Commercial Banking System

Commercial Banking System
• Topics
– Definition and Nature
– Evolution
– Functions of Commercial Banks
– Products of commercial banks

Definition of Commercial Banks
• Definition of banks take into account what
types of task is performed by the banks.
– According to the Indian Banking Company Act
1949, “A banking company means any company
which transacts the business of banking. Banking
means accepting of deposits from the public, for
the purpose of lending or investment, payable on
demand or otherwise withdraw able by cheque,
draft or otherwise.”

Nature of Commercial Banks
• Commercial banks are an organisation
which normally performs certain financial
transactions. It performs the twin task of
accepting deposits from members of
public and make advances to the needy
and worthy people from the society.

Evolution – Phase I
• Phase I - Pre Nationalisation Phase(prior to 1955)
– The first banks were
• The General Bank of India – started in 1786
• The Bank of Hindustan – started in 1790
– Both are now defunct
• The East India Company established
– Bank of Bengal – 1809
– Bank of Bombay – 1840
– Bank of Madras – 1843
• as independent units and called it Presidency Banks.
• The three Presidency Banks merged to form Imperial Bank of
India – 1921(which, upon India’s independence, became the
State Bank of India).

Evolution – Phase I (Contd….)
– The Allahabad Bank – established in 1865.
• Still functioning today and the oldest Joint Stock bank in India.
– Punjab National Bank – established in Lahore in 1895.
• Survived to the present and is now one of the largest banks in
India.
– Swadeshi Movement – period between 1906 – 1911 – The
Swadeshi movement inspired the establishment of many
banks like – Bank of India, Corporation Bank, Indian Bank,
Bank of Baroda, Canara Bank(1906), Central Bank of
India(established in 1911) and Bank of Mysore.
– RBI came into existence in 1935.

Evolution – Phase I (Contd….)
– Development after Freedom – The next milestone in
history of Indian Banking was India becoming a
sovereign republic wherein the banking sector
witnessed several benefits summarised as follows:
• Reserve Bank of India nationalized in 1949
• Enactment of Banking Companies Act in 1949, later renamed
as Banking Regulation Act.
– RBI assumed extensive regulatory and supervisory powers under
the Banking Regulation Act.
– Marked the change in the outlook of Bank Management, leading
towards the end of traditional banking.

Evolution – Phase II
• Phase II – Era of Nationalisation and Consolidation
Phase(1955 – 1990)
– In 1955 by passing the state bank of India 1955, the
Imperial Bank was taken over and a new bank, the State
Bank of India was formed.
• Extended the banking facilities on a large scale.
– 1956-59 saw the advent of State Bank of India and its 7
associate banks called as the State Bank group for the
purpose of diversification.
– The State Bank of India and its subsidiaries increased their
rural base substantially during the decade 1960’s.

– After Independence the major historical event in
banking sector was the Nationalization Process
which was an important phenomenon – signifying the
entry of Public Sector banks into Commercial
Banking in India.
• Nationalization of 14 major banks were nationalized in 1969.
• 6 more banks nationalized in 1980.
– Idea behind Nationalization of Banks was
• Allow Banking system reach out to rural and semi urban
ares.
• To meet the needs of the needs of diverse kinds of borrowers

– The nationalization of the Banks marked the beginning of
the expansion phase of the Indian Banking Industry.
• Objective of the expansion phase – expand the Banking
facilities in deficit areas and reduce inter-state and inter-district
disparities to support development activities.
• The expansion phase was marked by geographical and
numerical increase of the Bank branches.
– Consolidation Phase –
• 1985 – series of policy measures introduced by RBI to
strengthen Public Sector Banks.
• Emphasis on internal control, customer services, credit
management, staff productivity, and profitability of banks.

