
(viii) Expensiveness
This system of banking is expensive when compared to unit banking, with more
branches; there arises the problem of coordinating their activities. This requires recruitment
of additional staff, which is expensive.
(ix) Transfer of Funds from One Branch to Another
The funds collected in rural areas are transferred to urban areas for the purpose of
earning profit. This hinders the economic development of rural and neglected area.
2. Unit Bank
A unit bank is one, which conducts its banking operations through a single office
within a strictly limited area or with a limited number of offices in that area. It is essentially
a localized system. Usually the area of operations and the size of the bank is small. Unit
banking flourished in the USA at one time. Unit banks are often linked together by a system
of correspondent banks. This is to ease remittance facilities.
72
Notes
Merits of Unit Bank

Following are the main advantages of unit banking:
(i) Convenience of Management
Since the size of the bank under unit banking is small, its management supervision,
and control are easier and more convenient for the authorities Along with this, the wastages
here can also be controlled more effectively than under branch banking.
(ii) Discontinuance of Inefficient Branches
Under the branch banking system, strong and profitable branches feed weak and
non-profitable branches. This is not possible under unit banking. If a bank is weak,
inefficient and non-profitable, it will automatically cease to exist after some time.
(iii) Check on the Formation of Monopolistic Banks
Under unit banking, the banks are generally of small size. There is complete absence
of big sized banks under unit banking. Hence, there is no possibility of the growth of
monopolistic banks under this system.
(iv) No Delay in Banking Business
One great advantage of unit banking is that there is no delay of any kind in taking
decisions on important problems concerning the unit bank. The reason is that the bank
in question has not to wait for directives from the head office. The local officers of the
unit bank are competent to take decisions themselves on various problems confronting
the bank.
(v) Initiative in Business
Since the bank officers under the units banking system are fully acquainted with
the local problems, they can take initiative in taking important decisions on the various
issues confronting the bank. This makes the banking system more elastic than what it
is under the branch banking system.
(vi) No Neglect of Local Requirement
The bank officers of a unit bank are fully acquainted with the local heads; they cannot
neglect the requirements of local development. On the contrary, the requirements of local
development are generally neglected under the system of branch banking.
Demerits of Unit Bank
Following are the disadvantages of unit banking system:
(i) Absence of Division of Labor
Since the size of the unit bank is small and its financial resources limited, it cannot
make use of division of labor on any worthwhile scale consequently, it is deprived of the
advantages of division of labor.
(ii) No Geographical Distribution of Risks
Under the unit banking, geographical distribution of the business risks is not possible
because the bank is located at one place.
(iii) Expensiveness and Inconvenience in Remittance of Funds
Since the unit bank has no branches at other places in the country, it has to depend
upon the correspondent banks for effecting transfers of funds from one place to another.
This makes the movement of funds more expensive and inconvenient for the businessmen.
73
(iv) Inequality of Interest Rates
Notes
Since there is no arrangement for the cheap remittance of funds under unit banking
system, there often arises inequality in the rates of interest in different parts of the county.
For example, the interest rates are generally lower in big commercial and industrial centers
they are rather high in the backward and under developed areas of the country.
(v) Less Development of Banking in Smaller Towns and Cities
Unit banks are not in a position to open uneconomic branches in small localities
because their financial resources are already limited and they cannot afford to open
branches in small localities.
System Suitable in India
There was predominance of unit banking in India prior to independence because of
the following reasons:
(a) There were many provinces having different laws.
(b) Economic interests favored small banks serving a limited area.
(c) There was lack of initiative by the banks to open branches outside their local
areas of operation.
(d) Due to large number of illiterate people, personal contact and informal
procedures played an important role in dealing with the customers, which was
possible only in case of small regional banks.
Now, the situation has changed totally and the unit banks cannot meet the
requirements of our developing economy.
Branch banking is preferred in India because of the following reasons:
1. There is a probability of failure of small banks, which causes a serious setback
to the peoples faith in banking. This is evident from the fact they many banks
failed or merged with bigger banks during the early years of independence.
2. India has launched upon an ambitious and extensive programmes of economic
development, which requires adequate capital, which can be provided only by
large banks having branches.
3. Small banks are not suited to mobilize the savings of rural areas, as they cannot
function economically. In such areas, only the big banks can afford to open
their branches in rural areas and can provide financial and other help to the poor
people to get employment under the self-employment schemes.
4. In order to make the control measures of Central Government and Reserve Bank
effective, branch banking is suitable in India.
3. Group Bank
Group banking is that system of banking under which two or more banks are directly
or indirectly controlled by an association, trust, or corporation. This type of banking is
also known as holding company banking. The holding company holds the majority shares
in the companies under its control and the companies whose shares are held by the holding
company are known as subsidiary companies. In our country, the State Bank of India
is an example of the holding company and its seven subsidiaries, viz., (a) State Bank
of Bikaner and Jaipur, (b) State Bank of Indore, (c) State Bank of Hyderbad, (d) State
Bank of Patiala, (e) State Bank of Mysore, (f) State Bank of Saurashtra and (g) State
Bank of Trivandrum are the subsidiary banks.
74
Notes
Merits of Group Bank

1. Under this system, every member-bank retains its own separate identity and
maintains its own Board of Directors. The central administrative office, controlling
the various members of the group can take steps to improve the level of efficiency
in their day-to-day working.
2. This system ensures liquidity of financial resources. If a member-Bank falls short
of cash, it can be easily transferred to it from the other member-banks.
3. This system also results in an economy in advertising expenditure. The
corporation controlling the member banks can insert joint advertisement in the
newspapers.
4. Since the corporation controlling the member-bank is a big sized corporation,
it can easily obtain the services of experts in the management of the business
of the member-banks. This helps the member banks to place their investments
and banking business on a sound footing.
5. The group management can also take steps to secure new business for its
constituent units.
Drawbacks of Group Bank
1. If one member-bank of the group fails due to the adoption of unsound policies,
it has its adverse repercussion on the other member banks.
2. This system may not be conducive to the achievement of a high level of efficiency
in management, because the central administrative office is generally not in a
position to enforce codes of discipline on member
3. This system also gives rise to corruption because all the stores the memberbanks are purchased by one common purchasing organ, which may succumb
to pressures exerted by unscrupulous firms.
4. Chain Bank
This refers to a system where two or more banks are controlled by a single person
or group of persons through stock ownership or otherwise. This constitutes in a way a
less formal arrangement than group banking and is considerably less important. This
system, which developed in America towards the middle of the 19th century, reached the
zenith of its popularity around 1900. Since then, it has declined due to the widespread
failures of many chains. The chain banking system suffers from some drawbacks, as does
the group banking.
5. Correspondence Bank
Under this system, separately incorporated banks open their accounts by depositing
some money with one another. A bank having the deposits of another bank is known as
a correspondent bank. The relationship of having accounts and acting as one anothers
agent among various banks is known as correspondent banking. The correspondent banks
provide many services to one another. They facilitate the remittance of funds from place
to another and collection of customers cheques and bills of exchange. Correspondent
banking allows the unit banks to avail most of the financial branch banking. It also helps
in having connection with the banks in countries. Correspondent banking relations help
in transferring documents and collecting payments in international trade.
75
6. Savings Bank
Notes
A savings bank is a financial institution whose primary purpose is accepting savings

deposits. It may also perform some other functions. In Europe, savings banks originated
in the 19th or sometimes even the 18th century. Their original objective was to provide
easily accessible savings products to all strata of the population. In some countries,
savings banks were created on public initiative, while in others, socially committed
individuals created foundations to put in place the necessary infrastructure. These banks
were specially established to encourage thrift among small savers and therefore, they were
willing to accept small sums as deposits. They encourage savings of the poor and middle
class people. In India, we do not have such special institutions, but post offices perform
such functions. After nationalization, most of the nationalized banks accept the saving
deposits.
7. Agricultural Bank
National Bank for Agriculture and Rural Development (NABARD) is an apex
developmental bank in India having headquarters based in Mumbai (Maharashtra) and other
branches are all over the country. The Committee to Review Arrangements for Institutional
Credit for Agriculture and Rural Development (CRAFICARD), set up by the Reserve Bank
of India (RBI) under the Chairmanship of Shri B. Sivaraman, conceived and recommended
the establishment of the National Bank for Agriculture and Rural Development (NABARD).
It was established on 12 July 1982 by a special act by the parliament and its main focus
was to uplift rural India by increasing the credit flow for elevation of agriculture and rural
non farm sector and completed its 25 years on 12 July 2007. It has been accredited with
matters concerning policy, planning and operations in the field of credit for agriculture
and other economic activities in rural areas in India. RBI sold its stake in NABARD to
the Government of India, which now holds 99% stake.
Agriculture has its own problems and hence there are separate banks to finance
it. These banks are organized on cooperative lines and therefore do not work on the
principle of maximum profit for the shareholders. These banks meet the credit requirements
of the farmers through term loans, viz., short-, medium- and long-term loans. There are
two types of agricultural banks,
(a) Agricultural Cooperative Banks, and
(b) Land Mortgage Banks. Cooperative Banks are mainly for short periods. For long
periods, there are Land Mortgage Banks. Both these types of banks are
performing useful functions in India.
8. Exchange Bank
Exchange banks are those banks maintain the facilities to finance mostly for the
foreign trade of a country. Their main function is to discount, accept and collect foreign
bills of exchange. They buy and sell foreign currency and thus help businessmen in their
transactions. They also carry on the ordinary banking business.
In India, there are some commercial banks which are branches of foreign banks.
These banks facilitate for the conversion of Indian currency into foreign currency to make
payments to foreign exporters. They purchase bills from exporters and sell their proceeds
to importers. They purchase and sell forward exchange too and thus minimize the
difference in exchange rates between different periods, and also protect merchants from
losses arising out of exchange fluctuations by bearing the risk. The industrial and
commercial development of a country depends these days, largely upon the efficiency
of these institutions.
76
Notes
2.13 Central Bank or RBI

The financial system in India is regulated by independent regulators in the field of
banking, insurance, capital market, commodities market, and pension funds. However,
Government of India plays a significant role in controlling the financial system in India
and influences the roles of such regulators at least to some extent.
The following are the five major financial regulatory bodies in India:
(A) Statutory Bodies via Parliamentary Enactments
1. Reserve Bank of India (RBI)
Reserve Bank of India is the apex monetary Institution of India. It is also called as
the Central Bank of the country. The Reserve Bank of India was established on April 1,
1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The central
office of the Reserve Bank was initially established in Calcutta but was permanently moved
to Mumbai in 1937. The central office is where the Governor sits and where policies are
formulated. Though originally privately owned, since nationalization in 1949, the Reserve
Bank is fully owned by the Government of India. It acts as the apex monetary authority
of the country.
2. Securities and Exchange Board of India (SEBI)
SEBI Act, 1992: Securities and Exchange Board of India was first established in
the year 1988 as a non-statutory body for regulating the securities market. It became an
autonomous body in 1992 and more powers were given through an ordinance. Since then,
it regulates the market through its independent powers.
3. Insurance Regulatory and Development Authority (IRDA)
The Insurance Regulatory and Development Authority is a national agency of the
Government of India and is based in Hyderabad (Andhra Pradesh). It was formed by an
Act of Indian Parliament known as IRDA Act 1999, which was amended in 2002 to
incorporate some emerging requirements. Mission of IRDA as stated in the act is to
protect the interests of the policyholders, to regulate, promote and ensure orderly growth
of the insurance industry and for matters connected therewith or incidental thereto.
(B) Part of Ministries of the Government of India
1. Forward Market Commission India (FMC)
Forward Markets Commission headquartered at Mumbai, is a regulatory authority
which is overseen by the Ministry of Consumer Affairs, Food and Public Distribution,
Government. of India. It is a statutory body set up in 1953 under the Forward Contracts
(Regulation) Act, 1952 This Commission allows commodity trading in 22 exchanges in
India, out of which three are national level.
2. PFRDA under the Finance Ministry
Pension Fund Regulatory and Development Authority (PFRDA) was established by
Government of India on 23rd August, 2003. The Government has, through an executive
order dated 10th October 2003, mandated PFRDA to act as a regulator for the pension
sector. The mandate of PFRDA is development and regulation of pension sector in India.
77
2.14 History of the Reserve Bank of India
Notes
The Reserve Bank of India is the central banking institution of India and controls the
monetary policy of the rupee as well as US$ 300.21 billion (2010) of currency reserves.
The institution was established on 1 April 1935 during the British Raj in accordance with
the provisions of the Reserve Bank of India Act, 1934 and plays an important part in the
development strategy of the government. It is a member bank of the Asian Clearing Union.
1935-1950:
The Central Bank was founded in 1935 to respond to economic troubles after the
First World War. The Reserve Bank of India was set up on the recommendations of the
Hilton-Young Commission. The commission submitted its report in the year 1926, though
the bank was not set up for another nine years. The Preamble of the Reserve Bank of
India describes the basic functions of the Reserve Bank as to regulate the issue of bank
notes, to keep reserves with a view to securing monetary stability in India and generally
to operate the currency and credit system in the best interests of the country. The Central
Office of the Reserve Bank was initially established in Kolkata, Bengal, but was
permanently moved to Mumbai in 1937. The Reserve Bank continued to act as the central
bank for Myanmar till Japanese occupation of Burma and later up to April 1947, though
Burma seceded from the Indian Union in 1937. After partition, the Reserve Bank served
as the central bank for Pakistan until June 1948 when the State Bank of Pakistan
commenced operations. Though originally set up as a shareholders bank, the RBI has
been fully owned by the Government of India since its nationalization in 1949.
1950-1960:
Between 1950 and 1960, the Indian government developed a centrally planned
economic policy and focused on the agricultural sector. The administration nationalized
and established commercial banks based on the Banking Companies Act, 1949 (later
called Banking Regulation Act), a central bank regulation as part of the RBI. Furthermore,
the central bank was ordered to support the economic plan with loans.
1960-1969:
As a result of bank crashes, the Reserve Bank was requested to establish and
monitor a deposit insurance system. It restored the trust in the national bank system and
was initialized on 7 December 1961. The Indian government founded funds to promote
the economy and used the slogan-developing Banking. The Government of India
restructured the national bank market and nationalized a lot of institutes. As a result,
the RBI had to play the central part of control and support of this public banking sector.
1969-1985:
Between 1969 and 1980, the Indian government nationalized 6 more commercial
banks, following 14 major commercial banks being nationalized in 1969 (as mentioned
in RBI website). The regulation of the economy and especially the financial sector was
reinforced by the Government of India in the 1970s and 1980s. The central bank became
the central player and increased its policies for a lot of tasks like interests, reserve ratio
and visible deposits. The measures aimed at better economic development and had a huge
effect on the company policy of the institutes. The banks lent money in selected sectors,
like agri-business and small trade companies. The branch was forced to establish two
78
Notes
new offices in the country for every newly established office in the town. The oil crises
in 1973 resulted in increasing inflation, and the RBI restricted monetary policy to reduce
the effects.
1985-1991:
A lot of committees analyzed the Indian economy between 1985 and 1991. Their
results had an effect on the RBI. The Board for Industrial and Financial Reconstruction,
the Indira Gandhi Institute of Development Research and the Security and Exchange Board
of India investigated the national economy as a whole, and the security and exchange
board proposed better methods for more effective markets and the protection of investor
interests. The Indian financial market was a leading example for so-called financial
repression. The Discount and Finance House of India began its operations on the
monetary market in April 1988; the National Housing Bank, founded in July 1988, was
forced to invest in the property market and a new financial law improved the versatility
of direct deposit by more security measures and liberalization.
1991-2000:
The national economy came down in July 1991 and the Indian rupee was devalued.
The currency lost 1% relative to the US dollar, and the Narasimham Committee advised
restructuring the financial sector by a temporal reduced reserve ratio as well as the
statutory liquidity ratio. New guidelines were published in 1993 to establish a private
banking sector. This turning point reinforced the market and was often called neo-liberal.
The central bank deregulated bank interests and some sectors of the financial market
like the trust and property markets. This first phase was a success and the central
government forced a diversity liberalization to diversify owner structures in 1998.
The National Stock Exchange of India took the trade on in June 1994 and the RBI
allowed nationalized banks in July to interact with the capital market to reinforce their
capital base. The central bank founded a subsidiary company the Bharatiya Reserve Bank
Note Mudran Limited in February 1995 to produce Bank Notes.
Since 2000:
The Foreign Exchange Management Act from 1999 came into force in June 2000.
It helped in improving the foreign exchange market, international investments in India and
foreign transactions. The RBI promoted the development of the financial market in the last
years, allowed online banking in 2001 and established a new payment system in 20042005. The Security Printing and Minting Corporation of India Ltd., a merger of nine
institutions, was founded in 2006 which produced bank notes and coins.
The national economys growth rate came down to 5.8% in the last quarter of 20082009 and the central bank promoted the economic development.
2.15 Establishment of RBI

The Reserve Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank
was initially established in Calcutta but was permanently moved to Mumbai in 1937. The
Central Office is where the Governor sits and where policies are formulated. Though
originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned
by the Government of India.
79
The Preamble of the Reserve Bank of India
Notes
The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank as: To regulate the issue of Bank Notes and keeping of reserves with a
view to securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage.
2.16 Organizational Structure of RBI

The RBI Act laid down that the management should be vested with the central board
of directors comprising of 20 members. The Board consists of following: (i) One governor
appointed by the Central government, (ii) Four deputy governor appointed by the Central
government, (iii) Four directors nominated by the Central Government one from each of
the local board, (iv) Ten directors nominated by the central government, (v) One government
official nominated by the central government.
1. Central Board of Directors
The Central Board of Directors is the main committee of the Central Bank. The
Government of India appoints the directors for a four-year term. The Board consists of
a governor, four deputy governors, four directors to represent the regional boards, and ten
other directors from various fields.
2. Governors
The Central Bank till now was governed by 21 governors. The 22nd, Current Governor
of Reserve Bank of India.
3. Supportive Bodies
The Reserve Bank of India has four regional representations: North in New Delhi,
South in Chennai, East in Kolkata and West in Mumbai. The representations are formed
by five members, appointed for four years by the central government and server beside
the advice of the Central Board of Directors as a forum for regional banks and to deal
with delegated tasks from the central board. The institution has 22 regional offices.
The Board of Financial Supervision (BFS), formed in November 1994, serves as a
CBD committee to control the financial institutions. It has four members, appointed for
two years, and takes measures to strength the role of statutory auditors in the financial
sector, external monitoring and internal controlling systems. The Tarapore Committee was
set up by the Reserve Bank of India under the chairmanship of former RBI deputy governor
S.S. Tarapore to lay the road map to capital account convertibility. The five-member
committee recommended a three-year time frame for complete convertibility by 1999-2000.
On 1 July 2006, an attempt was made to enhance the quality of customer service
and strengthen the grievance redressal mechanism, the Reserve Bank of India constituted
a new department Customer Service Department (CSD).
4. Offices and Branches
The Reserve Bank of India has 4 regional offices, 15 branches and 5 sub-offices.
It has 22 branch offices at most state capitals and at a few major cities in India. Few
of them are located in Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh,
Chennai, Delhi, Guwahati, Hyderabad, Jaipur, Jammu, Kanpur, Kolkata, Lucknow,
Mumbai, Nagpur, Patna, and Thiruvananthapuram. Besides it has sub-offices at Agartala,
Dehradun, Gangtok, Kochi, Panaji, Raipur, Ranchi, Shimla and Srinagar. The bank has
also two training colleges for its officers, viz., Reserve Bank Staff College at Chennai and
College of Agricultural Banking at Pune. There are also four Zonal Training Centres at
Belapur, Chennai, Kolkata and New Delhi.
80
Notes
2.17 Functional Departments of RBI

The various functional departments of RBI are as follows:
1. Customer Service Department in RBI
The Customer Service Department was constituted to provide proper focus to the
entire range of customer service related activities of banks and the Reserve Bank of India.
The Department started functioning from July 1, 2006. This is acting as a nodal department
for the Banking Codes and Standards Board of India. Ensuring redressal of complaints
received directly by RBI on customer service in banks. Liaison between banks, Indian
Banks Association, BCSBI, Banking Ombudsman offices and the RBIs regulatory
departments on matters relating to customer services and grievance redressed.
2. Department of Currency Management in RBI
The department attends to the core statutory function of note and coin issue and
currency management. This involves forecasting the demand for fresh Bank Notes and
coins, placing the indent with four printing presses and mints, receiving supplies against
those indents and distributing them through its 18 Issue Offices and one Sub office, one
Currency Chest and a wide network of currency chests, (4428 as on June 30, 2006) and
small coin depots (4102 as on June 30, 2006). The Department also keeps an account
of bank notes in circulation and also the stocks at RBI offices and currency chests. (A
currency chest is an extended arm of the Issue department maintained with a commercial
bank where the RBI stores fresh and re-issuable bank notes and allows the commercial
banks to withdraw cash for its requirements and deposit its excess cash. A repository
is an extension of the currency chest wherein a portion of the currency chest balance
is permitted to be held at one or more other local branches of the same bank). Soiled
bank notes are also stocked in the chests pending transportation to RBI.
The department administers the Reserve Bank of India Rules. The rules lay down
the circumstances in which value of torn and mutilated bank notes can be refunded. Soiled
bank notes, which are unfit for circulation is mopped up from circulation for destruction.
The department reviews various security features of the currency notes for
incorporation in the bank notes from time to time. It studies the features of the counterfeit
bank notes detected and seized with a view to determining the steps needed to be taken
to strengthen the integrity of the bank notes. The department also acts as a nodal
department for the Bharatiya Reserve Bank Note Mudran Private Ltd.
3. Urban Banks Department
Primary Cooperative Banks, popularly known as Urban Cooperative Banks (UCBs)
are registered as cooperative societies under the provisions of, either the State Cooperative
Societies Act of the State concerned or the Multi State Cooperative Societies Act, 2002.
They are regulated and supervised by the Registrar of Cooperative Societies (RCS) of State
concerned or by the Central Registrar of Cooperative Societies (CRCS), as the case may
be. The Reserve Bank regulates and supervises the banking functions of UCBs under the
provisions of Banking Regulation Act, 1949 (AACS).
4. Rural Planning and Credit Department
The rural planning and credit department formulates policies relating to rural credit
and monitors timely and adequate flow of credit to the rural population for agricultural
activities and rural employment programmes. It also formulates policies relating to the
priority sector which includes agriculture, small-scale industries, tiny and village industries,
artisans and retail traders, professional and self-employed persons, state sponsored
organizations for Scheduled Castes and Scheduled Tribes and Government Sponsored
81
credit-linked programmes like Swarnajayanti Gram Swarojgar Yojana (SGSY), Prime

Ministers Rojgar Yojana (PMRY), etc. It implements and monitors the Lead Bank Scheme
which is aimed at forging a coordinated approach for providing bank credit to achieve overall
development of rural areas in the country. The department also oversees implementation
of the Banking Ombudsman Scheme.
Notes
5. Foreign Exchange Department in RBI

With the introduction of the Foreign Exchange Management Act 1999, (FEMA) with
effect from June 1, 2000, the objective of the Foreign Exchange Department has shifted
from conservation of foreign exchange to facilitating external trade and payment and
promoting the orderly development and maintenance of foreign exchange market in India.
The new Act has brought about structural changes in the exchange control
administration. Regulations have been framed for dealing with various types of transactions.
These regulations are transparent and have eliminated case-by-case approvals.
(i) The Department ensures timely realization of export proceeds and reviews, on
a continuous basis, the existing rules in the light of suggestions received from
various trade bodies.
(ii) The Department collects data relating to FOREX transactions from authorized
dealers on a daily basis for exchange rate management and on a fortnightly
basis for monthly quick estimates of balance of payments and quarterly balance
of payments compilation.
(iii) The Department lays down policy guidelines for risk management relating to
FOREX transactions in banks.
(iv) The Department is also entrusted with the responsibility of licensing banks/
money changers to deal in foreign exchange and inspecting them.
(v) There is a Standing Consultative Committee on Exchange Control consisting
of representatives from various trade bodies and authorized dealers which meets
twice a year and makes recommendations for policy formulation.
(vi) With a view of further improving facilities available to NRIs and removing irritants,
the Department is also engaged, on an ongoing basis, in reviewing and
simplifying the procedures and rules.
6. Financial Markets Department
The Financial Markets Department was constituted on July 6, 2005 with a view to
providing an integrated market interface for the Bank and to bringing about integration in
the Banks conduct of monetary operations. The mandated functions of the Department
are as under: monetary operations such as Open Market Operations (OMO), Liquidity
Adjustment Facility (LAF), and Market Stabilization Scheme (MSS); exchange rate
management; regulation and development of money market instruments such as call/term/
notice money, market repo, collateralized borrowing and lending obligation, Commercial
Paper (CP) and Certificate of Deposits (CD); and monitoring of money, government
securities and FOREX markets.
2.18 Objectives of Reserve Bank of India

Main objectives of RBI are as follows:
(i) To manage the monetary and credit system of the country.
(ii) To stabilize internal and external value of rupee.
(iii) To ensure for balanced and systematic development of banking in the country.
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Notes
(iv) To help for the development of organized money market in the country.
(v) To assist for proper arrangement of agriculture finance.
(vi) To assist for proper arrangement of industrial finance.
(vii) To assist for proper management of public debts.
(viii) To establish monetary relations with other countries of the world and
international financial institutions.
(ix) To helps for centralization of cash reserves of commercial banks.
(x) To maintain balance between the demand and supply of currency.
2.19 Role of Reserve Bank of India

Reserve Bank of India plays a significant role in the Indian banking and financial
system that relates to:
(i) Issuer of Currency
The Reserve Bank is the sole authority for the issue of currency in India. Since
currency is considered as a base for the expansion of money supply, regulation of currency
is an important element in monetary control of RBI.
(ii) Government Banker
The Reserve Bank is banker to the central bank as well as state governments. All
the current accounts of governments are maintained with RBI. All receipts and payments
are made on behalf of the government.
(iii) Bankers Bank
The Reserve Bank is statutory banker to the government of India. It maintains cash
reserves with central government to facilitate clearing operations and with state government
to facilitate funds for short-term and provides economical central clearing and remittance
facilities.
(iv) Supervising Authority
RBI is responsible for the development of an adequate and sound banking system
for catering the needs of trade, commerce, industry, agriculture, etc.
(v) Exchange Control Authority
RBI is the custodian of the foreign exchange reserves of the country. It manages
the exchange control in a very planned and meticulous manner.
(vi) Promoter of the Financial System
The Reserve Bank serves as advisor to government on economic planning, resource
mobilization, banking and financial matters. It is responsible for financial policies and other
initiatives concerning loans, agriculture finance, industrial finance, etc.
(vii) Regulator of Money and Credit
RBI controls the money supply and credit in the economy. This helps in achieving
price stability, flul employment, economic growth, equilibrium in the balance of payments,
etc.
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2.20 Main Functions of RBI
Notes
The main functions of Reserve Bank of India are as follows:

1. Monetary Authority
The Reserve Bank of India is the main monetary authority of the country and beside
that the central bank acts as the bank of the national and state governments. It formulates
implements and monitors the monetary policy as well as it has to ensure an adequate
flow of credit to productive sectors. Objectives are maintaining price stability and ensuring
adequate flow of credit to productive sectors. The national economy depends on the public
sector and the central bank promotes an expansive monetary policy to push the private
sector since the financial market reforms of the 1990s.
The institution is also the regulator and supervisor of the financial system and
prescribes broad parameters of banking operations within which the countrys banking and
financial system functions. Objectives are to maintain public confidence in the system,
protect depositors interest and provide cost-effective banking services to the public. The
Banking Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI)
for effective addressing of complaints by bank customers. The RBI controls the monetary
supply, monitors economic indicators like the gross domestic product and has to decide
the design of the rupee bank notes as well as coins.
2. Manager of Exchange Control
The central bank manages to reach the goals of the Foreign Exchange Management
Act, 1999. The objective is to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.
3. Issuer of Currency
The bank issues and exchanges or destroys currency and coins not fit for circulation.
The objectives are giving the public adequate supply of currency of good quality and to
provide loans to commercial banks to maintain or improve the GDP. The basic objectives
of RBI are to issue bank notes, to maintain the currency and credit system of the country
to utilize it in its best advantage, and to maintain the reserves. RBI maintains the economic
structure of the country so that it can achieve the objective of price stability as well as
economic development, because both objectives are diverse in themselves.
4. Developmental Role
The central bank has to perform a wide range of promotional functions to support
national objectives and industries. The RBI faces a lot of inter-sectoral and local inflationrelated problems. Some of these problems are results of the dominant part of the public
sector.
5. Related Functions
The RBI is also a banker to the government and performs merchant banking function
for the central and the state governments. It also acts as their banker.
6. Advisor to the Government
It also acts as adviser to Government on economic and financial matters. In brief,
as a banker to the Government, the RBI renders the following functions:
84
Notes
(a) Collects taxes and makes payments on behalf of the Government.

(b) Accepts deposits from the Government.
(c) Collects cheques and drafts deposited in the Government accounts.
(d) Provides short-term loans to the Government.
(e) Provides foreign exchange resources to the Government.
(f) Keep the accounts of various Government Department.
(g) Maintains currency chests in treasuries at some importance places for the
convenience of the government.
(h) Advises governments on their borrowing programmes.
7. Agent and Adviser of the Government
The RBI acts, as the financial agent and adviser to the Government. It renders the
following functions:
(a) As an agent to the Government, it accepts loans and manages public debts
on behalf of the Government.
(b) It issues Government bonds, treasury bills, etc.
(c) Acts as the financial adviser to the Government in all important economic and
financial matters.
8. Banker to the Banks
The RBI acts as banker to all scheduled banks. Commercial banks including foreign
banks, cooperative banks and RRBs are eligible to be included in the second schedule
of RBI Act subject to fulfilling conditions laid down under Section 42(6) of RBI Act.
RBI has powers to delete a bank from the second schedule if the bank concerned
fails to fulfill the laid down conditions such as erosion in paid-up capital below the
prescribed limits and the banks activities became detrimental to the interest of depositors,
etc.
All banks in India, should keep certain percentage of their demand and time liabilities
as reserves with the RBI. This is known as Cash Reserve Ratio or CRR. At end November
1999, it is 3% for RRBs and cooperative banks; 9% for commercial banks.
They also maintain Current Account with RBI for various banking transactions. This
centralization of reserves and accounts enables the RBI to achieve the following:
(a) Regulation of money supply credit.
(b) Acts as custodian of cash reserves of commercial banks.
(c) Strengthen the banking system of the country
(d) Exercises effective control over banks in Liquidity Management.
(e) Ensures timely financial assistance to the banks in difficulties.
(f) Gives directions to the banks in their lending policies in the public interest.
(g) Ensures elasticity in the credit structure of the country.
(h) Quick transfer of funds between member banks.
9. Acts as National Clearing House
In India, RBI acts as the clearing house for settlement of banking transactions. This
function of clearing house enables the other banks to settle their interbank claims easily.
Further, it facilitates the settlement economically.
85
Where the RBI has no offices of its own, the function of clearing house is carried
out in the premises of the State Bank of India. The entire clearing house operations carried
on by RBI are computerized. The inter-bank cheque clearing settlement is done twice a
day.
Notes
The RBI acts as a lender of last resort or emergency fund provider to the other member
banks. As such, if the commercial banks are not able to get financial assistance from
any other sources, then as a last resort, they can approach the RBI for the necessary
financial assistance.
In such situations, the RBI provides credit facilities to the commercial banks on
eligible securities including genuine trade bills which are usually made available at Bank
Rate.
RBI rediscounts bills under Section 17(2) and 17(3) and grants advances against
securities under Section 17(4) of RBI Act. However, many of these transactions are
practically carried out through separate agencies like DHFI, Securities Trading Corporation
of India, primary dealers.
The RBI now mainly provides refinance facilities as direct assistance. Rediscounting
of bills fall under the following categories:
(i) Commercial Bill
A bill arising out of bonfire commercial or trade transaction drawn and payable in
India and mature within 90 days from the date of purchase or discount is eligible for
rediscount.
(ii) Bills for Financing Agricultural Operations
A bill issued for purpose of financing seasonal agricultural operations or the marketing
of crops and maturing within 15 months from the date of purchase or rediscount.
(iii) Bills for Financing Cottage and Small-scale Industries
Bills drawn or issued for the purpose of financing the production and marketing of
products of cottage and small industries approved by RBI and mature within 12 months
from the date of discount.
(iv) Refinance
Under agricultural and small-scale industries, activities are now provided by NABARD
by obtaining financial assistance from RBI.
(v) Bill for Holding or Trading in Government Securities
Such a bill should mature within 90 days from the date of purchase or rediscounting
and be drawn and payable in India.
(vi) Foreign Bills
Bonfire bill arising out of export of goods from India and which mature within 180
days from the date of shipment of goods are eligible.
As lender of last resort, the RBI facilitates the following:
(a) Provides financial assistance to commercial banks at the time of financial needs.
(b) It helps the commercial banks in maintaining liquidity of their financial resources.
(c) Enables the commercial banks to carry out their activities with minimum cash
reserves.
(d) As a lender of last resort, the RBI can exercise full control over the commercial
banks.
86
Notes
10. Acts as the Controller of Credit

The RBI controls the credit creation by commercial banks. For this, the RBI uses
both quantitative and qualitative methods. The important methods used by RBI are:
(i) Bank Rate Policy
(ii) Open Market Operation
(iii) Variation of Cash Reserve Ratio
(iv) Fixing Margin Requirements
(v) Moral Suasion
(vi) Issue of Directives
(vii) Direct Action
By controlling credit, the RBI achieves the following:
(a) Maintains the desired level of circulation of money in the economy.
(b) Maintains the stability in the price level prevailing in the economy.
(c) Controls the effects of trade cycles.
(d) Controls the fluctuations in the foreign exchange rate.
(e) Channelize credit to the productive sectors of the economy.
11. Custodian of Foreign Exchange Reserves
The RBI acts as the custodian of foreign exchange reserves. Adequate reserves may
help maintain foreign exchange rates. In order to minimize the undue fluctuations in the
rates, it may buy and sell foreign currencies depending upon the situations.
Its purchase and sale of foreign currencies from the market is done like commercial
banks. However, the objective of the RBI will not be profit booking.
It may buy the foreign currency to build up adequate reserves or to arrest unwarranted
rise in the value of rupee which may be due to sudden inflow of foreign currencies into
India. It may also buy and sell foreign currencies in international market to switch the
portfolio of investments denominated in different international currencies depending upon
circumstances and needs.
These reserves are increased to ` 1,38,005 crore in March 1999. The value of foreign
currency assets of RBI, which form the largest portion in Indias Foreign Currency reserves,
is subject to changes even on daily basis depending upon ruling exchange rates, inflow
and outflow of currencies, intervention policy of the RBI, etc.
12. Publishes the Economic Statistics and Other Information
The RBI collects statistics on economic and financial matters. It publishes
periodically an analytical account of the operations of joint stock and cooperative banks.
It presents the genuine financial position of the government and companies.
The publications like the report on currency and finance, the report on the trend and
progress of banking in India, the review of cooperative movement present a critical account
and a balanced review of banking developments commercial, economic and financial
conditions of the country.
87
13. Fights against Economic Crisis
Notes
The RBI aims at economic stability in the country whenever, there is a danger to
the economic stability, it takes immediate measures to put the economy on proper course
by effective policy changes and implementation thereof.
The Reserve Bank of India is the main source of monetary information and data related
to banking. These information are very much essential for framing the economic policies
and banking policies. It is the duty of the reserve bank to collect and publish the information
regularly in the form of weekly statements, monthly bulletins, annual reports, reports on
trends and progress of banking sector in India, etc.
14. Promotion of Banking Habits
The RBI institutionalizes saving through the promotion of banking habit and expansion
of the banking system territorially and functionally.
Accordingly, RBI has set up deposit insurance corporation in 1962, Unit Trust of India
in 1964, the IDBI in 1964, the Agricultural Refinance Corporation in 1963, Industrial
Reconstruction Corporation of India in 1972, NABARD in 1982 and the National Housing
Bank in 1988, etc.
It has helped to bring into existence several industrial finance corporations such as
Industrial Finance Corporation of India, Industrial Credit and Investment Corporation of India
for industrialization of the country. Similarly, sector specific corporations took care of
development in their respective spheres of activity.
15. Provides Refinance for Export Promotion
The RBI takes the initiative for widening facilities for the provision of finance for foreign
trade particularly of exports.
The Export Credit and Guarantee Corporation (ECGC) and Exam Banks render useful
functions on this line. To encourage exports, the RBI is providing refinance facilities for
export credit given by commercial banks. Further, the rate of interest on export credits
continues to be prescribed by RBI at a lower rate.
The ECGC provides an insurance cover on export receivables. EXIM Bank extends
long-term finance to project exporters and foreign currency credit for promotion of Indian
exports. Students should know that many of these institutions were part of Reserve Bank
earlier although they are currently functioning as separate financial institutions.
16. Facilities for Agriculture
The RBI extends indirect financial facilities to agriculture regularly. Through NABARD,
it provides short-term and long-term financial facilities to agriculture and allied activities.
It established NABARD for the overall administration of agricultural and rural credit. Indian
agriculture would have starved of a cheap credit but for the institutionalization of rural credit
by RBI.
The Reserve Bank was extending financial assistance to the rural sector mainly
through contributions to the National Rural Credit Funds being operated by NABARD. RBI
presently makes only a symbolic contribution of ` 1.00 crore.
It, however, extends cheap indirect financial assistance to the agricultural sector by
providing large sums of money through General Line of Credit to NABARD. The loans and
advances extended to NABARD by RBI and outstanding as on June 1999 amounted to
` 5073 crore.
88
Notes
17. Facilities to Small-scale Industries

The RBI takes active steps to increase the supply of credit to small industries. It
gives directives to the commercial banks regarding the extension of credit facilities to
small-scale industries. It encourages commercial banks to provide guarantee services to
SSI sector. Banks advances to SSI sector are classified under priority sector advances.
SSI sector contributes to a very great extent to employment opportunities and for
Indian Exports. Keeping this in view, RBI has directed commercial banks to open
specialized SSI bank branches to provide adequate financial and technical assistance to
SSI branches. There are around 30 lakh SSI units operating in India. Meeting their financial
needs is one of the prime concerns of RBI.
18. Helps Cooperative Sector
RBI extends indirect financing to State Cooperative Banks thereby connects the
c-operative sector with the main banking system of the country. The finance is mostly,
is routed through NABARD. This way the financial needs of agricultural sector are taken
care of by RBI.
19. Prescription of Minimum Statutory Requirements for Banks
The RBI prescribes the minimum statutory requirements such as, paid-up capital,
reserves, cash reserves, liquid assets, etc. RBI prescribes reserves requirements both
under Banking Regulation Act and RBI Act to ensure different objectives.
For example, SLR prescription is done to ensure liquidity position of the bank. CRR
prescription is done to have effective monetary control and money supply. Statutory
Reserves Appropriation is done to ensure sound banking system, etc.
It also asks banks to set aside provisions against possible bad loans. With these
functions, it exercises control over the monetary and banking systems of the country to
ensure growth, price stability and sound banking practices.
20. Supervisory Functions
The Reserve Bank of India performs the following supervisory functions. By these
functions, it controls and administers the entire financial and banking systems of the country.
(a) Granting License to Banks
The RBI grants license to the banks, which like to commence their business in India.
Licenses are also required to open new branches or closure of branches. With this power,
RBI can ensure avoidance of unnecessary competitions among banks in particular location
evenly growth of banks in different regions, adequate banking facility to various regions, etc.
This power also helps RBI to weed out undesirable people from starting banking business.
(b) Function of Inspection and Enquiry
RBI inspects and makes enquiry in respect of various matters covered under Banking
Regulations Act and RBI Act. The inspection of commercial banks and financial institutions
are conducted in terms of the provisions contained in Banking Regulation Act.
These refer to their banking operations like loans and advances, deposits, investment
functions and other banking services. Under such inspection, RBI ensures that the banks
and financial institutions carry on their operations in a prudential manner, without taking
undue risk but aiming at profit maximization within the existing rules and regulations.
89
This type of inspection is carried on periodically once a year or two covering all
branches of banks. Banks are obliged to take remedial measures on the lapses/
deficiencies pointed out during inspection. In addition RBI also calls for periodical
information concerning certain assets and liabilities of the banks to verify that the banks
continue to remain in good health.
Notes
(c) Implementing the Deposit Insurance Scheme

RBI Implements the Deposit Insurance Scheme for the benefit of bank depositors.
This supervisory function has improved the standard of banking in India due to this
confidence building exercise. Under this system, deposits up to ` 1.00 lakh with the bank
branch are guaranteed for payment. Deposits with the banking system alone are covered
under the scheme.
For this purpose, banking system include accounts maintained with commercial
banks, cooperative banks and RRBs. Fixed Deposits with other financial institutions like
ICICI, IDBI, etc. and those with financial companies are not covered under the scheme.
ICICI is since merged with ICICI Bank Ltd. and IDBI is getting converted into a bank.
(d) Periodical Review of the Working of the Commercial Banks
The RBI periodically reviews the work done by commercial banks. It takes suitable
steps to enhance the efficiency of the banks and make various policy changes and
implement programmes for the well-being of the nation and for improving the banking
system as a whole.
(e) Controls the Non-Banking Financial Corporations
RBI issues necessary directions to the Non-Banking financial corporations and
conducts inspections through which it exercises control over such institutions. Deposit
taking NBFCs require permission from RBI for their operations.
2.21 Monetary Policy of Reserve Bank of India

The Reserve Bank of India Act, 1934 sets out broadly the objectives of monetary
policy: To regulate the issue of Bank notes and the keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage.
Although there is no explicit mandate for price stability, the objectives of monetary
policy in India have evolved as maintaining price stability and ensuring adequate flow of
credit to the productive sectors of the economy to support economic growth. The relative
emphasis placed on price stability and economic growth is modulated according to the
circumstances prevailing at a particular point in time and is spelt out, from time to time,
in the policy statements of the Reserve Bank. In the recent period, considerations of
financial stability have assumed an added importance in view of increasing openness of
the Indian economy.
The Reserve Bank has multiple instruments at its command for implementation of
monetary policy such as repo and reverse repo rates; cash reserve ratio (CRR); open
market operations, including LAF and market stabilization scheme (MSS); special market
operations; sector-specific liquidity facilities; and prudential tools.
90
Notes
Main Duties
Monetary Policy Department is entrusted with the responsibility of designing,
formulating and implementing monetary policy of the Reserve Bank. Accordingly, the
Department prepares Governors Statements on Monetary Policy. The Policy Statements
are currently brought out four times in a year. The Annual Policy (April) and its Second
Quarter Review (October) consist of two parts: Part A: Monetary Policy and Part B:
Developmental and Regulatory Policies. The First Quarter Review (July) and the Third
Quarter Review (January) of Monetary Policy comprise only Part A.
Monetary policy formulation is carried out by the Reserve Bank in consultation with
various stakeholders such as banks, market participants and industry and trade
associations. In pursuance of the objective of further strengthening the consultative process
of monetary policy formulation, a Technical Advisory Committee (TAC) on Monetary Policy
has been set up, which meets ahead of the Annual Policy and the quarterly reviews, to
review macroeconomic and monetary developments and advise the Reserve Bank on the
stance of monetary policy.
Main Activities
Preparation of Reserve Banks Annual Policy Statement and its Reviews in each
quarter. Conduct of Technical Advisory Committee meetings on Monetary Policy in each
quarter before the announcement of Policy Statement/Reviews or at any other time as
and when needed. Conduct of pre-policy consultation meetings with the bankers, market
participants, trade bodies, self-regulatory organizations and economists and journalists
to facilitate the policy formulation process.
Definitions of Monetary Policy
According to Prof. Harry Johnson, Monetary policy is a policy employing the central
banks control of the supply of money as an instrument for achieving the objectives of
general economic policy is a monetary policy.
According to A.G. Hart, Monetary policy is a policy which influences the public
stock of money substitute of public demand for such assets of both that is policy which
influences public liquidity position is known as a monetary policy.
2.22 Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its five
year plans. In a nutshell, planning in India aims at growth stability and social justice. After
the Keynesian revolution in economics, many people accepted significance of monetary
policy in attaining following objectives:
(i) To Ensure the Rapid Economic Growth
It is the most important objective of a monetary policy. The monetary policy can
influence economic growth by controlling real interest rate and its resultant impact on the
investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates,
the investment level in the economy can be encouraged. This increased investment can
speed up economic growth. Faster economic growth is possible if the monetary policy
succeeds in maintaining income and price stability.
(ii) To Help for Price Stability
All the economics suffer from inflation and deflation. It can also be called as Price
Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary
91
policy having an objective of price stability tries to keep the value of money stable. It helps
in reducing the income and wealth inequalities. When the economy suffers from recession,
the monetary policy should be an easy money policy but when there is inflationary
situation there should be a dear money policy.
Notes
(iii) To Assist for Exchange Rate Stability

Exchange rate is the price of a home currency expressed in terms of any foreign
currency. If this exchange rate is very volatile leading to frequent ups and downs in the
exchange rate, the international community might lose confidence in our economy. The
monetary policy aims at maintaining the relative stability in the exchange rate. The RBI
by altering the foreign exchange reserves tries to influence the demand for foreign exchange
and tries to maintain the exchange rate stability.
(iv) To Assist for Balance of Payments (BOP) Equilibrium
Many developing countries like India suffer from the Disequilibrium in the BOP. The
Reserve Bank of India through its monetary policy tries to maintain equilibrium in the
balance of payments. The BOP has two aspects, i.e., the BOP Surplus and the BOP
Deficit. The former reflects an excess money supply in the domestic economy, while the
later stands for stringency of money. If the monetary policy succeeds in maintaining
monetary equilibrium, then the BOP equilibrium can be achieved.
(v) To Ensure Full Employment
The concept of full employment was much discussed after Keyness publication of
the General Theory in 1936. It refers to absence of involuntary unemployment. In simple
words, Full Employment stands for a situation in which everybody who wants jobs get
jobs. However, it does not mean that there is Zero unemployment. In that sense, the full
employment is never full. Monetary policy can be used for achieving full employment. If
the monetary policy is expansionary then credit supply can be encouraged. It could help
in creating more jobs in different sector of the economy.
(vi) To Ensure the Neutrality of Money
Economist such as Wicksted and Robertson have always considered money as a
passive factor. According to them, money should play only a role of medium of exchange
and not more than that. Therefore, the monetary policy should regulate the supply of
money. The change in money supply creates monetary disequilibrium. Thus, monetary
policy has to regulate the supply of money and neutralize the effect of money expansion.
However, this objective of a monetary policy is always criticized on the ground that if money
supply is kept constant, then it would be difficult to attain price stability.
(vii) To Support for Equal Income Distribution
Many economists used to justify the role of the fiscal policy in maintaining economic
equality. However, in recent years, economists have given the opinion that the monetary
policy can help and play a supplementary role in attaining an economic equality. Monetary
policy can make special provisions for the neglect supply such as agriculture, small-scale
industries, village industries, etc. and provide them with cheaper credit for longer term.
This can prove fruitful for these sectors to come up. Thus, in recent period, monetary policy
can help in reducing economic inequalities among different sections of society.
2.23 Cooperative Banks

A cooperative bank is a financial entity which belongs to its members, who are at
the same time the owners and the customers of their bank. Cooperative banks are often
92
Notes
created by persons belonging to the same local or professional community or sharing a

common interest. Cooperative banks generally provide their members with a wide range
of banking and financial services (loans, deposits, banking accounts, etc.).
2.24 History of Cooperative Banking in India

The historical roots of the Cooperative Movement in the world days back to days
of misery and distress in Europe faced by common people who had little or no access
to credit to fund their basic needs, in uncertain times. The idea spread when the continent
was faced with economic turmoil which led large populations to live at subsistence level
without any economic security. People were forced to poverty and deprivation. It was the
idea of Hermann Schulze (1808-83) and Friedrich Wilhelm Raiffeisen (1818-88) which took
shape as cooperative banks of today across the world. They started to promote the idea
of easy availability of credit to small businesses and for the poor segment of society.
It was similar to the many microfinance institutions which have become highly popular
in developing economies of today. Although this helped spread cooperative movement in
many parts of Europe, in British Isles, it is came from the revivalist Christian movement
and found high acceptance with working class and lower middle class segments of society.
However, UK and Irish credit unions in 20th century were inspired by US credit unions
which in turn owe their emergence to Canadian adaptations of the German cooperative
banking concept. These movements were supported by governments of the respective
countries. This success was achieved due to the failure of the commercial banks to fund
and support the needs of small business owners and ordinary people who were outside
the formal banking net. Cooperative banks helped overcome the vital market imperfections
and serviced the poorer layers of society. Indian Cooperative Banks was also born out
of distress prevalent in Indian society. The Cooperative Credit Societies Act, 1904 led to
the formation of Cooperative Credit Societies in both rural and urban areas. The act was
based on recommendations of Sir Frederick Nicholson (1899) and Sir Edward Law (1901).
Their ideas in turn were based on the pattern of Raiffeisen and Schulze respectively. The
Cooperative Societies Act of 1912 further gave recognition to the formation of non-credit
societies and the central cooperative organizations. In independent India, with the onset
of planning, the cooperative organizations gained more leverage and role with the continued
governmental support. Machlagan Committee in 1915, highlighted the deficiencies of in
cooperative societies which seeped in due to lack of proper education to the masses.
He also laid down the importance of Central Assistance by the Government to support
the movement. The Royal Commission on Agriculture 1928, enumerated the importance
of education of members/staff for effective implementation of cooperative movement.
Saraiya Committee, in 1945, further recommended the setting up of a Cooperative Training
College in every state and a Cooperative Training Institute for Advanced Study and
Research at the Central level. Central Committee for Cooperative Training in 1953,
constituted by RBI for establishing Regional Training Centres. Rural Credit Survey
Committee, 1954 was the first committee formed till then to first delve into the problems
of Rural credit and other financial issues of rural society. The cooperative movement and
banking structures soon spread and resonated with the unexpressed needs of the rural
Indian and small scale businesses. Since, 1950s, they have come a long way to support
and provide assistance in activities like credit, banking, production, processing,
distribution/marketing, housing, warehousing, irrigation, transport, textiles, dairy, sugar
etc. to households.
Extent of Cooperative Banking
Indian cooperative structures are one of the largest such networks in the world with
more than 200 million members. It has about 67% penetration in villages and fund 46%
93
of the total rural credit. It also stands for 36% of the total distribution of rural fertilizers
and 28% of rural fair price shops.
Notes
2.25 Structure of Cooperative Banking in India

