Commercial Banks

in India
 Functions of Commercial Banks

There are basically two key functions for the

commercial banks

1. Primary functions
2. Secondary functions
 Functions of Commercial Banks
Primary functions include 
a. Accepting Deposits 
One of the basic objective of banking is to procure
the surplus funds from those who have excess and
distribute it to the sectors where it is necessary.
There are various types of accounts which a
depositor can select as per the convenience. Each
type of account will have different types of interest
rates depending upon the tenure of accounts.
 Functions of Commercial Banks
B. Granting loans and advances
Loans and advances are part of banking
functions.

1. Short term loans: for a period of less than one year 

2. Medium term loans: for a period less than 5 years
and
3. Long term loans: for a period above ten years
 Functions of Commercial Banks
C. Cash Credits
This is a facility of crediting a particular sum of
money or fund to the customer's account, he
or she may choose to withdraw at any point of
time as per their convenience. Interest will be
charged against the money withdrawn.
 Functions of Commercial Banks
D. Overdraft:
This is the facility offers for current account holders
to withdraw in excess of account balance,especially
those customers who has a sound track record. The
interest is charged against the money withdrawn
only.
 Functions of Commercial Banks
E. Discounting of Bills
This is a facility provided by the banks to those
who are in need of immediate financial
support. They may approach the bank with
the corresponding bill or receipt/promissory
note which has a longer expiry. But the bank
could discount it provided they may charge an
interest against that service.
 Functions of Commercial Banks
Apart from the basic functions of accepting
deposits and granting loans to the public
and industries, banks do have other functions
like
Agency & General Utility services :
Such as Payment of Electricity bills on behalf of its customers,
demand drafts, travellers's cheques, bank
guarantees, foreign exchange, locker facility etc
 Evolution of Banking In India

~1947 1947~1991 1991~present

Early Days prior to Nationalization: Social Liberalization: Banking
Independence Control Sector Reform
 Evolution of Banking In India
Prior to Independence, many banks were
formed and failed in the absence of adequate
regulation. After Independence, the Indian
government nationalized banks in order to
build a more inclusive banking sector by
expanding access to banking services for
disadvantaged sectors and regions.
 Evolution of Banking In India

However, the dominant government ownership

significantly weakened the viability of the
sector. Since 1991, the government has been
implementing a series of market-based
reforms in a gradual manner, thereby giving
banks more freedom to run their businesses.
 Banking in the Early Days (~1947)

A large number of small banks with low capital levels were formed
and failed in the absence of adequate regulation.
Types and Roles of Banks
– Commercial banks serving the needs of industry and commerce:
– Joint stock banks and the Imperial Bank of India (which later
became the State Bank of India), exchange banks, and foreign
banks (e.g., HSBC).
– Co-operative banks serving the needs of those who did not
have access to commercial banks.
– Other types of banks including indigenous bankers and loan
companies.
 Banking in the Early Days (~1947)

Major Developments
1850 The Companies Act (the first legislation regulating
banks).
1934 The Reserve Bank of India (“RBI”) Act.
1935 The Reserve Bank of India was established as the
central bank of India. Under the RBI Act, the RBI was
empowered to regulate issuance of bank notes and cash
reserves and act as the lender-of-last-resort.
Nationalization: “Social Control” (1947~1991)

When India became independent in 1947, all

banks were privately owned. However, the
government nationalized 14 commercial banks in
1969 and 6 more banks in 1980. By 1980, the
public sector’s share of deposits rose to 92
percent.
 Nationalization: “Social Control” (1947~1991)

Reasons for Nationalizing Banks

Breaking the Ties between banks and a small number of large
firms that existed during the colonial period.

Expanding Banking Services to rural areas and neglected but

important sectors such as agriculture and small scale industries.

