INDIAN BANKING

&
FINANCIAL SYSTEM

(FOR PRIVATE CIRCULATION ONLY)

2023
PROGRAMME COORDINATOR
Prof. Prashant Ubarhande

COURSE DESIGN AND REVIEW COMMITTEE

Prof. Avinash Nene Prof. Abhinav D. Jog
Dr. N.M. Vechlekar Prof. Dalip Mehra
Dr. Ravi Chitnis Prof. Sudhir Gijre
Dr. Bhama Venkataramani Prof. Arun Vartak
Dr. Deepa Gupta Dr. Dipti Kalkotwar

COURSE WRITER
Prof. Abhinav D Jog

EDITOR
Mr. Yogesh Bhosle

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

July, 2011 (Revision 05, 2023)

Copyright © 2023 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.

Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
 PREFACE

I am glad to write this SLM on “Indian Banking and Financial System” for students of SCDL.
Banking, Financial Services and Insurance (BFSI) sector is an important part of India’s growth story.
The business of banking is undergoing rapid changes and banks are expanding their activities into
new areas. Professionals joining the BFSI sector need to have strong domain knowledge to achieve
success in their career.

This SLM has been designed to meet the specific needs of students aspiring to work in the BFSI sector.
The entire range of banking topics and concepts has been covered in detail with suitable examples
for ease of understanding. It has been my endeavour to explain concepts and processes in a simple
language. I have used my industry exposure to make the content of the book relevant for practitioners,
both present and prospective.

It is my sincere hope that this SLM will be interesting and useful and will help students to understand
the various facets of banking and empower them with the requisite knowledge to pursue a career in
the BFSI sector. I take this opportunity to sincerely extend my thanks to the SCDL staff for giving me
an opportunity to write this book.

I would like to dedicate this book to my late parents, Prof (Dr) Dattatreya V. Jog and Mrs. Pournima
D. Jog who have been a source of inspiration for me to write this book. A special word of thanks also
to my wife, Sumita and my daughter, Avanti, for their support. I would welcome suggestions and
feedback from readers.

Prof. Abhinav D. Jog

iii
 ABOUT THE AUTHOR

Prof. Abhinav D. Jog has a fine blend of industry exposure and teaching experience. He has worked
for 25 years in the country’s premier bank - State Bank of India. He held the post of Assistant General
Manager until he quit the bank to pursue his passion for teaching.
During his tenure at the bank, he was selected for a foreign assignment and was posted at the bank’s
Osaka Branch in Japan for three years. He acquired expertise in International Banking during his stint
abroad. He has worked at two Industrial Finance Branches of the Bank in Pune. He also headed three
large-sized branches at rural, semi-urban and metro locations. He has wide exposure in the areas of
retail banking, international banking, SME and corporate finance and stressed assets management.
In 2007, he entered the education industry and joined Institute of Finance Banking and Insurance
(IFBI), a joint venture between ICICI Bank and NIIT as a Senior Faculty and performed the role of
a trainer as well as a mentor to groom students to become industry-ready professionals. He is now
working as an Associate Professor at Indira School of Business Studies, Pune.
He has rich teaching experience in all subjects of Banking and Insurance. His teaching strategy is to
impart industry-relevant education to students in a simple and lucid manner.

iv
 CONTENTS

Unit No. TITLE Page No.

1 Indian Financial System - An Overview 1-16
1.1 Introduction
1.2 Financial System - Meaning and its Components
1.3 Financial Markets
1.4 Financial Institutions
1.5 Financial Instruments
1.6 Regulatory Bodies
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Overview of Banking and Structure of Banking in India 17-32
2.1 Introduction
2.2 How did Banking Start
2.3 Banking in India
2.4 Structure of Banking Institutions
2.5 Changing Role of Development Finance Institutions (DFIs)
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
3 Role and Functions of Reserve Bank of India 33-48
3.1 Introduction
3.2 Need for Regulation of the Financial/Banking System
3.3 Constitution of RBI and its Objectives
3.4 Evolving Role of RBI
3.5 Main Functions of RBI
3.6 Instruments of Monetary Management
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

v
 Unit No. TITLE Page No.
4 Banks in India - Role and Functions 49-70
4.1 Introduction
4.2 Definition of Banking
4.3 Banking - A Business of Trust
4.4 Main Functions of Banks
4.5 Ancillary Services
4.6 Safe-Keeping
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
5 Changing Role of Banks 71-90
5.1 Introduction
5.2 The Changing Market Environment
5.3 Product Diversification and Innovative Services
5.4 Use of Technology to Improve Operational Efficiency and Increase
Customer Satisfaction
5.5 Centralization of Operations
5.6 Dynamic Queue Management (DQM)
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
6 Banker - Customer Relationship 91-118
6.1 Introduction
6.2 Definition of a Customer
6.3 Banker - Customer Relationship
6.4 Bankers’ Rights
6.5 Obligations of a Banker
6.6 Order
6.7 Obligation to Maintain Secrecy of Account
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
7 Types of Customers and Mode of Operation 119-136
7.1 Introduction
7.2 Accounts of Individuals
7.3 Corporate Customers
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
vi
Unit No. TITLE Page No.
8 Negotiable Instruments 137-154
8.1 Introduction
8.2 Definition of a Negotiable Instrument
8.3 Promissory Note
8.4 Bills of Exchange
8.5 Cheques
8.6 Legal Provisions regarding Protection to the Paying Banker
8.7 Legal Provisions regarding Protection to the Collecting Banker
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
9 Retail Banking Products - Deposits 155-170
9.1 Introduction
9.2 Retail Banking
9.3 Deposit Accounts
9.4 2-in-1 Accounts
9.5 Deposit Schemes for Non-Resident Indians
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
10 Retail Banking Products - Loan 171-184
10.1 Introduction
10.2 The Retail Boom
10.3 Features of Retail Loans
10.4 Stages in Retail Loan Process
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
11 Foreign Exchange Business of Banks 185-196
11.1 Introduction
11.2 Understanding the Concept of Foreign Exchange
11.3 Nostro Accounts and Vostro Accounts
11.4 The Concept of ‘Buy Low, Sell High’
11.5 Cover Operations
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
vii
 Unit No. TITLE Page No.
12 Insurance 192-210
12.1 Introduction
12.2 Evolution of Insurance Business in India
12.3 Meaning and Need for Insurance
12.4 Functions of Insurance
12.5 Life Insurance Products
12.6 General Insurance Products
12.7 Insurance Intermediaries
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
13 Mutual Funds 211-224
13.1 Introduction
13.2 Concept of a Mutual Fund
13.3 Evolution of Mutual Funds in India
13.4 Benefits of Investing in Mutual Funds
13.5 Types of Mutual Funds
13.6 Schemes of Mutual Funds
13.7 Distribution of Mutual Funds by Banks
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
14 Recent Trends in Banking Regulation 225-243
14.1 Introduction
14.2 Basel II Accord on Capital Adequacy
14.3 Banking Ombudsman Scheme
14.4 Corporate Governance
14.5 Anti-Money Laundering Guidelines
14.6 Know Your Customer (KYC) Guidelines
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
References 244

viii
Indian Financial System - An Overview
UNIT

1
Structure:
1.1 Introduction
1.2 Financial System - Meaning and its Components
1.3 Financial Markets
1.4 Financial Institutions
1.5 Financial Instruments
1.6 Regulatory Bodies
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Indian Financial System - An Overview 1

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Explain the meaning of financial systems
----------------------
• Analyse the structure and components of the Indian financial system
----------------------
• Describe the role and function of regulatory bodies
----------------------

---------------------- 1.1 INTRODUCTION

----------------------
A sound financial system is essential for the economic development of a
---------------------- country. The financial system comprises all those channels through which savings
become available for investment. The financial system consists of financial
---------------------- markets, financial institutions and financial instruments. In this unit, we shall
have an overview of the financial system and its components.
----------------------

---------------------- 1.2 FINANCIAL SYSTEM - MEANING AND ITS COMPONENTS

---------------------- A financial system in an economy plays a vital role in mobilising and
allocating finance and managing risks associated with financing. The primary
---------------------- function of a financial system is mobilization of savings of the community and
---------------------- effective deployment of those savings in the most productive sectors of the
economy. It provides cost-efficient linkage between the savers and the investors.
---------------------- It therefore, stimulates capital formation and accelerates economic growth.
---------------------- A vibrant financial system provides incentives for savings and attracts funds
of savers towards financial assets or instruments and induces them to hold fewer
---------------------- savings in physical assets such as gold or real estate. The funds thus mobilized
are channelized into productive sectors. This provides a boost to entrepreneurial
----------------------
activities and investments increase ultimately resulting in higher capital formation
---------------------- and economic growth. The economic development of any country, therefore,
depends upon the existence of a sound and well-organized financial system.
----------------------
The financial system comprises three inter-related components:
----------------------  financial markets
----------------------  financial institutions and

----------------------  financial assets or instruments

----------------------

----------------------

----------------------

----------------------

2 Indian Banking & Financial System

 Notes
Check your Progress 1
----------------------
Fill in the blanks. ----------------------
1. The primary function of the financial system is _______ of _________
----------------------
of the community and its deployment.
2. The financial system stimulates __________ and accelerates __________. ----------------------
3. Th1e three important components of financial system are __________, ----------------------
___________ and ___________.
----------------------

----------------------
Activity 1
----------------------

List out the important channels through which savings are available for ----------------------
investment.
----------------------

----------------------
1.3 FINANCIAL MARKETS
----------------------
The place where the transformation of savings into investment takes place
is called a financial market. It is a market in which savers and borrowers, both ----------------------
individual and institutional, come together and financial instruments are traded.
----------------------
The term financial market does not have a physical connotation. All financial
markets are virtual entities in the sense that they do not have any physical location ----------------------
or boundaries. They are a facilitating organization acting as a link between savers
and investors and providing a wide range of institutional facilities. ----------------------
The financial market comprises the organized sector and the unorganized ----------------------
sector. The unorganized sector has a notable presence in developing countries like
India and its operations are largely outside the control of market regulators, such ----------------------
as the central banking authority. The organized market, on the other hand, is well- ----------------------
regulated and its functions and operations are supervised by a market regulator.
In India, the players in the unorganized sector of the financial system ----------------------
include money lenders, chit funds, nidhis and indigenous bankers. Since ancient ----------------------
times, money lenders have been exploiting the poor, particularly in rural areas
by charging usurious rates of interest. Reserve Bank of India (RBI) has made ----------------------
efforts in the past to curb the unfair practices of money lenders but it has had
limited effect. However, some initiatives taken by RBI and the Government such ----------------------
as spread of banking facilities in rural areas and rural education together with ----------------------
the emphasis on financial inclusion hold promise of reducing the influence of
the unorganized sector. ----------------------
The formation of Government –aided and Non Government Organizations ----------------------
(NGO) –sponsored Self –Help Groups (SHGs) in various parts of the country
have also contributed to the reduced reliance of the rural poor on money lenders. ----------------------

Indian Financial System - An Overview 3

 Notes The main participants in the financial market include commercial banks,
financial institutions-domestic as well as foreign- stock exchanges, borrowers,
---------------------- lenders, savers, brokers, dealers and regulatory organizations.
---------------------- The functions of financial markets are as under:

---------------------- 1. Providing easy access of funds to borrowers to carry out their investment
activities
----------------------
2. Providing an opportunity to savers to invest in financial assets and securities
---------------------- in a well-regulated environment.

---------------------- 3. Providing liquidity through trading in various financial securities.

Types of financial market or division of financial market.
----------------------
A. Capital Market is a market for long term funds. It deals in medium and long
---------------------- term securities. It is a market for issuing and trading in equity and preference
---------------------- shares and medium and long term debt instruments such as bonds. Medium
term means tenure of above one year and up to three years. A period above
---------------------- three years is considered to be long-term. The maturity period of financial
securities in this market is above one year. The main purpose of the capital
---------------------- market is to channelize savings into long term capital. The capital market
---------------------- is the most active and largest segment of the financial system as almost all
participants of the financial system are active in this market.
----------------------
The capital market has three components:
---------------------- a) Equity Market which is a market for trading of shares of listed public
---------------------- limited companies.
b) Debt Market is a market in which the Central Government, State
----------------------
Governments, Public Sector and Private Sector Companies and
---------------------- Financial Institutions raise long term loans by issuing debt securities
such as debentures and bonds.
----------------------
c) Derivatives Market is a market in which derivative instruments such
---------------------- as futures and options are traded.

---------------------- Both the equity and debt markets have two segments –primary market and
secondary market.
----------------------
The primary market, also referred to as New Issue Market (NIM), enables
---------------------- the issuers of securities, mainly Government and the corporates, to raise
funds through new issue of equity and debt securities which are offered
---------------------- directly to investors, both individual and institutional. The primary market
performs the function of facilitating the transfer of resources from savers to
----------------------
entrepreneurs. This is also referred to as the function of origination. The new
---------------------- issues of securities are made in the form of initial public offerings (IPOs),
rights issues or private placements. The transactions in the primary market
---------------------- are made directly between issuers of capital and investors. The players in
the primary market include merchant bankers, registrars, underwriters and
----------------------
collecting bankers.

4 Indian Banking & Financial System

 The secondary market is a market in which the existing securities are Notes
traded between investors. The issuer of securities is not involved in these
transactions. The secondary market is represented by stock exchanges ----------------------
(SEs). The SEs provide an organized market place for the investors to
trade in securities. Initially, buyers and sellers had to meet to put through ----------------------
their transactions. After the advent of the internet, buyers and sellers no ----------------------
longer need to meet and transactions are effected in the virtual world. Stock
markets are the agencies that facilitate these transactions. The main function ----------------------
of the stock markets therefore is to provide liquidity through marketability
of existing securities. It also provides a platform for price discovery of ----------------------
securities. ----------------------
The primary and secondary markets are inter-linked. The secondary market
----------------------
exists only to facilitate trading in securities issued in the primary market. On
the other hand, investors participate in the primary market by subscribing ----------------------
to new issue of securities only because there is an exit option available for
them in the secondary market. ----------------------
Stock Exchanges in India ----------------------
There are 23 stock exchanges in India. Almost all these exchanges are
----------------------
constituted as companies under Companies Act.
BSE was established in 1875 and is the oldest stock exchange in Asia. ----------------------
Initially, it was constituted as an Association of Persons (AOP). In 2005, ----------------------
it was changed into a corporate entity and renamed as Bombay Stock
Exchange Ltd. BSE, which introduced securities trading in India, initially ----------------------
had open outcry system of trading. This was replaced in 1995 with the
totally automated trading through the BSE Online trading (BOLT) system. ----------------------
The BSE SENSEX is a popular stock market index and comprises 30 ----------------------
stocks.
In 1991, Pherwani Committee recommended the setting up of a National ----------------------
Stock Exchange. Accordingly, NSE was incorporated in 1992 by banks and ----------------------
financial institutions. It provides a nationwide trading facility for equities,
debt and hybrids. It is a ring less national computerized exchange. The ----------------------
Exchange provides trading in 4 different segments viz., Wholesale Debt
Market (WDM) segment, Capital Market (CM) segment, Futures & Options ----------------------
(F&O) segment and the Currency Derivatives Segment (CDS). ----------------------
S&P CNX Nifty is a well diversified 50 stock index accounting for 23
sectors of the economy. It is owned and managed by India Index Services ----------------------
and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. ----------------------
B. Money Market is a market in which funds are borrowed and lent for short
----------------------
term, i.e. a period not exceeding one year. It is a market for short-term
funds and financial assets that are close substitutes for money, i.e. which ----------------------
can be quickly converted into money. The major organizations participating
in the money market are RBI, Government, banks and development ----------------------
financial institutions and public and private sector undertakings. RBI
----------------------
plays a pivotal role and varies the liquidity available in the market through

Indian Financial System - An Overview 5

 Notes various instruments and thus influences the availability and cost of credit.
Banks borrow from the money market to meet sudden demand for funds in
---------------------- their business operations and also to raise funds to comply with statutory
requirements. The money market has some inter-related sub-segments such
---------------------- as call and short notice market, treasury bills market, commercial bills
---------------------- market, commercial paper (CP) market, certificate of deposits (CD) market
and repo market.
----------------------

---------------------- Check your Progress 2

----------------------
State True or False.
----------------------
1. The place where transformation of savings into investment takes
---------------------- place is known as “exchangemarket”.

---------------------- 2. The word financial market does not have a physical connotation.
3. Financial market comprises of only organised sector of the economy.
----------------------

----------------------
Activity 2
----------------------

---------------------- Visit the web site www.nseindia.com and prepare a short note on various
instruments used in derivatives market.
----------------------

----------------------
1.4 FINANCIAL INSTITUTIONS
----------------------
Financial institutions include regulatory bodies, intermediaries and non-
---------------------- intermediaries. Regulatory bodies comprise Reserve Bank of India (RBI),
Securities and Exchange Board of India (SEBI), Insurance Regulatory
---------------------- Development Authority (IRDA). Non-intermediaries engage in the activity of
---------------------- granting loans but they do not raise funds from savers.
Financial intermediaries perform the function of mobilizing funds from
----------------------
savers and lending them to entrepreneurs. The function of financial intermediation
---------------------- is performed by four major institutional players, namely:
1. Banking Institutions
----------------------
2. Non-banking Institutions
---------------------- 3. Mutual Fund Institutions
---------------------- 4. Insurance Companies
Banking Institutions accept deposits from the public for the purpose of
----------------------
lending and investment. In India, banking institutions comprise commercial
---------------------- banks, co-operative banks and regional rural banks (RRBs). Core financial
services provided by financial intermediaries include payments and liquidity,
---------------------- store of value, information processing and pooling of risks. Banks have

6 Indian Banking & Financial System

traditionally provided most of these services and are increasingly diversifying Notes
into other areas.
----------------------
Non-banking financial institutions (NBFIs), unlike banking institutions, do
not participate in the payment system, i.e. they do not provide transaction services. ----------------------
Moreover, unlike banking institutions, they do not accept deposits from savers.
NBFIs include All-India financial institutions (AIFIs) which were created for ----------------------
long-term financing with some of them having sectoral/regional focus. These
----------------------
include Industrial Finance Corporation of India (IFCI), Industrial Investment
Bank of India and Small Industries Development Bank (SIDBI). ----------------------
Another category of NBFIs are Primary dealers (PDs), which play an
----------------------
important role in both the primary and secondary Government securities market.
PDs act as underwriters in the primary debt markets and as market makers in ----------------------
the secondary debt markets. As of April 2020, there are 21 Primary Dealers in
Government Securities Market. These include eight standalone PDs including ----------------------
SBI DFHI Ltd, STCI Primary Dealer Limited, PNB Gilts Ltd and others. In
----------------------
addition, twelve banks have been permitted to function as PDs.
Apart from these NBFIs, there are some privately owned financial institutions ----------------------
which accept fixed deposits from the public and engage in specialized lending
----------------------
activities. These companies are called Non-Banking Finance Companies
(NBFCs). Although their activities are similar to banks, there are two main ----------------------
differences:
----------------------
1. NBFCs cannot accept demand deposits and
2. They do not participate in the payment and settlement system. ----------------------

NBFCs have broadened and diversified the range of products and services ----------------------
offered by the financial sector. They are regarded as being complementary to the
banking sector due to their customer-oriented services; simplified procedures; ----------------------
attractive rates of return on deposits; flexibility and timeliness in meeting the ----------------------
credit needs of specified sectors.
----------------------
All NBFCs are required to be registered with RBI. NBFCs are classified into
three categories: ----------------------
 Asset Finance Company (AFC)
----------------------
 Investment Company (IC)
----------------------
 Loan Company (LC)
Mutual Funds pool resources of a large number of individual investors and ----------------------
invest the funds collected in capital and money market instruments. Insurance ----------------------
refers to pooling of risks and sharing of cost within a particular group. Insurance
companies offer protection against risks and collect premium from a large ----------------------
pool insured persons. These funds are then invested mainly into capital market
instruments. Both mutual fund and insurance companies perform the function ----------------------
of intermediation. The difference between these organizations and banks is that ----------------------
while banks accept deposits from savers, these organizations mobilize public
savings for rendering other financial services including investment. ----------------------

Indian Financial System - An Overview 7

 Notes
Check your Progress 3
----------------------

---------------------- Fill in the blanks.

---------------------- 1. The function of financial intermediation is done by i) ___________

ii) ___________ iii) ___________ iv) ___________.
---------------------- 2. The two important aspects that differentiate a NBFC from a banking
---------------------- company are___________ and ___________.
3. NBFCs are classified in to three main categories: ___________,
----------------------
___________ and ___________.
----------------------

----------------------
Activity 3
----------------------
Visit www.nbfc.net.in/significance and list out five top NBFCs in India and
----------------------
the servicesprovided by them.
----------------------

---------------------- 1.5 FINANCIAL INSTRUMENTS

---------------------- A financial asset or instrument or security is a claim on a stream of income
---------------------- and/or asset of another economic unit and is held as a store of value and for
expected returns. Financial instruments are classified into marketable securities
---------------------- and non-marketable securities. Equity shares, bonds, debentures and derivative
instruments are examples of marketable instruments. Non-marketable financial
---------------------- instruments include bank, company and post office deposits, insurance policies
---------------------- and public provident fund accounts.
A. Capital Market Instruments:
----------------------
As we have seen earlier, Capital Market is a market for raising and lending
---------------------- long-term funds. Long term capital can be raised in the form of equity,
which is ownership capital or in the form of debt, which represents borrowed
----------------------
capital. This process is done through various capital market instruments,
---------------------- some of which are as under:
1. Equity Shares
----------------------
Equity capital represents ownership capital. It is the permanent capital
---------------------- of the company and is only returned in the event of winding up of
the company. The equity capital of a company is the capital raised
----------------------
through issuance of shares, which is referred to as equity shares or
---------------------- ordinary shares. Equity shareholders are collectively the owners of the
company. They bear the risk and enjoy the rewards of ownership. Equity
---------------------- shareholders earn dividend on their shares which depends upon the
earnings of the company. They enjoy voting rights and can participate
----------------------
in the management of the company.
8 Indian Banking & Financial System
 2. Preference Shares Notes
Preference shareholders enjoy preferential treatment over equity
----------------------
shareholders in the matter of payment of dividend and repayment of
capital. In other words, out of the profits of the company, dividend is ----------------------
paid to the preference shareholders first and only thereafter, dividend
is paid to equity shareholders. Similarly, in the event of liquidation of ----------------------
a company, the money raised through the sale of the company’s assets
----------------------
is first used to pay off its creditors and lenders, then to the preference
shareholders and finally to the equity shareholders. These shareholders ----------------------
usually do not enjoy voting rights. They are entitled to dividend at a
fixed rate. However, preference shares are not popular among investors ----------------------
because while the returns are limited or fixed, the risk is high. Preference
----------------------
shares can be convertible or non-convertible, cumulative or non-
cumulative and redeemable and irredeemable preference shares. ----------------------
3. Debentures
----------------------
A debenture is a certificate of indebtedness. A debenture is defined as
a certificate of agreement of loans which is given under the company’s ----------------------
seal and carries an undertaking that the debenture holder will get a fixed
----------------------
return and the principal amount whenever the debenture matures. Interest
at a fixed rate is usually paid half-yearly and the principal amount is ----------------------
repayable on a fixed date on redemption of the debentures. Debenture-
holders normally have a charge on the assets of the company, such as ----------------------
land and building, and are therefore, secured creditors. Debentures are
----------------------
assigned a credit rating by rating agencies.
4. Bonds ----------------------
A bond is a negotiable certificate evidencing indebtedness. It is normally ----------------------
unsecured. A bond security is normally issued by Government, Financial
Institutions, municipal corporations and companies. Bonds are usually ----------------------
issued as interest-bearing securities in which the issuer of the bond
----------------------
pays the bond-holder periodic interest over the tenure of the bond.
Some bonds are also issued as zero coupon bonds which are issued ----------------------
at a discount and repaid at a face value. There is no regular payment
of interest. The difference between the issue price and the redemption ----------------------
price represents the return to the bond-holder.
----------------------
5. Company Fixed Deposits
----------------------
Companies are also allowed to raise funds through fixed deposits. This is
an attractive source of raising working capital finance for companies as ----------------------
they are not required to commit any assets as security while mobilizing
fixed deposits. Company fixed deposits carry a rating given by agencies. ----------------------
B. Money Market Instruments ----------------------
1. Commercial Paper- These are unsecured, negotiable money market ----------------------
instruments issued by highly rated corporate borrowers to diversify
their sources of short-term borrowings beyond working capital limits ----------------------

Indian Financial System - An Overview 9

 Notes sanctioned to them by banks. CPs are preferred by financially strong
companies who are able to raise funds at lower rates by eliminating the
---------------------- intermediation of banks. They are issued at a discount and redeemed
at par. Primary Dealers (PDs) and Financial Institutions (FIs) are also
---------------------- permitted to issue CPs.
---------------------- 2. Certificate of Deposits- CD is a negotiable money market instrument
issued by scheduled commercial banks and financial institutions to
---------------------- mobilize large value deposits. CDs differ from conventional bank fixed
---------------------- deposits in respect of free negotiability and marketability. CDs are also
issued for a fixed period and carry a specified rate of interest. However,
---------------------- unlike FDs, they are marketable. This feature of marketability makes
CDs attractive for investors who need not break the deposit prematurely
---------------------- but can instead sell CDs in the market before maturity and get liquidity.
---------------------- Banks which do not have large branch networks, particularly foreign
and private sector banks use this instrument to raise funds.
---------------------- 3. Treasury Bills - A treasury bill is an instrument of short-term borrowing
---------------------- by the Government of India. T-bills are negotiable money market
instruments issued by RBI on behalf of the Central Government
---------------------- through auctions. They are issued at a discount to the face value and
are redeemed at par on maturity. The difference between the price at
---------------------- which they are sold and their redemption value is the effective return
---------------------- on T-bills. They have tenures of 91-days, 182-days and 364 days.

----------------------
Check your Progress 4
----------------------
Multiple Choice Single Response
----------------------
1. Financial instruments are:
----------------------
i. Marketable securities
---------------------- ii. Non- marketable securities
---------------------- iii. Gold in Bullion form
iv. i & ii
----------------------
v. All of these
---------------------- 2. Capital market instruments are:
---------------------- i. Equity shares
---------------------- ii. Preference shares
iii. Debentures
----------------------
iv. Bonds
---------------------- v. Company deposits
---------------------- vi. Commercial paper
vii. i to v
----------------------

10 Indian Banking & Financial System

 Notes
3. Commercial papers are issued by
i. Highly rated corporate ----------------------

ii. Partnership firms ----------------------

iii. Both I & ii ----------------------

----------------------
Activity 4 ----------------------

Visit www.irda.gov.inand study the steps initiated by IRDA for protecting ----------------------
investors’ interest. ----------------------

----------------------
1.6 REGULATORY BODIES
----------------------
The three main regulators in the Indian Financial System are:
----------------------
A. Reserve Bank of India (RBI) - the central banking authority
----------------------
B. Securities Exchange Board of India (SEBI) - the capital market regulatory
authority and ----------------------
C. Insurance Regulatory and Development Authority (IRDA) - the insurance ----------------------
regulator
----------------------
A. Reserve Bank of India
RBI is the nerve centre of the financial system and the main regulator of the ----------------------
banking system. The main functions of RBI are as under: ----------------------
1. To maintain monetary stability
----------------------
2. To maintain financial stability and ensure soundness of financial
institutions ----------------------
3. To maintain stable payment systems ----------------------
4. To promote the development of the financial infrastructure ----------------------
5. To ensure that credit allocation by the financial system is in accordance
----------------------
with national economic priorities
6. To regulate the overall volume of money and credit in the economy, ----------------------
with a view to ensure a reasonable degree of price stability.
----------------------
The roles performed by RBI are briefly mentioned below:
----------------------
 Note issuing authority
----------------------
 Banker to the Government
 Bankers’ bank ----------------------
 Supervisory authority ----------------------

Indian Financial System - An Overview 11

 Notes  Exchange control authority
 Promoter of the financial system
----------------------
 Regulator of money and credit
----------------------
The role and functions of RBI would be examined in detail in subsequent units.
---------------------- B. Securities and Exchange Board of India
---------------------- SEBI was set up in 1992 to serve as a watchdog and controller over the
institutions and intermediaries associated with capital market.
----------------------
Its objectives are primarily two-fold:
---------------------- i. To protect the interest of investors
---------------------- ii. To promote the development of and to regulate the securities market

---------------------- The functions performed by SEBI are as under:

1. Promotional role
----------------------
a. Promoting the development and regulate the securities market
---------------------- b. Promoting and regulating self regulatory organizations (SROs)
---------------------- c. Promoting investor education and training of intermediaries of
securities markets
----------------------
d. Conducting Research
----------------------
2. Registration role
---------------------- a. Registering and regulating various players associated with
securities markets
----------------------
b. Registering and regulating the working of depositories, depository
---------------------- participants, Foreign Institutional Investors (FIIs) and credit rating
agencies
----------------------
c. Registering and regulating the working of venture capital funds
---------------------- and collective investment schemes, including MFs
---------------------- 3. Regulatory role
a. Regulate business of SE/MF
----------------------
b. Regulate substantial acquisition of shares and take- over of
---------------------- companies
---------------------- c. Issue directives for orderly development of securities market and
orderly conduct of intermediaries
----------------------
d. Specify listing and transfer of securities
---------------------- 4. Control role
---------------------- a. Prohibit fraudulent and unfair practice

---------------------- b. Prohibit insider trading

c. Call for information from banks, other authority or board / corporation
---------------------- constituted by / under any Central / State or Provincial Act.

12 Indian Banking & Financial System

 d. In the interest of investor may restrain any person from accessing Notes
security market, suspend trading in Stock Exchange
----------------------
e. Cause investigation to be conducted if there is a violation of rules
& regulations ----------------------
C. Insurance Regulatory and Development Authority
----------------------
The insurance sector was opened up to the private sector in the late nineties
on the basis of the recommendations of Malhotra Committee. A need was felt ----------------------
to have a strong, independent and autonomous insurance regulatory authority. ----------------------
Accordingly, a statutory body named Insurance Regulatory Authority was
set up in 1996. In 1999 IRDA Act was passed and this body was renamed ----------------------
as Insurance Regulatory and Development Authority.
----------------------
The objectives of IRDA are as under:
----------------------
a) To protect the investor’s interest
b) To promote orderly growth of insurance industry in the country, ----------------------
including registration of insurance companies
----------------------
c) To administer the provisions of Insurance Acts
----------------------
d) To devise control activities needed for smooth functioning of the
insurance companies ----------------------
e) To lay down the accounting methodology and ----------------------
f) To adjudicate on disputes
----------------------
The functions of IRDA are as under:
----------------------
 Ensure orderly growth of Insurance Industry
 Protection of interest of policy holders ----------------------

 Issue consumer protection guidelines to insurance companies ----------------------

 Grant, modify, and suspend license for insurance companies ----------------------
 Lay down procedure for accounting policies to be adopted by the ----------------------
insurance companies
 Inspect and audit of insurance companies and other related agencies ----------------------

 Regulation of capital adequacy, solvency, and prudential requirements ----------------------

of insurance business
----------------------
 Regulation of product development and their pricing
----------------------
 Promote and regulate Self Regulating organisations in the insurance
industry ----------------------
 Re-insurance limit monitoring ----------------------
 Monitor investments
----------------------
 Vetting of accounting standards, transparency requirements in
reporting ----------------------

Indian Financial System - An Overview 13

 Notes  Ensure the health of the industry by preventing sickness through
appropriate action
----------------------
 Publish information about the industry
----------------------  Prescribe qualification and training needs of agents
----------------------  Monitor the charges for various services by insurance company
----------------------
Summary
----------------------
● A sound financial system is crucial for the economic growth of a country.
---------------------- The financial system comprises financial markets, financial institutions
and financial instruments. The organized sector of the financial market
----------------------
comprises capital market and money market.
---------------------- ● The capital market has three components-equity market, debt market
and derivatives market. Financial institutions include regulatory bodies,
----------------------
intermediaries and non-intermediaries. Financial instruments include
---------------------- capital market instruments and money market instruments.

----------------------
Keywords
----------------------
● Financial markets: The place where the transformation of savings into
---------------------- investment takes place is called a financial market. It is a market in which
savers and borrowers, both individual and institutional, come together
----------------------
and financial instruments are traded.
---------------------- ● Financial Instruments: A financial instrument is a claim on a stream
of income and/or asset of another economic unit and is held as a store of
----------------------
value and for expected returns.
---------------------- ● Primary Market: The primary market, also referred to as New Issue
---------------------- Market (NIM), enables the issuers of securities to raise funds through new
issue of equity and debt securities which are offered directly to investors.
---------------------- ● Secondary Market: The secondary market is a market in which existing
---------------------- securities are traded between investors. The issuer of securities is not
involved in these transactions. The secondary market is represented by
---------------------- stock exchanges (SEs).
---------------------- ● Capital Market: Capital Market is a market for long term funds. It
deals in medium and long term securities. It is a market for issuing and
---------------------- trading in equity and preference shares and medium and long term debt
---------------------- instruments such as bonds.
● Money Market: The money market is a market in which funds are
---------------------- borrowed and lent for short term, i.e. a period not exceeding one year.
---------------------- It is a market for overnight to short-term funds and for short-term
money and financial assets that are close substitutes for money, i.e.
---------------------- which can be quickly converted into money.

14 Indian Banking & Financial System

 Notes
Self-Assessment Questions
----------------------
1. What is financial system? Explain with components.
2. What kind of financial instruments operate in the Indian financial market? ----------------------
3. Which are the regulatory authorities in India? ----------------------

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
Fill in the blanks. ----------------------

1. The primary function of the financial system is mobilisation of savings of ----------------------

the community and its deployment.
----------------------
2. The financial system stimulates capital formation and accelerates economic
growth. ----------------------
3. The three important components of financial system are financial markets, ----------------------
financial institutions and financial assets or instruments
----------------------
Check your Progress 2
----------------------
State True or False.
1. False ----------------------

2. True ----------------------
3. False ----------------------
Check your Progress 3 ----------------------
Fill in the blanks. ----------------------
1. The function of financial intermediation is done by i) Banking institutions
----------------------
ii) Non-banking institutions iii) Mutual Fund institutions iv) Insurance
companies. ----------------------
2. The two important aspects that differentiate a NBFC from a banking
----------------------
company are NBFCs cannot accept demand deposits and NBFCs do not
participate in the payment and settlement system. ----------------------
3. NBFCs are classified in to three main categories: Asset Finance Company,
----------------------
Investment Company and Loan Company.
----------------------

----------------------

----------------------

----------------------

----------------------

Indian Financial System - An Overview 15

 Notes Check your Progress 4
Multiple Choice Single Response
----------------------
1. Financial instruments are:
----------------------
iv. i & ii
---------------------- 2. Capital market instruments are:
---------------------- vii. i to v
---------------------- 3. Commercial papers are issued by
i. Highly rated corporate
----------------------

----------------------
Suggested Reading
----------------------
1. Mutalik Desai, M.R. Banking developments in India.
----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

16 Indian Banking & Financial System

Overview of Banking & Structure of Banking in India
UNIT

2
Structure:
2.1 Introduction
2.2 How did Banking Start
2.3 Banking in India
2.4 Structure of Banking Institutions
2.5 Changing Role of Development Finance Institutions (DFIs)
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Overview of Banking & Structure of Banking in India 17

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• State the meaning of banking
----------------------
• Trace the evolution of banking
----------------------
• Describe the structure of banking in India
----------------------

----------------------
2.1 INTRODUCTION
----------------------
We have all been availing banking services. Students go to banks to get
---------------------- Demand Drafts to pay their University fees. Most working people have to open
a bank account in which their monthly salary is credited. From this account,
---------------------- people make payments through cheques. We also approach banks for availing
loans for buying a house, or a car or take education loans for studying in India
----------------------
or abroad. Banking, therefore, touches the lives of most of us.
---------------------- It is pertinent for a student of banking to understand the origin of banking
---------------------- and how it evolved and grew over the centuries gone by.
In the Indian context, banking went through a difficult phase of evolution in
---------------------- the pre-independence era and there were many bank failures. After independence,
---------------------- the Government passed the Banking Regulations Act, 1949 for regulating the
business of banks to provide protection to depositors. The importance of the
---------------------- banking system as a vital tool for economic development and progress was
recognized and numerous measures were initiated. During this period, the thrust
---------------------- was on institution building and getting the banks to contribute effectively to the
national objectives of poverty-alleviation, achieving balanced regional growth
----------------------
and ensuring availability of bank finance to the needy.
---------------------- The nationalized banks came to dominate the banking scene and played a
vital role in changing the business from class banking to mass banking. Branch
----------------------
expansion happened at a rapid pace and banking was extended to hitherto
---------------------- unbanked areas.
The era of Liberalization which started in the early 90s marked a shift
---------------------- in approach and it was recognized that the banking system, characterized by
---------------------- inefficiency and poor service quality of nationalized banks, needed an overhaul.
It was decided that private banks should be permitted to be set up to inject
---------------------- competition and improve the overall efficiency of the banking system. This period
brought about a rapid change as regulation was eased and banks were allowed to
---------------------- enter into new areas. While this created new opportunities for banks, they were
exposed to new and greater risks. Banks have responded by extensively using
----------------------
technology and bringing about improvements in their processes. Some banks,
---------------------- which were originally set up as specialized institutions catering to the needs of
specific target groups and sectors, have diversified their activities and now offer
---------------------- a wide variety of products and services to a broader group of clientele.

18 Indian Banking & Financial System

2.2 HOW DID BANKING START Notes

The word “bank” is derived from the Latin word “banca” meaning ‘bench’ ----------------------
or ‘counter’. The business of banking is believed to have started even before
----------------------
2000 BC in Babylonia when temples and palaces used to perform the function
of safekeeping of valuables such as grains and precious metals. The temples and ----------------------
palaces would issue receipts which were then used to transfer the stored items
to third parties. Gradually, this business was taken up by goldsmiths who started ----------------------
accepting valuables for safekeeping.
----------------------
People started depositing their surplus money with the goldsmiths, who,
much like the present day bankers, had strong rooms and employed watchmen. ----------------------
The written note of the owners (depositors) to the goldsmith to deliver the
----------------------
valuables to third parties evolved into ‘cheques’. Over the years, the goldsmiths
started enjoying the trust of people as custodians of their money and people would ----------------------
leave it with them for long periods. The goldsmiths saw an opportunity to earn
interest by lending a part of the money profitably for a definite period of time. ----------------------
As their interest earning from such lending activity increased and on sensing
----------------------
a growing demand for loans arising out of expanding commerce and trade, the
goldsmiths began offering interest on money deposited to attract more deposits. ----------------------
Thus, modern banking evolved and institutions in the form of banks emerged ----------------------
as custodians of peoples’ money and the trust gained by them encouraged them
to lend a portion of such funds. Over the centuries, the scope of banking activity ----------------------
widened and today it covers a broad range of financial activities which we shall ----------------------
understand subsequently.
----------------------
Check your Progress 1 ----------------------

----------------------
Fill in the blanks.
1. The word “bank” is derived from the Latin word __________. ----------------------

2. When banking was started 2000BC, safe-keeping function was ----------------------

performed by __________.
----------------------
3. In the earlier days, __________ started enjoying the trust of the
people as custodians of their money. ----------------------

----------------------
2.3 BANKING IN INDIA ----------------------

Since ancient times, banking activities were conducted in India by pawn ----------------------
brokers, Nidhis and Chit Funds. In most parts of the country, the needs of
----------------------
people were met by moneylenders, who lent out of their own resources and
were therefore, not bankers. Banks were set up during the British era and were ----------------------
modelled along the lines of British banks.
----------------------
We shall now look at the evolution of banking during the following phases:

Overview of Banking & Structure of Banking in India 19

 Notes 1. Pre-Independence Era: Most of the early banks were promoted by
Europeans. Bank of Hindustan was among the earliest such bank which
---------------------- could not last long and went into liquidation in 1832. In early 19th Century,
the East India Company promoted three banks at port centres to finance
---------------------- trade. These banks were:
----------------------  Bank of Bengal in 1809 - which was earlier set up as Bank of Calcutta
in 1806
----------------------
 Bank of Bombay in 1840 and
----------------------  Bank of Madras in 1843
---------------------- These banks together came to be known as Presidency Banks.
---------------------- Many other banks were floated in this period but they all collapsed and
went into liquidation. The banks to survive those early and turbulent times
---------------------- are Allahabad Bank, which was set up in 1865 and Punjab National Bank
which was established in 1895.
----------------------
Foreign banks also started setting up offices in this period. Hong Kong
---------------------- Shanghai Banking Corporation (HSBC) set up its office in 1869.
---------------------- Thanks to the Swadeshi movement, the first decade of the 20th Century saw
the setting up of many banks by Indians. Bank of India, Central Bank of
---------------------- India and Indian Bank are some present day banks which were set up in that
period. The Presidency Banks were merged in 1921 to form the Imperial
---------------------- Bank of India. The new bank performed the functions of a commercial bank
---------------------- and was also the banker to the government. Thereafter, the Reserve Bank of
India (RBI) was established as the central bank of the country in 1935 and
---------------------- Imperial Bank ceased to be banker to the Government of India and instead
became an agent of the Reserve Bank for the transaction of government
---------------------- business at centres at which the central bank was not established.
---------------------- 2. Post Independence Era: As we have seen earlier, the pre-independence
era was marked by numerous bank failures. The Government initiated steps
---------------------- to streamline the functioning of banks and to safeguard the interests of the
---------------------- depositors and enacted Banking Regulations Act, 1949. Reserve Bank of
India was granted powers of supervising the functioning of banks. RBI,
---------------------- which was originally a shareholder’s bank, was nationalized in 1948.

---------------------- After independence, a need was felt to develop a suitable banking structure
for meeting the credit requirements of both agriculture and industry. Towards
---------------------- this end, the Reserve Bank concentrated on regulating and developing
mechanisms for institution building.
----------------------
(A) Setting up of Term Lending Institutions
---------------------- The commercial banks in existence until then were unwilling to give
---------------------- large quantum of loans to industries and also stipulated short repayment
periods, which did not meet the needs of industries. With a view to
---------------------- ensure rapid industrialization and to meet the specific credit needs of
industries, RBI promoted term lending institutions or development
---------------------- financial institutions.

20 Indian Banking & Financial System

 1. Industrial Finance Corporation of India (IFCI) was the first Notes
such institution promoted in 1948 with its headquarters at New
Delhi. Its objective is to provide medium and long-term loans to ----------------------
industrial concerns.
----------------------
2. Industrial Credit & Investment Corporation of India Limited
(ICICI) the earlier avtaar of the present day ICICI bank was set up ----------------------
as a joint stock company and focused on granting long-term loans to
----------------------
industries, including loans in foreign currencies. The unique thing
about it was that it was a privately owned term lending institution. ----------------------
3. Industrial Development Bank of India IDBI was set up in 1964
----------------------
as a wholly owned subsidiary of RBI. In 1976, the ownership of
IDBI was transferred to the Government of India. It performed the ----------------------
role of a principal financial institution for coordinating the activities
of institutions engaged in financing, promoting and developing ----------------------
industry in the country.
----------------------
4. Industrial Investment Bank of India - The Industrial
Reconstruction Corporation of India Ltd was set up in 1971 ----------------------
primarily for undertaking rehabilitation of sick industrial units.
----------------------
It was subsequently renamed as Industrial Reconstruction Bank
of India (IRBI). In 1997, it was again renamed as Industrial ----------------------
Investment Bank of India (IIBI). Its role was enlarged and it
became a full-fledged development financial institution. ----------------------
5. Small Industries Development Bank of India (SIDBI) was set ----------------------
up in 1990 as the principal Development Financial Institution for
promotion, financing and development of industries in the small ----------------------
scale sector and for coordinating the functions of other institutions ----------------------
engaged in similar activities.
6. National Bank for Agriculture & Rural Development ----------------------
(NABARD) which was set up in 1982 is an apex institution ----------------------
specializing in agriculture & rural credit. It is also the regulator
of co-operative banks and Regional Rural Banks (RRBs). ----------------------
7. Export & Import Bank (EXIM Bank) is wholly owned by ----------------------
Government of India and was set up in 1982 as the apex financial
institution for financing foreign trade. It performs the roles of ----------------------
a financer, promoter, consultant and coordinator with regard to
India’s foreign trade. ----------------------

The above referred institutions operated at the national level and a need ----------------------
was felt to promote institutions at the state level to ensure balanced
----------------------
regional growth and accelerated industrialization. Towards this end,
State Finance Corporations (SFCs) and State Industrial Development ----------------------
Corporations (SIDCs) were set up by State Governments. To take the case
of Maharashtra, Maharashtra Industrial Development Corporation (MIDC) ----------------------
and Maharashtra State Finance Corporation (MSFC) have been set up by
----------------------
the state government.

Overview of Banking & Structure of Banking in India 21

 Notes (B) Credit Guarantee Institutions
1. Export Credit Guarantee Corporation ECGC, a Government
----------------------
of India undertaking, was set up in 1957 to provide export credit
---------------------- insurance support to Indian exporters. It provides guarantee cover
to banks for the loans granted for foreign trade. It also insures
---------------------- exporters against various risks involved.
---------------------- 2. Deposit Insurance and Credit Guarantee Corporation of India
DICGC, a wholly owned subsidiary of RBI, was set up in 1962
---------------------- and its primary function is to provide insurance cover to depositors
of banks and to provide guarantees to banks to cover loans granted
----------------------
to small borrowers.
---------------------- You may have heard people say that money deposited in banks is safe.
This is certainly true about Public Sector Banks where Government has a
----------------------
majority stake. But it is also true for private sector banks and co-operative
---------------------- banks. Do you know why? It is because deposits with banks, including
co-operative banks, are insured by DICGC without the depositor having
---------------------- to pay any premium-it is paid by banks. If a bank collapses, then DICGC
repays an amount up to Rs. 1 lac per depositor for the deposit held in the
----------------------
failed bank. So, if you are not sure about the future of private banks but
---------------------- still find the interest rate or service attractive, then it would be a good
idea to spread deposits among different banks and keep the aggregate
---------------------- amount within Rs. 1 lac and get the protection from DICGC.
---------------------- (C) Commercial Banks

---------------------- You may have heard the word ‘scheduled banks’. Schedule banks
are those banks which are included in the Second Schedule to the
---------------------- Reserve Bank of India Act 1934. Before including a bank in the Second
Schedule, RBI ensures that the following conditions are met:
----------------------
(a) The bank must have paid up capital and reserves of not less than
---------------------- Rs. 5 lacs.
---------------------- (b) It must also satisfy the RBI that its affairs are not conducted in a
manner which is harmful to the interests of its depositors.
----------------------
Schedule banks are required to maintain a certain amount of reserves
---------------------- with the RBI. In return, they enjoy certain financial facilities from RBI
at concession.
----------------------
For the purpose of our discussion, we shall further refer to Scheduled
---------------------- Commercial banks as commercial banks.

---------------------- Commercial banks are banks engaged in accepting deposits and granting
short to medium term loans (typically with tenures up to 10 years or
---------------------- so). Among the few banks which survived the pre-independence phase,
Imperial bank of India (IBI) was the largest commercial bank.
----------------------
However, like all other banks of that era, it had a narrow sphere of
---------------------- operation and concentrated mostly on affluent customers in urban

22 Indian Banking & Financial System

 areas. In the First Five Year Plan launched in 1951, the thrust was Notes
on rural development. The All India Rural Credit Survey Committee
recommended that a state-sponsored bank be set up to enhance formal ----------------------
credit in rural areas. In accordance with an enactment in Parliament,
IBI was taken over and converted into State Bank of India in 1955 with ----------------------
the mandate of rapidly developing its branch network in rural areas. ----------------------
Later, the State Bank of India (Subsidiary Banks) Act was passed in
1959, enabling the State Bank of India to take over seven former State- ----------------------
associated banks as its subsidiaries (later named Associates).These
banks together constitute the State Bank Group. ----------------------
SBI has done pioneering work in extension of rural credit and providing ----------------------
need-based finance to the hitherto neglected SSI sector through its
Liberalised Scheme. ----------------------
As regards the other major scheduled banks, it was found that large ----------------------
business houses exercised control over a number of them and were
cornering away a large chunk of loans thereby depriving other priority ----------------------
sectors such as agriculture, small scale industries and exports of their
due share of bank finance. With a view to curbing such mismanagement ----------------------
of banks, the Government initially imposed controls and restrictions
----------------------
which were referred to as social control.
Soon thereafter, the Government decided to nationalize 14 large ----------------------
banks on 19th July 1969 and it took over the ownership and control
of these banks. It was felt that public ownership of the major banks ----------------------
would help to effectively mobilize and develop national resources ----------------------
for productive purposes in accordance with the national objective of
achieving socialistic pattern of society. Nationalization was viewed ----------------------
as a revolutionary step signifying not merely a change of ownership
but a purposeful effort to use the banks as an instrument for achieving ----------------------
economic development and social justice.
----------------------
In April 1980, six more private banks were nationalized taking the tally
of nationalized banks to twenty and further extending public control ----------------------
over the country’s banking system. Of these twenty banks, one bank,
----------------------
New Bank of India was merged with Punjab National Bank, bringing
down the tally to nineteen. ----------------------
Why is it that SBI and its associates which were also taken over, are
not referred to as nationalized banks? Actually, the SBI Group was on a ----------------------
slightly different footing as compared to nationalized banks. While the ----------------------
nationalized banks were wholly owned by the Government of India, the
ownership of SBI was mainly with RBI. Together these 27 banks were ----------------------
referred to as Public Sector Banks. The Public Sector Banks dominated
the banking scene during the post-nationalization era. The benefits of ----------------------
nationalization were mainly- ----------------------
i) Extension of branches to hitherto unbanked areas
----------------------
ii) A quantum jump in the flow of credit to the priority sectors of the
economy. ----------------------

Overview of Banking & Structure of Banking in India 23

 Notes The banks shifted focus from class banking to mass banking and from
elite banking to social banking.
----------------------
RBI also set targets for lending by banks to Priority Sectors of the
---------------------- economy, mainly comprising agriculture, small scale sector and units
engaged in exports. Many schemes have been prepared to ensure that
---------------------- bank finance is made available to the poor and the weaker sections of
the society.
----------------------
With a view to promote balanced regional development, RBI also
---------------------- launched two important schemes:
---------------------- A. Lead Bank Scheme in 1969

---------------------- B. Service Area Approach in 1989.

Under the Lead Bank Scheme, specific districts were allotted to each
---------------------- commercial bank and the bank was designated as the Lead Bank for
---------------------- the district. The Lead Bank has a major role in the development of the
district. It has the responsibility of drawing up District Credit Plans for
---------------------- extending banking facilities to unbanked areas and ensuring availability
of finance to hitherto neglected sections of the district in coordination
---------------------- with other banks operating in the district.
---------------------- For example, Pune district has been allotted to Bank of Maharashtra.
---------------------- Service Area Approach (SAA) was introduced by RBI in 1989 in
order to bring about an orderly and planned development of rural and
---------------------- semi- urban areas of the country. Under the SAA, all rural and semi-
urban branches of banks were allocated around 15-25 villages. These
----------------------
branches had to conduct a survey of the villages, draw up an Annual
---------------------- Credit Plan and ensure that the credit needs of people in the identified
villages were met.
----------------------

---------------------- Check your Progress 2

---------------------- Fill in the blanks.

---------------------- 1. In ancient times, the banking activities were conducted by __________,
__________ and __________.
----------------------
2. East India Company promoted three banks; these were:
----------------------
i) __________ ii) __________ iii) __________
---------------------- 3. The Presidency banks were merged to form __________ in 1921.
---------------------- 4. Scheduled Banks are included in __________ schedule of RBI.

----------------------

----------------------

----------------------

24 Indian Banking & Financial System

 Notes
Match the following.
----------------------
Institution Objective/set up in
IFCI Set up as wholly owned subsidiary of RBI in 1964 ----------------------
ICICI  et up in 1990, to promote finance and for development of
S ----------------------
small scale industry
----------------------
IDBI Set up in 1948 to provide medium term/long term loans
SIDBI A Jt. stock company, privately owned term lending institution ----------------------

----------------------

Activity 1 ----------------------

----------------------
Refer to www.investopedia.com, www.studymode.com and trace the
evolution of banking across the world. Describe the functions the banks ----------------------
have continued to perform over the years.
----------------------

----------------------
2.4 STRUCTURE OF BANKING INSTITUTIONS
----------------------
Let us now study the present structure of banking institutions in India.
----------------------
The apex banking institution is RBI, which as the central bank, exercises
supervision and control over banks. ----------------------
The banking institutions comprise of the following: ----------------------
a) Commercial banks
----------------------
b) Co-operative banks
----------------------
c) Regional Rural Banks
a) Commercial banks are further sub-divided into: ----------------------

1. Public Sector Banks ----------------------

2. Private Sector Banks ----------------------
3. Foreign Banks
----------------------
1. Public Sector Banks (PSBs) comprise the nationalized banks, SBI
and its seven associates. Some nationalized banks are Punjab National ----------------------
Bank, Bank of India, Bank of Maharashtra, Bank of Baroda, Canara ----------------------
Bank etc. In addition, IDBI Bank is also a public sector bank.
The ownership pattern of PSBs has also undergone a change in recent ----------------------
years. The Government, which was the sole owner of nationalized ----------------------
banks, has now retained majority shareholding. However, these banks
have enlarged their capital base by offering shares to the public and ----------------------
the shares of nationalized banks are now listed and traded on stock
exchanges. Further, RBI which had a majority stake in SBI has now ----------------------

Overview of Banking & Structure of Banking in India 25

 Notes transferred its shares to the Government of India in 2007. Today, there
is very little distinction between SBI Group and the nationalized banks.
----------------------
2. Private Sector banks are of two types:
----------------------  Old Private Sector Banks
----------------------  New Generation Private Sector Banks

---------------------- The old private sector banks have existed even prior to nationalization
but were not nationalized because of their small size of operations.
---------------------- Some old private sector banks are Catholic Syrian Bank, Federal Bank,
Dhanalaxmi Bank, Karnataka Bank etc.
----------------------
The year 1991 saw the dawn of the era of liberalization, globalization and
---------------------- privatization. The Industrial Policy, 1991 was a major step in dismantling
government control over industries. In this environment, the performance
---------------------- of PSBs also came under scrutiny. It was found that PSBs were saddled
---------------------- with problems of inefficiency, overstaffing, low employee productivity,
unsatisfactory customer service and poor decision making.
---------------------- Narasimham Committee on Financial Sector (1991) recommended that
---------------------- setting up of banks in the private sector be allowed to inject competition
amongst the PSBs and to induce them to improve their operational
---------------------- efficiency. The recommendations were accepted and the RBI decided
to allow financially strong entities to float banks. The new banks were
---------------------- required to leverage technology to improve efficiency and offer superior
---------------------- quality of service. Private sector banks are required to be registered under
Companies Act, 2013.
----------------------
The early banks that were set up were mostly promoted by institutions-
---------------------- UTI Bank (which was later renamed as Axis Bank), HDFC Bank
and ICICI Bank. These banks were lean outfits, with minimum staff
---------------------- compliment, and optimized the use of technology. They are known as
New Generation Private Sector Banks.
----------------------
3. Foreign Banks: Foreign banks are banks incorporated abroad and are
---------------------- required to obtain a license from RBI to operate in India. RBI gives 12
new branch licenses to foreign banks every year. Earlier, they were allowed
----------------------
to operate only through branches. Now, RBI has permitted foreign banks
---------------------- to set up subsidiaries also. The capital requirement for a foreign bank to
open a branch in India is $25 million spread over three years. Foreign
---------------------- banks bring in new technology and facilitate in the introduction as well
as assimilation of international products into the domestic markets. They
----------------------
also help provide Indian corporations access to foreign capital markets.
---------------------- b) Co-operative banks
---------------------- Co-operative banks are organized on a co-operative basis and are governed
by their members according to co-operative laws.
----------------------
The beginning of co-operative banking in India dates back to 1904, when
---------------------- efforts were made to create a new type of institution based on principles of

26 Indian Banking & Financial System

 co-operative organization and management, which were considered to be Notes
suitable for solving the problems peculiar to Indian conditions.
The co-operative banking structure in India comprises: ----------------------

1. Urban co-operative banks (UCBs) and ----------------------

2. Rural co-operative credit institutions ----------------------
1. Urban co-operative banks: UCBs form an important part of the
----------------------
Indian banking system. In the past, these banks had numerous financial
problems and had suffered losses. In recent years, the performance of ----------------------
UCBs has shown improvement and there has been an increase in the
number of financially stronger UCBs. Some UCBs have operations in ----------------------
many states and are governed by Multi-State Co-operative Societies
----------------------
Act, 2002. Saraswat Co-operative Bank and Cosmos Co-operative Bank
are some co-operative banks having a presence in many states. ----------------------
2. Rural Co-operative Credit Institutions: Rural co-operative credit
----------------------
institutions have a three-tier structure. This sector comprises primary
agricultural credit societies (PACS), district central co-operative banks ----------------------
(DCCBs) and the state co-operative banks (StCBs). However, these
institutions have many problems such as low resources, inadequate ----------------------
business diversification and recoveries, high levels of accumulated losses,
weak management information systems (MIS) and poor internal controls. ----------------------

c) Regional Rural Banks (RRBs) ----------------------

In accordance with the recommendations of Narasimham Committee, RRBs ----------------------
were set up in 1975 under the Regional Rural Banks Act, 1976 and were
permitted to establish branches within a notified area. The capital of RRBs ----------------------
is contributed by Central Government (50%), concerned State Government
----------------------
(15%) and the sponsoring commercial bank (35%).The need for setting up
RRBs was felt because neither commercial banks nor co-operative banks ----------------------
could effectively meet the needs of rural people.
----------------------
The co-operative banks lacked a professional approach to appraisal, delivery
and supervision of credit. The commercial banks, on the other hand, were ----------------------
urban-oriented and were unable to tune their operations to meet the specific
needs of the rural masses. ----------------------
RRBs were conceived as banks with a local feel and familiarity with the ----------------------
rural economy and as a low cost alternative to commercial banks while doing
away with the failings of co-operative banks. However, the RRBs have not ----------------------
functioned effectively. The limited area of operation in resource poor areas,
----------------------
poor management, low employee productivity and high staff costs resulted
in mounting losses and most of the RRBs have become unviable. There has ----------------------
been a consolidation amongst RRBs and their number has declined from 197
to 86 at present. Further, As of 1 April 2021, there are 56 RRBs in India. ----------------------
As per data released by RBI, as of March 2009, there are 27 public sector ----------------------
banks, 7 new private sector banks, 15 old private sector banks, 31 foreign
banks and 86 regional rural banks in India. ----------------------

Overview of Banking & Structure of Banking in India 27

 Notes
Check your Progress 3
----------------------

---------------------- Fill in the blanks.

---------------------- 1. Banking institutions comprise of i) __________ ii) ____________

iii) __________.
----------------------
2. Private sector banks can be classified into i) ___________________
---------------------- ii) ___________.

