UNIT-2

Indian banking system:

ORIGIN AND GROWTH OF BANKING
Economists used to distinguish between commercial banking, investment banking mixed banking
systems. England was the home of the pure commercial banking. Pure commercial banking is one
where commercial banks mobilize deposits is to lend for short periods only. Industries require shortterm capital to purchase raw materials, intermediate products and so on. In England, banking had its
origin with the London goldsmiths who in the 17th century began to accept deposits from merchants
and others for safe-keeping of money and other valuables. As per public enterprise, banking made its
first appearance in Italy in 1157 when the Banks of Venice was founded.
Indian banking came into existence in a small way during 19th century. Some industrialists
established a few banks at that time. In the early years of 20th century the swadeshi movement gave
a stimulus for the setting up of banks in India by Indian national. In the beginning banks faced severe
financial crisis. Particularly during and after the First World War, about 87 banks liquidated. During
great depression in 1930s the bank failure in India was very severe. During 1937-48, as many as 620
banks failed. Thus the development of banking in India before independence was lopsided. It was
characterized as a crop of bank failures.
The Second World War brought a revolutionary change in the Indian banking system. In the wake of
huge war expenditure, deposits of the banks increased. Branches were opened in Public sector and
self-employment was to receive their due share in obtaining bank finance.
Apart from this the banks are required to reconstitute their board of directors. The government set up
National credit council in 1968. The Finance Minister was the chairman and the Governor of the
Reserve Bank was the vice chairman of the council.
The main functions of the National credit council were:
1. Assessing the volume of credit required for the economy as a whole.
2. Providing guidelines for the distribution of credit to the priority sector.
3. Ensuring equitable distribution of credit in the economy.
Without a sound and effective banking system in India it cannot have a healthy economy. The banking
system of India should not only be hassle free but it should be able to meet new challenges posed by
the technology and any other external and internal factors.
For the past three decades India's banking system has several outstanding achievements to its credit.
The most striking is its extensive reach. It is no longer confined to only metropolitans or cosmopolitans
in India. In fact, Indian banking system has reached even to the remote corners of the country. This is
one of the main reasons of India's growth process.
The government's regular policy for Indian bank since 1969 has paid rich dividends with the
nationalization of 14 major private banks of India.
Not long ago, an account holder had to wait for hours at the bank counters for getting a draft or for
withdrawing his own money. Today, he has a choice. Gone are days when the most efficient bank
transferred money from one branch to other in two days. Now it is simple as instant messaging or
dials a pizza. Money has become the order of the day.
The first bank in India, though conservative, was established in 1786. From 1786 till today, the journey
of Indian Banking System can be segregated into three distinct phases. They are as mentioned
below:
Early phase from 1786 to 1969 of Indian Banks
Nationalization of Indian Banks and up to 1991 prior to Indian banking sector Reforms.
New phase of Indian Banking System with the advent of Indian Financial & Banking Sector
Reforms after 1991.
To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II and
Phase III.
Phase-I
The General Bank of India was set up in the year 1786. Next came Bank of Hindustan and Bengal
Bank. The East India Company established Bank of Bengal (1809), Bank of Bombay (1840) and Bank
of Madras (1843) as independent units and called it Presidency Banks. These three banks were
amalgamated in 1920 and Imperial Bank of India was established which started as private
shareholders banks, mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab National Bank
Ltd. was set up in 1894 with headquarters at Lahore. Between 1906 and 1913, Bank of India, Central
Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. Reserve
Bank of India came in 1935.
During the first phase the growth was very slow and banks also experienced periodic failures between
1913 and 1948. There were approximately 1100 banks, mostly small. To streamline the functioning
and activities of commercial banks, the Government of India came up with The Banking Companies
Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act
No. 23 of 1965). Reserve Bank of India was vested with extensive powers for the supervision of
banking in India as the Central Banking Authority.
During those days public has lesser confidence in the banks. As an aftermath deposit mobilization
was slow. Abreast of it the savings bank facility provided by the Postal department was comparatively
safer. Moreover, funds were largely given to traders.
Phase II
Government took major steps in this Indian Banking Sector Reform after independence. In 1955, it
nationalized Imperial Bank of India with extensive banking facilities on a large scale especially in rural
and semi-urban areas. It formed State Bank of India to act as the principal agent of RBI and to handle
banking transactions of the Union and State Governments all over the country.
Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on 19th July, 1969,
major process of nationalization was carried out. It was the effort of the then Prime Minister of India,
Mrs. Indira Gandhi. 14 major commercial banks in the country were nationalized.
Second phase of nationalization Indian Banking Sector Reform was carried out in 1980 with seven
more banks. This step brought 80% of the banking segment in India under Government ownership.
The following are the steps taken by the Government of India to Regulate Banking Institutions in the
Country:
1949: Enactment of Banking Regulation Act.
1955: Nationalization of State Bank of India.
1959: Nationalization of SBI subsidiaries.
1961: Insurance cover extended to deposits.
1969: Nationalization of 14 major banks.
1971: Creation of credit guarantee corporation.
1975: Creation of regional rural banks.
1980: Nationalization of seven banks with deposits over 200 crore.
After the nationalization of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%.
Banking in the sunshine of Government ownership gave the public implicit faith and immense
confidence about the sustainability of these institutions.

