Basics of Banking

Circle of Trust

Financial intermediaries play an important economic function by facilitating the productive use of the
community’s surplus money. The continuous use of such resources by an economy will foster greater demand
for goods and services and in generation of income and employment in an economy.

The need for a financial intermediary arises because the savers would not voluntarily come forward to lend
directly fearing certain risks.

Banking is a Business of Trust

Banks are able to lend a major portion of their deposits, play the role of an intermediary and constitute the
payment system because of the understanding that banks will honour their commitments to the people. If this
trust is broken for any reason, banks will not be able to survive. This trust might suffer a setback if banks are
not able to return all the deposits on time.

To retain the trust of the people, banks have to adhere to some core principles while conducting their business.

The following figure shows the core banking principles.

Liquidity

Service
Safety
quality
Core
Banking
Principles

Profitabili
Secrecy
ty

The following risks are faced by the customers when they lend their money directly.

It is the risk of default by the borrower for any reason. It is possible that the
business does not generate sufficient income to repay the loan or the borrower is
Credit risk
not honest enough to honour his commitment. Credit risk is the most serious risk
that any lender faces and individual lenders cannot afford to take such a risk

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The borrower may have every intention to repay the loan and the business may
be doing well too. However, there could be occasions when the borrower is not
able to withdraw funds from the business when the lender demands repayment or
Liquidity risk when the repayment is due. There could be many types of temporary problems,
which may or may not be in the control of the borrower and which stand in the way
of timely repayment of the loan. Thus, the lender may not get his money when he
wants it.

Another risk in lending money is the possibility of loss due to change in the rate
of interest in the market. At the time of the transaction, the borrower may have
agreed to give interest at the prevailing rate of, say, 10 percent. Subsequently,
the borrower may ask for a reduction in the rate of interest, as money is available
Interest Rate
at a cheaper rate from other sources or repay the loan before the due date.
risk
Conversely, while the interest rate may have gone up in the market, the borrower
may refuse to pay a higher rate, quoting the terms of the original contract. Both
situations are detrimental to the lender and individuals prefer to insulate
themselves from such a risk of loss due to change in interest rates.

The risk-averse nature of normal savers and the risks inherent in any entrepreneurial activity necessitates
intermediaries who have the ability to insulate the savers from the risks inherent to business. This also makes
available the funds to entrepreneurs by managing the risks in an effective manner to minimise the chances
of loss. The process of transferring the funds from the savers to the entrepreneurs is called intermediation,
the essence of which is risk management.
Money needs to be circulated to be productive. If all savings are hoarded, the surplus of the community will
not be available for investments and this would lead to economic stagnation. Financial intermediaries play an
important economic function by facilitating productive use of the community’s surplus money. Further, these
intermediaries also generate employment and promote economic welfare by enabling production of goods
and services required by the community. Therefore, intermediation is a very important economic function.
Intermediation provides a business opportunity too. The depositors will be happy to earn interest at a rate
lower than the rate that the borrowers are prepared to pay because they are insulated from all risks. The
difference between the rate charged to the borrowers and the rate paid to the depositors, or spread as it is
called in banking parlance, can yield the bank substantial profits. The spread is the reward for managing risks.
All institutions in the financial sector do or enable some form of intermediation.

Evolution of Banking
Surprisingly, the advent of banking preceded that of coins. Banking originated even before 2000 BC in
Babylonia through the activities of temples and palaces. During that time, such places were preferred for
safekeeping of valuables such as grain, agricultural implements and precious metals.

The receipts issued by these temples and palaces were used to transfer the stored items to third parties. The
code of Hammurabi of Babylon (1792 – 1750 BC) contains laws governing banking. Pythius, who operated
throughout Asia Minor in 600 BC, is the first banker whose records exist.

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In Egypt too, receipts issued by granaries were used for making payments. The Greeks, who captured Egypt
in 323 BC, perfected the “giro” or system of transfer of funds through book entries without the movement of
money.

The government granaries, which acted as banks, developed the system of transferring grains from person
to person and from place to place merely by making entries in books. These

A Central Granary or Central Bank at Alexandria coordinated operations.

