Banking System in India

A commercial bank is a type of financial intermediary and a type of bank. It is a financial intermediary because it mediates between the savers and borrowers. It does so by accepting deposits from the public and lending money to businesses and consumers.. It also buys corporate bonds and government bonds. Its primary liabilities are deposits and primary assets are loans and bonds.
'"Commercial bank" is a type of bank because it has to be distinguished from another type called "investment bank". Investment banks assist public and private corporations in raising funds in the capital markets (both equity and debt), as well as in providing strategic advisory services for mergers. acquisitions and other types of financial transactions.
The commercial banking system in India consists of public sector banks, private sector banks and cooperative banks.
Currently, India has 88 scheduled commercial banks SCBs - 27 public sector banks (that is with the Government of India holding a stake) 31 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. Public sector banks hold over 75% of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively
Public Sector Banks
They are owned by the Government -either totally or as a majority stake holder.
State Bank of India and its six associate banks called the State Bank group
19 nationalised banks
Regional Rural Banks mainly sponsored by Public Sector Banks
Private Sector Banks include domestic and foreign banks
Co-operative Bank are another class of banks and are not considered as commercial banks as they social objectives and profit is not the motive (explained later)
Reserve Bank of India lays down the norms for banking operations and have the final supervising power.
Development Banks
Development Banks are those financial institutions which provide long term capital for industries and agriculture : Industrial Finance Corporation of India (IFCI) ; Industrial Development Bank of India (IDBI) ; insustrial Credit and Investment Corporation of India (ICICI) that was merged with the ICICI Bank in 2000; Industrial Investment Bank of India (IIBI); Small Industries Development Bank of India (SIDBI) ; National Bank for Agriculture and Rural Development (NABARD) ;Export Import Bank of India ; National Housing Bank (NHB).
The commercial banking network essentially catered to the needs of general banking and for meeting. the short-term working capital requirements of industry and agriculture. Specialised development financial institutions (DFIs) such as the IDBI, NABARD, NHB and SIDBI, etc., with majority ownership of the Reserve Bank.were set up to meet the long-term financing requirements of industry and agriculture. To facilitate the growth or these institutions, a mechanism to provide concessional finance to these institutions was also put in place by the Reserve Bank.
The first development bank in India - IFCI - was incorporated immediately after Independence in 1948 under the Industrial Finance Corporation Act as a statutory corporation to pioneer institutional credit to medium and large-scale. Then after in regular intervals the government started new and different development financial institutions to attain the dofferent objectives and helpful to five-year plans.
Government utilized·these institutions for the achievements in planning and development of the nation as a whole. The all India financial institutions can be classified under four heads according to their economic importance that are:
All-India Development banks
Specialized financial Institutions (SIDBI)
Investment Institutions (The industrial Reconstruction Corporation of India Ltd., set up in 1971 for rehabilitation of rick industrial companies)
State-level institutions (SFC)
S.H.Khan committee appointed by RBI (1997) recommended to transform the DFI (developmen finance institution) into universal banks that can provide a menu of financial services and leverage on their assets and talent.
Bnk Nationlization
In 1969 and again in 1980, Government nationalized private commercial banking units for channelizing banking capital into rural sectors: checking misuse of banking capital for speculative purposes; to shift from 'class banking'to mass banking' (social banking); and to make banking into an integral part of the planning process of socio-economic development in the country. Today, no other developing country can boast of a binking system comparable to India's in terms of geographic coverage, operational capabilities, range of services and technological prowess.
Commercial Banks
Today banks are broadly classified into two types-Scheduled Bank and Non-scheduled Banks
Scheduled banks are those banks which are included in the Second Schedule of the Reserve Bank Act, 1934. They satisfy two conditions under the Reserve Bank of India Act
paid-up capital and reserves of an aggregate value of not less than Rs 5 lakh
it must satisfy RBI that its affairs are not conducted in a manner detrimental to the depositors.