The structure of cooperative network in India can be divided into two broad segments:
1. Urban Cooperatives
2. Rural Cooperatives
1. Urban Cooperatives
Urban Cooperatives can be further divided into scheduled and non-scheduled. Both
the categories are further divided into multi-state and single-state. Majority of the banks
are fall in the non-scheduled and single-state category. Banking activities of Urban
Cooperative Banks are monitored by RBI. Registration and Management activities are
managed by Registrar of Cooperative Societies (RCS). These RCS operate in single-state
and Central RCS (CRCS) operate in multiple state.
2. Rural Cooperatives
The rural cooperatives are further divided into short-term and long-term structures.
The short-term cooperative banks are three tiered operating in different states. These are:
(i) State Cooperative Banks: They operate at the apex level in states.
(ii) District Central Cooperative Banks: They operate at the district levels.
(iii) Primary Agricultural Credit Societies: They operate at the village or grass-root
level.
Likewise, the long-term structures are further divided into:
(i) State Cooperative Agriculture and Rural Developmental Banks (SCARDS):
These operate at state-level.
(ii) Primary Cooperative Agriculture and Rural Developmental Banks (PCARDBS):
They operate at district/block level. The rural banking cooperatives have a
complex monitoring structure as they have a dual control which has led to many
problems. A Forum called State Level Task Force on Cooperative Urban Banks
(TAFCUB) has been set up to look into issues related to duality in control. All
banking activities are regulated by a shared arrangement between RBI and
NABARD. All management and registration activities are managed by RCS.
2.26 Cooperative Banks Irritants and Future Trends

A cooperative bank is an institution which is owned by its members. They are the
culmination of efforts of people of same professional or other community which have
common and shared interests, problems and aspirations. They cater to services like loans,
banking, deposits, etc. like commercial banks but widely differ in their values and
governance structures. They are usually democratic set-ups where the board of members
is democratically elected with each member entitled to one vote each. In India, they are
supervised and controlled by the official banking authorities and thus have to abide by
the banking regulations prevalent in the country. The basic rules, regulations and values
may differ amongst nations but they have certain common features:
1. Customer-owned Democratic structures
2. Profits are mainly pooled to form reserves while some amount is distributed to
members
94
Notes
3. Involved in community development

4. Foster financial inclusion by bringing banking to the doorstep of the lowest
segment of society
These banks are small financial institutions which are governed by regulations like
Banking Regulations Act, 1949 and Banking Laws Cooperative Societies Act, 1965. They
operate both in urban and rural areas under different structural organizations. Their
functions are decided by the level at which they operate and the type of people they cater
to. They greatly differ from the commercial banking entities. These are established under
specific acts of cooperative societies operating in different states unlike mainstream
commercial banks which are mainly joint-stock companies. They have a tiered network
with a bank at each level of state, district and rural. The state-level bank forms the apex
authority. Not all sections of banking regulation act are applicable to cooperative banks
The ultimate motive is community participation, benefit and growth as against profit
maximization for commercial banks.
2.27 Major Irritants in the Functioning of the Cooperative Banks

The duality in control by RCS of a state as Cooperation is a state subject. However,
financial regulatory control by RBI has led to many troubles as there is ambiguity in power
structure as there is no clear demarcation. Patchy growth of cooperative societies across
the map of India. It is said these have grown maximally in states of Gujarat, Maharashtra,
Tamil Nadu whereas the other parts of India dont have a heightened presence. The state
partnership has led to excessive state control and interference. This has eroded the
autonomous characters of many of these. Dormant membership has made them moribund
as there is a lack of active members and lack of professional attitude. Their main focus
being credit so they have reduced to borrower-driven entities and majority of members
are nominal and dont enjoy voting rights. Credit recovery is weak especially in rural areas
and it has sustainability crisis in some pockets. There is a lack of risk management
systems and lack of basic standardized banking models. There is a widening gap between
the level of skills and the increasing computerization of banks. The government needs
to have a serious look into the issues as they did not show an impressive growth in the
last 100 years.
2.28 Banking System in USA and India

The banking system in India is significantly different from other countries.
Reserve Bank of India is the Central Bank of our country. It was established on
1st April 1935 under the RBI Act of 1934. It holds the apex position in the banking structure.
RBI performs various developmental and promotional functions.
1. Central Bank
It has given wide powers to supervise and control the banking structure. It occupies
the pivotal position in the monetary and banking structure of the country. In many countries,
central bank is known by different names.
For example, Federal Reserve Bank of USA and Reserve Bank of India in India.
Central bank is known as a bankers bank. They have the authority to formulate and
implement monetary and credit policies. It is owned by the government of a country and
has the monopoly power of issuing notes.
95
2. Commercial Banks
Notes
Commercial bank is an institution that accepts deposit, makes business loans and
offer related services to various like accepting deposits and lending loans and advances
to general customers and business man.
These institutions run to make profit. They cater to the financial requirements of
industries and various sectors like agriculture, rural development, etc. it is a profit making
institution owned by government or private of both.
Commercial bank includes public sector, private sector, foreign banks and regional
rural banks:
(a) Public sector Banks
It includes SBI, seven (7) associate banks and nineteen (19) nationalized banks.
Altogether there are 27 public sector banks. The public sector accounts for 90% of total
banking business in India and State Bank of India is the largest commercial bank in terms
of volume of all commercial banks.
(b) Private Sector Banks
Private sector banks are those whose equity is held by private shareholders. For
example, ICICI, HDFC, etc. Private sector bank plays a major role in the development
of Indian banking industry.
(c) Foreign Banks
Foreign banks are those banks, which have their head offices abroad. CITI Bank,
HSBC, Standard Chartered, etc. are the examples of foreign bank in India.
(d) Regional Rural Banks (RRB)
These are state sponsored regional rural oriented banks. They provide credit for
agricultural and rural development. The main objective of RRB is to develop rural economy.
Their borrowers include small and marginal farmers, agricultural laborers, artisans, etc.
NABARD holds the apex position in the agricultural and rural development.
3. Cooperative Bank
Cooperative bank was set up by passing a cooperative act in 1904. They are
organized and managed on the principal of cooperation and mutual help. The main objective
of cooperative bank is to provide rural credit.
The cooperative banks in India play an important role even today in rural cooperative
financing. The enactment of Cooperative Credit Societies Act, 1904, however, gave the
real impetus to the movement. The Cooperative Credit Societies Act, 1904 was amended
in 1912, with a view to broad basing it to enable organization of non-credit societies.
Three tier structures exist in the cooperative banking:
(i) State cooperative bank at the apex level.
(ii) Central cooperative banks at the district level.
(iii) Primary cooperative banks and the base or local level.
96
Notes
4. Scheduled and Non-scheduled Banks

A bank is said to be a scheduled bank when it has a paid up capital and reserves
as per the prescription of RBI and included in the second schedule of RBI Act 1934. Nonscheduled bank are those commercial banks, which are not included in the second
schedule of RBI Act 1934.
5. Development Banks and Other Financial Institutions
A development bank is a financial institution, which provides a long term funds to
the industries for development purpose. This organization includes banks like IDBI, ICICI,
IFCI, etc. State level institutions like SFCs, SIDCs, etc. It also includes investment
institutions like UTI, LIC, GIC, etc.
6. Working Hours
Indian banks beat American banks. ICICI offers 8 a.m. to 8 p.m. banking, which is
very convenient during week days. American banks work half day on Saturday and do
not work on Sunday. Indian banks work on weekend very good for people working people.
7. Online Banking
Both are good. However, the Indian banks have edge here. They charge less when
money is transferred from one account to another account of another bank. In US, they
charge $3 which is very high.
8. Services
US banks provide good service compared to Indian banks. This would primarily
attribute this to this low population. If you have priority account with Indian bank, then
US banks are no match.
Indian banks offer lot of utility services for free cost. US banks also offers this, but
not as wider as Indian banks.
9. Cash Withdrawal Limit in ATM
Most Indian banks allow daily cash withdrawal up to ` 25,000/-, which is sufficient
in most cases. Here in US, daily cash withdrawal is $500.
10. Credit Cards
In India, if you have decent pay package, then you are eligible for credit card with
very attractive bonus. In US, even if you have good pay package and do not have credit
history, then no bank would offer credit card.
2.29 International Banking

International banking enables people who live or work abroad to manage their finances
in one central location. By keeping your money in one place, it allows you to make
transfers and payments in several currencies from a stable and secure offshore jurisdiction.
Providing you with a link between all of your banking arrangements, you can be in complete
control of your money, wherever you are in the world.
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2.30 Benefits of Having an International Banking
Notes
(a) There are many advantages to opening an international bank account with
Standard Bank Isle of Man.
(b) Safe and secure global access to your money 24/7.
(c) Quick and easy transfers in multiple currencies gives you greater flexibility over
your finances.
(d) Simple and convenient to operate and offers one central location for all your
banking requirements.
(e) Unlimited access to foreign exchange.
(f) Provides security against exchange rate fluctuations.
(g) Grow and protect your money in a stable offshore jurisdiction on the Isle of Man.
(h) Confidential service wherever you are in the world.
2.31 Banking Operations

Banking operations are the legal transactions executed by a bank in its daily
business, such as providing loans, mortgages and investments, depending on the focus
and size of the bank.
Retail banking is the banking that almost every reader will find most familiar. Retail
banking is the business of making consumer loans, mortgages and the like, taking
deposits and offering products such as checking accounts and CDs. Retail banking
generally requires significant investment in branch offices, as well as other customer
service points of contact, like ATMs and bank tellers.
Retail banks frequently compete on convenience, the accessibility of branches and
ATMs for example, cost such as (interest rates, and account service fees, or some
combination of the two. Retail banks also attempt to market multiple services to customers
by encouraging customers who have a checking account to also open a savings account,
borrow through its mortgage loan office, transfer retirement accounts, and so on.
Business banking is not altogether that different than consumer retail banking;
operations still revolve around collecting deposits, making loans and convincing customers
to use other fee-generating services.
One of the primary differences is that business customers tend to have somewhat
more sophisticated demands from their banks, often leaning on banks for assistance in
managing their payables, receivables and other treasury functions. Business banking also
tends to be less demanding in terms of branch networks and infrastructure, but more
competitive in terms of rates and fees.
Private Banking is the shrinking number of independent financial institutions that
focus exclusively on private banking, as it is increasingly conducted as a department of
a larger bank. Private banking is a euphemism for banking and financial services offered
to wealthy customers, typically those with more than $1 million of net worth.
In addition to standard bank service offerings, like checking and savings accounts
and safe deposit boxes, private banks often offer a host of trust, tax and estate planning
services. Perhaps not surprisingly, the bank secrecy laws of countries like Switzerland
have made them attractive locations for conducting private banking.
98
Notes
2.32 Retail Banking

Retail banking is the provision of services by a bank to individual consumers, rather
than to companies, corporations or other banks. Services offered include savings and
transactional accounts, mortgages, personal loans, debit cards, and credit cards.
All over the world, there is a shift in the economy from the manufacturing to the service
sector. The contribution of banking to the service economy is duly recognized. Banking
industry includes a number of businesses such as corporate banking, investment banking,
wealth management, capital market, etc. Retail banking is another segment of the banking
industry. It is a typical mass market banking characterized by a large customer base
and a large volume of transactions. There is a high level of cooperation between banks,
retailers, customers and consumers in this segment. Retail banking has brought in a
drastic make over in the overall banking scenario in India. The exceptional improvement
in the banking system in India is a result of strong initiatives taken up by both the
government and private companies. Retail Banking has been the new focus of the banking
industry across the world. The emergence of new economies and their rapid growth has
been the most important contributing factor behind this resurgence in Retail Banking.
Changing lifestyles, fast improvement in information technology, other service sectors and
increasing levels of income have contributed to the growth of retail banking in countries
like India that are developing at a good pace. In India, the Retail Banking scenario has
been the market changing from a sellers market to a buyers market.
Retail banks offer services like account opening, credit card, debit card, ATM, internet
banking, phone banking, insurance, investment, stock broking and so on. Retail banking
refers to the dealing of commercial banks with individual customers, both on liabilities
and assets sides of the balance sheet. Fixed/current/saving accounts on the liabilities
side, and mortgages loans (e.g., personal, housing, auto and educational on the assets
side, are the important products offered by banks). Related ancillary services include credit
cards or depository services. Retail banking refers to provision of banking services to
individuals and small business where the financial institutions are dealing with large number
of low value transactions. This is in contrast to whole sale banking where the customers
are large, often multinational companies, governments and government enterprises and
the financial institution deal in small number of high value transaction.
The concept of Retail Banking is not new to banks but is now viewed as an important
and attractive market segment that offers opportunities for growth and profits. Retail
banking and retail lending are often used as synonyms but in fact, the later is just the
part of retail banking. In retail banking, all the needs of individual customers are taken
care of in a well integrated manner. Retail banking in the country is characterized by
multiple products, multiple channels and multiple customer groups. This multiplicity of
the roles to be played by the retail bankers adds to the excitement as well as the
challenges faced by the bankers.
2.33 Meaning of Retail Banking

Retail banking is typically mass market banking where individual customers use local
branches of larger commercial banks. Services offered include savings and checking
accounts, mortgages, personal loans, debit cards, credit cards and so.
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2.34 Retail Banking in India
Notes
The Indian Banks are competing with one another to grab a pie of the retail banking
sector, which has tremendous potential as retail loans constitute only 8% of GDP in India,
whereas their percentage is about 35 in other Asian economies. Retail banking
environment today is changing fast. The changing customer demographics demands that
create a differentiated application based on scalable technology, improved service and
banking convenience. Higher penetration of technology and increase in global literacy
levels has set up the expectations of the customer higher than never before. Increasing
use of modern technology has further enhanced reach and accessibility. The market today
gives us a challenge to provide multiple and innovative contemporary services to the
customer through a consolidated window so as to ensure that the banks customer gets
Uniformity and Consistency of service delivery across time and at every touch point
across all channels. The pace of innovation is accelerating and security threat has become
prime of all electronic transactions. High cost structure rendering mass-market servicing
is prohibitively expensive. Present-day tech-savvy bankers are now more looking at
reduction in their operating costs by adopting scalable and secure technology thereby
reducing the response time to their customers so as to improve their client base and
economies of scale. The solution lies to market demands and challenges lies in innovation
of new offering with minimum dependence on branches a multi-channel bank, and to
eliminate the disadvantage of an inadequate branch network. Generation of leads to cross
sell and creating additional revenues with utmost customer satisfaction has become focal
point worldwide for the success of a Bank. Traditional lending to the corporate are slow
moving along with high NPA risk, treasure profits are now losing importance; hence, Retail
Banking is now an alternative available for the banks for increasing their earnings. Retail
Banking is an attractive market segment having a large number of varied classes of
customers. Retail Banking focuses on individual and small units. Customized and wide
ranging products are available. The risk is spread and the recovery is good. Surplus
deployable funds can be put into use by the banks. Products can be designed, developed
and marketed as per individual needs.
Currently retail banking is helping the banks in boosting their profit. As reported in
Financial Express, the banking sector witnesses during the period ended June 2010, with
their growth rising at 54.8%. A rise in commercial and retail lending rates, growth in feebased income and lower provisioning helped banks boost their profits.
2.35 Features of Retail Banking

One of the prominent features of Retail Banking products is that it is a volume driven
business. Further, Retail Credit ensures that the business is widely dispersed among a
large customer base unlike in the case of corporate lending, where the risk may be
concentrated on a selected few plans. Ability of a bank to administer a large portfolio
of retail credit products depends upon such factors:
1. Strong credit assessment capability
Because of large volume good infrastructure is required. If the credit assessment
itself is qualitative, then the need for follow up in the future reduces considerably.
2. Sound documentation
A latest system for credit documentation is necessary pre-requisite for healthy growth
of credit portfolio, as in the case of credit assessment. This will also minimize the need
to follow up at future point of time.
100
Notes
3. Strong possessing capability

Since large volumes of transactions are involved, today transactions, maintenance
of backups is required.
4. Regular constant follow- up
Ideally, follow up for loan repayments should be an ongoing process. It should start
from customer enquiry and last till the loan is repaid fully.
5. Skilled human resource
This is one of the most important pre-requisite for the efficient management of large
and diverse retail credit portfolio. Only highly skilled and experienced man power can
withstand the river of administrating a diverse and complex retail credit portfolio.
6. Technological support
This is yet another vital requirement. Retail credit is highly technological and intensive
in nature. Because of large volumes of business, the need to provide instantaneous service
to the customer, faster processing, maintaining database, etc. is imperative.
2.36 Scope for Retail Banking in India

Scope for Retail Banking in India can be summarized as follows:
1. All-round increase in economic activity.
2. Increase in the purchasing power. The rural areas have the large purchasing
power at their disposal and this is an opportunity to market Retail Banking.
3. India has 200 million households and 400 million middle class population more
than 90% of the savings come from the house hold sector. Falling interest rates
have resulted in a shift. Now People Want to Save Less and Spend More.
4. Nuclear family concept is gaining much importance which may lead to large
savings, large number of banking services to be provided are day-by-day
increasing.
5. Tax benefits are available, for example, in case of housing loans the borrower
can avail tax benefits for the loan repayment and the interest charged for the
loan.
2.37 Retail Banking Activities

Banks activities can be divided into retail banking, dealing directly with individuals;
business banking, providing services to mid-size business; corporate banking dealing with
large business entities; private banking, providing wealth management services to High
Net worth Individuals; and investment banking, relates to helping customers raise funds
in the Capital Markets and advising on mergers and acquisitions.
1. Internet Banking (E-Banking)
Internet banking (or E-banking) means any user with a personal computer and
browser can get connected to his banks website to perform any of the virtual banking
functions. In internet banking system the bank has a centralized database that is web
enabled.
2. Information System
General purpose information like interest rates, branch location, bank products and
their features, loan and deposit calculations are provided in the banks website.
101
3. Fully Electronic Transactional System
Notes
The system provides customer- specific information in the form of account balances,
transaction details and statement of accounts. This system allows bi-directional
capabilities. Transactions can be submitted by the customer for online update. This
system requires high degree of security and control.
4. Automated Teller Machine (ATM)
ATM is designed to perform the most important function of bank. It is operated by
plastic card with its special features. The plastic card is replacing cheques, personal
attendance of the customer, banking hours restrictions and paper based verification.
5. Credit Cards/Debit Cards
The Credit Card holder is empowered to spend wherever and whenever he wants with
his Credit Card within the limits fixed by his bank. Credit Card is a post-paid card. Debit
Card, on the other hand, is a prepaid card with some stored value.
6. Smart Card
Banks are adding chips to their current magnetic stripe cards to enhance security
and offer new service, called Smart Cards. Smart Cards allow thousands of times of
information storable on magnetic stripe cards.
7. Core Banking Solutions
Core Banking Solutions is new jargon frequently used in banking circles. The
advancement in technology especially internet and information technology has led to new
way of doing business in banking.
2.38 Wholesale Banking

Wholesale banking is the provision of services by banks to organizations such as
mortgage brokers, large corporate clients, mid-sized companies, real estate developers
and investors, international trade finance businesses, institutional customers (such as
pension funds and government entities/agencies), and services offered to other banks or
other financial institutions.
Wholesale banking involves providing banking services to other commercial banks,
mortgage brokers, large corporate, mid-size companies, real estate developers,
international trading businesses, institutional customers or other corporations. The
services which come under the net of wholesale banking involves wholesaling, underwriting,
market making, consultancy, mergers and acquisitions, joint ventures, fund management
etc. The focus is on high-level clients and high-value transactions.
2.39 Wholesale Banking in India

Wholesale banking in India is set for a period of sharp growth. Revenues from
wholesale banking activities are likely to more than double over the next five years as
infrastructure investment, expansion by Indian companies overseas, and further
Indianization of multinational businesses, among other trends, drive new business.
Foreign players and the countrys domestic banks, however, will find themselves in a tough
commercial environment and must overcome a range of challenges if they are to maintain,
or assume, a leading position in the market.
Prospects for Indias wholesale banking market are intriguing. Wholesale banking
revenues, which in India account for close to 30% of total banking revenues, are expected
102
Notes
to more than double, from roughly $16 billion in fiscal 2010 to between $35 billion and
$40 billion by 2015. McKinseys analysis shows that returns on equity are typically in
the range of 15% to 30%.
India presents a strong case for the growth of wholesale banking due to continued
globalization of Indian companies, India being seen as a favorable investment destination,
increase in infrastructure spending, stable government, robust markets, stable currency,
low deficits, etc. Wholesale banking thus comprises a major share of the banking revenues
due to the above factors and also due to an increased inclination of government towards
mid-segment companies which have increasing banking requirements. In wholesale
banking too, it is the corporate banking which comprises a lions share, i.e., about 85%.
Likewise, with the rebound of economy and a positive outlook, the possibility of a growth
in investment banking, M&A, etc. is highly likely. Wholesale clientele for banks are highly
significant for banks to drive business. Banks provide various forms of banking solutions
like project finance, leasing finance, working capital finance, merchant banking,
syndication services, etc. are also provided to clients The major advantage in wholesale
banking is that a client can have easy and one-place access to all its finances and their
details. This makes internal stock transfers, fund transfers, allocations and distributions
simpler. It however, it increases the risk it poses to the clients as all their funds are parked
in one institution and the businesses depend on the financial health of the bank for smooth
run. In cases of economic downturns, if the banks crash, all the dependent businesses
come to a standstill instantly. Thus, businesses usually diversify into several financial
institutions to remain afloat during any crisis. The major Indian Banks which are involved
in wholesale banking are SBI, ICICI, IDBI Bank, Canara Bank, Bank of India, Punjab
National Bank, Bank of Baroda, Central Bank of India, etc.
Wholesale banking includes high ticket exposures primarily to corporates. Internal
processes of most banks classify wholesale banking into mid corporates and large
corporates according to the size of exposure to the clients. A large portion of wholesale
banking clients also account for off balance sheet businesses. Hedging solutions form
a significant portion of exposures coming from corporates. Hence, wholesale banking
clients are strategic for the banks with the view to gain other business from them. Various
forms of financing, like project finance, leasing finance, finance for working capital, term
finance, etc. form part of wholesale banking transactions. Syndication services and
merchant banking services are also provided to wholesale clients in addition to the variety
of products and services offered.
Wholesale banking is also a well diversified banking vertical. Most banks have a
presence in wholesale banking. But this vertical is largely dominated by large Indian banks.
While a large portion of the business of foreign banks comes from wholesale banking,
their market share is still smaller than that of the larger Indian banks. A number of large
private players among Indian banks are also very active in this segment.
2.40 Near Banks

Financial intermediaries are all institutions that accept deposits from individuals,
businesses and governments and lend funds to borrowers. They include savings banks,
trust and mortgage loan companies, credit unions and caisses populaires. Their functions
are similar to those of the chartered banks; they are often referred to as near banks.
103
Notes
2.41 Universal Banking

Universal Banking is a banking system in which banks provide a wide variety of
financial services, including both commercial and investment services. Universal banking
is common in some European countries, including Switzerland. In the United States,
however, banks are required to separate their commercial and investment banking services.
Proponents of universal banking argue that it helps banks better diversify risk. Detractors
think dividing up banks operations is a less risky strategy.
Universal banks may offer credit, loans, deposits, asset management, investment
advisory, payment processing, securities transactions, underwriting and financial analysis.
While a universal banking system allows banks to offer a multitude of services, it does
not require them to do so. Banks in a universal system may still choose to specialize
in a subset of banking services.
2.42 Advantages of Universal Banking

The advantages of universal banking are:
1. Investors Trust
Universal banks hold stakes (equity shares) of many companies. These companies
can easily get other investors to invest in their business. This is because other investors
have full confidence and faith in the Universal banks. They know that the Universal banks
will closely watch all the activities of the companies in which they hold a stake.
2. Economies of Scale
Universal banking results in economic efficiency. That is, it results in lower costs,
higher output and better products and services. In India, RBI is in favor of universal banking
because it results in economies of scale.
3. Resource Utilization
Universal banks use their clients resources as per the clients ability to take a risk.
If the client has a high risk taking capacity then the universal bank will advise him to
make risky investments and not safe investments. Similarly, clients with a low risk taking
capacity are advised to make safe investments. Today, universal banks invest their clients
money in different types of Mutual funds and also directly into the share market. They
also do equity research. So, they can also manage their clients portfolios (different
investments) profitably.
4. Profitable Diversification
Universal banks diversify their activities. So, they can use the same financial experts
to provide different financial services. This saves cost for the universal bank. Even the dayto-day expenses will be saved because all financial services are provided less than one
roof, i.e., in the same office.
5. Easy Marketing
The universal banks can easily market (sell) all their financial products and services
through their many branches. They can ask their existing clients to buy their other products
and services. This requires less marketing efforts because of their well-established brand
name. For example, ICICI may ask their existing bank account holders in all their branches,
to take house loans, insurance, to buy their mutual funds, etc. This is done very easily
because they use one brand name (ICICI) for all their financial products and services.
104
Notes
6. One-stop Shopping
Universal banking offers all financial products and services under one roof. One-stop
shopping saves a lot of time and transaction costs. It also increases the speed or flow
of work. So, one-stop shopping gives benefits to both banks and their clients.
2.43 Disadvantages of Universal Banking

The disadvantages of universal banking are:
1. Different Rules and Regulations
Universal banking offers all financial products and services under one roof. However,
all these products and services have to follow different rules and regulations. This creates
many problems. For example, Mutual Funds, Insurance, Home Loans, etc. have to follow
different sets of rules and regulations, but they are provided by the same bank.
2. Effect of Failure on Banking System
Universal banking is done by very large banks. If these huge banks fail, then it will
have a very big and bad effect on the banking system and the confidence of the public.
For example, recently, Lehman Brothers a very large universal bank failed. It had very
bad effects in the USA, Europe and even in India.
3. Monopoly
Universal banks are very large. So, they can easily get monopoly power in the market.
This will have many harmful effects on the other banks and the public. This is also harmful
to economic development of the country.
4. Conflict of Interest
Combining commercial and investment banking can result in conflict of interest. That
is, Commercial banking versus Investment banking. Some banks may give more
importance to one type of banking and give less importance to the other type of banking.
However, this does not make commercial sense.
2.44 Non-Banking Financial Company (NBFC)

Non-banking financial companies, or NBFCs, are financial institutions that provide
banking services, but do not hold a banking license. These institutions are not allowed
to take deposits from the public. Nonetheless, all operations of these institutions are still
covered under banking regulations.
NBFCs do offer all sorts of banking services, such as loans and credit facilities,
retirement planning, money markets, underwriting and merger activates. The number of
non-banking financial companies has expanded greatly in the last several years as venture
capital companies, retail and industrial companies have entered the lending business.
Non-banking financial companies (NBFCs) are fast emerging as an important
segment of Indian financial system. It is an heterogeneous group of institutions (other than
commercial and cooperative banks) performing financial intermediation in a variety of ways,
like accepting deposits, making loans and advances, leasing, hire purchase, etc. They
raise funds from the public, directly or indirectly, and lend them to ultimate spenders.
They advance loans to the various wholesale and retail traders, small-scale industries and
self-employed persons. Thus, they have broadened and diversified the range of products
and services offered by a financial sector. Gradually, they are being recognized as
105
complementary to the banking sector due to their customer-oriented services; simplified

procedures; attractive rates of return on deposits; flexibility and timeliness in meeting the
credit needs of specified sectors; etc.
Notes
The working and operations of NBFCs are regulated by the Reserve Bank of India
(RBI) within the framework of the Reserve Bank of India Act, 1934 (Chapter IIIB) and the
directions issued by it under the Act. As per the RBI Act, a non-banking financial company
is defined as: (i) a financial institution which is a company; (ii) a non-banking institution
which is a company and which has as its principal business the receiving of deposits,
under any scheme or arrangement or in any other manner, or lending in any manner;
(iii) such other non-banking institution or class of such institutions, as the bank may, with
the previous approval of the Central Government and by notification in the Official Gazette,
specify.
Under the Act, it is mandatory for a NBFC to get itself registered with the RBI as
a deposit taking company. This registration authorizes it to conduct its business as an
NBFC. For the registration with the RBI, a company incorporated under the Companies
Act, 1956 and desirous of commencing business of non-banking financial institution,
should have a minimum net owned fund (NOF) of ` 25 lakh (raised to ` 200 lakh w.e.f.
April 21, 1999). The term NOF means, owned funds (paid-up capital and free reserves,
minus accumulated losses, deferred revenue expenditure and other intangible assets) less,
(i) investments in shares of subsidiaries/companies in the same group/all other NBFCs;
and (ii) the book value of debentures/bonds/outstanding loans and advances, including hirepurchase and lease finance made to, and deposits with, subsidiaries/companies in the
same group, in excess of 10% of the owned funds.
The registration process involves submission of an application by the company in
the prescribed format along with the necessary documents for RBIs consideration. If the
bank is satisfied that the conditions enumerated in the RBI Act, 1934 are fulfilled, it issues
a Certificate of Registration to the company. Only those NBFCs holding a valid Certificate
of Registration can accept/hold public deposits. The NBFCs accepting public deposits
should comply with the Non-Banking Financial Companies Acceptance of Public Deposits
(Reserve Bank) Directions, 1998, as issued by the bank. Some of the important regulations
relating to acceptance of deposits by the NBFCs are:
(a) They are allowed to accept/renew public deposits for a minimum period of
12 months and maximum period of 60 months.
(b) They cannot accept deposits repayable on demand.
(c) They cannot offer interest rates higher than the ceiling rate prescribed by RBI
from time to time.
(d) They cannot offer gifts/incentives or any other additional benefit to the
depositors.
(e) They should have minimum investment grade credit rating.
(f) Their deposits are not insured.
(g) The repayment of deposits by NBFCs is not guaranteed by RBI.
The types of NBFCs registered with the RBI are:
(i) Equipment leasing company is any financial institution whose principal
business is that of leasing equipments or financing of such an activity.
(ii) Hire-purchase company is any financial intermediary whose principal
business relates to hire purchase transactions or financing of such transactions.
(iii) Loan company means any financial institution whose principal business is that
of providing finance, whether by making loans or advances or otherwise for any
106
Notes
activity other than its own (excluding any equipment leasing or hire-purchase
finance activity).
(iv) Investment company is any financial intermediary whose principal business
is that of buying and selling of securities.
2.45 Summary
A financial intermediary is a financial institution that connects surplus and deficit
Financial Intermediaries are the firms that provide services and products which
customers may not be able to get more efficiently by themselves in final markets. In other
words, they act as middlemen between investors and borrowers in financial system.
Financial intermediary is a financial institution such as bank, building society,
insurance company, and investment bank or pension fund. A financial intermediary offers
a service to help an individual/firm to save or borrow money. A financial intermediary helps
to facilitate the different needs of lenders and borrowers.
Commercial bank is a profit-seeking business firm, dealing in money and credit. It
is a financial institution dealing in money in the sense that it accepts deposits of money
from the public to keep them in its custody for safety. So, it deals in credit, i.e., it creates
credit by making advances out of the funds received as deposits to needy people. It thus,
functions as mobilizer of savings in the economy. A bank is, therefore like a reservoir
into which how the savings, the idle surplus money of households and from which loans
are given on interest to businessmen and others who need them for investment or
productive uses. Commercial bank being the financial institution performs diverse types
of functions. It satisfies the financial needs of the sectors such as agriculture, industry,
trade, communication, etc. That means they play a very significant role in a process of
economic and social needs. The functions performed by banks are changing according
to changes in time and recently they are becoming customer centric and widening their
functions. Generally the functions of commercial banks are divided into two categories,
viz., primary functions and the secondary functions.
Commercial bank refers to a bank that lends money and provides transactional,
savings, and money market accounts and that accepts time deposit. A commercial bank
is a type of financial institution and intermediary. Commercial banks engage for providing
documentary and standby letter of credit, guarantees, performance bonds, securities
underwriting commitments and other forms of off balance sheet exposures.
Public Sector Banks (PSBs) are banks where a majority stake (i.e., more than
50%) is held by a government. The shares of these banks are listed on stock exchanges.
The Central Government entered the banking business with the nationalization of the
Imperial Bank of India in 1955. A 60% stake was taken by the Reserve Bank of India
and the new bank was named as the State Bank of India. The seven other state banks
became the subsidiaries of the new bank when nationalized on 19 July 1960. The next
major nationalization of banks took place in 1969 when the government of India, under
Prime Minister Indira Gandhi, nationalized an additional 14 major banks. The total deposits
in the banks nationalized in 1969 amounted to 50 crores. This move increased the
presence of nationalized banks in India, with 84% of the total branches coming under
government control.
107
Private sector banks in India are all those banks where greater parts of stake or equity
are held by the private shareholders and not by government. These are the major players
in the banking sector as well as in expansion of the business activities India. The present
private sector banks equipped with all kinds of contemporary innovations, monetary tools
and techniques to handle the complexities are a result of the evolutionary process over two
centuries. They have a highly developed organizational structure and are professionally
managed. Thus, they have grown faster and stronger since past few years.
Notes
Private sector banks have been functioning in India since the very beginning of the
banking system. Initially, during 1921, the private banks like bank of Bengal, bank of
Bombay and bank of Madras were in service, which all together formed Imperial Bank
of India.
Reserve Bank of India (RBI) came in picture in 1935 and became the centre of every
other bank taking away all the responsibilities and functions of Imperial bank. Between
1969 and 1980, there was rapid increase in the number of branches of the private banks.
In April 1980, they accounted for nearly 17.5% of bank branches in India. In 1980, after
6 more banks were nationalized, about 10% of the bank branches were those of private
sector banks. The share of the private bank branches stayed nearly same between 1980
and 2000. Then from the early 1990s, RBIs liberalization policy came in picture and with
this the government gave licences to a few private banks, which came to be known as
new private sector banks.
Loans are made against personal security, gold and silver, stocks of goods and other
assets. The second primary function of a commercial bank is to make loans and advances
to all types of persons, particularly to businessmen and entrepreneurs.
Credit creation is the multiple expansions of banks demand deposits. It is an open
secret now that banks advance a major portion of their deposits to the borrowers and keep
smaller parts of deposits to the customers on demand. Even then the customers of the
banks have full confidence that the depositors lying in the banks is quite safe and can
be withdrawn on demand.
ATM is a channel of banking service to its customers. Its traditional and primary use
is to dispense cash upon insertion of a plastic card and its unique PIN, i.e., Personal
Identification Number. The banks issue ATM card to their customers having current or savings
account holding a certain minimum balance in their accounts. ATM card is a plastic card
with a magnetic strip with the account number of the individuals. When the card is inserted
into the machine the sensing equipment of the machine identifies the account holder and
asks his PIN. It is a secret number which is known only to the account holder.
Industrial Bank is a financial institution with a limited scope of services. Industrial
banks sell certificates that are labeled as investment shares and also accept customer
deposits. They then invest the proceeds in installment loans for consumers and small
businesses. These banks are also known as Morris Banks or industrial loan companies.
A unit bank is one, which conducts its banking operations through a single office
within a strictly limited area or with a limited number of offices in that area. It is essentially
a localized system. Group banking is that system of banking under which two or more
banks are directly or indirectly controlled by an association, trust, or corporation. This
type of banking is also known as holding company banking. The holding company holds
the majority shares in the companies under its control and the companies whose shares
are held by the holding company are known as subsidiary companies.
Exchange banks are those banks maintain the facilities to finance mostly for the
foreign trade of a country. Their main function is to discount, accept and collect foreign
108
Notes
bills of exchange. They buy and sell foreign currency and thus help businessmen in their
transactions. They also carry on the ordinary banking business.
The Reserve Bank of India is the central banking institution of India and controls the
monetary policy of the rupee as well as US$ 300.21 billion (2010) of currency reserves.
The institution was established on 1 April 1935 during the British Raj in accordance with
the provisions of the Reserve Bank of India Act, 1934 and plays an important part in the
development strategy of the government. It is a member bank of the Asian Clearing Union.
A cooperative bank is a financial entity which belongs to its members, who are at
the same time the owners and the customers of their bank. Cooperative banks are often
created by persons belonging to the same local or professional community or sharing a
common interest. Cooperative banks generally provide their members with a wide range
of banking and financial services (loans, deposits, banking accounts, etc.).
Urban Cooperatives can be further divided into scheduled and non-scheduled. Both
the categories are further divided into multi-state and single-state. Majority of the banks
are fall in the non-scheduled and single-state category. Banking activities of Urban
Cooperative Banks are monitored by RBI. Registration and Management activities are
managed by Registrar of Cooperative Societies (RCS). These RCS operate in single-state
and Central RCS (CRCS) operate in multiple state.
The rural cooperatives are further divided into short-term and long-term structures.
The short-term cooperative banks are three tiered operating in different states. These are:
State Cooperative Banks They operate at the apex level in states. District Central
Cooperative Banks They operate at the district levels. Primary Agricultural Credit
Societies They operate at the village or grass-root level.
International banking enables people who live or work abroad to manage their finances
in one central location. By keeping your money in one place, it allows you to make
transfers and payments in several currencies from a stable and secure offshore jurisdiction.
Providing you with a link between all of your banking arrangements, you can be in complete
control of your money, wherever you are in the world.
Retail banking is the provision of services by a bank to individual consumers, rather
than to companies, corporations or other banks. Services offered include savings and
transactional accounts, mortgages, personal loans, debit cards, and credit cards.
Retail banking is typically mass market banking where individual customers use local
branches of larger commercial banks. Services offered include savings and checking
accounts, mortgages, personal loans, debit cards, credit cards and so.
Wholesale banking is the provision of services by banks to organizations such as
Mortgage Brokers, large corporate clients, mid-sized companies, real estate developers
other financial institutions.
Financial intermediaries are all institutions that accept deposits from individuals,
businesses and governments and lend funds to borrowers. They include savings banks,
trust and mortgage loan companies, credit unions and caisses populaires. Their functions
are similar to those of the chartered banks; they are often referred to as near banks.
Universal Banking is a banking system in which banks provide a wide variety of
financial services, including both commercial and investment services. Universal banking
is common in some European countries, including Switzerland. In the United States,
however, banks are required to separate their commercial and investment banking services.
109
Proponents of universal banking argue that it helps banks better diversify risk. Detractors
think dividing up banks operations is a less risky strategy.
Notes
Non-banking financial companies, or NBFCs, are financial institutions that provide

banking services, but do not hold a banking license. These institutions are not allowed
to take deposits from the public. Nonetheless, all operations of these institutions are still
covered under banking regulations.

1. __________ is a financial institution such as bank, building society, insurance
company, and investment bank or pension fund.
2. Commercial bank is a profit-seeking business firm, dealing in __________.
3. __________ are banks where a majority stake (i.e., more than 50%) is held
by a government.
4. Private sector banks in India are all those banks where greater parts of stake
or equity are held by the private shareholders and not by __________.
5. __________ banking is that system of banking under which two or more banks
are directly or indirectly controlled by an association, trust, or corporation.
6. A cooperative bank is a financial entity which belongs to its members, who are
at the same time the owners and the customers of their __________.
II. True or False
1. A financial intermediary is a financial institution that connects surplus and deficit
agents.
2. Commercial bank being the financial institution performs diverse types of
functions.
3. SBI came in picture in 1935 and became the centre of every other bank taking
away all the responsibilities and functions of Imperial bank.
4. Credit Card is the multiple expansions of banks demand deposits.
5. Industrial Bank is a financial institution with a limited scope of services.
6. The rural cooperatives are further divided into short-term and long-term
structures.
7. Retail banking is the provision of services by a bank to individual consumers,
rather than to companies, corporations or other banks.
8. Wholesale banking is the provision of services by banks to organizations such
as Mortgage Brokers, large corporate clients, mid-sized companies, real estate
developers and investors, international trade finance businesses, institutional
customers.
1. Which of the following is a financial institution that connects surplus and deficit
agents?
(a) Financial intermediary
(b) Banks
(c) Industry
(d) All the above
110
Notes
2. A commercial bank is a type of __________.

(a) Financial institution
(b) Intermediary
(d) None of these
3. Public Sector Banks (PSBs) are banks stake __________.
(a) More than 50%
(b) Less than 50%
(c) 50% only
(d) None of these

1. What is Financial Intermediary?
2. What is Commercial Bank?
3. State any two functions of Commercial Banks.
4. What is Central Bank?
5. What is Cooperative Bank?
6. What is International Banking?
7. Give the meaning of Retail Banking.
8. What is Wholesale Banking?
9. What is Near Bank?
10. What is Universal Banking?
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Discuss the classification of Financial Intermediaries.

Explain various functions of Financial Intermediaries.
Discuss the significance of Commercial Banks.
Explain the structure of Commercial Bank in India.
Explain the functions of Commercial Banks.
Discuss the Functional Departments of RBI.
Explain Banking system in USA and India.
Discuss the Retail Banking in India.
Explain various features of Retail Banking.
Discuss the Wholesale Banking in India.
Explain various advantages of Universal Banking.
Discuss about Non-Banking Financial Company.
2.48 Key Terms

z
Financial Intermediary: financial intermediary is a financial institution that

connects surplus and deficit agents.
111
Commercial Bank: Commercial bank is a profit-seeking business firm, dealing

in money and credit.
Public Sector Banks: Public Sector Banks (PSBs) are banks where a majority
stake (i.e., more than 50%) is held by a government.
Private-sector Banks: Private-sector banks are all those banks where greater
parts of stake or equity are held by the private shareholders and not by
government.
Credit creation: Credit creation is the multiple expansions of banks demand

deposits. It is an open secret now that banks advance a major portion of their
deposits to the borrowers and keep smaller parts of deposits to the customers
on demand.
Group Banking: Group banking is that system of banking under which two
or more banks are directly or indirectly controlled by an association, trust or
corporation.
Notes

1. Financial intermediary
2. Money and credit
3. Public Sector Banks (PSBs)
4. Government
5. Group
6. Bank
II. True or False
1. True
2. True
3. False
4. False
5. True
6. True
7. True
8. True
1. (a) Financial intermediary
2. (c) Both (a) and (b)
3. (a) More than 50%
2.50 Case Study

A 20-year old university student, Mr. D, lived at home and worked full-time in a local
supermarket during the vacations. He had a part-time job at the same supermarket during
term-time.
Mr. D applied successfully to his bank for a loan of 2,500, in order to buy and insure
a second-hand motorbike. But as soon as he told his mother about the loan, she
112
Notes
complained to the bank. She said its decision to lend her son the money had been "illjudged and irresponsible" and that it had taken advantage of her sons inexperience.
Mrs. D told the bank that her son had planned to go travelling for a year after he
graduated. She was concerned that the loan repayments would not only prevent him from
saving money for his travels, but also leave him short of cash. She also believed that,
by lending him the money, the bank had actively encouraged her son to buy a powerful
motorbike.
Mrs. D thought the bank should write-off the loan and take the motorbike in exchange.
The bank disagreed, so - with her sons knowledge and agreement Mrs. D brought the
dispute to us on his behalf.
Question:
1. As a bank manager, how to rectify the ill-judged and irresponsible?

Ryerson.
2. Banking through the Ages by Hoggson, N.F., New York, Dodd, Mead &
Company.
W.C and Tolbert S.M., Oxford University Press.
2.52 Bibliography
1. Kem, H.J. (2005), Global Retail Banking: Changing Paradigms, Chartered
Financial Analyst, ICFAI Press, Hyderabad, Vol. XI, No. 10, pp. 56-58.
2. Neetu Prakash, (2006), Retail Banking in India, ICFAI University Press,
Hyderabad pp. 2-10.
3. Dhanda Pani Alagiri (2006), Retail Banking Challenges, ICFAI University
Press, Hyderabad, pp. 25-34.
4. Manoj Kumar Joshi (2007). Growth Retail Banking in India, ICFAI University
5. Manoj Kumar Joshi (2007), Customer Services in Retail Banking in India, ICFAI
University Press, Hyderabad, pp. 59-68.
6. S. Santhana Krishnan (2007), Role of Credit Information in Retail Banking: A
Business Catalyst, ICFAI University Press, Hyderabad, pp. 68-74.
7. Sunil Kumar (2008), Retail Banking in India, Hindustan Institute of
Management and Computer Studies, Mathura.
8. Divanna, J.A. (2009), The Future Retail Banking", Palgrave Macmillan, New
York.
9. Birendra Kumar (2009), Performance of Retail Banking in India, Asochem
Financial Pulse (AFP), India.
10. Sapru R.K. (1994), Development Administration, Sterling, New Delhi.
Evaluation of Industrial Projects, Oxford and IBH, New York.
113
978-0470050828).
978-0465024995).
New York (ISBN 978-0470463383).
978-0631185086).
Ltd. (ISBN 0-333-76447-1).
Notes
114
Notes
Unit 3:
Norms and Practices in the

Banking Industry
Structure:
3.1 Introduction
3.2 Meaning of Bank Lending
3.3 Principles of Lending
3.4 Five Cs of Lending Principles
3.5 Forms of Lending
3.6 Types of Lending
3.7 Lending Facilities Granted by Banks
3.8 Who are the Borrowers?
3.9 Study of Borrowers
3.10 Balance Sheet Analysis
3.11 Goal of Balance Sheet Analysis
3.12 How to Perform a Balance Sheet Analysis?
3.13 Project Appraisal
3.14 Checklist for Project Appraisal
3.15 Project Appraisal Criteria
3.16 Marketing of Bank Services
3.17 Importance of Bank Marketing
3.18 Marketing Approach in Banks
3.19 Features of Bank Marketing
3.20 Prudential Norms
3.21 Prudential Guidelines on Restructuring of Advances
3.22 Narasimham Committee Recommendations
3.23 Recommendations of the Committee
3.24 Highlights of Narasimham Committee Recommendations on Banking Reforms
in India
3.25 Performance Analysis of Banks
3.26 Regulatory Institutions in India
3.27 Reserve Bank of India
3.28 Credit Control
3.29 Meaning of Credit Control
3.30 Objectives of Credit Control
3.31 Need for Credit Control
3.32 Methods of Credit Control
3.33 RBI Publications
3.34 Securities and Exchange Board of India
3.35 Organization of SEBI
Norms and Practices in the Banking industry
115
3.36 Management of the Board
Notes
3.37 Objectives of SEBI

3.38 Functions of SEBI
3.39 Powers of Securities and Exchange Board of India
3.40 Lenders Liability Act
3.41 Banking Innovations
3.42 Basel Committee Recommendations
3.43 Capital Adequacy Ratio (CAR)
3.44 Risk Weighted Assets
3.45 Risk Based Supervision
3.46 Asset Liability Management (ALM) in Commercial Banks
3.47 Benefits of ALM
3.48 Corporate Debt Restructuring
3.49 E-Banking
3.50 Development of E-Banking in India
3.51 E-Banking Services
3.52 Internet Banking
3.53 Internet Banking in India
3.54 Advantages of Internet Banking
3.55 Disadvantages of Internet Banking
3.56 Tele Banking
3.57 Online Banking
3.58 Core Banking
3.59 Mobile Banking
3.60 E-Banking Risk
3.61 Types of E-Banking Risk
3.62 E-finance
3.63 Electronic Money
3.64 Digital Signatures
3.65 How Digital Signatures Work?
3.66 RTGS
3.67 National Electronic Funds Transfer (NEFT)
3.68 Summary
3.71 Key Terms
3.73 Case Study
3.75 Bibliography
116
Notes
Objectives
z
Understand the overview of Principles of Lending
Detailed overview of Marketing of bank services
Detailed study of Narasimham Committee Recommendations
Regulatory Institutions RBI and SEBI
Understand the Banking Innovations
Understand the Capital Adequacy Ratio
Detailed study of Corporate Debt Restructuring
Understand the Internet Banking, Mobile Banking, E-Banking Risk and E-Finance
Detailed study of Electronic Money, Digital Signatures, RTGS and NEFT
3.1 INTRODUCTION
The successful banks operating within the financial system are those that consider
and coordinate basic principles of lending and monitor the activities of borrowers regularly.
The major business of banking company is to grant loans and advances to traders as
well as commercial and industrial establishment.
The most important use of banks money is lending. Yet, there are risks in lending.
While lending loans or advances, the banks usually keep such securities and assets as
support so that lending may be safe and secured. Suppose, any particular state is hit
by disaster, the bank gets advantage from lending to another states' units. Thus, the effect
on the entire business of banking is reduced.
The recent distress in the financial system witnessed more importantly in the banking
sector. Lending limit regulations restrict the total amount of loans and credits that a bank
may extend to a single borrower. This restriction is usually stated as a percentage of
the banks capital or assets.
It is widely held that a bank is an institution that accepts deposits from customers
and looks after their money, offers cheque books to customers to enable them to make
payments to others and provides other financial services which include lending. In a
nutshell, a banks major operation is the acceptance of deposits and granting of loans
to different kinds of customers.
The commercial banks engage in retail banking services through branch networks
and operate with a broad deposit base consisting of demand and time deposit. They provide
short-term lending. On the other hand, merchant banks are licensed to provide wholesale
banking, take deposit and arrange syndicated loan facilities for long term by pooling,
sometimes, a consortium of banks, including other financial institutions, to finance capital
intensive projects. From the foregoing, it is realized that banks are generally debtors; they
borrow money in order to lend them out to make profit. No bank can ever survive by just
being a custodian of deposit, but they exist by lending from the deposit on fixed interest
charged. Money lent on interest is always supposed to be secured on some guarantees
or security.
Since banks depend largely on lending, the need to adhere to the basic principles
of lending is quite inevitable. The principles, if strictly followed, will guarantee depositors
and shareholders funds, increase profitability and make a healthy turnover. Such advances
in turn assist in the transformation of rural environment, promote rapid expansion of banking
117
habit and improve and boost the nations economy. The basic considerations in bank
lending are the character of the client seeking loan from the bank. The client must be
an honest, upright customer whose record of transaction with the financial institution or
in the society is remarkable. The information on the character of the borrower could be
obtained through a completed form of his guarantor or his statement of account.
Notes
3.2 Meaning of Bank Lending

Bank lending refers to the process of disposing of money or property with the
expectation that the same thing will be returned. Credit is the provision of resources (such
as granting a loan) by one party to another party where that second party does not
reimburse the first party immediately, thereby generating a debt, and instead arranges
either to repay or return those resources (or material(s)) of equal value. Where the first
party would be the banker (lender or creditors) and the second party would be the customer
(borrower or debtor).
3.3 PRINCIPLES OF LENDING

Bank lending involves risk; banks need to follow certain basic principles at the time
of lending loans and advances. Some of the principles to be followed are:
1. Principle of Safety
Safety is the most important principle of good lending. When a banker lends, he
must feel certain that the advance is safe and the money will definitely come back. If
the borrower invests the money in an unproductive or speculative venture, or if the borrower
himself is dishonest, the advance would be in danger.
2. Principle of Liquidity
The borrower must be in a position to repay within a reasonable time after a demand
for repayment is made. This can be possible only if the money is employed by the borrower
for short-term requirements and not locked up in acquiring fixed assets, or in schemes
which take a long time to pay their way. This is the reason why bankers attach as much
importance to liquidity as to safety of their funds.
3. Principle of Purpose
The purpose should be productive so that the money not only remain safe but also
provides a definite source of repayment. The purpose should also be short termed so that
it ensures liquidity. Banks should discourage advances for hoarding stocks or for
speculative activities.
4. Principle of Profitability
Profitability is a financial benefit that is realized when the amount of revenue gained
from a business activity exceeds the expenses, costs and taxes needed to sustain the
activity. Banks must make profits because they have to pay interest on the deposits
received by them. They have to deserve expenses on establishment, rent, stationery, etc.
5. Principle of Security
It has been the practice of banks not to lend as far as possible except against
security. The banker carefully examines all the different aspects of an advance before
granting it.
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Notes
6. Principle of Spread
The principle of good lending is the diversification of advances. An element of risk
is always present in every advance. However, secure it might appear to be. In fact, the
entire banking business is one of taking calculated risks and a successful banker is an
expert in assessing such risks.
7. Principle of National Interest, Suitability, etc.
Even when an advance satisfies all good principles, it may still not be suitable. The
advance may run counter to national interest. The Central Bank may have issued a directive
prohibiting banks to allow a particular type of advance.
8. Principle of Ideal Advance
L.C. Mather describes an ideal advance as one which is granted to a reliable
customer for an approved purpose in which the customer has adequate experience, safe
in the knowledge that the money will be used to advantage and repayment will be made
within a reasonable period from trading receipts or known maturities due on or about given
dates.
3.4 FIVE CS OF LENDING PRINCIPLES

(a) Character
The character of the borrower indicates two things: the ability to pay versus the
willingness to pay. The ability to pay refers to the borrowers financial credibility to pay.
The lender should check on the borrowers character.
(b) Capacity
Capacity refers to the sources of repayment, i.e., the cash flow. The borrower must
be able to meet all his financial obligations on the due dates.
(c) Capital
Capital represents the degree of commitment and the ability to sustain this
commitment during bad times.
(d) Conditions
Condition refers to the macroeconomic environment. For example, if the loan is
needed for setting up a retail business in a particular area, then the lender must make
a study of the economic conditions (the degree of propensity to spend by residents in
that locality).
(e) Collateral
Collateral is the lenders second line of defence. If the payback is derived from cash
flows, then the collateral will not be liquidated for repayment.
3.5 FORMS OF LENDING

The Credit Process
Credit is the lifeline of the banking business. The fundamental objective of a
commercial bank is to make profitable loans with minimum risk. Bank management should
target specific industries and markets in which lending officers have expertise. However,
while competing goals of loan volume and loan quality must be balanced with the banks
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liquidity requirements, capital constraints and rate of return objectives. The credit process
relies on each banks system and controls that allow management and credit officers to
evaluate risk and return trade-offs. The credit process includes three functions:
(a) Business development and credit analysis, (b) Underwriting or credit execution and
administration and (c) Credit review.
Notes
A credit policy formalizes lending guidelines that employees follow to conduct bank
business. As already pointed out in our previous discussion that it identifies preferred loan
qualities and establishes procedures for granting, documenting and reviewing loans.
The managements credit philosophy determines how much risk the bank will take
and in what form. Here, we need to know a very important concept that is called a banks
credit culture. This refers to the fundamental principles that drive lending activities and
how management analysis risk. This lending philosophy would differ from bank to bank.
Values Driven
(a) Focus is on credit quality with strong risk management systems and controls.
(b) Primary emphasis is on bank soundness and stability and a consistent market
presence.
(c) Underwriting is conservative and significant loan concentrations are not allowed.
(d) Typical outcome is lower current profit from loans with fewer loan losses.
Current Profit Driven
(a) Focus is on short-term earnings.
(b) Primary emphasis is banks annual profit plan.
(c) Management is often attracted to high-risk and high-return borrowers.
(d) Outcome is typically higher profit in good times, followed by lower profit in bad
times when loan losses increase.
Market Share Driven
(a) Focus is on having the highest market share of loans among competitors.
(b) Primary emphasis is on loan volume and growth with the intent of having the
largest market share.
(c) Underwriting is very aggressive and management accepts loan concentrations
and above-average credit risk.
(d) Outcome is that loan quality suffers over time, while profit is modest because
loan growth comes from below-market pricing and greater risk taking.
3.6 TYPES OF LENDING

A. Fund Based Lending
1. Long-term Loan
(a) Project Finance
Term Loans and Non-convertible Debentures (NCDs) for projects in the industrial,
Services and infrastructure sectors and diversification, modernization and expansion of
existing projects:
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Notes
(i) Funding up to 60% of the cost of the project.