In addition to safekeeping of valuables and issuing receipts, which were used as currency notes, and
facilitating transfer of funds from person to person and place to place, the growth of trade between countries
led to currency exchange becoming an important banking activity.

Exchange bankers operated mostly in and around temples, where they set up temporary tables or benches.
The word “bank” is derived from the Italian word “banca” for bench or counter.

Greek bankers developed the skill in financing carriage of goods through ships, mining and construction. One
of the most successful Greek bankers was a slave called Pasion. He started his career in 394 BC and owned
other businesses.

The business of banking was practically destroyed after the fall of the Roman Empire. This happened because
the decline in trade led to decrease in the need for transferring money for financing trade. In the 12 th century,
Christians were prohibited from “usury” or charging interest. This led to Jews and another sect called Templars
emerging as bankers.

In the 13th century, the Lombard’s of Italy replaced the Jews and Florence became the most prominent
banking centre. The Bank of Barcelona was founded in 1401. It was the first bank whose records still exist.

The Italians developed the concept of double entry bookkeeping, which helped them immensely in their ascent
as leading bankers. The first book on double entry book-keeping was published in Italy in 1694.

The need to transfer money across countries with different currencies led to the development of the “bill of
exchange”. This was a written instruction from a person in one country to another person in another country
to pay a certain sum of money.

Both transfer of funds and exchange of currencies were achieved by using one instrument. Perhaps that
explains the rationale behind the name of the instrument being called “bill of exchange”. Although the Arabs
may have used bills of exchanges during the 8 th century, the earliest evidence is of a bill issued in 1156 AD
in Genoa, Italy.

During the Crusades between 1642 and 1651, people used to deposit their valuables with goldsmiths for
safekeeping. The instructions of the depositors to the goldsmith to deliver the valuables to third parties evolved
into “cheques”.

Throughout the centuries, banks have also been the biggest financiers of kings and governments. In fact,
several of such banks failed because the respective governments failed to honour their commitments.

Banking in India
Indigenous bankers existed in India from times immemorial and their successors can still be found in various
forms, such as pawnbrokers, nidhis, bishis, and chit funds. The first banking institution in India was the Bank
of Bengal. It was formed in 1809 but did not last long. Several Indian businesspersons formed their own banks
during the Swadeshi movement, between 1906 and 1913.

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The Imperial Bank of India was formed by the amalgamation of the three presidency banks, the Bank of
Bengal, the Bank of Bombay and the Bank of Madras, by an act passed by the Government of India in 1921.
The bank was rechristened as State Bank of India (SBI) in 1955 after RBI acquired a controlling interest in
the Bank. Although its shares were issued to the public in 1995, the SBI continues to be recognised as a
government bank and had monopoly over the banking business of the government until 2003. The SBI
continues to be the largest bank in India in terms of size of deposits and credit.

Soon after India gained independence, the Industrial Development Bank of India (IDBI) and the Industrial
Credit and Investment Corporation of India (ICICI) were promoted by the Government of India to provide long-
term (up to 10 years) financial assistance to industries.

This was required because there was a dearth of capital for setting up industries and the existing banks
specialised in providing short-term finance. The government and international development institutions, such
as World Bank lent funds to Indian industries. Both these institutions became commercial banks after 2002.

Banks, being commercial institutions, were reluctant to finance new and small business ventures, which were
considered risky. In addition, banks were reluctant to set up branches in rural areas because the business
potential was low.

The Government of India felt that providing banking services and financial assistance to all the sections of
the society was necessary to promote economic growth and welfare of the people. Therefore, it nationalised
14 large commercial banks in 1969 by paying off the owners.

The banks that were allowed to continue in the private sector were several in numbers but had insignificant
market share. As the owner, the government could influence the policies of the nationalised banks. The
orientation of the banks was changed from profit to development.

The next two decades saw unprecedented expansion of banks into rural and semi urban areas and bank
financing into agriculture, small industries and small business sectors. In 1980, another set of six commercial
banks were nationalised.

Subsequent to 2000, the government’s shareholding has been diluted because banks have raised capital
from the market. However, the management of banks is firmly controlled by the government. The public sector
banks continue to control over 70 per cent of the banking business in India.