Phase III
This phase has introduced many more products and facilities in the banking sector in its reforms
measure. In 1991, under the chairmanship of M. Narasimham, a committee was set up by his name
which worked for the liberalization of banking practices.
The country is flooded with foreign banks and their ATM stations. Efforts are being put to give a
satisfactory service to customers. Phone banking and net banking is introduced. The entire system
became more convenient and swift. Time is given more importance than money.
The financial system of India has shown a great deal of resilience. It is sheltered from any crisis
triggered by any external macroeconomics shock as other East Asian Countries suffered. This is all
due to a flexible exchange rate regime, the foreign reserves are high, the capital account is not yet
fully convertible, and banks and their customers have limited foreign exchange exposure.
MEANING AND FUNCTIONS OF BANKS
Meaning of Bank:
An institution/organization, usually a corporation, chartered by a state or federal government, which
does most or all of the following: receives demand deposits and time deposits, honors instruments

drawn on them, and pays interest on them; discounts notes, makes loans, and invests in securities;
collects checks, drafts, and notes; certifies depositor's checks; and issues drafts and cashier's checks.
According to Kinley, A bank is an establishment which makes to individuals such advances of
money as may be required and safely made, and to which individuals entrust money when not
required by them for use.
According to the Indian companies Act, 1949, banking means the accepting for the purpose
of Indian Companies lending or investment, of deposit of money from the public, repayable on
demand or otherwise, and withdrawable by cheque, draft or otherwise.
According to Kent Bank is an organization whose principle operations are concerned with
the accumulation of the temporarily idle money of the general public for the purpose of
advancing it to others for expenditures.
In the words of Sayers A Bank is an institution whose debts (bank deposits) are widely
accepted in settlement of other people debts to each other.
Functions of Commercial Banks
The functions of commercial banks are divided into two categories:
1. Primary functions, and
2. Secondary functions including agency functions.
1. Primary functions:
The primary functions of a commercial bank include:
a) Accepting deposits; and
b) Granting loans and advances;
a) Accepting deposits
The most important activity of a commercial bank is to mobilize deposits from the public. People who
have surplus income and savings find it convenient to deposit the amounts with banks. Depending
upon the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the
bank grow along with the interest earned. If the rate of interest is higher, public are motivated to
deposit more funds with the bank. There is also safety of funds deposited with the bank. The banks
maintain different types of account:
Current Deposit Account: Current deposit accounts are generally maintained by the traders and
business, which have to make a large numbers of financial transactions. It is also called demand
deposit, current deposit can be withdrawn by the depositor at any time by cheques. Businessmen
generally open current accounts with banks. Current accounts do not carry any interest as the amount
deposited in these accounts is repayable on demand without any restriction. 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.
Savings deposit/Savings Bank Accounts
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.
Fixed deposit
The term Fixed deposit means deposit repayable after the expiry of a specified period. Since it is
repayable only after a fixed period of time, which is to be determined at the time of opening of the
account, it is also known as time deposit. 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.
Recurring Deposits
Recurring Deposits are gaining wide popularity these days. Under this type of deposit, the depositor is
required to deposit a fixed amount of money every month for a specific period of time. Each