---------------------- 3. The cooperative banking structure in India comprises of

i) __________ ii) __________.
----------------------

----------------------
Activity 2
----------------------
---------------------- Refer to Wikipedia and prepare a note on “Role played by the private sector
bank ICICI in introducing competition in banking sector”.
----------------------

----------------------
2.5 CHANGING ROLE OF DEVELOPMENT FINANCE
---------------------- INSTITUTIONS (DFIs)
---------------------- We have seen earlier that numerous term lending institutions were set up
by RBI to achieve industrial progress and overall economic development. After
----------------------
the launch of financial reforms in 1991, the operating environment changed and
---------------------- the DFIs found themselves facing new challenges. Earlier, the RBI and Central
Government used to provide long term funds to DFIs at concession. With the
---------------------- implementation of financial reforms, this facility was withdrawn. DFIs had to raise
funds from the public at market related rates, which were obviously higher. This
----------------------
pushed up the cost of funds and their viability was threatened. DFIs broad-based
---------------------- their activities and started granting short-term loans in direct competition with
commercial banks. The PSBs were also facing competition from the newly floated
---------------------- private sector banks which were aggressively seeking to grab some of PSB’s market
share. PSBs also responded by venturing into the business of granting long-term
----------------------
loans to corporate customers and started competing with DFIs.
---------------------- The distinction between DFIs and commercial banks disappeared gradually.
In such a scenario, an institution like ICICI found it futile to operate as a DFI
----------------------
and have a separate existence from its own commercial banking arm, ICICI
---------------------- Bank. The two, therefore, merged in 2002 and ICICI Bank now operates as a
commercial bank, conducting the complete range of banking activities. IDBI
---------------------- followed suit and merged with IDBI Bank in 2004. This has been referred to
universal banking, under which banks offer a wide range of financial products
----------------------
and services under one roof.
----------------------

28 Indian Banking & Financial System

 Notes
Check your Progress 4
----------------------
Fill in the blanks. ----------------------
1. Financial reforms were launched in India in the year _______.
----------------------
2. After RBI withdrew the facility of providing funds at concessional
rates, Development Financial Institutions had to raise the funds from ----------------------
___________.
----------------------
3. ICICI was merged with ICICI Bank in the year _________.
----------------------

----------------------
Activity 3
----------------------
Prepare a chart showing the structure of banking institutions in India. Name ----------------------
three banks / institutions under each head.
----------------------

----------------------
Summary
----------------------
● Banking business has evolved from ancient times, when it was performed
by goldsmiths, to the modern era when it is carried out by large institutions. ----------------------
In India, the banking system matured in the post-independence era in
which many new institutions were created and a number of existing banks ----------------------
were nationalized to serve the national objective of achieving economic ----------------------
progress and social justice.
● The era of financial reforms in the 90s saw the opening up of the banking ----------------------
sector to private banks and a competitive spirit emerging in the banking ----------------------
system with an emphasis on operational efficiency and service quality.
----------------------
Keywords ----------------------
● Schedule Bank: A Scheduled bank is a bank whose name is included in ----------------------
the Second Schedule to the Reserve Bank of India Act 1934.
● Commercial Bank: A Commercial bank is a bank engaged in accepting ----------------------
deposits and granting short to medium term loans (typically with tenures ----------------------
up to 10 years or so).
● Service Area Approach: Service Area Approach (SAA) was introduced ----------------------
by RBI in order to bring about an orderly and planned development of ----------------------
rural and semi- urban areas of the country
----------------------

----------------------

----------------------

Overview of Banking & Structure of Banking in India 29

 Notes
Self-Assessment Questions
----------------------
1. Explain the role of banking in pre-independence and post-independence
---------------------- era.
2. Explain the structure of commercial banks in India
----------------------
3. How has the role of DFI changed after 1991?
----------------------

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
Fill in the blanks.
---------------------- 1. The word “bank” is derived from the Latin word “banca”.
---------------------- 2. When the banking was started in 2000BC, safe keeping function was
performed by temples and palaces.
----------------------
3. In the earlier days, goldsmiths started enjoying the trust of the people as
---------------------- custodians of their money.
----------------------

---------------------- Check your Progress 2

Fill in the blanks.
----------------------
1. In ancient times, the banking activities were conducted by pawnbrokers,
---------------------- Nidhis and Chit funds.
---------------------- 2. East India Company promoted three banks; these were: i) Bank of Bengal
- (1809) ii) Bank of Bombay (1840) iii) Bank of Madras (1943)
----------------------
3. The Presidency banks were merged to form Imperial bank of India in
---------------------- 1921.
4. Scheduled Banks are included in the Second schedule of RBI.
----------------------

----------------------
Match the following.
---------------------- i–c
---------------------- ii – d
---------------------- iii – a

---------------------- iv - b

----------------------

----------------------

----------------------

30 Indian Banking & Financial System

Check your Progress 3 Notes
Fill in the blanks.
----------------------
1. Banking institutions comprise of i) Commercial banks ii) Cooperative
banks iii) Regional Rural banks. ----------------------
2. Private sector banks can be classified into i) Old Private sector banks ----------------------
ii) New Private sector banks.
----------------------
3. The Co operative banking structure in India comprises of i) Urban Co
operative banks ii) Rural Co operative banks. ----------------------

----------------------
Check your Progress 4
----------------------
Fill in the blanks.
----------------------
1. Financial reforms were launched in India in the year 1991.
2. After RBI withdrew the facility of providing funds at concessional rates, ----------------------
Development Financial Institutions had to raise the funds from public. ----------------------
3. ICICI was merged with ICICI Bank in the year 2002.
----------------------

----------------------
Suggested Reading ----------------------
1. Varshney, P.N. Banking Law & Practice. ----------------------
2. Mutalik, V.R. Banking Development in India. ----------------------
3. Tannan, M.L. Banking Law and Practice.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Overview of Banking & Structure of Banking in India 31

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

32 Indian Banking & Financial System

Role and Functions of Reserve Bank of India
UNIT

3
Structure:
3.1 Introduction
3.2 Need for Regulation of the Financial/Banking System
3.3 Constitution of RBI and its Objectives
3.4 Evolving Role of RBI
3.5 Main Functions of RBI
3.6 Instruments of Monetary Management
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Role and Functions of Reserve Bank of India 33

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Assess the need to establish the Central bank in India
----------------------
• Analyse the role and function of RBI
----------------------

----------------------

---------------------- 3.1 INTRODUCTION

---------------------- The banking system in every country is regulated by its central bank. In
the US, this function is performed by the Federal Reserve and in UK the central
----------------------
banking authority is Bank of England. The central banking authority in India,
---------------------- Reserve Bank of India (RBI) was set up in 1935. In this unit, we shall understand
the role and functions of RBI.
----------------------

---------------------- 3.2 NEED FOR REGULATION OF THE FINANCIAL/

BANKING SYSTEM
----------------------
Banking is a business of trust. Over the years, the public has reposed
---------------------- confidence in the banking system and people have placed their hard earned savings
---------------------- with it. It is necessary for a regulator to supervise the functioning of banks in
order to protect the interest of depositors and to maintain their confidence and
---------------------- trust in the banking system on an ongoing basis.

---------------------- The rationale for regulation of the financial/banking system is:

 to generate, maintain and promote the confidence and trust of the public in
---------------------- the financial/banking system
----------------------  to protect the interest of depositors by adequate/timely disclosure by the
institutions
----------------------
 to ensure that the markets are both fair and efficient
----------------------
Thus, RBI, as the regulator of banks and SEBI as the regulator of the
---------------------- securities market play a pivotal role in achieving the objective of a stable banking/
financial system.
----------------------
The banking system is regulated through two major enactments, namely,
---------------------- Reserve Bank of India Act, 1934 and Banking Regulations Act, 1949.

----------------------

----------------------

----------------------

----------------------

34 Indian Banking & Financial System

 Notes
Check your Progress 1
----------------------
Fill in the blanks. ----------------------
1. Banking is a business of _____.
----------------------
2. It is necessary for RBI to regulate the functioning of banks. This is
done in order to _____ the _____ of the depositors. ----------------------
3. In India, the business of banking is regulated by two important Acts. ----------------------
These are i) _____ ii) _____.
----------------------

----------------------
3.3 CONSTITUTION OF RBI AND ITS OBJECTIVES
----------------------
We have seen earlier in the unit on evolution of banking in India that in
the pre-Independence era, Imperial Bank of India was performing the central ----------------------
banking functions. A committee was set up named Hilton Young commission in ----------------------
1926 which recommended the formation of Reserve Bank of India (RBI) as the
central banking authority in the country. RBI Act was passed in 1934 and RBI ----------------------
came into existence on 1st April 1935. Originally, it was a shareholder’s bank
and was later nationalized and taken over by the Government with effect from ----------------------
1st January 1949. ----------------------
The central office of RBI is located in Mumbai. It is governed by a Board of
Directors comprising a Governor, four Deputy Governors and fourteen directors ----------------------
nominated by the Central Government. ----------------------
The main objectives of RBI are as follows:
----------------------
1. To maintain monetary stability in the country
----------------------
2. To maintain financial stability and ensure the soundness of financial
institutions so that they can conduct their business with confidence. ----------------------
3. To maintain stable payment systems so that financial transactions can be ----------------------
executed safely and efficiently.
4. To ensure that credit allocation by the financial system broadly reflects the ----------------------
national economic priorities and social concerns. ----------------------
5. To regulate the overall volume of money and credit in the economy to ensure
----------------------
a reasonable degree of price stability.
6. To promote the development of financial markets and systems to enable ----------------------
itself to operate/regulate efficiently.
----------------------

----------------------

----------------------

----------------------

Role and Functions of Reserve Bank of India 35

 Notes
Check your Progress 2
----------------------

---------------------- Fill in the blanks.

---------------------- 1. The formation of RBI was recommended by _________ Commission

in 1926.
----------------------
2. RBI Act was passed in _________. RBI was nationalised and taken
---------------------- over by Govt. on _________.
---------------------- 3. One of the main objectives of RBI is to maintain _________ stability.

----------------------
Activity 1
----------------------

---------------------- Using the sites www.cmsfx.com, www.cnbc.com, collect information on

three major Central banks in the world.
----------------------

----------------------
3.4 EVOLVING ROLE OF RBI
----------------------
A. Initial Role
----------------------
After its inception in 1935, the initial role of RBI was largely confined to:
---------------------- a. regulating the issue of bank notes
---------------------- b. maintaining monetary stability
---------------------- c. credit and currency management
d. foreign exchange regulation
----------------------
B. Post-Independence Era
----------------------
In the post-independence era, Five Year Plans were started and RBI took up
---------------------- a developmental role to encourage savings and capital formation and widen
and deepen the agricultural and industrial credit set-up. It also took up the
---------------------- responsibility of institution building and was instrumental in the setting up
---------------------- of organizations like Deposit Insurance and Credit Guarantee Corporation
(DICGC), Unit Trust of India(UTI), Industrial Development Bank of India
---------------------- (IDBI), National Bank for Agriculture and Rural Development (NABARD)
and EXIM Bank, to name a few.
----------------------
C. Post-Liberalization Era
----------------------
Post 1991, there was a paradigm shift in the country’s economic and
---------------------- financial policies. The reforms era ushered in liberalization, privatization
and globalization. In the changing economic environment, the RBI focused
---------------------- on the following activities:
---------------------- a. monetary policy measures to manage liquidity, interest rates and prices.

36 Indian Banking & Financial System

 b. strengthening the existing and emerging institutions and market Notes
participants through supervision and regulation.
----------------------
c. developing financial markets, including the money market
d. adopting international best practices in different areas, such as, ----------------------
prudential regulation, banking technology, variety of monetary policy
----------------------
instruments, foreign exchange management and currency management.
D. The new Millennium ----------------------
The new millennium has seen the Reserve Bank play an active role in ----------------------
balancing the relationship between banks and customers, focusing on
financial inclusion, setting up administrative machinery to handle customer ----------------------
grievances, pursuing clean note policy and ensuring development and ----------------------
oversight of secure and robust payment and settlement systems.
The growing integration with the global economy has also exposed our ----------------------
economy to global shocks. Hence, maintaining financial stability has become ----------------------
an important role for the Reserve Bank. It is also maintaining effective
coordination and consultation with other regulators within the country and ----------------------
abroad.
----------------------
Check your Progress 3 ----------------------

----------------------
Fill in the blanks.
----------------------
1. Institution building was done by RBI by setting up
i) _________ ii) _________ iii) _________ iv) _________ ----------------------
State True or False. ----------------------
1. Management of liquidity, interest rates and prices is not the focused ----------------------
area for RBI post liberation.
2. RBI does not have any role in pursuing Clean Note Policy. ----------------------

----------------------

Activity 2 ----------------------

----------------------
Refer to www.scribd.com and www.iimahd.ernet.in and study the
recommendations of M. Narasimham Committee. ----------------------

----------------------
3.5 MAIN FUNCTIONS OF RBI ----------------------

The main functions performed by RBI are as under: ----------------------

1. Issuance of Notes: RBI has the sole authority to issue currency notes and ----------------------
put them into circulation and withdraw them. RBI has issued and put into
circulation notes in the denomination of Rs.2, 5,10,20,50,100,500 and ----------------------

Role and Functions of Reserve Bank of India 37

 Notes 1000, except Rs.1 notes and all coins, which are issued by the Government
of India.
----------------------
Although the government issues one rupee coins and notes, RBI is
---------------------- responsible for their distribution. For conversion of notes and coins of
various denominations for the public and banks, RBI maintains currency
---------------------- chests and small coins depots as its distribution points.
---------------------- The function of issuance of notes is carried out by two departments of RBI
– the Issue and Banking Departments. The Issue Department is concerned
---------------------- with issuance of currency. All currency is the monetary liability of RBI and
is backed by assets of equal value held by this department in the form of
----------------------
gold coins, bullion, foreign securities, rupee coins and the government’s
---------------------- rupee securities. The Banking Department takes care of the currency in
circulation and its withdrawal from circulation.
----------------------
2. Banker to the Government: RBI acts as a banker to the Central and State
---------------------- Governments. The Reserve Bank maintains their accounts, receives money
into and makes payments out of these accounts and facilitates the transfer
---------------------- of government funds. Government deposits are received free of interest
and RBI does not receive any remuneration for maintaining the banking
----------------------
accounts of the Government.
---------------------- RBI also manages the governments’ domestic debt with the objective of
---------------------- raising the required amount of public debt in a cost-effective and timely
manner. RBI is responsible for managing all the new issues of government
---------------------- loans, servicing government debt outstanding and nurturing the market for
government securities. It also advises the Government on the quantum,
---------------------- timing and terms of the issuance of government securities to enable the
---------------------- government to raise debt at a reasonable cost. RBI earns a commission for
managing the public debt.
---------------------- 3. Banker’s Bank: The role of RBI as a banker to the other banks is as follows:
----------------------  it holds some of the cash reserves of banks
----------------------  it lends for short periods
 it provides centralized clearing and quick remittance facilities.
----------------------
In the early days, banks deposited some of their cash reserves voluntarily
---------------------- with a leading bank. The reserves were deposited in a pool. This leading
---------------------- bank then took over the role of a central bank. It began to provide centralized
inter- bank clearing because the individual banks could settle their mutual
---------------------- claims in clearing by debiting or crediting to their individual accounts with
the leading bank. This meant that the leading bank could settle claims among
---------------------- banks by merely making book entries.
---------------------- In addition, individual banks could borrow from the leading bank whenever
required against the cash reserves maintained by them.
----------------------
Today, banks in India maintain their cash reserves in current accounts with
---------------------- RBI, which are used for settling their obligations arising from inter-bank

38 Indian Banking & Financial System

 settlement systems. The Cash Reserve Ratio (CRR) is now a statutory Notes
requirement.
----------------------
The Reserve Bank also acts as a lender of the last resort and provides liquidity
to banks which are unable to raise short term resources from the inter-bank ----------------------
market.
----------------------
4. Supervision of Banks: RBI’s banking supervisory function has been
separated from its traditional central banking function and is now ----------------------
undertaken by a separate board set up for this purpose, namely, Board
of Financial Supervision (BFS). BFS was set up in 1994 to oversee the ----------------------
Indian Financial System, comprising commercial banks, state co-operative
----------------------
banks, All India Financial Institutions (AIFIs) and Non-Banking Finance
Companies (NBFCs). Supervision is mainly done through on-site ----------------------
inspections and off-site surveillance, by calling for the required data from
the regulated entities. ----------------------
The Board for Financial Supervision oversees the Reserve Bank’s regulatory ----------------------
and supervisory responsibilities which include the following:
----------------------
 Granting Licenses for new banks and for branches of existing banks
 Prescribing minimum capital requirements, maintenance of reserves ----------------------
and other liquid assets ----------------------
 Monitoring governance
----------------------
 Setting prudential regulations to ensure solvency and liquidity of the
banks ----------------------
 Prescribing lending to certain priority sectors of the economy ----------------------
 Regulating interest rates in specific areas ----------------------
 Setting appropriate regulatory norms related to income recognition,
asset classification, provisioning, investment valuation and exposure ----------------------
limits. ----------------------
5. Development of the Financial System: As part of its developmental role,
RBI has created specialised institutions. Some of the institutions established ----------------------
by the RBI include: ----------------------
a. Deposit Insurance and Credit Guarantee Corporation (DICGC), to
----------------------
provide protection to bank depositors and guarantee cover to credit
facilities extended to certain categories of small borrowers ----------------------
b. Unit Trust of India (UTI), the first mutual fund of the country
----------------------
c. Industrial Development Bank of India (IDBI), a development finance
institution for industry ----------------------
d. National Bank for Agriculture and Rural Development (NABARD), ----------------------
for promoting rural and agricultural credit
----------------------
e. Discount and Finance House of India (DFHI), a money market
intermediary and a primary dealer in government securities ----------------------

Role and Functions of Reserve Bank of India 39

 Notes f. National Housing Bank (NHB), an apex financial institution for
promoting and regulating housing finance
----------------------
g. Securities and Trading Corporation of India (STCI), a primary dealer
---------------------- IDBI which was originally promoted as a development financial institution
has now been converted into a commercial bank and has been renamed as
----------------------
IDBI Bank Ltd.
---------------------- RBI has also initiated several schemes to ensure the development of banking
---------------------- over the past seven decades. Some of these include
i. Lead Bank Scheme for ensuring the banking development of each
---------------------- district of the country. A commercial bank has been designated as the
---------------------- lead bank for each district and has the responsibility to draw up plans
for its development in coordination with other agencies.
----------------------
ii. Priority Sector Advances Scheme to facilitate/enhance credit flow to
---------------------- employment intensive sectors such as agriculture, micro and small
enterprises (MSE), as well as for affordable housing and education
---------------------- loans.
---------------------- iii. Financial inclusion: This is the process of ensuring access to financial
services and timely and adequate credit, where needed by vulnerable
---------------------- groups such as weaker section and low income groups at an affordable
---------------------- cost.
6. Foreign Exchange Management: RBI is entrusted with the responsibility
----------------------
of maintaining the stability of the external value of the national currency-
---------------------- Indian Rupee. The Reserve Bank plays a key role in the regulation and
development of the foreign exchange market and assumes three broad roles
---------------------- relating to foreign exchange:
---------------------- a. Regulating transactions related to the external sector and facilitating
the development of the foreign exchange market
----------------------
b. Ensuring smooth conduct and orderly conditions in the domestic foreign
---------------------- exchange market

---------------------- c. Managing the foreign currency assets and gold reserves of the country
The Reserve Bank is responsible for administration of the Foreign Exchange
----------------------
Management Act (FEMA), 1999 and regulates the market by issuing
---------------------- licences to banks and other select institutions to act as Authorised Dealers
(ADs) in foreign exchange. The RBI’s Financial Markets Department
---------------------- (FMD) participates in the foreign exchange market by undertaking sales
/ purchases of foreign currency to ease volatility in periods of excess
----------------------
demand for/supply of foreign currency. RBI also manages and invests the
---------------------- country’s foreign exchange reserves in assets based on considerations of
safety, liquidity and return.
----------------------
7. Monetary Management: As the monetary authority, RBI manages the
---------------------- monetary policy of the country to ensure adequate flow of credit to the

40 Indian Banking & Financial System

 productive sectors of the economy to support economic growth and to Notes
maintain price and financial stability. To achieve these objectives, RBI
monitors and analyses the movement of a various indicators including ----------------------
interest rates, inflation rate, money supply, credit, exchange rate, trade,
capital flows and fiscal position, along with trends in output. ----------------------

----------------------
Check your Progress 4
----------------------
Fill in the blanks. ----------------------

1. As a Note issuing authority, RBI is authorised to issue notes of the ----------------------

_________ denominations.
----------------------
2. As a banker to the Government, RBI maintains accounts of
i) _________ ii) _________. ----------------------
3. RBI manages the monetary policy of the country with a view to ----------------------
i) _________ ii) _________.
----------------------

----------------------
Activity 3 ----------------------

Refer to www.business.mapsofindia.com and in the context of liberalisation, ----------------------

discuss the changed role of RBI.
----------------------

----------------------
3.6 INSTRUMENTS OF MONETARY MANAGEMENT
----------------------
RBI uses several direct and indirect instruments in the formulation and
----------------------
implementation of monetary policy. These include:
A. Direct Instruments: ----------------------
1. Cash Reserve Ratio (CRR): It refers to the cash that all banks, ----------------------
scheduled and non-scheduled, are required to maintain with RBI as a
percentage of their Demand and Time liabilities (DTL). The demand ----------------------
liabilities of a bank are the sum total of its current and savings account
----------------------
balances. Time liabilities refer to the banks’ term deposits such as Fixed
Deposits and Recurring Deposits which are repayable on specified ----------------------
maturities.
----------------------
CRR is an important tool for regulating the money supply in the
economy. We have seen earlier the process of credit creation done by ----------------------
banks. When a bank receives a deposit, it maintains some amount as
reserve and lends the remaining portion. The entire banking system ----------------------
creates credit in multiples of the initial deposit in the system. The ----------------------
process of credit creation increases the money supply in the economy.
The credit creation capacity of banks is dependent upon the reserve ----------------------

Role and Functions of Reserve Bank of India 41

 Notes requirement. Higher the reserve requirement, lower would be the credit
created by the banking system and vice versa.
----------------------
The process of credit creation increases the money supply in the
---------------------- economy which tends to create inflationary pressures. Inflation in
simple parlance is the rise in the prices of goods and commodities in
---------------------- the economy. Inflation happens when more money chases less goods
pushing up the demand for goods and in turn their prices. There is
----------------------
therefore, a need to align the growth in money supply with the rate of
---------------------- growth of goods and services.

---------------------- Money supply is measured by a term called broad money or M3. Gross
Domestic Product (GDP) indicates the value of goods and services
---------------------- produced in a country. Thus, if M3 is growing at a rate of say 12% and
the GDP is growing at a rate of 8%, then there would be inflationary
----------------------
pressures in the economy.
---------------------- In such a situation, to check rising inflation, RBI hikes the CRR. In
other words, the cash reserve required to be maintained by banks with
----------------------
RBI is increased. This reduces the credit creation capacity of banks and
---------------------- in turn slows down the growth of money supply or M3 in the economy.
Thus, an increase in CRR is used as a tool to mop up excess liquidity
---------------------- in the system.
---------------------- On the other hand, when there is a need to stimulate economic
activity, RBI injects money in the economy by reducing the CRR to
---------------------- be maintained by banks. The banks then have more lendable resources
---------------------- which are used to finance productive activities.
The Reserve Bank also requires banks to maintain a certain amount of
----------------------
cash in reserve as a percentage of their deposits to ensure that banks
---------------------- have sufficient liquidity to cover customer withdrawals.

---------------------- Reserve Bank of India Act, 1934 empowers RBI to determine the level
of CRR. The Act has not set any floor rate or ceiling for CRR.
---------------------- 2. Statutory Liquidity Ratio (SLR): In addition to maintain a cash
---------------------- reserve with RBI, all banks are required, in terms of the provisions
contained in Banking Regulations Act, 1949, to keep stipulated
---------------------- reserves in cash, gold and unencumbered approved securities as a
percentage of their Demand and Time Liabilities (DTL). SLR is
----------------------
currently 25% of DTL.
---------------------- SLR has three objectives:
---------------------- i. to restrict expansion of bank credit
---------------------- ii. to increase banks’ investments in approved securities and
iii. to ensure solvency of banks
----------------------
As in case of CRR, the effect of an increase in SLR is the reduction in the
---------------------- lending capacity of banks because a portion of their DTL is required to be

42 Indian Banking & Financial System

 invested in government securities. This eases inflationary pressures in the Notes
economy. The reverse phenomenon happens in case of a cut in SLR.
----------------------
Just as SLR is used in India, other countries have similar solvency ratios.
However, such solvency measures prevalent in most other emerging markets ----------------------
are lower than that in India. Many experts have questioned the relevance of
a high level of SLR in the liberalized era. It is felt that the Government is ----------------------
using the tool as an avenue for raising funds from banks. This availability
----------------------
of captive buyers for government bonds lessens the need for fiscal discipline
and limits the depth of the government debt market, as the government has ----------------------
little incentive to look for alternate and efficient funding sources outside
the banks. ----------------------
However, even today, the SLR is considered desirable both as a prudential ----------------------
measure and in view of the need to generate debt resources for the
Government. ----------------------
B. Indirect Instruments ----------------------
1. Liquidity Adjustment Facility (LAF): Under this facility, RBI ----------------------
undertakes daily infusion or absorption of liquidity on a repurchase
basis, through repo (liquidity injection) and reverse repo (liquidity ----------------------
absorption) auction operations, using government securities as
----------------------
collateral.
2. Open Market Operations (OMO): This refers to outright sales/ ----------------------
purchases of government securities by RBI, in addition to LAF, as
----------------------
a tool to determine the level of liquidity in the banking system and
thereby affect the lendable resources of banks. RBI can also bring about ----------------------
a change in the prevailing rates of interest through its pricing policy
for open market sale/purchase. ----------------------
3. Market Stabilisation Scheme (MSS): This instrument for monetary ----------------------
management was introduced in 2004. Liquidity of a more enduring
nature arising from large capital flows is absorbed through sale of ----------------------
short-duration government securities and treasury bills. The mobilised ----------------------
cash is held in a separate government account with the Reserve Bank.
4. Repo/reverse repo rate: These rates under the Liquidity Adjustment ----------------------
Facility (LAF) determine the corridor for short-term money market ----------------------
interest rates. The reverse repo rate is the rate of interest which the RBI
pays to commercial banks when it raises funds. Repo rate is the rate ----------------------
of interest charged by the RBI for borrowings made by the scheduled
banks to meet their liquidity requirements. Changes in these rates are ----------------------
used by RBI to influence changes in the financial markets. ----------------------
5. Bank rate: It is the rate at which the Reserve Bank is ready to buy or
----------------------
rediscount bills of exchange or other commercial papers. Bank rate is
the rate of interest charged by RBI on borrowings made by the scheduled ----------------------
commercial banks as refinance. Thus, by changing bank rate, RBI seeks
to influence the cost of bank credit. The bank rate at present is 6%. ----------------------

Role and Functions of Reserve Bank of India 43

 Notes However, since the adoption of liquidity adjustment facility (LAF) as the
major instrument of RBI’s liquidity operations effective June 2000, the role
---------------------- of the Bank Rate has seen a gradual decline in importance. At present, the
refinancing facilities for banks from the Reserve Bank are completely de-
---------------------- linked from the Bank Rate and the repo rate under LAF has emerged as the
---------------------- effective refinance rate.
Also, in the earlier era of regulated banking system, all lending rates of
----------------------
commercial banks were linked to the bank rate. Any change in the bank rate
---------------------- had an immediate impact on the entire interest rate structure of the banking
system. Thereafter, when the Prime Lending Rate (PLR) was introduced,
---------------------- the importance of bank rate got reduced. Nowadays, it is used by RBI a
medium term policy signaling rate.
----------------------

---------------------- Check your Progress 5

----------------------
Fill in the blanks.
----------------------
1. Banks are required to maintain cash balances with RBI at a certain
---------------------- percentage of their _________.
---------------------- 2. CRR is an important tool for _________ in the economy.
3. Monetary supply in the economy is measured by using a term called
----------------------
_________.
---------------------- 4. The main objectives for maintaining SLR are i) _________
---------------------- ii) _________ iii) _________.
Match the following.
----------------------
Terminology Meaning
----------------------
i. Repo rate a. Rate at which RBI is ready to buy or
---------------------- rediscount Bills of exchanges or other
commercial papers from banks
----------------------
ii. Reserve repo rate b. Rate of interest charged by RBI for
---------------------- borrowing made by banks
iii. Bank rate c. Interest rate RBI pays to Commercial
----------------------
banks when it raises funds from them
----------------------

----------------------
Activity 4
----------------------
Refer to www.cpolicy.rbi.org.in and study the important features of the
----------------------
latest monetary policy issued by RBI.
----------------------

----------------------

44 Indian Banking & Financial System

 Summary Notes

● Central banking authorities across the world have evolved from performing ----------------------
the traditional role of currency management to become regulators and
----------------------
supervisors.
● In India, RBI performs the important functions of monetary and foreign ----------------------
exchange management and bank supervision. It also acts as the lender of ----------------------
the last resort to the banking system and is responsible for ensuring an
efficient payment and settlement system. ----------------------

----------------------
Keywords
----------------------
● Cash Reserve Ratio (CRR): All banks, scheduled and non-scheduled,
are required to maintain with RBI a percentage of their Demand and Time ----------------------
liabilities (DTL) as a reserve. The objective of maintaining this reserve
----------------------
is to ensure that banks have adequate liquidity. RBI also varies the CRR
to achieve its objectives of monetary policy, namely price stability and ----------------------
economic growth.
----------------------
● Statutory Liquidity Ratio (SLR): In addition to CRR, all banks are
required to keep reserves in cash, gold and unencumbered approved ----------------------
securities as a percentage of their Demand and Time Liabilities (DTL).
----------------------
This ratio is referred to as SLR. The primary objectives are to promote
solvency of banks and to increase banks’ investments in government ----------------------
securities.
----------------------
● Demand and Time Liabilities (DTL): Deposits constitute a major
portion of the liabilities of banks. The demand liabilities are the sum ----------------------
total of its current and savings account balances. Time liabilities refer to
the banks’ term deposits such as Fixed Deposits and Recurring Deposits ----------------------
which are repayable on specified maturities. ----------------------
● Liquidity Adjustment Facility (LAF): It is a major instrument of RBI’s
----------------------
liquidity operations. Under this facility, RBI undertakes daily infusion
or absorption of liquidity on a repurchase basis, through repo (liquidity ----------------------
injection) and reverse repo (liquidity absorption) auction operations,
using government securities as collateral. ----------------------
● Open Market Operations (OMO): This refers to outright sales/ ----------------------
purchases of government securities by RBI, in addition to LAF, as a tool
to determine the level of liquidity in the banking system and thereby affect ----------------------
the lendable resources of banks. ----------------------
● Repo rate: Repo rate is the rate of interest charged by the RBI for
----------------------
borrowings made by the scheduled banks to meet their liquidity
requirements. ----------------------
● Reverse Repo rate: The reverse repo rate is the rate of interest which the
----------------------
RBI pays to commercial banks when it raises funds.

Role and Functions of Reserve Bank of India 45

 Notes
Self-Assessment Questions
----------------------
1. What are the main objectives of RBI?
---------------------- 2. Which are different functions of RBI?
---------------------- 3. Which are various instruments of monetary Management?

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
---------------------- Fill in the blanks.
---------------------- 1. Banking is a business of trust.
---------------------- 2. It is necessary for RBI to regulate the functioning of banks. This is done
in order to protect the interest of the depositors.
----------------------
3. In India, the business of banking is regulated by two important Acts.
---------------------- These are i) RBI Act 1934 ii) Banking Regulations Act 1949.

----------------------
Check your Progress 2
----------------------
Fill in the blanks.
---------------------- 1. The formation of RBI was recommended by Hilton Young Commission
---------------------- in 1926.
2. RBI Act was passed in 1934. RBI was nationalised and taken over by
----------------------
Govt. on 1st January 1949.
---------------------- 3. One of the main objectives of RBI is to maintain monetary stability.
----------------------

---------------------- Check your Progress 3

Fill in the blanks.
----------------------
1. Institution building was done by RBI by setting up i) DICGC ii) UTI
---------------------- iii) IDBI iv) NABARD v) EXIM bank.
---------------------- State True or False.
1. True
----------------------
2. False
----------------------

----------------------

----------------------

----------------------

----------------------

46 Indian Banking & Financial System

Check your Progress 4 Notes
Fill in the blanks.
----------------------
1. As a Note issuing authority, RBI is authorised to issue notes of the 2, 5,
10, 20, 50, 100, 500, 1000 denominations. ----------------------
2. As a banker to the Govt. RBI maintains accounts of i) Central Govt ----------------------
ii) State Govts
----------------------
3. RBI manages the Monetary policy of the country with a view to i) ensure
adequate flow of credit ii) to support economic growth iii) maintain price ----------------------
and fiscal stability.
----------------------

----------------------
Check your Progress 5
Fill in the blanks. ----------------------
1. Banks are required to maintain cash balances with RBI at a certain ----------------------
percentage of their Demand and Time liabilities.
----------------------
2. CRR is an important tool for regulating money supply in the economy.
3. Monetary supply in the economy is measured by using a term called ----------------------
Broad Money or M3 ----------------------
4. The main objectives for maintaining SLR are to i) restrict expansion
of bank credit ii) increase banks’ investments in approved securities ----------------------
iii) ensure solvency of banks. ----------------------
Match the following.
----------------------
i–b
----------------------
ii – c
iii - a ----------------------

----------------------

----------------------
Suggested Reading
----------------------
1. Vaswani, T.A. Indian Banking System.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Role and Functions of Reserve Bank of India 47

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

48 Indian Banking & Financial System

Banks in India - Role and Functions
UNIT

4
Structure:
4.1 Introduction
4.2 Definition of Banking
4.3 Banking - A Business of Trust
4.4 Main Functions of Banks
4.5 Ancillary Services
4.6 Safe-Keeping
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Banks in India - Role and Functions 49

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Define banking
----------------------
• Specify the role of banks in credit creation
----------------------
• Enumerate the main and ancillary functions of banks
----------------------

----------------------
4.1 INTRODUCTION
----------------------
We have discussed in the previous chapter about the evolution of banking
---------------------- in India over the past two centuries or so. Banking originated as a business of
safe custody of peoples’ money. The passing of the Banking Regulations Act,
----------------------
1949 immediately after independence was an important step in two ways. Firstly,
---------------------- it formally defined banking. Secondly, it spelt out the permitted and prohibited
business of banks and effectively drew the lakshman rekha or the broad boundaries
---------------------- within which banks could operate in India.
---------------------- Banks have been performing many important functions as financial
intermediaries and as providers of ancillary services.
----------------------
We shall now see the meaning of banking and also understand the traditional
---------------------- role and functions of banks.

----------------------
4.2 DEFINITION OF BANKING
----------------------
In the past, many attempts have been made to define banking. A
---------------------- comprehensive definition has been incorporated in the Banking Regulation Act
which defines banking as:
----------------------
Accepting, for the purpose of lending and investment, of deposits of money
---------------------- from the public, repayable on demand or otherwise and withdraw able by cheque,
draft, order or otherwise. [Section 5(b)]
----------------------
This definition is based on the functions performed by banks and is relevant
---------------------- even today.
---------------------- Let’s now break this definition into smaller components and understand it
in greater detail.
----------------------
a. Accepting for the purpose of lending and investment:
---------------------- The purpose for which the banks raise money by way of deposits is to lend
to others and to make investment. This differentiates banks from companies,
----------------------
such as Tata Motors or Bajaj Auto or M&M, to name a few, which accept
---------------------- deposits for using the funds to finance their own business activity. The crucial
difference is that banks accept money from depositors and lend it to those
---------------------- in need of funds.

50 Indian Banking & Financial System

 This also sets banks apart from moneylenders who also lend to others. But Notes
they do so from their own resources and do not accept deposits from others.
Hence, moneylenders are not bankers. ----------------------
b. Deposits of money from the public ----------------------
This implies that banks accept deposits of money and nothing else. The ----------------------
word public means that banks accept money from the general public. This
differentiates banking activity from that of chit funds and nidhis which accept ----------------------
money only from their members and not from the general public. However,
banks have a right to refuse to open an account and accept deposits for a ----------------------
person or an entity if Know Your Customer (KYC) requirements are not ----------------------
met to the requirements of bank. We shall discuss the KYC requirements
in detail a little later. ----------------------
c. Repayable on demand or otherwise and withdraw able by cheque, draft, ----------------------
order or otherwise
----------------------
The definition also explains the time and mode of withdrawal of deposits.
The depositor is required to make a demand for payment of funds and the ----------------------
bank does not, on its own, return the money, even if the period for which
the money is deposited has expired. The demand is also required to be made ----------------------
in a proper manner and it should be in writing and not made orally. ----------------------
The mode of withdrawal can be by a cheque or draft. The word ‘otherwise’
----------------------
also covers the modern technology-enabled modes of withdrawal, namely through
Automated Teller Machines etc. Banks are the only organizations allowed to ----------------------
open cheque-operated deposit accounts such as Savings accounts and Current
accounts. While companies also accept deposits, they can do so only for a fixed ----------------------
period and cannot issue cheque books to depositors for such accounts.
----------------------
The Act not only defines the term “banking”, but also states the essential
requirements to be fulfilled by an organization to be termed as a ‘bank’. ----------------------
These are: ----------------------
i) Only a firm or company and not an individual are permitted to act as a bank
----------------------
ii) An individual is not allowed to act as a bank and he cannot use this term.
A firm consisting of not more than ten partners or a company incorporated ----------------------
under Indian Companies Act, 1956 can be a bank, a banker or a banking
----------------------
company. According to the Act, “Banking Company” is any company
that transacts the business of banking in India. Every banking company is ----------------------
required to use as a part of its name at least one of the following words- bank,
banker or banking. At the same time, the Act prohibits any other company ----------------------
or firm, individual or group of individuals from using any of these words ----------------------
as part of its name.
Thus, the main function of a bank is to accept deposits from the public for ----------------------
the purpose of lending. In addition to this main function, banks are permitted to ----------------------
do some other business as spelt out under Section 6 of the Banking Regulations
Act. Some of these functions include: ----------------------

Banks in India - Role and Functions 51

 Notes a) Discounting of bills b) Collection of cheques and bills c) Remittances d)
Safe custody of articles e) Hiring of safe deposit lockers f) Conducting foreign
---------------------- exchange transactions g) Conducting government transactions h) Issuing letters
of credit and guarantees
----------------------
Banking Regulations Act prohibits banks from engaging directly or indirectly
---------------------- in trading activities and undertaking trading risks. Banks are also prohibited from
holding any immovable property, except for their own use, for a period exceeding
----------------------
seven years from the acquisition of such property. The Reserve Bank may, at its
---------------------- discretion, extend this period by another five years.

---------------------- Check your Progress 1

----------------------
Fill in the blanks.
----------------------
1. The definition of ‘banking’ is based on two important functions of the
---------------------- banks; these are i) _________ ii) __________.
---------------------- 2. While banks accept deposits from public, Chit funds and Nidhis
accept deposits from __________.
----------------------

----------------------

----------------------
Activity 1

---------------------- List the activities that the Government has permitted banks to undertake in
the post liberalisation era.
----------------------

----------------------
4.3 BANKING - A BUSINESS OF TRUST
----------------------
Let us now examine how banks, as institutions, have survived through the
---------------------- centuries. The main reason for the continued survival and growth of banking
---------------------- institutions is because banking business is built around trust. Deposits are the
life-line of banks and maintaining the trust of depositors is vital for the survival of
---------------------- banks. To maintain the trust, banks are required to meet depositors’ expectations
on the parameters of safety, liquidity and profitability.
----------------------
1. Safety: The main reason that people park their funds with banks is the
---------------------- perception that money with banks is safe. Banks need to assure depositors by
following prudent lending policies such that the money lent by them is fully
----------------------
recovered and available for returning to depositors whenever demanded by
---------------------- them. Banks should give loans after carefully evaluating the risks involved
and take precautions to safeguard their position. If they fall prey to the
---------------------- practice of favouritism or nepotism in their lending operations, then the
safety of depositors’ money would be endangered.
----------------------
We have seen numerous cases of bank failures, particularly in the co-
---------------------- operative sector, where loans given by banks could not be recovered. On

52 Indian Banking & Financial System

 the other hand, banks like State Bank of India have survived through many Notes
difficult times because of their sound lending policies.
----------------------
2. Liquidity: The trust and confidence of depositors is based on the belief that
the money deposited in banks can be withdrawn on demand. Hence, banks ----------------------
need to keep adequate cash reserves to meet the demand of customers. At
the same time, it should also lend a major portion of the amount received ----------------------
as deposits so as to earn interest on it. The depositors are paid interest out
----------------------
of such interest earned on loans. Banks need to, therefore, strike a judicious
balance between the need for maintaining liquidity and the need for earning ----------------------
profits by lending.
----------------------
3. Profitability: The profitability of banks is equally important. If they do not
earn profits, their long term viability would be endangered. They would ----------------------
start defaulting in payment of interest to depositors and ultimately, may
not even be able to repay deposits. The profitability of banks depends on ----------------------
the quality of the loans given and their recoverability and the efficiency of
----------------------
their operations.
----------------------
Check your Progress 2
----------------------

State True or False. ----------------------

1. Banking is a business of trust. To maintain this trust, banks have to ----------------------
meet depositors’ expectations as regards safety and profitability.
----------------------
2. The deposits kept with the banks can be withdrawn only after giving
sufficient notice of say 7 days. ----------------------
3. The profitability of the banks depends only upon size of the bank.
----------------------

----------------------
Activity 2
----------------------
Visit the sites books.google.co.in/books and www.iibf.org.in. Get information ----------------------
on profit planning of a bank.
----------------------

----------------------
4.4 MAIN FUNCTIONS OF BANKS
----------------------
1. Credit Creation
----------------------
A major function of banks is that of credit creation. Banks have
traditionally accepted deposits from people and lent them on to others. ----------------------
Through this lending activity, banks started creating money in the banking
system as a whole in multiples of the original deposit. This is called the ----------------------
multiplier effect. The multiplier effect is a measure of the change in a country’s
----------------------
money supply that occurs as the result of banks’ ability to lend. The multiplier
effect is dependent on how much reserves are maintained by banks out of the ----------------------

Banks in India - Role and Functions 53

 Notes deposit received. Let us assume that Bank A receives a deposit of Rs.100 and
maintains a reserve of 10%, then it must maintain an amount equivalent to
---------------------- Rs.10 (10% of 100) in cash. The balance 90% or 90 is available for lending.
Suppose this money is lent to Mr. X for buying goods. Mr. X would take
---------------------- the money lent and give it to the supplier of goods, say Mr. Y. Mr. Y would
---------------------- not hoard the money but will go to his bank, say Bank B and create a fresh
deposit of Rs.90. Thus the loan of Rs.90 created by Bank A flows back to the
---------------------- banking system as a deposit to Bank B. Bank B will in turn, keep 10% of this
amount, that is, Rs.9 as a reserve and lend Rs.81 to another person say Mr.
---------------------- Z. Mr. Z would take the loan of Rs.81 and pay to another person say, Mr. Q.
---------------------- Mr. Q would deposit the amount of Rs.81 received into his bank, say, Bank
C. Bank C would then keep the reserve of 10% and further lend the money
---------------------- and so on. Thus, we find that against an original deposit of Rs.100 received
by one bank, money in multiple thereof has been created. How much money
---------------------- will be created on a deposit of Rs.100 on a reserve requirement of 10%? This
---------------------- is calculated by the formula:

---------------------- Deposit
---------------------- Reserve Held

---------------------- In this case, it will be 100/10% or 100/0.10 which is Rs.1000. In other

---------------------- words, the initial deposit of Rs.100 in the banking system has grown to become
Rs.1000 and the additional loan created is Rs.900. This is referred to as credit
---------------------- creation. The reserve that is maintained by banks is determined based on their
own prudence to hold some cash in case there is some urgent and unanticipated
---------------------- request for withdrawal from the depositors. It is also mandated by the central
---------------------- bank of the country as a regulatory requirement.
The higher the reserve requirement, lower will be the multiplier effect on
---------------------- the money deposited and conversely, lower the reserve requirement, higher
---------------------- will be the multiplier effect on the money deposited. In other words, higher
the reserve requirement, lesser will be the credit created by banks and vice-
---------------------- versa.
---------------------- 2. Intermediation
The bank’s function of accepting deposits for the purpose of lending is
----------------------
referred to as financial intermediation. Intermediation means that banks function
---------------------- as the link between the savers of funds, who have money, and borrowers, who
need money. You might wonder why the savers and borrowers don’t meet directly,
---------------------- by-passing banks. The reason is that savers are, by nature, risk-averse people
while the borrowers, mostly entrepreneurs, are risk-takers. The savers hesitate
----------------------
to place their hard earned savings in the hands of risk-takers, fearing the risk of
---------------------- default. On the other hand, they have considerable trust in the banks, which have
been accepting deposits for centuries.
----------------------
Banks therefore, perform the function of financial intermediation and take
---------------------- the responsibility of accepting the deposits, lending the money to third parties,

54 Indian Banking & Financial System

recovering the amount lent and returning it back to the depositors whenever Notes
they demand it. In the process, they insulate the depositors from the associated
risks. How do banks get compensated for managing risk? Let us assume that ----------------------
a bank pays interest on deposit say at 8% and then lends it at say, 10%.In this
example, the difference between its lending rate and rate on deposits is 2% which ----------------------
is called interest spread or net interest income. Interest spread is nothing but the ----------------------
compensation that banks receive for risk management. It is also the main source
of profit for banks, arising from their core activity of acceptance of deposits for ----------------------
the purpose of lending.
----------------------
The process of intermediation has been depicted diagrammatically below:
----------------------

----------------------
Savers Banks Borrowers ----------------------

----------------------
----------------------
Check your Progress 3
----------------------

Fill in the blanks. ----------------------

1. Banks create money in the banking system as a whole in multiples of ----------------------
original deposit. This is known as ____________.
----------------------
2. Multiplier effect depends upon the ____________ maintained out of
deposits received. ----------------------
3. Intermidiation means banks function as a link between ____________ ----------------------
and ____________.
----------------------

4.5 ANCILLARY SERVICES ----------------------

----------------------
In addition to the main function of intermediation, that is, acceptance of
deposits and lending, banks also render certain ancillary services to customers. ----------------------
We have seen in the previous section that banks earn interest income through
the process of intermediation. On the other hand, while rendering ancillary ----------------------
services, banks earn income in the form of commission. The traditional ancillary
----------------------
services are mainly of two types: a. payment and remittance services and b.
custodial services ----------------------
A. Payment and remittance services: ----------------------
Banks are an important part of the payment system of the country. If one
had to receive money from someone else, one way is to get cash. However, one ----------------------
is then exposed to the risk associated with the quality and quantity of cash. In a ----------------------
developed financial system, the use of cash is minimal and people avail of the
various products or instruments that banks offer for payment and remittances. ----------------------

Banks in India - Role and Functions 55

 Notes There are two types of payment systems:
1. Paper based payment systems
----------------------
Paper based systems include traditional modes of payment and remittances.
---------------------- These include:
---------------------- a. Cheques
---------------------- b. Demand Drafts (DDs)
c. Pay Orders/ Bankers Cheques
----------------------
d. Mail Transfers (MTs)
---------------------- e. Telegraphic Transfers (TTs)
f. Multi-city cheques
----------------------
g. Traveller’s cheques
----------------------
Let us now study these products in detail:
----------------------
a. Cheques- We have seen earlier that customers deposit their savings with
---------------------- banks. These depositors then withdraw the money or direct the bank to
make payment to other parties through an instrument called a cheque.
----------------------
When a bank opens an account for a customer, it gives him a cheque book
---------------------- containing a set of blank cheques which enables the customer to operate
the account. Each cheque has the depositor’s name and his account number
---------------------- printed on it.
----------------------
Date 01/07/2011
----------------------
PAY Mr. Ram OR ORDER
----------------------
Rs.5,000/-RUPEES Five Thousand only——————————
----------------------
A/C NO. 001109999999
----------------------

----------------------
XYZ Bank sd/-
---------------------- Pune-411001. KRISHNA
---------------------- 123456 400456789 9999999 10

----------------------
Specimen of a Cheque
----------------------
A cheque is a written instruction given by the depositor to the bank holding
---------------------- his money to pay a specified amount to the person mentioned in the cheque.
You would observe that there are three parties to a cheque. The depositor who
---------------------- writes the cheque is referred to as drawer, the bank on whom the cheque is
---------------------- drawn is the drawee and the person to whom payment is required to be made
is the payee. In the above specimen, Krishna is the drawer of the cheque,
---------------------- XYZ Bank is the drawee and Mr. Ram is the payee.

56 Indian Banking & Financial System

 The important points to be noted about cheques are as under: Notes
i) A cheque is valid for a period of three months from the date mentioned
on it. If it is not encashed within this period, then it is called a stale ----------------------
cheque For example, the cheque shown above would be valid up to ----------------------
31/09/2011.
Banks do not make payment of stale cheques. Hence, if you have a ----------------------
cheque which you could not encash within the validity period, then you ----------------------
would need to get the drawer to cancel the existing date on the cheque,
write the current date and put his full signature near the alteration. This ----------------------
is called revalidation and the cheque becomes valid for a period of six
----------------------
months from the modified date.
ii) A cheque may have a date later than the current date, that is, it could ----------------------
be a post-dated cheque. For example, when you take a loan, the bank
----------------------
collects post-dated cheques for your future loan instalments. A post-
dated cheque contains an instruction to the bank to pay only on or after ----------------------
the date mentioned in the cheque. Hence, if a cheque is presented to the
bank before the date mentioned on the cheque, then it will not honour it. ----------------------
iii) A cheque may be crossed by putting two parallel lines, usually on the ----------------------
left top portion. A crossed cheque cannot be encashed across the counter
and the payee has to get the money collected through his bank. ----------------------
iv) A cheque can be altered after it is made but every alteration should be ----------------------
confirmed by the drawer with his full signature. However, it is not a
good idea to make too many alterations on a cheque because the banker ----------------------
may find it difficult to understand your instructions. In such cases, it is ----------------------
better to destroy the cheque and write a fresh one.
v) The drawer can also stop payment of a cheque by giving full particulars ----------------------
in writing to the bank. ----------------------
vi) A Bank will honour a cheque only if there is sufficient balance in the
account and provided it is drawn properly. ----------------------
The bank scrutinizes the cheque and confirms that: ----------------------
a. It bears a date and that the date is current i.e. not post dated or stale.
----------------------
The date should be written in full and should not be incomplete. For
example, a cheque dated 15th August would not be paid. ----------------------
b. The signature of the drawer tallies with the signature as per bank’s
----------------------
records.
c. Alterations, if any, are confirmed by the drawer with his full signature. ----------------------
d. Amount is written both in words and figures. If the amount stated in
----------------------
words and figures differs, then banks usually return such cheques.
b. Demand Drafts: We may need to send money to other locations either for ----------------------
business purposes or personal reasons. For example, if a party A, situated
----------------------
in Pune, buys material from a party B residing in New Delhi, then A is
required to make payment to B. Obviously, A cannot send cash because ----------------------

Banks in India - Role and Functions 57

 Notes it is risky. Likewise, if you are staying away from your sister, you may
want to send a small amount to her on the occasion of Raksha Bandhan.
---------------------- To cater to such needs of customers, banks have devised a cash equivalent
instrument called a demand draft (DD). A DD is similar to a cheque except
----------------------
that it is issued and signed by bank officials.
---------------------- One important point to be noted is that there is no need to have an account
with a bank to purchase a draft. One can simply go to a nearby bank
----------------------
and fill up a draft requisition slip, giving particulars of the amount to be
---------------------- sent, the place where the amount is to be sent and the full name of the
person to whom the amount is to be paid. After completing the slip, the
---------------------- cash for the amount of the DD and the commission payable to the bank
---------------------- is required to be tendered. The bank will then prepare the DD as per
instructions contained in the requisition slip. It will then be signed by
---------------------- the bank’s official and handed over to you against your signature on the
back of the requisition slip as an acknowledgement. You can then post
----------------------
it to the other party, who can encash it at his location. Banks, therefore,
---------------------- act as movers of funds without physically moving cash. A DD is valid
for three months from the date of issue. Based on the guidelines, issued
---------------------- by the Reserve Bank of India, a demand draft in India is valid up to three
---------------------- months, from the date of issue of the draft by the bank. After the lapse
of three months, the customer can re-validate the DD with a written
---------------------- request to the issuing bank.
---------------------- FLOW CHART OF A DD
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

58 Indian Banking & Financial System

 It is also possible that the issuing bank may not have a branch at the other Notes
party’s location. In the above example, let us assume that B is situated in Jhumri
Talaiya in Jharkhand. ICICI Bank may not have a branch at that location. To ----------------------
take care of such remittances, ICICI Bank has arrangements with other banks
having a large network of branches, like say, SBI. Under this arrangement, ----------------------
ICICI Bank, Pune would draw the DD on SBI, Jhumri Talaiya Branch. Such a ----------------------
transaction would involve two additional steps: -firstly, ICICI Bank would pass
on the funds received for the draft to SBI so that it can effect payment to the ----------------------
payee and secondly, it would also share the DD commission with SBI.
----------------------
Hence, while DDs are mostly drawn between two branches of the same
bank, it is also possible for one bank to draw DDs on branches of other banks, ----------------------
under an arrangement.
----------------------
c. Pay Orders/ Banker’s Cheques
----------------------
You would have observed that when you go to your university to pay fees,
cheques are not accepted. They either accept cash payment or require a banker’s ----------------------
cheque. A cheque is, therefore, not a universally accepted instrument. The reason
is that the bank would honour it only if there is sufficient balance in the drawer’s ----------------------
account. Moreover, the drawer can, at any time, stop payment of the cheque.
----------------------
A banker’s cheque, on the other hand, is issued by a bank itself and there is
certainty of payment. A banker’s cheque is, like a DD, a pre-paid instrument. ----------------------
The procedure for obtaining a banker’s cheque is the same as that for a DD.
----------------------
There are, however, some differences between the two. While a DD is used
for remittance of funds, a banker’s cheque is meant for local payments. ----------------------
Further, in case of a banker’s cheque, the issuing branch is also the paying
branch. Banker’s cheques are valid for three months. ----------------------
Both a DD and a Banker’s Cheque are issued at the request of a purchaser. ----------------------
If, afterwards, he changes his mind about sending it to the payee, then he can
tender the instrument to the bank for cancellation and get his money back. ----------------------
If the DD/ Banker’s Cheque is lost, banks do issue a duplicate after verifying ----------------------
that the original is not already paid. However, banks cannot stop payment
of DDs or Bankers’ Cheques. So, to protect themselves if both the original ----------------------
and duplicate are paid, banks require the purchaser to execute an indemnity
----------------------
bond, in which the latter undertakes to compensate the bank for loss that
may be caused due to such double payment. ----------------------
The points of difference between the two are summarized below:
----------------------
Banker’s Cheques Demand Drafts
----------------------
Issued for local payments Issued for remittance of funds from
one location to another ----------------------
Issuing Branch is also the paying Issued by one branch of a bank on ----------------------
branch another branch, or on the branch of
another bank under an arrangement. ----------------------
Validity is three months Validity is three months ----------------------

Banks in India - Role and Functions 59

 Notes Banks also issue banker’s cheques for their own payments. For example, the
electricity bill for the branch premises would be paid by a banker’s cheque.
----------------------
d. Multi-city cheques
---------------------- Today, most banks are networked and have a centralized computer system.
It is, therefore, possible for banks to put through transactions in any account
----------------------
from any place. So, you may have an account in Pune. But the bank can
---------------------- debit or credit your account from any other location. Thanks to this facility,
banks are now offering cheques payable at any branch. Such cheques are
---------------------- called multi-city cheques. So if you want to pay a party in, Chennai, then you
can simply give him a multi-city cheque. Multi-city cheques have to some
----------------------
extent replaced DDs. However, there is no certainty of payment of a cheque
---------------------- whereas a DD is a pre-paid instrument, payment of which is guaranteed by
the bank. So, the party in Chennai may not accept your multi-city cheque.
---------------------- Therefore, acceptability of a multi-city cheque in lieu of a DD depends upon
---------------------- the mutual trust and confidence between the parties to the transaction.
e. Traveller’s Cheques (TCs)
----------------------
TCs are issued for the convenience of travellers who are thereby relieved
---------------------- of the anxiety and risk associated with carrying cash. TCs are issued in
different denominations and it is not necessary to have an account with
----------------------
the bank from which TCs are to be purchased. The customer is required to
---------------------- deposit the money at the issuing branch and sign at the designated place
on the TC at the time of issuance. TCs can be encashed at any branches of
---------------------- the issuing bank and also at designated merchant establishments, such as
shops, departmental stores etc. At the time of encashment, the TC holder
----------------------
is again required to sign at a specified place and put the date and place of
---------------------- encashment. The signatures made at the time of issuance and at the time of
encashment should match.
----------------------
The popularity of TCs has declined after the advent of debit cards, credit
---------------------- cards and travel cards, which have been explained later in this chapter.

---------------------- 2. Technology-enabled or Electronic payment system:

The era of technology has ushered in many new products in the electronic
---------------------- payment system. These products are:
---------------------- a. Electronic Funds Transfer
---------------------- b. Debit Cards
c. Credit Cards
----------------------
d. Travel cards
----------------------
The last three products are referred to as plastic money.
----------------------
a. EFT (Electronic Funds Transfer): A technology-enabled mode of
---------------------- remittance now in vogue is the Electronic Funds Transfer (EFT).This
can be made between branches of the same bank as well as between
---------------------- two banks.

