UNIT I

LESSON 1

BANKING SECTOR IN INDIA

Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi

Objectives
After going through this lesson you should be able to:
• Understand the Concept of Banking
• Describe the Development of Banking in India
• Explain the Functions of Bank
• Differentiate Among Banking Sectors

Structure
1.1 Concept of Banking
1.2 Development of Banking in India
1.3 Functions of Bank
1.4 Banking Sectors
1.5 Summary
1.6 Test Question
1.7 Further Readings

The banking sector is the lifeline of any modern economy. It is one of the important pillars of the
financial system, which plays a vital role in the success/failure of an economy. Banks are one of
the oldest financial intermediaries in the financial system. They play an important role in
mobilization of deposits and disbursement of credit to various sectors of the economy. The
banking sector is dominant in India as it accounts for more than half the assets of the financial
sector.

1.1 Concept of Banking

Banks are institutions that accept various types of deposits and use those funds for granting
loans. The business of banking is that of an intermediary between the saving and investment
units of the economy. It collects the surplus funds of millions of individual savers who are
widely scattered and channelize them to the investor. According to section 5(b) of the Banking
Regulation Act, 1949, “banking” means the 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, and order or otherwise. Banking company means any company which transacts the
business of banking in India. No company can carry on the business of banking in India unless it
uses as part of its name at least one of the words bank, banker or banking. The essential
characteristics of the banking business as defined in section 5(b) of the Banking Regulation Act
are:
Acceptance of deposits from the public, For the purpose of lending or investment
a) Withdraw able by means of any instrument whether a cheques or otherwise.
1.2 Development of Banking in India

The history of banking dates back to the thirteenth century when the first bill of exchange
was used as money in medieval trade. There was no such word as ‘banking’ before 1640,
although the practice of safe-keeping and savings flourished in the temple of Babylon as
early as 2000 B.C. Chanakya in his Arthashastra written in about 300 B.C. mentioned about
the existence of powerful guilds of merchant bankers who received deposits, advanced loans
and issued hundis (letters of transfer). The Jain scriptures mention the names of two bankers
who built the famous Dilwara Temples of Mount Abu during 1197 and 1247 A.D.
The first bank called the ‘Bank of Venice’ was established in Venice, Itlay in 1157 to
finance the monarch in his wars. The bankers of Lombardy were famous in England. But
modern banking began with the English goldsmith only after 1640. The first bank in India
was the ‘Bank of Hindustan’ started in 1770 by Alexander & Co. an English agency house in
Calcutta which failed in 1782 with the closure of the agency house. But the first bank in the
modern sense was established in the Bengal Presidency as the Bank of Bengal in 1806.
History apart, it was the ‘merchant banker’ who first evolved the system of banking by
trading in commodities than money. Their trading activities required the remittances of
money from one place to another. For this, they issued ‘hundis’ to remit funds. In India, such
merchant bankers were known as ‘Seths’.
The next stage in the growth of banking was the goldsmith. The business of goldsmith
was such that he had to take special precautions against theft of gold and jewellery. If he
seemed to be an honest person, merchants in the neighborhood started leaving their bullion,
money and ornaments in his care. As this practice spread, the goldsmith started charging
something for taking care of the money and bullion. As evidence for receiving valuables, he
issued a receipt. Since gold and silver coins had no marks of the owner, the goldsmith started
lending them. As the goldsmith was prepared to give the holder of the receipt an equal
amount of money on demand, the goldsmith receipts became like cheques as a medium of
exchange and a means of payment.
The next stage in the growth of banking is the moneylender. The goldsmith found that on
an average the withdrawals of coins were much less than the deposits with him. So he started
advancing the coins on loan by charging interest. As a safeguard, he kept some money in the
reserve. Thus the goldsmith-money-lender became a banker who started performing the two
functions of modern banking that of accepting deposits and advancing loans.
In India our historical, cultural, social and economic factors have resulted in the Indian
money market being characterized by the existence of both the unorganized and the
organized sectors.

(a) Unorganized Sector: The unorganized sector comprises moneylenders and indigenous
bankers which cater to the needs of a large number of people especially in the rural areas.
They have been meeting the financial requirements of the rural populace since times
immemorial. Their importance can be gauged from the fact that Jagat Seths, hereditary
bankers of the Nawab of Bengal, were recognized even by Aurangzeb and the East India
Company who were compelled to borrow from them also publicly honored them.

The indigenous bankers are different from the proper banks in a number of ways. For
instance, they combine banking activities with trade whereas trading is strictly prohibited for

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 banks in the organized sector. They do not believe in formalities or paper work for making
deposits or withdrawing money. In fact, since a substantial percentage of their clientele is
illiterate, they frequently take a thumb impression of their customers on a blank paper. Even
if they use a ‘Hundi’ as a negotiable instrument yet it will not be indicated on its face
whether the transaction is supported by valuable consideration or it is merely as a result of
mutual accommodation. The rate of interest charged by them fluctuates directly with the need
of the borrower and may sometimes be as high as 300 percent! They are insulated from all
type of monetary and credit controls as they fall outside thy purview of RBI. Though they are
still the major source of funds for small borrowers, but now their market has started shrinking
because of the fast expansion of branches of banks in the unorganized sectors.

1.3 Functions of Bank

According to section 6 of the Banking Regulation Act, 1949, the primary functions of a bank are:
acceptance of deposits and lending of funds. For centuries, banks have borrowed and lent money
to business, trade, and people, charging interest on loans and paying interest on deposits. These
two functions are the core activities of banking. Besides these two functions, a commercial bank
performs a variety of other functions which can be categorized in two broad categories namely
(a) Agency or Representative functions (b) General Utility functions.
(a) Agency or Representative functions:
• Collection and Payment of Various Items: Banks carry out the standing
instructions of customers for making payments; including subscriptions, insurance
premium, rent, electricity and telephone bills, etc.
• Undertake government business like payment of pension, collection of direct tax
(e.g. income tax) and indirect tax like excise duty.
• Letter of Reference: Banks buy and sell foreign exchange and thus promote
international trade. This function is normally discharged by Foreign Exchange
Banks.
• Purchase and Sale of Securities: Underwrite and deal in stock, funds, shares,
debentures, etc.
• Government’s Agent: Act as agents for any government or local authority or any
other person or persons; also carry on agency business of any description
including the clearing and forwarding of goods, giving of receipts and discharges,
and otherwise acting as an attorney on behalf of customers, but excluding the
business of a managing Agent or Secretary and treasurer of a company.
• Purchase and Sale of Foreign Exchange: Banks buy and sell foreign exchange and
thus promote international trade. This function is normally discharged by Foreign
Exchange Banks.
• Trustee and Executor: Banks also act as trustees and executors of the property of
their customers on their advice.
• Remittance of Money: Banks also remit money from one place to the other
through bank drafts or mail or telegraphic transfers.

(a) General Utility functions:

• Locker facility: Banks provide locker facilities to their customers. People can keep
their gold or silver jewellery or other important documents in these lockers. Their
annual rent is very nominal.

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 • Business Information and Statistics: Being familiar with the economic situation of the
country, the banks give advice to their customers on financial matters on the basis of
business information and statistical data collected by them.
• Help in Transportation of Goods: Big businessmen or industrialists after consigning
goods to their retailers send the Railway Receipt to the bank. The retailers get this
receipt from the bank on payment of the value of the consignment to it. Having
obtained the Railway Receipt from the bank they get delivery of the consignment
from the Railway Goods Office. In this way banks help in the transportation of goods
from the production centers to the consumption centers.
• Acting as a Referee: If desired by the customer, the bank can be a referee i.e. who
could be referred by the third parties for seeking information regarding the financial
position of the customer.
• Issuing Letters of Credit: Bankers in a way by issuing letters of credit certify the
credit worthiness of the customers. Letters of credit are very popular in foreign trade.
• Acting as Underwriter: Banks also underwrite the securities issued by the government
and corporate bodies for commission. The name of a bank as an underwriter
encourages investors to have faith in the security.
• Issuing of Traveller’s Cheques and Credit Cards: Banks have been rendering great
service by issuing traveller’s cheques, which enable a person to travel without fear of
theft or loss of money. Now, some banks have started credit card system, under which
a credit card holder is allowed to avail credit from the listed outlets without any
additional cost or effort. Thus a credit card holder need not carry or handle cash all
the time.
• Issuing Gift Cheques: Certain banks issue gift cheques of various denominations e.g
some Indian banks issue gift cheques of the denomination of Rs. 101, 501, 1001 etc.
These are generally issued free of charge or a very nominal fee is charged.
• Dealing in Foreign Exchange: Major branches of commercial banks also transact
business of foreign exchange. Commercial banks are the main authorized dealers of
foreign exchange in India.
• Merchant Banking Services: Commercial banks also render merchant banking
services to the customers. They help in availing loans from non-banking financial
institutions.

1.4 Banking Sectors

The spectrum of needs and requirements of individuals, organizations and sectors of the
economy is very vast and diverse. Banks have come up with a whole range of banking products
and services to suit the requirements of their clients. Banking sectors include corporate banking,
international banking and rural banking.
Corporate Banking: Cooperative banking typically serves the financial needs of large
corporate houses- both domestic and multinational-public sectors and governments.
However, traditionally banks had primarily been focusing on production based activities and
financed working capital requirements as well as term loans to corporates due to following
reasons:
• From the beginning till the pre-reform era, business houses were heavily
dependent on banks for their financial needs. The capital markets were not well
developed, joint ventures norms had not been liberalized, mergers and

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 acquisitions were not the preferred route and numerous restrictions were placed
on raising finance from overseas markets.
• The banking institutions too showed a preference for providing credit to the
corporates. This way their paper work was markedly reduced as the numbers of
clients were less. Not only the workload was eased but also the risk involved was
considerably less as corporate borrowings were made against collaterals after
verifying their capacity for repayment.
• The government had also earmarked priority sectors, and as such banks had to
comply with the targets allotted to them.
After liberalization, many corporates could not face the competition and went into
the red. Economic downturn and recessionary environment resulted in poor performance
of many borrowers. As a direct consequence of all these, the NPAs of banks started
mounting. However, according to the RBI annual report of 2005-06, the credit demand by
the corporate sector has turned robust on the back of strong industrial performance.
Furthermore, banks are expected to have greater financing opportunities in the area of
project finance, especially in the infrastructure sector, given the conversion of two major
financial institutions into banks. Banks have been focusing mainly on syndication of debt
to ensure wider participation in project finance and wholesale leading segment.
Features
Corporate banking serves the need of corporates, those having a legal entity. They offer
business current accounts, make commercial loans, participate in syndicated lending and
are active in inter-bank markets to borrow/lend from/ to other banks. Many banks offer
structured products, capital market services and corporate solutions. Corporate banking
involves comparatively fewer borrowers and the account size is usually large and
sometimes it can turn into billions of dollars.
Services
I. Corporate banking services include:
II. Working capital and terms loans, overdrafts, bill discounting, project
financing.
III. Cash management both short term holdings of cash as well as funds
held for longer periods.
IV. Financing of exports and imports including export credit
arrangements.
V. Project finance
VI. Transmission and receipt of money.
VII. Handling foreign currency and hedging against changes in value.

In recent times, there has been a marked shift from corporate to retail banking. The major
reason for avoiding corporate accounts is the mounting non-performing corporate
accounts. Difficulty in pricing the services and high risks involved are some of the other
reasons for overlooking corporate accounts. However this is very lucrative segment
provided care is taken in identifying and focusing on selected business segments and
catering to their requirements, e.g. for the SME segment, credit is paramount whereas for
big corporates, customized solutions are needed. Systematic account planning process
can help to identify the profitable customers, and pricing of services can help the bank to
get rid of asset quality problem. Most developed nation’s banks have separate corporate
bank divisions which help them to avoid the pitfalls of one size fits all policies.

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 (B) Retail Banking: With a jump in the Indian economy from a manufacturing sector,
that never really took off, to a nascent service sector, Banking as a whole is
undergoing a change. A larger option for the consumer is getting translated into a
larger demand for financial products and customization of services is fast becoming
the norm than a competitive advantage. With the Retail banking sector expected to
grow at a rate of 30% players are focusing more and more on the Retail and are
waking up to the potential of this sector of banking. At the same time, the banking
sector as a whole is seeing structural changes in regulatory frameworks and
securitization and stringent NPA norms expected to be in place by 2004 means the
faster one adapts to these changing dynamics, the faster is one expected to gain the
advantage. In this article, we try to study the reasons behind the euphemism regarding
the Retail-focus of the Indian banks and try to assess how much of it is worth the
attention that it is attracting. Retail banking is typical mass-market banking in
which individual customers use local branches of larger commercial banks. Retail
banking is banking that provides direct services to consumers. Many people with
bank accounts have their accounts at a retail bank and banks that offer retail banking
services may also have merchant and commercial branches that work with businesses.
For people with high net worth and special banking needs, private retail banking
services may be pursued. These offer a high level of service with a number of options
that are not available to average members of the public. Services offered include
savings and checking accounts, mortgages, personal loans, debit/credit cards and
certificates of deposit (CDs).The most basic retail banking services include savings
and checking accounts. Most retail banks, however, try to make themselves into a one
stop shop for banking customers. This increases customer retention and loyalty,
ensuring that the bank has a steady supply of customers. Expanding banking services
also provides more opportunities for the bank to turn a profit.

Characteristics of Retail Banking

1. Large Number of Small Customers: Retail banking is characterized by the existence

of a large number of small customers, who consumes personal banking and small
business services. The essential prerequisite of retail banking is its orientation
towards the consumer whether it is in size, price, delivery channels or product profile.
2. Multiple Products: A basket of products including flexi deposits, cards, insurance,
medical expenses, auto loans are offered to the consumers. Besides these, there are a
number of value added services like de-mat accounts, issue of free ATM cards,
portfolio management, payment of water, electricity and telephone bills.
3. Multiple Delivery Channels: To increase penetration and access banks are not
limiting themselves to branches but are making extensive use of internet, call centres,
kiosks, etc.

Origin of Retail Banking: Origin of retail banking in India can be traced to a number of
developments.

1. Financial Sector Reforms and Liberalization: Before opening up of the economy during
the decade of the nineties, corporate banking had been the preferred goal for bankers.
However, after the reforms it no longer remained so. Corporates could now go in for
external commercial borrowings from any internationally recognized bank, export credit
agency, international capital market or supplier of equipment. They could also opt for
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 mergers and acquisitions. So banks had to look for other avenues than the corporate
sector for growth and expansion.
2. Spreading of Risk: Another consequence of liberalization was industrial recession,
economic downturn, industrial sickness which resulted in failure of many big corporates.
Mounting non-performing assets made banks more cautious about lending to business
houses, and diverting their funds into the retail segment, as retail banking has the
advantage of minimizing the risk and maximizing the returns. The returns from retail
segment are three to four percent as compared to one to two percent from the corporate
segment.
3. Growth in Banking Technology and Automation of Banking Processes: Technology has
opened up new vistas for the banking industry and redefined its nature, scope and extent.
State-of-the-art electronic technology has helped to increase penetration through ATMs
without opening more branches. Internet has made possible banking to be done from
home. Telebanking and phone banking are some other new technologies which have
revolutionized banking.
4. Changing profile of Customers: An ever-increasing middle class, with more disposable
income, higher education and a desire for higher standard of living have fuelled the
demand for retail banking services. More and more people seemed to have embraced the
credit culture, and are demanding consumer goods, holidays, education and a host of
other value added banking services.

(C) Rural Banking: On the birth anniversary of Mahatma Gandhi on October 2, 1975, Rural
Banks were established with a view to stepping up rural credit. In 1975, the Government of
India appointed a working group under the Chairmanship of M. Narasimham, the Deputy
Governor of the Reserve Bank of India to review the flow of institutional credit to the people
in rural areas. The committee was to study the availability of institutional credit to the weaker
section of the rural population and to suggest alternative agencies for this purpose. The
committee concluded that the commercial banks would not be able to meet the credit
requirements of the weaker sections of the rural areas in particular and rural community in
general. The Government accepted the recommendations of the working group and passed an
ordinance in September 1977 to establish Regional Rural Banks.

Need to Establish Regional Rural Banks

The main need and objective of the RBBs was to provide credit and other facilities to the small
and marginal farmers, agricultural laborers and artisans, who had, by and large, not been
adequately served by the existing credit institutions namely, cooperative banks and commercial
banks:

1. Co-operative Banks: So far as the co-operative credit structure is concerned, it lacks the
managerial talent, post credit supervision and the loan recovery. They are also not in a
position to mobilize necessary resources.
2. Commercial Banks: These banks are mostly centralized in urban areas and are urban-
oriented. Although these can play a crucial role as far as the rural credit is concerned. For
this they have to adjust their methods, procedures, training and orientation in accordance
with the rural environment. Further, due to high salary structure, staffing pattern and high
establishment expenses their operational cost is also higher. Thus, under these
circumstances, the commercial banks cannot provide credit, to the weaker sections of the
rural areas, at a cheap rate.
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 3. Need of a New Institution: Thus in accordance with the rural requirements, the necessity
was felt to establish such an institution i.e. a rural oriented bank which may fulfill credit
needs of the rural people particularly the weaker section. It may also combine the merits
of the above two mentioned institutions, keeping aside their drawbacks. The RRBs, as
subsidization to nationalized banks, are expected in the long run not only to provide
credit to farmers and village industries but also to mobilize deposits from rural
households. They may form an integral part of the rural financial structure in India.

Difference Between RRBs and Commercial Banks

Although the RRBs are basically the scheduled commercial banks, yet they differ from each
other in the following respects

1. The area of the RRB is limited to a specified region comprising one or more districts of a
state.
2. The RRBs grant direct loans and advance only to small and managerial farmers, rural
artisans and agricultural laborers and others of small having small means for productive
purposes.
3. The lending rates of RRBs are not higher than the prevailing lending rates of co-operative
societies, in any particular state. The sponsoring banks and the Reserve bank of India
provide many subsidies and concessions to RRBs to enable it to function effectively.

Organisation

The RRBs have been established by ‘Sponsor bank’ usually a public sector bank. The steering
committee on RRBs identifies the districts requiring these banks. Later, the Central Government
sets up RRBs with the consultation of the state government and the sponsor bank. Each RRBs
operates within local limits with such as name as may be specified by the Central Government.
The bank can establish its branches at any place within the notified areas.

Capital

The authorized capital of each RRBs is Rs. 5 crore which may be increased or reduced by the
Central Government but not below its paid up capital of Rs. 25 lakh. Of this fifty percent is
subscribed by the Central Government, 15 percent by the State Government and 35 percent by
the sponsor bank. At present the formula for subscription to RRBs has been fixed at 60:20:20
between central government, state government and the sponsor bank. The Central Government’s
contribution is made through NABARD.

Management

Each RRB is managed by a Board of Directors. The general superintendence, direction and
management of the affairs and business of RRBs vests with the nine member Board of Directors.
The Central Government nominates 3 directors. The chairman, usually an officer of the sponsor
bank but is appointed by the central Government. The Board of Directors is required to act on
business principles and in accordance with the directives and guidelines issued by the Reserve
Bank. At the State Level, State Level Coordination Committee have also been formed to have
uniformity of approach of different RRBs.

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Functions

The RRB are required to perform the following functions or operations:

1. Operations Related to Agricultural Activities: To grant loans and advances to small and
marginal framers and agricultural laborers, whether individually or in groups or to
cooperative societies including agricultural marketing societies, agricultural processing
societies, cooperative farming societies, primary agricultural societies for agricultural
purposes or for other related purposes.
2. Operations Related to Non-Agricultural Activities: Granting of loans and advances to
artisans, small entrepreneurs and persons of small means engaged in trade, commerce and
industry or other productive activities within its area of operation.

(D) Micro-Credit: In spite of the phenomenal outreach of formal credit institutions, the rural
poor still depend upon the informal sources of credit. Two major causes for this are the large
number of small borrowers with small and frequent needs. Also the ability of these borrowers to
provide collateral is very limited. Besides, the long and cumbersome bank procedures and their
risk perception have also been limiting factors. Micro-credit has emerged as the most suitable
and practical alternative to conventional banking in reaching the hitherto untapped poor
population.

Micro-credit or micro-finance means providing very poor families with very small loans to help
them engage in productive activities or grow their tiny businesses. Over time, the concept of
micro-credit been broadened to include a whole range of financial and non-financial services like
credit, equity and institution building support, savings, insurance etc. Micro-finance institution is
an organization that provides financial services to people with limited income who have
difficulty in accessing the formal banking sector. The objective of micro finance is to provide
appropriate financial services to significant numbers of low-income, economically active people
in order to finance micro-enterprises and non-farm income generating activities including agro-
allied activities and ultimately improve their condition as well as that of local economies.’

As per RBI micro-finance is the provision of thrift, credit and other financial services and
products of very small amount to the poor in rural, semi-urban and urban areas for enabling them
to raise their income levels, and improve their living standard. Micro-credit institutions are those
that provide these facilities. The micro-finance approach has emerged as an important
development in banking for channelizing credit for poverty alleviation directly and effectively.
The micro-credit extended by banks to individual borrowers directly or through any agency is
regarded as a part of banks priority sector loans.

(E ) Self-Help Groups: SHGs have been launched to combat the problem of growing poverty at
the grass roots level. Small, cohesive and participative groups of the poor are formed who
regularly pool their savings to make small interest bearing loans to its members. In the process,
they lean the nuances of financial discipline. Initially bank credit is not primary objective. It is
only after the group stabilizes and gains ability to undertake productive activity and bear risk that
micro-credit comes into play.

The SHG bank linkage programme has proved to be the major supplementary credit delivery
system with a wide acceptance by banks, NGOs and various government departments. It
encourages the rural poor to build their capacity to manage their own finances, and then
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negotiate bank credit on commercial terms. Certain norms have to be observed in the formation
of SHGs. To become a member, a person has to be below the poverty line. Only one member of
a family can become a member and that person cannot become a member of more than one SHG.
There is no limit of maximum number of members can be between 10 and 20. Members of SHGs
are supposed to meet regularly, that is, once a week or once a fortnight. However, registration is
optional and left to the discretion of the members.

(F) Non-Banking Financial Intermediaries: Non-Banking financial Intermediaries are a

heterogeneous group of financial institution, other than commercial and cooperative banks.
These institutions are an integral part of the Indian financial system. A wide variety of financial
institutions is included in it. These institutions raise funds from the public, directly and
indirectly, to lend them to ultimate spenders. The Development Banks (such as the IDBI, IFCI,
ICICI, SFCs, SIDCs, etc.) fall in this category. They specialize in making term loans to their
borrowers. LIC, GIC and its subsidiaries and the UTI are its other all India big term-lending
institutions. Out of these three, only UTI is a pure non-banking financial intermediary, the others
raise funds in the shape of premium from the sale of insurance. Besides this, there are provident
funds and post offices who mobilize public savings in a big way for onward transmission to
ultimate borrowers or spenders. A large number of small NBFs such as investment companies
loan companies, hire purchase finance companies and the equipment leasing companies, these
are private sector companies with only a few exceptions.

Functions of Non-Banking Financial Intermediaries: The main functions performed by NBFs

are as under:

1. Brokers of Loanable Funds: NBFs act as brokers of loanable funds and in this capacity
they intermediate between the ultimate saver and the ultimate investor. They sell indirect
securities to the savers and purchase primary securities from investors. Thus, they change
debt into credit. By doing so, they take risk on themselves and reduce the risk of ultimate
lenders. Not only that, by diversifying their financial assets they spread their risk widely
and thus reduce their own risk because low returns on some assets are offset by high
return on others.
2. Mobilization of Savings: These institutions mobilize savings for the benefit of the
economy. By providing expert financial services like easy liquidity, safety of the
principal amount and ready divisibility of savings into direct securities of different values
they are able to mobilize more funds and attract larger share of public savings.
3. Channelization of Funds into Investment The NBFs, by mobilizing savings, channelize
them into productive investments. Each intermediary follows its own investment policy.
For instance, savings and loan associations invest in mortgages; insurance companies
invest in bonds and securities etc. Thus this channelization of public savings into
investment helps capital formation and economic growth.
4. Stabilize the Capital Market These institutions trade in the capital market in a variety of
assets and liabilities, and thus equilibrate the demand for and supply of assets. Since they
function with a legal framework and rules and they protect the interests of the savers and
bring stability to the capital market.
5. Provide Liquidity Since the main functions of the NBF’s convert a financial asset into
cash easily, quickly and without loss in the capital value, they provide liquidity. They are
able to do so, because they advance short-term loans and finance them by issuing claims
against themselves for long periods and they diversify loans among different types of
borrowers.
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Types of Non Banking Financial Institutions: The main types of non-banking financial
institutions/intermediaries are as under:

The Life Insurance Companies: Life Insurance Corporation of India enjoys near monopoly of
life insurance in India. It is the biggest institutional investor. The LIC was established in 1
September, 1956 by nationalizing all the life insurance companies operating in India. Prior to
nationalization of insurance companies, 245 private insurance companies operate from 97
centres. The main objectives of LIC are (i) To carry on Life Insurance business in India. Life
insurance is a very important form of long term savings. (ii) The LIC aims in promoting savings.
(iii) To invest profitability the savings collected in the form of payments received from life
insurers. The LIC has two tier of capital structure- the initial capital, and premium capital. The
initial capital of LIC is Rs. 5 crore provided by the Government of India. The premium paid by
policy holders are the principal source of funds by LIC. Besides, the LIC receives interest,
dividends, repayments and redemptions which add to its investible resources. The LIC is
required to invest atleast 50% of its funds in government and other approved securities. LIC has
to invest 10% of its funds in other investments which include loans to state governments for
housing and water supply schemes, to Municipal Corporation, and corporation, and cooperative
sugar companies, loans to policy holders, fixed deposits with banks and cooperatives societies.
The main principle involved is security of funds rather than maximization of return on
investment.

General Insurance Companies: General Insurance Corporation of India was established in

January 1973, when General Insurance Companies were nationalized. At the time of
nationalization, there were 68 Indian companies and 45 non-Indian companies in the field. Their
business was nationalized and vested in the General Insurance Company and its four subsidiaries
viz., National Insurance Company Ltd. and United India Insurance Company Ltd. The GIC is
the holding company and its direct business is restricted only to aviation insurance; general
insurance is handled by the subsidiaries of GIC and they operate various types of policies to suit
the diverse needs of various segments of the society. They derive their income from insurance
premia and invest the funds in various types of securities as well as in the form of loans. GIC has
thus emerged as an important investment institution operating in Indian capital market.

Unit Trust of India: The UTI is an investment institution which offers the small investor a share
in India’s industrial growth and productive investment with minimum risk and reasonable
returns. The UTI was established as a Statutory Corporation in February 1964 under the UTI Act
1964. It commenced its operations from 1 July, 1964. The UTI was established with the
objective of mobilizing the savings of the community and channeling them into productive
investment. Its objective is to encourage widespread and diffused ownership of industry by
affording investors particularly the small investors, a means of acquiring shares assured of a
reasonable return with minimum risk. Thus, the primary objective of the Unit Trust in two fold
(i) To stimulate and pool the savings of the middle and low income groups (ii) To enable the unit
holders to share the benefits and prosperity of the rapidly growing industrialization in the
country. The UTI is managed by a board of trustees. It consists of a chairman and 9 other
trustees. The chairman is appointed by the government of India in consultation with the IDBI, 4
trustees nominated by the IDBI, one trustee each nominated by the RBI, LIC and SBI and 2
trustees selected by other institutions which contributed to the initial capital of the UTI. The head
office of UTI is in Mumbai. It has four zonal offices at Mumbai, Kolkata, Chennai and New
Delhi. It has 51 branch offices in various parts of the country.

11
(G) Mutual Funds: A mutual fund is a trust that pools the savings of a number of investors who
share a common financial gain. Anybody with an investible surplus of as little as a few thousand
rupees can invest in mutual funds. These investors buy units of a particular Mutual Fund Scheme
that has defined investment objective and strategy. The money thus collected is then invested by
the fund manager in different type of securities. The income earned through investments and the
capital appreciation realized by the scheme is shared by its unit holders in proportion to the
number of units owned by them. In India, the mutual fund industry started with the setting up of
Unit Trust of India in 1964. Public sector banks and financial institutions began to establish
mutual funds in 1987. The private sector and financial institutions were allowed to set up mutual
funds in 1993.

(H) Provident/ Pension Funds: These funds represent the most significant form of long-term
contractual saving of the household sector. At present the annual contribution to these funds is
running at double the rate than the rate of annual contribution to life insurance. In the financial
year 1999-2000, about Rs. 69.695 crore had accumulated in the provident fund and other
accounts with the Government of India. The resources mobilized by the funds during the same
year were Rs. 1,465 crore. The provident funds scheme practically started in the post-
independence period. Under the legalization, provident funds have been made compulsory in the
organized sector of industry, coal mining, plantation and services (such as government, banking,
insurance, teaching, etc.) There is a separate P.F. Legislation for coal mining, industries and
Assam tea plantations. With the growth of the organized sector of the economy and in wage
employment, savings mobilizations through PFs will growth further. The wage- earners are
encouraged to join, P.F. schemes and make contributions to them, because thereby alone they are
able to earn employers’ matching contribution to the fund.

(I) Post Offices: Post offices serve as the vehicle for mobilizing small savings of the public for
the government. These have been established with the sole motive of collecting people’s small
savings in urban, semi-urban and rural areas. They are generally known as “Savings Banks”. In
rural areas where majority of the population live, do not have such commercial banks. To create
banking habit among them and to collect their scattered small savings, the savings banks have
been opened. In India where there are no commercial banks, the Post-Office perform the
functions of commercial banks, they collect the deposits of the people, open their deposit
accounts and pay interest for the deposited money.

1.5 Conclusion
In simple words, bank refers to an institution that deals in money. This institution accepts
deposits from the people and gives loans to those who are in need. Besides dealing in money,
banks these days perform various other functions, such as credit creation, agency job and general
service. The spectrum of needs and requirements of individuals, organizations and sectors of the
economy is very vast and diverse. Banks have come up with a whole range of banking products
and services to suit the requirements of their clients. Banking sectors include corporate banking,
international banking and rural banking.

1.6 Test Questions

Q1. What is a Bank? Explain the main functions of a Bank.

Q2. Explain the various types of retail banking services offered by banks.

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Q3. Give an overview of different banking sectors in India.

1.7 Further Readings

Varshney P.N.& Mittal D.K. , “ Indian Financial System”, Sultan Chand &Sons
G. Ramesh Babu, “ Financial Markets and Institutions”, Concept Publishing Company.
Tripathi Prava Nalini, “ Financial Services”, Prentice Hall of India, 2008.
Jain T.R., “ Indian Financial System” , V.K. Publications.

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 LESSON 2

DEPOSITS AND ADVANCES

Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi
Objectives

After going through this lesson you should be able to:

• Know about Different Deposit Account
• Understand Principles of Sound Lending
• Explain the Methods of Granting Advances
• Analyze Different Modes of Creating Charges
Structure
2.1 Accepting of Deposits
2.2 Principles of Sound Lending
2.3 Methods of Granting Advances
2.4 Secured Advances
2.5 Modes of Creating Charges
2.6 Legal Mortgage vs. Equitable Mortgage
2.7 Summary
2.8 Test Question
2.9 Further Readings

Banks deal mainly with money and credit. They are manufacturers of money. Industrial and
economic evolution would not have occurred in the absence of banks. They play significant role
in the shaping and in the advancing of modern societies. They distribute the funds equitably,
reduce cyclical fluctuations. The industrial development will not be possible without the help of
the banks. They purchase and sell money and credit. Creation of credit is a special function of
banks. They are the architecture of the digital economy. They encourage trade and industry.

The functions are the main income sources of money. Every bank must follow these functions.
The basic functions of a bank are (1) Accepting of Deposits (2) Advancing of Loans (3) Secured
Advances

2.1 Accepting of Deposits

Deposits are the most important element in the banking sector. They collect surplus money from
the public. The deposits will be mobilized by banks. The money collected from the public are
preserved by banks and interest will be paid by the banks. The depositors are benefited and their
amount of money is safe at the banks. In this situation the banks can earn a sum of money on the
amount collected by them. The banks create credit on the basis of deposits. The level of creation
of credit depends upon the amount of deposits. The banks have introduced different types of
deposits to suit the various requirements of the depositors. The types of deposit schemes are
briefly discussed below:
(a) Fixed Deposits
(b) Current account
( c) Savings Bank Account
(d) Money Multiplier Account
(e) Other Accounts

Fixed Deposits: Under this scheme the banks mobilizes the deposits which are repayable after
the expiry of three months to five years. The banks are free to use the deposits for a certain
period. They grant loans at higher rate of interest on these deposits. They can use the deposits
money for a certain period of time for more remunerative purposes. The small savers will get
benefits from the scheme. The small customers are unable to make investments in the industrial
securities market. They do not want to take risk from the securities market. A large number of
savers prefer this mode of investment. The fixed deposit has become more lucrative as rate of
interest has increased up to 10 percent. The customers can earn more by combining the Fixed
Deposit account with recurring deposit account. The interest on FDR will be credited to the
recurring deposit account. The amount of fixed deposit cannot generally be withdrawn before the
expiry of the period of deposits. However banks can advance money of the security of fixed
deposits if the depositors are not willing to withdrawn the amounts deposited.
The fixed deposits are also known as Term Deposit. Fixed deposits have grown in
importance and popularity in India during recent years. These deposits constitute more than half
of the total bank deposits. The rate of interest and other terms and conditions are regulated by the
RBI. The RBI revised the rate of interest on fixed deposits several times. The main object of the
step was to make bank deposits more attractive as compared to other savings instruments.

Current Account: Current account is more beneficial to those who withdraw several times from
the account of deposits. No interest is paid on this account. Cheques are generally used for
withdrawing a certain amount from the deposits. Current accounts are more useful to the
businessmen. They can produce this account as an evidence of revenue for the assessment of
Income Tax. The businessmen are not required to keep with them a large amount of money. He
will make payments by issuing cheques to the parties. The cheques can be transferred to any
person for the settlement of dues. The current account is opened subject to the conditions.
Generally no interest is paid on the amount of deposit balances and no charges are required for
maintaining such account. Current accounts are more useful to the businessmen, firms,
companies and individuals.

Savings Bank Account: Savings bank account is useful to middle and low income groups. They
can save certain amount during a certain period. It is a flexible account. In this account, the
depositor can withdraw money about thrice a week. The account holder can deposit money at
any time. The interest is calculated on the minimum balance maintained each month. A person
wishing to open saving bank account will have to fill up a form. He has to furnish his specimen
signature. A passbook will be issued to the account holder. If the depositor wants to withdraw
money he must fill up a withdraw money he must fill up a withdrawal form and must present his
book for payment. Now some banks extended the cheques facility to the savings bank customers.

15
Money Multiplier Account: The persons who are interested to deposit money for more money
at short period of time. Under this scheme the amount of interest is also redeposited. The rate of
interest is highest on this deposit. The depositor can withdraw the accumulated money after
stipulated period. The depositor can withdraw the whole amount either in lump-sum or in
installments. If the depositor opted for installments higher amount is returned to the person. This
is most suitable for old age provision.

Other Accounts: There are so many saving deposit accounts like Recurring deposit account,
private savings account and special saving account. Recurring deposit accounts are more popular
in India. A fixed amount is deposited at a regular interval and it attracts accumulated at
compound rate of interest. Under this scheme the interest and the principal amount is returned to
the depositor after the fixed period. The rate of interest is higher than of saving account and
lower than of fixed deposit account. It is a great source of stimulating short deposits. These
schemes are designed to meet the requirements of education and marriage.

2.2 Principles of Sound Lending

The business of lending carries certain inherent risk, and banks can afford to take only calculated
risks as they deal in other people’s money. Another important facet of bank operations is the
need to have ready cash as a bank is under an obligation to return the customer’s money
whenever it is demanded. Hence, the nature of bank functions is such that it requires a very
prudent and diligent handling of bank funds. It is advisable that the following general principles
of sound lending should be followed by a banker at the time of granting advances.

1. Liquidity: Liquidity is an important principle of bank lending. Banks lend for short
periods only because they lend public money which can be withdrawn at any time by
depositors. They, therefore, advance loans on the security of such assets which are easily
marketable and convertible into cash at a short notice. A bank chooses such securities in its
investment portfolio which possess sufficient liquidity. It is essential because if the bank
needs cash to meet the urgent requirements of its customers, it should be in a position to sell
some of the securities at a very short notice without disturbing their price much. There are
certain securities such as central, state and local government bonds which are easily saleable
without affecting their market prices.
2. Safety: The safety of funds lent is another principle of lending. Safety means that the
borrower should be able to repay the loan and interest in time at regular intervals without
default. The repayment of the loan depends upon the nature of security, the character of the
borrower, his capacity to repay and his financial standing. Like other investments, bank
investments involve risk. But the degree of risk varies with the type of security. Securities of
the central government are safer than those of the state governments and local bodies. From
the point of view, the nature of security is the most important consideration while giving a
loan. Even then, it has to take into consideration the creditworthiness of the borrower which
is governed by his character, capacity to repay, and his financial standing. Above all, the
safety of bank funds depends upon the technical feasibility and economic viability of the
project for which the loan is advanced.
3. Diversity: In choosing its investments portfolio, a commercial bank should follow the
principle of diversity. It should not invest its surplus funds in a particular type of security but

16
in different types of securities. It should choose the shares and debentures of different types
of industries situated in different regions of the country. The same principle should be
followed in the case of state governments and local bodies. Diversification aims at
minimizing risks of the investment portfolio of a bank. The principle of diversity also applies
to the advancing of loans to varied types of firms, industries, businesses and trades. A bank
should follow the maxim: “Do not keep all eggs in one basket.” It should spread it risks by
giving loans to various trades and industries in different parts of the country.
4. Stability: Another important principle of a bank’s investment policy should be to invest in
those stocks and securities which possess a high degree of stability in their prices. The bank
cannot afford any loss on the value of its securities. It should, therefore, invest its funds in the
shares of reputed companies where the possibility of decline in their prices is remote.
Government bonds and debentures of companies carry fixed rates of interest. But the bank is
forced to liquidate a portion of them to meet its requirements of cash in case of financial
crisis. Thus bank investments in debentures and bonds are more stable than in the shares of
companies.
5. Profitability: This is the cardinal principle for making investment by a bank. It must earn
sufficient profits. It should, therefore, invest in such securities which assure a fair and stable
return on the funds invested. The earning capacity of securities and share depends upon the
interest rate and the dividend rate and the tax benefits they carry. It is largely the government
securities of the centre, state and local bodies that largely carry the exemption of their interest
from taxes. The bank should invest more in such securities rather than in the shares of new
companies which also carry tax exemption. This is because shares of new companies are not
safe investments.
6. Principle of Purpose: At the time of granting an advance the banker must enquire about
the purpose of the loan. If it is for speculative or unproductive purposes, it may prove to be a
burden on cash generation and repayment capacity of the borrower. On the other hand, it can
be reasonably anticipated that loans meant for productive purposes help generate incremental
income that results in prompt repayment of the loan.
7. Principle of Social Responsibility: At the time of evaluation of a loan project, bankers
should not put an overdue emphasis on the size of the borrower, and the security that he is
offering. The technical competency of the borrower and the economic viability of his project
should also be considered. The priority sector guidelines have also to be followed by the
bankers, if they want to contribute in the process of economic development by helping more
and more entrepreneurs to run successful ventures. The principle of social responsibility does
not, however, mean that adequate attention should not be paid to other principles.

2.3 Methods of Granting Advances

Bank deals with money of other persons. Bank does not lend its own money. It is the other’s
money in which it deals. The advances of bank may be granted in the form of loans,
overdraft, cash credit, credit discounting bills of exchange. The bank advances loan more
than the amount of deposits, because all the loans are not withdrawn immediately. Therefore
the loan creates deposits, while advancing loans; the bank gives priority to safety and next
profitability. In advancing loans, the principles of investment safety, liquidity and
profitability, diversification and social objectives are considered. The main methods of
granting advances in India may be classified as follows:

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 (a) Loans
(b) Cash Credit
(c) Overdraft
(d) Discounting of Bills

Loans: Loans are important element of the profitability of the banks. They are made by debiting
the customers loan account and by crediting his current account. The customer is allowed to
withdraw the loan amount by installments. The regular customers are permitted loans by
crediting to their accounts; proper care is taken while granting the loans. All of the loans require
a proper security or mortgage. Sometimes only the personal security is required for advancing
the loan. The interest is charged on the loan amount. Loans involve low operating cost than other
kind of loans. Loans are given against the securing of movable and immovable assets. A brief
description follows:
I. Short- term Loans: Short-term loans are loans which are granted for a period not
exceeding one year. These are advanced to meet the working capital requirements, again
security of movable assets like goods, commodities shares, debentures, etc. They are
usually taken to meet the working capital requirements of business.
II. Term-Loans: Medium and long-term loans are usually called term loans. These loans are
extended for periods ranging from one year to about eight or ten years on the security of
existing industrial assets or the assets purchased with the loan. Term loans are used for
purchase of capital assets for establishment of new industrial units, for expansion,
modernization or diversification. They involve an element of risk as they are intended to
be repaid out of the future profits over a period of years. Consequently, apart from the
financial appraisal of such loans, the technical feasibility and managerial competency of
the borrower should also be studied. Banks can charge fixed rates of interest for the entire
period or different prime lending rates for different maturities, provided transparency
and uniformity of treatment is maintained.
III. Bridge Loans: Bridge loans are essentially short-term loans that are granted pending
disbursement of sanctioned term loans. These help borrowers to meet their urgent and
critical needs during the period when formalities for availing of the term loans sanctioned
are being fulfilled. They are repaid out of the amount of such loans or from the funds
raised in the capital market if these loans are granted by financial institutions.
IV. Composite Loans: If a loan is taken for buying capital assets as well as for meeting
working capital requirements, it is called a composite loan. Usually such are availed by
small entrepreneurs, artisans and farmers.
V. Consumption Loans: Traditionally, banks used to focus on loans for productive purposes,
but during the recent past banks have increasingly started giving loans for consumption
purposes like education, medical needs and automobiles.

Cash Credit: Cash credit is another method of advances made by banks. In this method the
banker grants his customer to borrow money upto a certain sanctioned limit. The bank requires
security of certain bonds, promissory notes, shares, other commodities. Sometimes commodities
are kept in the possession of the bank in its godowns. The borrower is charged interest on the
amount of advance. Generally the cash credit system provides adequate amount for meeting
essential expenditures of the business. The large amount of credit is granted through credit
system because the whole amount of credit is not required to be withdrawn at once. It is the best

18
method to suit the requirements of the business community. Generally raw materials are
purchased on the basis of this credit. This type of loan is mostly short-term credit. The borrowers
can withdraw the sanctioned loan according to their convenient. The interest will be charged on
the dates of withdrawal of the amount.

Overdraft: Bank overdraft is allowed to current account holders. The current account holders
may be allowed to overdraw. The overdraft facility is more advantageous to the customers
because interest is charged only on the amount withdrawn. There is no need to provide collateral
security for the facility of overdraft. It can be used at any time of requirement. It is used for long-
term purposes. It is the most useful form of loans to commercial and industrial units to avail from
time to time. The overdraft will be granted by the bank with the mutual agreement with the
customer and bank. This form of advances has undoubtedly more benefits.

Discounting of Bills: The banks involves in discounting of bills. They discount only clear and
reputed bills. Discounting of bills is one of the methods of advances made by the banks. The
banks involve is discounting of bills. The working capital of the corporate sector is mainly
provided by banks through cash credit, overdrafts, and discounting of the commercial bills. The
bills are used for financing a deal in goods that takes same time to complete. The bill of
exchange reveals that the liability to make the payment on a fixed date when the goods are
bought on mercantile basis. The bills of exchange will be treated as negotiable instrument. The
bills are drawn by the seller on the buyer for the value of the goods delivered by him. These bills
are called as trade bills. If the trade bills are accepted by the commercial banks are known as
commercial bills. If the seller provide some time for the payment of the bill payable at a future
date is known as usance bill. If the seller party is in need of finance, he may approach the bank
for discount of the bill. The commercial banks generally finance the business community through
bill discounting method. The banks can rediscount the bills in the discount market. A bill is
always drawn by the creditor on the debtor. A bill may be payable at sight or after the expiry of a
certain specified time. There will be 3 days of grace period for a bill. The discount amount on the
trade bill becomes income to the commercial banks. It is an income generating activity for the
banks. The RBI introduced a bill market scheme in 1952. According to the scheme, the banks are
required to select the borrowers after careful examination of their credit worthiness and
reputation.