In 1994, the Government of India decided to permit setting up of banks in the private sector to inject an
element of competition in the banking industry because a virtual monopoly had made the public sector banks
rather complacent. Eight new banks, including ICICI Bank, HDFC Bank, IDBI Bank, and UTI Bank (now
renamed as Axis bank), were set up in the next three years. IDBI bank is considered as part of public sector
bank as the government owns a major share in it.

The new banks revolutionised the banking industry by embracing modern technology and management
practices. They were customer-oriented and profit-oriented. The rapid growth of the private sector banks
prompted the public sector banks to re-orient themselves by improving their functioning and many of them,
especially the SBI, transformed themselves in a big way.

In 2002, ICICI was merged with the ICICI Bank, and in 2004, IDBI was merged with the IDBI Bank.

Meanwhile, a few foreign banks, which have been operating in India for over 100 years, started expanding
aggressively from 2004. Their conservative attitude and reluctance to bring in capital prevented them from
growing as fast as the private sector banks. Since 2005, foreign banks have shown renewed interest in the
Indian market.

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The cooperative banks form another group of important players in the Indian banking scene. Some of these
banks originated well before independence. Others were set up with the active encouragement of the
government after 1947. While their financial health is poor because of mismanagement, these banks continue
to play a significant role, especially in the rural area.

In order to expedite financial inclusion, Finance Minister Mr. Arun Jaitley in his budget speech (July,2014)
had said that RBI would create a framework for licensing Payments Banks / Small Banks and other
differentiated banks.

These local area banks, payment banks and Small Banks were expected to meet credit and remittance needs
of small businesses, unorganized sector, low income households, farmers and migrant work force.

The financial health of the Indian banks has improved immensely over the last decade, primarily due to the
efforts of the RBI, which is the central bank of the country.

Classification of Banks in India

The classification of banks in India is shown in the diagram below.

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Examples of Public Sector Banks

• They are the nationalized banks

• Majority stakes of these banks are held by the government

Examples of Private Sector Banks

• Banks in which major stake or equity is held by private shareholders

Regulatory Bodies
The functioning of various organizations in the BFSI industry are controlled and regulated by various
regulators, namely:

The Reserve Bank of India (RBI) regulates banks, issues

banking licenses and acts as a banker to the government.

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The Securities Exchange Board of India (SEBI) regulates

the capital markets, stock exchanges and mutual funds.

The Insurance Regulatory Development Authority (IRDAI)

regulates the insurance industry.

The Pension Fund Regulatory Development Authority (PFRDA) regulates the pension funds and the National
Pension System (NPS).

Role of the banks

Normal investors are not ready to take the risks with their hard-earned money. There is an inherent risk in
any entrepreneurial activity and this necessitates intermediaries who have the ability to insulate the investors
from the risks inherent to business. This also makes available the funds to entrepreneurs by managing the
risks in an effective manner to minimise the chances of loss. The process of transferring the funds from the
investors to the entrepreneurs is called intermediation. Bank is one such intermediary.

Money needs to be circulated to be productive. If all savings are hoarded, the surplus of the community will
not be available for investments and this would lead to economic stagnation. Banks play an important
economic function by facilitating productive use of the community’s surplus money. Further banks also
generate employment and promote economic welfare by enabling production of goods and services required
by the community. Therefore, intermediation is a very important economic function.

Intermediation provides a business opportunity too. The depositors will be happy to earn interest at a rate
lower than the rate that the borrowers are prepared to pay because banks absorb the risks associated with
lending i.e. Credit Risk, Liquidity Risk and Interest Rate Risk.

Customers of the banks are depositors and borrowers. Banks gets their surplus money as deposits and lends
this money to the borrowers who have deficit money to fulfil their needs. The difference between the rate
charged to the borrowers and the rate paid to the depositors is called spread, which gives bank substantial
profits. The spread is the reward for managing risks. Bank needs customers for profitability and also to act as
instrument of national development.

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Bank’s main functions are categorized as under

1. Bank is an intermediary

2. Constituent of payment and settlement system

3. Provider of other financial services

4. Provider of Other Supportive Financial Services

Bank is an intermediary
Bank as an intermediary connects customers and users of money. Customers use liability products of the
bank and users/borrowers avail asset products of the banks.

