Indian Banking System - A Comprehensive Guide

INDIAN BANKING SYSTEM
Abhijeet V Deshmukh

INDEX
➤ Financial System and Financial Intermediaries
➤ Why Banking required??
➤ What is Banking??
➤ CRR, SLR, Fiscal Deficit, Market Ecosystem - Gsec Market Auction Calendar
➤ Money Market & Instruments
➤ History of Indian banking
➤ Post independence - DFI, Agency Problem, Nationalisation of Banks,
➤ Phases -
➤ Pre 1991,
➤ Post 1991 &
➤ 21st century
➤ Indian Banking System Structure
➤ Commercial Bank, Nationalise Bank, Private bank, Foreign Banks, Small Banks, Payment Banks, RRBs, NBFI, Co-operative
credit solution
➤ Indian Banking System - Market Data

FINANCIAL SYSTEM & FINANCIAL
INTERMEDIARIES

FINANCIAL SYSTEM
Financial System of a country is a important tool for the economic development of the country. It consists of
Financial Institutions – Banking & Non Banking with Regulatory, Intermediaries, Non-Intermediaries
Financial Markets
Financial Transactions
Financial Instruments
It helps in
Facilitating Financial Transactions and reducing its speed and cost through technology
Provide Financial & Advisory Services
Provide Legal & Regulatory Framework
Features of Financial System
Plays important role in economic development of a country
Encourages Saving & Investment & links saver & investor
Helps in Capital formation
Helps in allocation of risk from who can take it from who wants to give it
Helps in deepening & broadening of Financial Markets

FLOW OF FUNDS
Creation of Wealth / Allocation & Mobilisation of Savings / providing of funds - my linking Saving with Investment through flow of funds
from Savers ( Households) to Investors (Business Firms) for wealth creation and development of both the parties i.e. Financial Markets
by Financial intermediaries mostly by banks

INDIAN FINANCIAL SYSTEM - DETAIL

INDIAN FINANCIAL SYSTEM - REGULATORY

GLOBAL FINANCIAL SYSTEM
The Global Financial System is the
w o r l d w i d e f r a m e w o r k o f l e g a l
agreements, institutions, and both formal
and informal economic actors that
together facilitate international flows
of financial capital for purposes
of investment and trade financing
Since emerging in the late 19th century
d u r i n g t h e f i r s t m o d e r n w a v e
of economic globalisation, its evolution is
marked by the establishment of central
b a n k s , m u l t i l a t e r a l t r e a t i e s ,
and intergovernmental organisations for
ex World Bank, UN & NATO aimed at
improving the transparency, regulation,
and effectiveness of international
markets.

BANK’S ROLE OF AGGREGATION AND LIQUIDITY GENERATION
Most of the money released by RBI into the economy keeps going in and out of the commercial banking system
where businesses and households maintain their accounts.
Each bank is required to deposit a certain amount of its deposits with the RBI. This is called the cash reserve ratio
(CRR). If a bank gets Rs100 in deposits and the CRR is 10%, then it has to deposit Rs10 with the RBI. It now has Rs90
to lend. This Rs90 is then given to a borrower, who pays it to someone else who puts it in their bank. That bank
then has to deposit Rs9 with the RBI and can now lend Rs 81. This amount may be lent and may make its way to a
third bank, which then has to deposit Rs8.1 with the RBI.
This chain can continue, now looping in another bank which has to pay the RBI Rs7.29. The banks get
Rs100+90+81+72.9…and the RBI gets Rs10+9+8.1+7.29+…What the banks are getting is also going out to the
public and is being used as money.
As the chain of deposits and withdrawals is completed over time, the Rs100 deposit leads to the system getting
Rs1,000 and the RBI Rs100. You can see that the banking system, along with the RBI, has created 10 times the
money that the RBI released to begin with. This is called the money multiplier. This is how Banks play a role of
aggregation and liquidity creation.