Social Control The concept of “social control” was introduced in

1969 in an effort to expand banking services and allocate
resources to priority sectors by controlling the way banks
manage and allocate credit.
 Nationalization: “Social Control” (1947~1991)
Major Policy Instruments

• Directed Lending Programs to Priority Sectors: The government required

nationalized banks to lend 40 percent of their credit to priority sectors (e.g.,
agriculture and small scale industries).

• Branch Policies: The government required nationalized banks to expand

their branch network according to the prescribed target numbers, and to
establish and support regional rural banks.

• Statutory Preemptions: The government raised the statutory liquidity ratio

(“SLR”) and the cash reserve ratio (“CRR”) (which together often account for
over 50 percent of banks’ credit).
SLR are the reserves that banks must maintain in the forms of cash, gold or other
permitted securities.
CRR is a percentage of cash that must be deposited with the RBI.
 Nationalization: “Social Control” (1947~1991)

• Major Developments
• 1949 The Banking Companies Act provided the RBI with
extensive power to regulate and supervise the banking
sector.
• 1955 The State Bank of India (“SBI”) was established.
• 1959 Eight state banks were established (SBI’s associate
banks).
• 1961 The Deposit Insurance Corporation Act was
enacted.
• 1969 The Nationalization Act was enacted (14 banks
were nationalized).
• 1980 Six additional banks were nationalized.
 Liberalize, But Not So Fast! (1991~Present)

• During the “social control” phase, the banking sector

became more inclusive as more individuals and
entrepreneurs in neglected sectors gained access to
banking services. However, the government’s heavy
control over banks severely undermined the viability of
the sector. Banks had very low levels of capital, and
were neither profitable nor efficient in the absence of
healthy competition.
• In 1991, the balance-of-payments crisis in India
exposed the structural problems in the banking sector,
leading to a comprehensive reform process.
 Liberalize, But Not So Fast! (1991~Present)

Blueprint for Banking Reforms by the Narasimham

Committee
• The government organized two committees
(chaired by M. Narasimham) in 1991 and 1998 that
provided recommendations for banking reforms.
• Based on the recommendations, the government
implemented reform measures in a phased and
gradual manner while ensuring the stability of the
banking sector.
 Liberalize, But Not So Fast! (1991~Present)

• The First Phase of Reform (1991-1998) focused

on providing “operational flexibility” and
“functional autonomy,” as well as adequate
supervision and prudential norms.
• The Second Phase of Reform (1998-Present) has
focused on further strengthening the foundation
and stability of the banking sector to meet the
challenge of global integration of the banking
sector.
 Liberalize, But Not So Fast! (1991~Present)

Major Reform Areas and Measures

• Reducing the Statutory Pre-emptions: By
reducing the CRR and the SLR, the
government provided banks with more
discretion in lending decisions.
Liberalize, But Not So Fast! (1991~Present)

Current: SLR 24%, CRR 6%, Bank rate 6%, Repo Rate 5.75%, reverse repo
4.5%
 Liberalize, But Not So Fast! (1991~Present)

Deregulating Interest Rates: Previously, the RBI set the lending and deposit
rates. By gradually liberalizing interest rates, the government provided
banks with more flexibility to set their deposit and lending rates.
Lowering Entry Barriers to Increase Competition:
Allowing new banks to enter the market: Since 1969, the RBI had not
allowed any new private sector banks to enter the market. In 1993,
however, the RBI introduced new, less restrictive guidelines for creating
a new private sector bank.
Branch authorization policy: In order to provide banks with more
autonomy in opening and closing branches, the RBI changed its branch
authorization policy. For example, banks are free to open branches if
they meet three conditions (i.e., capital adequacy ratio of 9 percent, a
net profit for 3 consecutive years, and less than15 percent of non-
performing assets (“NPA”)).
 Liberalize, But Not So Fast! (1991~Present)

Reducing the Burden of Priority Sector Lending:

While the Narasimham Committee suggested reducing

directed credit from 40 percent to 10 percent, the
government has not changed the target percentage of 40
percent for domestic banks and 32 percent for foreign banks.

