IFS UNIT 2: BANKING INSTITUTIONS |Indian Financial System for B.Com Bangalore University
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UNIT 2:
BANKING INSTITUTIONS
Topics covered as per syllabus
Commercial Banking – Meaning and functions, Types of Banks –Public, Private and foreign Banks, Payments Bank, Small Finance Banks, Cooperative Banking System and RRB’s. Investment Policy of Commercial Banks and Consolidation of Banks in India
Scheduled banks
Non-scheduled banks
These banks are those that do not adhere to the RBI's regulations. They are not mentioned in the 2nd Schedule of the RBI Act, 1934, They are therefore considered incapable of serving and protecting depositors' interests. They must also meet the cash reserve requirement, with themselves and not with reserve banks. They are generally smaller in size and have narrow influence They are risky to do business with due to their financial limitations. The reserve capital of these banks is less than 5 lakh rupees.
Functions of Commercial Banks
1. It accepts deposits:
A commercial bank accepts deposits in the form of current, savings and fixed deposits. It collects the surplus balances of the Individuals, firms and finances the temporary needs of commercial transactions. The bank does this by accepting deposits from its customers.
Deposits are of three types as under:
- (i) Current account deposits:Current account deposits are payable on demand and are therefore called demand deposits.The bank does not pay any interest on these deposits and the depositor can withdraw it any number of times depending on the balance in the account.Usually business people maintain this type of account.
- (ii) Fixed deposits (Time deposits):Fixed deposits have a fixed period of maturity and are referred to as time deposits. The time period may range from a few days to a few years. They can be withdrawn only after the maturity of the specified fixed period. They carry higher rate of interest.
- (iii) Savings account deposits:. Savings account main objective is to save and is most suitable for individual households. They combine the features of both current account and fixed deposits. They are payable on demand and also withdraw able by cheque. Interest paid on savings account deposits in lesser than that of fixed deposit.
2. It gives loans and advances:
The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is,the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as reserve and lends the balance to the borrowers as loans and advances in the form of cash credit, demand loans, short-run loans, overdraft as explained under.
3. Discounting bills of exchange :
A bill of exchange represents a promise to pay a fixed amount of money at a specific point of time in future. It can also be encashed earlier through discounting process of a commercial bank. A bill of exchange is a document signed by the debtor and the creditor for a fixed amount payable on a fixed date in consideration of goods received
4. Overdraft facility:
An overdraft is a facility given ,to a depositor for overdrawing the amount than the balance amount in his account up to an agreed limit. Depositors of current account make arrangement with the banks that in case a cheque has been drawn by them which are not covered by the deposit, then the bank should grant overdraft and honour the cheque. The security for overdraft is generally financial assets like shares, debentures etc.
5. Agency functions of the bank:
The bank acts as an agent of its customers and gets commission for performing agency functions such as (i) Transfer of funds,(ii) Collection of funds,(iii) Payments of various items(iv) Purchase and sale of shares and securities(v) Collection of dividends, interest on shares and debentures on behalf of its customers(iv) Acts as Trustee and Executor of property of its customers (vii) Letters of References:
6. Performing general utility services:
The banks provide many general utility services, like (i)Issuing traveller’s cheques and gift cheques.(ii) Providing locker facility(iii) Underwriting securities issued by government, public or private bodies.(iv) Purchase and sale of foreign exchange (currency).
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Types of banks
1.Public Sector Banks
Public sector banks are banks in which the government has a major holding. These can be classified into two groups: (i) the State Bank of India and (ii) nationalised banks.
- i)State Bank of India : It is the world’s largest commercial bank in terms of branch network.
- ii)Nationalised banks-The major objectives of nationalisation were to widen the branch network of banks particularly in the rural and semi-urban areas which, in turn, would help in greater mobilisation of savings and flow of credit to neglected sectors such as agriculture, and small-scale industries.
The bulk of the banking business in the country is in the public sector. Public sector banks have expanded their branch network and catered to the socio-economic needs of a large mass of the population, especially the weaker section and in the rural areas.