(ii) Period up to 6 years for SME sector and 7 years for Infrastructure sector.
(iii) Financial assistance from ` 10 million (existing clients), 20 million (new clients)
to 150 million would be offered.
(b) Equipment Finance
(i) For purchase of additional or balancing equipments like energy saving devices,
pollution control facilities in an existing project.
(ii) Equipment that add value to the existing project.
(iii) Corporate (Medium Term) Loan.
(iv) Tenure of 1 year to 5 years.
(v) Companies having good past record and credit rating are preferred.
2. Short-term Loan
(a) Bill Discounting
(i) Ranging from 10 million to 150 million.
(ii) Aims at supplementing the working capital sources over and above the limits
sanctioned by the banks for rated companies.
(b) Factoring of Receivables
Factoring of Receivables ranging from 10 million to 150 million.
B. Non-fund Based Lending
Non-fund based lending facilities are as follows:
(i) Issuance of Bank Guarantee for purchase of machinery or goods on credit
(ii) Issuance of Bank Guarantee in lieu of Security Deposit/EMD/Performance
Guarantees
(iii) Financial guarantee against collateral securities/cash margin
(iv) Issuance/establishing BG/LC on behalf of lottery agents/liquor contractors/
liquor shops with 100% cash margin
Forward Sales, Forward Purchase Contracts, Letter of Credit with a minimum cash
margin of 25% (inland), Guarantees/Co-acceptance of Usance Bills with minimum 25%
cash margin, Discounting of Bills co-accepted by other banks, Partly secured/unsecured/
clean guarantee/co-acceptances with minimum of 25% cash margin.
Eligibility: Existing customers of the bank and whose past dealings have been found
satisfactory. Normally, this type of guarantee is required by the customers when he desires
to purchase machinery or goods on credit. The Deferred Payment Guarantee contains
an undertaking on the part of the bank to guarantee due payment of the deferred
instalments by the customers on the due date and declare that in the event of default
in payment, the bank would make the payment.
Period of Guarantee: For a period up to 5 to years. In exceptional cases, it may
be extended for a maximum period up to 10 years on merits of each case.
Margin: 25% cash margin on the cost of machinery/equipment to be acquired less
initial advance paid to the supplier plus interest portion, i.e., on the DPG amount.
Rate of Commission: 100 + 0.75% per quarter or part thereof with a minimum of
3% is the normal rate of metropolitan, urban and semi-urban branches. For rural branches,
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the rate of commission is 80 + 0.75% per quarter or part thereof with a minimum of 3%.
In respect of DPGs secured by 100% cash margin or by 100% term deposits, only 25%
of the applicable rate on issue of such guarantee with a minimum of 28 only, are leviable.
Notes
Security: Security provided for the guarantee may be in the form of our own deposits
or other acceptable tangible security, such as GP Notes, Insurance Policies having
adequate surrender value and easily marketable shares.
Issuance of Bank Guarantee in Lieu of Security Deposit/EMD/Performance Guarantees
1. Guarantees in favor of Government departments, such as Railways, PWD, etc.
who may require guarantees from their contractors in lieu of tender money or
performance of contracts to supply goods, etc.
2. Sales tax/Income-tax Authorities in respect of payment of taxes.
3. Companies of repute towards payments in respect of supply of materials.
4. Suppliers of machinery and plants on deferred payments basis require bank
guarantees in respect of instalments and interest payable by their purchasers.
5. Guarantees in favor of the Coffee Board in connection with renewal of the pool
sales permit for participation in the pool sales by dealers.
6. Guarantees are issued to Railway Authorities or Shipping Companies to take
delivery of relative goods without production of Railway Receipts (RRs) and Bills
of Lading and undertaking to produce them on receipt.
7. Besides the above, several other commercial transactions involve execution of
bank guarantees.
Security: Security provided for the guarantee may be in the form of our own deposits
or other acceptable tangible security, such as GP Notes, Insurance Policies having
adequate surrender value and easily marketable shares. Mortgage of immovable property
may be accepted as security only in exceptional cases where customers are well known,
provided at least 25% of the guarantee amount is covered by cash margin.
Commission: 100 plus 0.75% or 0.5% per quarter or part thereof towards financial
or performance guarantee respectively.
Financial Guarantee against Collateral Securities/Cash Margin:
1. Guarantees on behalf of constituents who are selling agents/lottery tickets/
airline tickets in favour of Government departments, Airlines, and other
companies in lieu of cash deposit or earnest money.
2. All mobilization guarantees issued on behalf of contractors.
3. Guarantees for release of retention money.
4. Guarantees for due payment of moneys for goods supplied, services rendered,
etc. (guarantees in favour of oil companies, fertiliser companies, airlines, excise
guarantees, etc.)
5. Guarantees in lieu of sales tax, income tax, excise duties/Government demands
against 100% cash deposit.
6. Guarantees given to courts for release of deposits/in lieu of payment to court.
7. Deferred Payment Guarantees.
C. Assets Based Lending
Asset based lending provides businesses with immediate funds and ongoing cash
flow based on a percentage of the value of the companys assets such as commercial
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Notes
accounts receivable, inventory, business equipment and machinery and recurring revenue
contracts. Funds from asset based finance can be used for day-to-day operating expenses
or as capital for restructuring, turnarounds, mergers and acquisitions and buyouts. First
Capital can custom tailor an asset based loan that fits your business needs. Asset based
finance can be underwritten relatively quickly and easily by First Capital to get the funding
that need when need it.
3.7 Lending Facilities Granted by Banks

1. Loan
2. Cash credit
3. Overdraft
4. Bills discounting
5. Letters of credit
1. Loan
Loan is an arrangement in which a lender gives money to a borrower and the borrower
agrees to return the money along with interest after a fixed period of time. Examples:
Home Loans, Car Loans, Personal Loans, etc.
2. Cash Credit
Cash credit is a short-term cash loan to a company. A bank provides this type of
funding, but only after the required security is given to secure the loan. Once a security
for repayment has been given, the business that receives the loan can continuously draw
from the bank up to a certain specified amount.
3. Overdraft
Overdraft is the amount by which withdrawals exceed deposits or the extension of
credit by a lending institution to allow for such a situation.
A bank overdraft is a limit on borrowing on a banks current account.
4. Bills Discounting
Bill discounting refers to the trading or selling a bill of exchange prior to the maturity
date at a value less than the par value of the bill. The amount of the discount will depend
on the amount of time left before the bill matures and on the perceived risk attached to
the bill.
5. Letters of Credit (LOC)
Letter of Credit refers to a letter from a bank guaranteeing that a buyers payment
to a seller will be received on time and for the correct amount. In the event that the buyer
is unable to make payment on the purchase, the bank will be required to cover the full
or remaining amount of the purchase. It is a payment term generally used for international
sales transactions.
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3.8 Who are the Borrowers?
Notes
Borrowers are the individuals who borrow money via bankers loans for short-term
needs or longer-term mortgages to help finance a house purchase. Companies borrow
money to aid short-term or long-term cash flows. They also borrow to fund modernization
or future business expansion. Governments often find their spending requirements exceed
their tax revenues. To make up this difference, they need to borrow. Governments also
borrow on behalf of nationalized industries, municipalities, local authorities and other public
sector bodies.
Public Corporations typically include nationalized industries. These may include the
postal services, railway companies and utility companies. Many borrowers have difficulty
raising money locally. They need to borrow internationally with the aid of foreign exchange
markets. Borrowers having similar needs can form into a group of borrowers. They can
also take an organizational form like Mutual Funds. They can provide mortgage on weight
basis. The main advantage is that this lowers the cost of their borrowings.
3.9 Study of Borrowers

The borrowing structure in an economy comprises of borrowers or entities that
finance their needs through borrowing. The needs of borrowers could involve incurring
expenditures on labor, plant and equipment, constructing residential, industrial or
commercial sites and building additions to inventories. The borrowers include the
government sector (central and state level), public sector and private sector corporations.
The borrowers provide or supply financial assets to savers by issuing primary securities
in financial markets, which in turn are reissued by financial intermediaries as secondary
securities (in financial markets) for the savers as investments. The flow of savings (from
the savings structure) to the flow of investments (to the borrowing structure) leads to capital
formation or long-term investments.
The flow of money from savings to investments leads to formation of capital stock
in the form of equipment, buildings, intermediate goods and inventories. Capital formation
reflects the countrys capability of producing and distributing goods and services across
different sectors and industries thus leading to an increase in the country national incomes
of economic growth. National income of a country or economic growth can be measured
by calculating the Gross Domestic Product (GDP) or Gross National Product (GNP) that
comprises economic activities in sectors like agriculture, industry and services requiring
financial resources to allocate labor, capital and other factors of production.
Financial markets are used to link savers to borrowers. For example, a business
can borrow money by selling shares or equity in the stock market. If a saver buys newly
issued shares of a stock in a specific company, this is an example of direct finance. The
saver's money is going directly to the company that is borrowing the money.
A more typical linkage between savers and borrowers is through a financial
intermediary. Examples of financial intermediaries include banks and mutual funds. Banks
receive money from depositors (savers) and loan it out. Mutual funds take in the money
of savers and select the specific stocks and bonds that savers invest in.
Banks, mutual funds, and other financial intermediaries allow savers to channel their
money to borrowers without the saver and borrower coming into direct contact. By pooling
the money of many savers, banks reduce transactions costs, decrease risk and allow
savers to earn a rate of return on their savings. Rather than contacting individual savers
for a loan, borrowers can work with the bank for funds.
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Notes
A saver who desires the higher average return of stock markets without the research
required to make quality stock selections can buy shares in a mutual fund. The mutual
fund manager will pool the money of many savers, taking the time and expense to study
different companies that trade stock shares. The goal is to make an educated selection
of shares that offer the highest possible return.
3.10 Balance Sheet Analysis

Balance sheet analysis can be defined as an analysis of the assets, liabilities, and
equity of a company. This analysis is conducted generally at set intervals of time, like
annually or quarterly. The process of balance sheet analysis is used for deriving actual
figures about the revenue, assets, and liabilities of the company.
3.11 Goal of Balance Sheet Analysis

The balance sheet analysis is helpful for the investors, investment bankers, share
brokers, and financial institutions, for verifying the profitability of investment for a specific
company.
3.12 How to Perform a Balance Sheet Analysis?

It is not a difficult task to perform a Balance Sheet Analysis. The main steps include:
(a) The primary step involves adding up liabilities and the paid-up equity share
capital. The sum must tally with the sum of total assets. After the process of
tallying is done, contrast the total assets with total liabilities. However, this
evaluation does not include the issued shares amount in the liabilities. If the
total assets are exceeding the total liabilities, the financial standing and
performance of the company is considered to be good.
(b) The next step involves looking at the current assets and liabilities. Sometimes,
it is considered as a good sign to have more unsecured liabilities.
(c) Another important step is calculating the ROA by dividing the net income by
assets. Producer companies feature a high ROA unlike the real estate and
leasing companies which feature a low ROA.
(d) The fourth step involves special concern for copyrights and patents. It is
important to consider the ratio between invested amount for research and the
consequent returns.
(e) Next step involves calculating the debt asset ratio by dividing total liabilities by
total assets. A lower liability dimension reflects a better performance by the
company.
(f) Another step includes estimating the receivables turnover ratio which signifies
the relation between investment in sales and money receivable. A better financial
status is reflected in high amount of money receivables.
(g) Another important ratio is the inventory turnover ratio which indicates the
companys capability of producing goods with available assets.
(h) The final step includes analyzing other features of company including goodwill,
credit ratings, and current projects. This analysis is helpful in evaluating the
company activities in near future.
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3.13 Project Appraisal
Notes
Project appraisal is the structured process of assessing the viability of a project or

proposal. It involves calculating the feasibility of the project before committing resources
to it. It is a tool that companies use for choosing the best project that would help them
to attain their goal. Project appraisal often involves making comparison between various
options and this is done by making use of any decision technique or economic appraisal
technique.
Project appraisal is a tool which is also used by companies to review the projects
completed by it. This is done to know the effect of each project on the company. This
means that the project appraisal is done to know, how much the company has invested
on the project and in return how much it is gaining from it. Project appraisal means a
pre-investment analysis of project to determine whether the project should be implemented
or not. There are some inherent differences between the terms Project Appraisal and
Project Valuation although they are often used interchangeably. Project appraisal refers
to an ex-ante examination of a proposal project to determine whether the same should
be implemented or not whereas project evaluation is an ex-post assessment of the impact
of an accomplished project.
3.14 Checklist for Project Appraisal

Whether you are involved in a partnership with an appraisal system in place, or
starting to design one from scratch, these questions are worth asking.
z
Are appraisals systematic and disciplined with a clear sequence of activities

and operating rules?
Is there an independent assessment of the project by someone who has not

been involved with the development of the project?
Does the appraisal process culminate in clear recommendations that inform

approval (or rejection) of the project?
Is the approval stage clearly separate?
Is the appraisal process well documented, with key documents signed, showing
ownership and agreement, and allowing the appraisal documentation to act as
a basis for future management, monitoring and evaluation?
Does the appraisal system comply with any relevant government guidance.
Are the right people involved at various stages of the process and, if necessary,
how can you widen involvement?
3.15 Project Appraisal Criteria

Appraisal of projects can be done by many ways, but the most common of them
are financial and economic appraisal. In case of financial project appraisal, the company
reviews the cost of the project and the expected revenues that will be generated by the
project. This type of appraisal helps the company to prevent overspending on a project.
It also helps in finding certain areas where alterations can be done for generating higher
revenues. Under economic appraisal, the company mainly focuses on the total benefit
of the project and less on the costs spent on the project. Other than these two types
of appraisal, there are also other types of project appraisal which include technical
appraisal, management or organizational appraisal and marketing and commercial
appraisal.
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Notes
1. Financial Appraisal
Financial appraisal is an objective evaluation of the profitability and financial strength
of a business unit. Many a times, the terms financial performance appraisal and financial
statement analysis are used as synonymous. The techniques of financial statement
analysis are used for the purpose of financial appraisal.
2. Economic Appraisal
Economic appraisal is a type of decision method applied to a project, programme
or policy that takes into account a wide range of costs and benefits, denominated in
monetary terms or for which a monetary equivalent can be estimated. Economic appraisal
is a methodology designed to assist in defining problems and finding solutions that offer
the best value for money (VFM). This is especially important in relation to public
expenditure and is often used as a vehicle for planning and approval of public investment
relating to policies, programmes and projects.
The principles of appraisal are applicable to all decisions, even those concerned with
small expenditures. However, the scope of appraisal can also be very wide. Good economic
appraisal leads to better decisions and VFM. It facilitates good project management and
project evaluation. Appraisal is an essential part of good financial management, and it
is vital to decision-making and accountability.
3. Technical Appraisal
Technical appraisal is an in-depth study to ensure that a project is: (i) soundly
designed, (ii) appropriately engineered and (iii) follows accepted standards. These
considerations differ from project to project. But, in any case, the emphasis is on the
inputs needed for the project and the resulting outputs of goods and services.
Put another way, such an appraisal determines whether the pre-requisites of a
successful project have been covered and good choices have been made in regard to
(i) location, (ii) plant capacity, (iii) raw materials requirements and (iv) other such factors
as availability of required professional, technicians and workers. In addition, project costs
are estimated and subsequently manufacturing costs are worked out. Adverse
environmental impact, if any, is also visualized and efforts are made to reduce it through
a better project design incorporating treatment of effluents and noise abatement.
4. Management or Organizational Appraisal
Management or Organizational Appraisal is a process which can look at an
organization and appraise it in a given context. Some tools appraise an organisation in
preparation of an award, others look at the performance of an organisation in preparation
for a buy-out/buy-in, raising venture capital, etc. Management appraisal is related to the
technical and managerial competence, integrity, knowledge of the project, managerial
competence of the promoters, etc. The promoters should have the knowledge and ability
to plan, implement and operate the entire project effectively. The past record of the
promoters is to be appraised to clarify their ability in handling the projects.
5. Marketing Appraisal
Marketing appraisal is an estate agents recommendation on how we can achieve
the best price for your property in a timescale that suits you. A valuation can only be
carried out by a qualified surveyor and is an evidence-based opinion on how much your
property is worth.
127
6. Commercial Appraisal
Notes
In the commercial appraisal many factors are coming. The scope of the project in
market or the beneficiaries, customer-friendly process and preferences, future demand of
the supply, effectiveness of the selling arrangement, latest information availability on all
areas, government control measures, etc. The appraisal involves the assessment of the
current market scenario, which enables the project to get adequate demand. Estimation,
distribution and advertisement scenario also to be considered here into.
3.16 Marketing of Bank Services

The ongoing process of economic reforms has completely changed the operational
environment for the whole banking industry in the country. Banks are now required to cope
with stiff competition in business and also the complex regulatory norms regarding capital
adequacy and provisioning. Banks are forced to adopt various marketing techniques and
approaches. Thus, marketing has become imperative for all banks including those in the
public sector. Marketing in banks can be stated as a new phenomenon that is shaping
well over the past one decade. Public sector bank hardly considered marketing as a tool
for business. The competition, deregulation that followed the reforms has changed the
environment for banks, where marketing has occupied the place in the business of banks.
Today, marketing in the banking industry is characterized by many innovations in products
and services, use of advanced technology in product design, upgradation of delivery
system, advertising and sales promotion activities, whether in public sector or private
sector. Banks now have a firm that marketing strategies alone can brighten the future
of banking business. Marketing in banks has become synonymous with customer and
banks are found engaged in several activities of discovering, creating and satisfaction of
customer needs. Indian banking is at crossroads today. With the deregulation and
liberalization process in full swing, the consequent policy changes introduced in the Indian
financial system in general and banking in particular are effecting unprecedented changes
in its functioning. With the emerging changes did spring up new challenges of commercial
viability, cost-effectiveness, effective marketing strategy, etc. Market oriented policies also
gave birth to new players like foreign and private sector banks and subsidiaries offering
varied high tech and cost-effective service. There was an absolute shift from sellers into
buyers market, establishing the consumer as the key factor in the market. The dictum
as the bank exists because of its customers, has become more pronounced and relevant
in the present context. Thus, marketing constitutes the key strategy for banks to retain
good customers and also anticipate their future demands.
3.17 Importance of Bank Marketing

1. Awareness among Customers
Modern technology has made customers aware of the developments in the economic
environment, which includes the financial system. Financial needs of the customers have
grown multifold into various forms like quick cash accessibility, money transfer, asset
security, increased return on surplus funds, financial advice, deferred payments, etc. With
a wide network of branches, even in a dissimilar banking scenario, customers expect the
banks to offer a more and better service to match their demands and this has compelled
banks to take up marketing in right earnest.
2. Quality as a Key Factor
With the opening up of the economy, fast change has been experienced in every
activity, and banking has been no exemption. Quality is the watchword in the competitive
128
Notes
world, which is market driven and banks have had to face up to this emerging scenario.
In fact, it may not be out of place to reiterate that quality in future will be the sole
determinant of successful banking ventures and marketing has to focus on this most
crucial need of the hour.
3. Growing Competition
Increased competition is being faced by the Indian banking industry from within the
system with other agencies both, local and foreign, offering value added services.
Competition is no more confined to resource mobilization but also to lending and other
areas of banking activity. The foreign commercial bank with their superior technology,
speed in operations and imaginative positioning of their services has also provided the
necessary impetus to the Indian banks to innovate and compete in the marketplace.
4. Technological Advances
Technological innovation has resulted in financial product development especially in
the international and investment banking areas. The western experience has demonstrated
that technology has not only made execution of work faster but has also resulted in greater
availability of manpower for customer contact.
3.18 Marketing Approach in Banks

With the need for marketing in banks having evolved out of the changing environment
and constant interplay of various interdependent factors, the importance of a systematic
approach to marketing cannot be overstressed. The application of a marketing approach
in banks will therefore involve:
(a) Identifying customers financial needs and wants;
(b) Developing appropriate banking services to meet these needs;
(c) Pricing for the services so developed;
(d) Setting up suitable outsells/banks branches;
(e) Advertising to promote the services to the existing as well as prospective
customers.
3.19 Features of Bank Marketing

Various features of Bank Marketing are:
1. Banking product cannot be seen or touched like manufactured products
(intangibility).
2. In marketing banking products, the product and the seller are inseparable; they
together define the banking product (inseparability).
3. Banking products are products and delivered at the same time; they cannot
be stored and inspected before delivering (perishability).
4. Standardization of banking product is difficult (variability).
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3.20 Prudential Norms
Notes
Prudential norms are the guidelines and general norms issued by the regulating
bank (the central bank) of the country for the proper and accountable functioning of bank
and bank-like establishments.
In recent years, we have across the term prudential norms too often particularly
in relation to the non-performing assets of the commercial banks. In the light of the
existence of huge non-performing asset in the balance sheets of the commercial banks
leading to the erosion of their capital base, the relevance of these prudential has acquired
particular significance.
The main elements of prudential norms are income recognition, asset classification,
provisioning for loans and advances and capital adequacy. In keeping with latest practices
at the international levels, commercial banks are not supposed to recognize their incomes
from non-performing assets on an accrual basis and these are to be booked only when
these are actually received.
If the balance sheet of a bank is to reflect the factual and true financial state of affairs
of the bank, it is pragmatic and desirable to have a system of recognition of income,
classification of assets and provisioning for sticky debts on a prudential basis. Banks have
been directed not to charge and take interest on non-performing assets to the income
account and classify their assets under three broad categories of Standard Assets, Substandard Assets, Doubtful Assets and Loss Assets. Taking into account the time-lag
between an account becoming doubtful of recovery, its recognition as such, the realization
of the security and the erosion over time in value of security charged to the banks, banks
are required to make provision against sub-standard assets, doubtful assets and loss assets.
The prudential accounting norms which were put into place in 1992-93 have been
further strengthened over the years. In respect of accounts where there are potential threats
of recovery on account of erosion in the value of the security or absence of security and
other factors such as fraud committed by the borrowers exist, such accounts are to be
classified as doubtful or loss assets irrespective of the period to which these remained
as non-performing. All the members banks in a consortium are required to classify their
advances according to each bank's own record of recovery. Depreciation on securities
transferred from the current category to the permanent category has to be immediately
provided for. Banks should value the specified government securities under ready forward
transactions at market rates on the balance date.
3.21 Prudential Guidelines on Restructuring of Advances

(i) A restructured account is one where the bank grants concessions, which would
not otherwise consider, taking into account the borrowers financial difficulty. Restructuring
involves modification of terms of advance/securities, which would generally include, among
others, alteration of repayment period/repayable amount/the amount of instalments/rate
of interest, etc.
(ii) Specified Period means a period of one year from the date when the first payment
of interest or instalment of principal falls due under the terms of restructuring package.
The guidelines on restructuring issued by RBI are grouped in four categories as under:
(i) Restructuring of advances extended to industrial units, (ii) Restructuring of advances
extended to industrial units under the Corporate Debt Restructuring (CDR) Mechanism,
(iii) Restructuring of advances extended to Small and Medium Enterprises (SMEs) and
(iv) Restructuring of all other advances.
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Notes
3.22 Narasimham Committee Recommendations

During the decades of the 60s and the 70s, India nationalized most of its banks.
This culminated with the balance of payments crisis of the Indian economy where India
had to airlift gold to International Monetary Fund (IMF) to loan money to meet its financial
obligations. This event called into question the previous banking policies of India and
triggered the era of economic liberalization in India in 1991. Given that rigidities and
weaknesses had made serious inroads into the Indian banking system by the late 1980s,
the Government of India (GOI), post-crisis, took several steps to remodel the countrys
financial system. The banking sector, handling 80% of the flow of money in the economy,
needed serious reforms to make it internationally reputable, accelerate the pace of reforms
and develop it into a constructive usher of an efficient, vibrant and competitive economy
by adequately supporting the countrys financial needs. In the light of these requirements,
two expert Committees were set up in 1990s under the chairmanship of M. Narasimham
(an ex-RBI (Reserve Bank of India) governor) which are widely credited for spearheading
the financial sector reform in India. The first Narasimham Committee (Committee on the
Financial System CFS) was appointed by Manmohan Singh as Indias Finance Minister
on 14 August 1991 and the second one (Committee on Banking Sector Reforms) was
appointed by P. Chidambaram as Finance Minister in December 1997. Subsequently, the
first one widely came to be known as the Narasimham Committee-I (1991) and the second
one as Narasimham-II Committee (1998). This article is about the recommendations of
the Second Narasimham Committee, the Committee on Banking Sector Reforms.
The purpose of the Narasimham-I Committee was to study all aspects relating to
the structure, organization, functions and procedures of the financial systems and to
recommend improvements in their efficiency and productivity. The Committee submitted
its report to the Finance Minister in November 1991 which was tabled in Parliament on
17 December 1991.
The Narasimham-II Committee was tasked with the progress review of the
implementation of the banking reforms since 1992 with the aim of further strengthening
the financial institutions of India. It focused on issues like size of banks and capital
adequacy ratio among other things. M. Narasimham, Chairman, submitted the report of
the Committee on Banking Sector Reforms (Committee-II) to the Finance Minister
Yashwant Sinha in April 1998.
3.23 Recommendations of the Committee

The 1998 report of the Committee to the GOI made the following major
recommendations:
Autonomy in Banking
Greater autonomy was proposed for the public sector banks in order for them to
function with equivalent professionalism as their international counterparts. For this, the
panel recommended that recruitment procedures, training and remuneration policies of
public sector banks be brought in line with the best-market practices of professional bank
management. Secondly, the committee recommended GOI equity in nationalized banks
be reduced to 33% for increased autonomy. It also recommended the RBI relinquish its
seats on the Board of Directors of these banks. The committee further added that given
that the government nominees to the board of banks are often members of parliament,
politicians, bureaucrats, etc., they often interfere in the day-to-day operations of the bank
in the form of the behest-lending. As such, the committee recommended a review of
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functions of banks boards with a view to make them responsible for enhancing shareholder
value through formulation of corporate strategy and reduction of government equity.
Notes
To implement this, criteria for autonomous status was identified by March 1999
(among other implementation measures) and 17 banks were considered eligible for
autonomy. But some recommendations like reduction in Governments equity to 33%, the
issue of greater professionalism and independence of the Board of Directors of public
sector banks is still awaiting Government follow-through and implementation.
Reform in the Role of RBI
First, the committee recommended that the RBI withdraw from the 91-day treasury
bills market and that inter-bank call money and term money markets be restricted to banks
and primary dealers. Second, the Committee proposed a segregation of the roles of RBI
as a regulator of banks and owner of bank. It observed that The Reserve Bank as a
regulator of the monetary system should not be the owner of a bank in view of a possible
conflict of interest. As such, it highlighted that RBIs role of effective supervision was not
adequate and wanted it to divest its holdings in banks and financial institutions.
Pursuant to the recommendations, the RBI introduced a Liquidity Adjustment Facility
(LAF) operated through repo and reverse repos in order to set a corridor for money market
interest rates. To begin with, in April 1999, an Interim Liquidity Adjustment Facility (ILAF)
was introduced pending further upgradation in technology and legal/procedural changes
to facilitate electronic transfer. As for the second recommendation, the RBI decided to
transfer its respective shareholdings of public banks like State Bank of India (SBI), National
Housing Bank (NHB) and National Bank for Agriculture and Rural Development (NABARD)
to GOI. Subsequently, in 2007-08, GOI decided to acquire entire stake of RBI in SBI,
NHB and NABARD. Of these, the terms of sale for SBI were finalized in 2007-08
themselves.
Stronger Banking System
The Committee recommended for merger of large Indian banks to make them strong
enough for supporting international trade. It recommended a three tier banking structure
in India through establishment of three large banks with international presence, eight to
ten national banks and a large number of regional and local banks. This proposal had
been severely criticized by the RBI employees union. The Committee recommended the
use of mergers to build the size and strength of operations for each bank. However, it
cautioned that large banks should merge only with banks of equivalent size and not with
weaker banks, which should be closed down if unable to revitalize themselves. Given the
large percentage of non-performing assets for weaker banks, some as high as 20% of
their total assets, the concept of narrow banking was proposed to assist in their
rehabilitation.
There were a string of mergers in banks of India during the late 90s and early 2000s,
encouraged strongly by the Government of India in line with the Committee's
recommendations. However, the recommended degree of consolidation is still awaiting
sufficient government impetus.
Non-performing Assets
Non-performing assets had been the single largest cause of irritation of the banking
sector of India. Earlier the Narasimham Committee-I had broadly concluded that the main
reason for the reduced profitability of the commercial banks in India was the priority sector
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Notes
lending. The committee had highlighted that priority sector lending was leading to the
buildup of non-performing assets of the banks and thus it recommended it to be phased
out. Subsequently, the Narasimham Committee-II also highlighted the need for zero nonperforming assets for all Indian banks with International presence. The 1998 report further
blamed poor credit decisions, behest-lending and cyclical economic factors among other
reasons for the buildup of the non-performing assets of these banks to uncomfortably high
levels. The Committee recommended creation of Asset Reconstruction Funds or Asset
Reconstruction Companies to take over the bad debts of banks, allowing them to start
on a clean-slate. The option of recapitalization through budgetary provisions was ruled
out. Overall the committee wanted a proper system to identify and classify NPAs, NPAs
to be brought down to 3% by 2002 and for an independent loan review mechanism for
improved management of loan portfolios. The Committees recommendations let to
introduction of a new legislation which was subsequently implemented as the
Securitization and Reconstruction of Financial Assets and Enforcement of Security
Interest Act, 2002 and came into force with effect from 21 June 2002.
Capital Adequacy and Tightening of Provisioning Norms
In order to improve the inherent strength of the Indian banking system, the committee
recommended that the Government should raise the prescribed capital adequacy norms.
This would also improve their risk taking ability. The committee targeted raising the capital
adequacy ratio to 9% by 2000 and 10% by 2002 and has penal provisions for banks that
fail to meet these requirements. For asset classification, the Committee recommended
a mandatory 1% in case of standard assets and for the accrual of interest income to be
done every 90 days instead of 180 days.
To implement these recommendations, the RBI in October 1998, initiated the second
phase of financial sector reforms by raising the banks capital adequacy ratio by 1% and
tightening the prudential norms for provisioning and asset classification in a phased manner
on the lines of the Narasimham Committee-II report. The RBI targeted to bring the capital
adequacy ratio to 9% by March 2001. The Mid-term Review of the Monetary and Credit
Policy of RBI announced another series of reforms, in line with the recommendations with
the Committee, in October 1999.
Entry of Foreign Banks
The committee suggested that the foreign banks seeking to set up business in India
should have a minimum start-up capital of $25 million as against the existing requirement
of $10 million. It said that foreign banks can be allowed to set up subsidiaries and joint
ventures that should be treated on a par with private banks.
Implementation of Recommendations
In 1998, RBI Governor Bimal Jalan informed the banks that the RBI had a three to
four year perspective on the implementation of the Committees recommendations. Based
on the other recommendations of the committee, the concept of a universal bank was
discussed by the RBI and finally ICICI Bank became the first universal bank of India. The
RBI published an Actions Taken on the Recommendations report on 31 October 2001
on its own website. Most of the recommendations of the Committee have been acted upon
(as discussed above) although some major recommendations are still awaiting action from
the Government of India.
133
Criticism
Notes
There were protests by employee unions of banks in India against the report. The
Union of RBI employees made a strong protest against the Narasimham II Report. There
were other plans by the United Forum of Bank Unions (UFBU), representing about
1.3 million bank employees in India, to meet in Delhi and to work out a plan of action
in the wake of the Narasimham Committee report on banking reforms. The committee was
also criticized in some quarters as anti-poor. According to some, the committees failed
to recommend measures for faster alleviation of poverty in India by generating new
employment. This caused some suffering to small borrowers (both individuals and
businesses in tiny, micro and small sectors).
3.24 Highlights of Narasimham Committee Recommendations on

Banking Reforms in India
The main recommendations of Narasimham Committee (1991) on the Financial
(Banking) System are as follows:
(i) Statutory Liquidity Ratio (SLR) is brought down in a phased manner to 25%
(the minimum prescribed under the law) over a period of about five years to give
banks more funds to carry business and to curtail easy and captive finance.
(ii) The RBI should reduce Cash Reserve Ratio (CRR) from its present high level.
(iii) Directed Credit Programme, i.e., credit allocation under government direction,
not by commercial judgement of banks under a free market competitive system,
should be phased out. The priority sector should be scaled down from present
high level of 40% of aggregate credit to 10%. Also the priority sector should
be redefined.
(iv) Interest rates to be deregulated to reflect emerging market conditions.
(v) Banks whose operations have been profitable is given permission to raise fresh
capital from the public through the capital market.
(vi) Balance sheets of banks and financial institutions are made more transparent.
(vii) Set up special tribunals to help banks recover their debt speedily.
(viii) Changes be introduced in the bank structure 3-4 large banks with international
character, 8-10 national banks with branches throughout the country, local
banks confined to specific region of the country, rural banks confined to rural
areas.
(ix) Greater emphasis is laid on internal audit and internal inspection in the banks.
(x) Government should indicate that there would be no further nationalization of
banks, the new banks in the private sector should be welcome subject to normal
requirements of the RBI, branch licensing should be abolished and policy
towards foreign banks should be more liberal.
(xi) Quality of control over the banking system by the RBI and the Banking Division
or the Ministry of Finance should be ended and the RBI should be made primary
agency for regulation of banking system.
(xii) A new financial institution called the Assets Reconstruction Fund (ARF). Should
be established which would take over from banks and financial institutions a
portion of their bad and doubtful debts at a discount (based on realizable value
of assets), and subsequently follow up on the recovery of the dues owed to
them from the primary borrowers.
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Notes
Follow-up Action
(i) Statutory Liquidity Ratio (SLR) on incremental Net Domestic and Time Liabilities
(NDTL) reduced from 38.5% in 1991-92 to 28% by December 1996.
(ii) Effective Cash Reserve Ratio (CRR) on the NDTL reduced from 14% to 10%
in January 1997.
(iii) In April 1992, the RBI introduced a risk assets ratio system for banks (including
foreign banks) in India as a capital adequacy measure. Under this, banks will
have to achieve a Capital to Risk Weighted Asset ratio (CRAR) of 8%. By March,
1996 out of 27 public sector banks 19 banks (including SBI and all its
subsidiaries) have attained 8% CRAR norm. In case of foreign banks, all of them
have already attained these norms.
(iv) New prudential norms for income recognition, classification of assets and
provisioning of bad debts introduced in 1992.
(v) In regard to regulated interest ratio structure: (a) considerable rationalization has
been effected in banks lending rates with the number of concessive slabs
reduced and some of the ratio have been raised thereby reducing the element
of subsidy; (b) regulated deposit late has been replaced by single prescription
of not exceeding 13% (revised to 11%) per annum for all deposit maturities of
46 days and above.
(vi) The SBI and some other nationalized banks have been allowed to seek capital
market access.
(vii) Less strong nationalized banks are being recapitalized by government through
budget provisions of ` 15000 crore till 1994-95.
(viii) Existing private sector banks given signal for expansion, more private sector
banks allowed to set up branches provided they confirms to the RBI guidelines.
(ix) Supervision system of the RBI is being strengthened with establishment of new
board for Financial Bank Supervision within the RBI.
(x) Banks given freedom to open new branches and upgrade extension counters
on attaining capital adequacy norms and prudential accounting standards. They
are permitted to close non-viable branches other than in rural areas.
(xi) Rapid computerization of banks being undertaken.
(xii) Agreement signed between the public sector bank and RBI to improve their
managerial and quality of performance.
(xiii) Recovery of debts due to banks and the Financial Institution Act 1993 recently
passed to facilitate quicker recovery of loans and arrears. Accordingly, six
special Debt Recovery Tribunals were set up along with an Appellate Tribunal
at Mumbai to expedite the recovery of bank loan arrears.
(xiv) Under the Banking Ombudsmen Scheme 1995, eleven Ombudsmen already
functioning out of a total of 15 to expedite inexpensive resolution of customers
complaints.
(xv) Ten new private banks have started functioning out of the thirteen in principle
approvals given for setting up new banks in private sector.
3.25 Performance Analysis of Banks

The performance of 27 PSBs is evaluated during the reform period 1992-93 and
2002-03. The analysis is carried out by disaggregating 27 PSBs into 3 groups, namely,
SBI (1), Associate Banks (7) and Nationalized Banks (19). The level of efficiency of banks
135
has been 106 studied in the context of branches and employees in terms of efficiency
indicators and profitability indicators. In a service industry like banking, it is not possible
to measure physical output in the absence of clear definition. However, most of the
measures that are used to study banks performance can be interpreted more correctly
as measuring the banks efficiency target rather than directly measuring their productivity.
The level of efficiency of banks is commonly measured at the level of branches and
employees, which are the two important wheels on which banking industry moves.
Considering the national priorities, involvement of banks in rural areas and development
schemes and vast infrastructure developed in terms of branches and manpower resources,
it is thought appropriate to assess the efficiency of banks in terms of the performance
at the level of branches and employees. Further, the size of banks varies widely; hence
it is more meaningful to study the performance of parameters indicating efficiency at the
level of branch and employee. In order to measure efficiency at the branch and employees
level, the following parameters are employed: (1) Business per Branch, (2) Operating
expenses per Branch, (3) Profit per Branch, (4) Business per Employee, (5) Establishment
expenses per Employee, and (6) Profit per Employee. The study, thus, measures
efficiency of a bank at the level of operational units, i.e., branch and employee, The
efficiency of each branch and employee in terms of averages of indicators can be compared
to assess the relative performance of different banks and bank groups.
Notes
Financial statements for banks present a different analytical problem than statements
for manufacturing and service companies. As a result, analysis of a banks financial
statements requires a distinct approach that recognizes a banks unique risks.
Banks take deposits from savers and pay interest on some of these accounts. They
pass these funds on to borrowers and receive interest on the loans. Their profits are derived
from the spread between the rate they pay for funds and the rate they receive from
borrowers. This ability to pool deposits from many sources that can be lent to many
different borrowers creates the flow of funds inherent in the banking system. By managing
this flow of funds, banks generate profits, acting as the intermediary of interest paid and
interest received, and taking on the risks of offering credit.
Banking is a highly leveraged business requiring regulators to dictate minimal capital
levels to help ensure the solvency of each bank and the banking system. A bank's primary
regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency,
the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending on
the charter of the bank. Within the Federal Reserve Board, there are 12 districts with
12 different regulatory staffing groups. These regulators focus on compliance with certain
requirements, restrictions and guidelines, aiming to uphold the soundness and integrity
of the banking system.
As one of the most highly regulated banking industries in the world, investors have
some level of assurance in the soundness of the banking system. As a result, investors
can focus most of their efforts on how a bank will perform in different economic
environments.
As financial intermediaries, banks assume two primary types of risk as they manage
the flow of money through their business. Interest rate risk is the management of the spread
between interest paid on deposits and received on loans over time. Credit risk is the
likelihood that a borrower will default on a loan or lease, causing the bank to lose any
potential interest earned as well as the principal that was loaned to the borrower. As
investors, these are the primary elements that need to be understood when analyzing a
banks financial statement.
136
Notes
The primary business of a bank is managing the spread between deposits (liabilities,
loans and assets). Basically, when the interest that a bank earns from loans is greater
than the interest it must pay on deposits, it generates a positive interest spread or net
interest income. The size of this spread is a major determinant of the profit generated
by a bank. This interest rate risk is primarily determined by the shape of the yield curve.
As a result, net interest income will vary, due to differences in the timing of accrual
changes and changing rate and yield curve relationships. Changes in the general level
of market interest rates also may cause changes in the volume and mix of a banks balance
sheet products. For example, when economic activity continues to expand while interest
rates are rising, commercial loan demand may increase while residential mortgage loan
growth and prepayments slow.
Banks, in the normal course of business, assume financial risk by making loans
at interest rates that differ from rates paid on deposits. Deposits often have shorter
maturities than loans and adjust to current market rates faster than loans. The result is
a balance sheet mismatch between assets (loans) and liabilities (deposits). An upward
sloping yield curve is favorable to a bank as the bulk of its deposits are short-term and
their loans are longer term. This mismatch of maturities generates the net interest revenue
banks enjoy.
3.26 Regulatory Institutions in India

The following are five major financial regulatory bodies in India: (We have given links
for these bodies. For more details about these, you can click and visit such websites).
(A) Statutory Bodies via Parliamentary Enactments
(i) Reserve Bank of India
the central bank of the country.
The Reserve Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank
was initially established in Calcutta but was permanently moved to Mumbai in 1937. The
Central Office is where the Governor sits and where policies are formulated. Though
originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned
by the Government of India.
It acts as the apex monetary authority of the country. The Central Office is where
the Governor sits and is where policies are formulated. Though originally privately owned,
since nationalization in 1949, the Reserve Bank is fully owned by the Government of India.
The preamble of the Reserve Bank of India is as follows:
...to regulate the issue of Bank Notes and keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of
the country to its advantage.
137
(ii) Securities and Exchange Board of India
Notes
SEBI Act, 1992: Securities and Exchange Board of India (SEBI) was first established
in the year 1988 as a non-statutory body for regulating the securities market. It became
an autonomous body in 1992 and more powers were given through an ordinance. Since
then, it regulates the market through its independent powers.
(iii) Insurance Regulatory and Development Authority
The Insurance Regulatory and Development Authority (IRDA) is a national agency
of the Government of India and are based in Hyderabad (Andhra Pradesh). It was formed
by an Act of Indian Parliament known as IRDA Act 1999, which was amended in 2002
to incorporate some emerging requirements. Mission of IRDA as stated in the act is to
protect the interests of the policyholders, to regulate, promote and ensure orderly growth
of the insurance industry and for matters connected therewith or incidental thereto.
(B) Part of the Ministries of the Government of India
(iv) Forward Market Commission India (FMC)
Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory
authority which is overseen by the Ministry of Consumer Affairs, Food and Public
Distribution, Government of India. It is a statutory body set up in 1953 under the Forward
Contracts (Regulation) Act, 1952 This Commission allows commodity trading in
22 exchanges in India, out of which three are national level.
(v) PFRDA under the Finance Ministry
Pension Fund Regulatory and Development Authority: PFRDA was established by
Government of India on 23rd August, 2003. The Government has, through an executive
order dated 10th October 2003, mandated PFRDA to act as a regulator for the pension
sector. The mandate of PFRDA is development and regulation of pension sector in India.
3.27 Reserve Bank of India

(Details explained in the Module II)
3.28 Credit Control

Credit Control is an important tool used by Reserve Bank of India, a major weapon
of the monetary policy used to control the demand and supply of money (liquidity) in the
economy. Central Bank administers control over the credit that the commercial banks
grant. Such a method is used by RBI to bring Economic Development with Stability.
It means that banks will not only control inflationary trends in the economy but also boost
economic growth which would ultimately lead to increase in real national income with
stability.
3.29 Meaning of Credit Control

Credit control refers to the process of monitoring and collecting the money owed
to a business. This includes those measures and procedures adopted by a firm to ensure
that its credit customers pay their accounts.
138
Notes
3.30 Objectives of Credit Control

Controlling credit in the Economy is amongst the most important functions of the
Reserve Bank of India. The basic and important objectives of Credit Control in the economy
are:
(i) To encourage the overall growth of the priority sector, i.e. those sectors of
the economy which is recognized by the government as prioritized depending
upon their economic condition or government interest. These sectors broadly
totals to around 15 in number.
(ii) To keep a check over the channelization of credit so that credit is not delivered
for undesirable purposes.
(iii) To achieve the objective of controlling Inflation as well as Deflation.
(iv) To boost the economy by facilitating the flow of adequate volume of bank credit
to different sectors.
(v) To develop the economy.
3.31 Need for Credit Control

Credit control policy is just an arm of Economic Policy which comes under the purview
of Reserve Bank of India, hence, its main objective being attainment of high growth rate
while maintaining reasonable stability of the internal purchasing power of money. The basic
and important need for Credit Control in the economy is:
(i) Ensure an adequate level of liquidity enough to attain high economic growth
rate along with maximum utilization of resource but without generating high
inflationary pressure.
(ii) Attain stability in exchange rate and money market of the country.
(iii) Meeting the financial requirement during slump in the economy and in the normal
times as well.
(iv) Control business cycle and meet business needs.
3.32 Methods of Credit Control

