BANKING SYSTEM

(ASSIGNMENT FOR MONEY AND BANKING)

BY
AAYUSH MISHRA(189064)
ARNUV JOSHI(189056)
DIKSHIL JAIN(189030)
HARMANPREET SINGH(189063)
SHUBHAM JHA(189059)

SUBMITTED TO:
MS. KAJLEEN KAUR
BANKING SYSTEM
(INTRODUCTION,ISSUES IN INDIA AND BASEL NORMS)

Banks are a huge part of our lives. We deposit our paychecks, take out loans, and set up saving accounts,
all at a bank. But what do banks do? What are the different types of banks? Let’s start finding some
answers to these questions by looking at the different types of banks that make up a banking system.

Definition: A bank is a financial institution licensed to receive deposits and make loans.

 WHAT IS A BANKING SYSTEM

A banking system is a group or network of institutions that provide financial services for us. These
institutions are responsible for operating a payment system, providing loans, taking deposits, and helping
with investments.

Structure of Banking System in India

RBI: The RBI is the supreme monetary and banking authority in the country and controls the banking
system in India. It is called the Reserve Bank’ as it keeps the reserves of all commercial banks.
There are two broad categories under which banks are classified in India:
1) Scheduled banks: Banks which have been included in the second scheduled of the RBI Act, 1934.
2) Non-scheduled banks: The banks which are not included in the list of the scheduled banks are
called the Non-Scheduled Banks.
Schedule banks needs to deposit CRR fund with RBI and non scheduled banks need to maintain CRR
fund but there is no compulsion to deposit it with RBI.
The scheduled banks include
a) Commercial banks: A commercial bank is a type of bank that provides services such as accepting
deposits, making business loans, etc.
b) Cooperative banks: A bank that holds deposits makes loans and provides other financial services
to cooperatives and member-owned organizations.
The commercial banks include
i) Regional rural banks: They have been created with a view of serving primarily the rural areas of
India with basic banking and financial services.
ii) Small finance bank: Small finance banks are a type of niche banks in India. Banks with a small
finance bank license can provide basic banking service of acceptance of deposits and lending.
iii) Foreign banks
iv) Private sector banks: Private shareholders hold majority stakes in private sector banks. Reserve
Bank of India lays down all the rules and regulations.
v) Public sector banks: These banks for more than 75% of the total banking business in the nation.
They are called nationalized banks. The government holds the majority stakes at these banks.
 vi) Payments bank: This is a new and upcoming model of banking in India. It has been conceptualized
and signed-off by RBI with restricted operations. Maximum of Rs. One Lakh is acceptable per
customer by these banks. Like other banks, they also offer Para-banking services like ATM cards,
Debit- Credit cards, net-banking, mobile banking etc.
Cooperative banks: Run by the elected members of a managing committee and registered under the
Cooperative Societies Act, 1912 are the cooperative banks. These are no-profit, no-loss banks and mainly
serve entrepreneurs, industries, small businesses, and self-employment.

 FUNCTIONS
Banking system perform several different functions, depending on the network of institutions. For
example, payment and loan functions at commercial banks allow us to deposit funds and use our
checking accounts and debit cards to pay our bills or to make purchases. They can also help us finance
our cars and homes.
The economic functions of banks include:
1. Issue of money in the form of bank notes and current account subject to cheque or payment at
the customer’s order. These claims on banks can act as money because they are negotiable or
repayable on demand, and hence valued at par.