The scheduled banks enjoy certain privileges like approaching RBI for financial assistance, refinance etc and correspondingly, they have certain obligations like maintaining certain cash reserves as prescribed the RBI etc. The scheduled banks in India comprise of State Banks of India and its associates (8), the other nationalised banks (19), foreign banks, provate sector banks, co-operative banks and regional rural banks. Today, there are about 300 scheduled banks in india having a total network of 65,000 branches among them.
Non-scheduled banks are those banks which are not included in the second schedule of the RBI Act as they do not comply with the above vriteria and so they do not enjoy the benefits either.
There are only 3 non-scheduled commercial banks operating in the country with a total of 9 branches
Cooperative Banks
Co-operative Banks are organised and managed on the principle of co-operation self-help, and mutual help. They function with the rule of "one member. one vote" and on "no profit, no loss" basis. Co-operative banks, as a principle, do not pursue the goal of profit maximisation.
Co-operative bank performs all the main banking functions of deposit mobilisation, supply of credit and provision of remittance facilities.
Co-operative Banks UCBs are located in urban and semi-urban areas. These banks, till 1996, were allowed to lend money only for non-agricultural purposes. This distinction does not hold today. Earlier, they essentially lent to small borrowers and businesses. Today, their scope of operations has widened considerable. Urban CBs provide working capital, loans and term loan as well
Co-operative banks are the first government sponsored, government-supported. and government-subsidised financial agency in India. They get financial and other help from the Reserve Bank of India, NABARD, central government and state governments. RBI provides financiaf resour.ces in the form of contribution to the initial capital (through state government), working capital, refinance.
Co-operative Banks belong to the money market as well as to the capital market - they offer short term and long term loans.
Primary agricultural credit societies provide short term and medium term loans State Cooperative Banks (SCBs)·and CCBs(Central Cooperative Banks at the district level) provide both short term anq term loans. Land Development Banks (LDBs) provide long-term loans.
Long term cooperative credit structure comprises of state cooperative agriculture and rural development bank SCARDB at the state level and primary PCARDBs or branches of SCARDB at the decentralised district or block level providing typically medium and long tem loans for making investments in agriculture. rural industries, and lately housing. The sources of their funds (resources) are
ownership funds
deposits or debenture issues.
central and state government
Reserve Bank of India
NABARD
other co-operative institutions
Some co-operative bank are scheduled banks, while other are non-scheduled banks. For instance, SCBs and some UCBs are scheduled banks (included in the Second Sechedule o f the Reserve Bank of Inda Act).
Co-operative Banks are subject to CRR and SLR requirements as other banks. However, their requirements are less than commercial banks.
Although the main aim of the co-operative bank is to provide cheaper credit to their members and not to maximize profits, they may access the money market to improve their income so as to remin viable.
Commercial banks and their weaknesses by 1991
The major factors that contributed to deteriorating bank performance upto the end of eighties were
high SLR and CRR locking up funds
low interest rates charged on government bonds
directed and concessional lending for populist reasons
administered interest rates and
lack of competition.
Some co-operative bank are scheduled banks, while other are non-scheduled banks. For instance, SCBs and some UCBs are scheduled banks (included in the Second Schedule of the Reserve Bank of India Act)
Co-operative Banks are subject to CRR and SLR requirements as other banks. However, their requirements are less than commercial banks.
Although the main aim of the co-operative bank is to provide cheaper credit to their members and not to maximize profits, they may access the money market to improve their income so as to remain viable.