BANK BALANCE SHEET & ACTIVITIES

UNION BUDGET 201819 - FISCAL DEFICIT

RUPEE COMES FROM RUPEE GOES TO

RBI AUCTION CALENDAR H1 2018-19

RBI AUCTION CALENDAR [WEEKLY -PLANNED VS ACTUAL]

MONEY MARKET
Money Market refers to a market where financial instruments with high liquidity and short-term maturities are traded.
Money market has become a component of the financial market for buying and selling of securities of short-term maturities,
ranging from overnight to one year, such as treasury bills and commercial papers. These instruments are very liquid and
considered extremely safe.
Money market transactions are wholesale, meaning that they are for large denominations and take place between financial
institutions, Banks and companies. Money market mutual funds offer individuals the opportunity to invest smaller amounts in these
assets.
Money market in India is diversified and has evolved through many stages, from the conventional platform of treasury bills and call
money to commercial paper, certificates of deposit, repos, CBLO, forward rate agreements (FRA) and most recently interest rate
swaps (IRS).
While the G-Secs market generally caters to the investors with a long term investment horizon, the money market provides
investment avenues of short term tenor. Money market transactions are generally used for funding the transactions in other markets
including G-Secs market and meeting short term liquidity mismatches.
Depending upon the tenors, money market is classified into:
i. Overnight market - The tenor of transactions is one working day.
ii. Notice money market – The tenor of the transactions is from 2 days to 14 days.
iii. Term money market – The tenor of the transactions is from 15 days to one year.

MONEY MARKET INSTRUMENTS
Call money market
Call money market is a market for un-collateralised lending and borrowing of funds. This market is predominantly
overnight and is open for participation only to scheduled commercial banks and the primary dealers.
Treasury Bill
Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued by the Government
of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon
securities and pay no interest. They are issued at a discount and redeemed at the face value at maturity as are used a
working capital of the Government.
Commercial Paper (CP)
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. Corporates,
primary dealers (PDs) and the all-India financial institutions (FIs) that have been permitted to raise short-term resources
under the umbrella limit fixed by the Reserve Bank of India are eligible to issue CP. CP can be issued for maturities
between a minimum of 7 days and a maximum up to one year from the date of issue.
Certificate of Deposit (CD)
Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form or as a
Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Banks
can issue CDs for maturities from 7 days to one year whereas eligible FIs can issue for maturities from 1 year to 3 years.

Repo market
Repo or ready forward two leg contact is an instrument for borrowing funds by selling securities with an agreement to
repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds
borrowed.
The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an
agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the
funds lent.
It can be seen from the definition above that there are two legs to the same transaction in a repo/ reverse repo. The duration
between the two legs is called the ‘repo period’. Predominantly, repos are undertaken on overnight basis, i.e., for one day
period. Settlement of repo transactions happens along with the outright trades in G-Secs.
The repo market is regulated by the Reserve Bank of India. All the above mentioned repo market transactions should be
traded/reported on the electronic platform called the Clearcorp Repo Order Matching System (CROMS).
These transactions take place in the OTC market and are required to be reported on FIMMDA platform within 15 minutes of the
trade & they are also to be reported on the clearing house of any of the exchanges for the purpose of clearing and
settlement.
As part of the measures to develop the corporate debt market, RBI has permitted select entities to undertake repo in
corporate debt securities. Only listed corporate debt securities that are rated ‘AA’ or above by the rating agencies are eligible
to be used for repo. Commercial paper, certificate of deposit, non-convertible debentures of original maturity less than one
year are not eligible for this purpose.

Collateralised Borrowing and Lending Obligation (CBLO)
CBLO is another money market instrument operated by the Clearing Corporation of India Ltd. (CCIL), for the benefit of
the entities who have either no access to the inter-bank call money market or have restricted access in terms of
ceiling on call borrowing and lending transactions.
CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from one day
to ninety days (up to one year as per RBI guidelines).
CCIL provides the Dealing System through Indian Financial Network (INFINET), a closed user group to the Members of
the RBI CBS E-Kuber, who maintain Current account with RBI and through Internet for other entities who do not maintain
Current account with RBI. Membership to the CBLO segment is extended to entities who are RBI- NDS members
By participating in the CBLO market, CCIL members can borrow or lend funds against the collateral of eligible
securities. Eligible securities are Central G-Secs including Treasury Bills, and such other securities as specified by CCIL
from time to time.
Borrowers in CBLO have to deposit the required amount of eligible securities with the CCIL based on which CCIL fixes
the borrowing limits. CCIL matches the borrowing and lending orders submitted by the members and notifies them.
While the securities held as collateral are in custody of the CCIL, the beneficial interest of the lender on the securities is
recognized through proper documentation.