installment may vary from Rs.5/- to Rs.500/- or more per month and the period of account may vary
from 12 months to 10 years. After the completion of the specified period, the customer gets back all
his deposits along with the cumulative interest accrued on the deposits.
Miscellaneous Deposits
Banks have introduced several deposit schemes to attract deposits from different types of people, like
Home Construction deposit scheme, Sickness Benefit deposit scheme, Children Gift plan, Old age
pension scheme, Mini deposit scheme, etc.
b) Grant of loans and advances
The second important function of a commercial bank is to grant loans and advances. Such loans and
advances are given to members of the public and to the business community at a higher rate of
interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and
advances varies depending upon the purpose, period and the mode of repayment. The difference
between the rate of interest allowed on deposits and the rate charged on the Loans is the main source
of a banks income.
i) Loans
A loan is granted for a specific time period. Generally, commercial banks grant short-term loans. But
term loans, that is, loan for more than a year, may also be granted. The borrower may withdraw the
entire amount in lump sum or in installments. However, interest is charged on the full amount of loan.
Loans are generally granted against the security of certain assets. A loan may be repaid either in lump
sum or in installments.
ii) Advances
An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense
that loans may be granted for longer period, but advances are normally granted for a short period of
time. Further the purpose of granting advances is to meet the day to day requirements of business.
The rate of interest charged on advances varies from bank to bank. Interest is charged only on the
amount withdrawn and not on the sanctioned amount.
Modes of short-term financial assistance
Banks grant short-term financial assistance by way of cash credit, overdraft and bill discounting.
a) Cash Credit
Cash credit is an arrangement whereby the bank allows the borrower to draw amounts up to a
specified limit. The amount is credited to the account of the customer. The customer can withdraw this
amount as and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit
is granted as per agreed terms and conditions with the customers.
b) Overdraft
Overdraft is also a credit facility granted by bank. A customer who has a current account with the bank
is allowed to withdraw more than the amount of credit balance in his account. It is a temporary
arrangement. Overdraft facility with a specified limit is allowed either on the security of assets, or on
personal security, or both.
c) Discounting of Bills
Banks provide short-term finance by discounting bills, which is, making payment of the amount before
the due date of the bills after deducting a certain rate of discount. The party gets the funds without
waiting for the date of maturity of the bills. In case any bill is dishonoured on the due date, the bank
can recover the amount from the customer.
ii) Secondary functions
Besides the primary functions of accepting deposits and lending money, banks perform a number of
other functions which are called secondary functions. These are as follows a) Issuing letters of credit, travelers cheques, circular notes etc.
b) Undertaking safe custody of valuables, important documents, and securities by providing safe
deposit vaults or lockers;
c) Providing customers with facilities of foreign exchange.
d) Transferring money from one place to another; and from one branch to another branch of the bank.
e) Standing guarantee on behalf of its customers, for making payments for purchase of goods,
machinery, vehicles etc.
f) Collecting and supplying business information;
g) Issuing demand drafts and pay orders; and,
h) Providing reports on the credit worthiness of customers.

Besides these two main activities, commercial banks also render a number of ancillary services.
These services supplement the main activities of the banks. They are essentially non-banking in
nature and broadly fall under two categories:
i) Agency services, and
ii) General utility services.
i) Agency Services
Agency services are those services which are rendered by commercial banks as agents of their
customers.
They include:
a) Collection and payment of cheques and bills on behalf of the customers;
b) Collection of dividends, interest and rent, etc. on behalf of customers, if so instructed by them;
c) Purchase and sale of shares and securities on behalf of customers;
d) Payment of rent, interest, insurance premium, subscriptions etc. on behalf of customers, if so
instructed;
e) Acting as a trustee or executor;
f) Acting as agents or correspondents on behalf of customers for other banks and financial institutions
at home and abroad.
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. These are available to the public on payment of a fee or
charge.
They include:
a) Issuing letters of credit and travelers cheques;
b) Underwriting of shares, debentures, etc.;
c) Safe-keeping of valuables in safe deposit locker;
d) Underwriting loans floated by government and public bodies.
e) Supplying trade information and statistical data useful to customers;
f) Acting as a referee regarding the financial status of customers;
g) Undertaking foreign exchange business.
STRUCTURE OF COMMERCIAL BANKING SYSTEM IN INDIA
Without a sound and effective banking system in India it cannot have a healthy economy. The banking
system of India should not only be hassle free but it should be able to meet new challenges posed by
the technology and any other external and internal factors. For the past three decades India's banking
system has several outstanding achievements to its credit. The most striking is its extensive reach. It
is no longer confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system
has reached even to the remote corners of the country. This is one of the main reasons of India's
growth process.
Indian banking system can be classified into two sectors:
1. Organised Sector.
2. Unorganised Sector.