There are two methods that the RBI uses to control the money supply in the economy:
A. Quantitative Methods
1. Bank Rate Policy
According to the Reserve Bank of India Act, the Bank Rate is defined as the standard
rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercial
papers eligible for purchase under the provisions of the Act.
Thus, the bank rate is the rate of interest at which RBI rediscounts the first-class
bills in the hands of commercial banks to provide them with liquidity in case of need.
However, presently, RBI does not accept any bills for rediscounting. This function is being
done by separate financial institutions like DHFI created for similar purposes.
Bank Rate: Whenever the RBI provides refinance or other financial assistance to
Commercial Banks, the rate of interest on such assistance is determined with reference
to Bank Rate. The RBI also charges interest with reference to Bank Rate on ways and
means advances to governments.
139
For a long period up to 1990-91, the rate remained unchanged at 10%. Later, from
October 1991 to April 1997, the rate remained at 12.00%. During 1997-98, the rate was
reactivated to serve as a reference rate for Commercial Banks lending rates.
Notes
When Reserve Bank wants a reduction in general lending rates of Commercial Banks,
it will signify its intention by reducing Bank Rate and vice versa. The Bank Rate was
changed five times during 1997-98. The Bank Rate which was 8% in November 1999 was
changed to 7.00% in April 2001.
It was brought down to 6.50% in October 2001, 6.25% in October 2002 and 6.00%
in April 2003. The rate frequently changes these days depending upon immediate monetary
policy objectives. Of late, the Reserve Bank makes changes in Bank Rate often depending
upon liquidity position of banks, short-term interest level, and inflation of the situation.
Ever since, Exchange Rate of rupee was allowed to be determined by market forces in
March 1993. Bank Rate has been changed a little more often.
The bank rate policy as an instrument of monetary control was not successful in
India for a long time. The main factors responsible for this are:
(i) Inherent inflexibility involved in the use of this instrument.
(ii) The dominance of the public sector whose investment requirements are cost
inelastic.
(iii) The higher rate of inflation experienced in the economy.
(iv) Restricted availability of refinance facilities to banks.
(v) As the government expenditure increase, the tax burden also increases. Under
heavy taxation, the businessmen feel that the interest rate is a minor factor.
And the decrease in the importance of interest rate has led to the decline in
the importance of bank rate.
2. Open Market Operations
Open market operations are conducted by the RBI mainly with a view to manage
short- term liquidity in the market. These operations directly or indirectly affect the reserves
of the commercial banks and thereby the extent of credit creation is controlled. Section
17(8) of the Reserve Bank of India Act confers legal powers on the Reserve Bank to use
this instrument of monetary policy. Under this section, the Reserve Bank is authorized
to purchase and sell the securities of the Central or State Government of any maturity
and the security of a local authority specified by the central government on the
recommendation of the banks central board.
However, at present, the Reserve Bank deals only in the securities issued by the
central government and not in those of State Governments and local authorities. It may
be noted that in terms of Section 33 of the Reserve Bank of India Act, securities issued
by the State Governments or local bodies are not eligible to be used as reserve assets
against note issue.
The Government securities market in India is narrow and is dominated by financial
institutions especially by commercial banks. The Reserve Bank of India occupies a pivotal
position in the market. It is continuously in the market, selling government securities of
different maturities on tap; it stands ready to buy them in switch operations. The Reserve
Bank of India does not ordinarily purchase securities against cash. There are no dealers
in the market who are engaged in continuous sale and purchase of securities on their
own account. Incidentally, it may be noted that the Reserve Bank affects purchases and
sales from time to time out of the surplus funds of IDBI, EXIM Bank, and NABARD under
special arrangement.
140
Notes
The market, however, is served by stock brokers who act as intermediaries between
prospective buyers and sellers of government securities. The Reserve Bank also enlists
the services of brokers, if necessary.
The role of open market operation as an instrument of credit control will assume
importance in the restructured monetary system. With the interest rate offered on
government securities becoming truly competitive, a broad enough securities market may
emerge for the Reserve Bank to use open market operations as an instrument of credit
control.
It will sell the securities in open market to drain out excess liquidity from the financial
system and thereby contraction of credit. When it buys securities, it injects additional
funds into the market and consequently credit expansion may take place. Repos and
Reverse Repos transactions may be considered a supplementary operation to this
system.
3. Variation of Cash Reserve Ratio
Under this requirement, certain percentage of deposit liabilities of banks is impounded
in cash form with RBI and/or to be maintained in liquid assets like government securities.
The reserve requirements were originally evolved as a means for safeguarding the interests
of depositors.
Later, it was developed as an instrument of credit control. The variation in the reserve
requirements has the effect of increasing or decreasing the funds available with commercial
banks for lending. In India, the reserve requirements are of two types. They are:
(a) Cash Reserve Ratio, and
(b) Statutory Liquidity Ratio.
(a) Cash Reserve Ratio
Under the provisions of the RBI Act, the scheduled banks were required to maintain
a minimum amount of cash reserve with the Reserve Bank. The reserve is made out of
demand and time liabilities at certain percentage fixed by the RBI.
The Cash Reserve Ratio is required to be maintained in cash with RBI, in addition
to the percentage to be maintained under the Statutory Liquidity Ratio. The Cash Reserve
Ratio cannot exceed 15% of the net demand and time liabilities.
The Cash Reserve Ratio at the time of notification of banks was 3% which having
been revised a number of times. The flat rate of 15% was introduced in the credit policy
for the first half of 1989-90.
It was observed that the credit control instruments in the hands of RBI have been
used to maintain the economic growth with controlled inflation and as a sharp knife to
curb inflation. RBI has used these flexibilities to ensure that institutional finances for
productive purposes are not lacking.
The CRR is being gradually reduced after initiating banking sector reforms from
1994- 95. The rate was 10.5% as on April 1999. It stands reduced to 10.0% from May
1999 and from November 1999 it stands further reduced to 9.0%.
Ever since financial sector reforms and market determined exchange for Rupee, the
RBI uses this instrument to influence liquidity in money market and thereby exchange
rate fluctuations.
In the recent past, when the exchange rate of rupee came under attack from bank
speculators, it increased the CRR thereby impounding excess liquidity in the market. This
141
policy helped RBI to maintain stable rate in short-term. The CRR was drastically reduced
during 2001, to 4.75% in November 2002. It stands at 4.50% from June 14, 2003.
Notes
(b) Statutory Liquidity Ratio

Under Section 24 of the Banking Regulation Act 1949, RBI is empowered to stipulate
the liquid assets every banking company is required to hold against their demand and
time liabilities in addition to cash reserve requirement.
Accordingly, the banks both scheduled and non-scheduled have to maintain liquid
assets in cash, gold or unencumbered approved securities amounting to not less than
25% of their net demand and time liabilities in India.
This requirement of 25% can be increased by the RBI from time to time by a
notification in the Official Gazette. But the ratio so prescribed cannot exceed 40% (In
the first half of 1986-87, the ratio was 37%), however Regional Rural Banks, Non-scheduled
Banks and Cooperative Banks are allowed to maintain Statutory Liquidity Ratio at 25%
only. Further, all banks are required to maintain this reserve only at 25% in respect of
NRE accounts.
The prescribed SLR on Commercial Banks in November 1999 stands at 25% of net
demand and time liabilities (NDTL) of each bank. The NDTL is worked out twice in a month
on reporting Fridays. The value of SLR securities for Balance Sheet purposes is determined
not with reference to cost of their acquisition but with reference to their market quotations.
Banks are required to submit position in regard to SLR to the Reserve Bank as on
alernate Fridays every month, before the 20th of succeeding month. But the Reserve Bank
can call for daily position in such form as it may prescribe.
The main objects of SLR are:
(a) To assure solvency of commercial banks by compelling them to hold low risk
assets up to the stipulated extent,
(b) To create or support a market for government securities in the economy which
do not have a developed capital market and
(c) To allocate resources to government for augmenting the resources of the Public
Sector.
Banks like Regional Rural Banks may hold entire SLR requirements in the form of
cash with the sponsor banks.
Effects of Statutory Liquidity Ratio
The main purpose of prescribing SLR is to ensure the liquidity position of banks in
meeting the withdrawal requirements of depositors. Since these funds are mostly invested
in Government Securities, they are considered to be highly liquid and also no risk of loss
of value, i.e., they can be encased at quick notice or immediately.
One of the effects of SLR is to raise or lower the liquidity requirements of banks
thus affecting their capacity to lend. In order to discourage the banks from contravening
the liquidity provisions, the RBI may not allow the defaulting banks access to further
refinance and may charge additional interest on their borrowings from it.
It is to be noted that stepping up SLR and CRR have the same effects, viz., they
reduce the capacity of commercial banks to expand credit to business and industry and
they are anti-inflationary.
142
Notes
4. Fixation of Lending Rates of Commercial Banks

The RBI controls the credit created by the commercial banks by fixing the lending
rates of the banks. When the lending rates are fixed at higher level, the credit becomes
costlier and it may lead to contraction of credit. Similarly when the rates are lowered,
it may result into expansion of credit.
Besides controlling the rates of interest on the advances made by the banks, the
RBI places certain restrictions on the grant of advances against term deposits. These relate
to the quantum of advance that can be granted and the rate of interest to be charged.
As such, banks usually grant only up to 75% of deposit value by way of advance.
However, after introduction of banking sector reforms in October, 1994, RBI has allowed
the banks to fix their own lending rates. The Reserve Bank no longer decides the lending
rates of Commercial Banks from 1996.
Each bank is however, required to fix a minimum lending rate known as Prime Lending
Rate (PLR). All loans and advances of each bank is a mark-up over PLR, i.e., the bank
will charge PLR plus 1% to 3% depending upon the customer risk and security offered
for loan.
The banks are also given freedom in October, 1997 to fix their own rates on deposits
accepted by them. This, is however not applicable to savings bank accounts.
5. Credit Squeeze
When the bank rate policy has not been successful in controlling the expansion of
credit, the method of credit squeeze is useful. Under this method, the maximum amount
of bank credit is fixed at a certain limit. And, the maximum limit for commercial banks
borrowing from the RBI is also fixed.
The banks are not allowed to expand the credit beyond these limits. These limits
may be fixed in general for all credits or may be sector-specific like for steel industry,
textile industry, etc.
But it should be noted that a general credit squeeze may make the trade and industry
suffer even for legitimate purposes. Reserve Bank rarely applies credit squeeze these days.
B. Qualitative Credit Control
The selective or qualitative credit control is intended to ensure an adequate credit
flow to the desired sectors and preventing excessive credit for less essential economic
activities. The RBI issues directives under Section 21 of the Banking Regulation Act 1949,
to regulate the flow of banks credit against the security of selected commodities.
It is usually applied to control the credit provided by the banks against certain
essential commodities which may otherwise lead to traders using the credit facilities for
hoarding and black marketing and thereby permitting spiraling prices of these
commodities. The selective credit control measures by RBI are resorted to commodities
like, wheat, sugar, oilseeds, etc.
3.33 RBI Publications

1. Annual: Annual Report, Report on Trends and Progress of Banking in India,
Report on Currency and Finance, Report on State Finances.
2. Quarterly: Occasional Papers (based on research), Banking Statistics.
143
3. Monthly: RBI Bulletin, Credit Information Review.
Notes
4. Weekly: Statistical Supplement.

5. Press Releases: Issued every day to convey policy decisions.
6. Website: updated daily with all publications, press releases, speeches of
Governor/Deputy Governors.
7. Address: www.rbi.org.in
3.34 Securities and Exchange Board of India

The Securities and Exchange Board of India (frequently abbreviated SEBI) is the
regulator for the securities market in India. It was established on 12 April 1992 through
the SEBI Act, 1992.
It was formed officially by the Government of India in 1992 with SEBI Act 1992 being
passed by the Indian Parliament. SEBI is headquartered in the business district of Bandra
Kurla Complex in Mumbai, and has Northern, Eastern, Southern and Western regional
offices in New Delhi, Kolkata, Chennai and Ahmedabad.
Controller of Capital Issues was the regulatory authority before SEBI came into
existence; it derived authority from the Capital Issues (Control) Act, 1947.
Initially, SEBI was a non-statutory body without any statutory power. However, in
1995, the SEBI was given additional statutory power by the Government of India through
an amendment to the Securities and Exchange Board of India Act 1992. In April 1998,
the SEBI was constituted as the regulator of capital markets in India under a resolution
of the Government of India.
The SEBI is managed by its members, which consists of following: (a) The chairman
who is nominated by central government; (b) Two members, i.e., officers of central ministry;
(c) One member from the RBI and (d) The remaining five members are nominated by the
central government, out of whom at least three shall be whole-time members.
The office of SEBI is situated at SEBI Bhavan, Bandra Kurla Complex, Bandra East,
Mumbai - 400051, with its regional offices at Kolkata, Delhi, Chennai and Ahmedabad.
It has recently opened local offices at Jaipur and Bangalore and is planning to open offices
at Guwahati, Bhubaneshwar, Patna, Kochi and Chandigarh.
3.35 Organization of SEBI

The affairs of SEBI shall be managed by a Board. The Board shall consist of the
following members:
1. A Chairman.
2. Two officials of the Central Government from the Ministry of Finance and Ministry
of Law, Justice and Company Affairs.
3. One official nominated by the Reserve Bank of India.
4. Two other members nominated by the Central Government.
The Chairman and the members should be persons of ability, integrity and standing
who have shown capacity in dealing with problems of the securities market. They are
required to have good knowledge or experience in the areas of finance, law, economics,
accountancy, administration, etc.
144
Notes
3.36 Management of the Board

1. The general superintendence, direction and management of the affairs of the
Board shall vest in Board of members, which may exercise all powers and do
all acts and things which may be exercised or done by the Board.
2. Save as otherwise determined by regulations, the Chairman shall also have
powers of general superintendence and direction of the affairs of the Board and
may also exercise all powers and do all acts and things which may be exercised
or done by that Board.
3. The Chairman and members referred to in clauses (a) and (d) of sub-section (1)
shall be appointed by the Central Government and the members referred to in
clauses (b) and (c) of that sub-section shall be nominated by the Central
Government and the respectively.
4. The Chairman and the other members referred to in clauses (a) and (d) of subsection (1) shall be persons of ability, integrity and standing who have shown
capacity in dealing with problems relating to securities market or have special
knowledge or experience of law, finance, economics, accountancy, administration
or in any other discipline which, in the opinion of the Central Government, shall
be useful to the Board.
5. The term of office and other conditions of service of the Chairman and the
members referred to in clause (d) of sub-section (1) of section 4 shall be such
as may be prescribed.
6. Secondary Market Advisory Committee (SMAC).
7. Mutual Fund Advisory Committee.
8. Corporate Bonds and Securitization Advisory Committee.
9. Takeover Panel.
10. SEBI Committee on Disclosures and Accounting Standards (SCODA).
11. High Powered Advisory Committee on consent orders and compounding of
offences.
12. Derivatives Market Review Committee.
13. Committee on Infrastructure Funds.
14. Regulation over Financial Terms of Various Authorities.
15. Technical Advisory Committee.
16. Committee for review of structure of market infrastructure institutions.
17. Members of the Advisory Committee for the SEBI Investor Protection and
Education Fund.
18. Takeover Regulations Advisory Committee.
19. Primary Market Advisory Committee (PMAC).
3.37 Objectives of SEBI

The various objectives of SEBI are given below:
1. To protect the interests of investors through proper education and guidance as
regards their investment in securities. For this, SEBI has made rules and
regulations to be followed by the financial intermediaries such as brokers, etc.
SEBI looks after the complaints received from investors for fair settlement. It
also issues booklets for the guidance and protection of small investors.
145
2. To regulate and control the business on stock exchanges and other security
markets. For this, SEBI keeps supervision on brokers. Registration of brokers
and sub-brokers is made compulsory and they are expected to follow certain
rules and regulations. Effective control is also maintained by SEBI on the
working of stock exchanges.
Notes
3. To make registration and to regulate the functioning of intermediaries such as

stock brokers, sub-brokers, share transfer agents, merchant bankers and other
intermediaries operating on the securities market.
4. To provide suitable training to intermediaries. This function is useful for healthy
atmosphere on the stock exchange and for the protection of small investors.
5. To register and regulate the working of mutual funds including UTI (Unit Trust
of India). SEBI has made rules and regulations to be followed by mutual funds.
The purpose is to maintain effective supervision on their operations and avoid
their unfair and anti-investor activities.
6. To promote self-regulatory organization of intermediaries. SEBI is given wide
statutory powers. However, self-regulation is better than external regulation.
Here, the function of SEBI is to encourage intermediaries to form their
professional associations and control undesirable activities of their members.
SEBI can also use its powers when required for protection of small investors.
7. To regulate mergers, takeovers and acquisitions of companies in order to protect
the interest of investors. For this, SEBI has issued suitable guidelines so that
such mergers and takeovers will not be at the cost of small investors.
8. To prohibit fraudulent and unfair practices of intermediaries operating on
securities markets. SEBI is not for interfering in the normal working of these
intermediaries. Its function is to regulate and control their objectionable practices
which may harm the investors and healthy growth of capital market.
9. To issue guidelines to companies regarding capital issues. Separate guidelines
are prepared for first public issue of new companies, for public issue by existing
listed companies and for first public issue by existing private companies. SEBI
is expected to conduct research and publish information useful to all market
players.
10. To conduct inspection, inquiries and audits of stock exchanges, intermediaries
and self-regulating organizations and to take suitable remedial measures
wherever necessary. This function is undertaken for orderly working of stock
exchanges and intermediaries.
11. To restrict insider trading activity through suitable measures. This function is
useful for avoiding undesirable activities of brokers and securities scams.
3.38 Functions of SEBI

According to SEBI Act, 1992, the main functions of SEBI are:
1. Regulating the securities market.
2. Recognition and regulation of the Stock Exchanges.
3. Registering and regulating the working of various intermediaries including
Merchant Bankers, Registrars, Share Transfer Agents, Stock-brokers, Subbrokers, Debenture Trustees, Bankers to the Issue, Underwriters, Portfolio
Managers, etc.
4. Registering and regulating the functioning of Depositories, Custodians and
Depository Participants.
146
Notes
5. Registration of Foreign Institutional Investors.

6. Registering and regulating the working of Venture Capital Funds, Mutual Funds
and other collective investment schemes including plantation schemes.
7. Promotion and regulation of Self-regulatory Organizations.
8. Prohibiting fraudulent and unfair trade practices relating to securities market.
9. Prohibiting insider trading in securities.
10. Regulating substantial acquisition of shares and takeover of companies.
11. Promoting investor education and training of intermediaries.
12. Conducting research relating to securities market.
3.39 Powers of Securities and Exchange Board of India

The important powers of Securities and Exchange Board of India are as follows:
1. Power relating to stock exchanges and intermediaries
SEBI has wide powers regarding the stock exchanges and intermediaries dealing
in securities. It can ask information from the stock exchanges and intermediaries regarding
their business transactions for inspection or scrutiny and other purpose.
2. Power to impose monetary penalties
SEBI has been empowered to impose monetary penalties on capital market
intermediaries and other participants for a range of violations. It can even impose
suspension of their registration for a short period.
3. Power to initiate actions in functions assigned
SEBI has a power to initiate actions in regard to functions assigned. For example,
it can issue guidelines to different intermediaries or can introduce specific rules for the
protection of interests of investors.
4. Power to regulate insider trading
SEBI has power to regulate insider trading or can regulate the functions of merchant
bankers.
5. Powers under securities contracts act
For effective regulation of stock exchange, the Ministry of Finance issued a
Notification on 13 September, 1994 delegating several of its powers under the Securities
Contracts (Regulations) Act to SEBI.
SEBI is also empowered by the Finance Ministry to nominate three members on
the Governing Body of every stock exchange.
6. Power to regulate business of stock exchanges
SEBI is also empowered to regulate the business of stock exchanges, intermediaries
associated with the securities market as well as mutual funds, fraudulent and unfair trade
practices relating to securities and regulation of acquisition of shares and takeovers of
companies.
3.40 Lenders Liability Act

There is a large volume of reported appellate cases on lender liability and most courts
are eager to decide each case after examining its unique facts. Lenders need to
understand, before taking action at any stage in the loan relationship, how to avoid legal
issues that can lead to costly litigation.
147
A common theory in lender liability actions is breach of contract, and the first contract
that is considered in the borrower-lender relationship is the loan commitment. This is the
most litigated loan contract, whether the initial contract to make the loan or a commitment
to extend or recast the loan as a result of borrower difficulties.
Notes
Although the lender has the right to refuse to make a loan, the lender must comply
with the laws governing the loan application process. For example, the lender cannot
discriminate against the borrower on the basis of race, religion, national origin, sex, marital
status, or age. The lender also has a duty to process a loan application with reasonable
care. The negligent calculation of the applicant's qualifications under standard industry
criteria may give rise to a cause of action against the lender for failure to use due care.
Processing the application is one thing; protecting the borrower from an improvident
deal is quite another. In the commercial loan setting, the lender is generally not required
to protect the inexperienced borrower from a bad business decision. A greater duty must
be established for the lender to be held liable.
Once the borrower and the lender agree on the terms of a loan, a contract, usually
a conditional contract, is formed. If a party breaches that contract, the usual contract
remedies apply. Lender liability is found when the lender breaches its promise to extend
financing. Similarly, the lender is liable for breach of its promise to forbear from the exercise
of remedies otherwise available to it under the loan documents or failing to honor previously
agreed-upon loan modification terms.
For example, in one case, a lump sum payment was due under a note. The borrower
had financial difficulties and agreed with the loan officer to convert the obligation to an
installment loan.
When the loan officer went out of town, the loan officers superior refused to convert the
note, accelerated its due date, and exercised the lender-banks offset rights against the other
accounts of the borrower. The court held the lender liable for the borrower's damages.
This does not mean that the lender as a matter of course is obligated to extend
the loan opening date. Rather, the lender is entitled to demand strict compliance with
the terms of the commitment and upon the borrowers breach, retain the commitment fee.
The lender will not be liable for breach of the covenant of good faith and fair dealing when
the loan commitment clearly states that the borrower was not entitled to a refund under
any circumstances and there was no contractual obligation on the lender to grant an
extension of time to perform. Further, the borrower must comply with the requirements
of the loan commitment, notwithstanding alleged oral statements by an officer of the lender
amending commitment requirements.
Although the lender may be liable for damages incurred by the borrower as a result
of the lenders breach of the loan commitment, punitive damages are generally not
recoverable.
Damages for breach of contract are limited to those necessary to compensate the
borrower for the lenders breach, that is, the excess interest required to be paid on
replacement financing. The old rule that the borrower could not specifically enforce the
loan commitment is falling into disfavor and borrowers are being granted the right to do
so. The opposite is not true, however; the courts generally do not allow the lender to enforce
a long-term commitment against the borrower.
Law of Lender Liability provides a comprehensive explanation of the major legal issues
that arise between lenders and borrowers at the various stages of the loan relationship.
It also provides practical guidance for developing and implementing protective measures
at every stage of the life of the loan.
148
Notes
This manual covers:

(i) Developments regarding federal pre-emption of state banking laws.
(ii) Federal agency warnings, guidance and advisories to financial institutions
concerning new types of financial products.
(iii) Cases exploring the outer reaches of guarantor liability.
(iv) Punitive damages decisions in the appellate courts.
(v) Challenges to arbitration clauses.
(vi) Court responses to lawsuits alleging breach of the lenders fiduciary duties.
(vii) Statutes and cases breaking new ground on privacy rights.
3.41 Banking Innovations

Innovation derives organization to grow, prosper and transform in sync with the
changes in the environment, both internal and external. Banking is no exception to this.
In fact, this sector has witnessed radical transformation of late, based on many innovations
in products, processes, services, systems, business models, technology, governance and
regulation. A liberalized and globalized financial infrastructure had provided an additional
impetus to this gigantic effort. The pervasive influence of information technology has
revolutionaries banking. Transaction costs have crumbled and handling of astronomical
brick and mortar structure has been rapidly yielding ground to click and order electronic
banking with a plethora of new products. Banking has become boundaryless and virtual
with a 24 7 model. Banks who strongly rely on the merits of relationship was banking
as a time-tested way of targeting and servicing clients have readily embraced Customer
Relationship Management (CRM), with sharp focus on customer centricity, facilitated by
the availability of superior technology. CRM has, therefore, has become a new mantra
in service management, which in both relationship based and information intensive. Thanks
to the regulatory changes and financial innovation, large banks have now become complex
organizations engaged in wide range of activities. Banking is now a one-stop provider with
a high degree of competition and competence. Banking has become a part of financial
services. Risk Management is no longer a mere regulatory issue. Basel-II has accorded
a primacy of place to this fascinating exercise by repositioning it as the core banking.
We now see the evolution of many novel deferral products like credit risk management
tool that enhances liquidity and market efficiency. The retail revolution with accent on retail
loans in the form of housing loans and consumer loans literally dominating the banking
globally is yet another example of product and service innovation. Various types of credit
and debit cards and indeed e-cash itself, which has the potential to redefine the role of
monetary authorities, are some more illustrious examples.
Over the years, the banking sector in India has seen a number of changes. Most
of the banks have begun to take an innovative approach towards banking with the objective
of creating more value for customers, and consequently, the banks. Some of the significant
changes in the Indian banking sector are discussed below:
With a majority of the Indian population living in rural areas, rural banking forms a
vital component of the Indian banking system. Besides, rural banking operations in India
are rather different from urban operations, due to the strong disparity that exists between
urban and rural life, and the needs of these two sections of people.
While traditionally, banking meant borrowing and lending, in the latter part of the
20th century, the word took on a different meaning altogether. Banks no longer restricted
themselves to traditional banking activities, but explored newer avenues to increase
business and capture new markets.
149
Many analysts predict still more revolutionary changes in the banking sector in India.
The chief of these are likely to be the concept of Universal Banks and the introduction
of Smart Card technology.
Notes
Although the Indian banking sector has made rapid progress particularly in the
number of innovations introduced, some analysts are skeptical about the efficacy and
practical use of many of these services.
Banking in India has already undergone a huge transformation in the years since
Independence. The rate of transformation was particularly high in the 1990s and 2000s,
when a number of innovations changed the way banking was perceived.
Information technology is one of the most important facilitators for the transformation
of the Indian banking industry in terms of its transactions processing as well as for various
other internal systems and processes. The various technological platforms used by banks
for the conduct of their day-to-day operations, their manner of reporting and the way in
which inter-bank transactions and clearing is affected has evolved substantially over the
years.
A combination of regulatory and competitive reasons has led to increasing importance
of total banking automation in the Indian Banking Industry. Information technology enables
sophisticated product development, better market infrastructure, implementation of reliable
techniques for control of risks and helps the financial intermediaries to reach geographically
distant and diversified markets. In view of this, technology has changed the contours of
three major functions performed by banks, i.e., access to liquidity, transformation of assets
and monitoring of risks. Information technology and the communication networking
systems have a crucial bearing on the efficiency of money, capital and foreign exchange
markets.
New Technology in Banking
The technological evolution of the Indian banking industry has been largely directed
by the various committees set up by the RBI and the Government of India to review the
implementation of technological change. No major breakthrough in technology implementation
was achieved by the industry till the early 80s, though some working groups and
committees made stray references to the need for mechanization of some banking
processes. This was largely due to the stiff resistance by the very strong bank employees
unions. The early 1980s were instrumental in the introduction of mechanization and
computerization in Indian banks. This was the period when banks as well as the RBI went
very slow on mechanization, carefully avoiding the use of computers to avoid resistance
from employee unions. However, this was the critical period acting as the icebreaker, which
led to the slow and steady move towards large-scale technology adoption.
The process of computerization marked the beginning of all technological initiatives
in the banking industry. Computerization of bank branches had started with installation
of simple computers to automate the functioning of branches, especially at high traffic
branches. Total Branch Automation was in use which did not involve bank level branch
networking and did not mean much to the customer.
Networking of branches are now undertaken to ensure better customer service. Core
Banking Solutions (CBS) is the networking of the branches of a bank, so as to enable
the customers to operate their accounts from any bank branch, regardless of which branch
he opened the account with. The networking of branches under CBS enables centralized
data management and aids in the implementation of internet and mobile banking. Besides,
CBS helps in bringing the complete operations of banks under a single technological
platform.
150
Notes
CBS implementation in the Indian banking industry is still underway. The vast
geographical spread of the branches in the country is the primary reason for the inability
of banks to attain complete CBS implementation.
Satellite banking is also an upcoming technological innovation in the Indian banking
industry, which is expected to help in solving the problem of weak terrestrial
communication links in many parts of the country. The use of satellites for establishing
connectivity between branches will help banks to reach rural and hilly areas in a better
way, and offer better facilities, particularly in relation to electronic funds transfers. However,
this involves very high costs to the banks. Hence, under the proposal made by RBI, it
would be bearing a part of the leased rentals for satellite connectivity, if the banks use
it for connecting the north-eastern states and the underbanked districts.
3.42 Basel Committee Recommendations

The Basel Committee on Banking Supervision (or Basel Committee for short) plays
a leading role in standardizing bank regulations across jurisdictions. Its origins can be
traced to June 26, 1974, when German regulators forced the troubled Bank Herstatt into
liquidation. That day, a number of banks had released payment of German marks to
Herstatt in Frankfurt in exchange for US dollars that was to be delivered in New York.
Because of time-zone differences, Herstatt ceased operations between the times of the
respective payments. The counterparty banks did not receive their dollar payments.
Responding to the cross-jurisdictional implications of the Herstatt debacle, G-10
countries and Luxembourg formed a standing committee under the auspices of the Bank
for International Settlements (BIS). Called the Basel Committee on Banking Supervision,
the committee comprises representatives from participant nations central banks and
regulatory authorities. Over time, the focus of the committee has evolved, embracing
initiatives designed to:
(i) Define roles of regulators in cross-jurisdictional situations;
(ii) Ensure that international banks or bank holding companies do not escape
comprehensive supervision by a home regulatory authority;
(iii) Promote uniform capital requirements so banks from different countries may
compete with one another on a level playing field.
The Basel Committees does not have legislative authority, but participant countries
are expected to implement its recommendations. Mostly, they do. Also, the committee
sometimes allows for flexibility in how local authorities implement recommendations, so
even when recommendations are implemented, national laws vary.
In recent decades, the Basel Committee has focused on developing a uniform system
of bank capital requirements, called the Basel Accords. Work commenced with a 1988
Basel Accord, which is today called Basel-I that set minimum capital requirements for
banks credit risk. A 1996 amendment added capital charges for market risk. Starting in
1999 and continuing into the early 2000s, the Basel Committee developed an overhaul
of Basel-I, which is called Basel-II. Implementation of Basel-II was nearing completion when
the 2008 financial crisis hit. With governments bailing out numerous financial institutions,
it was clear the Basel Accords were inadequate. The Basel Committee responded with
a number of stopgap measures, which have been called Basel 2.5, followed by a longerterm overhaul of bank capital requirements, which is called Basel-III.
The failure of the Basel Accords to prevent financial crises in either 2000-2001 or
2008 raises concerns. Some have come to view the Basel Committee as a bankers club,
151
populated by central bankers and regulators who either hailfrom or are otherwise beholden
to the banking industry. The focus of the Basel Accords has always been on regulating
bank capital and not bank practices. But capital requirements cannot protect against the
sorts of abuses that came to light in the two recent financial crises.
Notes
The Basel Committee on Banking Supervision's work is organized under four main
sub-committees:
(i) The Standards Implementation Group was originally established to share
information on, and promote consistency in, the implementation of the Basel
II Framework. In 2009, the Standards Implementation Groups goals were
broadened to concentrate on implementation of general Basel Committee
guidance and standards.
(ii) The Policy Development Group identifies and reviews emerging supervisory
issues. The Policy Development Group also proposes and develops policies
designed to create sound banking systems and supervisory standards.
(iii) The Accounting Task Force helps ensure that international accounting and
auditing standards and practices promote risk management at banks. The
Accounting Task Force also develops reporting guidance and takes an active
role in the development of these international accounting and auditing standards.
(iv) The Basel Consultative Group facilitates supervisory dialogue with non-member
countries on new committee initiatives by engaging senior representatives from
various countries, international institutions and regional groups of banking
supervisors that are not members of the committee.
BCBS members include representatives from Argentina, Australia, Belgium, Brazil,
Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea,
Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa,
Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The
BCBS encourages contact and cooperation between its members and other banking
supervisory authorities. It also circulates papers providing guidance on supervisory matters
to banking regulators all over the world.
3.43 Capital Adequacy Ratio (CAR)

Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine the
adequacy of their capital keeping in view their risk exposures. Banking regulators require
a minimum capital adequacy ratio so as to provide the banks with a cushion to absorb
losses before they become insolvent. This improves stability in financial markets and
protects deposit-holders. Basel Committee on Banking Supervision of the Bank of
International Settlements develops rules related to capital adequacy which member
countries are expected to follow.
The committees latest pronouncement on capital adequacy is Basel-III, issued
December 2010, revised June 2011.
The pronouncement requires banks to maintain the following minimum ratios as of
1 January 2013:
Common Equity Tier 1 Risk-weighted Exposures
3.5%
Tier 1 Capital Risk-weighted Exposures
4.5%
Total Capital Risk-weighted Exposures
8%
Since such pronouncements are frequently updated, please consult the Bank of
International Settlements website for latest guidance.
152
Notes
Formula:
Capital Adequacy Ratio = Tier 1 Capital + Tier 2 Capital
Risk-weighted Exposures
Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1
Total Capital = Tier 1 Capital + Tier 2 Capital
Risk-weighted exposures include weighted sum of the banks credit exposures
(including those appearing on the banks balance sheet and those not appearing). The
weights are determined in accordance with the Basel Committee guidance for assets of
each credit rating slab.
3.44 Risk Weighted Assets

Risk weighted assets is a measure of the amount of a banks assets, adjusted for
risk. The nature of a banks business means it is usual for almost all of a banks assets
will consist of loans to customers. Comparing the amount of capital a bank has with the
amount of its assets gives a measure of how able the bank is to absorb losses. If its
capital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent.
By adjusting the amount of each loan for an estimate of how risky it is, we can
transform this percentage into a rough measure of the financial stability of a bank. It is
not a particularly accurate measure because of the difficulties involved in estimating these
risks. These difficulties are exacerbated by the motivation banks have to distort it.
The main use of risk weighted assets is to calculate tier 1 and tier 2 capital adequacy
ratios.
Risk weighting adjusts the value of a asset for risk, simply by multiplying it be a
factor that reflects its risk. Low risk assets are multiplied by a low number, high risk assets
by 100% (i.e., 1).
Suppose a bank has the following assets: 1 billion in gilts, 2 billion secured by
mortgages, and 3 billion of loans to businesses. The risk weightings used are 0% for gilts
(a risk free asset), 50% for mortgages, and 100% for the corporate loans. The banks risk
weighted assets are 0 1 bn + 50% 2 bn + 100% 3 bn = 4 bn.
Basel I used a comparatively simple system of risk weighting that is used in the
calculation above. Each class of asset was assigned a fixed risk weight. Basel II uses
a different classification of assets with some types having weightings that depend on the
borrowers credit rating or the banks own risk models.
Banks have a motive to take on more risk. If they win their bets, the shareholders
(and management) take the profit, if they lose then the loss us likely to be shared with
debt holders or governments (as banks are rarely allowed to fail). Part of the motivation
for Basel-II was that banks were able to work around the Basel-I system by selecting
riskier business within each asset class. Given this, it seems remiss to have allowed the
banks to use their own risk models, especially given that model risk was quite high even
without the incentives the banks had to manipulate the models to understate risk.
3.45 Risk-based Supervision

Risk-based supervisions (RBS) main purpose is to develop a risk profiling of
commercial banks in India. Post the recent global economic crisis, there has been a shift
towards RBS, and away from the erstwhile CAMELS (Capital adequacy, Asset quality,
153
Management, Earnings appraisal, Liquidity and Systems and controls) approach, which
was more of a transaction testing model. The supervisory stance of RBS will extend to
an analysis of a banks propensity for failure and its likely impact on the financial system.
With banks moving into this uniform methodology of supervision, India will now be at par
with best practices around the world.
Notes
RBS can be termed forward looking as it seeks to assess risk buildup by examining
whether the supervised entity/bank follows regulatory prescriptions, and if its internal risk
management practices are aligned with regulatory expectations. In short, its goals are
to help banks optimize the utilization of supervisory resources and minimize the impact
of crises scenarios in the financial system.
Risk-based supervision is a supervisory approach that has either been implemented,
or is in the process of being implemented, by many supervisory authorities. In addition,
risk-based supervision concepts are embedded in the Basel Core principles for effective
banking supervision and are part of the IMF and World Banks Financial Sector
Assessment Programs (FSAPs) of countries.
In todays fast moving and interconnected world, along with carrying out on-site and
off-site activities at banks, supervisors need to be forward-looking, and develop plans for
intervening early, if a material problem surfaces at one or more of their domestic
systemically-important banks.
As such, we have designed a comprehensive program, which covers a variety of
current and relevant topics, to assist supervisors in becoming more effective and nimble
in their work.
Over 5 days, we plan to cover the following topics:
(a) Key concepts, principles and general approach for an effective risk-based
supervision framework.
(b) How to identify the significant activities in a bank and, in turn, rate the inherent
credit, market, operational and other risks for these activities.
(c) How to assess and rate the performance of board, senior management and the
independent oversight functions such as internal audit, risk management and
compliance, that oversee a bank.
(d) A walk-through on how FIN-FSA conducts its supervisory planning process as
well as how it carries out its on-site work for credit and liquidity.
(e) Macro prudential activities that enable one to identify and deal with problems
early.
(f) Cross-border cooperation and supervisory colleges, plus recovery and resolution
plans for Systemically Important Financial Institutions (SIFIs).
(g) Crisis preparedness and the importance of developing a crisis handbook.
3.46 Asset Liability Management (ALM) in Commercial Banks

ALM is a comprehensive and dynamic framework for measuring, monitoring and
managing the market risk of a bank. It is the management of structure of balance sheet
(liabilities and assets) in such a way that the net earnings from interest are maximized
within the overall risk preference (present and future) of the institutions. The ALM functions
extend to liquidity risk management, management of market risk, trading risk
management, funding and capital planning and profit planning and growth projection.
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Notes
3.47 Benefits of ALM

It is a tool that enables bank managements to take business decisions in a more
informed framework with an eye on the risks that bank is exposed to. It is an integrated
approach to financial management, requiring simultaneous decisions about the types of
amounts of financial assets and liabilities both mix and volume with the complexities
of the financial markets in which the institution operates
The concept of ALM is of recent origin in India. It has been introduced in Indian
Banking industry w.e.f. 1st April, 1999. ALM is concerned with risk management and
provides a comprehensive and dynamic framework for measuring, monitoring and managing
liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank
that needs to be closely integrated with the banks business strategy.
Therefore, ALM is considered as an important tool for monitoring, measuring and
managing the market risk of a bank. With the deregulation of interest regime in India,
the Banking industry has been exposed to the market risks. To manage such risks, ALM
is used so that the management is able to assess the risks and cover some of these
by taking appropriate decisions.
The assets and liabilities of the banks balance sheet are nothing but future cash
inflows or outflows. With a view to measure the liquidity and interest rate risk, banks use
of maturity ladder and then calculate cumulative surplus or deficit of funds in different time
slots on the basis of statutory reserve cycle, which are termed as time buckets.
As a measure of liquidity management, banks are required to monitor their cumulative
mismatches across all time buckets in their Statement of Structural Liquidity by
establishing internal prudential limits with the approval of the Board/Management
Committee.
As per RBI guidelines, commercial banks are to distribute the outflows/inflows in
different residual maturity period known as time buckets. The Assets and Liabilities were
earlier divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days;
181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period
to their maturity (also called residual maturity). All the liability figures are outflows while
the asset figures are inflows. In September, 2007, having regard to the international
practices, the level of sophistication of banks in India, the need for a sharper assessment
of the efficacy of liquidity management and with a view to providing a stimulus for
development of the term-money market, RBI revised these guidelines and it was provided
that:
(a) The banks may adopt a more granular approach to measurement of liquidity risk
by splitting the first time bucket (1-14 days at present) in the Statement of Structural
Liquidity into three time buckets, viz., next day, 2-7 days and 8-14 days. Thus, now we
have 10 time buckets.
After such an exercise, each bucket of assets is matched with the corresponding
bucket of the liability. When in a particular maturity bucket, the amount of maturing
liabilities or assets does not match, such position is called a mismatch position, which
creates liquidity surplus or liquidity crunch position and depending upon the interest rate
movement, such situation may turn out to be risky for the bank. Banks are required to
monitor such mismatches and take appropriate steps so that bank is not exposed to risks
due to the interest rate movements during that period.
(b) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14
days and 15-28 days buckets should not exceed 5%, 10%, 15% and 20% of the cumulative
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cash outflows in the respective time buckets in order to recognize the cumulative impact
on liquidity.
Notes
The Boards of the banks have been entrusted with the overall responsibility for the
management of risks and is required to decide the risk management policy and set limits
for liquidity, interest rate, and foreign exchange and equity price risks.
Asset-Liability Committee (ALCO) is the top most committee to oversee the
implementation of ALM system and it is to be headed by CMD or ED. ALCO considers
product pricing for deposits and advances, the desired maturity profile of the incremental
assets and liabilities in addition to monitoring the risk levels of the bank. It will have to
articulate current interest rates view of the bank and base its decisions for future business
strategy on this view.
3.48 Corporate Debt Restructuring

Debt restructuring is a process that allows a private or public company, or a sovereign
entity facing cash flow problems and financial distress to reduce and renegotiate its
delinquent debts in order to improve or restore liquidity so that it can continue its
operations.
Corporate Debt Restructuring (CDR) mechanism is a voluntary non statutory
mechanism under which financial institutions and banks come together to restructure the
debt of companies facing financial difficulties due to internal or external factors, in order
to provide timely support to such companies.
The intention behind the mechanism is to revive such companies and also safeguard
the interests of the lending institutions and other stakeholders. The CDR mechanism is
available to companies who enjoy credit facilities from more than one lending institution.
The mechanism allows such institutions, to restructure the debt in a speedy and
transparent manner for the benefit of all.
3.49 E-Banking
World over banks are reorienting their business strategies towards new opportunities
offered by e-banking. E-banking has enabled banks to scale borders, change strategic
behavior and thus bring about new possibilities. E-banking has moved real banking behavior
closer to neoclassical economic theories of market functioning. Due to the absolute
transparency of the market, clients both business as well as retail can compare the
services of various banks more easily. For instance, on the internet, competitors are only
one click away. If clients are not happy with the products, prices or services offered by
a particular bank, they are able to change their banking partner much more easily than
in the physical or real bank-client relationship. From the banks point of view, use of the
internet has significantly reduced the physical costs of banking operations.
Around the world electronic banking services, whether delivered online or through
other mechanisms, have spread quickly in recent years. It must be noted that the impact
of e-banking is not limited to industrial and advanced emerging economies. Even in
countries with underdeveloped banking systems, E-banking has offered many new
business opportunities.
E-business is a monolithic term encompassing the various business processes that
aim to integrate the vendors or traders with the consumers and suppliers using the Internet.
The entire process of setting up a website, helping the prospective customers navigate
through the website, showing them the available products, offering discounts and vouchers
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Notes
and doing everything possible to woo the prospective clients and converting them into
customers, comes under the purview of e-business. E-commerce, on the other hand, is
a subset of e-business and refers to online transactions that can be accounted for in
monetary terms. For instance, accepting credit card payment for products sold to
consumers or making payments for shopping online are examples of e-commerce. In other
words, e-commerce refers to the last stage of e-business, which involves collecting
payments for the goods sold by the business firm.
Meaning of E-Banking
E-banking is defined as the automated delivery of new and traditional banking
products and services directly to customers through electronic, interactive communication
channels.
3.50 Development of E-Banking in India

In India, e-banking is of fairly recent origin. The traditional model for banking has
been through branch banking. Only in the early 1990s, there has been start of non-branch
banking services. The good old manual systems on which Indian Banking depended upon
for centuries seem to have no place today. The credit of launching internet banking in
India goes to ICICI Bank. Citibank and HDFC Bank followed with internet banking services
in 1999.
Several initiatives have been taken by the Government of India as well as the Reserve
Bank to facilitate the development by e-banking in India. The Government of India enacted
the IT Act, 2000 with effect from October 17, 2000 which provided legal recognition to
electronic transactions and other means of electronic commerce. The Reserve Bank is
monitoring and reviewing the legal and other requirements of e-banking on a continuous
basis to ensure that e-banking would develop on sound lines and e-banking related
challenges would not pose a threat to financial stability.
A high level Committee under chairmanship of Dr. K.C. Chakrabarty and members
from IIT, IIM, IDRBT, Banks and the Reserve Bank prepared the IT Vision Document
2011-17, for the Reserve Bank and banks which provides an indicative road map for
enhanced usage of IT in the banking sector.
To cope with the pressure of growing competition, Indian commercial banks have
adopted several initiatives and e-banking is one of them. The competition has been
especially tough for the public sector banks, as the newly established private sector and
foreign banks are leaders in the adoption of e-banking.
3.51 E-Banking Services

Indian banks offer to their customers following e-banking products and services:
(i) Automated Teller Machines (ATMs)
(ii) Internet Banking
(iii) Mobile Banking
(iv) Tele Banking
(v) Electronic Fund Transfer
(vi) Standing Instructions
(vii) Online Mutual Fund Investment
(viii) Smart Cards
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(i) Automated Teller Machines (ATMs)
Notes
ATM is a modern device introduced by the banks to enable the customers to have
access to money day-in/day-out without visiting the bank branches in person. The system
is known as Any Time Money or Any Where Money because it enables the customers
to withdraw money from the bank from any of its ATMs round the clock.
(ii) Internet Banking
Internet banking is an electronic payment system that enables customers of a
financial institution to conduct financial transactions on a website operated by the
institution. Internet banking does offer many benefits for both banks and their customers.
So, the banks are doing what they can to encourage customers to try it.
(iii) Mobile Banking
Mobile banking is a system that allows customers of a financial institution to conduct
a number of financial transactions through a mobile device such as a mobile phone or
tablet. With the use of a mobile device, the user can perform mobile banking via call,
text, website or applications. It utilizes the mobile connectivity of telecom operators and
therefore does not require an internet connection. With mobile banking, users of mobile
phones can perform several financial functions conveniently and securely from their mobile.
(iv) Tele Banking
Telephone banking is a service provided by a bank or other financial institution that
enables customers to perform financial transactions over the telephone, without the need to
visit a bank branch or automated teller machine. Telephone banking times can be longer than
branch opening times, and some financial institutions offer the service on a 24 hour basis.
(v) Electronic Fund Transfer
Electronic Funds Transfer (EFT) is a system of transferring money from one bank
account directly. Transactions are processed by the bank through the Automated Clearing
House (ACH) network. The benefits of EFT include reduced administrative costs, increased
efficiency, simplified bookkeeping and greater security.
(vi) Standing Instructions
Standing instructions are a way of making an automatic payment of a fixed amount
to a loan, bill or credit card at the same time every week or month. It can be made from
deposit account and is most commonly used to make payments to a mortgage, car loan
or to pay bills.
(vii) Online Mutual funds Investment
Mutual fund is a professionally-managed trust that pools the savings of many
investors and invests them in securities like stocks, bonds, short-term money market
instruments and commodities such as precious metals. Investors in a mutual fund have
a common financial goal and their money is invested in different asset classes in
accordance with the funds investment objective. Indian banks and financial institutions
offer online mutual fund investment facilities.
(viii) Smart Cards
The banking industry enjoyed the benefits of magnetic stripe card technology for a
long time. This technology has revolutionized the payment card industry and increased
the level of card security. These cards use encryption and authentication technology which
is more secure than other methods associated with payment system. Example: State
Bank Smart Payout Card can be used for cash withdrawal at ATMs, for purchase
transactions at merchant establishments and for e-Commerce.
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Notes
3.52 Internet Banking

Internet banking system is a method in which a personal computer is connected
by a network service provider directly to a host computer system of a bank such that
customer service requests can be processed automatically without need for intervention
by customer service representatives. The system is capable of distinguishing between
those customer service requests which are capable of automated fulfillment and those
requests which require handling by a customer service representative. The system is
integrated with the host computer system of the bank so that the remote banking customer
can access other automated services of the bank.
Meaning of Internet Banking
Internet banking refers to a system allowing individuals to perform banking activities
at home, via the internet. Internet banking allows customers to conduct financial
transactions on a secure website operated by their retail or virtual bank.
3.53 Internet Banking in India

The Reserve Bank of India constituted a working group on Internet Banking. The group
divided the internet banking products in India into three types based on the levels of access
granted. They are:
(i) Information Only System
General purpose information like interest rates, branch location, bank products and
their features, loan and deposit calculations are provided in the banks website. There exist
facilities for downloading various types of application forms. The communication is normally
done through e-mail. There is no interaction between the customer and banks application
system. No identification of the customer is done. In this system, there is no possibility
of any unauthorized person getting into production systems of the bank through internet.
(ii) Electronic Information Transfer System
The system provides customer-specific information in the form of account balances,
transaction details, and statement of accounts. The information is still largely of the read
only format. Identification and authentication of the customer is through password. The
information is fetched from the banks application system either in batch mode or offline.
The application systems cannot directly access through the internet.
(iii) Fully Electronic Transactional System
This system allows bi-directional capabilities. Transactions can be submitted by the
customer for online update. This system requires high degree of security and control. In
this environment, web server and application systems are linked over secure infrastructure.
It comprises technology covering computerization, networking and security, inter-bank
payment gateway and legal infrastructure.
3.54 Advantages of Internet Banking

The various advantages of internet banking are as follows:
Internet banking does offer many benefits for both banks and their customers. So,
the banks are doing what they can to encourage customers to try it.
1. An internet banking account is simple to open and use. One just enter a few
answers to questions in a form while sitting comfortably in your own home or
159
office. To access the account, the customer has to establish security measures
such as usernames and passwords. To complete the set up of account,
customer has to just print, sign and send in a form.
Notes
2. Internet banking costs less. Because there are fewer buildings to maintain, and
less involvement by salaried employees, there is a much lower overhead with
online banks. These savings allow them to offer higher interest rates on savings
accounts and lower lending rates and service charges. Even traditional brick
and mortar banks offer better deals such as free bill paying services to encourage
their customers to do their banking online.
3. Comparing internet banks to get the best deal is easy. In a short time,
customers can visit several online banks to compare what they offer in savings
and checking account deals as well as their interest rates. Other things that
can be easily done is research about credit cards availability, credit card interest
rates, loan terms and the banks own rating with the FDIC.
4. Bouncing a cheque (accidentally) should be a thing of the past because it can
be monitored in the account online any time, day or night. Customers can track
your balance daily, see what cheques have cleared and when and know when
automatic deposits and payments are made. This is all possible by simply going
online to the banks website and logging into your account.
5. Banks keep the account balanced using computer and the monthly statement.
Customers bank account information can be downloaded into software
programs such as Microsoft Money or Quicken; making is easy to reconcile
with the account with just a few mouse clicks. The convenience of the data
capture online makes it much easier to budget and track where the money goes.
The internet bank account even allows to view copies of the cheques that have
been written each month.
6. With the ability to view the account at anytime, it is easier to catch fraudulent
activity in the account before much damage is done. As soon as the customer
logs into the account, he will be able to quickly see whether there is anything
amiss when there is a cheque on deposits and debits. If anyone writes a cheque
or withdraws funds from the account and customer is known, it wasnt the
intended person. This lets the customer to get started on correcting the problem
immediately rather than having to wait a month, even if it has a clue, it is
happening as would be the case with a traditional bank.
7. Internet banking offers a great deal more convenience than from a conventional
bank. Customers arent bound by bankers hours and dont have to go there
physically. Time is not wasted when there is work to do because the customer
can do offices banking without leaving the office. No matter wherever we are
or what time it is, customer can easily manage the money.
3.55 Disadvantages of Internet Banking

