Banking

IntroductionTypes of Banks

Central Bank The RBI is the central Bank that is fully owned by the Government. It is governed by a central board (headed by a Governor) appointed by the Central Government. It issues guidelines for the functioning of all banks operating within the country. Public Sector Banks State Bank of India and its associate banks called the State Bank Group 20 nationalized banks Regional rural banks mainly sponsored by public sector banks Private Sector Banks Old generation private banks New generation private banks Foreign banks operating in India Scheduled co-operative banks Non-scheduled banks

Co-operative Sector The co-operative sector is very much useful for rural people. The co-operative banking sector is divided into the following categories. State co-operative Banks Central co-operative banks Primary Agriculture Credit Societies

Development Banks/Financial Institutions

IFCI, IDBI, ICICI, NABARD, EXIM, NHB, SIDBI

Scheduled And Non-Scheduled BanksIn the case of a scheduled bank, it is licensed by the RBI to carry on extensive banking operations including foreign exchange operations, whereas, a non-scheduled bank can carry out only limited operations.

Commercial And Co-operative Banks

All the nationalized banks in India and almost all the private sector banks are commercial scheduled banks. There are a large number of private sector co-operative banks and most of them are non-scheduled banks.

At present, In India, the banks can be bifurcated into following categories.Public Sector Banks or Nationalized Banks, which are commercial and scheduled Examples: State Bank of India, Bank of India etc.Public Sector Banks, which are co-operative and non-scheduled-These are state owned banks like the Maharashtra State Co-operative Bank, Junnar Co-operative Society etc.Private Sector Banks, which are commercial and scheduled-These could be foreign banks, as well as Indian Banks. Examples: Foreign Banks- CITI Bank, Standard Chartered Bank etc.Indian Banks ? Bank of Rajasthan Limited, VYSYA Bank Limited etc.Private Sector Banks, which are co-operative and scheduled These are large co-operative sector banks but which are scheduled banks. Examples: Saraswat Co-operative Bank Limited, Cosmos Co-operative Bank Limited etc.Private Sector Banks, which are co-operative and non-scheduled-These are small co-operative banks but which are non-scheduled. Examples: Local co-operative banks which operate within a town or a city. Example: Mahesh Sahakari Bank Limited.Gramin Banks, that are also state owned. They operate at still smaller level than RRBs and serve at villages level.

Central Banking and Banking Sector Reforms Chapter 1

IntroductionMonetary policy refers to the policy of the central bank to control money supply, credit and inflation in an economy. The policy has influence on the pace and direction of overall economic activity, including not only the aggregate output and employment but also the general rate at which the prices rise or fall.Govt. carry out monetary policy typically via the central banks.The chief objective of a central bank has been to maintain stability of a countrys general price level (prevent inflation or deflation).Other goals could be maintaining exchange rates, preserving stability in financial markets and fostering increased capital investment to enhance growth.A bank holds reserves in proportion to its deposits. A banks ability to provide loans depends on its ability to create deposits; its total assets and liabilities expand or contract together.

Central Banking: tools and instrumentsOpen market operations and short-term interest rate: Open market operations is the buying and selling of securities (normally govt. securities) by a central bank in the market in order to increase or decrease the outstanding supply of bank reserves and thereby the total money circulation in the economy.An expansionary open-market operation creates downward pressure on short-term interest rates and a contradictory open-market operation creates upward pressure on short-term interest rates. Thus, a well-functioning central bank following these procedures can control short-term interest rates.

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR): Commercial banks are required to maintain reserves in the form of CRR and SLR. A reserve requirement is a percentage indicating how much in reserves a bank needs to hold in relation to its outstanding deposits.Lowering the reserve requirements has the same effect as expansionary and vice-versa.If the central bank increases reserve requirements, a banks credit-creation capacity will come down, i.e. banks would not be in a position to lend more money to the public.CRR is the rate at which banks are required to maintain the reserves with the central bank on a fortnightly basis.SlR refers to the rate at which banks are required to maintain their reserves in govt securities.

Repo contracts: Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often treasury securities.On the termination date, seller repurchases the asset at the same price at which he had sold it, and pays interest for the use of the funds.A repo is a short-term interest bearing loan against collateral,The annualized rate of interest paid on the loan is known as the repo rate.Repos are widely used in the over-the-counter market for investing surplus funds short term, or for borrowing short-term funds against the collateral.The central bank use repos to manage the aggregate reserves of the banking system.