2.Private Sector Banks
Private Sector Banks are those banks in which the majority of the stake is held by shareholders of the bank and not by the government. Even though private banks follow the nation's central bank guidelines, they can still formulate their own independent policies for their customers.
Private banks can make quick financial decision according to the market condition and because of this reason the interest rates fluctuate quickly on both deposit and loans.They also offer various customized services to the customer to fulfil their individual financial needs.
HDFC Bank, ICICI Bank, Yes Bank, etc. are the private sector banks in India. They provide all the banking products and services to the customers.
3.Foreign Banks
Many foreign banks from different countries set up their branches in India during the 1990's—the liberalisation period. Foreign banks are financial institutions that has its operations overseas within a foreign nation.The presence of foreign banks in India has benefited the financial system by enhancing competition,transfer of technology and specialised skills resulting in higher efficiency and greater customer satisfaction. They have also enabled large Indian companies to access foreign currency resources from their overseas branches in times of foreign currency constraint. They are active players in the money market and foreign exchange market which has contributed to enhancing the liquidity and deepening of these markets in terms of both volumes and products.
Standard Chartered Bank is the undisputed leader among the foreign banks with assets of over Rs. 30,000 crore followed by Citibank which is a distant second.
COOPERATIVE BANKING
Cooperative banks came into existence with the enactment of the Cooperative Credit Societies Act of 1904 which provided for the formation of cooperative credit societies. Subsequently, in 1912, a new act was passed which provided for the establishment of cooperative central banks. Cooperative credit institutions play a pivotal role in the financial system of the economy in terms of their reach, volume of operations, and the purpose they serve.
Cooperative banks fi ll in the gaps of banking needs of small and medium income groups not adequately met through by the public and private sector banks. The cooperative banking system supplements the efforts of the commercial banks in mobilising savings and meeting the credit needs of the local population.
A cooperative bank is member promoted and has to be registered with the state-based Registrar of Cooperative Societies. It functions with the rule of ‘one member one vote’ and on ‘no-profit, no loss basis’.
The cooperative credit sector in India comprises rural cooperative credit institutions and urban cooperative banks. The rural cooperative credit institutions comprise of institutions such as state cooperative banks, district central cooperative banks, and primary agricultural credit societies, which specialise in short-term credit, and institutions such as state cooperative agriculture and rural development banks and primary cooperative agriculture and rural development banks, which specialise in long-term credit.
Urban cooperative banks (UCBs) are mostly engaged in retail banking. They are not permitted to deal in foreign exchange directly because of the high risks involved in forex business. Only three UCBs, namely, the Saraswat Cooperative Bank Limited, the Bombay Mercantile Cooperative Bank Limited, and the Maharashtra State Cooperative Bank Limited, have been authorised by the Reserve Bank to deal in foreign exchange. Their exposure to non-fund business like issuance of bank guarantees and letters of credit is also limited. Their exposure to corporate (wholesale) banking is also limited due to factors such as small size of their balance sheet and inadequate expertise.
INVESTMENT POLICY OF COMMERCIAL BANKS
A bank makes investments for the purpose of earning profits. First it keeps primary and secondary reserves to meet its liquidity requirements.This is essential to satisfy the credit needs of the society by granting short-term loans to its customers. Whatever is left with the bank after making advances is invested for long period to improve its earning capacity.The investment policy of a bank consists of earning high returns on its unloaned resources. But it has to keep in view the safety and liquidity of its resources so as to meet the potential demand of its customers.
The revised Investment Policy of the Bank will be as under:-
1. Mandatory Investment In terms of mandatory requirement of Banking Regulation Act, it is compulsory to invest minimum 3% as Cash Reserve Fund (CRF) & 25% as Statutory Liquid Reserve (SLR- investment in Govt. & other asset will be treated normal.