Internet banking or electronic banking allows customers to access their accounts
at any time from any computer or smart phone. This banking style has a lot of advantages,
including 24-hour account monitoring, the ability to bank from anywhere and fast
transactions. However, this system has some distinct disadvantages, too.
1. Identity Confirmation
The regulations require that financial institutions confirm each customers identity.
This may present a logistical issue, as copying and faxing documents is sometimes
necessary.
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Notes
2. Security Concerns
With hacking and identity theft on the rise, Internet banking customers have to place
a certain amount of trust in the bank that their account information and personal information
are safe.
3. Customer Service
If the customer banks at a traditional bank, they can go to the bank and speak to
someone face to face about their problem but, with an Internet bank, they will likely spend
a lot of time on the phone being passed around and placed on hold.
4. Accessibility
If the Internet goes down in the area or the area of the banking office, the customer
will be unable to access the accounts. This includes being unable to withdraw money
from ATMs or to use the debit card.
5. Fees
Many Internet banks dont have ATMs, which means the customer will have to pay
ATM fees. This can cost more money than paying the regular monthly fees at a brick
and mortar bank.
3.56 Tele Banking

A system which enables banking transactions to be carried out by means of a
telecommunications network, most commonly achieved through a view data system or
an interactive computer link, or sometimes over an interactive cable TV network, with
provision for the user to send signals to the bank.
Undertaking a host of banking related services including financial transactions from
the convenience of customers chosen place anywhere across the GLOBE and any time
of date and night has now been made possible by introducing online tele banking services.
By dialing the given tele banking number through a landline or a mobile from anywhere,
the customer can access his account and by following the user-friendly menu, entire
banking can be done through Interactive Voice Response (IVR) system.
With sufficient numbers of hunting lines made available, customer call will hardly
fail. The system will be bilingual and has following facilities offered:
(i) Automatic balance voice out for the default account.
(ii) Balance inquiry and transaction inquiry in all.
(iii) Inquiry of all term deposit accounts.
(iv) Statement of account by fax, e-mail or ordinary mail.
(v) Cheque book request.
(vi) Stop payment which is online and instantaneous.
(vii) Transfer of funds with CBS which is automatic and instantaneous.
(viii) Utility Bill Payments.
(ix) Renewal of term deposit which is automatic and instantaneous.
(x) Voice out of last five transactions.
3.57 Online Banking

Online banking refers to the computerized service that allows a banks customers
to get online with the bank via telephone lines to view the status of their account(s) and
161
transaction history. It usually also allows them to transfer funds, pay bills, request cheque
books, etc.
Notes
History of Online Banking

The precursor for the modern home online banking services were the distance banking
services over electronic media from the early 1980s. The term online became popular in
the late 80s and referred to the use of a terminal, keyboard and TV (or monitor) to access
the banking system using a phone line. Home banking can also refer to the use of a
numeric keypad to send tones down a phone line with instructions to the bank. Online
services started in New York in 1981 when four of the citys major banks (Citibank, Chase
Manhattan, Chemical) offered home banking services using the videotex system. Because
of the commercial failure of videotex, these banking services never became popular except
in France where the use of videotex was subsidized by the telecom provider and the UK,
where the Prestel system was used.
Features of Online Banking
Online banking facilities offered by various financial institutions have many features
and capabilities in common, but also have some that are application specific. The common
features fall broadly into several categories. A bank customer can perform some nontransactional tasks through online banking, including:
(i) Viewing account balances.
(ii) Viewing recent transactions.
(iii) Downloading bank statements, for example in PDF format.
(iv) Viewing images of paid cheques.
(v) Ordering cheque books.
(vi) Download periodic account statements.
(vii) Downloading applications for M-banking, E-banking etc.
(viii) Funds transfers between the customers linked accounts.
(ix) Paying third parties, including bill payments (see, e.g., BPAY) and telegraphic/
wire transfers.
(x) Investment purchase or sale.
3.58 Core Banking

Core banking is services provided by a group of networked bank branches. Bank
customers may access their funds and other simple transactions from any of the member
branch offices. Core Banking is the meeting point of the largest banking services
segments, cutting edge Information Technology and the ever advancing Communication
Technology. It is all about providing the banking customers with the right products at the
right time through the right channels 24 hours a day, 7 days a week through a multilocation, multi-branch network.
Core Banking is normally defined as the business conducted by a banking institution
with its retail and small business customers. Many banks treat the retail customers as
their core banking customers, and have a separate line of business to manage small
businesses. Larger businesses are managed via the corporate banking division of the
institution. Core banking basically is depositing and lending of money.
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Notes
Nowadays, most banks use core banking applications to support their operations
where CORE stands for centralized online real-time environment. This basically means
that all the banks branches access applications from centralized datacenters. This means
that the deposits made are reflected immediately on the banks servers and the customer
can withdraw the deposited money from any of the banks branches throughout the world.
These applications now also have the capability to address the needs of corporate
customers, providing a comprehensive banking solution.
A few decades ago, it used to take at least a day for a transaction to reflect in the
account because each branch had their local servers and the data from the server in each
branch was sent in a batch to the servers in the datacenter only at the end of the day
(EoD).
Normal core banking functions will include deposit accounts, loans, mortgages and
payments. Banks make these services available across multiple channels like ATMs,
Internet banking, and branches.
Core banking functions differ depending on the specific type of bank. Retail banking,
for example, is geared towards individual customers; wholesale banking is business
conducted between banks; and securities trading involves the buying and selling of stocks,
shares and so on. Core banking systems are often specialized for a particular type of
banking. Products that are designed to deal with multiple types of core banking functions
are sometimes referred to as universal banking systems.
History of Core Banking
The major objectives of bank automation are better customer service, flawless book
keeping and prompt decision-making that leads to improved productivity and profitability.
The concept of bank automation started in the year 1981, but it was during the period
1984-1987 banks in India started the branch level automation, making use of the then
available MSDOS based stand-alone computers. This initiative was taken by the banks
on the basis of First Rangarajan Committee Report on bank computerization submitted
in the year 1984. ALPMs (Advance Ledger Posting Machines) were the fashion in those
days. However, the pace of bank automation was very slow in the banks primarily owing
to the lack of trade union consensus on bank automation.
Another committee was in 1988 under the chairmanship of Dr. C. Rangarajan, the
then Deputy Governor of RBI to slate down a perspective plan on automation of banks
for a five year period. This paved way to the implementation of multi-user Total Branch
Automation packages running on a LAN (Local Area Network), either on a Network or
a UNIX operating system. With the implementation of TBA, banks started to offer the
facilities of exclusive Customer Terminal, Single window transaction, online and off-site
ATMs, Tele Banking, etc.
But with the advent of new generation, private sector banks in India during 19941996, the real era of bank marketing started and these banks started to offer anywhere
and anytime banking facilities to its customers. This was possible for them mainly owing
to the fact that they opted for the implementation of a WAN (Wide Area Network) based
centralized banking solution rather than a LAN based banking solution to network their
limited number of branch outlets.
The old generation banks in India hesitated to follow this banking fashion on account
of its large network of branches on one hand and the then prevailing exorbitant IT cost
on the other hand. But with the globalization and liberalization of Indian market and with
the enactment of TRAI (with a mission to create and nurture conditions for growth of
163
telecommunications in the country in a manner and at a pace which will enable India to
play a leading role in emerging global information society) during the late nineties, there
happened a drastic reduction in IT cost.
Notes
Improved telecommunication facilities and reduction in hardware as well as

networking cost changed the mindset of the banks in India to try the CBS option. This
also equipped them with the required technology products and services, as those offered
by their new generation competitors.
Meaning of Core Banking
Core banking is a general term used to describe the services provided by a group
of networked bank branches. Bank customers may access their funds and other simple
transactions from any of the member branch offices. Core banking solution is a
comprehensive, integrated yet modular business solution. It provides the much-needed
flexibility to banks to adapt to a dynamic environment.
Examples: Core banking products include Infosys Finacle, Nucleus FinnOne and
Oracles Flexcube application (from their acquisition of Indian IT vendor i-flex).
3.59 Mobile Banking

Mobile banking is a term used to refer to systems that allow customers of a financial
institution to conduct a number of financial transactions through a mobile device such
as a mobile phone or tablet.
Mobile banking typically operates across all major mobile providers in the US through
one of three ways: SMS messaging; mobile web; or applications developed for iPhone,
Android or Blackberry devices.
Mobile text and alert is the simplest, allowing the user to transfer funds or access
account information via text message. Texting terminology varies from bank to bank, but
the overall function is generally the same. For example, texting Bal will obtain the account
balance while Tra will allow inter-account transfers. Users need to first register and verify
their phone numbers with their bank, but once thats completed, they can also set up
alerts to let them know about negative balances or deposit confirmations.
Mobile web is the second mobile banking option. Similar to online account access
from a home-based computer, this option allows for checking balances, bill payment and
account transfers simply by logging into the users account via a mobile web browser.
Mobile banking applications for Android, iPhone and Blackberry, connect the user
directly to the bank server for complete banking functionality without having to navigate
a mobile web browser. These applications can be downloaded either through the banks
website or through the iTunes store.
Advantages of Mobile Banking
(a) It utilizes the mobile connectivity of telecom operators and therefore does not
require an internet connection.
(b) With mobile banking, users of mobile phones can perform several financial
functions conveniently and securely from their mobile.
(c) You can check your account balance, review recent transaction, transfer funds,
pay bills, locate ATMs, deposit cheques, manage investments, etc.
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Notes
(d) Mobile banking is available round the clock 24/7/365, it is easy and convenient
and an ideal choice for accessing financial services for most mobile phone
owners in the rural areas.
(e) Mobile banking is said to be even more secure than online/internet banking.
Disadvantages of Mobile Banking
(a) Mobile banking users are at risk of receiving fake SMS messages and scams.
(b) The loss of a persons mobile device often means that criminals can gain access
to your mobile banking PIN and other sensitive information.
(c) Modern mobile devices like smartphones and tablets are better suited for mobile
banking than old models of mobile phones and devices.
(d) Regular users of mobile banking over time can accumulate significant charges
from their banks.
3.60 E-Banking Risk

E-banking has unique characteristics that may increase an institutions overall risk
profile and the level of risks associated with traditional financial services, particularly
strategic, operational, legal, and reputation risks. These unique e-banking characteristics
include:
(a) Speed of technological change,
(b) Changing customer expectations,
(c) Increased visibility of publicly accessible networks (e.g., the Internet),
(d) Less face-to-face interaction with financial institution customers,
(e) Need to integrate e-banking with the institutions legacy computer systems,
(f) Dependence on third parties for necessary technical expertise, and
(g) Proliferation of threats and vulnerabilities in publicly accessible networks.
3.61 Types of E-Banking Risk

1. Strategic Risk
A financial institutions board and management should understand the risks
associated with E-banking services and evaluate the resulting risk management costs
against the potential return on investment prior to offering E-banking services. Poor
E-banking planning and investment decisions can increase a financial institutions strategic
risk. On strategic risk, E-banking is relatively new and, as a result, there can be a lack
of understanding among senior management about its potential and implications. People
with technological, but not banking, skills can end up driving the initiatives. E-initiatives
can spring up in an incoherent and piecemeal manner in firms. They can be expensive
and can fail to recoup their cost. Furthermore, they are often positioned as loss leaders
(to capture market share), but may not attract the types of customers that banks want
or expect and may have unexpected implications on existing business lines. Banks should
respond to these risks by having a clear strategy driven from the top and should ensure
that this strategy takes account of the effects of E-banking, wherever relevant. Such a
strategy should be clearly disseminated across the business, and supported by a clear
business plan with an effective particular, become more significant requiring additional
processes, tools, expertise, and testing. Institutions should determine the appropriate level
165
of security controls based on their assessment of the sensitivity of the information to the
customer and to the institution and on the institutions established risk tolerance level.
Notes
2. Credit Risk
Generally, a financial institutions credit risk is not increased by the mere fact that
a loan is originated through an E-banking channel. However, management should consider
additional precautions when originating and approving loans electronically, including
assuring management information systems effectively track the performance of portfolios
originated through E-banking channels. The following aspects of online loan origination
and approval tend to make risk management of the lending process more challenging.
If not properly managed, these aspects can significantly increase credit risk.
Verifying the customers identity for online credit applications and executing an
enforceable contract;
Monitoring and controlling the growth, pricing, underwriting standards and ongoing
credit quality of loans originated through E-banking channels;
Monitoring and over sight of third-parties doing business as agents or on behalf of
the financial institution (for example, an Internet loan origination site or electronic payments
processor);
Valuing collateral and perfecting liens over a potentially wider geographic area;
Collecting loans from individuals over a potentially wider geographic area;
Monitoring any increased volume of, and possible concentration in, out-of-area
lending.
Liquidity, interest rate, price/market risks Funding and investment-related risks
could increase with an institutions E-banking initiatives depending on the volatility and
pricing of the acquired deposits. The Internet provides institutions with the ability to market
their products and services globally. Internet-based advertising programs can effectively
match yield-focused investors with potentially high-yielding deposits. But Internetoriginated deposits have the potential to attract customers who focus exclusively on rates
and may provide a funding source with risk characteristics similar to brokered deposits.
An institution can control this potential volatility and expanded geographic reach through
its deposit contract and account opening practices, which might involve face-to-face
meetings or the exchange of paper correspondence. The institution should modify its
policies as necessary to address the following E-banking funding issues:
Potential increase independence on brokered funds or other highly rate-sensitive
deposits;
Potential acquisition of funds from markets where the institution is not licensed to
engage in banking, particularly if the institution does not establish, disclose, and enforce
geographic restrictions;
Potential impact of loan or deposit growth from an expanded Internet market,
including the impact of such growth on capital ratios;
Potential increase in volatility of funds should E-banking security problems negatively
impact customer confidence or the markets perception of the institution.
3. Reputational Risks
This is considerably heightened for banks using the Internet. For example, the
Internet allows for the rapid dissemination of information which means that any incident,
166
Notes
either good or bad, is common knowledge within a short space of time. The speed of
the Internet considerably cuts the optimal response times for both banks and regulators
to any incident. Any problems encountered by one firm in this new environment may affect
the business of another, as it may affect confidence in the Internet as a whole. There
is, therefore, a risk that one scoundrel E-bank could cause significant problems for all
banks providing services via the Internet. This is a new type of systemic risk and is causing
concern to E-banking providers. Overall, the Internet puts an emphasis on reputational
risks. Banks need to be sure that customer rights and information needs are adequately
safeguarded and provided for.
4. Transaction/Operations Risk
Transaction/Operations Risk arises from fraud, processing errors, system disruptions,
or other unanticipated events resulting in the institutions inability to deliver products or
services. This risk exists in each product and service offered. The level of transaction risk
is affected by the structure of the institutions processing environment, including the types
of services offered and the complexity of the processes and supporting technology.
3.62 E-finance
E-finance is defined as the provision of financial services and markets using
electronic communication and computation. The term E-Finance is used differently by
different people. It can be defined as a provisioning of financing instruments to business
organizations using electronic tools and technology for the lengthwise process and this
incorporates the use of electronic channels for mobilizing e-finance services and electronic
methods to set up proper finance conditions and deal with the risk related to the finance
itself. E-finance, in simple words, is use of Internet and technologies in financial services.
It has enabled the people to have any financial transactions without any human interaction.
It saves time, reduces paperwork and chances of fraudulent. Nowadays, with the
emergence of e-commerce, E-finance has become a buzzword among the entrepreneur,
business firms and investors. Due to the increasing awareness about the use of internet
and computer technology in commercial purpose, E-finance has emerged as solution to
simplify the complexions involved in dealing with finance. It is somewhat the shift of system
of financial service from the real world to a virtual one. E-Finance to banking services has
been more varied across countries. It allows countries to establish a financial system
without first building a fully functioning financial infrastructure by its much cheaper since
it lowers processing costs for providers and search and switching costs for consumers.
Internet banking and e-commerce is changing the finance industry, having the major effects
on banking relationships. Banking is now no longer confined to the branches where one
has to approach the branch in person, to withdraw cash or deposit a cheque or request
a statement of accounts. In true, Internet banking is increasingly becoming a need to
have than a nice to have service. The net banking, thus, now is more of a norm rather
than an exception in many developed countries due to the fact that it is the cheapest
way of providing banking services. As of 2013, there are more than 15 million online banking
users in India and 53 banks are providing ATM facilities across the country.
The facility of e-banking can be provided solely through the internet without having
any physical office. The adoption of mobile banking has increased substantially in the
past year, in a world nearly 28% of mobile phone users in the survey report that they
used mobile banking in the past 12 months. E-banking provides enormous benefits to
consumers in terms of ease and cost of transactions, either through the Internet, telephone
or other electronic delivery. Electronic finance (E-finance) has become one of the most
167
essential technological changes in the financial industry. E-finance as the provision of

financial services and markets using Electronic communication and computation in
practice e-finance includes e-payment, e-trading, and e-banking. Three major factors
impacting financial services are globalization, deregulation (geographic and product),
advances in information technology, massive cost reductions in technology and
communications cost. In the B2C (retail) category are included single e-shops, shopping
malls, e-broking, e-auction, e-banking, service providers like travel related services,
financial services, etc., education, entertainment and any other form of business targeted
at the final consumer.
Notes
Banking plays a vital role in E-financing which allows countries to establish a financial
system without functioning financial infrastructure. In India, the position of E-finance is
still in its initial stage and has a lot to grow up, counted in one of the newest digitalized
part of E-commerce. It has put a great impetus on the other parts of business like
international market and financial accounting. It is a tool to overcome the lacuna of physical
delivery of financial services and has been proved as an aid for SMEs and developing
countries.
3.63 Electronic Money

Electronic money, or e-money, is the money balance recorded electronically on a
stored-value card. These cards have microprocessors embedded which can be loaded with
a monetary value.
E-money is electronic money which is exchanged electronically over a technical
device such as a computer or mobile phone. E-money in circulation operates as a prepaid
bearer instrument. The best known example of e-money is the Bitcoin, which can be bought
with real money and traded on an exchange like any other currency.
Advantages of Electronic Money
(a) Most money in todays world is electronic, and tangible cash is becoming less
frequent. With the introduction of internet/online banking, debit cards, online bill
payments and internet business, paper money is becoming a thing of the past.
(b) Banks now offer many services whereby a customer can transfer funds,
purchase stocks, contribute to their retirement plans (such as Canadian RRSP)
and offer a variety of other services without having to handle physical cash or
checks. Customers do not have to wait in lines; this provides a lower-hassle
environment.
(c) Debit cards and online bill payments allow immediate transfer of funds from an
individuals personal account to a businesss account without any actual paper
transfer of money. This offers a great convenience to many people and
businesses alike.
Disadvantages of Electronic Money
(a) Although there are many benefits to digital cash, there are also many significant
disadvantages. These include fraud, failure of technology, possible tracking of
individuals and loss of human interaction.
(b) Fraud over digital cash has been a pressing issue in recent years. Hacking into
bank accounts and illegal retrieval of banking records has led to a widespread
invasion of privacy and has promoted identity theft.
168
Notes
(c) There is also a pressing issue regarding the technology involved in digital cash.
Power failures, loss of records and undependable software often cause a major
setback in promoting the technology.
(d) Privacy questions have also been raised; there is a fear that the use of debit
cards and the like will lead to the creation by the banking industry of a global
tracking system. Some people are working on anonymous e-cash to try to
address this issue.
3.64 Digital Signatures

Digital signature is a mathematical technique used to validate the authenticity and
integrity of a message, software or digital document.
The digital equivalent of a handwritten signature or stamped seal, but offering far more
inherent security, a digital signature is intended to solve the problem of tampering and
impersonation in digital communications. Digital signatures can provide the added
assurances of evidence to origin, identity and status of an electronic document, transaction
or message, as well as acknowledging informed consent by the signer.
3.65 How Digital Signatures Work?

Digital signatures are based on public key cryptography, also known as asymmetric
cryptography. Using a public key algorithm such as RSA, one can generate two keys
that are mathematically linked: one private and one public. To create a digital signature,
signing software (such as an e-mail program) creates a one-way hash of the electronic
data to be signed. The private key is then used to encrypt the hash. The encrypted hash
along with other information, such as the hashing algorithm is the digital signature.
The reason for encrypting the hash instead of the entire message or document is that
a hash function can convert an arbitrary input into a fixed-length value, which is usually
much shorter. This saves time since hashing is much faster than signing.
The value of the hash is unique to the hashed data. Any change in the data, even
changing or deleting a single character, results in a different value. This attribute enables
others to validate the integrity of the data by using the signers public key to decrypt the
hash. If the decrypted hash matches a second computed hash of the same data, it proves
that the data hasnt changed since it was signed. If the two hashes dont match, the data
has either been tampered with in some way (integrity) or the signature was created with
a private key that doesnt correspond to the public key presented by the signer
(authentication).
A digital signature can be used with any kind of message whether it is encrypted
or not simply so the receiver can be sure of the senders identity and that the message
arrived intact. Digital signatures make it difficult for the signer to deny having signed
something (non-repudiation) assuming their private key has not been compromised as the
digital signature is unique to both the document and the signer, and it binds them together.
A digital certificate, an electronic document that contains the digital signature of the
certificate-issuing authority, binds together a public key with an identity and can be used
to verify a public key belongs to a particular person or entity.
Most modern e-mail programs support the use of digital signatures and digital
certificates, making it easy to sign any outgoing e-mails and validate digitally signed
incoming messages. Digital signatures are also used extensively to provide proof of
authenticity, data integrity and non-repudiation of communications and transactions
conducted over the Internet.
169
3.66 RTGS
Notes
The acronym RTGS stands for Real Time Gross Settlement, which can be defined
as the continuous (real-time) settlement of funds transfers individually on an order by order
basis (without netting). Real Time means the processing of instructions at the time they
are received rather than at some later time. Settlement in real time means payment
transaction is not subjected to any waiting period. The transactions are settled as soon
as they are processed. Gross Settlement means the settlement of funds transfer
instructions occurs individually (on an instruction by instruction basis). Gross settlement
means the transaction is settled on one-to-one basis without bunching with any other
transaction. Considering that the funds settlement takes place in the books of the Reserve
Bank of India, the payments are final and irrevocable. This is the fastest possible money
transfer system through the banking channel.
Features of RTGS
1. The RTGS system is primarily meant for large value transactions. The minimum
amount to be remitted through RTGS is ` 2 lakh. There is no upper ceiling for
RTGS transactions.
2. Under normal circumstances, the beneficiary branches are expected to receive
the funds in real time as soon as funds are transferred by the remitting bank.
The beneficiary bank has to credit the beneficiarys account within two hours
of receiving the funds transfer message.
3. The RTGS service window for customers transactions is available from 9.00
hours to 16.30 hours on weekdays and from 9.00 hours to 13.30 hours on
Saturdays for settlement at the RBI end. However, the timings that the banks
follow may vary depending on the customer timings of the bank branches.
4. With a view to rationalize the service charges levied by banks for offering funds
transfer through RTGS system, a broad framework has been mandated as under:
(a) Inward transactions Free, no charge to be levied.
(b) Outward transactions ` 2 lakh to ` 5 lakh not exceeding ` 30 per
transaction. Above ` 5 lakh not exceeding ` 55 per transaction.
5. The remitting customer has to furnish the following information to a bank for
effecting a RTGS remittance:
(a) Amount to be remitted.
(b) Remitting customers account number which is to be debited.
(c) Name of the beneficiary bank.
(d) Name of the beneficiary customer.
(e) Account number of the beneficiary customer.
(f) Sender to receiver information, if any.
(g) The IFSC Number of the receiving branch.
3.67 National Electronic Funds Transfer (NEFT)

NEFT is electronic funds transfer system, which facilitates transfer of funds to other
bank accounts in over several bank branches across the country. This is a simple, secure,
safe, fastest and cost-effective way to transfer funds especially for retail remittances.
170
Notes
Features and Benefits

1. Customers can remit any amount using NEFT: Customer intending to remit
money through NEFT has to furnish the following particulars:
(i) IFSC (Indian Financial System Code) of the beneficiary Bank/Branch
(ii) Full account number of the beneficiary
(iii) Name of the beneficiary.
2. The facility is also available through online mode for all internet banking and
mobile banking customers.
3. For corporate customers, bulk upload facility is also available at branches.
Timings
1. Customers can use this facility between 8 a.m. and 7 p.m. on all weekdays
and between 8 a.m. and 1 p.m. on Saturday. There are twelve hourly settlements
between 8 a.m. and 7 p.m. on all weekdays and six hourly settlements between
8 a.m. and 1 p.m. on Saturdays.
2. The money will be credited to the beneficiarys account on the same day or
at the most next day in case the message is sent during the last batch of
settlement. Union Bank offers NEFT facility to its customers through all its
branches.
Charges
` 5/ per transaction if the transaction amount is less than ` 1 lakh
` 25/- per transaction if the transaction amount is more than ` 1 lakh
3.68 Summary
Bank lending refers to the process of disposing of money or property with the
expectation that the same thing will be returned. Credit is the provision of resources (such
as granting a loan) by one party to another party where that second party does not
reimburse the first party immediately, thereby generating a debt, and instead arranges
either to repay or return those resources (or material(s) of equal value, where the first
party would be the banker (lender or creditors) and the second partly would be the customer
(borrower or debtor).
Loan is an arrangement in which a lender gives money to a borrower and the borrower
agrees to return the money along with interest after a fixed period of time. Examples:
Home Loans, Car Loans, Personal Loans, etc.
Cash credit is a short-term cash loan to a company. A bank provides this type of
funding, but only after the required security is given to secure the loan. Once a security
for repayment has been given, the business that receives the loan can continuously draw
from the bank up to a certain specified amount.
Overdraft is the amount by which withdrawals exceed deposits or the extension of
credit by a lending institution to allow for such a situation.
Letter of Credit refers to a letter from a bank guaranteeing that a buyers payment
to a seller will be received on time and for the correct amount. In the event that the buyer
is unable to make payment on the purchase, the bank will be required to cover the full
or remaining amount of the purchase. It is a payment term generally used for international
sales transactions.
171
Borrowers are the individuals borrow money via bankers loans for short-term needs
or longer-term mortgages to help finance a house purchase. Companies borrow money
to aid short-term or long-term cash flows. They also borrow to fund modernization or future
business expansion. Governments often find their spending requirements exceed their tax
revenues. To make up this difference, they need to borrow. Governments also borrow on
behalf of nationalized industries, municipalities, local authorities and other public sector
bodies.
Notes
Balance sheet analysis can be defined as an analysis of the assets, liabilities, and
equity of a company. This analysis is conducted generally at set intervals of time, like
annually or quarterly. The process of balance sheet analysis is used for deriving actual
figures about the revenue, assets, and liabilities of the company.
Project appraisal is the structured process of assessing the viability of a project or
proposal. It involves calculating the feasibility of the project before committing resources
to it. It is a tool that companys use for choosing the best project that would help them
to attain their goal. Project appraisal often involves making comparison between various
options and this done by making use of any decision technique or economic appraisal
technique.
Management or Organizational Appraisal is a process which can look at an
organization and appraise it in a given context. Some tools appraise an organization in
preparation of an award others look at the performance of an organization in preparation
for a buy-out/buy-in, raising venture capital, etc.
Marketing appraisal is an estate agents recommendation on how we can achieve
the best price for your property in a timescale that suits you. A valuation can only be
carried out by a qualified surveyor and is an evidence-based opinion on how much your
property is worth.
Technological innovation has resulted in financial product development especially in
the international and investment banking areas. The western experience has demonstrated
that technology has not only made execution of work faster but has also resulted in greater
availability of manpower for customer contact.
Prudential norms are the guidelines and general norms issued by the regulating
bank (the central bank) of the country for the proper and accountable functioning of bank
and bank-like establishments.
The prudential accounting norms which were put into place in 1992-93, have been
further strengthened over the years. In respect of accounts where there are potential threats
of recovery on account of erosion in the value of the security or absence of security and
other factors such as fraud committed by the borrowers exist, such accounts are to be
classified as doubtful or loss assets irrespective of the period to which these remained
as non-performing. All the members banks in a consortium are required to classify their
advances according to each banks own record of recovery.
the central bank of the country. The Reserve Bank of India was established on April 1,
1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central
Office of the Reserve Bank was initially established in Calcutta but was permanently moved
to Mumbai in 1937. The Central Office is where the Governor sits and where policies are
172
Notes
formulated. Though originally privately owned, since nationalization in 1949, the Reserve
Bank is fully owned by the Government of India.
Credit Control is an important tool used by Reserve Bank of India, a major weapon
of the monetary policy used to control the demand and supply of money (liquidity) in the
economy. Central Bank administers control over the credit that the commercial banks
grant. Such a method is used by RBI to bring Economic Development with Stability.
It means that banks will not only control inflationary trends in the economy but also boost
economic growth which would ultimately lead to increase in real national income with
stability.
Innovation derives organization to grow, prosper and transform in sync with the
changes in the environment, both internal and external. Banking is no exception to this.
In fact, this sector has witnessed radical transformation of late, based on many innovations
in products, processes, services, systems, business models, technology, governance and
regulation.
Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine the
adequacy of their capital keeping in view their risk exposures. Banking regulators require
a minimum capital adequacy ratio so as to provide the banks with a cushion to absorb
losses before they become insolvent. This improves stability in financial markets and
protects deposit-holders. Basel Committee on Banking Supervision of the Bank of
International Settlements develops rules related to capital adequacy which member
countries are expected to follow.
Risk weighted assets is a measure of the amount of a banks assets, adjusted for
risk. The nature of a banks business means it is usual for almost all of a banks assets
will consist of loans to customers. Comparing the amount of capital a bank has with the
amount of its assets gives a measure of how able the bank is to absorb losses. If its
capital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent.
Debt restructuring is a process that allows a private or public company, or a sovereign
entity facing cash flow problems and financial distress to reduce and renegotiate its
delinquent debts in order to improve or restore liquidity so that it can continue its
operations.
Corporate Debt Restructuring (CDR) mechanism is a voluntary non-statutory
mechanism under which financial institutions and banks come together to restructure the
debt of companies facing financial difficulties due to internal or external factors, in order
to provide timely support to such companies.
E-banking is defined as the automated delivery of new and traditional banking
products and services directly to customers through electronic, interactive communication
channels.
Internet banking system is a method in which a personal computer is connected
by a network service provider directly to a host computer system of a bank such that
customer service requests can be processed automatically without need for intervention
by customer service representatives. The system is capable of distinguishing between
those customer service requests which are capable of automated fulfillment and those
requests which require handling by a customer service representative. The system is
integrated with the host computer system of the bank so that the remote banking customer
can access other automated services of the bank.
Internet banking refers to a system allowing individuals to perform banking activities
at home, via the internet. Internet banking allows customers to conduct financial
transactions on a secure website operated by their retail or virtual bank.
173
Mobile banking is a term used to refer to systems that allow customers of a financial
institution to conduct a number of financial transactions through a mobile device such
as a mobile phone or tablet.
Notes
E-banking has unique characteristics that may increase an institutions overall risk
profile and the level of risks associated with traditional financial services, particularly
strategic, operational, legal, and reputation risks.
Electronic money, or e-money, is the money balance recorded electronically on a
stored-value card. These cards have microprocessors embedded which can be loaded with
a monetary value.
E-money is electronic money which is exchanged electronically over a technical
device such as a computer or mobile phone. E-money in circulation operates as a prepaid
bearer instrument.
Digital signature is a mathematical technique used to validate the authenticity and
integrity of a message, software or digital document. The digital equivalent of a handwritten
signature or stamped seal, but offering far more inherent security, a digital signature is
intended to solve the problem of tampering and impersonation in digital communications.
The acronym RTGS stands for Real Time Gross Settlement, which can be defined
as the continuous (real-time) settlement of funds transfers individually on an order by order
basis (without netting). Real Time means the processing of instructions at the time they
are received rather than at some later time. Settlement in real time means payment
transaction is not subjected to any waiting period.
National Electronic Funds Transfer (NEFT) is electronic funds transfer system, which
facilitates transfer of funds to other bank accounts in over several bank branches across
the country. This is a simple, secure, safe, fastest and cost-effective way to transfer funds
especially for retail remittances.

1. ____________ refers to the process of disposing of money or property with the
expectation that the same thing will be returned.
2. Loan is an arrangement in which a lender gives money to a borrower and the
borrower agrees to return the money along with interest after a ____________.
3. ____________ is the amount by which withdrawals exceed deposits or the
extension of credit by a lending institution to allow for such a situation.
4. ____________ refers to a letter from a bank guaranteeing that a buyers payment
to a seller will be received on time and for the correct amount.
5. Project appraisal is the structured process of assessing the viability of a
____________
6. ____________ norms are the guidelines and general norms issued by the
regulating bank (the central bank) of the country for the proper and accountable
functioning of bank and bank-like establishments.
7. ____________ is a specialized ratio used by banks to determine the adequacy
of their capital keeping in view their risk exposures.
8. ____________ is defined as the automated delivery of new and traditional
banking products and services directly to customers through electronic,
interactive communication channels.
174
Notes
II. True or False

1. A bank provides this type of funding, but only after the required security is given
to secure the loan.
2. Lenders are the individuals borrow money via bankers loans for short-term needs
or longer-term mortgages to help finance a house purchase.
3. Technological Appraisal is a process which can look at an organization and
appraise it in a given context.
4. Marketing appraisal is an estate agents recommendation on how we can
achieve the best price for your property in a timescale that suits for the customer.
5. Risk weighted assets is a measure of the amount of a banks assets, adjusted
for risk.
6. Internet banking system is a method in which a personal computer is connected
by a network service provider directly to a host computer system of a bank.
7. Mobile banking is a term used to refer to systems that allow customers of a
financial institution to conduct a number of financial transactions through a
mobile device such as a mobile phone or tablet.
8. Digital signature is a mathematical technique used to validate the authenticity
and integrity of a message, software or digital document.
1. Which of the following refers to the process of disposing of money or property
with the expectation that the same thing will be returned?
(a) Bank lending
(b) Borrowing
(c) Depositing
(d) All the above
2. Overdraft is the amount by which ____________
(a) Withdrawals exceed deposits
(b) The extension of credit by a lending institution
(d) None of these
3. Which of the following refers to a letter from a bank guaranteeing that a buyers
payment to a seller will be received on time and for the correct amount?
(a) Overdraft
(b) Letter of Credit
(c) Bank lending
(d) All the above

1. Give the meaning of bank lending.
2. State various types of lending.
3. Who are the Borrowers?
175
4. What is Balance Sheet Analysis?
Notes
5. What is Project Appraisal?

6. What is Bank Service?
7. Give the meaning of Bank Marketing.
8. What is Prudential Norm?
9. What is Reserve Bank of India?
10. What is Credit Control?
11. What is Securities and Exchange Board of India?
12. What is Lenders Liability Act?
13. Give the meaning of Banking Innovation.
14. What is Basel Committee?
15. What is Capital Adequacy Ratio (CAR)?
16. What is Risk-based Supervision?
17. What is RTGS?
18. What is National Electronic Funds Transfer (NEFT)?
1. Discuss various principles of Lending.
2. Explain various types of Lending.
3. Discuss lending facilities granted by Banks.
4. Explain about study of Borrowers.
5. How to perform a Balance Sheet Analysis? Discuss.
6. Discuss Project Appraisal Criteria.
7. Explain importance of Bank Marketing.
8. Discuss prudential guidelines on Restructuring of Advances.
9. Discuss Narasimham Committee Recommendations.
10. State various objectives of Credit Control.
11. Discuss objectives and functions of SEBI.
12. Explain the Basel Committee Recommendations.
13. Discuss about E-Banking Risk.
14. Write note on: E-finance and Electronic Money.
3.71 Key Terms

z
Bank lending: Bank lending refers to the process of disposing of money or

property with the expectation that the same thing will be returned.
Loan: Loan is an arrangement in which a lender gives money to a borrower

and the borrower agrees to return the money along with interest after a fixed
period of time.
Cash Credit: Cash credit is a short-term cash loan to a company. A bank

provides this type of funding, but only after the required security is given to
secure the loan.
Overdraft: Overdraft is the amount by which withdrawals exceed deposits or

the extension of credit by a lending institution to allow for such a situation.
176
Notes

z
Letter of Credit: Letter of Credit refers to a letter from a bank guaranteeing

that a buyer's payment to a seller will be received on time and for the correct
amount.
Balance sheet analysis: Balance sheet analysis can be defined as an analysis

of the assets, liabilities, and equity of a company.
Mobile banking: Mobile banking is a term used to refer to systems that allow
customers of a financial institution to conduct a number of financial transactions
through a mobile device such as a mobile phone or tablet.
National Electronic Funds Transfer: National Electronic Funds Transfer

(NEFT) is electronic funds transfer system, which facilitates transfer of funds
to other bank accounts in over several bank branches across the country.

1. Bank lending
2. Fixed period of time
3. Overdraft
4. Letter of Credit
5. Project or proposal
6. Prudential
7. Capital adequacy ratio (CAR)
8. E-banking
II. True or False
1. True
2. False
3. False
4. True
5. True
6. True
7. True
8. True
III.
Multiple Choice Questions

1. (a) Bank lending
3. (b) Letter of Credit
3.73 Case Study

The State Bank of India is the oldest and largest bank in India, with more than $250
billion (USD) in assets. It is the second-largest bank in the world in number of branches;
it opened its 10,000th branch in 2008. The bank has 84 international branches located
in 32 countries and approximately 8,500 ATMs. Additionally, SBI has controlling or
complete interest in a number of affiliate banks, resulting in the availability of banking
services at more than 14,600 branches and nearly 10,000 ATMs. SBI traces its heritage
to the 1806 formation of the Bank of Calcutta. The bank was renamed the Bank of Bengal
177
in 1809 and operated as one of the three premier presidency banks (the presidency banks
had the exclusive rights to manage and circulate currency and were provided capital to
establish branch networks). In 1921, the government consolidated the three presidency
banks into the Imperial Bank of India.
Notes
Question:
1. Do you think the SBI is self-sufficient to provide maximum satisfaction to
customers? Discuss.

Ryerson.
Company.
W.C and Tolbert S.M., Oxford University Press
3.75 Bibliography
1. Kem, H.J. (2005), Global Retail Banking: Changing Paradigms, Chartered
2. Neetu Prakash (2006), Retail Banking in India, ICFAI University Press,
Hyderabad, pp. 2-10.
3. Dhanda Pani Alagiri (2006), Retail Banking Challenges, ICFAI University Press,
4. Manoj Kumar Joshi (2007), Growth Retail Banking in India, ICFAI University
7. Sunil Kumar (2008), Retail Banking in India, Hindustan Institute of Management
and Computer Studies, Mathura.
8. Divanna, J.A. (2009), The Future Retail Banking", Palgrave Macmillan, New
York.
10. Sapru R.K. (1994), Development Administration, Sterling, New Delhi.
978-0470050828).
178
Notes
978-0465024995).
15. Marc M. Groz (2009), Forbes Guide to the Markets, John Wiley & Sons, Inc.,
New York (ISBN 978-0470463383).
978-0631185086).
Ltd. (ISBN 0-333-76447-1).
Developmental Financial Institutions
179
Notes
Unit 4:
Structure:
4.1 Introduction
4.2 Developmental Banks
4.3 Features of a Developmental Bank
4.4 Role of Developmental Banks in Industrial Financing
4.5 Types of Developmental Banks in India
4.6 Origin of Industrial Developmental Bank of India (IDBI)
4.6.1 The Present Scenario of IDBI
4.6.2 Objectives of Industrial Developmental Bank of India
4.6.3 Functions of Industrial Developmental Bank of India
4.6.4 Services of Industrial Developmental Bank of India
4.7 Origin of State Financial Corporations (SFCs)
4.7.1 Features of State Financial Corporations
4.7.2 Objectives of State Financial Corporations
4.7.3 Financial Resources of the SFCs
4.7.4 Functions of State Financial Corporations
4.7.5 SFCs Contributory to Development of Small-scale Industries in the
Indian Economy
4.8 Origin of State Industrial Developmental Corporations (SIDCs)
4.8.1 Objectives of State Industrial Developmental Corporations
4.8.2 Functions of State Industrial Developmental Corporations
4.9 Origin of Life Insurance Corporation of India (LICI)
4.9.1 Milestones in the Life Insurance Business in India
4.9.2 Milestones in the General Insurance Business in India
4.9.3 Objectives of Life Insurance Corporation of India
4.9.4 Features of Life Insurance Corporation of India
4.9.5 Functions of Life Insurance
4.10 Origin of Export-Import Bank of India (EXIM Bank)
4.10.1 Capital of Export-Import Bank
4.10.2 Objectives of Export-Import Bank of India
4.10.3 Functions of Export-Import Bank of India
4.11 National Bank for Agriculture and Rural Development (NABARD)
4.11.1 Objectives of NABARD
4.11.2 Role and Functions of NABARD
4.12 Resource Mobilization of Developmental Banks
4.13 Project Examination by Developmental Banks
4.14 Summary
180
Notes

4.17 Key Terms
4.19 Case Study
4.21 Bibliography
Objectives
z
Understand the role of Developmental Banks in Industrial Financing
Detailed study of Resource Mobilization of Developmental Banks
Understand the Project Examination by Developmental Banks
4.1 Introduction
Developmental Finance Institutions (DFIs) are national and international institutions
that provide loans, grants and other investments for projects and activities around the world.
While banks have traditionally met short-term working capital requirements of industry,
developmental finance institutions (DFIs) have mainly catered to the medium to long-term
financing requirements. Industrial Finance Corporation of India (IFCI) was the first DFI which
was established to extend long-term finance to industry. This was followed by the
establishment of several DFIs, both in public and private sector. DFIs can be classified
as: (i) term lending institutions such as Industrial Investment Bank of India (IIBI) Ltd.,
Export-Import Bank of India (EXIM) and Tourism Finance Corporation of India (TFCI) Ltd.
which provide long-term finance to various sectors; and (ii) refinance institutions such as
National Bank for Agriculture and Rural Development (NABARD), Small Industries
Developmental Bank of India (SIDBI) and National Housing Bank (NHB) which provide
finance to banking as well as non-banking financial intermediaries.
All the DFIs were government-owned; their operations were marked by near absence
of competition up to 1990. Moreover, DFIs were extended funds at concessional rates
in the form of Long-term Operations Fund of the RBI and government guaranteed bonds
on a long-term basis, with their maturity ranging from 10-15 years. Despite this, the
operations of DFIs became less profitable over the years. Thus, in order to impart market
orientation to operations of DFIs, various reform measures such as gradual phase out of
the market borrowing allocations of government guaranteed bonds and discontinuing the
access to low cost funds of RBI were announced in 1990s. Apart from this, prudential
norms pertaining to capital adequacy, income recognition, asset classification and
provisioning were recommended in 1994.
Between the period 1993 to 1998, DFIs took several measures such as offering
innovative products and diversification of activities into new areas of business, viz.,
investment banking, stock broking and custodial services to cope with the increased
competition. However, softening of interest rates and slowdown in industrial activity in the
second half of 1990s had adverse impact on the asset quality of DFIs. With declining
interest rates, high cost of funds raised by DFIs in the past became a cause of concern.
Despite increase in cost of funds, DFIs had to lend at a very competitive rate due to
increased competition from banks which ventured into project financing, in turn, resulting
in decline in spread and profitability of DFIs. Further, in January 2001, the RBI permitted
181
reverse merger of ICICI with its commercial bank subsidiary. This was followed by
conversion of IDBI into a banking company on October 1, 2004. The conversion of these
two large DFIs into banking companies led to the decline in share of DFIs in infrastructure
project finance. The earlier mentioned developments led to substantial decline in financial
assistance sanctioned and disbursed by DFIs during initial years of the current decade.
On an average, the financial assistance sanctioned and disbursed by DFIs declined to
` 389.1 billion during FY02-FY07 as compared with ` 836.8 billion during FY96-FY01.
The financial assistance sanctioned by DFIs, however, witnessed an upturn during FY08FY09 owing to increased sanction by investment institutions (especially LIC). During FY09,
the financial assistance sanctioned by DFIs witnessed an increase of 70.2% (y-o-y) while
disbursements witnessed an increase of almost 93.3%.
Notes
The intensification of global financial crisis and consequent liquidity crunch in the
domestic financial system led the RBI to take a slew of measures in order to provide
liquidity support to DFIs. For instance, the RBI provided refinance facility of ` 160 billion
(includes ` 70 billion for SIDBI, ` 50 billion for EXIM Bank and ` 40 billlion for NHB) to
DFIs to facilitate on-lending to Housing Finance Companies (HFCs), NBFCs, mutual funds
and exporters. Under the refinance facility, ` 213.98 billlion were drawn up to June 26,
2009, while total disbursements amounted to ` 153.12 billion (up to June 26, 2009). The
refinance facility had as many as 5,283 beneficiaries including 33 State Finance
Corporation and Banks, 22 NBFCs and 14 HFCs. In addition to this, the ceiling on
aggregate resources mobilized by SIDBI, NHB and EXIM Bank was raised to 12 times
of net owned funds (NOF) for SIDBI and NHB and 13 times of NOF for EXIM Bank. This
led to a 9.1% increase in resource mobilization by DFIs during FY09. Further, the umbrella
limit was raised for EXIM Bank and NHB and select DFIs were allowed to offer market
related yield to maturity.
4.2 Developmental Banks

Developmental Bank is a financial institution dedicated to fund new and upcoming
businesses and economic developmental projects by equity capital or loan capital.
Developmental banks are those financial institutions engaged in the promotion and
development of industry, agriculture and other key sectors.
Developmental bank is essentially a multi-purpose financial institution with a broad
developmental outlook. A developmental bank may, thus, be defined as a financial
institution concerned with providing all types of financial assistance (medium- as well as
long-term) to business units, in the form of loans, underwriting, investment and guarantee
operations, and promotional activities economic development in general, and industrial
development, in particular.
4.3 Features of a Developmental Bank

Following are the main characteristic features of a developmental bank:
1. It is a specialized financial institution.
2. It provides medium- and long-term finance to business units.
3. Unlike commercial banks, it does not accept deposits from the public.
4. It is not just a term-lending institution. It is a multi-purpose financial institution.
5. It is essentially a developmental-oriented bank. Its primary object is to promote
economic development by promoting investment and entrepreneurial activity in
a developing economy. It encourages new and small entrepreneurs and seeks
balanced regional growth.
182
Notes
6. It provides financial assistance not only to the private sector but also to the
public sector undertakings.
7. It aims at promoting the saving and investment habit in the community.
8. It does not compete with the normal channels of finance, i.e., finance already
made available by the banks and other conventional financial institutions. Its
major role is of a gap-filler, i.e., to fill up the deficiencies of the existing financial
facilities.
9. Its motive is to serve public interest rather than to make profits. It works in the
general interest of the nation.
4.4 Role of Developmental Banks in Industrial Financing

Various roles of Developmental Banks in Industrial Financing are:
1. Assistance for Small-scale Industries (SSI)
Developmental banks play an important role in the promotion and development of
the small-scale sector. Government of India (GOI) started Small Industries Development
Bank of India (SIDBI) to provide medium- and long-term loans to Small-scale Industries
(SSI) units. SIDBI provides direct project finance, and equipment finance to SSI units.
It also refinances banks and financial institutions that provide seed capital, equipment
finance, etc. to SSI units.
2. Development of Housing Sector
Developmental banks provide finance for the development of the housing sector. GOI
started the National Housing Bank (NHB) in 1988. NHB promotes the housing sector in
the following ways:
1. It promotes and develops housing and financial institutions.
2. It refinances banks and financial institutions that provide credit to the housing
sector.
3. Large-scale Industries (LSI)
Developmental banks promote and develop large-scale industries (LSI). Development
financial institutions like IDBI, IFCI, etc. provide medium- and long-term finance to the
corporate sector. They provide merchant banking services, such as preparing project
reports, doing feasibility studies, advising on location of a project, and so on.
4. Agriculture and Rural Development
Developmental banks like National Bank for Agriculture and Rural Development
(NABARD) helps in the development of agriculture. NABARD started in 1982 to provide
refinance to banks, which provide credit to the agriculture sector and also for rural
development activities. It coordinates the working of all financial institutions that provide
credit to agriculture and rural development. It also provides training to agricultural banks
and helps to conduct agricultural research.
5. Enhance Foreign Trade
Developmental banks help to promote foreign trade. Government of India started
Export-Import Bank of India (EXIM Bank) in 1982 to provide medium- and long-term loans
to exporters and importers from India. It provides Overseas Buyers Credit to buy Indian
capital goods. It also encourages abroad banks to provide finance to the buyers in their
country to buy capital goods from India.
183
6. Review of Sick Units
Notes
Developmental banks help to revive (cure) sick-units. Government of India (GOI)

started Industrial investment Bank of India (IIBI) to help sick units.
IIBI is the main credit and reconstruction institution for revival of sick units. It facilitates
modernization, restructuring and diversification of sick units by providing credit and other
services.
7. Entrepreneurship Development
Many developmental banks facilitate entrepreneurship development. NABARD, State
Industrial Developmental Banks and State Finance Corporations provide training to
entrepreneurs in developing leadership and business management skills. They conduct
seminars and workshops for the benefit of entrepreneurs.
8. Regional Development
Developmental banks facilitate rural and regional development. They provide finance
for starting companies in backward areas. They also help the companies in project
management in such less developed areas.
9. Contribution to Capital Markets
Developmental banks contribute the growth of capital markets. They invest in equity
shares and debentures of various companies listed in India. They also invest in mutual
funds and facilitate the growth of capital markets in India.
4.5 Types of Developmental Banks in India

Developmental banks in India are classified into following four groups:
1. Industrial Developmental Banks
It includes, for example, Industrial Finance Corporation of India (IFCI), Industrial
Developmental Bank of India (IDBI), and Small Industries Developmental Bank of India
(SIDBI).
2. Agricultural Developmental Banks
It includes, for example, National Bank for Agriculture and Rural Development
(NABARD).
3. Export-Import Developmental Banks
It includes, for example, Export-Import Bank of India (EXIM Bank).
4. Housing Developmental Banks
It includes, for example, National Housing Bank (NHB).
4.6 Origin of Industrial Development Bank of India (IDBI)