Commercial banks and their weaknesses by 1991
The major factors that contributed to deteriorating bank performance upto the end of eighties were
high SLR and CRR locking up funds
low interest rates charged on government bonds
directed and concessional leanding for populist reasons
administered interest rates and
lack of competition
The reforms to set the above problems right were
reduction of SLR to 25% to free up funds for lending to businesses and consumers
CRR was initially reduced but since 2006 has been going up to tame inflation and also to ensure that quality of credit is maintained (9% in 2008 August)
Floor and cap on SLR and CRR removed in 2006
interest rates were deregulated to make banks respond dynamically to the market conditions
near level playing field for public, private and foreign banks in entry
adoption of prudential norms-Reserve Bank of India issued guidelines for income recognition, asset classification and provisioning to make banks safer
Basel norms adopted for safe banking
VRS for better work culture and productivity
FDI upto 74% is permitted
One of the sectors that has been subjected to reforms as a part of the new economic policy since 1991 consistently is the banking sector. The objectives of banking sector reforms have been:
to make them competitive and profitable
to strengthen the sector to face global challenges
sound and safe benking
to help them technologically modernize for customer benefit
make available global expertise and capital by relaxing FDI norms.
Narasimham Committee
Banking sector reforms in India were conducted on the basis of Narasimham. Committee reports I and II (1991 and 1998 respectively) The recommendations of Narasimham committee 1991 are
No more nationalization
create a level playing field between the public sector, private sector and foreign sector banks
select few banks like SBI for global operations
reduce Statutory Liquidity Ratio (SLR) as that will leave more resources with banks of lending
reduce Cash Reserve Ratio (CRR) to increse lendable resources of banks
rationalize and better target priority sector lending as a sizeable portion of it is wasted and also much of it turning into non-performing asset
introduce prudential norms for better risk management and transparency in operations
deregulate interest rates
Set up Asset Reconstruction Company (ARC) that can take over some of the bad debts of the banks and financial institutions and collect them for a commission.
Most of these reforms are implemented except priority sector lending which is welfare-based and relates to agriculture. SLR is 25% today and CRR is 9%. Bank rate is 6%.
Divestment in public sector banks led to their listing on the stock exchanges and their performance has improved.
NPAs
Non-performing assets are those accounts of borrowers who have dc[aultqi in paymerit of interest or installment of the principal or both for more than 90 days.
In 2003. NP As stood at 9% and came down to 2.5% in 2008. They may grow to 5% by 20 II due to the current global crisis and the aggressive lending in recent years.
RBI rules require that banks should sd aside certain amount of money ( provisioning) for the NP As. Gross NP As include the amount due along with the amount provisioned. Net NP As include only the amount due.
NPAs are largely a fallout of banks' credit appraisal system, monitoring of end - usage of funds· and recovery procedures. It also depends on the overall economic environment, the business cycle and tne legal environment for recovery of defaulted loans. Wilful default~ priority sector problems among the poor etc are also responsible.
High levels of NPAs means: banks' profitability diminishes; precious capital is locked up; cost of borrowing will rise as lendable assets shrink: stock prices of banks will go down and investors will lose: investment suffers etc.
NP As are classi fied as sub-standard:doubtful and loss making assets for provisioning requirements.
The following are the RBI guidelines for NP As classification and provisioning: Sub Standard Assets - These are those accounts which have been classi lied as NP As for a period less than or equal to 18 months.
Doubtful Assets -These are those accounts \'vhich have remained as NPAs for a period exceeding 18 months.
Loss Assets - In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value. But a loss asset has not been vvritten off, wholly or partly.
What is being done
provisioning
CAR norms
securitizatign law
foreclosure norms
one time settlement
interest waiver
writeoffs
debt recovery tribunals
Foreclosure means taking over by the lender of the mortgaged property if the borrower does not conform to the terms of mortgage.
Securitization is the process of pooling a group of assets. such as loans or mortgages, and selling securities backed by these assets
SARFAESI Act 2002
to expedite recovery of loans and bring down the non-performing asset level of the Indian banking and financial sector, the government in 2002 made a new law that promises to make it much easier to recover bad loans from willful defaulters. Called the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (SARFAESI), the law has given unprescedented powers to banks, financial institutions and asset reconstruction/securitization companies to take over management control of a loan defaulter or even capture its assets.
Asset Reconstruction Company
Normally banks and FIs themselves recover the loans. But in the case of bad debts (sticky loans), it is outsourced to the ARCs who have built-in professional expertise in this task and who handle recovery as their core business. ARCs buy bad loans from banks and try to restructure them and collect them. Ares were recommended by Narasimham committee II. ARCIL-the first asset reconstruction company was set up recently.