2.4 Secured Advances

In accordance with the principles of safety and security of sound lending, commercial banks
prefer to make advances against securities. A secured advance is one which is made on the
security of either assets or against personal security or other guarantees. An advance which is not
secured is called an unsecured advance.
The basic objective of obtaining securities is to recover the unpaid amount of loan if
any, through the sale of these securities. Hence, the securities should be clearly identifiable be
easily marketable, have stability and their title should be clear and easily transferable.

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Classification of Securities: Based on their nature, securities can be divided into various
categories:
1. Personal Securities: These are also called intangible securities. In case of these, the
banker has a personal right of action against the borrower, e.g. promissory notes, bills or
exchange, a security bond, personal liability of guarantor etc.
2. Tangible Securities: These are forms of impersonal security, such as, land, buildings and
machinery. In the event of recovery of loans, banks have to get such securities enforced
or sold through the intervention of court.
3. Primary Securities: These are those securities or assets which are created with the help of
finance made available by the bank, like machinery or equipment purchased with the help
of bank finance.
4. Collateral Security: This security is not what is financed out of the bank advance. It is
additional security given by the borrower where the primary security is not enough to
recover the loan amount at the time of realization, e.g. the land of the factory is given as
security along with the machinery purchased out of the bank loan.

2.5 Modes of Creating Charges

In case of secured loan, a charge is created on the asset in favour of the bank. In other words, the
banker obtains a legal right to get payment of the loan amount out of the security charged.
Charges can be of the following types such as lien, pledge, assignment and mortgage. Charges
can also be categorized according to their nature such as fixed charge or floating charge. A fixed
charge is created on assets whose identity does not change, e.g., land and building. In the case of
floating charge, the identity of the asset keeps fluctuating, e.g., stocks.
The legal provisions regarding modes of creating charge over tangible assets and the rights
and obligations of various parties are explained hereinafter:

Lien: Lien means the right of the creditor to retain the goods and securities owned by the debtor
until the debt due from him is repaid. The creditor gets only the right to retain the goods and not
the right to sell. Lien can be either particular or general. The right of particular lien can be
exercised by a person who has spent his time, money or labour on the goods, e.g. a car mechanic,
a tailor, etc. It can be exercised against only those goods for which charges have to be paid. A
banker, however, enjoys the right of general lien.
Features:
The right of general lien right of a banker is a blanket right, and is applicable in respect of all
amounts which are due from the debtor such as security handed over to the banker for a
machinery loan after its repayment can also be used by the banker in respect of any other
advances outstanding in his name, e.g., against an overdraft taken by the borrower.
Even though this right is conferred upon the banker by the Indian Contract Act, yet it is advisable
to take a letter from the customer mentioning that the goods have been entrusted to the banker as
security, and he may exercise his right of lien against it.
The bankers’ right of lien is tantamount to an implied pledge. Unlike as in the case of particular
lien the creditor can only retain the goods till the amount due is paid, the banker has the right to
sell the goods in case of default of the customer.
Sometimes even a negative lien can be entered into. Under this arrangement, the borrower has to
1. give a declaration that the assets given as security are free from any charge or encumbrance, 2.

20
That no charge will be created on them nor will the borrower dispose of those assets without the
consent of the banker. The banker’s interests are only partially safe by securitizing a negative
lien as he cannot realize his dues from these assets.

Pledge: Pledge is the bailment of goods as security for payment of a debt or performance of a
promise. When a borrower secures a loan through a pledge, he is called a pawner or pledger, and
the bank is called the pawnee or pledge.
Features
• The goods can be pledged by the owner, a joint owner with consent of other joint owners,
a mercantile agent or in some cases by an unpaid seller.
• The banker can retain the goods for the payment of the debt, for any interest that has
accrued on it as well as any expenses incurred by him for keeping the goods safe and
secure.
• Goods can be retained for any subsequent advances also, but not for any existing debt
which is not covered by the pledge.
• In case of non-payment, the banker has the right to sell the goods and recover the amount
of loan along with the interest and expenses, if any.
• In case of default by the pledger, the banker has the right either to
• File a civil suit against the pledger and retain the goods as additional security or
• Sell the goods. In case of sale, banker must give due notice of sale to the borrower before
making a sale.
• This right is not limited by the law of limitation.
• Banker’s right of pledge prevails over any other dues including government dues except
worker’s wages.

Hypothecation: Hypothecation is an extended idea of pledge, whereby the creditor permits the
debtor to retain possession of goods, either on behalf of or in trust for him. Hypothecation is a
charge made on movable property in favour of a secured creditor without delivery or possession.
Charge is created only on movable goods like stocks, machinery and vehicles. The borrower
binds himself to give the possession of the goods to the banker, whenever the latter desires. It is a
convenient device in the circumstances in which the transfer of possession is either inconvenient
or impracticable such as buses and taxies, which are given as security by taxi operators, but are
used by them. The agreement is entered into through a deed of hypothecation.
The bank cannot take possession without the consent of the borrower, but after taking
possession, the banker is free to exercise the right of pledge, and sell the assets without
intervention of the court.

Assignment: Assignment of a contract means transfer of contractual rights and liabilities to a

third party. The transferor or borrower is called the assignor, and the transferee or banker is
called the assignee. The borrower can assign any of his rights, properties or debts to the banker
as security for a loan. These might be existing or future. Generally the ‘actionable claims’ are
assigned by the borrower. An actionable claim is a claim to any debt, other than a debt secured
by mortgage of immovable property, or by hypothecation or pledge of movable property, or to
any interest in movable property not in the possession, either actual or constructive, of the
claimant which the civil court recognizes as affording ground of relief, whether such debt or
beneficial interest be existent, accruing, conditional and contingent. Usually the borrower may

21
assign books debts, money due from government or semi-government or semi-government
organizations or life insurance policies.
Although notice of assignment of the debtor is not required under law (section 130 of
Transfer of Property Act, 1881), nevertheless it is in the interest of the assignee to give notice to
the debtor because in the absence of the notice, the assignee is bound by any payments which the
debtor might make to the assignor in ignorance of the assignment. For example, if the borrower
assigns his life insurance policy in favour of his banker as security for a loan, the bank should
give a notice to the Life Insurance Corporation (LIC), otherwise if any payment is made by the
LIC to the borrower, the banker will not be able to claim it.
Assignment may be legal or equitable. A legal assignment is effected through an
instrument in writing signed by the assignor. The assignor too informs the debtor in writing
about the assignment, the assignee’s name and address. The assignee also serves a notice on the
debtor of the assignor, and seeks confirmation of assigned balance. If the above conditions are
not fulfilled, i.e. assignment is not done in writing, or notice of assignment is not given to debtor,
then such assignment is called equitable assignment.

Mortgage: When a customer secures an advance on the security of specific immovable property
the charge created thereon is called a mortgage. Section 58 of the Transfer of Property Act, 1882,
defines a mortgage as, The transfer of an interest in a specific immovable property for the
purpose of securing the payment of money advanced or to be advanced by way of loan, on
existing or future debt, or the performance of an engagement which may give rise to pecuniary
liability. The instrument through which it is affected is called a mortgage deed, the customer
(transferor) is called the mortgagor and the bank (transferee) is called the mortgagee. The
payment so secured which includes both the principal money and the interest thereon is called
the mortgage money.
Section 58 of Transfer of Property Act, recognizes six types of mortgagers which are
discussed hereinafter.
Simple Mortgage: In case of simple mortgage, the mortgagor does not give possession of
property, but binds himself personally to pay the mortgage money. He agrees expressly or
impliedly that in case he fails to make the payment according to the contract, then the mortgagee
shall have right to cause the mortgage property to be sold and proceeds of sale to be applied, as
far as may be necessary, in payment of the mortgage money. The mortgagee himself cannot sell
the property, but has to seek intervention of the court.
Mortgage by Conditional Sale: Under this form of mortgage the mortgager ostensibly (on the
face of it) sells the mortgaged property with any one of the following conditions:
I. On default of payment of mortgage money, the sale shall become absolute.
II. On payment being made on a certain date, the sale shall become void.
III. When the payment is made, the buyer shall transfer the property to the seller.

Usufructuary mortgage: Unlike the simple mortgage which is non-possessory, in case of

usufructuary mortgage, the mortgagor delivers possession of the mortgaged property. The
mortgagee is also entitled to receive rents and profits accruing from the property and appropriate
the same in lieu of interest or in payment of mortgaged money or both. When the debt is so
discharged or repaid, the mortgagor is entitled to recover possession of his property. There is no
personal liability on the mortgagor.

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English Mortgage: In case of English mortgage, there is transfer of ownership on the condition
that the mortgagee will re-transfer the same on the payment of mortgage money. Further, the
mortgagor personally undertakes to repay the mortgaged money. In case of default, the
mortgagee has the right to sell the property without seeking permission of the court in the special
circumstances mentioned in section 69 of the Transfer of Property Act.

Mortgage by deposit of title deeds (equitable mortgage): This mortgage is affected by deposits of
title deeds of the property by the debtor in favour of the creditor to create a security thereon. This
type of mortgage is called equitable mortgage in English law. In India, it is restricted to the cities
of Delhi, Mumbai, Kolkata and Chennai or any other town which the concerned state
government may notify in the official gazette in this behalf. No registration is necessary and
delivery can be either actual or constructive. There is personal liability of the mortgagor to pay,
and the mortgagee can sell the property with the sanction of the court if the mortgaged money is
not repaid.
Anomalous Mortgage: A mortgage which is not simple mortgage, mortgage by conditional sale,
usufructuary mortgage, English mortgage and mortgage by deposit of title deeds (equitable
mortgage) is called an anomalous mortgage. If the terms of the mortgage do not strictly adhere to
any of the above five types, e.g. in case of simple mortgage if the mortgagee is allowed to use the
mortgage property, then it will not be called simple or usufructuary but an anomalous mortgage.
Under this the rights and liabilities of the parties are determined by the terms agreed upon in the
mortgage deed, and in the absence of such a deed by the local usage.

2.6 Legal Mortgage vs. Equitable Mortgage

From the point of view of transfer of title to the mortgaged property, a mortgage may either be a
legal mortgage or an equitable mortgage.

Legal Mortgage: legal mortgage can be enforced only if the mortgage money is Rs. 100 or
more. It is affected by transfer of legal title to the mortgage property by the mortgagor in favour
of the mortgagee. All this involves expenses in the form of stamp duty and registration charges.
At the time of repayment of mortgaged money, the property is retransferred to the mortgagor.

Equitable Mortgage: In case of equitable mortgage, only documents of title are transferred in
favour of the mortgagee and not the legal title. No registration is necessary and no stamp duty of
deposit, the mortgagor undertakes to execute a legal mortgage in case of default in payment
within the stipulated time. The reputation of the mortgagor is not affected, since in absence of
registration no one comes to know about the mortgage. However, this can prove risky also if
through negligence or fraud, another party is induced to advance money on the security of the
mortgaged property as the subsequent mortgagee will have priority over the first.

2.7 Conclusion

In conclusion, it is pertinent to mention that none of the principles should be considered in

isolation. While evaluating a loan proposal, judicious balance of all the cardinal principles of
sound lending are called for. This has become more imperative after 1991. Before liberalization,
banking business did not face much competition. As it was concentrated in a few hands, the

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policy environment was characterized by close regulation and control, and profitability was not
the dominant criterion on which the banks were supposed to function. But now the commercial
principles of viability, efficiency, prudence and profitability are receiving as much attention as
social banking.

2.8 Test Questions

Q1. Describe the various ways in which a commercial bank renders financial assistance to
borrowers.
Q2. Discuss the secured and unsecured advances of a bank.
Q3. Compare the relative advantages and drawbacks of equitable and legal mortgage.

2.9 Further Readings

Varshney P.N.& Mittal D.K. , “ Indian Financial System”, Sultan Chand &Sons
G. Ramesh Babu, “ Financial Markets and Institutions”, Concept Publishing Company.
Tripathi Prava Nalini, “ Financial Services”, Prentice Hall of India, 2008.

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 LESSON 3

ELECTRONIC BANKING
Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi
Objectives
After going through this lesson you should be able to:

• Understand the Concept of E-Banking

• Describe the New Dimensions & Products of Banking
• Differentiate Between Debit and Credit Card
• Explain the Risks in E-banking

Structure
3.1 Meaning of E-banking
3.2 Automated Teller Machine
3.3 Internet Banking
3.4 Telephone Banking
3.5 Electronic Clearing Service
3.6 Electronic Funds Transfer (EFT)
3.7 Credit Cards
3.8 Smart cards
3.9 Electronic Cheques
3.10 Debit Card
3.11 Risks in E-banking
3.12 Conclusion
3.13 Test Questions
3.14 Further Readings
The banking industry is now a very mature one and banks are being forced to change rapidly as
a result of open market forces such as threat of competition, customer demand, and
technological innovations such as growth of internet banking. If banks have to retain their
competitiveness, they must focus on customer retention and relationship management, upgrade
and offer integration and value added services. With the increasing customer demands, banks
have to constantly think of innovative customized services to remain competitive. That’s why
internet banking is becoming a necessity today.

3.1 Meaning of E-banking

Electronic banking (E-banking) is a generic term encompassing internet banking, telephone
banking, mobile banking etc. In other words, it is a process of delivery of banking services and
products through electronic channels such as telephone, internet, cell phone etc. The concept
and scope of E-banking is still evolving.
 Electronic services allow a bank’s customers and other stakeholders to interact and transact
with the bank seamlessly through a variety of channels such as the internet, wireless devices,
ATMs, on-line banking, phone banking and telebanking. Other services offered under E-
banking include electronic fund transfer, electronic clearing service and electronic payment
media including the credit card, debit card and smart card. On-line banking helps consumers to
overcome the limitations of place and time as they can bank anywhere, anytime as these
services are available twenty four hours, 365 days a year without any physical limitations of
space like a specific bank branch, city or region. They also bypass the paper based aspect of
traditional banking.
As compared to other countries, e-banking growth and development is at a nascent stage in
India, yet the changing profile of customers and the resultant competition from establishment
of new private sector banks and foreign banks has provided a fillip to its growth. As a result,
India has emerged as one of the fastest growing markets in the world.
Several initiatives taken by the Government of India as well as the Reserve Bank of India
(RBI) have facilitated the development of E-banking in India. As a regulator and supervisor,
the RBI has made considerable progress in consolidating the existing payment and settlement
systems, and in upgrading technology with a view to establishing an efficient, integrated and
secure system functioning in a real-time environment, which has further helped the
development of E-banking in India. The Government of India enacted the IT Act, 2000 with
effect from October 17, 2000, which provides legal recognition to electronic transactions and
other means of electronic commerce.

3.2 Automated Teller Machine

The Automated Teller Machine (ATM) is seen everywhere. This machine has brought
innovations in the Banking sector all over the world. The advent of the ATM has made the
concept of round the clock banking a reality. The ATM has been helpful to both the bankers
and the customers. The long crowd of customers in the banking hall of a branch waiting for
their turn to collect cash is disappearing. The branch business timings have lost significance to
the customers after the introduction of ATM.
The ATM is a device used by the bank customers to process account transactions. The
customer inserts into the ATM, a plastic card i.e. encoded with information on a magnetic strip.
The strip contains an identification code that is transmitted to the bank’s central computer by
modem. Every cardholder should be given a PIN (personal identification number) that he
should enter and after verifying the same with the records, ATM would allow operations.
Functions of ATM: The functions of ATM differ from bank to bank. The following features
are available in the ATM of all the banks.

• Fast Cash: When you want to do the only activity of drawing cash in pre-determined
amounts like Rs. 500, Rs. 1,000, Rs. 2,000, Rs. 5,000 etc. you can use this option.
• Normal Cash Withdrawal: Every bank has fixed a maximum limit of cash withdrawal
per account per day. It ranges between Rs. 10-15000. While in some banks the
maximum amount may be drawn in one shot (HDFC, ICICI) and in some other banks it

26
 should be drawn in lots (Syndicate Bank, State Bank of India). All withdrawals shall be
in multiple of Rs. 100 only.
• Balance Enquiry
• Mini statement of account: You get detail of last 5-10 transactions.
• Pin change:
• Cash Deposit: Varied procedures exist. Here special covers are available in the ATM
wherein the client has to fill up the challan, the denominations and key in these details.
Then, a window opens wherein the cover containing the cash has to be dropped. At the
end of the day, officials of the branch to which the ATM is attached, would open the
machine, take the cover and credit the account of the customer. If there is any cover, the
decision of the bank is final.
• Transfer transactions: If you want to transfer funds with in the bank i.e. from one
account to another at same branch or at different branch, you can use this option.
The ATMs are emerging as the most useful tool to ensure, “Any-Time Banking” and “Any-
where Banking” or “Any-Time Money”. While the benefits of ATM are immense, the cost of
ATM, though has come, down, it still prohibitive. An ATM costs between Rs. 8-10 lakh. If a
bank has to install 100 ATMs it should spend at least Rs. 8-10 crs. Added to this, is the
maintenance cost. Today any electronic device attracts and annual maintaing cost of Rs.8-12
per cent of capital cost. Besides this banks have to incur expenditure on the rent for retail
outlet, its ambience and on security personnel etc. While many public sector banks have gone
on a big way in opening ATMs there is a need for sufficient examination of their economic
viability. Already there is experience that the hits per ATM are less than 200 resulting in no big
gain for either the bank or customer. India with more population density should show a higher
average hit per day and this emerges as a critical factor in the overall ATM strategy towards
making the whole business idea profitable.
The rationale for banks introducing ATMs in 1970s, was to deliver their products more
cheaply than traditional branch networks which are loaded with expensive staff.

3.3 Internet Banking

Internet banking is the latest and the cheapest technology introduced in the banking industry. It
is acknowledged that the internet has already had a profound effect on delivery of financial
services and this likely to bring more radical changes. At the basic level, interknit banking can
mean the setting u of a web-page by a bank to give information about its products and services.
At an advance level, it involves provision of facilities such as accessing accounts, fund
transfer, and buying financial products or services online. This is called “Transactional Online
Banking”.
In general Internet Banking refers to the use if internet as a delivery channel for the banking
services, including traditional services, such as opening an account or transferring funds among
different accounts, as well as new banking services such as electronic bill presentation and
payment which allows the customers to pay and receive the bills on a bank’s website.
There are two ways to offer Internet Banking. First, an existing bank with physical offices
can establish a web-site and offer internet banking in addition to its traditional delivery
channel. Second, a bank may be established as a “branchless”, “Internet only”, or “Virtual

27
bank”. Further internet banking sites offer financial services products to customer in three
basic formats

• Information Only: Informational only presents online information about the different
banks services and products to the customers as well as general public and may include
unsecured e-mail contract, with no customer identification or verification required.
• Information Exchange: Information Exchange Customer Information such as name,
address and account information may be collected or displayed, with possible secure e-
mail and/or data transfer, with verification of customer identification required. No
financial transactions are to be made.
• Transactional: Transactional customer account information enquiry, financial
transactions such as transfer of funds, payment of bill, application for loans and a
variety of other financial transactions, with strong customer authentication required.
When it was introduced for the first time, Internet Banking was used mainly as an
information presentation medium in which banks marketed their products and services on their
web sites with the development of asynchronous technologies; however more banks have come
forward to use internet banking both as a transactional as well as an informational medium.
A successful Internet Banking solution offers:

• Exceptional rate on savings CDs, and IRAS.

• Checking with no monthly fee, free bill payment and rebates on ATM surcharges.
• Credit card with low rates.
• Easy online applications for all accounts, including personal loans and mortgages.
• 24 hours account access.
• Quality customer service with personal attention.
Internet banking is a cost-effective delivery channel for financial institutions. All the
transactions are encrypted, using sophisticated multi-layer security architecture, including fire
walls and filters. Firewall is a protection device to shield a vulnerable area from some form of
danger. In Internet, a firewall system set up specifically, to shield a web from outside.
Typically, this allows insiders to have full access to services on the outside, while granting
access into the internal system, selectively based on log-in-name and password.
Internet banking is somewhat different from PC banking. PC banking is transactions
through PC at one’s office or home, which is connected to the branch through a modem. PC
banking is available only when branch is open and is available only through any PC. But,
internet banking enables to do the same through any PC connected to the internet, from
anywhere in the world.

Advantages of Internet Banking

• Anywhere and anytime banking as services are provided round the clock.
• Worldwide connectivity as it transcends geographical boundaries.
• Easy access to recent and historical data.
• Direct customer control of international movement of funds.
• Greater processing speed and accuracy.

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3.4 Telephone Banking
The banks are aiming to make them more accessible by introducing telephone banking.
Telephone banking refers to dialing one telephone number using a telephone to access the
account, transfer funds, request statements or cheque book simply by following recorded
message and touching the keys on your phone. It allows the customers to check account at
convenient time and get simple things done without visiting bank premises. Telephone banking
aims at providing 24 hour service that is fast, convenient and secured for all customers. In the
modern society everyone has to access to telephone. Registering for telephone banking cost
nothing although there is a small transactions charge for making bill payment and frequent
usage charges.

3.5 Electronic Clearing Service

In 1994, RBI appointed a committee to review the mechanization in the banks and also to
review the electronic clearing service. The committee recommended in its report that electronic
clearing service-credit clearing facility should be made available to all corporate
bodies/Government institutions for making repetitive low value payment like dividend,
interest, refund, salary, pension or commission. It was also recommended by the committee
Electronic Clearing Service- Debit clearing may be introduced for pre-authorized debits for
payments of utility bills, insurance premium and installments to leasing and financing
companies. RBI has been necessary step to introduce these schemes, initially in Chennai,
Mumbai, Calcutta and New Delhi.

3.6 Electronic Funds Transfer (EFT)

For making inter-city payments customer usually make payments through demand drafts, mail
transfers and telegraphic transfers. In 1996, RBI devised an electronic fund transfer (EFT)
system to facilitate fast transfer of funds electronically. The funds can be transferred between
any two bank accounts even if the sender and the receiver are located in different cities or deal
with different banks. EFT has accelerated the movement of funds across the globe. E-cash or
cyber cash plays a predominant role in world of commerce. Such electronic funds movements
amounting to a few trillion dollars are settled on a daily basis in major international financial
centers. Society for worldwide inter-bank financial telecommunication is a classic example of
EFT among banks with its own standards for messages, which ensures speed, reliability,
security and accuracy. SWIFT, as a co-operative society was formed in May 1973 with 239
participating banks from 15 countries with its headquarters at Brussels. It started functioning in
May 1977. Reserve Bank of India and 27 other public sector banks as well as 8 foreign banks
in India have obtained the membership of the SWIFT. SWIFT provides rapid, secure, reliable
and cost effective mode of transmitting the financial messages worldwide. At present more
than 3000 banks are the members of the network. To cater to the growth in messages, SWIFT
was upgrade in the 80s and this version is called SWIFT-II. Banks in India are hooked to
SWIFT-II system.
SWIFT is a method of the sophisticated message transmission of international repute. This
is highly cost effective, reliable and safe means of fund transfer.

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 • This network facilitate the transfer of messages relating to fixed deposit, interest
payment, debit-credit statements, foreign exchange etc.
• This service is available throughout the year, 24 hours a day.
• This system ensure against any loss of mutilation against transmission.
• It serves almost all financial institution and selected range of other users.
The objective of establishing an EFT system is to facilitate an efficient, secure, economical,
reliable and expeditious system of funds transfer and clearing in the banking sector throughout
India, and to relieve the stress on the existing paper based funds transfer and clearing system.

Advantages of EFT

• Funds can get transferred easily and conveniently without delays and paper work.
• Built-in security measures ensure safety of funds during transfer.
• Losses and frauds are minimized due to easy tracking of transactions/customers.

3.7 Credit Cards

There are various ways of making payment through the banking system. These include
cheques, direct debits, bank drafts, electronic transfer, international money orders, letters of
credit, etc. Increasing affluence combined with increasing complexity of life has led to the
phenomenon of Credit Cards. They provide convenience and safety in the purchasing process.
It is generally known as plastic money. The credit card are made of plastic is widely used by
the consumers all around the globe. The changes in consumer behavior and tastes led to the
tremendous growth of credit cards. Credit card is a card which enables the consumers to
purchase products or services without paying immediately. This credit concept is based on the
principle of “Buy now pay later”. Credit card is a document that can be used for purchase of
goods and services all over the globe.
The world’s first credit card was issued by Mobil in 1940. This card was initially issued by
the Company to give specialized services to its regular customers. It helped to boost sales and
increase the customer base. After the tremendous success of Mobil card various organisations
began to think about the use of cards in different segments of the business. The Diners Club,
American Express and Carte Blanche Cards have emerged. The credit cards were popularly
known in USA. During the second World War US saw the growth of the credit cards. The first
bank card was issued by Fanklin National Bank, USA in the year 1952. In 1960, the credit
card operating system was developed by Bank of America, USA. An international bank card
system known as “VISA” International was established. Another international bank card
system called “Mastercard” was established. At present the market is dominated by the VISA
and Master Card. In the year 1988, the first woman card was launched “My Card” by
international bank of Asia in HongKong.
The credit cards are made of plastic. It is widely used by the consumers all around the globe
in the digital economy. The card identifies its owner. The owner of the card is entitled to
purchase the goods without cash. It provides purchase services without money and be eligible
to get credit from a number of merchant establishments. The issuer of the card issues credit
cards depending on the credibility of the customers. The card issuer enters into a tie up with
different merchant vendors located indifferent geographical places in various fields of business

30
activities. The card issuer will put up a credit limit for its card holders and a ceiling limit for
each vendor. The card offers the card holder an opportunity to buy air, rail tickets and stay at
hotels for payments. The card holder need only to present the card at the cash counter and has
to sign some firms. The credit cards can be considered as a substitute for cash and cheques.
The cards are not accepted by all the merchant vendors.

Process of Credit Card Business Cycle

Credit cards facilitate its holder to make purchases at various designated merchant
establishments. The establishments like travel agencies. Star hotels, Departmental stores will
accept all valid cards in lieu of cash payments. The card holder can avoid the risk of carrying
cash. The following steps are involved in the process of a transaction.
Step I: a card holder purchases goods and present the credit card to the designated merchant
establishment.
Step II: The retail vendor verifies the number on the card against the hot list provided to him
by the bank.
Step III: The card holder is required to sign on the voucher and the signature has to tally with
the one on the credit card.
Step IV: The Retailer has to present the sales vouchers to the bank for reimbursement for the
customers’ purchases. The bank also charges commission from the retailer.
Step V: The bank will make payment to the retailer on behalf of the card holder.
Step VI: After completion of the process. The bank sends the bill to the card holder and
received the money.

Benefits of the Credit Cards

The benefits of credit cards may be classified into two categories:
(A) Benefits to the Card Holders: There are so many benefits to the card holders for using the
cards:
• The card holder need not to carry cash at all times.
• The card holder will be covered by free insurance.
• The card can be used as identification card in some situations.
• The issuer of card offers rewards and gifts to the card holder.
• The card holders can avail special counters for Air and Travel reservations.
• The card holder can get complimentary magazines. For example, diners club
provide “signature” magazine to card holders.
• Family members of the card holder can avail this facility.
• The card holder can enjoy free credit uto 30 to 45 days.
• If the credit card is lost/stolen the liability is limited to a maximum of one
thousand rupees.
• Some credit holders will get free services such as confirmed ticket booking and
hotel reservations.

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 • Some card holders will get benefit from the world wide network, for example,
Master card, Amex, Visa etc.
(B) Benefits to the Card Holders: There are also advantages to credit issuers. Such advantages
are such as:
• This business offers higher profits.
• The issuers can also improve their name and image by serving large number of credit
card holder base.
• This business is an additional activity in the banking sector to enhance their
profitability.

(c ) Additional Facilities: The credit cards besides providing credit facility, the issuer extend
some additional facilities to attract more customers. These facilities and services are presented
below
a) Incidental Expenses: The credit card holders can use their cards to pay for incidental
expenses. They have to do is to call the issuer bank and instruct it to make payment like
telephone bills, electricity bills, payment to mutual funds, public issues etc.
b) Instant cash Withdrawal: Some issuers allows their credit card holder to withdraw
instant cash up to 60 percent of his credit line from ATMs in all metros. The card
holders can also draw cash in case of medical emergencies for meeting expenses on
treatment at other than their home town. This emergency medical advance facility is
available with all Indian and foreign banks.
c) 24× 7×365 Customer Service: The technology adopted by the banking sector makes
comfortable life to the customers. The revolutionary phone banking service ensures that
the banks are just a phone call away to assist the card holders around the clock. Foreign
banks provide a world class service to card holders. A credit card holder can call
“Citiphone banking” and ask for temporary credit line any time.
d) Free insurance: Some of the issuers, insures the card holder at free of cost for a
particular sum. Citibank offer a complimentary personal accident insurance. The Bank
of Baroda card extends insurance protection to card holders spouse also.
e) Buy Anything on Credit Card: The credit cards are well accepted by the public. The
card can be used for all occasions and seasons. The card is also useful for purchasing
essential commodities like groceries, fuel, auto accessories and cosmetics. The cards
are useful even passing customs duties and hospital bills. We can purchase everything,
anywhere at any time under the sum at designated locations.
f) Joint Credit card and ATM Facility: Indian banks and foreign banks have introduced a
joint card. The joint card holder can access his accounts with the bank through ATMs.
g) Hotel Discount Facility: The credit holders are entitled to get discounts at all leading
hotels and clubs. The card holders are eligible to avail the facilities as per the schemes
which were offered by the hotels, travel agencies and on air ticket. Even the consumer
products are also available in this method.
h) Fuel Facility at Petrol Pumps: The BOB, Citibank, Standard Chartered cards are
accepted at all Bharat petroleum outlets. This is very convenient foe card holders at all
leading metro cities.
i) Purchase Protection: The credit card facility protects the purchases against damage or
loss due fire and theft. For compensation the card holder can claim the value of the
product damaged or lost from The New India Assurance Company. This protection is

32
 available for a limited period from the date of purchase of the product on the credit
card. Some of these facilities are exclusive offers, airport lounges, special hospital
facilities, special travel services.

Types of Credit Cards

The credit card system is becoming very popular in India and abroad. The system facilitates a
wide range of products and services. The growth of service sector depends on the pulse of the
customer. The needs of the customers are taken care off by different card issuers. The credit
cards can be classified into 4 basic types based on the issuers: Travel and entertainment card,
bank card, retail card, fuel card. There are many types of cards which are popular in India and
abroad. These cards can also be classified as follows:
a) Based on Geographical Territory: Under this category, the credit cards can be
categorised as Domestic cards and International cards. The domestic cards are
generally available from most of the banks. These cards will be valid in India and
Nepal only. All the transactions will be in rupees only. International cards will be
issued to persons who travel foreign countries frequently. These cards are subject to
the rules and regulations of the RBI. These cards will be honoured in throughout the
world except in India and Nepal.
b) Based on Franchise: The credit cards can be classified based on the tie-ups. They are
Visa card, Master card, Proprietary card and tie-up card. Visa card can be issued by
any bank which is having tie-up with VISA international USA. The card holder can
avail the facilities of Visa network for their transitions. Master card is a brand name
for another type of credit card. The issuer of the card has to obtain permission from the
master card corporation of USA. It will be honoured in the master card network
Proprietary card will be issued by the issuer bank on their own brand name. These
cards will be issued by banks in addition to their other tie-up cards. Tie-up cards are
issued by banks having a collaboration with domestic card brands.
c) Based on Status: This type of credit cards will be further classified as standard cards,
business cards and gold card. The standard card is a normal card generally issued by
all issuing banks. The card holder is offered limited privileges when compared to the
other cards. These cards are issued by some banks under the brand name of “classic”
card. Business card is meant for tax consultants, chartered accountants, small firms,
solicitors and executives etc. These cards are very useful for their business trips more
and more convenient. The business card facilitates more privileges than the standard
card. Some banks are issuing these cards in the brand name of “executive”.
d) Based on User: Under this category the credit cards are further classified as Individual
cards and corporate cards. The individual cards are issued to individual persons. All
the brands of cards will be given to individual corporate cards are issued to corporate
companies and business firms only. The corporate cards are issued on the name of the
company. The cards will be utilized by the executives and top officials the firms. The
bills will be paid by the company to the banks.
e) Based on Credit Recovery: These type of cards are again classified into two categories.
They are Revolving credit type card and charge card. The revolving credit card is
generally based on the revolving credit principle. According to this scheme, the card
holder has to pay a percentage of the outstanding credit for every month. The interest

33
 is charged on the outstanding. The interest rate is charged on the outstanding amount.
The interest rate is more than 30 percent per annum charge card is a convenient
instrument. The issuer gives a consolidated bill for every month to the card holder.
The card holder shall pay the bills on presentation of the consolidation bills. Therefore,
there are no interest charges on this use of cards.

Credit Cards in India

The first credit card in India was Diners club card in the year 1964. Andhra Bank and Central
bank were the first to launch credit cards among the commercial banks. The Andhra bank
introduced the card in the year 1981 under the brand name of “Visa classic” followed by
Central bank of India in collaboration with Master Card Corporation in 1981. The other banks
Canara bank, bank of India and Bank of Baroda introduced credit cards in India. The foreign
banks such as Citi bank, Standard Chartered bank, Bank of America and American Express
bank have also introduced cards in India through their branches in India.

3.8 Smart cards

Smart card is a little plastic card. It is just like a credit card but it contains a micro-processor
and a storage unit. This card is developed with latest technology and it is an innovation that
overcomes all limitations. They are more expensive. The stored data is not exposed to physical
damage. These cards can store at least 100 times more data than magnetic strip cards. They are
more popular in Europe. They are categorized in two kinds; memory smart cards and
intelligent smart cards. Memory card contains less information and processing capabilities they
are used to record a monetary or unit value for a specific amount. Intelligent cards contain
more information and process a wider variety of information components than a memory smart
card. This card also has greater processing capabilities for programmed decision making for
various applications. The electronic purse is used to refer to monetary value, that is loaded on
to the smart cards microprocessor and that can be used by consumer for purchase. The
merchants, who are accepting the cards, must have a smart card reader. The smart card
technology may be used in either an online or offline mode as with magnetic strip cards.
Offline card technology can be used in underdeveloped countries. The functioning of offline
smart cards as presented below:
Step 1: Smart card holder inserts card into machine and downloads money from bank as to
microprocessor on the card.
Step 2: The consumer pays for merchandise/ service by inserting smart card into merchant’s
smart card reader.
Step 3: The merchant’s smart card reader records the transaction.
Step 4: At the end of the day, the merchant inserts a smart card to receive download of the
day’s sales.
Step 5: Take to bank for credit for day’s sale for cash.
Smart cards used in place of cash have the advantage of providing an electronic record for
purchases and the ability to printout transaction data which can serve as receipts.

34
 The smart card holder inserts his card into smart card reader enter a valid password and the
amount of the purchase is deducted from the balance from the balance on the card. The card
reader computes a running total of the sales amounts deducted from the customers. The smart
card can be taken to the bank for immediate cash payment. If the merchant has a networked
personal computer and banking software then it may insert the smart card and transfer the
amount on the smart card directly into a bank account. The telephone manufacturers are
introducing smart card phones that can be used for a variety of purposes. The phones can be
used to:
I. Pay for items purchased over the phone,
II. Download money from bank accounts to a smart card,
III. Transfer balances between accounts, and
IV. Check bank balances.

3.9 Electronic Cheques

Another mode for internet payments is the electronic cheques. In this method, the payor
instructs its bank to pay a specific amount to another party, the payee. The financial EDI
systems have performed this function for years using private communication circuits such as
value added network. The new generation of electronic cheques provides the following
functions:
I. Present the bill to the payor,
II. Allow the payer to initiate payment of the invoice,
III. Provide remittance information,
IV. Allow the payer to initiate automatic payment authorization,
V. Interface with financial management software, and
VI. Allow payments to be made at first time.
Electronic payment system involves two parties, payor and payee. An electronic bill contains
the same information as a hard copy bill transported to the payor through the postal system. An
electronic bill does not have to be received, a payor or can make payments for bills received
through the postal system.
Most electronic cheques can accommodate situations where the payee does not have account
at a financial institution; therefore many electronic cheque service providers will produce a
hard copy check for these types of payments. Electronic payment of bills is expected to
increase substantially over the forthcoming years.

3.10 Debit Card

Debit Card is the innovative instrument in the financial services sector. It is the most
convenient method of payment to the merchant establishment. It needs involvement of many
banks. The card holder will present the card on completion of his purchases at the merchant
establishment on production of a debit card. The card details are fed through a terminal at the
merchant’s establishment. The card holder is immediately debited from the card holder’s
account and transferred to the account of merchant establishment. No overdrawing is allowed
in the case of debit card. A debit card is the variant of an ATM card. It has the following
features:

35
 I. Whereas an ATM card can be used only where the ATM’s are provided by the banks,
and that too only for cash withdrawals, the debit card can be used in any merchant
outlet that is linked with the customer’s bank for making payment.
II. Credit card is issued to clients after a proper assessment of their credit standing. But for
a debit card holder there is no need to make such an assessment.
III. At the time of making payment through a debit card, the amount is instantly debited to
the customer’s account unlike payment made through the credit card where the account
of the customer is debited after a certain period.
IV. Debit card freeze the cardholder from carrying cash for his/her purchases.
V. Debit card is like a blank cheque, so it must be used carefully otherwise an
unscrupulous person can wipe the entire balance in the bank account of the holder.
VI. There are no chances of the debit card user to fall into the debt trap, since payment is
immediately debited to his account, as he can only use the money which is available in
his account.
VII. There are no transaction costs and no question of late fee payment in the use of debit
card.
VIII. Bankers also avoid the risk of bad debts.

3.11 Risks in E-banking

If internet banking has facilitated the banking service processes and made the customers life a
lot easier, it has also thrown new challenges in terms of various risks which may affect the
bank’s profitability, capital and reputation as well. Let us discuss some of the risk issues
related to the online banking.
1. Operational Risk: Operational risk is the price, which attaches to internet banking arising
from error, fraud and inability to provide services to customers or deliver products as per
the expectation, which may result in current and prospective loss to earnings of the bank.
Inaccurate processing of transactions, non privacy and confidentiality, attacks or
unauthorized access to banks systems and databases, weak technology adoption or
systems design or human factors like lack of awareness on the part of employees or
customers may lead to operational risk.
2. Credit Risk: Credit risk arises when a counter-party fails to settle an obligation when due
or any time henceforth for its full value. In internet banking scenario the credit worthiness
of the customer may not be properly evaluated. So any credit facilities provided to retail or
corporate customers requires proper evaluation and constant audit of lending as well as the
repayment progress at regular intervals to avoid such a risk.
3. Liquidity Risks: The bank may face liquidity crunch in short-term time horizon in internet
banking scenario as well. In this case, the outflow of fund may be sudden and hence the
banks, which are more exposed to internet banking, should ensure for sufficient liquidity
in case of redemption or settlement demands.
4. Foreign Exchange Risk: Due to the geographical and market extension of banks and
customers in internet banking scenario forex, legal and regulatory risk may arise. In cross
border transactions there would be difficulty in correctly assessing the counter parties
credentials and hence forex transaction against electronic money may lead to forex risk.
Different international cross-border jurisdiction can expose banks to legal and compliance
risks in view of different national rules, laws and regulations.

36
5. Security Risk: Security risk is one of very important issue in internet banking systems. In
internet banking information is considered as an asset and so worthy of protection.
Firewalls are frequently used on internet banking systems as security measure to protect
internal systems and should be considered for any system connected to an outside
network. Firewalls are a combination of hardware and software placed between two
networks through which all traffic must pass, regardless of direction flow. They provide
gateway to guard against unauthorized individuals gaining access to the bank’s `network.
Therefore, awareness among the internet banking customers as well as adoption of
security mechanism is essential.
6. Compliance Risk: The bank may face compliance and regulatory risk if it does not adhere
or follow the guidelines given by the supervisor or the regulator. Due to lack of awareness
and transparency the bank may fail in this matter and hence more care is required in this a.
7. Reputation Risk: A bank offering internet banking suffers reputation loss due to negative
opinion if the systems failed or discontinued for a considerable time or when the banking
products offered not found to their expectation or even the fraudulent activities by the
internal/external people or hackers using bona fide customer’s credentials. The bank-
customer relationship may suffer due to this and this may also affect bringing prospective
customers to its fold.
8. Legal Risk: Internet banking being a relatively a new phenomenon, the legal issues or
risks are usually less crystallized or ambiguous. They may arise from the violation of, or
non-conformance with laws, rules, and regulations or prescribed practices. A bank may
also face legal actions from the customers in case of hushing attacks or any other
fraudulent activities where the terms and conditions have not been framed adequately by
the bank.
9. Strategic Risk: Strategic risk may emanate from adverse business decisions due to wrong
implementation of unfavorable market conditions related to either the banking products
offered through electronic channel, or any technology or strategic decisions like
outsourcing policy, etc. Therefore, a proper market as well as technological survey is
essential in this regard before taking any final decision.
10. Money Laundering Risk: In view of the lack of personal interaction among the bank staff
and the customers in the internet banking scenario, the know your customers norms may
not be implemented effectively as fund transfer transactions of dubious nature may be
done by the offenders without much of hassles.
11. Interest Rate Risk: In case of electronic money becoming widely prevalent in the payment
system, the interest rate risk and market risk will have an impact on the value of the banks
assets against its electronic money liabilities.
3.12 Conclusion
Popularity which internet banking has won among customers, owing to its speed, convenience
and round-the-clock access they offer, is likely to increase in the future. That’s why internet
banking is a successful strategic weapon for banks to remain profitable in volatile and
competitive marketplace of today. Banks are in a position to lead consumer views, as well as to
cater to existing demands. Clearly, despites of all the threats in banking industry, there is an
enormous opportunity for farsighted banks to reap the rewards available from internet banking.
Internet banking is going to develop much faster than most people imagine. With the

37
revolution, a new financial system will evolve that in many ways will be far more secure than
the one we have today.

3.13 Test Questions

1. Discuss the various e-banking services offered by a bank.
2. ‘Plastic money has replaced paper money’. Critically analyze this statement. What are
the limitations of credit cards.
3. Write short notes on
a) Smart Card
b) ECS
c) Telebanking

3.14 Further Readings

“E-banking in India: Challenges and Opportunities” , Edited by R.K. Uppal and Rimpi jatana,
New Century Publications, New Delhi, India.
“Financial Services in India”, G.Ramesh Babu, Concept Publishing Company, New Delhi,
India.
“Financial Services”,Nalini Prava Tripathy, Prentice Hall of India, New Delhi.

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 LESSON 4

STRUCTURE OF THE INDIAN BANKING

Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi

Objectives

After going through this lesson you should be able to:

• Understand the Structure of Indian Banking System

• Explain the annual Reports of a Bank
• Describe the Items in the Balance sheet of Bank
Structure

4.1 Structure of Indian Banking System

4.2 Reserve Bank of India
4.3 Commercial Banks
4.4 Local Area Bank
4.5 Foreign Bank
4.6 Co-operative Banks
4.7 Regional Rural Banks
4.8 Annual Report
4.9 Balance Sheet of a Commercial Bank
4.10 Conclusion
4.11 Test Questions
4.12 Further Readings

The structure of banking varies widely from country to country. Often a country’s banking
structure is a consequence of the regulatory regime to which it is subjected. The banking system
in India works under the constraints that go with social control and public ownership.
Nationalization, for instance, was a structural change in the functioning of commercial banks
which was considered essential to better serve the needs of development of the economy in
conformation with national policy and objectives. Similarly, to meet the major objectives of
banking sector reforms, government stake was reduced up to 51 per cent in public sector banks.
New private sector banks were allowed and foreign banks were permitted additional branches.