The Industrial Development Bank of India (IDBI) was established on 1 July 1964 under
an Act of Parliament as a wholly owned subsidiary of the Reserve Bank of India. On
16 February 1976, the ownership of IDBI was transferred to the Government of India and
it was made the principal financial institution for coordinating the activities of institutions
engaged in financing, promoting and developing industry in the country. Although
Government shareholding in the Bank came down below 100% following IDBIs public issue
in July 1995, the former continues to be the major shareholder (current shareholding:
65.14%). IDBI provides financial assistance, both in rupee and foreign currencies, for
184
Notes
greenfield projects as also for expansion, modernization and diversification purposes. In

the wake of financial sector reforms unveiled by the government since 1992, IDBI also
provides indirect financial assistance by way of refinancing of loans extended by Statelevel financial institutions and banks and by way of rediscounting of bills of exchange
arising out of sale of indigenous machinery on deferred payment terms.
IDBI has played a pioneering role, particularly in the pre-reform era (1964-91), in
catalyzing broad based industrial development in the country in keeping with its
Government-ordained developmental banking charter.
In September 2003, IDBI diversified its business domain further by acquiring the entire
shareholding of Tata Finance Limited in Tata Home Finance Ltd., signaling IDBIs foray
into the retail finance sector. The fully owned housing finance subsidiary has since been
renamed IDBI Home Finance Limited. In view of the signal changes in the operating
environment, following initiation of reforms since the early nineties, Government of India
has decided to transform IDBI into a commercial bank without eschewing its secular
development finance obligations. The migration to the new business model of commercial
banking, with its gateway to low-cost current, savings bank deposits, would help overcome
most of the limitations of the current business model of development finance while
simultaneously enabling it to diversify its client/asset base. Towards this end, the IDBI
Act 2003 was passed by Parliament in December 2003.
IDBI Bank, with which the parent IDBI was merged, was a new generation bank.
The Private Bank was the fastest growing banking company in India. The bank was pioneer
in adapting to policy of first mover in tier 2 cities. The Bank also had the least NPA and
the highest productivity per employee in the banking industry.
The immediate fallout of the merger of IDBI and IDBI Bank was the exit of employees
of IDBI Bank. The cultures in the two organizations have taken its toll. The IDBI Bank
now is in a growing fold. With its retail banking arm expanding further after the merger
of United Western Bank.
IDBI would continue to provide the extant products and services as part of its
development finance role even after its conversion into a banking company. In addition,
the new entity would also provide an array of wholesale and retail banking products,
designed to suit the specific needs and cash flow requirements of corporate and individuals.
In particular, IDBI would leverage the strong corporate relationships built up over the years
to offer customized and total financial solutions for all corporate business needs, single
window appraisal for term loans and working capital finance, strategic advisory and handholding support at the implementation phase of projects, among others.
IDBIs transformation into a commercial bank would provide a gateway to low-cost
deposits like Current and Savings Bank Deposits. This would have a positive impact on
the banks overall cost of funds and facilitate lending at more competitive rates to its clients.
The new entity would offer various retail products, leveraging upon its existing relationship
with retail investors under its existing Suvidha Flexi-bond schemes.
The responsibility for maintaining standards of corporate governance lies with its
Board of Directors. Two Committees of the Board, viz., the Executive Committee and the
Audit Committee are adequately empowered to monitor implementation of good corporate
governance practices and making necessary disclosures within the framework of legal
provisions and banking conventions.
185
4.6.1 The Present Scenario of IDBI
Notes
Today, IDBI Bank is counted amongst the leading public sector banks of India, apart
from claiming the distinction of being the 4th largest bank, in overall ratings. It is presently
regarded as the tenth largest developmental bank in the world, mainly in terms of reach.
This is because of its wide network of 509 branches, 900 ATMs and 319 centers. Apart
from being involved in banking services, IDBI has set up institutions like The National Stock
Exchange of India (NSE), The National Securities Depository Services Ltd. (NSDL) and
the Stock Holding Corporation of India (SHCIL).
4.6.2 Objectives of Industrial Development Bank of India
The main objectives of IDBI are to serve as the apex institution for term finance for
industry in India. Its objectives include:
(i) To grant loans to any industrial concern.
(ii) To guarantee deferred payment due from any industrial concern.
(iii) To guarantee loans raised by industrial concerns in the market or from
institutions.
(iv) To provide consultancy and merchant banking services in or outside India.
(v) To provide technical, legal, marketing and administrative assistance to any
industrial concern or person for promotion, management or expansion of any
industry.
(vi) To act as trustee for the holders of debentures or other securities.
4.6.3 Functions of Industrial Development Bank of India
The IDBI has been established to perform the following functions:
(i) Coordination, regulation and supervision of the working of other financial
institutions such as IFCI, ICICI, UTI, LIC, Commercial Banks and SFCs.
(ii) Supplementing the resources of other financial institutions and thereby widening
the scope of their assistance.
(iii) Planning, promotion and development of key industries and diversification of
industrial growth.
(iv) Devising and enforcing a system of industrial growth that conforms to national
priorities.
(v) It grants loans and advances to IFCI, SFCs or any other financial institutions
by way of refinancing of loans granted by such institutions which are repayable
within 25 years.
(vi) It grants loans and advances to scheduled banks or state cooperative banks
by way of refinancing of loans granted by such institutions which are repayable
in 15 years.
(vii) It contributes loans and advances to IFCI, SFCs, other institutions, scheduled
banks and state cooperative banks by way of refinancing of loans granted by
such institution to industrial concerns for exports.
(viii) It underwrites or subscribes to shares or debentures of industrial concerns.
(ix) It subscribes to or purchase stock, shares, bonds and debentures of other
financial institutions.
(x) It grants line of credit or loans and advances to other financial institutions such
as IFCI, SFCs, etc.
186
Notes
(xi) It ensures the planning, promoting and developing industries to fill up gaps in
the industrial structure in India.
4.6.4 Services of Industrial Developmental Bank of India
In order to increase its customer base, the Industrial Developmental Bank of India
offers a number of customized and innovative banking services. The services are meant
to offer cent per cent satisfaction to the customers. Some of the well-known services
offered by the bank are:
1. Wholesale Banking Services
Wholesale banking service is the provision of services by banks to the likes of
Mortgage Brokers, large corporate clients, mid-sized companies, real estate developers
other financial institutions. The wholesale banking services form a major part of the banking
services of the bank.
The services that are offered under the wholesale division are:
(i) Cash Management
(ii) Transactional services
(iii) Finance of working capital
(iv) Agro based business transactions
(v) Trade services
The wholesale banking services are an important source of income in a number of
infrastructure projects such as power, transport, telecom, railways, roadways, and
logistics and so on.
2. Retail Banking Services
Retail banking service is banking activity in which banking institutions execute
transactions directly with consumers, rather than corporations or other banks. Services
offered include savings and transactional accounts, mortgages, personal loans, debit
cards, and credit card.
The Industrial Development Bank of India is also a leader in the retail banking
services. The Net Interest Income amounted to around ` 2166 crores while the Net Profit
amounted to around ` 187 crores. The main objective of the retail services is to provide
high quality financial products to the target market to give that one-stop solution to the
banking needs.
The retail products offered by the banks include:
(i) Housing loans
(ii) Personal loans
(iii) Securities loans
(iv) Mortgage loans
(v) Educational loans
(vi) Merchant establishment overdrafts
(vii) Holiday travel loans
(viii) Commercial property loans
187
3. Treasury Facilities and Services
Notes
The net interest income of this sector amounts to around ` 1283 crores while the
net profit amounts to around ` 44.8 crores. One can get an array of financial products
such as cash management services, deposit, treasury products, trade finance services
and so on.
The three segments in this sector are:
(i) Local Currency Money Market.
(ii) Debt Securities and Equities.
(iii) Foreign Exchange and Derivatives.
4. Other Services of Industrial Development Bank of India
In addition to these, IDBI also offers some allied services and financial solutions to
cater to the target audience. To cater to the capital market, the bank has floated the IDBI
Capital Market Services Limited, also known as IDBI Capital.
The various services offered in this section are:
(i) Corporate advisory services.
(ii) Financial product distribution.
(iii) Pension fund management.
(iv) Corporate and retail services.
(v) Debt management services.
The IDBI Home Finance Limited is also a subsidiary of the Industrial Development
Bank of India. It is used for the purpose of providing long-term loans and other financial
benefits to various companies of the industrial sector.
In addition to these, there is also the IDBI Intech Limited which is a trusted name
in the field of system support and implementation, applications, server hosting, system
integration and other related services. Another subsidiary of the Industrial Development
Bank of India is the IDBI Gilts Limited. The main services of this segment is trading of
bonds, offering insurance, auction underwriting and so on.
4.7 Origin of State Financial Corporations (SFCs)

State authorized each state of the Indian union to establish an SFC. Punjab
Government took the lead in organizing financial corporation and set up State Financial
Corporation in 1953. Gradually, financial corporations were established in different states.
By now, there are 18 SFCs functioning in different states in India. Of these, 17 were set
up under the SFCs Act, 1951. Tamil Nadu Industrial Investment Corporation Ltd. was
established in 1949 under the Companies Act as Madras Industrial Investment Corporation
Ltd. also functions as SFC. These institutions are closely modeled on the lines of the
IFCI with the difference in scope of their activity. While the IFCI limits its financial
assistance to larger industrial concerns. SFCs are intended to extend financial help to
smaller enterprises. Normally, the area of operations of an SFC is confined to one state.
However, activities of some of the State Financial Corporations cover the neighbouring
States/Union territories, which do not have SFCs of their own. With a view to reaching
the small-scale units spread out in their areas of operations, SFCs have opened a number
of regional/branch offices.
188
Notes
4.7.1 Features of State Financial Corporations

The main features of the State Financial Corporations are:
(i) The bill provides that the state government may, by notification in the official
gazette, establish a financial corporation for the state.
(ii) The share capital shall be fixed by the State government but shall not exceed
` 2 crores. The issue of the shares to the public will be limited to 25% of the
share capital and the rest will be held by the State Governments, the Reserve
Bank, Scheduled Banks, Insurance Companies, Investment Trusts, Cooperative
Banks and other financial institutions.
(iii) Shares of the corporation will be guaranteed by the State government as to the
repayment of principal and the payment of a minimum dividend to be prescribed
in consultation with the central government.
(iv) The corporation will be authorized to issue bonds and debentures for amounts
which together with the contingent liabilities of the corporations shall not exceed
five times the amount of the paid-up share capital and the reserve fund of the
corporations. These bonds and debentures will be guaranteed as to payment
of the principal and payment of interest at such rate as may be fixed by the
State government.
(v) The corporation may accept deposits from the public repayable after not less
than five years, subject to the maximum not exceeding the paid-up capital.
(vi) The corporation will be managed by a board consisting of a majority of Directors
nominated by the State governments, The Reserve Bank and the Industrial
Finance Corporation of India.
(vii) The corporation will be authorized to make long-term loans to industrial concerns
which are repayable within a period not exceeding 25 years. The Corporation
will be further authorized to underwrite the issue of stocks, shares, bonds or
debentures by industrial concerns, subject to the provision that the corporation
will be required to dispose of the shares, etc. This is acquired by it in fulfillment
of its underwriting liability within a period of 7 years.
(viii) Until a reserve fund is created equal to the paid-up share capital of the
Corporation and until the State Governments has been repaid, all amounts paid
by them, if any, in fulfillment of the guarantee liability, the rate of dividend shall
not exceed the rate guaranteed by the state government. Under no
circumstances shall the dividend exceed 5% p.a. and surplus profits will be
repayable to the State governments.
(ix) The corporation will have special privileges in the matter of enforcement of its
claims against borrowers.
4.7.2 Objectives of State Financial Corporations
The various objectives of SFCs are as follows:
(i) To provide medium and long-term financial assistance to small industrial
enterprises particularly in circumstances when normal banking facilities are not
available.
(ii) To assist for satisfying medium- and long-term capital requirements.
(iii) To underwrite the issue of shares, bonds and debentures of industrial concerns.
(iv) To subscribe to shares, bonds and debentures of industrial concerns.
189
(v) To provide assistance to new as well as existing industrial concerns for the
purpose of establishment, modernization, renovation, expansion and
diversification.
Notes
4.7.3 Financial Resources of the SFCs

The SFCs mobilize their financial resources from the following sources:
1. Their own share capital.
2. Income from investment and repayment of loans.
3. Sale of bonds.
4. Loans from IDBI.
5. Borrowings from the Reserve Bank of India.
6. Deposits from the public.
7. Loans from State Governments.
4.7.4 Functions of State Financial Corporations
The SFCs provide the following types of assistance to industrial units in their
respective states:
1. The SFCs while giving loans to industrial units see to it that loans are secured
by a Pledge, Mortgage, Hypothecation of movable and immovable property or
other tangible assets or guarantee by the state government or scheduled
commercial bank. They also accept personal pledge by the entrepreneur. SFCs
dont give loans on the basis of second mortgage.
2. Grant loans or advances to industrial concern repayable within a period not
exceeding 20 years.
3. Providing guarantee for loans raised by industrial units from commercial banks
and state cooperative banks.
4. Providing guarantee for deferred payments in cases where industrial units have
purchased capital goods on a deferred payment basis.
5. Guarantee loans raised by industrial concerns which is repayable within a period
not exceeding 20 years and which are floated in the public market.
6. SFCs grant loans to industrial units for the purchase of fixed capital assets like
land, machinery, etc. In some exceptional cases, some SFCs also provide loans
for working capital requirements in combination with loans for fixed capital.
7. SFCs provide loans in foreign currency for the import of machinery and technical
know-how, under the IDA (International Development Association) and World
Bank tie-up.
8. SFCs, however, are prohibited from subscribing directly to the shares or stock
of any company having limited liability except for underwriting purposes and
granting any loans or advance on the security of its own shares.
4.7.5 SFCs Contributory to Development of Small-scale Industries in the Indian
Economy
There are at present 18 State Financial Corporations and almost every state has
a financial corporation of its own. During 2000-2001, SFCs had sanctioned loans
aggregating to ` 2,800 crores and disbursed ` 2,000 crores. Their assistance in the form
of loans has declined subsequently due to the existence of a large amount of NonAmity Directorate of Distance and Online Education
190
Notes
performing assets. Over 70% of the total assistance sanctioned and disbursed by all SFCs
is provided to small-scale industries. Attempts are now being made to strengthen the role
of SFCs as regional developmental banks. The SFCs sanctioned seed capital assistance
under the seed capital schemes introduced and operated by IDBI. This assistance is
available to promoters of small business units. Since June 1989, SFCs have also been
implementing special schemes of seed capital assistance to women entrepreneurs.
Assistance is extended in the form of loan or grant or a combination of both to voluntary
agencies working for women in decentralized industries.
4.8 Origin of State Industrial Development Corporations (SIDCs)

The State Industrial Development Corporations act as catalyst for the promotion and
development of medium and large enterprises in their respective states. In tune with the
changing business environment and the challenges emanating from it, SIDCs are making
efforts to diversify their activities to cover a range of fee-based activities besides widening
the scope of fund-based activities.
The State Industrial Development Corporations (SIDCs) were established under the
Companies Act, 1956 as wholly owned undertakings of the state governments with the
specific objectives of promoting and developing medium and large industries in their
respective states/union territories. These corporations extend financial assistance in the
form of rupee loans, underwriting and direct subscriptions to shares/debentures,
guarantees, intercorporate deposits and also opens letters of credit on behalf of its
borrowers. SIDCs undertake a range of promotional activities including preparation of
feasibility reports, conducting industrial potential surveys, entrepreneurship training and
development programmes and developing industrial areas/estates. Some SIDCs also offer
a package of developmental services that include technical guidance, assistance in plant
location and coordination with other agencies. With a view to providing infrastructural
facilities for the establishment of industrial units, SIDCs are involved in the setting up of
industrial growth centres. To keep pace with the changing economic environment, SIDCs
have initiated various measures to expand the scope of their activities and have entered
into various fee-based activities. Of the 28 SIDCs in the country, those in Andaman and
Nicobar, Arunachal Pradesh, Daman and Diu and Dadra and Nagar Haveli, Goa, Manipur,
Meghalaya, Mizoram, Nagaland, Tripura, Pondicherry and Sikkim also act as SFCs to
provide assistance to small and medium enterprises and act as promotional agencies for
this sector.
4.8.1 Objectives of State Industrial Development Corporations
The various objectives of State Industrial Development Corporations are as follows:
(i) To liaise with and to represent to the Central and State Governments, term
lending and other financial institutions on the common problems and issues of
member corporations.
(ii) To promote coordination, collaboration, joint participation and general
understanding among the member corporations, etc.
(iii) To render assistance to member corporations in their efforts to improve efficiency
of operations of their assisted and sponsored units.
(iv) To organize common service facilities, training courses, seminars, meetings and
study tours for the benefit of the member corporations.
(v) To sponsor studies, surveys, research and development projects pertaining to
industries.
191
(vi) To establish and maintain at the Registered Office a commercial and technical
library and information centre for use of member corporations.
Notes
4.8.2 Functions of State Industrial Development Corporations

The various functions of State Industrial Development Corporations are as follows:
1. State Industrial Development Corporations provide the financial assistance to
the state level organizations to develop the organizational activities.
2. They are involved in developing industrial infrastructure like industrial estates,
industrial parks and setting up industrial projects either on their own or in the
joint sector in collaboration with private entrepreneurs or as wholly owned
subsidiaries.
3. SIDCs exist in all the States and have developed industrial infrastructure facilities
to enable prospective entrepreneurs to set up their industries in the states.
4. These corporations render technical assistance to the entrepreneurs in the
formulation of the project reports and also provide common facilities in the
industrial estates.
5. These corporations provide loans and advances to the industrial units in the
medium and large sectors to the maximum of ` 400 lakhs.
6. State Industrial Development Corporations ensures the interest rate ranges
between 13.5% to 17% depend upon the size of the loan.
4.9 Origin of Life Insurance Corporation of India (LICI)

The nationalization of insurance business in the country resulted in the establishment
of Life Insurance Corporation of India (LIC) in 1956 as a wholly owned corporation of the
Government of India. The broad objectives of LIC are to serve people through financial
security by providing products and services of aspired attributes with competitive returns,
and by rendering resources for economic development. With a view to spreading life
insurance across the country, particularly, in the rural areas and to the socially and
economically backward classes, LIC currently offers over 50 plans to cover life at various
stages through a network of 2048 branches, all of which are fully computerized. LIC has
installed information kiosks at select locations for dissemination of information on its
products as also for accepting premium payments. It has also installed Interactive Voice
Response Systems in 59 urban centers, enabling its customers to get select information
about their policies.
With a view to widening its reach in the prevalent competitive and deregulated
business environment, and following the internationally prevalent Bank Assurance Model.
LIC issues Corporate Agency licenses to several public and private sector banks in India
for marketing its policies to corporate houses through their combined branch network.
Besides conducting insurance business, LIC, in pursuance of Government guidelines,
invests a major portion of its funds in Central and State Government securities and other
approved securities, including special deposits with Government of India. In addition, LIC
extends assistance to develop infrastructure facilities like housing, rural electrification,
water supply and sewerage and provides financial assistance to the corporate sector by
way of term loans, underwriting of and direct subscription to shares and debentures. LIC
also provides resource support to financial institutions through subscription to their shares/
bonds and by way of term loans.
192
Notes
4.9.1 Milestones in the Life Insurance Business in India

Some of the important milestones in the life insurance business in India are:
1818: Oriental Life Insurance Company, the first life insurance company on Indian
soil started functioning.
1870: Bombay Mutual Life Assurance Society, the first Indian life insurance company
started its business.
1912: The Indian Life Assurance Companies Act enacted as the first statute to
regulate the life insurance business.
1928: The Indian Insurance Companies Act enacted to enable the government to
collect statistical information about both life and non-life insurance businesses.
1938: Earlier legislation consolidated and amended to by the Insurance Act with the
objective of protecting the interests of the insuring public.
1956: 245 Indian and foreign insurers and provident societies are taken over by the
Central Government and nationalized. LIC formed by an Act of Parliament, viz., LIC Act,
1956, with a capital contribution of ` 5 crores from the Government of India.
The General insurance business in India, on the other hand, can trace its roots to
the Triton Insurance Company Ltd., the first general insurance company established in
the year 1850 in Calcutta by the British.
4.9.2 Milestones in the General Insurance Business in India
Some of the important milestones in the general insurance business in India are:
1907: The Indian Mercantile Insurance Ltd. set up the first company to transact all
classes of general insurance business.
1957: General Insurance Council, a wing of the Insurance Association of India, frames
a code of conduct for ensuring fair conduct and sound business practices.
1968: The Insurance Act amended to regulate investments and set minimum solvency
margins and the Tariff Advisory Committee set up.
1972: The General Insurance Business (Nationalization) Act, 1972 nationalized the
general insurance business in India with effect from 1st January 1973. 107 insurers
amalgamated and grouped into four companies, viz., the National Insurance Company Ltd.,
the New India Assurance Company Ltd., the Oriental Insurance Company Ltd. and the
United India Insurance Company Ltd. GIC incorporated as a company.
4.9.3 Objectives of Life Insurance Corporation of India
The various objectives of LICI are as follows:
(a) To carry on capital redemption business, annuity certain business or
reinsurance business insofar as such reinsurance business relating to life
insurance business;
(b) To invest the funds of the Corporation in such manner as the Corporation may
think fit and to take all such steps as may be necessary or expedient for the
protection or realization of any investment; including the taking over of and
administering any property offered as security for the investment until a suitable
opportunity arises for its disposal;
193
(c) To acquire, hold and dispose of any property for the purpose of its business;
Notes
(d) To transfer the whole or any part of the life insurance business carried on outside
India to any other person or persons, if in the interest of the Corporation it is
expedient to do so;
(e) To advance or lend money upon the security of any movable or immovable
property or otherwise;
(f) To borrow or raise any money in such manner and upon such security as the
Corporation may think fit.
(g) To carry on either by itself or through any subsidiary any other business in any
case where such other business was being carried on by a subsidiary of an
insurer whose controlled business has been transferred to and vested in the
Corporation by this act;
(h) To carry on any other business which may seem to the Corporation to be
capable of being conveniently carried on in connection with its business and
calculated directly or indirectly to render profitable the business of the
Corporation; and
(i) To do all such things as may be incidental or conducive to the proper exercise
of any of the powers of the Corporation.
4.9.4 Features of Life Insurance Corporation of India
The main features of LIC are given below:
1. Saving Institution
Life insurance both promotes and mobilizes saving in the country. The income tax
concession provides further incentive to higher income persons to save through LIC
policies. The total volume of insurance business has also been growing with the spread
of insurance-consciousness in the country. The total new business of LIC during 199596 was ` 51815 crore sum assured under 10.20 lakh policies. The LIC business can grow
at still faster speed if the following improvements are made:
(i) The organizational and operational efficiency of the LIC should be increased.
(ii) New types of insurance covers should be introduced.
(iii) The services of LIC should be extended to smaller places.
(iv) The message of life insurance should be made more popular.
(v) The general price level should be kept stable so that the insuring public does
not get cheated of a large amount of the real value of its long-term saving through
inflation.
2. Term Financing Institution
LIC also functions as a large term financing institution (or a capital market) in the
country. The annual net accrual of investible funds from life insurance business (after
making all kinds of payments liabilities to the policyholders) and net income from its vast
investment are quite large. During 1994-95, LICs total income was ` 18,102.92 crore,
consisting of premium income of ` 1152,80 crore investment income of ` 6336.19 crore,
and miscellaneous income of ` 238.33 crore.
3. Investment Institution
LIC is a big investor of funds in government securities. Under the law, LIC is required
to invest at least 50% of its accruals in the form of premium income in government and
other approved securities. LIC funds are also made available directly to the private sector
194
Notes
through investment in shares, debentures, and loans. LIC also plays a significant role in
developing the business of underwriting of new issues.
4. Stabilizer in Share Market
LIC acts as a downward stabilizer in the share market. The continuous inflow of new
funds enables LIC to buy shares when the market is weak. However, the LIC does not
usually sell shares when the market is overshot. This is partly due to the continuous
pressure for investing new funds and partly due to the disincentive of the capital gains
tax.
4.9.5 Functions of Life Insurance
The various functions of a Life Insurance Corporation are given below:
(a) Life Insurance Corporation carries on capital redemption business, annuity
certain business or reinsurance business insofar as such reinsurance business
relating to life insurance business;
(b) It invests the funds of the Corporation in such manner as the Corporation may
think fit and to take all such steps as may be necessary or expedient for the
protection or realization of any investment; including the taking over of and
administering any property offered as security for the investment until a suitable
opportunity arises for its disposal;
(c) It acquires, holds and disposes of any property for the purpose of its business;
(d) It transfers the whole or any part of the life insurance business carried on outside
India to any other person or persons, if in the interest of the Corporation it
is expedient so to do;
(e) It advances or lends money upon the security of any movable or immovable
property or otherwise;
(f) It borrows or raises any money in such manner and upon such security as the
Corporation may think fit;
(g) It carries on either by itself or through any subsidiary any other business in
any case where such other business was being carried on by a subsidiary of
an insurer whose controlled business has been transferred to and vested in the
Corporation by this act;
(h) It carries on any other business which may seem to the corporation to be
capable of being conveniently carried on in connection with its business and
calculated directly or indirectly to render profitable the business of the
Corporation.
4.10 Origin of Export-Import Bank of India (EXIM Bank)

Export-Import Bank of India was set up in 1982 by an Act of Parliament for the
purpose of financing, facilitating and promoting Indias foreign trade. It is the principal
financial institution in the country for coordinating the working of institutions engaged in
financing exports and imports. EXIM Bank is fully owned by the Government of India and
the Banks authorized and paid-up capital are ` 10,000 crore and ` 2,300 crore
respectively.
EXIM Bank lays special emphasis on extension of Lines of Credit (LOCs) to overseas
entities, national governments, regional financial institutions and commercial banks. EXIM
Bank also extends Buyers credit and Suppliers credit to finance and promote countrys
exports. The Bank also provides financial assistance to export-oriented Indian companies
195
by way of term loans in Indian rupees or foreign currencies for setting up new production
facility, expansion/modernization or upgradation of existing facilities and for acquisition
of production equipment or technology. EXIM Bank helps Indian companies in their
globalization efforts through a wide range of products and services offered at all stages
of the business cycle, starting from import of technology and export product development
to export production, export marketing, pre-shipment and post-shipment and overseas
investment.
Notes
The Bank has introduced a new lending programme to finance research and
development activities of export-oriented companies. R&D financed by Exim Bank is in
the form of term loan to the extent of 80% of the R&D cost. In order to assist in the creation
and enhancement of export capabilities and international competitiveness of Indian
companies, the Bank has put in place an Export Marketing Services (EMS) Programme.
Through EMS, the Bank pro-actively assists companies in identification of prospective
business partners to facilitating placement of final orders. Under EMS, the Bank also
assists in identification of opportunities for setting up plants or projects or for acquisition
of companies overseas. The service is provided on a success fee basis.
EXIM Bank supplements its financing programmes with a wide range of value-added
information, advisory and support services, which enable exporters to evaluate international
risks, exploit export opportunities and improve competitiveness, thereby helping them in
their globalization efforts.
4.10.1 Capital of Export-Import Bank
The authorized capital of the EXIM Bank is ` 200 crore and paid-up capital is ` 100
crore, wholly subscribed by the Central Government. The bank can raise additional
resources through:
(i) Loans/grants from Central Government and Reserve Bank of India;
(ii) Lines of credit from institutions abroad;
(iii) Funds rose from Euro Currency markets;
(iv) Bonds issued in India.
4.10.2 Objectives of Export-Import Bank of India
The various objectives of Export-Import Bank of India are:
(i) To translate national foreign trade policies into concrete action plans.
(ii) To provide alternate financing solutions to the Indian exporter, aiding him in his
efforts to be internationally competitive.
(iii) To develop mutually beneficial relationships with the international financial
community.
(iv) To initiate and participate in debates on issues central to Indias international
trade.
(v) To forge close working relationships with other export development and financing
agencies, multilateral funding agencies and national trade and investment
promotion agencies.
(vi) To anticipate and absorb new developments in banking, export financing and
information technology.
(vii) To be responsive to export problems of Indian exporters and pursue policy
resolutions.
196
Notes
(viii) To ensure the provision of financial technical and administrative assistance in

the export-import sectors;
(ix) To make the planning promotion development and financing of export oriented
concerns;
(x) To ensure the undertaking and financing research surveys and techno-economic
studies in connection with the promotion and development of foreign trade.
4.10.3 Functions of Export-Import Bank of India
The main functions of the EXIM Bank are as follows:
(i) Financing of exports and imports of goods and services, not only of India but
also of the third world countries;
(ii) Financing of exports and imports of machinery and equipment on lease basis;
(iii) Financing of joint ventures in foreign countries;
(iv) Providing loans to Indian parties to enable them to contribute to the share capital
of joint ventures in foreign countries;
(v) It helps to undertake limited merchant banking functions such as underwriting
of stocks, shares, bonds or debentures of Indian companies engaged in export
or import; and
(vi) It ensures to provide technical, administrative and financial assistance to parties
in connection with export and import.
4.11 National Bank for Agriculture and Rural Development (NABARD)

NABARD has been established as an apex development bank with a mandate for
facilitating credit flow for the promotion and development of agriculture, small-scale
industries, cottage and village industries, handicrafts and other rural crafts. It is also
mandatory for NABARD to support all other allied economic activities in rural areas,
promote integrated and sustainable rural development and secure prosperity of the rural
areas.
4.11.1 Objectives of NABARD
(a) To plan operational aspects in the field of credit for the promotion of agriculture,
small-scale industries, cottage and village industries, handicrafts and other rural
crafts and other allied economic activities in rural areas.
(b) To serve as a refinancing institution for institutional credit such as long-term,
short-term for the promotion of activities in the rural areas.
(c) To provide direct lending to any institution as may approved by the Central
Government.
4.11.2 Role and Functions of NABARD
(a) It is accredited with all the matters concerning policy planning and operations
in the field of credit for agriculture and other economic activities in the rural areas.
(b) It act as a refinancing agency for the institutions providing investment and
production credit for the promoting the various development activities in rural areas.
(c) It takes measures towards institution building for improving absorptive capacity
of the credit delivery system, including monitoring, formulation of rehabilitation
schemes, restructuring of credit institutions, training of personnel, etc.
197
(d) It coordinates the rural financing activities of all the institutions engaged in
developmental work at the field level and maintains liaison with Government of
India, State Governments, Reserve Bank of India and other national level
institutions concerned with policy formulation.
Notes
(e) It prepares, on an annual basis, rural credit plans for all districts in the country.
(f) It undertakes monitoring and evaluation of projects refinanced by it.
(g) It promotes research in the fields of rural banking, agriculture and rural
development.
4.12 Resource Mobilization of Developmental Banks

The Bank is authorized to assist in the financing of development projects in its
regional developing member countries by means of the following types of operations:
1. Lending operations
2. Technical cooperation;
3. Assistance in obtaining additional external financing to meet project needs;
4. Guarantees extended by the IDB for loans from other sources.
The Bank will not finance a project in a member country if the government of the
country objects to same.
1. Lending Operations
Using its own resources and funds that it administers, the Bank participates in the
financing of lending operations in the developing member countries as described below:
z
Loans for Specific Projects are designed to finance one or more specific projects
or subprojects that are wholly defined at the time the Banks loan is approved.
Loans for Multiple Works Programmes are designed to finance groups of similar
works which are physically independent of each other and whose feasibility does
not depend on the execution of any given number of the works projects.
Global Credit Loans are granted to intermediary financial institutions (IFIs) or

similar agencies in the borrowing countries to enable them to onlend to endborrowers (sub-borrowers) for the financing of multi-sector projects.
Sector Adjustment Loans provide flexible support for institutional and policy
changes on the sector or sub-sector level, through fast-disbursing funds. At the
request of the borrower, a sector adjustment loan may include an investment
component, in which case it becomes a Hybrid Loan.
Time Slice Operations are investment loans in which the investment programme
for a sector or sub-sector is adjusted from time to time within the general criteria
and global objectives agreed upon with the Bank for a project.
The Project Preparation Facility provides funding for supplementary activities

necessary to prepare a project. The basic objective is to strengthen the project
preparation stage and shorten the time required, thus facilitating Bank approval
of the loan and execution of the project.
Small Projects Financing is intended to make credit available to individuals and

groups that generally do not have access to commercial or development loans
on regular market terms. In these cases, the Bank finances operations through
intermediary institutions which then channel the funds to the final beneficiaries.
Direct Lending to the Private Sector, without sovereign guarantees, in each

instance with the concurrence of the government of the member country. At
198
Notes
the outset, this financing would be targeted exclusively towards infrastructure

and public utility projects providing services usually performed by the public
sector.
z
The Emergency Reconstruction Facility has the objective to make available

resources to the country stricken by catastrophic disaster to cover the
immediate expenses of restoring basic services to the population. It is important
to understand that what drives the utilization of this facility is the urgency of
having resources of the ground in the first few hours after the disaster take place.
2. Technical Cooperation
The Bank finances technical cooperation activities to transfer technical know-how
and expertise for the purpose of supplementing and strengthening the technical capacity
of entities in the developing member countries. The financing is determined largely on the
basis of the field of activity into which a project falls and the relative development status
of the region, country, or countries involved. It may take one of the following forms:
z
Technical cooperation with Non-reimbursable Funding, which is a subsidy

granted by the Bank to a developing member country to finance technical
cooperation activities. This cooperation is particularly targeted to the leastdeveloped countries of the region and/or those which have insufficient markets.
Technical cooperation with Contingent Recovery Resources, whereby the Bank

finances technical cooperation activities where there exists a reasonable
possibility of a loan either from the Bank or another lending institution. If the
beneficiary should obtain a loan from any source for the project for which the
technical cooperation was provided, the borrower is obligated to reimburse the
funding received from the Bank.
Technical cooperation with Reimbursable Resources, which is a loan financed

by the Bank to carry out technical cooperation activities.
3. Assistance for the Mobilization of Other Financial Resources

The Bank considers that as a complement to the financing it provides out of its own
resources and the funds it administers, it is called upon to act as a Catalyst in the
mobilization of additional funds from external sources for financing specific projects in its
regional developing member countries. To this end, the Bank encourages and cooperates
with the borrowers in securing additional external financing from different sources. The
principal forms of mobilizing additional resources are:
z
Export Credit, in which, at the request of borrowing institutions, the Bank

furnishes advisory assistance and cooperates with them in arranging for credits
from specialized agencies in the advanced industrialized countries to finance
the procurement of goods and services required for projects for which the Bank
has made loans.
Parallel Credit from Other Public Financial Institutions, in which the Bank
coordinates its activities with national and international public financial
institutions with an interest in offering financing for projects or programmes in
the regional developing member countries. To facilitate COFINANCING for such
projects, the Bank is prepared to perform studies and undertake missions in
conjunction with other organizations for project identification and evaluation and
to enter into agreements with those organizations to administer financing
granted by them on their behalf.
Other Parallel Credits, in which at the request of borrowers, the Bank cooperates
with them in obtaining parallel loans from banks or institutional investors of other
countries.
199
4. Banks Guarantees
Notes
According to the Agreement establishing the Bank, and to promote the investment
in the borrowing countries, the Bank can guarantee loans made by private financial sources
to public and private sectors.
The Bank can provide guarantees with or without counter-guarantees of the borrowing
countrys government. Guarantees to private sector lenders without government counterguarantee of the borrowing country, in whose territory the project is to be carried out,
will not exceed 25% of the total cost of the project or $75 million, whichever is less.
The guarantees could be used for any kind of investment project, although the initial
emphasis in guarantee operations will be on infrastructure projects.
Other Financing
z
Export Financing, in which the Bank grants national agencies in the borrowing
countries a revolving line of credit to finance intra-regional exports of
nontraditional goods.
The Bank may carry out other forms of financing with Funds under Administration
that it manages on behalf of third parties, in accordance with the terms of the
contracts they have signed for the administration of said funds, for example,
loans for the purchase of shares and direct equity investments.
4.13 Project Examination by Developmental Banks

Developmental Bank is a polygonal development finance institution devoted to
improving the social and monetary development of its associate nations. Its main emphasis
is the welfare of the people. For example, the Asian Developmental Banks overarching
goal is to decrease poverty in Asia and the Pacific. It helps improve the value of peoples
lives by providing loans and scientific support for a broad variety of development activities.
New types of activities that generate fee income include securities brokerage, film
financing, equity participation in business, real estate brokerage services, real estate
development, real estate equity participation, and insurance brokerage activities. Banks
also receive fee income from a number of off-balance sheet items including loan
commitments, note issuance facilities, letters of credit, foreign exchange services, and
derivative activities (contracts for futures, forwards, interest rate swaps, and other derivative
contracts).
The essential function of a bank is to provide services related to the storing of value
and the extending credit because bank is a financial institution that provides banking and
other financial services. Banks can differ markedly in their sources of income. Some focus
on business lending, some on household lending, and some on fee-earning activities.
Increasingly, however, most banks are diversifying into fee-earning activities. Traditionally,
fee income has been very stable; but, also traditionally, it has been a small part of the
earnings stream of most banks.
Although the type of services offered by a bank depends upon the type of bank and
the country, services provided usually include:
(i) Directly take deposits from the general public and issue Savings accounts and
Current accounts.
(ii) Earning specials like the fixed deposits, recurring deposits.
(iii) Lend out money to companies and individuals.
200
Notes
(iv) Issue credit cards, ATM, and debit cards.

(v) Online banking and Internet banking.
(vi) Storage of valuables, particularly in a safe deposit box.
(vii) Granting loans.
4.14 Summary
Development Finance Institutions (DFIs) are national and international institutions
that provide loans, grants and other investments for projects and activities around the world.
While banks have traditionally met short-term working capital requirements of industry,
development finance institutions (DFIs) have mainly catered to the medium- to long-term
financing requirements. Industrial Finance Corporation of India (IFCI) was the first DFI which
was established to extend long-term finance to industry.
Developmental Bank is a financial institution dedicated to fund new and upcoming
businesses and economic development projects by equity capital or loan capital.
Developmental banks are those financial institutions engaged in the promotion and
development of industry, agriculture and other key sectors.
Developmental bank is essentially a multi-purpose financial institution with a broad
development outlook. A developmental bank may, thus, be defined as a financial institution
concerned with providing all types of financial assistance (medium as well as long term)
to business units, in the form of loans, underwriting, investment and guarantee operations,
and promotional activities economic development in general, and industrial development,
in particular.
Developmental banks play an important role in the promotion and development of
the small-scale sector. Government of India (GOI) started Small industries Developmental
Bank of India (SIDBI) to provide medium- and long-term loans to Small-scale Industries
(SSI) units. SIDBI provides direct project finance, and equipment finance to SSI units.
It also refinances banks and financial institutions that provide seed capital, equipment
finance, etc. to SSI units.
Developmental banks provide finance for the development of the housing sector. GOI
started the National Housing Bank (NHB) in 1988.
Developmental banks promote and develop large-scale industries (LSI). Development
financial institutions like IDBI, IFCI, etc. provide medium- and long-term finance to the
corporate sector. They provide merchant banking services, such as preparing project
reports, doing feasibility studies, advising on location of a project, and so on.
Developmental banks like National Bank for Agriculture and Rural Development
(NABARD) helps in the development of agriculture. NABARD started in 1982 to provide
refinance to banks, which provide credit to the agriculture sector and also for rural
development activities. It coordinates the working of all financial institutions that provide
credit to agriculture and rural development. It also provides training to agricultural banks
and helps to conduct agricultural research.
Developmental banks help to promote foreign trade. Government of India started
Export-Import Bank of India (EXIM Bank) in 1982 to provide medium- and long-term loans
to exporters and importers from India. It provides Overseas Buyers Credit to buy Indian
capital goods. It also encourages abroad banks to provide finance to the buyers in their
country to buy capital goods from India.
201
Developmental banks help to revive (cure) sick-units. Government of India (GOI)

started Industrial investment Bank of India (IIBI) to help sick units.
Notes
IIBI is the main credit and reconstruction institution for revival of sick units. It facilitates
modernization, restructuring and diversification of sick units by providing credit and other
services.
Developmental banks facilitate rural and regional development. They provide finance
for starting companies in backward areas. They also help the companies in project
management in such less developed areas.
Developmental banks contribute the growth of capital markets. They invest in equity
shares and debentures of various companies listed in India. They also invest in mutual
funds and facilitate the growth of capital markets in India.
State authorized ea6ch state of the Indian Union to establish an SFC. Punjab
Government took the lead in organizing financial corporation and set up State Financial
Corporation in 1953. Gradually, financial corporations were established in different states.
By now, there are 18 SFCs functioning in different states in India. Of these, 17 were set
up under the SFCs Act, 1951. Tamil Nadu Industrial Investment Corporation Ltd. was
established in 1949 under the Companies Act as Madras Industrial Investment Corporation
Ltd. also functions as SFC.
The State Industrial Development Corporations act as catalyst for the promotion and
development of medium and large enterprises in their respective states. In tune with the
changing business environment and the challenges emanating from it, SIDCs are making
efforts to diversify their activities to cover a range of fee-based activities besides widening
the scope of fund-based activities.
The nationalization of insurance business in the country resulted in the establishment
of Life Insurance Corporation of India (LIC) in 1956 as a wholly owned corporation of the
Government of India. The broad objectives of LIC are to serve people through financial
security by providing products and services of aspired attributes with competitive returns,
and by rendering resources for economic development. With a view to spreading life
insurance across the country, particularly, in the rural areas and to the socially and
economically backward classes, LIC currently offers over 50 plans to cover life at various
stages through a network of 2048 branches, all of which are fully computerized. LIC has
installed information kiosks at select locations for dissemination of information on its
products as also for accepting premium payments. It has also installed Interactive Voice
Response Systems in 59 urban centers, enabling its customers to get select information
about their policies.
Export-Import Bank of India was set up in 1982 by an Act of Parliament for the
purpose of financing, facilitating and promoting Indias foreign trade. It is the principal
financial institution in the country for coordinating the working of institutions engaged in
financing exports and imports. EXIM Bank is fully owned by the Government of India and
the Banks authorized and paid up capital are ` 10,000 crore and ` 2,300 crore respectively.
NABARD has been established as an apex developmental bank with a mandate for
facilitating credit flow for the promotion and development of agriculture, small-scale
industries, cottage and village industries, handicrafts and other rural crafts. It is also
mandatory for NABARD to support all other allied economic activities in rural areas,
promote integrated and sustainable rural development and secure prosperity of the rural
areas.
202
Notes

1. ______________ are national and international institutions that provide loans,
grants and other investments for projects and activities around the world.
2. Developmental bank is essentially a multi-purpose financial institution with a
broad ______________
3. Development financial institutions like IDBI, IFCI, etc. provide medium- and longterm finance to the ______________
4. NABARD started in the year ______________ to provide refinance to banks,
which provide credit to the agriculture sector and also for rural development
activities.
5. ______________ Bank of India was set up in 1982 by an Act of Parliament
for the purpose of financing, facilitating and promoting Indias foreign trade.
II. True or False
1. Developmental banks are those financial institutions engaged in the promotion
and development of industry, agriculture and other key sectors.
2. Developmental banks play an important role in the promotion and development
of the small-scale sector.
3. Government of Karnataka started Small industries Development Bank of India
(SIDBI) to provide medium- and long-term loans to Small-scale Industries (SSI)
units.
4. Developmental banks like National Bank for Agriculture and Rural Development
(NABARD) helps in the development of agriculture.
5. Government of India started Export-Import Bank of India (EXIM Bank) in 1982
to provide medium- and long-term loans to exporters and importers from India.
6. The IDBI acts as catalyst for the promotion and development of medium and
large enterprises in their respective states.
1. Which of the following is the national and international institution that provides
loans, grants and other investments for projects and activities around the world?
(a) Development Finance Institution
(b) RBI
(c) SEBI
(d) All the above
2. Government of India (GOI) started Small industries Development Bank of India
(SIDBI) to provide ______________
(a) Medium-term loans
(b) Long-term loans
(d) None of these
3. Developmental banks facilitate ______________
(a) Rural Development
(b) Regional Development
203
Notes
(d) None of these

1. What is Developmental Bank?
2. State any two features of a Developmental Bank.
3. What is Industrial Development Bank of India (IDBI)?
4. What is State Financial Corporations (SFCs)?
5. What is the origin of State Industrial Development Corporations (SIDCs)?
6. What is the origin of Life Insurance Corporation of India (LICI)?
7. What is Export-Import Bank of India (EXIM Bank)?
8. What is National Bank for Agriculture and Rural Development (NABARD)?
1. State various features of a Developmental Bank.
2. Discuss various types of Developmental Banks in India.
3. State objectives of Industrial Developmental Bank of India.
4. Discuss functions of Industrial Developmental Bank of India.
5. Explain objectives and functions of State Financial Corporation.
6. Discuss various functions of State Industrial Development Corporations.
7. Explain various functions of Life Insurance.
8. Discuss objectives and functions of Export-Import Bank of India.
9. Explain the role and functions of NABARD.
10. Discuss the resource mobilization of Developmental Banks.
4.17 Key Terms

z
Development Finance Institutions: Development Finance Institutions (DFIs)

are national and international institutions that provide loans, grants and other
investments for projects and activities around the world.
Developmental Bank: Developmental Bank is a financial institution dedicated

to fund new and upcoming businesses and economic development projects by
equity capital or loan capital.
State Industrial Development Corporations: The State Industrial Development

Corporations act as catalyst for the promotion and development of medium and
large enterprises in their respective states.
Export-Import Bank of India: Export-Import Bank of India was set up in 1982

by an Act of Parliament for the purpose of financing, facilitating and promoting
Indias foreign trade.
NABARD: NABARD has been established as an apex developmental bank with

a mandate for facilitating credit flow for the promotion and development of
agriculture, small scale industries, cottage and village industries, handicrafts
and other rural crafts.
204
Notes

1. Development Finance Institutions (DFIs)
2. Development outlook
3. Corporate sector
4. 1982
5. Export-Import
II. True or False
1. True
2. True
3. False
4. True
5. True
6. False
1. (a) Development Finance Institution
4.19 Case Study

The bank faced several extraordinary challenges in implementing a centralized core
processing system. These challenges included finding a new core system that could
process approximately 75 million accounts daily a number greater than any bank in
the world was processing on a centralized basis. Moreover, the bank lacked experience
in implementing centralized systems, audits large employee base took great pride in
executing complex transactions on local branch in 2002-2009. The Tower Group Inc. may
not be reproduced by any means without express permission. All rights reserved systems.
This practice led some people to doubt that the employees would effectively use the new
system.
Another challenge was meeting SBIs unique product requirements that would require
the bank to make extensive modifications to a new core banking system. The products
include gold deposits (by weight), savings accounts with overdraft privileges, and an
extraordinary number of passbook savings accounts.
Question:
1. Discuss about major challenges for SBI?