2. Loans & Advances : Bank can invest up to 75% of own funds and up to 70% of total deposits in loans & advances, out of which, after observing the prescribed norms for priority sector & weaker section of the society, remaining portion can be advanced as per Loan Policy of the Bank keeping in view the ceiling of maximum amount of advance to a single person, similar type of business & on similar type of securities to minimize the risk involved.
3. Investment with other Citizen Cooperative Banks: Bank will not make any investment with these Banks except undertaking normal transactions in the accounts opened for clearing and transfer of funds purpose.
4. Investment in other Banks: Bank may invest its surplus funds in any commercial, private & cooperative Banks but if any such bank provides considerably higher rate of interest then its financial position has to be analysed. Investment of the liquid surplus funds from time to time has to be made in such a way that there should not be any difficulty in meeting out the funds requirement for daily clearing adjustment as well as payment of the deposits on due dates of maturity.
5. Investment in non- SLR Debt Securities: In compliance of the instructions issued by RBI from time to time and also keeping in view the additional income on investment and safety of surplus funds, investment may be made in Liquid Funds enjoying good market credit rating and also trading in Government Securities.
6. Investment in other Institutions, Corporations & Companies :Bank will not invest its surplus funds in any other institution, company , corporation etc whatsoever be the attractive rate of interest.
7. Investment in share money of Cooperative institutions :Bank may invest 2% of its personal funds in the share money of the Cooperative Institutions but it will be in accordance of the directives of the Reserve Bank of India.
8. Investment in private companies Bank will not make any investment in private companies or in Shares / Debentures of other institutions other than Cooperative Institutions.
9. Investment in Government Securities “Government Securities” will mean securities issued by the Central & State Governments.
10. Cash Management Except in abnormal conditions, cash balance in the bank will be kept within the fixed limit as excess cash will affect the profitability of the Bank.
11. Besides above, day to day asset, liability management should be prepared in such a way that after complying the mandatory requirements, Bank should earn maximum profit.
12. No amendments/ modification in the provisions of the sanctioned Investment policy will be made without the Board of Directors.
13. In the process of investment, in no circumstances provisions of the Reserve Bank of India will be violated.
Consolidation of banks in India
In the context of India, it is felt that there is ample room for consolidation in the banking sector, especially among PSB's without creating issues of moral hazard . It does appear that the banking system in India is too fragmented at present. The desirability of consolidation in Indian banking sector is widely felt across the spectrum. There are at present times several factors that indicate that consolidation in Indian banking scene has its right time.
They are as follows:
The need for consolidation is specially felt now, due to the fact that although India is seventh largest economy in the world in terms of nominal GDP, there is no Indian bank in the list of 70 large banks in terms of asset size. large banks reap certain advantages in terms of efficiency, risk diversification and capacity to finance large projects.
It is also felt that a larger bank may be less risky than a smaller bank as the larger bank will have a more diversified portfolio resulting in less volatility in its earnings. Consequently, a large bank may command higher credit rating than a smaller bank.
A report, mentioned the following: ‘More stable banking systems tend to be structured around a number of large ‘pillar’ banking groups. These large banks in a consolidated banking system enjoy scale benefits leading to better diversification of risks and stronger overall profitability contributing to higher credit ratings.’
Large banks do benefit from economies of scale in terms of risk diversification, although this benefit disappears when banks become excessively large beyond a certain threshold size. This threshold size has been subject of much debate in the discipline of finance.
A comparison of performance of larger PSBs with smaller PSBs does indicate that larger PSBs perform better. For example, among all PSBs, larger PSBs like SBI and Bank of Baroda are trading at higher Price to Book Value ratio in comparison to other smaller PSBs. SBI has been able to maintain relatively strong capital ratios and appears to be in a better position to withstand shocks to asset-quality. This indicates that under Indian conditions, there is lot of scope for banks to grow in size to become efficient and diversify their risks.
The other important aspect which needs to be considered is credit demand of a growing economy. As Indian companies increase their business and become global in nature, their demand for large scale credit will become higher. Banks also have to grow in size to meet the higher demand of credit. The banking system will be required to enhance its capacity to lend to larger companies and to larger projects.
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