4.1 Structure of Indian Banking System

The Indian financial system comprises a large number of commercial and cooperative banks,
specialized developmental banks for industry, agriculture, external trade and housing, social
security institutions, collective investment institutions, etc. The banking system is at the heart of
the financial system.
The Indian banking system has the RBI at the apex. It is the central bank of the country under
which there are the commercial banks including public sector and private sector banks, foreign
banks and local area banks. It also includes regional rural banks as well as cooperative banks.

Figure1
Indian Banking System

4.2 Reserve Bank of India

The central bank plays an important role in the monetary and banking structure of nation. It
supervises controls and regulates the activities of the banking sector. It has been assigned to
handle and control the currency and credit of a country. In older days, the central banks were
empowered to issue the currency notes and bankers to the Union governments. The first central
bank in the world was Riks Banks of Sweden which was established in 1656. The Reserve Bank
of India, the central bank of our country, was established in 1935 under the aegis of Reserve
Bank of India Act, 1934. It was a private shareholders institution till January 1949, after which it
became a state-owned institution under the Reserve Bank of India Act, 1948. It is the oldest
central bank among the developing countries. As the apex bank, it has been guiding, monitoring,
regulating and promoting the destiny of the Indian financial system.
Objectives of RBI
It plays a more positive and dynamic role in the development of a country. The financial muscle
of a nation depends upon the soundness of the policies of the central banking. The objectives of
the central banking system are presented below:
1. The central bank should work for the national interest of the country.
2. The central bank must aim for the stabilization of the mixed economy.
3. It aims at the stabilization of the price level at average prices.

40
 4. Stabilization of the exchange rate is also essential.
5. It should aim for the promotion of economic activities.
Constitution and Management
Reserve Bank of India has been constituted as a corporate body having perpetual succession and
a common seal. Its capital is Rs. 5 crore wholly owned by the Government of India. The general
superintendence and direction of the affairs and business of the Bank has been vested in the
Central Board of Directors. The Central Government, however, is empowered to give such
directions to the Bank as it may, after consultation with its Governor, consider necessary in the
public interest.
The Central Board of Directors consists of the following:
a) A Governor and not more than four Deputy Governor to be appointed by the Central
Government.
b) Four directors to be nominated by the Central Government, one from each of the four
local boards.
c) Ten directors to be nominated by the Central Government.
d) One Government official to be nominated by the Central Government.
Besides the Central Board of Directors, four Local Boards have also been constituted for each of
the four areas specified in the first schedule to the Act. A Local Board has five members
appointed by the Central Government to represent as far as possible, territorial and economic
interests and the interests of cooperative and indigenous banks. A Local Board advises the
Central Board on matters referred to it by the Central Board and performs such duties as are
delegated to it by the Central Board.
Functions of RBI
The RBI functions are based on the mixed economy. The RBI should maintain a close and
continuous relationship with the Union Government while implementing the policies. If any
differences arise, the government’s decision will be final. The main functions of the RBI are
presented below:
1. Welfare of the public
2. To maintain the financial stability of the country.
3. To execute the financial transactions safely and effectively.
4. To develop the financial infrastructure of the country.
5. To allocate the funds effectively without any partiality.
6. To regulate the overall credit volume for price stability.
Authorities
The RBI has the full authority in the following aspects:
1. Currency issuing authority
2. Monitoring authority
3. Banker to the Union Government
4. Foreign exchange control authority
5. Promoting authority.

41
1. Currency Issuing Authority- The RBI has the sole authority to issue the currency notes and
coins. It is the fundamental right of the RBI. The coins and one rupee notes are issued by the
Government of India and they are circulated through the RBI. The notes issued by the RBI issues
by the RBI will have legal identity everywhere in India. The RBI issues the notes of the
denomination of RS. 1000, 500, 100, 50, 20 and 10. The RBI has the authority to circulate and
withdraw the currency from circulation. It has also the authority to exchange notes and coins
from one denomination to other denominations as per the requirement of the public. The
currency notes may be distributed throughout the country through its 15 full pledged offices, 2
branch offices, and more than 4000 currency chests. The currency chests are maintained by
different banks in various locations. The RBI issues currency notes, based on the availability of
balances of gold, bullion, foreign securities, rupees, coins and permitted bills.
2. Monitoring Authority- The RBI has the full authority to control all the aspects of the banking
system in India. The RBI is known as the Banker’s Bank. The banking system in India works
according to the guidelines issued by the RBI. The RBI is the premier banking institute among
the commercial banks. All the commercial banks, foreign banks and cooperative urban banks in
India should obey the rules and regulations which are issued by the RBI from time to time. The
RBI controls the deposits of the commercial banks through the CRR and the SLRs. Every bank
should deposit a certain amount in the RBI. The commercial banks have the power to borrow the
money from the RBI when they are in need of finance. Hence it is known as the lender of the last
resort. The RBI has the authority to control the credit supply in the economy or monetary
systems of the nation.
3. Banker to the Union Government- Generally in any country all over the world the Central
bank dominates the banking sector. It advises the government on monetary policies. The RBI is
the bankers to the Union Government and also to the state governments in the country. It
provides a wide range of banking services to the government. It also transfers the funds, collects
the receipts and makes the payment on behalf of the Government. It also manages the public
debts. The Government will not pay any remuneration or brokerage to the RBI for rendering the
financial services. Any deficit or surplus in the Central Government account with the RBI will be
adjusted by creation or cancellation of the treasury bills. The treasury bills are known as the
Adhoc Treasury bills.
4. Foreign Exchange Regulation Authority- The RBI’s another major function is to control the
foreign exchange reserves position from time to time. It maintains the stability of the external
value of the rupee through its domestic policies and forex market. The RBI has the full authority
to regulate the market as discussed below:
• To monitor the foreign exchange control.
• To prescribe the exchange rate system.
• To maintain a better relation between rupee and other currencies.
• To interact with the foreign counterparts.

42
 • To manage the foreign exchange reserves.
It administers the FERA, 1973. It is replaced by the FEMA which would be consistent with full
capital account convertibility with policies of the Central Government.
The RBI administers the control through the authorized forex dealers. The RBI is the custodian
of the country’s foreign exchange reserves. The foreign exchange is precious and it takes the
responsibility of the better utilization.
5.Promoting Authority:
The RBI’s function is to look after the welfare of the financial system. It renders the promotion
services to strengthen the country’s banking and financial structure. It helps in mobilizing the
savings and diverting them towards the productive channel. Thus the economic development can
be achieved. After the nationalization of the commercial banks, the RBI has taken a number of
series of actions in various sectors such as agriculture sector, industrial sector, lead bank scheme
and cooperative sector.

4.3 Commercial Banks

Amongst the banking institutions in the organized sector, commercial banks are the oldest
institutions, some of them having their genesis in the nineteenth century. Initially, they were set
up in large numbers, mostly as corporate bodies with shareholdings by private individuals. In the
sixties of the twentieth century, a large number of weaker and smaller banks were merged with
other banks. As a consequence, a stronger banking system emerged in the country. Subsequently,
there has been a drift towards state ownership and control. Today 27 banks constitute strong
public sector in Indian commercial banking. Commercial banks operating in India fall under
different sub-categories on the basis of their ownership and control over management.
Public Sector Banks
Public sector in Indian banking emerged to its present position in three stages. First, the
conversion of the then existing Imperial Bank of India into the State Bank of India in 1955,
followed by the taking over of the seven state associated banks as its subsidiary banks, second
the nationalization of 14 major commercial banks on July 19, 1969 and last, the nationalization
of 6 more commercial banks on April 15, 1980. Thus 27 banks constitute the Public sector in
Indian Commercial Banking.
Private Sector Banks
After the nationalization of major banks in the private sector in 1969 and 1980, no new bank
could be set up in India for about two decades, though there was no legal bar to that effect. The
Narasimham Committee on Financial Sector Reforms recommended the establishment of new
banks in India. Reserve Bank of India, thereafter, issued guidelines for the setting up of new
private sector banks in India in January 1993.
These guidelines aim at ensuring that the new banks are financially viable and technologically
up-to-date from the start. They have to function in a professional manner, so as to improve the
image of commercial banking system and to win the confidence of the public.

43
 In January 2001 Reserve Bank of India issued new rules for the licensing of new banks in the
private sector. The salient features are as follows:
1. A new bank may be started with a capital of Rs. 200 crore. The net worth is to be raised
to Rs. 300 crore in three years.
2. The promoter’s minimum holding in the capital shall be 40 per cent with a lock-in-period
of 5 years. Excess holding over 40 per cent will have to be diluted within a year.
3. Non-resident Indians can pick up 40 per cent equity share in the new bank. Any foreign
bank or finance company may join as technical collaborators or as co-promoter, but their
equity participation will be restricted to 20 per cent, which will be within the ceiling of
40 per cent allowed to Non –resident Indians.
4. Corporates have been allowed to invest up to meet existing priority sector norms and
prudential norms and also to open 25 % of their branches in rural and semi-urban areas.
Preference will be given to promoters with expertise in financing priority areas and rural
and agro based industries.
5. Non-banking finance companies may convert themselves into banks if their net worth is
Rs. 200 crore, capital adequacy ratio is 12%, non performing assets below 5% and
possess triple A credit rating.
In addition to the above guidelines, the new banks are governed by the provisions of the Reserve
Bank of India Act, the Banking Regulation Act and other relevant statutes.

4.4 Local Area Bank

In 1996, Government decided to allow new local area banks with the twin objectives of
Providing an institutional mechanism for promoting rural and semi-urban savings, and For
providing credit for viable, economic activities in the local areas.
Such banks can be established as public limited companies in the private sector and can be
promoted by individuals, companies, trusts and societies. The minimum paid up capital of such
banks would be Rs. 5 crore with promoter’s contribution at least Rs. 2 crore. They are to be set
up in district towns and the area of their operations would be limited to a maximum of 3
geographically contiguous districts. At present, five Local Area Banks are functional, one each in
Punjab, Gujrat, Maharashtra and two in Andhra Pradesh.

4.5 Foreign Bank

Foreign Commercial Banks are the branches in India of the joint stock banks incorporated
abroad. Their number has increased to forty as on 31st March, 2002. These banks, besides
financing the foreign trade of the country, undertake normal banking business in the country as
well.
Licensing of Foreign Bank: In order to operate in India, the foreign banks have to obtain a
license from the Reserve Bank of India. For granting this license, the following factors are
considered:

44
 1. Financial soundness of the bank.
2. International and home country rating.
3. Economic and political relations between home country and India.
4. The bank should be under consolidated supervision of the home country regulator.
5. The minimum capital requirement is US $ 25 million spread over three branches - $ 10
million each for the first and second branch and $5 million for the third branch.
6. Both branches and ATMs require licenses and these are given by the RBI in conformity
with WTO’s commitments.
Function of Foreign Banks: The main business of foreign banks is the financing of India’s
foreign trade which they can handle most efficiently with their vast resources. Recently, they
have made substantial inroads in internal trade including deposits, advances, discounting of bills,
mutual funds, ATMs and credit cards. A large part of their credit is extended to large enterprises
and MNCs located mostly in the tier one cities- mainly the metros, though some banks are now
foraying in the rural sector as well. Technology used by these banks has been a major driver of
change in the Indian banking industry. A highly trained and efficient workforce and the huge
pool of capital resources at the disposal of these banks have created tremendous goodwill and
prestige of foreign banks in India.
Apart from their main businesses, foreign banks are also instrumental in shaping the attitudes,
perceptions and policies of foreign governments, corporates and other clients towards India,
especially in the following areas:
1. Bringing together foreign institutional investors and Indian companies.
2. Organizing joint ventures.
3. Structuring and syndicating project finance for telecommunication, power and mining
sectors.
4. Providing a thrust to trade finance through securitization of export loan.
5. Introducing new technology in data management and information systems.

Performance: Foreign banks are not subject to the stringent norms regarding opening of rural
branches, priority sector lending or bound by the social philosophy of Indian banks. These
factors combined with the financial, technical and human resources of the foreign banks have
ensured a healthy growth of these banks in India.

4.6 Co-operative Banks

Besides the commercial banks, there exist in India another set of banking institutions called co-
operative credit institutions. These have been in existence in India since long. They undertake the
business of banking both in urban and rural areas on the principle of co-operation. They have
served a useful role in spreading the banking habit throughout the country. Yet, their financial
position is not sound and a majority of co-operative banks has yet to achieve financial viability
on a sustainable basis.

45
 The cooperative banks have been set up under the various Co-operative Societies Acts enacted
by the State Governments. Hence the State Governments regulate these banks. In 1966, need was
felt to regulate their activities to ensure their soundness and to protect the interests of depositors.
Consequently, certain provisions of the Banking Regulation Act 1949 were made applicable to
co-operative banks as well. These banks have thus fallen under dual control viz., that of the State
Govt. and that of the Reserve Bank of India which exercises control over them so far as their
banking operations are concerned.
Features of Cooperative banks
• These banks are government sponsored government supported and government
subsidized financial agencies in India.
• Unlike commercial banks which focus on profits, cooperative banks are organized and
managed on principles of cooperation, self help and mutual help. They function on a “no
profit, no loss” basis.
• They perform all the main banking functions but their range of services is narrower than
that of commercial banks.
• Some of them are scheduled banks but most are unscheduled banks.
• They have a federal structure of three-tier linkages and vertical integration.
• Cooperative banks are financial intermediaries only, particularly because a significant
amount of their borrowings is from the RBI, NABARD, the central and state
governments and cooperative apex institutions.
• There has been a shift of cooperative banks from the rural to the urban areas as the urban
and non-agricultural business of these banks has grown over the years.

Weaknesses: Cooperative banks suffer from too much dependence on RBI, NABARD and the
government.
• They are subject to too much officialization and politicization. Both the quality of loans
assets and their recovery are poor. The primary agricultural cooperative societies- a vital
link in the cooperative credit system- are small in size, very week and many of them are
dormant.
• The cooperative banks suffer from existence of multiple regulation and control
authorities.
• Many urban cooperative banks have failed or are in the process of liquidation.
• Cooperative banks have increasingly been facing competition from commercial banks,
LIC, UTI and small savings organizations.

4.7 Regional Rural Banks

Regional Rural Banks are relatively new banking institutions which supplement the efforts of the
cooperative and commercial banks in catering to the credit requirements of the rural sector.
These banks have been set up in India since October 1975, under the Regional Rural Banks Act,

46
1976. At present there are 196 RRBs functioning in 484 districts. The distinctive feature of a
Regional Rural Bank is that though it is a separate body corporate with perpetual succession and
a common seal. It is very closely linked with the commercial bank which sponsors the proposal
to establish it and is called the sponsor bank. The central government establishes a RRB, at the
request of the sponsor bank and specifies the local limits within which it shall establish its
branches and agencies.
Business of a Regional Rural Bank
A Regional rural bank carries on the normal banking business i.e., the business of banking as
defined in section 5(b) of the Banking Regulation Act, 1949 and engages in one or more forms of
businesses specified in Section 6 (1) of that Act. A Regional rural bank may in particular,
undertake the following types of businesses, namely:
1. The granting of loans and advances, particularly to small and marginal farmers and
agricultural laborers, and to cooperative societies for agricultural operations or for other
connected purposes, and
2. The granting of loans and advances, particularly to artisans, small entrepreneurs and
persons of small means engaged in trade, commerce or industry or other productive
activities within the notified areas of a rural bank.
Regional Rural Banks are thus primarily meant to cater to the needs of the poor and small
borrower in the countryside.
Capital
The authorized capital of a RRB shall be Rs. 5 crore which may increased or reduced(not below
Rs. 25 lakh) by the Central Government in consultation with NABARD and the sponsor bank.
The issued capital shall not be less than Rs. 25 lakh. Of the issued capital, the Central
Government shall subscribe fifty percent, the sponsor bank thirty five percent and the concerned
State Government fifteen percent.
The shares of the Rural Banks shall be deemed to be included in the securities enumerated in
Section 20 of the Indian Trusts Act, 1882 and shall also be deemed to be approved securities for
the purpose of the Banking Regulation Act 1949.
Management
Each Rural Bank is managed by a Board of Directors. The general superintendence, direction
and management of the affairs and business vest in the Board. In discharging its functions the
Board of Directors acts on business principles and shall have due regard to public interests. A
regional rural bank is guided by the directions, issued by the Central Government in regard to
matters of policy involving public interest.

4.8 Annual Report

An annual report is a reflection of the company’s philosophy, policies, achievements and
shortcomings. The annual report gives general information regarding the name(s) of the
chairman/MD, chief executive officer and all the directors, the bankers and auditors of the

47
company, registered office, date, time and venue of the annual general meeting. An annual report
comprises two parts.

Part I: It includes

Notice of the meeting of the shareholders.

Directors’ Report: The chairman of the company presents the Director’s report which
usually highlights the company’s achievements in the given macro and micro-
environment, new initiatives/ products/ technology, etc. proposed to be used, constraints
if any faced by the company, future plans for modernization, diversification, etc.

The company’s philosophy that describes how the company does business, is delineated
in a separate section.

Social responsibility report: It has initiatives for environment conservation and corporate
social responsibility. Since banks do not manufacture goods, therefore, treatment of
effluents is not relevant. However, most banks do conduct a number of social outreach
programmes for education, training etc. for the poor and underprivileged sectors of the
society.

Corporate Governance report: Corporate Governance deals with conducting the affairs of
the organization with integrity, transparency and commitment to principles of good
governance. It has to be certified that all mandatory requirements as stipulated by
Securities and Exchange Board of India (SEBI) have been complied with.

Declaration of dividend (if any) is provided.

Retirement, reappointment of existing directors or appointment of new directors.

For the sake of uniformity and transparency in reporting, banks are also supposed to give
details of their non-performing assets (NPA). NPAs are those assets which have remained
unpaid for a period of ninety days. They are further categorized as sub-standard, doubtful
and loss.
Part II: The second part of the report deals with performance highlights of the organization.

It includes a balance sheet, a profit and loss account, cash flow statement and other
statements and explanatory material that are an integral part of the financial statements.

An auditors’ report certifying that the financial statements together present a true and fair
view of the company’s affairs, and are in compliance with existing accounting standards,
applicable laws and regulations.

4.9 Balance Sheet of a Commercial Bank

One of the best ways to learn about the business of banking is through a perusal of a typical
bank’s balance sheet. Balance sheet of a commercial bank is a statement of its assets and
liabilities at a particular point of time. It throws light on the financial health or otherwise of
the bank.
Another way of viewing a balance sheet is as a statement of the sources and uses of bank
funds. Banks obtain funds in the form of deposits (fixed, savings and current) by borrowing

48
from other banks (RBI, commercial banks, etc.) and by obtaining equity funds from the
owners (i.e. the shareholders of the bank) through the capital account. All these constitute the
liabilities of the bank. Banks use these funds to grant loans, invest in securities, purchase
equipment and hold cash items such as currency and deposits in other banks. All these are the
assets of the bank.
According to section 29 of the Banking Regulation Act, 1949, at the expiration of each
calendar year (or at the expiration of a period of twelve months ending with such date as the
Central Government may, by notification in the official gazette, specify in this behalf), every
banking company incorporated in India, in respect of all business transacted through its
branches in India, in respect of all business transacted through its branches in India, shall
prepare with reference to that year or period, as the case may be, a balance sheet and profit
and loss account as on the last working day of the year or the period, as the case may be, in
the forms set out in the third schedule or as near thereto as circumstances admit.
The balance sheet and profit and loss account shall be signed:
in the case of a banking company incorporated in India, by the manager or the principal
officer of the company. Where there are more than three directors of the company, by at least
three are more than three directors. Where there are not more than three directors, by all the
directors, and
in the case of a banking company incorporated outside India by the manager or agent of the
principal office of the company in India.

Audit
The balance sheet and profit and loss account prepared in accordance with section 29 shall be
audited by a person duly qualified under any law for the time being in force to be an auditor
of companies.
Where the Reserve Bank is of opinion that audit is necessary in the interest of the public or
the banking company or its depositors, it may, at any time order a special audit of the
banking company’s accounts, for any such transaction or class of transactions or for some
specific period or periods as it deems necessary. The RBI may through its order either
appoint a person duly qualified under any law for the time being in force to be an auditor of
companies or direct the auditor of companies or direct the auditor of the banking company
himself to conduct such special audit.
Submission of Returns
The accounts and balance sheet referred to in sanction 29 together with the auditor’s report
shall be published in the prescribed manner, and three copies thereof shall be furnished as
returns to the Reserve Bank within three months from the end of the period to which they
refer.
A banking company which furnishes its accounts and balance sheet in accordance with the
provisions of section 31 shall send three copies of such accounts, balance sheet and the
auditor’s report to the registrar.

49
 It is mandatory for all banking companies incorporated outside India that before the first
Monday in August of any year in which it has carried on business, it must display a copy of
its last audited Balance Sheet and profit and Loss Account prepared under section 29, in a
conspicuous place in its principal office and every branch office in India. These should be
kept on display until they are replaced by a copy of the subsequent Balance Sheet and profit
and Loss Account.

Items of the Balance Sheet of a Bank

The balance sheet of a commercial bank like any other balance sheet comprises two sides;
conventionally the left side shows liabilities and capital, while the right side shows assets. A
bank’s assets are indications of what the bank owns or the claims that the bank has on
external entities: individuals, firms, governments, etc. A bank’s liabilities are indications of
what the bank owes as claims which are held by external entities of the bank. The net worth
or capital is calculated by subtracting total liabilities from total assets.
Assets-Liabilities = Net worth
Or
Assets= Liabilities+ Net worth

Liabilities and Assets of a Bank

Many institutions offer financial services. It is the taking of deposits and granting of loans
that single out a bank from other financial institutions. Deposits are liabilities for banks,
which must be managed if the bank is to maximize profits. Likewise they need to manage the
assets created by lending. The liabilities and assets of a bank explained below:
Liabilities of a Bank
Liabilities of a commercial bank are claims on the bank. They represent the amounts which
are due from the bank to its shareholders, depositors, etc. Bank liabilities are the funds that
banks obtain and the debts they incur, primarily to make loans and purchase securities. The
major components of the liabilities of a bank are as follows:
1. Capital: Capital and reserves what the customer regards as an asset, the same bank
deposit is a liability for the bank as the customer gains claims over them. The paid up
share capital implies the liability of the bank to its shareholders. It is the amount
actually received by the bank out of the total subscribed capital. Adequate share
capital is considered as a source of strength for the bank as it provides confidence to
the depositors about the solvency of the bank.
2. Reserve Fund: Reserves are created out of the undistributed profits which are retained
over a period of years by the bank. Creation of reserve fund is a statutory requirement
in most of the countries of the world. Reserve requirements limit the portion of the
bank’s funds that it can use to give loans and purchase securities. Banks build up
reserves to strengthen their financial position and also to meet unforeseen liabilities or
unexpected losses. Reserve fund, together with capital represents the capital structure

50
 or net worth of the bank. Net worth is a residual term that is calculated by subtracting
total liabilities from total assets.
3. Deposits: Deposits constitute the major sources of funds for banks. What the
customer regards as an asset, the same bank deposit is a liability for the bank as the
customer gains claim over them. Banks get funds from investment and these are
indirectly the source of its income. Banks keep a certain percentage of its time and
demand deposits in cash and after meeting the liquidity requirement, they lend the
remaining amount on interest. Indian banks accept two main types of deposits,
demand deposits and term deposits. Demand deposits, as the name suggests, are
repayable on particular period. The prosperity, growth and goodwill of the bank
depend upon the amount of these deposits. Fixed deposits have specific maturity and
so can be used by banks to earn income. Demand deposits can be further subdivided
into current and savings. Current deposits are chequeable accounts with no restriction
on the number of withdrawals. It is possible to obtain clean on secured overdraft on
these accounts. Saving deposits are more liquid than fixed deposits as money can be
withdrawn when needed, though some banks restrict the number of withdrawals per-
month or per-quarter.
4. Borrowing from Other Sources: In case of need, banks can borrow from the Reserve
Bank of India, other commercial banks, development banks, non-bank financial
intermediaries like LIC, UTI, GIC, etc. Secured loans are obtained on the basis of
some recognized, securities whereas unsecured loans are out of its reserve funds lying
with the central bank.
5. Other Liabilities: Other liabilities include bills payable, bills sent for collection,
acceptance, endorsement, etc. The amounts of all such bills are shown on the liability
side of the balance sheet.
6. Contingent Liability: Contingent liabilities are those liabilities which may arise in
future but cannot be determined accurately, e.g. guarantee given on behalf of others,
outstanding forward exchange contracts, etc. These are shown on the liability side as
a rough estimate.
7. Profit or loss: Profit is unallocated surplus or retained earnings of the year after
paying tax and dividends to shareholders. As shareholders have claim over the bank’s
profit, it is shown as a liability. In case of loss, the figure will be shown on the assets
side.

Assets of a Bank
Like all other business firms banks also strive for profit. Commercial banks use their funds
primarily to purchase income earning assets, mainly loans and investments. These assets are
shown in the balance sheet of the bank in decreasing order of the liquidity. The major assets
of the bank include:

51
 1. Cash: Cash in hand and cash balances with the Reserve Bank of India are the most
liquid assets of a bank. Cash assets provide bank funds to meet the withdrawals of
deposits and to accommodate new loan demand. Maintaining of cash reserve ratio
with RBI is a statutory requirement for the banks.
2. Money at Call and Short Notice: This is the money lent by the banks to other banks,
bill brokers, discount houses and other financial institutions for a very short period of
time varying from 1 to 14 days. When these funds are repayable on demand without
prior notice, it is called money at call. On the other hand, if some prior notice is
required, it is known as money at short notice. In the balance sheet, both are shown as
a single item on the asset side. Banks charge very low rate of interest on these. If the
cash position continues to remain comfortable, these loans may be renewed day after
day.
3. Loans and Advances: Loans and advances are the bank’s earning assets. The interests
earned from these assets generate the bulk of commercial bank revenues. Loans may
be demand loans or term loans which may be repayable is single or in many
installments. Advances are usually made in the form of cash credit and overdraft.
4. Investments: Commercial banks use funds for investment in various types of
securities like the gilt edged securities of the central and state government as well as
shares and debentures of corporate undertakings. The securities issued by government
are safe from the risk of default though they are subject to risk from change in rate of
interest. These securities include treasury bills, treasury deposit certificates, etc. The
long-term investments have the greatest profitability.
5. Bills Receivable: Bills receivable and other credit instruments accepted by the
commercial banks on behalf of their customers are also shown on the asset side of the
balance sheet. The reason is that the bank has a claim on the payee, on whose behalf
it has accepted the bills. Thus, the same amount appears on assets as well as liabilities
sides of the balance sheet of the bank.
6. Other Assets: These include the physical assets of a bank like the bank premises,
furniture, computers, machine equipment, etc. These also include the collaterals
which the bank has repossessed from the borrowers in default.

4.10 Conclusion

The Indian financial system comprises a large number of commercial and cooperative banks,
specialized developmental banks for industry, agriculture, external trade and housing, social
security institutions, collective investment institutions, etc. The banking system is at the heart
of the financial system. The Indian banking system has the RBI at the apex. It is the central
bank of the country under which there are the commercial banks including public sector and
private sector banks, foreign banks and local area banks. It also includes regional rural banks
as well as cooperative banks. In India, only those banks are called Commercial Banks which
have been established in accordance with Indian Companies Act 1913. Important commercial

52
 banks in India are Punjab National Bank, Bank of Baroda, Indian Bank, Central Bank of
India, etc. State Bank of India and its 7 subsidiaries are not included in the category of
commercial banks because these were established under a separate act. One of the best ways
to learn about the business of banking is through a perusal of a typical bank’s balance sheet.
Balance sheet of a commercial bank is a statement of its assets and liabilities at a particular
point of time. It throws light on the financial health or otherwise of the bank.

4.11 Test Questions

Q1. Distinguish between Indian bank and Foreign bank..
Q2. Write a short note on Regional Rural Banks.
Q3. Explain the various assets and liabilities of a bank.

4.12 Further Readings

Varshney P.N.& Mittal D.K. , “ Indian Financial System”, Sultan Chand &Sons
G. Ramesh Babu, “ Financial Markets and Institutions”, Concept Publishing Company.
Tripathi Prava Nalini, “ Financial Services”, Prentice Hall of India, 2008.

53
 UNIT II
LESSON 5
FORMS AND TYPES OF ADVANCES AND COLLATERALS
Dr. Ashish Kumar
LBSIM

Process And Documentation Of Bank Lending

The banking sector plays an important role in the mobilization of deposits and disbursement of
credit to various sectors of the economy. Traditional banking has come a long way through from
goldsmiths who were the initial bankers to the virtual banks. Banking is going through a
metamorphosis. Technology, deregulation, disintermediation and securitization are the major
forces that are producing ripples in the industry.
Supported by the latest technology, banks are working to identify new business niches to
develop customized services, to implement innovative strategy and to capture new market
opportunities. With further globalization, consolidation, deregulation of the financial industry,
the banking sector will become even more complex.
Over the past decade, there has been an increasing convergence between the activities of
investment and commercial banks because of the deregulation of the financial sector. Today
some investment and commercial banking institutions compete directly money market
operations, private placement, project finance, bonds underwriting and financial advisory work.
Furthermore, the modern banking industry has brought greater business diversifications. Some
banks in the industrialization world are entering into investments, underwriting of securities,
portfolio management and the insurance businesses. Taken together these changes have made
banks an even more important entity in the global business community.
Lending is an indispensable aspect of banking and a banker earn bulk of his income
through lending. The other major reason of lending function is to add value to bank. By lending
the funds moralization bank will be in position to earn spreads to sustain profitability.
Profitability through lending will be attainable if the bank is in a position to take and manage
credit risk that arises on account of the quality of the borrower and liquidity risk that may arise
by borrowing short and lending long in order to attain greater spreads. The lending decisions of a
bank are guided by its loan policy or credit policy.
The credit policy outlines the crucial lending decisions of a bank. It lays down the rules
and regulations that guide the sanctioning of loans. However, to sustain profitability, prudent
decision needs to be taken both prior to and after sanctioning the credit. These rules generally
relate to the amount of credit to be extended during financial year, the industries to focus on the
geographical spread, the type of credit to offer, the type of proposals to finance, the disbursal
mechanism, the collateral value, the method of pricing, the repayment schedule, the monitoring
process etc. these macro and micro level considerations of lending activity contribute to the
achievement of the banks’ objectives. The bank’s management should thus, ensure that lending
decision fall in line with the bank’s overall objectives.
The credit policy of a bank is primarily aimed at accomplishing this mission. It is a
byword of the bank's approach to sanctioning, managing and monitoring credit risk. Its
main aim is to make the bank's systems and controls more effective. The policy applies to
the entire bank's domestic lending.

The policy is laid down by the top management and deals with the following:
• Exposure levels
• Credit risk assessment
• Credit appraisal standards
• Documentation standards
• Delegation of powers
• Pricing
• Review and renewal of advances
• Takeover of advances.
Besides the above, the policy deals with credit facilities to companies whose directors are
in the defaulters list of the RBI. The policy also lays down the norms of major and minor
deviations and the authority for sanctioning/ approving them. The policy also discusses
different kinds of advances such as personal loans, export credit, advances to priority
sector and maturity period of bank's advances. In the final pages, the policy details the
strengths, weaknesses and the prospects of the bank.
Lending Principles
Banks deal with the funds of a large number of depositors and banks are required to
return the money to the depositors with the promised amount of interest. Further, banks are
also required to monitor the loans and also ensure that the loans do not turn bad.
Consequently, they have to follow the principles of credit management to avoid the danger
of failing.
These fundamental principles are like a rudder to a ship, which have been guiding
the function of lending ever since banking has evolved as a profession. The fundamental
principles that are followed by a bank in managing the credit portfolio are safety, security,
liquidity and profitability. These principles have undergone changes with changing times
and developments in the banking industry.
Lending is a crucial activity for a bank as it enables the bank to generate income.
But to sustain income generation, prudent decisions need to be taken both prior to and
after sanctioning the credit. These decisions generally relate to the size, security and
repayment of credit to be extended during a financial year, the industries to focus on, the
geographical spread, the type of credit to offer, the type of proposals to finance, the
disbursal mechanism, the collateral value, the method of pricing, the repayment schedule,
the monitoring process, etc. The macro and micro level policies of the lending activity
contribute to the achievement of the bank's financial objectives. The bank's management
should thus, ensure that lending decisions fall in line to sub-serve the bank's overall
objectives of growth and stability.

55
Credit Management in the Changing Scenario
The prevalent credit scenario in the near past was:
• Slackness in growth of quality credit
• Stiff competition to acquire blue-chip corporate business at PLR/Sub-PLR rates
• Reduction in rates of interest on loans and advances
• Slackness in industrial growth
• Declining and thinner spreads
• Stiff income recognition norms
• Increased operational costs.
In this changing scenario banks should have a wide mix of products wholesale banking,
retail banking, and consumer financing. Products should be dovetailed in such a way that
banks have loans for just about anything. Banks have to adopt quickly products/ services
(rates, charges) in tune with the market realities.
Easy documentation and quick delivery should be the strategy. Speedy processing
is also very important. Previously there were three Cs - capital, capacity, and character.
However in the recent past, a new 'C' - collateral - has emerged which refers to the assets
that are pledged as a security in a credit transaction. Collateral provides a secondary
source of repayment. It can be the asset financed by the loan or other assets owned by the
individual or the personal guarantee of a cosigner on the loan.
Credit operations have to be revved up. High value credit with low margins has
also to be added to bank's kitty, especially, with respect to top league companies. Banks
should go for increased fee-based income to reduce the cost of lending.
They should have different outlets for Mass banking and Quality banking even in
credit so that the approaches are different. Under Priority Sector Lending, focus should be
more on high yielding and well performing sectors, e.g. High yielding agro advances,
Self-Help Groups, Kisan Credit Card, etc.
There are too many tiers for credit decisions. Banks have to verify whether there is
value addition at each and every level. They have to curtail the number of layers in
lending decisions and also curtail the time taken in processing a proposal. Banks have to
modify the products (quality/cost) to meet the needs of the clients within the shortest
possible time. Quality service after credit delivery is also very vital.
Who Needs Credit?
Banks extend credit to different categories of borrowers for different purposes. For most of these
borrowers, barn credit is the primary and cheapest source of debt financing. Both the demand
and supply sides of the economy need bank credit. Consumers of goods and services constitute
the demand side of the economy, and they require bank credit to enable them acquire assets such
as consumer durables, housing or for plain consumption. Or the supply side, the need for credit
arises from the corporate and government sectors engaged in manufacturing trading and services.
These sectors require bank credit for capital investment in long-term projects and for day-to-day
operations.
In more common terms, financing the demand side of the economy, the large class of
consumers, is called retail banking (also termed mass banking). Financing the supply side of the

56
economy, which is more customize, in nature and calls for specialized skills, is called wholesale
banking or corporate banking or class banking.
Features of Bank Credit
For a bank, good loans are its most profitable assets. And any loan is 'good' till the borrower
defaults in repayment. In its role as a financial intermediary, the direct assumption of financial
risk is the bank's defining characteristic.
Consequently, banks have to look for higher returns. Returns come in the direct form of
loan interest, or in the indirect form of fee-based ancillary services. Further, the borrowers may
also contribute to generation of deposits, which, in turn, can be invested by the bank. The most
prominent risk in lending is default risk (known as credit risk), which can arise due to several
factors. Borrowers may default due to industry downturns and business cycles (such as in real
estate) or due to specific problems related to the borrowers' firms or activities, such as
mismanagement, problems with labour, technological obsolescence and change in consumer
preferences. Banks, therefore, make it a practice to set aside substantial reserves (called
'provisions') to compensate for anticipated losses due to credit risk. 4
There can be another kind of risk associated with credit decisions-interest rate risk.'
Fluctuations in interest rates give rise to earnings volatility. Loan maturities, pricing and the
methods of principal repayments all impact the timing and magnitude of banks' cash inflows.
Keeping these prominent risks in view, risk-based capital standards require that banks
maintain a stipulated amount of capital for every loan created in their books.' This implies that
banks choosing to lend to a specific borrower, group or sector must mobilize additional capital to
keep growing. Banks have sought to circumvent these requirements by resorting to
'securitization" or 'off-Balance sheet lending arrangements', Under 'off-balance sheet lending',
the bank does not directly extend credit but involves itself with the borrower either as an
underwriter for arranging financing (as in 'Loan syndications"), or by issuing a letter of credit to
import inventory rather than finance acquisition of inventory. In both cases, the bank earns a 'fee-
based income' for its services, but creates a 'contingent liability' in its books." A contingent
liability is, however, not free of risks. If the borrower defaults, the bank becomes liable, i.e., the
bank's obligation to make payment under the contract arises from the happening of a contingent
event.
Types/Forms of Advances
Broadly, three types of advances can be identified:
• Fund-based Advances: This is the most direct form of lending. It is granted as a loan or
advance with an actual outflow of cash to the borrower .by the bank. In most cases, such
lending is supported by prime and/or collateral securities.'·
• Non-Fund-based Advances: There are no funds outlays for the bank at the time of
entering into an agreement with a counter party on behalf of the bank's customer.
However, such arrangements may crystallize into fund based advances for the bank if the
customer fails to fulfill the terms of his contract with the counterparty. Most 'contingent
liabilities' of the bank, more prominently, letters of credit (LCs) and bank guarantees
(BGs), fall under this category.
• Asset-based Advances: This is an emerging category of bank lending. In this type of

57
 lending, the bank looks primarily or solely to the earning capacity of the asset being
financed, for servicing its debt. In most cases, the bank will have limited or no recourse
to the borrower. Specialized lending practices, such as securitization or project finance
fall under this category.
Fund-based advances can be further classified based on the tenure of the loans. The traditional
approach is to make the following distinction: short-term loans, long-term loans and revolving
credits. We will examine the basic features of these loans in the following paragraphs.
Short-Term Loans: Typically, these are loans with maturities of I year or less. Most of these
loans are granted with the primary purpose of financing working capital needs of the borrower,
resulting from temporary buildup of inventories and receivables. In the case of such loans,
repayments would flow out of conversion of current assets to cash.
Sometimes, seasonal lines of credit are granted to borrowers whose. businesses are
subjected to seasonal sales cycles, and hence, periodic peaking of inventory and other current
assets. The amount of credit is made available based on the estimated peak and non-peak funding
requirements of the borrowers. The borrowers draw upon the seasonal lines of credit during
periods of peak production to meet seasonal demand, and repay the loans as inventories are liq-
uidated and cash flows from sales come in. Interest accrues only on the amounts drawn down
from the line of credit.
Both the above types of loans are generally made as 'secured loans'. This implies that the
banks make the loans based on the strength of underlying securities, such as inventories,
receivables and other current assets. Such securities, the values of which directly affect the
amount that can be granted as loan, are called 'prime securities'. The other type of securities
backing the loan repayments is 'collateral securities'. Such securities are not directly linked to the
operations of the borrower, but are offered either in lieu of or along with prime securities, as a
cushion against probable default by the borrower. The idea is that banks can liquidate these
securities in the event of default and realize the amount due under the loan agreement.
A third category of short-term loans, granted for 'special purposes' , mayor may not be
secured. Such loans are called 'unsecured loans'. They may arise due to a host of reasons,
including temporary but unexpected or unusual increases in current assets, or a temporary cash
crunch in the borrower's firm. Such requests are considered as falling outside the borrower's
estimated needs for short-term working capital financing, and, depending on the borrower's
creditworthiness, may be granted as 'temporary' or 'ad hoc' loans. These loans are often granted
with terms and conditions different from those applicable to the assessed working capital needs
of the borrower. Such loans may require full payment of interest and principal at maturity, i.e., a
'bullet'. The term for such loans is determined by estimating the time at which the borrower can
generate cash flows to make the repayment. The risk in these loans arises from a change in the
assumed circumstances on which the decision to grant the loans were based.
Long-Term Loans: Bank lending, which used to traditionally focus on 'short-term' loans, started
looking at lending for periods longer than a year only from the 1930s onwards. These are called
'term loans' and have the following characteristics:
• Original maturities of more than I year.
• Repayments are structured based on future cash flows rather than on liquidation of short-
term assets.

58
• The primary purpose of these loans could be acquisition of fixed assets (versus current
assets in the case of short-term loans), or funding expansion/modernization/diversification
plans of the borrower's firm.
• The term loans may be used as substitutes for equity or for financing permanent working
capital needs.
• Typically, these loans are fully disbursed at inception, and principal and interest are repaid
depending on the borrower's capacity to generate operating cash flows.
• The amount and structure of these loans will closely match the transaction being financed.
• Mostly, the securities for the term loans 'will be the bank's claims on assets purchased from
the term loan proceeds.
• Though banks do not customarily lend for very long periods," the maximum tenure
(maturity) of term loans is 10 years, the average ranging between 3 and 5 years.
Thus, long-term loans are generally structured to be more adaptable to borrowers' specific
requirements.

Revolving Credits: Revolving credits offer the most flexibility to borrowers. Assessed to meet
the borrowers' requirements over a period of I year or more, revolving credits permit drawings
from the line of credit at any time, and similarly, repay the whole or part of the outstanding loans
as and when cash inflows happen in the borrowers' firms. The revolving credit is usually a
secured loan, with terms and conditions as applicable to other types of loans. The amount of
revolving facility granted will be based on the assessed need of borrowers, underlying
securities and borrowers' creditworthiness.
In rare cases, revolving loans are structured to convert to term loans or automatically
renew on maturity. The automatic renewal facility, termed the 'evergreen' facility, continues till
the borrower gives notice of termination. Such arrangements, needless to say, will put the banks
more at risk of default than the other two types of lending.
THE CREDIT PROCESS
The risks involved in lending render it imperative that banks should have systems and controls
that enable bank managers to take credit decisions after objectively evaluating risk-return trade
offs. Whether it is consumer or commercial lending, credit decisions impact the profitability of
banks, and ultimately their competitiveness and survival in the industry,
Credit decisions are by no means easy. The credit officer has to deal with conflicting
objectives of increasing the loan portfolio (his targets) while maintaining loan quality (the risks
inherent in the loan portfolio as well as in individual loans). He also has to balance these
objectives with the bank's profitability and market value objectives, liquidity requirements and
constraints of capital. He should be able to investigate and appraise the risks inherent in every
opportunity to lend, and take decisions that will fit in with the overall strategy of the bank.
Above all, he should not take or lead the bank to a wrong credit decision.
Despite the availability of tools and techniques and a huge body of knowledge to support
decision-making, credit decisions are largely judgmental. However well versed the credit officer

59
is in appraising and lending to risky projects, his contribution may not suit the bank if his
decisions do not fall in line with the overall strategy of the bank. Therefore, apart from their
expertise in credit appraisal, the strategic role of credit officers assumes utmost importance.
Constituents of the Credit Process
The Loan Policy : To ensure alignment of individual goals of credit officers to the bank's overall
goals, banks formulate 'loan policies'. These l\I"C written documents, authorized by individual
bank's Board of Directors, that formalize and set guidelines for lending to be followed by
decision-makers in the bank.
The loan policy specifies the bank's overall strategy for lending, identifies loan qualities and
parameters, and lays down procedures for appraising, sanctioning, granting, documenting and
reviewing loans. Loan policies emerge from and are fine-tuned by past experience of individual
banks in extending credit, and the best practices followed in the industry. While supervising bank
operations, regulators examine banks' documented loan policies to ensure that existing lending
practices conform to the organization's objectives and acceptable guidelines. The stance taken by
individual bank managements determines the extent and form of risk that the bank would be
willing to take.
Business Development and Initial Recommendations: With in the broad framework of the loan
policy of the bank, and based on the bank's goals in building its loan asset portfolio, credit
officers seek to reinforce the relationship with existing customers, build new clientele and cross
sell non-credit services. Though every employee of the bank, from the front office personnel to
the top management, is responsible for overall business development, credit development
requires a more focused approach. For one, not every prospective customer can be invited to be a
borrower. There are enormous risks attached to making a bad loan than bypassing an opportunity
for making a good loan.
Therefore, business development efforts for credit expansion should preferably begin
with market research and detailed credit investigation. The outcome of this research will be
reflected in the annual business plan of the bank, which would specify the broad industries, or
areas where the bank would like to expand, and the extent to which the bank would like
exposure to each industry or area.
Based on the plan, the bank embarks upon publicity for its proposed credit products in the
case of retail lending, or special campaigns for attracting target customers. In the case of
corporate borrowers, the credit officers formulate call programs. Once prospective credit
customers are identified, credit officers try to obtain formal loan requests from these customers.
The loan requests, once found acceptable in principle, would be processed further based on
various documents called for, such as the prospective borrower's financial statements, credit
reports, the relevant project report and the legal resolution to borrow.
Sufficient information is sought from the prospective borrower to analyse
creditworthiness. Credit appraisal is essentially an analysis of the risks or vulnerabilities in
respect of the borrower and his business. The risks are analysed with a view to determining how
each of them, individually or in combination, can affect the debt servicing capacity of the
borrower. A typical credit appraisal would deal with the following issues:
• What are the risks inherent in the borrower's business? These risks are classified into
market-related risks, technology-related risks, environment related risks and so on.