60 Indian Banking & Financial System

 It is now possible to make a remittance electronically between two Notes
branches of the same bank because all branches are connected under
a centralized computer system and transactions can be put through to ----------------------
any account from any place. Thus, the sending branch will debit the
account of the sender and immediately credit the payee’s account at ----------------------
the branch indicated by the sender. ----------------------
If , for example, A, residing in Pune, has to send money to B at
----------------------
Hyderabad and both have accounts in ICICI Bank, then ICICI Bank
will collect the amount from the remitter/sender, A and immediately ----------------------
credit the account of B in ICICI Bank, Hyderabad.
----------------------
This mode of remittance is more efficient because it does not involve
any delay, which sending the amount by DD would entail. Further, ----------------------
there is a risk of theft and misuse of DDs in transit. This possibility is
eliminated in EFT and it is a safe mode of remittance. The banks are ----------------------
also benefited because the cost of electronic transfer is much lower than
----------------------
the cost involved in issuance of DD (which is printed form requiring
special stationery). ----------------------
The electronic transfer requires minimum human effort whereas the
----------------------
DD involves handling at both the branches. Further, in view of the
time lag involved, the issuance and payment of DDs is required to be ----------------------
monitored through inter-branch reconciliation to prevent frauds. This
is not necessary in EFT which involves instantaneous transfer of funds. ----------------------
When a customer opts for a DD, the time lag between its issuance ----------------------
and payment allows the bank to enjoy the money, called float –funds
for some time. This benefit is lost in EFTs. Nonetheless, the benefits ----------------------
derived from EFT more than compensate the loss of float-funds and it ----------------------
is the preferred mode of remittance both for banks and customers.
Inter-bank fund transfers electronically: Fund transfers can also be ----------------------
made between two banks through their accounts maintained with RBI. ----------------------
The sender’s bank would request RBI to debit its account and credit the
payee’s bank with RBI. On getting a confirmation of credit, the payee’s ----------------------
bank would credit the payee’s account. In the above example, let us
assume that B, to whom A wants to send money, maintains an account, ----------------------
not with ICICI Bank, but with SBI at Hyderabad. ICICI Bank which is ----------------------
the sender’s bank will collect the money from A and then request RBI to
debit its account and credit the account of SBI held with RBI, giving full ----------------------
particulars of the payee’s name and his account number at Hyderabad
branch. On receipt of intimation of credit from RBI, SBI would credit the ----------------------
account of B at its Hyderabad branch. This inter-bank remittance facility, ----------------------
through RBI is called National Electronic Fund Transfer (NEFT). Under
this system, the fund transfer happens within a few hours. ----------------------
Another inter-bank remittance facility for high value transactions, which ----------------------
is also operated by RBI, is called Real Time Gross Settlement System
(RTGS). Under this system, fund transfer happens immediately. ----------------------

Banks in India - Role and Functions 61

 Notes b. Debit Cards - A debit card is a product that offers the facility to make
payment from one’s account without having to write a cheque. There is
---------------------- no need to carry cash or cheques. It is plastic money. VISA and MASTER
CARD are the two main card companies. Various banks are now issuing
---------------------- cards in tie up with these global payment systems. For personal withdrawals
---------------------- there is now no need to write a cheque payable to oneself and get cash. We
can simply go to an Automated Teller Machine (ATM), swipe the card and
---------------------- get cash in a hassle-free manner. Moreover, the ATM facility is available
round the clock-24/7. One only needs to use the Personal Identification
---------------------- Number (PIN) given by the bank. The PIN is like the signature on the
---------------------- cheque and serves the purpose of authentication of the transaction. Debit
cards can also be used at Point of Sale (POS) terminals available at shops,
---------------------- petrol pumps and other establishments. Instead of writing a cheque, which
should conform to numerous banking requirements, one can simply swipe
---------------------- the card at the POS terminal and effect payment electronically. Banks earn
---------------------- income in the form of a fee from the establishments, who are also happy
because the convenience of purchasing with cards results in increased
---------------------- consumer spending and consequently, they can do more business. Debit
cards can also be used for effecting payments electronically through the
---------------------- internet. For example, payment for railway bookings can be done using a
---------------------- debit card through the internet.
c. Credit Cards
----------------------
All the services that we have seen above are pre-paid or pre-funded
---------------------- services. The remittance services are pre- paid services as the customer
is required to tender his funds and the bank then moves the money as
----------------------
per his instructions. In case of cheques and debit cards, the customer
---------------------- can only draw up to the balance held in his account and these are,
therefore, pre-funded facilities.
----------------------
Credit cards on the other hand, work on the concept- BUY NOW, PAY
---------------------- LATER. In effect, the card issuing bank gives credit and allows you to
pay after the date of purchase or transaction effected by using the card.
---------------------- So while operationally, they work like debit cards, the difference is that
when a debit cards is used, the card-holder’s savings bank account is
----------------------
instantly debited whereas in a credit card, the customer’s credit card
---------------------- account is debited and the card-holder gets an interest-free credit period
of up to 50 days to effect the payment. The card issuing bank fixes a
---------------------- limit, based on the financial standing of the card-holders, up to which
transactions can be made. Every month, the credit card issuing bank
----------------------
generates a statement indicating the amount due for payment for card
---------------------- transactions made earlier and the date by which the payment is to be
made. Once the amount due is paid, the limit gets restored.
----------------------
Thus, the card-holder gets revolving credit. If he defaults in payment of the
---------------------- amount due, then the card issuing bank charges interest at an exorbitant
rate- in excess of 30% per annum. Hence, credit card users must make
---------------------- payment before the due date to avoid delayed interest payment.

62 Indian Banking & Financial System

 Like debit cards, credit cards can also be used at POS terminals and for Notes
making payment through the internet. A facility of withdrawal of cash
using a credit card is also available, but should be avoided. For such ----------------------
transactions, there is no interest-free period. Instead, the bank recovers
interest from the date of withdrawal till the date of payment. ----------------------

It is rightly said that a credit card is a passport to safety, credit, ----------------------

convenience and prestige. One should however, use it judiciously.
----------------------
Banks do not charge any issuance fee or annual charges on cards. Their
main earning is interest on delayed payment. They also recover a fee ----------------------
from merchant establishments, at a higher rate than that on debit cards.
----------------------
These charges are higher for credit cards to compensate for the money
that the bank expends by way of free credit period for the cardholder ----------------------
and the cost of printing and mailing statements to them.
----------------------
A transaction at a POS terminal involves the following players:
1. The card-holder ----------------------

2. The merchant establishment ----------------------

3. The card issuing bank which issues the card and raises bills on the ----------------------
customer periodically.
----------------------
4. The acquiring bank, which has installed the POS terminal and
provides reimbursement to the merchant. ----------------------
5. The payment service provider, usually Visa or Master Card.
----------------------
The charges recovered from the merchant establishments are shared as
under: ----------------------
Usually, the card issuing bank gets 80%, the acquiring bank gets 15% ----------------------
and the balance 5% goes to the payment service provider.
----------------------
The difference between debit cards and credit cards has been given below:
----------------------
Credit cards Debit Cards
Card-holder may or may not have Customer must maintain an account ----------------------
an account with the issuer from which payments are made
electronically ----------------------
Transactions can be made up to the Transactions can only be made up ----------------------
limit sanctioned by the issuer to the balance in the account
Interest-free credit period of up to The amount is immediately debited ----------------------
50 days is available from the date of to the customer’s account as soon
transaction. Until then, the amount as the transaction is made ----------------------
is debited to credit card account ----------------------
Payments can be made from any Payment only from the designated
bank account account with the card issuing bank ----------------------
Card issuing banks are exposed to No credit risk to issuing bank as
----------------------
credit risk as the card-holder may the card-holder can only draw up
not pay dues to balance in his account ----------------------

Banks in India - Role and Functions 63

 Notes d. Travel Cards
Travel cards are pre-loaded debit cards. In case of a regular debit card,
----------------------
the amount is recovered from the customer’s account as and when the
---------------------- card is swiped. In a travel card, on the other hand, at the time of issuance
itself, a lump sum amount is taken out from the bank account of the
---------------------- customer, as per his request and loaded on to the card. This amount gets
reduced as transactions are made, much like a pre-paid mobile phone
----------------------
facility. These cards are generally not used for domestic transactions
---------------------- because today that can be easily done using Debit or credit cards. These
cards are used for foreign travel and are loaded with foreign currencies
---------------------- such as US Dollar, EURO, Pound Sterling etc.
---------------------- HDFC Bank‘s ForexPlus Card, Axis Bank’s Travel Currency Card,
SBI’s Vishwa Yatra card are some foreign travel cards.
----------------------
Banks also issue International Credit Cards (ICCs) to residents for
---------------------- making payments abroad.
---------------------- We have seen above a range of paper-based bank products and
technology-enabled products. A comparison of the above products
---------------------- would reveal that technology-enabled products are superior, more cost-
---------------------- efficient and safer than paper-based products. As a result, technology
enabled products are now replacing the traditional paper-based products.
---------------------- Debit cards have emerged as a replacement for cheques. Travel cards
have replaced traveller’s cheques. EFT is gradually replacing DDs. It’s
---------------------- only a matter of time before paper-based products are rendered obsolete
---------------------- and become part of some museum of banking products! What an idea,
sirji!!
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

64 Indian Banking & Financial System

 Notes
Check your Progress 4
----------------------
Fill in the blanks. ----------------------
1. While banks earn interest on funds lent, commission is earned from ----------------------
________ .
----------------------
2. The traditional ancillary services offered by banks are i) _________
ii) __________. ----------------------
3. The parties to a cheque issued by a customer are i) _________ ----------------------
ii) __________ iii) _________.
----------------------
4. A cheque that bears a date later than the current date when issued is
termed as ________ . ----------------------

State True or False. ----------------------

1. It is not necessary to maintain an account with a bank to purchase a ----------------------
demand draft.
----------------------
2. A demand draft payable after 30 days can be issued.
----------------------
3. While a demand draft is meant for remittance of funds, a banker’s
cheque (Pay order) is meant for local payment. ----------------------

Fill in the blanks. ----------------------

1. Multi City cheques are issued by banks if they are ________ and ----------------------
have ________ system.
----------------------
2. Technology has enabled the banks to offer new products in
the electronic payment system. The products are i) ________ ----------------------
ii) ________ iii) ________ iv) ________ .
----------------------
3. The interbank remittance facility for high value funds available
through RBI is known as ________ . ----------------------
4. To operate a bank account through ATM, the customer should have ----------------------
________ number.
5. Credit cards work on the concept of ‘________ ’. ----------------------

6. Travel cards are ________ debit cards. ----------------------

----------------------

----------------------
Activity 3
----------------------
Visit a bank and study various forms/ slips used for opening of account,
----------------------
purchase of DDs, availing NEFT, RTGS facilities etc.
----------------------

Banks in India - Role and Functions 65

 Notes 4.6. SAFE-KEEPING
---------------------- In addition to being custodians of customers’ money, banks have been
offering the facility of safe custody of valuables since ancient times. For this
---------------------- purpose, banks have specially designed strong rooms and safes. Banks offer the
facility of accepting packets containing valuables and hold them in safe custody.
----------------------
At select branches, they rent out lockers or vaults or bins in their strong rooms
---------------------- for customers to keep their jewellery and other precious belongings.

---------------------- 1. Safe Custody:

Customers can put articles in a box, lock it, cover it with a thick cloth and
---------------------- then seal it. This packet is then handed over to the bank. The bank would
---------------------- accept the packet and issue a safe custody receipt. While claiming the box
back, the customer has to produce the receipt and sign on the reverse. This
---------------------- facility is usually availed by banks to deposit the duplicate keys of their
branch with nearby banks. This is because if, for some reason, the original
---------------------- keys are not traceable, the keys from the nearby bank can be withdrawn and
---------------------- banking operations can be started. To cite an instance, ABN AMRO Bank
in Deccan Gymkhana, Pune may deposit its duplicate in a sealed box with
---------------------- Canara Bank, Deccan Gymkhana Branch Pune which is located nearby.
Canara Bank would accept the packet and issue a safe custody receipt to
---------------------- ABN AMRO Bank. In case of need, the latter will tender the receipt, duly
---------------------- signed and claim back the packet of keys.
2. Safe Deposit lockers
----------------------
Banks offer, at select branches, lockers or vaults on rent basis in their strong
---------------------- room. Lockers are available in different sizes and the rent varies accordingly.
Further, the rent is higher at metro centres than that at semi-urban and rural
---------------------- centres. Banks recover annual rent in advance. The customer availing of
---------------------- the locker facility, also referred to as hirer, is required to maintain a savings
account with the bank from which the annual rent is recovered.
---------------------- The arrangement is that of a lease and the bank and the hirer enter into a
lease agreement. The bank is not aware of the contents of the locker- it
----------------------
merely rents it out. The details of allotment of locker number etc are entered
---------------------- in a Safe Deposit Locker Register and the customer’s specimen signature
is obtained. The customer is then handed over a key called the hirer’s key.
---------------------- When a hirer approaches the bank for accessing the locker, the bank records
the date and time of operation in a Locker Access Register and obtains the
----------------------
hirer’s signature which is tallied with the specimen as per bank’s records.
---------------------- The branch official then accompanies the hirer to the locker room. The
bank’s master key and the hirer’s key are simultaneously operated to open
---------------------- the locker. Thereafter, the branch official leaves the locker room. For locking,
the hirer’s key is sufficient. The important point to be noted is that the bank
----------------------
does not have a duplicate of the hirer’s key and the hirer cannot operate the
---------------------- locker only with his key. Hence, if the hirer’s key is lost, then the bank has
no option but to call the locker manufacturing company, break open the
---------------------- locker, at the hirer’s cost, and hand over the contents to the hirer.

66 Indian Banking & Financial System

 Notes
Check your Progress 5
----------------------
Fill in the blanks. ----------------------
1. When a packet is handed over to a bank for safe custody, the bank
issues ________. ----------------------
2. A customer availing locker facility is required to maintain ________ ----------------------
with the bank.
3. In case of locker services availed from a bank, the arrangement is that ----------------------
of ________ and the customer enters in to a ________. ----------------------

----------------------
Activity 4
----------------------
Prepare a list of activities performed while opening and operating a bank ----------------------
locker.
----------------------

Summary ----------------------

● Banking has been defined under Banking Regulations Act. The Act ----------------------
also spells out the permitted and prohibited businesses that banks can ----------------------
undertake.
● The main function of banks is that of a financial intermediary from which ----------------------
they derive interest income. In addition, banks also render ancillary ----------------------
services which yield commission income.
----------------------
Keywords ----------------------
● Banking: Banking is defined as, accepting, for the purpose of lending and ----------------------
investment, of deposits of money from the public, repayable on demand
or otherwise and can be withdrawn by cheque, draft, order or otherwise. ----------------------
● Cheque: A cheque is a written instruction given by the depositor to the ----------------------
bank holding his money to pay a specified amount to the person mentioned
in the cheque. ----------------------
● Demand Draft (DD): A DD is an instrument issued by a bank, at the ----------------------
request of its customer, for remittance of funds from one place to another.
----------------------
● Banker’s Cheque or Pay Order: A banker’s cheque is issued by a bank,
on behalf of its customer, for local payments. ----------------------
● Debit Card: A debit card is a product that offers the facility to make ----------------------
payment from one’s bank account without having to write a cheque.
● Credit Card: A credit card allows a customer to make purchases ----------------------
immediately and pay later. ----------------------

Banks in India - Role and Functions 67

 Notes
Self-Assessment Questions
----------------------
1. Why are banks treated as an organization for trust?
---------------------- 2. What are the main functions of Bank?
---------------------- 3. List out various Ancillary services provided by bank.

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
---------------------- Fill in the blanks.
---------------------- 1 The definition of ‘banking’ is based on two important functions of the
banks, these are i) accepting for the purpose of lending and investment,
---------------------- deposits of money from the public ii) repayable on demand or otherwise
---------------------- withdrawal by cheque etc.
2. While banks accept deposits from public, Chit funds and Nidhis accept
----------------------
deposits from their members.
----------------------

---------------------- Check your Progress 2

State True or False.
----------------------
1. True
----------------------
2. False
---------------------- 3. False
----------------------
Check your Progress 3
----------------------
Fill in the blanks.
----------------------
1. Banks create money in the banking system as a whole in multiples of
---------------------- original deposit. This is known as multiplier effect.

---------------------- 2. Multiplier effect depends upon how much reserves are maintained out of
deposits received.
----------------------
3. Intermediation means banks function as a link between savers of money
---------------------- and borrowers.

----------------------
Check your Progress 4
----------------------
Fill in the blanks.
---------------------- 1. While banks earn interest on funds lent, commission is earned from
rendering ancillary services.
----------------------
2. The traditional ancillary services offered by banks are i) payment and
---------------------- remittances ii) custodial services.

68 Indian Banking & Financial System

3. The parties to a cheque issued by a customer are i) Drawer ii) Payee Notes
iii) Drawee.
----------------------
4. A cheque that bears a date later than the current date when issued is termed
as post-dated. ----------------------
State True or False.
----------------------
1. True
----------------------
2. False
3. True ----------------------

Fill in the blanks. ----------------------

1. Multi City cheques are issued by banks if they are networked and have ----------------------
centralised computer system.
----------------------
2. Technology has enabled the banks to offer new products in the electronic
payment system. The products are i) EFT ii) debit cards iii) credit cards ----------------------
iv) travel cards.
----------------------
3. The interbank remittance facility for high value funds available through
RBI is known as RTGS. ----------------------
4. To operate a bank account through ATM, the customer should have ----------------------
Personal Identification Number (PIN).
5. Credit cards work on the concept of ‘Buy now pay later’. ----------------------

6. Travel cards are pre-loaded debit cards. ----------------------

----------------------
Check your Progress 5 ----------------------
Fill in the blanks.
----------------------
1. When a packet is handed over to a bank for safe custody, the bank issues
a safe custody receipt. ----------------------
2. A customer availing locker facility is required to maintain an account ----------------------
with the bank.
----------------------
3. In case of locker services availed from a bank, the arrangement is that of
lease and the customer enters in to a lease agreement. ----------------------

----------------------

Suggested Reading ----------------------

----------------------
1. Indian Institute of Banking and Finance. Principles and Practice of
Banking. ----------------------

----------------------

----------------------

Banks in India - Role and Functions 69

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

70 Indian Banking & Financial System

Changing Role of Banks
UNIT

5
Structure:
5.1 Introduction
5.2 The Changing Market Environment
5.3 Product Diversification and Innovative Services
5.4 Use of Technology to improve Operational Efficiency and Increase Customer
Satisfaction
5.5 Centralization of Operations
5.6 Dynamic Queue Management (DQM)
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Changing Role of Banks 71

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Define the changing role of banks
----------------------
• Discuss the technology-enabled delivery channels
----------------------
• Illustrate the various fee-based products and services
---------------------- • Enumerate the services offered by banks under one umbrella
----------------------

---------------------- 5.1 INTRODUCTION

---------------------- We have seen in the previous chapter that banks have been traditionally engaged
in the business of intermediation and providing ancillary services. The ancillary
----------------------
services have mainly been payment and remittance services and custodial services.
---------------------- We have also seen how banks have leveraged technology to improve the payment
and remittance services. The traditional products and services were the cornerstones
---------------------- of banking business until the 80s. During this period, banks, which mainly comprised
public sector banks, saw a big growth in their business as they started penetrating
----------------------
into under-banked and unbanked areas. They operated in a regulated environment
---------------------- in which RBI prescribed uniform interest rates, on loans as well as advances, for all
banks and it also set targets for lending to the priority sector.
----------------------
The scenario changed in the 80s when major threats emerged caused by
---------------------- two processes which got unleashed simultaneously. One was the process of
deregulation, in which banks were allowed to set their own interest rates. The
---------------------- other, was the process of disintermediation, which saw, on the one hand, the
savers of money by-passing the banking system and investing in the financial
----------------------
markets directly and on the other hand, the corporate borrowers started tapping
---------------------- the capital markets directly to raise funds at cheaper rates. Competition started
heating up in the nineties, when private sector banks, armed with state of the art
---------------------- technology, entered the market and redefined the rules of the game.
---------------------- It was also an era of opportunities. During this period, new business areas
were opened up for banks. Since the late eighties, banks were allowed to enter
---------------------- the mutual fund business and in the late nineties, they were allowed to foray
---------------------- into insurance. These events caused a paradigm shift in the banking business
and in addition to the traditional services, banks added many more products and
---------------------- services to attract and retain customers.

---------------------- Another important development was with regard to the extensive use of
technology in product innovation, improving processes and creating more value
---------------------- for customers.

---------------------- All these factors have caused an enormous change in the banking industry.
In this chapter, we shall see the changing profile of modern day banks and their
---------------------- emerging role.

72 Indian Banking & Financial System

5.2 THE CHANGING MARKET ENVIRONMENT Notes

1. The process of deregulation ----------------------

As we have seen earlier, the nationalization of SBI in 1955 was followed by ----------------------
nationalization of 14 banks in 1969 and thereafter by nationalization of 6
more banks in 1980. Ownership of majority of banks got concentrated in the ----------------------
hands of the Government and banks started serving the national objectives,
----------------------
under the control and guidance of the Government and RBI. It was an era
of administered interest rates. RBI would fix interest rates for all categories ----------------------
of loans and advances and banks had to merely apply the rates. The primary
objective was to ensure that credit was made available to the priority sector ----------------------
at low rates of interest. A policy of cross-subsidization was adopted under
----------------------
which large corporate were charged very high rates of interest. This ensured
that the interest spread, (the difference between the banks’ lending rates and ----------------------
borrowing rates), was protected. However, there was inefficiency in the
system and banks had high operating costs, particularly staff costs. There ----------------------
was no incentive for banks to improve efficiency by pruning costs because
----------------------
of the complacency brought in by the protection of interest spread. This
system of insulating banks from price competition was reviewed and on the ----------------------
basis of the recommendations of the Chakravarty Committee Report, the
process of liberalization of interest rates began in the mid-eighties and got ----------------------
further momentum after the recommendations made by the Narasimham ----------------------
Committee on financial reforms.
Banks had now to set their own interest rates. The industrial borrowers ----------------------
started clamouring for market-aligned rates as interest was a major cost. This ----------------------
brought about an interest rate war to retain customers. Banks were compelled
to lower the interest rates on loans. While efforts were made by banks to ----------------------
correspondingly bring down interest rates on deposits, they could not quite
----------------------
achieve that. This was because interest on deposits had to compensate for
inflation, which was quite high in the 90s and also there was increasing ----------------------
competition from more market players, particularly in the private sector.
This put pressure on the interest spread and banks sought new products ----------------------
and services to broad-base their business. Simultaneously, they focused on
----------------------
improving efficiency and cutting costs by leveraging technology.
The process of deregulation also offered new opportunities as banks were ----------------------
permitted to enter the business of merchant banking, leasing, mutual funds ----------------------
and insurance by setting up subsidiaries.
2. The process of Disintermediation ----------------------

The process of disintermediation is a worldwide phenomenon and it ----------------------

impacted the Indian banking system in the 80s. Disintermediation refers to
----------------------
consumers investing directly in securities rather than leaving their money
in savings accounts with banks, then later to borrowers going to the capital ----------------------
markets rather than to banks. Until the mid-eighties, banks were the main
financial intermediaries, collecting deposits from savers and lending the ----------------------

Changing Role of Banks 73

 Notes money to borrowers and thereby earning a spread on the interest received
and paid. Thereafter, the scene changed primarily due to the following
---------------------- reasons:
---------------------- a. With the liberalisation of the economy, the capital markets in India
started maturing. This encouraged financially strong corporate to tap
---------------------- funds directly from investors and reduce their cost of funds.
---------------------- b. Securities Exchange Board of India (SEBI) was set up in 1989 and took
up the role of a market regulator. It initiated a series of measures to
---------------------- protect the interest of investors. This boosted the confidence of investors
and their participation in the capital markets started increasing and
----------------------
deposits from banks got diverted to the stock markets.
---------------------- c. With the advent of technology, market information became available
---------------------- more easily to the public through the internet. This made decision-
making by investors much easier and also contributed to their increased
---------------------- participation in the capital markets.
---------------------- d. Unit Trust of India, the first mutual fund in India, was a Government
owned-undertaking which was in operation since 1964. It offered
---------------------- assured return schemes, which began attracting investors as a low risk
avenue of investing in markets.
----------------------
These factors together, caused the savers to by-pass banks and invest their
---------------------- money directly in capital markets and also the large borrowers’ by-pass banks and
raise funds from the capital markets directly. These developments impacted the
----------------------
balance sheet size of banks and resulted in shrinkage in their deposits (liabilities)
---------------------- as well as their loans (assets). It also threatened their core source of income-
interest spread. Banks therefore sought new business avenues to offset the loss
---------------------- of business.
---------------------- In response to these changing conditions, banks have focused on boosting
their fee-based income, which is derived from rendering services not involving
---------------------- lending of funds. Banks have now emerged as financial super-markets offering a
---------------------- wide range of financial products and services under one roof. In addition to the
traditional role, banks now offer third party products such as mutual funds and
---------------------- insurance policies. They also provide third party services, such as collection of
Government taxes and payment of electricity and mobile bills.
----------------------
Customer acquisition and retention has assumed greater significance.
---------------------- The emphasis is not merely on ensuring customer satisfaction, but on creating
customer delight. Banks have now positioned themselves as one stop financial
----------------------
shops. They have evolved marketing strategies for cross selling their own products
---------------------- as also the products of other organizations to ensure customer retention and to
acquire a greater share of his financial services wallet.
----------------------
For example, every bank now sells mutual fund products of its own subsidiary
---------------------- and also those of other organizations. This ensures that all the financial needs
of a customer are met under one roof and he does not go to any other financial
---------------------- service provider.

74 Indian Banking & Financial System

 Notes
Check your Progress 1
----------------------
Fill in the blanks. ----------------------
1. 14 major commercial banks were nationalised in _________ and
----------------------
6 more in _________ .
2. The primary objective of administered interest rate by RBI was ----------------------
_________ .
----------------------
3. The process of liberalisation of interest rates began in 80s on the basis
of the recommendation of _________ committee. ----------------------

4. SEBI was set up in _________ and took up the role of _________ . ----------------------
5. _______ was the first mutual fund set up in India in the year _______. ----------------------

----------------------
Activity 1 ----------------------

Visit site www.bankipedia.in, www.amfiindia.com and collect information ----------------------

on five MFs started by public sector banks.
----------------------

----------------------
5.3 PRODUCT DIVERSIFICATION AND INNOVATIVE
SERVICES ----------------------

----------------------
Let us now see some of the functions performed by banks in the modern
era as financial supermarkets. ----------------------
1. Distribution of mutual fund schemes ----------------------
A mutual fund is a vehicle of collective investment. Like banks, mutual
fund companies are also financial intermediaries. They prepare schemes ----------------------
and mobilize funds from investors for investing in various securities such as ----------------------
equity, bonds, money market instruments etc in accordance with the stated
objectives of the scheme. ----------------------
For example, an equity scheme would invest the funds mobilized in equity ----------------------
shares. A debt fund would invest mainly in bonds issued by Government,
Public sector undertakings and Corporate. The investors are allotted units ----------------------
which are similar to shares issued by companies to their shareholders. The
returns earned on the collective investment are distributed amongst unit- ----------------------
holders. ----------------------
Mutual fund is a good investment avenue for investors who may not have the
----------------------
time or the expertise to invest directly in the market and track the performance
of their investments. It is like having a car and not being sure of one’s own ----------------------
driving skills. The way out is to employ a driver, give him charge of your car
and enjoy the beauty along the way and safely get to the destination without ----------------------

Changing Role of Banks 75

 Notes having to worry about the one-ways, the signals and the traffic. Similarly, you
can give your funds to a mutual fund company, the expert- who will help you
---------------------- reach your financial goal. In driving, there is always the danger of an accident
in the traffic, which can happen even when you are driving yourself. Likewise,
----------------------
investing in mutual funds is also subject to market risk.
---------------------- Mutual funds do try to protect unit-holders from ‘accidents’ i.e., losses.
---------------------- They invest in many securities and the risk gets spread adequately. They
constantly track the performance of the companies they invest in and churn
---------------------- the portfolio to maximize returns. This has contributed to the growing
popularity of mutual funds among investors.
----------------------
In the late 80s, public sector banks were permitted to enter into mutual fund
---------------------- business. Since the 90s, private sector banks and corporate have also been
permitted to enter the business. Today, most banks have set up subsidiaries
----------------------
to handle mutual fund business. The branch network of banks serves as a
---------------------- powerful distribution network for marketing its own mutual fund schemes
as well as those of other entities. This distribution function enables banks to
---------------------- earn commission as well as to meet the investment needs of their customers
---------------------- and retain them on their books. In the past, banks, like other distributors,
were earning two types of commission from mutual fund companies:
----------------------
a) Upfront fee, which used to be paid out of the entry load collected from
---------------------- investors. This was around 2.25% of the amount invested.

---------------------- b) Trail commission is paid periodically until the investor stayed invested
in the schemes of the fund house.
----------------------
The main earning was on account of upfront fee, that was the bread and butter
---------------------- of most distributors. However, from August 2009, Securities and Exchange
Board of India (SEBI) banned entry load on mutual funds, which, while
---------------------- being a welcome initiative for investor protection, has hurt the business of
---------------------- distributors in general. This has also impacted the revenue of banks from
this business. Nonetheless, through distribution of mutual fund products,
---------------------- banks derive an important benefit in retaining customers on their books.
---------------------- 2. Distribution of Insurance products
Insurance is basically a means of getting protection from financial losses.
----------------------
It involves transfer of risk from the insured (policy-holder) to the insurer
---------------------- (insurance company), who does risk management by collecting insurance
premium from a large pool of individuals exposed to similar risks. Insurance
---------------------- companies have designed several products to meet the needs of people. In
---------------------- addition to providing risk cover, insurance policies are also being designed
and marketed as investment products.
----------------------
For example, unit-linked insurance policies offer a combination of insurance
---------------------- and investment. A part of the premium that you pay is invested for your
protection needs. The other portion is invested in the capital markets to give
---------------------- you a good return on investment.

76 Indian Banking & Financial System

 If we need to take a life insurance policy or do an insurance of our house, Notes
then we need to contact an insurance agent who arranges for the insurance
through insurance companies. Agents are the marketing arms of insurance ----------------------
companies who reach out to customers, popularize the products and get
----------------------
business for insurance companies.
Banks have also been allowed to sell insurance products. The distribution of ----------------------
insurance products through the distribution channels of banks, i.e. branches ----------------------
is called bancassurance. Under an arrangement with insurance companies,
banks can act as corporate agents and sell their products. Bank can use their ----------------------
vast network of branches and strong customer base to cross-sell insurance
----------------------
products.
Cross-selling refers to the marketing strategy of selling new products to ----------------------
existing customers. This broadens the range of products and services offered ----------------------
and it also enhances customer loyalty. The branch model also provides
the opportunity for face to face interaction with walk-in customers and is ----------------------
therefore ideally suited for marketing of insurance products. Banks earn
----------------------
substantial commission as corporate agents. This business offers further
potential for banks because insurance penetration, which was very low in ----------------------
the past, has now started picking up due to the popularity of products like
ULIPs and increasing awareness among people about the need for insurance. ----------------------

Recently, post offices have been permitted by Insurance Regulatory and ----------------------
Development Authority (IRDA) to act as corporate agents for selling
----------------------
insurance products. So now, banks have to contend with another competitor,
one that also has a huge network of offices. ----------------------
3. Distribution of gold coins ----------------------
In addition, to selling financial products, banks have broad-based their
business to include selling of gold coins. As distributors of insurance and ----------------------
mutual fund products, banks are competing with agents. As sellers of gold ----------------------
coins, banks are, to some extent, competing with jewellers. Banks have
traditionally enjoyed the customers’ trust as custodians of their money. They ----------------------
have now leveraged their position to sell gold coins also. So if one wants
----------------------
to buy gold on the occasion of Akshay Tritiya, then one can just as well get
it at the neighbourhood bank. Banks sell gold coins of 5 to 50 grams. They ----------------------
purchase coins in bulk and make a profit on the sale to the customer.
----------------------
4. Government Bonds
----------------------
Government bonds, such as RBI Relief Bonds, were earlier sold through the
offices of RBI only. Subsequently, the Government decided to allow banks ----------------------
to also distribute the bonds through their branches. RBI bonds are currently
offered at an interest rate of 8 % per annum. The investor has the option to ----------------------
either receive the interest at half-yearly intervals or at maturity. Banks issue ----------------------
the bonds at their branches on behalf of RBI and earn commission. They
also offer the service of collecting interest periodically and credit the amount ----------------------

Changing Role of Banks 77

 Notes to the customer’s account. RBI Bonds compete with bank fixed deposits
and currently offer higher interest. The customer may therefore not keep
---------------------- his money in bank deposits. However, by selling the bonds and collecting
interest as and when due, banks not only earn commission to offset the loss
----------------------
of business but are also able to ensure customer satisfaction.
---------------------- 5. Collection of taxes and utility bills
---------------------- The business of collecting taxes such as income tax, excise duty and
custom duty was originally handled by SBI, which acts as an agent of RBI.
----------------------
Subsequently, other public sector banks were also allowed to handle this
---------------------- business and now, even private sector banks can collect taxes on behalf of
the Government. This is another source of fee-based business for banks.
----------------------
Earlier, this business involved a lot of paper work and banks had to handle
---------------------- multiple copies of challans which caused unproductive manual work. The
procedure has been streamlined and now there is a single challan. This has
----------------------
considerably reduced the manual work for banks and Government business
---------------------- has become an attractive avenue for earning commission. Further, banks
get up to three days to deposit the money collected on account of taxes to
---------------------- the concerned Govt. account. During this period, they get to use these float
---------------------- funds, free of interest.
Banks also collect payment for utility bills, such as electricity and telephone
----------------------
bills and earn a commission on the amount collected.
---------------------- 6. DEMAT Services
---------------------- Shares were earlier held in physical form, i.e. in the form of share certificates.
This system had a number of drawbacks. The shareholders had to keep them
----------------------
safely. In case the share certificates were lost, then the procedure for issuance
---------------------- of duplicate share certificates was quite cumbersome. Fake certificates
were also used by unscrupulous people to cheat genuine investors resulting
---------------------- in losses. Transfer of shares was a tedious, costly and time consuming
---------------------- process. With a view to overcome these problems, an improved system was
evolved using technology wherein shares could be held in an electronic or
---------------------- dematerialised form.
---------------------- The enactment of Depositories Act, 1996 paved the way for the setting up
of the first depository in India, namely, National Securities Depository Ltd.
---------------------- (NSDL). Subsequently, Central Depository Services (India) Limited (CDSL)
---------------------- was set up. These depositories were set up with the objective of providing
convenient, dependable and secure depository services at affordable cost to
---------------------- all market participants. They have replaced the manual system of transfer,
settlement of transactions and physical delivery of shares by a method of
----------------------
simple book entries. Shareholders are no longer required to hold their shares
---------------------- in physical form. Instead, they can hold shares in an electronic form with
depositories. This system is a vast improvement over the earlier system and
---------------------- offers the following advantages:

78 Indian Banking & Financial System

  The risks associated with physical shares-bad delivery, theft, fake Notes
certificates are eliminated
----------------------
 Reduction in paper work
 Ease in transfer of shares ----------------------

 Reduction in transaction costs ----------------------

Thus, the facility of holding of and trading in securities in electronic form ----------------------
has increased efficiency, minimized risk and reduced costs.
----------------------
The two depositories NSDL & CDSL facilitate holding of securities in an
electronic form. The accounts of investors are maintained by Depository ----------------------
Participants (DPs) who, as agents of the depository, offer depository services
----------------------
to investors. Financial institutions, banks, custodians, stockbrokers, etc. are
eligible to act as DPs. The investor who is known as beneficial owner (BO) ----------------------
has to open a demat account through any DP for dematerialisation of his
holdings and transferring securities. ----------------------
The DP acts as a service centre and provides investors with statements and ----------------------
processes their request for nomination, transfer of shares, etc. In many ways,
the demat account is similar to a savings account. While a savings bank ----------------------
account is meant for safe custody of money, securities are held in demat ----------------------
accounts and reflected as a book entry. When we deposit money in the bank,
the savings account is credited and when we withdraw money, our account ----------------------
is debited. Similarly, when we buy shares, our demat account is credited
and when we sell shares, our demat account is debited. ----------------------

Banks now offer the facility of on line trading with 3-in-1 accounts which is ----------------------
an integrated platform of Savings Bank A/c, Demat A/c and Online Trading
----------------------
A/c to give you a convenient and paper free trading experience. Investors
usually hold large balances in savings accounts linked to their trading ----------------------
accounts and this boosts the level of deposits for banks.
----------------------
7. Wealth Advisory services
----------------------
The robust growth of the Indian economy is creating a growing class of
High Networth Individuals (HNIs). These are typically people with assets ----------------------
of rupees 1 crore and above. However, these HNIs are professionals from
various fields and many of them do not have the expertise to manage their ----------------------
financial portfolio to achieve their goal of maximizing returns with minimum
----------------------
risk. Moreover, there is a variety of financial products available in the market
which creates confusion in the minds of the investors. ----------------------
Banks offer customized packages of products, tailored to meet the clients’
needs and thus, help them realize their financial goals. Here the approach is not ----------------------
that of product selling but rather that of a professional financial advisory. Banks ----------------------
earn a fee for this specialized service.
----------------------

----------------------

Changing Role of Banks 79

 Notes
Check your Progress 2
----------------------

---------------------- Fill in the blanks.

1. Mutual funds try to protect investors’ interest by _______.
----------------------
2. Most of the banks handle mutual fund business by setting up _______.
---------------------- 3. Insurance involves transfer of _______ from _______ to _______.
---------------------- 4. The distribution of insurance products through distribution channels
of banks is called _______.
---------------------- 5. The regulatory authority for insurance industry is _______.
---------------------- 6. Banks compete with jewelers when they undertake the business of
_______.
---------------------- 7. Banks undertake the activity of sale of Govt. bonds, collection of
---------------------- taxes and utility bills, as it helps to improve their _______.
8. Wealth advisory services are generally offered/ are useful to _______.
----------------------

----------------------
Activity 2
----------------------

---------------------- Visit site www.indg.in/e governance and collect information from bank/
share brokers as regards maintenance/ operations of DMAT account.
----------------------

---------------------- 5.4 USE OF TECHNOLOGY TO IMPROVE OPERATIONAL

EFFICIENCY AND INCREASE CUSTOMER SATISFACTION
----------------------
We shall now see how banks have used technology to improve efficiency,
----------------------
cut costs and enhance customer satisfaction.
---------------------- 1. Core Banking Solutions
---------------------- We have studied above that banks have evolved new products and services
to cater to the changing needs of the customers. The above mentioned
---------------------- products and services have helped banks increase their fee-based income
and offset the decline in interest spread caused by the effects of competition
----------------------
and disintermediation. Thus, banks have been able to minimize the impact
---------------------- of competition on their profitability through product innovation and product
diversification.
----------------------
Banks have also had to curb their operating costs and improve their operating
---------------------- efficiency and profitability. This has been achieved by leveraging technology.
So much so, that the entire model of product and service delivery has
---------------------- undergone a sea-change in the past two decades or so.
---------------------- In the initial stages, the use of technology varied between banks. Public
sector banks were the slowest to adopt technology. The Rangarajan
---------------------- Committee on branch computerization, set up in 1989, laid down a roadmap

80 Indian Banking & Financial System

 for computerization of bank branches. The initial years of computerization Notes
focused on computerization of back-office processes while the front office
operations were mostly conducted manually. The task of full computerization ----------------------
was taken up by banks in the mid-nineties, starting initially from the metros
and gradually extending it to the urban and semi-urban areas. ----------------------

However, the entry of tech-savvy private sector banks hastened the pace of ----------------------
computerization in the banking system. Banks upgraded their software and
----------------------
created a network in which all branches were connected under a centralized
computer system called CORE Banking Solutions (CBS). ----------------------
Here, CORE stands for Centralized Online Real-time Exchange. This platform
----------------------
for delivery of banking products and services has emerged due to the convergence
of communication technology and information technology. In the initial phase ----------------------
of full computerization, the computer software was installed at local servers at
branches and performed the operations of banking like recording of transactions, ----------------------
passbook maintenance, and interest calculations on loans and deposits etc. ----------------------
Under core banking, the software installed at different branches of the bank is
now interconnected by means of communication lines like telephones, satellite, ----------------------
internet etc. and the entire bank’s branches access applications from a centralized ----------------------
data centre. The bank’s database which was earlier held on a standalone basis
at local servers at different branch locations is now stored at a centralized data ----------------------
centre. This data can be accessed and transactions can be put through from any
location, thus creating the model of Any Time Any Where Banking. Under this ----------------------
arrangement, branches have become remote workstations in the network and ----------------------
are only sales and service delivery channels. One can open an account at one
branch, referred to as the home branch, but just as well operate it at any branch. ----------------------
Hence, withdrawal of cash and deposit of cheques can be done at any branch
because the database can be accessed by any branch from any location. In fact, ----------------------
the network has been expanded to include multiple delivery channels such as ----------------------
ATMs and internet, in addition to branches, through which the transactions can
now be done from any location. ----------------------
The CBS platform offers the following advantages to banks: ----------------------
 Reduction in costs:
----------------------
The cost of high volume, repetitive activities at various branches is
reduced due to centralized processes. Transaction costs and manpower ----------------------
costs have also been reduced. ----------------------
 Higher efficiency
----------------------
As the entire database can be accessed from any location for putting
through transactions, many operations such as opening of accounts, ----------------------
issuance of cheque books are now centralized. As a consequence, the
----------------------
operating staff, which was doing identical work at various locations,
has now been freed from doing routine processing work and has been ----------------------
redeployed for marketing activities. This has improved employee
productivity and efficiency. ----------------------

Changing Role of Banks 81

 Notes  Improved internal controls
Centralization has strengthened the internal control and audit function.
----------------------
Controlling offices can now access the central database and better
---------------------- monitor compliance of regulatory requirements by branches. Centralised
tracking of quality of loan accounts at branches and remote audit of
---------------------- branch operations are other advantages that have caused a strengthening
of the banks’ internal control systems. Risk management systems have
----------------------
also been strengthened.
----------------------  Enhanced customer satisfaction
---------------------- The customer can now access his account at any time anywhere from
a wide range of delivery channels. Cash withdrawal, getting account
---------------------- statement, deposit of local cheques can be done at any branch or ATM.
---------------------- The banks can also use the central database to analyze and understand
customer behaviour and preferences and evolve innovative products
---------------------- and services tailored to suit their requirements and create customer
---------------------- delight.
2. Single window system
----------------------
In the traditional branch set up, a customer had to move from one bank
---------------------- counter to another to complete a single transaction. For example, a customer
requiring a DD had to fill in the requisition slip and pay cash at the cash
---------------------- counter. Thereafter, he would have to stand in the queue at the DD counter
---------------------- and wait until the requisition slip reached the DD issuing counter. After
preparing the DD, the counter clerk would send it to a designated official
---------------------- for signing. Sometimes, non-availability of one or more of these personnel
would cause further delays. In the process, the customer would end up
---------------------- spending hours at the bank.
---------------------- With the view to reduce the inconvenience caused to customers banks have
launched the single window system. Under this system, all the needs of the
----------------------
customer are met at one counter (window) since every terminal can perform
---------------------- all the banking functions under CBS. Hence, the task of issuance of DD is
now done at one counter only- the same person receives cash, prepares the
---------------------- DD and also signs it. The single window system has therefore, emerged as
a single point of service delivery thereby improving the turnaround time
----------------------
and enhancing customer satisfaction.
---------------------- 3. Alternate Delivery Channels
---------------------- The traditional model for delivery of banking products and services is the
branch. The customer is required to visit the branch for his banking needs.
---------------------- This model is referred to as the ‘brick and mortar’ model. However, this
---------------------- model has a number of drawbacks. The costs of setting up a branch are
quite high. Various procedures have to be completed for obtaining branch
---------------------- licence and permission from RBI has to be obtained before a new branch
can be obtained causing delays. The operating costs are also very high with
---------------------- the rent of the premises being a major component of the cost. The limited

82 Indian Banking & Financial System

 resources of the branch are constantly under strain and activities of branch Notes
functionaries are directed towards meeting the routine needs of customers
such as cash deposits and withdrawal. The focus of the branch officials on ----------------------
business development and customer acquisition gets diluted.
----------------------
A number of technology-enabled delivery channels, which are also called
‘click and portal’ models, have emerged in the past decade or so. These include: ----------------------
A. Automated Teller Machines (ATMs) ----------------------
B. Internet banking
----------------------
C. Mobile Banking or m-banking
D. Point of Sale (POS) Terminals ----------------------
E. Phone Banking ----------------------
All the above channels are self-service channels, except phone banking,
in which the customer also has the option of availing the services of a Phone ----------------------
Banking Officer (PBO). ----------------------
A. Automated Teller Machines
----------------------
The invention of Automated Teller Machines-ATMs- and their use as cash
dispensers by John Shepherd-Barron (who incidentally died recently) was ----------------------
a revolutionary step in electronic banking. ATMs were initially used on a
----------------------
standalone basis for account-holders of the branch to which the ATM was
attached. After the introduction of CBS, ATMs, like branches, have also ----------------------
been networked. The range of services offered has also increased to include
non-cash transactions such as balance enquiry, mini statement, cheque book ----------------------
request and electronic fund transfers.
----------------------
Most banks issue an ATM-cum-debit card to the depositor at the time of
opening of the account itself. This card has to be used at the ATM together ----------------------
with the Personal Identification Number (PIN) which is a numeric code to
----------------------
be kept confidential by the depositor.
ATMs have become a powerful platform for delivery of a range of products ----------------------
and services on a 24*7 basis in an efficient and error-free manner. The ----------------------
cost of setting up and maintaining an ATM is much lower as compared to
that of a branch. The transaction cost is also much lower than at a branch. ----------------------
Reserve Bank of India has now permitted Banks to install ATMs at centres/
places identified by them, without having the need to take permission from ----------------------
the Reserve Bank in each case. Thus, now, setting up of an ATM involves ----------------------
much lesser time. This is also an effective strategy for market penetration
and increasing the visibility of the bank in the market. ----------------------
B. Internet Banking ----------------------
This is another technology-enabled self-service channel in which the
customer can log on to the bank’s web page and access his account and ----------------------
perform banking transactions from the comfort of his or her home or office. ----------------------
It is also called ‘armchair banking’ because of the convenience and the
comfort that the customer enjoys. ----------------------

Changing Role of Banks 83

 Notes The customer is usually given a User ID and a password in a sealed
packet for availing this facility. The password should be changed when
---------------------- the first transaction is put through and is thereafter required to be changed
periodically. In addition to the login password, some banks also require
----------------------
the use of a transaction password which is an additional security measure.
---------------------- A number of services can be availed using the internet such as:
 Fund transfer
----------------------
 Balance enquiry
----------------------
 Account statement
----------------------
 Request for cheque book
----------------------  Stop payment request
----------------------  Request for issuance of DDs and Pay orders

----------------------  Payment of utility bills

C. Mobile banking
----------------------
Mobile Banking refers to provision of banking and financial services with
---------------------- the help of mobile telecommunication devices. With mobile technology,
---------------------- banks can offer services to their customers such as making funds transfer
while travelling, receiving online updates of stock price or even performing
---------------------- stock trading while being stuck in traffic.

---------------------- In India, mobile banking is, as of now, largely confined to information related
to transactions through text message alerts.
----------------------
There are two types of alerts:
---------------------- a) Push Alerts and
---------------------- b) Pull alerts

---------------------- Push alerts are originated by banks for sending account information
whenever a debit or credit transaction takes place in an account.
----------------------
Pull alerts are initiated by customers seeking account information, such as
---------------------- balance, by sending a key word as an SMS to a specified number. The bank
responds by sending an SMS containing the desired information.
----------------------
The usage of this medium is growing rapidly all over the world, including
---------------------- India. Mobile phones are emerging as wireless wallets. A large unbanked
population, and the deeper and wider reach of mobile phones, makes
---------------------- India very conducive for mobile banking and payments. Now, RBI has
---------------------- granted permission to transfer funds across various mobile-phone service
providers and the popularity of m-banking is expected to grow rapidly in
---------------------- the coming years.
---------------------- Mobile trading has been recently launched by BSE in India. Trading or
broker houses complying with regulatory and security norms have been
---------------------- allowed to start providing mobile trading services to investors.

84 Indian Banking & Financial System

 The growing popularity of m-banking, along with internet banking, is a Notes
pointer to the possibility that not only branches, but even ATMs, may become
less relevant as delivery channels in the future. ----------------------
D. Point of Sale (POS) Terminals ----------------------
POS terminals are swipe machines that are located at merchant establishments
----------------------
such as shops, restaurants, petrol pumps etc. A debit card or a credit card can
be swiped at the terminal for making payment to merchant establishments, ----------------------
who gets the funds immediately. Banks are benefited by having a client base
of both card-holders and retailers. Customers are able to make cash-less ----------------------
purchases and the retailers benefit because the system eliminates the need ----------------------
to handle cash.
E. Phone banking ----------------------

Phone banking, or telebanking, is another banking channel offering ----------------------

24*7 services. It features a user friendly service menu to access account
----------------------
transactions, together with a security requirement whereby the customers is
required to use a TPIN, or a Telephone Personal Identification Number. The ----------------------
customer can also take the assistance of a Phone Banking Officer (PBO).
The facility can be used for: ----------------------
1. Checking balance in the account ----------------------
2. Making stop payment of cheques ----------------------
3. Reporting loss of ATM-cum- Debit card or credit card
----------------------
4. Requesting for a cheque book
----------------------
All the delivery channels described above have several advantages over the
traditional branch model. Some of the advantages are: ----------------------
 The transaction cost is much lower than that at branches. Studies have ----------------------
revealed that while a transaction put through at a branch costs the bank
Rs.50, it costs only Rs.18 and Rs.10 per transaction at an ATM and ----------------------
internet respectively.
----------------------
 Overcrowding at branches gets reduced causing less delays, which was
a major irritant in the traditional model ----------------------
 Banks are able to handle customer requests more efficiently and quickly. ----------------------
 Bank employees are free from routine activities and can focus ----------------------
on customer acquisition and retention. A new class of Customer
Relationship Managers (CRMs) has emerged who maintain close ----------------------
liaison with customers, meet their specific needs and also cross-sell
other products. ----------------------

 Bank employees are able to do quality work. This enhances their job ----------------------
satisfaction and morale.
----------------------
The thrust of banks is now to “push” customers out of branches and to ensure
their migration to alternate delivery channels and thereby reduce foot-falls ----------------------

Changing Role of Banks 85

 Notes at branches. Channel migration has now become the mantra to improve
efficiency, cut costs and handle growing volume of customer transactions
---------------------- efficiently.
----------------------
Check your Progress 3
----------------------
Fill in the blanks.
----------------------
1. The Network, which connects all branches of a bank under a centralised
---------------------- computer system, is called __________.
---------------------- 2. Single window system offers single point of service delivery, which
helps to improve _______ and enhances _______.
---------------------- 3. Internet banking is also referred to as “-------------- banking”.
---------------------- 4. Mobile banking provides two types of alerts: i) _______ ii) _______.
5. While using phone banking, as a security measure, the customer is
---------------------- required to use _______.
----------------------

---------------------- Activity 3
----------------------
Identify the precautions to be taken while using alternate channels for
---------------------- putting through banking transactions.
----------------------

---------------------- 5.5 CENTRALISATION OF OPERATIONS

---------------------- As we have seen earlier, the branch has been the traditional model for delivery
of banking products and services. The advantage is that the branch functionaries
---------------------- have a close rapport with customers and are able to accord priority to valued
customers. Service delivery in certain areas is quick. For example, issuing cheque
---------------------- book is a matter of merely branding the customer’s account number using a
---------------------- rubber stamp on all leaves of a blank cheque book, entering the particulars in the
computer system under account details and handing the cheque book over to the
---------------------- customer, against his acknowledgement in the Cheque Book Issued Register.
---------------------- However, the branch model suffers from many drawbacks which are as follows:
1. During peak days, typically the first ten days of a month, customer service
----------------------
gets delayed.
---------------------- 2. There is no standardization in the work done by branch functionaries at
---------------------- different location, exposing the bank to the risk of frauds and errors.
3. The quality of service depends upon the skills, efficiency and motivation
---------------------- of employees which can vary between branches creating inconsistency in
---------------------- service delivery.
4. Adherence to bank’s laid down policies and to risk management guidelines
---------------------- is difficult.

86 Indian Banking & Financial System

 With the networking of branches under Core Banking Solutions and the Notes
resultant capability to access the database from any location, banks started
doing certain similar and repetitive operations at centralized locations to ease the ----------------------
burden on branches and to improve the Turn Around Time (TAT). To begin with,
centralization was done for processing of clearing cheques and later extended ----------------------
to processing of account opening forms and loan proposals. Thus, banks set up ----------------------
Centralised Processing Centres (CPCs) as specialized units to process repetitive
activities. These CPCs have acquired speed and efficiency in handling repetitive ----------------------
work and thus, reduced the TAT. The activities are conducted in a standardized
manner and in strict adherence to bank’s policies and procedures. The wastages ----------------------
resulting from duplicating similar activities at different locations have also been ----------------------
eliminated.
----------------------
Check your Progress 4 ----------------------

Fill in the blanks. ----------------------

1. TAT stands for __________. ----------------------
2. With a view to improve the efficiency, many banks have set up ----------------------
__________ for handling repetitive work.
----------------------

----------------------
Activity 4
----------------------
Present a comparative analysis of branch operations and centralised ----------------------
operations and bring out their relative advantages and disadvantages.
----------------------

5.6 DYNAMIC QUEUE MANAGEMENT (DQM) ----------------------

----------------------
Despite the efforts by banks to move their customers away from branches
to alternate delivery channels, it has been found that customers still show a ----------------------
marked preference for branch-based services. Some customers, notably senior
citizens and rural customers continue to prefer the branch model because they ----------------------
prefer face to face interaction for service delivery and are not comfortable with
----------------------
the mechanical and transaction-oriented nature of service delivery at technology-
enabled channels. Moreover, with the increasing customer base, foot-falls at ----------------------
branches have continued to increase, notwithstanding the availability of alternate
delivery channels. This has caused crowding at bank counters. ----------------------
To help reduce waiting time, DQM system has been introduced at some ----------------------
banks, notably ICICI Bank, to assign specific banking services to each of the
service counters at the branch. The system automatically assigns incoming ----------------------
customers to relevant counters and paper tokens are issued. If all counters ----------------------
are busy, then the customers can sit in the lounge until their token number is
flashed on an electronic display together with the counter number. They can ----------------------

Changing Role of Banks 87

 Notes then approach the designated counter and get their needs attended to. This
helps to reduce bottlenecks at particular counters, reduces the customer waiting
---------------------- time and adds to their satisfaction. Even during peak hours customers do not
get anxious or irritated as this system brings orderliness in customer handling.
---------------------- It also helps branch heads to manage resources under pressure of increasing
---------------------- footfalls.

---------------------- Check your Progress 5

----------------------
State True or False.
----------------------
1. With the presence of alternate channels, nobody now prefers branch-
---------------------- based service.

---------------------- 2. Dynamic Queue Management system has been introduced by some of

the banks. This helps to reduce the bottlenecks at certain counters.
----------------------
----------------------
Activity 5
----------------------
Visit the site www.enso-secutrack.com for more information on DQM.
----------------------
Suggest ways to further reduce the customer waiting time.
----------------------

---------------------- Summary
---------------------- ● We have seen above the responses of banks to the changes in the external
environment brought about by deregulation, disintermediation and
----------------------
competition.
---------------------- ● Banks have widened the scope of their operations to emerge as financial
supermarkets offering a broad range of products and services under one
----------------------
roof. Banks have also used the power of technology to improve their
---------------------- operational efficiency, prune costs and create value for customers.

---------------------- Keywords
----------------------
● Disintermediation: Disintermediation refers to consumers investing
---------------------- directly in securities rather than leaving their money in savings accounts
with banks, then later to borrowers going to the capital markets rather
---------------------- than to banks.
---------------------- ● Insurance: Insurance is a way of getting protection from financial losses.
It involves transfer of risk from the insured (policy-holder) to the insurer
---------------------- (insurance company), who does risk management by collecting insurance
premium from a large pool of individuals exposed to similar risks.
----------------------
● Point of Sale (POS) Terminals: POS terminals are swipe machines that
---------------------- are located at merchant establishments such as shops, restaurants, petrol

88 Indian Banking & Financial System

 pumps etc. A debit card or a credit card can be swiped at the terminal Notes
for making payment to merchant establishments, who gets the funds
immediately. ----------------------

----------------------
Self-Assessment Questions
----------------------
1. Elaborate on the changing market environment of banks.
----------------------
2. How has technology improved efficiency and customer satisfaction in
banking system? ----------------------
3. Explain DQM. ----------------------

----------------------
Answers to Check your Progress ----------------------
Check your Progress 1 ----------------------
Fill in the blanks. ----------------------
1. 14 major commercial banks were nationalised in 1969 and 6 more in 1980.
----------------------
2. The primary objective of administered interest rate by RBI was to make
available credit to priority sector at low rate of interest. ----------------------
3. The process of liberalisation of interest rates began in 80s on the basis of ----------------------
the recommendation of Chakravarty Committee.
----------------------
4. SEBI was set up in 1989 and took up the role of a market regulator.
5. Unit Trust of India was the first mutual fund set up in India in the ----------------------
year 1964. ----------------------

Check your Progress 2 ----------------------

Fill in the blanks. ----------------------

1. Mutual funds try to protect investors’ interest by investing in many ----------------------
securities and spreading the risk.
----------------------
2. Most of the banks handle mutual fund business by setting up separate
subsidiaries. ----------------------
3. Insurance involves transfer of risk from insured to insurer. ----------------------
4. The distribution of insurance products through distribution channels of
banks is called bancassurance. ----------------------

5. The regulatory authority for insurance industry is IRDA. ----------------------

6. Banks compete with jewelers when they undertake the business of selling ----------------------
of Gold coins.
----------------------
7. Banks undertake the activity of sale of Govt. bonds, collection of taxes
and utility bills as it helps to improve their fee-based income. ----------------------

Changing Role of Banks 89

 Notes 8. Wealth advisory services are generally offered/ are useful to High Net
worth individuals.
----------------------

---------------------- Check your Progress 3

---------------------- Fill in the blanks.

---------------------- 1. The Network, which connects all branches of a bank under a centralised
computer system, is called Core Banking Solution (CBS).
---------------------- 2. Single window system offers single point of service delivery, which helps
---------------------- to improve Turn around Time (TAT), and enhances customer satisfaction.
3. Internet banking is also referred to as “Armchair banking”.
----------------------
4. Mobile banking provides two types of alerts: i) Push alerts ii) Pull alerts.
----------------------
5. While using phone banking, as a security measure, the customer is
---------------------- required to use Telephone Personal Identification Number (TPIN).