MONEY MARKET OPERATIONS AS ON 31ST MAY 2018

INDIAN BANKING SYSTEM -
HISTORY & EVOLUTION

HISTORY OF INDIAN BANKING
There are phases of Indian Banking System
Pre Independence (pre 1947) phase
Post Independence 1947 - 67 (End of Managing Agency Houses)
Post Independence 1967 - 1991-92 (Nationalisation Phase)
Post Financial Reforms 1992 - 97 - Phase I
Post Financial Reforms 1997- beyond - Phase II

PRE INDEPENDENCE (PRE 1947) PHASE
This phase is characterised by the presence of a large number of banks (more than 600)
There were no entry norms and Swadeshi Movement was instrumental for existence of many banks. This phase saw two
World Wars and a Great Depression which lead to failure of many banks which either were very small to withstand the
pressure or were mismanaged by the shareholders.
In light of failure of many banks, RBI was formed in April 1935 based on recommendation of Hilton Young Commission but
it couldn’t stop the failure of banks and couldn’t gain public confidence in the banking system. Also its control over banks
was limited.
Public continued to rely on dominating unorganised sector i.e. money lenders
Few highlights of this phase
The first bank in India was Bank of Hindustan in Calcutta (1770 - 1832)
Some successful banks which are still continuing - Allahabad Bank (1865); Punjab National Bank (1894 HQ Lahore);
Bank of India (1906); Bank of Baroda (1908), Central Bank of India (1911)
Bank of Bengal (1806), Bank of Bombay (1840) Bank of Madras (1843) merged to form Imperial Bank of India in 1921.

POST INDEPENDENCE 1947 - 67
The first major development post independence was enactment of The Banking Companies Act (also known as Banking
Regulation Act) in 1949 to address the issue of banking failure.
On 1st Jan 1949, Reserve Bank of Indian (RBI) was nationalised. RBI was empowered to regulate and control the banking
sector. RBI in this phase was able to improve the safety and soundness of the banking sector to some extent
Deposit insurance was introduced during this period to gain the public confidence in the banking system.
The Imperial Bank of India later renamed as State Bank of India in 1955. The branch network of SBI was expanded to
reach out to the rural area during this phase.
Establishment of major Development Financial Institutions was the highlight of this phase to counter the domination of
British controlled Agency Managers which continued till end of 1960’s.
However the nexus between banks and big industrial houses resulted in very little credit percolating down to the
productive sector - small industries, public and agriculture. RBI tried to address this issue through micro controls but this in
turn resulted in the birth of complex structure of regulated interest rates.

POST INDEPENDENCE 1947-67 - END OF MANAGING AGENCY HOUSES
The former servants of the East India Company set up their business as general merchants. In the Course of trading, they
came to acquire an intimate knowledge of the local markets and of the ways to exploit them. These traders, making
effective use of their connections with the British monopolies and acting as their agents, constituted a sort of pipe-
line “through which British Capital flowed to India even after independence for almost 15 years and got distributed
among the varied enterprises promoted by the British managing agent thus stroking deep roots in the industrial
organisation of India.
Many attribute the emergence of the Managing Agencies Houses to the shortage or absence of well-developed
modern banks
There were 3944 active managing agencies in the whole of India in 1954-55.
The concentration of capital and economic power was the highest in the case of a handful of leading agencies as is
evident from the fact that a mere 17 managing agents managed 359 companies representing 1/4 of the entire paid up
capital of all managed companies.
The control of the managing agency was by far the greatest in the case of public limited companies where they
controlled 40.7% of the companies accounting for 66.3% of the paid-up capital of all public limited companies in the
country.