60
 • What are the antecedents of the borrower? What is his reputation and integrity? How is
his track record?
• What are the financial risks inherent in the borrower's business? Is the project
economically viable? Is the project financially feasible?
• What risks are inherent in the operations of the business?
• What have the managers of the borrower firm done to mitigate these risks?
• Does the bank want to lend to this borrower in spite of the risks? If so, what steps should
the bank take to ensure that debt repayments are not hampered?
• What risks will the bank have to take if it decides to fund the borrower? How does the
bank propose to mitigate these risks?
The first three questions focus on appraisal of the borrower, his firm, the project for which he
has sought funds and his capacity to repay. The next two questions enable the credit analyst to
examine the internal management and operations of the firm. The analysis leads to a decision-to
lend or not to lend? Once the analyst decides to recommend lending, the safeguards in and
structure of the loan agreement has to be put in place.
Traditionally, key risk factors were analysed using pragmatic considerations, such as
creditworthiness of the borrower, security offered, prospects of the firm and longevity of the
relationship. These were considered the 'canons of lending', and were addressed as the 'five Cs',
(capacity, capital, collateral, conditions, character) or remembered through mnemonics such as
'CCC' (capital, character, capability) or 'PARTS'" (purpose, amount, repayment, terms, security),
or 'CAMPARI' (character, ability, means, purpose, amount, repayment, insurance).
In all these models, the inherent assumption was that the borrower's past would be
indicative of the future, an assumption that may not hold well in a highly dynamic or volatile
environment.
Modern credit analysis uses the traditional concepts in making subjective evaluation,
along with wide use of financial ratios and risk evaluation models to determine if a borrower is
creditworthy. The accent on risk evaluation implies that the banker lends only if he is satisfied
that risks are mitigated to ensure that the borrower's future cash flows (and hence debt service)
will not be affected.
Broad Steps to Credit Analysis
Step I-Building the 'credit file': The first step to effective credit analysis is gathering
information to build the 'credit file'. The preliminary information so obtained would throw light
on the borrower's antecedents, his credit history and track record. If the project is a Greenfield
project, the credit officer will have to do a thorough research into various aspects of the project,
as well as into the borrower's financial and managerial capacity to make the project a success. If
the borrower is an existing one, seeking additional credit, the information would be readily
available with the credit officer. The credit file is an important tool box for the credit officer. It
should contain all pertinent information on the borrower, including call report summaries, past
and present financial statements, cash flow projections and plans for the future, relevant credit
reports, details of insurance coverage, fixed and other assets, collateral values and security
documents. The file for an existing borrower should also contain copies of past loan agreements,

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comments by prior loan officers and all correspondence with the customer. In the case of long
standing borrowers, such credit files may run into several volumes. It is advisable for the credit
officer to peruse all the volumes of the credit file before embarking on credit analysis.
Step 2-Project and financial appraisal: Once the preliminary investigation is done, the internal
and external factors, such as management integrity and capability, the company's performance
and market value and the industry characteristics are evaluated. One of the important activities at
this stage is financial analysis. An illustrative list of inputs and activities is as follows:
• Past financial statements. While the borrower's audited financial statements are typically the
starting point / many banks additionally ask for financial statements presented in the bank's
own format. Typically, past financial statements pertain to the last 2-3 years, along with
estimates for the current year.
• Cash flow statements. This statement would reveal the usage of own and borrowed funds by
the borrower.
• The above data from the borrower enables the credit officer to analyse the liquidity position
of the borrower! his firm. Adequate liquidity is a vital indicator of the borrower's financial
health to the bank, as loss of liquidity through delayed cash flows or diversion of short-term
funds or leakage in cash, is bound to adversely affect the borrower's repayment capacity.
Liquidity is assessed through a set of financial ratios. Most banks recast the financial
statements of the borrower to reveal the true picture-for example, banks remove ageing
receivables or slow moving/obsolete inventory from current assets. Hence, more detailed
information is sought from the borrower before the financial statements are analysed.
• The financial risk of an entity is measured by the debt it has incurred in the course of
business compared with the owner's stake. Banks generally stipulate maximum debt to value
ratios for various categories of borrowers, beyond which the borrowers will have to increase
their stake in the business to avail more bank credit. Credit officers look more to the
'tangible net worth' on the borrower's books as the measure of owner's stake in the business.
'Tangible net worth' represents the net worth less intangible assets, such as losses or
goodwill.
• Once the borrower's current financial health is gauged, the projections are examined. The
borrower's debt servicing capacity is determined by assessing the quality of cash flow
projections given by the borrower. The experienced credit analyst questions the borrower's
projections, especially the sales. projections, till he satisfies himself that they are indeed
realistic, achievable, and more importantly, the cash flows are sufficient to service the debt
(principal + interest). Further, sensitivity analyses are carried out on the projections to test
the strength of the underlying assumptions and assess the impact on debt service capacity
under various stress conditions. While every scenario cannot be adequately tested, the worst
case scenario will indicate the most pessimistic outcome for the bank and it is then for the
bank to decide whether it wants to undertake the risk.
• Even the most scientifically done projections cannot predict the onslaught of future
uncertainties. Hence, the lender looks for a secondary source of repayment, which is
provided by the collateral securities. The credit officer evaluates the strength of the
collateral securities to determine the amount that can be recovered by liquidating these
securities in the worst possible scenario. It is to be noted that loans should not be made

62
 based on the strength of the collateral securities alone. The securities should be treated as
the second line of defence and not the raison-d' etre of the loan itself.
Step 3-Qualitative analysis: Integrity is the most important quality that the banker looks for in a
borrower, and the most difficult to measure. So is assessment of the quality of the management
team. However, lenders will have to make qualitative assessment of the borrower on most of the
criteria by evolving suitable measures. Many poor credit decisions have been the result of not
knowing enough about the customer.
Step 4-Due diligence: Bypassing due diligence can be very costly for a bank. Many loans have
run into problems since bankers did not take this step seriously. This is a time-consuming
activity but well worth the effort. Due diligence can include checking on the borrower's address
(if a new borrower), pre-approval inspections of the borrower's workplace, and interviews with
the borrower's competitors, suppliers, customers and employees. A comprehensive due diligence
can also include-reviews of technology used by the borrower, planned capital expenditures, other
obligations to outsiders, credit reports from other debtors, the internal management control and
information system, industrial relations, employee compensation and benefits, and environmental
audit. Disclosure of contingent liabilities by the borrower is an essential part of due diligence,
since any such contingent claim on the borrower would directly impact the assessed debt service
capacity.
Step 5-Risk assessment: A key function of the credit officer is to identify and analyse the key
risks associated with the proposed credit. All potential internal and external risks are to be
identified and their severity assessed in terms of how these risks would impact the borrower's
future cash flows and hence the debt service capacity. The risk assessment would form an
important input for structuring the credit facility and the terms of the loan agreement.
Step 6---Making the recommendation: Finally, based on a thorough analysis of the project, the
borrower and the market, and after examining the 'fit' of the credit with the 'loan policy', the
credit officer makes his recommendations to consider the loan favourably or reject it outright.
Sometimes, in the case of clients with a long history of relationship with the bank, even if the
criteria for consideration of the current proposal fall short of expectations, the credit officer can
suggest procedures to improve the borrower's financial condition and the repayment prospects. If
warranted, the credit officer can also call for a revised credit proposal from the borrower. After a
preliminary negotiation with the borrower, the credit officer's recommendations would specify
the credit terms, including loan amount, maturity, pricing, repayment schedule, description of
prime and collateral securities and the required terms and conditions for the borrower's
compliance.

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 LESSON 6

CREDIT DELIVERY AND ADMINISTRATION

Dr. Ashish Kumar
LBSIM
Who takes the decision to lend? Depending on the size of the bank, the loan size and type of
exposures planned, the final decision to lend may be taken by an authorized layer of the bank.
Typically, banks fix 'discretionary limits' -monetary ceilings up to which personnel at each level
can take credit decisions-for each layer of authority starting from credit officers themselves to
branch heads to senior and they move up the organizational hierarchy.
For all decision-makers above the level of loan officers, the loan officer's appraisal forms the
very basis of decision-making. Hence, the loan officer's role in the credit decision-making
process is extremely critical. Many banks create a separate channel in the hierarchy for grooming
and equipping credit officers with the essential attitude and skills for the lending function.
The hierarchical levels over and above the credit officer merely review the recommendations
made by the credit officer, and add their insights and comments before making the decision. It is
not necessary that a favourable recommendation from a credit officer after extensive research has
to be approved by the ultimate decision-maker. Accountability demands at every level of the
bank require that the decision-making authority forms an independent opinion of the borrower's
creditworthiness and takes decisions accordingly in the best interests of the bank.
Some very large banks have a centralized 'underwriting department'. This corporate service
essentially sources new business for the bank and manages select existing relationships. For
these select customers, this centralized department processes the credit request and conveys
approval 'in principle', in order to cut the process and time required for a sanction through the
regular process. Many large banks use customized software to evaluate credit requests. However,
as already emphasized, sophisticated tools can be used as aids, and not as substitutes, for the
credit officer's or the credit sanctioning authority's judgment.
Once a loan is approved, the officer communicates the sanction to the borrower through a
formal 'sanction letter'. The sanction letter is generally in the form of a 'loan agreement', to be
signed by the borrower(s) and guarantors, if any. The loan agreement contains the following
essential features.
• Nature/type of credit facility.
• Interest/discount/charges as applicable.
• Repayment terms.
• Stipulations regarding end use of each facility.
• Additional fees applicable such as processing fees, closing fees or commitment fees.
• Prime security for each credit facility.
• Full description of the collateral securities.
• Details of personal/third party guarantees.
• Covenants-terms and conditions under which the loan facilities are being granted.
• Events of default and penal provisions.
Loan Documentation
Different types of borrowers and different types of security interests necessitate loan
documentation procedures that would be valid in a court of law. Accordingly, once the loan
agreement is signed, the borrowers and guarantors execute the loan documents. The security
interest is said to be 'perfected' when the bank's claim on the borrower's assets forming the
security is senior to that of any other creditor. If the borrower defaults on a secured loan, the
bank has the right to take possession of the assets and liquidate them to recover its dues. Proper
loan documentation secures this right.
Terms and Conditions of Advances
These are very important ingredients of any loan agreement. The bank derives control over the
borrower's operations and also mitigates the risks of lending through this part of the loan
agreement. The terms and conditions comprise of three distinct portions:
(I) Conditions precedent: These are requirements that a borrower should satisfy before the
bank acquires the legal obligation to disburse the loan amount. Some illustrative and
commonly used conditions precedent are auditor's certificate for having brought in
the committed capital amount, relevant legal opinions sought for and board resolution
to borrow. An important condition precedent is a material adverse change clause that
covers the financial statements and projections. The clause protects the bank in the
event of a material change occurring after the loan is sanctioned but prior to
disbursement, which may jeopardize the bank's chance recovery of its dues from the
borrower.
(II) Representations and warranties: The assumptions based on which credit appraisal is done
and the bank agreed to lend money, emanate from the information the borrower
himself provides to the bank. In executing the loan agreement, the borrower is
assumed to confirm the truth and accuracy of the information provided to the bank.
Any misrepresentation constitutes an event of default and renders the agreement
invalid. The principal representations and warranties include the following:
• All information provided, including financial statements, is true and correct.
• The borrower is authorized by law to carry on the business.
• The signatories to the loan agreement are authorized to do so, and their
commitment is legal and binding.
• All statutory obligations, such as payments of taxes, have been met.
• There are no major legal proceedings pending or threatened against the
borrower.
• There are no factual omissions or misstatements in the information provided.
• Collateral and prime securities are unencumbered.
The third and most negotiated part of the loan agreement is the 'covenants' of the
borrower.
These are the operative part of the terms and conditions, and set standards
and codes of conduct for the borrower's future business, as long as the borrower is
indebted to the bank. The covenants are used by astute credit officers to mitigate
the risks of the borrower's business, in order that credit risk is mitigated for the
bank. Covenants are sacred, and any violation will be treated as an 'event of
default'. They normally take two distinct forms-'affirmative' and 'negative'.
(III) Affirmative covenants are those actions the borrower should take to legally and
ethically carry on the business. Illustrations of affirmative covenants include the
following.
• Ensuring that the funds are applied for the purpose for which they were
intended.
• The indicators ensuring financial health, such as a strong current ratio, a safe
debt to equity ratio, appreciable sales growth and a healthy return on equity
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 (ROE).
• Ensuring that proper records and controls are maintained within the firm.
• Ensuring compliance with the law, and reporting requirements required under
statute.
• Ensuring compliance with infom13tion requirements by the bank and periodic
reporting of financial operating performance.
• Ensuring that the prime and collateral securities are adequately insured.
• Ensuring that property, fixed assets and other assets belonging to the
borrower's firm are properly maintained.
• The bank will retain its right of inspecting the assets offered as security at any
time, without prior notice.
(IV) Negative covenants place clear and significant restrictions on the borrower's
activities. Such covenants are intended to prompt managerial decisions that may
adversely impact cash flows and hence jeopardize the rower's debt service capacity.
Borrowers would generally be more inclined to negotiate negative covenants since
they may be perceived as restricting operational autonomy. Some typical negative
covenants are as follows:
• Limiting further capital expenditure.
• Limiting investment of funds.
• Restricting additional outside liabilities.
• Restricting investment in subsidiaries, other businesses.
• Restricting sale of assets, subsidiaries.
• Restricting dividend payouts.
• Restricting prepayment of other debts.
• Limits on debt in the capital structure.
• Restrictions on mergers or share repurchase.
• Restriction on starting or carrying on other business.
• Restriction on encumbering assets (negative lien).
The last restriction, negative lien, 18 is a covenant that is widely used by banks to
prevent the borrower creating encumbrances on assets, so as to benefit other creditors.
The bank may employ these restrictions and limitations selectively, to ensure that the
risks in the borrower's business are mitigated. The ultimate objective of these
restrictions is to ensure that the borrower's financial health is not impaired, and the
bank's dues are paid on time.
(V) Events of Default: Such events, when they happen, may trigger the end of the banker-
borrower relationship. An illustrative list of situations that may lead to an event of
default include the following:
• Failure to repay principal when due.
• Failure to service interest payments on due dates.
• Failure to honour a covenant.
• Misrepresentation of facts.
• Reneging on declarations made under representations and warranties.
• Diversion of funds without bank's knowledge to other creditors or other
accounts of the borrower.
• Change in management or ownership structure.
• Bankruptcy or liquidation proceedings.
• Falsification or tampering with records.
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 • Impairment of collateral, or entering into invalid agreements.
• Material adverse changes that drastically change the assumptions under which
the loan agreement was entered into.
• All other force majeure events that imperil debt service.
The happening of which event of default may signify the end of the banker-borrower
relationship is left for the banker to decide on the merits of each case. Under certain
circumstances, where the risks of such events are considered less significant, the
loan agreement can provide the borrower a grace period within which to rectify the
breach of a covenant. In case the borrower is unable to rectify the breach within the
grace period, the bank can downgrade or recall the advances made; agree for the take
over of the borrowing account by another bank; or, if the borrower is not in a
position to repay the bank's dues, enforce the securities and liquidate the outstanding
advance.
In case of the third scenario given above, the bank will initially set off any
unencumbered deposits of the borrower" or cash margins'· against the advances
outstanding. It will then sell off the securities to realize its dues or invoke the outside
guarantees till the advance is completely liquidated. Since the banker-borrower
relationship is generally considered valuable by both parties, banks do not act in
haste in the event of default.
(VI) Updating the Credit File and Periodic Follow-Up The credit file has to be
continuously updated throughout the above process. Further, once the loan is
disbursed, the following activities have to be carried out either by the credit officer
himself or a team designated for the purpose.
• Process loan payments and send reminders in case loan payments are
received late. The simple practice of reminding the borrower for every
payment not received on due date, would ensure that defaults are noticed
on time by the bank and timely action taken in case defaults persist,
ultimately preventing a credit risk to the bank.
• The borrower will have to submit updates of financial performance
periodically or as per the accounting practices in force. The bank can call
for financial data at any point of time if it feels that the borrower's
financial health deserves mid-course scrutiny.
• The bank can call on the borrower at any time, even without prior
intimation. When the bank's representative visits the borrower, the primary
objective will be to ensure that the borrower's activities are in accordance
with the bank's expectations.

(VII) Credit Review and Monitoring: This is the most important step in credit
management, and one that lends value to bank financing. Banks that have
succeeded in credit management, and hence reduction of credit risk, are those that
have separated credit review and monitoring from credit analysis, execution and
administration.
The credit review and monitoring process is typically bifurcated into the distinct
functions of monitoring the performance of existing loans and problem accounts.
Monitoring performance of existing loans is done in two ways. One is a continuous
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 monitoring of the transactions in the accounts of the borrower. This is best done at
the office from which the credit has been disbursed. The credit officers at the
disbursing office have to be alert to symptoms exhibited by day-to-day operations
in the borrower's loan account, and send warning signals to the borrower if they
detect signs of incipient deterioration of financial health or misdemeanor. The
second type of monitoring will be done through external or internal audit teams,
and will be periodic or continuous, depending on the size of credit exposures or the
importance of the credit disbursing office in the bank. The deficiencies in loan
documentation or conduct uncovered by the audit team will have to be rectified by
the credit team. The deficiency could be rectified simply by getting signatures on
loan documents or filing the required statutory returns for perfecting the security. If
the audit team points out violation of any loan covenant, then the credit team can
persuade the borrower to fall in line.
However, what causes most concern would be deterioration in the financial
condition of the borrower, which is manifested as the inability of the borrower to
meet debt service requirements. Such accounts would be put on a 'watch list' and
monitored closely, so that they do not turn 'non-performing'.22 Sometimes, banks
will have to modify the repayment terms in order to increase the probability of
repayment. Such modified terms include restructuring interest and principal payments
to suit the current cash flows of the borrower, or lengthening maturity of the loans. In
such cases, the bank may also seek additional securities or additional capital from the
borrower to compensate for the increased credit risk. It would be prudent to separate
the loans under restructuring from the general credit stream, so that monitoring would
be made more intense. Similarly, a separate set of specialists would man the credit
monitoring or restructuring function.
In some cases, the borrower's financial condition deteriorates to such an
extent that the loan will have to be 'recalled'. In such cases, liquidation of assets or
take over by another bank willing to take on the risk will be considered. It is more
likely that the former action will have to be instituted. If all other avenues of
restructuring and forbearance fail, the bank would resort to legal action. Once legal
action is under way, the borrower loses the option to restructure the loans or be
rehabilitated back to financial health. At this stage, many borrowers opt for 'out of
court settlement', thus avoiding long and protracted legal hassles.

DIFFERENT TYPES OF LOANS AND THEIR FEATURES

Though classified under the single nomenclature-loan-on the bank's balance sheet, every loan
or class of loans is unique. Each loan or type of loan has distinguishing features based on the
purpose, the collateral, the repayment period and the borrower profile. We will examine the
predominant characteristics of some popular loan types from ~e points of view of the borrower
as well as the credit officer.
Loans for Working Capital
Banks are generally considered primary lenders to working capital requirements of firms, small
and large. The rationale for banks having built up considerable expertise in funding short-term
working capital is explained by the nature of bank liabilities, which are essentially short-term in
nature.
A firm's Net Working Capital (NWC) is measured as the difference between its current
assets and current liabilities. If a firm's working capital is positive, it implies that its current
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assets exceed its current liabilities, i.e., its current assets have been partly financed by
'spontaneous liabilities', such as trade creditors, and short-term bank debt and other current
debt, and partly by long-term funds, including equity. A positive NWC is construed as a sign of
healthy liquidity in the firm, since it is assumed that the liquidation of current assets at any
point of time would enable the firm to pay off its current creditors fully.
Every firm begins by investing cash in current assets. Manufacturing firms invest in raw
material that would be converted to finished goods to be sold in the market. Retail firms invest
in merchandize for display at their showrooms. Service firms need cash for operations and
office supplies. Almost all firms encourage credit sales to stimulate growth. Thus, there is a
time lag between the investment of cash and the realization of cash from sales. The longer the
firm takes to complete the cash-to-cash or 'working capital' cycle, the longer the firm has to
wait to get back its cash investment. During this time lag, operations liave to continue. The firm
will have to continue investing in raw material or merchandize or day-to-day expenses. Where
will the cash for this investment come from? As noted earlier, cash for operations will have to
come from external creditors or internal generation. Working capital management is, therefore,
a continuous process.
Each type of business depends on appropriate financing methods to stimulate investment
and growth. Some firms depend on trade credit to finance the current assets-that is, they defer
payment for inputs, in agreement with the supplier, for a specified number of days within which
they hope to realize cash from sales. Some firms additionally defer expenses till the cash comes
in from sales. However, the majority of firms depend on bank debt to manage the need for
working capital. Thus, bank debt is a predominant source of funding working capital for all
types of businesses and borrowers.
How much can a bank lend for working capital? The amount of loan will depend on the
envisaged 'working capital gap'(WCG), determined by the borrower's decision to take trade
credit offered, or defer payment of certain accrued expenses. In balance sheet terms, this would
represent the projected current assets less current liabilities, without bank borrowings being
taken into account. The working capital gap represents the borrower's need for cash for
uninterrupted operations, after taking into account sources of funds available in the natural
course of expect that the borrower brings in his stake to fund the gap. This is called the
'margin'. Bank debt with therefore, typically amount to the working capital gap less the margin.
Many businesses find that their working capital fluctuates over time. The reasons could
be unexpected fluctuations in demand, changes in market dynamics or seasonality. Of these,
seasonal sales are the easiest to predict and firms build up inventories temporarily and incur
higher operating expenses in time for the peak sales season. During the off-season, working
capital needs increase since the inventory has already been invested in, peak sales have not taken
place and cash flow from receivables will happen only when the inventories are liquidated. If
seasonal patterns are discernible, the bank assesses working capital needs as 'peak level' and
'non-peak level'. Thus two sets of working capital assessments would be required.
An important point to be noted here is that most firms have a stable level of working
capital in the system irrespective of seasonal and other fluctuations. In other words, just as fixed
assets are at a predictable level, there are always some inventories, accounts receivable and other
current assets that form a permanent part of the business. The only difference between the fixed
assets and these 'permanent' current assets is that the latter changes its composition, as and when
inventories are sold off and replaced, accounts receivable are realized and replace with fresh
ones, and so on. This 'permanent' working capital need, every year, is approximately equivalent
to the minimum level of current assets minus the minimum level of current liabilities, without
taking into consideration short-term bank debt and installments of long-term debt repayable in
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the short term (within the next 12 month). This difference reflects the requirement of long-term
debt or equity financing for the 'permanent' current assets. It is important for borrowing firms
and banks to be able to assess such 'permanent' working capital requirements and fund them with
long-term investment. The increase over this 'permanent' working capital base due to sales
growth would be financed through short-term credit from banks.
Working capital loans are structured as loans against the prime securities of inventories
and/or book debts as credit limits against bills raised on buyers of the goods and services of the
borrowing firm. The price of the loan (the interest rate charged) depends on the additional
securities available as collateral, and the credit score rating of the borrower. The repayment of
the loan should closely match the working capital cycle, and the covenants should be able to
mitigate the risks and vulnerabilities in the borrower's business and financials.
It is extremely important for the bank and the borrower to assess the working capital
requirements accurately. A mistake often made by inexperienced credit officers is granting a
loan for a larger amount or for a longer maturity than what is required, especially to 'first class'
customers. In a purpose-oriented loan, such as for working capital irrespective of the standing
of or relationship with the borrower, it is imperative to estimate funding needs accurate in order
to help the borrower's business and minimize the bank's risks. Both under- and overestimation
have their pitfalls. If the working capital need is overestimated, the borrower may not use the
additional money judiciously may purchase assets over which the bank does not have lien." If
the working capital is underestimated, the borrower may face a liquidity crunch during the
operational cycle and may have to re-approach the bank for additional loan, or borrow from
outside sources at exorbitant rates. In both cases, the bank faces default risk by the borrower.
Loans for Capital Expenditure and Industrial Credit
Firms need to invest periodically in capital assets to expand, modernize or diversify their
business. In such case their credit needs will extend beyond a year. 'Term loans' are the
preferred choice in such cases-with maturities more than I year, repayment spread over the life
of the asset or depending on the repaying capacity of the borrower. Most term loans are granted
for purposes, such as a permanent increase in working capital (as discussed earlier for purchase
of fixed assets or to finance start up costs for a new project. They generally carry maturities
ranging from over 1-7 years. Though banks can, in theory, finance longer maturities, in practice
they do not find it prudent to do so, because of the typically short- to medium-term maturity of
bank liabilities. Lending for longer maturity may create a mismatch between asset and liability
maturities and lead to a liquidity problem in banks.
Since repayment runs into several years, the bank's decision to lend would be based
more on the long-term cash generation capacity of the borrower firm or the assets being
invested in. The benchmark ratio used predominantly is debt service coverage ratio (DSCR),
the minimum desirable level generally pegged at 2. The bank typically would require collateral
for long-term lending, more as a secondary source for repayment in case of borrower default.
The characteristics of term loans are determined by the use of the loan amount. In the
case of a term loan for purchase of a capital asset, the cost of the asset less a suitable margin is
disbursed in full (in most cases direct the supplier of the equipment) after the loan agreement is
executed. The repayment terms are a function of the useful life of the asset, and the borrower's
capacity to generate cash flows sufficient to service the debt. The interest charged reflects the
bank's perception of the default risk of the borrower and the collateral liquidation value over the
duration of the loan. The covenants are more stringent than for working capital loans, since
term loans extend over several years, and the borrowers may tend to dilute the negotiated terms.
From the bank's side too, the credit officer who was instrumental in getting the loan sanctioned
may no longer be available, and loan agreements may become unenforceable for lack of clarity.
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Term loan repayments and interest payments could be structured in any of the following ways.
• Repayments in fully amortized equal annual/half yearly/quarterly installment. Each
periodic repayment will include interest and principal in varying amounts. The
installment are treated as annuities and equated to the present value of principal plus
interest to arrive at the installment. Interest is recovered in full in every installment, and
the remaining amount of the installment is taken towards principal repayment. As the
principal gets repaid, the interest component, calculated on declining principal balances,
decreases, and the principal component increases. Thus, in this method, the amount of
payment per period remains constant, but the composition of the payment (principal and
interest) varies from payment to payment.
• Repayment of principal in equal installments over the designated period, with interest
calculated separately on declining balances. In this case, the amount of debt service will
vary from period to period. In contrast to the annualized method of repayment, each
periodic payment in this mode will vary, but the amount of principal will remain
constant.
• Occasionally, the loan agreement may call for 'balloon repayments'. In this case, the
borrower is required to service only the periodic interest over the period of the loan. The
entire principal amount becomes due only on maturity (also called a 'bullet loan'). The
difference between a 'bullet' and 'balloon' repayments is that in the case of 'bullet
repayment' 100 per cent of the principal is due only at maturity while in the latter case,
the credit (interest and principal) gets partially repaid during the term and presents lumpy
repayment at maturity.
• In rare cases, a variation of the above method is used. The principal and interest are
amortized over a very long period, say 25 to 30 years. At the end of the period, the
remaining principal amount is repaid in full.
• For construction loans or project loans, the agreed amount is released in stages, as and
when progress is shown in construction/the project.
Loan Syndication
Large projects need enormous funding requirements. It may not be possible for one bank to
finance the project requirements, from the viewpoint of both capital regulations and the risk of
exposure. For the banks arranging the syndication and participating in it, syndication can be a
source of substantial fee income as well. In essence, arranging a syndicated loan allows the lead
bank to meet its borrower's demand for loan commitments without having to bear the market
and credit risk alone, and also earn non-interest income in the process.
Syndicated loans are credits granted by a group of banks to a borrower. They are hybrid
instruments combining features of relationship lending and publicly traded debt. They allow the
sharing of credit risk between various financial institutions without the disclosure and marketing
burden that bond issuers face.
Syndicated credits are a very significant source of international financing, with signings
of international syndicated loan facilities accounting for no less than a third of all international
financing, including bond, commercial paper and equity issues. Increasing trends of
privatizations in emerging markets have enabled banks, utilities and transportation and mining
companies from these regions to displace sovereigns as the major borrowers. However, and
understandably so, the amount of international syndicated loan facilities, showed a decline since
2007. Quarters 2 and 3 of2009 have shown a slight pick up, indicating confidence returning to
the market (Source: BIS locational statistics, December 2009).
In a syndicated loan, two or more banks agree jointly to make a loan to a borrower. Every
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syndicate member has a separate claim on the debtor, although there is a single loan agreement
contract. The creditors can be divided into two groups. The first group consists of senior
syndicate members and is led by one or several lenders, typically acting as mandated arrangers,
arrangers, lead managers or agents. These senior banks are appointed by the borrower to bring
together the syndicate of banks prepared to lend money at the terms specified by the loan. The
syndicate is formed around the arrangers often the borrower's relationship banks-who retain a
portion of the loan and look for junior participants. The junior banks, typically bearing manager
or participant titles, form the second group of creditors. Their number and identity may vary
according to the size, complexity and pricing of the loan as well as the willingness of the
borrower to increase the range of its banking relationships. These bank roles have been
enumerated above in decreasing order of 'seniority', and the hierarchy plays a decisive role in
determining the syndicate composition, negotiating the pricing and administering the facility.
Junior banks typically earn just a margin and no fees. However, they may find it
advantageous to participate ill a syndicated loan-they may lack origination capability in certain
types of transactions, geographical areas or industrial sectors, or a desire to cut down on
origination costs. For these banks participation is also relationship building with the borrower
who may reward them later with more profitable and prestigious business opportunities.
Loans for Agriculture
Loans for agriculture are similar to other types of loans in the following respects.
• Most of the loans for agriculture are short-term loans.
• Agriculture being seasonal in nature, the norms for seasonal industries is applicable.
• They can be likened to working capital loans, in that the loan is used for purchase of
inventory, such as seeds, fertilizer and pesticides, and also to pay operating costs.
• The sales are realized when the harvested crops are sold in the market.
• Long-term loans for agriculture are given for investment in land, equipment or
livestock.
• Loans are paid out of cash flows arising from sale of crops harvested or produced
from livestock.
The fundamental difference between loans for agriculture and other loans arises from the
fact that agriculture is a vital national priority in many developed and developing countries. The
governments and central banks of these countries have framed policies and institutional support
systems to ensure that banks are involved in lending to this important sector, even when it
appears that the sector may incur losses for a particular period.
Therefore, though loans for agriculture are to be assessed on similar lines as other loans,
they are to be treated differently in terms of the outcome of such lending. Most countries have
framed elaborate policies and institutional framework to ensure that agriculture and its allied
activities are supported by banks.
Loans for Infrastructure-Project Finance
Project finance is a prominent form of 'Asset-based lending'. Simply put, project finance
involves the creation of a legally independent project company, with equity from one or more
sponsoring firms, and non- or limited recourse debt, for the purpose of investing in a single
purpose, industrial asset."
Structuring a project finance deal entails substantial transaction costs in the nature of fees
to lawyers, consultants and financial advisors, apart from obtaining necessary permits and
environmental clearances. A deal could typically take 5-7 years to structure, since it also
involves identifying and entering into suitable contracts with construction companies, suppliers
72
 of equipment and inputs, purchasers of output, operating companies and tying up the financing
with various capital providers. Project companies are characterized by their highly leveraged
structures with mean debts as high as 70 per cent, and the remaining equity contributed by the
group of sponsoring firms in the form of either equity or quasi equity (subordinated debt), debt
being non-recourse to the sponsors. The debt is also termed 'project recourse' since debt service
depends exclusively on project cash flows.
A predominant share of project finance comes from banks in the form of debt, syndicated
loans, or through subscription to bond issues of project companies. The risks for the lender are
high, since the bank has limited or no recourse to the sponsor, unlike in conventional corporate
financing. Thus, there are several supplementary credit arrangements that characterize project
financing.
The primary mode of credit delivery is through term loans. The challenge in credit
appraisal lies in the credit officer and the decision maker understanding the project and its risks
in detail and instituting suitable risk mitigation measures for ensuring timely debt service.
Loans to Consumers or Retail Lending
Individual consumers generally seek bank finance to purchase durable goods, education, medical
care, housing and other expenses. The average loan per borrower is small in relation to the bank's
lending to corporate or business borrowers. Most loans have repayment periods ranging from 1-5
years, can be longer in the case of housing loans, carry fixed interest rates and are repaid in equal
installments. Individual consumers are generally seen as more prone to defaulting on loan
repayment commitments than corporate borrowers. Interest rates on consumer loans are, thus,
higher to compensate for the higher default risk. However, the loss to the bank when an
individual customer defaults is not as great as when a corporate borrower does.
Consumer loans can also be classified based on repayment terms as installments loans,
credit cards and non-installments loans. Installment’s loans have a fixed periodic repayment
schedule, which requires that a portion of both principal and interest are paid periodically.
Payments on credit cards vary with the amount utilized. Non-installments loans are special
purpose loans, in which the individual expects a large cash inflow at a particular point of time
that will enable him repay the debt entirely. An example of this would be a bridge loan for
paying an advance for purchase of a new house, which will be repaid once the old house is sold
off.
Banks are increasingly resorting to retail lending to take advantage of increased consumer
spending and also because pools of such assets can be securitized thus leading to removal of
default risk and greater liquidity for the banks, which, in turn, would lead to improved
profitability.
Non-Fund Based Credit
LCs and BGs (BGs or letters of guarantee-LGs) are the common forms of non-fund-based credit
limits granted to borrowers to carry on their business. They are non-fund based since there is no
outlay of funds for the bank at the time of granting the facility. The income earned from these
services is classified under noninterest income.
The fact that this type of credit is granted with no funds disbursement at the outset, does
not render it free of credit risk. LCs and BGs are off-balance sheet exposures for the bank, but
they carry equal or more risks than on balance sheet credit exposures. Their risk arises from the
fact that the bank is called upon to pay the counterparty or beneficiary, if the applicant or
borrower fails to pay. The liability of the bank to the counterparty is determined by the relevant
statute and the bank will have to pay the agreed amount to the counterparty without demur. It is
then left to the bank to proceed legally or otherwise against the borrower or applicant to recover
the loss.
73
 It is, thus evident that the bank will have to assess any request for non-fund based credit
with the same rigor as it assesses the fund-based credit request. The default risk of the borrower
remains, whether the bank has exposed itself to fund-based or non- fund-based credit.

74
 LESSON 7

PRIORITY SECTOR ADVANCES

Dr. Ashish Kumar
LBSIM

At a meeting of the National Credit Council held in July 1968, it was emphasized that
commercial banks should increase their involvement in the financing of priority sectors, viz.,
agriculture and small scale industries. The description of the priority sectors was later formalized
in 1972 on the basis of the report submitted by the Informal Study Group on Statistics relating to
advances to the Priority S2ctors constituted by the Reserve Bank in May 1971. On the basis of
this report, the Reserve Bank prescribed a modified return for reporting priority sector advances
and certain guidelines were issued in t11is connection indicating the scope of the items to be
included under the various categories of priority sector. Although initially there was no specific
target fixed in respect of priority sector lending, in November 1974 the banks were advised to
raise the share of these sectors in their aggregate advances to the level of 331/3 per cent by
March 1979.
At a meeting of the Union finance Minister with the Chief Executive Officers of public
sector banks held in March 1980, it was agreed that banks should aim at raising the proportion of
their advances to priority sector to 40 per cent by March 1985. Subsequently, on the basis of the
recommendations of the Working Group on the Modalities of Implementation of Priority Sector
Lending and the Twenty Point Economic Programme by Banks (Chairman: Dr. K. S.
Krishnaswamy), all commercial banks were advised to achieve the target of priority sector
lending at 40 per cent of aggregate bank advances by 1985. Sub-targets were also specified for
lending to agriculture and the weaker sections within the priority sector. Since then, there have
been several changes in the scope of priority sector lending and the targets and sub-targets
applicable to various bank groups.
On the basis of the recommendations made in September 2005 by tile Internal Working Group
(Chairman: Shri C. S. Murthy), set up in Reserve Bank to examine, review and recommend
changes, if any, in the existing policy on priority sector lending including the segments
constituting the priority sector, targets and sub-targets, etc. and the comments/suggestions
received thereon from banks, financial institutions, public and the Indian Banks' Association
(IBA), it has been decided to include only those sectors as part of the priority sector, that impact
large sections of the population, the weaker sections and the sectors which are employment-
intensive such as agriculture, and tiny and small enterprises.
Accordingly, the broad categories of priority sector for all scheduled commercial banks will be
as under.
I. Categories of Priority Sector
(i) Agriculture (Direct and Indirect finance): Direct finance to agriculture shall include short,
medium and long term loans given for agriculture and allied activities (dairy, fishery,
piggery, poultry, bee-keeping, etc.) directly to individual farmers, Self-Help Groups
(SHGs) or Joint Liability Groups ULGs) of individual farmers without limit and to others
(such as corporates, partnership firms and institutions) up to the limits indicated in Section
I, for taking up agriculture/ allied activities. Indirect finance to agriculture shall include
loans given for agriculture and allied activities as specified in Section I, appended.
(ii) Small Enterprises (Direct and Indirect Finance): Direct finance to small enterprises shall
include all loans given to micro and small (manufacturing) enterprises engaged in
manufacture/ production, processing or preservation of goods, and micro and small
(service) enterprises engaged in providing or rendering of services, and whose investment
 in plant and machinery and equipment (original cost excluding land and building and such
items as mentioned therein) respectively, does not exceed the amounts specified in Section
I, appended. The micro and small (service) enterprises shall include small road & water
transport operators, small business, professional and self-employed persons, and all other
service enterprises, as per the definition given in Section I appended. Indirect finance to
small enterprises shall include finance to any person providing inputs to or marketing the
output of artisans, village and cottage industries, handlooms and to cooperatives of
producers in this sector.
(iii) Retail Trade shall include retail traders/ private retail traders dealing in essential
commodities (fair price shops), and consumer co-operative stores, as per the definition
given in Section I appended.
(iv) Micro Credit: Provision of credit and other financial services and products of very small
amounts not exceeding Rs. 50,000 per borrower, either directly or indirectly through a
SHG/JLG mechanism or to NBFC/MFI for on lending up to Rs. 50,000 per borrower, will
constitute micro credit.
(v) Education loans: Education loans include loans and advances granted to only individuals
for educational purposes up to Rs. 10 lakh for studies in India and Rs. 20 lakh for studies
abroad, and do not include those granted to institutions;
(vi) Housing loans: Loans up to Rs. 20 lakh to individuals for purchase/ construction of
dwelling unit per family, (excluding loans granted by banks to their own employees) and
loans given for repairs to the damaged dwelling units of families up to Rs. 1 lakh in rural
and semi-urban areas and up to Rs. 2 lakh in urban and metropolitan areas.

II. Other Important Features

(i) Investments by banks in securitized assets, representing loans to various categories of
priority sector, shall be eligible for classification under respective categories of priority
sector (direct or indirect) depending on the underlying assets, provided the securitized
assets are originated by banks and financial institutions and fulfill the Reserve Bank of
India guidelines on securitization. This would mean that the banks' investments in the
above categories of securitized assets shall be eligible for classification under the
respective categories of priority sector only if the securitized advances were eligible to be
classified as priority sector advances before their securitization.
(ii) Outright purchases of any loan asset eligible to be categorized under priority sector, shall
be eligible for classification under the respective categories of priority sector (direct or
indirect), provided the loans purchased are eligible to be categorized under priority sector;
the loan assets are purchased (after due diligence and at fair value) from banks and
financial institutions, without any recourse to the seller; and the eligible loan assets are not
disposed of, other than by way of repayment, within a period of six months from the date of
purchase.
(iii) Investments by ban!<s in Inter Bank Participation Certificates (IBPCs), on a risk sharing
basis, shall be eligible for classification under respective categories of priority sector,
provided the underlying assets are eligible to be categorized under the respective categories
of priority sector and are held for at least 180 days from the date of investment.
(iv) The targets and sub-targets under priority sector lending would be linked to Adjusted Net
Bank Credit (ANBC) (Net Bank Credit plus investments made by banks in non-SLR bonds
held in HTM category) or Credit Equivalent amount of Off-Balance Sheet Exposures
(OBE), whichever is higher, as on March 31 of the previous year. The outstanding FCNR
(B) and NRNR deposits balances will no longer be deducted for computation of ANBC for
76
 priority sector lending purposes. Investments made by banks in the Recapitalization Bonds
floated by Government of India will not be taken into account for the purpose. Existing
investments, as on the date of this circular, made by banks in non-SLR bonds held in HTM
category will not be taken into account for calculation of ANBC, lip to March 31, 2010.
However, fresh investments by banks in non-SLR bonds held in HTM category will be
taken into account for the purpose. Deposits placed by banks with NABARD /SIDBI, as
the case may be, in lieu of non-achievement of priority sector lending targets/ sub-targets,
though shown under Schedule 8 - 'Investments' in the Balance Sheet at item I (vi) - 'Others',
will not be treated as investment in non-SLR bonds held under HTM category. For the
purpose of calculation of credit equivalent of off-balance sheet exposures, banks may use
current exposure method. Inter-bank exposures will not be taken into account for the
purpose of priority sector lending targets/sub-targets.
(v) Fresh deposits placed by banks' on or after the date of this circular with NABARD /SIDBI
on account of non-achievement of priority sector lending targets/ sub-targets would not be
eligible for classification as indirect finance to agriculture/Small Enterprises Sector, as the
case may be. However, the deposits placed with NABARD/SIDBI by banks on the abo\'e
account and outstanding as on the date of this circular would be eligible for classification as
indirect finance to agriculture/Small Enterprises sector, as the case may be, till the date of
maturity of such deposits or March 31,2010, whichever is earlier.

III. TARGETS/SUB-TARGETS
The targets and sub-targets set under priority sector lending for domestic commercial and foreign
banks operating in India are furnished below:
Total Priority Sector advances
40 per cent of Adjusted Net Bank Credit (ANBC) or credit equivalent amount of Off-
Balance Sheet Exposure, whichever is higher. 32 per cent of ANBC or credit equivalent amount
of Off-Balance Sheet Exposure, whichever is higher.
Total agricultural advances
18 per cent of ANBC or credit equivalent amount of Off-Balance Sheet Exposure,
whichever is higher.
No target
Of this, indirect lending in excess of 4.5% of ANBC or credit equivalent amount of Off-
Balance Sheet Exposure, whichever is higher, will not be reckoned for computing performance
under 18 per cent target. However, all agricultural advances under the categories' direct' and
'indirect' will be reckoned in computing performance under the overall priority sector target of 40
per cent of ANBC or credit equivalent amount of Off-Balance Sheet Exposure, whichever is
higher.
Small Enterprise advances
Advances to small enterprises sector will be reckoned in computing performance under
the overall priority sector target of 40 per cent of ANBC or credit equivalent amount of Off-
Balance Sheet Exposure, whichever is higher. 10 per cent of ANBC or credit equivalent amount
of Off-Balance Sheet Exposure; whichever is higher.
Micro enterprises within Small Enterprises sector
(i) 40 per cent of total advances to small enterprises sector should go to micro
(manufacturing) enterprises having investment in plant and machinery up to Rs 5 lakh
and micro (service) enterprises having investment in equipment up to Rs. 2 lakh;
ii) 20 per cent of total advances to small enterprises sector should go to micro
(manufacturing) enterprises with investment in plant and machinery above Rs 5 lakh

77
 and up to Rs. 25 lakh, and micro (service) enterprises with investment in Equipment
above Rs. 2 lakh and up to Rs. 10 lakh. (Thus, 60 per cent of small enterprises advances
should go to the micro enterprises).