----------------------
Check your Progress 4
----------------------
Fill in the blanks.
----------------------
1. TAT stands for Turn Around Time.
---------------------- 2. With a view to improve the efficiency, many banks have set up Centralised
Processing Cells (CPC) for handling repetitive work.
----------------------

----------------------
Check your Progress 5
---------------------- State True or False.
---------------------- 1. False
---------------------- 2. True

----------------------

---------------------- Suggested Reading

----------------------
1. Khan, M.Y. Financial Systems.
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

90 Indian Banking & Financial System

Banker - Customer Relationships
UNIT

6
Structure:
6.1 Introduction
6.2 Definition of a Customer
6.3 Banker - Customer Relationship
6.4 Bankers’ Rights
6.5 Obligations of a Banker
6.6 Order
6.7 Obligation to Maintain Secrecy of Account
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Banker - Customer Relationship 91

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Describe the relationship between the bank and the customer
----------------------
• Explain the rights of a banker
----------------------
• Enumerate the obligations of a banker
---------------------- • Discuss the duties of a banker with regard to garnishee order and
---------------------- income tax attachment order

----------------------

---------------------- 6.1 INTRODUCTION

---------------------- We have seen in earlier units that the primary function of a bank is to accept
deposits and lend the same by way of loans and investment. Thus, banks mainly
---------------------- deal with depositors and borrowers. We have also seen that banks provide other
facilities such as issuing DDs, providing locker facility and collecting outstation
----------------------
cheques. Depending upon the nature of services rendered, different types of
---------------------- relationships are created between the bank and its customers.
In this unit, we shall understand the meaning of the term ‘customer’ and also
----------------------
the relationship that exists between the bank and its customer. Banks have also
---------------------- been conferred with some rights by law for recovery of their dues and should
also comply with statutory provisions regarding honouring customers’ cheques
---------------------- and must maintain secrecy with regard to customers’ accounts.
----------------------
6.2 DEFINITION OF A CUSTOMER
----------------------
We have already seen the definition of the term banking under Banking
---------------------- Regulations Act. In addition to the primary function of accepting deposits and
using the same for lending and investment, banks also perform other functions
----------------------
as permitted under the Banking Regulations Act. These functions give rise to
---------------------- certain relationships between them. Let us now understand the meaning of the
term ‘customer’.
----------------------
The term ‘customer’ has not been defined by law. Generally, the term
---------------------- customer is used to mean a person, company, or other entity which buys goods
and services produced by another person, company, or other entity. In the context
---------------------- of banking, does this mean that anybody who buys say, a DD, from a bank is its
customer, whether he has an account or not? The answer is no. Normally, only
----------------------
a person who has an account with the bank is considered a customer.
---------------------- In the past, an attempt was made to define a customer on the basis of the
duration of the dealings between the customer and the bank. This theory was
----------------------
called the duration theory and was put forth by Sir. John Paget. However, this
---------------------- theory was not found acceptable and has been discarded. The commonly accepted

92 Indian Banking & Financial System

definition, therefore, is that a customer is any person who maintains an account Notes
with a bank. In other words, as soon as the account opening formalities are
completed and an initial deposit is made by a depositor, a contractual relationship ----------------------
arises between the bank and the customer. The customer is entitled to avail the
banking services and the bank is entitled to be compensated for the services ----------------------
rendered on basis of the agreed terms and conditions. The status remains the same ----------------------
even if the account is not operated subsequently and there are no transactions
after the initial deposit. However, it is expected that the customer would have ----------------------
regular dealings with the bank after opening the account.
----------------------
It is important to note that the status of a person as a customer is derived from
the nature of his dealings with the banker. In other words, his dealings with the ----------------------
banker should be related to the business of banking. The primary function of banks
----------------------
is to accept deposits for the purpose of lending and investment. Therefore, if any
person does not deal with a banker with regard to the above referred function but ----------------------
avails of any ancillary service rendered by the bank, then such person would not
be termed as a customer of the bank. If, for example, a person deposits cash in a ----------------------
bank and requests for issuance of a DD , but does not maintain an account with
----------------------
the bank, then he cannot be called a customer of the bank because his dealings
with the banker are not with regard to the essential function of a banker. ----------------------
Thus, a customer should fulfil the following criteria:
----------------------
1. He or she must maintain a bank account by making necessary deposit of
money and ----------------------
2. The dealing between the banker and customer should be in the nature of ----------------------
banking business
----------------------
A customer can be a natural person as well as a legal entity. A firm, a
company, a society, trusts, a Government department or any other separate legal ----------------------
entity can be a customer.
----------------------

Check your Progress 1 ----------------------

----------------------
Multiple Choice Single Response
----------------------
1. The term customer has been defined under:
i. Negotiable Instruments Act ----------------------
ii. Indian Contract Act ----------------------
iii. Banking Regulation Act ----------------------
iv. Has not been defined anywhere
----------------------
2. Duration theory refers to
----------------------
i. Time required opening an account
ii. Defining a customer, based on duration of dealings with the bank ----------------------
iii. The maximum time for which a deposit can be kept with the bank ----------------------

Banker - Customer Relationship 93

 Notes
3. A person (natural or legal) will be called customer if he fulfills the
---------------------- criteria:

---------------------- i. Maintains minimum balance of Rs 5000 in the account

ii. Maintain an account and deposit money
----------------------
iii. The dealings are in the nature of banking business
----------------------
iv. Should comply with ii and iii above
---------------------- v. There is no such requirement
----------------------

---------------------- Activity 1
----------------------
Visit a bank branch and study the requirements for opening an account in
---------------------- the names of a firm and a limited company.
----------------------

---------------------- 6.3 BANKER - CUSTOMER RELATIONSHIP

---------------------- 1. Debtor- Creditor (Bank is a Debtor and Customer is a Creditor)

The relationship between the bank and the customer is primarily that of
---------------------- debtor and creditor. When a customer deposits money with his bank, the
---------------------- customer becomes a lender and the bank becomes the borrower. The money
handed over to the bank represents a debt which the bank has to repay to
---------------------- the depositor.

---------------------- Thus the relationship between the bank and the customer is that of a debtor
and creditor. The creditor has a right to demand back his money from
---------------------- the banker and the banker is under an obligation to repay the debt as and
when required to do so. But the creditor does not have any charge or right
---------------------- on the assets of the bank and if the bank fails, then the creditor-depositor
---------------------- cannot have a claim on the assets of the bank. The depositor is, therefore,
an unsecured creditor of the bank. However, as we have seen in an earlier
---------------------- unit, the depositor’s position is safeguarded to some extent by DICGC which
insures deposits up to Rupees 1 lac.
----------------------
This relationship of debtor-creditor between the bank and the customer is
---------------------- different from a similar relationship that arises from a commercial transaction
where the seller of goods becomes the creditor and the buyer becomes the
---------------------- debtor. These two are different in the following respects:
---------------------- i) Demand for payment must be made by the creditor
---------------------- In a normal commercial transaction, the debtor pays the debt to the
creditor either on the agreed date or when demanded by the creditor,
---------------------- as per the terms of the contract between them. In the case of a bank
deposit, the bank, as a debtor does not make payment on its own. It
---------------------- makes payment only when the creditor-depositor makes a demand

94 Indian Banking & Financial System

 for payment in the proper manner. This is because a banker is not an Notes
ordinary debtor. When a bank accepts a deposit, it hands over a cheque
book to the creditor allowing him to draw the money whenever required ----------------------
and takes the obligation to honour such cheques. The discretion to
decide the time of withdrawal and the amount of withdrawal is entirely ----------------------
with the depositor-creditor. If the bank returns the amount deposited ----------------------
on its own by closing the account, some cheques that the customer
may have issued would get dishonoured and his reputation would be ----------------------
adversely affected by bank’s unilateral action in returning the money.
Hence, a demand by the creditor-depositor is necessary for the refund ----------------------
of the amount deposited. ----------------------
ii) The demand should be made in a proper manner. The customer should
----------------------
demand payment, not verbally or by making a telephone call, but by
a cheque, draft or in accordance with the common usage amongst the ----------------------
banks. Moreover, the demand for payment should be done on a working
day and during the working hours of the bank. ----------------------
iii) A seller of goods in a commercial transaction can ask for security from ----------------------
the buyer-debtor for the repayment of the debt. In case of a bank deposit,
the depositor cannot ask for security from the bank for the repayment ----------------------
of the deposit.
----------------------
2. Creditor-Debtor (Bank is a Creditor and Customer is a Debtor)
----------------------
When the bank gives a loan to the customer, it becomes the lender and the
customer is the borrower. The relationship between the banker and customer ----------------------
is that of a creditor and a debtor. While granting loans, the bank may, at
its discretion, obtain security in the form of a charge on the assets of the ----------------------
borrower-debtor. In such cases, the bank becomes a secured creditor. ----------------------
The following table summarizes the banker-customer relationship:
----------------------
BANK CUSTOMER
----------------------
DEPOSIT ACCOUNT DEBTOR CREDITOR
----------------------
LOAN ACCOUNT CREDITOR DEBTOR
----------------------

It is also possible that in a single account the relationship may change ----------------------
depending on the balance in the account. For example, a current account is a
----------------------
deposit account opened for business purposes and the relationship basically is
that bank is a debtor and the customer is the creditor. The customer’s account ----------------------
with the bank would show a credit balance. However, the bank may, at its
discretion, allow the customer to overdraw up to a certain limit whenever ----------------------
he needs funds. In such circumstances, when the customer draws beyond
----------------------
the available balance, the account will show a debit balance. The amount
then represents dues from the customer to the bank and the bank becomes ----------------------
the creditor and the customer becomes the debtor. A current account is a
running account and the customer may deposit and withdraw money as per ----------------------

Banker - Customer Relationship 95

 Notes his needs. The account may, therefore, subsequently turn into credit if funds
are deposited by the customer and the relationship would again be reversed.
----------------------
3. Bank as a Trustee
---------------------- Normally, a banker is a debtor in respect of the deposits made by the
depositor. In certain circumstances, he also acts as a trustee. A trustee is a
----------------------
person or entity who holds assets or money for the benefit of some person
---------------------- called beneficiary.

---------------------- The position of a banker as a trustee or as a debtor depends upon the

circumstances of each case. If the banker does something in the ordinary
---------------------- course of his business, without any specific instructions from the customer,
the relationship is that of debtor-creditor. When money or cheques are
---------------------- deposited with the bank for a specific purpose, the nature of relationship
---------------------- would be determined by ascertaining whether the amount was actually
debited or credited to the customer’s account or not. For example, when a
---------------------- customer deposits a cheque with a bank for collection from another bank,
---------------------- a) Until the cheque is realized, the relationship is that of a trustee and
beneficiary between the bank and the customer.
----------------------
b) After the cheque is realized and the amount is credited to the customer’s
---------------------- account, the bank becomes a debtor for the amount.

---------------------- The relationship between the banker and his customer as a trustee depends
upon the specific instruction given by the customer to the banker regarding
---------------------- the use of money deposited or documents entrusted to the banker. Thus, a
relationship of trustee-beneficiary arises in the following cases:
----------------------
a) When money is paid to a bank with specific instructions to retain the
---------------------- same, pending further instructions or
---------------------- b) To pay the same to another person who has no account with the bank
and the bank accepts the instruction and holds the money, pending
---------------------- instructions from that person or
---------------------- c) Where instructions are given by the customer to his banker that a part
of the amount lying in his account should be forwarded to another bank
---------------------- and the amount is sent by the bank as directed.
---------------------- Similarly, when a person purchases a DD from the bank and dispatches it to
the payee, then the bank holds the money as the trustee for the payee, who
----------------------
becomes the beneficiary of the amount stated in the DD.
---------------------- 4. Banker as Agent
---------------------- One of the ancillary services rendered by the bank is remittance of funds
by DD and other modes, collection of cheques, bills etc on behalf of the
---------------------- customers. The banker also accepts and executes standing instructions for
---------------------- periodic payment of electricity bills, telephone bills, insurance premium
etc. In all such cases, the bank acts as an agent and the customer becomes
---------------------- the principal.

96 Indian Banking & Financial System

5. Banker as a Bailee Notes
We have seen earlier that banks accept packets for safe custody which are
----------------------
returned when demanded by the customer. In such cases, besides being a
trustee, bank becomes a bailee and the customer is the bailor. The contract ----------------------
becomes a contract of bailment. Bailment is defined under Indian Contract
Act as 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. Thus, the purpose of delivery of the valuables to the bank ----------------------
is for safe custody and the bank is required to return them when demanded
by the customer. Bank, as bailee, is further required to take due care of the ----------------------
valuables in its custody as a man of normal prudence would take of his own
goods. If the bank acts negligently, then it shall be liable to the customer- ----------------------
bailor for the loss caused by such negligence.
----------------------
6. Bank as Lessee or Licensee
----------------------
Banks also provide safe deposit lockers to customers who hire them on
lease basis and pay lease rent for the same. In this case, the relationship is ----------------------
that of lessor and lessee. That is, the bank is the lessor and the locker hirer
is the lessee. In some banks, this relationship is also termed as licensor and ----------------------
licensee.
----------------------
7. Bank as Indemnified (Customer is the Indemnifier)
----------------------
A contract of indemnity is a contract by which one person promises to save
the other from the loss caused to him by the conduct of the promisor himself ----------------------
or by the conduct of any other person. In banking transactions, when a
purchaser requests for issuance of a duplicate draft in lieu of a lost draft, an ----------------------
indemnity is obtained to protect the bank from loss which may be caused
by double payment. This is because the bank cannot stop payment of its ----------------------
own draft. So if the bank is required to pay the lost draft also in addition ----------------------
to the duplicate draft, then it would amount to double payment and the
Bank would suffer a loss. The indemnity obtained at the time of issuance ----------------------
of duplicate DD is then invoked and the amount is recovered from the
purchaser, the indemnifier. Indemnity bonds are also obtained at the time ----------------------
of issuing duplicate Fixed Deposit Receipt (FDRs). ----------------------

Check your Progress 2 ----------------------

----------------------
State True or False.
----------------------
1. The relationship between the bank and customer is primarily that of
creditor and debtor. ----------------------
2. The depositor is an unsecured creditor of the bank. ----------------------
3. The bank should repay the deposit on its own without waiting for the
----------------------
customer to make a demand.
----------------------

Banker - Customer Relationship 97

 Notes
Fill in the blanks.
---------------------- 1. In case of a loan account, the relationship between the banker and
customer is that of _______ and _______.
----------------------
2. When a customer deposits a cheque with a bank for realisation, till
---------------------- such time the cheque is realised, the relationship between the bank
---------------------- and the customer is that of _______ and _______.
3. The banker accepts standing instructions for periodic payment of
---------------------- bills etc. from the customer’s account. In this case, the bank acts as
---------------------- _______ and the customer as _______.
4. In case of safe deposit locker availed by a customer, the relationship
---------------------- between the bank and the customer is that of _______ and _______.
---------------------- 5. The right of the creditor to retain the goods and securities owned by
the debtor until the debt due from him is repaid is called _______.
----------------------
----------------------
Activity 2
----------------------

---------------------- Analyse the relationship in the following types of transactions:

---------------------- a. Overdraft/loan in debit balance
b. Sale/purchase of shares, securities on behalf of customer
----------------------
c. Issue of a demand draft on the request of the customer
----------------------
d. Bank is the payee of a demand draft
---------------------- e. money tendered to the bank pending instructions of its disposal
----------------------

---------------------- 6.4 BANKERS’ RIGHTS

----------------------
The law confers upon bankers certain rights for recovery of their dues.
---------------------- These rights are as follows:
---------------------- 1. Right of General Lien

---------------------- 2. Right of set-off

1. Bankers’ Right of General 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. It confers upon the
creditor the right to retain the security belonging to the debtor. Such right
---------------------- can be exercised by the creditor in respect of goods and securities entrusted
---------------------- to him by the debtor with the intention to be retained by him as security for
a debt due by the debtor. This means that the creditor must already be in
---------------------- possession of goods and only then can he exercise the right of lien on them.

98 Indian Banking & Financial System

 Lien may be either Notes
i) A general lien or
----------------------
ii) A particular lien
----------------------
i) A particular lien can be exercised by a craftsman or a person who
has spent time, labour and money on goods retained. It gives the ----------------------
right to retain goods for a particular debt only. For example, a
mobile repair shop owner has the right to retain the mobile repaired ----------------------
by him until his repairing charges are paid. It should be noted
----------------------
that a particular lien confers upon the creditor the right to retain
goods and not the right to sell the goods. In the above example, ----------------------
the repair shop owner cannot sell the mobile to recover his charges
he can merely retain the mobile with him until the mobile owner ----------------------
the debtor- pays the dues.
----------------------
ii) A general lien is applicable not to a particular debt alone but to all
amounts due from the debtor to the creditor. This right is conferred ----------------------
on banks in accordance with Section 171 of the Indian Contract ----------------------
Act which states that bankers may in the absence of a contract to
the contrary, retain as security for a general balance of account, ----------------------
any goods bailed to them. The words ‘in the absence of a contract
to the contrary’ mean that if the goods are handed over to the bank ----------------------
for some specific purpose, then the bank cannot have a lien on ----------------------
them. Further, the goods and securities should have been entrusted
to the banker in his capacity as a banker. ----------------------
The bank can, therefore, exercise the right of lien if the following ----------------------
conditions are fulfilled:
1. The relationship is that banker is the creditor and the customer is ----------------------
the debtor. ----------------------
2. The bank is, in fact, a secured creditor. The borrower should
----------------------
deliver securities or goods as security for loan and not for any
other purpose. Thus, another relationship, arising from the above, ----------------------
is formed- the borrower is the pledgor and the bank is the pledgee.
----------------------
3. The creditor-banker should be in possession of the goods.
4. The goods or securities should be entrusted to the banker in its ----------------------
capacity as a banker. ----------------------
The special features of a banker’s right of general lien are:
----------------------
a) A banker’s lien is equivalent to an implied pledge.
----------------------
We have seen above that the right of lien does not give the creditor
the right of sale but only the right to retain goods until the debt is ----------------------
repaid. A banker’s lien is, however, equivalent to an implied pledge.
In case of pledge, the creditor enjoys the right of sale. Pledge is ----------------------
defined as bailment of goods as security for payment of a debt or
----------------------
performance of a promise. A banker’s right of lien is more than a

Banker - Customer Relationship 99

 Notes general lien. It confers the power to the banker to sell the goods
and securities in case of default by the customer. The banker’s
---------------------- right of general lien is similar to a pledge and it is also referred
to as implied pledge. The banker thus enjoys the privileges of a
---------------------- pledgee and can dispose of the securities after giving proper notice
---------------------- to the customer.
b) The right of lien is conferred by law and no separate agreement
----------------------
or contract is necessary for the purpose. However, as an abundant
---------------------- measure of precaution, the banker takes a letter of lien from the
customer mentioning that the goods are entrusted to the bank
---------------------- as security for a loan-existing or future- and that the banker can
exercise his right of lien on them.
----------------------
c) The right of lien can be exercised on goods or other securities in
---------------------- the name of the customer-borrower only and not on any securities
jointly held with some other person(s).
----------------------
d) The banker can exercise his right of lien on the securities remaining
---------------------- in his possession after the loan for which they were lodged, is
repaid by the borrower, if no contract to the contrary exists. In
----------------------
such cases, it is presumed that the borrower has re-offered the
---------------------- same securities for any other advance outstanding on that date or
taken subsequently. The bank continues to have rights as pledgee
---------------------- on the securities in its possession.
---------------------- Let us assume that a borrower A has taken two loans from a bank-
a Personal Loan of Rs. 10,000/ without giving any security and a
---------------------- Gold Loan of Rs.15,000/- against the security of gold ornaments
---------------------- pledged to the bank. Now even if A fully repays the Gold Loan,
the bank can still retain the gold ornaments as security for the
---------------------- repayment of the Personal Loan. The bank’s right of lien continues
for existing as well as future loans.
----------------------
The banker does not have the right of general lien in the following
---------------------- circumstances:
---------------------- i) Safe custody articles: When a customer deposits securities, documents,
ornaments and other valuables for safe custody, then the banker acts as
---------------------- a trustee/ bailee with the purpose to ensure their safety from theft, fire,
etc. Here, there is no creditor-debtor relationship. The customer has
---------------------- deposited valuables, not as security for any loan, but for safe custody.
---------------------- Therefore, a contract inconsistent with the right of lien exists and the
banker cannot exercise the right of lien.
----------------------
ii) Documents deposited for special purpose: If a customer gives
---------------------- documents with specific instructions to utilize its proceeds for any
specific purpose, then a contract inconsistent with the bank’s right of
---------------------- lien exists. For example, if a customer deposits some Government bonds
with the bank to collect interest thereon and with the instructions that
----------------------
the interest amount when realized should be credited to his savings

100 Indian Banking & Financial System

 account, then the bank is acting as an agent of the customer for the Notes
purpose of collection of interest. The amount so realized will, therefore,
not be subject to banker’s lien. ----------------------
iii) Securities left with the banker negligently: The securities should ----------------------
come in the possession of the bank in its capacity as a banker. Thus,
if some documents or valuables are inadvertently or negligently left ----------------------
behind by a customer in the bank premises, then the banker does not
----------------------
possess any right of lien on such documents or valuables.
iv) A banker possesses the right of set off and not the right of lien on money ----------------------
deposited. Thus, money deposited in deposit accounts with the banker
----------------------
will not qualify for the right of lien.
v) Stolen goods: If the customer has stolen the goods/securities and ----------------------
delivered them to the bank, the bank cannot have its lien even though
----------------------
the transaction has occurred in the ordinary course of business.
2. Banker’s Right of Set-Off ----------------------

We have seen above, that the right of lien can be exercised in situations where ----------------------
the bank is the creditor and the customer is the debtor. The right of set-off,
on the other hand, can be exercised where two accounts are maintained with ----------------------
the bank by the same customer- one a deposit account and the other a loan ----------------------
account.
In case of deposit accounts, the bank is the debtor and the customer is the ----------------------
creditor. In case of loan accounts, the bank is a creditor and the customer ----------------------
is the debtor. In other words, a bank can have a claim against a borrower
in one account and also owe money to him in another account. The right of ----------------------
set off enables the bank to adjust mutual claims and pay only the remaining
amount to the customer. To take an example, assume that A has taken a loan ----------------------
from Bank X worth Rs.5,000/- and he also has an amount of Rs.8,000/- in ----------------------
savings account with the same bank. Then, the bank has a right to appropriate
an amount of Rs.5,000/- from the savings account and adjust it against the ----------------------
loan outstanding. The net position is that the bank is a debtor for the net
balance of Rs.3,000/- now remaining in the savings account. ----------------------

The right of set-off is a statutory right which enables a debtor to take into ----------------------
account a debt owed to him by a creditor before the latter could recover the
----------------------
debt due to him from the debtor. A banker, like other debtors, possesses this
right of set-off which enables him to combine two accounts in the name of ----------------------
the same customer and to adjust the debit balance in one account with the
credit balance in the other. ----------------------
The right of set-off can be exercised by the banker if there is no agreement- ----------------------
express or implied- contrary to this right. Before exercising this right, the
bank should serve a notice on the customer intimating him of its intention ----------------------
to exercise the right of set-off.
----------------------
The bank can, however, exercise the right of set-off even without giving
notice in the following cases: ----------------------

Banker - Customer Relationship 101

 Notes i) Death, insanity or insolvency of the customer
ii) Insolvency of a partner or on winding up of a company
----------------------
iii) Receipt of Garnishee Order or Income Tax Attachment Order
----------------------
A comparative analysis of Bank’s Right of Lien and Right of set-off is given
---------------------- below:

---------------------- Similarities
1. Both the rights are conferred upon banks by law.
----------------------
2. The rights can be exercised only if no contract, express or implied exists
---------------------- to the contrary
---------------------- Points of Difference

---------------------- Right of lien Right of set-off

Existence of a creditor-debtor Can be exercised if there are two
----------------------
relationship is essential accounts of the same customer
---------------------- with the bank-that is, bank is both
a debtor and a creditor for two
---------------------- separate accounts with regard to the
same customer
----------------------
Can be exercised on goods and Can be exercised on money
---------------------- securities in the possession of the deposited with the bank
bank as a pledgee
----------------------
Notice is required to be given to the In the cases mentioned above,
---------------------- borrower before exercising the right notice need not be given to the
to sell the goods or securities customer while exercising the right
----------------------
of set-off.
---------------------- The bank can exercise the right of set-off subject to the fulfilment of the
---------------------- following conditions:
1. The accounts must be in the same name and in the same right.
----------------------
The words ‘the same right’ mean that the capacity of the account-holder
---------------------- in both or all the accounts must be the same, that is, the funds available in
one account are held by him in the same right or capacity in which a debit
----------------------
balance stands in another account. This means that funds belonging to
---------------------- someone else, but held by the customer in a fiduciary capacity, should not
be made available to satisfy the customer’s personal debts.
----------------------
We shall now examine the banker’s right of set-off in respect of certain types
---------------------- of accounts:

---------------------- a) Sole Proprietary Concern: A sole proprietary concern is not a legal

entity and the concern is not separate from its owner. Hence, the
---------------------- accounts in the name of the proprietary concern and in the personal
name of the owner are both considered to be in the same right and the
---------------------- balances in the accounts can be set-off against one another by the bank.

102 Indian Banking & Financial System

 b) Partnership Firms: If the account of a partnership firm and also the Notes
accounts of the individual partners are maintained at the same bank, the
bank cannot set off dues of the firm against the individual accounts of ----------------------
the partners. But if the partners have given an undertaking to be jointly
and severally liable for the firm’s debt, then the bank can set off the ----------------------
firm’s debt against the credit balance in the personal accounts of the ----------------------
partners.
----------------------
c) Trust Accounts: The funds held in a trust account are deemed to be in
different rights and cannot be used to set –off the personal dues of the ----------------------
trustee.
----------------------
d) The balance held in the clients’ account of an advocate and the
amount held in his personal accounts are also deemed to be in ----------------------
different rights.
----------------------
e) Joint Accounts: In case of a joint account, a debt due from one of the
joint account-holders in his individual capacity cannot be set-off against ----------------------
an amount due to him by the bank in the joint account.
----------------------
f) An account in the name of a person in his capacity as a guardian for
a minor is not treated in the same right as his own account with the ----------------------
banker.
----------------------
2. The right can be exercised in respect of debts due and not in respect of
future debts and contingent debts. For example, the right of set-off can be ----------------------
exercised for recovery of an amount of a bill which is already due but not
in respect of a bill which will mature in future. ----------------------

3. The amount of debt must be certain. It is essential that the amount of debts ----------------------
due from both parties to each other must be certain. For example, if A stands
a guarantor for a loan of Rs.10,000/- given by a bank to B, his liability as ----------------------
a guarantor will arise only after B defaults in making payment. The banker ----------------------
cannot set-off the credit balance in his account till his liability as a guarantor
is determined. For this purpose, it is essential that the banker must first ----------------------
demand payment from the debtor. If the latter defaults in making payment
of his debt, only then the liability of the guarantor arises and the banker can ----------------------
exercise his right of set-off against the credit balance in the account of the ----------------------
guarantor.
----------------------
4. The right may be exercised in the absence of an agreement to the contrary.
If there is an agreement, express or implied inconsistent with the right of ----------------------
set-off, the banker cannot exercise such right.
----------------------
5. For the purpose of exercising this right of set-off all the branches of a bank
constitute one entity and the bank can combine two or more accounts in the ----------------------
name of the same customer at more than one branch.
----------------------

----------------------

----------------------

Banker - Customer Relationship 103

 Notes
Check your Progress 3
----------------------

---------------------- State True or False.

1. A banker’s lien is not an implied pledge.
----------------------
2. A general lien is applicable only to a particular debt.
----------------------
3. The right of lien can be exercised on goods or other securities in the name
---------------------- of the customer-borrower only and not held jointly with other person.

---------------------- 4. A banker does not have a right of general lien when a customer
deposits securities documents for safe custody.
---------------------- 5. The right to set off enables the banker to combine two accounts in the
---------------------- name of the customer and adjust the debit balance in one account with
the credit balance in other account.
----------------------
---------------------- Activity 3
----------------------
‘Lien does not include right to sell’. Discuss.
----------------------

---------------------- 6.5 OBLIGATIONS OF A BANKER

----------------------
The obligations of banks are essentially two-fold:
---------------------- I. Obligation to honour cheques.
---------------------- II. Obligation to maintain secrecy of Account.

---------------------- I. Obligation to honour cheques

We have seen that banks accept deposits from customers. Saving account and
---------------------- Current account are types of accounts in which the depositor is given a cheque
---------------------- book and the bank is required to honour cheques on demand. The depositor is
the drawer of cheque and the bank is the drawee. The bank, as the drawee, has
---------------------- the statutory obligation to honour cheques as per provisions contained in Section
31 of the Negotiable Instruments Act, 1881, which states that:
----------------------
The drawee of a cheque, having sufficient funds of the drawer in his hands,
---------------------- properly applicable to the payment of such cheque, must pay the cheque when
duly required to do so and in default of such payment must compensate the
---------------------- drawer for any loss or damage caused by such default.
---------------------- The above-referred section clearly spells out the following:
---------------------- 1. The conditions under which the bank is under an obligation to pay cheques
2. The person to whom the bank is liable in the event of default
----------------------
3. The extent of liability of the bank in case of default, i.e., wrongful dishonour
---------------------- of cheques

104 Indian Banking & Financial System

1. The banker is bound to honour the customer’s cheques provided the Notes
following conditions are complied with:
----------------------
 There must be sufficient funds of the drawer in the hands of the drawee.
By sufficient funds is meant funds at least equal to the amount of the ----------------------
cheque presented. A cheque contains an instruction from the drawer
directing the bank to pay a specified sum of money and if such some is ----------------------
not in the hands of the banker at the time of presentment of the cheque,
----------------------
then the bank is under no obligation to make part payment of the cheque.
The bank would be justified in returning the cheque. ----------------------
A question that may arise is what about the minimum balance stipulated
----------------------
by the bank? Can the bank exclude such minimum balance to decide
whether funds are sufficient to honour the cheque or not? The answer ----------------------
is no. The entire money belongs to the customer and he has the right
to draw a cheque for the full balance in the account. The bank can ----------------------
separately and subsequently recover charges as per its rules for non-
----------------------
maintenance of the minimum balance. But the cheque should be
honoured if the balance in the account is sufficient to honour it. ----------------------
There could also be a situation where the payee may approach the
----------------------
bank with a cheque drawn by the drawer and of his own accord, make
a deposit of an amount in the drawer’s account after which the balance ----------------------
becomes sufficient to honour the cheque. If, thereafter, he presents the
cheque for cash payment at the bank’s counter, then the bank would ----------------------
be justified in making payment of the cheque. But the bank should not,
----------------------
under any circumstances, divulge the balance in the drawer’s account to
the payee. If it does so, it would be liable to pay damages to the drawer ----------------------
of the cheque for breach of secrecy relating to his account. So, when
the balance in the drawer’s is insufficient to pay a cheque, banks prefer ----------------------
to give the reason ‘refer to drawer’ so as to maintain secrecy pertaining
----------------------
to the customer’s account and to protect his reputation.
 The drawee should have sufficient funds in his hand at the time the ----------------------
cheque is presented for payment. ----------------------
The funds should be available with the bank when the cheque is
presented for payment. Cheques sent for collection are not treated as ----------------------
cash in the hands of the banker until the same are realized. The bank ----------------------
credits the amount of such cheques to the account of the customer
only on realization. If the customer draws a cheque on such unrealized ----------------------
amounts, then the banker would be justified in dishonoring the cheque.
----------------------
Further, the credit balances in accounts of the customer at other branches
or head office of the bank need not be taken into account in computing ----------------------
the sufficiency of funds for this purpose. Cheques are generally payable
at the branch where the account of the customer is kept and each branch ----------------------
of a bank is treated as a distinct entity. ----------------------
However, the banker has an obligation to honour cheques beyond the
----------------------
available balance in the account if an agreement is reached between

Banker - Customer Relationship 105

 Notes the banker and the customer, either expressly or impliedly, whereby the
banker agrees to sanction an overdraft to the customer. In such cases,
---------------------- the banker’s obligation to honour the customer’s cheques is extended
up to the amount of overdraft sanctioned.
----------------------
 The funds must be properly applicable to the payment of the cheque.
---------------------- A customer might be having several accounts. It is essential, however,
that the account on which the cheque is drawn must have sufficient
----------------------
funds. For example, a customer may have a savings account as well
---------------------- as a fixed deposit account at a branch. If a cheque is received for
payment for an amount exceeding the balance in the savings account,
---------------------- the bank cannot, on its own, break the fixed deposit and transfer the
money to the savings account for honouring the cheque drawn by
----------------------
the customer on his savings bank account. This is because the bank
---------------------- is under a contractual obligation to return the maturity value of fixed
deposit to the depositor after the agreed fixed period and not prior to
---------------------- that. Thus, funds held in a fixed deposit account of a customer cannot
be properly applied to payment of cheques drawn by the customer on
----------------------
his savings account.
---------------------- Further, if a court or any other lawful authority passes an order
restraining the bank from making payment from a particular account,
----------------------
then even if there is balance in the account, the same is not available
---------------------- for the payment of the customer’s cheques until the order is in force.
A customer may, after issuing a cheque and before it is presented to
----------------------
the bank, instruct the bank to stop payment of the cheque. In such a
---------------------- case also, although the bank may hold funds in the account sufficient
to honour the cheque, it cannot do so since the funds are not available
---------------------- for honouring a cheque, payment of which has been stopped by the
customer.
----------------------
 The banker must be duly required to pay. The banker is bound to
---------------------- honour a cheque only when he is duly required to pay. This means
---------------------- that the cheque must be properly made and be complete and in order,
that is, it must have a proper date, it must have the full signature of the
---------------------- drawer, which should match with the specimen as per bank’s records
and alterations if any should be confirmed with the full signature of
---------------------- the drawer. The cheque should be presented within the business hours
---------------------- of the bank. It should not be stale, i.e., it should not bear a date more
than six months prior to the date on which it is presented for payment.
---------------------- It should also not be post-dated.

---------------------- If any of the above requirements are not complied with, then the bank
is not bound to pay the cheque. Thus, when it has valid reasons for
---------------------- refusing payment, the bank does not incur any liability.
---------------------- 2. The person to whom the bank is liable in the event of default.
In case the bank defaults in payment of a cheque which meets with all
----------------------
the requirements under Section 31 of N. I. Act as enumerated above,

106 Indian Banking & Financial System

 then it shall be liable for wrongful dishonour to the drawer and not to Notes
the payee. The exception is when the bank is wound up, in which case
the holder of the cheque becomes the creditor of the bank and can claim ----------------------
the amount.
----------------------
3. Liability of the bank in case of wrongful dishonor of cheques
----------------------
If all the conditions mentioned above are met and even then the bank
fails to pay the cheque either because of mistake or negligence on the ----------------------
part of its employees or for any reason whatsoever, it shall be liable for
wrongful dishonor of the cheque. If for example, a post-dated cheque is ----------------------
paid by the bank before the date of the cheque and owing to such payment,
----------------------
some other valid cheque is subsequently returned for the reason that the
balance is insufficient, the bank would be liable for wrongful dishonor ----------------------
of the cheque.
----------------------
Wrongful dishonour of a cheque by a bank is a serious lapse. In fact, Courts
in India have ruled that the dishonour of a cheque by the bank despite ----------------------
availability of sufficient balance is not only an actionable civil wrong but a
criminal offence also. ----------------------
The bank is therefore liable to compensate the drawer for any loss or damage ----------------------
caused in dishonouring the customer’s cheques without sufficient reason.
The words ‘loss or damage’ under Section 31 mean and include: ----------------------

a) The monetary loss suffered by the customer ----------------------

b) The loss of credit or reputation in the market ----------------------
Thus, banks are liable to compensate the drawer not only for the actual
----------------------
monetary loss suffered by him, but also the injury to or loss of his reputation
as a result of wrongful dishonor of the cheque. ----------------------
The latter is more important for traders because their business depends on
----------------------
reputation or credit. Hence, it is presumed in law, that if a trader’s cheque
is wrongly dishonoured by the bank, then he suffers a loss of reputation. ----------------------
In such cases, the trader is entitled to claim from his bank not only general
damages but also substantial damages for such loss or damage suffered by ----------------------
him. Such loss or damage is presumed and he need not even prove it. The
----------------------
Court therefore, determines the actual amount of substantial damages by
taking into account all relevant facts such as, the financial position of the ----------------------
trader, his reputation in the market and the customs and practices of his trade
or business. ----------------------
In case of non-traders, the loss of credit or reputation is not presumed as a ----------------------
result of wrongful dishonour of their cheques. Such customers are entitled
to nominal damages only, unless they are able to prove that they sustained ----------------------
special damages. ----------------------

----------------------

----------------------

Banker - Customer Relationship 107

 Notes
Check your Progress 4
----------------------

---------------------- Fill in the blanks.

1. Under Section _________ of the Negotiable Instruments Act, the
----------------------
bank is under obligation to honour the cheques drawn by a customer.
---------------------- 2. When the balance in the account is not sufficient to honour the
cheque, banks normally prefer to return the cheque with the remark
----------------------
‘______________’.
---------------------- State True or False.
---------------------- 1. The bank has to honour the cheque if it is otherwise in order, even
if a legal authority passes an order restraining the payment from the
---------------------- account.
---------------------- 2. Banks must pay cheques even if they are presented for payment after
the business hours.
----------------------
3. In case the cheque is wrongfully dishonoured, the bank is liable to the
---------------------- drawer and the payee of the cheque.
----------------------

---------------------- Activity 4
----------------------
Mr. Kumar has both savings and a current account with bank A. He issues
---------------------- a cheque for Rs. 2500/- from the S/B account. The balance in the SB a/c is
Rs 2010/ only but the current account shows balance of Rs.10500/-. Should
---------------------- the bank honour the cheque by transferring some amount from the C/A?
Discuss.
----------------------

----------------------
6.6 ORDER
----------------------
A banker’s obligation to honour the cheques of a customer is extinguished
---------------------- on receipt of the following:

---------------------- A. A Garnishee Order issued by a Court

B. An Attachment Order issued by Income Tax Authorities
----------------------
A. Garnishee Order
----------------------
A Garnishee Order is issued by a court, at the request of a creditor for
---------------------- attaching funds of his debtor held by a banker.

---------------------- Let us take an example to understand this. Assume that A had sold goods
worth Rs.10, 000/- to B on a credit of 60 days. Here, A is the creditor and B
---------------------- is the debtor. Assume that after 60 days, B does not pay the dues of Rs.10,
000/- to A. Let us assume further that A has information that B has an account
---------------------- with X Bank. Now, A can approach a court to issue a garnishee order to attach

108 Indian Banking & Financial System

the balance lying in B’s account with X Bank and thereby prevent B from Notes
withdrawing the balance in his bank account and also prohibiting the bank
from making payment to B. ----------------------
In the above case, A, who is the creditor and at whose request the garnishee ----------------------
order is issued by the court, is called the judgment creditor. The debtor whose
bank balance is frozen, in the above example, B is called the judgement debtor. ----------------------
X Bank on whom the order issued is called the garnishee. X Bank which holds
----------------------
the funds of B as his debtor is also called the judgement debtor’s debtor. This
further means that only those accounts in which bank is a debtor are covered by ----------------------
a garnishee order. A garnishee order is not applicable to loan accounts where the
bank is not a debtor but is itself a creditor. ----------------------
On receipt of a garnishee order, the banker is under no obligation to honour ----------------------
cheques or make payment from the account.
----------------------
The Garnishee Order is issued in two parts:
i) order nisi ----------------------

ii) order absolute ----------------------

i) order nisi ----------------------
As a first step, when the court is approached by the judgement creditor, it
----------------------
issues an order nisi to the garnishee (the Bank) directing it to stop payments
from the account of the judgement debtor. The court also seeks a response ----------------------
from the bank as to why the funds should not be utilized for meeting the
claim of the judgement creditor. ----------------------
On receipt of the Garnishee Order, the bank must first confirm that the ----------------------
name mentioned in the Garnishee Order matches exactly with the name of
the customer’s name as per bank’s records. If so, it must immediately take ----------------------
action as given below:
----------------------
a) Stop honouring the customer’s cheques
----------------------
b) Inform the customer about the order and the banker’s inability thereafter
to honour his cheques ----------------------
At this stage, the bank can exercise its right of set-off and adjust its claims ----------------------
against the balance in the customer’s account. In the above example,
assume that B has balance of Rs.15,000/- in his current account and has ----------------------
also availed of a loan from the bank, in which he owes the bank Rs.3,000/.
In this case, the bank can exercise its right of set off and recover an ----------------------
amount of Rs.3,000/- from the account of B and close his loan account. It ----------------------
can then advise the remaining balance of Rs.12,000/- in the account of B,
the judgement debtor, to the court. What would happen if the balance in ----------------------
B’s current account was only Rs.1,000/- and not Rs.15,000/- as assumed
earlier? In such a case, X Bank can adjust the full balance of Rs.1,000/- ----------------------
and inform the court that there is no balance in the customer’s account. ----------------------

----------------------

Banker - Customer Relationship 109

 Notes ii) order absolute
After receiving a response from the bank, the court may issue an Order
----------------------
Absolute, which is the final order. As per this order, either the entire balance
---------------------- in the account or specified amount is attached. On receipt of such an order, the
bank should recover the amount as directed by the court from the customer’s
---------------------- account and deposit it with the court. Thereafter, the bank’s liability towards
his customer is discharged to that extent. After the amount is remitted as per
----------------------
the court’s instructions, the bank, as garnishee, is also completely discharged
---------------------- of its responsibility under the order. Hence, after payment of the amount to
the court, the suspended account can be revived and normal operations can
---------------------- be permitted, as earlier.
---------------------- The Garnishee Order is applicable in the following cases:
a) The balance standing in the account of the judgement debtor at the time
----------------------
the order is served. It attaches the amount already due in the savings
---------------------- and current accounts.

---------------------- b) A cheque presented for payment but its payment is yet to be effected
and in the meantime, the Garnishee Order is served on the bank.
---------------------- c) It is served on the head office of the bank concerned. The head office
---------------------- is, however, given reasonable time to inform the branches concerned.
d) A joint account where the garnishee order is received in the names of
---------------------- both the persons having the joint account. For example, if a garnishee
---------------------- order is received in the name of X & Y jointly and the two also hold a
joint account with the bank, then such account will be attached.
----------------------
e) The personal accounts of partners can also be attached in case of a debt
---------------------- taken by a partnership firm because the liability of partners is joint and
several.
----------------------
The Garnishee Order is not applicable in the following cases:
---------------------- i) Money held abroad by the judgement debtor
---------------------- ii) Securities held in safe custody of the banker

---------------------- iii) Any amount deposited in the judgement debtor’s account after the
Garnishee Order has been served on the banker. In other words, the
---------------------- order has no prospective operation.
---------------------- iv) The amounts of cheques, bills, etc, sent for collection by the customer,
which remain uncleared at the time of receipt of the order.
----------------------
v) A joint account where anyone or all the joint account holders are not
---------------------- the judgement debtors mentioned in the garnishee order. For example,
if a garnishee order is received in the name of X & Y and the bank
---------------------- maintains an account in the name of X, Y & Z, then such account is
not attached by the garnishee order.
----------------------
vi) If the order specifies an amount, any amount deposited over and above
---------------------- such specified amount will not be covered by garnishee order.

110 Indian Banking & Financial System

 vii) The outstanding amount in a trust account cannot be attached, if the Notes
judgement debtor has deposited the amount as a trustee.
----------------------
B. Income Tax Attachment Order
If a person does not make payment of his tax dues, then the Income Tax ----------------------
authorities can attach the credit balance in his account with a bank by ----------------------
issuing an attachment order as per Income Tax (IT) Act. In order to recover
arrears of tax, IT officers are empowered by IT Act to issue a notice to the ----------------------
assessee or to a bank which holds funds or may subsequently hold funds of
----------------------
such customer. The order may be for an amount equal to the amount of the
arrears or the whole amount lying in the account. ----------------------
An assessee is any person, whose income is assessed by the IT department. ----------------------
If the bank fails to make payment of the amount mentioned in the order,
then the bank shall be treated as an assessee in default and the IT authorities ----------------------
may take action against the bank for recovery of the amount.
----------------------
On receipt of an IT Attachment Order, the bank should immediately inform
the customer. After making payment to IT as per the order, the bank should ----------------------
inform the details thereof to the customer. As in the case of a Garnishee ----------------------
Order, the bank is entitled to exercise its right of set-off and recover its dues,
if any, and then hand over the remaining balance to the IT authorities. ----------------------
An Income Tax Order shall be applicable in the following cases: ----------------------
a) Any debts due and payable
----------------------
b) Debts due but not payable on the date of receipt of the notice
----------------------
c) If a notice is received in the name of one person and if he holds an
account jointly with another person, then such joint account will be ----------------------
attached. It will be presumed, unless the contrary is proved, that the
----------------------
share of joint holders is equal.
d) Amount deposited after the order is served on the bank. ----------------------

e) Amount lying in the accounts of deceased and insolvent customers is ----------------------

also attached.
----------------------
A comparative analysis of Garnishee Order and Income Tax Attachment
Order is given below: ----------------------

Similarities ----------------------
Both are applicable when bank is a debtor holding the customer’s ----------------------
(creditor’s) funds.
----------------------
In other words, they apply to deposit accounts only and not to loan accounts.
Bank can exercise its right of set-off to recover its dues first and then the ----------------------
remaining balance, if any, is available for being attached by the order served on ----------------------
the bank.
----------------------

Banker - Customer Relationship 111

 Notes Points of Difference

---------------------- Garnishee Order Income Tax Attachment Order

Judgement Creditor has to obtain an Income- Tax authorities are empowered
---------------------- order from a court to recover dues from to Income- Tax authorities are
---------------------- judgement debtor’s bank empowered to bank for recovery of
dues
----------------------
Balance lying in the judgement debtor’s Subsequent credits are also attached
---------------------- account at the time the order is served
only is attached. The order does not
---------------------- apply to subsequent credits
---------------------- Does not attach a joint account if Attaches balance in any joint account
order is in the name of one of the joint even if only one of the account-
---------------------- account-holders only holdersis named in the order.
---------------------- Amount lying in the account of an Amount lying in the account of an
insolvent person is not attached insolvent person is also attached
----------------------

---------------------- Check your Progress 5

----------------------
Fill in the blanks.
----------------------
1. An order issued by a court at the request of the creditor attaching
---------------------- funds of his debtor held by the bank is called __________.

---------------------- 2. Garnishi order is issued in two parts. These are: i) _______

ii) _______.
---------------------- State True or False.
---------------------- 1. Income tax authorities can attach credit balances in the account.
---------------------- 2. IT attachment is also applicable to amount deposited after the order is
served on the bank.
----------------------
3. IT attachment order is not applicable to balance lying in the accounts
---------------------- of deceased and insolvent customers.

----------------------
6.7 OBLIGATION TO MAINTAIN SECRECY OF ACCOUNT
----------------------
The information held by banks pertaining to its customers’ transactions
----------------------
and accounts is confidential. If any such information is made known to others,
---------------------- the customer’s reputation may suffer and he may incur losses also. Banks are
therefore under an obligation to maintain secrecy about the customer’s accounts
---------------------- and take necessary precautions not to disclose any information to third parties
or public.
----------------------
Special care is required to be taken while divulging information in non- face
---------------------- to face interactions such as, over phone. Today, banks extend phone banking

112 Indian Banking & Financial System

facility to their customers. The customer can either use menu options to get Notes
desired information about his account or he can speak to a Phone banking
Officer (PBO). But in each case, before account-related queries are attended to ----------------------
the customer is required to furnish information for verification purposes, such
----------------------
as mother’s maiden name, date of birth, address, etc. Banks, thus, ensure that
the secrecy of customer’s account is maintained and that account information is ----------------------
shared with the customer after proper verification only.
----------------------
Banks are, however, required to disclose information pertaining to the
customer’s account in some cases. Such cases fall into two categories: ----------------------
A. Disclosure authorized by Law ----------------------
B. Disclosure as per Banking Practice
----------------------
A. Disclosure authorised by Law:
----------------------
The bank is statutorily required to disclose information related to a customers’
account in the following cases: ----------------------
i) By Order of the Court: In accordance with the provisions of Banker’s ----------------------
Book of Evidence Act, a Court may direct the bank to disclose
information related to a customer’s account. The Court is also ----------------------
empowered to allow any party to legal proceedings to inspect or copy
from the books of the banker for the purpose of such proceedings. ----------------------

ii) Under Reserve Bank of India Act: RBI is empowered to collect credit ----------------------
information from banking companies and banks are under a statutory
----------------------
obligation to furnish such credit information.
iii) Under Banking Regulations Act: Banks are required to submit an annual ----------------------
return of all accounts in India which have not been operated upon for
----------------------
10 years.
iv) Under Income-Tax Act: Income Tax authorities have powers to examine ----------------------
bank officials on oath, compel the production of books of accounts and ----------------------
other documents and to call for all necessary information from bankers
for the purpose of conducting the tax assessment of bank’s customers. ----------------------
v) Under Companies Act: When the Central Government appoints an ----------------------
inspector to investigate the affairs of a company in accordance with
the provisions of the Companies Act, bankers are under an obligation ----------------------
to make available to such inspectors any documents related to the
----------------------
company which are in their custody.
vi) Under Criminal Procedure Code: Police officers conducting an ----------------------
investigation may also inspect the banker’s books for the purpose of
----------------------
their investigation.
vii) Under Foreign Exchange Management Act: The enforcement ----------------------
authorities under the Act are empowered to inspect books and accounts ----------------------
and banks are under an obligation to provide all information called
for by them. ----------------------

Banker - Customer Relationship 113

 Notes B. Disclosure permitted as per Banker’s Practices and Usages
Banks are permitted by practices and usages to disclose certain information
----------------------
under the following circumstances:
---------------------- a) With the express or implied consent of the customer: Banks can divulge
information related to a customer’s account with his express or implied
----------------------
consent. Nowadays, banks share information relating to borrowers’
---------------------- accounts with credit information bureaus such as Credit Information
Bureau of India Limited (CIBIL) on the basis of a clause incorporated in
---------------------- the loan agreement executed between the bank and the borrower under
which the borrower explicitly consents to such sharing of information
----------------------
with CIBIL.
---------------------- b) Banker’s reference: It is an accepted practice among banks to share
information related to customer’s accounts and provide information
----------------------
or opinion when requested by other banks. This is done on the format
---------------------- prescribed by Indian Banks Association (IBA). The information is
furnished as a general statement without disclosing specific details. It
---------------------- is a usual practice for banks to use the following standard expressions
while conveying their opinion about a customer’s financial standing:
----------------------
“Very Large Means, Large Means, Moderate Means” etc.
----------------------
The letter sent by the bank furnishing the opinion also includes a
---------------------- disclaimer clause stating that the information furnished is without any
responsibility on the part of the bank or any of its officials.
----------------------
c) The bank may disclose information related to a customer’s account to
---------------------- protect its own interest legally. For example, the bank may disclose
information related to a borrower’s dues to his guarantor or to an
---------------------- advocate to initiate legal action.
---------------------- d) Disclosure in public interest:
---------------------- Banks are required to disclose, in public interest, information pertaining
to a customer’s account in the following cases:
----------------------
 When information is sought by Government officials to apprehend
---------------------- persons who have committed crime.

----------------------  When the bank has suspicion, on the basis of transactions in the account,
that the customer is engaged in anti-national activities.
----------------------  Where the account of the customer reveals that the customer is
---------------------- contravening the provisions of any law and
 Where sizeable funds are received from abroad causing suspicion about
----------------------
the source and purpose of the remittance.
----------------------

----------------------

----------------------

114 Indian Banking & Financial System

 Notes
Check your Progress 6
----------------------
Fill in the blanks. ----------------------
1. Banks have to disclose information pertaining to customer’s account
----------------------
when: i) __________ ii) __________ .
2. CIBIL stands for __________ . ----------------------

----------------------

Activity 5 ----------------------

----------------------
How will you deal with the following situation?
----------------------
You are the Branch manager of a bank. A person in official uniform
approaches you. He is representing a well-known furniture shop. He has ----------------------
with him a cheque of Rs. 17000/- drawn in favour of the shop by your
customer. He wants to conform that the account has sufficient balance. ----------------------

----------------------

Summary ----------------------

● Banks perform various functions as part of their banking business which ----------------------
gives rise to different relationships with customers. The law confers
----------------------
upon bankers certain rights for recovery of their dues directly from the
customer’s account or by selling his goods and securities in its possession. ----------------------
● A responsibility is also cast by law on banks to honour cheques drawn by
----------------------
a customer on his account and default by banks in performing this duty is
deemed to be an offence. Bankers are also under an obligation to maintain ----------------------
secrecy related to the customer’s account and his transactions.
----------------------
Keywords ----------------------
● 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. It confers upon
the creditor the right to retain the security belonging to the debtor. ----------------------
● Set-Off: The right of set-off is a statutory right which enables a debtor to ----------------------
take into account a debt owed to him by a creditor before the latter could
recover the debt due to him from the debtor. ----------------------
● Garnishee Order: A Garnishee Order is issued by a court, at the request ----------------------
of a creditor for attaching funds of his debtor held by a banker.
----------------------

----------------------

----------------------

Banker - Customer Relationship 115

 Notes
Self-Assessment Questions
----------------------
1. How does the banker-customer relationship change in banks?
---------------------- 2. What are various rights of banks for recovery of debts?
---------------------- 3. Which are various obligations of banker?

---------------------- 4. What is Garnishee Order?

----------------------
Answers to Check your Progress
----------------------

---------------------- Check your Progress 1

Multiple Choice Single Response
----------------------
1. The term customer has been defined under:
----------------------
iv) Has not been defined anywhere
---------------------- 2. Duration theory refers to
---------------------- ii) Defining a customer, based on duration of dealings with the bank

---------------------- 3. A person (natural or legal) will be called customer if he fulfills the criteria:
iv) Should comply with ii and iii above
----------------------

---------------------- Check your Progress 2

---------------------- State True or False.
1. False
----------------------
2. True
----------------------
3. False
---------------------- Fill in the blanks.
---------------------- 1. In case of a loan account, the relationship between the banker and customer
is that of creditor and debtor.
----------------------
2. When a customer deposits a cheque with a bank for realisation, till such
---------------------- time the cheque is realised, the relationship between the bank and the
customer is that of trustee and beneficiary.
----------------------
3. The banker accepts standing instructions for periodic payment of bills etc.
---------------------- from the customer’s account. In this case, the bank acts as agent and the
---------------------- customer as principal.
4. In case of safe deposit locker availed by a customer, the relationship
---------------------- between the bank and the customer is that of lessor and lessee.
---------------------- 5. The right of the creditor to retain the goods and securities owned by the
debtor until the debt due from him is repaid is called Lien.-
----------------------

116 Indian Banking & Financial System

Check your Progress 3 Notes
State True or False.
----------------------
1. False
----------------------
2. False
3. True ----------------------
4. True ----------------------
5. True ----------------------

----------------------
Check your Progress 4
----------------------
Fill in the blanks.
1. Under Section 31 of the Negotiable Instruments Act, the bank is under ----------------------
obligation to honour the cheques drawn by a customer. ----------------------
2. When the balance in the account is not sufficient to honour the cheque,
banks normally prefer to return the cheque with the remark ‘Refer to ----------------------
drawer’. ----------------------
State True or False.
----------------------
1. False
----------------------
2. False
3. True ----------------------

----------------------
Check your Progress 5 ----------------------
Fill in the blanks.
----------------------
1. An order issued by a court at the request of the creditor attaching funds of
his debtor held by the bank is called Garnishee order. ----------------------
2. Garnishi order is issued in two parts. These are: i) ordernishi ii) order ----------------------
absolute.
----------------------
State True or False.
1. True ----------------------

2. True ----------------------
3. False ----------------------

----------------------

----------------------

----------------------

----------------------

Banker - Customer Relationship 117

 Notes Check your Progress 6
Fill in the blanks.
----------------------
1. Banks have to disclose information pertaining to customer’s account
---------------------- when: i) Disclosure is authorised by law ii) Disclosure as per banking
practice.
----------------------
2. CIBIL stands for Credit information Bureau of India.
----------------------

---------------------- Suggested Reading

---------------------- 1. Varshney, P.N. Banking law and Practice.
----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

118 Indian Banking & Financial System

Types of Customers & Mode of Operation
UNIT

7
Structure:
7.1 Introduction
7.2 Accounts of Individuals
7.3 Corporate Customers
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Types of Customers & Mode of Operation 119

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Identify various types of customers
----------------------
• Describe various modes of operation of bank accounts
----------------------

----------------------
7.1 INTRODUCTION
----------------------

---------------------- As we have seen in the previous unit, while the primary relationship between
the bank and its customer is that of a debtor-creditor, various other relationships
---------------------- also arise out of the other functions performed by banks. The customers who
maintain their accounts are of different types such as individuals, companies,
---------------------- partnership firms, trusts, etc. Banks are required to ascertain the capacity to
---------------------- contract of the persons opening bank accounts. They have to also adhere to various
legal provisions that apply to various categories of customers in the matter of
---------------------- opening and conduct of accounts. Where more than one customer jointly opens
accounts, there are various modes in which such joint accounts can be operated
---------------------- upon. In this unit, we shall understand the various types of customers and the
---------------------- modes of operation of accounts.

---------------------- 7.2 ACCOUNTS OF INDIVIDUALS

---------------------- A. Single Accounts
---------------------- Such accounts are opened in the sole name of an individual. Naturally,
all powers to operate the account are vested in the individual account holder
---------------------- concerned only and no one else. The account holder will solely instruct the bank
---------------------- in matters such as issue of cheque books, withdrawal and transfer of funds lying
in the account, request for updating of cheque book and account statements and
---------------------- make stop payment of cheques issued. Here, even the closest relatives are treated
as third parties and these include blood relatives-such as father, mother, brother
---------------------- and sister, children and spouse.
---------------------- In other words, even blood relatives and spouse have no authority to represent
the sole account holder and cannot ask for account balance or give any instructions
---------------------- to the bank in relation to the account. Banks are bound by the duty of secrecy and
---------------------- the state of affairs of the customer’s account should not be disclosed to anyone
else. It is a different matter that some people leave their ATM cards with other
---------------------- individuals, give them their password and allow them to operate the account. Such
transactions are done without the knowledge of the bank and at the sole risk of the
---------------------- account-holder concerned. The account-holder cannot subsequently dispute such
---------------------- payments when he has explicitly permitted third parties to operate their accounts.
The only matter in which a third party can do a transaction is for
---------------------- depositing cash or cheques in such accounts. In such cases, a deposit slip can

120 Indian Banking & Financial System

be filled and signed by the third party and the bank would credit the account Notes
of the individual concerned. It is also not necessary for such third party to
be a customer of the bank. ----------------------
A single account creates problems in the following situations: ----------------------
1) In the event of sudden incapacitation of the customer due to injury, accident
----------------------
or illness such as paralysis.
2) In the event that the customer is not able to operate the account because he ----------------------
has to go abroad ----------------------
3) Death of the sole account holder.
----------------------
The first scenario above can happen suddenly. There are further complications
because the customer has to be hospitalized and there arises an urgent need to ----------------------
withdraw funds from the account for medical treatment.
----------------------
In such situations, even if the customer is not able to sign cheques, bankers
usually look at the unusual circumstances and permit withdrawal on the basis ----------------------
of the following:
----------------------
a) Thumb impression of the customer on the cheque affixed in the presence
of a bank official. ----------------------
b) If the customer has lost both hands, then his toe impression is taken. ----------------------
c) Medical certificate of the attending doctor is obtained and kept attached ----------------------
with the cheque.
The remedy found by most customers in scenario 2) above is to leave blank ----------------------
signed cheques with relatives so that they can withdraw funds as and when ----------------------
required. This solution is fraught with risk because the cheques can fall into
the hands of unauthorized persons who can then practically withdraw the entire ----------------------
balance in the account. Further, it only serves the purpose of withdrawing funds
but the relatives cannot still ascertain the account balance from the bank or give ----------------------
stop payment instructions. ----------------------
In the event of death also, the balance remains in the account of the
deceased until legal formalities, which are cumbersome and time- consuming, ----------------------
are completed by the legal heirs for claiming the funds. ----------------------
Let us now see the manner in which problems arise due to situations under
----------------------
2) and 3) above can be avoided in respect of single accounts.
A sole account-holder can ensure a hassle-free transfer of balance in his ----------------------
account to his relatives after his death by opting for the facility of nomination.
----------------------
In a situation in which an account holder is going abroad for a short period,
he can authorize a person to operate the account on his behalf during his absence. ----------------------
This can be done by executing either a mandate or a power of attorney. ----------------------
Mandate
----------------------
A mandate is an authority given by the account holder in favour of a third
person to operate the account on his behalf. A mandate can be oral or in writing. ----------------------

Types of Customers & Mode of Operation 121

 Notes However, banks only accept mandate in writing. There is no standard form to
be filled up. The account-holder has to submit an authority letter, duly signed, to
---------------------- the bank mentioning the full name of the person to whom the authority is being
given and also the period for which the authority shall remain in force. In his
----------------------
letter, the account-holder also obtains the signature of the mandate-holder and
---------------------- attests it. The mandate should be clearly worded and should not contain onerous
conditions. The mandate can be revoked or cancelled by the account-holder at
---------------------- any time. Further, the authority gets cancelled on the death of the account-holder.
---------------------- On receipt of a mandate, the bank tallies the signature of the customer
appearing on the authority letter and the specimen as per bank’s records.
---------------------- Thereafter, the details of the mandate, such as the validity and the full name of
---------------------- the mandate-holder, are recorded in the computer system in the account details of
the account-holder. The signature of the mandate-holder is also scanned and held
---------------------- as a specimen signature. The mandate-holder is allowed to operate the account
only up to the date indicated by the account-holder.
----------------------
Power of Attorney
----------------------
The customer may also execute a power of attorney (POA), which is a
---------------------- document executed by the account- holder as a donor in favour of another person
who is known as a POA holder or attorney. The relationship between the donor
---------------------- and attorney is that of a principal and an agent. It is a stamped and registered
document. The POA holder signs on behalf of the account-holder as
----------------------
Per Pro ————————
----------------------
Sd/- Constituted Attorney
---------------------- POA can be of two types:
---------------------- 1. General Power of Attorney
2. Special Power of Attorney
----------------------
A General POA gives extensive powers to the attorney and he can represent
---------------------- the donor in more than one transactions. On the basis of a General POA, the
attorney can sign cheques, stop payment of cheques and transfer funds on behalf
---------------------- of the account-holder. On the other hand, a special or limited POA is granted
---------------------- for a specific and limited purpose. For example, a person may execute a Special
POA in favour of another person for selling a property, owned by the donor, and
---------------------- for handing over the sale proceeds to him.
---------------------- The POA lapses after the transaction is completed. Banks do not accept
POAs with onerous conditions because it would be difficult to ensure compliance
---------------------- of the terms and conditions stipulated therein. While permitting operations in
the account, the bank should ensure that the acts done by the attorney are not
----------------------
beyond the powers conferred upon him.
---------------------- The difference between a mandate and a power of attorney is that a mandate
---------------------- is a simple letter of authority whereas a power of attorney is a legal document
and is required to be stamped. Further, institutions cannot issue a mandate: they
---------------------- are required to execute a POA.