Deposit (Liability) products of the banks

Deposits are also known as liability products for the banks. These refer to the money deposited by the
customers, and banks have a liability to repay the money as per the terms of contract. Banks accept demand
deposits and fixed or term/time deposits. Demand deposits are repayable on demand whereas term deposits
are repayable only after the agreed period. Because demand deposits are more liquid than term deposits,
interest is paid on such deposits at a lower rate or no interest is paid at all. Lower the liquidity, higher is the
rate of interest. Therefore, generally, longer the period of the term deposit, higher is the rate at which interest
is paid.

While demand deposits are cheaper to the banks in terms of the interest paid on them, the cost of maintaining
demand deposit accounts is higher than that of term deposit accounts in view of the large number of
transactions in the demand deposit accounts.

Deposit services are categorised under two broad headings:

Demand Deposits Time or Term Deposits

• Savings accounts (SA) • Fixed Deposit (FD) account

• Current Accounts (CA) • Recurring Deposit (RD) accounts

Demand Deposits

Demand deposits are deposits that are repayable on demand, and has no fixed time factor attached to it. The
depositor can withdraw the deposited funds at any time without any prior notice to the bank. SAs and CAs
are the two types of deposit services that are offered by bank.

Savings Bank Accounts

The amount deposited in SB accounts falls under the category of demand deposits. These accounts
enable the customers to temporarily store their surpluses, which are not immediately needed for use.

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By depositing such surpluses, the customers are able to earn interest and become entitled to certain
banking services, such as collection of cheque, remittance facility, Automated Teller Machine (ATM)
or debit card, depending on the product features made available by each bank. With a view to reduce
the dependence on bank branches for withdrawing money, obtaining mini statement of accounts,
knowing balance or ordering for cheque books, banks have come out with ATM facility/Internet
Banking/iMobile etc. RBI has also instructed banks that a customer of a bank can operate his/her
account from ATM of any bank subject to certain restrictions and need not necessarily go to the ATM
of the bank in which he/she has an account.

Current Accounts

Current Accounts are opened to meet the business needs of customers. CAs can, therefore, be
opened for an organisation or individual. The operations on these accounts are unrestricted, which
enable the account holders to route all their banking transactions.

No restrictions are imposed on the number of withdrawals that can be made from these accounts. As
it is a demand deposit, bankers need to maintain sufficient liquidity to take care of the withdrawal
needs of the account holders.

The account opening formalities are similar for individual account holders as in the case of SB
accounts. However, in case of organisations, such as partnership firms, joint stock companies, HUF
and trusts, certain additional formalities need to be complied with. No interest is paid on current
accounts.

Time/Term Deposits

Fixed Deposit Accounts

As the name suggests, FD accounts are opened with the banks for a certain period, as agreed upon
at the time of making such deposits. Under such an arrangement, banks can look forward to the
deposits remaining with them for the period contracted. Banker’s obligation to repay such deposits
would be deemed to arise after the period for which the deposit was contracted at the time of making
the deposit.

The principal difference between demand deposits and FDs is that in FDs, the customer cannot ask
the banks to return the deposit by drawing a cheque on the account. Therefore, these deposits remain
with the banks for longer periods and, consequently, banks generally pay higher rate of interest than
the SB account. The rate of interest depends upon the period of the deposit.

In FDs the interest is calculated and paid to customers at quarterly intervals. However, if the customer
has chosen the cumulative option, then the interest is deemed to be re-invested in the same deposit.
In this case, the principal and the accumulated interest (including interest on interest reinvested) are
paid to the customer on maturity of the deposit.

Banks also agree to pay interest on monthly basis in which the interest payable is discounted and is
less than the amount due and is payable on quarterly basis. Such schemes, which provide regular
income on a month-to-month basis, could be positioned for those customers who need regular income
to take care of their monthly needs.

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The interests earned on FDs are subject to Tax Deduction at Source (TDS), if the amount of interest
payable is Rs. 40,000 per annum or more (Rs. 50,000 in case of senior citizens). Banks are under
obligation to deduct the tax and remit it to appropriate authorities within the stipulated period. Tax may
not be deducted if the customer submits form 15G or 15H at the time of making such deposits or
before first payment of interest in respect of the deposit. It is mandatory to provide such form in every
financial year. Form 15G is meant for resident individuals who are of the age below 60 years and
HUFs. Form 15H is meant for senior citizens only who are of the age of 60 years or more.