However, the government reduced the burden to some extent

by broadening the definition of “priority sector” and
liberalizing interest rates on loans over Rs 200,000.
 Liberalize, But Not So Fast! (1991~Present)

Moving towards International Best Practices:

The RBI issued guidelines to provide prudential norms for income

recognition, asset classification and provisioning for potential loan
losses. Assets with unpaid interest for one year were formally
classified as NPAs in 1992- 1993, but the period was later
shortened to 90 days.

In April 1992, the government adopted the Basel Accord Capital

Standard, and first introduced an 8 percent minimum capital
adequacy ratio for the period between 1993 and 1996 and then
changed to 9 percent in 1999.
 Liberalize, But Not So Fast! (1991~Present)

Reducing the Government Ownership of Banks:

Prior to the partial privatization of the government-owned public sector banks

(“PSBs”), the government began taking steps to improve the viability of PSBs.

In 1991-92 and 1992-93, the government injected nearly Rs 40 billion, and then
Rs 120 billion between1993 and 1999. To reduce the high level of NPAs by
accelerating debt recovery procedures, the Government enacted laws such as
the Recovery of Debt Act under which the Debt Recovery Tribunals were
established.

In 1994, the government allowed PSBs to private ownership up to 49 percent.

However, the government imposed a 10 percent limit on total voting rights
for individual shareholders.
Liberalize, But Not So Fast! (1991~Present)
Levels of Non-Performing Assets

Gross NPA

Net NPA
Current Banking System:
Still Dominated by Government
Banks

As a result of reforms, competition increased

and the health of the banking sector improved
significantly. However, the public sector banks’
assets still accounted for almost 72 percent of
total commercial banking assets as of March
2009.
Current Banking System:
Still Dominated by Government
Banks
 Structure of Scheduled Banks

Scheduled Banks

Sche du le d Sche du le d
C ommer cial B an ks (1 66 ) C oo p er ative Banks

Pub licSec torBa nks(2 7) Pr ivateS ecto rBank s(22)

Foreign Banks Regional Rural

Nationalized Banks (19)
+ IDBI Ltd.
State Bank of India & 6 Associated Banks
(7)
OldPriv ateBan ks(1 5)for medb efore 1994

(31) Ne w P rivate B an ks(7 )

fo rm ed aft er1 9 9 4

Banks (86) Scheduled Urban Cooperative Banks (53) Scheduled State Cooperative Banks (16,)
Current Banking System:
Still Dominated by Government
Banks
Scheduled banks The Scheduled Commercial Banks have been listed
under the Second Schedule of the Reserve Bank of India Act, 1934
by satisfying the two conditions of section 42(6)(a) of the RBI Act of
1934.

1. Maintain a paid-up capital and reserves of not less than Rs 500,000.

2. Satisfy the RBI that their business is not being conducted in a
manner detrimental to the depositors’ interests.

Cooperative banks are major channels that provide financial services

in rural areas. In addition to scheduled cooperative banks, there are
over 97,000 non-scheduled cooperative banks.
 Banking Regulation

The Reserve Bank of India regulates and

supervises the banking sector pursuant to the
RBI Act of 1934 and the Banking Regulation
Act of 1949.

The supervisory power is exercised by the

Board for Financial Supervision (“BFS”).
 Main Areas of Regulation of Commercial Banks

• Branch Authorization Policy: The RBI reviews

branch-opening applications on an annual basis,
and the branch policy also applies to foreign banks.
• Deposit Insurance Scheme: The scheme covers (up
to Rs1,000,000/per depositor) commercial banks
and eligible cooperative banks as defined in the law.
• Statutory Pre-emptions: SLR (25.0%) and CRR
(5.75%) as of March 2010
 Main Areas of Regulation of Commercial Banks

Prudential Norms
Prudential norms relate to income recognition, asset classification, provisioning of
NPAs and capital adequacy ratios( capital to risk weighted asset ratio, CRAR)

Asset Classifications: Banks must classify their assets as 1) standard 2) sub-standard

3) doubtful or 4) loss assets. The last three categories are classified as NPAs.

