The banking system is a fundamental pillar of any modern economy. It plays a crucial role in facilitating financial transactions, providing loans, and supporting economic growth.
History of Banking
Banks have come a long way since their inception. Historically, banking can be traced back to ancient civilizations like the Babylonians, who engaged in basic financial activities. Over time, the concept of banking evolved, with notable developments in Renaissance Italy and the establishment of central banks in the 17th century. Understanding this history is essential to appreciate the significance of the modern banking system.
Types of Banks
Commercial Bank
A commercial bank is a type of financial organization that handles all transactions involving public money deposits and withdrawals, lending money for investments, and other similar activities. These banks are for-profit organizations that operate solely for financial gain.
Lending and borrowing are a commercial bank’s two main qualities. The bank accepts deposits and disburses funds to various initiatives so that interest (profit) can be earned. The borrowing rate is the interest rate that a bank charges its depositors, whereas the lending rate is the interest rate at which a bank extends credit.
Commercial banks are split into the following three categories:
Public Sector Banks (PSBs)
It is a particular class of nationalized bank in which the government has a sizable ownership interest. For instance, Bank of Baroda, Punjab National Bank, Dena Bank, Corporation Bank, and State Bank of India (SBI).
Private Sector Banks
More than 51% of the share capital in this bank is owned by private organizations. Like the Industrial Credit and Investment Corporation of India (ICICI) Bank, Yes Bank, Kotak Mahindra Bank, and other similar banks, or the Housing Development Finance Corporation (HDFC) Bank.
Foreign Sector Banks
Over 51% of the share capital in this bank is owned by foreign entities. Examples of such banks are American Express Bank, Citibank, Standard & Chartered Bank, and Hong Kong and Shanghai Banking Corporation (HSBC).
Differential Banks
Differential banks, often known as “niche banks,” offer banking services. These banks may differ in terms of capital requirements, the range of their activities, or the needs of a particular demographic group they serve. The Nachiket Mor group proposed the differentiated bank concept in 2014 to promote financial inclusion. It can be categorized as a payment bank, small finance bank, regional rural bank, local area bank, wholesale and long term finance bank.
Regional Rural Bank (RRB)
RRB is a financial institution that makes sure that agriculture and other rural sectors get enough financing. They were described as a low-cost institution with a “rural ethos and pro-poor focus” but commercial bank experience. In 1975, it was established in accordance with the Narshiman Committee’s recommendations.
In a ratio of 50:15:35, the central government, the relevant state government, and the sponsor each hold a piece of RRB’s share capital.
Regarding CRR and SLR, RRB is on par with commercial banks. RRB’s priority sector lending goal is 75%.
Small Finance Bank
They offer unbanked groups like small and marginal farmers, MSMEs, and unorganized sector entities basic banking services like receiving deposits and lending money.
They focus primarily on tiny areas in rural and semi-urban settings. They had to keep the CRR and SLR in check.
The goal for lending to the prioritized sectors is 75%.
At least 25% of a small finance bank’s branches must be located in rural areas, and at least 50% of the portfolio must be made up of loans under 25 lakh.
Payment Bank
Payment Bank is a differential bank with a limited range of products. A deposit of up to 1 lakh rupees may be made. It can issue ATM cards, however CRR and SLR regulations must be followed. It can provide loans and credit cards, unlike typical banks.
Development Bank
Other names for development banks include All India Financial Institution (AIFI). Development Banks are created by a parliamentary legislation. As a result, they are financially supported by the government through budget.
They don’t take deposits from regular citizens instead they offer medium to long term financing to companies together with support services like arranging foreign exchange, technical or management consulting, bank guarantees, etc.
There are now 4 development banks in India, each of which attempts to develop a specific industry.
Export and Import Bank of India (EXIM)
Established in January, 1982. It encourages cross-border investment and trade while providing loans and foreign currency to importers and exporters.
National Bank for Agriculture and Rural development (NABARD)
Founded in July, 1982. For the growth of agricultural and rural areas, it offers indirect refinancing to farmers and rural residents. Additionally, NABARD serves as a regulating body for RRBs and cooperative banks.
National Housing Bank (NHB)
Launched in 1988. For housing-related purposes, it offers financing to banks and NBFCs (non-banking finance companies).