Ryerson.
Company.
3. Investing in Development: Lessons of the World Bank Experience by Baum W.C
and Tolbert S.M., Oxford University Press.
4. Projects, Preparation, Appraisal, Budgeting and Implementation by Prasanna
205
4.21 Bibliography
Notes
1. Kem, H.J. (2005), Global Retail Banking Changing Paradigms, Chartered

8. Divanna, J.A. (2009), The Future Retail Banking, Palgrave Macmillan, New
York.
10. Sapru, R.K. (1994), Development Administration, Sterling, New Delhi.
Portfolio Theory and Investment Analysis, John Wiley & Sons, New York
(ISBN 978-0470050828).
14. E.F. Fama (1976), Foundations of Finance, Basic Books Inc., New York
(ISBN 978-0465024995).
New York (ISBN 978-0470463383).
16. R.C. Merton (1992), Continuous Time Finance, Blackwell Publishers Inc.
(ISBN 978-0631185086).
17. Keith Pilbeam (2010), Finance and Financial Markets, Palgrave
(ISBN 978-0230233218).
Ltd. (ISBN 0-333-76447-1).
206
Notes
Unit 5:
Insurance Institutions
Structure:
5.1 Introduction
5.2 Meaning of Insurance
5.3 Definition of Insurance
5.4 Historical Background of Insurance
5.5 Historical Background of Insurance in India
5.6 Types of Insurance
5.6.1 Life Insurance
5.6.2 General Insurance
5.7 Role of Insurance Companies
5.8 Role of Insurance Companies in Industrial Financing
5.9 Principles of Insurance
5.10 Life Insurance
5.11 Meaning of Life Insurance
5.12 Purposes of Life Insurance
5.13 The Importance of Life Insurance
5.14 Life Insurance Products and Policies
5.15 General Insurance
5.16 Meaning of General Insurance
5.17 Objectives for Practicing of General Insurance
5.18 Principles of General Insurance
5.19 Features of General Insurance
5.20 Functions of General Insurance
5.21 General Insurance Corporation of India (GICI)
5.22 The General Insurance Business (Nationalization) Amendment Act, 2002 Act
No. 40 of 2002
5.23 Insurance Sector Reforms in India
5.24 Major Policy Changes under IRDA Act
5.25 Insurance Companies in India
5.26 Protection of the Interest of Policyholders
5.27 New Developments in Insurance as a Sector in the Indian Financial System
5.28 Bancassurance
5.29 Various Models for Bancassurance
5.30 Status of Bancassurance in India
5.31 Bancassurance Models in Europe
5.32 Bancassurance Models in India
5.33 The Major Need for Bancassurance in India
207
5.34 Obstacles in the Success of Bancassurance
Notes
5.35 Regulating Guidelines of IRDA

5.36 Recommendations of Committee Constituted by IRDA on Bancassurance
5.37 Bancassurance Models in India
5.38 Summary
5.41 Key Terms
5.43 Case Study
5.45 Bibliography
Objectives
z
Understand the role of Insurance companies in Industrial Financing
Detailed study of Life Insurance and General Insurance
Understand New developments in insurance as a sector in the Indian Financial

System
Detailed study of Bancassurance Models in Europe and India
5.1 Introduction
Insurance is a contract between two parties whereby one party agrees to undertake
the risk of another in exchange for consideration known as premium and promises to pay
a fixed sum of money to the other party on happening of an uncertain event (death) or
after the expiry of a certain period in case of life insurance or to indemnify the other party
on happening of an uncertain event in case of general insurance.
Insurance provides financial protection against a loss arising out of happening of an
uncertain event. A person can avail this protection by paying premium to an insurance
company. A pool is created through contributions made by persons seeking to protect
themselves from common risk. Premium is collected by insurance companies which also
act as trustee to the pool. Any loss to the insured in case of happening of an uncertain
event is paid out of this pool.
Insurance works on the basic principle of risk-sharing. A great advantage of insurance
is that it spreads the risk of a few people over a large group of people exposed to risk
of similar type. Insurance is the equitable transfer of the risk of a loss, from one entity
to another in exchange for payment. It is a form of risk management primarily used to
hedge against the risk of a contingent, uncertain loss.
An insurer, or insurance carrier, is a company selling the insurance; the insured,
or policyholder, is the person or entity buying the insurance policy. The amount of money
to be charged for a certain amount of insurance coverage is called the premium. Risk
management, the practice of appraising and controlling risk, has evolved as a discrete
field of study and practice.
The concept behind insurance is that a group of people exposed to similar risk come
together and make contributions towards formation of a pool of funds. In case a person
208
Notes
actually suffers a loss on account of such risk, he is compensated out of the same pool
of funds. Contribution to the pool is made by a group of people sharing common risks
and collected by the insurance companies in the form of premiums.
Insurance may be described as a social device to reduce or eliminate risk of life
and property. Under the plan of insurance, a large number of people associate themselves
by sharing risk, attached to individual. The risk, which can be insured against include
fire, the peril of sea, death, incident and burglary. Any risk contingent upon these may
be insured against at a premium commensurate with the risk involved.
Insurance is actually a contract between two parties whereby one party called insurer
undertakes in exchange for a fixed sum called premium to pay the other party on happening
of a certain event. Insurance is a contract whereby, in return for the payment of premium
by the insured, the insurer pays the financial losses suffered by the insured as a result
of the occurrence of unforeseen events. With the help of Insurance, large number of people
exposed to similar risks makes contributions to a common fund out of which the losses
suffered by the unfortunate few, due to accidental events, are made good. An insurer is
a company selling the insurance; an insured or policyholder is the person or entity buying
the insurance. The insurance rate is a factor used to determine the amount to be charged
for a certain amount of insurance coverage, called the premium.
5.2 Meaning of Insurance

Insurance refers to a contract or policy in which an individual or entity receives
financial protection or reimbursement against losses from an insurance company. The
company pools clients risks to make payments more affordable for the insured.
5.3 Definition of Insurance

According to J.B. Maclean, Insurance is a method of spreading over a large number
of persons a possible financial loss too serious to be conveniently borne by an individual.
According to Oxford Dictionary, Insurance is an arrangement by which a company
or the State undertakes to provide a guarantee of compensation for specified loss, damage,
illness, or death in return for payment of a specified premium.
5.4 Historical Background of Insurance

Insurance concept started by considering the methods of transferring or distributing
risk were practiced by Chinese and Babylonian traders as long ago as the 3rd and 2nd
millennia BC, respectively. Chinese merchants travelling treacherous river rapids would
redistribute their wares across many vessels to limit the loss due to any single vessels
capsizing. The Babylonians developed a system which was recorded in the famous Code
of Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants. If
a merchant received a loan to fund his shipment, he would pay the lender an additional
sum in exchange for the lenders guarantee to cancel the loan should the shipment be
stolen.
Achaemenian monarchs of Ancient Persia were the first to insure their people and
made it official by registering the insuring process in governmental notary offices. The
insurance tradition was performed each year in Nowruz (beginning of the Iranian New Year);
the heads of different ethnic groups as well as others willing to take part, presented gifts
to the monarch. The most important gift was presented during a special ceremony. When
209
a gift was worth more than 10,000 Derrik (Achaemenian gold coin) the issue was registered
in a special office. This was advantageous to those who presented such special gifts.
For others, the presents were fairly assessed by the confidants of the court. Then the
assessment was registered in special offices.
Notes
A thousand years later, the inhabitants of Rhodes (an island in Greece) created the
general average, which allowed groups of merchants to pay to insure their goods being
shipped together. The collected premiums would be used to reimburse any merchant
whose goods were jettisoned during transport, whether to storm or sinkage. The ancient
Athenian maritime loan advanced money for voyages with repayment being cancelled
if the ship was lost. In the 4th century BC, rates for the loans differed according to safe
or dangerous times of year, implying an intuitive pricing of risk with an effect similar to
insurance.
The Greeks and Romans introduced the origins of health and life insurance c. 600
BCE when they created guilds called benevolent societies which cared for the families
of deceased members, as well as paying funeral expenses of members. Guilds in the
Middle Ages served a similar purpose. The Talmud deals with several aspects of insuring
goods. Before insurance was established in the late 17th century, friendly societies
existed in England, in which people donated amounts of money to a general sum that
could be used for emergencies.
Separate insurance contracts (i.e., insurance policies not bundled with loans or other
kinds of contracts) were invented in Genoa (a city and important seaport in northern Italy)
in the 14th century, as were insurance pools backed by pledges of landed estates. The
first known insurance contract dates from Genoa in 1343, and in the next century maritime
insurance developed widely and premiums were intuitively varied with risks. These new
insurance contracts allowed insurance to be separated from investment, a separation of
roles that first proved useful in marine insurance. The first printed book on insurance was
the legal treatise on Insurance and Merchants Bets by Pedro de Santarm (Santerna),
written in 1488 and published in 1552. Insurance as we know it today can be traced to
the Great Fire of London, which in 1666 devoured 13,200 houses. In the aftermath of this
disaster, Nicholas Barbon opened an office to insure buildings. In 1680, he established
Englands first fire insurance company, The Fire Office, to insure brick and frame homes.
The concept of health insurance was proposed in 1694 by Hugh the Elder Chamberlen
from the Peter Chamberlen family. In the late 19th century, accident insurance began
to be available, which operated much like modern disability insurance. This payment model
continued until the start of the 20th century in some jurisdictions (like California), where
all laws regulating health insurance actually referred to disability insurance.
The first insurance company in the United States underwrote fire insurance and was
formed in Charles Town (modern-day Charleston), South Carolina in 1732, but it provided
only fire insurance.
The sale of life insurance in the US began in the late 1760s. The Presbyterian Synods
in Philadelphia and New York founded the Corporation for Relief of Poor and Distressed
Widows and Children of Presbyterian Ministers in 1759; Episcopalian priests created a
comparable relief fund in 1769. Between 1787 and 1837, more than two dozen life insurance
companies were started, but fewer than half a dozen survived.
5.5 Historical Background of Insurance in India

In India, insurance has a deep-rooted history. It finds mention in the writings of Manu
(Manusmrithi), Yagnavalkya (Dharmasastra) and Kautilya (Arthasastra). The writings talk
210
Notes
in terms of pooling of resources that could be redistributed in times of calamities such

as fire, floods, epidemics and famine. This was probably a precursor to modern-day
insurance. Ancient Indian history has preserved the earliest traces of insurance in the
form of marine trade loans and carriers contracts.
Insurance in India has evolved over time heavily drawing from other countries, England
in particular. 1818 saw the advent of life insurance business in India with the establishment
of the Oriental Life Insurance Company in Calcutta. This Company, however, failed in 1834.
In 1829, the Madras Equitable had begun transacting life insurance business in the Madras
Presidency. 1870 saw the enactment of the British Insurance Act and in the last three
decades of the nineteenth century, the Bombay Mutual (1871), Oriental (1874) and Empire
of India (1897) were started in the Bombay Residency. This era, however, was dominated
by foreign insurance offices which did good business in India, namely Albert Life
Assurance, Royal Insurance, Liverpool and London Globe Insurance and the Indian offices
were up for hard competition from the foreign companies.
In 1914, the Government of India started publishing returns of Insurance Companies
in India. The Indian Life Assurance Companies Act, 1912 was the first statutory measure
to regulate life business. In 1928, the Indian Insurance Companies Act was enacted to
enable the Government to collect statistical information about both life and non-life
business transacted in India by Indian and foreign insurers including provident insurance
societies. In 1938, with a view to protecting the interest of the Insurance public, the earlier
legislation was consolidated and amended by the Insurance Act, 1938 with comprehensive
provisions for effective control over the activities of insurers.
The Insurance Amendment Act of 1950 abolished Principal Agencies. However, there
were a large number of insurance companies and the level of competition was high. There
were also allegations of unfair trade practices. The Government of India, therefore, decided
to nationalize insurance business.
An Ordinance was issued on 19th January, 1956 nationalizing the Life Insurance
sector and Life Insurance Corporation came into existence in the same year. The LIC
absorbed 154 Indian, 16 non-Indian insurers as also 75 provident societies, 245 Indian
and foreign insurers in all. The LIC had monopoly till the late 90s when the Insurance
sector was reopened to the private sector.
The history of general insurance dates back to the Industrial Revolution in the west
and the consequent growth of sea-faring trade and commerce in the 17th century. It came
to India as a legacy of British occupation. General Insurance in India has its roots in the
establishment of Triton Insurance Company Ltd. in the year 1850 in Calcutta by the British.
In 1907, the Indian Mercantile Insurance Ltd. was set up. This was the first company to
transact all classes of general insurance business.
1957 saw the formation of the General Insurance Council, a wing of the Insurance
Association of India. The General Insurance Council framed a code of conduct for ensuring
fair conduct and sound business practices.
In 1968, the Insurance Act was amended to regulate investments and set minimum
solvency margins. The Tariff Advisory Committee was also set up then.
In 1972 with the passing of the General Insurance Business (Nationalization) Act,
general insurance business was nationalized with effect from 1st January, 1973. 107 insurers
were amalgamated and grouped into four companies, namely National Insurance Company
Ltd., the New India Assurance Company Ltd., the Oriental Insurance Company Ltd. and
the United India Insurance Company Ltd. The General Insurance Corporation of India was
incorporated as a company in 1971 and it commence business on January 1st 1973.
211
This millennium has seen insurance come a full circle in a journey extending to nearly
200 years. The process of reopening of the sector had begun in the early 1990s and the
last decade and more has seen it been opened up substantially. In 1993, the Government
set up a committee under the chairmanship of R.N. Malhotra, former Governor of RBI,
to propose recommendations for reforms in the insurance sector. The objective was to
complement the reforms initiated in the financial sector. The committee submitted its report
in 1994 wherein, among other things, it recommended that the private sector be permitted
to enter the insurance industry. They stated that foreign companies are allowed to enter
by floating Indian companies, preferably a joint venture with Indian partners.
Notes
Following the recommendations of the Malhotra Committee report, in 1999, the

Insurance Regulatory and Development Authority (IRDA) was constituted as an
autonomous body to regulate and develop the insurance industry. The IRDA was
incorporated as a statutory body in April, 2000. The key objectives of the IRDA include
promotion of competition so as to enhance customer satisfaction through increased
consumer choice and lower premiums, while ensuring the financial security of the
insurance market.
The IRDA opened up the market in August 2000 with the invitation for application
for registrations. Foreign companies were allowed ownership of up to 26%. The Authority
has the power to frame regulations under Section 114A of the Insurance Act, 1938 and
has from 2000 onwards framed various regulations ranging from registration of companies
for carrying on insurance business to protection of policyholders interests.
In December, 2000, the subsidiaries of the General Insurance Corporation of India
were restructured as independent companies and at the same time, GIC was converted
into a national reinsurer. Parliament passed a bill delinking the four subsidiaries from GIC
in July, 2002.
Today, there are 24 general insurance companies including the ECGC and Agriculture
Insurance Corporation of India and 23 life insurance companies operating in the country.
The insurance sector is a colossal one and is growing at a speedy rate of 15-20%. Together
with banking services, insurance services add about 7% to the countrys GDP. A welldeveloped and evolved insurance sector is a boon for economic development as it provides
long-term funds for infrastructure development at the same time strengthening the risk
taking ability of the country.
The insurance sector in India has completed all the facets of competition from being
an open competitive market to being nationalized and then getting back to the form of
a liberalized market once again. The history of the insurance sector in India reveals that
it has witnessed complete dynamism for the past two centuries approximately.
5.6 Types of Insurance

Different types of insurance are used to cover different properties and assets such
as vehicles, home, health care, etc. Basically, an insurance policy can also be known
as a protection net which secures from any financial losses in future. The Insurance can
be broadly classified into two categories such as:
1. Life Insurance
2. Non-life Insurance or General Insurance
212
Notes
5.6.1 Life Insurance

Life Insurance refers to the insurance which gives a protection against the loss of
income that would result if the insured passed away. The named beneficiary receives the
proceeds and is thereby safeguarded from the financial impact of the death of the insured.
Types of Life Insurance
Life insurance protection comes in many forms and not all policies are created equal.
While the death benefit amounts may be the same, the costs, structure, durations, etc.
vary tremendously across the types of policies.
(i) Whole Life Insurance
Whole life insurance provides guaranteed insurance protection for the entire life of
the insured, otherwise known as permanent coverage. These policies carry a cash value
component that grows tax deferred at a contractually guaranteed amount usually a low
interest rate until the contract is surrendered. The premiums are usually level for the life
of the insured and the death benefit is guaranteed for the insureds lifetime.
With whole life payments, part of your premium is applied toward the insurance
portion of your policy, another part of your premium goes toward administrative expenses
and the balance of your premium goes toward the investment, or cash, portion of your
policy.
(ii) Universal Life Insurance
Universal life insurance is a variation of whole life insurance. Like whole life, it is
also a permanent policy providing cash value benefits based on current interest rates.
The feature that distinguishes this policy from its whole life cousin is that the premiums,
cash values and level amount of protection can each be adjusted up or down during the
contract term as the insureds needs change. Cash values earn an interest rate that is
set periodically by the insurance company and is generally guaranteed not to drop below
a certain level.
(iii) Variable Life
Variable life insurance is designed to combine the traditional protection and savings
features of whole life insurance with the growth potential of investment funds. This type
of policy is comprised of two distinct components: the general account and the separate
account. The general account is the reserve or liability account of the insurance provider,
and is not allocated to the individual policy. The separate account is comprised of various
investment funds within the insurance companys portfolio, such as an equity fund, a
money market fund, a bond fund, or some combination of these. Because of this underlying
investment feature, the value of the cash and death benefit may fluctuate, thus the name
variable life.
(iv) Variable Universal Life
Variable universal life insurance combines the features of universal life with variable
life and gives the consumer the flexibility of adjusting premiums, death benefits and the
selection of investment choices. These policies are technically classified as securities
and are therefore subject to Securities and Exchange Commission (SEC) regulation and
the oversight of the State Insurance Commissioner. Unfortunately, all the investment risk
lies with the policy owner; as a result, the death benefit value may rise or fall depending
on the success of the policys underlying investments. However, policies may provide some
type of guarantee that at least a minimum death benefit will be paid to beneficiaries.
213
(v) Term Life
Notes
Term insurance can help protect your beneficiaries against financial loss resulting
from your death; it pays the face amount of the policy, but only provides protection for
a definite, but limited, amount of time. Term policies do not build cash values and the
maximum term period is usually 30 years. Term policies are useful when there is a limited
time needed for protection and when the dollars available for coverage are limited. The
premiums for these types of policies are significantly lower than the costs for whole life.
They also (initially) provide more insurance protection per dollar spent than any form of
permanent policies. Unfortunately, the cost of premiums increases as the policy owner
gets older and as the end of the specified term nears.
5.6.2 General Insurance
General insurance or non-life insurance policies, including automobile and
homeowners policies, provide payments depending on the loss from a particular financial
event. General insurance typically comprises any insurance that is not determined to be
life insurance.
Types of General Insurance
(i) Motor Insurance Plans
A standard motor insurance or better known as a car insurance policy is usually
the insurance coverage mandated by law to drive on the road. Thus, it primarily covers
you against liability damages and unexpected repairs. These liability damages can be
of two types. First is when a bodily injury has been caused to a third person. Second
is where the property of a third person and own car.
(ii) Health Insurance
Health is insurance against the risk of incurring medical expenses among individuals.
By estimating the overall risk of health care and health system expenses among a targeted
group, an insurer can develop a routine finance structure, such as a monthly premium
or payroll tax, to ensure that money is available to pay for the health care benefits specified
in the insurance agreement. The benefit is administered by a central organization such
as a government agency, private business, or not-for-profit entity.
(iii) Marine Insurance
Marine Insurance and marine cargo insurance cover the loss or damage of vessels
at sea or on inland waterways, and of cargo in transit, regardless of the method of transit.
When the owner of the cargo and the carrier are separate corporations, marine cargo
insurance typically compensates the owner of cargo for losses sustained from fire,
shipwreck, etc., but excludes losses that can be recovered from the carrier or the carriers
insurance. Many marine insurance underwriters will include time element coverage in
such policies, which extends the indemnity to cover loss of profit and other business
expenses attributable to the delay caused by a covered loss.
(iv) Travel Insurance
Travel insurance is insurance that is intended to cover medical expenses, financial
default of travel suppliers, and other losses incurred while travelling, either within ones
own country, or internationally. Temporary travel insurance can usually be arranged at
the time of the booking of a trip to cover exactly the duration of that trip, or a multitrip policy can cover an unlimited number of trips within a set time frame.
214
Notes
(v) Aviation Insurance

Aviation Insurance grants protection against the loss of or damage to the aircraft
as also the legal liability to third parties and to passengers arising out of the operation
of the aircraft.
It covers Freight liability, Airmail liability, Personal accident insurance and Loss of
license insurance. Aviation insurance protects aircraft hulls and spares, and associated
liability risks, such as passenger and third-party liability. Airports may also appear under
this sub-category, including air traffic control and refueling operations for international
airports through to smaller domestic exposures.
(vi) Personal Accident Insurance
This policy provides that if the insured shall sustain any bodily injury resulting solely
and directly from accident caused by external violent and visible means, then the company
shall pay to the insured or his legal representative, the sum or sums set forth in the policy.
Statistics reveal that at least thirteen people die every hour in road accidents in India.
Accident can make a terrible impact on finances with increased spending towards
treatment and disrupting income until recovery. In such a bumpy scenario, it is personal
accident insurance that can be vital to keep finances smooth and sailing.
(vii) Disability Insurance
Disability Insurance policies provide financial support in the event of the policyholder
becoming unable to work because of disabling illness or injury. It provides monthly support
to help pay such obligations as mortgage loans and credit cards. Short-term and longterm disability policies are available to individuals, but considering the expense, long-term
policies are generally obtained only by those with at least six-figure incomes, such as
doctors, lawyers, etc. Short-term disability insurance covers a person for a period typically
up to six months, paying a stipend each month to cover medical bills and other necessities.
Long-term disability insurance covers an individuals expenses for the long term, up
until such time as they are considered permanently disabled and thereafter. Insurance
companies will often try to encourage the person back into employment in preference to
and before declaring them unable to work at all and therefore totally disabled.
Disability overhead insurance allows business owners to cover the overhead
expenses of their business while they are unable to work.
Total permanent disability insurance provides benefits when a person is permanently
disabled and can no longer work in their profession, often taken as an adjunct to life
insurance.
Workers compensation insurance replaces all or part of a workers wages lost and
accompanying medical expenses incurred because of a job-related injury.
(viii) Crime Insurance
This is a form of casualty insurance that covers the policyholder against losses
arising from the criminal acts of third parties. For example, a company can obtain crime
insurance to cover losses arising from theft or embezzlement.
Crime insurance is insurance to manage the loss exposures resulting from criminal
acts such as robbery, burglary and other forms of theft. It is also called fidelity insurance.
Many businesses purchase crime insurance that allows them to file claims for employee
theft or other offenses with the potential to cause financial ruin.
215
Because crime insurance loss exposures can vary significantly among policyholders
and require special underwriting skills, insurers prefer to insure certain types of crime
insurance loss under separate Commercial Crime Insurance forms. These forms allow
organizations to cover crime losses that are not insured under other insurance policies.
Notes
Briefly described, commercial crime insurance covers money, securities and other
property against a variety of criminal acts, such as employee theft, robbery, forgery,
extortion and computer fraud. Many insurers use Insurance Service Offices (ISOs)
commercial crime forms.
5.7 Role of Insurance Companies

Insurance companies are a special type of financial institution that deals in the
business of managing risk. A corporation periodically gives them money and, in return,
they promise to pay for the losses the corporation incurs if some unfortunate event occurs,
causing damage to the well-being of the organization.
Here are a few terms you need to know when considering insurance companies:
z
Deductible: The amount that the insured must pay before the insurer will pay
anything.
Premium: The periodic payments the insured makes to ensure coverage.
Co-pay: An expense that the insured pays when sharing the cost with the
insurer.
Indemnify: A promise to compensate one for losses experienced.
Claim: The act of reporting an insurable incident to request that the insurer
pay for coverage.
Benefits: The money the insured receives from the insurance company when
something goes wrong.
5.8 Role of Insurance Companies in Industrial Financing

The economic crisis of late 2007 and early 2008 highlighted the growing importance
of the role of the worlds financial sectors in ensuring global financial stability. The finance
industry, however, is not homogenous. Insurers, in particular, have a distinct profile within
the industry. This was the subject of leading speakers at the Role of Insurance in Global
Financial Stability event, held at the Swiss Re Centre for Global Dialogue, 29 June 2010.
Among other qualities, insurers receive premiums upfront, so are not subject to a run of
withdrawals; and through matching liabilities with assets, are long-term stabilizing
investors. There are also distinct challenges in regulating the insurance industry. Some
of these were discussed by John Maroney, of the International Association of Insurance
Supervisors.
The International Association of Insurance Supervisors (IAIS) in Basel last
September, one of the key tasks has been to assist the IAIS (via its Financial Stability
Committee) to develop its views on the implications of the global financial crisis for possible
changes to insurance supervision. The insurance industry is an important part of the global
financial system and economy. As the international standard setter for insurance, the IAIS
has been analyzing the potential for financial instability in this sector to determine what,
if any, regulatory and supervisory action might be appropriate. Many risks and
circumstances where systemic risk might apply to the insurance sector have been
examined, regardless of whether these circumstances emanate from the insurance sector
or are merely transmitted to the insurance sector from another financial sector.
216
Notes
The IAIS has presented its position on key financial stability issues in insurance,
initially in November 2009 and more recently in June, as described in this article. As part
of the analysis, the basic insurance business model is described. Following this, the
potential for systemic risk to emerge in the insurance sector is discussed. Then the
applicability to insurance of recognized systemic characteristics and insurance resolution
is considered, followed by some proposals by the IAIS for insurance supervisory
enhancements.
Insurance Business Model
Traditionally, the primary purpose of insurance is to indemnify policyholders (both
individuals and corporations) from claims associated with adverse events (e.g., property
damage, premature death, liability claims, etc.) and to provide stable long-term savings,
including during the future lifetimes of retirees and other policyholders. Diversification of
risk is the main tool used in the insurance process; diversification takes place by pooling
policyholders risks, by insuring a wide variety of policyholder pools, by underwriting in
different geographic areas and by diversifying across different types of risks (such as
underwriting and investment risk).
To the extent that risk remains after diversification, further mitigation techniques are
used by insurers, including reinsurance, hedging, insurance linked securities and the use
of certain life insurance products (whereby policyholders take most or all investment risk,
often via separate accounts). Generally, insurers incorporate strong risk management
practices, including asset-liability management, to mitigate asset and liability mismatches.
In addition, supervisory processes and regulatory requirements (such as capital and claim
provisioning requirements) help to maintain solvency in the industry. In many parts of the
world, there is a strong involvement by the actuarial profession in insurance risk
management, with statutory requirements in some jurisdictions for insurers to obtain
appropriate actuarial advice and reports.
In spite of such strong risk management practices, insurers sometimes become
financially distressed and, in a competitive market, financial distress and insolvencies may
occur from time to time. The financial distress of an insurer usually plays out over a long
time horizon. That is, assets of the insurer do not need to be liquidated until claims or
benefits under the policies need to be paid, and this will not occur until months or even
years in the future. Accordingly, regulators usually have the time to intervene to reduce
potential losses to policyholders from the insolvency, although this will not always be the
case.
Insurers and banks share some common characteristics and risks because they are
both financial intermediaries (for example, financial guarantee insurance bears some
similarity to banking type products); however, the roles of banks and insurers in the
economy differ substantially. That is, banks are part of the payment and settlement system
and are involved in the transmission of monetary policy, while insurers are not. Banks
tend to rely to a larger extent on short-term borrowed money, and hence are exposed
to liquidity risk; on the other hand, insurers receive premium payments in advance of claims
so that liquidity risk is not usually an issue but can be so if large borrowings have been
utilized to finance acquisitions or rapid organic growth.
Systemic Relevance and Systemic Risk
The insurance sector is susceptible to systemic risks generated in other parts of
the financial sector. For most classes of insurance, however, there is little evidence of
insurance either generating or amplifying systemic risk, within the financial system itself
217
or in the real economy. This is because of the fundamentally different role of insurers in
the economy as compared to banks. It is also important to note the stabilization role that
the insurance sector typically plays in the economy may help to limit systemic risk. This
stabilization role was an important factor during the financial crisis, as the majority of
insurers were able to withstand the fluctuations in capital markets, without having to resort
to fire-sales of assets or similar drastic actions.
Notes
The G20, International Monetary Fund (IMF), Financial Stability Board (FSB) and
Bank for International Settlements (BIS) reports have focused on three characteristics of
systemically important financial institutions: size, interconnectedness and substitutability.
These characteristics warrant careful inspection from an insurance perspective.
By itself, size is not a particularly good measure for assessing the potential for
systemic risk in insurance. In fact, size has a beneficial effect for most insurers by allowing
for greater diversification of risk (via the law of large numbers). Also, because premiums
are funded in advance of claims, insurers typically are required by operation of the business
model and regulatory requirements to have a large amount of assets on hand relative to
liabilities in comparison to banks, which can be critical in the event of insolvency.
Reinsurance activities help redistribute risks among insurers; but also contribute to
interconnectedness within the insurance sector. Hypothetically, failure of a large reinsurer
and/or a reinsurance spiral could conceivably have a significant impact on capacity among
primary insurers and cause disruption to the real economy (although neither such
occurrence has occurred to date). IAIS monitors these potential risks with its Global
Reinsurance Market Report, which has shown that reinsurance risk exposures have so
far been well managed and diversified.
Insurers are interconnected with financial and non-financial firms, including through
equity shareholdings, corporate debt holdings, other investments, treasury operations and
securities lending. However, whether these interconnections are of systemic importance
would depend on how much the total exposure of insurers investments account for in
the overall economy. Further, as already indicated, immediate liquidation of an insurers
investments does not occur when an insurer becomes insolvent. Hence, a fire-sale of large
blocks of investments which might depress asset prices does not typically occur in the
insolvency of an insurer.
Lack of substitutability in the insurance sector may lead to market disruptions,
especially when insurance coverage is necessary to conduct business. For example, a
market disruption can occur when compulsory or widely used insurance products become
unavailable. This occurred in Australia following the failure of the countrys second largest
insurer, HIH, in 2001; and to some extent after the World Trade Centre attacks in 2001.
Also, insurance against catastrophes can become unavailable or extremely costly after
a catastrophic event. There is also a possibility that a market failure will occur where
insurance capacity disappears in a particular segment of the insurance market, such that
parts of the real economy are disrupted and government intervention is required. Market
disruptions or failures of this nature are typically relatively short term, as new insurers
and/or reinsurers can usually move into the affected region to create capacity for the
product(s) in question, although this is not always the case. An effective regime of
regulation and supervision can help mitigate this possibility.
An important part of the IAIS analysis has been exploring ways in which insurers
may amplify systemic risk under certain circumstances. For example, the participation
of life insurers in capital markets can contribute to selling pressure, if the insurers
collectively hold significant positions in equities, bonds or hedging instruments and need
to liquidate their positions simultaneously in a falling market.
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Notes
Of course, as conditions change in the future, in theory, the possibility exists that
insurers may become systemically important. Some cases where insurers might generate
systemic risk include: (1) widespread distribution of financial products that contain a
minimum guarantee and/or distribution of other types of banking-like products;
(2) widespread (naked) derivatives trading, especially extensive distribution of credit default
swaps (CDSs); (3) expansive offering of financial guarantee insurance; and (4) insurers
using regulatory arbitrage to offer products or services that end up being systemically
important.
Indeed, the nature of the insurance industry has already been changing. Some parts
of the industry have been growing in complexity, diversity and global reach. Financial
innovation and the rapidly changing financial environment have contributed to the formation
of some insurance entities and groups spanning jurisdictional borders and/or sectors. In
light of continuing financial instability since 2007, there has been an increased focus, by
many parties, on issues of financial stability and the risks associated with large and
complex financial organizations operating on a cross-border and/or cross-sector basis.
This is a major concern of the FSB and G20 discussions and will be one of the key issues
considered by G20 Leaders during their summit in Seoul in November.
Of particular concern has been the potential risks emerging from non-regulated
entities of financial conglomerates (as in the case of AIG) and some insurance activities
(such as financial guarantee insurance) which can generate or amplify systemic risk and
may be instrumental to contagion within conglomerates or between sectors. Further,
contagion effects might also occur if a member of a group exhibits financial distress.
Resolvability
The ease with which an insolvent insurer can be resolved depends on many factors,
including the role of insurance guarantee schemes, where they exist. For insurers (unlike
banks), there can be life after death. That is, failed insurers often can be managed through
orderly run-off, and sometimes even brought back to life with new capital.
All insurers are regulated at the solo entity (company) level. However, there is
widespread recognition that the resolvability of internationally operating financial entities,
groups, or conglomerates poses significant legal challenges. Enhanced supervisory
oversight for such entities is underway and cooperation with other sectors will be required.
Again, this is another major concern of the FSB and G20 discussions and will be
considered by G20 Leaders in November, when they focus on how to better control
systemically important financial institutions.
Proposed Supervisory Enhancements
The IAIS agrees that it is necessary for insurers and insurance groups to be
supervised on a solo entity basis and on a group-wide basis. Group supervision should
include consideration of non-regulated entities and/or non-operating holding companies
within a group. Other supervisory enhancements are under consideration and/or
development (particularly in cooperation with the Joint Forum) to reduce the potential for
regulatory arbitrage. These enhancements should reduce the probability and potential
impact of future insolvencies and insurance market failures. The enhancements should
increase the role of insurers as stabilizers and decrease their potential susceptibility to
systemic risk or their roles as potential transmitters or amplifiers of systemic risk. The
enhanced insurance supervisory framework should contribute to financial stability and
should also improve micro-prudential supervision and policyholder protection.
219
Since interdependencies between the sectors may increase in the future through
products, markets and conglomerates, the IAIS is promoting enhancements to supervision
and supervisory processes, combined with stronger risk management and enhanced
approaches to resolvability to minimize adverse externalities. These enhancements include
group-wide supervision and the development of a Common Framework for the Supervision
of Internationally Active Insurance Groups (ComFrame). The IAIS is also promoting crosssectoral macro-prudential monitoring of potential build-up of systemic risk and planning
to develop measures for national authorities to assess degrees of systemic risk.
Notes
In particular, ComFrame will develop methods of operating group-wide supervision

of Internationally Active Insurance Groups in order to make group-wide supervision more
effective and more reflective of actual business practices; establish a comprehensive
framework for supervisors to address group-wide activities and risks and also set grounds
for better supervisory cooperation in order to allow for a more integrated and international
approach; and foster global convergence of regulatory and supervisory measures and
approaches.
Clearly, there are many challenges on the insurance regulatory reform agenda in the
months and years ahead. Hopefully, these challenges will be successfully faced both by
supervisors and insurers and both policyholder protection and financial stability will be
enhanced.
5.9 Principles of Insurance

The seven principles of insurance are:
1. Principle of Utmost Good Faith
2. Principle of Insurable Interest
3. Principle of Indemnity
4. Principle of Contribution
5. Principle of Subrogation
6. Principle of Loss Minimization, and
7. Principle of Causa Proxima (Nearest Cause).
1. Principle of Utmost Good Faith
The Principle of Utmost Good Faith is a very basic and first primary principle of
insurance. According to this principle, the insurance contract must be signed by both
parties (i.e., insurer and insured) in an absolute good faith or belief or trust. The person
getting insured must willingly disclose and surrender to the insurer his complete true
information regarding the subject matter of insurance. The insurers liability gets void (i.e.,
legally revoked or cancelled) if any facts, about the subject matter of insurance are either
omitted, hidden, falsified or presented in a wrong manner by the insured.
The principle of insurable interest states that the person getting insured must have
insurable interest in the object of insurance. A person has an insurable interest when the
physical existence of the insured object gives him some gain but its non-existence will
give him a loss. In simple words, the insured person must suffer some financial loss by
the damage of the insured object.
For example: The owner of a taxicab has insurable interest in the taxicab because
he is getting income from it. But, if he sells it, he will not have an insurable interest left
in that taxicab.
220
Notes
Indemnity means security, protection and compensation given against damage, loss
or injury. According to the principle of indemnity, an insurance contract is signed only
for getting protection against unpredicted financial losses arising due to future
uncertainties. Insurance contract is not made for making profit, else its sole purpose is
to give compensation in case of any damage or loss. In an insurance contract, the amount
of compensations paid is in proportion to the incurred losses. The amount of
compensations is limited to the amount assured or the actual losses, whichever is less.
The compensation must not be less or more than the actual damage. Compensation is
not paid if the specified loss does not happen due to a particular reason during a specific
time period. Thus, insurance is only for giving protection against losses and not for making
profit. However, in case of life insurance, the principle of indemnity does not apply because
the value of human life cannot be measured in terms of money.
4. Principle of Contribution
Principle of Contribution is a corollary of the principle of indemnity. It applies to all
contracts of indemnity, if the insured has taken out more than one policy on the same
subject matter. According to this principle, the insured can claim the compensation only
to the extent of actual loss either from all insurers or from any one insurer. If one insurer
pays full compensation, then that insurer can claim proportionate claim from the other
insurers.
For example: Mr. John insures his property worth ` 100,000 with two insurers AIG
Ltd. for ` 90,000 and MetLife Ltd. for ` 60,000. Johns actual property destroyed is
worth ` 60,000, then Mr. John can claim the full loss of ` 60,000 either from AIG Ltd.
or MetLife Ltd., or he can claim ` 36,000 from AIG Ltd. and ` 24,000 from MetLife Ltd.
So, if the insured claims full amount of compensation from one insurer, then he cannot
claim the same compensation from other insurer and make a profit. Secondly, if one
insurance company pays the full compensation, then it can recover the proportionate
contribution from the other insurance company.
5. Principle of Subrogation
Subrogation means substituting one creditor for another. Principle of Subrogation is
an extension and another corollary of the principle of indemnity. It also applies to all
contracts of indemnity. According to the principle of subrogation, when the insured is
compensated for the losses due to damage to his insured property, then the ownership
right of such property shifts to the insurer.
This principle is applicable only when the damaged property has any value after the
event causing the damage. The insurer can benefit out of subrogation rights only to the
extent of the amount he has paid to the insured as compensation.
For example: Mr. John insures his house for ` 1 million. The house is totally destroyed
by the negligence of his neighbour Mr. Tom. The insurance company shall settle the claim
of Mr. John for ` 1 million. At the same time, it can file a law suit against Mr. Tom for
` 1.2 million, the market value of the house. If insurance company wins the case and
collects ` 1.2 million from Mr. Tom, then the insurance company will retain ` 1 million
(which it has already paid to Mr. John) plus other expenses such as court fees. The balance
amount, if any will be given to Mr. John, the insured.
6. Principle of Loss Minimization
According to the Principle of Loss Minimization, insured must always try his level
best to minimize the loss of his insured property, in case of uncertain events like a fire
221
outbreak or blast, etc. The insured must take all possible measures and necessary steps
to control and reduce the losses in such a scenario. The insured must not neglect and
behave irresponsibly during such events just because the property is insured. Hence, it
is a responsibility of the insured to protect his insured property and avoid further losses.
Notes
For example: Assume, Mr. Johns house is set on fire due to an electric short-circuit.
In this tragic scenario, Mr. John must try his level best to stop fire by all possible means,
like first calling nearest fire department office, asking neighbors for emergency fire
extinguishers, etc. He must not remain inactive and watch his house burning hoping, Why
should I worry? Ive insured my house.
7. Principle of Causa Proxima (Nearest Cause)
Principle of Causa Proxima (a Latin phrase), or in simple English words, the Principle
of Proximate (i.e., Nearest) Cause, means when a loss is caused by more than one
causes, the proximate or the nearest or the closest cause should be taken into
consideration to decide the liability of the insurer. The principle states that to find out
whether the insurer is liable for the loss or not, the proximate (closest) and not the remote
(farest) must be looked into.
For example: A cargo ships base was punctured due to rats and so sea water entered
and cargo was damaged. Here, there are two causes for the damage of the cargo ship
(i) The cargo ship getting punctured because of rats, and (ii) The sea water entering
ship through puncture. The risk of sea water is insured but the first cause is not. The
nearest cause of damage is sea water which is insured and therefore the insurer must
pay the compensation.
However, in case of life insurance, the principle of Causa Proxima does not apply.
Whatever may be the reason of death (whether a natural death or an unnatural death),
the insurer is liable to pay the amount of insurance.
5.10 Life Insurance

Life insurance is a way of providing income replacement for financial dependents (the
beneficiaries) after the insured person dies. It is intended to replace lost income and pay
for any additional expenses that are experienced by those left behind when a family
member who contributes income or services to a household is lost. It can also be used
for final expenses like medical bills or funeral costs that survivors would have to pay when
a death occurs. Life insurance is an important part of financial planning for families and
individuals.
A life insurance policy is a legal contract between the insured person and the life
insurance company, and like all contracts, it is enforceable by law and shouldnt be entered
into lightly. Both parties have certain rights and obligations which are explained in the
policy. So, it is critical that anyone buying protection read the contract and its fine print
before signing it.
There may be exclusions in the contract for certain causes of death, such as suicide,
where the company can legally refuse to pay the death benefit. Additionally, deaths
occurring within 2 years of purchasing coverage, also known as the exclusionary period,
may not be eligible for a death benefit payout and may result in your carrier returning
your premiums instead.
222
Notes
5.11 Meaning of Life Insurance

Life insurance is a contractual agreement between a policyholder and a life insurance
company. Policyholders agree to make premium payments to the company and the
company agrees to pay the beneficiaries a sum of money if he/she dies. A life insurance
policy provides a stated benefit upon the holders death, provided that the death occurs
within a certain specified time period.
5.12 Purposes of Life Insurance

The purpose of life insurance is to maintain the financial security and well-being of
ones family or dependents in case of a wage-earners death. However, life insurance can
also be used for the following reasons:
(i) Mortgage Protection to cover your mortgage loan or payments.
(ii) Retirement the savings, cash value build-up or investment opportunity help
build a familys net worth or nest egg.
(iii) Childcare to replace a home-makers contribution.
(iv) Estate Protection to help cover estate taxes.
(v) Protect Business to protect a business against the loss of a key employee,
known as keyman life insurance.
(vi) Employee Benefits typically offered as group life insurance through your
employer.
5.13 The Importance of Life Insurance

The importance of Life Insurance can be summarized as follows:
(i) An essential part of financial planning is creating provisions for your family and
loved ones following your death. Life insurance can ensure financial security
to those who mean the most to you, such as your spouse, children and
dependent parents. A carefully executed life insurance policy can help prepare
for lifes uncertainties and give peace of mind knowing that the future of those
who rely on you is secure.
(ii) Life insurance pays for immediate expenses. Bills can start accumulating fast
in the event of a death. Life insurance can be used to pay for immediate
expenses, such as funeral services, unsettled hospital and medical bills,
mortgage payments, business commitments and meeting college expenses for
children.
(iii) Its a cash resource. Life insurance gives access to cash to pay for grocery
bills and other daily expenses. It also helps secure your estate by providing
tax-free cash to pay estate and other obligations.
(iv) Your familys standard of living can be maintained. With the right coverage, your
familys lifestyle and standard of living can be sustained, adding much needed
normalcy during a difficult time.
(v) You have a wide range of options. There are two basic types of life insurance:
term life and whole life. Term life policies offer death benefits. So, if you die,
you will get money back, but if you live past the pre-determined length of the
policy, you get no benefits. Whole life or permanent insurance is more
expensive, but these policies are open-ended and also accumulate a cash value
223
that the policyholder can earn dividends and borrow against or cash-in upon
surrendering the policy.
Notes
(vi) Customize your policy and coverage. If you have dependent children, a spouse
and parents to care for, youd want a policy that would protect them after death.
Typically, policies are opened for the breadwinner of the family, but a stay-athome spouses contributions are often overlooked. You might consider a policy
to cover childcare, carpooling and household chore expenses in the event of
a stay-at-home spouses death. On the flip side, as you get older and children
or parents are no longer dependent on you for income, you can reduce your
coverage or drop it entirely.
(vii) Adequate coverage makes a difference. An old school rule of thumb is that your
life insurance policy equals five to ten times your annual income. Nowadays,
advisors will look at the number of dependents you have, how long they will
be dependent upon you, and the lifestyle they expect to live after your death.
Its not a simple equation, but in general, you will need more coverage than
a typical plan offered by an employer, which usually totals one or two years
of your gross salary.
(viii) You can improve your credit rating. A life insurance policy is considered a
financial asset and may increase your credit score, which could be beneficial
when trying to obtain medical insurance or a home or business loan.
(ix) Life insurance may be exempt from bankruptcy. Most life insurance plans will
not be affected by bankruptcy and will remain intact if you claim bankruptcy.
However, youll need to confer with a bankruptcy expert, as each case is unique.
(x) Life insurance is not a simple product. Its wise to talk to an expert who can
walk you through the pros and cons of available plans and help choose coverage
that works best for your individual situation, now and in the future.
5.14 Life Insurance Products and Policies

1. Term Insurance
This type of life insurance policy is a contract between the insured and the life
insurance company to pay the persons he/she has given entitlement to receive the money,
in the case of his/her death, after a certain period of time. These policies can be taken
for 5, 10, 15, 20 or 30 years.
2. Endowment Policy
In an endowment policy, periodic premiums are received by the insured person and
a lump sum is received either on the death of the insured or once the policy period expires.
3. Moneyback Life Insurance Policy
This policy offers the payment of partial survival benefits (moneyback), as is
determined in the insurance contract, while the insured is still alive. In case the insured
dies during the period of the policy, the beneficiary gets the full sum insured without the
deduction of the moneyback amount given so far.
4. Group Life Insurance
This is when a group of people have been named under a single life insurance policy.
It is popular for an employer or a company to add employees under the same policy.
Each member of the group has a certificate as legal evidence of insurance.
224
Notes
5. Unit Linked Insurance Plan

ULIPs (Unit Linked Insurance Plan) offer the insured the double benefit of protection
from risk and investment opportunities. ULIPs are linked to the market where the insureds
money is invested to help earn additional monetary benefits.
5.15 General Insurance

General Insurance comprises of insurance of property against fire, burglary, etc.,
personal insurance such as Accident and Health Insurance, and liability insurance which
covers legal liabilities. There are also other covers such as Errors and Omissions insurance
for professionals, credit insurance, etc.
Non-life insurance companies have products that cover property against fire and allied
perils, flood storm and inundation, earthquake and so on. There are products that cover
property against burglary, theft, etc. The non-life companies also offer policies covering
machinery against breakdown, there are policies that cover the hull of ships and so on.
A Marine Cargo Policy covers goods in transit including by sea, air and road. Further,
insurance of motor vehicles against damages and theft forms a major chunk of non-life
insurance business.
In respect of insurance of property, it is important that the cover is taken for the
actual value of the property to avoid being imposed a penalty should there be a claim.
Where a property is undervalued for the purposes of insurance, the insured will have to
bear a ratable proportion of the loss. For instance, if the value of a property is ` 100 and
it is insured for ` 50/-, in the event of a loss to the extent of say ` 50/-, the maximum
claim amount payable would be ` 25/ (50% of the loss being borne by the insured for
underinsuring the property by 50%). This concept is quite often not understood by most
insureds.
Personal insurance covers include policies for Accident, Health, etc. Products
offering Personal Accident cover are benefit policies. Health insurance covers offered by
non-life insurers are mainly hospitalization covers either on reimbursement or cashless
basis. The cashless service is offered through Third Party Administrators who have
arrangements with various service providers, i.e., hospitals. The Third Party Administrators
also provide service for reimbursement claims. Sometimes, the insurers themselves
process reimbursement claims.
Accident and health insurance policies are available for individuals as well as groups.
A group could be a group of employees of an organization or holders of credit cards or
deposit holders in a bank, etc. Normally, when a group is covered, insurers offer group
discounts.
Liability insurance covers such as Motor Third Party Liability Insurance, Workmens
Compensation Policy, etc. offer cover against legal liabilities that may arise under the
respective statutes Motor Vehicles Act, The Workmens Compensation Act, etc. Some
of the covers such as the foregoing are compulsory by statute. Liability Insurance not
compulsory by statute is also gaining popularity these days. Many industries insure
against Public liability. There are liability covers available for products as well.
There are general insurance products that are in the nature of package policies
offering a combination of the covers mentioned above. For instance, there are package
policies available for householders, shopkeepers and also for professionals such as
doctors, chartered accountants, etc. Apart from offering standard covers, insurers also
offer customized or tailor-made ones.
225
Suitable general insurance covers are necessary for every family. It is important to
protect ones property, which one might have acquired from ones hard earned income.
A loss or damage to ones property can leave one shattered. Losses created by
catastrophes such as the tsunami, earthquakes, cyclones, etc. have left many homeless
and penniless. Such losses can be devastating but insurance could help mitigate them.
Property can be covered, so also the people against Personal Accident. A Health
Insurance Policy can provide financial relief to a person undergoing medical treatment
whether due to a disease or an injury.
Notes
Industries also need to protect themselves by obtaining insurance covers to protect

their building, machinery, stocks, etc. They need to cover their liabilities as well. Financiers
insist on insurance. So, most industries or businesses that are financed by banks and
other institutions do obtain covers. But are they obtaining the right covers? And are they
insuring adequately are questions that need to be given some thought. Also organizations
or industries that are self-financed should ensure that they are protected by insurance.
Most general insurance covers are annual contracts. However, there are few products that
are long-term. It is important for proposers to read and understand the terms and conditions
of a policy before they enter into an insurance contract. The proposal form needs to be
filled in completely and correctly by a proposer to ensure that the cover is adequate and
the right one.
5.16 Meaning of General Insurance

General insurance refers to the insurance contracts that do not come under the field
of life insurance. The different forms of general insurance are fire, marine, motor, accident
and other miscellaneous non-life insurance.
Explanation: The tangible assets are susceptible to damages and a need to protect
the economic value of the assets is needed. For this purpose, general insurance products
are bought as they provide protection against unforeseeable contingencies like damage
and loss of the asset. Like life insurance, general insurance products come at a price
in the form of premium.
5.17 Objectives for Practicing of General Insurance

The practices of General Insurance are having the following objectives:
(i) To provide for the acquisition of the shares of the existing general insurance
companies.
(ii) To serve the needs of the economy by development of general insurance
business.
(iii) To establish the GIC by the Central Government under the provisions of the
Companies Act of 1956, with an initial authorized share capital of seventy-five
crores.
(iv) To aid, assist, and advise the companies in the matter of setting up of standards
in the conduct of general insurance business.
(v) To encourage healthy competition amongst the companies as far as possible.
(vi) To ensure that the operation of the economic system does not result in the
concentration of wealth to the common detriment.
(vii) To ensure that no person shall take insurance in respect of any property in India
with an insurer whose principal registered office is outside India.
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Notes
(viii) To carry on of any part of the general insurance business if it thinks it is desirable
to do so.
(ix) To advice the companies in the matter of controlling their experience and
investment of funds.
(x) To provide need-based and low-cost general insurance covers to rural population.
(xi) To administer a crop insurance scheme for the benefit of the farmers.
(xii) To develop and introduce covers with social security benefits
5.18 Principles of General Insurance

The important principles of General Insurance are as follows:
1. Principles of Utmost Good Faith
Utmost Good Faith can be defined as A positive duty to voluntarily disclose,
accurately and fully all facts material to the risk being proposed whether requested for
or not. In insurance contracts, Utmost Good Faith means that each party to the proposed
contract is legally obliged to disclose to the other all information which can influence the
others decision to enter the contract.
In Fire Insurance: The construction of the building, the nature of its use, i.e., whether
it is of concrete or Kucha having thatched roofing and whether it is being used for residential
purposes or as a godown, whether firefighting equipment is available or not.
In Motor Insurance: The type of vehicle, the purpose of its use, its age (model),
cubic capacity and the fact that the driver has a consistently bad driving record.
In Marine Insurance: Type of packing, mode of carriage, name of carrier, nature
of goods, the route, etc.
In Personal Accident Insurance: Age, height, weight, occupation and previous
medical history if it is likely to increase the choice of an accident, bad habits such as
drinking, etc.
Burglary Insurance: Nature of stock, value of stock, type of security precautions
taken, etc.
One of the essential ingredients of an Insurance Contract is that the insured must
have an insurable interest in the subject matter of the contract. Insurance without insurable
interest would be a mere wager and as such unenforceable in the eyes of law.
The subject matter of the Insurance Contract may be a property, or an event that
may create a liability but it is not the property or the potential liability which is insured
but it is the pecuniary interest of the insured in that property or liability which is insured.
Insurable Interest is defined as the legal right to insure arising out of a financial
relationship recognized under the law between the insured and the subject matter of
Insurance.
There are four essential components of Insurable Interests:
1. There must be some property, right, interest, life, limb or potential liability
capable of being insured.
2. Any of these above, i.e., property, right, interest, etc. must be the subject matter
of Insurance.
227
3. The insured must stand in a formal or legal relationship with the subject matter
of the Insurance. Whereby he benefits from its safety, well-being or freedom
from liability and would be adversely affected by its loss, damage existence
of liability.
Notes
There are a number of ways by which Insurable Interest arises or is restricted.

(a) By Common Law: Cases where the essential elements are automatically
present can be described as Insurable Interest having arisen by common law.
Ownership of a building, car, etc. gives the owner the right to insure the property.
(b) By Contract: In some cases, a person will agree to be liable for something
which he would not be ordinarily for. A lease deed for a house, for example,
may make the tenant responsible for the repair and maintenance of the building.
Such a contract places the tenant in a legally recognized relationship with the
house or the potential liability and this gives him the insurable interest.
(c) By Statute: Sometimes, an Act of the Parliament may create an insurable
interest by granting some benefit or imposing a duty and at times removing a
liability may restrict the Insurable Interest.
Marine Insurance Insurable Interest
In Marine Insurance, Insurable Interest must exist at the time of loss/claim and it
is not required at the time of inception.
Property and Other Insurance Insurable Interest
In Property and other Insurance, Insurable Interest must exist at the time of inception
as well as at the time of loss/claims.
In Insurance, the word indemnity is defined as financial compensation sufficient to
place the insured in the same financial position after a loss as he enjoyed immediately
before the loss occurred.
Indemnity, thus, prevents the insured from recovering more than the amount of his
pecuniary loss. It is undesirable that an insured should make a profit out of an event like
a fire or a motor accident because if he was able to make a profit, there might well be
more fires and more vehicle accidents.
As in the case of Insurable Interest, the principle of indemnity also relies heavily
on the financial evaluation of the loss but in the case of life and disablement it is not
possible to be precise in terms of money.
The Insurers normally provide indemnity in the following manner and the choice is
entirely of the insurer:
1. Cash Payment
2. Repairs
3. Replacement
4. Reinstatement
1. Cash Payment: In majority of the cases, the claims will be settled by cash
payment (through cheques) to the assured. In liability claims, the cheques are made
directly in the name of the third party thus avoiding the cumbersome process of the Insurer
first paying the Insured and he in turn paying to the third party.
228
Notes
2. Repair: This is a method of Indemnity used frequently by insurer to settle claims.