Lending by the Central Bank at the Bank rate: Bank rate is the rate at which central banks lend money to other banks by discounting the bill brought to it.Setting the interest rate at which the central banks lend money to the banks effectively establishes a benchmark for short-term market rates.

Reserve Bank of IndiaThe RBI was set up in 1934, with the stated objective of monetary stability and operations on currency and credit system in India.Shortly after independence, the RBI was nationalised. The early years were characterised by fiscal harmony in monetary policy.The period from 1948 to 1969 was the maturing stage of the RBI into a full-fledged professionally managed central bank.The third phase started with the nationalisation of major banks in 1969. The government became the owner of a number of banks, but the supervision of these banks was conducted by the RBI. The interest rates were administered and the SLR requirements of the banking sector were periodically hiked.Significant achievements in financial reforms including strengthening of the banking supervision capabilities of the RBI have enhanced its credibility and independence.

RBI and monetary policyThe policy of the RBI, known as monetary policy is guided by the objective of provision of adequate liquidity to meet credit growth and support investment demand in the economy while maintaining price levels.The RBI has a policy mix of sterilization, prepayment of external debt and liberalisation of foreign exchange transactions to maintain monetary conditions in line with its overall objectives.Ensuring macro-economic stability has been a concurrent objective with monitoring of price movements.

Terms used by the RBIBank rate: The bank rate is the rate at which banks borrow from the RBI.Repo rate: The repo rate is the rate at which the RBI borrows from the bank. CRR: Cash reserve ratio is the percentage of net funds that commercial banks have to park fortnightly with the RBI to do business.

Banking sector reforms:The Narasimham committeeThe banking sector reforms in the 1990s in India were based on the report of the committee headed by Mr. M. Narasimham in 1991. The committee recommended phasing out of concessional interest rates.The said committee, in its second report on banking sector reforms, submitted in April 1998, made a series of sweeping recommendation which are being used as a launching pad to take Indian banking into future.The report covers an entire gamut of issues ranging from bank mergers and the creation of globalised banks to bank closures, recasting bank boards and revamping banking legislations.

Chapter 2: Interest Rates, Banking and the Financial SectorMonetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with the economys ability to produce goods and services. This stops the output from rising too quickly or slowly.Interest rates are increased to moderate demand and inflation and they are reduced to stimulate demand. If rates are set too low, this may encourage the build-up of inflationary pressure; if they are set too high, demand will be lower than necessary to control inflation.

The Bank rate: Monetary policy operates by influencing the price of money, i.e., the cost of borrowing and the income from saving. The RBI sets the bank rate.This is an interest rate for RBIs own market transactions with financial institutions-the rate at which the RBI will make short-term loans to banks and other financial institutions.

Bank rate and inflationChanges in the bank rate then affects the whole range of interest rates set by commercial banks and other financial institutions, for their own savers and borrowers. It will influence interest rates charged for overdrafts and mortgages, as well as savings accounts.A change in the bank rate also tends to affect the price of financial assets such as bonds and shares, and the exchange rate.These changes in financial markets affect consumer business demand and in turn, output that have an impact on the labour market-employment levels and wage costs-which in turn influence producer and consumer prices.

Bank rate to PLR and deposit rates:As there is a positive correlation between a cut in the bank rate and movement in the interest rate, most banks make downward adjustment in their respective lending and deposit rates following a slash in the bank rate.While a cut in the lending rate would bring down the interest income, it is only logical that most banks would try to compensate for the loss of income by bringing down the interest out-go through an adjustment in deposit rates so as to neutralize the impact on their net interest income.

The effect on demand-spending and saving decisionsWhen interest rates are changed, demand can be affected in various ways. A change in the cost of borrowing affects spending decisions.An increase in interest rates will make saving more attractive and borrowing less. This will tend to reduce current spending, by both consumers and firms.Conversely, a reduction in interest rates will tend to increase spending by consumers and firms.

Cash Flow:A change in the interest rates will affect consumers and fims cash flow. For savers, a rise in interest rates will increase the money received from interest-bearing banks and other deposits. But it will also mean higher interest payments for people and firms with loans-debtors- who are being charged variable interest rates.Lower interest rates will have the opposite effect on savers and borrowers.

Asset pricesA change in interest rates affects the value of certain assets such as house and share prices.Higher interest rates increase the return on savings in banks and PPFs. This might encourage savers to invest less of their money in alternatives, such as property and company shares.Any fall in demand of these assets is likely to reduce their prices. Again, lower rates have the opposite effect-they tend to increase asset prices.