122 Indian Banking & Financial System

 You might wonder which one is more appropriate a mandate or a power Notes
of attorney. This depends upon the nature of the transaction and the persons
involved. If you want to allow a near relative to operate your savings account ----------------------
for withdrawing funds for household needs, then a mandate would suffice. If,
on the other hand, you are appointing someone to represent you in business or ----------------------
to handle a valuable asset such as property, then it would be more appropriate ----------------------
to execute a POA in which the duties and responsibilities of the attorney can be
clearly spelt out to avoid any legal complications subsequently. ----------------------
As regards transfer of balance after death, a customer can avail of the facility ----------------------
of nomination. Banking Companies (Nomination) Rules 1985 permit banks to
pay dues to nominees in the event of death of depositor(s) without asking for ----------------------
succession certificate or verifying claims of legal heirs. The nomination facility is
----------------------
intended to facilitate expeditious settlement of claims in the accounts of deceased
depositors and to minimize hardship caused to the family members on the death ----------------------
of a depositor. It simplifies settlement. Nomination facility is available for all
types of deposit accounts, viz. savings bank accounts, current accounts, cash ----------------------
certificates, etc., irrespective of the nomenclature used by different banks, and
----------------------
safe deposit lockers, safe custody articles. This facility is optional. But while
opening deposit accounts, banks usually explain the benefits of nomination to ----------------------
customers.
----------------------
Nomination facility is meant to facilitate transfer of balances of in the
accounts of customers on their death as per their instructions. It follows, therefore, ----------------------
that this facility is available to natural persons only and not legal persons such
as partnership firms, companies, trusts or societies. ----------------------
You can fill the details of nominee in the nomination form, which forms ----------------------
a part of the account opening form, and mention his/her name and address.
The form needs to be signed by a witness. A minor can also be appointed as a ----------------------
nominee. In that case, the minor’s date of birth and the name of the guardian of
the minor are also required to be mentioned in the nomination form. You can ----------------------
also cancel or change the nomination. Banks are required to register in their ----------------------
books the nomination, cancellation and/or variation of the nomination made by
you. The bank will also acknowledge the receipt of the duly completed form of ----------------------
nomination, cancellation and/or variation of the nomination. Your pass book or
statement of account will carry the legend ‘Nomination Registered’. Further, if ----------------------
you agree, the bank will also indicate the name of the nominee in the pass books/ ----------------------
statement of accounts.
In the event of the death of the account-holder, the nominee has to produce ----------------------
a copy of the death certificate of the deceased. The bank would then verify the ----------------------
identity of the nominee by scrutinizing documents containing his photograph such
as passport, election card or driving license. If the nominee is the account-holder of ----------------------
the bank, the balance is directly credited to his account. In case of non- customers,
the bank pays the money by a DD or Pay Order and also obtains a stamped receipt ----------------------
evidencing full and final settlement of the balance lying the account of the deceased. ----------------------
On making payment in accordance with the procedure described above, the bank
shall be fully discharged of its liability in respect of the deposit. ----------------------

Types of Customers & Mode of Operation 123

 Notes Can the nominee be a person other than a legal heir of the account-holder
say, a friend or a colleague? The answer is yes. In such cases, the question that
---------------------- arises is that what happens to the rights of the legal heirs? The bank is absolved
of its liability by paying to the person nominated by the depositor and shall not
---------------------- entertain the claim of anybody else.
---------------------- The legal position is that a nominee is only a person authorized to receive
the amount lying in the bank account of the deceased, as per the instructions of
----------------------
the account-holder. But he does not become the absolute owner of the amount.
---------------------- He is, in fact, the trustee of the legal heirs and is accountable to them. In such
cases, the amount is payable by the nominee to the legal heirs.
----------------------
B. Joint Accounts
---------------------- Joint accounts are opened for two or more persons. The account opening
form is required to be completed and signed by all the joint account-holders. In
----------------------
joint accounts, banks take customers’ instructions regarding:-1) Mode of operation
---------------------- and 2) Payment of balance in the event of death of any account-holder(s).Joint
accounts can be of two types:
----------------------
1. Accounts that involve joint operations- the account will be operated by both
---------------------- or all account holders jointly. In such accounts, operations are permitted
only with the mandate or authority of both or all the account-holders jointly.
---------------------- Banks give cheque books which are required to be signed by both or all
---------------------- the account-holders. Such accounts are preferred by customers when they
both or all of them want to have control over the funds. Can an ATM card
---------------------- be given in an account with joint operations? The issue to be examined
here is that operations in the account, through ATMs can be made using a
---------------------- single password by one account-holder whereas in such accounts, the joint
---------------------- authorisation of each joint account-holder has to be taken. There is a risk
that the bank may be held liable for payment under the authority of one of
---------------------- the account-holders only. Banks do issue only one card to a joint account
holder, but in such cases, the other joint account holder(s) is/are expressly
---------------------- required to agree with and give consent on the bank’s application form for
---------------------- issue of ATM card.
2. Account with survivorship clause- The account would be operated by:
----------------------
a) Either or survivor E or S – This is the most popular type of joint account
---------------------- because it provides convenience of operation as well as payment of
balance to survivor. The account can be operated by any account holder
---------------------- independently. In the event of death of one of the account holders, the
---------------------- balance is paid to the survivor. The account-holders can also nominate a
person in the event of death of both the account-holders. The nomination
---------------------- form is required to be signed by both the account-holders. Such accounts
are commonly opened among family members, such as husband and wife.
----------------------
b) Anyone or survivor- Such accounts are opened when there are more
---------------------- than two account holders. The operations in the account and settlement
of balance in the event of death of one of the account-holders are done
----------------------
in the same manner as in case of E or S accounts.

124 Indian Banking & Financial System

 In case of both the accounts, multiple ATM cards can be issued to both Notes
or all the account-holders.
----------------------
c) Former or survivor: In such accounts, while ease in settlement of
balance to the survivor is ensured, the operations are done solely by ----------------------
the former account-holder. In other words, the customer whose name
is appearing first or earlier in the account opening form is authorized to ----------------------
solely operate the account during his lifetime. Upon the death of such
----------------------
account-holder, the balance is payable to the survivor. For example, if
an account is opened in the names of A and B, with former or survivor ----------------------
clause, then A would solely operate the account in his lifetime and after
his death, B would be entitled to the balance in the account. An ATM ----------------------
card is only issued to the former account-holder- in the above example,
----------------------
it would be issued to A.
It would be observed that accounts with former or survivor clause ----------------------
have some similarity with the procedure of nomination. In the above
----------------------
example, A has instructed the bank to pay the balance in his account
to B after his death. Thus, he has, in effect, nominated B to receive the ----------------------
balance in the account after his death. However, the difference between
nomination and former or survivor facility is that in nomination, the ----------------------
nominee is not an account-holder and he does not have the status of an
----------------------
account-holder. His name does not appear on the passbook or account
statement as an account-holder but only as a nominee, and that too only ----------------------
if the account-holder wishes so. Upon the death of the account-holder,
the nominee has to approach the bank with identity documents and can ----------------------
only then claim the balance.
----------------------
On the other hand, in an account with former or survivor clause, the
person identified by the customer to receive funds also becomes the ----------------------
account-holder, although with no rights to operate the account during
----------------------
the lifetime of the former mentioned in the account. He tenders identity
documents to the bank at the time of opening the account itself and ----------------------
his name appears as an account-holder in the passbook and account
statement. On death of the former account-holder, transfer of balance ----------------------
to the survivor is even quicker than in case of nomination since the
----------------------
verification process based on the requisite documents is already done
at the time of opening the account. ----------------------
d) Jointly or survivor: This is an account with survivorship clause, but ----------------------
during the lifetime of the account-holders, operations on the account
are made jointly. In the event of death of a joint account-holder, the ----------------------
balance becomes payable to the survivor.
----------------------
Procedure for conversion of single account into a joint account:
The account-holder is required to complete a fresh Account Opening ----------------------
Form (AOF) and also submit a request letter for addition of name. ----------------------
Identity documents, such as PAN card, passport and documents for
address proof should be obtained of the person whose name is being ----------------------

Types of Customers & Mode of Operation 125

 Notes added to the account. The mode of operation is to be mentioned in
the AOF. If there is an existing nomination, all account-holders, after
---------------------- addition of names, should sign a fresh nomination form and confirm
the nomination.
----------------------
C. Minors
----------------------
A person who has not completed 18 years of age is a minor. A per Indian
---------------------- Contract Act, a minor is not competent to enter into a contract and any contract
entered into with a minor is not only void (or not valid) but it is void ab initio,
---------------------- that is, it is void from the beginning. This means that a contract entered into with
---------------------- a minor cannot be subsequently ratified or confirmed by him after he attains
majority. In other words, he would have to enter a separate contract after he
---------------------- attains majority. A void contract cannot be enforced by law. The law therefore,
gives protection to minors because they may not be able to understand the full
----------------------
implications of transactions that they are getting into and also to protect them
---------------------- from being cheated by unscrupulous persons. A minor can however be a party
in the following cases:
----------------------
1. A minor can draw or endorse a cheque. Endorsement means transfer of a
---------------------- cheque by a payee to a third party by signing at the back of the cheque.
---------------------- 2. A minor can be appointed as an agent. However, unlike a normal contract
between a principal and an agent, a minor cannot be held liable by the
---------------------- principal.
---------------------- 3. A minor can be admitted to the benefits of a partnership with the consent
of all partners but he or she shall not be liable for the losses or debts of the
---------------------- firm.
---------------------- As a minor is incapable of entering into contracts, he is represented by a
guardian. There are two types of guardians:
----------------------
a) Natural Guardian
----------------------
b) Legal Guardian or court appointed guardian when there are no natural
---------------------- guardians.

---------------------- The natural guardian of a minor is the father of the minor and after the
father’s death; the minor’s mother becomes the natural guardian (except in case
---------------------- of Muslim minors). However, a mother can become a natural guardian when
the father is alive but is not available or is indifferent or is not interested in the
----------------------
welfare of his minor child.
---------------------- Banks may open a savings bank account in any of the following ways:
---------------------- 1. In the name of the minor, to be operated upon by the natural guardian or
the legal guardian. For example, an account can be opened in the name
---------------------- of A, minor, to be operated by his father, X. In such cases, the cheques
---------------------- are signed by the guardian not in his individual capacity, but as natural
guardian. In the above example, X will sign the cheques as “X, natural
---------------------- guardian of A”.

126 Indian Banking & Financial System

 The bank records the date of birth of the minor as given by the minor or his/ Notes
her guardian. On attainment of majority, the account should be closed and
the balance paid to the minor (now major) or transferred to a new account ----------------------
in his/her name. In case the minor dies before attaining majority, the balance
in the account is paid to guardian. If the guardian dies during the minority, ----------------------
then the balance is paid the minor after he attains majority. ----------------------
2. In the sole name of minor. Usually, this is permitted after the minor has
----------------------
attained an age of 10 years and is able to maintain a uniform signature.
D. Illiterates ----------------------
An account can be opened for an illiterate customer by obtaining his left ----------------------
hand thumb impression (LHTI) on the account opening form, along with a recent
photograph. The account is preferably opened as a joint account with a close, literate ----------------------
blood relative. This is done with a view to protect the illiterate customer from cheats
----------------------
and fraudsters. The illiterate customer is required to personally visit the branch for
each withdrawal. His thumb impression is taken on the space for signature in the ----------------------
presence of a bank official, who then writes below the thumb impression-
----------------------
LHTI of Shri. —————— (full name of the customer).
The photograph is then referred to for verification purposes. ----------------------

E. Proprietary Concerns ----------------------

An individual may run his business not in his own name but by giving a ----------------------
separate name. For example, Mr. Ganesh may start business of trading in computer
stationery under the name of Ganesh Computer Stationery. He would be the sole ----------------------
proprietor of the business. The individual owner receives all profits and bears
----------------------
all risks. His liability is, therefore, unlimited. Legally, the proprietary concern
is not separate from its owner. The account would be operated by Mr. Ganesh ----------------------
by signing as under:
----------------------
For Ganesh Computer Stationery
Proprietor ----------------------

----------------------
Check your Progress 1
----------------------
Fill in the blanks. ----------------------
1. Banks do not reveal the status of account even to closest relatives in
case of account being in the single name, as they have to maintain ----------------------
___________. ----------------------
2. A sole account holder can ensure easy transfer of the balance on his
death by opting for ___________ facility. ----------------------
3. An authority given by the account holder in favour of third person to ----------------------
operate the account is called ___________ .
4. The relationship between the person granting the power of attorney ----------------------
and the POA holder is that of ___________ and ___________.
----------------------

Types of Customers & Mode of Operation 127

 Notes
5. Nomination facility can be availed by ___________ person and not
---------------------- by ___________ person.

---------------------- 6. A person is considered minor up to ___________ age.

7. The authorisation for payment from an illiterate customer will be by
---------------------- way of ___________.
---------------------- 8. In case of a Proprietary concern, the proprietor’s liability will be
_______.
----------------------

----------------------

----------------------
Activity 1

---------------------- Visit a branch of a nationalised bank and collect and study the format
used for registering Power of Attorney.
----------------------
----------------------
7.3 CORPORATE CUSTOMERS
----------------------
A. Partnership
----------------------
A small business can be started as proprietary concern. However, as the
---------------------- business grows, it needs more capital which the sole proprietor alone cannot raise.
---------------------- In the above example, Mr. Ganesh may form a partnership with Mr. Nagesh to
manage the growing business and name the firm G, N & Co. Persons who have
---------------------- entered into partnership with one another are called “partner” individually and
collectively “a firm”.
----------------------
Partnership is defined as the relationship between persons who have agreed
---------------------- to share the profits of a business carried on by all or any of them acting for all.
---------------------- Thus, the features of partnership are:

---------------------- 1. It is a relationship between persons. This means that partnership is the

result of an agreement between persons joining together to do some lawful
---------------------- business. The agreement may be oral or written.

---------------------- 2. The partners should agree to share the profits of the business. In other words,
the coming together should be to earn profit by doing business.
----------------------
3. The business would be carried on by all or any of them acting for all. There
---------------------- is a mutual relation of ‘agency’ between the partners. Every partner is an
authorized agent of the partnership firm and can represent the firm in its
---------------------- business dealings.
---------------------- A partnership can have a minimum of two partners and a maximum of twenty
(ten in case of a banking company).
----------------------
A written agreement between the partners is referred to as a partnership deed.
---------------------- If there is no written agreement, then the rights and liabilities of the partners

128 Indian Banking & Financial System

are governed by Partnership Act, 1932. For example, the partners, Mr. Ganesh Notes
and Mr. Nagesh in the above firm may agree to share profits in the ratio of say,
3:2 and incorporate it in a partnership deed. However, if there is no partnership ----------------------
deed, then the provisions of the Act will apply according to which profits would
be shared equally. ----------------------

Banks obtain a partnership letter signed by all partners, which is standard ----------------------
document obtained to bind all partners jointly and severally. The partners are
----------------------
required to furnish information related to the nature of business, names and
addresses of all partners along with instructions related to operation of the ----------------------
account.
----------------------
B. Joint Stock Company
A joint stock company is an artificial person having perpetual succession ----------------------
and is created and governed as per the provisions of the Companies Act, 1956.
----------------------
A company is a legal person which is created by law and can only be dissolved
by the law. It is separate from its members and can enter into contracts and can ----------------------
acquire and own property in its own name. The liability of shareholders is limited
to the extent of their shareholding. The company seal is affixed on documents ----------------------
executed by a company. The company seal is the signature of the company. The
----------------------
day to day affairs are managed on behalf of the company by a board of directors
appointed by the shareholders. ----------------------
The distinction between a company and a partnership firm is given below: ----------------------
Partnership Company
----------------------
Registration is not compulsory Registration is compulsory
Number of partners: Minimum 2 & Number of members-Pvt. Ltd.–Min. 2; ----------------------
Max.20 (10 in case of banking business) Max.50Public Ltd. - Min. 7; Max.- no
----------------------
limit
No separate legal existence Separate legal existence from its ----------------------
members
----------------------
Does not have perpetual existence Has perpetual existence
Managed by partners Managed by board of directors appointed ----------------------
by shareholders
----------------------
Liability of partners is unlimited Liability of shareholders is limited
A person can be admitted to the firm A transferee of shares of a company ----------------------
with the consent of all existing partners becomes its shareholder and consent
of existing shareholders is not required ----------------------
Death of a partner results in dissolution Death of any or all members does not ----------------------
of firm, unless the partnership deed affect the existence of a company
provides to the contrary ----------------------
Every partner is an agent of the other Members of a company are not agents ----------------------
of each other or of the company
----------------------

----------------------

Types of Customers & Mode of Operation 129

 Notes The points of distinction between a private limited company and a public limited
company are as under:
----------------------
Private Limited Company Public Limited Company
---------------------- Number of members- Min.-2; Max.-50 Number of members- Min.-7; Max.-no limit
Can commence business after obtaining In addition to certificate of incorporation,
---------------------- certificate of incorporation should obtain certificate of commencement
---------------------- of business
The name should include the words The name should include the word ‘Limited’
---------------------- ‘Private Ltd.’ at the end
Restrictions on transfer of shares No restrictions on transfer of shares
----------------------
Cannot invite subscription from public No such restriction
---------------------- to shares
Shares are neither listed on stock Shares are listed and traded on stock
---------------------- exchanges nor are they traded publicly. exchanges imparting easy liquidity.Value
Hence, valuation of shares is difficult. of shares is also readily available.
----------------------
The operations of a company are governed by some important documents
---------------------- which should be thoroughly scrutinized by banks before opening an account and
allowing operations in it. The important documents are:
----------------------
1. Certification of Incorporation and Certificate of Commencement of Business:
----------------------
These certificates are issued by the Registrar of Companies and provide
---------------------- conclusive proof that the company is a duly incorporated body and all the
necessary formalities regarding its formation have been performed by its
---------------------- promoters.
---------------------- 2. Memorandum of Association: The Memorandum of Association (M/A) is
the main document of the company and is called the charter of the company.
---------------------- The bank should scrutinize the M/A and ensure that the contracts entered
---------------------- into by the company are in accordance with the objectives stated therein
otherwise such contracts would be ultra vires, i.e. beyond the powers of the
---------------------- company and cannot be enforced against it.
---------------------- 3. Articles of Association: The Articles of Association (A/A) contain the rules
and regulations of a company regarding its internal management, including
---------------------- the rights and powers of the company. The bank should scrutinize the A/A
---------------------- to ascertain the powers of the directors and the procedure and authority
to operate the bank account and draw cheques on behalf of the company.
---------------------- The board of directors takes decisions by passing resolutions in properly
convened meetings in accordance with the provisions of A/A.
----------------------
While opening an account, banks obtain the following documents:
----------------------
a) Certified copy of Memorandum of Association
---------------------- b) Certified copy of Articles of Association
---------------------- c) Certified copy of Certificate of Incorporation and in case of a public
limited company, certified copy of Certificate of Commencement of
---------------------- Business.

130 Indian Banking & Financial System

 d) Copy of board resolution appointing the bank as the company’s bank Notes
and indicating the names of the company officials authorized to operate
the account. ----------------------
e) Specimen signatures of all authorized signatories ----------------------
C. Joint Hindu Family or Hindu Undivided Family (HUF)
----------------------
An HUF is a legal entity which owns ancestral property and conducts
ancestral business. Where a Hindu dies, leaving a business, it passes on to legal ----------------------
heirs according to Hindu Law and the property becomes HUF property. The eldest
----------------------
male child is the manager or the karta and the other members of the family are
called coparceners. In the past, the legal provision was that the property would ----------------------
pass on to male children only. In 2005, the Hindu Succession Act was amended
and now a daughter has the same rights in ancestral property as a son. ----------------------
At the time of opening an account, banks obtain an HUF letter signed by ----------------------
all adult coparceners, in which they furnish a declaration that the business is
ancestral business. Normally, coparceners are liable to the extent of their share ----------------------
in the family property and do not incur any personal liability. However, if the ----------------------
business carried on by them turns out to be other than their ancestral business,
then the HUF letter enables the bank to hold all the coparceners personally liable. ----------------------
In case the HUF has minor coparceners, then the HUF letter is signed by the
guardian of the minor and the minor’s date of birth is recorded. On the minor ----------------------
attaining majority, a fresh HUF letter is obtained and his signature is obtained ----------------------
on it along with that of all other coparceners.
The karta has the authority to carry on the ancestral business on behalf of ----------------------
the family and to operate the bank account. ----------------------
D. Trusts
----------------------
A trust is an entity created by a person called the author who reposes
confidence in a person called a trustee to hold and manage the trust property for ----------------------
the benefit of certain persons or entities. A trust essentially has three ingredients:
----------------------
1. Purpose of a trust
----------------------
2. Trust property and
3. Beneficiaries of the trust. ----------------------

Trusts can be religious trusts, educational trusts, charitable trusts and medical ----------------------
trusts. Siddhi Vinayak Trust in Mumbai is an example of a religious trust which
holds and maintains the temple for the devotees who are the beneficiaries of the ----------------------
trust. It is also a public trust. A private trust, on the other hand, is a trust created ----------------------
for the benefit of a specified person or group in a family. A trust is formed by
executing a document called a trust deed which specifies the objectives of the ----------------------
trust, the beneficiaries of the trust and the authority of the trustees.
----------------------
While opening an account of a trust, the bank should scrutinize the trust
deed and ascertain the names of the trustees authorized to open and operate the ----------------------
account. In case there is more than one trustee, all trustees must jointly operate
----------------------
the bank account, unless stated otherwise in the trust deed. Trustees cannot

Types of Customers & Mode of Operation 131

 Notes delegate their powers to others unless specifically authorized by the trust deed.
While permitting withdrawals from the trust account, the bank must meticulously
---------------------- ensure that the withdrawals are being made in accordance with the purpose of the
trust. Cheques drawn favouring the trust should not be credited to the personal
---------------------- account of the trustees.
---------------------- E. Co-operative Societies
---------------------- A society may be created for the promotion of literature, music, or any other
common purpose. We also come across housing co-operative societies. Such
---------------------- societies are required to be incorporated and registered, after which they get a
legal status, as an entity separate from the members.
----------------------
The rules and bye-laws of the society should be examined to ascertain
---------------------- the powers and functions of the persons managing its affairs. The Managing
Committee of the society must pass a resolution mentioning the names of the
----------------------
persons authorized to operate the account. A copy of the resolution should be
---------------------- maintained by the bank along with the account opening form. The specimen
signatures of the authorized signatories should be obtained. If the person
---------------------- authorized to operate the account dies or resigns, the transactions in the account
must be stopped until the society nominates another person.
----------------------

----------------------
Check your Progress 2
----------------------
Fill in the blanks.
----------------------
1. The business organisation where persons come together and agree to
---------------------- share the profits/losses of a business carried on by all or any of them
acting for all is called _____.
----------------------
2. A partnership carrying on the business other than banking, the
---------------------- minimum number and maximum number of members should be
---------------------- _______ and _______.
3. The liability of a member of a limited company is limited to the extent
---------------------- of _______.
---------------------- State True or False.
---------------------- 1. In case of a private limited company, the minimum number of
members is two and maximum fifty.
----------------------
2. Members of a limited company are agents of the company.
---------------------- 3. A private limited company cannot invite subscription from general
public.
----------------------
4. The public limited company should obtain Certificate to Commence
---------------------- business.
----------------------

----------------------

132 Indian Banking & Financial System

 Notes
Multiple Choice Single Response
1. The Karta of a HUF is ----------------------
i. The eldest female member of the family ----------------------
ii. The eldest male member of the family
iii. Member unanimously elected by the family ----------------------
iv. None of these ----------------------
2. In the context of HUF, the term coparcener means
----------------------
i. All other members except Karta
ii. Only adult male members of the family ----------------------
iii. Only adult female members of the family ----------------------
iv. Both ii & iii
----------------------
3. A trust is formed by
i. Executing a document called “trust deed” ----------------------
ii. Forming a partnership of likeminded persons
----------------------
iii. Incorporating a private limited company
iv. None of these ----------------------
4. For opening an account in the name of a Co-operative society, the ----------------------
documents required are
i. A simple letter addressed to the bank ----------------------
ii. A copy of resolution passed by the managing committee and ----------------------
copy of certificate of registration
iii. Specimen signatures of persons authorised to operate the ----------------------
account ----------------------
iv. List of Trustees with their photographs
v. ii, iii & iv ----------------------

----------------------

----------------------
Activity 2
----------------------
Prepare a chart for customers for the following categories:
----------------------
Account in single name, joint account, Account in the name of illiterate
persons, HUF, Proprietary concern, Partnership, Jt stock Co, Trust, Co ----------------------
operative society.
----------------------
Use the following format.
----------------------
Type of Basic Authorised Mode of Documents
customer documents signatories operation specifying mode of ----------------------
operation
----------------------

----------------------

Types of Customers & Mode of Operation 133

 Notes Summary
---------------------- ● Banks have to deal with various types of customers and are required to
adhere to various legal provisions pertaining to different customers.
----------------------

---------------------- Keywords
---------------------- ● Mandate: A mandate is an authority given by the account holder in favour
---------------------- of a third person to operate the account on his behalf.
● Power of Attorney: A power of attorney (POA) is a document executed
---------------------- by the account- holder as a donor in favour of another person who is known
as a POA holder or attorney. It is a stamped and registered document.
----------------------
● Minor: A minor is a person who has not completed 18 years of age.
----------------------
● Partnership: Partnership is the relationship between persons who have
---------------------- agreed to share the profits of a business carried on by all or any of them
acting for all.
----------------------
● Joint Stock Company: A joint stock company is an artificial person
---------------------- having perpetual succession and is created and governed as per the
provisions of the Companies Act, 1956.
---------------------- ● Hindu Undivided Family: An HUF is a legal entity which owns ancestral
---------------------- property and conducts ancestral business.

---------------------- Self-Assessment Questions

----------------------
1. How are individual accounts maintained in banks?
---------------------- 2. Which kinds of accounts are maintained by banks with corporate
---------------------- customers?

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1
---------------------- 1. Banks do not reveal the status of account even to closest relative in case
of account being in the single name, as they have to maintain secrecy of
---------------------- state of affairs of the customer’s account.
---------------------- 2. A sole account holder can ensure easy transfer of the balance on his death
by opting for nomination facility.
----------------------
3. An authority given by the account holder in favour of third person to
---------------------- operate the account is called mandate.
---------------------- 4. The relationship between the person granting the power of attorney and
the POA holder is that of principal and agent.
----------------------
5. Nomination facility can be availed by natural person and not by legal
---------------------- person.

134 Indian Banking & Financial System

6. A person is considered minor up to 18 age. Notes
7. The authorisation for payment from an illiterate customer will be by way
----------------------
of obtaining Left Hand Thumb Impression (LHTI).
8. In case of a Proprietary concern, the proprietor’s liability will be unlimited. ----------------------

----------------------
Check your Progress 2 ----------------------
Fill in the blanks.
----------------------
1. The business organisation where persons come together and agree to share
the profits/losses of a business carried on by all or any of them acting for ----------------------
all is called partnership.
----------------------
2. A partnership carrying on the business other than banking, the minimum
number and maximum number of members should be 2 and 20. ----------------------
3. The liability of a member of a limited company is limited to the extent of ----------------------
his shareholding.
----------------------
State True or False.
1. True ----------------------

2. False ----------------------
3. True ----------------------
4. True
----------------------
Multiple Choice Single Response
----------------------
1. The Karta of a HUF is
ii. The eldest male member of the family ----------------------

2. In the context of HUF, the term coparcener means ----------------------

i. All other members except Karta ----------------------
3. A trust is formed by
----------------------
i. Executing a document called “trust deed”
----------------------
4. For opening an account in the name of a Co-operative society, the
documents required are ----------------------
v. ii, iii & iv ----------------------

----------------------
Suggested Reading
----------------------
1. Varshney, P.N. Banking law and Practice.
----------------------

----------------------

----------------------

Types of Customers & Mode of Operation 135

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

136 Indian Banking & Financial System

Negotiable Instruments
UNIT

8
Structure:
8.1 Introduction
8.2 Definition of a Negotiable Instrument
8.3 Promissory Note
8.4 Bills of Exchange
8.5 Cheques
8.6 Legal Provisions regarding Protection to the Paying Banker
8.7 Legal Provisions regarding Protection to the Collecting Banker
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Negotiable Instruments 137

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• State various types of negotiable instruments
----------------------
• Analyse the legal protection available for paying and collecting banker
----------------------

---------------------- 8.1 INTRODUCTION

----------------------
We have seen earlier that, under the paper-based payment system, transactions
---------------------- are mainly done using cheques. Despite the advent of technology-enabled modes
of payment, the use of cheques continues to be done on an extensive scale. Owing
---------------------- to the continued popularity of cheques, banks are required to handle large volumes
of cheques during their day to day operations.
----------------------
Cheques are a sub-set of instruments called negotiable instruments. The
---------------------- other types of negotiable instruments include bills of exchange and promissory
notes. Demand drafts are a type of bills of exchange. Negotiable instruments are
----------------------
in turn a sub-set of transferable instruments.
---------------------- It is important to understand the features of negotiable instruments and the
responsibilities and obligations of banks while handling them. In this unit, we shall
----------------------
understand the legal and operational aspects of handling negotiable instruments.
----------------------
8.2 DEFINITION OF A NEGOTIABLE INSTRUMENT
----------------------
The Negotiable Instruments Act states that there are three types of negotiable
----------------------
instruments- promissory note, bill of exchange and a cheque. All the above instruments
---------------------- are transferable instruments i.e., they can be transferred from one person to another.
But they possess a special characteristic of negotiability which is something more
---------------------- than mere transferability which distinguishes them from transferable instruments.
---------------------- Normally, when transfer of a commodity or an article is made, the transferee
cannot get a better title than that of the transferor. For example, assume that
---------------------- A steals a laptop from its true owner a dealer Y and offers to sell it to another
person B. Now, even if B does not have any ground to disbelieve A to be the
----------------------
true owner and if he pays the full value of the laptop, he cannot still be the true
---------------------- owner. This is because A, himself, does not have any title to the laptop and so he
cannot transfer any title to B. B is bound to return to return it to the true owner
---------------------- the dealer Y. He can only claim the money back from A.
---------------------- A negotiable instrument is an exception to this general rule of law. Let us
take the same example and now assume that B receives a stolen cheque from A. In
---------------------- such a case, if B takes the cheque in good faith and without any prior knowledge
---------------------- about the theft, then he would not have a good title to the cheque and shall not
be liable to the true owner, Y. Y can only recover the amount from the thief of
---------------------- the cheque, A, but not from B. B becomes a holder in due course.

138 Indian Banking & Financial System

 A holder in due course is a person who receives a negotiable instrument in Notes
good faith, after paying the value thereof and without notice of the defective title
of the transferor. He then gets the instrument free from prior defects and has the ----------------------
right to recover the above amount of the instrument. In the above example, B
shall have the right to encash the cheque. ----------------------

Thus, while all negotiable instruments are transferable instruments, all ----------------------
transferable instruments are not negotiable instruments. This has been shown
----------------------
diagrammatically below:
----------------------
Transferable Instruments
----------------------
Negotiable
Instruments ----------------------

----------------------

----------------------
Based on the mode of transfer, negotiable instruments are classified into ----------------------
bearer instruments and order instruments. A bearer instrument can be transferred
by mere delivery. An order instrument, on the other hand, can be transferred by ----------------------
endorsement and delivery. Endorsement is usually done by signing at the back
----------------------
of a cheque. For example, if a cheque is drawn:
a) Payable to A, or bearer, and if A wants to transfer it to B, then he can do so ----------------------
by merely delivering it to B.
----------------------
b) Payable to A, or order, and if A wants to transfer it to B, then A must first
make an endorsement as under: ----------------------
Pay to B or order ----------------------
Sd. /-
----------------------
A
----------------------
Thereafter, he must deliver it to B for the transfer to be complete.
Let us now understand the three types of negotiable instruments in detail: ----------------------

----------------------
Check your Progress 1
----------------------

Fill in the blanks. ----------------------

1. ______, ______, ______ are negotiable instruments. ----------------------
2. A person receiving a negotiable instrument in good faith, for value,
----------------------
without notice of defective title of the transferee is called ______.
----------------------

----------------------

----------------------

Negotiable Instruments 139

 Notes
Activity 1
----------------------

---------------------- Negotiability is not the same thing as transferability of a negotiable

instrument. Discuss with examples.
----------------------

---------------------- 8.3 PROMISSORY NOTE

---------------------- A promissory note (PN) is an instrument in writing signed by the maker
containing an unconditional undertaking to pay a certain sum of money only to
---------------------- or to the order of a certain person or to the bearer of the instrument. A promissory
note has two parties- a maker and a payee.
----------------------
Let us assume that A & Co. has sold some goods to B & Sons. B & Sons
---------------------- would sign a promissory note in favour of A& Co. or order. In this example,
A & Co is the creditor and B & Sons is the debtor. This is shown diagrammatically
----------------------
below:
----------------------
Debtor & Goods Creditor &
---------------------- Maker of PN Payee of PN
---------------------- [Undertaking to pay]
---------------------- Promissory Note

---------------------- You would observe for the above diagram that a PN is drawn by the buyer/
maker, in this case B & Sons, in favour of the seller/payee, i.e. A & Co.
---------------------- It contains an unconditional undertaking to pay. In the above example,
---------------------- B & Sons undertakes to pay to A & Co. the value of goods supplied by him. A PN
may be drawn payable on demand or it may be payable at a future date. If some
---------------------- time period is permitted by commercial usage for the payment of the promissory
note to the buyer, then such period is referred to as usance and the PN is referred
---------------------- to as a usance promissory note. A usance PN is required to be stamped.
----------------------
Rs.10,000/- PUNE 1st July 2011
----------------------

----------------------

---------------------- One month after date, we promise to pay A& Co. or order the sum of Rupees
Ten Thousand Only for value received.
----------------------

---------------------- For B & Sons

----------------------
STAMP
----------------------
AUTHORISED SIGNATORY
---------------------- Specimen of a Promissory Note

140 Indian Banking & Financial System

 In the past, while granting loans, banks (as creditors) used to obtain a separate Notes
promissory note signed by the borrower (debtor) containing an unconditional
undertaking to repay the loan amount. Nowadays, banks incorporate a clause in ----------------------
the loan document which contains an unconditional undertaking of the borrower
to pay. Hence, promissory notes are now not taken by banks. ----------------------

----------------------
Creditor & Goods Debtor &
Drawer of B/E Drawee of B/E ----------------------

----------------------
B/E [Order to pay to
payee] ----------------------
(Owes a debt) ----------------------
Payee
----------------------

----------------------
Check your Progress 2
----------------------
State True or False.
----------------------
1. Promissory note has three parties.
----------------------
2. A promissory note contains an unconditional undertaking to pay.
3. There are two types of promissory notes: Demand P/N and Usance ----------------------
P/N. ----------------------

----------------------
Activity 2 ----------------------

In the light of relevant sections of NI Act, examine the following statement: ----------------------

While cheques can be issued as bearer or order, the P/N is not issued as ----------------------
bearer.
----------------------

----------------------
8.4 BILLS OF EXCHANGE
----------------------
A bill of exchange (B/E) is
----------------------
i) An instrument in writing
----------------------
ii) Signed by the maker or drawer
iii) Containing an unconditional order ----------------------
iv) Directing a certain person or drawee ----------------------
v) To pay a certain sum of money ----------------------
vi) To a certain person or payee
----------------------

Negotiable Instruments 141

 Notes There are three parties to a bill of exchange – the drawer, drawee and payee.
The payee can be the drawer himself or any other person. In the above example, B
---------------------- & Sons as debtors had signed a PN favouring the creditor, A & Co. Alternatively,
A & Co., as drawer, can draw a B/E on B& Sons, the drawee, directing them to
---------------------- pay the amount to another party, say N, who becomes the payee of the B/E.
---------------------- As in case of PNs, B/E can be either demand bills or usance bills. A demand
bill is to be paid by the drawee on demand; a usance bill is to be paid after a
----------------------
certain period. A usance bill is required to be stamped.
---------------------- A demand draft is an example of a demand bill of exchange in which the
issuing branch is the drawer and the paying branch is the drawee.
----------------------
Rs.10,000/- PUNE 1st July 2011
----------------------

----------------------
One month after date, pay N or order the sum of Rupees Ten Thousand Only
---------------------- for value received.

----------------------
A& Co
----------------------
To B & Sons Accepted
----------------------
STAMP For B & Sons
---------------------- AUTHORISED SIGNATORY
----------------------

---------------------- AUTHORISED SIGNATORY

Specimen of a Bill of Exchange
----------------------
Currency Notes and Negotiable Instruments: A currency note is a
---------------------- negotiable instrument. It is a promissory note issued by Reserve Bank of India,
as the maker, payable to the bearer on demand. However, RBI is the sole note
---------------------- issuing authority in the country. The RBI Act, therefore, prevents any person
---------------------- (other than RBI) to make, draw or issue a promissory note or bill of exchange
payable to bearer on demand. This restriction is imposed with the objective that
---------------------- instruments similar to currency notes are not issued by a private party.
Days of Grace: As we have seen above, promissory notes and bills of
----------------------
exchange can be payable either on demand or after a certain period called usance
---------------------- period. In the case of usance PNs and B/Es, the maturity date is the date on which
they fall due for payment. Such usance promissory notes or bills of exchange
---------------------- mature on the third day after the day on which they are expressed to be payable.
The additional three days given for payment are called “Days of Grace”.
----------------------
Let us now see some examples for calculation of maturity dates
---------------------- A. In case the PN or B/E is expressed payable after a certain number of days,
the date of the bill shall be excluded while calculating the maturity date.
----------------------
For example, a bill dated 1st July 2011 drawn payable 30 days after sight
---------------------- would be payable on 3rd August 2011.

142 Indian Banking & Financial System

B. In case the bill is expressed in number of months. Notes
If a bill is drawn on 15 July 2011 and payable three months after date, then
th
----------------------
the three month period would terminate on 15th October 2011.Adding three
days of grace period, the bill would mature on 18th October 2011. ----------------------
If a bill matures on a public holiday, it would become due for payment on the
----------------------
previous working day. For example, if a bill matures on 26th January 2012,
which is a public holiday, it would be due for payment on 25th January 2012. ----------------------
A usance bill is required to be presented twice-once for acceptance, and
----------------------
then again for payment on maturity date.
Presentment for Acceptance: In the case of usance bills of exchange, ----------------------
presentment for acceptance is necessary. The drawer of the bill or his agent must ----------------------
present the bill to the drawee or his agent for acceptance. After acceptance of the
bill, the drawee becomes the acceptor and is liable for payment of the amount ----------------------
of the bill. Bills must be presented within a reasonable time after they are drawn
and during business hours and on a business day. ----------------------

Presentment for Payment: Presentment for payment is necessary for all ----------------------
cheques, bills of exchange and promissory notes. Presentment should be made
as under: ----------------------

a) Cheques-to the drawee bank during banking hours and on a working day. ----------------------
b) Bills of exchange - to the drawee or acceptor, as the case may be, during ----------------------
usual hours of business.
----------------------
c) Promissory Notes- to the maker
d) A usance promissory note or bill of exchange should be presented on the ----------------------
maturity date. ----------------------
e) A negotiable instrument payable on demand should be presented for payment
within a reasonable time. In case of cheques, in accordance with customs ----------------------
and practice, the time for presentment of cheque is within six months from ----------------------
the date of the cheque.
Dishonour of Negotiable Instruments: A negotiable instrument is ----------------------
dishonoured by ----------------------
a) Non-acceptance
----------------------
b) Non-payment.
----------------------
When a negotiable instrument is dishonoured for either of the reasons
mentioned above, the holder must take the following steps: ----------------------
i) He must give notice of dishonour to all prior parties to the instrument and ----------------------
ii) He must get it noted and protested. Noting is done by a Notary Public, who
formally makes a demand for acceptance or payment and upon dishonour ----------------------
of the instrument, notes or records the fact of dishonour on the instrument ----------------------
or on a paper attached thereto. After recording a note of dishonour on the
dishonoured instrument, the Notary Public issues a certificate to this effect. ----------------------

Negotiable Instruments 143

 Notes This is called protest. Noting and protest is a conclusive proof of the fact of
dishonour of the instrument and can be used to initiate legal action against
---------------------- the drawee or acceptor or maker.
---------------------- Bankers’ role in bill transactions: As we have seen earlier, a bill of
exchange normally arises out of a trade transaction and creates a creditor-debtor
---------------------- relationship between the seller and the buyer. The creditor may arrange to have
the bill realized through his banker. He may also seek a loan against the B/E
----------------------
from the bank. Hence, banks offer two kinds of services in bill transactions:
---------------------- a) Bill collection: Banks arrange to collect the proceeds of the bill through
the debtor’s bank and thus act as an agent for collection of the creditor. The
----------------------
process is called bill collection and banks earn commission income.
---------------------- b) Bill Purchase & Bill Discounting: Banks providing finance against bills
drawn by the creditor and then arranging to recover its loan by realizing the
----------------------
proceeds of the bill from the debtor, through his banker. In such cases, banks
---------------------- earn interest. However, the bank can decide, after evaluating the financial
standing of the creditor, whether or not to give a loan against B/Es and if
---------------------- so, on what terms and conditions. When banks give finance against demand
bills, it is termed as bill purchase and finance against usance bills is called
----------------------
bill discounting. In the process, the bank becomes the holder of the B/E and
---------------------- can claim payment from the drawee or acceptor. You may wonder as what the
bank would do if the bill is dishonoured by the drawee. In case of dishonour,
---------------------- the bank can recover the money from the creditor to whom finance was given
against the bill. It can also have the bill noted and protested and initiate legal
----------------------
action against the drawee or acceptor for recovery of the amount of the bill.
----------------------
Check your Progress 3
----------------------

---------------------- Fill in the blanks.

---------------------- 1. A bill of exchange has ___________ parties.
---------------------- 2. A B/E can be either ___________ bill or ___________ bill.

---------------------- 3. ___________ Act prevents from issuing P/N or B/E payable to bearer
on demand.
---------------------- Match the following.
---------------------- Type of instrument Presented to
---------------------- i. Cheque a. The drawee or acceptor during usual business
hours
----------------------
ii. Bill of Exchange b. The maker if usance on maturity date
----------------------
iii. Promissory Note c. Drawee bank, during working hours, on a
---------------------- working day

----------------------

144 Indian Banking & Financial System

 Notes
Activity 3
----------------------
Refer to www.mergersindiainfo.com, www.legalpundits.com. Collect ----------------------
information on the latest rates of stamp duty payable on usance instruments.
----------------------

----------------------
8.5 CHEQUES
----------------------
A cheque is a bill of exchange drawn on a specified banker and is always
payable on demand. Hence, it is a B/E in which the drawee is always a specified ----------------------
banker and cannot be anybody else and cheques are always payable on demand.
----------------------
In other words, there cannot be any usance cheques. The meaning of the words
‘drawee as a specified banker’ is that you can only draw cheques on the bank ----------------------
which is holding your funds as a debtor and not on any other bank. Hence, in
case of cheques also, there exists a debtor-creditor relationship between the bank ----------------------
and the customer. In all other respects, cheques are similar to bills of exchange.
----------------------
The diagrammatic representation of a cheque transaction is given below:
----------------------
Customer & Banker &
Drawer Drawee ----------------------
[Cheque-order to pay to payee]
----------------------
Payee
----------------------

----------------------
Date 01/07/2011 ----------------------
PAY Mr. Ram OR ORDER
----------------------
Rs.5,000/-RUPEES Five Thousand only———————
----------------------
A/C NO. 001109999999 Rs. 5,000/-
----------------------
XYZ Bank sd/-
Pune-411001. KRISHNA ----------------------

123456 400456789 9999999 10 ----------------------

Specimen of a Cheque ----------------------
Let us now examine the various aspects of a cheque:
----------------------
A. Printed Form: When an account is opened, the customer is handed over a
cheque book containing cheque leaves which the customer should use while ----------------------
operating the account. However, legally, there is no requirement for the
----------------------
customer to give instructions to his banker through a cheque. The customer
can also give the instructions on a piece of paper. Banks, nevertheless, ----------------------
insist on the use of printed cheque forms because they ensure uniformity
and enable banks to process them quickly. It is convenient for the customer ----------------------

Negotiable Instruments 145

 Notes also to draw cheques and he can also maintain a proper record of cheques
issued on the counterfoils provided by the bank as part of the cheque book.
---------------------- In case the customer is required to make stop payment of any cheque, it
convenient for the customer to quote the cheque number and other details
---------------------- and also for the bank to comply with the same.
---------------------- B. Date: A cheque should be properly dated. This means that it should not:
---------------------- i) be stale, i.e. presented for payment more than three months from the
date mentioned on the cheque. In the above example, the cheque will
---------------------- become stale after 30th September 2011 and will not be paid by the
bank if presented after that date.
----------------------
ii) be post-dated, i.e. the date on the cheque should not be a future date with
---------------------- reference to the date on which it is presented to the bank. For example,
if the above cheque is presented to the bank for payment on any date
----------------------
before the date mentioned on the cheque, i.e., 1st July 2011, then it will be
---------------------- a post-dated cheque and the bank will not payment against such cheque.
It will pay it only on or after the date mentioned on the cheque.
----------------------
iii) be undated if a cheque does not bear a date , it would not be paid by
---------------------- the bank. If for example, in the above cheque, no date is mentioned,
then it will not be paid by the bank.
----------------------
iv) have an impossible date- for example, if the above cheque bears a date
---------------------- of 31st June 2011, it is an impossible date. In such cases, however,
banks are entitled to assume that the drawer intended to put the last
---------------------- date of June as the date of the cheque. The bank would, therefore, pay
---------------------- the cheque on after 30th June 2011.
v) have an incomplete date i.e. it should have the full particulars of date,
---------------------- month and year. If in the above cheque, if the date is mentioned only
---------------------- as July 2011, it is an incomplete date and the bank would not pay the
cheque.
----------------------
C. Payee
---------------------- i) The payee of a cheque should be a certain person. In addition to an
individual, the term person includes legal persons such as companies,
----------------------
societies, institutions etc.
---------------------- ii) The payee may be more than one person. The drawer may draw the cheque
---------------------- payable to more than one payee jointly or to any one of those named in
the cheque. In the above cheque the drawer may draw it payable to “Mr.
---------------------- Ram and Mr. Rahim jointly” or to “Mr. Ram or Mr. Rahim”.

---------------------- iii) A cheque drawn payable to bearer would be paid to the person in
possession thereof.
---------------------- iv) A cheque payable to order shall be paid after identification of the
---------------------- presenter. The above cheque is drawn payable to order and if Mr. Ram
presents it for payment at the bank, then it would be paid after verifying
---------------------- the identity of Mr. Ram based on his driving licence, passport or election

146 Indian Banking & Financial System

 card. An order instrument can also be transferred by endorsement and Notes
delivery. If Mr. Ram endorses the cheque to someone else, then the
bank would satisfy itself about the identity of the presenter and then ----------------------
make payment.
----------------------
v) Payment of a crossed cheque would only be made to the payee’s account
through his banker. The bank would not make cash payment against a ----------------------
crossed cheque.
----------------------
D. Amount: The amount mentioned in words and figures must tally. Legally,
if the amount in words and figures differ, then banks would be well within ----------------------
their right to make payment as per the amount mentioned in words. However,
----------------------
as a matter of practice, banks return such cheques with the reason “amount
in words and figures differs” so as to seek a clear mandate or instruction ----------------------
from the drawer of the cheque.
----------------------
The amount mentioned in the cheque should, of course, be less than the
balance in the account at the time of presentation at the bank. Otherwise, ----------------------
the bank has no obligation to honour the cheque.
----------------------
E. Alterations: Every alteration on the cheque requires the full signature(s)
of the account-holder(s). However, while making alterations, the drawer(s) ----------------------
should ensure that clarity is maintained. If a cheque requires too many
alterations, it is better to cancel it and issue a separate cheque. ----------------------

F. Signature: The customer’s signature is most important as the mandate or ----------------------

instructions are authenticated by the customer’s signature. Every cheque,
to be valid, must bear the customer’s signature and the signature should ----------------------
match with the signature furnished by the customer at the time of opening ----------------------
of account.
Crossing of cheques ----------------------

When a cheque is issued by a drawer, he takes precautions to ensure that it ----------------------

is not misused and encashed by an unauthorized person. One way of doing this
----------------------
is by putting a crossing on the cheque. Normally, a payee can encash an open
cheque across the counter and need not even maintain a bank account. A crossing ----------------------
is a specific instruction to the drawee bank regarding the mode of payment of
a cheque. It is a direction to the paying bank to pay the cheque only through a ----------------------
banker and not directly to anyone presenting it at the counter.
----------------------
Crossing can be of two types:
----------------------
A. General Crossing is done by putting two parallel transverse lines on the
cheque with or without any thing written between these lines. Some examples ----------------------
of general crossing are given below:
----------------------

A/C PAYEE ONLY NOT NEGOTIABLE ----------------------

----------------------

----------------------

Negotiable Instruments 147

 Notes The two transverse parallel lines are essential in general crossing. The effect
of general crossing is that the cheque should be presented to the paying bank
---------------------- only through a bank and payment would not be made across the counter.
---------------------- The payee should deposit the cheque with his bank which would arrange
to collect the amount from the paying bank and then arrange to credit the
---------------------- payee’s account.
---------------------- ‘Account Payee only’ is a very common form of general crossing and it is
an instruction to the bank that the money should be credited to the account
---------------------- of payee only and not anybody else.
---------------------- ‘Not negotiable’ crossing does not make the cheque non-transferable but
---------------------- it removes the characteristic of negotiability from the instrument. In other
words, in a cheque bearing the crossing ‘Not Negotiable’, the transferee
---------------------- cannot get a better title than that of the transferor. This protects the interest
of the true owner of the cheque and any party getting possession of such a
----------------------
cheque should be sure about the title of the transferor. If a person acquires
---------------------- an instrument with a defective title, then he shall be liable to the true owner
even if he has acquired the cheque by paying the value thereof.
----------------------
B. Special Crossing: In a special crossing, the name of a bank is mentioned.
---------------------- It is not necessary to draw two parallel transverse lines. A special crossing
---------------------- is an instruction to the paying bank to make payment to the bank mentioned
in the crossing only.
----------------------
Some examples of special crossing are given below:
----------------------
i) STATE BANK OF INDIA ii) ICICI BANK
----------------------
The paying bank should ensure that a cheque bearing a general crossing
---------------------- is paid only to a banker and a cheque bearing a special crossing should be
---------------------- paid only to the bank mentioned in the crossing.
Double crossing: A cheque should normally be specially crossed to one bank
----------------------
only, which is supposed to collect the cheque and credit the proceeds to the
---------------------- payee. However, it is possible that the bank to which the cheque is crossed
specially may not have a branch at the centre of the paying bank. In such a
----------------------
case, it can put another crossing by putting the name of another bank. Such
---------------------- bank becomes the agent for collection of the first bank.

---------------------- For example, if a drawer draws a cheque on his bank at Nandurbar, in

Maharashtra, and puts a special crossing of Yes Bank and gives it to a person
---------------------- in Pune. It is possible that Yes Bank may not have a branch in Nandurbar. In
---------------------- such a situation, Yes Bank will put another crossing favouring another bank,
say, SBI, which will then become the agent for collection of Yes Bank.
----------------------
The words ‘as agent for collection’ should be included in the crossing. Thus,
---------------------- the crossing should appear as under:

148 Indian Banking & Financial System

 YES BANK Notes
TO ----------------------
STATE BANK OF INDIA ----------------------
As agent for collection
----------------------
Material Alteration: A material alteration is an alteration which makes a
significant change in the mandate or instructions given in the cheque. In general, ----------------------
a crossing which increases the risk for the drawer of the cheque or substantially ----------------------
alters the liability of the drawer or the other parties to the instrument is a material
alteration. A change in the date, place of payment or the amount of the cheque is ----------------------
a material alteration. Changes which are considered as material alterations and
those which are not considered as material alterations are given below: ----------------------

Material Alteration Not considered as Material Alteration ----------------------

Conversion of a crossed cheque into an Conversion of an open cheque into a ----------------------
open cheque by cancelling the crossing crossed cheque
----------------------
Conversion of a special crossing into a Conversion of a general crossing into a
general crossing special crossing ----------------------
Conversion of an order cheque into a Conversion of a bearer cheque into a ----------------------
bearer cheque. order cheque
----------------------
All material alterations must be confirmed with the full signature of the drawer.
----------------------
Check your Progress 4
----------------------

State True or False. ----------------------

1. A cheque is always drawn on a bank and payable on demand. ----------------------
2. Banks insist on customer to use printed cheque forms, though there is
----------------------
no such legal requirement.
3. A cheque can be paid by the bank even after 3 months from the date ----------------------
it was drawn. ----------------------
4. A cheque can be drawn payable to two persons jointly.
----------------------
5. A bank can make payment of a crossed cheque in cash.
----------------------
6. If the amount on the cheque written in words differs from the amount
stated in figures, the cheque is return by the bank. ----------------------
Fill in the blanks.
----------------------
1. Crossing is a specific direction to the ______ regarding the mode of
payment. ----------------------
2. A cheque is called specially crossed when ________ is written across ----------------------
the cheque.
----------------------

Negotiable Instruments 149

 Notes
Activity 4
----------------------

---------------------- Refer www.lawzonline.com. Study the latest guidelines on alterations of a

cheque and its validity.
----------------------

---------------------- 8.6 LEGAL PROVISIONS REGARDING PROTECTION TO

THE PAYING BANKER
----------------------
The paying banker is required to comply with the instructions of the drawer
---------------------- and make payments against cheques. The Negotiable Instruments Act, 1881
---------------------- contains provisions regarding protection available to a paying banker.
The relevant provisions are discussed below:
----------------------
1. Section 10- Payment in due course: Banks can get legal protection by making
---------------------- payment in due course. This means:
---------------------- a. in accordance with the apparent tenor of the instrument
b. in good faith and without negligence
----------------------
c. payment to any person in possession thereof
----------------------
d. the bank should not have any reasonable ground to believe that the presenter
---------------------- is not entitled to receive payment of the amount stated in the cheque
---------------------- a. Apparent Tenor: Banks should make payment of cheques in accordance
with the apparent tenor of the instrument, i.e. in accordance with the
---------------------- instructions of the drawer. For example, a cheque bearing a future date should
not be paid earlier because the instruction of the drawer is that payment
----------------------
should be made on or after the date mentioned on the cheque. Likewise,
---------------------- crossing of a cheque is an instruction of the drawer that the amount of the
cheque should be paid only through a bank. In such a case, if a bank makes
---------------------- cash payment across the counter, it would not be in accordance with the
tenor of the instrument and would not therefore be payment in due course.
----------------------
b. In good faith and without negligence: When a cheque is presented for
---------------------- payment, the banker should thoroughly scrutinize it and only then effect
payment. It should confirm that the date is proper and that the cheque is
----------------------
properly signed and all alterations bear the signature of the drawer of the
---------------------- cheque. If a banker pays an unsigned cheque or an undated cheque, it would
be an act of negligence. This would not be payment in due course and the
---------------------- banker would lose legal protection.
---------------------- Further, if a bank pays a cheque where the drawer’s signature is forged,
it would also amount to gross negligence. If a cheque is paid by the bank
---------------------- after banking hours, then also the bank would be deemed to have acted
negligently. If a customer stops payment of a cheque by writing to his bank
----------------------
and despite that the bank effects payment, then bank has acted negligently
---------------------- and it cannot debit the amount of the cheque to the customer’s account.