2. Netting and settlement of payments – banks act as both collection and paying agents for
customers, participating in interbank clearing and settlement systems to collect, present, be
presented with, and pay payment instruments. This enables banks to economize on reserves held
for settlement of payments, since inward and outward payments offset each other. It also enables
the offsetting of payment flows between geographical areas, reducing the cost of settlement
between them.
3. Credit intermediation – banks borrow and lend back-to-back on their own account as middle men.
4. Credit quality improvement – banks lend money to ordinary commercial and personal borrowers
(ordinary credit quality), but are high quality borrowers. The improvement comes from
diversification of the bank's assets and capital which provides a buffer to absorb losses without
defaulting on its obligations. However, banknotes and deposits are generally unsecured; if the
bank gets into difficulty and pledges assets as security, to raise the funding it needs to continue to
operate, this puts the note holders and depositors in an economically subordinated position.
5. Asset liability mismatch/Maturity transformation – banks borrow more on demand debt and short
term debt, but provide more long term loans. In other words, they borrow short and lend long.
With a stronger credit quality than most other borrowers, banks can do this by aggregating issues
(e.g. accepting deposits and issuing banknotes) and redemptions (e.g. withdrawals and
redemption of banknotes), maintaining reserves of cash, investing in marketable securities that
can be readily converted to cash if needed, and raising replacement funding as needed from
various sources (e.g. wholesale cash markets and securities markets).
6. Money creation/destruction – whenever a bank gives out a loan in a fractional-reserve banking
system, a new sum of money is created and conversely, whenever the principal on that loan is
repaid money is destroyed.

MAJOR REFORMS POST THE 1991 LIBERALISATION THAT LEAD TO BETTER PERFORMANCE OF BANKING
SECTOR IN INDIA
1. Licensing private sector banks to increase competition
2. FDI+FII up to 74% allowed in private sector banks.
3. Listing of PSBs on stock exchanges and allowing them to access capital markets for augmenting
their equity,subject to maintaining Government shareholding at a minimum of 51%.Private
shareholders represented on PSBs.
4. Progressive reduction in statuatory requirements of SLR and CRR to induce greater credit
expansion towards private sector.
5. Deregulation of a complex structure of deposit and lending interest rates improve allocative
efficiency and strengthen the transmission of monetary policy.
6. Introduction of Base Rate
7. Other-Use of IT to increase efficiency,KYC and Anti Money Laundering(AML) Norms,improvement
in risk management culture.

ISSUES AND CHALLENGES WITH BANKING SYSTEM IN INDIA

These are some of the challenges faced by the Indian Banking System
1. Ownership of the Bank - Public or Private

Private ownership, on one hand, brings competition, professionalism and operational efficiency whereas
Public ownership makes it easier to pursue social objectives such as mass banking, financial inclusion etc.
Private banks have comparatively greater freedom in terms of recruitment, salary and compensation
compared to PSBs, which are perceived to offer more job security with lower employee turnover

2. Consolidation of Banks

The second issue deals with mergers and consolidation of Indian Banks to form larger institutions.

Consolidation assumed significance after the introduction of financial reforms. SInce the first round of
nationalisation of banks in 1969, there have been a total of 41 mergers and amalgamation. Of these, 24
happened after the onset of reforms in 1991.
Consolidation will help with creating a larger capital base, which means larger financing for
projects. Larger institutions also achieve cost efficiency through economies of scale and scope.
Meanwhile, it creates a moral hazard with the banks being Too Big To Fail, which has an adverse effect on
financial stability. It could also pose other problems like monopolisation.

3. Size of Banks - Large or Small

Consolidation leads us to the advantages and disadvantages of having a large bank vs a small bank.
Large banks benefit from economies of scale as well as scope, leading to economic efficiency, increase in
capacity( so that they can meet the huge funding requirements of the infra sectors), diversity and global
support.
This also has the drawback that the larger banks can use their power to dilute competitions, which is not
health for a financially stable environment.

Small banks have comparative advantage in the supply of credit to small business units and other
unorganised sectors.
They are flexible enough to cater to unbanked areas and meet localised needs.
They require less infrastructure, staff and are low on expenses, due to which failure does not result in
systematic risk.
On the other hand, small banks are vulnerable to sector concentration risk since they rely on specific
lending areas.
Also, they can't finance infra projects as they are influenced by big banks and require humongous
amounts of funding.