Prudential Norms
Prudential norms relate to
income recognition
asset classification
provisioning for NPAs
capital adequacy norms (capital to risk-weighted asset ratio, CRAR.
A proper definition of income is essential in order to ensure that banks take into account income that is actually realized (received). It helps in classifying an asset as NPA in certain cases. Once classified as NPA, funds must be set apart to balance the banks's operations so as to maintain safety of operations in case of non-recovery of NPAs. Thus, income recognition, asset classification and provisioning norms are inter-related.
Prudential norms make the operations transparent, accountable and safe.
Prudential norms serve two primary purposes: bring out the true position of a bank's loan portfolio and help in prevention of its deterioration.
Basel Norms
Banks lend to different types of borrowers and each carries its own risk. They lend the deposits of public as well as money raised from the market-equity and debt. The intermediation activity exposes the bank to a variety of risk. Cases of big banks collapsing. due to their inability to sustain the risk exposures are readily available. Therefore, banks have to keep aside a certain percentage of capital as security against the risk of non-recovery. Bsel committee provided the norms called Basel norms to tackle the risk.
Capital to Risk Weighted Assets Ratio (CRAR) as given by the Basel committee mandates CRAR at 9% of the risk weighted assets. It is the capital is required to be set aside for absorbing risks. It is not to be provisioned from deposits raised but has to be additionally provided from debt, equity, reserves etc.
For the public sector banks. when they could not set aside finances in compliance of prudential norms, Government recap.italised them (lent them money).
In 1988 Basel committee gave the first set of norms (Basel I) and presently the Basel II norms are being complied with by Indian banks as follows:
by 2008- foreign banks and Indian banks with overseas operation and
by 2009 other Indian banks except local area banks and RRBs.
Basel 2 norms are 8% of CRAR.RBI made it 9% for greater security.
India adopted basel I norms in 1992 as a part of launch of economic reforms.
One of the problems perceived in Basel I norms was that all sovereign debt, in general, was given a risk weight of zero, while all corporate debt was given similarly an equal weight irrespective of the difference in risk of the corporate concerned.
The risk weights led to some cJlrious behaviour in lending. Banks started preferring to lend to governments. which required no capital addition. while even risk-free corporates. which had good rating. demanded additional capital provisioning under adequacy norms. Thus, one size fits all approach brought in distortions in lending.
Basel Committee revised Basel 1 norms and announced Basel2 norms in 2004.
Basel II
Basel-II aims to strengthen Basel I.
Not only credit risk but also market risk and operational risk are covered.
Credit risk
A bank always faces the risk that some of its borrowers may not repay loan, interest or both. This risk is called credit risk, whci varies from borrower to borrower depending on their credit quality. Basel II requires banks to accurately measure credit risk to hold sufficient capital to cover it.
Market risk
As part of the staturory requirement, in the form of SLR (statutory liquidity ratio). banks are required to invest in liquid assets such as cash, gold, government and other approved securities. For instance, Indian banks are required to invest 24% of their net demand and term liabilities in cash, gold, government securities and other eligible securities to complay with SLR requirements (2008-09).
Such investments are risky because of the change in their prices. This volatility in the value of a bank's investment portfolio in known as the market risk. as it is driven by the market.
Operational risk
Several events that are neither due to default by third party non because of the vagaries of the market. These events are called operational risks and can be attributed to internal system, processes, people and external factors.
Basel II uses a "three pillars" concept:
Pillar I Specifies new standards for minimum capital requirements, along with the methodology for assigning risk weights on the basis of credit risk and market risk; and operational risk.
Pillar 2 Enlarges the role of banking supervisors and gives them power to them to review the banks's risk management systems.
Pillar 3 Defines the standards and requirements for higher disclosure by banks on capital adequacy, asset quality adn other risk management processes.