150 Indian Banking & Financial System

c. Payment should be made to the right person and after proper identification. Notes
The bank should not have any ground to believe that the person presenting
the cheque is not entitled to receive payment. For example, if a cheque for ----------------------
Rs.10 lacs is presented by a bearer of the cheque, then the bank should make
payment only after proper verification. ----------------------

The Negotiable Instruments Act also contains provisions regarding protection ----------------------
to a paying banker with regard to:
----------------------
a. bearer cheque
b. order cheque ----------------------
c. crossed cheque and a ----------------------
d. cheque containing material alterations
----------------------
a. Payment of a bearer cheque: Banks get protection by making payment in
due course. ----------------------
b. Payment of an order cheque: Banks get protection by making payment ----------------------
in due course and after confirming that the endorsements on the cheque are
regular. ----------------------
c. Payment of a crossed cheque: Banks get protection by making payment in ----------------------
due course and in accordance with requirements of the crossing. A cheque
bearing a general crossing should be paid only to a bank and a cheque ----------------------
bearing a special crossing should be paid only to the banker specified in the ----------------------
crossing.
d. Payment of a cheque having a material alteration: Banks get protection ----------------------
by making payment in due course and if the alteration is not apparent. Thus, ----------------------
if the amount on a cheque is chemically altered and if such alteration is not
apparent, then the bank is protected. Banks also use ultra-violet (UV) lamps ----------------------
to detect alterations on cheques.
----------------------

----------------------
Check your Progress 5
----------------------
Fill in the blanks.
----------------------
1. Payment in due course is covered under section ________ of NI act.
----------------------
2. A cheque bearing special crossing should be paid only to the ________.
----------------------

8.7 LEGAL PROVISIONS REGARDING PROTECTION TO ----------------------

THE COLLECTING BANKER ----------------------
Protection is available to a banker under Section 131 if the following ----------------------
conditions are fulfilled:
----------------------
a. it is a crossed cheque
b. the cheque is collected for a customer and account-holder ----------------------

Negotiable Instruments 151

 Notes c. the bank has acted in good faith and without negligence. The bank
should open accounts after proper verification of identity documents
---------------------- and after obtaining the introduction of an existing customer otherwise it
would be held liable for negligence. If a cheque payable to a company
---------------------- is credited into the account of any of its directors, then the collecting
---------------------- banker would be deemed to have acted negligently and no protection
would be available to it.
----------------------

----------------------
Check your Progress 6

---------------------- Fill in the blanks.

---------------------- 1. A collecting bank gets protection under section ______ of the NI Act.

---------------------- 2. To get the protection, the collecting bank has to fulfill certain conditions:
i) ______ ii) ______ iii) ______.
----------------------
----------------------

---------------------- Activity 5

---------------------- A crossed cheque for Rs 11500/- drawn by a current account customer of

Model Bank is presented for payment by State bank of India (SBI) local
----------------------
branch. It is observed that the name of State Bank of Hyderabad, which is
---------------------- an associate of SBI, is appearing on the cheque. Will it be a payment in due
course if Model Bank pays the cheque?
----------------------

----------------------
Summary
----------------------
● Banks are required to handle the cheques and bills of exchange of
----------------------
customers. In doing so, they should ensure meticulous compliance with
---------------------- the legal provisions to get protection.

---------------------- Keywords
----------------------
● Negotiable Instrument: A negotiable instrument is a transferable
---------------------- instrument with an additional attribute of negotiability, according to which
a transferee can get a better title than that of the transferor on fulfilment
---------------------- of certain conditions.
---------------------- ● Bearer Instrument: A bearer instrument can be transferred by mere
delivery.
---------------------- ● Order Instrument: An order instrument is transferable by endorsement
---------------------- and delivery.
● Demand Bills: Demand bills are bills of exchange payable on demand.
---------------------- A cheque is an example of a demand bill of exchange.

152 Indian Banking & Financial System

● Usance Bills: Usance bills are payable after a certain period as agreed by Notes
the parties. A usance bill requires acceptance by the drawee.
● Crossing of a cheque: A crossing is a specific instruction to the drawee ----------------------
bank regarding the mode of payment of a cheque. It is a direction to the ----------------------
paying bank to pay the cheque only through a banker and not directly to
anyone presenting it at the counter. ----------------------
● Days of Grace: Usance promissory notes or bills of exchange mature on ----------------------
the third day after the day on which they are expressed to be payable. The
additional three days given for payment are called “Days of Grace”. ----------------------

----------------------
Self-Assessment Questions
----------------------
1. “All negotiable instruments are transferable instruments; all transferable
instruments are not negotiable instruments”. Explain with examples. ----------------------
2. Explain various types of Negotiable instruments. ----------------------
3. What is crossing of Cheque?
----------------------

Answers to Check your Progress ----------------------

Check your Progress 1 ----------------------

Fill in the blanks. ----------------------
1. Cheque, Bill of Exchange, Promissory Note are negotiable instruments. ----------------------
2. A person receiving a negotiable instrument in good faith, for value,
without notice of defective title of the transferee is called Holder in due ----------------------
course. ----------------------

----------------------
Check your Progress 2
----------------------
State True or False.
1. False ----------------------
2. True ----------------------
3. True ----------------------

----------------------
Check your Progress 3
----------------------
Fill in the blanks.
1. A bill of exchange has three parties. ----------------------
2. A B/E can be either Demand bill or Usance bill. ----------------------
3. RBI Act prevents from issuing P/N or B/E payable to bearer on demand. ----------------------

----------------------

Negotiable Instruments 153

 Notes Match the following.
i–c
----------------------
ii – b
----------------------
iii - a
----------------------
Check your Progress 4
----------------------
State True or False.
---------------------- 1. True
---------------------- 2. True
---------------------- 3. False
4. True
----------------------
5. False
----------------------
6. True
----------------------
Fill in the blanks.
----------------------
1. Crossing is a specific direction to the paying banker regarding the mode
---------------------- of payment.
---------------------- 2. A cheque is called specially crossed when the name of bank is written
across the cheque.
----------------------
Check your Progress 5
----------------------
Fill in the blanks.
----------------------
1. Payment in due course is covered under section 10 of NI act.
---------------------- 2. A cheque bearing special crossing should be paid only to the bank
mentioned in the crossing.
----------------------

---------------------- Check your Progress 6

---------------------- Fill in the blanks.

1. A collecting bank gets protection under section 131 of the NI Act.
----------------------
2. To get the protection, the collecting bank has to fulfill certain conditions:
----------------------
i) It is a crossed cheque; ii) Cheque is collected for a customer/ account
---------------------- holder; iii) The bank has acted in good faith and without negligence.

----------------------
Suggested Reading
----------------------

---------------------- 1. NI Act - Indian laws Bare act.

----------------------

154 Indian Banking & Financial System

Retail Banking Products - Deposits
UNIT

9
Structure:
9.1 Introduction
9.2 Retail Banking
9.3 Deposit Accounts
9.4 2-in-1 Accounts
9.5 Deposit Schemes for Non-Resident Indians
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Retail Banking Products - Deposits 155

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Describe the concept of retail banking
----------------------
• Identify various types of deposit accounts for residents
----------------------
• Get acquainted with deposit schemes for non-residents
----------------------

----------------------
9.1 INTRODUCTION
----------------------
As we have already seen, the main function of banks is acceptance of deposits
----------------------
and granting loans. Deposits are the lifeline of banks. Banks have come up with
---------------------- various products to suit the needs of customers. In this unit, we shall understand
the various deposit products offered by banks and their features.
----------------------

---------------------- 9.2 RETAIL BANKING

---------------------- Retail banking refers to doing banking business to cater to the specific needs
of individual customers and small organizations. Earlier, retail banking was
---------------------- confined to banking business related to the liability side of the banks’ balance-
sheet. In other words, the thrust was on devising and marketing of deposit
---------------------- products, such as savings accounts, fixed deposit accounts etc. In recent years,
---------------------- it has grown to cover retail asset products like home loans, personal loans, auto
loans and education loans. Ancillary services have also evolved namely, credit
---------------------- cards, debit cards and depository services to name a few.
---------------------- In India, banks have traditionally been tapping deposits from various
categories of customers, including individuals. However, their lending activity
---------------------- was directed towards industries which were starved of funds as the capital
markets were not properly developed. Bank funds were also deployed for
----------------------
financing agriculture. The emphasis, therefore, was on giving loans for productive
---------------------- purposes, i.e. loans were granted for acquiring income-generating assets such
as machinery, equipments, etc. The needs of individuals for acquiring personal
---------------------- and non-productive assets such as consumer durables, vehicles etc were mostly
neglected by the banking sector.
----------------------
This scenario changed after deregulation in the early 1990s when banks
---------------------- were allowed greater operational freedom to tap new business avenues. At the
same time, the banking sector was opened up to the private sector increasing
----------------------
competition. Banks therefore, started focusing on the hitherto neglected
---------------------- individuals and their financial needs.

---------------------- The new generation private sector banks were armed with state of the art
technology and were well equipped to handle retail banking business, which was
---------------------- high volume and low value business. They found it difficult to enter into corporate

156 Indian Banking & Financial System

and institutional banking segment which was dominated by the public sector Notes
banks. They therefore, leveraged their technology-edge to enter into the retail
banking business. The post-liberlisation-era led to a quantum jump in economic ----------------------
growth. The services sector particularly started growing rapidly. This resulted in
a rise in the income levels of the large working population of the country. The ----------------------
youth started showing a marked shift away from the conservative values of the ----------------------
earlier generations. The stigma attached to debt has declined. In India too we
have started witnessing rising consumerism and a growing credit culture. This ----------------------
has created what is referred to as the retail boom in India.
----------------------
The growth in retail banking business was led by private sector banks,
notably, ICICI Bank. These banks had scarce resources- both human and capital- ----------------------
but used their superior technology to successfully ride the retail boom. The retail
----------------------
banking business model is essentially based on three pillars:
1. Centralisation: Repetitive business operations such as account opening and ----------------------
clearing are done at a centralized location to avoid duplication of work.
----------------------
2. Multiple-Delivery Channels such as ATMs, POS terminals, Internet banking
and Phone Banking are used to service the large volume of business. ----------------------
3. Outsourcing some none critical activities such as loading of cash in ATMs ----------------------
are now outsourced to third parties.
----------------------
Check your Progress 1 ----------------------

----------------------
State True or False.
1. Retail banking covers deposit products, assets product and ancillary ----------------------
services.
----------------------
2. The needs of individuals for acquiring personal and non-productive
assets have been neglected by banks. ----------------------

3. Retail banking business is being done in a haphazard manner; there is ----------------------

no well-developed model.
----------------------

----------------------
Activity 1
----------------------
Ref www.ssmrae.com Study the models used especially by new private ----------------------
sector banks to make inroads in to the retail banking business.
----------------------

----------------------
9.3 DEPOSIT ACCOUNTS
----------------------
Banks have enjoyed the trust of the public and are therefore able to attract
deposits. According to RBI’s Report on Trend and Progress of Banking in ----------------------
2009-10, bank deposits constitute around 78% of the total liabilities of banks
in India. ----------------------

Retail Banking Products - Deposits 157

 Notes Bank deposits offer three-fold benefits in terms of safety, liquidity and return
which few other investment avenues can offer. Bank deposits can be withdrawn
---------------------- easily and also offer a decent return. The main feature of bank deposits is,
however, the element of safety which primarily attracts depositors. There is an
---------------------- inverse relationship between return on the one hand and safety and liquidity on
---------------------- the other hand. Higher the level of safety and liquidity lower is the return and
lower the level of safety and liquidity, higher is the return. Hence, as compared
---------------------- with other investment avenues, bank deposits rank higher in terms of liquidity
and safety but lower in terms of returns.
----------------------
Let us now look at the different types of deposits that banks offer.
----------------------
There are basically two types of bank deposits:
---------------------- 1. Demand Deposits
---------------------- 2. Time Deposits

---------------------- 1. Demand Deposits are in turn of two types:

 Savings Accounts and
----------------------
 Current Accounts
----------------------
2. Time Deposits are also of two types:
----------------------  Fixed Deposits or Term Deposits and
----------------------  Recurring Deposits

---------------------- 1. Demand Deposits - Demand deposits are deposits which are payable on
demand. There is high liquidity and consequently, returns are low. Banks
---------------------- are the only institutions which are allowed to accept deposits repayable on
demand. These deposits can be withdrawn by writing a cheque or through
---------------------- a technology enabled platform such as ATM, etc.
---------------------- From the point of view of banks these are an important source of low-cost
funds which are ultimately utilized for lending to earn profits. Demand
----------------------
deposits are made up of savings accounts and current accounts which are
---------------------- referred to by market analysts as CASA. Banks with a high proportion of
CASA are favoured by investors because these deposits are available at a low
---------------------- cost to the banks and therefore, the banks’ interest spread and profitability
is likely to be better. Most public sector banks have a high proportion of
----------------------
CASA deposits because of their vast branch network and well-established
---------------------- position in the market. However, four public sector banks IDBI, UCO Bank,
OBC and Vijaya Bank were found to have a low level of CASA ( below
---------------------- 30%) and were recently asked by the government to make efforts to raise
the as government is also the majority shareholder of these banks.
----------------------
The private sector banks have had to make extra efforts to tap deposits
---------------------- from the public and have used aggressive marketing strategies and their
superior technology to woo depositors. Thus, private sector banks now
----------------------
approach customers at their residence or office and complete account opening
---------------------- formalities without the customer even having to visit the branch at which

158 Indian Banking & Financial System

 the account is opened! The customer is given a complete kit comprising a Notes
cheque book, an ATM cum-debit card and an internet user ID and password.
These banks also have tie-ups with companies for opening salary accounts ----------------------
for their employees. HDFC bank has a CASA of about 49% which is the
----------------------
highest in the industry. Public sector banks have also responded to the
competition and are now having corporate tie-ups for salary accounts. ----------------------
The flip side is that demand deposits entail high servicing costs for banks ----------------------
because the volume of transactions is much higher. Banks are however, using
technology to keep these costs under control. Demand deposits therefore ----------------------
are much sought after by banks.
----------------------
Let us now look at the types of demand deposits.
----------------------
 Savings Bank Account - As the name suggests, savings accounts are
meant for inculcating the habit of savings. In this account, depositors ----------------------
can park their savings which can be subsequently used for investment ----------------------
or for future expenditure. The salary earned by a person is usually
credited to his savings account from which he can make withdrawals ----------------------
for household expenses and for making payments to various service
----------------------
providers. Business entities are not permitted to open savings bank
accounts. However, non-profit organizations can open such accounts. ----------------------
Individuals, including minors, are allowed to open savings accounts.
----------------------
Among deposit accounts, savings bank account is the only account
on which the interest rate is fixed by RBI. All banks are required to ----------------------
pay interest on SB accounts at the rate of 3.5% per annum only. So, ----------------------
whether you open an account in a co-operative bank or in a foreign
bank, you would get a uniform rate of interest of 3.5%. Interest ----------------------
is payable half-yearly. Earlier interest was calculated on monthly
----------------------
products based on the minimum balance between the 10th of the month
and the last day of the month. The reasoning was that the interest ----------------------
should be paid only on the savings remaining in the account after all
payments are made. ----------------------

From April 1, 2010, interest on all savings bank account deposits is ----------------------
being calculated on a daily basis, thereby earning account holders
----------------------
higher interest income. This is due to the fact that the Reserve Bank of
India has instructed banks to change the mechanism of interest income ----------------------
calculation from monthly basis to ‘daily balance method’, with the rate
of interest remaining the same at 3.5% p.a. This is a welcome change ----------------------
from the point of depositors since they can earn higher interest on SB ----------------------
accounts. From the perspective of banks, it has increased their cost of
funds slightly. ----------------------
Savings bank accounts are meant for holding savings and most ----------------------
banks impose restrictions on the number of withdrawals from the
account in their savings bank account rules. ----------------------

Retail Banking Products - Deposits 159

 Notes Banks also stipulate that certain minimum balance should be maintained
in SB accounts. The requirement of minimum balance is higher in metro
---------------------- centres and lower at semi-urban and rural centres. While some banks
stipulate a minimum balance to be maintained at all times, other banks
---------------------- insist on an average minimum balance during a quarter. This provides
---------------------- flexibility to a customer because he needs to only maintain average
balance in a quarter. Some banks chose to stipulate a minimum average
---------------------- relationship value meaning that the total of savings and fixed deposits
are reckoned before levying charges. This is beneficial to customers
---------------------- who can keep large amounts in fixed deposits and have relatively less
amount in savings bank accounts.
----------------------
In response to the Government directive to increase its share of current
---------------------- and savings account (CASA) deposits, IDBI has recently done away
---------------------- with the concept of minimum balance on these accounts.
Customers can see a record of the transactions in the account by
---------------------- getting the passbook updated from the bank. The use of passbooks is
---------------------- however, declining in the modern era. Most customers prefer to see their
transactions through the internet banking facility. A mini-statement of the
---------------------- previous 5-10 transactions is also available from ATMs. Private sector
and foreign banks prefer to send account statements by e-mail thereby
---------------------- saving on the cost of stationery. However, there are many customers
who do not have access to computers or internet. RBI has therefore
----------------------
issued guidelines to banks to invariably offer pass book facility to all its
---------------------- savings bank account holders. The cost of providing such Pass Book or
Statements should not be charged to the customer. It follows therefore,
---------------------- that a customer can, if required, insist on a passbook from his bank and
banks are bound to issue the same without levying any charges.
----------------------
 Current Account- Current accounts are opened for business purposes
---------------------- and can be opened by natural and legal persons. RBI prohibits banks
from paying any interest on the balance lying in current accounts. As
----------------------
the accounts are meant for business purposes, there are no restrictions
---------------------- on the number of withdrawals. Consequently, the transaction costs
are higher and banks stipulate higher minimum balance requirements
---------------------- as compared with savings bank accounts. Although this is basically
a deposit account, business entities also request banks to grant over
---------------------- drawings in the current account for business exigencies. Banks may, at
---------------------- their discretion, accede to such requests for temporary periods during
which the account would show a debit balance. Thus, a creditor-debtor
---------------------- relationship between the bank and the current account holder is created
until the amount borrowed is repaid. In view of this feature, minors
---------------------- are not allowed to open current accounts because any overdraft given,
---------------------- even inadvertently, to a minor cannot be recovered from him.
2. Time Deposits
----------------------
 Fixed Deposits- Fixed deposits or term deposits are accepted by
---------------------- banks for a fixed period ranging from 7 days to 120 months or

160 Indian Banking & Financial System

 10 years. Fixed Deposits involve a contract under which banks agree Notes
to return the amount of initial deposit together with interest thereon at
the contracted rate after the expiry of the fixed period. Although these ----------------------
deposits come at a higher cost to the bank, there is certainty that the
funds would be available to bank till maturity and the transaction costs ----------------------
are also very low compared with demand deposits. As there is virtually ----------------------
no requirement to keep liquidity against FDs, banks offer higher rates
of interest than on SB accounts. The minimum amount for FD varies ----------------------
from bank to bank. Banks are also free to decide the rates of interest
on their FDs. Banks have been permitted to offer additional interest of ----------------------
0.25% to senior citizens. They can also offer higher than their normal ----------------------
rates of interest on FDs of a value exceeding Rs.15 lacs.
----------------------
Fixed Deposits are of two types:
a. Ordinary Deposits: Under these deposits, the interest on the amount ----------------------
of deposit is periodically paid to the depositor, usually quarterly. At
----------------------
maturity, the amount of deposit with interest for the last quarter is paid
to the depositor. ----------------------
For example, if A keeps an amount of Rs.1000 for one year with a bank
----------------------
under ordinary deposit with interest at 8% p.a. on it, then he would get
simple interest of Rs.20/- every quarter and at maturity, he would get ----------------------
a total of Rs.1020/- including the interest for the last quarter.
----------------------
Such deposits offer regular income streams to depositors and are ideally
suited for retired persons and pensioners. ----------------------
b. Cumulative Deposits: In this type of fixed deposit, the interest is ----------------------
reinvested and compounded and the depositor gets the initial amount
plus the accumulated interest at maturity. There is no periodic payment ----------------------
of interest. Such deposits are preferred by persons who are earning a
regular income and are willing to set aside money in FD for a long ----------------------
period and earn interest at a compounded rate. ----------------------
If the depositor requires funds prior to the maturity of the FD, banks
offer loans by retaining the FD with them as a security. The rate ----------------------
of interest charged on the loan against FD is up to 2% higher than ----------------------
the rate payable by the bank on the FD. The loan amount is usually
restricted to around 80-90% of the value of the deposit. In the above ----------------------
example, if A wants a loan against his FD of Rs.1,000/-, then the
bank may give up to Rs.900/- as loan and the balance would be ----------------------
treated as margin. ----------------------
Although banks are legally bound to repay the deposits only at maturity,
----------------------
they do entertain requests from customers for premature withdrawal.
In such cases, interest is paid at the prevailing rate for the period for ----------------------
which the deposit has remained with the bank and not at the contracted
rate. For instance, if a deposit is made with a bank for three years at a ----------------------
rate of 8% p.a. and the depositor approaches the bank for premature
----------------------
withdrawal after one year, then the applicable interest rate for one year

Retail Banking Products - Deposits 161

 Notes only, and not the contracted rate of 8%, is paid to the depositor. While
paying such interest on premature withdrawals, banks are entitled to
---------------------- recover a penalty. In the past many banks used to deduct penal interest
of up to 1%. However, now with increasing competition and a growing
---------------------- emphasis on customer retention, most banks do not charge any penalty
---------------------- for premature withdrawals in order to attract deposits.
At or prior to maturity, the depositor is required to submit the original
----------------------
fixed deposit receipt to the bank with instructions for renewal of deposit
---------------------- failing which banks are not bound to pay interest on matured deposits.
To avoid any loss of interest to depositors, banks offer the facility of
----------------------
automatic renewal of FDs, under which, in the absence of instructions
---------------------- from the depositor, FDs are automatically renewed for the same period
as the original deposit at the rate prevailing on the date of renewal.
----------------------
 Recurring Deposits
---------------------- Recurring deposits are suitable for people who wish to set aside some
---------------------- money regularly to create a corpus for making a purchase in the future.
For example, if a person wishes to purchase a LCD T.V. after two years,
---------------------- then he can open a recurring deposit account for two years and deposit
a fixed amount every month so as to have enough funds, including
---------------------- interest on the deposit, for the purchase. Thus, recurring deposits
---------------------- involve a deposit of a fixed amount every month for a pre-determined
period. While opening the account, banks issue a pass book indicating
---------------------- the maturity value of the deposit. The features of an RD account are
similar to those of FDs, except that no TDS is recovered on interest on
---------------------- RD accounts.
----------------------
Check your Progress 2
----------------------

---------------------- Fill in the blanks.

1. The deposits of the banks are classified into
----------------------
i) _________ ii) __________
---------------------- 2. Generally, the requirement for maintenance of minimum balance in
S.B. Account is _________ in metro centers and _________ in urban
---------------------- centers.
---------------------- State True or False.
1. Business entities are not permitted to open SB accounts.
----------------------
2. Under Cumulative Deposit scheme, interest is paid to the depositor at
---------------------- quarterly intervals.
3. Saving deposits offer higher return and high liquidity.
----------------------
4. Banks cannot prematurely pay the term deposits accepted from the
---------------------- customers.
5. Banks can accept term deposits for a maximum period of 15 years.
----------------------

162 Indian Banking & Financial System

 Notes
Activity 2
----------------------
Visit few branches of public sector banks as well as private sector ----------------------
banks. Collect information on various investment products offered to the
customers. ----------------------

----------------------
9.4 2-IN-1 ACCOUNTS
----------------------
We have seen above the traditional deposit products offered by banks. The ----------------------
advent of technology has enabled banks to devise innovative products. The 2-in-1
account is one such product. It is a combination of savings bank account and fixed ----------------------
deposit account. The advantage of a SB account is that there is high liquidity and
the depositor can withdraw the amount at will by writing a cheque. The benefit of ----------------------
high liquidity is to some extent negated by the low rate of return on SB account ----------------------
as compared with an FD. The 2-in-1 account links the SB account with the FD
account and the depositor can maintain a minimum balance in the savings account. ----------------------
If the balance in the SB account is insufficient to honour a cheque, then a FD is
broken and the amount is credited to the SB account and the cheque is paid. The ----------------------
depositor therefore, enjoys the benefit of liquidity and also gets interest at FD rate. ----------------------
A 2-in-1 account has two features:
----------------------
1. Auto sweep facility and
----------------------
2. Reverse Sweep Facility
1. Auto sweep facility ensures that amounts above a stipulated balance do not ----------------------
remain idle in the SB account and are automatically “swept” or transferred
----------------------
from SB account to create FDs thus earning higher interest.
While opening a 2-in-1 account, the depositor has to indicate a minimum ----------------------
level which should be maintained in his SB account at all times. For example,
----------------------
a customer may indicate that an amount of Rs.10,000/- should at all times be
retained in the SB account. If the balance exceeds this amount, then he can ----------------------
authorize the bank to create FDs of round amounts of say, Rs.1,000/- each.
The bank’s software would check the balance at a specified frequency, say, ----------------------
weekly or fortnightly. In the above example, let us assume that the balance
----------------------
subsequently increases to Rs.12,280/-. In such a situation, the system
would automatically create two FDs of Rs.1,000/- each leaving a balance ----------------------
of Rs.10,280/- in the account. The depositor therefore, earns higher interest.
----------------------
2. Reverse Sweep Facility
While the auto sweep facility ensures higher returns, the reverse sweep ----------------------
facility provides liquidity to honour cheques as and when required. ----------------------
If a cheque for an amount in excess of the balance in the SB account is presented,
----------------------
then FDs are automatically broken for the amount of shortfall. The amount, with
applicable interest, is credited to the SB account and the cheque is paid. ----------------------

Retail Banking Products - Deposits 163

 Notes If for example, in the above case, a cheque issued by the customer for
Rs.11,200/- is received against the balance of Rs.10,280/- , then one FD
---------------------- worth Rs.1,000/- would be broken automatically and the FD amount plus
interest would be credited to the customer’s SB account and the cheque
---------------------- would be honoured. The question that may arise in your mind is- which of
---------------------- the two FD worth Rs.1,000/- would be broken?
In such cases, the principle adopted is- Last in First Out. In other words,
----------------------
the FD that was created later would be broken first so that that the earlier
---------------------- FD continues to earn interest as long as possible.

----------------------
Check your Progress 3
----------------------

---------------------- State True or False.

1. Under auto sweep facility, a fixed amount is transferred from S.B.
---------------------- account every month and invested in FD.
---------------------- 2. Reverse sweep facility provides liquidity to honour cheques when
necessary.
----------------------
3. In case of reverse sweep facility, the principle First In Last Out is applicable.
----------------------
4. Two-in-one accounts are combination of S.B. and Current account.
----------------------

---------------------- 9.5 DEPOSIT SCHEMES FOR NON-RESIDENT INDIANS

---------------------- Non-Resident Indians or NRIs form a sizeable segment of the banks’
customer base. Many Indians have settled abroad for employment or business
---------------------- particularly in US, Europe and the Middle East. These NRIs earn income abroad
---------------------- and periodically send remittances of money through banks to their relatives in
India. They also place deposits in banks, both in Indian Rupees and in foreign
---------------------- currencies. Remittances and deposits in foreign exchange from NRIs constituted
an important source of foreign exchange for the country. The Government has
---------------------- offered income tax and wealth tax exemptions on NRI deposits and has, since
---------------------- the era of liberalization, opened up investment opportunities for them. Various
deposit schemes have also been designed to suit the needs of NRIs and attract
---------------------- deposits from them.
---------------------- Who is an NRI?
An NRI is an Indian citizen who holds a valid passport and who stays abroad
----------------------
for an indefinite period for the purpose of business, employment or vocation.
---------------------- Persons going abroad for vacation or medical treatment are not considered
as NRIs. Officials deputed by central or state governments and Public Sector
---------------------- Undertakings are also treated as NRIs during their tenure abroad.
---------------------- You must have also heard the term PIO- Person of Indian Origin. PIOs are, as
the name suggests, persons of Indian origin who have now become foreign citizens.
---------------------- However, a Pakistani or Bangladeshi citizen cannot be considered as a PIO.

164 Indian Banking & Financial System

 Thus, a PIO is a foreign citizen, other than a citizen of Pakistan or Notes
Bangladesh who:
----------------------
a. at any time held an Indian passport
b. he, or any of his grandparents was a citizen of India by virtue of the ----------------------
constitution of India or according to the Citizenship Act, 1955. ----------------------
PIOs are extended facilities similar to those for NRIs and can open deposit
accounts. ----------------------

Citizens of Nepal and Bhutan are however, treated on par with Indian ----------------------
residents and they can have Rupee accounts with Indian banks just like any
----------------------
resident of India.
Let us now look at the various types of deposit accounts available for NRIs. ----------------------
NRIs are permitted to have the following types of accounts: ----------------------
1. Non-Resident Ordinary (NRO) Accounts ----------------------
2. Non-Resident External (NRE) Accounts
----------------------
The above two accounts can only be maintained in Indian Rupees (INR).
----------------------
3. Foreign Currency Non- Resident (FCNR) Accounts, which can be opened
in permitted foreign currencies. ----------------------
NRO Accounts
----------------------
NRO accounts are similar to domestic savings accounts. When a person goes
----------------------
abroad and his status changes to that of an NRI, his existing savings account is
designated as an NRO account. The person can subsequently send remittances ----------------------
from abroad for credit of this account. However, the balance in this account
is non-repatriable and can be used only for making local payments. An NRO ----------------------
account can be opened jointly with a resident Indian. ----------------------
NRO accounts can be maintained in Indian Rupees in the form of Savings
----------------------
Bank Accounts, Current Accounts or Fixed Deposit Accounts. Such accounts are
suitable for persons who have assets in India and need to make payments locally. ----------------------
Interest earned on NRO deposits is, however, taxable. ----------------------
NRE Accounts ----------------------
Like NRO accounts, NRE accounts are also maintained in Indian Rupees in
----------------------
the form of savings bank accounts, current accounts or fixed deposit accounts.
However, in joint NRE accounts, both or all the account-holders should be ----------------------
NRIs. In other words, a NRE account cannot be opened jointly with a resident
Indian. ----------------------

All credits into an NRE account have to be from foreign inward remittances. ----------------------
The balance in the account is freely repatriable. The term repatriable means that ----------------------
the balance held in the account in India can be taken out of India. Interest on
NRE accounts is exempt from Income - Tax. ----------------------

Retail Banking Products - Deposits 165

 Notes FCNR Accounts
FCNR accounts can be opened in six currencies- US Dollar (USD), Euro,
----------------------
Japanese Yen (JPY), Pound Sterling (GBP), Canadian Dollars (CAD), and
---------------------- Australian Dollars (AUD). The accounts can be opened in the form of fixed
deposits only for tenures ranging from one year to five years. The income earned
---------------------- on FCNR deposits is fully exempt from Income Tax. Joint accounts can be opened
---------------------- between two NRIs only. Balances in FCNR accounts are freely repatriable.

---------------------- Such accounts are suitable for NRIs who have permanently settled abroad and
have very little transactions in India. Since these accounts can be maintained in
---------------------- foreign currencies, the depositors are not exposed to exchange risk. For example,
an NRI residing in USA can maintain an FCNR account in US Dollars and get
----------------------
the amount repatriated in the same currency without getting exposed to the risk
---------------------- of fluctuation in foreign exchange rates.

---------------------- When the scheme was launched initially, the foreign exchange risk was
borne by RBI. Subsequently, the scheme was modified and now the exchange
---------------------- risk is borne by banks. The scheme is now also referred to as FCNR (B).
---------------------- A comparative analysis of the types of NRI accounts is given below:

---------------------- NRO Account NRE Account FCNR Account

Types of Accounts SB, CsA, FD & SB, CA, FD & FD accounts only
---------------------- RD RD - from 1 year to 5
years
---------------------- Currency INR INR USD, JPY, GBP,
EURO, AUD, CAD
---------------------- Source of Funds Funds from abroad Funds should be Funds should be
and local credits from abroad. received from
----------------------
are permitted Local credits are abroad
---------------------- permitted in x only
from abroad cases.
---------------------- Tax Deducted Interest Income is Interest Income is Interest Income is
at Source (TDS) taxable fully exempt from fully e xempt from
---------------------- Income Tax Income Tax
Exchange Risk Borne by the Borne by the Borne by the bank
---------------------- depositor depositor accepting the
deposit
----------------------
Repatriation of Permitted only in Freely permitted Freely permitted
---------------------- Funds specific cases
Transfer of Funds From NRO to NRE From NRE to From FCNR to
---------------------- or FCNR is not NRO or FCNR NRE or NRO is
permitted is freely permitted freely permitted
---------------------- Types of Accounts SB, CsA, FD & SB, CA, FD & FD accounts only
RD RD - from 1 year to 5
---------------------- years
Currency INR INR USD, JPY, GBP,
---------------------- EURO, AUD, CAD
----------------------

166 Indian Banking & Financial System

 NRO Account NRE Account FCNR Account Notes
Source of Funds Funds from abroad Funds should be Funds should be
and local credits from abroad. received from ----------------------
are permitted Local credits are abroad
permitted in x only ----------------------
from abroad cases.
Tax Deducted Interest Income is Interest Income is Interest Income is ----------------------
at Source (TDS) taxable fully exempt from fully e xempt from ----------------------
Income Tax Income Tax
Exchange Risk Borne by the Borne by the Borne by the bank ----------------------
depositor depositor accepting the deposit
Repatriation of Permitted only in Freely permitted Freely permitted ----------------------
Funds specific cases
Transfer of Funds From NRO to NRE From NRE to From FCNR to ----------------------
or FCNR is not NRO or FCNR NRE or NRO is
permitted is freely permitted freely permitted ----------------------
Resident Foreign Currency Accounts ----------------------
RFC accounts can be opened for returning NRIs, i.e. NRIs who are returning ----------------------
to India permanently. They are allowed to open RFC accounts in three currencies-
USD, Euro and GBP. The minimum period of RFC deposits is one year and ----------------------
maximum period is 3 year. Rules applicable to RFC fixed deposits are the same
as those applicable to FCNR accounts. ----------------------

RFC (Domestic) ----------------------

Resident individuals are permitted to maintain a current account in USD, ----------------------
GBP and EURO for keeping foreign currency received by them from friends or
relatives as gifts or through other legitimate sources. As it is a current account, no ----------------------
interest is payable. The advantage is that the depositor does not have to convert
----------------------
the foreign currency when it is received by him and again when he has to send
a remittance abroad in foreign currency. ----------------------

Check your Progress 4 ----------------------

----------------------
Fill in the blanks.
----------------------
1. NRI deposits are encouraged by the Government, as it is a source of
__________. ----------------------
2. All credits to NRE accounts have to be from __________. ----------------------

----------------------
Activity 3
----------------------
Your neighbor’s son is proceeding for higher studies to USA. He will be ----------------------
getting a fixed amount as scholarship every month; besides, he is entitled
for fee waiver. ----------------------
Guide him as regards opening / maintaining accounts in India. ----------------------

Retail Banking Products - Deposits 167

 Notes Summary
---------------------- ● Acceptance of deposits is an important first step in the function of
disintermediation performed by banks. Deposits are of two types –
----------------------
demand deposits and term deposits. Demand deposits offer the facility of
---------------------- high liquidity but provide low returns to the depositor.
● From the banks’ perspective, demand deposits are low cost sources of
----------------------
funds. Time deposits provide higher returns to depositors. Banks do grant
---------------------- loans against FDs providing liquidity. Various deposit accounts are also
offered to NRI customers.
----------------------

---------------------- Keywords
---------------------- ● Retail Banking: Retail banking refers to doing banking business to cater
to the specific needs of individual customers and small organizations.
----------------------
● Demand Deposits: Demand deposits are deposits which are payable on
---------------------- demand. These include savings accounts and current accounts.
● Term Deposits: These are deposits kept for a fixed tenure and include
----------------------
fixed deposits and recurring deposits.
---------------------- ● Non- Resident Indian (NRI): An NRI is an Indian citizen who holds
a valid passport and who stays abroad for an indefinite period for the
----------------------
purpose of business, employment or vocation
----------------------
Self-Assessment Questions
----------------------
1. Which are types of retail deposit accounts in bank?
----------------------
2. What is the 2-in-1 account?
----------------------
3. Which kinds of schemes are offered to NRI customer by bank?
----------------------

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
---------------------- State True or False.
---------------------- 1. True
---------------------- 2. True
3. False
----------------------

----------------------

----------------------

----------------------

168 Indian Banking & Financial System

Check your Progress 2 Notes
Fill in the blanks.
----------------------
1. The deposits of the banks are classified into
----------------------
i) Demand deposits ii) Time deposits
2. Generally, the requirement for maintenance of minimum balance in S.B. ----------------------
Account is higher in metro centers and lower in urban centers. ----------------------
State True or False.
----------------------
1. True
----------------------
2. False
3. False ----------------------
4. False ----------------------
5. False ----------------------
Check your Progress 3
----------------------
State True or False.
----------------------
1. False
2. True ----------------------
3. False ----------------------
4. False ----------------------

----------------------
Check your Progress 4
----------------------
Fill in the blanks.
1. NRI deposits are encouraged by the Government, as it is a source of foreign ----------------------
exchange for the country. ----------------------
2. All credits to NRE accounts have to be from foreign inward remittances.
----------------------

----------------------
Suggested Reading
----------------------
1. www.researchandmarkets.com
2. Retail banking in India – Comprehensive Industry report ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Retail Banking Products - Deposits 169

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

170 Indian Banking & Financial System

Retail Banking Products - Loans
UNIT

10
Structure:
10.1 Introduction
10.2 The Retail Boom
10.3 Features of Retail Loans
10.4 Stages in Retail Loan Process
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Retail Banking Products - Loans 171

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Describe the concept of retail banking
----------------------
• Identify various types of deposit accounts for residents
----------------------
• Get acquainted with deposit schemes for non-residents
----------------------

---------------------- 10.1 INTRODUCTION

---------------------- Retail Banking refers to banking business done to cater to the needs of
individuals and small organizations. In the previous unit, we have seen the various
---------------------- liability products offered by banks, i.e. deposit schemes offered both to resident
Indians as well as NRIs. In this unit, we shall have an overview of the features
----------------------
of retail asset products of banks and the stages in retail credit process.
----------------------
10.2 THE RETAIL BOOM
----------------------
As we have seen earlier, retail banking activity in banks was largely focused
---------------------- on mobilizing deposits from individuals and then lending to industry and trade.
Retail lending activity was neglected. Prior to the entry of the private sector in
----------------------
the banking space, the major players were public sector banks. These banks were
---------------------- reluctant to enter into retail lending activity in a big way because retail loans were
typically small sized loans requiring monitoring, follow–up and documentation
---------------------- which put a lot of strain on human resources, in the absence of computerization.
Thus, lucrative business from corporate sector was given more importance. The
----------------------
middle class showed a marked tendency to avoid borrowings. RBI was also
---------------------- not in favour of commercial banks granting retail loans as financial resources
were required to be directed to the needs of the priority sector, comprising small
---------------------- scale industries and agriculture. It was also felt that banks should grant short
to medium term loans only and not long term loans like housing loans which
----------------------
involve a repayment period exceeding fifteen years.
---------------------- The scenario has changed since the late nineties and we have witnessed a
retail revolution unfolding in the country. The factors fuelling the retail boom
----------------------
are as under:
---------------------- 1. Favourable regulatory policies:
---------------------- (a) RBI relaxed its norms in the mid-nineties and permitted commercial
banks to provide home loans directly to retail clients.
----------------------
(b) RBI guidelines require public and private sector banks to ensure that
---------------------- their lending to priority sector is at least 40% (32% in respect of foreign
banks) of their net bank credit. Housing loans up to Rs. 15 lacs and
---------------------- education loan up to Rs. 10 lacs for domestic education and up to Rs.
---------------------- 20 lacs for overseas education are treated as priority sector advances.
Housing and education loans are relatively less risky compared with
172 Indian Banking & Financial System
 other categories of priority sector advances, such as lending to small Notes
scale sector and agriculture. Hence, banks prefer to meet their targets
for priority sector lending by granting housing and education loans. ----------------------
2. Sustained economic growth over the past decade and the consequent increase ----------------------
in purchasing power has given a boost to consumer spending. A large class
of mass affluent customers has emerged with high disposable incomes at ----------------------
their command. This segment offers enormous business opportunities and
----------------------
banks in the West have already started focusing on “mass affluent banking”.
In India too, this sub-segment is being aggressively wooed by bankers. ----------------------
3. Declining interest rates: Interest rates have declined steadily since the
----------------------
nineties. The declining burden of loan repayment or EMI coupled with
higher disposable incomes has lead to a huge demand for retail loans. ----------------------
4. Tax Incentives: Home loans enjoy the following tax incentives: ----------------------
a. interest on loans availed for construction or purchase of property for
self-occupation is exempt from Income-Tax up to Rs.1.50 lacs. ----------------------

b. repayment up to Rs.1.00 lacs on account of principal is allowed as ----------------------

rebate under Section 80C of the Income Tax Act.
----------------------
These tax incentives have also contributed to a spurt in demand for housing
loans from banks. ----------------------
5. Since the early nineties, there has been a tightening of provisioning norms ----------------------
for banks in line with international standards. Banks are required to make
provisions out of their profits on bad loans or non-performing assets (NPAs). ----------------------
Their asset quality is closely monitored by rating agencies and market
----------------------
analysts. In this context, the quality of retail assets is generally good because
the delinquency rate or the default rate is relatively low. Moreover, the “ticket ----------------------
size” or quantum of loan is relatively small compared with loans to corporates.
----------------------
For example, some banks have given large loans worth crores of rupees to
airline companies like Jet Airways and King Fisher Airlines which are reeling ----------------------
under losses. SBI alone has given loans worth Rs.3,000 crores to the airline
sector. There is a danger that these loans could become NPAs. ----------------------
However, retail loans are loans for small amounts. For example, a two- ----------------------
wheeler loan would typically be in the range of Rs.0.50 lacs. Thus, even
if some two-wheeler loans become NPAs, it does not have a big impact on ----------------------
the balance sheet and profitability of banks. In other words, the risk in retail ----------------------
lending is well-diversified. Hence, banks have been aggressively increasing
their portfolio of retail loans. ----------------------
6. The convergence between banking and technology has made it easier for ----------------------
banks to handle the business of retail banking, which is a relatively low
value and large volume business. You can imagine the difficulties that banks ----------------------
would encounter if they were to handle a portfolio of say, 1000 two-wheeler
loans manually. Calculation of month interest, monitoring repayment of ----------------------
instalments in each account etc would be cumbersome activities. Thanks ----------------------
to technology, banks are able to handle such volumes with ease.

Retail Banking Products - Loans 173

 Notes Moreover, technology has created ‘convenience banking’ through self-
service channels such as ATMs and internet banking and it has become
---------------------- easier for the younger generation to conduct banking transactions.

---------------------- Thus, technology has emerged as an enabling factor for the retail boom in India.
7. Demographic factors have also caused a big spurt in retail lending. Around
---------------------- 69% of India’s population is below 35 years of age and the working
---------------------- population makes up more than 50% of the total population. This young
population creates a huge demand for consumer goods and also retail loans
---------------------- such as education loans, housing loans and vehicle loans.

---------------------- 8. The changing social scenario has also created new needs for individuals
which are being met through innovative products.
---------------------- A recent trend is that life expectancy is going up. In India it was 69.42 during
---------------------- 2018. It is expected to go up to 77 years in India in the next decade. This
is creating its own set of problems because the span of post-retirement or
---------------------- non-earning life of people is increasing. The cost of medical treatment is also
going up creating financial problems for the aged. In response to the need
---------------------- of such customers, banks have devised a product called reverse mortgage,
which enables senior citizens to raise money against their self-occupied
----------------------
property. The unique feature of such loans is that they do not carry a burden
---------------------- of repayment during the lifetime of borrowers. The legal heirs have the option
of repaying the bank’s loan and redeeming the property. If no repayment is
---------------------- forthcoming from the legal heirs, banks dispose of the property and recover
their dues.
----------------------
9. The emergence of nuclear families as against joint families earlier has
---------------------- also created a demand for retail loan products. Earlier, the entire family
would stay in one house and have one T.V. set. Now, families are staying
---------------------- separately creating demand for housing, consumer goods and vehicles and
---------------------- also increasing the demand for retail loans for these requirements.
10. The concept of wholesale banking has also gained acceptance and banks
---------------------- have started offering a wide range of products- retail as well as wholesale-
---------------------- under one roof.

---------------------- Check your Progress 1

----------------------
State True or False.
----------------------
1. One of the important factors for boost to retail loans is relaxation in
---------------------- RBI norms.
2. Priority sector lending by public sector banks has been stipulated at
----------------------
25% of bank’s total loans.
---------------------- 3. There is no tax incentive for payment of interest in housing loans.
---------------------- 4. Convergence between banking and technology has made it easy for
banks to handle retail business.
----------------------

174 Indian Banking & Financial System

 Notes
Activity 1
----------------------
Refer to www.bankofmaharashtra.in/credit and study the loan scheme ----------------------
formulated by the nationalised bank for purchase of consumer goods.
----------------------

10.3 FEATURES OF RETAIL LOANS ----------------------

----------------------
Retail loans are essentially loans with a small ticket size. The portfolio
comprises a large number of borrowers and the risk is well-diversified. ----------------------
We shall now understand the features of retail loans.
----------------------
1. The facility is granted either by way of a loan or by way of an overdraft.
----------------------
Loans involve disbursement of the amount by the bank and thereafter the
borrower is required to make repayment periodically. The loan is granted ----------------------
for a specified period within which it should be fully repaid.
----------------------
Overdrafts, on the other hand, are running accounts which allow flexibility
to the customer to borrow the amount required within a limit fixed by the ----------------------
bank. Whenever, the borrower has surplus money, he can deposit it in the
account. Interest is charged on the amount utilized and the period for which ----------------------
it is utilized. ----------------------
For example, let us assume that A has been granted an overdraft of Rs.1.00
lacs, which becomes the limit up to which he can draw from the bank. An ----------------------
overdraft account is opened and a cheque book is given to A, who can ----------------------
issue cheques up to the limit of Rs.1.00 lacs as and when required. Let us
assume that he draws an amount of Rs.0.50 lacs for 10 days after which he ----------------------
deposits back the amount into his account. In this case, he would have to
pay interest to the bank on the amount borrowed, i.e. Rs.0.50 and for the ----------------------
period for which this amount is borrowed, in this case 10 days. Overdrafts ----------------------
may be granted as secured loans or as unsecured loans.
----------------------
2. Retail loans may be granted as Secured loans or as unsecured loans.
A secured loan is one which is backed by an asset owned by the borrower, ----------------------
such as shares, vehicle, house, gold, fixed deposit etc. The bank as the
----------------------
lender is said to have a charge over the assets of the borrower i.e. in case,
there is default in repayment of the loan as per the stipulated terms, the ----------------------
bank has a right to sell the assets and recover its dues. Thus, in retail loans
the assets acquired out of the loan become the security for the bank. For ----------------------
example, in a home loan, the house purchased is the security available to
----------------------
the bank.
In addition to having a charge on the assets of the borrower, the bank may ----------------------
further secure its position by taking a guarantee from a third party. The bank
----------------------
executes a guarantee agreement with the guarantor who agrees to repay the
loan in the event of default by the borrower. ----------------------

Retail Banking Products - Loans 175

 Notes The various types of secured loans are:
a. Home loans
----------------------
b. Vehicle loans
---------------------- c. Loans against shares, FDs etc.
---------------------- Unsecured loans or clean loans are not granted on the basis of any security
but are granted after evaluating the creditworthiness of a borrower. A
----------------------
borrower’s creditworthiness is based on his networth, i.e. the surplus of his
---------------------- personal assets over his liabilities. Banks usually use a credit scoring model
in which a questionnaire is filled up on the basis of information furnished
---------------------- by the borrower and the creditworthiness of the borrower is assessed.
---------------------- 3. Loan to Value Ratio (LVR)
Banks do not grant loans to the extent of the full value of the asset financed.
---------------------- Instead, they require some portion of the value of asset to be met out of the
---------------------- borrower’s own funds which represents his margin. Margin is stipulated so
that the borrower has a financial stake in the asset. If the asset is entirely
---------------------- financed out of bank funds, then the borrower would not have any interest
in the asset and may allow it to decay or deteriorate in value.
----------------------
The term ‘loan to value (of the asset) ratio’ therefore, means that the loan
---------------------- is always granted as a certain percentage of the value of the asset. So the
LVR may be 70% or 80% and so on. The LVR is not the same for all loans.
---------------------- It depends on the nature of the asset. If the value of the asset is stable such
---------------------- as an FD, then the LVR is high. Banks even give loans up to 90% of the
value of the FD. If, on the other hand, the value of the asset depreciates like
---------------------- in the case of a computer or is subject to wide fluctuation- as in the case of
shares then the LVR is relatively lower.
----------------------
To sum-up, according to RBI, following loan to value ratio is present during
---------------------- 2021-22
---------------------- Loan Slab LTV Ratio
Up to ` 30 Lakh 90% of the property value
---------------------- Between ` 30 Lakh & ` 75 Lakh 80% of the property value
More than ` 75 Lakh 75% of the property value
----------------------
4. Rate of interest:
----------------------
Interest rates on retail loans may be of two types:
---------------------- a. fixed rate of interest
---------------------- b. floating rate of interest
In case of fixed rate loans, interest is charged at the rate of interest fixed at the
---------------------- time of granting the loan and is not aligned with the changing market rates.
---------------------- Thus, even if the market rates go up, the customer continues to pay at the fixed
rate of interest. Borrowers opt for fixed rate loans when the interest rates are
---------------------- low and there is an expectation that interest would only go up in future. It is
to be noted that the interest rate does not remain fixed throughout the tenure
---------------------- of the loan. Banks insert a reset clause in the loan agreement allowing them

176 Indian Banking & Financial System

 to reset interest rates after a specified period of time, usually three years. So Notes
in effect, interest rates remain fixed only for the period specified in the loan
agreement and not for the entire tenure of the loan. ----------------------
In case of floating rate loans, the rate of interest charged on the loan amount ----------------------
fluctuates or varies with a change in interest rates in the market. The rate
of interest on such loans is linked to the base rate of the bank. Thus, if the ----------------------
bank’s base rate is 12%, and the loan is granted at say, 1% above the base
rate, the effective rate for the borrower would be 13% per annum. If the base ----------------------
rate is subsequently revised by the bank to 13%, then the rate of interest on ----------------------
the loan is automatically reset to 14% per annum.
5. Insurance ----------------------

There are two aspects of insurance in retail loans-one is the general insurance ----------------------
of the asset financed such as house, vehicle etc. The other is the term
----------------------
insurance cover on the life of the borrower.
In respect of secured loans, the asset purchased out of bank finance is the ----------------------
security available to the bank. The bank, therefore, has an insurable interest
----------------------
in the asset and arranges to obtain an insurance of the asset- say house, car
etc - the premium for which is borne by the borrower. ----------------------
The borrower has the option of taking a term insurance policy on his life
----------------------
to the extent of the loan amount, particularly in respect of loans involving
a long repayment period such as home loans. This is referred to as loan ----------------------
protection insurance. If the borrower dies anytime during the tenure of the
loan, then the insurer would pay off his entire loan outstanding at the time ----------------------
of his death and the home would belong to his family, free of any loan.
----------------------
6. Disbursement
----------------------
The loan amount is disbursed or released by direct payment to the party
supplying the asset and is not given to the borrower. In case of car loans, ----------------------
payment out of the loan account is made directly to the car dealer by a pay
order or a demand draft. In case of home loans the DD or pay order is made ----------------------
out in favour of the builder. In case of resale flats, payment is made directly ----------------------
to the seller of the flat. This is done to ensure end-use of funds. If the money
is given to the borrower, he may spend it away and may not buy the asset ----------------------
at all and the bank’s loan would become an unsecured loan.
----------------------
In cases where home loans are given for flats or bungalows under
construction, the disbursement of the loan is made in stages after looking at ----------------------
the completion of work. In case of education loans also, the loan is released
----------------------
in stages as and when the course fees are payable.
7. Repayment ----------------------
The loan is required to be repaid in a specified period. The repayment has ----------------------
three aspects:
----------------------
a. Tenure/Period: The period allowed for repayment of loan is decided
on the basis of two factors: ----------------------

Retail Banking Products - Loans 177

 Notes i. the useful life of the asset i.e. the period after which the asset
would get depreciated completely and its realizable value would
---------------------- become nil. The loan should be fully repaid before the realizable
value of the asset is estimated to become zero.
----------------------
ii. the repaying capacity of the borrower.
----------------------
If the borrower has a high repayment capacity, then a shorter repayment
---------------------- schedule can be stipulated.
b. Repayment frequency: Retail loans are usually given to people with
----------------------
fixed or regular income. For such types of borrowers, the bank stipulates
---------------------- repayment in Equated Monthly Instalments (EMIs). EMI represents a
fixed amount to be paid every month. It has two components- principal
---------------------- amount and interest portion. As the loan is repaid, the loan out standings
gets reduced. Since interest is charged on reducing balance, the interest
----------------------
amount also gets reduced. Thus, as repayment is made, the interest
---------------------- component in the EMI decreases and the principal portion increases.

---------------------- c. Moratorium- The moratorium period is the period in which no

repayment of principal is required to be made. Normally, repayment
---------------------- starts immediately after the disbursement is made. However,
disbursement in respect of housing loans and education loans is
---------------------- made in stages. In such cases, the repayment starts only after the final
---------------------- disbursement is made. Until then, the borrower is only required to
repay the monthly interest.
----------------------
Check your Progress 2
----------------------

---------------------- Fill in the blanks.

---------------------- 1. Retail loans are given to _______.

---------------------- 2. When a bank has recourse to a specific asset financed by it for

recovery, the loan is said to be _______.
---------------------- 3. In _______ loans, no specific asset will be available.
---------------------- 4. Loan to Value Ratio (LVR) means loan is always granted as _______
of the value of assets.
----------------------
5. The rate of interest on loan changes with the change in the interest
---------------------- rates in the market; this is referred to as _______ rate of interest.
---------------------- 6. In case of retail loans, bank (housing loan) ensures end use of funds
by _______.
----------------------
7. To enable the borrower to repay the loan easily, the repayments are
---------------------- _______ or _______, based on income of the borrower.

---------------------- 8. The period during which no repayment of principal is required to be

made is called _______ period.
----------------------

178 Indian Banking & Financial System

 Notes
Activity 2
----------------------

Mr. Ramdeo is maintaining a well-conducted S.B account with a bank ----------------------

for the last 1 year. He is a marketing executive in a well know PSU. He
travels on a motor bike. What credit facility will you suggest for him? ----------------------

----------------------
10.4 STAGES IN RETAIL LOAN PROCESS ----------------------
The stages in a retail loan process are: ----------------------
1. Pre-sanction process
----------------------
2. Sanction process
3. Pre-disbursement formalities ----------------------
4. Post-disbursement process ----------------------
1. Pre-Sanction Process
----------------------
The first step is to evaluate the loan proposal. The proposal may emanate
from the marketing efforts of the sales executives or there could be a walk- ----------------------
in at the branch. It could also be repeat business from an existing customer.
----------------------
In the latter case, the basic identity documents are already available and the
bank can proceed to collect documents pertaining to the loan proposal. In ----------------------
case it is an entirely new relationship, the bank should complete the KYC
process. The following documents are collected from the applicant: ----------------------
a. Loan application form, duly signed and completed ----------------------
b. Identity proof document, i.e. copy of a document containing the ----------------------
photograph of the loan applicant. This would include copy of PAN
card, passport, driving licence etc. ----------------------
c. Address Proof- copy of electricity bill, credit card statement, mobile ----------------------
or telephone bill or passport.
----------------------
d. Photographs
e. Income proof, i.e. copies of the past three years’ income-tax returns, ----------------------
duly acknowledged by the Income Tax Officer and Form 16 issued by
----------------------
the employer in respect of salaried persons.
The applicant is required to submit a Credit Information Report (CIR) ----------------------
from Credit Information Bureau (India) Ltd (CIBIL). CIBIL is a ----------------------
repository of information which contains a credit history of borrowers.
The applicant has to pay the requisite fees after which it issues a ----------------------
CIBIL CIR, which is a record of credit payment history compiled from
information received from Credit Institutions. The CIR is an important ----------------------
document and is scrutinized by the bank to assess the nature and ----------------------
quantum of existing borrowings of the applicant and whether repayment
is being made regularly or not. ----------------------

Retail Banking Products - Loans 179

 Notes The next stage involves verification of documents. If the applicant visits
the branch with the original documents, then the copies of documents are
---------------------- verified with the originals and are branded with the stamp:
---------------------- Verified with originals
Verifying official
----------------------
Alternatively, the bank’s personnel may also visit the applicant’s residence
---------------------- or office and carry out document verification.
---------------------- The complete set of documents is then submitted to the loan processing
cell. The appraising official again scrutinizes the file for completeness. In
---------------------- case of home loans, he also conducts a pre-sanction verification by visiting
---------------------- the construction site and checks the work done. He then prepares a site
inspection report, which is placed along with the other documents.
----------------------
2. Sanction Process:
---------------------- The sanction process involves scrutiny of the proposal taking into account
---------------------- the following considerations:
i. Ability to pay of the applicant. - The income of the applicant for
---------------------- the previous three years is reckoned based on the I-T returns and
---------------------- Form16 (incase of salaried persons). An assessment is made whether
the applicant would have a regular flow of income to pay the EMIs
---------------------- regularly throughout the tenure of the loan.
---------------------- ii. The security available. - In addition to the asset purchased out of bank
finance, which is treated as a primary security, the bank may obtain
---------------------- additional security. For example, in a housing loan, in addition to taking
the house as a security, the bank may obtain additional security in the
----------------------
form of assignment of insurance policies or pledge of shares.
---------------------- iii. Adherence to bank’s credit policy guidelines - The proposal is also
---------------------- scrutinized to ensure compliance with the bank’s internal circulars and
guidelines. If in a proposal some norms are not complied with, then it
---------------------- is considered as a deviation from the laid down norms. For example,
the bank’s norms for housing may stipulate that, in case of financing
---------------------- of existing house, it should not be more than 25 years old at the time
---------------------- of sanction. If a proposal is considered for granting a housing loan in
respect of a house which is more than 25 years old, then it represents
---------------------- a deviation from norms and the sanctioning authority has to refer the
deviation to a higher authority for approval. The higher authority
---------------------- may, while giving approval, stipulate some conditions for reducing
---------------------- the risk associated with the deviation. For example, the approval may
be subject to getting a certificate from a civil engineer to the effect
---------------------- that the building has a residual life exceeding the period of the loan.
---------------------- Thereafter, the appraising official prepares an appraisal note and submits it
to the sanctioning authority as the bank’s delegation of powers. Based on
---------------------- the recommendations of the appraising official, the sanctioning authority

180 Indian Banking & Financial System

 accords his or her sanction to the proposal. The details of sanction are then Notes
reported to the next higher authority for control purposes.
----------------------
3. Pre-disbursement formalities:
i. A sanction letter is given to the borrower and the guarantor, if any, after ----------------------
incorporating details regarding the amount of loan sanctioned and the
----------------------
terms and conditions on which the loan is sanctioned including the
repayment period, the rate of interest and the margin to be contributed ----------------------
by the borrower. The borrower and guarantor are asked to return a copy
of the sanction letter, duly signed, conveying acceptance of the terms ----------------------
and conditions.
----------------------
ii. The loan agreement, duly stamped at the applicable rate, is executed
between the bank and the borrower on the bank’s standard printed form ----------------------
after filling up the blank spaces in the document.
----------------------
iii. Post-dated cheques are obtained
----------------------
iv. In case of home loans, the bank’s mortgage charge over the house
property is created by executing a mortgage deed and the original ----------------------
documents relating to the property are held with the bank. In case of
vehicle loans the relevant RTO forms are signed by the bank and the ----------------------
borrower for creating a hypothecation charge in the books of the RTO ----------------------
in favour of the bank.
Disbursement is then made directly in the name of the builder in case of ----------------------
home loans and in the name of the dealer in case of vehicle loans. ----------------------
4. Post-disbursement process:
----------------------
i. Asset verification is again done at this stage.
----------------------
ii. Comprehensive insurance is done of the asset financed- house, car or
two-wheeler. ----------------------
ii. Collection of instalments is ensured by depositing the post-dated ----------------------
cheques (PDCs) periodically.
If the cheques are bounced, then the customer is contacted immediately and ----------------------
the amount is collected separately. ----------------------
Banks have devised various retail loan schemes such as home loans, car
----------------------
loans, two wheeler loans, consumer loans and personal loans. The criteria
regarding eligibility, LVR, security, rate of interest and repayment period vary ----------------------
from bank to bank.
----------------------

----------------------

----------------------

----------------------

----------------------

Retail Banking Products - Loans 181

 Notes
Check your Progress 3
----------------------

---------------------- Fill in the blanks.

