FIN 6002 – Session 1- 4

Pradeepta Sethi
TAPMI
 Market Frictions

• The Market for Lemons – George Akerlof (1970)

• Information Asymmetry

• Information is not the same for both the buyer and seller

• Adverse Selection

• Occurs when one side of the market has better information than the other
side and so there is a selection of only high cost or low value being bought or
sold

• Moral Hazard

• Under certain circumstances (Guaranteed of protection) individual will alter

their behavior and take more risks

• Too big to fail

 Market Frictions

• In the presence of information asymmetry

• Adverse selection occurs before the transaction

• The people who are the most undesirable (less credit worthy) from the
bank’s point of view are the ones who are most likely to want to engage in
the financial transaction.

• Moral hazard happens after the transaction

• is the risk (hazard) that the borrower might engage in activities that are
undesirable (immoral) from the lender’s point of view.
 Why we need banks ?

Market Frictions – (Information, Transaction)

Financial Systems

Financial Functions

Channels: Capital Accumulation & TFP

Economic Growth
Source: Levine, R. (1997). " Financial Development and Economic Growth: Views and Agenda." Journal of Economic Literature, 35(2)
 Evolution of banks

¢ 3,900 B.C. - Egypt adopted a banking service utilizing cows as units of exchange

¢ Money lending activity in India could be traced back to the Vedic period, i.e., 2000
to 1400 BC.

¢ Kautilya’s Arthashastra dating back to 400 BC contained references to creditors,

lenders and lending rates.

¢ Modern Banking has European origin.

¢ The word ‘Bank’ is derived either from Old Italian Banca or Middle
French Banque – both meaning a table or bench

¢ A bench for keeping, lending, and exchanging of money or coins in the market
place by money lenders and money changers.

¢ Oldest surviving bank - Monte dei Paschi di Siena - origins in1472 in the Tuscan
city
 History of banking in India

Bank of Hindostan (1770 - 1832)

General Bank of India (1786 - 1791)

Bank of Calcutta (1806) - Bank of Bengal (1809)

Bank of Bombay (1840), Bank of Madras (1843)

Imperial Bank of India (1921)

Reserve Bank of India (1935)

Bank Nationalization (1969)

Entry of Private Banks (1994)

Small Finance & Payment Bank (2014)

 Definition of banks

• “Banking as accepting for the purpose of lending or investment, of deposits

of money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order otherwise.”

- The banking regulation act 1949 Sec 5(b)

• 3 primary activities of a commercial bank

• maintaining deposit accounts including current accounts,

• issue and pay cheques, &

• collect cheques for the bank's customers

 Primary functions of banks
• Accepting deposits

• Current account, Savings account and Fixed deposits

• Advancing loans

• Cash credit, Term loan, Demand loan, Overdraft, Bill discounting

• Creation of credit

• Clearing of cheques

• Financing (foreign) trade

• Letters of Credit, EPC, PCFC

• Remittance of funds
 Maturity Transformation

• Maturity transformation is a key function of banking.

• Borrowing short term and lending long term

• Banks are still called to transfer funds from agents in

surplus demanding short-term deposits to agents in deficit
with long-term financing needs (Hicks, 1946).
Fractional
reserve
banking
BANK DEPOSIT RESERVE LOAN
A 100.00 20.00 80.00
B 80.00 16.00 64.00
C 64.00 12.80 51.20
D 51.20 10.24 40.96
E 40.96 8.19 32.77
F 32.77 6.55 26.21
G 26.21 5.24 20.97
H 20.97 4.19 16.78
I 16.78 3.36 13.42
J 13.42 2.68 10.74
K 10.74 10.74 -
457.05 100.00 357.05
 Types of Commercial Banks
• Scheduled Commercial Banks (SCBs)

• State Bank of India (SBI) – 1 (PSBs)

• Nationalized banks – 11 (PSBs)

• Private sector banks – 22

• Foreign banks – 44

• Regional rural banks (RRBs) – 56 (43) 38

• Small finance banks – 10

• Payment banks – 4 (7), (11)

• Nonscheduled Commercial Banks

 Commercial Banks

¢ Both scheduled and nonscheduled commercial banks are regulated

under Banking Regulation Act, 1949.

