Principles & Practices of Principles & Practices of BankingBanking

Module AModule A

Indian Financial SystemIndian Financial System

K ChockalingamK Chockalingam

IIBFIIBF

Financial System Financial System

An institutional framework existing in a An institutional framework existing in a country to enable financial transactionscountry to enable financial transactions

Three main partsThree main parts Financial assets (loans, deposits, bonds, equities, Financial assets (loans, deposits, bonds, equities,

etc.)etc.) Financial institutions (banks, mutual funds, insurance Financial institutions (banks, mutual funds, insurance

companies, etc.)companies, etc.) Financial markets (money market, capital market, Financial markets (money market, capital market,

forex market, etc.)forex market, etc.)

Regulation is another aspect of the Regulation is another aspect of the financial system (RBI, SEBI, IRDA, FMC)financial system (RBI, SEBI, IRDA, FMC)

Financial assets/instrumentsFinancial assets/instruments Enable channelising funds from surplus units to Enable channelising funds from surplus units to

deficit unitsdeficit units There are instruments for savers such as There are instruments for savers such as

deposits, equities, mutual fund units, etc.deposits, equities, mutual fund units, etc. There are instruments for borrowers such as There are instruments for borrowers such as

loans, overdrafts, etc.loans, overdrafts, etc. Like businesses, governments too raise funds Like businesses, governments too raise funds

through issue of bonds, Treasury bills, etc.through issue of bonds, Treasury bills, etc. Instruments like PPF, KVP, etc. are available to Instruments like PPF, KVP, etc. are available to

savers who wish to lend money to the savers who wish to lend money to the governmentgovernment

Money Market InstrumentsMoney Market Instruments Call money- money borrowed/lent for a day. Call money- money borrowed/lent for a day.

No collateral is required.No collateral is required. Inter-bank term money- Borrowings among Inter-bank term money- Borrowings among

banks for a period of more than 7 daysbanks for a period of more than 7 days Treasury Bills- short term instruments issued Treasury Bills- short term instruments issued

by the Union Govt. to raise money. Issued at by the Union Govt. to raise money. Issued at a discount to the face valuea discount to the face value

Certificates of Deposit- Issued by banks to Certificates of Deposit- Issued by banks to raise money. Minimum value is Rs. 1 lakh, raise money. Minimum value is Rs. 1 lakh, tradable in the markettradable in the market

CDs can be issued by banks/FIsCDs can be issued by banks/FIs

Money Market Instruments Money Market Instruments (2)(2) Commercial Paper (CPs) are issued by Commercial Paper (CPs) are issued by

corporates to raise short term moneycorporates to raise short term money Issued in multiple of Rs.25 lakhs, can be Issued in multiple of Rs.25 lakhs, can be

issued by companies with a net worth of issued by companies with a net worth of at least Rs. 5 croresat least Rs. 5 crores

CP is an unsecured promissory note CP is an unsecured promissory note privately placed with investors at a privately placed with investors at a discount rate to face value. The maturity discount rate to face value. The maturity of CP is between 3 and 6 monthsof CP is between 3 and 6 months

Financial InstitutionsFinancial Institutions Includes institutions and mechanisms Includes institutions and mechanisms

whichwhich Affect generation of savings by the communityAffect generation of savings by the community Mobilisation of savingsMobilisation of savings Effective distribution of savingsEffective distribution of savings

Institutions are banks, insurance Institutions are banks, insurance companies, mutual funds- companies, mutual funds- promote/mobilise savingspromote/mobilise savings

Individual investors, industrial and Individual investors, industrial and trading companies- borrowerstrading companies- borrowers

Financial MarketsFinancial Markets

Money Market- for short-term funds Money Market- for short-term funds (less than a year)(less than a year)

Organized (Banks)Organized (Banks) Unorganized (money lenders, chit funds, etc.)Unorganized (money lenders, chit funds, etc.)