POST INDEPENDENCE 1947-67 - END OF MANAGING AGENCY HOUSES
In the case of some 59 industries including coal mining, rayon manufacture, paper and paper board, cement,
jute spinning and weaving, cotton mills, matches, tea, sugar, Iron and steel and Artificial silk - more than 50% of
the groups’ paid up capital belonged to companies managed by managing agencies.
According to the commission which conducted enquiry into the jute industry in 1953, 75% of all the mills were
controlled by a dozen managing agencies while four of them controlled 45% of all weaving looms.
The overwhelming majority of the agencies continued to be concentrated in the three major business states of
Bengal, Bombay and Madras which together controlled 4/5 of all joint-stock companies managed by managing
agents in the country.
There was a decline in the number after August, 1960 when all old managing agency agreements expired. On 31
March, 1964, the number of managing agents came down to 885 fro 3944 in 1955. There after there was end of
Managing Agencies era due growth of banking system in India as nationalisation of banks happened. Also
Development Finance Institutes became very active across India.

POST INDEPENDENCE 1967 - 1991-92 (NATIONALIZATION PHASE)
The major highlight of this phase was introduction of ‘Priority Sector’ i.e. equitable credit flow to the agriculture, small
sector & public.
This phase also saw nationalisation of major banks. Regional Rural Banks (RRB) formed in 1975 on recommendation of
Narasimhan committee to serve large unserved population. New DFI were established for various sectors NABARD(1982),
EXIM(1982), NHB(1988) & SIDBI(1990)
The bank branches expansion was rapid and credit was mostly went to meet the high target set for lending to Priority
sector. Thus credit to medium and large industries was more difficult to get. This was knee jerk reaction to the previous
phase were most of the credit went to industries.
Banking system was suffering from low profitability, efficiency & productivity due to
High lending to Priority sector the asset quality was low and thus there was no income to the banks from it (in today’s
term NPA) coupled with low capital
High statutory ratio’s CRR & especially SLR to fund government borrowing at low interest rate. This phenomena is also
know as subservience of monetary policy to the fiscal policy blocking the development of the financial system
Stringent norms on credit to non-priority sector i.e. medium and large industries
Administered and regulated interest rates
Excessive micro-regulation by RBI on interbank funds (flow of funds between banks)
Entry barrier to efficient player in the banking arena
Lack of transparency in account practices and disclosures
The Capital and Forex market were excessively controlled leading to malpractices in these markets
The Foreign Exchange Regulation Act (FERA) was legislation passed in India in 1973 that imposed strict regulations and
it resulted in a serious balance of payment problem where we left with Forex reserves were hardly sufficient to cover
three weeks import. This lead to a new era of globalisation which changed everything.

NATIONALISATION OF BANKS
“Nationalisation of Banks” is defined as “government taking control over assets and over a private corporation, usually by
acquiring the majority or the whole stake in the privately held banks.
Reason for Nationalisation of Banks
majority of the banks where in hands of private.
The banks were mostly catering to needs of large industries and big industry houses
Sector such as agriculture, small-scale industries and export were lagged behind.
Poor public were continued to be exploited by the dominant Money lenders
Fourteen commercial banks were nationalised on 19th July 1969 - Central Bank of India, BOI, PNB, BOB, United Commercial
Bank, Canara Bank, Dena Bank, United Bank, Syndicate Bank, Allahabad Bank, Indian Bank, Union Bank of India, Bank of
Maharashtra, Indian Overseas Bank.
Six additional banks were nationalised in April 1980 - Andhra Bank, Corporation Bank, New Bank of India, Oriental Bank of
Commerce, Punjab & Sindh Bank & Vijaya Bank
Impact of Nationalisation of Banks
Improved efficiency in the Banking System - since the public confidence got boosted.
Economic growth due to credit flow to priority sector like agriculture, small & medium industries
Increased penetration of Bank branches in the rural areas.