Same as for domestic banks

Export credit
Export credit is not a part of priority sector for domestic commercial banks. 12 per cent of
ANBC or credit equivalent amount of Off-Balance Sheet Exposure, whichever is higher.
Advances to weaker sections
10 per cent of ANBC or credit equivalent amount of Off-Balance Sheet Exposure,
whichever is higher.

No target
Differential Rate of Interest Scheme
1 per cent of total advances outstanding as at the end of the previous year. It should be
ensured that not less than 40 per cent of the total advances granted under DRI scheme go to
scheduled caste/scheduled tribes. At least two third of DRI advances should be granted
through rural and semi-urban branches.

No target
[ANBC or credit equivalent of Off-Balance Sheet Exposures (as defined by Department of
Banking Operations and Development of Reserve Bank of India from time to time) will be
computed with reference to the outstanding as on March 31 of the previous year. For this
purpose, outstanding FCNR (B) and NRNR deposits balances will no longer be deducted for
computation of ANBC for priority sector lending purposes. For the purpose of priority
sector lending, ANBC denotes NBC plus investments made by banks in non-SLR bonds
held in HIM category. Investments made by banks in the Recapitalization Bonds floated by
Government of India will not be taken into account for the purpose of calculation of ANBC.
Existing investments, as on the date of this circular, made by banks in non-SLR bonds held
in HIM category will not be taken into account for calculation of ANBC, up to March 31,
2010. However, fresh investments by banks in non-SLR bonds held in HTM category will
be taken into account for the purpose. Deposits placed by banks with NABARD/SIDBI, as
the case may be, in lieu of non-achievement of priority sector lending targets/ sub-targets,
though shown under Schedule 8 - 'Investments' in the Balance Sheet at item I (vi) - 'Others',
will not be treated as investment in non-SLR bonds held under HTM category. For the
purpose of calculation of credit equivalent of off-balance sheet exposures, banks may use
current exposure method. Inter-bank exposures will not be taken into account for the
purpose of priority sector lending targets/ sub-targets.]
The detailed guidelines in this regard are given hereunder.

SECTION I
I.AGRICULTURE
1.1 DIRECT FINANCE
Finance to individual farmers [including Self Help Groups (SHGs) or Joint Liability Groups
(JLGs), i.e. groups of individual farmers, provided banks maintain disaggregated data on
such finance] for Agriculture and Allied Activities (dairy, fishery, piggery, poultry, bee-
keeping, etc.)
1.1.1 Short-term loans for raising crops, i.e. for crop loans. This will include traditional/

78
 non-traditional plantations and horticulture.
1.1.2 Advances up to Rs. 10 lakh against pledge/hypothecation of agricultural produce
(including warehouse receipts) for a period not exceeding 12 months, irrespective of
whether the farmers were given crop loans for raising the produce or not.
1.1.3 Working capital and term loans for financing production and investment
requirements for agriculture and allied activities.
1.1.4 Loans to small and marginal farmers for purchase of land for agricultural purposes.
1.1.5 Loans to distressed farmers indebted to non-institutional lenders, against appropriate
collateral or group security.
1.1.6 Loans granted for pre-harvest and post-harvest activities such as spraying, weeding,
harvesting, grading, sorting, processing and transporting undertaken by individuals,
SHGs and cooperatives in rural areas.
1.2 Finance to others [such as corporates, partnership firms and institutions]for
Agriculture and Allied Activities (dairy, fishery, piggery, poultry, beekeeping, etc.)
1.2.1 Loans granted for pre-harvest and post-harvest activities such as spraying, weeding,
harvesting, grading, sorting and transporting.
1.2.2 Finance up to an aggregate amount of Rs. one crore per borrower for the purposes
listed atl.1.1, 1.1.2, 1.1.3 and 1.2.1 above.
1.2.3 One-third of loans in excess of Rs. one crore in aggregate per borrower for agriculture
and allied activities.

INDIRECT FINANCE
1.3 Finance for Agriculture and Allied Activities
1.3.1 Two-third of loans to entities covered under 1.2 above in excess of Rs. one crore in
aggregate per borrower for agriculture and allied activities.
1.3.2 Loans to food and agro-based processing units with investments in plant and machinery
up to Rs. 10 crore, undertaken by those other than 1.1.6 above.
1.3.3 (i)Credit for purchase and distribution of fertilizers, pesticides, seeds, etc. Loans up to Rs.
40 lakh granted for purchase and distribution of inputs for the allied activities such as
cattle feed, poultry feed, etc.
1.3.4 Finance for setting up of Agriclinics and Agribusiness Centres.
1.3.5 Finance for hire-purchase schemes for distribution of agricultural machinery and
implements.
1.3.6 Loans to farmers through Primary Agricultural Credit Societies (P ACS), Farmers'
Service Societies (FSS) and Large-sized Adivasi Multi-Purpose Societies (LAMPS).
1.3.7 Loans to cooperative societies of farmers for disposing of the produce of members.
1.3.8 Financing the farmers indirectly through the co-operative system (otherwise than by
subscription to bonds and debenture issues).
1.3.9 Existing investments as on March 31,2007, made by banks in special bonds issued by
NABARD with the objective of financing exclusively agriculture/ allied activities may
be classified as indirect finance to agriculture till the date of maturity of such bonds or
March 31, 2010, whichever is earlier. Fresh investments in such special bonds made
subsequent to March 31, 2007 will, however, not be eligible for such classification.
1.3.10 Loans for construction and running of storage facilities (warehouse, market yards, god
owns, and silos), including cold storage units designed to store agriculture produce/
products, irrespective of their location. If the storage unit is registered as SSI unit/ micro
or small enterprise, the loans granted to such units may be classified under advances to
Small Enterprises Sector
79
l.3.11 Advances to Custom Service Units managed by individuals, institutions or organizations
who maintain a fleet of tractors, bulldozers, well-boring equipment, threshers, combines,
etc., and undertake work for farmers on contract basis.
1.3.12 Finance extended to dealers in drip irrigation/sprinkler irrigation system/ agricultural
machinery, irrespective of their location, subject to the following conditions:
a) The dealer should be dealing exclusively in such items or if dealing in other products,
should be maintaining separate and distinct records in respect of such items.
b) A ceiling of up to Rs. 30 lakh per dealer should be observed.
3.1.13 Loans to Arthias (commission agents in rural/ semi-urban areas functioning in
markets/mandies) for extending credit to farmers, for supply of inputs as also for buying
the output from the individual fanners/ SHGs/ JLGs.
1.3.14 Fifty per cent of the credit outstanding under loans for general purposes under General
Credit Cards (GCC).
1.3.15 The deposits placed in RIDF with NABARD by banks on account of non-achievement of
priority sector lending targets/ Sub-targets and outstanding as on the date of this circular
would be eligible for classification as indirect finance to agriculture sector till the date of
maturity of such deposits or March 31,2010, whichever is earlier.
1.3.16 Loans already disbursed and outstanding as on the date of this circular to State Electricity
Boards (SEBs) and power distribution corporations/ companies, emerging out of
bifurcation/ restructuring of SEBs, for reimbursing the expenditure already incurred by
them for providing low tension connection from step-down point to individual farmers
for energizing their wells and for Systems Improvement Scheme under Special Project
Agriculture (SI-SP A), are eligible for classification as indirect finance till the dates of
their maturity/repayment or March 31, 2010, whichever is earlier. Fresh advances will,
however, not be eligible for classification as indirect finance to agriculture.
1.3.17 Loans to National Co-operative Development Corporation (NCDC) for on-lending to the
co-operative sector for purposes coming under the priority sector will be treated as
indirect finance to agriculture till March 31,2010.
1.3.18 Loans to Non-Banking Financial Companies (NBFCs) for on lending to individual
farmers or their SHGs/JLGs.
1.3.19 Loans granted to NGOs/MFIs for on-lending to individual farmers or their SHGs/JLGs.

2 SMALL ENTERPRISES
DIRECT FINANCE
2.1 Direct Finance in the small enterprises sector will include credit to:
2.1.1 Manufacturing Enterprises
(a) Small (manufacturing) Enterprises: Enterprises engaged in the
manufacture/production, processing or preservation of goods and whose
investment in plant and machinery [original cost excluding land and building and
the items specified by the Ministry of Small Scale Industries vide its notification
no. S.O. 1722 (E) dated October 5, 2006] does not exceed Rs. 5 crore.
(b) Micro (manufacturing) Enterprises: Enterprises engaged in the manufacture/
production, processing or preservation of goods and whose investment in plant
and machinery [original cost excluding land and building and such items as in
2.1.1 (a)] does not exceed Rs. 25 lakh, irrespective of the location of the unit.
2.1.2 Service Enterprises
(a) Small (service) Enterprises: Enterprises engaged in providing/rendering of
services and whose investment in equipment (original cost excluding land and

80
 building and furniture, fittings and other items not directly related to the service
rendered or as may be notified under the MSMED Act, 2006) does not exceed Rs.
2 crore.
(b) Micro (service) Enterprises: Enterprises engaged in providing/rendering of
services and whose investment in equipment [original cost excluding land and
building and furniture, fittings and such items as in 2.1.2 (a)] does not exceed Rs.
10 lakh. (c) The small and micro (service) enterprises shall include small road &
water transport operators, small business, professional & self-employed persons,
and all other service enterprises.
2.1.3 Khadi and Village Industries Sector (KVI): All advances granted to units in the KVI
sector, irrespective of their size of operations, location and amount of original investment
in plant and machinery. Such advances will be eligible for consideration under the sub-
target (60 per cent) of the small enterprises segment within the priority sector.

INDIRECT FINANCE
2.2 Indirect finance to the small (manufacturing as well as service) enterprises sector will
include credit to:
2.2.1 Persons involved in assisting the decentralized sector in the supply of inputs to and
marketing of outputs of artisans, village and cottage industries.
2.2.2 Advances to cooperatives of producers in the decentralized sector viz. artisans village and
cottage industries.
2.2.3 Existing investments as on March 31, 2007, made by banks in special bonds issued by
NABARD with the objective of financing exclusively non-farm sector may be classified
as indirect finance to Small Enterprises sector till the date of maturity of such bonds or
March 31, 2010, whichever is earlier. Investments in such special bonds made subsequent
to March. 31, 2007 will, however, not be eligible for such classification.
2.2.4 The deposits placed with SIDBI by foreign banks, having offices in India, on account of
non-achievement of priority sector lending targets/ sub-targets and outstanding as on the
date of this circular would be eligible for classification as indirect finance to Small
Enterprises sector till the date of maturity of such deposits or March 31, 2010, whichever
is earlier.
2.2.5 Loans granted by banks to NBFCs for on-lending to small and micro enterprises
(manufacturing as well as service).

3. Retail Trade
3.1 Advances granted to retail traders dealing in essential commodities (fair price shops),
consumer co-operative stores, and;
3.2 Advances granted to private retail traders with credit limits not exceeding Rs. 20 lakh.

4. Micro Credit
4.1 Loans of very small amount not exceeding Rs. 50,000 per borrower provided by banks
either directly or indirectly through a SHG/JLG mechanism or to NBFC/ MFI for on-
lending up to Rs. 50,000 per borrower.
4.2 Loans to poor indebted to informal sector: Loans to distressed persons (other than
farmers) to prepay their debt to non-institutional lenders, against appropriate collateral or
group security, would be eligible for classification under priority sector.

5. State Sponsored Organizations for Scheduled Castes/Scheduled Tribes

81
 Advances sanctioned to State Sponsored Organizations for Scheduled Castes/ Scheduled
Tribes for the specific purpose of purchase and supply of inputs to and/ or the marketing
of the outputs of the beneficiaries of these organizations.

6.Education
6.1 Educational loans granted to individuals for educational purposes up to Rs. 10 lakh for
studies in India and Rs. 20 lakh for studies abroad. Loans granted to institutions will not
be eligible to be classified as priority sector advances.
6.2 Loans granted by banks to NBFCs for on-lending to individuals for educational purposes
up to Rs. 10 lakh for studies in India and Rs. 20 lakh for studies abroad.

7. Housing
7.1 Loans up to Rs. 20 lakh, irrespective of location, to individuals for purchase/ construction
of a dwelling unit per family, excluding loans granted by banks to their own employees.
7.2 Loans given for repairs to the damaged dwelling units of families up to Rs. 1 lakh in rural
and semi-urban areas and up to Rs. 2 lakh in urban and metropolitan areas.
7.3 Assistance given to any governmental agency for construction of dwelling units or for
slum clearance and rehabilitation of slum dwellers, subject to a ceiling of Rs. 5 iakh of
loan amount per dwelling unit.
7.4 Assistance given to a non-governmental agency approved by the NHB for the purpose of
refinance for construction/ reconstruction of dwelling units or for slum clearance and
rehabilitation of slum dwellers, subject to a ceiling of loan component of Rs. 5 lakh per
dwelling unit.

8. Weaker Sections
The weaker sections under priority sector shall include the following:
• Small and marginal farmers with land holding of 5 acres and less, and
• landless labourers, tenant farmers and share croppers;
• Artisans, village and cottage industries where individual credit limits do not exceed Rs.
50,000;
• Beneficiaries of Swarnjayanti Gram Swarozgar Yojana (SGSY); Scheduled Castes and
Scheduled Tribes;
• Beneficiaries of Differential Rate of Interest (DR!) scheme;
• Beneficiaries under Swarna Jayanti Shahari Rozgar Yojana (SJSRY); Beneficiaries under
the Scheme for Liberation and Rehabilitation of Scavengers (SLRS);
• Advances to Self Help Groups;
• Loans to distressed poor to prepay their debt to informal sector, against appropriate
collateral or group security.

9. Export Credit
This category will form part of priority sector for foreign banks only.

SECTION 2
PENALTIES FOR NON ACHIEVEMENT OF PRIORITY SECTOR LENDING
TARGET /SUB-TARGETS
1. Domestic scheduled commercial banks - Contribution by banks to Rural Infrastructure
Development Fund (RIDF):
1.1 Domestic scheduled commercial banks having short fall in lending to priority sector
82
 target (40 per cent of ANBC or credit equivalent amount of Off-Balance Sheet Exposure,
whichever is higher) and / or agriculture target (18 per cent of ANBC or credit equivalent
amount of Off-Balance Sheet Exposure, whichever is higher) shall be allocated amounts
for contribution to the Rural Infrastructure Development Fund (RIDF) established with
NABARD. For the purpose of allocation of RIDF tranche, the achievement level of
priority sector lending as on the last reporting Friday of March of the immediately
preceding financial year will be taken into account. The concerned banks will be called
upon by NABARD, on receiving demands from various State Governments, to contribute
to RIDF.
1.2 The corpus of a particular tranche of RIDF is decided by Government of India every year.
Fifty per cent of the corpus shall be allocated among the domestic commercial banks
having short fall in lending to priority sector target of 40 per cent of ANBC or credit
equivalent amount of Off-Balance Sheet Exposure, whichever is higher, on a pro-rata
basis. The balance fifty per cent of the corpus shall be allocated among the banks having
shortfall in lending to agriculture target of18 per cent of ANBC or credit equivalent
amount of Off-Balance Sheet Exposure, whichever is higher, on a pro-rata basis. The
amount of contribution by banks to a particular tranche of RIDF will be decided in the
beginning of the financial year.
1.3 The interest rates on banks' contribution to RIDF shall be fixed by Reserve Bank of India
from time to time.
1.4 Details regarding operationalization of the RIDF such as the amounts to be deposited by
banks, interest rates on deposits, period of deposits, etc., will be communicated to the
concerned banks separately by August of each year to enable them to plan their
deployment of funds.
2. Foreign Banks - Deposit by Foreign Banks with SIDBI
2.1 The foreign banks having shortfall in lending to stipulated priority sector target/ sub-
targets will be required to contribute to Small Enterprises Development Fund (SEDF) to
be set up by Small Industries Development Bank of India (SIDBI), or for such other
purpose as may be stipulated by Reserve Bank of India from time to time.
2.2 For the purpose of such allocation, the achievement level of priority sector lending as on
the last reporting Friday of March of the immediately preceding financial year will be
taken into account.
2.3 The corpus of SEDF shall be decided by Reserve Bank of India on a year to year basis.
The tenor of the deposits shall be for a period of three years or as decided by Reserve
Bank from time to time. Fifty per cent of the corpus shall be contributed by foreign banks
having shortfall in lending to priority sector target of 32 per cent of ANBC or credit
equivalent amount of Off-Balance Sheet Exposure, whichever is higher, on a pro-rata
basis. The balance fifty per cent of the corpus shall be contributed by foreign banks
having aggregate shortfall in lending to Small Enterprises sector and export sector ofl0
per cent and 12 per cent respectively, of ANBC or credit equivalent amount of Off-
Balance Sheet Exposure, whichever is higher, on a pro-rata basis. The contribution
required to be made by foreign banks would, however, not be more than the amount of
shortfall in priori ty sector lending target/sub-targets of the foreign banks.
2.4 The concerned foreign banks will be called upon by SIDBI or such other institution
as may be decided by Reserve Bank, as and when funds are required by them, after
giving one month's notice.
2.5 The interest rates on foreign banks' contribution, period of deposits, etc. shall be
fixed by Reserve Bank of India from time to time.

83
3. Non-achievement of priority sector targets and sub-targets will be taken into
account while granting regulatory clearances/ approvals for various purposes.

84
 LESSON 8
EXPORT CREDIT
Dr. Ashish Kumar
LBSIM

To promote the export in India, government of India started Export Credit Guarantee
Corporation of India (ECGC) and Export Import Bank India (EXIM Bank). Details of the two
are as follows:
Export Credit Guarantee Corporation of India (ECGC):
Export Credit Guarantee Corporation of India Limited, was established in the year 1957
by the Government of India to strengthen the export promotion drive by covering the risk of
exporting on credit. Being essentially an export promotion organization, it functions under the
administrative control of the Ministry of Commerce & Industry, Department of Commerce,
Government of India. It is managed by a Board of Directors comprising representatives of the
Government, Reserve Bank of India, banking, insurance and exporting community. ECGC is the
fifth largest credit insurer of the world in terms of coverage of national exports. The present
paid-up capital of the company is Rs.800 crores and authorized capital Rs.1000 crores.
Need and Objectives of ECGC:
Export credit insurance is essential for exporters to avoid the various risk factors. It offers
insurance protection to exporters against risk of payment, and gives guidance in all import export
related activities. Besides this, ECGC makes information available on various countries with its
own credit ratings, makes the process of obtaining export finance from banks/financial
institutions easy, provides information on credit-worthiness of the overseas buyer and helps
exporters in recovering bad debts.
Export Credit Guarantee Corporation is required for the smooth functioning of all aspects
relate to exports of goods. Payments for exports are prone to risks even in good times and in the
present political and economically changing scenario the risk is even higher in regards to the
payments. Factors like a coup, an outbreak of a war or civil war, problems in balance of payment
and such other risks can happen at any time. Besides all these, commercial risks of a foreign
buyer becoming bankrupt are enhanced due to the prevailing political and economic
uncertainties. To tackle all these and various other issues related to exports, it is very important
to have an organization like Export Credit Guarantee Corporation to safeguard the interest of the
exporter.
Product and Services of ECGC:
(I) Standard Policy of ECGC or Credit Insurance Policy:
ECGC has different products and services to take care of all the export credit insurance
needs of exporters. Shipments policy, well known as the standard policy is a policy that is ideal
to cover risks of goods exported on short term credit. The policy covers political and commercial
risks starting from the date of the shipment. This policy is issued to exporters whose expected
export turnover for the next twelve months is more than Rs.50 Lakh. Some of the commercial
risk covered by the standard policy includes bankruptcy of the buyer, failure by the buyer to
make the due payment within specified period and the buyer's failure to accept the goods, subject
to certain conditions.
Some of the political risks against which the Export Credit Guarantee Corporation
provides protection are: war, civil war, revolution or civil disturbances in the buyer's country,
imposition of limitation by the Government of the buyer's country which may block or delay the
transfer of payment made by the buyer, new import limitations or termination of a valid import
license in the buyer's country and any other cause of loss occurring outside India not normally
covered by general insurers, and beyond the control of both the exporter and the buyer.
a. Commercial Risks
Insolvency of the buyer.
• Failure of the buyer to make the payment due within a specified period, normally
four months from the due date.
• Buyer's failure to accept the goods, subject to certain conditions.
b. Political Risks
• Imposition of restriction by the Government of the buyer's country or any
Government action, which may block or delay the transfer of payment made by the
buyer.
• War, civil war, revolution or civil disturbances in the buyer's country. New import
restrictions or cancellation of a valid import license in the buyer's country.
• Interruption or diversion of voyage outside India resulting in payment of additional
freight or insurance charges which can’t be recovered from the buyer.
• Any other cause of loss occurring outside India not normally insured by general
insurers, and beyond the control of both the exporter and the buyer.
(II) Guarantee to Banks:
Timely and adequate credit facilities at the pre-shipment stage are essential for exporters
to realize their full export potential. Exporters may not, however, be easily able to obtain such
facilities from their bankers for several reasons, e.g. the exporter may be relatively new to export
business, the extent of facilities needed by him may be out of proportion to the equity of the
firms or the value of collateral offered by the exporter may be inadequate. The Packing Credit
Guarantee of ECGC helps the exporter to obtain better and adequate facilities from their bankers.
The Guarantees assure the banks that, in the event of an exporter failing to discharge his
liabilities to the bank, ECGC would make good a major portion of the bank's loss. The bank is
required to be co-insurer to the extent of the remaining loss. Any loan given to an exporter for
the manufacture, processing, purchasing or packing of goods meant for export against a firm
order or Letter of Credit qualifies for Packing Credit Guarantee. Pre-shipment advances given by
banks to parties who enter into contracts for export of services or for construction works abroad
to meet preliminary expenses in connection with such contracts are also eligible for cover under
the Guarantee. The requirement of lodgement of Letter of Credit or export order for granting
packing credit advances is waived if the bank grants such advances in accordance with the
instructions of the Reserve Bank of India in that respect.
(III) Special Schemes:
Exchange Fluctuation Risk Cover: The Exchange Fluctuation Risk Cover is intended to
provide a measure of protection to exporters of capital goods, civil engineering contractors and
consultants who have often to receive payments over a period of years for their exports,
construction works or services. Where such payments are to be received in foreign currency, they
are open to exchange fluctuation risk as the forward exchange market does not provide cover for
such deferred payments. Exchange Fluctuation Risk Cover is available for payments scheduled
over a period of 12 months or more, upto a maximum of 15 years. Cover can be obtained from
the date of bidding right up to the final installment. At the stage of bidding, an
exporter/contractor can obtain Exchange Fluctuation Risk (Bid) Cover. The basis for cover will
be a reference rate agreed upon. The reference rate can be the rate prevailing on the date of bid or
rate approximating it. The cover will be provided initially for a period of twelve months and can
be extended if necessary. If the bid is successful, the exporter/contractor is required to obtain
Exchange Fluctuation (Contract) cover for all payments due under the contract. The reference
86
rate for the contract cover will be either the reference rate used for the Bid Cover or the rate
prevailing on the date of contract, at the option of the exporter/contractor. If the bid is
unsuccessful 75 percent of the premium paid by the exporter/contractor is refunded to him.
Functions of ECGC:
• Offers insurance protection to exporters against payment risks
• Provides guidance in export-related activities
• Makes available information on different countries with its own credit ratings
• Makes it easy to obtain export finance from banks/financial institutions
• Assists exporters in recovering bad debts
• Provides information on credit-worthiness of overseas buyers
Export- Import Bank of India:
Export-Import Bank of India is the premier export finance institution of the
country, set up in 1982 under the Export-Import Bank of India Act 1981. Government of
India launched the institution with a mandate, not just to enhance exports from India, but
to integrate the country’s foreign trade and investment with the overall economic growth.
Since its inception, Exim Bank of India has been both a catalyst and a key player in the
promotion of cross border trade and investment. Commencing operations as a purveyor of
export credit, like other Export Credit Agencies in the world, Exim Bank of India has,
over the period, evolved into an institution that plays a major role in partnering Indian
industries, particularly the Small and Medium Enterprises, in their globalization efforts,
through a wide range of products and services offered at all stages of the business cycle,
starting from import of technology and export product development to export production,
export marketing, pre-shipment and post-shipment and overseas investment.
The Initiatives
• Exim Bank of India has been the prime mover in encouraging project exports from
India. The Bank provides Indian project exporters with a comprehensive range of
services to enhance the prospect of their securing export contracts, particularly
those funded by Multilateral Funding Agencies like the World Bank, Asian
Development Bank, African Development Bank and European Bank for
Reconstruction and Development.
• The Bank extends lines of credit to overseas financial institutions, foreign
governments and their agencies, enabling them to finance imports of goods and
services from India on deferred credit terms. Exim Bank’s lines of Credit obviate
credit risks for Indian exporters and are of particular relevance to SME exporters.
• The Bank’s Overseas Investment Finance programme offers a variety of facilities
for Indian investments and acquisitions overseas. The facilities include loan to
Indian companies for equity participation in overseas ventures, direct equity
participation by Exim Bank in the overseas venture and non-funded facilities such
as letters of credit and guarantees to facilitate local borrowings by the overseas
venture.
• The Bank provides financial assistance by way of term loans in Indian
rupees/foreign currencies for setting up new production facility,
expansion/modernization/upgradation of existing facilities and for acquisition of
production equipment/technology. Such facilities particularly help export oriented
Small and Medium Enterprises for creation of export capabilities and enhancement
of international competitiveness.
• Under its Export Marketing Finance programme, Exim Bank supports Small and
Medium Enterprises in their export marketing efforts including financing the soft
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 expenditure relating to implementation of strategic and systematic export market
development plans.
• The Bank has launched the Rural Initiatives Programme with the objective of
linking Indian rural industry to the global market. The programme is intended to
benefit rural poor through creation of export capability in rural enterprises.
• In order to assist the Small and Medium Enterprises, the Bank has put in place the
Export Marketing Services (EMS) Programme. Through EMS, the Bank seeks to
establish, on best efforts basis, SME sector products in overseas markets, starting
from identification of prospective business partners to facilitating placement of
final orders. The service is provided on success fee basis.
• Exim Bank supplements its financing programmes with a wide range of value-
added information, advisory and support services, which enable exporters to
evaluate international risks, exploit export opportunities and improve
competitiveness, thereby helping them in their globalisation efforts.
Services provided by the EXIM Banks:
Exim Bank offers the following Export Credit facilities, which can be availed of by
Indian companies, commercial banks and overseas entities.
(I) Export Credit:
For Indian Companies executing contracts overseas
• Pre-shipment credit: Exim Bank's Pre-shipment Credit facility, in Indian Rupees
and foreign currency, provides access to finance at the manufacturing stage -
enabling exporters to purchase raw materials and other inputs.
• Supplier's Credit: This facility enables Indian exporters to extend term credit to
importers (overseas) of eligible goods at the post-shipment stage.
• For Project Exporters: Indian project exporters incur Rupee expenditure while
executing overseas project export contracts i.e. costs of mobilisation/acquisition of
materials, personnel and equipment etc. Exim Bank's facility helps them meet
these expenses.
• For Exporters of Consultancy and Technological Services: Exim Bank offers a
special credit facility to Indian exporters of consultancy and technology services,
so that they can, in turn, extend term credit to overseas importers.
• Guarantee Facilities: Indian companies can avail of these to furnish requisite
guarantees to facilitate execution of export contracts and import transactions.
For commercial Banks
• Exim Bank offers Rediscounting Facility to commercial banks, enabling them to
rediscount export bills of their SSI customers, with usance not exceeding 90 days.
• It also offer Refinance of Supplier's Credit, enabling commercial banks to offer
credit to Indian exporters of eligible goods, who in turn extend them credit over
180 days to importers overseas.
Other Facilities for Indian Companies
Indian companies executing contracts within India, but which are categorized as
Deemed Exports in the Foreign Trade Policy of India or contracts secured under
international competitive bidding or contracts under which payments are received
in foreign currency, can avail of credit under our Finance for Deemed Exports
facility, aimed at helping them meet cash flow deficits.
For Overseas Entities
• Buyer's Credit: Overseas buyers can avail of Buyer's Credit from Exim Bank, for
import of eligible goods from India on deferred payment terms.
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 • Eligible Goods: Capital goods, plant and machinery, industrial manufactures,
consumer durables and any other items eligible for being exported under the 'Exim
Policy' of the Government of India.
(II) Term Finance (For Exporting Companies)
• Project Finance
• Equipment Finance
• Import of Technology & Related Services
• Domestic Acquisitions of businesses/companies/brands
• Export Product Development/ Research & Development
• General Corporate Finance
(III) (A) Working Capital Finance (For Exporting Companies)
• Funded
o Working Capital Term Loans [< 2 years]
o Long Term Working Capital [up to 5 years]
o Export Bills Discounting
o Export Packing Credit
o Cash Flow financing
• Non-Funded
o Letter of Credit Limits
o Guarantee Limits
(B) Working Capital Finance (For Non- Exporting Companies)
o Bulk Import of Raw Material

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 LESSON 9
ASSESSMENT OF CREDIT NEEDS FOR PROJECT AND
WORKING CAPITAL FINANCE
Dr. Ashish Kumar
LBSIM
Working Capital
Apart from financing for investing in fixed assets, every business also requires funds on a
continual basis for carrying on its operations. These include amounts expenses incurred for
purchase of raw material, manufacturing, selling, and administration until such goods are sold
and the monies realized. Business transactions are generally carried on credit with a number of
days elapsing subsequent to the sale being effected for realization of proceeds1. While part of the
raw material maybe purchased by credit, the business would still need to pay its employees, meet
manufacturing & selling expenses (wages, power, supplies, transportation and communication)
and the balance of its raw material purchases. Working capital refers to the source of financing
required to by businesses on a continual basis for meeting these needs.
Thus the need for working capital arises from the prevalence of credit in business
transactions, need to fund manufacturing and support and to account for the variations in the
supply of raw material and demand for finished goods.
Characteristics of working capital
• It is continually required for a going concern
• However, the quantum of working capital fluctuates depending on the level of activity
• Working Capital is impacted by numerous transactions on a continual basis
The above characteristics render limit based financing from banks ideal for working capital
financing. This is because the client is charged interest only on the average outstanding utilized
and is saved with the bother of reinvesting short term surpluses arising out of low working
capital utilization at a point in time. Further since the transactions of the business are generally
routed through a current account with a bank, availing a credit limit from the same bank is really
convenient. Thus, working capital requirements are generally financed through limit based
financing from banks.
Bank Financing for Working Capital
The financing limits are granted based on assessment of the working capital requirement. The
assessment factors include various characteristics such as the nature of industry, industry norms,
actual level of activity for the previous year and the projected level of activity for the subsequent
year to arrive at the working capital requirement. The bank financing limit is thereafter decided
after factoring in margins on the different types of current assets forming part of the working
capital.
The Bank Financing Limit is fixed on an annual basis. However, since such limit is
provided to meet specific requirements, utilizing the limits is subjected to the Drawing Power,
which is decided on a monthly/ quarterly basis.
The effective bank financing is therefore to the extent of the lower of:
• Bank Financing Limit: Determined on an annual basis based on an assessment of the
current year’s projections and the actuals for the previous year.
• Drawing Power: Linked to the quantum of current assets (and current liabilities) owned
by the business with appropriate margins. Fixed on a monthly/ quarterly basis depending
on the submission of Monthly/Quarterly Information System returns indicating the
position of the stock statement, receivables, Work in Progress, payables, etc.
Forms of Bank Finance: Working capital advance is provided by commercial banks in three
primary ways: (1) cash credits/overdrafts, (2) loans (3) purchase / discount of bills. In addition to
these direct forms, commercial banks help their customers in obtaining credit from other sources
through the letter of credit arrangement.
1. Cash Credits/Overdrafts: Under a cash credit or overdraft arrangement, a pre-determined
limit for borrowing is specified by the bank. The borrower can draw as often as required
provided the out standings do not exceed the cash credit/overdraft limit. The borrower
also enjoys the facility for repaying the amount, partially or fully, as and when he desires.
Interest is charged only on the running balance, not on the limit sanctioned. A minimum
charge may be payable irrespective of the level of borrowing for availing of this facility.
This form of advance is highly attractive from the borrower’s point of view because
while the borrower has the freedom of drawing the amount in installments as and when
required, the interest is payable only on the amount actually outstanding.
2. Loans: These are advances of fixed amounts to the borrower. The borrower is charged
with interest on the entire loan amount, irrespective of how much he draws. In this
respect, this system differs markedly from the overdraft or cash credit arrangement
wherein interests is payable only on the amount actually utilized. Loans are payable
either on demand or in periodical installments. When payable on demand, loans are
supported by a demand promissory note executed by the borrower. There is often a
possibility of renewing the loan.
3. Purchase /Discount of bills: A bill arises out of a trade transaction. The seller of goods
draws the bill on the purchaser. The bill may be either clean or documentary (a
documentary bill is supported by a document of title to goods like a railway receipt or a
bill of lading) and may be payable on demand or after usance period which does not
exceed 90 days. On acceptance of the bill by the purchaser, the seller presents it to the
bank for discount/ purchase. When the bank discounts/purchases the bill, it releases the
funds to the seller. The bank presents the bill to the purchaser (acceptor of the bill) on the
due date and gets its payment.
4. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its customer to
obtain credit from its (customer’s) suppliers. When a bank opens a letter of credit on
favor of its customer for some specific purchases, the bank undertakes the responsibility
to honor the obligation of its customer, should the customer fail to do so.

Estimation of Working Capital Requirement

Lack of adequate working capital is often stated as one of the major reasons for sickness in
industry (especially in case of SMEs). The counter arguments from the banks have been that
most firms face problems of inadequate working capital due to credit indiscipline (diversion of
working capital to meet long term requirements or to acquire other assets). In this context it
would be pertinent to understand the method adopted by banks in computing the working capital
requirement of the business and the quantum of bank financing to be provided by the bank.
Main factors considered in the estimation of working capital requirement
• The nature of business and sector-wise norms
Factors such as seasonality of raw materials or of demand may require a high level of
inventory being maintained by the company. Similarly, industry norms of credit allowed
to buyers determine the level of debtors of the company in the normal course of business.
• The level of activity of the business
Inventories and receivables are normally expressed as a multiple of a day’s production or
sale. Hence, higher the level of activity, higher the quantum of inventory, receivables and

91
 thereby working capital requirement of the business. So in order to arrive at the working
capital requirement of the business for the year, it is essential to determine the level of
production that the business would achieve. In case of well-established businesses, the
previous year’s actuals and the management projections for the year provide good
indicators. The problems arise mainly in the case of determining the limit for the first
time or in the initial few years of the business. Banks often adopt industry standard norms
for capacity utilization in the initial years.
Steps involved in arriving at the level of Working Capital Requirement
• Based on the level of activity decided and the unit cost and sales price projections, the
banks calculate at the annual sales and cost of production.
• The quantum of current assets (CA) in the form of Raw Materials, Work-in-progress,
Finished goods and Receivables is estimated as a multiple of the average daily turnover.
The multiple for each of the current assets is determined generally based on the industry
norms.
• The current liabilities (CL) in the form of credit availed by the business from its creditors
or on its manufacturing expenses are deducted from the current assets (CA) to arrive at
the Working Capital Requirement (WCR).
Standard Formulae for determination of Working Capital
The issue of computation of working capital requirement has aroused considerable debate and
attention in this country over the past few decades. A directed credit approach was adopted by
the Reserve Bank of ensuring the flow of credit to the priority sectors for fulfillment of the
growth objectives laid down by the planners. Consequently, the quantum of bank credit required
for achieving the requisite growth in Industry was to be assessed. Various committees such as the
Tandon Committee and the Chore Committee were constituted and studied the problem at length.
Norms were fixed regarding the quantum of various current assets for different industries
(as multiples of the average daily output) and the Maximum Permissible Bank Financing
(MPBF) was capped at a certain percentage of the working capital requirement thus arrived at.
Working Capital assessment on the formula prescribed by the Tandon Committee.

Working Capital Requirement (WCR) =

[Current assets i.e. CA (as per industry norms) – Current Liabilities i.e. CL]
Permissible Bank Financing [PBF} =
WCR – Promoter’s Margin Money i.e. PMM (to be brought in by the promoter)

As per Formula 1: PMM = 25% of [CA – CL] and thereby PBF = 75% of [CA – CL]
As per Formula 2: PMM = 25% of CA and thereby PBF = 75%[CA] – CL

As is apparent Formula 2 requires a higher level of PMM as compared to Formula 1.

Formula 2 is generally adopted in case of bank financing. In cases of sick units where the
promoter is unable to bring in PMM to the extent required under Formula 2, the difference in
PMM between Formulae 1 and 2 may be provided as a Working Capital Term Loan repayable in
installments over a period of time.
Illustrative Example:
Turnover of a manufacturing unit: Rs. 750 lakh p.a (assumed uniform across the year)
Assumed value addition norm: 50% (i.e. cost of raw material = 50% of Realisation)

Promoter Projections
Current Assets Current Liabilities
92
 - Raw materials Rs. 50 lakh - Payables Rs. 35 lakh
- Work in progress Rs. 25 lakh
- Finished Goods Rs. 60 lakh
- Receivables Rs. 125 lakh

Requirement assessed as per norms applicable for the industry:

Industry Amount as per Promoter Applicable

Norm (a) Norm (b) Projection (c) norm (d)
Current Asset
- Raw material 1 month Rs. 31.25 lakh Rs. 50 lakh Rs. 31.25 lakh
- Work in Progress (assumed at
10 days Rs. 15.62 lakh Rs. 25 lakh Rs. 15.62 lakh
50% complete)
- Finished Goods 15 days Rs. 31.25 lakh Rs. 60 lakh Rs. 31.25 lakh
- Receivables
1.5 months Rs. 112.50 lakh Rs. 125 lakh Rs. 112.50 lakh

Rs. 190.62 lakh Rs. 260.0 lakh Rs. 190.62 lakh

Current Liabilities
- Payables 15 days Rs. 18.80 lakh Rs. 35 lakh Rs. 18.80 lakh

Working Capital Requirement Rs. 171.82 lakh Rs. 225.0 lakh Rs. 171.82 lakh

Notes:
• Assumptions here include: No export turnover, uniform working capital requirement
through out the year
• Industry norms have been specified in the Tandon Committee Report for all important
industry categories
• Raw materials have been valued at cost of raw material (assumed at 50% of realization)
• Work in progress has been valued at 50% complete basis
• Applicable norm (d) is the more conservative of (b) or (c) from the bank’s point of view.

Computation of working capital requirement

Working Capital Requirement arrived at therefore is Rs. 171.82 lakh
Formula 1
PMM (Promoter Margin Money) as per formula 1 = 25% of 171.82 lakh = Rs. 42.95 lakh
Hence, Permissible Bank Finance 1 = Rs. 129 lakh
Formula 2
PMM as per formula 2 = 25% of Rs. 190.6 lakh = Rs. 47.65 lakh
Permissible Bank Financing as per formula 2 =[75% of 190.6 – Rs. 18.8] = Rs.124.1 lakh
The difference between the 2 methods is Rs. 4.90 lakh (which may be extended as a Working
Capital Term Loan in case of sick units.

Thus the PMM while being at 25% of the Working Capital requirement1 could actually translate
to as high as Rs. 225 lakh – Rs. 124 lakh i.e. Rs. 101 lakh assuming that the promoter projections
93
really reflect his genuine need for working capital. It should however be understood by the
entrepreneur that he ought to keep his working capital requirements to the minimum (whether or
not bank financing is available) to ensure that his interest burden and capital blocked is kept to
the minimum.
The following further points maybe worth mentioning here:
• In case of export financing sought by the entrepreneur, the quantum of bank financing for
the Working Capital build up for this purpose would normally be at a higher percentage
• Within the overall limits, there could be sub-limits for bills financing (in case of
receivables) with the result that such limits might not be fully available to the business.
• The Bank Financing Limit arrived above is the Overall limit for the year. The actual
quantum of bank financing that could be availed by the unit at a given point in time
depends upon its drawing power based on its periodical returns filed to the banker.

Procedures to avail working capital financing from banks

Banks exercise extreme caution in lending to first time applicants starting up their business. A
first time applicant would be asked for collateral in the form of land, building or residential
property. This would be in addition to a second charge on the fixed assets of the enterprise.
Sequence of steps to avail working capital
• Application for the working capital: Most of the large commercial banks are moving
towards the trend of specialized SSI branches near the industrial concentrations. The
applications for working capital are generally accepted and processed at these branches.
• List of Documents accompanying the application: The application for working capital
would need to have a covering letter containing a request for sanction of working capital
limits. The following documents would need to be enclosed along with:
o Detailed Project Report containing the detailed financials at projected levels of
operations for the next 5 years
o Memorandum and Articles of Association
o Copies of Incorporation documents (relating to formalities with the Registrar of
Companies in case of corporates)
o Statutory approvals obtained/ applied for such as for power, water, pollution
control, environment clearance, clearances from other agencies/ departments with
purview over the business.
o Other relevant documents – Letters of intent/ confirmed orders from prospective
buyers.
o Networth statement of promoters.
In case of the larger loans (above Rs. 5 crore in case of most banks), the projections are
generally submitted in the CMA format prescribed by Reserve Bank of India (earlier
mandatory).
• In- Principle Sanction for Working Capital: The timeframe for in-principle sanction
depends upon two factors:
o Time taken for submission of necessary documents
o The decision structure at the bank
Most of the large banks have specialized SSI branches at the industrial concentrations in
the country. These branches are headed by senior executives often with sanctioning
power of Rs. 5-6 crores at the branch. In such instances, delays for processing the
applications at the bank are limited. Infact the stage of in-principle sanction maybe
dispensed with and final sanction accorded on full appraisal.

94
 In other cases, such processing may take 30-45 days for according In-Principle Sanction
to the project. The newer private sector banks are generally faster in according such
approval. The significance of the in-principle sanction of working capital is that such
sanction is necessary for obtaining term funding from the financial institutions. While
these financial institutions accord sanction to a industry,
• Appraisal and Final Sanction: The appraisal and final sanction of the request for working
capital is based on a thorough appraisal of the Detailed Project Report (DPR). The
traditional banks generally have specified formats for submission of the DPR. The usual
coverage of the DPR includes:
o Overview of the business
o Background of promoters
o Details of products to be manufactured – manufacturing process and raw material
o Market overview and competition Sensitivity Analysis – ‘What if’ on Finished
Goods prices, raw material costs and so on
o Detailed financial projections covering the Balance Sheet, Profit and Loss
Account, Funds Flow and the Financial Ratios.
The timeframe for a Final Sanction in cases where all the requirements have already been
submitted by the borrowing unit is 90 days from the submission of the application.
• Post Sanction Requirements: Post sanction requirements involve completion of
documentation creating a charge in favour of the bank. This could include a charge on
assets related to the business and charge on collateral offered (if any). In case of the
assets of the business already being mortgaged with the term lending institution, a second
or third charge maybe created in favour of the bank. The financing facilities sanctioned
can thereafter be availed by the borrower.
• Monitoring and follow-up: Working capital financing is extended for the
current asset buildup of a business, which is linked to its activity level. These assets are
mobile (in case of inventory) and also easily convertible into cash. At best, the banks
have a second charge on the fixed assets of the enterprise and without the power of
Seizure (u/s Sec 29 as available to the state financial institutions) realizing money from
the security is time consuming. Hence, banks pay extremely high importance to the
monitoring and follow-up of the loan. The system of a current account through which all
the transactions are routed acts as an in-built check on the operations of the borrower. By
studying the current account transactions in detail, the banker is able to make an
assessment of the business. In addition to this, the banks also undertake other forms of
monitoring. These include:
• Stock Statements collected on a monthly basis from the borrower.
• Quarterly Operating Statement giving details of the operations for the quarter
In addition to these checks, banks often employ methods such as:
• Stock Audit by independent firms of chartered accountants.
• Branch Inspection conducted by the internal audit/ bank staff
In case of larger loans, Consortium meetings where the operations of the unit are jointly
reviewed are also undertaken.
• Review, enhancement of limits and adhoc limits: Review of limits is usually undertaken
on an annual basis. In cases where a request for enhancement of limits is made by the
borrower during the course of the year, such a request is processed based on the stock
statements and QoS submitted. In case of temporary need, an adhoc limit of upto 25% of
the existing limits could be granted on request.