Capital Market- for long-term fundsCapital Market- for long-term funds Primary Issues MarketPrimary Issues Market Stock MarketStock Market Bond MarketBond Market

Organized Money MarketOrganized Money Market

Call money marketCall money market Bill MarketBill Market

Treasury billsTreasury bills Commercial billsCommercial bills

Bank loans (short-term)Bank loans (short-term) Organized money market comprises Organized money market comprises

RBI, banks (commercial and co-RBI, banks (commercial and co-operative)operative)

Call money market (1)Call money market (1)

It deals with one-day loans (overnight, to be It deals with one-day loans (overnight, to be precise) called call loans or call moneyprecise) called call loans or call money

Participants are mostly banks. Also called inter-Participants are mostly banks. Also called inter-bank call money market.bank call money market.

The borrowing is exclusively limited to banks, The borrowing is exclusively limited to banks, who are temporarily short of funds.who are temporarily short of funds.

On the lending side, besides banks with excess On the lending side, besides banks with excess cash and as special cases few FIs like LIC, UTIcash and as special cases few FIs like LIC, UTI

All others have to keep their funds in term All others have to keep their funds in term deposits with banks to earn interestdeposits with banks to earn interest

Call money market (2)Call money market (2) Call loans are generally made on a clean basis- Call loans are generally made on a clean basis-

i.e. no collateral is requiredi.e. no collateral is required The main function of the call money market is The main function of the call money market is

to redistribute the pool of day-to-day surplus to redistribute the pool of day-to-day surplus funds of banks among other banks in temporary funds of banks among other banks in temporary deficit of fundsdeficit of funds

The call market helps banks earn interest and The call market helps banks earn interest and yet improve their liquidityyet improve their liquidity

It is a highly competitive and sensitive marketIt is a highly competitive and sensitive market It acts as a good indicator of the liquidity It acts as a good indicator of the liquidity

positionposition

Bill MarketBill Market Treasury Bill market- Also called the T-Bill Treasury Bill market- Also called the T-Bill

marketmarket– These bills are short-term liabilities (91-day, 182-These bills are short-term liabilities (91-day, 182-

day, 364-day) of the Government of Indiaday, 364-day) of the Government of India– It is an IOU of the government, a promise to pay the It is an IOU of the government, a promise to pay the

stated amount after expiry of the stated period stated amount after expiry of the stated period from the date of issuefrom the date of issue

– They are issued at discount to the face value and at They are issued at discount to the face value and at the end of maturity, the face value is paidthe end of maturity, the face value is paid

– The rate of discount and the corresponding issue The rate of discount and the corresponding issue price are determined at each auctionprice are determined at each auction

Commercial Bill market- Not as developed in Commercial Bill market- Not as developed in India as the T-Bill marketIndia as the T-Bill market

Indian Banking SystemIndian Banking System Central Bank (Reserve Bank of India)Central Bank (Reserve Bank of India) Commercial banksCommercial banks Co-operative banksCo-operative banks Banks can be classified as:Banks can be classified as:

Scheduled (Second Schedule of RBI Act, 1934)Scheduled (Second Schedule of RBI Act, 1934) Non-ScheduledNon-Scheduled

Scheduled banks can be classified as:Scheduled banks can be classified as: Public Sector Banks Public Sector Banks Private Sector Banks (Old and New) Private Sector Banks (Old and New) Foreign Banks Foreign Banks Regional Rural Banks Regional Rural Banks

Indigenous bankersIndigenous bankers

Individual bankers like Shroffs, Seths, Sahukars, Individual bankers like Shroffs, Seths, Sahukars, Mahajans, etc. Combine trading and other Mahajans, etc. Combine trading and other business with money lending.business with money lending.

Vary in size from petty lenders to substantial Vary in size from petty lenders to substantial ShroffsShroffs

Act as money changers and finance internal Act as money changers and finance internal trade through hundis (internal bills of exchange)trade through hundis (internal bills of exchange)

Indigenous banking is usually family owned Indigenous banking is usually family owned business employing own working capitalbusiness employing own working capital

At one point, it was estimated that IB met about At one point, it was estimated that IB met about 90% of the financial requirements of rural India90% of the financial requirements of rural India

RBI and indigenous bankers RBI and indigenous bankers (1)(1) Methods employed by the indigenous bankers Methods employed by the indigenous bankers

are traditional with vernacular system of are traditional with vernacular system of accounting.accounting.