– In 1990 – Balance of Payment Crisis occurred
showing that the economic policies were out
of line with the changing environments.
– This crisis facilitated major changes in 1990’s

Evolution – Phase III
• Phase III – Liberalisation Phase(1990 onwards)
– 1990’s – Narasimha Rao Government embarked on a
policy of liberalisation and licensing of a small number
of Private Sector Banks.
• The Private Sector Banks came to be known as New
Generation Tech savvy Banks.
• New generation banks included
– Global Trust Bank(later amalgamated with Oriental Bank of
Commerce).
– Axis Bank(earlier as Unit Trust of India)
– Industrial Credit and Investment Corporation of India Bank(ICICI)
– Housing Development Finance Corporation Limited Bank(HDFC)

– Relaxation in the norms related to Foreign Direct
Investment.
– This phase witnessed the liberal entry of Private and
Foreign Banks, operational freedom, deregulation of
the interest rates, reduction in the SLR and CRR.
– Brought in competitiveness and helped in improving
profitability.
– Another significant instance of this phase was the
entry of mass Computerisation to handle increased
volumes of business effectively and to improve
customer service.

– 1992 onwards –Banking Sector reforms undertaken in
India – primarily aimed at the safety and soundness of the
financial system and to make the Banking industry strong,
efficient and competitive.
– Indian Banking Industry categorized into Scheduled Banks
and Non-Scheduled Banks.
– Scheduled Banks constituted of Commercial Banks and
Co-operative Banks.
– Year 1998 onwards – New delivery channels developed
– ATM, Phone Banking, Internet Banking etc.
– Need for centralised database – due to alternate delivery
channels – solution was Core Banking Solutions(CBS)

– As a part of financial sector reforms State Banks were
given operational flexibility and functional autonomy by
diluting the stake of the Indian Government to 51 percent.
– 2004 – Reforms in monetary and credit policy introduced.
– Another major emphasis in this phase was to have
international accounting standards – introduced in
phased manner with a view to make the Indian Banks
internationally competitive with sound capital base.
– During this phase the RBI stressed on objectives like
• Strengthening of prudential and supervisory norms for Banks,
Improving credit delivery system, Developing technological and
institutional infrastructure for efficient financial sector, Ensuring
stability, Modernising the payment system.

Functions of Commercial Banks
• Commercial Banks perform a variety of
functions broadly classified as
– Primary Functions
– Secondary Functions

• Primary Functions or Banking Functions
– Accepting deposits
– Making Advances
– Credit Creation
• Secondary Functions or Non Banking
Functions
– Agency Services
– General utility services

• Primary Functions or Banking Functions
– Commercial Banks performs various primary
functions :
• Accepting Deposits – Commercial bank accepts
various types of deposits from public especially from its
clients. It includes Savings account deposits, recurring
account deposits, fixed deposits etc. These deposits
are payable at certain time periods.
• Making Advances – The commercial banks provide
loans and advances in various forms. It includes an
over draft facility, cash credit, bill discounting etc. They
also give demand and term loans to all types of clients
against property security.

• Credit Creation – It is the most significant function
of the Commercial Banks. While sanctioning a loan
to a customer, a bank does not provide cash to the
borrower. Instead it opens a deposit account from
where the borrower can withdraw. In oter words
while sanctioning a loan a bank automatically
creates deposits. This is known as a credit creation
from commercial banks.

• Secondary Functions
– The secondary functions of commercial banks can be
divided into agency functions and utility functions:
• Agency Functions – Banks perform certain functions on
behalf of their customers. While performing these services,
banks act as agents to their customers and hence these are
called agency services.Various agency functions of
commercial banks are:
– To collect and clear cheques, dividends , interest warrants and any
other receipts which are to be received by the customer. For these
services banks charge a nominal amount.
– Banks make payments on behalf of their customers like paying
rent, insurance premiums, taxes, elecricity, phone bills etc for
which commission is charged.