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Self-Assessment Questions:
Question 1: Explain the credit analysis procedure of banks.
Question 2: Define the credit process and also state the various constituents of credit process.
Question 3: Explain various types of loans and their features.
Question 4: What do you mean by priority sector? Elaborate the features priority sector
advances.
Question 5: Writes a note on priority sector advances in India.
Question 6: What kind of steps Indian government taken to boost up export through improving
financing?
Question 7: Write short notes on:
(i) Export Import Bank
(ii) Export Credit Guarantee Corporation of India
(iii)Loan Syndication
(iv) Working Capital Financing
(v) Capital Expenditure Financing
(vi) Agriculture Financing
Question 8: Define the meaning of working capital. How commercial banks appraise the working
capital requirement of a concern?
Question 9: Define the procedure of determining working capital requirement of concern by
commercial banks.

Suggested Readings:
• Sundhram, K.P.M., Banking Theory Law and Practice, Sultan Chand & Co. Ltd., New
Delhi.
• Desai, Vasant, Banking and Financial System, Himalaya Publishing House, New Delhi
• Bihari, S.C. and Baral S.K., Modern Banking Management, Skylark Publications, New
Delhi.
• Suresh, Padmalatha and Paul, Justin, Management of Banking and Financial Services,
Pearson Publications, New Delhi.
• www.indiamarkets.com

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 LESSON 10
BANK CUSTOMER RELATIONSHIP: CONCEPT AND CASES
Dr. Ashish Kumar
LBSIM

The relationship between a banker and a customer depends on the activities; products or services
provided by bank to its customers or availed by the customer. Thus the relationship between a
banker and customer is the transactional relationship. Bank’s business depends much on the
strong bondage with the customer. “Trust” plays an important role in building healthy
relationship between a banker and customer.

Definition of a ‘BANKER’
The Banking Regulations Act (B R Act) 1949 does not define the term ‘banker’ but defines what
banking is? As per Sec.5 (b) of the B R Act “Banking' means 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 or otherwise."
As per Sec. 3 of the Indian Negotiable Instruments Act 1881, the word “banker includes
any person acting as banker and any post office savings bank”.
According to Sec. 2 of the Bill of Exchange Act, 1882, ‘banker includes a body of
persons, whether incorporated or not who carry on the business of banking.’
Sec.5(c) of BR Act defines "banking company" as a company that transacts the business
of banking in India. Since a banker or a banking company undertakes banking related activities
we can derive the meaning of banker or a banking company from Sec 5(b) as a body corporate
that:
(a) Accepts deposits from public.
(b) Lends or
(c) Invests the money so collected by way of deposits.
(d) Allows withdrawals of deposits on demand or by any other means.
Accepting deposits from the ‘public’ means that a bank accepts deposits from anyone
who offers money for the purpose. Unless a person has an account with the bank, it does not
accept deposit. For depositing or borrowing money there has to be an account relationship with
the bank. A bank can refuse to open an account for undesirable persons. It is banks right to open
an account. Reserve Bank of India has stipulated certain norms “Know Your Customer”
(KYC) guidelines for opening account and banks have to strictly follow them. In addition to the
activities mentioned in Sec.5 (b) of B R Act, banks can also carry out activities mentioned in
Sec. 6 of the Act.

Who is a ‘Customer’?
The term Customer has not been defined by any act. The word ‘customer’ has been derived from
the word ‘custom’, which means a ‘habit or tendency’ to-do certain things in a regular or a
particular manner’s .In terms of Sec.131 of Negotiable Instrument Act, when a banker receives
payment of a crossed cheque in good faith and without negligence for a customer, the bank does
not incur any liability to the true owner of the cheque by reason only of having received such
payment. It obviously means that to become a customer account relationship is must. Account
relationship is a contractual relationship.
 It is generally believed that any individual or an organisation, which conducts banking
transactions with a bank, is the customer of bank. However, there are many persons who do
utilize services of banks, but do not maintain any account with the bank.
Thus bank customers can be categorized in to four broad categories as under:
• Those who maintain account relationship with banks i.e. Existing customers.
• Those who had account relationship with bank i.e. Former Customers
• Those who do not maintain any account relationship with the bank but frequently visit
branch of a bank for availing banking facilities such as for purchasing a draft, encashing a
cheque, etc. Technically they are not customers, as they do not maintain any account with
the bank branch.
• Prospective/ Potential customers: Those who intend to have account relationship
with the bank. A person will be deemed to be a 'customer' even if he had only
handed over the account opening form duly filled in and signed by him to the bank
and the bank has accepted the it for opening the account, even though no
account has actually been opened by the bank in its books or record.

The practice followed by banks in the past was that for opening account there has to be an initial
deposit in cash. However the condition of initial cash deposit for opening the account appears to
have been dispensed with the opening of ‘No Frill’ account by banks as per directives of
Reserve Bank of India. ‘No Frill’ accounts are opened with ‘Nil’ or with meager balance.
The term 'customer' is used only with respect to the branch, where the account is
maintained. He cannot be treated as a ‘customer' for other branches of the same bank. However
with the implementation of’ ‘Core Banking Solution’ the customer is the customer of the bank
and not of a particular branch as he can operate his account from any branch of the bank and
from anywhere. In the event of arising any cause of action, the customer is required to approach
the branch with which it had opened account and not with any other branch.
‘Know Your Customer’ Guidelines and Customer:
As per ‘Know Your Customer’ guidelines issued by Reserve Bank of India, customer has been
defined as:
a) A person or entity that maintains an account and/or has a business relationship
with the bank;
b) One on whose behalf the account is maintained (i.e. the beneficial owner);
c) Beneficiaries of transactions conducted by professional intermediaries, such as
Stock Brokers, Chartered Accountants, Solicitors etc. as permitted under the
law, and
d) Any person or entity connected with a financial transaction, which can pose
significant reputational or other risks to the bank, say, a wire transfer or
issue of a high value demand draft as a single transaction.
Banker-Customer Relationship:
Banking is a trust-based relationship. There are numerous kinds of relationship between the bank
and the customer. The relationship between a banker and a customer depends on the type of
transaction. Thus the relationship is based on contract, and on certain terms and conditions.
These relationships confer certain rights and obligations both on the part of the banker
and on the customer. However, the personal relationship between the bank and its customers is
the long lasting relationship. Some banks even say that they have generation-to-generation
banking relationship with their customers. The banker customer relationship is fiducial

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relationship. The terms and conditions governing the relationship is not be leaked by the banker
to a third party.

Classification of Relationship:
The relationship between a bank and its customers can be broadly categorized in to General
Relationship and Special Relationship. If we look at Sec 5(b) of Banking Regulation Act, we
would notice that bank’s business hovers around accepting of deposits for the purposes of
lending. Thus the relationship arising out of these two main activities are known as General
Relationship. In addition to these two activities banks also undertake other activities mentioned
in Sec.6 of Banking Regulation Act. Relationship arising out of the activities mentioned in Sec.6
of the act is termed as special relationship.

General Relationship:
1. Debtor-Creditor: When a 'customer' opens an account with a bank, he fills in and signs the
account opening form. By signing the form he enters into an agreement/contract with the bank.
When customer deposits money in his account the bank becomes a debtor of the customer and
customer a creditor. The money so deposited by customer becomes bank’s property and bank has
a right to use the money as it likes. The bank is not bound to inform the depositor the manner of
utilization of funds deposited by him. Bank does not give any security to the depositor i.e.
debtor. The bank has borrowed money and it is only when the depositor demands, banker pays.
Bank’s position is quite different from normal debtors.
Banker does not pay money on its own, as banker is not required to repay the debt
voluntarily. The demand is to be made at the branch where the account exists and in a proper
manner and during working days and working hours.
The debtor has to follow the terms and conditions of bank said to have been mentioned in
the account opening form. {Though the terms and conditions are not mentioned in the account
opening form, but the account opening form contains a declaration that the terms and conditions
have been read and understood or has been explained. In fact the terms and conditions are
mentioned in the passbook, which is issued to the customer only after the account has been
opened.}
In the past while opening account some of the banks had the practice of giving a printed
handbill containing the terms and conditions of account along with the account opening form.
This practice has since been discontinued. For convenience and information of prospective
customers a few banks have uploaded the account opening form, terms and conditions for
opening account, rate charge in respect of various services provided by the bank etc., on their
web site.
While issuing Demand Draft, Mail / Telegraphic Transfer, bank becomes a debtor as it
owns money to the payee/ beneficiary.

2. Creditor–Debtor: Lending money is the most important activities of a bank. The resources
mobilized by banks are utilized for lending operations. Customer who borrows money from bank
owns money to the bank. In the case of any loan/advances account, the banker is the creditor and
the customer is the debtor. The relationship in the first case when a person deposits money with
the bank reverses when he borrows money from the bank. Borrower executes documents and
offer security to the bank before utilizing the credit facility.

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 In addition to opening of a deposit/loan account banks provide variety of services, which
makes the relationship more wide and complex. Depending upon the type of services rendered
and the nature of transaction, the banker acts as a bailee, trustee, principal, agent, lessor,
custodian etc.

Special Relationship:
1. Bank as a Trustee: As per Sec. 3 of Indian Trust Act, 1882 ‘ A "trust" is an obligation
annexed to the ownership of property, and arising out of a confidence reposed in and accepted by
the owner, or declared and accepted by him, for the benefit of another, or of another and the
owner.’ Thus trustee is the holder of property on behalf of a beneficiary.
As per Sec. 15 of the ‘Indian Trust Act, 1882 ‘A trustee is bound to deal with the trust-
property as carefully as a man of ordinary prudence would deal with such property if it were his
own; and, in the absence of a contract to the contrary, a trustee so dealing is not responsible for
the loss, destruction or deterioration of the trust-property.’ A trustee has the right to
reimbursement of expenses (Sec.32 of Indian Trust Act.).
In case of trust banker customer relationship is a special contract. When a person entrusts
valuable items with another person with an intention that such items would be returned on
demand to the keeper the relationship becomes of a trustee and trustier. Customers keep certain
valuables or securities with the bank for safekeeping or deposits certain money for a specific
purpose (Escrow accounts) the banker in such cases acts as a trustee. Banks charge fee for
safekeeping valuables
2. Bailee – Bailor: Sec.148 of Indian Contract Act, 1872, defines "Bailment" "bailor" and
"bailee". A "bailment" is the delivery of goods by one person to another for some purpose, upon
a contract that they shall, when the purpose is accomplished, be returned or
otherwise disposed of according to the directions of the person delivering them.
The person delivering the goods is called the "bailor". The person to whom they
are delivered is called, the "bailee".
Banks secure their advances by obtaining tangible securities. In some cases physical
possession of securities goods (Pledge), valuables, bonds etc., are taken. While taking physical
possession of securities the bank becomes bailee and the customer bailor. Banks also keeps
articles, valuables, securities etc., of its customers in Safe Custody and acts as a Bailee. As a
bailee the bank is required to take care of the goods bailed.
3.Lessor and Lessee: Sec.105 of ‘Transfer of property Act 1882’ defines lease, Lessor, lessee,
premium and rent. As per the section “A lease of immovable property is a transfer of a right to
enjoy such property, made for a certain time, express or implied, or in perpetuity, in
consideration of a price paid or promised, or of money, a share of crops, service or any other
thing of value, to be rendered periodically or on specified occasions to the transferor by the
transferee, who accepts the transfer on such terms.”

Definition of Lessor, lessee, premium and rent:

(1)The transferor is called the lessor,
(2)The transferee is called the lessee,
(3)The price is called the premium, and
(4)The money, share, service or other thing to be so rendered is called the rent.”

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 Providing safe deposit lockers is as an ancillary service provided by banks to customers.
While providing Safe Deposit Vault/locker facility to their customers bank enters into an
agreement with the customer. The agreement is known as “Memorandum of letting” and attracts
stamp duty.
The relationship between the bank and the customer is that of lessor and lessee. Banks
lease (hire lockers to their customers) their immovable property to the customer and give them
the right to enjoy such property during the specified period i.e. during the office/ banking hours
and charge rentals. Bank has the right to break-open the locker in case the locker holder defaults
in payment of rent. Banks do not assume any liability or responsibility in case of any damage to
the contents kept in the locker. Banks do not insure the contents kept in the lockers by customers.
4. Agent and Principal: Sec.182 of ‘The Indian Contract Act, 1872’ defines “an agent” as a
person employed to do any act for another or to represent another in dealings with third persons.
The person for whom such act is done or who is so represented is called “the Principal”.
Thus an agent is a person, who acts for and on behalf of the principal and under the
latter’s express or implied authority and the acts done within such authority are binding on his
principal and, the principal is liable to the party for the acts of the agent.
Banks collect cheques, bills, and makes payment to various authorities viz., rent,
telephone bills, insurance premium etc., on behalf of customers. . Banks also abides by the
standing instructions given by its customers. In all such cases bank acts as an agent of its
customer, and charges for these services. As per Indian contract Act agent is entitled to charges.
No charges are levied in collection of local cheques through clearing house. Charges are levied
in only when the cheque is returned in the clearinghouse.
5. As a Custodian: A custodian is a person who acts as a caretaker of something. Banks take
legal responsibility for a customer’s securities. While opening a dmat account bank becomes a
custodian.
6. As a Guarantor: Banks give guarantee on behalf of their customers and enter in to their
shoes. Guarantee is a contingent contract. As per sec 31,of Indian contract Act guarantee is a "
contingent contract ". Contingent contract is a contract to do or not to do something, if some
event, collateral to such contract, does or does not happen.

It would thus be observed that banker customer relationship is transactional relationship.

Termination of relationship between a banker and a customer:

The relationship between a bank and a customer ceases on:
(a) The death, insolvency, lunacy of the customer.
(b) The customer closing the account i.e. Voluntary termination
(c) Liquidation of the company
(d) The closing of the account by the bank after giving due notice.
(e) The completion of the contract or the specific transaction

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 Leading cases explaining the relationship of bank and customer
Case 1:

Tai Hing Cotton Mill Ltd. Appellant v. Liu Chong Hing Bank Ltd.
and
Others Respondents Privy Council, Lord Scarman, Lord Roskill, Lord Brandon of
Oakbrook, Lord Brightman and Lord Templeman

LORD SCARMAN.
This is an appeal by a company against a decision of the Court of Appeal in Hong Kong whereby
its action to recover from three banks sums of money alleged to have been wrongfully debited
against its current account with each was dismissed. The appeal raises a question of general
principle in the law governing the relationship of banker and customer. Additionally, the appeal
calls for consideration of a number *97 of questions arising from the particular circumstances of
the company's business relationship with each of the three banks.

The company was a customer of the banks, and maintained with each of them a current account.
The banks honoured by payment on presentation some 300 cheques totalling approximately
HK$5.5 million which on their face appeared to have been drawn by the company and to bear the
signature of Mr. Chen, the company's managing director who was one of the company's
authorised signatories to its cheques. The banks in each instance debited the company's current
account with the amount of the cheque. These cheques, however, were not the company's
cheques. They were forgeries. On each the signature of Mr. Chen had been forged by an
accounts clerk employed by the company, Leung Wing Ling. The central issue in the appeal is
upon whom the loss arising from Leung's forgeries is to fall, the company or the banks. The
question of general principle is as to the nature and extent of the duty of care owed by a customer
to his bank in the operation of a current account.
Very briefly, the company's submission is that, unless banker and customer agree
otherwise, the customer's duty is limited to two sets of circumstances. First, the customer must
exercise reasonable care in drawing his cheque. If a breach of this duty causes the bank to pay on
the cheque, the customer bears the loss. Otherwise, if the signature on the cheque is forged, it is
not his cheque and the bank has no authority to pay it or to debit it to the customer's account. The
loss falls on the bank. Secondly, the customer must notify the bank of any forgery of which the
customer becomes aware so as to enable the bank to take adequate precautions against future
loss. Put with equal brevity, the submission of the banks on the general question is that the
relationship of banker and customer gives rise in contract and in tort to a duty owed by the
customer to the bank to exercise such precautions as a reasonable customer in his position would
take to prevent forged cheques being presented to the bank ("the wider duty"); or, if that be too
wide, at the very least to check his monthly (or other periodic) bank statements so as to be able to
notify the bank of any items which were not, or may not have been, authorised by him ("the
narrower duty"). Both the company and the banks accept that Hong Kong law on the point is the

102
same as English law: but they differ fundamentally as to what the law of England is.
If the banks fail on the general point of principle, they have submissions to make which arise
from the particular circumstances of their respective relationships with the company. They rely
on their banking contracts with the company and, if they cannot escape by contract, they seek
protection by way of estoppel, submitting that the company is estopped by its own conduct from
asserting that the various current accounts were incorrectly debited.
Finally, if the company succeeds in obtaining an order for the repayment of any of the
sums debited to its account by any of the banks, there is an issue as to whether the bank is liable
to pay interest on the sums so debited. *98
The facts The company, Tai Hing Cotton Mill Ltd., is a textile manufacturer carrying on
business in Hong Kong. The managing director is Mr. Chen who came from Shanghai and
started the company in Hong Kong in 1957. The company was described by the trial judge,
Mantell J., as medium sized and reasonably successful. It showed a profit on its trading for every
year but one between 1957 and 1978, the year in which the forgeries were exposed.
The company conducts its business in divisions. During the period 1957 to 1978 the
company included five manufacturing divisions. The appeal concerns three of them: the garment
division, which used the company's current account with Dah Sing Bank Ltd. (Dah Sing not
being a party to the litigation) and later the current account with Chekiang First Bank Ltd.
("Chekiang"), the third defendant; the texturising division, which used the current account with
the Bank of Tokyo Ltd. ("Tokyo"), the second defendant; and the spinning and weaving division
which used the current account with Liu Chong Hing Bank Ltd. ("Liu Chong Hing"), the first
defendant.
Towards the end of 1972 the company took into its employment Leung Wing Ling as an
accounts clerk. Leung was dishonest: but he was trusted until 1978 when he was exposed. At
first he was given responsibility for the books of account of the garment and texturising division.
Almost at once he began to steal from the company. He opened bank accounts in names similar
to those of real suppliers to the company and persuaded Mr. Chen to sign cheques in their favour
by producing to him forged documents as evidence of transactions with these fictitious suppliers.
The trial judge records that between 4 December 1972 and 31 January 1974 Leung stole
HK$317,068.04 from the company's bank account with Dah Sing. He stole also from the
company's accounts with Tokyo and Chekiang during the same period and by the same method.
There came a time when he adopted another, and he may have thought a safer, method of
stealing his employer's money, that of forging the signature of Mr. Chen on cheques purporting
to be drawn by the company. It is with this method of stealing, and these forged cheques, that the
appeal is concerned. At first, he passed forged cheques through the company's accounts with
Tokyo and Chekiang. In November 1977 Leung's superior, Mr. Wang, retired through ill-health
and Leung assumed the additional responsibility of managing the current account with Liu
Chong Hing used by the spinning and weaving division. He immediately began to draw forged
cheques for substantial sums upon this account.

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 Between 1972 and 1978 Leung made away with some HK$7 million by fraud and
forgery. The forged cheques accounted for some HK$5.5 million of the loss. The judge
summarised his defalcations in a few simple words:
"the defalcations remained undetected for over five years. They involved approximately
500 cheques of which about 300 were *99 forged. The total face value of the cheques was
approximately HK $7 million."
The judge then asked himself this question: how was Leung able to get away with it for
so long? The judge's answer to his own question is now accepted. Leung was trusted. He was in
a position to manipulate the accounts for which he was responsible; and the company's system of
internal control was ill-adapted either to prevent fraud or to find out about it afterwards. There
was no division of function, Leung being responsible for, and in almost sole control of, the
receipts and payments made through the accounts for which he was responsible; and there was
substantially no supervision. Specifically, the judge found that there was a failure to check or
supervise Leung's reconciliation of the monthly bank statements with the cash books of the
company. Mr. Wang, until ill health forced him to retire in November 1977, was supposed to
undertake the task of checking and supervising but did not. After Wang retired, Leung assumed
sole control of the accounts for which he was responsible. The judge summed up his view of the
company's system of internal financial control as unsound and, from the point of view of
preventing or detecting fraud, inadequate.
The frauds were uncovered in May 1978 when a newly appointed accountant entered
upon the simple, though tedious, task which had not previously been undertaken, of reconciling
bank statements with the company's account books. He realised almost at once that something
was seriously wrong. He reported to Mr. Chen. Leung was interrogated and admitted the frauds.
The litigation
The company now acted with some alacrity. On 15 May 1978 it issued a writ against the three
banks, Leung, and his wife Wance Cheng in which it claimed repayment of sums totalling
approximately HK$7 million. A modest recovery has been obtained from the wife by a
negotiated settlement. Leung has fled to Taiwan, leaving the company and the banks to fight out
who of the innocent victims of his crimes are to bear the financial loss. The litigation is, so far as
it concerns the banks, limited to the cheques bearing the forged signature of Mr. Chen, the total
of which is of the order of HK$5.5 million.
Mantell J., basing himself on the fundamental premise that a forged cheque is no mandate
to pay and that, prima facie, the customer is entitled to be relieved of the loss arising from a
bank's payment upon a forged cheque, held that the banks must establish affirmatively that in
this case they were entitled to debit their customer's current account with the amounts of the
forged cheques. The judge negatived a defence that the company was vicariously liable for
Leung's fraud: and that point is no longer pursued.
On the question of general principle the judge accepted the company's submission and
rejected both of the two alternative formulations of duty put forward by the banks. He held that
English law had been settled as submitted by the company as long ago as 1918 by the decision of

104
the House of Lords in London Joint Stock Bank Ltd. v. Macmillan [1918]A.C. 777 *100 and that
it was not for him at first instance to reject law ascertained and settled for so long a time. He
considered a submission made on behalf of the banks that, even if their formulation of the
customer's duty could not be implied into the banking contract, it could nevertheless arise in tort
and held that, where parties are in a contractual relationship, their rights and duties as between
themselves cannot be more extensive in tort than they are in contract.
Turning to the particular defences raised by the banks, he rejected the submissions of the
banks that their terms of business, which he accepted were contractual and to which their
Lordships will refer as "the banking contracts," should be construed as ousting the common law
rule which he had held to be as submitted by the company.
The judge then turned to the defence of estoppel raised by each bank. This defence had
been put to him in two ways: first, that the company was estopped by its negligence in the
management of its bank accounts from asserting that the accounts had been wrongly debited; and
secondly, that the company was estopped by a representation to be implied from its course of
conduct that the periodic bank statements were correct. He rejected estoppel by negligence but
held that in the case of each bank the company, by failing to challenge the debits shown on the
bank statements, had represented to each bank that the debits had been correctly made. He held
that Tokyo and Chekiang had acted in reliance upon the representations so made by their
willingness to continue operating their respective accounts and to expose themselves to the risk
of paying out on forged cheques. He did not find the same prejudice had been suffered by Liu
Chong Hing as it only became exposed to the fraud in November 1977, the first representation to
it not being made until the company's failure to query the December 1977 statement of account.
The judge found that the chance of recovery from Leung had not been substantially diminished
during the period (December 1977 to May 1978) during which it could be said that the estoppel
was operative.
The judge accordingly gave the company judgment against Liu Chong Hing but
dismissed its claims against the other two banks. The company appealed, and Liu Chong Hing
cross-appealed. The Court of Appeal differed from the trial judge on the general question. Cons
J.A. and Hunter J. delivered judgments, with which Fuad J.A. agreed, to the effect that the
banker-customer relationship is such as to give rise to a general duty of care in the operation of
its banking accounts. They held that the company was in breach of the duty which they held it
owed to the banks and must bear the loss. The duty they held arose in tort as well as in contract.
The judges were not, however, agreed as to the true effect of the banking contracts. Cons J.A.
construed the contracts as meaning that if the customer did not object within the time specified in
the contracts the bank statements were "final" as between customer and banks; in other words,
that the statements became conclusive evidence of the correctness of the debits recorded therein.
Hunter J., with whom Fuad J.A. agreed, held that none of the banking contracts could be
construed as including a term requiring the monthly statements to be treated after a period of
time or at all as conclusive evidence of the state *101 of the account. All three judges, however,

105
agreed that the company was estopped by its own negligence from challenging the correctness of
the bank statements.
The banks, therefore, emerged from the Court of Appeal with total success. The company
suffered total defeat, and now appeals to Her Majesty in Council. The company submits that,
save in respect of the estoppel point, the judgment of the trial judge was correct in law and, save
on estoppel, should be restored. The respondent banks seek to hold the judgment which they
obtained in the Court of Appeal for the reasons, which they submit are sound, developed in the
judgments of Cons J.A. and Hunter J.
The question of general principle
The question can be framed in two ways. If put in terms of the law's development, it is
whether two House of Lords' decisions, one in 1918 and the other in 1933, represent the existing
law. If put in terms of principle, the question is whether English law recognises today any duty
of care owed by the customer to his bank in the operation of a current account beyond, first, a
duty to refrain from drawing a cheque in such a manner as may facilitate fraud or forgery, and,
secondly, a duty to inform the bank of any forgery of a cheque purportedly drawn on the account
as soon as he, the customer, becomes aware of it. The first duty was clearly enunciated by the
House of Lords in London Joint Stock Bank Ltd. v. Macmillan [1918] A.C. 777, and the second
was laid down, also by the House of Lords, in Greenwood v. Martins Bank Ltd. [1933] A.C. 51.
The banks accept, of course, that both duties exist and have been recognised for many
years to be part of English law. Their case is that English law recognises today, even if it did not
in 1918 or 1933, an altogether wider duty of care. This is, they submit, a duty upon the customer
to take reasonable precautions in the management of his business with the bank to prevent forged
cheques being presented to it for payment. Further, and whether or not they establish the
existence of this wider duty, they contend that the customer owes a duty to take such steps to
check his periodic (in this case, monthly) bank statements as a reasonable customer in his
position would take to enable him to notify the bank of any debit items in the account which he
has not authorised. They submit that, given the relationship of banker and customer and the
practice of rendering periodic bank statements, the two duties for which they contend are
"necessary incidents" of the relationship. The source of obligation, they say, is to be found both
in the contract law as an implied term of the banking contract and in the tort law as a civil
obligation arising from the relationship of banker and customer.
They accept that the reasoning to be found in Macmillan's case [1918] A.C. 777 appears
at first sight to negative the existence of both the duties for which they contend: but they offer
the explanation that the law of contract and the tort law were significantly different in 1918 from
the state of the relevant modern law. In particular, they point to developments in the law relating
to the circumstances in which the courts will now imply a term into a contract, and to the
changes in tort *102 law both as to the range of relationships giving rise to liability in tort and as
to the circumstances in which loss or damage will be held to result from breach of a duty of care.
Their implied term point they base on the decision of the House of Lords in Liverpool City
Council v. Irwin [1977] A.C. 239; and their two tort points on decisions of the Board in Overseas

106
Tankship (U.K.) Ltd. v. Morts Dock and Engineering Co. Ltd. (The Wagon Mound) [1961] A.C.
388 and of the House of Lords in Anns v. Merton London Borough Council [1978] A.C. 728.
The Court of Appeal accepted the banks' submissions. Cons J.A. was led "after a great deal of
hesitation" to conclude:
"that, in the world in which we live today, it is a necessary condition of the relation of the
banker and customer that the customer should take reasonable care to see that in the operation of
the account the bank is not injured." He, therefore, held that, in the absence of express agreement
to the contrary, the duty would be implied into the banking contract as a necessary incident of the
relationship between customer and banker. Turning to tort, he based himself on the now famous
passage in the speech of Lord Wilberforce in Anns v. Merton London Borough Council, at pp.
751-752:
"Through the trilogy of cases in this House - Donoghue v. Stevenson [1932] A.C. 562,
Hedley Byrne & Co. Ltd. v. Heller & Partners Ltd. [1964] A.C. 465, and Dorset Yacht Co. Ltd.
v. Home Office [1970] A.C. 1004, the position has now been reached that in order to establish
that a duty of care arises in a particular situation, it is not necessary to bring the facts of that
situation within those of previous situations in which a duty of care has been held to exist. Rather
the question has to be approached in two stages. First one has to ask whether, as between the
alleged wrongdoer and the person who has suffered damage there is a sufficient relationship of
proximity or neighbourhood such that, in the reasonable contemplation of the former,
carelessness on his part may be likely to cause damage to the latter - in which case a prima facie
duty of care arises. Secondly, if the first question is answered affirmatively, it is necessary to
consider whether there are any considerations which ought to negative, or to reduce or limit the
scope of the duty or the class of person to whom it is owed or the damages to which a breach of
it may give rise: see Dorset Yacht case [1970] A.C. 1004, per Lord Reid at p. 1027."
He held that in the relationship of banker and customer there was a sufficient degree of
proximity to give rise to the duty for which the banks contend. Hunter J., in the course of an
elaborate and learned judgment, drew heavily on the law of tort in concluding that the duty
contended for by the banks exists in the modern law. He expressed the opinion that the source of
the obligation was not so important as the recognition of its existence and scope: and he referred
to a comment by Lord Roskill in Junior Books Ltd. v. Veitchi Co. Ltd. [1983] A.C. 520, 545,
that the *103 issue is not "whether the proper remedy should lie in contract or in tort" but
depends upon the answer to the two questions posed by Lord Wilberforce in the passage already
quoted from his speech in Anns' case. If the Court of Appeal was correct in law to rule as it did,
the appeal must be dismissed. For there is no challenge to the finding of the trial judge that, if
either of the two duties for which the banks contend exists, the company was in breach of its
obligations to the banks.
First, it is necessary to determine what Macmillan's case [1918] A.C. 777 decided. Upon
this point their Lordships are in no doubt. The House held that the customer owes his bank a duty
in drawing a cheque to take reasonable and ordinary precautions against forgery. "The duty... is
to draw the cheques with reasonable care to prevent forgery, and if, owing to neglect of this duty,

107
forgery takes place, the customer is liable to the bank for the loss": per Lord Finlay L.C., at p.
793.

In so formulating the duty the House excluded as a necessary incident of the banker-customer
relationship any wider duty, though of course it is always open to a banker to refuse to do
business save upon express terms including such a duty. Lord Finlay L.C. expressly excluded
any such duty saying, at p. 795: "Of course the negligence must be in the transaction itself, that
is, in the manner in which the cheque is drawn. It would be no defence to the banker, if the
forgery had been that of a clerk of a customer, that the latter had taken the clerk into his service
without sufficient inquiry as to his character." and the House approved the judgment of Bray J. in
Kepitigalla Rubber Estate Ltd. v. National Bank of India Ltd. [1909] 2 K.B. 1010. In that case
the judge held that, while it is the duty of a customer in issuing his mandates (i.e., his cheques) to
his bank to take reasonable care not to mislead the bank, there is no duty on the part of the
customer to take precautions in the general course of carrying on his business to prevent
forgeries on the part of his servants. Put in the terms of the banks' submission in this case, Bray
J. negatived the existence of the two duties for which the banks contend, and the House of Lords
in Macmillan's case [1918] A.C. 777 agreed with him.
So far as English law is concerned, Macmillan's case has until now been accepted as a
binding precedent on the question under consideration, though it would be true to say that
leading writers on banking law, notably Sir John Paget, and many of the banking community
have never extended it a very warm welcome. Martell J., correctly in their Lordships' view, held
himself bound to follow the decision. He noted that it had been followed as recently as 11 March
1983 by McNeill J. at first instance in Wealdon Woodlands (Kent) Ltd. v. National Westminster
Bank Ltd. (unreported), 11 March 1983, McNeill J.; that it has been cited with approval in the
High Court of Australia, and followed by the Court of Appeal in New Zealand: Commonwealth
Trading Bank of Australia v. Sydney Wide Stores Pty. Ltd. (1981) 55 A.L.J.R. 574; *104
National Bank of New Zealand Ltd. v. Walpole and Patterson Ltd. [1975] 2 N.Z.L.R. 7. In the
New Zealand case Richmond J., who delivered the judgment of the court, summarised the law as
settled in 1918 in succinct terms, at p. 19:
"The Kepitigalla case was cited with approval by Lord Finlay L.C. in the Macmillan case
[1918] A.C. 777, 801, and also by Viscount Haldane in the passage which I have already cited. I
know of no sufficient reason why we should not retain, in New Zealand, the principle so clearly
laid down by the House of Lords that the only type of negligence on the part of a customer which
will remove from the banker the risk of paying on a forged cheque is negligence in or
immediately connected with the drawing of the cheque itself."
It appears also that the courts of Hong Kong took the same view of the law prior to the
decision of the Court of Appeal now under review: Asien-Pazifik Merchant Finance Ltd. v.
Shanghai Commercial Bank Ltd. [1982] H.K.L.R. 273, and Lam Yin-fei trading as Wah Shing
Garment Manufacturing Co. v. Hang Lung Bank Ltd. [1982] H.K.L.R. 215.

108
 The banks seek to attack the authority of the Macmillan ruling in a number of ways.
Their Lordships take first their least plausible attack: the submission that the decision can be
reviewed because it proceeded on a now outmoded and rejected view of the nature of the causal
link which the law requires to be proved between breach of duty and damage if a plaintiff is to
recover damages in an action based on the tort of negligence. It is, of course, true that
Macmillan's case was decided before the Board in The Wagon Mound [1961] A.C. 388
substituted "foreseeability" for "direct cause" as the test of liability in such cases. But, in their
Lordships' view, it is a travesty of the House's reasoning in Macmillan's case to suggest that
causation in the law of tort had anything to do with their limiting the duty of care of the customer
to the transaction of drawing the cheque. Indeed their Lordships read the speeches in
Macmillan's case as proceeding upon the basis, which their Lordships have no doubt is correct,
that the relationship between banker and customer is contractual and that its incidents, in the
absence of express agreement, are such as must be implied into the contract because they can be
seen to be obviously necessary.
Their Lordships turn now to the weightier submissions advanced by the banks on the
general question. There are two: that a wider duty (a term which in this context covers both of
the duties for which the banks contend) must be implied into the contract, alternatively that such
a duty arises in tort from the relationship between banker and customer.
Implied term
Their Lordships agree with Cons J.A. that the test of implication is necessity. As Lord
Wilberforce put it in Liverpool City Council v. Irwin [1977] A.C. 239, 254: "such obligation
should be read into the contract as the nature of the contract itself implicitly requires, no more,
no less: a test, in other words, of necessity." *105 Cons J.A. went on to quote an observation by
Lord Salmon in the Liverpool case to the effect that the term sought to be implied must be one
without which the whole transaction would become "inefficacious, futile and absurd"(p. 262).
Their Lordships accept as correct the approach adopted by Cons J.A. Their Lordships prefer it to
that suggested by Hunter J. which was to ask the question: does the law impose the term?
Implication is the way in which necessary incidents come to be recognised in the absence of
express agreement in a contractual relationship. Imposition is apt to describe a duty arising in
tort, but inept to describe the necessary incident arising from a contractual relationship.
Their Lordships, however, part company with Cons J.A. in his conclusion (reached only
after great hesitation, he said) that it is necessary to imply into the contract between banker and
customer a wider duty than that formulated in Macmillan's case. Macmillan's case itself
decisively illustrates that it is not a necessary incident of the banker-customer relationship that
the customer should owe his banker the wider duty of care.
The relationship between banker and customer is a matter of contract. The classic, though
not necessarily exhaustive, analysis of the incidents of the contract is to be found in the judgment
of Atkin L.J. in Joachimson v. Swiss Bank Corporation [1921] 3 K.B. 110, 127: "I think that
there is only one contract made between the bank and its customer. The terms of that contract
involve obligations on both sides and require careful statement. They appear upon consideration

109
to include the following provisions. The bank undertakes to receive money and to collect bills for
its customer's account. The proceeds so received are not to be held in trust for the customer, but
the bank borrows the proceeds and undertakes to repay them. The promise to repay is to repay at
the branch of the bank where the account is kept, and during banking hours. It includes a promise
to repay any part of the amount due against the written order of the customer addressed to the
bank at the branch, and as such written orders may be outstanding in the ordinary course of
business for two or three days, it is a term of the contract that the bank will not cease to do
business with the customer except upon reasonable notice. The customer on his part undertakes
to exercise reasonable care in executing his written orders so as not to mislead the bank or to
facilitate forgery."
Atkin L.J. clearly felt no difficulty in analysing the relationship upon the basis of the
limited duty enunciated in Macmillan's case. and in Macmillan's case itself the protracted
discussion, which is now only of historical interest, as to the true ratio decidendi of Young v.
Grote (1827) 4 Bing. 253 reveals vividly that the House was aware of the possibility of a wider
duty but rejected it.
The argument for the banks is, when analysed, no more than that the obligations of care placed
upon banks in the management of a customer's account which the courts have recognised have
become with the development of banking business so burdensome that they should be *106 met
by a reciprocal increase of responsibility imposed upon the customer: and they cite Selangor
United Rubber Estates Ltd. v. Cradock (No. 3) [1968] 1 W.L.R. 1555 (Ungoed-Thomas J.) and
Karak Rubber Co. Ltd. v. Burden (No. 2) [1972] 1 W.L.R. 602 (Brightman J.). One can fully
understand the comment of Cons J.A. that the banks must today look for protection. So be it.
They can increase the severity of their terms of business, and they can use their influence, as they
have in the past, to seek to persuade the legislature that they should be granted by statute further
protection. But it does not follow that because they may need protection as their business
expands the necessary incidents of their relationship with their customer must also change. The
business of banking is the business not of the customer but of the bank. They offer a service,
which is to honour their customer's cheques when drawn upon an account in credit or within an
agreed overdraft limit. If they pay out upon cheques which are not his, they are acting outside
their mandate and cannot plead his authority in justification of their debit to his account. This is a
risk of the service which it is their business to offer. The limits set to the risk in the Macmillan
[1918] A.C. 777 and Greenwood [1933] A.C. 51 cases can be seen to be plainly necessary
incidents of the relationship. Offered such a service, a customer must obviously take care in the
way he draws his cheque, and must obviously warn his bank as soon as he knows that a forger is
operating the account. Counsel for the banks asked rhetorically why, once a duty of care was
recognised, should it stop at the Macmillan and Greenwood limits. They submitted that there was
no rational stopping place short of the wider duty for which they contended. With very great
respect to the ingenious argument addressed to the Board their Lordships find in certain
observations of Bray J. in Kepitigalla's case [1909] 2 K.B. 1010 a convincing statement of the
formidable difficulties in the way of this submission. Bray J. said, at pp. 1025-1026:"I think Mr.

110
Scrutton's contention equally fails when it is considered apart from authority. It amounts to a
contention on the part of the bank that its customers impliedly agreed to take precautions in the
general course of carrying on their business to prevent forgeries on the part of their servants.
Upon what is that based? It cannot be said to be necessary to make the contract effective. It
cannot be said to have really been in the mind of the customer, or, indeed, of the bank, when the
relationship of banker and customer was created. What is to be the standard of the extent or
number of the precautions to be taken? Applying it to this case, can it be said to have been in the
minds of the directors of the company that they were promising to have the pass-book and the
cash-book examined at every board meeting, and to have a sufficient number of board meetings
to prevent forgeries, or that the secretary should be supervised or watched by the chairman? If
the bank desire that their customers should make these promises they must expressly stipulate
that they shall. I am inclined to think that a banker who required such a stipulation would soon
lose a number of his customers. The truth is that the number of cases where bankers sustain
losses of this kind are infinitesimal in comparison with the *107 large business they do, and the
profits of banking are sufficient to compensate them for this very small risk. To the individual
customer the loss would often be very serious; to the banker it is negligible." Their Lordships
reject, therefore, the implied term submission.
Tort
Their Lordships do not believe that there is anything to the advantage of the law's development
in searching for a liability in tort where the parties are in a contractual relationship. This is
particularly so in a commercial relationship. Though it is possible as a matter of legal semantics
to conduct an analysis of the rights and duties inherent in some contractual relationships
including that of banker and customer either as a matter of contract law when the question will
be what, if any, terms are to be implied or as a matter of tort law when the task will be to identify
a duty arising from the proximity and character of the relationship between the parties, their
Lordships believe it to be correct in principle and necessary for the avoidance of confusion in the
law to adhere to the contractual analysis: on principle because it is a relationship in which the
parties have, subject to a few exceptions, the right to determine their obligations to each other,
and for the avoidance of confusion because different consequences do follow according to
whether liability arises from contract or tort, e.g. in the limitation of action. Their Lordships
respectfully agree with some wise words of Lord Radcliffe in his dissenting speech in Lister v.
Romford Ice and Cold Storage Co. Ltd. [1957] A.C. 555. After indicating that there are cases in
which a duty arising out of the relationship between employer and employee could be analysed
as contractual or tortious Lord Radcliffe said, at p. 587: "Since, in any event, the duty in question
is one which exists by imputation or implication of law and not by virtue of any express
negotiation between the parties, I should be inclined to say that there is no real distinction
between the two possible sources of obligation. But it is certainly, I think, as much contractual as
tortious. Since in modern times the relationship between master and servant, between employer
and employed, is inherently one of contract, it seems to me entirely correct to attribute the duties
which arise from that relationship to implied contract." Their Lordships do not, therefore,

111
embark on an investigation as to whether in the relationship of banker and customer it is possible
to identify tort as well as contract as a source of the obligations owed by the one to the other.
Their Lordships do not, however, accept that the parties' mutual obligations in tort can be any
greater than those to be found expressly or by necessary implication in their contract. If,
therefore, as their Lordships have concluded, no duty wider than that recognised in Macmillan
[1918] A.C. 777 and Greenwood [1933] A.C. 51 can be implied into the banking contract in the
absence of express terms to that effect, the banks cannot rely on the law of tort to provide them
with greater protection than that for which they have contracted. *108 For these reasons their
Lordships answer the general question by accepting the submission of the company that in the
absence of express terms to the contrary the customer's duty is in English law as laid down in
Macmillan and Greenwood. The customer's duty in relation to forged cheques is, therefore,
twofold: he must exercise due care in drawing his cheques so as not to facilitate fraud or forgery
and he must inform his bank at once of any unauthorised cheques of which he becomes aware.
Their Lordships cannot leave the general question without making some comment on a matter of
some importance which was discussed in argument before them. It was suggested, though only
faintly, that even if English courts are bound to follow the decision in Macmillan's case the
Judicial Committee is not so constrained. This is a misapprehension. Once it is accepted, as in
this case it is, that the applicable law is English, their Lordships of the Judicial Committee will
follow a House of Lords' decision which covers the point in issue. The Judicial Committee is not
the final judicial authority for the determination of English law. That is the responsibility of the
House of Lords in its judicial capacity. Though the Judicial Committee enjoys a greater freedom
from the binding effect of precedent than does the House of Lords, it is in no position on a
question of English law to invoke the Practice Statement (Judicial Precedent) [1966] 1 W.L.R.
1234 of July 1966 pursuant to which the House has assumed the power to depart in certain
circumstances from a previous decision of the House. and their Lordships note, in passing, the
Statement's warning against the danger of disturbing retrospectively the basis on which contracts
have been entered into. It is, of course, open to the Judicial Committee to depart from a House of
Lords' decision in a case where, by reason of custom, statute, or for other reasons peculiar to the
jurisdiction where the matter in dispute arose, the Judicial Committee is required to determine
whether English law should or should not apply. Only if it be decided or accepted (as in this
case) that English law is the law to be applied will the Judicial Committee consider itself bound
to follow a House of Lords' decision. An illustration of the principle in operation is afforded by
the recent New Zealand appeal Hart v. O'Connor [1985] A.C. 1000, in which the Board reversed
a very learned judgment of the New Zealand Court of Appeal as to the contractual capacity of a
mentally disabled person, holding that because English law applied, the duty of the New Zealand
Court of Appeal was not to depart from what the Board was satisfied was the settled principle of
that law.
The express terms of business
The company, it is now accepted, operated its current account with each bank pursuant to the
bank's printed terms and conditions.