Stock Prices:Ordinarily, a significant fall in interest rates can be expected to reflect in higher stock prices.

Exchange rates:A particular influence on prices comes through the exchange rate.A rise in interest rates relative to those in other countries will tend to result in an increase in the amount of funds flowing into India, as investors are attracted to the higher rates.Other things being equal, an increase in the value of the rupee will reduce the price of imports. A higher rupee will also tend to reduce the demand abroad for Indian goods and services.

Impact of low interest rates:A reduction in the interest rate will have a two-fold effect: it will bring down the interest burden of the corporates and it will help reduce the cost of capital.The feel good factorNot good for risk-averse investorsCheaper loans for the common man

Chapter 3: Banking Functions, Retail Banking and Laws in Everyday BankingNegotiable instruments: instruments that imply transfer by endorsement if payable to the order or by delivery if payable to bearer. These instruments have gained prominence as the principal instruments for making payment and discharging business obligations. The major negotiable instruments are bill of exchange and cheque payable either to order or bearer.

Bill of exchange: it is an instrument in writing, containing an unconditional order, signed by the maker, directing a person to pay a certain sum of money to a certain person or to the order of that certain person or to the bearer of the instrument.

Cheque: the characteristic features of a cheque can be specified as given below:As per the NI Act, a cheque is a bill of exchangeIt is always drawn on a bank and is payable on demandIt has three parties: drawer-a person who draws the cheque on a bank, drawee- a bank on whom the cheque is drawn, payee-a person to whom the payment is to be made by the bank.A cheque can be payable either to order or to bearerWhen a cheque is crossed, the banker shall not pay the amount over the counterWhen a payee accepts a cheque and if it is dishonoured, he can claim the money from the drawerA customer has the right to stop payment before the due date , after he issues the cheque

Difference between cheque and bill of exchange:Every cheque is a bill of exchange but every bill of exchange is not necessarily a cheque.A bill of exchange need not necessarily be drawn on a banker, but a cheque is always drawn on a bank.A bill of exchange may be payable on demand or payable on a future date, not in the case of a cheque.

Types of deposits: classified into demand and timeDemand Deposit: these are two types-Savings deposit: minimum balance, 3.5% int., organisations whose purpose is profit are not allowed to open such accounts as savings accounts are meant to encourage savings habit.Current deposit: since this account is to meet the transaction needs of the consumer, there is no restriction on the number of transactions in the account. No interest paid.

Time deposit: these are also called as fixed deposits or term deposits. These are repayable after the expiry of a specified period varying from 7 days to >5 years. Senior citizens get higher interest rates.

NRI accounts: bank accounts for Non-Resident Indians (NRIs) have three categories:Non-resident(External) Rupee account (NRE)Non-resident (Ordinary) rupee account (NRO)Foreign currency non-resident (Bank) account FCNR (B)

These accounts can be distinguished as follows:While nro and nre accounts can be kept in the form of current, savings or term deposit accounts, FCNR (B) deposit can be kept only in the form of term deposits, for specified periods ranging from 6 months to 3 years.Remittances from abroad can be credited to any of these accounts. But earnings of NRI on the property held by them in India, which are non-repatriable can be credited to only NRO account.Money, from an nro account is non-repatriable but NRE and FCNR deposits are repatriable.The entire interest earned on nro accounts is eligible for repatriation. Persons of Indian nationality who have been NRIs for period of not less than 1 year and have returned to India are eligible to open a RFC-resident foreign currency account.An nro account may be jointly held by residents while nre and fcnr accounts cannot be jointly held with residents. But power of attorney for local payments and investments in India is permitted.Balance held in nre/fcnr accounts are exempted from wealth tax and interest earned is exempted from income tax. There are no tax exemptions on interest earned on nro accounts.

Mandates and power of attorney: an account holder can appoint a third person to act on his behalf to do certain acts like drawing cheques or instructing bank to debit the account for various purposes like issuance of drafts.

Mandates: Features-It is a stamped document and generally executed in the presence of a notary/magistrate of a court.Two types of powers are granted: special and general powers of attorney. Special power of attorney is often for a single transaction and general power of attorney confers an agent very extensive powers.

Lien: lien is the right of the creditor to retain possession of the goods and securities owned by the debtor until the debt due from the latter is paid. General lien gives a right to possess the goods, bankers lien adds to it, the right of sale in case of default by the latter. Therefore, it is called an implied pledge.