Banks also grant loans against FDs to their customers to meet their emergency requirements. The
rate of interest chargeable is generally two per cent over the rate of interest payable on the deposit.
Such facility enables depositors to meet their emergency needs without resorting to premature closure
of deposits, which may result in loss of interest for the customer.

Although, FDs are made for a fixed period, banks do permit the customers to withdraw these deposits
before the expiry of the term to meet unanticipated demands that may arise. Banks, at times, charge
a penalty for effecting premature closure, which is generally one per cent below the rate of interest
payable on such deposits for the period the deposit had remained with the bank. The interest rate
applicable in such cases would be the one prevailing at the time of making the deposit. In the case of
withdrawal of deposits due to death of the depositor, banks do not charge any penalty.

Recurring Deposit Accounts

Recurring Deposits accounts are for the benefit of those who would like to save a fixed sum every
month over a long period of one to ten years. This enables the customers, at the end of the period, to
have a reasonably large sum. It is equivalent to making FDs of Rs. 500, every month in such a way
that all the FDs will mature on the same date.

Deposits cannot be withdrawn before the due date without penalty. Therefore, the rate of interest paid
on RDs is usually the rate applicable to FDs for similar periods. A penalty is levied on the depositor if
he/she defaults in making deposit in any month or withdraws the deposit prematurely. Further, interest
payable will also get reduced according to the period the deposit has stayed with the bank as per rate
prevailing at the time of making the deposit. TDS is also deducted on the interest amount as per
guidelines applicable to fixed deposits.

Asset Products

Car Loan

Car loans are given for purchase of new car from an Authorized Car Dealer. Bank also gives loan for
a used car. The term ‘used car’ is used when the invoice date and insurance cover note date is more
than 30 days old.

Education Loan

Education loan is granted to a student, having secured admission to higher education course in
recognised institutions identified by the bank.

Students Eligible as per basic threshold score defined in student and Employability score card
Psychometric test shall be considered for funding

Age of applicant is 16-40

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Personal Loan

Personal loan is a general-purpose loan given to the customers on the basis of:

• Net monthly take home salary

• Current obligations such as loan EMIs, credit card outstanding (if any)

• Employer category

• Required loan tenure

• Relationship type with the Bank

Home Loan

Home loan is a most secured loan. It is given to the customers for purchase of ready
house/construction of house/renovation of house. Repayment period is generally 20 to 25 years.

Payment services (Bank is a constituent of payment system)

The various products offered as a part of the payment service are:
• Cheques • Debit cards
• Pay Order (PO)/Banker’s Cheque • Credit cards
• Demand Draft (DD) • ECS
• Multi-city cheques • Travel cards
• National Electronic Funds Transfer (NEFT) • Mobile Banking (IMPS)
• RTGS • Online Transfer

The services provided by banks under the role of provider of financial services are
• Distribution
• Collection of taxes and bills
• Dematerialised or Demat accounts
• Safekeeping
• Advisory services

The products offered by banks within distribution service are

• Mutual Fund units
• Insurance products
• Government bonds
• Gold coins
• Mobile phone recharge
• Shares of organisations offering public issues

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Why do customers come to a bank?

Open new accounts

Savings - savings, current,
deposits

Avail of financial
Investment
services like MFs

Service
Why customers
Borrowing Avail of loans across all
comes to bank
segments

Payments Avail of NEFT/RTGS

Risk Coverage Avail of Insurance

Types of Customers

Are persons, can open all types of accounts in a bank, singly or

Individuals
jointly with others

Sole Proprietorship firm Business owned by one individual

Partnership firm Business is owned by two or more individuals

Limited companies Created by law having continuous existence and a common seal

Trust / Associations / Clubs Created by persons to carry on some activities for the benefit of a
/ Societies / Co-operatives person or a group of persons

Unique legal entity comprising of Karta and other members of the

Hindu Undivided families
family who are Co-parceners

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