112
Chekiang. The company opened an account with the bank in September 1957. Chekiang was
authorised to pay cheques on behalf of the company if signed by Mr. Chen or by any two of four
named signatories. By his request to open the account Mr. Chen agreed on behalf of the company
to comply with the bank's "rules and procedures in force from time to time governing the
conduct of such account." Mr. *109 Chen had notice of the rules current when he made the
request. Rule 7 provided, so far as material: "A monthly statement for each account will be sent
by the bank to the depositor by post or messenger and the balance shown therein may be deemed
to be correct by the bank if the depositor does not notify the bank in writing of any error therein
within 10 days after the sending of such statement..." From the opening of the account until
March 1978 the company returned, upon receipt of its periodic bank statement, a confirmation
slip signed by two authorised signatories. No cleared cheques were ever returned to the company
Tokyo. The company opened an account with the bank in November 1961. By letter of 17
November 1961 Mr. Chen agreed on behalf of the company to observe the provisions of an
agreement appearing on the back of the bank's pro-forma letter. The company accordingly
undertook to hold the bank free from any loss resulting from a failure by it to abide by the
provisions of the agreement. Clause 10 provided: "The bank's statement of my/our current
account will be confirmed by me/us without delay. In case of absence of such confirmation
within a fortnight, the bank may take the said statement as approved by me/us."
The bank was authorised to pay the company's cheques if signed by Mr. Chen or two authorised
signatories. Periodic bank statements were rendered by the bank, but cleared cheques were not
returned. No bank statement relevant to this case was ever confirmed by the company.
Liu Chong Hing. The company opened an account with the bank in November 1962. By
his letter of request dated 8 November 1962 Mr. Chen stated that the company wished to open
the account subject to the bank's rules and regulations. Rule 13 provided: "A statement of the
customer's account will be rendered once a month. Customers are desired:(1) to examine all
entries in the statement of account and to report at once to the bank any error found therein, (2)
to return the confirmation slip duly signed. In the absence of any objection to the statement
within seven days after its receipt by the customer, the account shall be deemed to have been
confirmed." The bank was authorised to pay cheques if signed by Mr. Chen or by any two
authorised signatories. The bank never did send any confirmation slips to the company; nor did it
return cleared cheques. The company never sent the bank any confirmation slip.
Their Lordships agree with the views of the trial judge and Hunter J. as to the
interpretation of these terms of business. They are contractual in effect, but in no case do they
constitute what has come to be called "conclusive evidence clauses." Their terms are not such as
to bring home to the customer either "the intended importance of the inspection he is being
expressly or impliedly invited to make," or that they are intended to have conclusive effect
against him if he raises no query, or *110 fails to raise a query in time, upon his bank statements.
If banks wish to impose upon their customers an express obligation to examine their monthly
statements and to make those statements, in the absence of query, unchallengeable by the
customer after expiry of a time limit, the burden of the objection and of the sanction imposed

113
must be brought home to the customer. In their Lordships' view the provisions which they have
set out above do not meet this undoubtedly rigorous test. The test is rigorous because the bankers
would have their terms of business so construed as to exclude the rights which the customer
would enjoy if they were not excluded by express agreement. It must be borne in mind that, in
their Lordships' view, the true nature of the obligations of the customer to his bank where there is
not express agreement is limited to the Macmillan and Greenwood duties. Clear and
unambiguous provision is needed if the banks are to introduce into the contract a binding
obligation upon the customer who does not query his bank statement to accept the statement as
accurately setting out the debit items in the accounts.

Estoppel
Their Lordships having held that the company was not in breach of any duty owed by it to the
banks, it is not possible to establish in this case an estoppel arising from mere silence, omission,
or failure to act.
Mere silence or inaction cannot amount to a representation unless there be a duty to
disclose or act: Greenwood's case [1933] A.C. 51, 57. and their Lordships would reiterate that
unless conduct can be interpreted as amounting to an implied representation, it cannot constitute
an estoppel: for the essence of estoppel is a representation (express or implied) intended to
induce the person to whom it is made to adopt a course of conduct which results in detriment or
loss: Greenwood's case, per Lord Tomlin, at p. 57.
The company, it is accepted, did not know of the forgeries until the exposure of Leung in
May 1978. Had the company been under either of the duties (the "wider" or the "narrower") for
which the banks contend, it is plain that the company would have been in breach of such duty
during substantially the whole period covered by Leung's frauds, in which event an estoppel
could have arisen. But in that event the estoppel question would have been of academic interest
only. For the breach of duty by the customer and the resultant loss of the banks would have
afforded the banks a defence by way of set-off or counterclaim.
For the same reason the banks gain nothing from their submission that an estoppel arises
from their terms of business. The trial judge clearly thought that two of the banks could show
that they had suffered loss by relying on the failure of the company to raise objection to the debit
items shown in the bank statements. He held that, while their terms of business could not be
construed so as to impose a contractual duty upon the company to accept in the absence of
objection the monthly statements as accurate in so far as they related to debit items, their
contractual effect was "to turn failure to respond into a representation" that the bank statements
were correct. Their Lordships *111 cannot agree. The contractual effect of the terms of business
was that on the expiry of the time limit without objection raised by the company either the bank
statements became conclusive as to the correctness of the debit items or they did not. Once it is
held that they were not conclusive, silence, i.e. in this case failure to object, cannot be interpreted
as a representation that the statements were correct for the simple reason that the company was
not precluded by the terms of business from asserting that they were incorrect.

114
 The same position is therefore reached. Either there was a duty to accept that bank
statements to which no objection had been raised were correct in which event failure to object
could be relied on either as a breach of duty causing loss or as an implied representation of their
correctness estopping the company from asserting otherwise; or there was no such duty, in which
event failure to object could not be interpreted as a representation that they were correct.
For these reasons their Lordships hold that, if the banks fail to establish either of the two
duties of care for which they contend, they have no fall-back defence in the doctrine of estoppel.

Interest
Their Lordships respectfully agree with the trial judge in his rejection of the submission that
because the sums wrongly debited were in non-interest bearing accounts interest is not
recoverable. The company has lost the opportunity of placing the money at interest as a result of
the unauthorised debits made by the banks to the respective current accounts. Interest is,
therefore, payable. In the circumstances of this case interest should run from 15 May 1978: for
by issuing its writ on that day the company required the banks to eliminate the unauthorised
debits from the relevant current accounts and to repay what was due.
For these reasons their Lordships will humbly advise Her Majesty that the appeal should
be allowed and an order made in the following terms:
"1. (i) The judgment of the Court of Appeal of Hong Kong dated 27 January 1984 ought to be
reversed; (ii) the judgment of the High Court of Hong Kong dated 12 July 1983 ought to be set
aside save in relation to the sum of $187,195.74 thereof; (iii) judgment ought to be entered for
the appellant for declarations that the respondents were not entitled to debit the appellant's
account with the following sums and that the respondents ought to pay to the appellant such
sums, namely;
First respondent - H.K.$3,082,214.20
Second respondent - H.K.$809,804.80
Third respondent - H.K.$1,599,070.20
together with interest on the above sums at the rate of 1 1/2 per cent. over the prime rate in force
in Hong Kong from time to time, to be calculated from 15 May 1978 to the date of payment.
"2. As against each of the respondents: (i) the costs of the action, the costs of the appeal to the
Court of Appeal and the costs of the appeal to the Judicial Committee of the Privy Council to be
taxed and paid by the respondents to the appellant; (ii) the orders *112 for costs in favour of the
first, second, and third respondents made by the High Court on 12 July 1983 and by the Court of
Appeal on 27 January 1984 to be set aside and such costs, if any, paid by the appellant to the
respondents, or any of them, to be repaid to the appellant together with interest, if any, earned
thereon.
"3. Certificate for three counsel."

115
 Case 2: Kepitigalla Rubber Estates Ltd v National Bank of India Ltd [1909]

In that case, the secretary of a company forged the signatures of two of its directors on a number
of cheques. The defendants, who were the company’s bankers, paid those cheques and the
plaintiffs contended that the cheques were paid without its authority. The bank on its part
contended that the customer was under a duty to keep his cheque book under lock and key and if
by his breach of duty, a third party is given the opportunity to forge the customer’s signature, the
loss must fall on the customer. The trial judge, Bray J, whilst acknowledging that there was a
duty on the part of a customer to exercise care in drawing up his order, rejected the suggestion
that there was a corresponding duty on the part of the customer to take reasonable Precautions to
prevent his servants from forging his signature. He was the view that it was unnecessary to imply
such a term into the contract between a banker and his customer and that, as between two
innocent parties, the banker was in a better position to bear the loss. His Lordship said, at p 1025:
If the bank desire that their customers should make these promises they If the bank desire that
their customers should make these promises they must expressly stipulate that they shall I am
inclined to think that a banker who required such a stipulation would soon lose a number of
customers. The truth is that the number of cases where bankers sustain losses of this kind are
infinitesimal in comparison with the large business they do, and the profits of banking are
sufficient to compensate them for this very small risk. To the individual customer the loss would
often be very serious; to the banker it is negligible.

116
 LESSON 11 (B)
RESERVE BANK OF INDIA ACT 1934
Dr. Ashish Kumar
LBSIM
The growth of joint-stock banking in India is associated with the agency houses in the
beginning of the 18th century. Earlier, indigenous bankers, nidhis and money lenders acted as
bankers. They worked on the norms and taboos of the community. However, with the growth of
joint-stock banking and, moreover, with a large number of agency houses entering banking field,
it was necessary to modify into law the rules and regulations governing them. A need for the
central bank in India to control the banking system, therefore, arose in 1773. During the early
period, there was an increase in the number of mushroom companies, many of which were
failures. The banking companies were then registered under the Companies Act and were
governed by that Act. Banking legislation aims at protecting the interests of the depositors,
ensuring control over the volume of credit, developing banking on sound lines, and avoiding
bank failures.
Early Efforts
The need for the Central Bank in India arose in 1773. However it was the Hilton Young
Commission in 1926 that recommended the establishment of a central bank. The Government
introduced a bill in the Legislative Assembly in January 1927. The Reserve Bank of India Bill
was dropped "after acrimonious and kaleidoscopic discussion," as the late Sir James Taylor put
it. The Legislative Assembly was divided on the point of the constitution of the board, for the
Muslim and the minority communities insisted on safeguards to protect the minorities which was
guaranteed in the Assembly. Thereafter it took seven years to pass the Act in 1934, establishing
it as a shareholders' bank.
After Independence, the Government proposed to take steps to nationalize the Reserve
Bank after 30th September, 1948, when it would cease to be the common banker for India and
Pakistan. The demand for State-owned, controlled and managed bank dates back to 1927.
Thereafter, the demand for nationalization was revived in a minute appended to the report of the
select committee of the Legislative Assembly. Later, in the Central Legislative Assembly,
resolutions was moved in February 1947, seeking the nationalization of the Reserve Bank. This
indicates the political attitude of the legislators as well as of the public to the nationalization of
these premier institutions of banking in India. Moving the Reserve Bank (Transfer to I Public
Ownership) Bill, K.C Neogy, the then Union Finance Minister, observed: "The first piece of
legislation to bring about our ideas of nationalization should relate to an institution which is
really the pivot of the financial system of the country and on which, to a very large extent,
depends the economic well-being of the people." The bill was welcomed by the members of the
Legislative Assembly, who enacted it into law and with effect from 1st January 1949, the
Reserve Bank of India became the State-owned Bank. The nationalization of the Reserve Bank
was considered premature by the Board of the Bank. C D. Deshmukh, the then Governor of the
Reserve Bank observed:" Although the Board of the Bank sincerely believe that this decision is
premature and not logically necessary in view of the state of economic development reached by
the country, they will be, in the event of the decision proving to be irrevocable, co-operate with
the Government in evolving a scheme of nationalisation that is best calculated to ensure its
success." The contention of the Board evidently was that mere transfer from the private to the
public sector would not affect the relations between the Bank and the Government or the well-
being of the people. And that was why CD. Deshmukh aptly observed: "After all, it is not the
theoretical constitution of the institution that matters, but the spirit in which the partnership
between the Ministry of Finance and the Bank is worked." Prior to the Act, the relation between
the Government, particularly the Ministry of Finance, and the Reserve Bank was close,
confidential, even intimate; and it was factual rather than legal. By the Act of 1949, the
Government of India established a legal connection between the two.

Board of Directors
Under the Reserve Bank of India Act, the Bank is a corporate body with special powers
and obligations for serving the national interest. The establishment of the issue and the banking
departments as well as the agricultural credit department was the statutory responsibility of the
Bank. The other departments have been set up to perform the functions which have devolved on
them from time to time.
The general superintendence and direction of the Bank's affairs is vested of the Bank's
affairs is vested in the Central Board of Directors, which comprises: (i) A Governor and not
more than four deputy governors appointed by the Central Government under Section 8(1)(a) of
the Act; (ii) Four directors nominated by the Central Government, one from each of the four
local boards, in terms of Section 8(1)(b); (iii) Ten directors nominated by the Central Govern-
ment under section 8(1)(c); and (iv) One Government official nominated by the Central
Government under Section 8(1)(d).
The Reserve Bank is a liaison between the Government and the commercial banks,
financial corporations and small savings boards. Apart from this, it plays an important role in the
development of the institutional machinery of industrial finance and agricultural credit, as well
as in the development of commercial banking. Moreover, it has nursed the whole co-operative
credit structure. In other words, the Reserve Bank has assisted in the steady growth of industry,
agriculture, commerce, trade, and small-scale industry.
Salient Features
The following are the salient features of the Reserve Bank of India Act of 1934;
• It has regularized the issue of Bank Notes (Currency).
• It has ensured the monetary stability in the country. The issue of currency notes must be
backed by assets in the form of gold bullion, gold coins, foreign securities and rupee
securities to such an aggregate amount as is not less than the total liabilities of the Issue
Department. The aggregate value of gold coins, gold bullion, and foreign securities held
as asses shall not at any time be less than 2/5th of the assets of the Issue Department of
the Reserve Bank, and the aggregate value of gold coins and gold bullion shall not fall
below Rs. 40 crores. The Governor is the Chairman of the Board of Directors. There are
four Deputy Governors to assist him. The London Branch of the Reserve Bank of India
was closed in 1963 and its functions were vested in the State Bank of India. Three per
cent deposits of scheduled banks are kept as cash reserves with the Reserve Bank free of
interest (which is known as Statutory Reserve). Reserve Bank has the power to raise
these reserves from 3 per cent to 15 per cent if the circumstances so warrant In such
circumstances the Reserve Bank may pay interest in excess of 3 per cent on the reserves.
(This happened in 1960). The Reserve Bank was established on 1st April 1935.
• It is a lender of the last resort. The Reserve Bank is the Bankers' Bank.
• It is a banker to the Government. It manages public debts. It acts as an adviser to the
Government in regard to the floating of loans, etc. The Bank Rate was raised from 4 and
half per cent to 5 per cent on 29th May 1964 and to 6 per cent on 17th February 1965.
125
 The implication of the rise in the Bank Rate is that when it goes higher, the Government
security rate drops. The term non-terminable security refers to loans or securities issued
without deciding the time of maturity, i.e three and half per cent loan. It was issued at Rs.
100 but now the price is Rs. 66 only. The Reserve Bank may lend at a lower than the
prevailing Bank Rate to improve agriculture.
Weapons of Reserve Bank
The important monetary weapons of the Reserve Bank of India are:
i. Bank Rate - a rate at which Reserve Bank of India lends to various institutions;
ii. Open market operations;
iii. Variable cash reserves;
iv. Selected credit control or directions.
The capital of the Reserve Bank of India shall be five crores according to Sec. 28 (5). The
special one-rupee note shall be deemed to be included in the expression "Rupee coin." Section 29
exempts bank notes from stamp duty.
Sec. 31 (1): No person in India, other that the Reserve Bank of India or, as expressly
authorised by this Act, the Central Government, shall draw, accept, make or issue any bill of
exchange, hundi, promissory note or engagement for the payment of money payable to bearer on
demand or take up any sum or sums of money on the bills, hundies or notes payable to bearer on
demand of any such person. Provided that cheques or drafts, including hundies payable to bearer
on demand or otherwise, may be drawn on a person's account with a banker, shroff or agent.
Sec. 42 (2): If the average daily balance held at the Reserve Bank by a scheduled bank
during any week is below the minimum prescribed limit, such scheduled bank shall be liable to
pay to the Reserve Bank of India in respect of that week a penal interest at 3 per cent above the
Bank Rate on the amount by which such balance with the Reserve Bank of India falls short of
the prescribed minimum. If it continues for a subsequent week, then at 5 per cent above the
Bank Rate, and every director, manager or secretary of that bank, who is knowingly and
willfully a party to the default, shall be punishable with fine which may extend to five hundred
rupees for each subsequent week during which the default continues, and the bank may be
prohibited from receiving Jresh deposits from the public.
Sec. 46-A (1): The Reserve Bank of India shall establish and "maintain a fund to be
known as the National Agricultural Credit (Long-Term Operation) Fund, to which shall be
credited:
(a) An initial sum of Rs. 10 crores by the Reserve Bank of India;
(b) Such further sums of money as the Reserve Bank of India may contribute every year.

Ownership and Profits

The Bank was originally established as a shareholders' bank, with a share capital of Rs. 5
crores. In addition, the Central Government contributed an equal amount to form the Reserve
Fund of the Bank. In January 1949, the Bank was nationalised and its entire share capital was
acquired by the Central Government. As at the end of June 1967, the share capital stood at the
same figure (Rs. 5 crores) while the Reserve Fund stood at Rs. 80 crores.
Under Section 47 of the Act, the profit of the Bank is to be paid to the Central
Government. In arriving atthe figure of profit, the Bank is entitled to make provisions for (i) bad
126
and doubtful debts (ii) depreciation in assets (iii) all other matters for which provision is
required to be made in terms of the Act and (iv) all matters which are usually provided for by
bankers. The Bank thus has considerable latitude and flexibility for building up reserves
including secret reserves. Apart from the Reserve Fund, the Bank has created certain special
funds in terms of the obligations placed on it by sections 46A, 46B, and 46C of the Act, which
respectively require the creation of three special funds, two in connection with agricultural credit
and one for industrial finance.
The two funds for agricultural credit are the National Agricultural Credit (Long Term
Operations) Fund and the National Agricultural Credit (Stabilisation) Fund. These were created
in 1956, following the recommendations of the Committee of Direction, All India Rural Credit
Survey. The long term operations fund is used (i) for long-term loans to state governments for a
maximum period of 20 years to enable them to subscribe directly or indirectly to the share capital
of co-operative credit institutions (ii) for medium-term loans (between 15 months and 5 years) to
state co-operative banks for agricultural purposes, (iii) for long-term loans to central land mort-
gage banks. The Stabilization Fund is applied exclusively for granting medium-term loans to
state co-operative banks so that they may be able to convert their short-term credits into medium-
term credits, whenever it becomes necessary to do as a result of drought, famine or other natural
calamities. In 1965-66 (July-June) the Bank was obliged for the first time to have recourse to the
Stabilization fund for converting the short-term borrowings of Rs. 4.68 crores of some state co-
operative banks (in the areas affected by scarcity conditions) into medium-term borrowings.
As at the end of June 1967, the long-term operations fund stood at Rs. 131 crores while the
stabilization fund amounted to Rs. 25 crores.
The special fund relating to industrial finance was established in 1964, to provide funds to
the Industrial Development Bank of India in the form of loans or by purchase of bonds and
debentures issued by the Development Bank. The fund was started with Rs. 10 crores, which was
the Reserve Bank's initial contribution, and stood at Rs. 30 crores at the end of June 1967.
The Bank's accounting year is July-June and the annual accounts of the Bank along with a
report of the directors of the central , board, are required to be submitted to the central
government within two months, i.e., by end of August. The Bank is also required to prepare a
weekly account of its Issue and Banking departments.
During 1966-67 the net profit available for payment to Government amounted to Rs. 60
crores as against Rs. 50 crores during 196566. There was a significant rise of Rs. 17.79 crores in
the Bank's . income, from Rs. 67.33 crores in 1965-66 to Rs. 85.12 crores in 1966-67, the rise in
the expenditure being Rs. 7.59 crores, from Rs. 17.53 crores to Rs. 25.12crores. The Bank has
attributed the rise in its income to the increased earnings by way of discount on treasury bills and
interest on its security holdings. The increased expenditure is mainly due to the higher agency
charges paid to the State Bank of India and its subsidiaries in respect of government transactions.
The Bank is exempted from payment of income-tax or super tax on its income, profits or
gains. The annual accounts of the Bank are required to be audited by two auditors who are
appointed by the Central Government and ' their remuneration is also fixed by that government.
The Central government is also empowered to appoint the comptroller and Auditor General of
India to examine and report on the accounts of the Bank.
Management
The management of the Bank is vested in the Central Board of Directors and they may
exercise all powers and do all acts and things which may be exercised or done by the Bank. The
authority vested in the Board is subject to the power of the Central Government to issue
127
directions to the Bank. The Central Government has also the power to supersede the Board and
entrust the Bank's management to such other agency as it may determine. If such an action is
taken, a report thereof must be laid before the Parliament within three months.
The acts or proceedings of the Board cannot be questioned on the ground merely of the
existence of any vacancy or any defect in the constitution of the Board. The meetings of the
Central Board are to be held at least six times in a year and at least once in each quarter. The
meetings are to be convened by the Governor but any four directors can ask for a meeting at any
time and it is obligatory foe the Governor to call a meeting.
The Governor (and in his absence, a Deputy Governor authorized by the Governor)
presides at the meetings of the Central Board, and in the event of an equality of votes, has a
second or casting vote. Subject to any regulations made by the Central Board in this behalf, the
Governor and in his absence, the Deputy Governor nominated by him for the purpose, will have
powers of general superintendence and direction of the affairs and business of the Bank and he
may exercise all powers and do all acts and things which may be exercised or done by the Bank.
The Governor is also authorized in terms of Section 54A of the Act to delegate to a Deputy
Governor, by means of a general or special order and subject to conditions and limitations that
maybe specified in the order, such of his powers and functions as he may consider appropriate
for the efficient administration of the affairs of the Bank.
The Governor and the Deputy Governors hold office for such periods not exceeding five
years as may be fixed by the Central Government at the time of their appointment, and are
eligible for reappointment. 'The directors nominated under Section 8(1)(c) hold office for four
years, but may continue thereafter till their successors have been nominated; the terms of office
of those nominated under Section 8(1)(b) is related to their membership of the local boards. The
Government official holds office during the pleasure of the Central Government. The Governor,
and in his absence, a Deputy Governor nominated by him, is the chairman of the central board.
The Deputy Governors and the Government's official nominee are not entitled to vote at the
meetings of the board.
For the day-to-day conduct of the bank's business the Central Board, in terms of the
powers vested in it under section 58 of the Act can make such regulations as it may consider
necessary. The regulations so made will be effective only with the prior sanction of the Central
Government. The powers of the Board to make regulations .are fairly wide in that the Board can
make regulations to cover all matters for which provision is necessary or convenient for the
purpose of giving effect to the provisions of the Act. In particular, the Board is authorised to
make regulations in regard to the following matters:
1. Conduct of the business of the Central Board and the procedure that may be followed at
its meetings;
2. Conduct of business of Local Boards;
3. Delegation of powers and functions to Local Boards;
4. Delegation of powers and functions of the Central Board to Deputy Governors, Directors,
or Officers of the Bank;
5. Formation of committees of the Central Board and delegation of functions and powers to
such committees;
6. Constitution and management of staff and superannuation funds;
7. Execution of contracts binding on the Bank;

128
 8. Use of the common seal of the Bank;
9. Maintenance of accounts and preparation of balance sheets of the Bank;
10. Remuneration that may be paid to the Directors;
11. The relations of the scheduled banks with the Bank;
12. The returns submitted by the scheduled banks to the Bank;
13. Conduct and management of clearing houses for scheduled banks;
14. Refund of currency notes of the Government of India or bank notes which are lost, stolen,
mutilated or imperfect;
15. For the efficient conduct of the business of the Bank.
Copies of all regulations made by the Central Board under Section 58 of the Act can be
obtained by the public on payment. The bank has framed regulations which cover items 1 to 12
and 14 listed above. The regulations which would be of interest to the general public are:
(i) Reserve Bank of India General Regulations, 1935.
(ii) Reserve Bank of India (Note Issue) Regulations, 1935.
(iii) Reserve Bank of India Scheduled Banks' Regulations, 1951.
The year mentioned against each set of regulations, indicates that the regulations were
first made in those years. The regulations have, however, been amended from time to time.
The legal provisions in regard to the management and conduct of the bank's affairs can
thus be summarized as under:
i. the management of the Bank is vested in the Central Board of Directors;
ii. he Governor (and in his absence the Deputy Governor nominated by him for the purpose)
has concurrent powers of management, subject to any regulations framed by the Board in
this behalf; and
iii. the Central Board can, with the prior approval of Central Government, frame regulations
for the smooth and efficient conduct of the Bank's business.
Central Board Composition and Terms of Appointments
The strength of the Central Board is at present fixed at twenty Directors, comprising the
Governor, four Deputy Governors, four Directors nominated from amongst the four Local
Boards (one from each), one Government Official (generally secretary of the Finance Ministry)
and ten other persons. All the Directors including the Governor and the Deputy Governors are
appointed/nominated by the Central Government.
The Governor and the Deputy Governors are appointed for such terms, not exceeding five
years, as the Central Government may fix when appointing them. They can be reappointed for a
further rm. They are full-time officers of the Bank and their remuneration is fixed by the Central
Board with the approval of the Central Government. At the request of the Central Government or
any State Government, the Central Board may permit them to undertake such part-time honorary
work as is not likely to interfere with their duties.
Although the Deputy Governors and the Government official are directors of the Central
Board and can attend its meetings and take part in its deliberations, they are not entitled to vote.
There is no fixed term for the appointment of the Government official and he holds the
129
office (of Director) at the pleasure of the Central Government. In the case of the four directors
who are nominated from amongst the members of the Local Boards, their period of appointment
will coincide with the period of their membership of the respective Local Boards. The remaining
ten Directors are appointed for a period of four years. A retiring Director is eligible for re-
appointment.
The Central Government is vested with the powers to remove from office any Director
including the Governor and the Deputy Governor.

Committee of the Central Board

As a matter of practical convenience, the board has delegated some of its functions, by
means of statutory regulations made under Section 58(2) of the Act, to a committee called the
committee of the central board, cons is ting of the Governor, the Deputy Governors and such
other directors as may be present at the relevant time in the area in which the meeting is held.
The committee meets once a week, generally on Wednesdays, at the office of the Bank where
the Governor has his headquarters for the time being to attend to the current business of the
Bank, including the approval of the Bank's weekly accounts pertaining to the issue and the
banking departments. To assist the committee of the central board, two sub-committees, one for
matters relating to building projects and the other for dealing with staff and other matters, have
been set up.

Local Boards
For each of the four regional areas of the country specified in the First Schedule to the
Act, there is a local board with headquarters in Bombay, Calcutta, Madras and New Delhi. Local
boards consist of five members each, appointed by the Central Government for a term of four
years (but may continue thereafter until their successors have been appointed) to represent, as
far as possible territorial and economic interests and the interests of co-operative and indigenous
banks. The local board members elect from amongst themselves the chairman of the board; the
managers in charge of the Bank's offices in Mumbai, Kolcutta, Madras and New Delhi are the
ex-officio secretaries of the local boards in these centers. The functions of the local boards are to
advise the central board on such matters as may be generally or specifically referred to them and
to perform such duties as the central board may delegate to them.

Governor is the Chief Executive

As the chairman of the central board of directors. The Governor is the Bank's chief
executive authority. It has the powers of general superintendence and direction of the affairs and
business of the bank, and many exercise all the powers which may be exercised by the Bank,
unless otherwise provided in the regulations made by the central board. In the absence of the
Governor, the Deputy Governor nominated by him would exercise his powers. The Governor is
assisted at present in the performance of his duties by four Deputy Governors and four executive
directors. The executive directors come in between the Deputy Governors and the chief
manager. They are not members of the central board but attend the board meeting by invitation.
The first post of executive director in the Bank was created in October 1950 to hold charge of
the new department of banking development. With the enlargement of the Bank's activities in
various spheres and the consequent increase in the work load of the Deputy Governors, the
number of executive directors was increased in later years. 1hey are now in charge of different
operations of the bank.

130
Reserve Bank’s Instruments of Credit Control
The government through the reserve bank of India employs the monetary policy as an instrument
of achieving the objectives of general economic policy. The main objectives of the monetary
policy are as follows:

1. Regulation of monetary growth and maintenance of price stability

2. Ensuring adequate expansion of credit
3. Assist economic growth
4. Encourage flow of credit into priority and neglected sectors
5. Strengthening of the banking system of the country

The quantitative or general measures influence the total volume of the credit while the qualitative
measures influence the selective or particular use of credit. Reserve Bank of India has the power
to influence the volume of credit created by banks in India. The banking regulation act 1949 says
that the Reserve Bank of India can ask any particular bank (or even all the banks i.e. banking
system of the country) to not to lend to particular groups/ persons. Apart from this RBI is armed
with weapons to control the money market in India. For example each bank has to get a license
from RBI to do banking business in India and this license is always subject to cancellation by
RBI provided the bank does not fulfill the requirements stipulated by RBI. Each scheduled bank
needs to send a weekly report to RBI which shows its assets and liabilities.
Quantitative measures: The quantitative measures of credit control are:
2. Bank Rate Policy: The bank rate is the Official interest rate at which RBI rediscounts the
approved bills held by commercial banks. For controlling the credit, inflation and money
supply, RBI will increase the Bank Rate. Current Bank Rate is 6%.
3. Open Market Operations: OMO The Open market Operations refer to direct sales and
purchase of securities and bills in the open market by Reserve bank of India. The aim is to
control volume of credit.
4. Cash Reserve Ratio: Cash reserve ratio refers to that portion of total deposits in
commercial Bank which it has to keep with RBI as cash reserves. The current Cash reserve
Ratio is 6%.
5. Statutory Liquidity Ratio: It refers to that portion of deposits with the banks which it has
to keep with itself as liquid assets(Gold, approved govt. securities etc.) . the current SLR is
25%.
If RBI wishes to control credit and discourage credit it would increase CRR & SLR.
Qualitative measures: Qualitative credit is used by the RBI for selective purposes. Some of
them are:
1. Margin requirements: This refers to difference between the securities offered and and
amount borrowed by the banks.
2. Consumer Credit Regulation: This refers to issuing rules regarding down payments and
maximum maturities of installment credit for purchase of goods.
3. Guidelines: RBI issues oral, written statements, appeals, guidelines, warnings etc. to the
banks.
4. Rationing of credit: The RBI controls the Credit granted / allocated by commercial banks.

131
5. Moral Suasion: psychological means and informal means of selective credit control.
6. Direct Action: This step is taken by the RBI against banks that don’t fulfill conditions and
requirements. RBI may refuse to rediscount their papers or may give excess credits or
charge a penal rate of interest over and above the Bank rate, for credit demanded beyong a
limit.

132
 LESSON 11 (a)

BANKING REGULATION ACT, 1949

Dr. Ashish Kumar
LBSIM

Banking Reforms and Regulations

Bank is the main confluence that maintains and controls the “flow of money” to make the
commerce of the land possible. Government uses it to control the flow of money by managing
Cash Reserve Ratio (CRR) and thereby influencing the inflation level. The functions of the bank
include accepting deposits from the public and other institutions and then to direct as loans and
advances to parties mainly for growth and development of industries. It extends loans for the
purpose of education, housing etc. and as a part of social duty, some percentage to Agricultural
sector as decided by the RBI. The banks take the deposit at the lower rate of interest and give
loans at the higher rates of interest. The difference in this transaction constitutes in number of
banks the main source of income.
Banking in India has undergone startling changes in terms of growth and structure.
Organized Banking was active in India since the establishment of The General Bank of India in
1786. The Reserve Bank of India (RBI) was established as the central bank and in 1955. The
Imperial bank of India, the biggest bank at that time, was taken over by the government to form
State owned State Bank of India (SBI). RBI undertook an exercise to reduce the fragmentation in
the Indian Banking Industry post-independence by merging weaker banks with stronger banks.
The total number of banks reduced from 566 in 1951 to 85 in 1969.With the objective of
reaching out to the masses and servicing credit needs of all sections of people, the government
nationalized 14 large banks in 1969 followed by another six banks in 1980. This period saw the
enormous growth in the number of branches and the bank’s branch network became wide enough
to reach the weaker section of the society in a vast country like India.
The economic reforms unleashed by the government in early nineties included banking
sector too, to a significant extent. Entry of new private banks was permitted by RBI under
specific guidelines. A number of liberalization and deregulation measures like efficiency, asset
quality, capital adequacy and profitability have been introduced by the RBI to bring Indian banks
in line with International best practices. With a view of giving the State owned banks operational
flexibility and functional autonomy, partial privatization has been authorized as a first step,
enabling them to reduce the stake of the government to 51%. Beside that a number of the
legislation aims at protecting the interests of the depositors, ensuring control over the volume of
credit, streamlining procedure, evolving uniform banking practices and developing banking on
sound lines. The central banking enquiry committee stated that the banking institutions of a
country serve as a repository of the cash resources of all classes of individuals and exercise a
very powerful influence on the economic life of the people. Since banking business has come to
be regarded as quasi-public in its nature warranting legislation to safeguard the interest of
depositors, on whose confidence rests the entire banking structure of a nation and for ensuring
and fostering the growth of banking on sound lines.
Legislation for safeguarding the business of banking companies most intensively was
undertaken after the failure of the Travancore National and Quilon Bank. Between January 1937
and September 1948, three amendments to the Indian Companies Act were promoted.
Meanwhile, a bill regulating the business of banking introduced in November 1944 lapsed in
October 1945. Another bill introduced in March 1946 was withdrawn because of numerous
amendments which were found necessary and reintroduced in March 1948. This final version of
the bill as modified by the select committee became law, which effect from March 16, 1949.

(A) Banking Regulation Act 1949

Banking regulation act came in existence in 1949 with numerous provisions which may
be classified into two categories: (i) built in safeguards and (ii) power and consequential
functions and responsibilities of the Reserve Bank of India. The other important set of provisions
pertains to the suspension of business by and winding up of banking companies.
The provisions which fall in first category namely of built in safeguard relate to the
organization management and operation of a banking company. The power and function of the
RBI cover the entire gamut of operations of a bank and vest with adequate control and authority
in this behalf.
The organizational, managerial and operations safeguard can be further categorized and
examined under the following subheads:
I) Organizational Safeguard:
i) Business of banking companies: In addition to the business of banking, banking company
may engage in any one or more of the following forms of business (U/s 6), namely:
(a) The borrowing, raising, or taking up of money; the lending or advancing of money either
upon or without security; the drawing, making, accepting, discounting, buying, selling, collecting
and dealing in bills of exchange, hundis promissory notes, coupons, drafts, bills of lading,
railway receipts, warrants, debentures, certificates, scripts and other instruments, and securities
whether transferable or negotiable or not; the granting and issuing of letters of credit, traveller's
cheques and circular notes; the buying, selling and dealing in bullion and specie; the buying and
selling, of foreign exchange including foreign bank notes; the acquiring holding, issuing on
commission, underwriting and dealing in stock, funds, shares debentures, debenture stock,
bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds,
scrips or other forms of securities on behalf of constituents or others, the negotiating of loans and
advances; the receiving of all kinds of bonds, scrips or valuables on deposit or for safe custody or
otherwise; the providing of safe deposit vaults; the collecting and transmitting of money and
securities.
(b) Acting as agents for any Government or local authority or any other person or persons; the
carrying on of agency business of any description including the clearing and forwarding of
goods, giving of receipts and discharges and otherwise acting as an attorney on behalf of
customers, but excluding the business of a 1[managing agent or secretary and treasurer] of a
company.
(c) Contracting for public and private loans and negotiating and issuing the same;
(d) The effecting, insuring, guaranteeing, underwriting, participating in managing and carrying
out of any issue, public or private, of State, municipal or other loans or of shares, stock,
debentures, or debenture stock of any company, corporation or association and the lending of
money for the purpose of any such issue;
(e) Carrying on and transacting every kind of guarantee and indemnity business;

118
(f) Managing, selling and realizing any property which may come into the possession of the
company in satisfaction or part satisfaction of any of its claims;
(g) Acquiring and holding and generally dealing with any property or any right, title or interest in
any such property which may form the security or part of the security for any loans or advances
or which may be connected with any such security;
(h) Undertaking and executing trusts;
(i) Undertaking the administration of estates as executor, trustee or otherwise;
(j) Establishing and supporting or aiding in the establishment and support of association,
institutions, funds, trusts and conveniences calculated to benefit employees or ex-employees of
the company or the dependents or connections of such persons; granting pensions and benevolent
objects or for any exhibition or for any public, general or useful object;
(k) The acquisition, construction, maintenance and alteration of any building or works necessary
or convenient for the purposes of the company;
(l) selling, improving, managing, developing, exchanging, leasing, mortgaging, disposing of or
turning into account or otherwise dealing with all or any part of the property and rights of the
company;
(m) Acquiring and undertaking the whole or any part of the business of any person or company,
when such business is of nature enumerated or described in this sub-section;
(n) Doing all such other things as are incidental or conducive to the promotion or advancement
of the business of the company;
(o) Any other forms of business which the Central Government may by notification in the
Official Gazette, specify as a form of business in which it is lawful for a banking company to
engage.
Section 6 further provides that a banking company cannot engage itself in any other type
of business. The rigidity ;of this provisions is strengthened by those of section 8 which
specifically prohibit a banking company from engaging itself in any trade or buying and selling
of goods except for realization of any security held by it. These in brief are the limitations
which the act provides in respect of the business that a banking company may or may not
transact.

Disposal of non-banking assets - Notwithstanding anything contained in Sec. 6, no banking

company shall hold any immovable property, howsoever acquired, except such as is required for
its own use, for any period exceeding seven years from the acquisition thereof or from the
commencement of this Act, whichever is later or any extension of such period as in this section
provided, and such property shall be disposed of within such period or extended period, as the
case may be: Provided that the banking company may, within the period of seven years as
aforesaid, deal or trade in any such property from the purpose of facilitating the disposal thereof.
Provided further that the Reserve Bank may in any particular case extend the aforesaid period of
seven years by such period not exceeding five years where it is satisfied that such extension
would be in the interests of the depositors of the banking company.

Restriction on nature of subsidiary companies - A banking company shall not form any
subsidiary company except a subsidiary company formed for one or more of the following
purposes, namely: (a) the undertaking of any business which, under Cls. (a) to (o) of subsection
(1) of Sec. 6, is permissible for a banking company to undertake, or (b) with the previous
119
permission in writing of the Reserve Bank, the carrying on of the business of banking
exclusively outside India, or (c) the undertaking of such other business, which the Reserve Bank
may, with the prior approval of the Central Government, consider to be conducive to the spread
of banking in India or to be otherwise useful or necessary in the public interest.
No banking company shall hold shares in any company, whether as pledgee, mortgagee
or absolute owner, of an amount exceeding thirty per cent of the paid-up share capital of that
company or thirty per cent of its own paid-up share capital and reserves, whichever is less:
Provided that any banking company which is on the date of the commencement of this Act
holding any shares in contravention of the provisions of this sub-section shall not be liable to any
penalty therefor if it reports the matter without delay to the Reserve Bank and if it brings its
holding of shares into conformity with the said provisions within such period, not exceeding two
years, as the Reserve Bank may think fit to allow. A banking company shall not, after the expiry
of one year from the date of the commencement of this Act, hold shares, whether as pledgee,
mortgagee or absolute owner, in any company in the management of which any Managing
Director or manager of the banking company is in any manner concerned or interested.

Use of words "bank", "banker", "banking" or "banking company" - (1) No company other
than a banking company shall use as part of its name 15[or, in connection with its business] any
of the words "bank", "banker" or "banking" and no company shall carry on the business of
banking in India unless it uses as part of its name at least one of such words. (2) No firm,
individual or group of individuals shall, for the purpose of carrying on any business, use as part
of its or his name any of the words "bank", "banking" or "banking company". (3) Nothing in this
section shall apply to- (a) a subsidiary of a banking company formed for one or more of the
purposes mentioned in sub-section (1) of section 19, whose name indicates that it is a subsidiary
of that banking company; (b) any association of banks formed for the protection of their mutual
interests and registered under section 25 of the Companies Act, 1956.

II) Operational Safeguard: Operational sage guards are also provided in this Act which relate
to (i) Maintenance of cash reserves assets in India, (ii) Grant of unsecured loans and advances
and (iii) Opening of new branches.

Maintenance of liquid resources: It is essential for a bank to maintain a satisfactory liquid

position and many a bank have run into difficulties and come to grief for non-observance of this
prime requirement even though they were ultimately found to be solvent. In fact, "liquidity" is
the very foundation of banking because it represents the faith or confidence that the general
public have, that banks will always meet their obligations. It is this faith or confidence which
enables banks to attract and retain deposits. A bank is able to inspire this confidence by
demonstrating, inter alia, its ability to repay its deposits as and when required in accordance with
the tenure of the deposits; sometimes a bank may find it necessary even to repay a time deposit
before its maturity. Every bank must, therefore, maintain the required "liquidity" or cash
resources. As has been humorously remarked, "if a cheque is to be returned for insufficient
funds, it should be because of insufficient funds in the depositor's account and not insufficient
funds on the part of the bank."
The Act seeks to secure this healthy feature in the operations of commercial banks by
prescribing a minimum liquidity ratio which they must maintain. As in the case of commercial
banks, primary (urban) cooperative banks are also required to maintain certain amount of cash
reserve and liquid assets. The scheduled primary (urban) cooperative banks are required to
maintain with the Reserve Bank of India an average daily balance, the amount of which should
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not be less than 5 per cent of their net demand and time liabilities in India in terms of Section 42
of the Reserve Bank of India Act, 1934. Non-scheduled (urban) cooperative banks, under the
provision of Section 18 of Banking Regulation Act, 1949 (As Applicable to Cooperative
Societies) should maintain a sum equivalent to at least 3 per cent of their total demand and time
liabilities in India on day-to-day basis. For scheduled cooperative banks, CRR is required to be
maintained in accounts with Reserve Bank of India, whereas for non-scheduled cooperative
banks, it can be maintained by way of either cash with themselves or in the form of balances in a
current account with the Reserve Bank of India or the state co-operative bank of the state
concerned or the central cooperative bank of the district concerned or by way of net balances in
current accounts with public sector banks. In addition to the cash reserve, every primary (urban)
cooperative bank (scheduled/non-scheduled) is required to maintain liquid assets in the form of
cash, gold or unencumbered approved securities which should not be less than 25 per cent of the
total of its demand and time liabilities in accordance with the provisions of Section 24 of the
Banking Regulation Act, 1949 (As Applicable to Cooperative Societies). Out of the prescribed
SLR, the UCBs have been advised to maintain a certain amount in the form of SLR Securities as
under:

Minimum SLR holding in Government and other

Sr.No. Category of bank approved securities as percentage of Net Demand and
Time Liabilities (NDTL)
1. Scheduled banks 25%
Non-Scheduled banks
a) with NDTL of Rs.25
2. crore & above 15%
b) with NDTL of less than 10%
Rs.25 crore

The Act further requires that the assets in India of every banking company should not be less
than 75 per cent of its demand and time liabilities in India. A banking company is also
precluded from creating a floating charge on its assets and properties unless the creation of
such charge is certified by the Reserve Bank as not being detrimental to the interests of the
depositors of the banking company.