RBI suggested that bankers give up their trading RBI suggested that bankers give up their trading and commission business and switch over to the and commission business and switch over to the western system of accounting.western system of accounting.

It also suggested that these bankers should It also suggested that these bankers should develop the deposit side of their businessdevelop the deposit side of their business

Ambiguous character of the hundi should stopAmbiguous character of the hundi should stop Some of them should play the role of discount Some of them should play the role of discount

houses (buy and sell bills of exchange)houses (buy and sell bills of exchange)

RBI and indigenous bankers RBI and indigenous bankers (2)(2) IB should have their accounts audited by IB should have their accounts audited by

certified chartered accountantscertified chartered accountants Submit their accounts to RBI periodicallySubmit their accounts to RBI periodically As against these obligations the RBI promised As against these obligations the RBI promised

to provide them with privileges offered to to provide them with privileges offered to commercial banks includingcommercial banks including– Being entitled to borrow from and rediscount bills Being entitled to borrow from and rediscount bills

with RBIwith RBI The IB declined to accept the restrictions as The IB declined to accept the restrictions as

well as compensation from the RBIwell as compensation from the RBI Therefore, the IB remain out of RBI’s purviewTherefore, the IB remain out of RBI’s purview

Development Oriented Development Oriented BankingBanking Historically, close association between banks and Historically, close association between banks and

some traditional industries- cotton textiles in the some traditional industries- cotton textiles in the west, jute textiles in the eastwest, jute textiles in the east

Banking has not been mere acceptance of Banking has not been mere acceptance of deposits and lending money to include deposits and lending money to include development bankingdevelopment banking

Lead Bank Scheme- opening bank offices in all Lead Bank Scheme- opening bank offices in all important localitiesimportant localities

Providing credit for development of the districtProviding credit for development of the district Mobilising savings in the district. ‘Service area Mobilising savings in the district. ‘Service area

approach’ approach’

Progress of banking in India Progress of banking in India (1)(1) Nationalisation of banks in 1969: 14 banks Nationalisation of banks in 1969: 14 banks

were nationalisedwere nationalised Branch expansion: Increased from 8260 in Branch expansion: Increased from 8260 in

1969 to 68500 in 20051969 to 68500 in 2005 Population served per branch has come Population served per branch has come

down from 64000 to 15000down from 64000 to 15000 A rural branch office serves 15 to 25 A rural branch office serves 15 to 25

villages within a radius of 16 kmsvillages within a radius of 16 kms Still only 32,180 villages out of 5 lakh have Still only 32,180 villages out of 5 lakh have

been coveredbeen covered

Progress of banking in IndiaProgress of banking in India (2)(2) Deposit mobilisation:Deposit mobilisation:

1951-1971 (20 years)- 700% or 7 times1951-1971 (20 years)- 700% or 7 times 1971-1991 (20 years)- 3260% or 32.6 times1971-1991 (20 years)- 3260% or 32.6 times 1991- 2006 (11 years)- 1100% or 11 times1991- 2006 (11 years)- 1100% or 11 times

Expansion of bank credit: Growing at 20-Expansion of bank credit: Growing at 20-30% thanks to rapid growth in industrial 30% thanks to rapid growth in industrial and agricultural outputand agricultural output

Development oriented banking: priority Development oriented banking: priority sector lendingsector lending

Progress of banking in India Progress of banking in India (3)(3) Diversification in banking: Banking has Diversification in banking: Banking has

moved from deposit and lending tomoved from deposit and lending to Merchant banking and underwritingMerchant banking and underwriting Mutual fundsMutual funds Retail bankingRetail banking ATMsATMs Anywhere bankingAnywhere banking Internet bankingInternet banking Venture capital fundsVenture capital funds Factoring-Factoring-

Profitability of Profitability of Banks(1)Banks(1)

Reforms has shifted the focus of Reforms has shifted the focus of banks from being development banks from being development oriented to being commercially oriented to being commercially viableviable