– To deal in foreign exchange transactions
– To purchase and sell securities – As per customers
instructions banks undertake sale and purchase of
securities, shares and any other financial assets for
nominal charges.
– To act as trusty, attorney, correspondent and executor –
As a trustee, banks become custodian and manager of
customer funds. Bank also act as executor of deceased
customer’s will. As an attorney the Banks sign the
documents on behalf of the customer.
– To accept tax proceeds and tax returns

• General Utility Functions – The General Utility functions of
the commercial banks include
– To provide safety locker facility to customers
– To provide money transfer facility
– To issue traveller’s cheque.
– To act as referees. – Banks supply information about business
transactions and financial standing of their customers on enquiries
made by third parties.
– To accept various bills for payment eg. Phone bills, gas bills, water
bills etc.
– To provide merchant banking facility. – This is the function of
underwriting of securities. They underwrite a portion of the Public
issue of shares, debentures and bonds. Such underwriting ensures
the expected minimum subcription and also convey to the public
about the quality of the company issuing the securities.
– To provide various cards such as credit cards, debit cards, smart
cards etc.

Products of Commercial Banks
• The products of the Banking industry broadly
include:
– deposit products,
– credit products and
– customized banking services.
• Most banks offer the same kind of products
with minor variations. The basic
differentiation is attained through quality of
service and the delivery channels that are
adopted.

• Deposit Products – Deposit Products are of 2
types
– Time Deposit – These are deposits repayable
after a certain fixed period. These deposits are
can not be withdraw by cheque, draft or by other
means. It includes the following
• Fixed Deposits –
– Deposits can be withdrawn only after expiry of certain
period.
– High rate of interest depending on amount and period of
time.
– In times of urgent needs, premature closure of FD allowed
by paying interest at reduced rate.

• Recurring Deposits –
– Customer opens account deposit certain sum of money
every month
– After certain period, accumulated amount along with
interest paid to customers.
– Interest paid is generally on cumulative basis
– Useful mechanism for regular savers of money.
• Cash Certificate –
– Issued to public for longer period of time
– Its maturity value is in multiples of sum invested
– Attractive and high yielding investment
– These are generally issued at discount to the face value

– Demand Deposit - These are deposits payable on
demand either through cheque or otherwise. Demand
Deposit may serve as medium of exchange, because
their ownership may be transferred from person to
person through cheques. It includes the following:
• Savings Deposits –
– Can only be held by individuals
– Rate of interest is lower than that of time deposits
– Restrictions on withdrawals
– Advantage of liquidity(as in CA) and small income in the form of
interests
• Current Account Deposits –
– Business firms and institutions
– No interest paid on current deposits
– No restriction on withdrawals

• Credit Products – The commercial banks
provide credits in the following forms:
– Overdraft –
• Facility given to holders of Current A/cs only
• Arrangement with the bankers thereby the customer is
allowed to draw money over and above the balance in
his/her account.
• Overdrawing facility Pre-arranged with the bank upto a
certain limit
• Short-term temporary fund facility
• Interest charged on the amount overdrawn
• Facility available to business firms and companies

– Cash Credit –
• Form of working capital credit to the business firms
• Customer opens an account and sactioned amount
credited with the account
• Customer can operate the account within the
sanctioned limit as and when required
• It is made against secutiry of goods, personal security
etc.
• Bank charges interest only on the amount utilized nd
not on the total amount sanctioned/ credited
• Slowly phased out from banks and replaced by loan
accounts.

– Discounting of Bills –
• Banks purchase inland and foreign bills at
discounted values
• The bills are purchased by the bank at face value
less the interest at the current rate till the time
when the bill falls due.
• Bankers reserve rights to debit accounts of the
customers in case the bills are dishonoured
• Banks discount only genuine Commercial bills i.e.,
those drawn against sale of goods against credit

– Loans and Advances
• Short Term – granted to meet the working capital
requirements
• Long Term – granted to meet the capital expenditure
– Direct loans and advances given to all types of customers
mainly to businessmen and investors against personal
security or goods of movable or immovable in nature.
– Loan amount can be paid in cash or by credit to the
customer account which the customer can draw at any time
– Interest is charged for the full amount whether he withdraws
the money from his account or not

– The following types of loans can be availed
from the banks
• Home Loan
• Car Loan
• Education Loan
• Personal Loans – Bank grant credit to household
in a limited amount to buy some durable customer
goods like TV, refrigerators, washing machine etc.
Such loans are repaid in installments.