Retail Banking: Nature and scopeRetail banking encompasses retail deposit schemes, retain loans, credit cards, deposit cards, insurance products, mutual funds, depository services including demat facilities.It includes various products and services forming a part of the assets as well as the liabilities segment of the banks. It is banking catering to the multiple requirements of individuals relating to deposits, advances and associated services.

Emerging issues in handling retail banking:Knowing the customerTechnology issuesProduct innovationPricing of productsIssues related to human resourcesLow cost and no deposits

Strategies for success in retail banking:Adoption of advanced and latest technologySkilled manpower in all branches and officesBalanced and sustained growth in deposits and advancesStrategic cost mgmtMarket research and market intelligence, in order to formulate competitive and innovative productsRisk managementCustomers relationship mgmtUniversal banking/financial supermarketsMore delivery channelsService quality with a human touch

SWOT analysis of retail banking:

Strengths: low level of NPAs, tendency to default a retail loan is low as these are backed by mortgages of houses in case of housing loans and post-dated cheques in case of other loans like vehicle loans. The housing loan has been proved as a safe advance as a house is considered as the most sensitive and essential asset of a family.

Weaknesses: longer tenure of loans, ranging from min 3 years to 15/20 yrs as against the average deposits of less than 3 yrs

Opportunities: growth in retail lending has outperformed other segments in recent yrs and is expected to continue at much higher rates. Opportunities for banks to offset the demand of funds from the corporate sector. Banks have more opportunities for cross-selling of products.

Threats: incidences of concurrent borrowings are on an increase in case of retail loans through credit cards/other routes. Shrinkage in current accounts (no cost deposits), thereby increasing the average cost of deposits for the bank.

Customer Relationship Management (CRM)CRM and advertising are an integral part of marketing. Advertising is too expensive. On the other hand, CRM is based on word of mouth. Hence, meeting customer needs is most important in the competitive banking sector.CRM has three application areas:Customer acquisitionCustomer value maximisationCustomer retention

Laws in everyday banking:The RBI Act, 1934: the preamble of the act prescribes the objective of the RBI as follows: to regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. The RBI Act, 1934 has defined the mains functions of the RBI as follows:Monetary authorityRegulator and supervisor of the financial systemManager and exchange controlDevelopment roleRelated functions

The Negotiable Instrument Act, 1881:This act was passed to define the law relating to promissory notes, bills of exchange and cheques.

The Banking Regulation Act: It was passed as the Banking Companies Act, 1949 and later changed to Banking Regulation Act,1949 w.e.f 1st March, 1966.Banking means accepting for the purpose of lending or investment of deposits of money from the public repayable on demand or otherwise and withdrawal by cheque, draft order or otherwise.Banking company means any company which transacts the business of banking

Different customers-different laws: there are different laws that apply to different groups which are classified as follows:HUF: it possesses ancestral properties and carries on an ancestral business. The ownership of such property passes on to the member of the family according to the Hindu law.

Societies: voluntary societies committed to promotion of art, science, literature, or to charitable purpose may be incorporated under the following acts:The Societies Registration Act, 1860The companies Act, 1956The Co-operative Societies ActA society gets legal recognition as an entity separate from its members only after its incorporation under one of these acts.

Trusts: according to the Indian Trusts Act, 1882, a trust is an obligation annexed to the ownership of the property, arising out of a confidence reposed by the owner, or declared and accepted by the owner for the benefit of the author, or of the author and the owner.Author: the person who reposes the confidenceTrustee: the person on whom confidence is reposedBeneficiary: the person for whose benefit the trust is formedTrust deed: the document by means of which the trust is formed.

Joint Stock company: it is an artificial entity with perpetual succession brought into existence under the provision of the companies act. While opening a bank account it has to submit certificate of incorporation and certificate of commencement, memorandum of association, articles of association and board resolution.

Sole proprietor and partnership: an individual running business or commercial activity under a name other than his/her own is known as a sole-proprietor.Partnership is defined as relation between two or more persons who have agreed to share the profit of business, run by all or any of them acting for all.