Prior to reforms, banks were not Prior to reforms, banks were not profitable and in fact made losses for profitable and in fact made losses for the following reasons:the following reasons:

Declining interest incomeDeclining interest income Increasing cost of operationsIncreasing cost of operations

Profitability of banks (2)Profitability of banks (2)

Declining interest income was for the Declining interest income was for the following reasons:following reasons:

High proportion of deposits impounded for High proportion of deposits impounded for CRR and SLR, earning relatively low CRR and SLR, earning relatively low interest ratesinterest rates

System of directed lendingSystem of directed lending Political interference- leading to huge NPAsPolitical interference- leading to huge NPAs

Rising costs of operations for banks was Rising costs of operations for banks was because of several reasons: economic because of several reasons: economic and politicaland political

Profitability of Banks (3)Profitability of Banks (3)

As per the Narasimham Committee (1991), As per the Narasimham Committee (1991), the reasons for rising costs of banks were:the reasons for rising costs of banks were:

Uneconomic branch expansionUneconomic branch expansion Heavy recruitment of employeesHeavy recruitment of employees Growing indiscipline and inefficiency of staff due Growing indiscipline and inefficiency of staff due

to trade union activitiesto trade union activities Low productivityLow productivity

Declining interest income and rising cost of Declining interest income and rising cost of operations of banks led to low profitability in operations of banks led to low profitability in the 90sthe 90s

Bank profitability: Bank profitability: SuggestionsSuggestions Some suggestions made by Narasimham Some suggestions made by Narasimham

Committee are:Committee are: Set up an Asset Reconstruction Fund to Set up an Asset Reconstruction Fund to

take over doubtful debtstake over doubtful debts SLR to be reduced to 25% of total depositsSLR to be reduced to 25% of total deposits CRR to be reduced to 3 to 5% of total CRR to be reduced to 3 to 5% of total

depositsdeposits Banks to get more freedom to set Banks to get more freedom to set

minimum lending ratesminimum lending rates Share of priority sector credit be reduced Share of priority sector credit be reduced

to 10% from 40%to 10% from 40%

Suggestions (cont’d)Suggestions (cont’d)

All concessional rates of interest should be All concessional rates of interest should be removedremoved

Banks should go for new sources of funds such Banks should go for new sources of funds such as Certificates of Depositsas Certificates of Deposits

Branch expansion should be carried out strictly Branch expansion should be carried out strictly on commercial principleson commercial principles

Diversification of banking activitiesDiversification of banking activities Almost all suggestions of the Narasimham Almost all suggestions of the Narasimham

Committee have been accepted and Committee have been accepted and implemented in a phased manner since the implemented in a phased manner since the onset of Reformsonset of Reforms

NPA ManagementNPA Management

The Narasimham Committee The Narasimham Committee recommendations were made, among recommendations were made, among other things, to reduce the Non-other things, to reduce the Non-Performing Assets (NPAs) of banksPerforming Assets (NPAs) of banks

To tackle this, the government enacted To tackle this, the government enacted the Securitization and Reconstruction the Securitization and Reconstruction of Financial Assets and Enforcement of of Financial Assets and Enforcement of Security Act (SARFAESI) Act, 2002Security Act (SARFAESI) Act, 2002

Enabled banks to realise their dues Enabled banks to realise their dues without intervention of courtswithout intervention of courts

SARFAESI ActSARFAESI Act Enables setting up of Asset Management Companies Enables setting up of Asset Management Companies

to acquire NPAs of any bank or FI (SASF, ARCIL are to acquire NPAs of any bank or FI (SASF, ARCIL are examples)examples)

NPAs are acquired by issuing debentures, bonds or NPAs are acquired by issuing debentures, bonds or any other securityany other security

As a second creditor can serve notice to the As a second creditor can serve notice to the defaulting borrower to discharge his/her liabilities in defaulting borrower to discharge his/her liabilities in 60 days60 days

Failing which the company can take possession of Failing which the company can take possession of assets, takeover the management of assets and assets, takeover the management of assets and appoint any person to manage the secured assetsappoint any person to manage the secured assets

Borrowers have the right to appeal to the Debts Borrowers have the right to appeal to the Debts Tribunal after depositing 50% of the amount Tribunal after depositing 50% of the amount claimed by the second creditorclaimed by the second creditor

The Indian Capital Market The Indian Capital Market (1)(1) Market for long-term capital. Demand Market for long-term capital. Demand

comes from the industrial, service sector comes from the industrial, service sector and governmentand government

Supply comes from individuals, Supply comes from individuals, corporates, banks, financial institutions, corporates, banks, financial institutions, etc.etc.