4.Licensing Policy
India follows a universal bank licensing regime and issues licenses under section 22 of banking Regulation
Act, of 1949. Over time, India has licensed multiple banks under various different minimum capital
requirement. In terms of licensing of foreign banks, India follows the commitments under WTO to allow
12 branches per year for foreign banks.
Development Financial Institutions (DFIs) established to meet long-term demands for funds for industrial
projects were never required a license to function. They had access to low cost funds from RBI and other
agencies, and they issue bonds which qualified for SLR requirements. The functions and prominence of
DFIs has reduced significantly over time due to rise in competition from banks offering funds at lower
rates. Operational guidelines for enabling a DFI to convert to a universal bank were issued in 2001.
Specialised entities have expertise in risk assessment and structuring of infrastructure finance. Employing
their core competency for enhancing productivity can result in reduced intermediation cost, better price
discovery and improved allocative efficiency. With differentiated licenses, we can get around issues of
conflict of interest that arise when a bank performs multiple functions. One can view this argument in
light of speciales banks being prone to concentration risk because of narrower business models. Also a
universal bank will be able to cross subsidise across sectors.
5.Investment Banking
An investment bank is an entity providing services like asset management, capital raising, trading in
securities, portfolio management, merchant banking, underwriting, broking, those offering business and
financial advisory services. With the advent of US Financial crisis, investment banks are usually looked at
with great scepticism, since it was their mismanagement and over leveraging that resulted into worsening
of global economy. Such entities are absent in India till date.
But what we really need to ask ourselves is that do we actually require institutions of pure investment
type which help in corporate banking and capital arrangements specially when Indian corporation are
themselves going global. We still need to deliberate a long way to develop an understanding on this
matter before we can implement it.

6.Financial Sector Legislative Reforms Commission (FSLRC)

The objective of constituting FSLRC was to redefine the rules of legislation. It proposes new scheme of
regulation with introduction of new institutions and bodies namely:
 Unifies Financial Authority (UFA)
 RBI
 Financial Sector Appellate Tribunal
 Financial Redressal Agency
 Financial Sector Development Council
 Public Debt Management Agency
FSLRC endorses the view that RBI should restrict its functions towards monetary policy and traditional
central banking activity and give away the rest to the new institutions. It implies unique and
unoverlapping roles to each of the 6 bodies.
But given the deep interlink ages of NBFCs with banking system and excessive intermediation by
these shadow banks during 2008, serious regulatory concerns have been raised for which RBI should
also be the regulator of non-banking institutions.

7.Non-Operative Financial Holding Companies

RBI had constituted a Working Group in 2010 to study the different holding company structures
internationally and to indicate a roadmap for adoption of the holding company structure in India.
New Banks in the private sector would be setup under NOFHC and registered as a non-banking
financial company. This was done keeping in mind the objective of formation of a NOFHC that will act
as an investment company for the Government, and will also hold a major portion of the Govt’s
shareholding in all PSBs and to raise long term debt from domestic and international markets to
infuse equity into PSBs.

8.Subsidiarisation of Foreign Banks

Since Foreign banks only operate through branches in India, the proposals are in favour of allowing
foreign banks to set up wholly owned subsidiaries of foreign banks in India. Local incorporation of
foreign banks will cause the following benefits:
Ring fenced capital within the host country
Easier definition laws to which jurisdiction apply
Better corporate governance, local board of directors
Effective control in a banking crisis and enabling host country authorities to act more
independently as against branch operations
Regulatory comfort
A potent risk is that of domination by these foreign banks over their Indian counterparts. This process of
subsidiarisation requires alteration in domestic laws like Income Tax Act for exempt of capital gains tax.
Issues related to conversion of foreign bank branches into wholly owned subsidiaries, mainly of a legal
nature, like transfer of rights and liabilities, finality of a transfer, etc. which are under examination of the
Reserve bank.
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 inter mediation activity exposes the bank
to a variety of risks. 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. Basel committee has produced norms called Basel Norms for Banking to
tackle the risk.
Basel Norms are Banking Supervision Accords/Regulations which are issued by the BCBS.