Small Industries Development Bank of India (SIDBI)
It was started in 1990 with the intention of growing small industries.
Cooperative Bank
Under the 1966 Banking Regulation Act, cooperative banks are governed by the RBI. For cooperative banks, CRR and SLR are applicable, although RBI will maintain a different rate. Lending to priority sectors is only available to urban cooperative banks. Members will be given priority in deposits and borrowing.
Each member of the cooperative society, regardless of the amount of capital they contributed, is given one vote. In Karnataka, Maharashtra, Gujarat, West Bengal, and other states, cooperative banks are most common.
Casteism, politics, poor loan recovery, nepotism, money laundering, fund diversion, etc. are some of the biggest problems cooperative banks face.
main credit for agriculture Cooperative societies are not banks; they cannot issue cheque books and are not governed by the RBI; instead, they are governed by the state cooperative registrar.
As a result of scams and subpar loan recovery, cooperative banks in urban areas are frequently in the headlines. To safeguard depositors, the government modified the Banking Regulation Act of 1949 in September 2020. This amendment states that only the RBI will have control over the urban cooperative bank.
State and RBI control will be shared over the remaining cooperative banks (rural cooperative banks). Recently, the RBI established the Viswanathan Committee to enhance urban cooperative banks. There is also a proposal to turn urban cooperative banks into small finance banks, giving the RBI sole responsibility over these institutions.
How Banks Operate
Banks operate through various activities, including accepting deposits, granting loans, and offering a wide range of financial services such as asset management and investment advisory. These operations are the lifeblood of the banking system, fueling economic activities, investments, and personal financial goals.
Non Banking Financial Companies (NBFCs)
NBFCs are subject to Companies Act regulation. There are around 10,200 registered NBFCs. Only 108 of them accept deposits. The remainder does not accept deposits. Only deposit-taking NBFCs are permitted to accept deposits that are time deposits. They are unable to issue debit cards, credit cards, or cheque books. SLR only applies to NBFC-D, however RBI may impose a different percentage. Any sort of NBFC is exempt from CRR.
Banking and Financial Inclusion
An inclusive finance refers to the provision of financial services (not just banking at an affordable cost) to the great majority of the society’s underprivileged and low-income groups. In order to help vulnerable groups like low-income groups and weaker sections, etc., raise their income, acquire capital, manage risk, and work their way out of poverty, financial inclusion enables them to do so by gaining access to savings, responsible credit, insurance products, and payment services.
To attain financial inclusion, a number of initiatives were started. For instance:
Nationalization of private banks
Lead bank scheme, 1969
Priority sector lending, 1972
Establishment of RRBs
Narshiman Committee on bank sector reforms, 1991 and 1998
No frills account, 2005
Banking correspondent agent model, 2006
Swabhiman scheme, 2011
Pradhan mantra jan dhan yojana, 2014
Establishment of payment bank
Establishment of small finance bank
Non Performing Assets (NPA)
If a loan account’s principal or interest payments are past due by more than 90 days, it is categorized as a “non-performing asset.”
For agricultural loans, NPA is measured in cropping seasons rather than days. NPAs have occurred with respect to 10% of scheduled commercial banks’ loans.
The Narshiman Committee on Banking Sector Reforms noted that regular courts issue stay orders to borrowers. Therefore, it is difficult for banks to recover NPA. Therefore, he suggested creating DRTs (Debt Recovery Tribunals). DRT was thus formed across India in 1993.
The Narshiman II Committee noted in 1998 that DRT required legal reinforcement. He therefore suggested passing the SARFACEA Act. The SARFACAE Act was passed in 2002. Act on the securitization, reconstruction, and enforcement of security interests.
When a loan is not repaid, lenders may attach collateral or mortgage assets under the SARFACAE statute. They can alter the BOD of such corporations, put such assets up for auction, or sell them to firms that specialize in asset rehabilitation. The SARFACAE Act does not apply to loans for agriculture. Loan defaulter cannot go to regular courts to request a stay order. For DRT, he will have to approach. He may file an appeal with the Debt Recovery Appellate Tribunal (DRAT) if the DRT is unhelpful. However, the court should receive 50% of the loan balance. The burrower may approach the High Court or Supreme Court following DRAT.