Can be classified into:Can be classified into: Gilt-edged marketGilt-edged market Industrial securities market (new issues Industrial securities market (new issues

and stock market)and stock market)

The Indian Capital Market The Indian Capital Market (2)(2) Development Financial InstitutionsDevelopment Financial Institutions

Industrial Finance Corporation of India (IFCI)Industrial Finance Corporation of India (IFCI) State Finance Corporations (SFCs)State Finance Corporations (SFCs) Industrial Development Finance Corporation (IDFC)Industrial Development Finance Corporation (IDFC)

Financial IntermediariesFinancial Intermediaries Merchant BanksMerchant Banks Mutual FundsMutual Funds Leasing CompaniesLeasing Companies Venture Capital CompaniesVenture Capital Companies

Industrial Securities MarketIndustrial Securities Market

Refers to the market for shares and Refers to the market for shares and debentures of old and new companiesdebentures of old and new companies

New Issues Market- also known as the New Issues Market- also known as the primary market- refers to raising of new primary market- refers to raising of new capital in the form of shares and capital in the form of shares and debenturesdebentures

Stock Market- also known as the Stock Market- also known as the secondary market. Deals with securities secondary market. Deals with securities already issued by companiesalready issued by companies

Financial Intermediaries (1)Financial Intermediaries (1) Mutual Funds- Promote savings and Mutual Funds- Promote savings and

mobilise funds which are invested in the mobilise funds which are invested in the stock market and bond marketstock market and bond market

Indirect source of finance to companiesIndirect source of finance to companies Pool funds of savers and invest in the stock Pool funds of savers and invest in the stock

market/bond marketmarket/bond market Their instruments at saver’s end are called Their instruments at saver’s end are called

unitsunits Offer many types of schemes: growth fund, Offer many types of schemes: growth fund,

income fund, balanced fundincome fund, balanced fund Regulated by SEBIRegulated by SEBI

Financial Intermediaries (2)Financial Intermediaries (2)

Merchant banking- manage and underwrite new Merchant banking- manage and underwrite new issues, undertake syndication of credit, advise issues, undertake syndication of credit, advise corporate clients on fund raisingcorporate clients on fund raising

Subject to regulation by SEBI and RBISubject to regulation by SEBI and RBI SEBI regulates them on issue activity and SEBI regulates them on issue activity and

portfolio management of their business.portfolio management of their business. RBI supervises those merchant banks which are RBI supervises those merchant banks which are

subsidiaries or affiliates of commercial bankssubsidiaries or affiliates of commercial banks Have to adopt stipulated capital adequacy Have to adopt stipulated capital adequacy

norms and abide by a code of conductnorms and abide by a code of conduct

ConclusionConclusion

There are other financial intermediaries There are other financial intermediaries such as NBFCs, Venture Capital Funds, such as NBFCs, Venture Capital Funds, Hire and Leasing Companies, etc.Hire and Leasing Companies, etc.

India’s financial system is quite huge and India’s financial system is quite huge and caters to every kind of demand for fundscaters to every kind of demand for funds

Banks are at the core of our financial Banks are at the core of our financial system and therefore, there is greater system and therefore, there is greater expectation from them in terms of expectation from them in terms of reaching out to the vast populace as well reaching out to the vast populace as well as being competitive.as being competitive.

hank hank ouou

K ChockalingamK Chockalingam

TEL : 9322295394 TEL : 9322295394

e.mail: chockalingam_2000@yahoo.come.mail: chockalingam_2000@yahoo.com chockalingam@iibf.org.inchockalingam@iibf.org.in