Capital - Tier 1 And Tier 2
Capital dequacy norms divide the capital into two categories. Tier one capital is used to absorb losses while the Tier 2 capital is meant to be used at the time of winding up:
Tier I Capital: Actual contributed equity plus retained earnings.
Tier II Capital: Preferred shares plus 50% of subordinated debt (junior debt)
Subordinated debt figures between bebt and equity - coming after the first in terms of eligibility for benefits like compensation.
Recapitalization is lending to the bank the resources needed to conform to the capital adequacy norms which stand at 8% today - minimum level.
Shadow banks
NBFCs are largely refered to as shadow banking system or the shadow financial system. They have become the major financial intermediaries. As seen the note on NBFCs elsewhere, shadow institutions do not accept demand deposits and therefore are not subject to the same regulations. Familiar examples of shadow institutions included Bear Sterns and Lehman Brothers. Hedge funds, pension funds, mutual funds and investment banks are some examples.
Shadow institutions are not as effectively regulated as banks and so carry higher risk of failure.
BIS
The Bank for International Settlements (BIS) is an international organization of central banks which fosters international monetary and financial cooperation and serves as a bank central banks." It also provides banking services, but only to central banks, or to international organization. Based in Basel, Switzerland, the BIS was established by the Hague agreements of 1930.
As an organization of central banks, the BIS seeks to make monetary policy more predicatable and transparent amonng its 55 member central banks. The BIS main role is in setting capital adequacy requirements to safeguard bank's operations.
Universal Banking in india
Universal banking in India was recommended by the second narasimham Committee (1998) and the Khan Committee (1998) reports. It aims at widening and integration of financial activities.
Universal Banking is a multi-purpose and multi-functional financial supermarket. 'Universal banking' refers to those banks that offer a wide range of financial services, beyond the commercial banking functions like Mutual Funds. Merchant Banking. Factoring. Credit Cards. Retail loans, Housing Finance. Auto loans, Investment banking, Insurance etc. this is most common in European countries.
Benefits to banks from universal banking are that, since they have competence in the related areas, they can reduce average costs and thereby improve spreads (difference between cost of borrowing and the return on lending) by diversification. Many financial services are inter-linked activities, e.g. insurance stock broking and lending. A bank can use its instruments in one activity to exploit the other, e.g., in the case of project lending to the same firm which has purchased insurance ffrom the bank. To the customers, 'one - stop - shoping' saves transaction costs.
However, one drawback is that universal banking leads to a loss in specialisation. There is also the problem of the bank indulging in too many risky activities. ICICI (Industrial Credit and Investment Corporation of India) merged with its subsidiary-ICICI Bank in a reverse merger( parent merging with the slIhsidiary. the ICICI Bank). Other banks are also· emerging as universal banks which are popular in Europe.
The compulsions for the DEls like ICICI, IDBI, IFCI etc to become UBs is the following:
Earlier in the sixties and seventies, the pFIs specialized in project finance for the industries \vith long term capital needs. But the industries of late are mobilizing the finances from external sources or from the stock market and so the DFI business suffered. The cheap Gov.ernment funds that were available in the earlier pre-liberalization era also are not available today.Banks and DFIs are having to compete for the same clients. Banks have an advantage in that they have a deposit base but the OFls do not have same.
Financial inclusion
Many people, particularly those living on low incomes, cannot access mainstream financial products such as bank accounts and low cost loans. This financial exclusion foreces them to borrow from the moneylenders at high cost. Therefore, financial inclusion has been the goal of government's policy since late sixties.
Financial inclusion or taking banking services to the common man was the main driver of bank nationalization in 1969 and 1980 powered by three priority areas
access to banking
access to affordable credit. and
access to free face-to-face money advice
Thus, financial inclusion is the delivery of banking services at an affordable cost to the vast sections of disadvantaged and low-income groups. The Government of India's rationale for creating Regional Rlural Banks (RRBs) in the years in 1975 following the nationalization of the country's banks was to ensure that banking services reached poor people.