BASEL 1

 Basel I, followed by Basel II and III, laid framework for banks to mitigate risk as outlined by law.
 Basel I is considered too simplified, but was the first of the three "Basel accords."
 Banks are classified according to risk, and are required to maintain emergency capital based on
that classification.
 According to Basel I, banks are required to keep capital of at least 8% of their determined risk
profile on hand.
Assets of banks were classified and grouped into five categories according to credit risk,
carrying risk weights of:

 0% (for example cash, home country debt like Treasuries),

 20% (securitizations such as MBS rated AAA)
 50%,
 100% (for example, most corporate debt), and
 Some assets are given no rating

India adopted Basel 1 guidelines in 1999. The twin

Objectives of Basel I was:

1. To ensure an adequate level of capital in the international banking system

2. To create a more level playing field in the competitive environment

BASEL 2
Basel II is an international business standard that requires financial institutions to maintain enough cash
reserves to cover risks incurred by operations. The Basel accords are a series of recommendations on
banking laws and regulations issued by the Basel Committee on Banking Supervision (BSBS).
The three essential requirements of Basel II are:
1) Mandating that capital allocations by institutional managers are more risk sensitive.
 2) Separating credit risks from operational risks and quantifying both.
3) Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or
economic risk precisely with regulatory assessment.

BASEL NORMS AND INDIA

Basel III or Basel 3 released in December 2010 is the third in the series of Basel Accords. These guidelines
were introduced in response to the financial crisis of 2008. These accords deal with risk management
aspects for the banking sector. In a nutshell, we can say that Basel III is the global regulatory standard
(agreed upon by the members of the Basel Committee on Banking supervision) on bank capital adequacy,
stress testing, and market liquidity risk.

BASEL 3
Objectives/aims of the Basel III:

 Improve the banking sector's ability to absorb shocks arising from financialand
economic stress, whatever the source
 Improve risk management and governance
 Strengthen banks' transparency and disclosures

Pillars of the Basel Norms for Banking

1. Pillar 1
Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs): Maintaining capital
calculated through credit, market and operational risk areas.
2. Pillar 2:
Supervisory Review Process: Regulating tools and frameworks for dealing with peripheral risks that banks
face.
3. Pillar 3:
Market Discipline: Increasing the disclosures that banks must provide to increase the transparency of
banks

The Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II or
the Major Features of Basel III:

Better Capital Quality: One of the key elements of Basel 3 is the introduction of a much stricter definition
of capital. Better quality capital means the higher loss-absorbing capacity. This, in turn, will mean that
banks will be stronger, allowing them to better withstand periods of stress.
Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required to hold a
capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks
maintain a cushion of capital that can be used to absorb losses during periods of financial and economic
stress.
Counter cyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has
been introduced with the objective to increase capital requirements in good times and decrease the
same in bad times. The buffer will slow banking activity when it overheats and will encourage lending
when times are tough i.e.in bad times. The buffer will range from 0% to 2.5%, consisting of common
equity or other fully loss-absorbing capital.
Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for common
equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total
risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but
also other qualifying financial instruments, will also increase from the current minimum of 4% to
6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required
total capital will increase to 10.5% when combined with the conservation buffer.
Leverage Ratio: A review of the financial crisis of 2008 has indicated that the value of many assets fell
quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to
serve as a safety net. A leverage ratio is a relative amount of capital to total assets (not risk-weighted).
This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of
Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new
Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018,
respectively.
Systemically Important Financial Institutions (SIFI): As part of the macro- prudential framework,
systemically important banks will be expected to have loss- absorbing capability beyond the Basel III
requirements. Options for implementation include capital surcharges, contingent capital, and
bail-in-debt.

BENEFITS OF BASEL NORMS:

 Safer and well protected financial system with lesser systematic risk.
 For immunised economies(less affected by the crisis),it reduces the risks that globalisation
render such as contagion across countries.
 Minimization of costs for banks by retention of maximum amount of earnings initially to
compensate higher lending costs afterwards.
 Maintenance of liquidity positions,fresh capital issue,transperancy and discipline.