POST FINANCIAL REFORMS 1992 - 97 - PHASE I
This phase was on backdrop of the balance of payment problem. There was need for a vibrant and competitive
banking and financial sector.
Government of India constituted a committee on financial system (CFS) under the chairmanship of Shri M
Narasimham popularly know as Narasimham committee. The salient feature of the committee’s recommendations
are widely acknowledged as the very foundation of the country’s financial sector reform process.
The approach to reform was guided by the ‘Pancha Sutras’
1. cautious and sequenced reform measures
2. introduction of reinforcing norms
3. introduction of complimentary reforms across relevant sectors - monetary, fiscal, external & financial
4. Development of financial institutions
5. development and integration of financial markets
A major highlight was that the improved profitability, competitiveness, capital position & asset quality of most banks.
However, banks do developed a risk aversion attitude which translated into a slower credit growth especially to the
agriculture sector.

POST FINANCIAL REFORMS 1997 & BEYOND - PHASE II
This phase of banking shown the push towards prudential norms in line with international best practices i.e. BASEL norms.
New private sector banks were allowed and it enhances competition amongst banks. Kotak Mahindra Bank (2001) & Yes
Bank (2004)
Thrust in this phase was on improving credit delivery and customer services, strengthening corporate governance
practices, improving Urban Co-operative bank sector, promoting financial inclusion & control NPA levels. Banks were able
to reduce NPA levels sharply in this phase and thus it added to the capital adequacy of the banks as asset quality
improved.
This phase also witnessed increasing use of technology by banks and customers
The Raghuram Rajan committee report 2009 offer its view on three critical aspects of economic growth for India -
financing infrastructure growth, financing old age pension & information generation.
This phase post 1991 seems many committees being constituted and the reports were implemented as well - Narasimham
committee 1991 & 1998 on Financial sector reform and banking sector reforms; Mt Tarapore committee 2006 on Full
account convertibility; Raghuram Rajan committee 2009 on financial sector reforms.
The Financial Code 2015 has proposed many changes most of which are towards reducing the pressure on the Reserve
Bank of India and allowing finance ministry to participate actively in the market.
The way forward for the Indian Financial System is Financial Stability coupled with adopting technology in banking
operations

EVOLUTION OF THE INDIAN BANKING SYSTEM - SNAPSHOT

THE STRUCTURE

THE STRUCTURE OF INDIAN BANKING SYSTEM - SNAPSHOT

PUBLIC SECTOR BANKS
There are 27 public sector banks in India including SBI & its five associate banks
PSU bank are regulated by statutes of the Parliament and some important provisions under Sec 51 of BR Act, 1949.
Three phases of Equity infusion
1992-93 all nationalised banks were capitalised without any predetermined norm
1993-95 - some ‘weak’ nationalised bank were put on recovery path for compliance with BASEL norms
2006-07 - banks were allowed to raise capital through equity issue uphill 49% of their equity base
Board of PSU bank comprise of Whole time director - chairman, Managing director(s), executive directors,
Government nominated director, RBI nominee director, workmen and non-workmen directors and other elected
directors
as per latest news, Indian Government has recently constituted the Bank Board Bureau (BBB) for selection of
Managing Directors and Directors of PSU banks & Financial Institutions. This is light of recent frauds and unprofessional
management in PSU banks leading to high NPA levels.

PRIVATE SECTOR BANKS
There are 22 Private sector banks in India
Underlying principle in permitting the private sector is to ensure that ownership and control is well-diversified and
sound corporate governance principles are observed.
The eligible capital requirement is INR 5 billion and this is also minimum net worth that should be retained at all the
times
As per latest guidelines for licensing new banks in 2013
Permission to business/industrial houses to promote banks,
Conversion of NBFC to banks,
Public sector entities cans setup private sector banks through Non-operative Financial Holding Company (NOHFC)
structure.
In August 2016, RBI permitted ‘on tap’ licensing of new private bank to float Universal bank as continuation to
guidelines issues in 2013. Accordingly, IDFC Ltd & Bandhan Financial Services were allowed to set up universal bank
with condition to list its share on stock exchange with six years from commencement of business.