The branches of commercial banks and the RRBs grew from 8.321 in 1969 to 68,282.
Priority sector credit under which 40% of all bank advances should go to certain specified areas like agriculture is a form of directed credit that is aimed at financial inclusion.
Micro-finance (savings, insurance and lending in small quantities) and self-help groups are another innovation in financial inclusion.
Differential rate of interest: kisan credit cards; no - frills account (allowing opening of account with very little or no minimum balances) etc are examples of financial inclusion.
Scaling-up access to finance for India's rural poor, to meet their diverse financial needs (savings, credit, insurance, etc.) through flexible products at competitive prices is the goal of financial inclusion.
The total number of no-frill accounts opened over a two-year period (April I. 2007 to May 30,2009) stands at 25.1 million.
While it is beyond doubt that financial acess of people has significantly improved in the last three-and-a-hald decades, and even more so in the last two years, the focus now should be on how to accelerate it as financial inclusion inclusion is important for economic growth, equity and poverty alleviation.
Unique identification number has some advantages for financial inclusion
KYC (know your customer) bottlenecks will be dramatically reduced. Millions of new customers will become bankable. Growth will get a boost. Risk management will undergo a'paradigm shift. Credit histaries will be available on tap. Profitability will improve and so will customer service. We could finall) have a technology initiative to extend financial inclusion.
Bank consolidation
Merging public sector banks to form big and globally aspiring bank is bank consolidation. It is expected to bring about financial stabilit)- and was recommended by the Narasimham Committee-Il (1997) on financial sector reform.
SBI merger with its smallest associate, the State Bank of Saurashtra has been achieved and the remaining six are to be merged. Government says that bigger banks can take on competition; can raise more than smaller banks;
Rationalising the manpower and branch network after bank mergers is a challenge and the criticism also includes that the bigger banks will be so much more bureaucratized. Bigness also does not reduce chances of failure as seen int he west in the current meltdown.
India has more than 175 commercial banks, out of which 28 state-run banks account for the majority of the banking sector's assets followed by private sector banks and foreign banks, which have a tiny share.
Financial stability
Financial stability is a situation where the financial system operates with no serious failures or undesirable impacts on development of the economy as a whok. while shmving a high degree of resilience to shocks.
Financial stability may be disturbed both by processes inside the financial sector leading to the emergence of weak spots like excessive of leverage: dealing in doubtful products like collateralized debt options(CDS) etc. It can also he undermined through regulatory lapses and inadequate safeguards prescribed by law.
In India, the banking system was not impacted badly by the world financial crisis as Indian banks are well-regulated through proper supervision. They are also well capitalized through capital adequacy ratio according to the Bank of International Settlements (Basel. Switzerland).
Calibrated globalizat.ion also meant that we would open upon only on achieving the strength to compete successfully.
Words
PLR
Prime Lending Rate (PLR) is the rate at which banks lend to the best customers. About 15% today (2009)
Basis point
Changes in interest rates and other variables are expressed in terms of basis points to magnify and express the importance of changes. One basis point is 1% of 1%.
Weak Bank - Narasimham Committe - II
A 'Weak Bank' has been defined by the committee as follows: Where a total accumulated loses of the bank and net NPA amount exceed the net worth of the bank.
Narrow banking
For restoring weak banks to strength, restructuring is needed. Such restructuring is generally attempted by operating the banks(s) as narrow bank(s). among other things. Narrow banking would restrict banks to holding liquid and safe government bonds. It prevents bank run.
Bank run
A bank run is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank fear it is insolvent and withdraw their deposits.
Subordinated debt
It is also known as junior debt. It is a finance term to describe debt that is unsecured or has a lesser priority than that of other debt claim on the same asset. This means that if the party that issued the debt decaults on it, people holding subordinated debt get paid after the holders of the "senior debt". A subordinated debt there fore carries more risk than a normal debt, Subordinated debt has a higher expected rate of return than senior debt due to the increased inherent risk.