• Other Customised Banking Services and Products -
– Letters of Credit:
• Letter of Credit is a payment document provided by the buyer's
banker in favour of seller. This document guarantees payment to
the seller upon production of document mentioned in the Letter
of Credit evidencing dispatch of goods to the buyer.
• The letter of credit is an important method of payment mostly
used in international trade.
• There are primarily 4 parties to a letter of credit. The buyer or
importer, the bank which issues the letter of credit, known as
opening bank, the person in whose favour the letter of credit is
issued or opened (The seller or exporter, known as 'Beneficiary
of Letter of Credit'), and the credit receiving/advising bank.
• The Letter of Credit is generally advised/sent through the
seller's bank, known as Negotiating or Advising bank.

– Travellers Cheques:
• Banks issue travellers cheques to help carry
money safely while travelling within India or
abroad. Thus, the customers can travel without
fear, theft or loss of money.
– Money Transfer :
• Many banks provide simple and convenient, online
remittance facility.
• The money can be sent to accounts at all the
branches of the banks across India.

– Credit cards:
• Banks have introduced credit card system. Credit cards
enable a customer to purchase goods and services
from certain specified retail and service establishments
up to a limit without making immediate payment. In
other words, purchases can be made on credit basis on
the strength of the credit card.
– Debit Cards :
• Like a Credit card a debit card too is a payment
mechanism which allows its holder to make purchases
without making any immediate payment.
• At the time of making payment through a debit card, the
amount is instantly debited to the customer’s account.

– Merchant Banking:
• The commercial banks provide valuable services
through their merchant banking divisions or
through their subsidiaries to the traders. This is the
function of underwriting of securities. They
underwrite a portion of the Public issue of shares,
Debentures and Bonds of Joint Stock Companies.
• Such underwriting ensures the expected minimum
subscription and also convey to the investing
public about the quality of the company issuing the
securities. Currently, this type of services can be
provided only by separate subsidiaries, known as
Merchant Bankers as per SEBI regulations.

– Advice on Financial Matters:
• The commercial banks also give advice to their
customers on financial matters particularly on
investment decisions such as expansion,
diversification, new ventures, rising of funds etc.
– Safety Locker facility:
• Safekeeping of important documents, valuables like jewels
are one of the oldest services provided by commercial banks.
'Lockers' are small receptacles which are fitted in steel racks
and kept inside strong rooms known as vaults. These lockers
are available on rental basis.
• The bank merely provides lockers and the key but the
valuables are always under the control of its users.
• Only customers of safety lockers after entering into a register
his name account number and time can enter into the vault.

– Internet Banking Services :
• Internet banking is the ability to use ones’s personal
computer to communicate with one’s bank.
• It enables the customers to execute bank transations
from the PC through financial software of the bank.
• It is being used as a distribution channel to build up
customer contracts in a systematic way in order to
inform, counsel, and sell products and services.
• Internet banking provides anywhere and anytime
banking as services are provided round the clock, easy
access to recent and historical data, direct consumer
control of movement of funds, greater processing
speed and accuracy.

– ATM Services:
• An automated teller machine or automatic teller
machine(ATM) is a computerised telecommunication
device that provides a bank’s customers a secure
method of performing financial transactions in a public
space without a human clerk or bank teller.
• Under this system the customers can withdraw their money
easily and quickly and 24 hours a day.
• A consumer can use an ATM for : deposits/withdrawals
of cash, making balance enquiry, obtaining account
statement, inter account transfer of funds, making utility
payments of bills e.g., electricity, telephone etc. ,
requisition of cheque books

– Mobile Banking :
• Also known as M-Banking, sms Banking etc., refers to
provision and availment of banking and financial
services with the help of mobile telecommunication
devices.
• The scope of offered services may include facilities to
conduct bank and stock market transactions, to
administer accounts and to access customized
informations.
– Demand Draft:
• It is a written order for making payments.
• The person making payments is called drawee and the
recipient is alled payee. The bank providing the service
is called payer.

Commercial Banking System

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