1. The stages in retail loan process are i) _______ ii) _______
----------------------
iii) _______ iv) _______.
---------------------- 2. When loan for purchase of a house is granted, the house is _______
security.
----------------------
3. A loan sanction letter contains _______ and _______.
----------------------
4. The right to take possession and sell the asset is known as a _______
---------------------- on the asset.
----------------------

---------------------- Activity 3
----------------------
Refer to www.axisbank.com and www.bankof baroda.com. Prepare a
---------------------- comparative chart showing the features of home loan schemes of a private
bank and a public sector bank.
----------------------

---------------------- Summary
---------------------- ● The retail boom in India has created many opportunities for banks. Banks
---------------------- have designed various retail loan products to cater to the needs of the
individuals.
---------------------- ● During Covid 19 period, Govt of India instructed all banks to reduce the
---------------------- interest rate

---------------------- Keywords
---------------------- ● Loan to value Ratio (LVR) Banks do not lend for the full value of an
---------------------- asset. The loan is always granted as a percentage of the value of the asset
being purchased. For example, the bank may grant a housing loan to the
---------------------- extent of 80% of the cost of the house. In this case, the LVR is 80%.
● Margin Banks require some portion of the value of asset to be met out
----------------------
of the borrower’s own funds which represents his margin. Margin is
---------------------- stipulated so that the borrower has a financial stake in the asset. If the
asset is entirely financed out of bank funds, then the borrower would not
---------------------- have any interest in the asset and may allow it to decay or deteriorate in
value. In the above example of housing loan, margin is 20%.
----------------------
● Moratorium The moratorium period is the period in which no repayment
---------------------- of principal is required to be made. It is a repayment holiday. A moratorium
period of six months would mean that repayment would start six months
---------------------- after disbursement of loan.

182 Indian Banking & Financial System

 ● Secured Loans A secured loan is a loan, the bank has a right or a charge Notes
over an asset owned by the borrower as security for repayment of loan. For
example, in home loans, the bank has a charge over the house purchased. ----------------------
These are asset backed loans.
----------------------
● Unsecured Loans In an unsecured loan, the bank does not have any
charge over the assets of the borrower. Such loans are given to borrowers ----------------------
whose creditworthiness is high. A personal loan is an example of an
unsecured loan. ----------------------
● Reverse Mortgage In a traditional mortgage loan, the lender lends an ----------------------
amount against the security of property and the borrower is thereafter
required to repay the loan in stipulated instalments. Reverse mortgages ----------------------
have been designed for senior citizens who own house property and ----------------------
need cash to meet expenses during their old age. In a reverse mortgage,
the borrower mortgages his house to a bank and the bank gives a loan ----------------------
usually as regular payment during the lifetime of the borrower. Unlike
a traditional loan, no periodic repayment is stipulated. The amount of ----------------------
loan together with the accumulated interest is recovered in one lump sum ----------------------
through sale of the house after the death of the senior citizen. The legal
heirs also have the option of repaying the loan out standings and get the ----------------------
mortgage on the property released.
----------------------
Self-Assessment Questions ----------------------

1. What are the features of retail loans? ----------------------

2. What are the stages of retails loan process? ----------------------

----------------------
Answers to Check your Progress ----------------------
Check your Progress 1 ----------------------
State True or False.
----------------------
1. True
----------------------
2. False
3. False ----------------------

4. True ----------------------

----------------------
Check your Progress 2
----------------------
Fill in the blanks.
----------------------
1. Retail loans are given to individuals.
2. When a bank has recourse to a specific asset financed by it for recovery, ----------------------
the loan is said to be secured. ----------------------

Retail Banking Products - Loans 183

 Notes 3. In unsecured loans, no specific asset will be available.
4. Loan to Value Ratio (LVR) means loan is always granted as percentage of
----------------------
the value of assets.
---------------------- 5. The rate of interest on loan changes with the change in the interest rates
in the market; this is referred to as fluctuating rate of interest.
----------------------
6. In case of retail loans, bank (housing loan) ensures end use of funds by
---------------------- effecting direct payment to the builder/seller.
---------------------- 7. To enable the borrower to repay the loan easily, the repayments are
monthly or quarterly, based on income of the borrower.
----------------------
8. The period during which no repayment of principal is required to be made
---------------------- is called moratorium period.
----------------------
Check your Progress 3
----------------------
Fill in the blanks.
----------------------
1. The stages in retail loan process are i) pre-sanction ii) sanction of loan
---------------------- iii) pre-disbursement formalities iv) post-disbursement process.

---------------------- 2. When loan for purchase of a house is granted, the house is primary
security.
---------------------- 3. A loan sanction letter contains the terms and conditions and the amount
---------------------- sanctioned.
4. The right to take possession and sell the asset is known as a Charge on the
----------------------
asset.
----------------------
Suggested Reading
----------------------
1. Retail banking in India – Comprehensive Industry report
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

184 Indian Banking & Financial System

Foreign Exchange Business of Banks
UNIT

11
Structure:
11.1 Introduction
11.2 Understanding the Concept of Foreign Exchange
11.3 Nostro Accounts and Vostro Accounts
11.4 The Concept of ‘Buy Low, Sell High’
11.5 Cover Operations
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Foreign Exchange Business of Banks 185

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Analyse the mechanism of foreign exchange
----------------------
• Study the role of banks in the foreign exchange market
----------------------

----------------------
11.1 INTRODUCTION
----------------------
Foreign exchange transactions have grown in value and volume in this era
---------------------- of globalization. Banks as Authorized Dealers (ADs) are dominant players in
the foreign market. In this unit, we shall understand the mechanism of foreign
----------------------
exchange and the role of banks as market players.
----------------------
11.2 UNDERSTANDING THE CONCEPT OF FOREIGN
----------------------
EXCHANGE
----------------------
Foreign exchange refers to the conversion of the currency of one country
---------------------- into the currency of another country. The most basic form of foreign exchange
involves the conversion of home currency into foreign currency and vice-versa.
---------------------- Let us now understand the two terms- home currency and foreign currency clearly.
---------------------- Home currency is the currency of the country where it is recognized as legal
tender. Legal tender is the currency that is accepted as payment for a debt. For
---------------------- example, if you want to make payment for purchase of books at a shop in Pune
then, you would have to pay in Indian Rupees only. (You may be aware that many
---------------------- other countries have rupee as their currency such as Sri Lanka, Pakistan Nepal,
---------------------- Burma, Bhutan etc. Hence, in foreign exchange business, the word rupee is not
used in isolation but it is used along with the name of its country for clarity).
---------------------- Foreign currency, on the other hand, is a commodity that is bought and sold
---------------------- just like any other commodity such as shares, wheat, crude oil or gold. When we
buy a commodity, we pay its price in rupees and when we sell a commodity, we
---------------------- get the sale proceeds in rupees. Likewise, we buy foreign currency by tendering
rupees and when we sell foreign currency, we get rupees. The rate at which this
---------------------- conversion takes place in the foreign exchange market is called exchange rate.
---------------------- The need for foreign exchange or FOREX arises primarily due to two reasons:
---------------------- 1. Trade – Import and Export Transactions
2. Remittances- Inward and Outward
----------------------

----------------------

----------------------

----------------------

186 Indian Banking & Financial System

This has been depicted diagrammatically below: Notes

FOREIGN EXCHANGE ----------------------

----------------------

----------------------

----------------------

TRADE REMITTANCES ----------------------

----------------------

----------------------

----------------------
IMPORTS EXPORTS INWARD OUTWARD
----------------------
[INFLOW OF [OUTGO OF [INFLOW OF [OUTGO OF
GOODS & GOODS & FX/INR] FX/INR] ----------------------
SERVICES- SERVICES
OUTFLOW OF FX] -INFLOW OF FX]
----------------------
(FX= Foreign Currency) (INR= Indian Rupees) ----------------------
Let us understand this with some examples.
----------------------
1. Trade
----------------------
A & Co. is an exporter of garments to various countries. It earns payment
in foreign currency for the value of the goods exported. The most ----------------------
commonly used currency in foreign trade is US Dollars or USD although
some transactions also take place in currencies like Pound Sterling (GBP), ----------------------
Japanese Yen (JPY) and Euro (EUR). ----------------------
The foreign currency that the exporter earns is of little use to him because
out of the sale proceeds, he has to make local payments, such as payments to ----------------------
suppliers, taxes etc, in INR only. He, therefore, sells the foreign currency in ----------------------
the foreign exchange market at the applicable exchange rate and gets rupees.
----------------------
The reverse happens in case of an import transaction in which the importer
has to make payment in foreign currency to the foreign supplier. An importer, ----------------------
therefore, buys foreign currency in the foreign exchange market.
----------------------
2. Remittances
Some of you may have applied for admission to courses in foreign ----------------------
universities. In such cases, you must have paid the initial fees by a sending
----------------------
a Bank Draft in USD or GBP. In effect, what you have done is that you have
bought foreign currency by giving equivalent rupees and made an outward ----------------------
remittance in foreign currency.
----------------------
Likewise, Indians who work abroad send remittances to support their
relatives in India. The remittance may be made by a Bank Draft or Electronic ----------------------

Foreign Exchange Business of Banks 187

 Notes Transfer and represents an inward remittance in foreign currency. The
amount in foreign currency is of little use to the beneficiary in India. He
---------------------- therefore sells it in the foreign exchange market and gets equivalent rupees
at the prevailing exchange rate.
----------------------
Banks which have been authorized by RBI to deal in foreign exchange
---------------------- (and are thus authorized dealers-ADs) become the counter-party in all the
above transactions. Therefore, banks buy foreign currency from exporters
----------------------
and sell foreign currency to importers. They buy foreign currency from the
---------------------- beneficiary of an inward remittance and sell foreign currency to the remitter
in an outward remittance.
----------------------

---------------------- Check your Progress 1

---------------------- Fill in the blanks.

---------------------- 1. Home currency is the currency of a country where it is a ________.
---------------------- 2. Foreign currency is a ________ and is bought and sold as any other
________.
----------------------
3. Banks are ________ dealers of Foreign exchange. They buy FX from
---------------------- ________ and sell FX to ________.

----------------------

---------------------- Activity 1
----------------------
Refer to www.currencies-ofthe-world.com and list out the important word
---------------------- currencies.

----------------------
11.3 NOSTRO ACCOUNTS AND VOSTRO ACCOUNTS
----------------------
In doing these FOREX transactions with customers, banks are like traders
---------------------- of commodities doing buying and selling transactions. The position of a bank is
similar to that of a trader in shares who may buy shares, hold them for some time
---------------------- and later sell them. A trader of shares holds them in a Demat account. Similarly,
---------------------- banks hold foreign currency, which is also a commodity like shares, in an account
called Nostro account. Since banks deal in many currencies, they have Nostro
---------------------- accounts in various currencies in various banks abroad and in various countries.
The accounts are maintained as current accounts and the banks with whom the
---------------------- accounts are maintained are called Correspondents.
---------------------- For example, ICICI Bank may maintain an account in USD with Citi Bank,
New York. It may maintain an account in EUR with Deutsche Bank in Frankfurt
---------------------- in Germany and an account in JPY with The Bank of Tokyo-Mitsubishi UFJ, Ltd,
---------------------- Tokyo. All the above accounts are Nostro accounts and the banks mentioned above
are correspondents of ICICI Bank. Thus, Nostro accounts are current accounts
---------------------- maintained by banks in India with banks in foreign centres in foreign currency.
All transactions in foreign currency take place through Nostro accounts.
188 Indian Banking & Financial System
 The transactions in a Demat account and a Nostro account are also similar. Notes
When we buy shares, our demat account is credited and when we sell shares our
demat account is debited. Similarly, when a bank buys foreign currency, it is ----------------------
deposited with its correspondent and the Nostro account is credited. When a bank
sells foreign currency, it instructs its correspondent to debit its Nostro account. ----------------------

Another way of looking at a foreign exchange transaction is that it has two parts- ----------------------
one a debit or credit to the bank’s nostro account in foreign currency and the second,
a corresponding debit or credit to the customer’s account in INR. For example, in an ----------------------
export transaction in which the bank buys foreign currency, the amount gets credited ----------------------
to the bank’s nostro account. The bank, in turn, credits the customer’s account with
equivalent rupees. The reverse happens in an import transaction. The bank’s nostro ----------------------
account is debited with the foreign currency amount and the bank, in turn, recovers
the rupee equivalent by debiting the customer’s account. ----------------------

It is also possible that an NRI may want to make a remittance to his relatives ----------------------
in India in INR and not a foreign currency. There could, therefore, be an inward
remittance in INR. For example, a NRI working in Kuwait may go to Commercial ----------------------
Bank of Kuwait, tender Kuwaiti Dinar and ask them to make a remittance in ----------------------
India rupees. Thus, banks abroad also need to maintain current accounts in INR,
which is a foreign currency for them. In the above example, Commercial Bank ----------------------
of Kuwait may maintain a current account in INR with SBI, Overseas Branch,
Mumbai through a correspondent relationship. Such current accounts in INR ----------------------
maintained by banks abroad with banks in India are called Vostro Accounts. ----------------------
The above transaction would be put through the Vostro account of
Commercial Bank of Kuwait (CBK) who would advise their correspondent, SBI, ----------------------
Overseas Branch, Mumbai to make payment in rupee. SBI, Overseas Branch, ----------------------
Mumbai would therefore, debit the Vostro Account of CBK and pay the amount
of remittance to the beneficiary in rupees. ----------------------
Similarly, we can also make outward remittances in INR. For example, you ----------------------
may want to send an outward remittance to your cousin studying in the US in
INR through SBI. Let us assume that Citi Bank, New York has a vostro account ----------------------
with SBI in India. SBI would then credit the proceeds of the remittance to the
Vostro Account of Citi Bank and advise them to pay the proceeds in equivalent ----------------------
USD to your cousin in USA. ----------------------
It should be noted that transactions in Vostro accounts are always in INR
----------------------
and do not involve any foreign exchange transaction in India.
Thus, while Nostro accounts are always in foreign currency, Vostro accounts ----------------------
are always in INR.
----------------------
To summarize,
----------------------
Nostro Accounts are - OUR Accounts in FOREIGN CURRENCIES
maintained ABROAD ----------------------
Vostro Accounts are- THEIR Accounts in INR maintained in India. ----------------------
The various foreign exchange transactions can be shown in a diagrammatic
form as under: ----------------------

Foreign Exchange Business of Banks 189

 Notes (A) Exports
(B) Imports
----------------------
(C) Inward remittance in foreign currency
----------------------
(D) Outward remittance in foreign currency
---------------------- (E) Inward remittance in INR
---------------------- (F) Outward remittance in INR
---------------------- Exporter earns FX Bank’s Nostro A/c
Bank buys FX
---------------------- credited

----------------------

----------------------
Importer requires Bank sells FX Bank’s Nostro
---------------------- FX Account debited

----------------------

----------------------
Beneficiary’s Banker Beneficiary’s Beneficiary’s banker
---------------------- gets intimation of informs beneficiary
Bankers’ Nostro
remittance credited & Buys FX
----------------------

----------------------

---------------------- Remitter approaches Bank sells FX Bank’s Nostro

bank with INR Account Debited
----------------------

----------------------

---------------------- Remitter abroad Bank abroad advises Bank in India debits

tenders local its correspondent Vostro Account and
---------------------- currency & requests pays beneficiary
in India to pay
---------------------- conversion in INR beneficiary in INR

----------------------

----------------------
Remitter tenders INR Bank in India credits Bank abroad converts
---------------------- in India with details Vostro Account of INR into local
o f b e n e f i c i a r y ’s Correspondent in the currency and credits
---------------------- account abroad beneficiary’s country Beneficiary A/C
----------------------

----------------------

----------------------

190 Indian Banking & Financial System

 Notes
Check your Progress 2
----------------------
State True or False. ----------------------
1. When banks undertake FOREX transactions, they are like traders of
----------------------
commodities doing buying and selling transactions.
2. Banks maintain Nostro account in India, through which they put ----------------------
through FOREX transactions.
----------------------
3. When a bank buys foreign currency, Nostro account is credited.
----------------------
4. Vostro accounts are accounts of foreign/correspondent banks
maintained in India in INR. ----------------------

----------------------
Activity 2 ----------------------
----------------------
M/s Chitale and Sons export sweets worth US$ 10,000 through SBI, Pune
to “Indian Bazar” in New York. Explain as to how the sales proceeds will ----------------------
be realised and which bank accounts will get affected.
----------------------

11.4 THE CONCEPT OF ‘BUY LOW, SELL HIGH’ ----------------------

----------------------
You may have read exchange rates in newspapers being quoted as under:
IUSD= Rs.44.50 ----------------------
These rates are inter-bank foreign exchange rates. The inter-bank market is ----------------------
a wholesale market and banks are wholesalers. Like all wholesalers, banks load
their profit margin to the inter-bank rates and then quote their rates to customers. ----------------------
The FOREX transactions between banks and customers are called merchant ----------------------
transactions. The rates quoted by banks to customers are called merchant rates.
----------------------
Types of Merchant Rates
As we have seen earlier, banks buy various foreign currencies from exporters ----------------------
and beneficiaries of inward remittances. They therefore, quote buying rates for ----------------------
various currencies every day based on the rates prevailing in the inter-bank
foreign exchange market. The rates quoted by banks for inward remittances are ----------------------
called TT Buying Rates and the rates quoted for discounting bills of exchange
drawn by exporters are called Bill Buying Rates. ----------------------

Similarly, banks quote rates for selling foreign exchange to importers and ----------------------
remitters in respect of outward remittances. Banks apply TT Selling Rates for
----------------------
outward remittances and Bill Selling Rates for handling import bill documents.
Although all banks quote rates based on the inter-bank rates, different banks quote ----------------------
different rates. These rates are usually decided at 10.00 A.M. in the morning
everyday and are displayed at the foreign exchange department of branches. ----------------------

Foreign Exchange Business of Banks 191

 Notes In their dealings with customers, banks are traders in foreign currency and
like all traders; they seek to make profits out of their trading activity. Therefore,
---------------------- when they buy foreign currency, they quote a lower price and then sell at a price
higher than the purchase price to make some profit out of the FOREX activity.
---------------------- Thus, the rate at which banks buy foreign currency is always lower than its selling
---------------------- rates. Therefore, the maxim for quoting FOREX rates is Buy Low, Sell high.

---------------------- 11.5 COVER OPERATIONS

---------------------- During a day, a bank’s dealing with its customers results in buying and selling
---------------------- of foreign currency. The net effect of buying and selling activity gives rise to
what is referred to as the bank’s open position in a currency. The open position
---------------------- may be an over-bought position or an over-sold position. If the foreign currency
bought by a bank is in excess of what it has sold, then the bank is said to have
---------------------- an over-bought position in the currency or it is said to be ‘long’ in the currency.
If, on the other hand, the bank has sold more amount of a foreign currency than
----------------------
what it has bought, then the bank is said to be over-sold or ‘short’ in the currency.
---------------------- An open position in a foreign currency-either over-bought or over-sold- exposes
a bank to price risk or foreign exchange risk.
----------------------
This is because foreign currency, as stated earlier, is a commodity. All
---------------------- commodity prices are subject to fluctuation. The prices may go up or come down.
The same is true with foreign currencies. Banks are therefore exposed to foreign
---------------------- exchange risk arising out of fluctuations in the exchange rate.
---------------------- Banks therefore, try to minimize the risk arising from an open position by
maintaining a square position or a near square position by doing cover operations.
---------------------- In other words, they cover their open position. So, if a bank has an over-bought
position, then it would do a sale transaction for the corresponding amount in the
----------------------
inter-bank market so that it has a net near square position in the currency.
---------------------- However, it would be imprudent for a bank to do a cover operation at a
loss, merely to square its position. Let us assume that a bank has an over-bought
----------------------
position of USD1 million which it has bought at Rs.45.00. Now, if the rate in the
---------------------- inter-bank market falls to Rs.44.90 towards the end of the working day, then it
would incur a loss if it squares its entire position of USD 1 million by selling it
---------------------- at the prevailing rate. While there are chances of a further fall in the exchange
rates, there is also a possibility that, when the market opens the next day, the
----------------------
exchange rate may go above Rs.45.00. If the exchange rate does go up, the bank
---------------------- would have an opportunity to make a profit out of its open position.
Every bank, therefore, decides a limit up to which an open position can
----------------------
be kept as a risk management strategy. The tolerable open positions are set
---------------------- currency-wise and are called exposure limits. As soon as this limit is exceeded,
the bank buys or sells foreign currency, as the case may be, and brings down the
---------------------- open position within the exposure limit.
---------------------- In the above example, let us assume that the open position set by the bank
is USD700, 000. In the above case, there is an over-bought position in excess of
---------------------- the exposure limit by USD300, 000. Hence, a sale transaction of at least USD300,

192 Indian Banking & Financial System

000 (depending upon the assessment of market movement for the next day) would Notes
be done in the inter-bank foreign exchange market at the prevailing rate and the
open position would be brought within the exposure limit of USD700, 000. ----------------------
Banks prescribe two types of exposure limits-Day Light Limit and Over ----------------------
Night Limit. The Day Light Limit is the open position that can be kept during
the day and the Over Night Limit is the open position that can be kept overnight. ----------------------
We have seen a simple example above to consider the open position of a bank. ----------------------
However, in practice many branches of a bank simultaneously undertake purchase
and sale of various currencies. There is therefore, a need for consolidation of the ----------------------
FOREX activity at the bank-level to monitor the overall open position and to
ensure that the exposure limits are not exceeded. The task of tracking the open ----------------------
position of the bank and undertaking cover operations is done by an official called ----------------------
FOREX Dealer or Trader. All branches handling FOREX business are required
to immediately report transactions undertaken by them to enable the Dealer or ----------------------
Trader to track open position and to undertake cover operations as and when
required. Some banks have more than one dealer or trader who specializes in ----------------------
trading in specific currencies only. For example, a bank may have separate traders ----------------------
in USD, EUR and JPY. The FOREX trading activities are done by these dealers
or traders from an office referred to as FOREX Dealing or Trading Room. This ----------------------
room and its support staff constitute the FOREX Treasury.
----------------------

Check your Progress 3 ----------------------

----------------------
Fill in the blanks.
----------------------
1. The rates of foreign currency quoted by banks to their customers are
called ____________. ----------------------
2. Bank’s open position in foreign currency is the result of buying and ----------------------
_______ activity.
3. When a bank has over bought position, then it would do a _______ ----------------------
transaction for the corresponding amount. ----------------------

----------------------
Activity 3 ----------------------

----------------------
Refer to www.corporatebanking.kotak.com and collect information on
“FOREX Dealing Room of a bank”. ----------------------

----------------------

----------------------

----------------------

----------------------

Foreign Exchange Business of Banks 193

 Notes Summary
---------------------- ● Banks are dealers authorized by RBI to trade in foreign exchange. This
business is a good source of revenue for banks. By undertaking this
----------------------
activity, banks also facilitate the country’s foreign trade.
----------------------
Keywords
----------------------
● Nostro Accounts: Banks hold foreign currency that they buy and sell in
----------------------
an account called Nostro account. Since banks deal in many currencies,
---------------------- they have Nostro accounts in various currencies in various banks abroad
and in various countries. Nostro accounts are current accounts maintained
---------------------- by banks in India with banks in foreign centres in foreign currency. All
transactions in foreign currency take place through Nostro accounts.
----------------------
● Vostro Accounts: Banks abroad also need to maintain current accounts in
---------------------- INR, which is a foreign currency for them. These accounts are maintained
with Indian banks situated in India. Such current accounts in INR maintained
----------------------
by banks abroad with banks in India are called Vostro Accounts.
---------------------- ● Cover Operations: In the course of its dealing in foreign currencies, a
bank may have an open position during a day. Such an open position
----------------------
exposes the bank to exchange risk arising out of adverse fluctuation in
---------------------- exchange rates. Banks therefore, try to minimize the risk arising from an
open position in a currency by maintaining a square position or a near
---------------------- square position by doing cover operations.
---------------------- ● Merchant Rates: The FOREX transactions between banks and customers
are called merchant transactions. The rates quoted by banks to customers
---------------------- are called merchant rates.
----------------------
Self-Assessment Questions
----------------------
1. What is Nostro account and Vostro Account?
----------------------
2. How does the concept ‘buy low, sell high’ work in foreign exchange?
----------------------

----------------------
Answers to Check your Progress
----------------------
Check your Progress 1
----------------------
Fill in the blanks.
---------------------- 1. Home currency is the currency of a country where it is a legal tender.
---------------------- 2. Foreign currency is a commodity and is bought and sold as any other
commodity.
----------------------
3. Banks are authorised dealers of Foreign exchange. They buy FX from
---------------------- exporters and sell FX to importers.

194 Indian Banking & Financial System

Check your Progress 2 Notes
State True or False.
----------------------
1. True
----------------------
2. False
3. True ----------------------
4. True ----------------------

----------------------
Check your Progress 3
----------------------
Fill in the blanks.
----------------------
1. The rates of foreign currency quoted by banks to their customers are
called merchant rates. ----------------------
2. Bank’s open position in foreign currency is the result of selling and selling ----------------------
activity.
3. When a bank has over bought position, then it would do a sale transaction ----------------------
for the corresponding amount. ----------------------

----------------------
Suggested Reading
----------------------
1. www.rbi.org.in
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Foreign Exchange Business of Banks 195

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

196 Indian Banking & Financial System

Insurance
UNIT

12
Structure:
12.1 Introduction
12.2 Evolution of Insurance Business in India
12.3 Meaning and Need for Insurance
12.4 Functions of Insurance
12.5 Life Insurance Products
12.6 General Insurance Products
12.7 Insurance Intermediaries
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Insurance 197
 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Discuss the meaning and importance of insurance
----------------------
• Analyse the various insurance products
----------------------

----------------------

----------------------
12.1 INTRODUCTION

---------------------- Insurance is a very old concept and has been used to transfer or distribute
the risk of potential loss. In the initial stages, insurance was done to protect
---------------------- assets against natural calamities such as fire and floods. The concept of general
insurance was more popular. Subsequently, the need to insure human life was
---------------------- also felt and the business of life insurance also gained popularity. In this lesson,
---------------------- we shall understand the nature and importance of insurance and the various types
of insurance products available.
----------------------
12.2 EVOLUTION OF INSURANCE BUSINESS IN INDIA
----------------------

---------------------- The evolution of insurance in India involves three phases:

A. Pre- Independence era
----------------------
B. Post-Independence & Nationalization Phase
----------------------
C. Post-liberalization era
---------------------- A. Pre- Independence era
---------------------- In India, insurance has a deep-rooted history and finds mention in the writings
of Manu in Manusmruti and in Kautilya’s Arthasastra.
----------------------
The business of insurance truly developed in India under the British Rule.
---------------------- In the year 1818, the first insurance company was set up in Kolkata by
the British named Oriental Insurance Company. Its basic objective was
---------------------- to provide for the British widows. It did cover Indian lives but they were
---------------------- considered as sub-standard and risky. The company therefore charged higher
insurance premium for covering Indian lives. The first Indian insurance
---------------------- company, Bombay Mutual Life Assurance Society started business in 1870.

---------------------- In 1850, Triton Insurance Company Ltd., established by the British, became
the first general insurance company in the country. In 1907, the Indian
---------------------- Mercantile Insurance Ltd. was set up and became the first company to
transact all classes of general insurance business.
----------------------
Insurance regulation formally began in India through the passing of two
---------------------- Acts, the Life Insurance Companies Act, 1912 and the Provident Fund
Act, 1912. However despite this, the industry was plagued by fraudulent
----------------------
practices. A comprehensive set of regulations was put in place to stem this

198 Indian Banking & Financial System

 problem and with a view to protect the interests of the insuring public, the Notes
earlier legislations were amended and consolidated into a new act namely,
Insurance Act, 1938. ----------------------
B. Post-Independence & Nationalization Phase ----------------------
After Independence, the business of insurance grew at a rapid pace.
----------------------
However, despite this, insurance business remained an urban phenomenon.
The insurance industry was beset with many problems such as misuse of ----------------------
insurance funds, excessive costs, poor post-sales services, high policy lapses,
numerous complaints related to claim settlement and frequent closures of ----------------------
insurance companies. This shook the confidence of the public and also
----------------------
deprived policy holders of their saving and security.
The Government felt that nationalization of insurance companies would ----------------------
reduce these problems. In 1956, it brought more than 200 private life ----------------------
insurance companies under one monopoly entity and Life Insurance
Corporation was formed on 1st September 1956. ----------------------
It was felt that nationalization would lead to: ----------------------
1. Better and more economical management of the business of life
insurance. ----------------------

2. Reduction in administrative costs ----------------------

3. Improvement in the quality of service ----------------------
4. Greater insurance coverage of rural population
----------------------
5. By taking over the business of insurance, the Government would be in
a better position to channel resources for saving and investment. ----------------------

The non-life insurance business was nationalized in 1972 and General ----------------------
Insurance Corporation of India was created. All the 107 private non-life
insurance companies that were in existence at that time were amalgamated ----------------------
and absorbed into one of the following four subsidiaries of GIC: ----------------------
 Oriental Insurance Co.
----------------------
 United India Insurance Co.
----------------------
 New India Assurance Co. and
 National Insurance Co. ----------------------
C. Post-liberalization era ----------------------
As we have seen above, the insurance sector was brought under government ----------------------
control after independence. However, the functioning of the state-owned
companies was marred by inefficiency and bureaucracy. ----------------------
The early nineties brought liberalization on all major economic fronts. ----------------------
However, initially insurance was left untouched. It was in 1993 that the
Government set up a committee under the Chairmanship of former RBI Governor, ----------------------
Mr. R. N. Malhotra to propose recommendations for reforms in the insurance
----------------------
sector. The committee found several weaknesses in the state-owned insurance

Insurance 199
 Notes companies such as low insurance coverage, poor customer service, hierarchical
management and an excessive lapse ratio of policies. The committee, therefore,
---------------------- recommended that the private sector be permitted to enter the insurance industry
to induce a spirit of competition amongst the insurance companies and to provide
---------------------- greater choice to the consumers. The committee further stated that foreign
---------------------- companies should be allowed to enter the industry by setting up joint ventures
with Indian companies.
---------------------- In accordance with the recommendations of the committee, the Government
---------------------- enacted the IRDA Act leading to the establishment of Insurance Regulatory and
Development Authority. IRDA was incorporated as a statutory body in April
---------------------- 2000. The main objective of setting up of IRDA was to protect the interest of
policy-holders and to regulate, promote and ensure orderly development of the
---------------------- insurance sector. Foreign companies were allowed ownership of up to 26% in
---------------------- joint ventures set up with Indian companies. There is a proposal to raise this
ceiling from 26% to 49%.
---------------------- Earlier, General Insurance Corporation of India (GIC) was the parent
---------------------- company and the four general insurance companies were its subsidiaries. Since
the year 2000, GIC is engaged in reinsurance business and the four erstwhile
---------------------- subsidiaries have now been delinked from GIC.

---------------------- As of 2021, the total number of life insurers registered with IRDA is 24.
The total number of general insurers registered with IRDA is also 23.
----------------------
12.3 MEANING AND NEED FOR INSURANCE
----------------------
Insurance is a method for providing protection against financial losses due
---------------------- to any accident such as death, theft and natural calamities such as fire, floods
etc. Insurance can also be defined as the process of pooling of risk and sharing
----------------------
of cost within a particular group. It is a form of risk management. Insurance
---------------------- operates on the principle of shared risk. A group of people pay specified
premiums to a common pool. Funds from the pool are used to cover individual
---------------------- losses.
---------------------- Insurance is, therefore, a contract between two parties- the insurer (the
insurance company) and the insured (the person seeking protection). The insurer
---------------------- agrees to pay the insured for financial losses arising out of any unforeseen event
---------------------- in return for a regular payment of premium.
Insurance involves preserving and maintaining the economic wealth and
---------------------- assets created by through human efforts. These assets provide the owner with
---------------------- regular income. However, each asset has a definite life span, after which it
becomes worth less and ceases to yield any income. Every owner, therefore, sets
---------------------- aside a certain sum out of his regular income to create a Replacement Fund. This
Fund can then be used to purchase a new asset to replace the old one so that the
---------------------- flow of income continues uninterrupted. But what would happen if a working
---------------------- asset were to be destroyed by an accident or a natural calamity before its expiry?
The income generation from the asset would stop and the owner would face
---------------------- financial problems.

200 Indian Banking & Financial System

 For example, an auto rickshaw owner depends for his livelihood on the income Notes
earned by plying the rickshaw. If the rickshaw is destroyed in an accident, then
the owner would suffer a severe economic setback. In such a situation, insurance ----------------------
plays an important role by providing compensation so that the loss is minimized.
----------------------
Thus, income generating assets are insured with the objective of wealth
preservation. It can be said that insurance is an intangible asset which serves ----------------------
the purpose of protecting the value of personal and business assets through
----------------------
replacement and repairs.
Generally, floods, volcanoes, lightening, earthquakes and other such ----------------------
calamities cause a partial or total loss to assets or wealth. These phenomena
----------------------
which cause loss are perils and the possibility of loss which occurs because of
them is called risk. Perils are the events; risks are the consequential losses or ----------------------
damages. Risk means the possibility of occurrence of loss, which may or may
not occur. Uncertainty is an important element of risk. Insurance is done on ----------------------
the presumption that loss will occur. It is to be noted that insurance provides
----------------------
protection against a peril but does not prevent losses from perils. Insurance cannot
avoid the occurrence of perils. It does not eliminate risk but only tries to reduce ----------------------
the impact of risk on the owner of the asset.
----------------------
The importance of insurance is generally well understood in relation to
tangible assets, such as car, machinery building etc. Thus, the concept of general ----------------------
insurance has wide acceptance. However, life insurance is not such a widely
accepted phenomenon even today. A lot of people compare life insurance products ----------------------
with investment products and do not opt for insurance saying that there are better
----------------------
investment avenues giving higher returns. Some only look at life insurance
products to avail of tax benefits. It is important to understand that the primary ----------------------
objective of insurance is to provide protection against contingencies.
----------------------
In life insurance, the main risk that is widely acknowledged and understood
is the risk of premature death and the need to compensate the family for economic ----------------------
loss caused by the untimely death of its bread-earner. A human being is also an
income earning asset. In the event of early death, the income would stop causing ----------------------
financial hardship to the person’s dependents. Hence, insurance is taken as a ----------------------
protection against early death.
While dying young is a problem, living too long can also create its own ----------------------
problems. Both these risks are safeguarded against insurance. A person, who ----------------------
may have made arrangements for his needs after his retirement, would also need
insurance. This is because the arrangements would have been made on the basis ----------------------
of some expectations such as likelihood of living for another 15 years or that the
children would support the person during old age. If any of these expectations ----------------------
do not come true, the original arrangement would be inadequate and there could ----------------------
be financial difficulties. Buying a pension plan can help a person tide over such
situations. ----------------------
Thus the risks in respect of human beings which need to be insured against are: ----------------------
a. early death, b. living too long, c. permanent disability, d. sickness,
e. unemployment ----------------------

Insurance 201
 Notes
Check your Progress 1
----------------------

---------------------- Fill in the blanks.

1. The first Indian Insurance company, Bombay Mutual Life Assurance
----------------------
Society started business in the year _____.
---------------------- 2. _____ was started in 1956 by taking over private life insurance
companies.
----------------------
3. in 1972, GIC was created with 4 subsidiaries: i) _____ ii) _____ iii)
---------------------- _____ iv) _____.
---------------------- 4. IRDA was incorporated in _____.
---------------------- 5. Insurance operates on the principle of _____.
6. The primary objective of insurance is to provide _____ against _____.
----------------------
----------------------
Activity 1
----------------------

---------------------- Refer to www.insureatclick.com/insurance forms. Collect and study a

proposal form for a fresh car insurance policy.
----------------------

----------------------
12.4 FUNCTIONS OF INSURANCE
----------------------
The functions of insurance are of two types:
----------------------
i. Primary functions
---------------------- ii. Secondary functions
---------------------- i. Primary functions:

---------------------- a. Provide protection: Insurance provides protection against future risks.

It is a protection against economic loss by sharing the risk with others.
---------------------- b. Collective bearing of risk: Insurance is a mechanism to share the
---------------------- financial loss of a few among a large number of persons. Every insured
contributes premium towards a fund out of which the person exposed
---------------------- to a particular risk is compensated.
---------------------- c. Risk assessment: Insurance determines the probable volume of risk
after evaluating various factors that give rise to risk. Risk is also the
---------------------- basis for determining the rate of premium.
---------------------- d. Provides certainty: Insurance helps to change a situation of uncertainty
into certainty.
----------------------

----------------------

202 Indian Banking & Financial System

ii. Secondary functions: Notes
a. Promotes loss prevention: Insurance creates awareness amongst
----------------------
the general public to initiate measures and adopt devices to prevent
unfortunate consequences of risk. Thus, the risk of theft can be reduced ----------------------
by installing a security system. The risk of loss by fire can be reduced
by installing a fire extinguisher. ----------------------
b. Large risk can be covered by making a small contribution: Entrepreneurs ----------------------
can make small payments of insurance premium and get large risks
covered. The risk inherent in any business is reduced at least to some ----------------------
extent through insurance.
----------------------
12.5 LIFE INSURANCE PRODUCTS ----------------------

a. Term Insurance: It provides pure risk cover without any element of savings. ----------------------
The premium is the lowest. Hence, term insurance is low cost insurance
providing high risk cover. The sum assured is payable only if the insured ----------------------
dies within the policy term. If the policy holder survives beyond the policy ----------------------
term, then no amount is payable.
b. Whole Life Insurance: This insurance involves coverage throughout the ----------------------
life of the policy holder. The sum assured is payable only on the death of ----------------------
the policy holder to his family.
----------------------
c. Endowment Plans: This policy is a combination of risk cover with financial
savings. It not only covers the life of the assured in the event of his early ----------------------
death, but provides for payment of a lumsp sum to the assured if he survives
the date of maturity. ----------------------
d. Money Back policy: It is also known as anticipated endowment policy. This ----------------------
is a variant of endowment policy. Here the policy holder need not wait until
maturity to get a return on his policy. The policy is structured to provide funds ----------------------
required periodically as anticipated expenses, such as marriage, education etc.
----------------------
e. Children’s assurance plan: Children’s assurance plan covers the life of a
child even when he or she is a minor, i.e. below 18 years of age. After the ----------------------
child becomes a major, he or she has the option to continue the policy.
----------------------
f. Unit Linked Insurance Plans: A ULIP is a life insurance policy which is a
combination of life cover and investment. This is the most popular insurance ----------------------
product today. At present, over 70% of the new business premium for most
insurance companies comes from ULIPs, covering thousands, if not lakhs of ----------------------
customers. In ULIPs, out of the premium paid by the insured, a certain sum is ----------------------
adjusted towards the cost of insurance cover and charges. The balance, called
the allocated premium, is invested in a fund that the policy holder chooses and ----------------------
a certain number of units of the chosen fund are purchased at the prevailing
NAV. One important point to be noted is that in ULIPs, unlike the traditional ----------------------
insurance products, the investment risk is entirely borne by the policy holder. ----------------------
A number of changes have been made in ULIPs as per the directives of
IRDA with effect from 1st September 2010. Some of these changes are: ----------------------

Insurance 203
 Notes i. There is now an even distribution of charges during the policy period.
This removes any high front ending of charges.
---------------------- ii. The lock in period for all unit linked plans has been increased from 3
years to 5 years.
----------------------
iii. Higher risk coverage
---------------------- iv. Lower charges
---------------------- v. Unit linked pension/annuity products will now offer a minimum
guaranteed return of 4.5% per annum. This percentage can be reviewed
---------------------- by IRDA from time to time.
---------------------- g. Group Insurance Plans: Group insurance is an insurance plan which
provides life cover to a number of individuals under a single policy called a
---------------------- ‘Master Policy”. The advantage is that the premium is comparatively lesser
because of the low administrative cost involved in handling only one policy
----------------------
instead of many policies. The insurance contract is between the insurer and
---------------------- a body that represents the group of individuals covered, such as employer.
Because the contract is with the body, that body is the policy holder and the
---------------------- individuals are the beneficiaries.
---------------------- h. Annuities: Annuity refers to a stream of payments. You can buy an annuity
from an insurance company and make payment of initial premium. As per
---------------------- the contract, the insurance company would then make periodic payment
---------------------- to you for a specified period or as long as you live, as per the terms of the
contract. As the recipient of regular payments from the insurance company,
---------------------- you become the annuitant. Annuities are a form of pension and are an
important tool for retirement planning. In such a type of insurance, the
---------------------- insurance company takes into account longevity risk.
----------------------
Check your Progress 2
----------------------

---------------------- Fill in the blanks.

1. Term insurance is low-cost insurance, which provides ________.
----------------------
2. Endowment policy is a combination of ________ with ________.
----------------------
3. ULIP is a combination of ________ and ________.
----------------------

----------------------
Activity 2
----------------------
A senior executive with an MNC desires to take a policy to take care of
----------------------
liabilities on account of a housing loan Rs. 75 lakh and education and
---------------------- marriage of one daughter- age 14 years. He has no other liabilities. He is
presently having savings to the tune of Rs 25.00 lakh. His net monthly
---------------------- income is Rs. 95000/-. Suggest him a suitable policy.
---------------------- Refer to www.easypolicy.com/life/insurance/term insurance.

204 Indian Banking & Financial System

12.6 GENERAL INSURANCE PRODUCTS Notes

i. Marine Insurance: Marine insurance is a contract of insurance under ----------------------

which the insurer undertakes to indemnify the insured against marine losses
----------------------
incidental to marine adventure. It may cover loss or damage to the ship,
cargo, freight or any other subject matter of marine adventure. ----------------------
ii. Fire Insurance: It is a contract in which the insurer undertakes to indemnify
----------------------
the insured for destruction of or damage to property caused by fire, riots,
floods or earthquake. ----------------------
iii. Motor Vehicle Insurance: Motor Vehicle Insurance is of two types:
----------------------
a. Third party liability insurance which is compulsory and covers only
the accident to third parties. The damage to the vehicle is not covered. ----------------------

b. Comprehensive policy which covers the entire range of risks caused ----------------------
to the vehicle by fire, riots, burglary or earthquake in addition to third
party liability. The premium for such policies is higher. ----------------------

iv. House Insurance: An integrated policy is offered by insurance companies ----------------------

covering various risks like fire, earthquake, theft and robbery. The policy
----------------------
covers the house itself, jewelry, ornaments and household items such as
T.V., Computer and other electrical gadgets and equipments. ----------------------
v. Health Insurance: Under this policy, the insurer pays the medical expenses
----------------------
incurred by the insured in the event of hospitalization. In India, it is popularly
known as mediclaim. Earlier, these policies were only on reimbursement ----------------------
basis. Nowadays, cash-less facility is available under which an intermediary
appointed by the insurer, referred to as third party administrator (TPA), ----------------------
makes payment directly to the hospital and the insured need not make any
----------------------
cash payment for the medical treatment.
----------------------
12.7 INSURANCE INTERMEDIARIES
----------------------
Intermediaries are links between the insurance company and the public.
----------------------
These include the following:
A. Agents ----------------------
B. Brokers ----------------------
C. Third Party Administrators ----------------------
D. Bancassurance
----------------------
E. Post Offices
----------------------
A. Agents
An insurance agent represents an insurance company and is required to solicit ----------------------
and procure insurance business in a manner consistent with the interests of
----------------------
both the policy holder and the insurance company. The agent explains the
scope of cover, the terms and conditions and assists the proposer to fill up ----------------------

Insurance 205
 Notes the proposal form. An agent is required to complete the training stipulated
by IRDA before getting agency license. He is entitled to commission from
---------------------- the insurance company. He can be a part-time or full time agent. However,
he can do business for only one life insurer and/or one general insurer.
----------------------
Agents can be individuals or corporates. In other words, firms and companies
---------------------- such as travel agents can also act as corporate agents.
---------------------- B. Brokers
While an insurance agent is a representative of the insurance company, the
----------------------
insurance broker represents the client. An insurance broker is an independent,
---------------------- full-time professional who has to meet the criteria laid down by IRDA and is then
granted a license to solicit, procure and service insurance business. An insurance
---------------------- agent works for only one insurance company while an insurance broker can give
business to any insurer. He assesses the needs of the customer and offers him a
----------------------
suitable insurance product. The broker gets brokerage from the insurers.
---------------------- C. Third Party Administrator (TPA)
---------------------- TPA is a service provider appointed by an insurance company in respect of
mediclaim insurance. The TPA collects the claim papers from the insured,
---------------------- processes them and effects payment to the hospital or to the inured as per
---------------------- the terms agreed upon. It then gets reimbursement for the claims settled and
also recovers its service charges from the insurance company.
---------------------- D. Bancassurance
---------------------- Banks also function as corporate agents of insurance companies by selling
their products through their branch network. The branches become a common
----------------------
distribution network for selling insurance as well as banking products to
---------------------- the bank’s clientele. Bancassurance is a model offering seamless services
of banking and insurance products and services on an integrated platform.
----------------------
Banks, with their geographical spread and penetration in terms of customer
---------------------- reach of all segments, have emerged as a viable source for the distribution
of insurance products. They possess familiarity with the financial needs and
---------------------- saving pattern of their customers. Banks also have lower distribution costs
which can result in reduction in premium.
----------------------
There are four models of bancassurance in vogue internationally. They are:
----------------------
1. Corporate agency model or distribution alliance model
---------------------- 2. Joint venture model, where an insurance company and a bank share
---------------------- the equity capital of the joint venture
3. Merger between a bank and an insurer
----------------------
4. Build or buy own insurance operation
----------------------
In India, only the first model of corporate agency has been adopted.
---------------------- As per IRDA norms, banks, including co-operative banks and RRBs, can
---------------------- become corporate agents for one insurance company only. They cannot act
as insurance brokers.
206 Indian Banking & Financial System
 The benefits of bancassurance to banks are as follows: Notes
i. It results in customer retention
----------------------
ii. It helps banks to position themselves as a one stop financial super market
offering the entire range of financial products and services under one ----------------------
roof
----------------------
iii. Efficient use of available resources
iv. Boosts the banks’ fee-based income which is risk-free ----------------------

The benefits to the insurance company are: ----------------------

a. greater geographical outreach ----------------------
b. leverage synergies with banks
----------------------
c. helps in building the company’s brand equity in remote locations also
d. channel diversification ----------------------
e. Innovative Group insurance policies are also being marketed to a large ----------------------
section of the bank’s customers.
----------------------
Thus, bancassurance is a WIN-WIN situation for insurance companies,
banks and the insured. ----------------------
E. Post Offices: Recently, IRDA has allowed post offices to act as a corporate ----------------------
agent of insurers. The Indian postal service has a large distribution network
of 1.55 lac offices. With their presence throughout the country, the post ----------------------
offices would be in a great position to increase the coverage area of insurance
products. The wide reach of post offices will help the people in rural areas ----------------------
and villages to have insurance coverage. This would also contribute to ----------------------
attaining the objective of financial inclusion.
----------------------
Check your Progress 3 ----------------------

State True or False. ----------------------

1. An insurance agent can do business for many companies simultaneously ----------------------
2. An insurance broker can give business to any insurer.
----------------------
3. TPA is a service provider appointed by Govt of India.
4. In India, the bancassurance model adopted is Corporate Agency model. ----------------------

----------------------
Activity 3 ----------------------

Visit offices of general insurance company and life insurance company ----------------------
run by a bank and study the claim settlement procedure. ----------------------

----------------------

----------------------

Insurance 207
 Notes Summary
---------------------- ● The insurance sector is a major contributor to the financial savings of the
household sector in the country, which are further channelized into various
----------------------
investment avenues. The Indian life insurance industry is considered the
---------------------- fifth largest life insurance market, and is growing at a rapid pace of 32-34
per cent annually.
----------------------
● There is a huge potential for further growth of insurance in India as there
---------------------- is still a vast untapped market, especially in rural areas. Higher levels
of literacy and increasing life expectancy are creating awareness about
---------------------- insurance. General insurance is also expected to grow at a rate of 17% in
the next five years.
----------------------
● Bancassurance has emerged as a viable model for distribution of insurance
---------------------- products and insurance companies and banks are expected to ride the
boom in the sector for the next decade or so.
----------------------
---------------------- Keywords
---------------------- ● Insurance: Insurance is a method of providing protection against financial
losses due to any accident such as death, theft and natural calamities such
----------------------
as fire, floods etc. Insurance can also be defined as the process of pooling
---------------------- of risk and sharing of cost within a particular group. It is a form of risk
management.
----------------------
● Perils: Generally, floods, volcanoes, lightening, earthquakes and other
---------------------- such calamities cause a partial or total loss to assets or wealth. These
phenomena which cause loss are perils.
----------------------
● Bancassurance: Distribution of insurance products through branches of
---------------------- banks is referred to as Bancassurance. Bancassurance is a model offering
seamless services of banking and insurance products and services on an
---------------------- integrated platform
----------------------
Self-Assessment Questions
----------------------
1. Which are evolutionary phases of insurance in India?
----------------------
2. Which are various functions of insurance?
---------------------- 3. Which kinds of products are offered by life insurance company?
---------------------- 4. Which are the insurance intermediaries in India?
----------------------

----------------------

----------------------

----------------------

208 Indian Banking & Financial System

Answers to Check your Progress Notes
Check your Progress 1 ----------------------
Fill in the blanks. ----------------------
1. The first Indian Insurance company, Bombay Mutual Life Assurance
Society started business in the year 1870. ----------------------

2. Life Insurance Corporation of India (LIC) was started in 1956 by taking ----------------------
over private life insurance companies.
----------------------
3. In 1972, GIC was created with four subsidiaries: i) Oriental Insurance Co.
ii) United India Insurance Co. iii) New India assurance Co. iv) National ----------------------
Insurance Co.
----------------------
4. IRDA was incorporated in April 2000.
----------------------
5. Insurance operates on the principle of shared risk.
6. The primary objective of insurance is to provide protection against ----------------------
contingencies. ----------------------

----------------------
Check your Progress 2
----------------------
Fill in the blanks.
1. Term insurance is low-cost insurance, which provides high-risk cover. ----------------------
2. Endowment policy is a combination of risk cover with financial savings. ----------------------
3. ULIP is a combination of life cover and investment. ----------------------

----------------------
Check your Progress 3
----------------------
State True or False.
1. False ----------------------
2. True ----------------------
3. False ----------------------
4. True
----------------------

----------------------
Suggested Reading ----------------------

1. www.eindiainsurance.com ----------------------

----------------------

----------------------

----------------------

Insurance 209
 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

210 Indian Banking & Financial System

Mutual Funds
UNIT

13
Structure:
13.1 Introduction
13.2 Concept of a Mutual Fund
13.3 Evolution of Mutual Funds in India
13.4 Benefits of investing in Mutual Funds
13.5 Types of Mutual Funds
13.6 Schemes of Mutual Funds
13.7 Distribution of Mutual Funds by Banks
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Mutual Funds 211

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Explain the concept of mutual funds
----------------------
• Describe the evolution of mutual fund industry in India
----------------------
• Discuss the types of mutual funds
----------------------

----------------------
13.1 INTRODUCTION
----------------------
The growth of the capital markets in India over the past two decades and the
---------------------- attractive returns from investments in stock markets have caught the attention of
retail investors who are eager to join the bandwagon and reap the benefits. However,
---------------------- many investors have lost money by investing without first understanding the market
---------------------- dynamics. A number of investors have also stayed on the sidelines because they are
unable to devote the time required to do stock picking and to monitor the portfolio
---------------------- of stocks. The emergence of mutual funds has created an attractive investment
avenue for many such investors who have benefited from the professional advice
---------------------- of fund managers. In this unit, we shall understand the role of mutual funds and
---------------------- the various types of mutual funds available to the investors.

---------------------- 13.2 CONCEPT OF A MUTUAL FUND

---------------------- A Mutual Fund (MF) represents a vehicle for collective investment. A mutual
fund acts as an investment conduit. It is a trust that pools the savings of a large
----------------------
number of investors and then invests the money thus collected in accordance with a
---------------------- stated objective. The investors are the mutual owners of the fund. Mutual funds issue
securities known as units to the investors who are known as unit-holders. Mutual
---------------------- Funds invest the money collected in three broad categories of financial assets:
---------------------- a. capital market investments such as shares, debentures

---------------------- b. debt market instruments such as government securities, corporate securities

and financial institutions bonds
----------------------
c. money market instruments such as treasury bills, certificate of deposits
---------------------- (CDs) and commercial paper (CPs)
The MF hires professional managers to manage the investments for the benefit
----------------------
of the investors. The returns on the investments are then distributed amongst the
---------------------- investors by the MF after retaining its management fee. The organization that
manages the investment is called the Asset Management Company (AMC). The
---------------------- managers appointed by AMCs are called fund managers.
---------------------- It is to be noted that investments in most capital market investments are
subject to market risk. The investment activity may also result in losses which
---------------------- are to be borne by the investors up to the amount invested.

212 Indian Banking & Financial System

 Mutual Funds launch various schemes to suit the needs of various categories Notes
of investors. For example, equity schemes invest mainly in equity shares and
are best suited for aggressive investors who are willing to take higher risk while ----------------------
seeking higher returns. On the other hand, debt schemes are launched to meet
the needs of conservative investors, who seek relatively safe and steady returns. ----------------------

When an Asset Management Company (AMC) wishes to launch a new ----------------------

mutual fund scheme, they are required to formulate the details of the scheme and
----------------------
register it with SEBI before announcing the scheme and inviting the investors to
subscribe to the fund. Launch of a new mutual fund scheme is called a new fund ----------------------
offer (NFO). This is similar to the issue of new shares by a company through its
Initial Public Offer (IPO). The document containing the details of a new offer ----------------------
that the AMC prepares and circulates to the prospective investor is called the
----------------------
Offer Document. This is similar to the prospectus issued by the companies while
offering shares to the public for subscription. ----------------------
Thus, MFs launch many schemes to suit the preferences and needs of
----------------------
various classes of investors. The scheme’s money is managed in trust by MFs
for investors, who are the beneficiaries. In other words, a MF is a trust and the ----------------------
investors subscribe to the units of a scheme launched by the fund. The unit-holders
then become part owners of the fund’s assets. ----------------------
Since the units held by investors evidence the ownership of the fund’s assets, ----------------------
the value of total assets less liabilities and divided by the total number of units
issued by the mutual fund gives us the net value of one unit. This is called the ----------------------
Net Asset Value (NAV) of one unit. ----------------------
Thus, NAV = Assets-liabilities
No. of Outstanding Units ----------------------

The NAV will go up or down depending upon the market value of securities ----------------------
held by the fund.
----------------------
MFs participate both in the primary and secondary markets. In the primary
capital market, MFs act as financial intermediaries. They serve as an important ----------------------
link between the public and the corporate sector by channelizing savings from
----------------------
investors to companies. In the secondary capital markets, they participate as
investors and trade with other investors. ----------------------
There is a major difference between mutual funds and other intermediaries
----------------------
such as banks. Banks assume the responsibility of risk management and insulate
their depositors from losses. Mutual funds do use the services of professional fund ----------------------
managers, who try to minimize risk, but the investments are inherently subject to
market risk and the unit holder must also bear the risk. Hence, while the potential ----------------------
returns from mutual funds are higher than bank deposits, it is accompanied
----------------------
by the risk of loss. It is for this reason that the mutual fund industry is highly
regulated by Securities Exchange Board of India (SEBI) which requires, inter ----------------------
alia, numerous disclosures to be made to protect the interest of investors.
----------------------
SEBI, as the market regulator, has taken numerous initiatives for the benefit
of investors. One such initiative was the abolition of entry load charged by mutual ----------------------

Mutual Funds 213

 Notes funds with effect from 1st August 2009. This load was charged to compensate the
MF houses for marketing and distribution costs. The entry load was recovered
---------------------- upfront from the investment made by the investor initially resulting in less money
being invested in an MF scheme. With the abolishment of the entry load, the
---------------------- entire amount contributed by the investor is used for making investments in the
---------------------- MF scheme.
Mutual Funds can however, continue to charge exit load, which is deducted
----------------------
from the redemption proceeds payable to the investor.
----------------------
13.3 EVOLUTION OF MUTUAL FUNDS IN INDIA
----------------------
The Mutual fund industry started in the USA. In India, it is still a relatively
---------------------- new financial intermediary.
---------------------- In 1963, the first mutual fund, Unit Trust of India (UTI), was set up by
Reserve Bank of India and the Government of India jointly. The history of mutual
----------------------
funds in India can be broadly divided into four phases.
---------------------- A. Phase I -1964 to 1987: Domination of UTI - UTI was set up in 1963 by an
act of parliament and had a monopoly in the mutual fund business. Its most
----------------------
popular scheme was Units Scheme 1964 (US 64). It offered Monthly Income
---------------------- Schemes (MIS) which gave assured returns and attracted a lot of investors. It
also launched Mastershare, which is the first diversified investment scheme
---------------------- in India.
---------------------- B. Phase II- 1987- 1993: Entry of Public Sector Funds - With the opening up
of the economy, public sector banks and financial institutions were allowed
---------------------- to establish mutual funds from 1987. SBI became the first such organization
to set up its mutual fund and was followed by LIC, GIC, Canara Bank Punjab
----------------------
National Bank and by many other public sector banks. During this period,
---------------------- the interest of investors in mutual funds increased and they started allocating
a larger share of their investments in funds. UTI continued to dominate the
---------------------- market during this phase and enjoyed a market share of around 80%.
---------------------- C. Phase III- 1993-2002: Entry of Private Funds - The era of liberalization
brought reforms in the financial sector. The banking sector was opened up
---------------------- to the private sector and steps were taken to open up the insurance sector
---------------------- too. In the mutual fund industry also, permission was granted for the entry
of private sector funds to bring in an element of competition for the existing
---------------------- public sector funds and also to give a wider choice to the investors. As in
the case of the banking sector, the private sector entered the mutual fund
---------------------- industry with state of the art technology and innovative products. In 1993,
---------------------- the first private sector mutual fund -Kothari Pioneer- was set up. It has
since been merged with Franklin Templeton. SEBI, which was set up in
---------------------- 1992, introduced a comprehensive set of regulations for all mutual funds
operating in India under SEBI (Mutual Fund) Regulations, 1996.
----------------------
D. Phase IV- February 2003 – April 2014 - In February 2003, following
---------------------- the repeal of the Unit Trust of India Act 1963, UTI was bifurcated into

214 Indian Banking & Financial System

 two separate entities, viz., the Specified Undertaking of the Unit Trust of Notes
India (SUUTI) and UTI Mutual Fund which functions under the SEBI
MF Regulations. With the bifurcation of the erstwhile UTI and several ----------------------
mergers taking place among different private sector funds, the MF
industry entered its fourth phase of consolidation. ----------------------

Following the global melt-down in the year 2009, securities markets all over ----------------------
the world had tanked and so was the case in India. Most investors who had
----------------------
entered the capital market during the peak, had lost money and their faith in MF
products was shaken greatly. The abolition of Entry Load by SEBI, coupled ----------------------
with the after-effects of the global financial crisis, deepened the adverse impact
on the Indian MF Industry, which struggled to recover and remodel itself for ----------------------
over two years, in an attempt to maintain its economic viability which is evident
----------------------
from the sluggish growth in MF Industry AUM between 2010 to 2013.
Phase V: Current, since May 2014 ----------------------
Taking cognisance of the lack of penetration of MFs, especially in tier ----------------------
II and tier III cities, and the need for greater alignment of the interest of
various stakeholders, SEBI introduced several progressive measures in ----------------------
September 2012 to “re-energize” the Indian Mutual Fund industry and
----------------------
increase MFs’ penetration.
In due course, the measures did succeed in reversing the negative trend ----------------------
that had set in after the global melt-down and improved significantly after ----------------------
the new Government was formed at the Center.
Since May 2014, the Industry has witnessed steady inflows and increase ----------------------
in the AUM as well as the number of investor folios (accounts). ----------------------
The Industry’s AUM crossed the milestone of ₹10 Trillion (₹10 Lakh Crore)
for the first time as on 31st May 2014 and in a short span of about three ----------------------
years the AUM size had increased more than two folds and crossed ₹ 20 ----------------------
trillion (₹20 Lakh Crore) for the first time in August 2017. The AUM size
crossed ₹ 30 trillion (₹30 Lakh Crore) for the first time in November 2020. ----------------------
The overall size of the Indian MF Industry has grown from ₹ 7.31 trillion ----------------------
as on 31st May 2011 to ₹ 33.06 trillion as on 31st May 2021, more than
4½ fold increase in a span of 10 years. ----------------------
The MF Industry’s AUM has grown from ₹ 13.82 trillion as on May 31, ----------------------
2016 to ₹33.06 trillion as on May 31, 2021, more than 2 fold increase in
a span of 5 years. ----------------------
The no. of investor folios has gone up from 4.84 crore folios as on 31- ----------------------
May-2016 to 10.04 crore as on 31-May-2021, more than 2 fold increase
in a span of 5 years. ----------------------
On an average 8.66 lakh new folios are added every month in the last 5 ----------------------
years since May 2016.
----------------------
The growth in the size of the Industry has been possible due to the twin
effects of the regulatory measures taken by SEBI in re-energising the MF ----------------------

Mutual Funds 215

 Notes Industry in September 2012 and the support from mutual fund distributors
in expanding the retail base.
---------------------- MF Distributors have been providing the much needed last mile connect
---------------------- with investors, particularly in smaller towns and this is not limited to just
enabling investors to invest in appropriate schemes, but also in helping
---------------------- investors stay on course through bouts of market volatility and thus
experience the benefit of investing in mutual funds.
----------------------
MF distributors have also had a major role in popularising Systematic
---------------------- Investment Plans (SIP) over the years. In April 2016, the no. of SIP
accounts has crossed 1 crore mark and as on 31st May 2021 the total no.
---------------------- of SIP Accounts are 3.88 crore.
----------------------
Check your Progress 1
----------------------

---------------------- Fill in the blanks.