Understaffing affects DRT and DRAT. The number of open cases exceeds 100,000. Even if DRT alone holds an auction of the asset later, the item’s worth will have decreased because the case will drag on for years and the debtor will still be in control of it.
In some industries, the banks may not receive the best return from an auction on liquidation. In such circumstances, if loans were restructured to lower interest rates, extend terms, etc., banks may have generated more value, but the SARFACAE Act prevents such arbitration or resolution, therefore the government created a new law in 2016 known as the Insolvency and Bankruptcy Code.
Insolvency and Bankruptcy Code, 2016
IBBI requests 330 days of DRT time when the case involves it. An insolvency specialist will develop a resolution strategy during that time, such as lowering loan interest rates, extending loan terms, finding new investors to fund the project, etc.
If there are several lenders, then 66% of the loan amount must be agreed to by each lender before a resolution plan can be implemented; otherwise, liquidation will be advised as a means of recouping the debt.
The following burrowers are exempt from IBC:
Willful Defaulter
A borrower who has the capacity to pay back the debt but is not doing so.
Incapable Defaulter
A borrower whose loan account has been in non-performing status for more than a year and who is unable to repay even a small portion of the loan.
Insolvency and Bankruptcy Board of India (IBBI)
It is a statutory body tasked with monitoring and implementing the IBC, 2016. only has one chairman. A total of 10 individuals in all, eight from the government and one nominee from the RBI. IBBI is under the administrative supervision of the Ministry of Corporate Affairs. Professional insolvency firms are selected by IBBI. These organizations will enroll and oversee the members who are employed as insolvency professionals (IP). There are presently three organizations designated as IPAs.
The Indian Institute of Chartered Accountants.
The Indian Institute of Company Secretaries.
The Indian Institute of Cost Accountants.
IBBI also selects the information utility company to maintain the borrower database.
In2017, National E-Governance Service Limited, or NeSC, was the first to contact IBBI to request information utility status. Lenders must give the Information Utility their data. Prime Borrower and Sub-Prime Borrower are the two categories of borrowers.
The ability to repay the loan is what the term “prime borrower” refers to. A sub-prime borrower is one who lacks the ability to pay back the loan. Giving subprime borrowers high rate home loans caused the subprime crisis in the USA in 2007–2008, which ultimately contributed to the world financial crisis. Overleveraged borrowing refers to a firm that has borrowed more money than it is able to repay. Up until 2005, the world economy was booming. Indian corporate enterprises took out enormous loans and overleveraged themselves.
India’s exports declined in 2007–2008 due to the global financial crisis and subprime mortgage crisis. Projects were hampered by the inaction of government policy, judicial activism, environmental activism, etc. Companies started having trouble completing the project and paying back the debt.
By 2013, companies with an interest coverage ratio of 1 or below, or IC-1 corporations, owned 1/3 of all bank loans. which indicates that they were not making even enough money to pay the interest on the loans. If the interest coverage ratio is greater than 1, the company is a good company; if it is lower than 1, the company is a bad company.
As a result, the balance sheets of some major corporations that are PSBs have weakened, leading an economic survey conducted in 2015–16 to coin the term “Twin Balance-sheet Syndrome.”
Starting in 2013, NCLT (National Company Law Tribunal) will be in charge of handling company NPA matters, while DRT will be in charge of individual NPA cases.
Prompt Corrective Actions (PCA)
Bimal Jalan, the governor of the RBI at the time, designed PCA in 2002 for all scheduled commercial banks aside from RRBs. Urjeet Patel substantially strengthened PCA standards in 2017. NABARD announced a unique PCA framework for RRBs in 2018. The following variables are tracked for all commercial banks under the PCA framework:
Capital sufficiency (Basel III)
Asset quality (NPA)
Profitability (Return on Assets)
The banks were categorized by RBI into risk threshold I, II, and III. The risk is greater the higher the number. RBI will then take corrective action in accordance with this by performing.
Stern warnings, deeper audits, and supervision.
Limiting bank directors’ pay and dividend payments to shareholders.
Limiting the opening of new bank branches and lending activities.
Under the 1949 Banking Regulation Act, a foreign merger or shutdown is permitted.
A PCA listed company would need to lower its NPA, acquire more capital, and boost its profitability if it sought to exit the market.