Rights of a banker:The important rights of a banker are:Right of general lien: lien is the right of a creditor to retain the goods and securities owned by his debtor until the debt is paid.Right of set off: under this right, the bank may use the credit balance in another account, when both accounts belong to the same customer.Right of appropriation: at times, a customer takes several loans from the bank. When the receives the payment from the customer, against which loan should the deposit be appropriated? According to the Indian Contract Act, the right of appropriation vests with the debtor. Alternatively, the payment may be under circumstances clearly implying the debt to be discharged. In the absence of such circumstances and instruction from the debtor, the bank, as the creditor can exercise the right. Right to charge interest, levy charges etc.: as a creditor, the bank has the implied right to charge interest on loans given to customers. Periodically the customer account is debited with interest due. The banks may also levy charges to meet incidental expenses incurred on a current account.

Obligations of a banker:Honour chequesWrong dishonour of cheques: the banker is responsible not only for the monetary loss but also for the injury to the customers reputation.Maintain confidentiality: the banker should not disclose any information regarding the account to a third party, ensure no such information is leaked out and prevent such disclosure even after the account is closed except in case required by law and practice and usage among bankers.Premature closure: a bank may allow premature encashment of a fixed deposit at the request of customer and is obliged to ensure that the customer is informed about the penal interest rates and inform the customer while opening the account whether the bank disallows premature withdrawals on large deposits held by entities other than individuals and HUF.Act in good faith without negligence.Deceased depositors: if depositor expires, the banker is obliged to pay the amount to the credit of a deposit account to the nominee.Closure of accounts: the banker must comply with a written directive from the customer to close his/her account. The customer must be asked to return unused cheques.

Chapter 4: Capital-Risk, Regulation and AdequacyBanks need to be regulated because of the risk of a systemic crisis and the inability of depositors who are the primary creditors to monitor banks.More capital may ensure safety and stability, but may reduce profitability. If banks have low risk assets they remain safe, however, banking assets are risky. Banks should increase capital relative to the risks of the assets they hold.One aspect of bank regulation is to ensure that depositors who donot need to withdraw at present are given enough assurance that they will be paid in the future. Depositors need assurance that the bank has enough liquid assets to meet all demands made by depositors.There are four ways to provide this assurance-adequate bank equity capital, deposit insurance, lender of last resort and subordinated debt (A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings). In the early 1980s, concern about international banks financial health increased, as did complaints of unfair competition. It was then that the Basel Committee on Banking Supervision began thinking in terms of setting capital standards for banks.The first Basel agreement (1988) contained some important features, which took into account the relationship between capital and asset portfolio.It is directly linked by a simple formula, the capital requirement of a bank to the credit risk, determined by the banks asset composition. The greater the default risk of the asset portfolio, the higher the required capital.It also prescribed, based on the risk profile of the assets, a minimum amount of equity capital.The capital norms were standardised across countries.At present, Basel II is implemented.

Basel II

The Terminology

Capital to Risk Weighted Assets Ratio (CRAR) is also known as Capital Adequacy Ratio which indicates a bank's risk-taking ability. The RBI uses CRAR to track whether a bank is meeting its statutory capital requirements and is capable of absorbing a reasonable amount of loss.CRAR = (Tier I capital + Tier II capital) / Risk-Weighted Assets

Tier I capital (core capital) is the most reliable form of capital. The major components of Tier I capital are paid up equity share capital and disclosed reserves viz. statutory reserves, general reserves, capital reserves (other than revaluation reserves) and any other type of instrument notified by the RBI as and when for inclusion in Tier I capital. Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative, and retained earnings.

Tier II capital (supplementary capital) is a measure of a bank's financial strength with regard to the second most reliable forms of financial capital. It consists mainly of undisclosed reserves, revaluation reserves, general provisions, subordinated debt, and hybrid instruments. This capital is less permanent in nature.The reason for holding capital is that it should provide protection against unexpected losses. This is different from expected losses for which provisions are made.

Basel II framework rests on the following three mutually- reinforcing pillars:Pillar 1: Minimum Capital Requirements prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk along with market and credit risk. Pillar 2: Supervisory Review Process (SRP) envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority. Pillar 3: Market Discipline seeks to achieve increased transparency through expanded disclosure requirements for banks.

Basel II Norms for Indian Banks

The minimum capital to risk-weighted asset ratio (CRAR) in India is placed at 9%, one percentage point above the Basel II requirement.

As per Basel II norms, Indian banks should maintain tier I capital of at least 6%. The Government of India has emphasized that public sector banks should maintain CRAR of 12%. For this, it announced measures to re-capitalize most of the public sector banks, as these banks cannot dilute stake further, as the Government is required to maintain a stake of minimum 51% in these banks.