Provisioning Requirements: Banks must hold capital in provision against potential

losses on outstanding assets (e.g., 10% on sub-standard assets).
Capital Adequacy: The minimum CRAR for banks is set as 9 percent. Since March
2009, all banks have been following the Basel II norms, and they must follow the
basic indicator approach for operational risk and the standardized approach for
credit risk.
 Main Areas of Regulation of Commercial Banks

• Corporate Governance
A single entity or a group cannot own more than 10 percent of
the paid-up capital of a bank in the private sector. A bank must
not own more than 5 percent of shares of another bank in India.
The RBI provides “fit and proper” criteria which a bank must use
to decide whether a person is suitable to be appointed to the
bank’s board of directors.
• Electronic Banking
Only licensed and supervised banks having a physical presence
in India are allowed to provide internet banking to resident
account holders in India (only in local currencies).
 Main Areas of Regulation of Commercial Banks

• Annual Financial Inspection The BFS conducts on-site inspection based on

a modified version of CAMELS ratings (Capital adequacy, Asset quality,
Management, Earnings, Liquidity, and System and control).
Under the “off-site surveillance and monitoring system (“OSMOS”),” banks
are also required to provide quarterly and monthly reports regarding their
capital adequacy and liquidity positions, large exposures, NPAs, etc.

• Financial Conglomerates Banks are allowed to conduct non-traditional

businesses such as insurance and mutual funds by establishing subsidiaries
and affiliates. A parent bank must consolidate all subsidiaries.
The RBI, along with the Securities and Exchange Board of India (“SEBI”)
and Insurance Regulatory and Development Authority (“IRDA”), set up the
“FC monitoring framework” in 2004.
 Main Areas of Regulation of Commercial Banks

• Foreign Banks Foreign banks can operate through a

branch, a wholly-owned subsidiary, or a subsidiary
with aggregate foreign investment up to 74 percent
in a an existing private bank.

Foreign banks can undertake any activities permitted

to Indian banks. There are no restrictions on
establishment of non-banking financial subsidiaries
by a foreign bank or its group companies.
 Future Challenges
• Regulatory Challenges
Enhancing Supervisory Capacity with Limited Resources:
As the Banking sector rapidly grows, the RBI needs more
efficient and less time consuming inspection methods. In this
regard, the RBI has been considering moving from a uniform,
on-site inspection model to a risk-based supervision model
under which supervisory resources are allocated according to
the risk profiles of each bank.
Moving towards Risk-based Deposit Insurance System:
The RBI has also considered moving from a flat rate premium
system to a risk-based premium system. By charging different
premiums based on the risk profiles of banks, a risk-based
system can reduce excessive risk-taking activities. However,
properly quantifying the risks of banks can be challenging.
 Future Challenges
• Regulatory Challenges
Regulating Financial Conglomerates:
The current FC monitoring framework needs to address some
limitations (e.g., no prudential regulations for FCs). Post-crisis, the
government announced that it would establish a “apex-level”
Financial Stability And Development Council (“FSDC”) which
Monitors operation of financial conglomerates and promote inter-
regulatory coordination while preserving the independence of each
regulator.
Cooperating with Overseas Regulators:
The RBI has not entered into a formal agreement with overseas
regulators for supervisory cooperation. However, a road map for
adopting a framework for cross-border supervision and cooperation
with overseas regulators is now under review by the RBI.
 Promoting Financial Inclusion

• Despite the government’s continued efforts to build an

inclusive banking system through measures such as priority
sector lending and establishment of regional rural banks, 2/3
of Indians still do not have a bank account. India is ranked 2nd
in the world in terms of the number of financially excluded
people.
• While expanding access for financially excluded households
and firms will enhance the efficiency of India’s financial
system, it would also be a great source of credit. Indians’
household savings account for nearly 70 percent of the
nation's gross national savings, but currently banks only
access 47 percent of the savings.