Basel III Norms
The Bank for International Settlement (BIS) is a global organization with its main office in Basel, Switzerland and membership in the central banks of 60 nations.
It has a committee called the Basel Committee on Banking Supervision, which establishes standards to guarantee financial stability on a global scale.
Basel I was issued in 1988, Basel II in 2004, and Basel II in 2011.
RBI started implementing Basel III standards in India on April 1, 2013. Prior to March 31, 2014, banks must calculate their risk-weighted assets. Against these assets, banks must maintain minimum capital of 9% or more.
Depending on each country’s circumstances, the central bank of each member country may prescribe a different percentage.
Bank asset quality declines and its weighted asset grow as the amount of problematic loans rises. Thus, banks must set aside additional capital to comply with the standards.
A bank will be added to the PCA list by the RBI if it is unable to adhere to Basel standards. In the worst situation, the bank would have to shut down or combine with another bank.
Basel norms also apply to cooperative banks, all-India financial institutions, and a specific class of NBFCs. However, RBI may impose a distinct cap and timeline for them.
The government is supplying capital to meet Basel standards as the PSBs struggle with NPA. The government has injected 3.5 lakh crore rupees in capital into PSBs during the past five years, a process known as “recapitalization of PSBs,” “capital infusion of PSBs,” or “bail out of PSBs.”
Deposit Insurance and Credit Guarantee Corporation Act, 1961 (DICGC)
All types of banks are required by the DICGC Act of 1961 to get insurance from the DICGC for their deposit accounts.
Banks must pay an additional fee for this insurance.
100% of DICGC is held by RBI. The chairman of DICGC is a deputy governor of the RBI. Mumbai is where its corporate headquarters are.
When a bank closes, DICGC will reimburse each depositor up to 1 lakh rupees for their principal and interest.
Government changed the DICGC in 2021 and raised the amount to Rs. 5,000,000.
A customer who deposited more than Rs. 5,00,000 will only receive Rs. 5,00,000 from DICGC and will have to wait till the RBI registrar liquidates the bank for the remaining cash.
Primary agricultural credit cooperative societies and NBFCs are not covered under DICGC.
These victims might need to go to court.
Public Credit Registry (PCR)
Several organizations currently maintain databases on borrowers or credit histories, including:
IBBI has granted NeSL permission to serve as an information utility under IBC.
The RBI has granted licenses to companies like CIBIL, Equifor, Experian, CRIF Highmark, etc. under the Credit Information Company Regulation Act of 2005.
For loans beyond Rs. 5 crore, the RBI has its own central repository of information on huge credit. Weekly updates must be sent to this website by banks and NBFCs. However, not all of these databases are directly managed by RBI. Each uses a different methodology for gathering and tabulating data, and not all of these databases provide information on all private and business borrowers.
Therefore, the Yaswant Deosthale Committee advised creating a digitized public credit registry.
Section 7 of RBI Act, 1934
The government may consult with the RBI Governor in the public interest under section 7(1) of the RBI Act. For the first time in India’s independent history, this happened in October 2018. Begin section 7(1) consultation between the government and RBI Governor Urjeet Patel over PCA standards, Basel III date, increased government dividend, cheap monetary policy, etc.
The government may issue a binding directive to the RBI central board to carry out its intentions even though it is wary of the media and opposition parties under section 7(2) if the governor of the Reserve Bank of India does not respond favorably to such section 7(1) consultation. The government did not provide the RBI Board any particular instructions.
Conclusion
In conclusion, the banking system is a multifaceted and dynamic component of the modern economy. It has a rich history, diverse types of institutions, and is adapting to the challenges and opportunities presented by the digital age. Understanding the banking system is essential for individuals, businesses, and policymakers, as it plays a vital role in the economic well-being of society.
FAQs
- What is the primary function of commercial banks in the banking system? Commercial banks primarily offer everyday banking services to individuals and businesses, including savings accounts, loans, and credit cards.
- How have advancements in technology changed the banking industry? Technological advancements have led to the development of online banking, mobile apps, and fintech solutions, making banking more convenient and accessible.
- Why is understanding banking regulations important for consumers? Understanding banking regulations helps consumers protect their financial interests and ensures that banks operate responsibly and ethically.