¢ Operate on a ‘for profit’ basis.

¢ Primarily engage in the acceptance of deposit and extend loans to the

general public, businesses and the government.
 Scheduled Banks

¢ A bank which is listed in the 2nd Schedule of the Reserve Bank of India Act,
1934.

¢ Eligible for loans from the Reserve Bank of India at bank rate & are also given
membership to clearing houses.

¢ Paid up capital and reserves not less than ₹ 5 lakhs - ₹ 25 lakhs. Now as per
Basel –III requirements.

¢ The list includes State Bank of India (minimum 55% shareholding by central
government), Nationalized Banks (minimum 51% shareholding by central
government), Foreign Banks, Regional Rural Banks & Other Scheduled
Commercial Banks (Private Banks).
 Non-Scheduled Banks

¢ Banks not under the 2nd schedule of R.B.I Act of 1934.

¢ They are not entitled to borrow from the RBI for normal banking purposes,
except, in emergency or “abnormal circumstances”.

¢ Paid up capital and reserves less than ₹ 5 lakhs – ₹ 25 lakhs.

¢ Non–scheduled state cooperative banks e.g. Delhi State Cooperative Bank

Ltd.

¢ Non-scheduled urban cooperative banks e.g. Akhand Anand Cooperative Bank

Ltd., Surat.
 Cooperative Banks

¢ The Banking Regulation Act, 1949 was made applicable to primary co-
operative banks commonly known as Urban Co-operative Banks (UCBs) w.e.f.
March 1, 1966.

¢ These are also registered under the Cooperative Societies Act, 1912.

¢ Play a vital role in mobilizing deposits and purveying credit to people of small
means.

¢ An important vehicle for financial inclusion and facilitate payment and

settlement.

¢ These banks run by an elected managing committee with provisions of

members’ rights and a set of “communally developed and approved by laws
and amendments.

¢ Work on “no profit, no loss” basis – do not pursue the goal of profit
maximization.
 Cooperative Banks – Post PMC
¢ Dual control - Registrar of Cooperative Societies and RBI.
¢ Role of registrar of cooperative societies includes incorporation, registration,
management, audit, supersession of board and liquidation.
¢ RBI is responsible for regulatory functions such maintaining cash reserve and
capital adequacy etc.
¢ Ordinance to bring cooperative banks under RBI regulation
¢ Seeks to protect the interests of depositors and strengthen cooperative banks by
improving governance and oversight.
¢ 1482 urban cooperatives banks and 58 multi-State cooperative banks - Depositor
base of 8.6 crore, amounting to ₹4.84 lakh crore.
¢ Audited according to RBI rules and appointment of CEOs would require prior
approval from the central bank.
¢ Enables cooperative banks to raise money via public issue and private
placement, of equity or preference shares and unsecured debentures.
 Regional Rural Banks (RRBs)

¢ RRBs were established under the RRB Act, 1976 with a view to develop the
rural economy.

¢ Serve the rural areas and agricultural sectors with basic banking and adequate
financial services.

¢ RRBs were set up to eliminate other unorganized financial institutions like

money lenders and supplement the efforts of co-operative banks.

¢ The capital base is held by the central government, respective state

government, and the commercial bank that sponsors them in the ratio 50:15:35
respectively.

¢ Commercial banks sponsor RRBs e.g. Maharashtra Gramin Bank (sponsored by

the Bank of Maharashtra).

¢ Multiple controlling authorities – RBI (regulator) & NABARD (supervisor).

 Small Finance Banks

¢ Setup with the objective to further financial inclusion - licensed under Section 22
of the Banking Regulation Act, 1949.

¢ The small finance bank shall primarily undertake basic banking activities of
acceptance of deposits and lending to unserved and underserved sections
including small business units, small and marginal farmers, micro and small
industries and unorganized sector entities.

¢ The minimum paid-up equity capital for small finance banks shall be ₹ 100 crore.