Motor Insurance is the best example of this where garages are authorized to carry out
the repairs of damaged vehicles. In some countries, Insurance companies even own
garages and Insurance companies spend a lot on research on motor repairs to arrive at
better methods of repair to bring down the costs.
3. Replacement: This method of Indemnity is normally not preferred by Insurance
companies and is mostly used in Glass Insurance where the insurers get the glass
replaced by firms with whom they have arrangements and because of the volume of
business they get considerable discounts. In some cases of Jewellery loss, this system
is used specially when there is no agreement on the true value of the lost item.
4. Reinstatement: This method of Indemnity applies to Property Insurance where
an insurer undertakes to restore the building or the machinery damaged substantially to
the same condition as before the loss. Sometimes, the policy specifically gives the right
to the insurer to pay money instead of restoration of building or machinery.
5.19 Features of General Insurance

The insurance has the following characteristics which are, generally, observed in case
of life, marine, fire and general insurances:
1. Sharing of Risk
Insurance is a device to share the financial losses which might befall on an individual
or his family on the happening of a specified event. The event may be death of a breadwinner to the family in the case of life insurance, marine perils in marine insurance, fire
in fire insurance and other certain events in general insurance, e.g., theft in burglary
insurance, accident in motor insurance, etc. The loss arising from these events if insured
are shared by all the insured in the form of premium.
2. Cooperative Device
The most important feature of every insurance plan is the cooperation of large number
of persons who, in effect, agree to share the financial loss arising due to a particular risk
which is insured. Such a group of persons may be brought together voluntarily or through
publicity or through solicitation of the agents.
An insurer would be unable to compensate all the losses from his own capital. So,
by insuring or underwriting a large number of persons, he is able to pay the amount of
loss. Like all cooperative devices, there is no compulsion here on anybody to purchase
the insurance policy.
3. Value of Risk
The risk is evaluated before insuring to charge the amount of share of an insured,
herein called, consideration or premium. There are several methods of evaluation of risks.
If there is expectation of more loss, higher premium may be charged. So, the probability
of loss is calculated at the time of insurance.
4. Payment at Contingency
The payment is made at a certain contingency insured. If the contingency occurs,
payment is made. Since the life insurance contract is a contract of certainty, because
the contingency, the death or the expiry of term, will certainly occur, the payment is
certain. In other insurance contracts, the contingency is the fire or the marine perils, etc.
may or may not occur. So, if the contingency occurs, payment is made, otherwise no
amount is given to the policyholder.
229
Similarly, in certain types of life policies, payment is not certain due to uncertainty
of a particular contingency within a particular period. For example, in term insurance,
payment is made only when death of the assured occurs within the specified term, may
be one or two years. Similarly, in Pure Endowment, payment is made only at the survival
of the insured at the expiry of the period.
Notes
5. Amount of Payment
The amount of payment depends upon the value of loss occurred due to the particular
insured risk provided insurance is there up to that amount. In life insurance, the purpose
is not to make good the financial loss suffered. The insurer promises to pay a fixed sum
on the happening of an event.
If the event or the contingency takes place, the payment does fall due if the policy
is valid and in force at the time of the event, like property insurance, the dependents will
not be required to prove the occurring of loss and the amount of loss. It is immaterial
in life insurance what was the amount of loss at the time of contingency. But in the property
and general insurances, the amount of loss as well as the happening of loss, are required
to be proved.
6. Large Number of Insured Persons
To spread the loss immediately, smoothly and cheaply, large number of persons
should be insured. The cooperation of a small number of persons may also be insurance
but it will be limited to smaller area. The cost of insurance to each member may be higher.
So, it may be unmarketable.
Therefore, to make the insurance cheaper, it is essential to insure large number of
persons or property because the lesser would be cost of insurance and so, the lower would
be premium. In past years, tariff associations or mutual fire insurance associations were
found to share the loss at cheaper rate. In order to function successfully, the insurance
should be joined by a large number of persons.
7. Insurance is Not a Gambling
The insurance serves indirectly to increase the productivity of the community by
eliminating worry and increasing initiative. The uncertainty is changed into certainty by
insuring property and life because the insurer promises to pay a definite sum at damage
or death.
From a family and business point of view, all lives possess an economic value which
may at any time be snuffed out by death, and it is as reasonable to ensure against the
loss of this value as it is to protect oneself against the loss of property. In the absence
of insurance, the property owners could at best practice only some form of self-insurance,
which may not give him absolute certainty.
Similarly, in absence of life insurance, saving requires time; but death may occur
at any time and the property, and family may remain unprotected. Thus, the family is
protected against losses on death and damage with the help of insurance.
From the companys point of view, the life insurance is essentially non-speculative;
in fact, no other business operates with greater certainties. From the insured point of view,
too, insurance is also the antithesis of gambling. Nothing is more uncertain than life and
life insurance offers the only sure method of changing that uncertainty into certainty.
In fact, insurance is just the opposite of gambling. In gambling, by bidding, the person
exposes himself to risk of losing; in the insurance, the insured is always opposed to risk,
and will suffer loss if he is not insured.
230
Notes
By getting insured his life and property, he protects himself against the risk of loss.
In fact, if he does not get his property or life insured, he is gambling with his life on property.
8. Insurance is Not Charity
Charity is given without consideration but insurance is not possible without premium.
It provides security and safety to an individual and to the society although it is a kind
of business because in consideration of premium it guarantees the payment of loss. It
is a profession because it provides adequate sources at the time of disasters only by
charging a nominal premium for the service.
5.20 Functions of General Insurance

The various functions of General Insurance are:
3. Indirect Functions
(i) Provide Protections
The most important function of insurance is to provide protection against risk of loss.
(ii) Provide Certainty
We know future is totally uncertain. Any misfortune happening may occur at any
stage of life. The amount of loss and time of losses both are uncertain. No doubt, better
planning and administration can reduce the chances of happening these types of accidents
but it requires lots of attention towards strengths and weaknesses, special knowledge
of the field after all these precautions, the uncertainty remains steady. Insurance provides
certainly towards the losses. The policyholders pay the premium to by certainty.
(iii) Distribution of Risk
It is a cooperative effort where the risk is distributed among the group of people.
Thus, no one have to bear the losses occurred due to uncertainty.
(i) Helps in Economic Progress
Insurance plays an important role in economic progress. It gives full certainty to the
industrialists towards the risks. The entrepreneurs can more concentrate on innovative
and profitable techniques of the production. They should not require thinking over the risks.
The industrialists can establish new industries in environment. Thus, industries have got
development in economic and commerce of the nation.
(ii) Prevents Losses
Insurance plays a vital role in preventing the losses. The amount of premium can
be minimized by using such appliances like the fire extinguisher. If one uses interior
machinery which may be caused for misfortune, the amount of premium will be high. Thus,
indirectly, insurance provides help to minimize the chances of risks. It will be useful for
the agencies which are directly related with the same functions like:
(a) Loss Prevention Association of India.
231
(b) The Salvage Crops of Loss Prevention Association of India.
Notes
(c) Survey and Inspection of Risks, etc.

3. Indirect Functions
(i) A Forced Savings
Life Insurance is also a method of savings in India. Income Tax Act gives relief in
payment of income tax because government wants to habituate general public to save
money. It encourages the habit of thrift and savings among the people. Thus, it becomes
compulsory savings to people of nation.
(ii) Promote Foreign Trade
It is compulsory to take marine insurance policy in foreign trade in India. Foreigners
cannot issue the foreign trade bill unless the cargo is fully insured. Thus, foreign trade
totally depends upon the insurance sector of the nation. It gives relief to entrepreneurs
from the uncertainty of foreign trade.
(iii) Others
Insurance provides certainties towards risks in entrepreneurship. It gives confidence
in general public. It is one of the important source of investment which develops the trade
and commerce of the nation.
5.21 General Insurance Corporation of India (GICI)

The entire general insurance business in India was nationalized by General Insurance
Business (Nationalization) Act, 1972 (GIBNA). The Government of India (GOI), through
nationalization, took over the shares of 55 Indian insurance companies and the
undertakings of 52 insurers carrying on general insurance business.
General Insurance Corporation of India (GIC) was formed in pursuance of Section
9(1) of GIBNA. It was incorporated on 22 November 1972 under the Companies Act, 1956
as a private company limited by shares.
GIC was formed for the purpose of superintending, controlling and carrying on the
business of general insurance. As soon as GIC was formed, GOI transferred all the shares
it held of the general insurance companies to GIC.
Simultaneously, the nationalized undertakings were transferred to Indian insurance
companies. After a process of mergers among Indian insurance companies, four
companies were left as fully owned subsidiary companies of GIC:
(i) National Insurance Company Limited
(ii) The New India Assurance Company Limited
(iii) The Oriental Insurance Company Limited
(iv) United India Insurance Company Limited.
The next landmark happened on 19th April 2000, when the Insurance Regulatory and
Development Authority Act, 1999 (IRDAA) came into force.
This Act also introduced amendment to GIBNA and the Insurance Act, 1938. An
amendment to GIBNA removed the exclusive privilege of GIC and its subsidiaries carrying
on general insurance in India.
232
Notes
In November 2000, GIC was renotified as the Indian Reinsurer and through
administrative instruction, its supervisory role over the four subsidiaries was ended. With
the General Insurance Business (Nationalization) Amendment Act 2002 (40 of 2002)
coming into force from March 21, 2003, GIC ceased to be a holding company of its
subsidiaries.
The ownership of the four erstwhile subsidiary companies and also of the General
Insurance Corporation of India was vested with Government of India. GIC Re is a wholly
owned company of Government of India.
5.22 The General Insurance Business (Nationalization) Amendment

Act, 2002 Act No. 40 of 2002
Section 1: Short title and commencement.(1) This Act may be called the General
Insurance Business (Nationalization) Amendment Act, 2002. (2) It shall come into force
on such date as the Central Government may, by notification in the Official Gazette,
appoint.
Section 2: Amendment of section 9.In section 9 of the General Insurance Business
(Nationalization) Act, 1972 (57 of 1972) (hereinafter referred to as the principal Act),
(a) in sub-section (1), the following proviso shall be inserted, namely:Provided that on
and from the commencement of the General Insurance Business (Nationalization)
Amendment Act, 2002, the provisions of this sub-section shall have effect as if for the
words superintending, controlling and carrying on the business of general insurance, the
words carrying on reinsurance business had been substituted.; (b) in sub-section (2),
the following proviso shall be inserted, namely: Provided that the Central Government may,
by notification, increase or reduce the authorized capital or subscribed capital, as the
case may be, as it deems fit.
Section 3: Insertion of new section 10A.After section 10 of the principal Act, the
following section shall be inserted, namely:10A. Transfer to Central Government of
shares vested in Corporation.All the shares in the capital of the acquiring companies,
being (a) the National Insurance Company Limited; (b) the New India Assurance
Company Limited; (c) the Oriental Insurance Company Limited; (d) the United India
Insurance Company Limited, and vested in the Corporation before the commencement of
the General Insurance Business (Nationalization) Amendment Act, 2002 shall, on such
commencement, stand transferred to the Central Government.
Section 4: Amendment of section 18.In section 18 of the principal Act,(a) in
sub-section (1), after clause (e), the following proviso shall be inserted, namely:
Provided that all the functions of the Corporation specified in this sub-section, on and
from the commencement of the General Insurance Business (Nationalization) Amendment
Act, 2002, shall be performed by the Central Government.; (b) in sub-section (2), for the
word Corporation, the words Central Government shall be substituted.
Section 5: Amendment of section 19.In section 19 of the principal Act, in subsection (3), for the word Corporation, the words, brackets and figures Central Government
or the Insurance Regulatory and Development Authority established under sub-section (1)
of section 3 of the Insurance Regulatory and Development Authority Act, 1999 (41 of 1999)
shall be substituted.
Section 6: Amendment of section 22.In section 22 of the principal Act, for the
words The Corporation may at any time transfer any officer, the words The Central
Government or any person authorized by it may at any time transfer any officer shall
be substituted.
233
Section 7: Amendment of section 24A.In section 24A of the principal Act, the
following proviso shall be inserted, namely:Provided that the Corporation shall, on and
from the commencement of the General Insurance Business (Nationalization) Amendment
Act, 2002, cease to carry on general insurance business.
Notes
Section 8: Amendment of section 39.In section 39 of the principal Act, in subsection (2), for clause (b), the following clauses shall be substituted, namely:(b) the
conditions, if any, subject to which the Corporation shall carry on reinsurance business;
(ba) the conditions, if any, subject to which the acquiring companies shall carry on general
insurance business.
5.23 Insurance Sector Reforms in India

In 1993, Malhotra Committee headed by former Finance Secretary and RBI Governor
R.N. Malhotra was formed to evaluate the Indian insurance industry and recommend its
future direction.
The Malhotra Committee was set up with the objective of complementing the reforms
initiated in the financial sector. The reforms were aimed at creating a more efficient and
competitive financial system suitable for the requirements of the economy keeping in mind
the structural changes currently underway and recognizing that insurance is an important
part of the overall financial system where it was necessary to address the need for similar
reforms
In 1994, the committee submitted the report and some of the key recommendations
included:
1. Structure
z
Government stake in the insurance Companies to be brought down to 50%.
Government should take over the holdings of GIC and its subsidiaries so that
these subsidiaries can act as independent corporations.
All the insurance companies should be given greater freedom to operate.
2. Competition
z
Private Companies with a minimum paid-up capital of ` 1 bn should be allowed

to enter the industry.
No Company should deal in both Life and General Insurance through a single
entity.
Foreign companies may be allowed to enter the industry in collaboration with

the domestic companies.
Postal Life Insurance should be allowed to operate in the rural market.
Only one State-level Life Insurance Company should be allowed to operate in

each state.
3. Regulatory Body
z
The Insurance Act should be changed.
An Insurance Regulatory body should be set up.
Controller of Insurance (currently a part from the Finance Ministry) should be

made independent.
4. Investments
z
Mandatory Investments of LIC Life Fund in government securities to be reduced

from 75% to 50%.
234
Notes

z
GIC and its subsidiaries are not to hold more than 5% in any company (Their
current holdings to be brought down to this level over a period of time).
5. Customer Service
z
LIC should pay interest on delays in payments beyond 30 days.
Insurance companies must be encouraged to set up unit linked pension plans.
Computerization of operations and updating of technology to be carried out in

the insurance industry.
The Committee emphasized that in order to improve the customer services and
increase the coverage of the insurance industry should be opened up to competition.
But at the same time, the Committee felt the need to exercise caution as any failure
on the part of new players could ruin the public confidence in the industry. Hence, it was
decided to allow competition in a limited way by stipulating the minimum capital
requirement of ` 100 crores. The Committee felt the need to provide greater autonomy
to insurance companies in order to improve their performance and enable them to act as
independent companies with economic motives. For this purpose, it had proposed setting
up an independent regulatory body.
5.24 Major Policy Changes under IRDA Act

Insurance sector has been opened up for competition from Indian private insurance
companies with the enactment of Insurance Regulatory and Development Authority Act,
1999 (IRDA Act). As per the provisions of IRDA Act, 1999, Insurance Regulatory and
Development Authority (IRDA) was established on 19th April, 2000 to protect the interests
of holder of insurance policy and to regulate, promote and ensure orderly growth of the
insurance industry. IRDA Act 1999 paved the way for the entry of private players into the
insurance market which was hitherto the exclusive privilege of public sector insurance
companies/corporations. Under the new dispensation, Indian insurance companies in
private sector were permitted to operate in India with the following conditions:
z
Company is formed and registered under the Companies Act, 1956;
The aggregate holdings of equity shares by a foreign company, either by itself

or through its subsidiary companies or its nominees, do not exceed 26%, paidup equity capital of such Indian insurance company;
The companys sole purpose is to carry on life insurance business or general

insurance business or reinsurance business.
The minimum paid-up equity capital for life or general insurance business is
` 100 crores.
The minimum paid-up equity capital for carrying on reinsurance business has
been prescribed as ` 200 crores.
The Authority has notified 27 Regulations on various issues which include

Registration of Insurers, Regulation on Insurance Agents, Solvency Margin, Reinsurance,
Obligation of Insurers to Rural and Social Sector, Investment and Accounting Procedure,
Protection of Policyholders Interest, etc. Applications were invited by the Authority with
effect from 15th August, 2000 for issue of the Certificate of Registration to both life and
non-life insurers. The Authority has its headquarter at Hyderabad.
235
5.25 Insurance Companies in India
Notes
IRDA has so far granted registration to 12 private life insurance companies and
9 general insurance companies. If the existing public sector insurance companies are
included, there are currently 13 insurance companies in the life insurance business and
13 companies operating in general insurance business. General Insurance Corporation has
been approved as the Indian reinsurer for underwriting only reinsurance business.
Particulars of the life insurance companies and general insurance companies including
their web address is given below:
LIFE INSURERS
Websites
Public Sector
Life Insurance Corporation of India
www.licindia.com
Private Sector
Allianz Bajaj Life Insurance Company Limited
www.allianzbajaj.co.in
Birla Sun-Life Insurance Company Limited
www.birlasunlife.com
HDFC Standard Life Insurance Co. Limited
www.hdfcinsurance.com
ICICI Prudential Life Insurance Co. Limited
www.iciciprulife.com
ING Vysya Life Insurance Company Limited
www.ingvysayalife.com
Max New York Life Insurance Co. Limited
www.maxnewyorklife.com
MetLife Insurance Company Limited
www.metlife.com
Om Kotak Mahindra Life Insurance Co. Ltd.
www.omkotakmahnidra.com
SBI Life Insurance Company Limited
www.sbilife.co.in
TATA AIG Life Insurance Company Limited
www.tata-aig.com
AMP Sanmar Assurance Company Limited
www.ampsanmar.com
Dabur CGU Life Insurance Co. Pvt. Limited
www.avivaindia.com
GENERAL INSURERS
Public Sector
National Insurance Company Limited
www.nationalinsuranceindia.com
New India Assurance Company Limited
www.niacl.com
Oriental Insurance Company Limited
www.orientalinsurance.nic.in
United India Insurance Company Limited
www.uiic.co.in
Private Sector
Bajaj Allianz General Insurance Co. Limited
www.bajajallianz.co.in
ICICI Lombard General Insurance Co. Ltd.
www.icicilombard.com
IFFCO-Tokio General Insurance Co. Ltd.
www.itgi.co.in
Reliance General Insurance Co. Limited
www.ril.com
Royal Sundaram Alliance Insurance Co. Ltd.
www.royalsun.com
TATA AIG General Insurance Co. Limited
www.tata-aig.com
236
Notes
Cholamandalam General Insurance Co. Ltd.
www.cholainsurance.com
Export Credit Guarantee Corporation
www.ecgcindia.com
HDFC Chubb General Insurance Co. Ltd.

REINSURER
General Insurance Corporation of India
www.gicindia.com
5.26 Protection of the Interest of Policyholders

IRDA has the responsibility of protecting the interest of insurance policyholders.
Towards achieving this objective, the Authority has taken the following steps:
z
IRDA has notified Protection of Policyholders Interest Regulations 2001 to

provide for: policy proposal documents in easily understandable language;
claims procedure in both life and non-life; setting up of grievance redressal
machinery; speedy settlement of claims; and policyholders servicing. The
Regulation also provides for payment of interest by insurers for the delay in
settlement of claim.
The insurers are required to maintain solvency margins so that they are in a
position to meet their obligations towards policyholders with regard to payment
of claims.
It is obligatory on the part of the insurance companies to disclose clearly the

benefits, terms and conditions under the policy. The advertisements issued by
the insurers should not mislead the insuring public.
All insurers are required to set up proper grievance redressal machinery in their
head office and at their other offices.
The Authority takes up with the insurers any complaint received from the
policyholders in connection with services provided by them under the insurance
contract.
5.27 New Developments in Insurance as a Sector in the Indian

Financial System
The insurance industry of India consists of 52 insurance companies of which 24 are
in life insurance business and 28 are non-life insurers. Among the life insurers, Life
Insurance Corporation (LIC) is the sole public sector company. Apart from that, among
the non-life insurers there are six public sector insurers. In addition to these, there is sole
national reinsurer, namely, General Insurance Corporation of India. Other stakeholders in
Indian Insurance market include agents (individual and corporate), brokers, surveyors and
third party administrators servicing health insurance claims.
Out of 28 non-life insurance companies, 5 private sector insurers are registered to
underwrite policies exclusively in health, personal accident and travel insurance segments.
They are Star Health and Allied Insurance Company Ltd., Apollo Munich Health Insurance
Company Ltd., Max Bupa Health Insurance Company Ltd., Religare Health Insurance
Company Ltd. and Cigna TTK Health Insurance Company Ltd. There are two more
specialized insurers belonging to public sector, namely, Export Credit Guarantee
Corporation of India for Credit Insurance and Agriculture Insurance Company Ltd. for crop
insurance.
237
Market Size
Notes
Indias life insurance sector is the biggest in the world with about 36 crore policies
which are expected to increase at a compound annual growth rate (CAGR) of 12-15%
over the next five years. The insurance industry plans to hike penetration levels to 5%
by 2020, and could top the US$ 1 trillion mark in the next seven years.
The total market size of Indias insurance sector is projected to touch US$ 350-400
billion by 2020 from US$ 66.4 billion in FY13.
The general insurance business in India is currently at ` 77,000 crore (US$ 12.41
billion) premium per annum industry and is growing at a healthy rate of 17%.
The ` 12,606 crore (US$ 2.03 billion) domestic health insurance business accounts
for about a quarter of the total non-life insurance business in the country.
Investment corpus in Indias pension sector is anticipated to cross US$ 1 trillion by
2025, following the passage of the Pension Fund Regulatory and Development Authority
(PFRDA) Act 2013, according to a joint report by CII-EY on Pensions Business in India.
Indian insurance companies are expected to spend ` 117 billion (US$ 1.88 billion)
on IT products and services in 2014, an increase of 5% from 2013, as per Gartner Inc.
Also, insurance companies in the country could spend ` 4.1 billion (US$ 66.11 million)
on mobile devices in 2014, a rise of 35% from 2013.
Investments
Insurance sector of India needs capital infusion of ` 50,000 crore (US$ 8.06 billion)
to expand, maintain a healthy capital base and improve solvency standards, according
to Insurance Regulatory Development Authority (IRDA).
The following are some of the major investments and developments in the Indian
insurance sector.
z
Life Insurance Corporation of India (LIC) has earmarked a total of around ` 1

trillion (US$ 16.12 billion) for investments in bonds, including non-convertible
debentures (NCDs), certificates of deposit (CDs), commercial papers (CPs) and
collateralized borrowing and lending obligations (CBLOs), with primary focus on
infrastructure and real estate in the year to March 31, 2015.
Aditya Birla Financial Services Group has signed an agreement to form a health
insurance joint venture (JV) with MMI Holdings of South Africa. The two will enter
into a formal JV in which the foreign partner will hold a 26% stake.
South African Financial Services Group Sanlam plans to increase stake in its
Indian JV Shriram Life Insurance from 26% to 49%.
JLT Independent plans to develop India as a service hub for all countries that
are a part of South Asian Association for Regional Cooperation (SAARC),
according to Mr. Sanjay Radhakrishnan, CEO, JLT Independent.
Kotak Mahindra Bank became the first bank to get the permission from Reserve
Bank of India (RBI) to set up a wholly-owned non-life insurance company.
Government Initiatives
The Government of India has taken a number of initiatives to boost the insurance
industry. Some of them are as follows:
z
The Reserve Bank of India (RBI) has allowed banks to become insurance
238
Notes
brokers, permitting them to sell policies of different insurance firms subject to

certain conditions.
z
The select committee of the Rajya Sabha gave its approval, permitting 49%
composite foreign equity investment in insurance companies. A broad
agreement has also been achieved with the states on most of the issues
concerning the implementation of the single goods and services tax (GST),
which is scheduled to be rolled out from April 1, 2016.
The Government of India plans to implement a ` 1,900 crore (US$ 306.41 million)
e-governance project called Panch Deep to automate transactions of the
Employees State Insurance Corporation (ESIC), said Mr. Bandaru Dattatreya,
Union Minister for Labour and Employment with Independent Charge,
Government of India. Under the project, enterprise resource planning (ERP)
solution would be installed across the country which will give a unique card to
the employees and facilitate clearance of third party bills.
The Government of India plans to launch a new insurance scheme to protect
farmers and their incomes against production and price risks.
Under the Pradhan Mantri Jan Dhan Yojana, it has been decided that even those
accounts which had been opened prior to August 28, 2014 and have zero
balance will get ` 100,000 (US$ 1,612.55) insurance cover.
Road Ahead
Indias insurable population is anticipated to touch 75 crore in 2020, with life
expectancy reaching 74 years. Furthermore, life insurance is projected to comprise 35%
of total savings by the end of this decade, as against 26% in 2009-10.
The future looks interesting for the life insurance industry with several changes in
regulatory framework which will lead to further change in the way the industry conducts
its business and engages with its customers.
Demographic factors such as growing middle class, young insurable population and
growing awareness of the need for protection and retirement planning will support the
growth of Indian life insurance.
Exchange Rate Used: INR 1 = US$ 0.016 as on February 25, 2015
5.28 Bancassurance
Bancassurance is a French term referring to the selling of insurance through a banks
established distribution channels. In other words, we can say Bancassurance is the
provision of insurance (assurance) products by a bank. The usage of the word picked up
as banks and insurance companies merged and banks sought to provide insurance,
especially in markets that have been liberalized recently. It is a controversial idea, and
many feel it gives banks too great a control over the financial industry. In some countries,
bancassurance is still largely prohibited, but it was recently legalized in countries like
USA when the Glass Steagall Act was repealed after the passage of the Gramm Leach
Bililey Act.
Bancassurance is the selling of insurance and banking products through the same
channel, most commonly through bank branches. Selling insurance means distribution
of insurance and other financial products through banks. Bancassurance concept
originated in France and soon became a success story even in other countries of Europe.
In India, a number of insurers have already tied up with banks and some banks have already
flagged off bancassurance through select products.
239
Bancassurance has become significant. Banks are now a major distribution channels
for insurers, and insurance sales a significant source of profits for banks. The latter partly
being because banks can often sell insurance at better prices (i.e., higher premiums) than
many other channels, and they have low costs as they use the infrastructure (branches
and systems) that they use for banking.
Notes
Bancassurance primarily rests on the relationship the customer has developed over
a period of time with the bank. And pushing risk products through banks is a much more
cost-effective affair for an insurance company compared to the agent route, while, for
banks, considering the falling interest rates, fee based income coming in at a minimum
cost is more than welcome.
5.29 Various Models for Bancassurance

Various models are used by banks for bancassurance:
(a) Strategic Alliance Model
Under this model, there is a tie-up between a bank and an insurance company. The
bank only markets the products of the insurance company. Except for marketing the
products, no other insurance functions are carried out by the bank.
(b) Full Integration Model
This model entails a full integration of banking and insurance services. The bank sells
the insurance products under its brand acting as a provider of financial solutions matching
customer needs. Bank controls sales and insurer service levels including approach to
claims. Under such an arrangement, the Bank has an additional core activity almost similar
to that of an insurance company.
(c) Mixed Models
Under this model, the marketing is done by the insurers staff and the bank is
responsible for generating leads only. In other words, the database of the bank is sold
to the insurance company. The approach requires very little technical investment.
5.30 Status of Bancassurance in India

Reserve Bank of India (RBI) has recognized bancassurance wherein banks are
allowed to provide physical infrastructure within their select branch premises to insurance
companies for selling their insurance products to the banks customers with adequate
disclosure and transparency, and in turn earn referral fees on the basis of premia collected.
This would utilize the resources in the banking sector in a more profitable manner.
Bancassurance can be an important source of revenue. Fee based income can be
increased through hawking of risk products like insurance.
There is enormous potential for insurance in India and recent experience has shown
massive growth pace. A combination of the socio-economic factors is likely to make the
insurance business the biggest and the fastest growing segment of the financial services
industry in India.
However, before taking the plunge into this new field, banks as insurers need to work
hard on chalking out strategies to sell risk products especially in an emerging competitive
market. However, future is bright for bancassurance. Banks in India have all the right
ingredients to make Bancassurance a success story. They have large branch network,
huge customer base, enjoy customer confidence and have experience in selling nonAmity Directorate of Distance and Online Education
240
Notes
banking products. If properly implemented, India could take leadership position in

bancassurance all over the world
Government of India Notification dated August 3, 2000, specified Insurance as a
permissible form of business that could be undertaken by banks under Section 6(1)(o)
of the Banking Regulation Act, 1949. Then onwards, banks are allowed to enter the
insurance business as per the guidelines and after obtaining prior approval of Reserve Bank
of India.
5.31 Bancassurance Models in Europe

The growth of bancassurance has been one of the most significant movements across
the European financial services industry over the last three decades. Powerful forces of
competition and consolidation are evident in the reconstruction of the conventional barriers
between the supply and demand of financial products and services. The developments
towards the homogenized bancassurance phenomenon have been determined by changes
across a broad spectrum of regulatory, political, economic, behavioural and cultural
characteristics. Driven by a deregulatory and increasingly integrated marketplace, the
European banking and insurance sectors have acknowledged the necessity for innovation
and a re-evaluation of their operations.
The aim of this discussion is to review the major developments behind bancassurance
in Europe. The phenomenon has been primarily European, but few studies have attempted
to draw together the fragmented literature pertaining to the region as a whole and to
individual nation states. Examining the relevant academic literature, publicly available
research, the financial press and market activity, this article analyses the historical trends,
strategic issues and the likely future of bancassurance in Europe.
This will be a three-part analysis of bancassurance, focusing on Europe. Various
parts were written as a standalone academic study prior to the onset of the financial crisis.
Part three is currently being researched and will attempt to draw together and analyze
more recent post-crisis developments when the data and information is available. This is
an overview of the European market environment, discusses the strategic issues in the
bancassurance market with an emphasis on life insurance, followed by the key models
of development and a descriptive analysis of the regulatory and legal developments in
Europe. This introduces a comparative analysis of national markets in Continental Europe,
discussing both the development and rationale behind domestic activities, and evaluates
the outlook and realities for the industry in Europe. This will bring the discussion up to
date in the context of the global financial crisis, evolving economic and regulatory trends,
and the changing roles and activities of banks and insurers.
The motive behind the microeconomic integration of financial services is ultimately
a matter of bringing certain advantages to at least one party involved in the transaction.
One of the forces underlying the convergence of banks and insurers is the compatibility
of these industries. For instance, both banks and insurance companies operate in the
asset accumulation business and in some cases, both cater to the individuals financial
services needs. The distribution channels they use may be complementary and when they
overlap they may provide cost synergies. These similarities provide depth to the rationale
for bringing these institutions together.
The Association of British Bankers defines bancassurers as insurance companies
that are subsidiaries of banks and building societies and whose primary market is the
customer base of the bank or building society. Accordingly, a bank may own an insurance
company, may only operate as an intermediary, distributing insurance products
241
constructed by another, or may have a joint venture with an insurer, sharing capabilities
in distribution and manufacturing. The magnitude of the operations may also differ. The
insurance business may provide a marginal concern for the banking institution or represent
a significant share of total revenue and income. The benefits earned by each participant
must, therefore, be assessed carefully before arriving at any conclusion as to the success
of bancassurance activities. Pertinent considerations include how a bank benefits from
any insurance practices, how an insurer or insurance operation benefits from its
association with the bank, the links between the businesses and if the grouping will ever
generate an operation greater than the mere sum of its parts.
Notes
5.32 Bancassurance in India

In India, banking and insurance sectors are regulated by two different entities. The
banking sector is governed by Reserve Bank of India and the insurance sector is regulated
by Insurance Regulatory and Development Authority (IRDA). Bancassurance, being the
combination of two sectors comes under the purview of both the mentioned regulators.
Each of them has elaborate and descriptive rules, restrictions and guidelines.
5.33 The Major Need for Bancassurance in India

(a) Now, banks have realized that by entering into the product value services in
insurance sector, they can meet client expectations and earn more profit while
carrying on their banking business.
(b) In an insurance product, there is a periodic nature of premium deposit which
is positive for the bank.
(c) Banks have also realized that customers loyalty increases profit.
(d) Banks are projected as a shoppers stop to provide all kind of financial services.
(e) Insurance sector is in the extensive need to use the banks distribution network,
large client base and huge customer database, which are helpful in selling their
products.
(f) It reduces the cost of distribution of insurance products in comparison to the
traditional agency channel.
5.34 Obstacles in the Success of Bancassurance

(a) There are some cultural differences between the bank and insurance company
which are hurdles in the way of success of bancassurance.
(b) There may be a problem at the time of implementation of banassurance
partnership.
(c) Poor manpower management is one of the biggest hurdles in this area.
(d) Lack of sales culture and no involvement of branch manager.
(e) Insufficient product promotions and failure to integrate marketing plans.
(f) The most important in all of them is the negative attitude of the bank staff towards
insurance and unwieldy marketing strategy.
(g) Besides that, following are the specific cultural differences between both of them.
(h) Banks provides tangible services whereas an insurance company provides
intangible services.
(i) Banks sell its product on good faith. On the other hand, insurance companies
sell their products on utmost good faith.
242
Notes
(j) Banks provided services are immediate whereas insurance provided services
are futuristic.
(k) Bank provides short-term finance whereas insurance companies provide longterm finance.
(l) Banks generally deal with their customers directly whereas insurance
companies deals with their customers through intermediaries.
(m) Bank customers have their accounts in banks whereas insurance customers
unaware of their accounts.
(n) Dealing with banks is highly personal whereas dealing with insurance is less
personal.
(o) The Reserve Bank of India in its 2009-2010 circular made it mandatory for bank
to disclose in the Notes to Accounts from the year ending March 31, 2010,
the details of fees or remuneration received in respect of bancassurance
business undertaken by them.
5.35 Regulating Guidelines of IRDA

Insurance Regulation and Development Authority Act 1999 provides the entry norms
for any new company for operation in insurance sector. Any such new company must
have:
(a) Minimum paid-up capital of ` 100 crores;
(b) Investment of policyholders fund only in India;
(c) Restriction of foreign companies to minority equity holding of 26%;
(d) Following are Bancassurance Models approved for business;
(e) Insurance business carried out by banks;
(f) It allows any scheduled bank to undertake life or non-life insurance business
on specified fee basis but without any risk participation.
Joint Venture by Bank
Banks after satisfying required criteria are allowed to set up a joint venture company
for undertaking insurance business with risk participation subject to certain safeguards.
The maximum equity which a bank is allowed to hold in such joint venture is 52% of the
paid-up capital of the insurance company on a selective basis. However, in certain cases
with the permission of RBI, the bank can initially invest more than 52% but there must
be reduction of equity to the statutory level. For example, ICICI Prudential Life Insurance
company does nearly 20% of the life insurance sale through the Bancassurance channel.
SBI, HDFC and ICICI Banks are the subscribers of their respective holding companies.
Banks are also tying up with regional rural banks to make the benefit out of rural and
semi-urban region . Similarly, AVIVA Insurance has its tie-up with more than 21 banking
companies which includes private, public and foreign sector banks.
Restriction on Subsidiaries
A subsidiary of a bank or another bank shall not normally be allowed to join the
insurance company on risk participation basis. Subsidiaries means and includes here bank
subsidiaries undertaking merchant banking securities, mutual fund, leasing finance and
housing finance business, etc.
243
Investing in an Insurance Company
Notes
Banks which are not eligible for joint venture can invest in an Insurance company
without risk participation. Currently, banks can invest up to 10% of the net worth of the
bank, or ` 50 crores, whichever is lower.
Merger and Acquisition
This model is not very popular in India due to various national laws forbidding mergers
between banks and insurance sectors. In this model, either a bank acquires the insurance
company or merges with it or vice versa.
Organic Start-up
Under this model instead of merger or acquisition of the bank or insurance company,
believe in building skills organically. The advantage of this model is that it reduces the
chance of cultural differences between the Bank and insurance company.
5.36 Recommendations of Committee Constituted by IRDA on

Bancassurance
The banks are not allowed to sell insurance products of more than one insurance
company. But due to persistent request from the side of various life and general insurance
companies from the IRDA led to formation of a seven-member committee in the mid of
2009 to look after the matter. The committee had to submit its report and to examine
the desirability for a differential treatment of insurance intermediation by banks under the
Bancassurance model consistent with intermediation best practices and modified suitably
to meet domestic regulatory requirements. The committee submitted its recommendation
on 26th May, 2011.
Following are some of the recommendations of the Committee: channel and therefore
there is need to enact a comprehensive legislation to cover all aspects of the working
of the Bancassurance activities:
Banks should be allowed to tie up with any of the following two sets of insurers:
(b) Two in life insurance sector
(c) The Committee admitted that at present there is ambiguity on the organization
and practices of the Bancassurance
(d) Two in non-life insurance sector excluding health
(e) Two in health insurance sector
(f) ECGC and AIC.
Efforts should be made to more use of information technology which would reduce
the manpower requirement and would increase more structured, transparent and efficient
organization.
The tenure of the agreement between the banker and insurer is normally one to three
years at present. This makes the relationship between the two unstable. Therefore, the
minimum period of the agreement between the banker and the insurer shall not be less
than five years. Here, the Committee also made a very significant point that the
responsibility of servicing of the policies issued already through the bank or subsidiary
or special purpose vehicle shall remain with the bancassurance partner even if the
tie-up ends and the said partner shall receive the renewal commission on per renewed
244
Notes
policy basis. For all this purpose, there is need of proforma for memorandum of agreement
between bank and insurer with minimum requirement.
As far as inspection and supervision is concerned, the proposed regulation must
contain separate provision which empowers IRDA and RBI to inspect any of the
Bancassurance partner.
The regulation must have provisions of maintaining accounts and certification which
should be furnished in periodical returns to the authority. Corporate governance norms
regarding disclosure should be complied by the banks treating bancassurance as integral
part of banks business operation.
Regulations should make it mandatory that the bank staff be fully trained in handling
insurance products so that the sale process is transparent and the policyholder gets full
disclosure of the features of the product.
The Committee gave the green light for multiple insurers but only if a bank fulfills
all other conditions specified in the Committees recommendations. The Committee
recommended abolition of the referral system of bancassurance because it is costlier than
corporate agent model. The reason behind the high cost is that the insurer has not only
to pay the higher amount of first year premium as referral fee but also has to deploy staff
and infrastructure in the bank premises.
5.37 Bancassurance Model in India

Referral Model
This model of Bancassurance India is regulated by Insurance Regulatory and
Development Authority (Sharing of Database for Distribution of Insurance Products)
Regulations, 2010. Any commercial bank can undertake insurance business as an agent
of insurance company on fee basis. The bank does not participate in risk under this
category. This is also known as referral model. In this model, a referral arrangement is
done between Referral Company and insurer for selling of insurance products. The referral
company only shares the database of its customers and does not directly indulge in
soliciting or selling of insurance product through agent or corporate agent or insurance
intermediaries. In other words, the actual transaction is done by the staff of the insurance
company either at the bank premise or elsewhere. The bank charges only fees or
commission for every business from their customers.
5.38 Summary
Insurance is a contract between two parties whereby one party agrees to undertake
the risk of another in exchange for consideration known as premium and promises to pay
a fixed sum of money to the other party on happening of an uncertain event (death) or
after the expiry of a certain period in case of life insurance or to indemnify the other party
on happening of an uncertain event in case of general insurance.
Insurance provides financial protection against a loss arising out of happening of an
uncertain event. A person can avail this protection by paying premium to an insurance
company. A pool is created through contributions made by persons seeking to protect
themselves from common risk. Premium is collected by insurance companies which also
act as trustee to the pool. Any loss to the insured in case of happening of an uncertain
event is paid out of this pool.
245
Insurance refers to a contract or policy in which an individual or entity receives

financial protection or reimbursement against losses from an insurance company. The
company pools clients risks to make payments more affordable for the insured.
Notes
Insurance concept started by considering the methods of transferring or distributing

risk were practiced by Chinese and Babylonian traders as long ago as the 3rd and 2nd
millennia BC, respectively. Chinese merchants travelling treacherous river rapids would
redistribute their wares across many vessels to limit the loss due to any single vessels
capsizing. The Babylonians developed a system which was recorded in the famous Code
of Hammurabi, c. 1750 BC, and practiced by early Mediterranean sailing merchants. If
a merchant received a loan to fund his shipment, he would pay the lender an additional
sum in exchange for the lenders guarantee to cancel the loan should the shipment be
stolen.
The sale of life insurance in the US began in the late 1760s. The Presbyterian Synods
in Philadelphia and New York founded the Corporation for Relief of Poor and Distressed
Widows and Children of Presbyterian Ministers in 1759; Episcopalian priests created a
comparable relief fund in 1769. Between 1787 and 1837, more than two dozen life insurance
companies were started, but fewer than half a dozen survived.
Insurance in India has evolved over time heavily drawing from other countries, England
in particular, 1818 saw the advent of life insurance business in India with the establishment
of the Oriental Life Insurance Company in Calcutta. This Company, however, failed in 1834.
In 1829, the Madras Equitable had begun transacting life insurance business in the Madras
Presidency. 1870 saw the enactment of the British Insurance Act and in the last three
decades of the nineteenth century, the Bombay Mutual (1871), Oriental (1874) and Empire
of India (1897) were started in the Bombay Residency. This era, however, was dominated
by foreign insurance offices which did good business in India, namely Albert Life
Assurance, Royal Insurance, Liverpool and London Globe Insurance and the Indian offices
were up for hard competition from the foreign companies.
Life Insurance refers to the insurance which gives a protection against the loss of
income that would result if the insured passed away. The named beneficiary receives the
proceeds and is thereby safeguarded from the financial impact of the death of the insured.
General insurance or non-life insurance policies, including automobile and
homeowners policies, provide payments depending on the loss from a particular financial
event. General insurance typically comprises any insurance that is not determined to be
life insurance.
Insurance companies are a special type of financial institution that deals in the
business of managing risk. A corporation periodically gives them money and, in return,
they promise to pay for the losses the corporation incurs if some unfortunate event occurs,
causing damage to the well-being of the organization.
The economic crisis of late 2007 and early 2008 highlighted the growing importance
of the role of the worlds financial sectors in ensuring global financial stability. The finance
industry, however, is not homogenous. Insurers, in particular, have a distinct profile within
the industry. This was the subject of leading speakers at the Role of Insurance in Global
Financial Stability event, held at the Swiss Re Centre for Global Dialogue, 29 June 2010.
The principle of insurable interest states that the person getting insured must have
insurable interest in the object of insurance. A person has an insurable interest when the
physical existence of the insured object gives him some gain but its non-existence will
give him a loss. In simple words, the insured person must suffer some financial loss by
the damage of the insured object.
246
Notes
Indemnity means security, protection and compensation given against damage, loss
or injury. According to the principle of indemnity, an insurance contract is signed only
for getting protection against unpredicted financial losses arising due to future
uncertainties. Insurance contract is not made for making profit, else its sole purpose is
to give compensation in case of any damage or loss.
Insurance sector has been opened up for competition from Indian private insurance
companies with the enactment of Insurance Regulatory and Development Authority Act,
1999 (IRDA Act). As per the provisions of IRDA Act, 1999, Insurance Regulatory and
Development Authority (IRDA) was established on 19th April 2000 to protect the interests
of holder of insurance policy and to regulate, promote and ensure orderly growth of the
insurance industry. IRDA Act 1999 paved the way for the entry of private players into the
insurance market which was hitherto the exclusive privilege of public sector insurance
companies/corporations.
IRDA has so far granted registration to 12 private life insurance companies and
9 general insurance companies. If the existing public sector insurance companies are
included, there are currently 13 insurance companies in the life insurance business and
13 companies operating in general insurance business. General Insurance Corporation has
been approved as the Indian reinsurer for underwriting only reinsurance business.
Bancassurance is a French term referring to the selling of insurance through a banks
established distribution channels. In other words, we can say Bancassurance is the
provision of insurance (assurance) products by a bank. The usage of the word picked up
as banks and insurance companies merged and banks sought to provide insurance,
especially in markets that have been liberalized recently. It is a controversial idea, and
many feel it gives banks too great a control over the financial industry. In some countries,
bancassurance is still largely prohibited, but it was recently legalized in countries like
USA when the Glass Steagall Act was repealed after the passage of the Gramm Leach
Bililey Act.

1. Insurance provides financial protection against a loss arising out of happening
of an _____________.
2. _____________ refers to the insurance which gives a protection against the loss
of income that would result if the insured passed away.
3. _____________ policies, including automobile and homeowners policies,
provide payments depending on the loss from a particular financial event.
4. Insurance companies are a special type of financial institution that deals in the
business of _____________.
5. General Insurance Corporation has been approved as the Indian reinsurer for
underwriting only ____________.
II. True or False
1. Insurance is a contract between two parties whereby one party agrees to
undertake the risk of another in exchange for consideration known as premium
and promises to pay a fixed sum of money.
2. The sale of life insurance in the US began in the late 1760s.
3.
247
Life Insurance refers to the insurance which gives a protection against the loss
of income that would result if the insured passed away.
Notes
4. The economic crisis of late 2007 and early 2008 highlighted the growing
importance of the role of the worlds financial sectors in ensuring global financial
stability.
5. The principle of insurable interest states that the person getting insured must
have insurable interest in the object of insurance.
1. Which of the following is a contract between two parties whereby one party
agrees to undertake the risk of another in exchange for consideration?
(a) Insurance
(b) Banking
(c) Lending
(d) All the above
2. Insurance concept started by considering the methods of transferring or
distributing risk were practiced by _____________
(a) Chinese traders
(b) Babylonian traders
(d) None of these
3. The sale of life insurance in the US began in the late _____________
(a) 1750s
(b) 1760s
(c) 1740s
(d) 1780s

1. Give the meaning of Insurance.
2. What is Life Insurance?
3. What is General Insurance?
4. State any two purposes of Life Insurance.
5. What is the origin of General Insurance Corporation of India (GICI)?
6. What is IRDA Act?
7. What is Bancassurance?
8. State any two Regulating Guidelines of IRDA.
1. Discuss the historical background of Insurance.
2. Explain various types of Insurance.
3. Discuss role of Insurance companies in Industrial Financing.
4. Explain various principles of Insurance.
248
Notes
5. Discuss features of General Insurance.

6. Explain about Insurance sector reforms in India.
7. Discuss about new developments in insurance as a sector in the Indian Financial
System.
8. Discuss various models for Bancassurance.
5.41 Key Terms

z
Insurance: Insurance is a contract between two parties whereby one party

agrees to undertake the risk of another in exchange for consideration known
as premium and promises to pay a fixed sum of money to the other party on
happening of an uncertain event.
Life Insurance: Life Insurance refers to the insurance which gives a protection
against the loss of income that would result if the insured passed away.
General insurance: General insurance or non-life insurance policies, including

automobile and homeowners policies, provide payments depending on the loss
from a particular financial event.
Principle of Utmost Good Faith: The Principle of Utmost Good Faith is a very
basic and first primary principle of insurance.
Principle of insurable interest: The principle of insurable interest states that

the person getting insured must have insurable interest in the object of
insurance.
Bancassurance: Bancassurance is a French term referring to the selling of

insurance through a banks established distribution channels.

1. Uncertain event
2. Life Insurance
3. General insurance or non-life insurance
4. Managing risk
5. Reinsurance business
II. True or False
1. True
2. True
3. True
4. True
5. True
1. (a) Insurance
3. (b) 1760s
249
5.43 Case Study
Notes
Recognizing the need for large-scale centralized systems expertise, SBI sought
proposals from a number of vendor consortiums that were headed by the leading systems
integrators. From these proposals, the bank narrowed down the potential solutions to
vendor consortiums led by IBM and TCS. The TCS Group included Hewlett-Packard,
Australia-based Financial Network Services (FNS), and China Systems (for trade finance).
Although SBI favoured the real-time processing architecture of FNSs BaNCS system over
that of the IBM consortiums memo post/batch update architecture, the bank had several
concerns about the TCS consortium proposal. They included the small size and relatively
weak financial strength of FNS (TCS would eventually purchase FNS in 2005) and the
ability of the UNIX-based system to meet the scalability requirements of the bank.
Therefore, it was agreed that TCS would be responsible for the required systems
modifications and ongoing software maintenance for SBI. Additionally, scalability tests
were performed at HPs lab in Germany to verify that the system was capable of meeting
the banks scalability requirements. These tests demonstrated the capability of TCS
BaNCS to support the processing requirements of 75 million accounts and 19 million daily
transactions. Tata Consultancy Services and TCS BaNCs Tata Consultancy Services,
headquartered in Mumbai, India, is one of the worlds largest technology companies with
particular expertise in systems integration and business process outsourcing. The
company has more than 130,000 employees located in 42 countries and achieved revenues
of $ 5.7 billion in fiscal 2008. Although TCS has long been a leader in core systems
integration services for banks, after it purchased FNS in 2005, the company also became
a leading global provider of core banking software for large banks. The BaNCS system
is based on service-oriented architecture (SOA) and is platform and database independent.
In addition to SBI, TCS BaNCS clients include the Bank of China (installation in process),
China Trust, Bank Negara Indonesia, Indias Bank Maharashtra, National Commercial
Bank (Saudi Arabia), and Koram Bank (Korea). TCS has also expanded its US footprint
with the opening of its largest resource delivery center in North America (near Cincinnati,
Ohio) that can house 20,000 personnel. The company is seeking to license and implement
the BaNCS system in North America and recently completed a major part of an effort
to ensure that the BaNCS system meets US regulatory and compliance requirements.
Question:
1. Do you think the Vendor Consortium Selection is up to the mark? Discuss.

Ryerson.
Company.
3. Investing in Development: Lessons of the World Bank Experience by Baum W.C
and Tolbert S.M., Oxford University Press.
4. Projects, Preparation, Appraisal, Budgeting and Implementation by Prasanna
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250
Notes
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Management of Financial Institutions

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Management of Financial Institutions

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Management of Financial Institutions