Unsecured and other loans and advances. The safeguards pertaining to loan and advances
preclude a banking company from (a) granting advances against the security of its own shares,
(b) granting unsecured advances of specified types and (c) writing offer remitting advances
except with the prior approval of the Reserve Bank. A banking company cannot allow an
unsecured advance to:
• Any of its directors
• To firms in which a director is a partner or guarantor
• A private limited company in which a director is a managing
• Agent or guarantor
• Any individual where a director is a guarantor
• To any company in which the chairman of the banking company is (i) a chairman or
managing director, if such a company has no managing agent or (ii) the managing agent
or director or partner of the managing agent of such company.

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To mitigate the hardships of the above blanket restrictions on the grant of unsecured advances,
the Act has deleted advances made against bills of exchange arising out of bona fide commercial
or trade transactions, supply bills and trust receipts, from the purview of unsecured advances.

Apart from the restrictions on the grant of unsecured loans and advances, the Act has laid
down that advances, both secured and unsecured outstanding against (i) a director of a bank (ii)
any firm or company in which any of the directors is interested as director, partner, managing
agent or guarantor and (iii) any individuals if any of the directors is his partner or guarantor,
cannot be remitted or written off in whole or in part without the prior approval of the Reserve
Bank.

Opening New Offices: The third operational safeguard relates to the opening of new offices by
banks. The Act, provides that, without obtaining prior permission of the Reserve Bank, no
banking company shall open a new place of business in India.
Sec. 23 (2) of the Banking Regulation Act, 1949, clearly states: "Before granting any
permission under this Section, the Reserve Bank may require to be satisfied by an inspection
under Section 35 or otherwise as to the financial condition and history of the company, the
general character of its management, the adequacy of its capital structure and earning prospects,
and that public interest will be served by the opening or, as the case may be, change of location,
of the place of business," of a banking institution.
This Section of the Act inter alia laid stress on the financial management, the adequacy of
capital and the earning prospects of the bank. Public convenience as regards the location was
also stressed. The then existing circumstances must have forced the Reserve Bank to lay greater
stress on the functioning and the soundness of the bank. An uneven development of banking in
the different areas of the country was even at that time engaging the attention of the Reserve
Bank; but the promotion and building up of good business practices were considered to be
primary objectives.

Miscellaneous Provisions: These are in brief the organizational, managerial and operational
safeguards provided in the Act in respect of banking companies. The provisions relating to paid-
up capital and reserves and maintenance of liquid resources and assets in India do not apply to a
banking company which has been refused a license or whose license has been cancelled or which
has been prohibited from accepting fresh deposits under any compromise, arrangement or
scheme sanctioned by a court.
There are several other provisions which arise out of and/ or are ancillary to these
safeguards. For example every banking company is, required to prepare its annual accounts
comprising the balance sheet and profit and loss account in the forms prescribed under the
Act. The accounts are required to be audited by a qualified auditor. The banking company is
further required to publish its balance sheet and 'profit and loss account and to send copies
thereof to the Reserve Bank of India as also to the Registrar of companies. Copies of such
balance sheets and profit and loss account are also required to be displayed in a conspicuous
place at its principal office and at its other offices.
Section 46 of the Act provides for punitive action against directions, officers and other
persons for failure to comply with the provisions of the Banking Regulation Act. The offences
for which punitive action can be taken are:

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 (i) willfully making a false statement or omitting a material statement in any retuin, balance
sheet or other document;
(ii) failure to produce books and records or answer questions during an inspection under
section 35;
(iii)receiving of deposits after a bank has been prohibited from accepting deposits;
(i) failure to comply with any other provision of the Act.

Offences under the Banking Regulation Act so far have been neither serious nor numerous. The
Reserve Bank usually does not take a serious view of petty contraventions which may have been
the result of ignorance or inadvertence.

Objectives of Banking Regulation Act 1949

The Banking Act was enacted in February1949 with the following objectives:
(i) The provision of the Indian Companies Act 1913 was found inadequate and unsatisfactory
to regulate banking companies in India. Therefore a need was felt to have a specific
legislation having comprehensive coverage on banking business in India.
(ii) Due to inadequacy of capital many banks failed and hence prescribing a minimum capital
requirement was felt necessary. The banking regulation act brought in certain minimum
capital requirements for banks.
(iii) One of the key objectives of this act was to avoid cut throat competition among banking
companies. The act was regulated the opening of branches and changing location of
existing branches.
(iv) To prevent indiscriminate opening of new branches and ensure balanced development of
banking companies by system of licensing.
(v) Assign power to RBI to appoint, reappoint and removal of chairman, director and officers
of the banks. This could ensure the smooth and efficient functioning of banks in India.
(vi) To protect the interest of depositors and public at large by incorporating certain provisions,
viz. prescribing cash reserve and liquidity reserve ratios. This enable bank to meet demand
depositors.
(vii) Provider compulsory amalgamation of weaker banks with senior banks, and thereby
strengthens the banking system in India.
(viii) Introduce few provisions to restrict foreign banks in investing funds of Indian depositors
outside India.
(ix) Provide quick and easy liquidation of banks when they are unable to continue further or
amalgamate with other banks.

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 LESSON 12 (a)

DEFICIENCIES IN INDIAN BANKING SYSTEM

Dr. Ashish Kumar
LBSIM
The banking system in India is significantly different from that of other Asian nations
because of the country’s unique geographic, social, and economic characteristics. India has a
large population and land size, a diverse culture and extreme disparities in income, which are
marked among its regions. There are high levels of illiteracy among a large percentage of its
population but, at the same time, the country has a large reservoir of managerial and
technologically advanced talents. Between about 30 and 35 percent of the population resides in
metro and urban cities and the rest is spread in several semi-urban and rural centers. The
country’s economic policy framework combines socialistic and capitalistic features with a heavy
bias towards public sector investment. India has followed the path of growth-led exports rather
than the “export led growth” of other Asian economies, with emphasis on self-reliance through
import substitution. These features are reflected in the structure, size, and diversity of the
country’s banking and financial sector. The banking system has had to serve the goals of
economic policies enunciated in successive five year development plans, particularly concerning
equitable income distribution, balanced regional economic growth, and the reduction and
elimination of private sector monopolies in trade and industry. In order for the banking industry
to serve as an instrument of state policy, it was subjected to various nationalization schemes in
different phases (1955, 1969, and 1980). As a result, banking remained internationally isolated
(few Indian banks had presence abroad in international financial centers) because of
preoccupations with domestic priorities, especially massive branch expansion and attracting
more people to the system. Moreover, the sector has been assigned the role of providing support
to other economic sectors such as agriculture, small-scale industries, exports, and banking
activities in the developed commercial centers (i.e., metro, urban, and a limited number of semi-
urban centers). The banking system’s international isolation was also due to strict branch
licensing controls on foreign banks already operating in the country as well as entry restrictions
facing new foreign banks. A criterion of reciprocity is required for any Indian bank to open an
office abroad. These features have left the Indian banking sector with weaknesses and strengths.
A big challenge facing Indian banks is how, under the current ownership structure, to attain
operational efficiency suitable for modern financial intermediation. On the other hand, it has
been relatively easy for the public sector banks to recapitalize, given the increases in
nonperforming assets (NPAs), as their Government dominated ownership structure has reduced
the conflicts of interest that private banks would face.
The banking industry in India is undergoing a major transformation due to changes in
economic conditions and continuous deregulation. These multiple changes happening one after
other has a ripple effect on a bank trying to graduate from completely regulated seller market to
completed deregulated customers market. So that’s why the Indian banking sector is facing
following challenges:
Deregulation: This continuous deregulation has made the Banking market extremely
competitive with greater autonomy, operational flexibility and decontrolled interest rate and
liberalized norms for foreign exchange. The deregulation of the industry coupled with decontrol
in interest rates has led to entry of a number of players in the banking industry. At the same time
reduced corporate credit off take thanks to sluggish economy has resulted in large number of
competitors batting for the same pie.
New rules: As a result, the market place has been redefined with new rules of the game. Banks
are transforming to universal banking, adding new channels with lucrative pricing and freebees
to offer. Natural fall out of this has led to a series of innovative product offerings catering to
various customer segments, specifically retail credit.
Efficiency: This in turn has made it necessary to look for efficiencies in the business. Banks
need to access low cost funds and simultaneously improve the efficiency. The banks are facing
pricing pressure, squeeze on spread and have to give thrust on retail assets.
Diffused Customer loyalty: This will definitely impact Customer preferences, as they are bound
to react to the value added offerings. Customers have become demanding and the loyalties are
diffused. There are multiple choices, the wallet share is reduced per bank with demand on
flexibility and customization. Given the relatively low switching costs; customer retention calls
for customized service and hassle free, flawless service delivery.
Misaligned mindset: These changes are creating challenges, as employees are made to adapt to
changing conditions. There is resistance to change from employees and the Seller market
mindset is yet to be changed coupled with Fear of uncertainty and Control orientation.
Acceptance of technology is slowly creeping in but the utilization is not maximized.
Competency Gap: Placing the right skill at the right place will determine success. The
competency gap needs to be addressed simultaneously otherwise there will be missed
opportunities. The focus of people will be on doing work but not providing solutions, on
escalating problems rather than solving them and on disposing customers instead of using the
opportunity to cross sell.
Other Challenges: Beside the above said challenges Indian banking sector is facing some other
challenges too:
• Implementation of Basel II
• Implementation of latest technology
• How to reduce NPA
• Corporate governance
• Man power planning
• Talent management
• Loan waiver: A new challenge
• Risk management
• Transparency and disclosures
• Challenges in banking security
• Growth in business
• Enhancing customer service
• Financial Inclusion
• Coping up with new IFRS

Non-Performing Assets in Indian Banks

Non-performing Asset (NPA) has emerged since over a decade as an alarming threat to
the banking industry in our country sending distressing signals on the sustainability and
endurability of the affected banks. The positive results of the chain of measures affected under
banking reforms by the Government of India and RBI in terms of the two Narasimhan
Committee Reports in this contemporary period have been neutralized by the ill effects of this
surging threat. Despite various correctional steps administered to solve and end this problem,
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 concrete results are eluding. It is a sweeping and all pervasive virus confronted universally on
banking and financial institutions. The severity of the problem is however acutely suffered by
Nationalised Banks, followed by the SBI group, and the all India Financial Institutions.
An asset is classified as Non-performing Asset (NPA) if due in the form of principal and
interest are not paid by the borrower for a period of 180 days. However with effect from March
2004, default status would be given to a borrower if dues are not paid for 90 days. If any advance
or credit facilities granted by banks to a borrower becomes non-performing, then the bank will
have to treat all the advances/credit facilities granted to that borrower as non-performing without
having any regard to the fact that there may still exist certain advances / credit facilities having
performing status.
Though the term NPA connotes a financial asset of a commercial bank, which has
stopped earning an expected reasonable return, it is also a reflection of the productivity of the
unit, firm, concern, industry and nation where that asset is idling. Viewed with this perspective,
the NPA is a result of an environment that prevents it from performing up to expected levels.
The definition of NPAs in Indian context is certainly more liberal with two quarters norm being
applied for classification of such assets. The RBI is moving over to one-quarter norm from 2004
onwards.

Magnitude of NPAs
In India, the NPAs that are considered to be at higher levels than those in other countries
have of late, attracted the attention of public. The Indian banking system had acquired a large
quantum of NPAs, which can be termed as legacy NPAs. NPAs seem to be growing in public
sector banks over the years. The following table of gross and net NPAs of various sector banks
revealing the real picture.

GROSS AND NET NPAs OF SCHEDULED COMMERCIAL BANKS BANK GROUP-WISE

(Amount in Rupees crore)
Year Advances Non-performing assets (NPAs)
(end- Gross Net Gross Net
March) Amount As As Amount As As
Percentag Percent Percentage Percentag
e of gross age of of net e of Total
advances total advances Assets
assets
1 2 3 4 5 6 7 8 9
Scheduled Commercial Banks
1997-98 352696 325522 50815 14.4 6.4 23761 7.3 3.0
1998-99 399436 367012 58722 14.7 6.2 28020 7.6 2.9
1999-00 475113 444292 60408 12.7 5.5 30073 6.8 2.7
2000-01 558766 526328 63741 11.4 4.9 32461 6.2 2.5
2001-02 680958 645859 70861 10.4 4.6 35554 5.5 2.3
2002-03 778043 740473 68717 8.8 4.1 29692 4.0 1.8
2003-04 902026 862643 64812 7.2 3.3 24396 2.8 1.2
2004-05 1152682 1115663 59373 5.2 2.5 21754 2.0 0.9
2005-06 1551378 1516811 51097 3.3 1.8 18543 1.2 0.7

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2006-07 2012510 1981237 50486 2.5 1.5 20101 1.0 0.6
2007-08 2507885 2476936 56309 2.3 1.3 24730 1.0 0.6
2008-09 3038254 3000906 68973 2.3 1.3 31424 1.1 0.6
Public Sector Banks
1997-98 284971 260459 45653 16.0 7.0 21232 8.2 3.3
1998-99 325328 297789 51710 15.9 6.7 24211 8.1 3.1
1999-00 379461 352714 53033 14.0 6.0 26187 7.4 2.9
2000-01 442134 415207 54672 12.4 5.3 27977 6.7 2.7
2001-02 509368 480681 56473 11.1 4.9 27958 5.8 2.4
2002-03 577813 549351 54090 9.4 4.2 24877 4.5 1.9
2003-04 661975 631383 51537 7.8 3.5 19335 3.1 1.3
2004-05 877825 848912 48399 5.5 2.7 16904 2.1 1.0
2005-06 1134724 1106288 41358 3.6 2.1 14566 1.3 0.7
2006-07 1464493 1440146 38968 2.7 1.6 15145 1.1 0.6
2007-08 1819074 1797401 40452 2.2 1.3 17836 1.0 0.6
2008-09 2283473 2260156 45156 2.0 1.2 21033 0.9 0.6
Old Private Sector Banks
1997-98 25580 24353 2794 10.9 5.1 1572 6.5 2.9
1998-99 28979 26017 3784 13.1 5.8 2332 9.0 3.6
1999-00 35404 33879 3815 10.8 5.2 2393 7.1 3.3
2000-01 39738 37973 4346 10.9 5.1 2771 7.3 3.3
2001-02 44057 42286 4851 11.0 5.2 3013 7.1 3.2
2002-03 51329 49436 4550 8.9 4.3 2598 5.2 2.5
2003-04 57908 55648 4398 7.6 3.6 2142 3.8 1.8
2004-05 70412 67742 4200 6.0 3.1 1859 2.7 1.4
2005-06 85154 82957 3759 4.4 2.5 1375 1.7 0.9
2006-07 94872 92887 2969 3.1 1.8 891 1.0 0.6
2007-08 113404 111670 2557 2.3 1.3 740 0.7 0.4
2008-09 130352 128512 3072 2.4 1.3 1165 0.9 0.5
New Private Sector Banks
1997-98 11173 11058 392 3.5 1.5 291 2.6 1.1
1998-99 14070 13714 871 6.2 2.3 611 4.5 1.6
1999-00 22816 22156 946 4.1 1.6 638 2.9 1.1
2000-01 31499 30086 1617 5.1 2.1 929 3.1 1.2
2001-02 76901 74187 6811 8.9 3.9 3663 4.9 2.1
2002-03 94718 89515 7232 7.6 3.8 1365 1.5 0.7
2003-04 119511 115106 5983 5.0 2.4 1986 1.7 0.8
2004-05 127420 123655 4582 3.6 1.6 2353 1.9 0.8
2005-06 232536 230005 4052 1.7 1.0 1796 0.8 0.4
2006-07 325273 321865 6287 1.9 1.1 3137 1.0 0.5
2007-08 412441 406733 10440 2.5 1.4 4907 1.2 0.7
2008-09 454713 446824 13911 3.1 1.8 6253 1.4 0.8
Foreign Banks In India
1997-98 30972 29652 1976 6.4 3.0 666 2.2 1.0
1998-99 31059 29492 2357 7.6 3.1 866 2.9 1.1
1999-00 37432 35543 2614 7.0 3.2 855 2.4 1.0
2000-01 45395 43063 3106 6.8 3.0 785 1.8 0.8

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 2001-02 50631 48705 2726 5.4 2.4 920 1.9 0.8
2002-03 54184 52171 2845 5.3 2.4 903 1.7 0.8
2003-04 62632 60506 2894 4.6 2.1 933 1.5 0.7
2004-05 77026 75354 2192 2.8 1.4 639 0.8 0.4
2005-06 98965 97562 1928 1.9 1.0 808 0.8 0.4
2006-07 127872 126339 2263 1.8 0.8 927 0.7 0.3
2007-08 162966 161133 2859 1.8 0.8 1247 0.8 0.3
2008-09 169716 165415 6833 4.0 1.5 2973 1.8 0.7
Data Source: RBI Site

Causes for Non-Performing Assets

A strong banking sector is important for a flourishing economy. The failure of the
banking sector may have an adverse impact on other sectors. The Indian banking system, which
was operating in a closed economy, now faces the challenges of an open economy. On one hand
a protected environment ensured that banks never needed to develop sophisticated treasury
operations and Asset Liability Management skills. On the other hand a combination of directed
lending and social banking relegated profitability and competitiveness to the background. The
net result was unsustainable NPAs and consequently a higher effective cost of banking services.
One of the main causes of NPAs into banking sector is the directed loans system under
which commercial banks are required a prescribed percentage of their credit (40%) to priority
sectors. As of today nearly 7 percent of Gross NPAs are locked up in 'hard-core' doubtful and
loss assets, accumulated over the years. The problem India Faces is not lack of strict prudential
norms but
• The legal impediments and time consuming nature of asset disposal proposal.
• Postponement of problem in order to show higher earnings.
• Manipulation of debtors using political influence.
Macro Perspective Behind NPAs
A lot of practical problems have been found in Indian banks, especially in public sector
banks. For Example, the government of India had given a massive wavier of Rs. 15,000 Crs.
under the Prime Minister ship of Mr. V.P. Singh, for rural debt during 1989-90. This was not a
unique incident in India and left a negative impression on the payer of the loan.
Poverty elevation programs like IRDP, RREP, SUME, SEPUP, JRY, PMRY etc., failed on
various grounds in meeting their objectives. The huge amount of loan granted under these
schemes were totally unrecoverable by banks due to political manipulation, misuse of funds and
non-reliability of target audience of these sections. Loans given by banks are their assets and as
the repayment of several of the loans were poor, the quality of these assets were steadily
deteriorating. Credit allocation became 'Lon Melas', loan proposal evaluations were slack and as
a result repayment were very poor.here are several reasons for an account becoming NPA.
* Internal factors
* External factors

Internal factors:
1. Funds borrowed for a particular purpose but not use for the said purpose.
2. Project not completed in time.
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 3. Poor recovery of receivables.
4. Excess capacities created on non-economic costs.
5. In-ability of the corporate to raise capital through the issue of equity or other debt
instrument from capital markets.
6. Business failures.
7. Diversion of funds for expansion\modernization\setting up new projects\ helping or
promoting sister concerns.
8. Willful defaults, siphoning of funds, fraud, disputes, management disputes, mis-
appropriation etc.,
9. Deficiencies on the part of the banks viz. in credit appraisal, monitoring and follow-ups,
delay in settlement of payments\ subsidiaries by government bodies etc.
External factors:
1. Sluggish legal system
2. Scarcity of raw material, power and other resources.
3. Industrial recession.
4. Shortage of raw material, raw material\input price escalation, power shortage, industrial
recession, excess capacity, natural calamities like floods, accidents.
5. Failures, non payment\ over dues in other countries, recession in other countries,
externalization problems, adverse exchange rates etc.
6. Government policies like excise duty changes, Import duty changes etc.,

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 LESSON 12 (b)

BANKING SECTOR REFORMS

Dr. Ashish Kumar
LBSIM

The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991),
essentially catered to the needs of planned development in a mixed-economy framework where
the public sector had a dominant role in economic activity. The strategy of planned economic
development required huge development expenditure, which was met through Government’s
dominance of ownership of banks, automatic monetization of fiscal deficit and subjecting the
banking sector to large pre-emptions – both in terms of the statutory holding of Government
securities (statutory liquidity ratio, or SLR) and cash reserve ratio (CRR). Besides, there was a
complex structure of administered interest rates guided by the social concerns, resulting in cross-
subsidization. These not only distorted the interest rate mechanism but also adversely affected
the viability and profitability of banks by the end of 1980s. There is perhaps an element of
commonality of such a ‘repressed’ regime in the financial sector of many emerging market
economies. It follows that the process of reform of financial sector in most emerging economies
also has significant commonalities while being specific to the circumstances of each country. A
narration of the broad contours of reform in India would be helpful in appreciating both the
commonalities and the differences in our paths of reforms.

Contours of banking reforms in India

• First, reform measures were initiated and sequenced to create an enabling environment
for banks to overcome the external constraints – these were related to administered
structure of interest rates, high levels of pre-emption in the form of reserve requirements,
and credit allocation to certain sectors. Sequencing of interest rate deregulation has been
an important component of the reform process which has imparted greater efficiency to
resource allocation. The process has been gradual and predicated upon the institution of
prudential regulation for the banking system, market behavior, financial opening and,
above all, the underlying macroeconomic conditions. The interest rates in the banking
system have been largely deregulated except for certain specific classes; these are:
savings deposit accounts, non-resident Indian (NRI) deposits, small loans up to Rs.2 lakh
and export credit. The need for continuance of these prescriptions as well as those
relating to priority sector lending have been flagged for wider debate in the latest annual
policy of the RBI. However, administered interest rates still prevail in small savings
schemes of the Government.
• Second, as regards the policy environment of public ownership, it must be recognized
that the lion’s share of financial intermediation was accounted for by the public sector
during the pre-reform period. As part of the reforms programme, initially, there was
infusion of capital by the Government in public sector banks, which was followed by
expanding the capital base with equity participation by the private investors. The share of
the public sector banks in the aggregate assets of the banking sector has come down from
90 per cent in 1991 to around 75 per cent in 2004. The share of wholly Government-
owned public sector banks (i.e., where no diversification of ownership has taken place)
sharply declined from about 90 per cent to 10 per cent of aggregate assets of all
scheduled commercial banks during the same period. Diversification of ownership has
 led to greater market accountability and improved efficiency. Since the initiation of
reforms, infusion of funds by the Government into the public sector banks for the purpose
of recapitalization amounted, on a cumulative basis, to less than one per cent of India’s
GDP, a figure much lower than that for many other countries. Even after accounting for
the reduction in the Government's shareholding on account of losses set off, the current
market value of the share capital of the Government in public sector banks has increased
manifold and as such what was perceived to be a bail-out of public sector banks by
Government seems to be turning out to be a profitable investment for the Government.
• Third, one of the major objectives of banking sector reforms has been to enhance
efficiency and productivity through competition. Guidelines have been laid down for
establishment of new banks in the private sector and the foreign banks have been allowed
more liberal entry. Since 1993, twelve new private sector banks have been set up. As
already mentioned, an element of private shareholding in public sector banks has been
injected by enabling a reduction in the Government shareholding in public sector banks
to 51 per cent. As a major step towards enhancing competition in the banking sector,
foreign direct investment in the private sector banks is now allowed up to 74 per cent,
subject to conformity with the guidelines issued from time to time.
• Fourth, consolidation in the banking sector has been another feature of the reform
process. This also encompassed the Development Financial Institutions (DFIs), which
have been providers of long-term finance while the distinction between short-term and
long-term finance provider has increasingly become blurred over time. The complexities
involved in harmonizing the role and operations of the DFIs were examined and the RBI
enabled the reverse-merger of a large DFI with its commercial banking subsidiary which
is a major initiative towards universal banking. Recently, another large term-lending
institution has been converted into a bank. While guidelines for mergers between non-
banking financial companies and banks were issued some time ago, guidelines for
mergers between private sector banks have been issued a few days ago. The principles
underlying these guidelines would be applicable, as appropriate, to the public sector
banks also, subject to the provisions of the relevant legislation.
• Fifth, impressive institutional and legal reforms have been undertaken in relation to the
banking sector. In 1994, a Board for Financial Supervision (BFS) was constituted
comprising select members of the RBI Board with a variety of professional expertise to
exercise 'undivided attention to supervision'. The BFS, which generally meets once a
month, provides direction on a continuing basis on regulatory policies including
governance issues and supervisory practices. It also provides direction on supervisory
actions in specific cases. The BFS also ensures an integrated approach to supervision of
commercial banks, development finance institutions, non-banking finance companies,
urban cooperatives banks and primary dealers. A Board for Regulation and Supervision
of Payment and Settlement Systems (BPSS) has also been recently constituted to
prescribe policies relating to the regulation and supervision of all types of payment and
settlement systems, set standards for existing and future systems, authorize the payment
and settlement systems and determine criteria for membership to these systems. The
Credit Information Companies (Regulation) Bill, 2004 has been passed by both the
Houses of the Parliament while the Government Securities Bills, 2004 is under process.
Certain amendments are being considered by the Parliament to enhance Reserve Bank’s
regulatory and supervisory powers. Major amendments relate to requirement of prior
approval of RBI for acquisition of five per cent or more of shares of a banking company
with a view to ensuring ‘fit and proper’ status of the significant shareholders, aligning the
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 voting rights with the economic holding and empowering the RBI to supersede the Board
of a banking company.
• Sixth, there have been a number of measures for enhancing the transparency and
disclosures standards. Illustratively, with a view to enhancing further transparency, all
cases of penalty imposed by the RBI on the banks as also directions issued on specific
matters, including those arising out of inspection, are to be placed in the public domain.
• Seventh, while the regulatory framework and supervisory practices have almost
converged with the best practices elsewhere in the world, two points are noteworthy.
First, the minimum capital to risk assets ratio (CRAR) has been kept at nine per cent i.e.,
one percentage point above the international norm; and second, the banks are required to
maintain a separate Investment Fluctuation Reserve (IFR) out of profits, towards interest
rate risk, at five per cent of their investment portfolio under the categories ‘held for
trading’ and ‘available for sale’. This was prescribed at a time when interest rates were
falling and banks were realizing large gains out of their treasury activities.
Simultaneously, the conservative accounting norms did not allow banks to recognize the
unrealized gains. Such unrealized gains coupled with the creation of IFR helped in
cushioning the valuation losses required to be booked when interest rates in the longer
tenors have moved up in the last one year or so.
• Eighth, of late, the regulatory framework in India, in addition to prescribing prudential
guidelines and encouraging market discipline, is increasingly focusing on ensuring good
governance through "fit and proper" owners, directors and senior managers of the banks.
Transfer of shareholding of five per cent and above requires acknowledgement from the
RBI and such significant shareholders are put through a `fit and proper' test. Banks have
also been asked to ensure that the nominated and elected directors are screened by a
nomination committee to satisfy `fit and proper' criteria. Directors are also required to
sign a covenant indicating their roles and responsibilities. The RBI has recently issued
detailed guidelines on ownership and governance in private sector banks emphasizing
diversified ownership. The listed banks are also required to comply with governance
principles laid down by the SEBI – the securities markets regulator.

Features of banking Sector Reform in India

Recalling some features of financial sector reforms in India would be in order, before narrating
the processes.
• First, financial sector reform was undertaken early in the reform-cycle in India.
• Second, the financial sector was not driven by any crisis and the reforms have not been
an outcome of multilateral aid.
• Third, the design and detail of the reform were evolved by domestic expertise, though
international experience is always kept in view.
• Fourth, the Government preferred that public sector banks manage the over-hang
problems of the past rather than cleanup the balance sheets with support of the
Government.
• Fifth, it was felt that there is enough room for growth and healthy competition for public
and private sector banks as well as foreign and domestic banks. The twin governing
principles are non-disruptive progress and consultative process.

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Processes of banking reform
In order to ensure timely and effective implementation of the measures, RBI has been adopting a
consultative approach before introducing policy measures. Suitable mechanisms have been
instituted to deliberate upon various issues so that the benefits of financial efficiency and
stability percolate to the common person and the services of the Indian financial system can be
benchmarked against international best standards in a transparent manner. Let me give a brief
account of these mechanisms.
• First, on all important issues, workings group are constituted or technical reports are
prepared, generally encompassing a review of the international best practices, options
available and way forward. The group membership may be internal or external to the RBI
or mixed. Draft reports are often placed in public domain and final reports take account
of inputs, in particular from industry associations and self-regulatory organizations. The
reform-measures emanate out of such a series of reports, the pioneering ones being:
Report of the Committee on the Financial System (Chairman: Shri M. Narasimham), in
1991; Report of the High Level Committee on Balance of Payments (Chairman: Dr. C.
Rangarajan) in 1992; and the Report of the Committee on Banking Sector Reforms
(Chairman: Shri M. Narasimham) in 1998.
• Second, Resource Management Discussions meetings are held by the RBI with select
commercial banks, prior to the policy announcements. These meetings not only focus on
perception and outlook of the bankers on the economy, liquidity conditions, credit flow,
development of different markets and directions of interest rates, but also on issues
relating to developmental aspects of banking operations.
• Third, we have formed a Technical Advisory Committee on Money, Foreign Exchange
and Government Securities Markets (TAC). It has emerged as a key consultative
mechanism amongst the regulators and various market players including banks. The
Committee has been crystallizing the synergies of experts across various fields of the
financial market and thereby acting as a facilitator for the RBI in steering reforms in
money, government securities and foreign exchange markets.
• Fourth, in order to strengthen the consultative process in the regulatory domain and to
place such a process on a continuing basis, the RBI has constituted a Standing Technical
Advisory Committee on Financial Regulation on the lines similar to the TAC. The
Committee consists of experts drawn from academia, financial markets, banks, non-bank
financial institutions and credit rating agencies. The Committee examines the issues
referred to it and advises the RBI on desirable regulatory framework on an on-going basis
for banks, non-bank financial institutions and other market participants.
• Fifth, for ensuring periodic formal interaction, amongst the regulators, there is a High
Level Co-ordination Committee on Financial and Capital Markets (HLCCFCM) with the
Governor, RBI as the Chairman, and the Heads of the securities market and insurance
regulators, and the Secretary of the Finance Ministry as the members. This Co-ordination
Committee has authorised constitution of several standing committees to ensure co-
ordination in regulatory frameworks at an operational level.
• Sixth, more recently a Standing Advisory Committee on Urban Co-operative Banks
(UCBs) has been activated to advise on structural, regulatory and supervisory issues
relating to UCBs and to facilitate the process of formulating future approaches for this
sector. Similar mechanisms are being worked out for non-banking financial companies.
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 • Seventh, the RBI has also instituted a mechanism of placing draft versions of important
guidelines for comments of the public at large before finalisation of the guidelines. To
further this consultative process and with a specific goal of making the regulatory
guidelines more user-friendly, a Users’ Consultative Panel has been constituted
comprising the representatives of select banks and market participants. The panel
provides feedback on regulatory instructions at the formulation stage to avoid any
subsequent ambiguities and operational glitches.
• Eighth, an extensive and transparent communication system has been evolved. The
annual policy statements and their mid-term reviews communicate the RBI’s stance on
monetary policy in the immediate future of six months to one year. Over the years, the
reports of various working groups and committees have emerged as another plank of two-
way communication from RBI. An important feature of the RBI’s communication policy
is the almost real-time dissemination of information through its web-site. The auction
results under Liquidity Adjustment Facility (LAF) of the day are posted on the web-site
by 12.30 p.m the same day, while by 2.30 p.m. the ‘reference rates’ of select foreign
currencies are also placed on the website. By the next day morning, the press release on
money market operations is issued. Every Saturday, by 12 noon, the weekly statistical
supplement is placed on the web-site providing a fairly detailed, recent data-base on the
RBI and the financial sector. All the regulatory and administrative circulars of different
Departments of the RBI are placed on the web-site within half an hour of their
finalization.
• Ninth, an important feature of the reform of the Indian financial system has been the
intent of the authorities to align the regulatory framework with international best
practices keeping in view the developmental needs of the country and domestic factors.
Towards this end, a Standing Committee on International Financial Standards and Codes
was constituted in 1999. The Standing Committee had set up ten Advisory Groups in key
areas of the financial sector whose reports are available on the RBI website. The
recommendations contained in these reports have either been implemented or are in the
process of implementation. I would like to draw your attention to two reports in
particular, which have a direct bearing on the banking system, viz., Advisory Group on
Banking Supervision and Advisory Group on Corporate Governance. Subsequently, in
2004, we conducted a review of the recommendations of the Advisory Groups and
reported the progress and agenda ahead.

What has been the impact?

These reform measures have had major impact on the overall efficiency and stability of the
banking system in India. The present capital adequacy of Indian banks is comparable to those at
international level. There has been a marked improvement in the asset quality with the
percentage of gross non-performing assets (NPAs) to gross advances for the banking system
reduced from 14.4 per cent in 1998 to 7.2 per cent in 2004. The reform measures have also
resulted in an improvement in the profitability of banks. The Return on Assets (RoA) of the
banks rose from 0.4 per cent in the year 1991-92 to 1.2 per cent in 2003-04. Considering that,
globally, the RoA has been in the range 0.9 to 1.5 per cent for 2004, Indian banks are well
placed. The banking sector reforms also emphasized the need to review the manpower resources
and rationalize the requirements by drawing a realistic plan so as to reduce the operating cost and
improve the profitability. During the next five years, the business per employee for public sector
banks more than doubled to around Rs.25 million in 2004.

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 Considerable emphasis has been led down on appropriate mix between the elements of
continuity and change in the process of reform, but the dynamic elements in the mix are
determined by the context. While there is usually a consensus on the broad direction, relative
emphasis on various elements of the process of reform keeps changing, depending on the
evolving circumstances. Perhaps it will be useful to illustrate this approach to contextualizing the
mix of continuity and change.
The mid-term review in November 2003, reviewed the progress of implementation of
various developmental as well as regulatory measures in the banking sector but emphasized
facilitating the ease of transactions by the common person and strengthening the credit delivery
systems, as a response to the pressing needs of the society and economy. The annual policy
statement of May 2004 carried forward this focus but flagged major areas requiring urgent
attention especially in the areas of ownership, governance, conflicts of interest and customer-
protection. Some extracts of the policy statement may be in order:
"First, it is necessary to articulate in a comprehensive and transparent manner
the policy in regard to ownership and governance of both public and private
sector banks keeping in view the special nature of banks. This will also
facilitate the ongoing shift from external regulation to internal systems of
controls and risk assessments. Second, from a systemic point of view, inter-
relationships between activities of financial intermediaries and areas of
conflict of interests need to be considered. Third, in order to protect the
integrity of the financial system by reducing the likelihood of their becoming
conduits for money laundering, terrorist financing and other unlawful activities
and also to ensure audit trail, greater accent needs to be laid on the adoption
of an effective consolidated know your customer (KYC) system, on both assets
and liabilities, in all financial intermediaries regulated by RBI. At the same
time, it is essential that banks do not seek intrusive details from their customers
and do not resort to sharing of information regarding the customer except with
the written consent of the customer. Fourth, while the stability and efficiency
imparted to the large commercial banking system is universally recognised,
there are some segments which warrant restructuring."
The annual policy statement for the current year reiterates the concern for common person, while
enunciating a medium term framework, for development of money, foreign exchange and
government securities markets; for enhancing credit flow to agriculture and small industry; for
action points in technology and payments systems; for institutional reform in co-operative
banking, non-banking financial companies and regional rural banks; and, for ensuring
availability of quality services to all sections of the population. The most distinguishing feature
of the policy statement relates to the availability of banking services to the common person,
especially depositors.
The statement reiterates that depositors’ interests form the focal point of the regulatory
framework for banking in India, and elaborates the theme as follows:
“A licence to do banking business provides the entity, the ability to accept
deposits and access to deposit insurance for small depositors. Similarly,
regulation and supervision by RBI enables these entities to access funds from a
wider investor base and the payment and settlement systems provides efficient
payments and funds transfer services. All these services, which are in the
nature of public good, involve significant costs and are being made available

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 only to ensure availability of banking and payment services to the entire
population without discrimination”.
The policy draws attention to the divergence in treatment of depositors compared to borrowers
as:
“ … while policies relating to credit allocation, credit pricing and credit
restructuring should continue to receive attention, it is inappropriate to ignore
the mandate relating to depositors’ interests. Further, in our country, the
socio-economic profile for a typical depositor who seeks safe avenues for his
savings deserves special attention relative to other stakeholders in the banks”.
Another significant area of concern has been the possible exclusion of a large section of
population from the provision of services and the Statement pleads for financial inclusion. It
states:
“There has been expansion, greater competition and diversification of
ownership of banks leading to both enhanced efficiency and systemic resilience
in the banking sector. However, there are legitimate concerns in regard to the
banking practices that tend to exclude rather than attract vast sections of
population, in particular pensioners, self-employed and those employed in
unorganised sector. While commercial considerations are no doubt important,
the banks have been bestowed with several privileges, especially of seeking
public deposits on a highly leveraged basis, and consequently they should be
obliged to provide banking services to all segments of the population, on
equitable basis.”
Operationally, it has been made clear that RBI will implement policies to encourage banks which
provide extensive services while disincentivising those which are not responsive to the banking
needs of the community, including the underprivileged.
The quality of services rendered has also invited attention in the current policy.
“Liberalisation and enhanced competition accord immense benefits, but
experience has shown that consumers’ interests are not necessarily accorded
full protection and their grievances are not properly attended to. Several
representations are being received in regard to recent trends of levying
unreasonably high service/user charges and enhancement of user charges
without proper and prior intimation. Taking account of all these
considerations, it has been decided by RBI to set up an independent Banking
Codes and Standards Board of India on the model of the mechanism in the UK
in order to ensure that comprehensive code of conduct for fair treatment of
customers are evolved and adhered to”.
It is essential to recognize that, while these constitute contextual nuanced responses to changing
circumstances within the country, the overwhelming compulsion to be in harmony with global
developments must be respected and that essentially relates to Basel II.
Basel II and India
RBI’s association with the Basel Committee on Banking Supervision dates back to 1997 as India
was among the 16 non-member countries that were consulted in the drafting of the Basel Core
Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in
1998 and subsequently became a member of the Core Principles Working Group on Capital.
Within the Working Group, RBI has been actively participating in the deliberations on the New
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Accord and had the privilege to lead a group of six major non-G-10 supervisors which presented
a proposal on a simplified approach for Basel II to the Committee.
Commercial banks in India will start implementing Basel II with effect from March 31,
2007. They will adopt Standardised Approach for credit risk and Basic Indicator Approach for
operational risk, initially. After adequate skills are developed, both at the banks and also at
supervisory levels, some banks may be allowed to migrate to the Internal Rating Based (IRB)
Approach.
The RBI had announced in its annual policy statement in May 2004 that banks in India
should examine in depth the options available under Basel II and draw a road-map by end-
December 2004 for migration to Basel II and review the progress made at quarterly intervals.
The Reserve Bank organized a two-day seminar in July 2004 mainly to sensitise the Chief
Executive Officers of banks to the opportunities and challenges emerging from the Basel II
norms. Soon thereafter all banks were advised in August 2004 to undertake a self-assessment of
the various risk management systems in place, with specific reference to the three major risks
covered under the Basel II and initiate necessary remedial measures to update the systems to
match up to the minimum standards prescribed under the New Framework. Banks have also been
advised to formulate and operationalize the Capital Adequacy Assessment Process (CAAP)
within the banks as required under Pillar II of the New Framework.
It is appropriate to list some of the other regulatory initiatives taken by the Reserve Bank of
India, relevant for Basel II. First, we have tried to ensure that the banks have suitable risk
management framework oriented towards their requirements dictated by the size and complexity
of business, risk philosophy, market perceptions and the expected level of capital. Second, Risk
Based Supervision (RBS) in 23 banks has been introduced on a pilot basis. Third, we have been
encouraging banks to formalize their capital adequacy assessment process (CAAP) in alignment
with their business plan and performance budgeting system. This, together with the adoption of
RBS would aid in factoring the Pillar II requirements under Basel II. Fourth, we have been
expanding the area of disclosures (Pillar III), so as to have greater transparency in the financial
position and risk profile of banks. Finally, we have tried to build capacity for ensuring the
regulator’s ability for identifying and permitting eligible banks to adopt IRB / Advanced
Measurement approaches.
As per normal practice, and with a view to ensuring migration to Basel II in a non-disruptive
manner, a consultative and participative approach has been adopted for both designing and
implementing Basel II. A Steering Committee comprising senior officials from 14 banks (public,
private and foreign) has been constituted wherein representation from the Indian Banks’
Association and the RBI has also been ensured. The Steering Committee had formed sub-groups
to address specific issues. On the basis of recommendations of the Steering Committee, draft
guidelines to the banks on implementation of the New Capital Adequacy Framework have been
issued.
Implementation of Basel II will require more capital for banks in India due to the fact that
operational risk is not captured under Basel I, and the capital charge for market risk was not
prescribed until recently. Though last year has not been a very good year for banks, they are
exploring all avenues for meeting the capital requirements under Basel II. The cushion available
in the system, which has a CRAR of over 12 per cent now, is, however, comforting.
India has four rating agencies of which three are owned partly/wholly by international rating
agencies. Compared to developing countries, the extent of rating penetration has been increasing
every year and a large number of capital issues of companies has been rated. However, since

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rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I
standards for credit risks in respect of non-retail exposures. While Basel II provides some scope
to extend the rating of issues to issuers, this would only be an approximation and it would be
necessary for the system to move to rating of issuers. Encouraging rating of issuers would be
essential in this regard. In this context, current non-availability of acceptable and qualitative
historical data relevant to ratings, along with the related costs involved in building up and
maintaining the requisite database, does influence the pace of migration to the advanced
approaches available under Basel II.
Above all, capacity building, both in banks and the regulatory bodies is a serious challenge,
especially with regard to adoption of the advanced approaches. We in India have initiated
supervisory capacity-building measures to identify the gaps and to assess as well as quantify the
extent of additional capital which may be required to be maintained by such banks. The
magnitude of this task, which is scheduled to be completed by December 2006, appears daunting
since we have as many as 90 scheduled commercial banks in India.
In the current scenario, banks are constantly pushing the frontiers of risk management.
Compulsions arising out of increasing competition, as well as agency problems between
management, owners and other stakeholders are inducing banks to look at newer avenues to
augment revenues, while trimming costs. Consolidation, competition and risk management are
no doubt critical to the future of banking but I believe that governance and financial inclusion
would also emerge as the key issues for a country like India, at this stage of socio-economic
development.
Self-Assessment Questions:
Question 1: Discuss the main provisions of Banking Regulation Act, 1949?
Question 2: State the various statutory provisions of Reserve Bank of India Act 1934.
Question 3: Specify the various challenges faced by the Indian Banking system.
Question 4: What do you mean by NPA? What are the causes that an account turned as NPA?
State the Indian banks conditions in respect of NPAs.
Question 5: Specify the banking sector reforms taken place in India and discuss the effectiveness
of the same also.
Question 6: Explain the need for regulations of banking sector in India. Briefly discuss the
important reforms which have taken place in this sector.
Suggested Readings:
• Sundhram, K.P.M., Banking Theory Law and Practice, Sultan Chand & Co. Ltd., New
Delhi.
• Desai, Vasant, Banking and Financial System, Himalaya Publishing House, New Delhi
• Bihari, S.C. and Baral S.K., Modern Banking Management, Skylark Publications, New
Delhi.
• Suresh, Padmalatha and Paul, Justin, Management of Banking and Financial Services,
Pearson Publications, New Delhi.

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581126 Neha Maggon 2008

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