¢ 75% of their assessed net bank credit (ANBC) will go towards priority sector
lending and 50% of the loan portfolio will constitute loans upto ₹ 25 lakh.

¢ The promoter's minimum initial contribution to the paid-up equity capital shall at
least be 40%.

¢ Individual banks can decide upon the type of membership to the clearing house
– direct or through sub-member route.
 Payment Banks
¢ Setup with the objective to further financial inclusion by providing small savings
accounts and payments/remittance services to migrant labour workforce, low
income households, small businesses, other unorganized sector entities and
other user.

¢ Licensed under Section 22 of the Banking Regulation Act, 1949.

¢ Acceptance of demand deposits - restricted to holding a maximum balance of ₹

100,000 per individual customer. Issuance of ATM/debit cards. No credit card

¢ Payments bank cannot undertake lending activities.

¢ It is required to invest minimum 75% of its "demand deposit balances" in SLR

eligible Government securities/treasury bills with maturity up to one year.

¢ The minimum paid-up equity capital shall be ₹ 100 crore.

¢ The promoter's minimum initial contribution to the paid-up equity shall be at least
be 40% for the first five years from the commencement of its business.
 Proposed Four tiers of banking system

¢ First tier - International Banks - 3 - 4 large Indian banks with domestic

and international presence along with branches of foreign banks in India.

¢ Second tier – National Banks - PSBs, New private sector banks, mid-
sized banking institutions including niche banks with economy-wide
presence.

¢ Third tier - Regional Banks - Old private sector banks, RRBs, and
multi state Urban Cooperative Banks

¢ Fourth tier – Local banks - Small private local banks & cooperative
banks.
 Banking system || Types of bank

• Commercial bank || Investment bank

• Universal bank

• Branch banking || Unit banking

• Retail banking || Wholesale banking

 Shadow banking

• Coined by Paul McCulley in 2007 to describe the legal structures used by big
Western banks before the financial crisis to keep opaque and complicated
securitized loans off their balance-sheets.

• Financial Stability Board (FSB) broadly describes shadow banking as credit

intermediation involving entities and activities outside the regular banking system.

• Shadow banks are financial firms that perform similar functions and assume
similar risks to banks.

• Being outside the formal banking sector generally means they lack a strong safety
net, such as publicly guaranteed deposit insurance or lender of last resort facilities
from central banks.

• Operate with a different, and usually lesser, level of prudential regulatory

standards and regulatory oversight.
Source: Adrian T, D Covitz, Liang JN. 2012. Financial Stability Monitoring. Federal Reserve Bank of New York Staff Reports 601
 Shadow banking

• Shadow banking is more of a catch-all than a category - encompassing a very

broad range of heterogeneous activities.

• Help spur economic growth by making financial services more widely available.

• Broaden access to financial services by enhancing competition and diversification

of the financial sector - complement banks.

• In India these are known as Non-Banking Financial Company (NBFC).

• Niche area of business - Investment and Credit Company, hire-purchase, chit-

business, micro-financing, factoring, infrastructure financing, mortgage guarantee,
housing finance, insurance and collective investment activities.

• Depending on the area of business regulators differ - (e.g. For insurance - IRDA,
Pension fund – PFRDA etc.)
 Non-Banking Financial Company

• Broadly 2 categories - Non-deposit accepting NBFCs with asset size of less

than ₹500 crore (NBFCs-ND)

• Non-deposit accepting NBFCs with assets of ₹500 crore and above (NBFCs-
ND-SI) and deposit accepting NBFCs (NBFCs-D).

• NBFC should have a minimum net owned fund of ₹ 2 crores.

• NBFC cannot accept demand deposits.

• NBFCs do not form part of the payment and settlement system and cannot
issue cheques drawn on itself.

• Deposit insurance facility of Deposit Insurance and Credit Guarantee

Corporation is not available to depositors of NBFCs, unlike in case of banks.
Share of total national financial assets in (%)

Source: Global Monitoring Report on Non-Bank Financial Intermediation 2019