------------------------------------------BANKING INDUSTRY IN INDIA

Banking in India originated in the last decades of the 18th century. The oldest bank in existence in India is the
State Bank of India, a government-owned bank that traces its origins back to June 1806 and that is the largest
commercial bank in the country. Central banking is the responsibility of the Reserve Bank of India, which in
1935 formally took over these responsibilities from the then Imperial Bank of India, relegating it to commercial
banking functions. After India's independence in 1947, the Reserve Bank was nationalized and given broader
powers. In 1969 the government nationalized the 14 largest commercial banks; the government nationalized the
six next largest in 1980.
Currently, India has 96 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. According to a report by ICRA Limited, a rating agency, the public sector
banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding
18.2% and 6.5% respectively
The primary operations of banks include:

Keeping money safe while also allowing withdrawals when needed

Issuance of checkbooks so that bills can be paid and other kinds of payments can be delivered by post
Provide personal loans, commercial loans, and mortgage loans (typically loans to purchase a home,
property or business)
Issuance of credit cards and processing of credit card transactions and billing
Issuance of debit cards for use as a substitute for checks
Allow financial transactions at branches or by using Automatic Teller Machines (ATMs)
Provide wire transfers of funds and Electronic fund transfers between banks
Facilitation of standing orders and direct debits, so payments for bills can be made automatically
Provide overdraft agreements for the temporary advancement of the Bank's own money to meet
monthly spending commitments of a customer in their current account.
Provide Charge card advances of the Bank's own money for customers wishing to settle credit advances
monthly.
Provide a check guaranteed by the Bank itself and prepaid by the customer, such as a cashier's check or
certified check.
Notary service for financial and other documents

Other types of bank services

Private banking - Private banks provide banking services exclusively to high net worth individuals.
Many financial services firms require a person or family to have a certain minimum net worth to
qualify for private banking services. Private banks often provide more personal services, such as wealth
management and tax planning, than normal retail banks.
Capital market bank - bank that underwrite debt and equity, assist company deals (advisory services,
underwriting and advisory fees), and restructure debt into structured finance products.
Bank cards - include both credit cards and debit cards. Bank Of America is the largest issuer of bank
cards.
Credit card machine services and networks - Companies which provide credit card machine and
payment networks call themselves "merchant card providers".

Functions of Commercial Banks

The functions of a commercial banks are divided into two categories:
i) Primary functions, and
ii) Secondary functions including agency functions.

Primary functions:
The primary functions of a commercial bank include:
a) Accepting deposits; and
b) Granting loans and advances;
a) Accepting deposits
The most important activity of a commercial bank is to mobilise deposits from the public. People who have
surplus income and savings find it convenient to deposit the amounts with banks. Depending upon the nature of
deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow along with the interest
earned. If the rate of interest is higher, public are motivated to deposit more funds with the bank. There is also
safety of funds deposited with the bank.
b) Grant of loans and advances
The second important function of a commercial bank is to grant loans and advances. Such loans and advances
are given to members of the public and to the business community at a higher rate of interest than allowed by
banks on various deposit accounts. The rate of interest charged on loans and advances varies depending upon the
purpose, period and the mode of repayment. The difference between the rate of interest allowed on deposits and
the rate charged on the Loans is the main source of a banks income.
Modes of short-term financial assistance
Banks grant short-term financial assistance by way of cash credit, overdraft and bill discounting.
a) Cash Credit
Cash credit is an arrangement whereby the bank allows the borrower to draw amounts up to a specified limit.
The amount is credited to the account of the customer. The customer can withdraw this amount as and when he
requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted as per agreed terms and
conditions with the customers.
b) Overdraft
Overdraft is also a credit facility granted by bank. A customer who has a current account with the bank is
allowed to withdraw more than the amount of credit balance in his account. It is a temporary arrangement.
Overdraft facility with a specified limit is allowed either on the security of assets, or on personal security, or
both.
c) Discounting of Bills
Banks provide short-term finance by discounting bills, that is, making payment of the amount before the due
date of the bills after deducting a certain rate of discount. The party gets the funds without waiting for the date
of maturity of the bills. In case any bill is dishonoured on the due date, the bank can recover the amount from
the customer.
Secondary functions
Besides the primary functions of accepting deposits and lending money, banks perform a number of other
functions which are called secondary functions. These are as follows
a) Issuing letters of credit, travelers cheques, circular notes etc.
b) Undertaking safe custody of valuables, important documents, and securities by providing safe deposit vaults
or lockers;
c) Providing customers with facilities of foreign exchange.
d) Transferring money from one place to another; and from one branch to another branch of the bank.
e) Standing guarantee on behalf of its customers, for making payments for purchase of goods, machinery,
vehicles etc.
f) Collecting and supplying business information;
g) Issuing demand drafts and pay orders,