1. Mutual funds invest the money in financial assets such as i) _________
----------------------
ii) ___________ iii) ________.
---------------------- 2. The organisation that manages the mutual fund is known as ________.
---------------------- 3. NAV per unit is worked our as ________.

----------------------

---------------------- Activity 1
---------------------- Refer to www.amfiindia.com and list out top performing MFs and their
---------------------- schemes.

----------------------
13.4 BENEFITS OF INVESTING IN MUTUAL FUNDS
----------------------
Investing in mutual funds involves less risk as compared with investing in
---------------------- equities directly.
Let us now understand the advantages of investing mutual funds:
----------------------
1. Portfolio Diversification and reduction of risk: A major advantage of
---------------------- investing in mutual funds is that one can invest a small amount and at the
same time hold a diversified portfolio and limit the associated risk. For
----------------------
example, if you want to invest Rs.10,000/- in shares, then you would be able
---------------------- to own shares of only one reputed company and that too only a few shares.
You then get exposed to the stock specific risk. On the other hand, if you
---------------------- were to invest the same money in mutual funds, then that money would be
a part of a large pool of funds out of which many shares would be bought
---------------------- and you would then have a fractional holding of more than one company’s
---------------------- shares. Thus the risk involved is reduced.
2. Professional Management: There are a number of financial institutions
----------------------
which provide specialized services to individual investors for professional

216 Indian Banking & Financial System

 management of their investment portfolio. This is referred to as Portfolio Notes
Management Service (PMS). However, this facility is only offered to
investors with a portfolio of at least Rs.10.00 lacs. ----------------------
On the other hand, even a small investor in mutual funds benefits from the ----------------------
professional management skills brought in by the fund in the management
of the investor’s portfolio. The professional management of the portfolio ----------------------
ensures a much better return on investment than what the investor can
----------------------
manage by investing himself.
3. Reduction in transaction costs: An investor investing directly in equity ----------------------
has to bear the cost of investing such as brokerage and other charges. On
----------------------
the other hand, an investor in mutual funds benefits from economies of scale
and his proportionate share of the cost works out much lesser. ----------------------
4. Convenience: The process of investing, redeeming and switching is simple
----------------------
in mutual funds. The fund manager manages the portfolio for the benefit
of the unit-holder. It is like being a pillion rider on a bike. A pillion-rider ----------------------
can enjoy the ride on a bike without worrying about driving. Likewise, as a
unit holder, you can put your funds in the custody of professional managers ----------------------
in MFs and then get relieved of the need to track market movement and to
----------------------
take buying and selling decisions. You can simply enjoy the fruits of the
fund manager’s efforts! ----------------------
5. Flexibility: Mutual funds offer a lot of flexibility in the sense that you can ----------------------
easily switch your holdings from one scheme to another. There is also a
facility of investing and withdrawing money at regular intervals using the ----------------------
Systematic Investment Plan (SIP) or the Systematic Withdrawal Plan (SWP).
----------------------
6. Choice of Schemes: Mutual Fund is a vehicle for investing not only in
shares but in various other asset classes such as debt and money market ----------------------
instruments. Thus, as an investor you can choose a scheme, from amongst
many options, that best suits your needs. ----------------------

7. Transparency: The investor gets updated information about the scheme, its ----------------------
fund manager, the value of investment, the details of allocation to different
assets and the costs and charges incurred. ----------------------

8. Well regulated: Mutual fund industry is well-regulated by SEBI, with ----------------------

whom all funds are required to be registered. SEBI lays down rules regarding
----------------------
valuation, disclosures and other procedures to protect the interest of investors.
9. Liquidity: Investments in mutual funds are highly liquid and can be ----------------------
redeemed at NAV related prices on any working day.
----------------------
Investing in Mutual Funds through Systematic Investment Plans (SIP):
----------------------
An investor can make a one-time lump sum investment in mutual funds.
Alternatively, he can opt for investing through a SIP. ----------------------
SIP is a simple method of investing a fixed sum of money every month over ----------------------
a period of time through mutual funds. The benefits of SIP are given below:
----------------------
1. Affordable: It is possible to make investments of small amounts.

Mutual Funds 217

 Notes 2. Disciplined: This method ensures discipline and takes emotions out
of the approach to investing. The amount is invested irrespective of
---------------------- whether the market is going up or down. When investors make lump
sum investments, they tend to ‘time’ the market. They try to estimate
---------------------- the right time to invest and try to predict the peak at which to exit. The
---------------------- market is, however, too complex for this strategy to work. It is instead
best to stay invested for a long term through SIPs.
----------------------
3. Rupee Cost Averaging: SIP uses the concept of ‘Rupee Cost
---------------------- Averaging’, which means that by investing the same amount every
month, you buy more units of a Mutual Fund when the market is down
---------------------- and fewer units when the market is trading at a high level. This ensures
that over a period of time, the average cost of unit works out lower.
----------------------
4. Powerful: Even a modest monthly investment can grow to become a
---------------------- substantial amount thanks to the power of compounding.
----------------------
13.5 TYPES OF MUTUAL FUNDS
----------------------
There are essentially two types of funds:
----------------------
a. Open ended funds: An open ended fund sells and repurchases units
---------------------- continuously. The scheme does not have a fixed maturity. Investors can
conveniently buy or sell at NAV related prices, which are declared on a daily
---------------------- basis. The number of units goes up or down every time the fund sells new
units or repurchases existing units. Redemptions are unanticipated and hence
----------------------
the fund has to maintain higher liquidity to provide for possible redemptions.
---------------------- b. Closed-ended funds: Such a fund is for a fixed tenure. It involves a one-time
sale of a fixed number of units. The fund is open for subscription only during
----------------------
a specified period at the time of launch of the scheme. After the offer closes,
---------------------- closed ended funds do not allow investors to buy or redeem units directly from
the fund. However, to provide liquidity to investors, closed ended funds are
---------------------- listed on stock exchanges. These mutual funds generally disclose NAV on
a weekly basis. In the secondary market, the units of closed ended schemes
----------------------
usually sell at a discount to their net asset value (NAV). Hence, unlike in an
---------------------- open ended fund, the unit holder does not realise a fair value of his investment.

---------------------- The fund manager of a closed ended scheme can manage the investment
better because the corpus fund is available for the entire duration of the
---------------------- scheme and he is not required to maintain liquidity to take care of redemption
during its life time.
----------------------

---------------------- Check your Progress 2

---------------------- State True or False.
---------------------- 1. Open-ended funds sell and purchase units continuously.
2. The number of units in open-ended funds remains the same.
---------------------- 3. Close-ended funds are for fixed tenure.

218 Indian Banking & Financial System

 Notes
Activity 2
----------------------
Refer to www.money-zine.com and study the methodology adopted by ----------------------
MF rating agencies.
----------------------

13.6 SCHEMES OF MUTUAL FUNDS ----------------------

----------------------
Based on their objectives, mutual funds can be classified as follows:
1. Money Market or Liquid Funds: Liquid Funds invest in securities having ----------------------
maturity of less than one year-such as Treasury Bills, Certificate of Deposits
----------------------
and Commercial Paper. These funds offer high liquidity and the principal
is quite safe. These funds are ideal for investors who wish to park funds for ----------------------
a very short period.
----------------------
2. Gilt Funds: Gilts are government securities with medium to long term
maturities, usually more than one year. Since the issuer is the government, ----------------------
these funds have virtually no risk of default and offer protection of principal.
----------------------
3. Debt Funds or Income Funds: Debt funds invest in debt securities issued
not only by the government, but also by banks, financial institutions and ----------------------
private companies. As compared with gilt funds, these funds have a higher
risk of default. These funds are suitable for investors seeking regular ----------------------
income. ----------------------
4. Equity Funds: Equity funds invest a major portion of their corpus in equity
shares. Share prices fluctuate due to a variety of economic, political and ----------------------
social reasons. The issuer of equity shares also does not guarantee repayment ----------------------
of capital. Hence, an investor in equity is exposed to higher risk. On the
other hand, unlike debt instruments that offer fixed amount of repayments, ----------------------
equities can appreciate in value in tune with the issuer’s earnings potential
and therefore, offer the highest potential for growth in capital. Some types ----------------------
of equity funds are described below: ----------------------
i. Sector Funds: Sector Funds invest in only one industry or sector of
the market such as Banking, IT, etc. There is no diversification and ----------------------
these funds carry a higher level of sector or company specific risk than ----------------------
diversified funds.
----------------------
ii. Diversified Equity Funds: These funds invest in a number of sectors
and shares of different companies and are therefore, able to reduce the ----------------------
sector or stock specific risk through diversification.
----------------------
iii. Equity Linked Savings Schemes (ELSS): These funds invest in equity
shares with the objective of achieving long term capital appreciation. ----------------------
There is a lock-in period of three years for investments in ELSS. Tax
----------------------
concessions are available under Section 80C of the Income Tax Act.
HDFC Taxsaver is an example of an ELSS scheme. ----------------------

Mutual Funds 219

 Notes iv. Equity Index Funds: This is an investment approach based on a passive
style of fund management. An index fund tracks the performance of a
---------------------- specific stock market index. The objective is to match the performance
of the stock market by tracking an index that represents the overall
----------------------
market such as S & P Nifty Index or Sensex. The fund invests in shares
---------------------- that constitute the index and in the same proportion as the index. These
funds take only overall market risk, while reducing the sector and stock
---------------------- specific risks through diversification.
---------------------- Owing to the passive investment strategy adopted by them, index funds
---------------------- offer two advantages:

---------------------- (i) Recurring expenses are low because no equity research is required

---------------------- (ii) Transaction costs are low because portfolio turnover is negligible.
Examples of index funds include Franklin India NSE Nifty, HDFC
---------------------- Index Fund SENSEX Plus Plan etc.
---------------------- v. Balanced funds: Balanced funds (also called Hybrid funds) provide
investors with a single mutual fund that combines both growth
---------------------- (equity) and income (debt), by investing in both stocks and bonds.
---------------------- Such diversification ensures that the funds will manage downside of
the stock market fluctuations without too much of a loss the flip side
---------------------- is that balanced funds will usually give returns less than an all-equity
fund during a bull market.
----------------------
vi. Exchange Traded Funds (ETFs): An Exchange Traded Fund (ETF)
----------------------
combines the best features of open end and closed end structures. It tracks
---------------------- a market index and trades like a single stock on the stock exchange. ETFs
resemble index funds. However, one important difference is that you can
---------------------- buy and sell ETFs throughout the day at prevailing market price, whereas
---------------------- index funds can be traded only at the day’s closing NAV.

---------------------- vii. Fund of Funds: A fund of funds scheme, instead of investing in stocks
or bonds, invests in mutual fund schemes. It provides a higher degree
---------------------- of diversification and thereby reduces risk further. However, the cost
of investing is higher as you incur the expenses of the fund of funds
----------------------
scheme as well as the expenses of the schemes in which the fund of
---------------------- funds scheme invests.

----------------------
13.7 DISTRIBUTION OF MUTUAL FUNDS BY BANKS
----------------------
Banks have now started undertaking universal banking by offering a wide
---------------------- range of financial products and services under one roof. In tune with this strategy,
banks act as corporate distributors and cross-sell mutual fund products to their
---------------------- customers. This has become an additional avenue of earning fee-based income.
---------------------- Moreover, this strategy helps banks to retain customers on their books and earn
their loyalty.
220 Indian Banking & Financial System
 Notes
Check your Progress 3
----------------------
State True or False. ----------------------
1. A liquid fund has high risk.
----------------------
2. Balanced fund is treated like an equity fund for tax purposes.
----------------------
3. Mutual fund is a company.
4. Banks act as corporate distributors and cross-sale the MF products to ----------------------
their customers. ----------------------

----------------------
Activity 3
----------------------

Refer to www.moneycontrol.com. Make a detailed note on the various ----------------------

aspects you will look into before making an investment in a MF scheme
----------------------

----------------------
Summary
----------------------
● In a scenario of increasing complexities of financial markets, the mutual
fund industry plays an important role in assisting the investor in securing ----------------------
maximum returns on his investment with minimum risk.
----------------------
● Banks have also been cross selling mutual fund products with the twin
objectives of customer retention and earning fee-based income. ----------------------

----------------------
Keywords
----------------------
● Net Asset Value (NAV): NAV is an indicator of the performance of a
mutual fund. The calculation of NAV is done as under: ----------------------

NAV= Net Assets of the scheme ----------------------

Number of Units Outstanding ----------------------
● Offer Document: An offer document is issued by a mutual fund company
and is similar to the prospectus issued by companies. It is a legal document ----------------------
and contains the objectives of the scheme. It also contains important ----------------------
disclosures as required by SEBI and is an important source of information
for the prospective investor. ----------------------
● Key Information Memorandum: KIM is an abridged form of the offer ----------------------
document and is generally distributed along with the application form.
----------------------
● New Fund Offer (NFO): When a fund house launches a new scheme,
it is called NFO. It is similar to an Initial Public Offer (IPO) made by a ----------------------
company.
----------------------

Mutual Funds 221

 Notes ● Systematic Investment Plan (SIP): SIP is a disciplined approach to
invest in mutual funds. A fixed sum of money is invested in a specific
---------------------- mutual fund scheme every month over a period of time. This systematic
method of investing lowers the cost of investment for the investor.
----------------------
● Open-ended Funds: An open ended fund sells and repurchases units
---------------------- continuously. The scheme does not have a fixed maturity. Investors can
conveniently buy or sell at NAV related prices, which are declared on a
----------------------
daily basis.
---------------------- ● Closed-ended Funds: It is a fund with a fixed tenure. It involves a one-
time sale of a fixed number of units. The fund is open for subscription
----------------------
only during a specified period at the time of launch of the scheme.
---------------------- ● Index Funds: An index fund tracks the performance of a specific stock
market index such as Sensex or Nifty. The fund invests in shares that
----------------------
constitute the index and in the same proportion as the index.
---------------------- ● Fund of Funds: A fund of funds scheme does not invest directly in stocks
---------------------- or bonds. Instead, it invests in other mutual fund schemes. It provides a
higher degree of diversification and thereby reduces risk further.
---------------------- ● Equity Linked Savings Scheme (ELSS): This is an equity scheme in
---------------------- which investors get tax benefits. Unlike a normal equity scheme, the
investment is subject to a lock-in period of three years.
---------------------- ● Exchange Traded Fund (ETF): An Exchange Traded Fund (ETF)
---------------------- combines the best features of open end and closed end structures. It tracks
a market index and trades like a single stock on the stock exchange.
----------------------

---------------------- Self-Assessment Questions

---------------------- 1. Explain the concept of mutual funds and various benefits of mutual funds.

---------------------- 2. Describe the evolution of mutual fund industry in India.

3. Discuss the types of mutual funds.
----------------------
4. Which are various schemes of mutual funds?
----------------------

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1

Fill in the blanks.
----------------------
1. Mutual funds invest the money in financial assets such as i) Capital market
---------------------- products ii) debt market instruments iii) money market instruments.
---------------------- 2. The organisation that manages the mutual fund is known as Asset
management Company (AMC).
----------------------
3. NAV per unit is worked out as Assets (-) Liabilities /No of outstanding
---------------------- units.

222 Indian Banking & Financial System

Check your Progress 2 Notes
State True or False.
----------------------
1. True
----------------------
2. False
3. True ----------------------

----------------------
Check your Progress 3 ----------------------
State True or False.
----------------------
1. False
----------------------
2. True
3. False ----------------------

4. True ----------------------
----------------------

----------------------
Suggested Reading
----------------------
1. www.researchand markets.com
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Mutual Funds 223

 Notes

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

224 Indian Banking & Financial System

Recent Trends in Banking Regulation
UNIT

14
Structure:

14.1 Introduction
14.2 Basel II Accord on Capital Adequacy
14.3 Banking Ombudsman Scheme
14.4 Corporate Governance
14.5 Anti-Money Laundering Guidelines
14.6 Know Your Customer (KYC) Guidelines
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading

Recent Trends in Banking Regulation 225

 Notes
Objectives
----------------------

---------------------- After going through this unit, you will be able to:
• Enumerate the important aspects of banking ombudsman scheme
----------------------
• Outline the capital adequacy requirements for banks as per Basel II
---------------------- norms
---------------------- • Discuss the concept of corporate governance and its importance

---------------------- • Explain Know Your Customer (KYC) and anti-money laundering

(AML) guidelines
----------------------

----------------------

---------------------- 14.1 INTRODUCTION

---------------------- Banking in India has undergone a sea-change in the past two decades,
particularly in the post-liberalization era. Banking business is now
---------------------- characterized by growing use of technology, business outsourcing, product
---------------------- innovation and aggressive marketing strategies. New business opportunities
have opened up for banks particularly in the areas of mutual funds, insurance,
---------------------- international and investment banking. These have also exposed banks to
higher risks. In such a scenario, supervisory function across the world has
---------------------- focused on risk management practices in banks. Banks are now required to
---------------------- ensure adequacy of capital to cope with the business risks in compliance with
Basel II guidelines.
---------------------- With a view to protect the interests of customers, RBI has notified a Banking
---------------------- Ombudsman Scheme in 1995 which provides a system of redressal of grievances
against banks. The scheme was subsequently modified by RBI in 2002. At present
---------------------- Banking Ombudsman Scheme, 2006, with modifications made in 2017, is in
force and provides a forum for quick redressal of customer complaints related
---------------------- to banking services.
---------------------- The rising incidents of corporate frauds in the developed countries brought
into focus the concept of corporate governance to protect the interest of all
----------------------
stakeholders. In India, SEBI has devised a code on Corporate Governance which
---------------------- is mandatory for all listed companies. RBI has also issued guidelines to banks
to strengthen the corporate governance in the banking sector.
----------------------
With a view to protect banks from being misused by criminals for money
---------------------- laundering activities, Prevention of Money Laundering Act (PMLA) was passed.
RBI has also issued Know Your Customer (KYC) guidelines to be followed by
---------------------- banks.
---------------------- In this unit, we shall understand the above concepts in detail and the
initiatives taken in this regard.
----------------------

226 Indian Banking & Financial System

14.2 BASEL ACCORD ON CAPITAL ADEQUACY Notes

Basel II Accord ----------------------

The Basel Committee on Banking Supervision (BCBS) is a committee of ----------------------
banking supervisory authorities that was established by the central bank governors
of a group of ten countries in 1985. This committee usually meets at the Bank ----------------------
of International Settlement (BIS) in Basel, Switzerland. Hence, it is known as
----------------------
Basel Committee.
In 1988, the Committee provided the framework for capital adequacy, which is ----------------------
referred to as Basel Accord. In a scenario of growing globalization and increasing ----------------------
cross-border financial transactions, a need was felt to have a standardized approach
regarding the minimum capital that banks had to maintain in relation to their assets ----------------------
with a view to ensure better risk management practices amongst banks.
----------------------
The Committee therefore defined the components of capital, allotted risk weight
age to different categories of assets and prescribed the minimum ratio of capital that ----------------------
should be maintained in relation to the sum total of risk-weighted assets. Under Basel
I Accord, only credit risk was considered and the minimum requirement of ----------------------
capital was prescribed at 8% of the total risk-weighted assets. Credit risk refers to the ----------------------
possibility of losses caused by default to meet repayment obligations by borrowers
resulting in erosion in the quality of loan assets of the bank. ----------------------
In India, banks are required to maintain a minimum Capital to Risk Weighted ----------------------
Assets Ratio (CRAR) at a higher level of 9%.
----------------------
An exercise for revision of the capital adequacy framework was undertaken
in 1999 and after incorporating improvements, the modified framework was ----------------------
finalized in 2004 with the approval of the Basel Committee. This revised frame
work is referred to as Basel II Accord and it seeks to strengthen the soundness ----------------------
and stability of the banking system. Under the revised accord, capital allocation
----------------------
is required to be made for operational risk also. Operational risk has been defined
by Basel Committee as the risk of loss resulting from inadequate or failed internal ----------------------
processes, people and systems or from external events. Basel II requires banks
to manage risks by not only allocating regulatory capital but also by disclosing ----------------------
greater risk information and setting standards for risk management processes.
----------------------
The Committee retained the requirement under Basel I for banks to maintain a
minimum capital equivalent to 8% of their risk-weighted assets. ----------------------
The Basel II Accord rests on three pillars:
----------------------
Pillar I - Minimum capital requirements
----------------------
Pillar II - Supervisory review process
Pillar III - Market discipline ----------------------

Pillar I- Minimum Capital Requirements ----------------------

The capital ratio is calculated using the definition of regulatory capital and ----------------------
risk-weighted assets. Regulatory capital consists of Tier-1, Tier-2 and Tier-3
capital. The total capital ratio should not be less than 8%. ----------------------

Recent Trends in Banking Regulation 227

 Notes Tier-1 capital or core capital consists of paid up capital, free reserves and
unallocated surpluses less specified deductions.
----------------------
Tier-2 capital or supplementary capital comprises subordinated debt of not
---------------------- more than five years’ maturity, loan loss reserves, revaluation reserves, investment
fluctuation reserves and limited life preference shares.
----------------------
Tier-3 capital consists of short term subordinated debt for the sole purpose
---------------------- of meeting a portion of the capital requirement for market risk.
Total risk weighted assets include the capital requirement for market risk
----------------------
and operational risk multiplied by 12.5 (i.e. reciprocal of minimum capital
---------------------- requirement of 8%) along with risk weighted assets for credit risk.

---------------------- Thus, Total Risk weighted Assets = Risk weighted assets for credit risk
+ 12.5*Capital requirement for market risk
----------------------
+ 12.5*Capital requirement for operational risk
----------------------
Capital Adequacy Ratio = Regulatory capital/total risk weighted assets
---------------------- Pillar II- Supervisory Review Process
---------------------- The committee has identified four key principles of supervisory review
which are briefly described below:
----------------------
Principle 1-Bank management should have a process for assessing their
---------------------- capital adequacy in relation to their risk profile and a strategy for maintaining
their capital levels.
----------------------
Principle 2-Supervisors should review and evaluate banks’ internal capital
---------------------- adequacy assessments and strategies, as well as their ability to monitor and
ensure their compliance with regulatory capital ratios. Supervisors should take
---------------------- appropriate action if they are not satisfied with the result of this process.
---------------------- Principle 3-Supervisors should expect banks to operate above the minimum
regulatory capital ratio and would require banks to operate with a buffer over
----------------------
and above the Pillar I standard.
---------------------- Principle 4-Supervisors should seek to intervene at an early stage to prevent
capital from falling below the minimum levels required to support the risk
----------------------
characteristics of a particular bank and should require rapid remedial action if
---------------------- capital is not maintained or restored.
Pillar III- Market Discipline
----------------------
Pillar III provides disclosure requirements for banks using Basel II
---------------------- framework. These disclosures would allow market participants to assess key
---------------------- information and thereby make informed decision about a bank. Market discipline
can contribute to a safe and sound banking environment.
---------------------- Basel III Accord
---------------------- The global financial crisis following the crisis in the US sub-prime market
has again prompted a change in the approach to capital adequacy norms and
---------------------- BCBS is now formulating a new regulatory framework Basel III.

228 Indian Banking & Financial System

 The new international regulatory framework for banks called Basel III was Notes
announced in September 2010.
----------------------
The framework is aimed to prevent any repeat of the international financial
crisis. The Basel-III norms involve two regulatory standards for managing ----------------------
liquidity risk — a liquidity coverage ratio to ensure resilience over the short
term and a net stable funding ratio to promote resilience over the longer term. ----------------------
According to RBI, Indian banks are well capitalized and can comfortably ----------------------
adjust to the latest international regulatory framework under Basel III.
----------------------
Basel IV Accord
The Basel IV standards are changes to global bank capital requirements that ----------------------
were agreed in 2017 and are due for implementation in January 2023. They amend ----------------------
the international banking standards known as the Basel Accords. Regulators
argue that these changes are simply completing the Basel III reforms, agreed ----------------------
in principle in 2010–11, although most of the Basel III reforms were agreed
in detail at that time. The Basel Committee (BCBS) itself calls them simply ----------------------
“finalised reforms” and the UK Government has called them “Basel 3.1”. Critics ----------------------
of the reform, in particular those from the banking industry, argue that Basel IV
require a significant increase in capital and should be treated as a distinct round ----------------------
of reforms
----------------------
Check your Progress 1 ----------------------

----------------------
Fill in the blanks.
1. Banks are required to ensure _______ to cope with the business risks ----------------------
in compliance with _______.
----------------------
2. Banking Ombudsman scheme was launched in the year _______ and
was last modified in _______. ----------------------
3. Basel Accord refers to the framework for _______. ----------------------
4. Basel committee defined the components of _______, assigned ----------------------
_______ and prescribed _______.
----------------------

----------------------
Activity 1
----------------------
Refer to www.allbankingsolutions.com and collect information on the ----------------------
latest Basel Accord.
----------------------

14.3 BANKING OMBUDSMAN SCHEME ----------------------

----------------------
Ombudsman is an independent and non-partisan official who deals with
complaints of the public against administrative injustice and maladministration. ----------------------

Recent Trends in Banking Regulation 229

 Notes Banking Ombudsman is a quasi judicial authority originally established by RBI
under Banking Ombudsman Scheme, 1995. The scheme aims at resolution and
---------------------- settlement of customer complaints of the public against banks without resorting
to courts. The Scheme, thus, provides an expeditious and inexpensive forum to
---------------------- bank customers for resolution of their complaints related to banking services.
---------------------- Banking Ombudsman Scheme was subsequently modified in 2002 and again in
2006 to enlarge the extent and scope of the authority and functions of banking
---------------------- ombudsman to redress the grievances against deficiency in banking services
related to loans and advances also. All scheduled commercial banks, regional
---------------------- rural banks and scheduled primary co-operative banks are covered by the modified
scheme.
----------------------
The Reserve Bank may appoint one or more of its officers in the rank of Chief
---------------------- General Manager or General Manager to be known as Banking Ombudsmen to
---------------------- carry out the functions entrusted to them by or under the Scheme.
The appointment of Banking Ombudsman is made for a period not exceeding
---------------------- three years at a time.
---------------------- The Banking Ombudsman shall receive and consider complaints related to
the deficiencies in banking or other services and facilitate their satisfaction or
---------------------- settlement by agreement or through conciliation and mediation between the bank
---------------------- concerned and the aggrieved parties or by passing an Award in accordance with
the Scheme.
---------------------- Grounds of complaint
---------------------- Any person may file a complaint with the Banking Ombudsman having
jurisdiction alleging deficiency in banking including internet banking or other
---------------------- services on any one of the following grounds-
---------------------- (a) Non-payment or inordinate delay in the payment or collection of cheques,
drafts, bills etc.
----------------------
(b) Non-acceptance, without sufficient cause, of small denomination notes
---------------------- tendered for any purpose, and for charging of commission in respect
thereof
----------------------
(c) Non-acceptance, without sufficient cause, of coins tendered and for charging
---------------------- of commission in respect thereof
---------------------- (d) Non-payment or delay in payment of inward remittances
(e) Failure to issue or delay in issue of drafts, pay orders or bankers’ cheques
----------------------
(f) Non-adherence to prescribed working hours
----------------------
(g) Failure to provide or delay in providing a banking facility (other than
---------------------- loans and advances) promised in writing by a bank or its direct selling
agents
----------------------
(h) Delays, non-credit of proceeds to parties’ accounts, non-payment of deposit
---------------------- or non-observance of the Reserve Bank directives, if any, applicable to rate
of interest on deposits in any savings, current or other account maintained
---------------------- with a bank

230 Indian Banking & Financial System

(i) Complaints from Non-Resident Indians having accounts in India in relation Notes
to their remittances from abroad, deposits and other bank related matters
----------------------
(j) Refusal to open deposit accounts without any valid reason for refusal
(k) Levying of charges without adequate prior notice to the customer ----------------------
(l) Non-adherence by the bank or its subsidiaries to the instructions of Reserve ----------------------
Bank on ATM/Debit card operations or credit card operations
----------------------
(m) Non-disbursement or delay in disbursement of pension (to the extent the
grievance can be attributed to the action on the part of the bank concerned, ----------------------
but not with regard to its employees)
----------------------
(n) Refusal to accept or delay in accepting payment towards taxes, as required
by Reserve Bank/Government ----------------------
(o) Refusal to issue or delay in issuing, or failure to service or delay in servicing ----------------------
or redemption of Government securities
----------------------
(p) Forced closure of deposit accounts without due notice or without sufficient
reason ----------------------
(q) Refusal to close or delay in closing the accounts
----------------------
(r) Non-adherence to the fair practices code as adopted by the bank
----------------------
(s) Non-adherence to the provisions of the Code of Bank’s Commitments to
Customers issued by Banking Codes and Standards Board of India and as ----------------------
adopted by the bank
----------------------
(t) Non-observance of Reserve Bank guidelines on engagement of recovery
agents by banks ----------------------
(u) Any other matter relating to the violation of the directives issued by the ----------------------
Reserve Bank in relation to banking or other services
----------------------
A complaint alleging deficiency in banking service in respect of loans and
advances may be filed with the Banking Ombudsman on any one of the following ----------------------
grounds-
----------------------
(a) Non-observance of Reserve Bank Directives on interest rates;
(b) Delays in sanction, disbursement or non-observance of prescribed time ----------------------
schedule for disposal of loan applications; ----------------------
(c) Non-acceptance of application for loans without furnishing valid reasons
to the applicant ----------------------

(d) Non-adherence to the provisions of the fair practices code for lenders as ----------------------
adopted by the bank or Code of Bank’s Commitment to Customers, as the
case may be; ----------------------

(e) Non-observance of Reserve Bank guidelines on engagement of recovery ----------------------

agents by banks
----------------------
(f) Non-observance of any other direction or instruction of the Reserve Bank
as may be specified by the Reserve Bank for this purpose from time to time. ----------------------

Recent Trends in Banking Regulation 231

 Notes The Banking Ombudsman may also deal with such other matter as may be
specified by the Reserve Bank from time to time in this behalf.
---------------------- Procedure for filing complaint
---------------------- (1) Any person who has a grievance against a bank on any one or more of
the grounds mentioned above may, himself or through his authorized
---------------------- representative (other than an advocate), make a complaint to the Banking
Ombudsman within whose jurisdiction the branch or office of the bank
----------------------
complained against is located.
---------------------- (2) (a) The complaint in writing shall be duly signed by the complainant or
his authorized representative and shall state clearly:
----------------------
 the name and the address of the complainant,
----------------------  the name and address of the branch or office of the bank against
which the complaint is made,
----------------------
 the facts giving rise to the complaint,
----------------------  the nature and extent of the loss caused to the complainant, and
----------------------  the relief sought for.
(b) The complainant shall file along with the complaint, copies of the
---------------------- documents, if any, which he proposes to rely upon and a declaration
---------------------- that the complaint is maintainable
(c) A complaint made through electronic means shall also be accepted by
---------------------- the Banking Ombudsman and a print out of such complaint shall be
taken on the record of the Banking Ombudsman.
----------------------
(d) The Banking Ombudsman shall also entertain complaints covered by
---------------------- this Scheme received by Central Government or Reserve Bank and
forwarded to him for disposal.
----------------------
(3) No complaint to the Banking Ombudsman shall lie unless:-
---------------------- (a) the complainant had, before making a complaint to the Banking
Ombudsman, made a written representation to the bank and the bank
----------------------
had rejected the complaint or the complainant had not received any reply
---------------------- within a period of one month after the bank received his representation
or the complainant is not satisfied with the reply given to him by the
---------------------- bank
---------------------- (b) the complaint is made not later than one year after the complainant has
received the reply of the bank to his representation or, where no reply
---------------------- is received, not later than one year and one month after the date of the
representation to the bank
----------------------
(c) the complaint is not in respect of the same subject matter which was
---------------------- settled or dealt with by the Banking Ombudsman in any previous
proceedings
----------------------
(d) the complaint does not pertain to the same cause of action, for which
---------------------- any proceedings before any court, tribunal or arbitrator or any other
forum is pending or a decree or Award or order has been passed by
---------------------- any such court, tribunal, arbitrator or forum;

232 Indian Banking & Financial System

 (e) the complaint is not frivolous or vexatious in nature; and Notes
(f) the complaint is made before the expiry of the period of limitation
prescribed under the Indian Limitation Act, 1963 for such claims. ----------------------
Power to call for information ----------------------
For the purpose of carrying out his duties under this Scheme, a Banking
Ombudsman may require the bank against which the complaint is made or any ----------------------
other bank concerned with the complaint to provide any information or furnish ----------------------
certified copies of any document related to the complaint which is or is alleged
to be in its possession. ----------------------
Settlement of complaint by agreement
----------------------
The Banking Ombudsman shall send a copy of the complaint to the branch or
office of the bank named in the complaint, and endeavour to promote a settlement ----------------------
of the complaint by agreement between the complainant and the bank through
----------------------
conciliation or mediation.
Award by the banking ombudsman ----------------------
(1) If a complaint is not settled by agreement within a period of one month from the
----------------------
date of receipt of the complaint or such further period as the Banking Ombudsman
may allow the parties, he may, after affording the parties a reasonable opportunity ----------------------
to present their case, pass an Award or reject the complaint.
----------------------
(2) The Banking Ombudsman shall take into account the evidence placed before
him by the parties, the principles of banking law and practice, directions, ----------------------
instructions and guidelines issued by the Reserve Bank from time to time
and such other factors which in his opinion are relevant to the complaint. ----------------------
(3) The award shall state briefly the reasons for passing the award. ----------------------
(4) The Award passed shall contain the direction/s, if any, to the bank for specific
performance of its obligations and in addition to or otherwise, the amount, ----------------------
if any, to be paid by the bank to the complainant by way of compensation
----------------------
for any loss suffered by the complainant, arising directly out of the act or
omission of the bank. ----------------------
(5) However, the Banking Ombudsman shall not have the power to pass an
----------------------
award directing payment of an amount which is more than the actual loss
suffered by the complainant as a direct consequence of the act of omission ----------------------
or commission of the bank, or ten lakh rupees whichever is lower.
(6) In the case of complaints, arising out of credit card operations, the Banking ----------------------
Ombudsman may also award compensation not exceeding Rs.1 lakh to the ----------------------
complainant, taking into account the loss of the complainant’s time, expenses
incurred by the complainant, harassment and mental anguish suffered by ----------------------
the complainant.
----------------------
(7) A copy of the Award shall be sent to the complainant and the bank.
----------------------
An award shall lapse and be of no effect unless the complainant furnishes
to the bank concerned within a period of 30 days from the date of receipt ----------------------
of copy of the Award, a letter of acceptance of the Award in full and final
settlement of his claim. ----------------------

Recent Trends in Banking Regulation 233

 Notes The bank shall, unless it has preferred an appeal, within one month from the date
of receipt by it of the acceptance in writing of the Award by the complainant,
---------------------- comply with the Award and intimate compliance to the Banking Ombudsman.
---------------------- Rejection of the complaint
The Banking Ombudsman may reject a complaint at any stage if it appears
----------------------
to him that the complaint made is;
---------------------- (a) beyond the pecuniary jurisdiction of Banking Ombudsman or
---------------------- (b) requiring consideration of elaborate documentary and oral evidence and
the proceedings before the Banking Ombudsman are not appropriate for
---------------------- adjudication of such complaint; or
---------------------- (c) without any sufficient cause; or

---------------------- (d) that it is not pursued by the complainant with reasonable diligence; or
in the opinion of the Banking Ombudsman there is no loss or damage or
---------------------- inconvenience caused to the complainant.

---------------------- Appeal before the appellate authority

Any person aggrieved by an Award or rejection of a complaint may within 30
---------------------- days of the date of receipt of communication of Award or rejection of complaint,
---------------------- prefer an appeal before the Appellate Authority;
Provided that in case of appeal by a bank, the period of thirty days for filing
---------------------- an appeal shall commence from the date on which the bank receives letter of
---------------------- acceptance of Award by complainant
Provided that the Appellate Authority may, if he is satisfied that the applicant
---------------------- had sufficient cause for not making the appeal within time, allow a further period
---------------------- not exceeding 30 days.
Provided that appeal may be filed by a bank only with the previous sanction
---------------------- of the Chairman or, in his absence, the Managing Director or the Executive
---------------------- Director or the Chief Executive Officer or any other officer of equal rank.
The Appellate Authority shall, after giving the parties a reasonable
---------------------- opportunity of being heard
---------------------- (a) Dismiss the appeal; or
---------------------- (b) Allow the appeal and set aside the Award; or
(c) remand the matter to the Banking Ombudsman for fresh disposal in
----------------------
accordance with such directions as the Appellate Authority may consider
---------------------- necessary or proper; or
(d) Modify the Award and pass such directions as may be necessary to give
----------------------
effect to the Award so modified; or
---------------------- (e) Pass any other order as it may deem fit.
---------------------- The order of the Appellate Authority shall have the same effect as the Award
passed by Banking Ombudsman or the order rejecting the complaint, as the case
---------------------- may be.

234 Indian Banking & Financial System

 Banks to display salient features of the scheme for common knowledge of Notes
public
----------------------
(1) The banks covered by the Scheme shall ensure that the purpose of the Scheme
and the contact details of the Banking Ombudsman to whom the complaints ----------------------
are to be made by the aggrieved party are displayed prominently in all the
offices and branches of the bank in such manner that a person visiting the ----------------------
office or branch has adequate information of the Scheme.
----------------------
(2) The banks covered by the Scheme shall ensure that a copy of the Scheme
is available with the designated officer of the bank for perusal in the office ----------------------
premises of the bank, if anyone, desires to do so and notice about the
----------------------
availability of the Scheme with such designated officer shall be displayed
along with the notice under sub-clause (1) of this clause and shall place a ----------------------
copy of the Scheme on their websites.
----------------------
(3) The banks covered by the Scheme shall appoint Nodal Officers at their
Regional/Zonal Offices and inform the respective Office of the Banking ----------------------
Ombudsman under whose jurisdiction the Regional/Zonal Office falls.
The Nodal Officer so appointed shall be responsible for representing the ----------------------
bank and furnishing information to the Banking Ombudsman in respect of
----------------------
complaints filed against the bank. Wherever more than one zone/region of
a bank falls within the jurisdiction of a Banking Ombudsman, one of the ----------------------
Nodal Officers shall be designated as the ‘Principal Nodal Officer’ for such
zones or regions. ----------------------

----------------------
Check your Progress 2
----------------------
State True or False. ----------------------
1. Banking ombudsman is an independent and non-partisan official.
----------------------
2. Only Public sector banks are covered under the banking Ombudsman
scheme. ----------------------
3. Complaint with banking Ombudsman can be filed for deficiency in ----------------------
banking services.
----------------------
4. Banking Ombudsman can handle complaints even after the expiry
period prescribed under Indian Limitation Act. ----------------------
5. An aggrieved person may appeal against the award of the Ombudsman ----------------------
within 30 days of the receipt of the award.
----------------------

----------------------
Activity 2
----------------------
Visit the website www.rbi.org.in/publications. Collect information on
----------------------
how many banking Ombudsmen have been appointed and what their
duties and responsibilities entail. ----------------------

Recent Trends in Banking Regulation 235

 Notes 14.4 CORPORATE GOVERNANCE
---------------------- Corporate Governance means monitoring the functions of a company to
ensure enhancement of shareholder’s value through ethical conduct of business.
---------------------- It involves management of the business in a manner that ensures that the interest
of all stakeholders is protected. It places emphasis on transparency of transactions
----------------------
and accountability of the board of directors.
---------------------- The essential elements of Corporate Governance are:
---------------------- 1. Adequate disclosure of financial transactions and reporting
---------------------- 2. Distribution of power
3. Supervision and audit of executive function and performance through
----------------------
constitution of audit committees.
---------------------- 4. Strengthening the expertise of the Board of Directors and having a higher
proportion of non-executive directors.
----------------------
5. Compliance with laws
----------------------
6. Use of best management practices
---------------------- The corporate sector is now characterized by diversified ownership. It is
---------------------- important, therefore, that the principles of Corporate Governance should be
applied to protect the interest of all stakeholders in a company. The principal
---------------------- stakeholders are the shareholders, the board of directors, employees, customers,
creditors, suppliers, and the community at large.
----------------------
Kumar Mangalam Birla Committee suggested measures to promote and
---------------------- raise the standard of Corporate Governance in India. Based on Birla Committee
recommendations, SEBI came up with the Code on Corporate Governance.
----------------------
RBI Guidelines regarding Private Sector Banks
----------------------
Any acquisition of shares of five percent and above of the paid up capital
---------------------- of private sector banks would require acknowledgement of RBI. Further, in the
interest of diversified ownership of banks, no single entity or group shall have
---------------------- shareholding or control, directly or indirectly, in any bank in excess of ten per cent
of the paid up capital of the private sector bank. Any higher level of acquisition
----------------------
would require prior approval of RBI.
---------------------- RBI Guidelines regarding Public Sector Banks
---------------------- The principles of Corporate Governance have been statutorily recognized
as per Banking Companies (Acquisition and Transfer of Undertakings) Financial
---------------------- Institutions Laws (Amendment) Act, 2006 which provides for shareholder
---------------------- directors to be “fit and proper’ persons as per the criteria laid down by RBI.
Despite these guidelines, scams and frauds have continued to rock Corporate
----------------------
India with alarming regularity. The Satyam fraud and the housing loan frauds
---------------------- involving senior executives of LIC Housing Finance and Central Bank of India,
among others, have highlighted the need to make the guidelines on Corporate
---------------------- Governance more effective. There is a need for greater transparency and

236 Indian Banking & Financial System

accountability of the Board of Directors to protect the interest of all stakeholders Notes
and to gain and retain the trust of investors. There is a need for the market
regulators- RBI and SEBI- to have a relook at the guidelines to better achieve ----------------------
the goal of Corporate Governance in India.
----------------------
14.5 ANTI-MONEY LAUNDERING GUIDELINES ----------------------
Money laundering is the process of converting ‘black’ or ‘dirty’ or illegal ----------------------
money into ‘white’ or ‘clean’ or legal money. It is defined as the practice of engaging
in financial transactions to conceal the identity, source and destination of money. ----------------------

Money laundering typically involves a three stage process: ----------------------

1. Placement- This is the initial disposal of the proceeds arising from the illegal ----------------------
activity into the banking system with a view to convert it into legitimate money.
----------------------
2. Layering- This involves a series of financial transactions undertaken through
various businesses to conceal the illegal source of the money. ----------------------
3. Integration–In this stage, the illegal proceeds are made to appear to have
----------------------
come from respectable activities and are finally integrated into the legitimate
system as clean money. ----------------------
Money laundering activities are being carried out for many years by ----------------------
criminals, smugglers and drug dealers among others. However, the 9/11 attacks
brought into sharp focus the threat posed by such illegal money in funding ----------------------
of dastardly acts of terror. Governments across the world initiated legislative
measures to curb the menace of money laundering and to prevent banks from ----------------------
being misused as conduits for money laundering activities. ----------------------
In India, the Prevention of Money Laundering Act, 2002 (PMLA) forms the
core of the legal framework put in place to combat money laundering. It came ----------------------
into force with effect from July 1, 2005. ----------------------
The PMLA 2002 imposes obligations on banking companies, financial
institutions and intermediaries to verify identity of clients maintain records and ----------------------
furnish information to the Financial Intelligence Unit- India (FIU-IND). The Act ----------------------
provides for the freezing, seizure and confiscation of the proceeds of crime.
----------------------
RBI has issued guidelines to banks to initiate the following measures to
prevent money laundering activities through banking channels: ----------------------
A. Maintenance of Records:
----------------------
Banks are required to maintain records for a minimum period of ten years
in respect of the following transactions: ----------------------
i. Cash transactions, both receipts and payments of Rs.10.00 lacs and above ----------------------
ii. Transactions pertaining to forged currency notes ----------------------
iii. Suspicious Transactions
----------------------
Banks are required to monitor transactions in the account of customers and
flag transactions which appear to be suspicious in nature. An example of a ----------------------

Recent Trends in Banking Regulation 237

 Notes suspicious transaction is frequent withdrawal and deposit of large amounts
of cash in the bank account.
----------------------
B. Appointment of Money Laundering Reporting Officer (MLRO)
---------------------- Every bank, financial institution and intermediary must appoint a Money
Laundering Reporting Officer to ensure compliance with the AML guidelines
----------------------
issued by RBI. He shall have the responsibility to report suspicious transactions
---------------------- to the Financial Intelligence Unit attached to the Ministry of Finance (MOF).
C. Staff Training
----------------------
The operating staff of the bank should be trained about the provisions of
---------------------- PMLA and the need to monitor all transactions and to promptly report
---------------------- suspicious transactions to the bank’s MLRO.
D. Audit/Compliance
----------------------
Responsibility has also been cast on the bank’s internal and external or
---------------------- statutory auditors. Internal auditors should check all transactions to verify
that they have been done in compliance with AML guidelines and suspicious
---------------------- transactions, if any, are promptly reported. Statutory auditors are required
---------------------- to issue a certificate about the status of compliance with AML guidelines.

---------------------- Check your Progress 3

----------------------
Multiple Choice Single Response
----------------------
1. This Committee suggested measures to promote and raise the standard
---------------------- of corporate governance.
i. Marathe Committee
----------------------
ii. M. Narsimham Committee
---------------------- iii. Kumarmangalam Birla Committee
2. Corporate governance means
----------------------
i. Monitoring the functions of a company to ensure enhanced
---------------------- shareholder value
---------------------- ii. Appointing professionals to look after the day do day activities
of the company
---------------------- iii. The control exercised by SEBI on a company
---------------------- 3. Money laundering means:
i. Use of only brand new notes by the public
----------------------
ii. It refers to the clean note policy of RBI
---------------------- iii. It is the process of converting money obtained illegally into
legal money
----------------------
4. Money Laundering involves:
---------------------- i. Placement, Layering& Integration
ii. Changing soiled currency with fresh notes
----------------------
iii. Hiding money underground
238 Indian Banking & Financial System
 Notes
Activity 3
----------------------
Refer to www.sebi.gov.in and study the recommendations of Kumarmangalam ----------------------
Birla Committee report.
----------------------

14.6 KNOW YOUR CUSTOMER (KYC) GUIDELINES ----------------------

----------------------
In 2003, RBI issued KYC guidelines with the following objectives:
a) To protect banks against financial frauds ----------------------
b) To identify money laundering and suspicious activities and c)to monitor ----------------------
high value transactions.
----------------------
The guidelines emphasis the importance of Customer Due Diligence (CDD)
while opening customer accounts. KYC has now become an important part of the ----------------------
risk management strategy of banks. In the past, opening of deposit accounts of
customers was perceived to be a low risk activity. In their eagerness to mobilize ----------------------
deposits and achieve business targets, bankers were tempted to accept deposits ----------------------
without ascertaining the source of funds and the credentials of the depositor. It was
only in the lending activity that bankers were more aware of risks involved and ----------------------
consciously tried to manage default risk through proper scrutiny of the borrower’s
integrity and viability of the project. The 9/11 terrorist attacks changed the risk ----------------------
perception of banks when it came to light that banking channels had been misused ----------------------
to fund the attacks. The central banks of countries then went into overdrive and
anti-money laundering and KYC guidelines were framed and advised to banks ----------------------
for compliance.
----------------------
RBI has advised banks to frame KYC guidelines by incorporating the
following key elements for customer accounts: ----------------------
A. Customer Acceptance Policy (CAP) ----------------------
B. Customer Identification Process (CIP)
----------------------
A. Customer Acceptance Policy (CAP)
----------------------
Banks are required to develop a clear policy regarding the criteria for
acceptance of customers. Banks should ensure that no anonymous or ----------------------
fictitious accounts are opened. The account opening process should involve
compilation of a profile of the customer by requiring him to submit some ----------------------
personal financial information. Banks have also been advised to seek
----------------------
introductory reference from an existing account-holder before opening new
accounts. Based on the customer profile, risk categorization of the customer ----------------------
should be done as under:
----------------------
1. Low Risk Category: This category includes accounts of salaried
persons, Government Departments, Government owned companies ----------------------
and regulatory bodies. In view of the low risk involved, accounts can
be opened with minimum identity and address proof documents. ----------------------

Recent Trends in Banking Regulation 239

 Notes 2. Medium Risk Category: These include non-resident customers, high
net worth individuals, trust, charitable organizations. Banks are required
---------------------- to be more vigilant while opening accounts of such customers.
---------------------- 3. High Risk Category: This includes Politically Exposed Persons (PEP).
In respect of such customers, higher due diligence measures should be
---------------------- put in place, while opening and monitoring transactions in accounts.
---------------------- KYC guidelines are applicable to accounts of existing customers also. If it
is found that an account does not meet the parameters set under the bank’s
---------------------- CAP, then it had a right to close the account of the customer, after giving
due notice to him or her.
----------------------
B. Customer Identification Processes
----------------------
Customer Identification Processes (CIP) is a set of processes approved by
---------------------- a bank’s board laying down the means for identifying a customer. This
process tell us down that the identity of the customer should be ascertained
---------------------- by verifying independent and reliable source documents such as passport,
---------------------- election card driving licence, etc. Before establishing a relationship with
the bank, the customer is required to submit the following documents:
---------------------- 1. Identity Proof Documents: This involves verification on the basis of photo
---------------------- identity documents issued by independent authorities to ensure that fictitious
accounts are not opened. The documents that are accepted as identity proof
---------------------- documents include passport, election card, driving licence and PAN card.
---------------------- 2. Address Proof Documents: Banks are required to send various
communications to customers at their address as per bank’s records.
---------------------- Hence while opening an account; the customer is required to submit
documentary proof for the address mentioned in the account opening
---------------------- form. Documents accepted by banks as address proof include copies
---------------------- of recent electricity, telephone or mobile bills. Passport is accepted as
both identity proof document as well as address proof document.
----------------------
It is to be noted that KYC is not a one- time activity and the customer
---------------------- accounts are required to be monitored on an ongoing basis by banks.
With effect from 1st January 2011, KYC guidelines have been made applicable
----------------------
to all mutual fund investors also irrespective of the amount of investment.
----------------------
Check your Progress 4
----------------------

---------------------- Fill in the blanks.

1. The main objectives of KYC norms are i) __________ ii) ___________
----------------------
iii) ________.
---------------------- 2. RBI has directed banks to frame KYC guidelines, which should cover
i) __________ ii) ___________ iii) ________.
----------------------
3. When a new account is opened with a bank, the customer should
---------------------- furnish i) __________ ii) ___________.

240 Indian Banking & Financial System

 Notes
Activity 4
----------------------
Visit a branch of a PSB and that of a new private bank and study their ----------------------
account opening forms with special attention to requirement of documents.
----------------------

Summary ----------------------

----------------------
● During recent years, RBI has initiated measures, in line with international
standards, to strengthen the soundness of the financial system by requiring ----------------------
banks to maintain capital to the extent of 9% of their risk-weighted
assets as against the Basel II guidelines of 8%. It has also formulated ----------------------
and implemented the banking ombudsman scheme to provide a forum for
----------------------
redressal of customer complaints.
● With a view to ensure transparency and accountability of board of directors ----------------------
of banks to achieve corporate governance, it has provided guidelines
regarding ‘fit and proper’ criteria for directors of banks. Banks are required ----------------------
to comply with KYC and AML guidelines to ensure that banking channels ----------------------
are not misused as a conduit for money laundering activities.
----------------------
Keywords ----------------------
● Banking Ombudsman: The banking ombudsman scheme provides ----------------------
the public with a grievance redressal forum against a bank which fails
to resolve grievances. It offers a grievance settlement mechanism to ----------------------
customers in addition to the existing Consumer Protection Act. The
----------------------
banking ombudsman is an official appointed by RBI and he or she seeks
to promote settlement of disputes through conciliation and mediation. If ----------------------
mediation fails, the ombudsman has powers to issue an award.
● Capital Adequacy: With a view to promote safety and soundness of ----------------------
banks internationally, Basel Committee has stipulated that all banks ----------------------
should maintain adequate capital funds to meet the various risks arising
from the assets held on their balance sheet. ----------------------
● Corporate Governance: This refers to ethical conduct of business to ----------------------
protect the interest of the various stakeholders. It emphasizes transparency,
integrity and accountability of the board of directors through supervision ----------------------
and audit.
----------------------
Self-Assessment Questions ----------------------
1. Explain banking ombudsman scheme in detail. ----------------------
2. Discuss the concept of corporate governance and its importance. ----------------------
3. Explain Know Your Customer (KYC) and anti-money laundering (AML)
guidelines in banking. ----------------------

Recent Trends in Banking Regulation 241

 Notes Answers to Check your Progress
---------------------- Check your Progress 1

---------------------- Fill in the blanks.

1. Banks are required to ensure adequacy of capital to cope with the business
---------------------- risks in compliance with Basel II guidelines.
---------------------- 2. Banking Ombudsman scheme was launched in the year 1995 and was last
modified in 2017.
----------------------
3. Basel Accord refers to the framework for capital adequacy.
----------------------
4. Basel committee defined the components of capital, assigned weightage
---------------------- and prescribed minimum ratio of capital.

----------------------
Check your Progress 2
----------------------
State True or False.
----------------------
1. True
---------------------- 2. False
---------------------- 3. True

---------------------- 4. False
5. True
----------------------
Check your Progress 3
----------------------
Multiple Choice Single Response
---------------------- 1. This Committee suggested measures to promote and raise the standard of
corporate governance.
----------------------
iii. Kumarmangalam Birla Committee
----------------------
2. Corporate governance means
---------------------- i. Monitoring the functions of a company to ensure enhanced
---------------------- shareholder value
3. Money laundering means:
----------------------
iii. It is the process of converting money obtained illegally into legal
---------------------- money 4.Money
---------------------- 4. Money Laundering involves:

---------------------- i. Placement, Layering& Integration

----------------------

----------------------

----------------------

242 Indian Banking & Financial System

Check your Progress 4 Notes
Fill in the blanks.
----------------------
1. The main objectives of KYC norms are i) To protect banks from financial
loss ii) To identify money laundering and suspicious transactions iii) To ----------------------
monitor high value transactions.
----------------------
2. RBI has directed banks to frame KYC guidelines, which should cover
i) Customer acceptance policy; ii) Customer identification policy; ----------------------
iii) Customer acceptance policy.
----------------------
3. When a new account is opened with a bank, the customer should furnish
i) Identity proof documents ii) Address proof documents. ----------------------

----------------------

----------------------
Suggested Reading
----------------------
1. rbidocs.rbi.org.in
----------------------
2. Prevention of money laundering Act 2002 (amended in 2017)
3. Risk Management IIBF ----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

Recent Trends in Banking Regulation 243

 Notes References
----------------------
Banking Law and Practice in India - Tannan’s
----------------------
Principles and Practices of Banking - Indian Institute of Banking &Finance
----------------------
Legal Aspects of Banking - Indian Institute of Banking &Finance Indian
----------------------
Financial System - M.Y. Khan
----------------------
Banking Law and Practice - P.N. Varshney
----------------------

---------------------- Risk Management - Indian Institute of Banking &Finance

----------------------

----------------------
----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

----------------------

244 Indian Banking & Financial System