FOREIGN BANKS
There are 44 foreign banks in India
Foreign banks were allowed to foster the inherent potential for sustained growth in the domestic economy and growing
integration with the global economy.
In 2004, RBI came up with regulation to set Wholly Owned Subsidiaries (WOS) for the foreign banks and roadmap was
published in 2005 in tow phases - First phase March 2005 - March 2009 & phase two based on review of Phase I and for
period beyond 2009
First Phase 2005-09, Foreign Banks operating in India were allowed to convert existing branches to WOS
Second Phase - Apr 2009 onward - only WOS route is permitted for foreign bank to operate in India.
WOS advantages are - Local incorporation with separate legal entity and own capital base & Local BOD with same
treatment as PSU banks in conduct of business; Clear distinction between WOS and Parent bank;
Eligibility is paid up capital of INR 5 billion; dilution of stake from 100% to 74%.
To prevent dominance of Foreign bank post implementation of WOS, entry of new WOS will be restricted if capital &
reserve of all WOS operating in India exceed 20% of capital & reserves of entire Indian Banking System.

SMALL FINANCE BANKS (SFB)
To cater needs of small value customers, so in Nov 27, 2014, RBI permitted licence to Small Finance Banks. It is regulated by Sec
5(b) & 6(1)(a)to(o) of BR Act, 1949.
As per guidelines, objectives are - give a fillip to Financial Inclusion by
providing saving vehicle; supplying credit to small business units, smaller and marginal farmers, micro and small industries and
unorganised sector through high technology, low cost operations.
Eligibilty - Individual/professional with 10 year experience in Banking & Finance industry; companies or societies owned &
controlled by resident including existing NBFC, Micro Finance Institutions (MFI) & Local Area Bank (LAB); Minimum paid up
capital is INR 1 billion and minimum initial contribution should be 40%. Foreign shareholding will be determined by the FDI
policy.
SFB is required to follow all prudential norms & regulations applicable to commercial banks including maintaining CRR & SLR.
Also SFB lending is to be made to sector specified by RBI.
In March 2017, Ten SFB have been granted licence of which 8 are MFIs.
MFI are a category of NBFC which are permitted to lend to Self Help Groups (SHG) & Joint Liability Groups (JLG) by borrowing
funds from banks.
MFI prefer to become SFB coz they get access to deposit; participate in bank payment system enabling cheque payment a&
e-payment & now they can make bigger loans to small borrowers.

PAYMENT BANKS
They are essentially ‘Narrow Banks’ i.e. they don't undertake Lending activities and just safeguard deposit placed
with it by investing in Government securities.
In November 2014, Payment banks were authorised by RBI to provide - small saving accounts; payment /
remittence services to migrants labour workforce; low income households; small businesses; unorganised sectors.
Permitted activities
To accept deposit with restriction of INR 1 lac per customer; can distribute non-risk sharing simple financial
products like mutual fund and insurance products; need to maintain CRR; Minimum 75% of demand deposit should
be in invested in SLR; Maximum 25% should be held in demand or fixed deposit with other commercial bank
Eligibility: minimum paid up capital of INR 1 billion; promoter should contribute at least 40% of the equity and hold
the stake for the first five years. Foreign holding is as per FDI policy.
Since payment banks are intended as a tool for Financial Inclusion, they have to provide 25% of its branches in
unbanked rural centres (population up to 9,999 as per the latest census)
As per June 2017 six payment banks are permitted to function.

REGIONAL RURAL BANKS (RRB)
RRB’s were formed for rural credit delivery and ensure Financial Inclusion.
These are jointly held by Central Government, State Government & sponsor Commercial Bank int he ratio of
50: 15 : 35.
Recently, amalgamation & recapitalisation of RRB’s has been initiated in phase manner.
In phase one for period 2005 - 2010; RRBs of the same sponsor banks within a state were amalgamated and
number of RRB’s were reduced to 82 from 196.
Phase two, starting from October 2012, geographically contiguous RRBs within a state but under different
sponsor banks would be amalgamated to have just One RRB in a medium sized state and two or three in a
large state. Currently there are 56 RRB’s out of which 45 are profitable.
The main issue hampering RRB’s efficiency is the multiplicity of control - RBI & NABARD.

NON BANKING FINANCIAL INSTITUTIONS (NBFI)

NBFI - ALL INDIA FINANCIAL INSTITUTIONS

NBFI - NON BANKING FINANCIAL COMPANIES (NBFC)

THE MARKET

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